financial statement analysis financial rations
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Financial Statement AnalysisFinancial Rations
Marcel Rindisbacher
September 18, 2001
MGT337: Business Finance
Objectives: Financial Statements Analysis
Have argued that an appropriate goal of the firm is to maximize shareholdervalue. Before we introduce fundamental valuation principles we give a quickoverview over the diagnostic tools used to analyze corporations.
Financial Statement Analysis:
• Where do we find relevant financial information about a firm ?
• How do we measure the performance of a firm?
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MGT337: Business Finance
Financial Statement Analysis
What are the basic sources of information for valuation ?
• balance sheet: Lists assets, debt and equity.
• income statement: Shows changes in net worth over period.
• statements of changes in financial conditions: shows changes in financialpositions. Different statements:
– sources and uses of working capital– sources and uses of cash– cash vs. working capital from operations
Remark: All three statements must appear in annual report of the corporation
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MGT337: Business Finance
Additional Sources of Information
• Prospectus (issue of new securities)
• Quarterly shareholder reports
• Press releases
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MGT337: Business Finance
Balance Sheet
Informational content: Lists assets, liabilities and shareholder’s equity fromaccounting point of view: Assets=Liabilities+Equity.
Shortcoming for valuation of firm: Contains accounting values according togenerally accepted accounting principles (GAAP),not economic values. ⇒ historicalpoint of view of accounting is not always appropriate for valuation of a firm.
Examples:
• Book and market value of the firm do not coincide.
• Exclusion of intangible assets of firm ⇐ Lack of objective valuation principles.(patents, copyrights, brand names etc.)
• Exclusion of liabilities on the balance sheet ⇐ Lack of objective valuationprinciples. (Example: liabilities from potential environmental clean-up of achemical company).
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MGT337: Business Finance
Income Statement
Informational content: Shows changes in accounting income (earnings orprofits) : Changes in net worth (Assets - Liabilities).
Shortcomings for valuation of firm:
• Value of firm depends on cash flows not earnings. Earnings differ from cash flowssince books of firm are on accrual not cash basis. (Example: Sales revenues arerecorded when goods are sold not when cash is collected)
• Accounting income differs from economic income (changes in net wealth duringa period). ⇐ economic income depends on future cash flows associated withfirms’ assets and liabilities. (Sales forecasts, R & D expenditures and advertisingexpenditures).
• Replacement cost of inventories (FIFO, LIFO).
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MGT337: Business Finance
Statements of Changes in Financial Position
Informational Content: The sources and uses of funds statements attempts toaccount for the sources and using of funds.
Remark: Comes closest to measure cash flows ⇒ Important for financialmanagment.
Different Statements:
1. Sources and use of working capital statements: Reports firms liquidity.
2. Sources of uses of cash: Reports (a) how much cash did the firm generate duringthe accounting period ? (b) where did the cash come from ? What did the firmdo with its cash ?
3. Cash vs. working capital from operations: Reports changes in cash fromoperations.
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MGT337: Business Finance
Financial Ratio Analysis
Objective: Diagnostic tool to evaluate financial condition of the firm
(a) comparison over time
(b) comparison with industry averages.
Warning : Financial ratios should only be interpreted in the context of businessstrategy !
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MGT337: Business Finance
Categories of Financial Ratios
Liquidity ratios: How likely is critical gap in short-term cash in- and outflows ?
Activity ratios: How efficient does firm operate ?
Leverage ratios: How likely is default ?
Profitability ratios: How efficient are managers ?
Market value ratios: How does market evaluate company performance ?
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MGT337: Business Finance
Liquidity ratios
• Current ratio: = Current assets / Current liabilities
• Quick ratio := (Current assets -Inventories)/ Current liabilities
Remark: Inventories are least liquid current asset ⇒ Current ratio moreconservative indicator of liquidity than quick ratio.
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MGT337: Business Finance
Activity ratios
• Accounts receivable turnover := Net credit sales / receivables
Remark: a low accounts receivable turnover means that firm manages itsreceivables well. Alternatively, could measure the average collection periodof receivables.
• Inventory turnover := Cost of goods sold / inventory
Remark: a high inventory turnover indicates that inventories are moving fastthrough the company and therefore generate sales quickly.
• Fixed asset turnover := Net sales / net fixed assets
Remark: a high fixed assets turnover means that fixed assets generate a highrevenue. (Important: sensible to depreciation policy).
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MGT337: Business Finance
• Total asset turnover := Net sales / average total assets
Remark: a high asset turnover indicates efficient management.
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MGT337: Business Finance
Financial Leverage Ratios
• Debt ratio := Total liabilities / total assets
Remark: a high debt ratio indicates that default is more likely.
• Debt equity ratio := Total liabilities / total equity
Remark: a high debt equity ratio means that shareholder’s stakes are at risk.
• Interest coverage (Time interest earned) := EBIT / Annual interest expenses
Remark: a high time interest earned means that firm has higher capacity to meetits interest payments out of its operating earnings.
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MGT337: Business Finance
Profitability Ratios
• Gross profit margin := Gross profit / net sales
Remark: a high gross profit margin indicates either low costs and/or highmark-ups. (depends on elasticity of demand).
• Operating profit margin := EBIT / net sales
Remark: a high operating profit margin measures profitability of company runningits operations.
• Net profit margin := Net income / net sales
Remark: like gross profit margin, but corrects for tax effects.
• Return on total asset := Net income / total assets
Remark: Also known as return on investments. a low return on investment canindicates low net revenues.
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MGT337: Business Finance
• Net profit margin := Net income / Net sales
Remark: a low net profit margin indicates that the firms operations havedifficulties to meet the company’s financial liabilities.
• Return on total assets := Net income / total assets
Remark: difficulties to measure income and assets
• Return on net assets := EBIT(1-Tax rate)/(Debt + Equity)
Remark: important for comparison of firms.
• Return on equity := Net income / Shareholder’s equity
Remark: a high return on equity indicates an efficient management.
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MGT337: Business Finance
Market Value Ratios
• Price-earnings ratio := Market price per share / earnings per share
Remark: a high price-earning ratio reflects market perception of firm’s growthand profit opportunities, but is also affected by changes in the risk-free rate andeconomic growth conditions.
• Market-to-book ratio := Market price per share / book value per share
Remark: a high market-to-book value means that company creates a high netpresent value.
• Tobin’s q := (Market value of debt + equity)/ replacement cost of assets
Remark: like market-to-book value put uses replacement costs instead of bookvalue to correct problems caused by inflation.
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