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Chapter 14 ANALYSIS OF FINANCIAL STATEMENTS Chapter 14 Questions Questions to be answered: What are the major financial statements provided by firms and what specific information does each of them contain?

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Chapter 14

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Chapter 14


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Chapter 14 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 14 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, growth potential, and external liquidity?

  • How can the DuPont analysis help evaluate a firm’s return on equity over time?

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Chapter 14 Questions

  • What is “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 sheet

    • Income statement

    • Statement 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 principles

    • Can be good for firms in different situations

    • Can represent a challenge for analysis

    • Financial 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 from

    • Operating activities

    • Investing activities

    • Financing activities

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Alternative Measures of Cash Flow

  • Cash flow from operations

    • Traditional cash flow equals net income plus depreciation expense and deferred taxes

    • Also 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 firm

    • Modifies cash flow from operations to reflect necessary capital expenditures and projected divestitures

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Purpose of Financial Statement Analysis

  • Evaluate management performance in

    • Profitability

    • Efficiency

    • Risk

  • 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 numbers

    • Puts numbers in perspective with other numbers

    • Helps 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 economy

    • Its industry or industries

    • Its major competitors within the industry

    • Its 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 group

    • Construct 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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Six Categories of Financial Ratios

  • Common size statements

  • Internal liquidity (solvency)

  • Operating performance

    • Operating efficiency

    • Operating profitability

  • Risk analysis

    • Business risk

    • Financial risk

    • External liquidity risk

  • 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

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Evaluating Internal Liquidity

  • Quick Ratio adjusts current assets by removing less liquid assets

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Evaluating Internal Liquidity

  • Cash ratio relates cash (ultimate liquid asset) to current liabilities

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Evaluating Internal Liquidity

  • Receivables turnover examines the management of accounts receivable

Receivables turnover can be converted into an average collection period

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Evaluating Internal Liquidity

  • Inventory turnover relates inventory to sales or cost of goods sold (CGS)

Given the turnover values, you can compute the average inventory processing time

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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 business

    • Operating efficiency ratios

      • Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales

    • Operating profitability ratios

      • Examine 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

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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

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Operating Profitability Ratios

  • Operating profitability ratios measure

    • The 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?

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Operating Profitability Ratios

  • Operating profit margin measures the rate of profit on sales after operating expenses

    • Operating profit is sometimes called Earnings before interest and taxes (EBIT)

    • Operating income can be thought of as the “bottom line” from operations

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Operating Profitability Ratios

  • Net profit margin relates net income to sales

    • Shows the combined effect of operating profitability and the firm’s financing decisions (since net income is after interest and tax payments)

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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 once

    • It 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

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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

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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 equity

    • Deducts preferred dividends, which are a priority claim on net income

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Operating Profitability Ratios

  • The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight

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Profit Total Asset Financial

Margin Turnover Leverage




Operating Profitability Ratios

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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

  • We begin with the operating profit margin (EBIT divided by sales) and introduce additional ratios to derive an ROE value

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Operating Profitability Ratios

This is the operating profit return on total assets. To consider the negative effects of financial leverage, we examine the effect of interest expense as a percentage of total assets

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Operating Profitability Ratios

We consider the positive effect of financial leverage with the financial leverage multiplier

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Operating Profitability Ratios

This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect.

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Operating Profitability Ratios

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Operating Profitability Ratios

  • In summary, we have the following five components of return on equity (ROE):

    • Operating profit margin

    • Total asset turnover

    • Interest expense rate

    • Financial leverage multiplier

    • Tax retention rate

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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 factors

    • Financial 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 costs

    • Greater fixed production costs cause greater profit volatility with changes in sales

    • Fixed costs represent operating leverage

    • Greater 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 income

    • These are fixed obligations

  • Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline

    • Fixed 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 risk

    • Balance sheet ratios

    • Earnings or cash flow available to pay fixed financial charges

  • Acceptable levels of financial risk depend on business risk

    • A 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 Ratios

    • Relate operating income (EBIT) to fixed payments required from debt obligations

    • Higher 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 charges

    • Lease obligations (Fixed charge coverage)

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Financial Risk

  • Cash flow ratios

    • Fixed 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 expense

      • Total fixed charges

      • The 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 traded

    • This can be estimated from the total market value of outstanding securities

    • It 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 potential

    • Important to both creditors and owners

      • Creditors interested in ability to pay future obligations

      • For 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 Model

    • Suggests 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 ratio

      • Anything 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 of

    • Net profit margin

    • Total asset turnover

    • Financial 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 debt

    • Assets with market value greater than book

    • No 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 structure

    • This 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 analysis

    • Estimate cash flows

    • Estimate 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 stock

    • Sometimes we estimate the value of a stock through various price ratios such as P/E

      • Would 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 variables

    • Predicting 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 bankruptcy

    • A number of variables have a rather strong relationship to the bankruptcy experience of firms in the past

    • Can 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

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