How to Analyse Financial Statements <ul><li>There is a great deal of valuable information in financial statements.  </li><...
Financial Statement Analysis <ul><li>When an unconscious patient arrives at the emergency room of the hospital, what does ...
Financial Vital Signs <ul><li>Short-term Liquidity </li></ul><ul><li>Profitability: </li></ul><ul><ul><li>On Revenue </li>...
Short-term Liquidity <ul><li>Short-term Liquidity means being able to meet the payroll and pay the bills. </li></ul><ul><l...
Short-term Liquidity <ul><li>Current Assets & Current Liabilities are items to be received or paid in cash within a year. ...
Short-term Liquidity: continued <ul><li>The Quick Ratio . </li></ul><ul><li>Quick Ratio = (Current Assets, excluding Inven...
Short-term Liquidity: continued <ul><li>Accounts Receivable Turnover . </li></ul><ul><li>Receivables Turnover = Sales/Acco...
Short-term Liquidity: continued <ul><li>Inventory Turnover . </li></ul><ul><li>Inventory Turnover = (Cost of Sales)/Invent...
Short-term Liquidity continued <ul><li>Accounts Payable Turnover . </li></ul><ul><li>Payables Turnover = Cost of Sales/Acc...
Short-term Liquidity continued <ul><li>Cash Flow Ratios </li></ul><ul><li>Cash from Operations/Sales: represents cash yiel...
Summary: Short-term Liquidity  <ul><li>Ratios measuring Short-term Liquidity : </li></ul><ul><li>Current Ratio </li></ul><...
Profitability <ul><li>Profitability is measured in two different ways: </li></ul><ul><li>Profitability on Revenue </li></u...
Asset Turnover <ul><li>Total Asset Turnover :  </li></ul><ul><li>Total Asset Turnover = Total Revenue/Total Assets </li></...
Long-Term Leverage <ul><li>Long-Term Leverage measures long-run risk . </li></ul><ul><li>Times Interest Earned (Interest C...
Market Ratios <ul><li>Market-based ratios reflect the investor view . </li></ul><ul><li>Price-Earnings Ratio = Market Pric...
Dupont Analysis <ul><li>So far, we have looked at ratios individually. </li></ul><ul><li>But Dupont Analysis is a way to s...
The Dupont Formula <ul><li>NI/SA x SA/TA x TA/EQ x EQ/MV = EP </li></ul><ul><ul><li>NI = Net Income. SA = Sales </li></ul>...
Dupont Analysis for Business Strategy <ul><li>Long-term strategy goal: maximize the firm's Price/Earnings ratio. </li></ul...
Profit on Sales <ul><li>Ways to optimize profit on sales include: </li></ul><ul><li>Differentiate products to raise margin...
Total Asset Turnover <ul><li>Ways to optimize total asset turnover are: </li></ul><ul><li>Adopt &quot;just-in-time&quot; i...
Leverage <ul><li>Increase leverage, within safe limits: </li></ul><ul><li>Repurchase outstanding stock  </li></ul><ul><li>...
Benchmarking <ul><li>In order to be meaningful, financial ratios need to be compared with benchmark ratios. </li></ul><ul>...
Example of NAICS <ul><li>NAICS code 2002  </li></ul><ul><li>Includes NAICS Title:  21  Mining  </li></ul><ul><li>211111  C...
Sources of Industry Data <ul><li>Most sources of industry data require purchase of a subscription </li></ul><ul><li>Howeve...
Industry Data <ul><li>One caution is that some companies operate in several different industries. </li></ul><ul><li>For ex...
Financial Ratio Calculation <ul><li>Financial ratios have a numerator and a denominator. </li></ul><ul><li>These numerator...
Financial Ratio Calculation (continued)‏ <ul><li>Balance Sheets show financial position as of one specific date. </li></ul...
Summary <ul><li>Use financial ratios to analyze: </li></ul><ul><ul><li>Short-term solvency </li></ul></ul><ul><ul><li>Prof...
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Financial Statement Analysis

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Financial Statement Analysis

  1. 1. How to Analyse Financial Statements <ul><li>There is a great deal of valuable information in financial statements. </li></ul><ul><li>But we must know how to extract and refine it. </li></ul><ul><li>The process is like a doctor diagnosing a patient's health. </li></ul><ul><li>The process is similar, but our tools of analysis are not quite the same. </li></ul><ul><li>Our tools of analysis are financial ratios. </li></ul>
  2. 2. Financial Statement Analysis <ul><li>When an unconscious patient arrives at the emergency room of the hospital, what does the doctor do? </li></ul><ul><li>Answer: check the vital signs, like pulse, blood pressure, temperature, etc. </li></ul><ul><li>Similarly, when we analyse financial statements, we check the vital signs of the organization. </li></ul><ul><li>What are these vital signs? They include: </li></ul><ul><ul><li>Short-term Liquidity </li></ul></ul><ul><ul><li>Profitability: </li></ul></ul><ul><ul><ul><li>Profitability on Revenue </li></ul></ul></ul><ul><ul><ul><li>Profitability on Investment </li></ul></ul></ul><ul><ul><li>Long-Term Asset Turnover </li></ul></ul><ul><ul><li>Long-term Leverage </li></ul></ul><ul><li>For more, see the next slide. </li></ul>
  3. 3. Financial Vital Signs <ul><li>Short-term Liquidity </li></ul><ul><li>Profitability: </li></ul><ul><ul><li>On Revenue </li></ul></ul><ul><ul><li>On Investment </li></ul></ul><ul><li>Long-Term Asset Turnover </li></ul><ul><li>Long-term Leverage </li></ul><ul><li>Market Performance </li></ul><ul><li>Dupont Analysis </li></ul><ul><li>Benchmarks (Yardsticks)‏ </li></ul><ul><li>Data Sources </li></ul>
  4. 4. Short-term Liquidity <ul><li>Short-term Liquidity means being able to meet the payroll and pay the bills. </li></ul><ul><li>Organizations unable to meet the payroll and pay the bills will soon collapse. </li></ul><ul><li>That is why our first step in financial statement analysis is to test short-term liquidity. </li></ul><ul><li>If an organization cannot survive the short term, there is no need to examine its long term signs. </li></ul>
  5. 5. Short-term Liquidity <ul><li>Current Assets & Current Liabilities are items to be received or paid in cash within a year. </li></ul><ul><li>As Current Assets turn into cash, the cash is used to pay off Current Liabilities. </li></ul><ul><li>For short-term liquidity, Current Assets should be greater than Current Liabilities. </li></ul><ul><li>We begin measuring short-term liquidity with the Current Ratio. </li></ul><ul><ul><li>Current Ratio = Current Assets/Current Liabilities. </li></ul></ul><ul><ul><li>Current Ratio should usually be > 1 for satisfactory liquidity – except for companies that generate ample cash. </li></ul></ul>
  6. 6. Short-term Liquidity: continued <ul><li>The Quick Ratio . </li></ul><ul><li>Quick Ratio = (Current Assets, excluding Inventory)/Current Liabilities. </li></ul><ul><li>Same idea as Current Ratio </li></ul><ul><li>But recognizes that inventory is a fickle asset. </li></ul><ul><li>Inventory can lose value fast through spoilage, shrinkage, evaporation, obsolescence & other hazards. </li></ul><ul><li>Inventory cannot be sold off fast in a crunch – except at fire sale prices. </li></ul><ul><li>So Quick Ratio conservatively – but realistically - expects no value from inventory. </li></ul><ul><li>Quick Ratio: should be > 1 for health. </li></ul>
  7. 7. Short-term Liquidity: continued <ul><li>Accounts Receivable Turnover . </li></ul><ul><li>Receivables Turnover = Sales/Accounts Receivable. </li></ul><ul><ul><li>Example: Annual Sales = $120,000, Average Receivables = $30,000. </li></ul></ul><ul><ul><li>Receivables Turnover = $120,000/$30,000 = 4 times per year </li></ul></ul><ul><li>Can express as days' Receivables on hand: </li></ul><ul><ul><li>365 days/Receivables Turnover </li></ul></ul><ul><ul><li>Example continued: 365/4 = 91 days. </li></ul></ul><ul><li>Receivables Turnover should be consistent; </li></ul><ul><ul><li>With the firm's credit terms. </li></ul></ul><ul><ul><li>From period to period </li></ul></ul><ul><li>Receivables Turnover measures the organization's efficiency in collecting accounts receivable. </li></ul><ul><ul><li>The faster the turnover the better the efficiency. </li></ul></ul>
  8. 8. Short-term Liquidity: continued <ul><li>Inventory Turnover . </li></ul><ul><li>Inventory Turnover = (Cost of Sales)/Inventory. </li></ul><ul><ul><li>Example: Annual Cost of Sales = $100,000, Average Inventory = $15,000. </li></ul></ul><ul><ul><li>Inventory Turnover = $100,000/$15,000 = 6.7 times per year </li></ul></ul><ul><li>Can be expressed as days' Inventory on hand: </li></ul><ul><ul><li>365 days/Inventory Turnover </li></ul></ul><ul><ul><li>Example continued: 365/6.67 = 54.7 days. </li></ul></ul><ul><li>Why is Cost of Sales the numerator, rather than Sales? </li></ul><ul><ul><li>Sales are shown at selling price. Inventory is shown at cost. </li></ul></ul><ul><ul><li>To make numerator and denominator consistent, both should be at cost. </li></ul></ul><ul><li>Inventory Turnover measures the efficiency of inventory management. </li></ul><ul><ul><li>Toyota and other Japanese firms using &quot;just in time&quot; inventory showed the importance of speeding up inventory turnover. </li></ul></ul>
  9. 9. Short-term Liquidity continued <ul><li>Accounts Payable Turnover . </li></ul><ul><li>Payables Turnover = Cost of Sales/Accounts Payable. </li></ul><ul><ul><li>Example: Annual Cost of Sales = $100,000, Average Payables = $20,000. </li></ul></ul><ul><ul><li>Payables Turnover = $100,000/$20,000 = 5 times per year </li></ul></ul><ul><li>Can be expressed as days' Payables on hand: </li></ul><ul><ul><li>365 days/Payables Turnover </li></ul></ul><ul><ul><li>Example continued: 365/5 = 73 days. </li></ul></ul><ul><li>Why is Cost of Sales the numerator, rather than Sales? </li></ul><ul><ul><li>Sales are at selling price. Payables are at cost, being amounts owed to suppliers. </li></ul></ul><ul><ul><li>For consistency, both numerator and denominator should be at cost. </li></ul></ul><ul><li>Payables Turnover measures how promptly suppliers are being paid – and whether cash discounts are being taken, or lost. </li></ul>
  10. 10. Short-term Liquidity continued <ul><li>Cash Flow Ratios </li></ul><ul><li>Cash from Operations/Sales: represents cash yield from Sales. Watch trend period to period. </li></ul><ul><li>Cash from Operations/Average Total Assets: represents cash yield from Total Assets. Watch trend period to period. </li></ul><ul><li>Free Cash Flow/Sales: Free Cash Flow is Cash from Operations – Dividends – Net Capital Expenditures. This is discretionary cash. Watch trend period to period. </li></ul>
  11. 11. Summary: Short-term Liquidity <ul><li>Ratios measuring Short-term Liquidity : </li></ul><ul><li>Current Ratio </li></ul><ul><li>Quick Ratio </li></ul><ul><li>Receivables Turnover & Days' Receivables </li></ul><ul><li>Inventory Turnover & Days' Inventory </li></ul><ul><li>Payables Turnover & Days' Payables </li></ul><ul><li>Cash Flow Ratios </li></ul>
  12. 12. Profitability <ul><li>Profitability is measured in two different ways: </li></ul><ul><li>Profitability on Revenue </li></ul><ul><ul><li>Gross profit ratio: Gross Profit/Sales </li></ul></ul><ul><ul><li>SG & A ratio: SG & A Expenses/Sales </li></ul></ul><ul><ul><li>EBIT ratio: EBIT/Sales </li></ul></ul><ul><ul><li>Net Income ratio: Net Income/Sales </li></ul></ul><ul><ul><li>Useful, but does not consider how much cash is invested. Therefore we should consider cash invested. </li></ul></ul><ul><li>Profitability in Relation to Investment </li></ul><ul><ul><li>Raw Earning Power: EBIT/(LT Debt + Equity). Shows earning power on total long-term capital invested, regardless of type of financing. </li></ul></ul><ul><ul><li>Return on Equity: Net Income/Equity. Shows profit in relation to owner equity capital invested. </li></ul></ul>
  13. 13. Asset Turnover <ul><li>Total Asset Turnover : </li></ul><ul><li>Total Asset Turnover = Total Revenue/Total Assets </li></ul><ul><li>Measures capital intensity. </li></ul><ul><li>Capital intensity affects total amount of capital needed </li></ul><ul><li>The faster the turnover of Total Assets, the lower the total amount of capital that needs to be invested in Total Assets. </li></ul>
  14. 14. Long-Term Leverage <ul><li>Long-Term Leverage measures long-run risk . </li></ul><ul><li>Times Interest Earned (Interest Coverage): </li></ul><ul><ul><li>Ratio of EBIT to Interest Expense. </li></ul></ul><ul><ul><li>Shows how much profit &quot;cushion&quot; there is to cover interest payments. </li></ul></ul><ul><li>Debt to Equity Ratio: </li></ul><ul><ul><li>Ratio of Long-Term Debt to LT Debt + Equity </li></ul></ul><ul><ul><li>Shows &quot;leverage&quot; which is extent of reliance on Debt </li></ul></ul><ul><ul><li>More debt adds more risk, because debt repayment must be made, whether times are good or bad. </li></ul></ul><ul><ul><li>More leverage makes the good times better, and the bad times worse. </li></ul></ul>
  15. 15. Market Ratios <ul><li>Market-based ratios reflect the investor view . </li></ul><ul><li>Price-Earnings Ratio = Market Price per Share/Earnings per Share. </li></ul><ul><ul><li>Shows how much the market is paying per dollar of current earnings. </li></ul></ul><ul><li>Market:Book Ratio . </li></ul><ul><ul><li>Total Market Value of Equity/Book Value of Equity. </li></ul></ul><ul><ul><li>This is the ultimate measure of management success. </li></ul></ul><ul><ul><li>It shows how much the management has increased the market value of the stock above the amount invested by stockholders. </li></ul></ul>
  16. 16. Dupont Analysis <ul><li>So far, we have looked at ratios individually. </li></ul><ul><li>But Dupont Analysis is a way to see the combined effect of the major ratios. </li></ul><ul><li>This is very important for business strategy. </li></ul><ul><li>The following slides explain how and why. </li></ul>
  17. 17. The Dupont Formula <ul><li>NI/SA x SA/TA x TA/EQ x EQ/MV = EP </li></ul><ul><ul><li>NI = Net Income. SA = Sales </li></ul></ul><ul><ul><li>TA = Total assets </li></ul></ul><ul><ul><li>EQ = Total Equity (at book value)‏ </li></ul></ul><ul><ul><li>ROE = NI/EQ </li></ul></ul><ul><ul><li>MV = Total Market Value of Stock </li></ul></ul><ul><ul><li>PS = Price per share </li></ul></ul><ul><ul><li>EP = Earnings per Share to Price per Share (the inverse of the Price/Earnings Ratio). </li></ul></ul><ul><li>NI/SA = profit on sales </li></ul><ul><li>SA/TA = total asset turnover (capital intensity)‏ </li></ul><ul><li>TA/EQ = leverage </li></ul><ul><li>EQ/MV = equity at book to equity at market value </li></ul><ul><li>EP = earnings to price (inverse of P/E ratio)‏ </li></ul>
  18. 18. Dupont Analysis for Business Strategy <ul><li>Long-term strategy goal: maximize the firm's Price/Earnings ratio. </li></ul><ul><li>Dupont analysis tells us exactly how to do this. </li></ul><ul><li>Optimize one or more of the following: </li></ul><ul><ul><li>NI/SA = profit on sales </li></ul></ul><ul><ul><li>SA/TA = total asset turnover (capital intensity)‏ </li></ul></ul><ul><ul><li>TA/EQ = leverage </li></ul></ul>
  19. 19. Profit on Sales <ul><li>Ways to optimize profit on sales include: </li></ul><ul><li>Differentiate products to raise margins. </li></ul><ul><li>Revive and promote old products (Jell-O)‏ </li></ul><ul><li>Promote the most profitable products. </li></ul><ul><li>Prune the least profitable products. </li></ul><ul><li>Cut costs of production. </li></ul><ul><li>Improve efficiency of operations </li></ul><ul><li>Outsource. </li></ul>
  20. 20. Total Asset Turnover <ul><li>Ways to optimize total asset turnover are: </li></ul><ul><li>Adopt &quot;just-in-time&quot; inventory </li></ul><ul><li>Sell off obsolete inventory </li></ul><ul><li>Improve receivables collection efficiency </li></ul><ul><li>Sell and lease back property & plant </li></ul><ul><li>Slow down paying of accounts payable </li></ul><ul><li>Cut back on executive jets, corporate yachts </li></ul><ul><li>Seek out less capital intensive methods of operation </li></ul><ul><li>Relocate operations to less expensive locations </li></ul><ul><li>Outsourcing </li></ul>
  21. 21. Leverage <ul><li>Increase leverage, within safe limits: </li></ul><ul><li>Repurchase outstanding stock </li></ul><ul><li>Increase debt financing </li></ul><ul><li>Repurchase stock & issue more debt </li></ul><ul><li>Repurchase common stock & issue more preferred stock </li></ul>
  22. 22. Benchmarking <ul><li>In order to be meaningful, financial ratios need to be compared with benchmark ratios. </li></ul><ul><li>Possible Benchmarks: </li></ul><ul><ul><li>Same company, in earlier period </li></ul></ul><ul><ul><li>Competitor company, in same period </li></ul></ul><ul><ul><li>Group of competitor companies, in same period </li></ul></ul><ul><ul><li>An industry benchmark, such as The North American Industry Classification System (NAICS) </li></ul></ul><ul><ul><ul><li>NAICS provides standard classifications for industries, for example, see the next slide </li></ul></ul></ul>
  23. 23. Example of NAICS <ul><li>NAICS code 2002 </li></ul><ul><li>Includes NAICS Title: 21 Mining </li></ul><ul><li>211111 Crude Petroleum and Natural Gas Extraction </li></ul><ul><li>211112 Natural Gas Liquid Extraction </li></ul><ul><li>212111 Bituminous Coal and Lignite Surface Mining </li></ul><ul><li>212112 Bituminous Coal Underground Mining </li></ul><ul><li>212113 Anthracite Mining </li></ul><ul><li>These 6-digit codes describe standard industry classifications. For more, see http://www.census.gov/epcd/naics02/ </li></ul>
  24. 24. Sources of Industry Data <ul><li>Most sources of industry data require purchase of a subscription </li></ul><ul><li>However, the UMUC Library offers access to several industry databases, such as Dun & Bradstreet (D&B) </li></ul><ul><ul><li>http://www.umuc.edu/library/resources/?cmd=createSubjectPages&template_id=635&subjectIDs=7&submit=Write#Library_Databases </li></ul></ul><ul><li>Two sources that offer limited industry data free are: </li></ul><ul><ul><li>Yahoo Finance </li></ul></ul><ul><ul><li>MSN Money </li></ul></ul>
  25. 25. Industry Data <ul><li>One caution is that some companies operate in several different industries. </li></ul><ul><li>For example, General Electric Company (GE) is a diversified industrial corporation engaged in developing, manufacturing and marketing a wide variety of products for the generation, transmission, distribution, control and utilization of electricity. On June 23, 2005, GE announced reorganization of its 11 businesses into six industry-focused businesses effective July 5, 2005. The six businesses are GE Infrastructure, GE Industrial, GE Commercial Financial Services, GE NBC Universal, GE Healthcare and GE Consumer Finance. </li></ul><ul><li>It is difficult to find industry benchmarks for conglomerates like GE. Benchmarks are easier for companies in one industry. </li></ul>
  26. 26. Financial Ratio Calculation <ul><li>Financial ratios have a numerator and a denominator. </li></ul><ul><li>These numerators and denominators are items from the Balance Sheet or the Income Statement. </li></ul><ul><li>Example: Current Ratio = Current Assets/Current Liabilities. </li></ul><ul><li>Continued on next slide ... </li></ul>
  27. 27. Financial Ratio Calculation (continued)‏ <ul><li>Balance Sheets show financial position as of one specific date. </li></ul><ul><li>But one specific date cannot represent an entire accounting period – such as a year. </li></ul><ul><li>Therefore, when computing ratios, we AVERAGE all Balance Sheet items in order to: </li></ul><ul><ul><li>Avoid distortion, and </li></ul></ul><ul><ul><li>To represent an entire accounting period – such as a year, </li></ul></ul><ul><li>Average = (Amount at beginning of period + Amount at end of period)/2 </li></ul><ul><li>ALWAYS be sure to average Balance Sheet items when computing ratios. </li></ul>
  28. 28. Summary <ul><li>Use financial ratios to analyze: </li></ul><ul><ul><li>Short-term solvency </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Long-term solvency </li></ul></ul><ul><li>Use Dupont Analysis to: </li></ul><ul><ul><li>Devise strategy </li></ul></ul><ul><ul><li>Implement strategy. </li></ul></ul><ul><li>Benchmarking </li></ul><ul><ul><li>Industry comparisons </li></ul></ul>

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