Chapter 11Chapter 11
ANALYSIS OF FINANCIAL STATEMENTS
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Chapter 11 Questions
Questions to be answered: What are the major financial statements provided by firms
and what specific information does each of them contain? Why do we use financial ratios to examine the performance
of a firm, and why is it important to examine performance relative to the economy and to a firm’s industry?
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Chapter 11 Questions
What are the major categories for financial ratios and what questions are answered by the ratios in these categories?
What specific ratios help determine a firm’s internal liquidity, operating performance, risk profile, and growth potential?
How can the DuPont analysis help evaluate a firm’s past and future return on equity?
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Chapter 11 Questions
What is a quality balance sheet or income statement? Why is financial statement analysis done if markets are
efficient and forward-looking? What major financial ratios help analysts in the following
areas: stock valuation, estimating and evaluating systematic risk, predicting the credit ratings on bonds, and predicting bankruptcy?
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Analyzing Financial Statements
We will be considering asset valuation. Financial asset values are a function of two
variables:Discount rate ( the required rate of return)Expected future cash flows
Financial statement analysis can be useful in estimating both of these valuation inputs.
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Major Financial Statements
Corporate shareholder annual and quarterly reports must include:Balance sheetIncome statementStatement of cash flows
Reports filed with Securities and Exchange Commission (SEC)10-K and 10-Q
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Generally Accepted Accounting Principles
GAAP are formulated by the Financial Accounting Standards Board (FASB)
Provides some flexibility of accounting principlesCan be good for firms in different situationsCan represent a challenge for analysisFinancial statements footnotes must disclose which
accounting principles are used by the firm
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Balance Sheet
Shows resources (assets) of the firm and how it has financed these resources
Indicates current and fixed assets available at a point in time
Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity
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Income Statement
Contains information on the profitability of the firm during some period of time
Indicates the flow of sales, expenses, and earnings during the time period
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Statement of Cash Flows
Integrates the information on the balance sheet and income statement
Shows the effects on the firm’s cash flow of income statement items and changes in various items on the balance sheet
Three sections show cash flows fromOperating activitiesInvesting activitiesFinancing activities
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Alternative Measures of Cash Flow
Cash flow from operationsTraditional cash flow equals net income plus depreciation
expense and deferred taxesAlso adjust for changes in operating assets and liabilities
that use or provide cash Free cash flow recognizes that some investing and financing
activities are critical to ongoing success of the firmModifies cash flow from operations to reflect necessary
capital expenditures and projected divestitures
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Alternative Measures of Cash Flow
EBITDAEarnings Before Interest, Taxes, Depreciation, and
AmortizationA more generous measure of operating earnings, since all of
these items are added backPerhaps a somewhat questionable measure of actual
operating performance
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Purpose of Financial Statement Analysis
Evaluate management performance inProfitabilityEfficiencyRisk
Although financial statement information is historical, it is used to project future performance
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Analysis of Financial Ratios
Ratios can often be more informative that raw numbersPuts numbers in perspective with other numbersHelps control for different sizes of firms
Ratios provide meaningful relationships between individual values in the financial statements
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Importance of Relative Financial Ratios
In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks
Examine a firm’s performance relative to:The aggregate economyIts industry or industriesIts major competitors within the industryIts own past performance (time-series analysis)
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Comparing to the Aggregate Economy
Most firms are influenced by economic expansions and contractions in the business cycle
Analysis helps you estimate the future performance of the firm during subsequent business cycles
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Comparing to the Industry Norms
Most popular comparison Industries affect the firms within them differently, but the
relationship is always significant The industry effect is strongest for industries with
homogenous products Can also examine the industry’s performance relative to
aggregate economic activity
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Comparing to the Firm’s Major Competitors
Industry averages may not be representative A firm may operate in several distinct industries Several approaches:
Select a subset of competitors for the comparison groupConstruct a composite industry average from the different
industries in which the firm operates
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Comparing to the Firm’s Own Past Performance Determine whether it is progressing or declining Helpful for estimating future performance Consider trends as well as averages over time
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Five Categories of Financial Ratios
1. Common size statements2. Internal liquidity (solvency)3. Operating performance
Operating efficiency Operating profitability
4. Risk analysis Business risk Financial risk External liquidity risk
5. Growth analysis
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Common Size Statements
Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales
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Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
Current Ratio examines current assets and current liabilities
sLiabilitieCurrent
AssetsCurrent RatioCurrent
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Evaluating Internal Liquidity
Quick Ratio adjusts current assets by removing less liquid assets
sLiabilitieCurrent
sReceivableSecurities MarketableCashRatioQuick
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Evaluating Internal Liquidity
Cash ratio relates cash (ultimate liquid asset) to current liabilities
sLiabilitieCurrent
Securities MarketableCashRatioCash
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Evaluating Internal Liquidity
Receivables turnover examines the management of accounts receivable
sReceivable Average
Sales AnnualNet Turnover sReceivable
Receivables turnover can be converted into an average collection period
Turnover Annual
365Period Collection sReceivable Average
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Evaluating Internal Liquidity
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Inventory Average
Sold Goods ofCost TurnoverInventory
Given the turnover values, you can compute the average inventory processing time
Turnover Annual
365Period ProcessingInvetory Average
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Evaluating Internal Liquidity
Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover
CCC = Receivables Collection Period + Inventory Processing Period - Payables Payment Period
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Evaluating Operating Performance
Ratios that measure how well management is operating a businessOperating efficiency ratios
Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales
Operating profitability ratiosExamine how management is doing at controlling costs so
that a large proportion of the sales dollar is converted into profit
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Operating Efficiency Ratios
Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales
AssetsNet Total Average
SalesNet TurnoverAsset Total
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Operating Efficiency Ratios
Net fixed asset turnover reflects utilization of fixed assets
This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales
Assets FixedNet Average
SalesNet TurnoverAsset Fixed
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Operating Profitability Ratios
Operating profitability ratios measureThe rate of profit on sales
(profit margin)The percentage return on
capital
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Operating Profitability Ratios
Gross profit margin measures the rate of return after cost of goods sold
What proportion of the sales dollar is left after cost of goods sold?Is the firm buying inputs (inventory and direct labor) at
good prices?
SalesNet
Profit GrossMarginProfit Gross
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Operating Profitability Ratios
Operating profit margin measures the rate of profit on sales after operating expensesOperating profit is sometimes called Earnings before
interest and taxes (EBIT)Operating income can be thought of as the “bottom
line” from operations
SalesNet
Profit OperatingMarginProfit Operating
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Operating Profitability Ratios
Net profit margin relates net income to salesShows the combined effect of operating profitability
and the firm’s financing decisions (since net income is after interest and tax payments)
SalesNet
IncomeNet MarginProfit Net
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Common Size Income Statement
Since Net Sales is in the denominator of all of the three previous ratios, the common size income statement gives all of these ratios at onceIt also allows us to focus on any categories of
expenses that are out of line with the appropriate benchmark
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Operating Profitability Ratios
Return on total capital relates the firm’s earnings to all capital invested in the business
Capital Total Average
ExpenseInterest IncomeNet Capital Totalon Return
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Operating Profitability Ratios
Consideration of Lease ObligationsLeases for assets are economically similar to debt
obligations, but have different accounting treatmentMay want to capitalize operating leases in order to get a
more accurate measure of assets and financingShould also consider the implied interest and depreciation
for leases when including the impact of leases on the Return on total capital
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Operating Profitability Ratios
Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used
Equity Total Average
IncomeNet Equity Totalon Return
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Operating Profitability Ratios
Return on owner’s equity (ROE) can be computed for the based only on the common shareholder’s equityDeducts preferred dividends, which are a priority claim
on net income
EquityCommon Average
Dividend Preferred-IncomeNet Equity sOwner'on Return
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Operating Profitability Ratios
The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight
EquityCommon
SalesNet
SalesNet
IncomeNet
EquityCommon
IncomeNet ROE
Equity
Assets Total
Assets Total
Sales
Equity
Sales
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Operating Profitability Ratios
EquityCommon
Assets Total
Assets Total
Sales
Sales
IncomeNet
EquityCommon
IncomeNet
Profit Total Asset Financial
Margin Turnover Leverage= xx
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Operating Profitability Ratios
An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE
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Risk Analysis
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into two basic sources:Business risk: The uncertainty in a firm’s operating income,
highly influenced by industry factorsFinancial risk: The added uncertainty in a firm’s net income
resulting from a firm’s financing decisions (primarily through employing leverage).
External liquidity analysis considers another aspect of risk from an investor’s perspective
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Business Risk
Variability of the firm’s operating income over time Can be measured by calculating the standard
deviation of operating income over time or the coefficient of variation
In addition to measuring business risk, we want to explain its determining factors.
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Business Risk
Two primary determinants of business risk Sales variability
The main determinant of earnings variability Cost Variability and Operating leverage
Production has fixed and variable costsGreater fixed production costs cause greater profit volatility
with changes in salesFixed costs represent operating leverageGreater operating leverage is good when sales are high and
increasing, but bad when sales fall
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Financial Risk
Interest payments are deducted before we get to net incomeThese are fixed obligations
Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business declineFixed financing costs are called financial leverage
The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high
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Financial Risk
Two sets of financial ratios help measure financial riskBalance sheet ratiosEarnings or cash flow available to pay fixed financial
charges Acceptable levels of financial risk depend on
business riskA firm with considerable business risk should likely
avoid lots of debt financing
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Financial Risk
Proportion of debt (balance sheet) ratios Long-term debt can be related to:
Equity (L-t D/Equity)How much debt does the firm employ in relation to its use of
equity?Total Capital [L-t D/(L-t D +Equity)]
How much debt does the firm employ in relation to all long-term sources of funds?
Total debt can be related to:Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]
Assessment of overall debt load, including short-term
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Financial Risk
Earnings or Cash Flow RatiosRelate operating income (EBIT) to fixed payments
required from debt obligationsHigher ratio means lower risk
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Financial Risk
Interest Coverage or Times Interest Earned Ratio Measures the number of times Interest payments are
“covered” by EBIT
Interest Coverage = EBIT/Interest Expense
May also want to calculated coverage ratios that reflect other fixed chargesLease obligations (Fixed charge coverage)
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Financial Risk
Cash flow ratiosFixed financing costs such as interest payments must be
paid in cash, so these ratios use cash flow rather than EBIT to assess the ability to meet these obligations
Relate the flow of cash available from operations to:Interest expenseTotal fixed chargesThe face value of outstanding debt
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External Liquidity Risk
Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information
External market liquidity is a source of risk to investors
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External Liquidity Risk
The most important factor of external market liquidity is the dollar value of shares tradedThis can be estimated from the total market value of
outstanding securitiesIt will be affected by the number of security owners
Numerous buyers and sellers provide liquidity
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Analysis of Growth Potential
Want to determine sustainable growth potentialImportant to both creditors and owners
Creditors interested in ability to pay future obligationsFor owners, the value of a firm depends on its future growth
in earnings, cash flow, and dividends
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Determinants of Growth
Sustainable Growth ModelSuggests that the sustainable growth rate is a function of
two variables: What is the rate of return on equity (which gives the maximum
possible growth)?How much of that growth is put to work through earnings retention
(rather than being paid out in dividends)?g = ROE x Retention rate
The retention rate is one minus the firm’s dividend payout ratioAnything that impacts ROE would also be a determinant of future
growth
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Determinants of Growth
ROE (recall the DuPont equation) is a function ofNet profit marginTotal asset turnoverFinancial leverage (total assets/equity)
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Analysis of Non-U.S. Financial Statements
Statement formats will be different Differences in accounting principles Ratio analysis will reflect local accounting
practices
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The Quality of Financial Statements
“Quality financial statements” reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are
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The Quality of Financial Statements
High-quality balance sheets typically have Conservative use of debtAssets with market value greater than bookNo liabilities off the balance sheet
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The Quality of Financial Statements
High-quality income statements Reflect repeatable earnings
Gains from nonrecurring items should be ignored when examining earnings
High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs
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The Value of Financial Statement Analysis
Financial statements, by their nature, are backward-looking An efficient market will have already incorporated these past
results into security prices, so why analyze the statements?Analysis provides knowledge of a firm’s operating and
financial structureThis aids in estimating future returns
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Uses of Financial Ratios
Stock valuation Identification of corporate variables affecting a
stock’s systematic risk (beta) Assigning credit quality ratings on bonds Predicting insolvency (bankruptcy) of firms
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Financial Ratios and Stock Valuation Models
Stock valuation often considers discounted cash flow analysisEstimate cash flowsEstimate an appropriate discount rate
A number of financial ratios can be useful in arriving at estimates for each of these inputs
Price ratio analysis for a stockSometimes we estimate the value of a stock through various
price ratios such as P/EWould need to estimate variables such as expected growth rate of
earnings and dividends
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Financial Ratios and Systematic Risk
A firm’s systematic risk (as measured by beta) is related to a number of financial statement variables
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Financial Ratios and Bond Ratings
Changes in bond ratings are linked to changes in various financial statement variablesPredicting such changes in ratings before they occur
can increase the return on a bond or stock portfolio
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Financial Ratios and Insolvency (Bankruptcy)
Certainly, analysts and investors are concerned with the possibility of bankruptcyA number of variables have a rather strong relationship
to the bankruptcy experience of firms in the pastCan use financial statement analysis to identify firms
where insolvency is a likely outcomes
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Limitations of Financial Ratios
Always consider relative financial ratios Accounting treatments may vary among firms, especially
among non-U.S. firms Firms may have have divisions operating in different
industries making it difficult to derive industry ratios Are the results consistent? Ratios outside an industry range may be cause for concern