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  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Financial Statements summarize the results of the firm’s activities over the accounting period. Ratios provide a useful way to analyze financial statements and evaluate the firm’s performance over the period. Focusing on the ratios in the DuPont system helps structure the analysis and show the relationship between the firm’s operations, its capital structure and its profitability for investors. Using ratio analysis along with predictions about sustainable growth rates can help us predict future performance of the firm.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Ratios are compared to industry averages. There are 14 to 16 common ratios grouped into 4 types. Dun and Bradstreet and Robert Morris Associates give industry average ratios for hundreds of industries. We will describe the types of ratios and focus on several important financial ratios. Financial Statements   1. Financial statements report a firm’s position at a point in time and on operations over some past period 2. Investors use financial statements to predict future earnings/dividends 3. Management uses financial statements to help anticipate future conditions and as starting point for planning actions that will affect future event Financial ratios 1. Help evaluate a financial statement 2. Facilitate comparison of firms
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz   Balance Sheet Statement of financial position at specific point in time  Income Statement Summarizes revenues and expenses over an accounting period Statement of Cash Flows Amount of cash generated during period is not what is shown on balance sheet Tells you what happened to cash generated during specified period Categories in Statement of Cash Flows (a) Operating activities (b) Investing activities (c) Financing activities Statement of Retained Earnings Reports how much of earnings retained in business rather than paid out in dividends over the life of the firm   Retained earnings is claim against assets (a) Earnings retained to expand business (b) Do not represent cash
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Liquidity Ratios: Current Ratio Quick (Acid Test) Ratio Cash Ratio Net Working Capital to Total Assets Leverage Ratios: Total Debt Ratio Debt to Equity Ratio Equity Multiplier Long-term Debt Ratio Times Interest Earned Ratio Cash Coverage Ratio Activity (Turnover) Ratios: Inventory Turnover Days’ Sales in Inventory Receivables Turnover Days’ Sales in Receivables NWC Turnover Fixed Asset Turnover Total Asset Turnover Profitability Ratios: Profit Margin Return on Assets Return on Equity Valuation Ratios: Price to Earnings Market to Book
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Uses 1.      Managers – to help analyze, control, improve a firm’s operations 2.      Credit analysts – to help ascertain a company’s ability to pay its debts 3.      Stock analysts – to determine a company’s efficiency, risk and growth potential
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Balance Sheet Statement of financial position at specific point in time  Shows assets owned by the firm and sources of the money used to purchase those assets. Liquidity Order  Assets: length of time typically to convert to cash  Liabilities: how soon must be paid Characteristics Cash versus other assets  Only cash represents actual money  Noncash assets should produce cash in time   Liabilities versus stockholders’ equity Both claims against assets   Breakdown of common equity accounts  Common stock  Retained earnings Impacted by Inventory accounting Depreciation methods Position at one point in time
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Dell’s Balance Sheet: Assets the firm owns total more that $11 billion** , more short-term assets than long-term assets like plant and equipment. Those assets were purchased with money that came mainly from equity and short-term borrowing. Relatively little long-term debt.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Dell had more than $25 billion sales during the period. A large part of revenues went to pay for the raw materials that went into production. Depreciation reflects expenditure on a long-term asset which firm must expense over several years for tax purposes. It does not reflect an actual expenditure during this particular accounting period.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Used to study ability to cover current obligations Can firm raise cash to pay its current and upcoming bills on time? Basic Formulation: Liquid asset measures include: Current Assets Current Assets minus Inventories If industry average is 3.5, then Dell has fewer current assets per dollar of current liabilities than the norm If acid test ratio > 1, then Dell can meet all current liabilities even if sales cease
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Measure ability to cover long term debt How much debt has the firm issued? Can the firm afford to pay its long term interest and principal obligations? Basic formulation: Debt and debt service measures include: Total liabilities Long term debt Annual interest expenses Asset, profit or cash flow measures include: Total assets Total capitalization EAT, Profit... 1-Debt Ratio is fraction of firm owned by equity holders If industry average is 2.5 then revenues for Dell relative to interest expenses exceed industry norm
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Used to study operating profitability. How do profits compare to sales or assets? Basic Formulation: Profit measures include: Sales less costs Net Income Income Available to Common Stock Holders Sales/Asset measures include: Sales Total Assets Common Equity NOTE: Some books use: If yours does, use these equations AND adjust the DuPont Method accordingly by adding the the debt burden.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Used to study operating profitability. How do profits compare to sales or assets? Basic Formulation : Profit measures include: Sales less costs Net Income Income Available to Common Stock Holders Sales/Asset measures include: Sales Total Assets Common Equity
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Profitability is also affected by the firm’s ability to use its assets efficiently. Used to study operating efficiency. How do sales compare to the assets used in production? Basic Formulation: Assets include: All Assets Inventories Accounts Receivable If industry average is 1.25, then Dell gets more sales per dollar invested in assets than typical in the industry If industry average is 2, then Dell turns its inventory over more times on average than industry (Few assets are tied up in inventories)
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz DuPont Chart and Equation - Tie the Ratios Together Shows how profit margin, asset turnover ratio, and equity multiplier determine ROE Shows how expense control (profit margin), efficient use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity. Ties together all aspects of firm - production and financing.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders. The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative. Raising the s magnifying effect also raises the risk for stockholders.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each dollar of sales raises the Profit Margin. At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the dollar of sales produced with each dollar invested in assets. This is often thought of as sales volume. Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Dells ROE 31.39% is higher than the industry standard (24.1% average over the past 4 years). Where is Dell making these high profits? Dell’s ROE comes from: Dell’s profit margin is 6.59% The industry average over the preceding 4 years is only 3.69%. So, Dell is nearly twice as efficient as the industry average in generating profits from its sales. Dell’s sales-to-assets ratio is 2.20. The industry average over the preceding 4 years is 2.05. So, Dell is about average is generating sales from its assets. Dell’s equity multiplier is 2.16. The industry average over the preceding 4 years is 2.50. So, Dell is a little below average in its equity multiplier (using a little more equity and a little less debt than an average company in the industry.) Thus, we can conclude that Dell’s profitability comes from it’s operating efficiency!
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Knowing the absolute level of a single entry on the income statement or balance sheet doesn’t provide sufficient information to evaluate performance. Ratios help by focusing on relationships among entries on the financial statements. The ratios in the DuPont system show the connection between the firm’s operations, its capital structure and the returns for investors. Because a firm’s size affects financial statement values, it’s hard to evaluate performance using absolute levels. By controlling for differences in size to make comparisons ratios facilitate the evaluation of a firm’s performance.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Limitations 1.      Large firms operate different divisions in different industries  a.  Difficult to develop meaningful industry averages  b.  More useful for small, narrowly focused firms 2.      Firms want to be better than average  a.  Attaining average performance not necessarily good  b.  Best to focus on industry leaders’ ratios 3.      Inflation may have distorted balance sheets  a.  Must consider effects when comparing over time 4.      Seasonal factors distort ratio analysis  a.  Use monthly averages for season items such as inventory 5.      Window dressing can make financial statements look better 6.      Different accounting practices can distort comparisons  a.  Inventory valuation, depreciation methods 7.      Difficult to generalize whether a ratio is “good” or “bad”  a.  High current ratio – strong liquidity or too much cash (nonearning) 8.      Ratios can give “mixed” view of company  a.  Analyze net effects of a set of ratios
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Stock prices can be thought of as discounted present value of expected future dividends. Dividends are paid out of earnings. Therefore expectations of future dividends would be based on current earnings (ROE) and sustainable growth rate on earnings. Ratio analysis can help evaluate current performance as well as firm’s likelihood to be able to sustain performance. High current ROE that is the result of high Equity Multiplier implies higher risk for stockholders. High ROE that derives from high ROA is less risky and possibly more sustainable.
  • Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Annual Report Used by investors to help form expectations about future earnings and dividends Verbal Section Explain why things turned out the way they did Describes firms operating results during past year Discusses new developments that will affect future earnings Financial Statements Report what actually happened to assets, earnings, dividends Balance sheet Income statement Statement of retained earnings Statement of cash flows Advantages and Disadvantages of Data Sources The advantage of Annual reports is that give a great deal of information. They are available through the web now. The disadvantage is that they are not in a standard format and they are frequently affected by subtle differences in accounting rules. The advantage of published data on ratios is that they standardize the financial statements and compute ratios based on this information. The disadvantage is that this may hide important factors and the information my be far from current. The advantage of investment sites on the web is that they have the most current data. Some of them even standardize statements (e.g., Microsoft’s MoneyCentral). Of course, this has advantages and disadvantages.
  • Financial statment presentation

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    2. 2.  ARUN DASSI 13 AKSHAY SHELAR 52 ABIJEET DIWATE 14 PRAFUL UBEROI 59 SAMAD SHAIKH 49 HEMANT GANDHI 16 IRSHAD TIGALA 58 DURGESH SAWANT 41 2
    3. 3.  Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. 3
    4. 4. There are various methods or techniques that areused in analyzing financial statements, among themare horizontal or trend analysis, and vertical analysisand ratios analysis, which are most widely used. 4
    5. 5.  Horizontal and Vertical Analysis: Ratios Analysis: 5
    6. 6.  Horizontal Analysis or Trend Analysis: Comparison of two or more years financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form. Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base 6
    7. 7.  Vertical Analysis: Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements. 7
    8. 8.  Review of Financial Statements Ratios  Types of Ratios  Examples The DuPont Method Summary  Strengths  Weaknesses  Ratios and Forecasting 8
    9. 9.  Assessment of the firm’s past, present and future financial conditions Done to find firm’s financial strengths and weaknesses Primary Tools:  Financial Statements  Comparison of financial ratios to past, industry, sector and all firms 9
    10. 10.  Balance Sheet Income Statement Cash flow Statement Statement of Retained Earnings 1
    11. 11. 1
    12. 12. 1
    13. 13. 1
    14. 14.  Ratio analysis - tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, as well as the effectiveness of management’s resource utilization. The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. 1
    15. 15.  Financial Ratios:  Liquidity Ratios  Assess ability to cover current obligations  Leverage Ratios  Assess ability to cover long term debt obligations Operational Ratios:  Activity (Turnover) Ratios  Assess amount of activity relative to amount of resources used  Profitability Ratios  Assess profits relative to amount of resources used Valuation Ratios:  Assess market price relative to assets or earnings 1
    16. 16. Activi t y Ra ti o s Net sales Inventory turnover ratio indicates the number of timesmerchandise movesthrough a business. Average of inventory Net salesTotal asset turnover ratio indicates how much insales each dollar invested in assets generates. Average of total assets 1
    17. 17. Liquidi ty R a ti o s Total current assets Current ratio compares current assets to current liabilities. Total current liabilitiesAcid-test (or quick) ratio Cash and equivalentsmeasures the ability of a + short-term investments firm to meet its debt + accounts receivable payments on short notice. Total current liabilities 1
    18. 18. P rofitabilit y R a ti o s Profitability ratios measure the organization’s overall financialperformance by evaluating its ability to generate revenues in excess of operating costs and other expenses. 1
    19. 19. Levera ge Ratios • Leverage ratios measure the extent to which a firm relies on debt financing.• Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity. 1
    20. 20.  Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations 2
    21. 21.  A firm has resources It converts resources into profits through  production of goods and services  sales of goods and services Ratios  Measure relationships between resources and financial flows  Show ways in which firm’s situation deviates from  Its own past  Other firms  The industry  All firms 2
    22. 22. Assets Liabilities and Equity Current assets:  Current liabilities:  Cash & securities  Payables  Receivables  Short-term debt  Inventories  Long-term liabilities Fixed assets:  Shareholders equity  Tangible assets  Intangible assets 2
    23. 23.  Assets:  Current Assets: $7,681.00  Non-Current Assets: $3,790.00  Total Assets: $11,471.00 Liabilities:  Current Liabilities: $5,192.00  LT Debt & Other LT Liab.: $971.00  Equity: $5,308.00  Total Liab. and Equity: $11,471.00 2
    24. 24. Sales $25,265.00Costs of Goods Sold -$19,891.00Gross Profit $5,374.00Cash operating expense -$2,761.00EBITDA 2,613.00Depreciation & Amortization -$156.00Other Income (Net) -$6.00EBIT $2,451.00Interest -$0.00EBT $2,451.00Income Taxes -$785.00Special Income/Charges -$194.00Net Income (EAT) $1,666.00 2
    25. 25.  Current Ratio: Quick (Acid Test) Ratio: 2
    26. 26.  Debt Ratio: 2
    27. 27.  Return on Assets (ROA): Return on Equity (ROE): 2
    28. 28.  Net Profit Margin: Retention Ratio 2
    29. 29.  Total Asset Turnover Ratio: Inventory Turnover Ratio: 2
    30. 30.  Method to breakdown ROE into:  ROA and Equity Multiplier ROA is further broken down as:  Profit Margin and Asset Turnover Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers 3
    31. 31. RO E RO A E q u it y M u lt ip lie rP r o f it M a r g in T o ta l A s s e t T u rn o v e r 3
    32. 32. RO E RO A E q u i t y M u lt ip li e rP r o f i t M a r g in T o ta l A s s e t T u rn o v e rROE = ROA × Equity Multiplier Net Income Total Assets = × Total Assets Common Equity 3
    33. 33. RO E RO A E q u i t y M u lt ip li e r P r o f i t M a r g in T o ta l A s s e t T u rn o v e rROA = Profit Margin × Total Asset Turnover Net Income Sales = × Sales Total Assets 3
    34. 34. RO E RO A E q u i t y M u lt ip li e r P r o f i t M a r g in T o ta l A s s e t T u rn o v e rROE = Profit Margin × Total Asset Turnover × Equity Multiplier Net Income Sales Total Assets = × × Sales Total Assets Common Equity 3
    35. 35. Net Income Sales Total AssetsROE = × × Sales Total Assets Common Equity = Profit Margin × Total Asset Turnover × Equity Multiplier = ROA × Equity Multiplier $1,666.00 $25,265.00 $11,471.00ROE = × × $25,265.00 $11,471.00 $5,308.00 = 0.0659 × 2.2025 × 2.1611 = 0.1452 × 2.1611 = 31.39% 3
    36. 36.  Ratios help to:  Evaluate performance  Structure analysis  Show the connection between activities and performance Benchmark with  Past for the company  Industry Ratios adjust for size differences 3
    37. 37.  A firm’s industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios 3
    38. 38.  Common stock valuation based on  Expected cashflows to stockholders  ROE and ρ are major determinants of cashflows to stockholders Ratios influence expectations by:  Showing where firm is now  Providing context for current performance Current information influences expectations by:  Showing developments that will alter future performance 3
    39. 39.  Simplifies Financial Statements Facilitates inter-firm comparison Helps in Planning Helps in investment decisions Makes intra-firm comparison possible 3
    40. 40.  Comparative study required Ratios alone are not adequate Problems of price level change Lack of adequate standard Limited use of single ratios Personal bias 4
    41. 41.  Annual reports  Via E mail, SEC or company websites Published collections of data Investment sites on the web  Examples  http://moneycentral.msn.com/investor  http://dell.com  http://www.marketguide.com 4
    42. 42. Thank You 4

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