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Investments: Financial Statement Analysis (review). Professor Scott Hoover Business Administration 365. What questions are important in assessing the health of a firm? Can the firm meet its debt obligations? How well are assets being managed? How profitable is the firm?

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investments financial statement analysis review

Investments:Financial Statement Analysis (review)

Professor Scott Hoover

Business Administration 365

What questions are important in assessing the health of a firm?
    • Can the firm meet its debt obligations?
    • How well are assets being managed?
    • How profitable is the firm?
    • How risky is the firm?
    • What does the market think of the firm?
    •  Ratio Analysis: interpretation of accounting and market information to assess the health of companies.
Why do we use ratios?
    • We must consider things on a relative basis, not an absolute one.
      • e.g.: If one company has earnings of $2,000,000 and another of $1,000,000, which is better?
        • We can’t say because one company may be considerably bigger than the other.
    • By using ratios, we are able to compare a company to its peers.
  • There are no hard-and-fast rules here. We can and should be creative by creating our own ratios to investigate specific areas.
The DuPont Relationship
    • We begin any analysis by examining the factors that contribute to the Return on Equity (ROE).
      • Why?
        • Measures the return to shareholders
    • DuPont: ROE  NI / E = (NI / S)  (S / TA)  (TA / E ) = profit margin  asset turnover  leverage multiplier
      • Note that ROE = ROA  (TA / E )
      • leverage multiplier = TA / E = TA / (TA - D) = 1 / (1 - debt ratio)
The DuPont approach is nice because it divides the firm into three tasks
    • expense management (measured by the profit margin)
    • asset management (measured by asset turnover)
    • debt management (represented by the debt ratio or leverage multiplier)
  • The DuPont Method
    • layered approach
      • examine the three components
      • dig deeper to identify possible weaknesses and strengths
      • dig deeper to find specific causes and hopefully to identify possible corrective action
factors of the profit margin
    • sales
    • cost of goods sold
    • SG&A expenses
    • R&D expenses
    • depreciation
    • interest
    • taxes
    • other expenses
factors of the asset turnover
    • sales
    • assets
      • current assets
        • cash
        • receivables
        • inventory
      • fixed assets
        • property
        • plant
        • equipment
factors of the leverage multiplier?
    • Since we are concerned with whether or not the firm can meet its debt obligations, the “factors” don’t really matter.
    • Instead…
      • current assets vs. current liabilities
        • current ratio
        • quick ratio
      • profits vs. debt payments
        • ROIC vs. after-tax interest
        • times-interest-earned
    • Ultimately, we must assess debt on a cash flow basis.
    • Common Size statements
      • express the balance sheet as a percentage of total assets
      • express the income statement as a percentage of sales
    • Indexed statements
      • express the financial statements from one period as a percentage of some base year.
    • See spreadsheet example
Profit Measures
    • Earnings (net income)
      • accounting profits
      • useful if not misleading (intentionally or otherwise),
      • problem: does not reflect cash flow
        • includes Depreciation as an expense
        • ignores Capital Expenditures
        • uses Sales instead of receipts
        • uses Cost of Goods Sold instead of disbursements
    • EBITDA
      • earnings without Depreciation, Interest, Taxes
      • looks at earnings without the effects of financing and accounting decisions
      • useful for understanding the ability to service debt
      • problem: still does not reflect cash flow
Free Cash Flow
    • measures the true cash flow of the firm in a given period, ignoring all financing-related cash flows and effects
      • Why ignore financing?
    • can be misleading due to fixed asset effects
      • e.g., firm with old, fully depreciated equipment vs. one that has bought new equipment during the period.
    • very useful when viewed over multiple periods
    • provides the basis for the DCF model
Building the Free Cash Flow Equation
    • How do earnings differ from cash flow?
      • Earnings include financing-related cash flows
        • adjust by using EBIT(1-T) (i.e., NOPAT) instead of earnings.
        • This is just net income assuming zero interest expense
      • Depreciation: subtracted, but is not a cash flow
        • adjust by adding depreciation
      • Capital Expenditures: ignored entirely
        • adjust by subtracting CapEx
      • Sales: recorded when made, not when cash is received.
        • adjust by subtracting the increase in receivables
      • Cost of Goods Sold: recorded when sold, not when the goods are paid for
        • adjust by subtracting the increase in inventory
        • and by subtracting the decrease in payables
      • Ignores cash needed for operations
        • adjust by subtracting the increase in operating cash
        • Note that most financial analysts ignore this effect entirely
Note the following
    • subtracting the increases in cash, inventory, and receivables  subtracting the increase in current assets.
    • adding the increase in payables  subtracting the decrease in current liabilities.
  • It follows that we subtract CA- CL.
  • Since Net Working Capital (NWC) is CA-CL, we subtract NWC. This gives us our final equation
  • The Free Cash Flow Equation
FCF yield = FCF / EV
    • EV  enterprise value = equity + preferred stock + debt – cash & equivalents
    • i.e., EV is the amount of capital the firm has currently invested
    • Why do we subtract cash & equivalents?
  • What happens if FCF yield < WACC?
    • company earns less than what it “owes” investors
    • higher sales  lower stock value!
Another Look at ROE
    • ROE = NI/E
    • NI = (EBIT-Interest)(1-t) = (EBIT-iD)(1-t)
      • t  effective tax rate
      • i  interest rate on debt
      • D  amount of outstanding debt
    • We can rearrange these equations to get an expression that is more helpful.
    • First, recall that the Return on Invested Capital is
The ROIC is entirely independent of capital structure.
    •  2ndterm of the last equation reflects the impact of capital structure on ROE.
    • The sign of the 2nd term tells us whether or not debt helps or hurts ROE.
What do we learn from this exercise?
      • i(1-t)<ROIC  taking on more debt will increase ROE.
      • i(1-t)>ROIC  taking on more debt will decrease ROE.
      • Implications
        • optimal strategy might be to use debt whenever the after-tax interest rate on marginal debt is below the ROIC and to use equity otherwise.
        • But….
          • How far into the future should we look? One data point is hardly sufficient to draw strong conclusions.
          • The equation does not incorporate risk.
          • The equation ignores other important factors.
  • Revisiting our example…
Difficulties with Financial Statement Analysis
    • Information is always old.
    • Book values are reported instead of market values
    • We often must compare companies at different points in time.
    • Companies often use different terminology
    • Managers may have incentives to mislead
    • Financial statements often lack detail
    • Industry averages are often misleading
      • Should we include negative ratios in averages?
      • Should we include outliers in averages?
Other Comments
    • We should always consider the notes to the financial statements.
      • They give explanations for unusual items as well as notes that suggest an accounting explanation for a peculiarity.
    • We should always consider news stories on the company.
      • They often contain statements concerning the financial condition of the firm and/or comments on things to expect.
      • They provide updates since the date of the last financials.