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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?
- 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?

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?

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?

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.

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

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

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

Evaluating Internal Liquidity

- Quick Ratio adjusts current assets by removing less liquid assets

Evaluating Internal Liquidity

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

Evaluating Internal Liquidity

- Receivables turnover examines the management of accounts receivable

Receivables turnover can be converted into an average collection period

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

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

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

- Operating efficiency ratios

Operating Efficiency Ratios

- Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales

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

Operating Profitability Ratios

- Operating profitability ratios measure
- The rate of profit on sales (profit margin)
- The percentage return on capital

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?

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

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)

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

Operating Profitability Ratios

- Return on total capital relates the firm’s earnings to all capital invested in the business

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

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

Operating Profitability Ratios

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

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

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

Operating Profitability Ratios

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

Operating Profitability Ratios

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

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

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

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.

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

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

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

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?

- Equity (L-t D/Equity)
- Total debt can be related to:
- Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]
- Assessment of overall debt load, including short-term

- Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]

Financial Risk

- Earnings or Cash Flow Ratios
- Relate operating income (EBIT) to fixed payments required from debt obligations
- Higher ratio means lower risk

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

- Measures the number of times Interest payments are “covered” by EBIT
- May also want to calculated coverage ratios that reflect other fixed charges
- Lease obligations (Fixed charge coverage)

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

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

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

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

- Important to both creditors and owners

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

- Suggests that the sustainable growth rate is a function of two variables:

Determinants of Growth

- ROE (recall the DuPont equation) is a function of
- Net profit margin
- Total asset turnover
- Financial leverage (total assets/equity)

Analysis of Non-U.S. Financial Statements

- Statement formats will be different
- Differences in accounting principles
- Ratio analysis will reflect local accounting practices

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

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

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

- Reflect repeatable earnings

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

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

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

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

Financial Ratios and Systematic Risk

- A firm’s systematic risk (as measured by beta) is related to a number of financial statement variables

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

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

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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