Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Re

1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown Chapter 10

2. Chapter 10Analysis of Financial Statements 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 a firm’s industry?

3. Chapter 10Analysis of Financial Statements • 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?

4. Chapter 10Analysis of Financial Statements • What are some of the major differences between U.S. and non-U.S. financial statements and how do these differences affect the financial ratios? • What is a “quality” balance sheet or income statement? • Why is financial statement analysis done if markets are efficient and forward-looking?

5. Chapter 10Analysis of Financial Statements • 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?

6. Major Financial Statements • Corporate shareholder annual and quarterly reports must include

7. Major Financial Statements • Corporate shareholder annual and quarterly reports must include • Balance sheet

8. Major Financial Statements • Corporate shareholder annual and quarterly reports must include • Balance sheet • Income statement

9. Major Financial Statements • Corporate shareholder annual and quarterly reports must include • Balance sheet • Income statement • Statement of cash flows

10. 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)

11. 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

12. Generally Accepted Accounting Principles (GAAP) • Formulated by the Financial Accounting Standards Board (FASB) • Provides some choices of accounting principles • Financial statements footnotes must disclose which accounting principles are used by the firm

13. 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

14. 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

15. 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 flows and changes in various items on the balance sheet

16. It has three sections: Cash Flow from Operating Activities – the sources and uses of cash that arise from the normal operations of a firm Cash Flow from Investing activities – change in gross plant and equipment plus the change in the investment account Cash Flow from Financing activities– financing sources minus financing uses Statement of Cash Flows

17. 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 • Capital expenditures and dividends

18. Purpose of Financial Statement Analysis • Evaluate management performance in three areas: • Profitability • Efficiency • Risk

19. Analysis of Financial Ratios • Ratios are more informative that raw numbers • Ratios provide meaningful relationships between individual values in the financial statements

20. Importance of Relative Financial Ratios • Compare to other entities • Examine a firm’s performance relative to: • The aggregate economy • Its industry or industries • Its major competitors within the industry • Its past performance (time-series analysis)

21. 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

22. Comparing to A Firm’s Industry • 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 • Examine the industry’s performance relative to aggregate economic activity

23. Comparing to A Firm’s Major Competitors • Industry averages may not be representative • Select a subset of competitors to compare to using cross-sectional analysis, or • Construct a composite industry average from industries the firm operates in

24. Comparing to A Firm’s Historical Performance • Determine whether it is progressing or declining • Helpful for estimating future performance • Consider trends as well as averages over time

25. Five Categories of Financial Ratios 1. Internal liquidity (solvency) 2. Operating performance • a. Operating efficiency • b. Operating profitability 3. Risk analysis • a. Business risk • b. Financial risk

26. Six Categories of Financial Ratios 4. Growth analysis

27. Six Categories of Financial Ratios 5. External liquidity (marketability)

28. 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

29. 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

30. Evaluating Internal Liquidity • Quick Ratio adjusts current assets by removing less liquid assets

31. Evaluating Internal Liquidity • Cash Ratio is the most conservative liquidity ratio

32. Evaluating Internal Liquidity • Receivables turnover examines the quality of accounts receivable • Receivables turnover can be converted into an average collection period

33. 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 Average Inventory Processing Period = 365/Annual Turnover

34. Evaluating Internal Liquidity • Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover Receivable Days +Inventory Processing Days -Payables Payment Period Cash Conversion Cycle

35. Evaluating Operating Performance • Ratios that measure how well management is operating a business • (1) Operating efficiency ratios • Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories • (2) Operating profitability ratios • Analyze profits as a percentage of sales and as a percentage of the assets and capital employed

36. Operating Efficiency Ratios • Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets)

37. Operating Efficiency Ratios • Net fixed asset turnover reflects utilization of fixed assets

38. Operating Profitability Ratios • Operating profitability ratios measure • 1. The rate of profit on sales (profit margin) • 2. The percentage return on capital

39. Operating Profitability Ratios • Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)

40. Operating Profitability Ratios • Operating profit margin measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative (SG + A) expenses)

41. Operating Profitability Ratios • Net profit margin relates net income to sales

42. Operating Profitability Ratios • Return on total capital relates the firm’s earnings to all capital in the enterprise

43. 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

44. Operating Profitability Ratios • Return on owner’s equity (ROE) can be computed for the common- shareholder’s equity

45. Operating Profitability Ratios • The DuPont System divides the ratio into several components that provide insights into the causes of a firm’s ROE and any changes in it

46. Profit Total Asset Financial Margin Turnover Leverage x x = Operating Profitability Ratios

47. 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

48. 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

49. Operating Profitability Ratios

50. 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