chapter three financial statement analysis j. d. han

CHAPTER THREECHAPTER THREE

Financial Statement Financial Statement AnalysisAnalysis

J. D. HanJ. D. Han

Learning ObjectivesLearning Objectives

1.1. How do we measure the health and the How do we measure the health and the prospect of a company?prospect of a company?

Unfortunately, one indicator does not give a Unfortunately, one indicator does not give a whole picture. whole picture.

2. What types of ratios are used in financial 2. What types of ratios are used in financial analysis?analysis?

3.3. What are the trade-offs among these ratios?What are the trade-offs among these ratios? Illustrate them with the DuPont system of Illustrate them with the DuPont system of

financial analysis of return on equity.financial analysis of return on equity.

3. 1 Learning Objectives3. 1 Learning Objectives

4.4.What kinds of distortions would inflation What kinds of distortions would inflation (changing prices) cause in the financial (changing prices) cause in the financial statement and on the income statement statement and on the income statement respectively?respectively?

5.5.Discuss some of the implications of foreign Discuss some of the implications of foreign exchange rates for Canadian companies exchange rates for Canadian companies with global operations.with global operations.

3.2 Ratio Analysis3.2 Ratio Analysis

Ratios are helpful for comparison Ratios are helpful for comparison purposespurposes

Ratios are divided into four Ratios are divided into four categories:categories:

1.1. Liquidity RatiosLiquidity Ratios

2.2. Leverage and Coverage RatiosLeverage and Coverage Ratios

3.3. Profitability and Activity RatiosProfitability and Activity Ratios

4.4. Market Value RatiosMarket Value Ratios

Liquidity Ratios: Liquidity Ratios: measuring a company’s short-term ability measuring a company’s short-term ability to pay its debtto pay its debt

Current Ratio = current Current Ratio = current assetsassets

current current liabilitiesliabilities

Most widely used liquidity ratioMost widely used liquidity ratio A value of > 2 is considered a crude A value of > 2 is considered a crude suitable measurement for suitable measurement for current ratiocurrent ratioWhat is ‘working capital’? What is ‘working capital’?

Liquidity RatiosLiquidity Ratios

Used to evaluate a business’ ability to Used to evaluate a business’ ability to meet current obligations when meet current obligations when inventory is considered to be a inventory is considered to be a concernconcern

Acid TestAcid Test

Quick ratio = current assets – Quick ratio = current assets – inventoriesinventories

current liabilitiescurrent liabilities


Indicates an organization’s efficiency Indicates an organization’s efficiency of inventory managementof inventory management

inventory turnover signals efficient inventory turnover signals efficient managementmanagement

Inventory turnover = cost of goods Inventory turnover = cost of goods soldsold

average average inventoryinventory


Indicates the average number of Indicates the average number of days that credit sales are days that credit sales are outstandingoutstanding

Avg. collection period = receivablesAvg. collection period = receivables avg. daily credit avg. daily credit

salessales

Leverage and Coverage Leverage and Coverage RatiosRatios

Common measure of a firm’s Common measure of a firm’s financial leveragefinancial leverage

Used as a safety margin that Used as a safety margin that shareholders are provided in the shareholders are provided in the event of liquidationevent of liquidation

Debt-to-equity = long-term debtDebt-to-equity = long-term debt shareholders’ shareholders’

equityequity


Broad measurement that looks at the Broad measurement that looks at the proportion of a firm’s total assets proportion of a firm’s total assets that are financed through debt and that are financed through debt and other liabilitiesother liabilities

Total debt-to-asset = total Total debt-to-asset = total debtdebt total total assetsassets


Measures the amount of assets a Measures the amount of assets a firm finances with debt or equityfirm finances with debt or equity

The The ratio, the proportion of ratio, the proportion of company’s assets financed through company’s assets financed through equity equity

Equity multiplier = Total assetsEquity multiplier = Total assets total equitytotal equity


Used to detect excessive leverageUsed to detect excessive leverage An indicator of the safety of a firm’s An indicator of the safety of a firm’s

periodic interest paymentsperiodic interest payments

Times interest earned = EBITTimes interest earned = EBIT interest interest chargescharges

Profitability and Activity Profitability and Activity Ratios:Ratios:

Different Measures of ProfitsDifferent Measures of Profits

Sales (revenues) – Cost of Goods sold Sales (revenues) – Cost of Goods sold ––Operating Expenses Operating Expenses = EBIT = EBIT = NOP= NOP

––Financing Charges Financing Charges =EBT =EBT––Income TaxesIncome Taxes =Net Profits =Net Profits

––Dividends on Preferred Shares= Profit Dividends on Preferred Shares= Profit available to common available to common

shareholdersshareholders

Profitability and Activity Profitability and Activity Ratios:Ratios:asses the overall managerial efficiency asses the overall managerial efficiency and profitabilityand profitability

Net operating margin = Net operating margin = EBITEBIT salessales

Gross operating margin = Gross operating margin = sales – sales – COGSCOGS salessales

Asset turnover = Asset turnover = salessales total assetstotal assets

Profitability RatiosProfitability Ratios

Broad measure of how well Broad measure of how well management is employing assets management is employing assets to earn profitsto earn profits

ROA = net profitROA = net profit total assetstotal assets

Profitability RatiosProfitability Ratios

Measures how well management Measures how well management serves shareholders’ interest by serves shareholders’ interest by determining the profit generation per determining the profit generation per dollar of equity invested in the firmdollar of equity invested in the firm

ROE = net profitROE = net profit shareholders’ equityshareholders’ equity

DuPont SystemDuPont System

Allows for analysis of critical components that Allows for analysis of critical components that influence ROE and help predict future trendsinfluence ROE and help predict future trends

The three ratios used in the DuPont system of The three ratios used in the DuPont system of financial analysis of return on equity are financial analysis of return on equity are Profitability, Leverage, and Asset Turnover.Profitability, Leverage, and Asset Turnover.

For instance, this shows that you can raise ROE For instance, this shows that you can raise ROE by decreasing the equity – what would be the by decreasing the equity – what would be the resultant problem or trade-offs between short-resultant problem or trade-offs between short-term and long-term welfares of the firm?term and long-term welfares of the firm?

ROE = net profit x sales x total assetsROE = net profit x sales x total assets sales total assets shareholders’ sales total assets shareholders’ equityequity

Market Value RatiosMarket Value Ratios

Most widely used market value ratioMost widely used market value ratio Reflects what investors are willing to Reflects what investors are willing to

pay for each dollar of reported pay for each dollar of reported annual common share earningsannual common share earnings

Price-Earnings Ratio = price per common Price-Earnings Ratio = price per common shareshare earning per common earning per common shareshare


Tobin’s q Ratio = Market Value of debt and Tobin’s q Ratio = Market Value of debt and equityequity

replacement costreplacement cost

Market-to-book ratio = Market Value of debt and Market-to-book ratio = Market Value of debt and equityequity

book value of assetsbook value of assets

The difference between the replacement cost and the book value is “depreciation”, both technical and physical.

3.3 Common-Size Analysis3.3 Common-Size Analysis

Involves converting dollar amounts Involves converting dollar amounts on the financial statements into on the financial statements into percentagespercentages

Helps compare financial statements Helps compare financial statements and identify trends that are not and identify trends that are not caused by the overall size of the caused by the overall size of the businessbusiness

Enables comparison of companies of Enables comparison of companies of different sizedifferent size


Indicates the percentage of earning paid to Indicates the percentage of earning paid to shareholders in the form of dividendsshareholders in the form of dividends

Dividend payout = common share Dividend payout = common share dividenddividend

common share common share earningsearnings

Dividend yield = dividend per common Dividend yield = dividend per common shareshare

price per common price per common shareshare Widely used market value ratioWidely used market value ratio Measures how much investors are willing Measures how much investors are willing to pay for a firm’s dividendto pay for a firm’s dividend

SummarySummary

1.1. The four categories of ratios used in The four categories of ratios used in financial analysis are:financial analysis are:

• Liquidity ratios highlight the firm’s short-Liquidity ratios highlight the firm’s short-term ability to meet financial obligations.term ability to meet financial obligations.

• Leverage ratios reflect the company’s long-Leverage ratios reflect the company’s long-term financing decisions, while coverage term financing decisions, while coverage ratios indicate its long-term ability to service ratios indicate its long-term ability to service outstanding debt.outstanding debt.

• Profitability and activity ratios portray the Profitability and activity ratios portray the earnings power of an enterprise and the earnings power of an enterprise and the efficiency with which its resources are used.efficiency with which its resources are used.

3.4 Effect of Inflation on 3.4 Effect of Inflation on Financial Statement Financial Statement

AnalysisAnalysis1)1) Effect on Balance SheetEffect on Balance Sheet

(1) Inflation makes Book and Market Values of (1) Inflation makes Book and Market Values of Asset diverge:Asset diverge:

Asset Value in the Book = Historical CostAsset Value in the Book = Historical Cost Inflation increases the Market Value of Asset – Inflation increases the Market Value of Asset –

the book value is below thi, being understated.the book value is below thi, being understated. For instance, the apparent ROA is For instance, the apparent ROA is

exaggerated. exaggerated.

(2) Real Value of Debt falls with inflation:(2) Real Value of Debt falls with inflation: Inflation decreases the Real Value of debtInflation decreases the Real Value of debt A falling inflation rate, and deflation increases A falling inflation rate, and deflation increases

the Real Value of debtthe Real Value of debt

3.4 Effect of Inflation on 3.4 Effect of Inflation on Financial Statement Financial Statement

AnalysisAnalysis2) Effects on Income Statement2) Effects on Income Statement

Inflation exaggerates the inventory Inflation exaggerates the inventory values, and thus earnings.values, and thus earnings.

Inflation understates the cost of Inflation understates the cost of depreciation.depreciation.

Overall, inflation overstates Overall, inflation overstates earnings.earnings.

3.6 International Considerations3.6 International Considerations When firms hold assets and liabilities When firms hold assets and liabilities

denominated in foreign currencies, the denominated in foreign currencies, the procedure for recognizing the gains or procedure for recognizing the gains or losses resulting from changes in foreign losses resulting from changes in foreign exchange rates becomes important.exchange rates becomes important.

chapter three financial statement analysis j. d. han

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