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Review- Financial Statement Analysis


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Review- Financial Statement Analysis

  1. 1. Financial Analysis Purpose Ratio Analysis Cash Flow Analysis
  2. 2. Purpose of Financial Analysis <ul><li>Assess Corporate Performance in the context of stated goals and strategy. </li></ul><ul><li>Assess current financial position, including liquidity. </li></ul>
  3. 3. Tools of Financial Statement Analysis <ul><li>Ratio analysis </li></ul><ul><li>Signal approach </li></ul><ul><li>Cash Flow analysis </li></ul>
  4. 4. Ratio Analysis <ul><li>Tools for interpreting financial statements </li></ul><ul><li>Often used to facilitate comparison via deflation. </li></ul><ul><li>Common size financial statements- when the whole statement is converted to ratio form. </li></ul>
  5. 5. Ratio Analysis <ul><li>Financial ratios are typically grouped into four classes </li></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Liquidity ratios </li></ul></ul><ul><ul><li>Solvency ratios </li></ul></ul><ul><ul><li>Funds management ratios </li></ul></ul>
  6. 6. Profitability and growth- Strategic Areas of Influence <ul><li>Operating management </li></ul><ul><li>Investment management </li></ul><ul><li>Financing strategy </li></ul><ul><li>Dividend policies </li></ul>
  7. 7. Drivers of Profit and Growth Operating Management Investment Management Financing Management Dividend Policy Managing Revenue and Expenses Managing Working Capital and Fixed Assets Managing Liabilities and Equity Managing Payout Product Market Strategies Financial Market Strategies Profitability and Growth
  8. 8. Ratios can be used: <ul><li>To compare the same firm over several years </li></ul><ul><li>To compare to other firms in the industry </li></ul><ul><li>To compare to an absolute benchmark </li></ul>
  9. 9. Operating Management (managing revenues and expenses) <ul><li>Return on equity (ROE) -- ROE = (Net Income) / (Shareholder’s Equity) </li></ul><ul><li>Return on Assets -- Income / (Total Assets) </li></ul><ul><li>Return on sales (ROS) -- Net Income / Sales </li></ul><ul><li>Gross Profit Margin- (Sales-COGS)/Sales </li></ul><ul><li>Numerous variations of the above are computed in practice </li></ul>
  10. 10. An Example-Return on Equity (ROE) <ul><ul><li>Beginning balances, ending balances, average balances ? </li></ul></ul><ul><ul><li>Often adjusted for preferred stock dividends </li></ul></ul><ul><ul><li>Average for US industries is from 11 to 13% (PBH) </li></ul></ul>
  11. 11. The need for an analysis framework <ul><li>What do ROE, NPM, ROA, etc., mean as a group? </li></ul><ul><li>What if they differ as to outcome (e.g., one firm has a higher NPM but lower ROE)? </li></ul><ul><li>What story do they tell, collectively? </li></ul><ul><li>How do they relate to each other? </li></ul>
  12. 12. The Notion of Ratio Decomposition (Dupont Analysis) <ul><li>ROE = ROA * Assets/equity (Financial leverage) </li></ul><ul><li>ROA= net income/ assets </li></ul><ul><li>Financial leverage indicates the dollar of assets the firm is able to deploy for dollar invested by shareholders </li></ul>
  13. 13. The Problem of mixed operating and non-operating financial statement components <ul><li>What if a firm has a large block of assets and/or liabilities that are not involved in operations? </li></ul><ul><li>What if net income includes numerous non-operating items? </li></ul>
  14. 14. A Variation on the usual definition of ROA <ul><li>Operating ROA </li></ul><ul><li>Focus is on operating return only -- excludes interest income </li></ul><ul><ul><li>(Net Income + (Interest exp - Interest income) * (1-tax rate)) / (Equity + Debt - Cash and Short-tern investments) </li></ul></ul>
  15. 15. Decomposition Using Operating ROA <ul><li>ROE= Operating ROA (RNOA) + Spread x Leverage </li></ul>
  16. 16. Operating/Nonoperating vs. Core/Transitory
  17. 17. Level I-Based Decomposition Example: ROE, RNOA & Leverage
  18. 18. Financial Leverage and Risk <ul><li>Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? </li></ul><ul><ul><li>The answer is because debt is risky. This increased risk increases the expected return that investors require to provide capital to the firm. </li></ul></ul><ul><ul><li>Higher financial leverage also results in a higher interest rate on the company’s debt. </li></ul></ul>
  19. 19. Leverage and Income Variability
  20. 20. Level II-Based Decomposition Example: ROE, ROA & Leverage <ul><li>ROE= ROA x assets/equity </li></ul><ul><li>ROA= net income/sales x sales/assets </li></ul><ul><li>Therefore: </li></ul><ul><ul><li>ROE=Net profit margin x </li></ul></ul><ul><ul><li>asset turnover x </li></ul></ul><ul><ul><li>leverage </li></ul></ul>
  21. 21. Level II Analysis of Operating Margin and Operating Turnover
  22. 22. Margin vs. Turnover
  23. 23. Return on Sales (ROS) <ul><li>Shows profitability of firm’s operating activities </li></ul><ul><li>Used extensively by Japanese management </li></ul><ul><li>Indicates how much profit is generated per dollar of sales </li></ul>
  24. 24. NOPAT Margin
  25. 25. Turnover of NOA here
  26. 26. Level 3 Analysis — Disaggregation of Operating Margin and Operating Turnover
  27. 27. Level III Analysis using the standard definition of ROA
  28. 28. Sustainable Growth Rate ROE ROS Asset Turnover Fin Leverage Dividend payout GOGS/ Sales GP/ Sales SG&A/Sales R&D/Sales OE/ Sales Non OE / Sales EBT / Sales Tax Expenses / Sales CA Turnover WC Turnover AR Tirnover Inv Tirnover AP Turnover Days Rec Days Pay PP&E Turnover Current Ratio Quick Ratio Cash Ratio Oper CF Ratio Liab to Equity Debt to Equity Debt to Capital Int Coverage
  29. 29. Sustainable Growth 1 <ul><li>ROE * (1-Dividend payout ratio) </li></ul>
  30. 30. Gross Profit Margin <ul><li>A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing. </li></ul>
  31. 31. Gross Profit Margin <ul><li>Two main factors determine gross profit margins: </li></ul><ul><ul><li>Competition – The more competition, the lower margins tend to be. </li></ul></ul><ul><ul><li>Product mix – The greater the volume of low profit/high turnover goods, the lower the margins. </li></ul></ul><ul><li>Very relevant for comparisons within an industry -- not much outside </li></ul>
  32. 32. Operating Expense Margin <ul><li>Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category. </li></ul><ul><li>Expense ratios are calculated as follows: </li></ul><ul><li>Operating expense percentage = Expense item/Net sales </li></ul>
  33. 33. Drivers of Profit and Growth Operating Management Investment Management Financing Management Dividend Policy Managing Revenue and Expenses Managing Working Capital and Fixed Assets Managing Liabilities and Equity Managing Payout Product Market Strategies Financial Market Strategies Profitability and Growth
  34. 34. Investment Management <ul><li>Working Capital and Fixed Assets </li></ul><ul><ul><li>Receivables </li></ul></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>LT operating assets </li></ul></ul><ul><ul><li>Payables </li></ul></ul>
  35. 35. Turnover <ul><li>Turnover measures relate to the productivity of company assets, i.e., how much capital is required to generate a specific sales volume? </li></ul><ul><li>Turnover ratios are calculated as follows: </li></ul><ul><li>Turnover = Sales volume/Average Assets </li></ul><ul><li>As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced. </li></ul>
  36. 36. Accounts Receivable Turnover (ART)
  37. 37. Inventory Turnover (INVT)
  38. 38. L-T Operating Asset Turnover (LTOAT)
  39. 39. Accounts Payable Turnover (APT)
  40. 40. Net Operating Working Capital Turnover (WOCT)
  41. 41. Evaluating Financial Management <ul><li>Short-term evaluations </li></ul><ul><li>Long-term evaluations </li></ul>
  42. 42. Short-term evaluations 1 <ul><li>Current ratio </li></ul><ul><ul><li>(Current assets) / (Current liabilities) </li></ul></ul>
  43. 43. Short-term evaluations 2 <ul><li>Quick ratio </li></ul><ul><ul><li>(Cash + Short-term investments + Accounts Receivable) / (Current liabilities) </li></ul></ul>
  44. 44. Short-term evaluations 3 <ul><li>Operating cash flow ratio </li></ul><ul><ul><li>(Cash flow from operations) / (Current liabilities) </li></ul></ul>
  45. 45. Long-term evaluations <ul><li>Debt is typically cheaper that equity </li></ul><ul><li>Interest is tax deductible dividends are not </li></ul><ul><li>Can impose discipline on management (explicit contracts) </li></ul><ul><li>Easier to communicate proprietary information to private lenders than to public markets </li></ul>
  46. 46. Standard ratios <ul><li>Liabilities-to-equity-ratio </li></ul><ul><li>Debt-to-equity ratio </li></ul><ul><li>Debt-to-capital </li></ul><ul><li>Interest coverage </li></ul>
  47. 47. Liabilities-to-equity <ul><li>(Total Liabilities) / (Shareholders’ equity) </li></ul>
  48. 48. Debt-to-equity <ul><li>(Short-term debt + Long-term debt) / (Shareholders’ equity) </li></ul>
  49. 49. Interest coverage <ul><li>(Net income + Interest expense + Tax expense) / (Interest expense) </li></ul>
  50. 50. Problems with Ratios <ul><li>Mis-specification of deflator (e.g., size) </li></ul><ul><li>Accounting imperfections </li></ul><ul><li>Problem of assumed linearity </li></ul><ul><li>Ratio blow-up </li></ul><ul><li>Negative numbers. What do they mean? </li></ul><ul><li>Assumed 0 intercept. </li></ul><ul><li>Omitted variables </li></ul>
  51. 51. In Search of Fundamentals- Lev and Thiagarajan’s Signals Approach <ul><li>Inventory </li></ul><ul><li>Accounts receivable </li></ul><ul><li>Capital Expenditure, R&D </li></ul><ul><li>Gross margin </li></ul><ul><li>Sales and Administrative Expenses </li></ul>
  52. 52. In Search of Fundamentals: Lev and Thiagarajan Signals Approach <ul><li>Effective tax </li></ul><ul><li>Order backlog </li></ul><ul><li>Labor force </li></ul><ul><li>LIFO changes </li></ul><ul><li>Audit qualifications </li></ul>
  53. 53. Inventory <ul><li>Considered disproportionate increases in inventory as a negative signal </li></ul><ul><li>Percentage Change in Inventory - Percentage Change in Sales </li></ul>
  54. 54. Accounts Receivable <ul><li>Disproportionate increases considered negative </li></ul><ul><li>Percentage Change in AR - Percentage Change in Sales </li></ul>
  55. 55. Capital Expenditures R&D <ul><li>Relative Decreases Considered negative </li></ul><ul><li>Percentage change in industry - Percentage change in Firm </li></ul>
  56. 56. Gross Margin <ul><li>Disproportionate decreases with respect to sales negative </li></ul><ul><li>Percentage change in Gross Margin - Percentage change in sales </li></ul>
  57. 57. Selling and Administrative <ul><li>Disproportionate increases to sales negative </li></ul><ul><li>% change in S&A - % change in sales </li></ul>
  58. 58. Provision for doubtful accounts <ul><li>Increases less than the increases in accounts receivable is viewed as negative </li></ul><ul><li>% Change in Accounts receivable - % Change in doubtful accounts </li></ul>
  59. 59. Effective tax Rate <ul><li>Unusual decrease in effective tax rate considered negative </li></ul><ul><li>PTE this year * (Effective rate last year- effective rate this year) </li></ul>
  60. 60. Order Backlog <ul><li>Unfilled orders is often viewed as a leading indicator </li></ul><ul><li>% change in sales -% change in order backlog </li></ul><ul><li>A negative signal is Good? or Bad? </li></ul>
  61. 61. Labor Force Changes <ul><li>Labor force reductions are usually considered good news by analysts </li></ul><ul><li>Defined as percentage change in sales per employee </li></ul>
  62. 62. LIFO <ul><li>LIFO considered positive </li></ul>
  63. 63. Audit Qualification <ul><li>Adverse opinion considered bad news </li></ul>
  64. 64. Results <ul><li>Regression analysis with Excess Return as the dependent variable came out about as hypothesized </li></ul><ul><li>Found that results are not constant for macro economic conditions </li></ul>
  65. 65. From Business Activities to Financial Statements Accounting System Financial Statements Accounting Strategy Business Environment Accounting Environment Business Strategy Business Activities
  66. 66. Drivers of Profit and Growth Operating Management Investment Management Financing Management Dividend Policy Managing Revenue and Expenses Managing Working Capital and Fixed Assets Managing Liabilities and Equity Managing Payout Product Market Strategies Financial Market Strategies Profitability and Growth
  67. 67. Cash Flow Analysis- Based on Business Activities Operating Activities Investment Activities Financing Activities
  68. 68. Cash Flow <ul><li>The Direct Method </li></ul><ul><li>The Indirect Method </li></ul>
  69. 69. Cash Flow -- Direct Method <ul><li>Recommended by the FASB </li></ul><ul><li>Most companies use the Indirect Method </li></ul>
  70. 70. Cash Flow -- Indirect Method - 1 Net Income Plus/Less Adjustments for receivables inventories, payables, taxes Equals Cash Flow from Operations Non-cash income items Add
  71. 71. Cash Flow -- Indirect Method - 2 Cash Flow from Operations Cash flow - Investment activities Cash flow - Financing activities Change in cash and cash equivalents PLUS/LESS PLUS/LESS EQUALS
  72. 72. From Profit to Cash Net Income + Noncash charges CF from op After Wc Changes before int +/- Chg in Working Cap Cash Flow From Oper. bef. WC chgs, Inv & Int
  73. 73. From Profit to Cash -- 2 CF +/- Interest +/- Chg Fixed Capital Cash Flow From Operations Free Cash Flow
  74. 74. Free Cash Flow <ul><li>Jensen (1988) defines free cash flow as the cash left after managers have invested in all positive NPV projects </li></ul><ul><ul><li>He also asserts that managers will invest in negative NPV projects rather pay it out to shareholders </li></ul></ul><ul><li>The Free cash flow used in out context is the cash flow from operations plus the net investment cash flow </li></ul>
  75. 75. Free cash Flow and Interest <ul><li>You may add interest back. Depends on the purpose of the Free Cash Flow. See p. 6-3. </li></ul>
  76. 76. Free Cash Flow From Working Capital <ul><li>Adjust Working Capital from operations for changes in current accounts to get Cash Flow From Operations </li></ul><ul><li>Add the net capital investment </li></ul><ul><li>What you get is Free Cash Flow </li></ul>