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Financial Statement Analysis

Financial Statement Analysis. FIL 341 Prepared by Keldon Bauer. Ratio Analysis. Financial ratios are the vital signs of the business. They are used to assess the health of the business.

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Financial Statement Analysis

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  1. Financial Statement Analysis FIL 341 Prepared by Keldon Bauer

  2. Ratio Analysis • Financial ratios are the vital signs of the business. • They are used to assess the health of the business. • When they are off the norm, they should be taken together with all known information to get a correct diagnosis. • Norms should be seen as a normal range, not just one number.

  3. Ratio Analysis • Ratios also allow for better comparison through time or between companies. • As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important. • Ratios are used both internally and externally.

  4. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Asset management or efficiency ratios • Long-term solvency or financial leverage ratios • Debt coverage ratios • Profitability ratio • Market value ratios

  5. Liquidity Ratios • Relate short-term sources of and uses for cash. • Current Ratio:

  6. Liquidity Ratios • Quick (Acid Test) Ratio:

  7. Liquidity Ratios • Cash ratio:

  8. Asset Management Ratios • Purpose is to assess how well the firm is managing assets • Inventory turnover ratio (IT):

  9. Asset Management Ratios • Accounts receivable turnover (ART):

  10. Asset Management Ratios • Accounts payable turnover (APT):

  11. Asset Management Ratios • Fixed asset turnover (FAT):

  12. Efficiency Ratios • Total Asset Turnover (TAT):

  13. Leverage Ratios • Relate debt to equity sources of investment funds . • Debt Ratio:

  14. Leverage Ratios • Debt-Equity Ratio: • Measures the proportion of debt to equity currently used to finance the firm.

  15. Coverage Ratios • Measure of ability to meet debt contracts. • Times Interest Earned (TIE) Ratio: • Measures how many times the interest expense could be covered by operating earnings.

  16. Coverage Ratios • EBITDA Ratio: • Conservatively estimates how many times the principal and interest payments could be made from operating cash flow.

  17. Profitability Ratios • What’s the bottom line? • Gross Profit Margin (GPM): • Measures how much profit is gained due to pricing.

  18. Profitability Ratios • Operating Profit Margin (OPM): • Measures how much profit can be pulled through ongoing operations.

  19. Profitability Ratios • Net Profit Margin (NPM): • Measures how much money from every dollar is pulled through as net profit.

  20. Profitability Ratios • Basic earning power ratio (BEP):

  21. Profitability Ratios • Return on Total Assets (ROA): • This is a measure of the return on assets owned. • Therefore, it is a measure of return to all invested funds.

  22. Profitability Ratios • Return on Equity (ROE): • This is a measure of return to the equity holder (whether or not they get a dividend).

  23. Profitability Ratios • Return on Common Equity (ROCE): • This is a measure of return to all equity holders.

  24. Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TE) (TA / TA) • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange • ROE = (NI / TA) (TA / TE) (Sales / Sales) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM

  25. Predicting Financial Distress • Altman’s Z was developed using a Probit model to estimate the probability that a firm would go into bankruptcy. • His model was not published. • Since 1968, private firms have duplicated his work to give us a similar model (only published this time).

  26. Predicting Financial Distress • There are two models: • For publicly traded companies: • Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5 • For private firms: • Z = 0.717X1+0.847X2+3.107X3+0.42X4+0.998X5 • Z is a normally distributed variable, where: • Z<1.81 Bankruptcy is predicted within a year. • 1.81<Z<2.675 Financial distress, possible bankruptcy • Z>2.675 No financial distress predicted

  27. Predicting Financial Distress • X1 = Net Working Capital /Total Assets • X2 = Retained Earnings/Total Assets • X3 = EBIT/Total Assets • X4 = Market Value of All Equity/Book Value of Total Liabilities • In the private firm model Book Value of Equity is substituted for Market Value of Equity • X5 = Sales/Total Assets • What does each variable measure?

  28. Trend Analysis • Seeing how ratios change over time. • Are they getting better or worse over time? • Helps to determine the direction the firm is heading. • Show example. • Can be enhanced by graphing them.

  29. Trend Analysis

  30. Industry Averages • To compare the firm’s performance to that of similar firms, many use industry averages: • Risk Management Association (RMA) • Focuses on private companies. • The target audience is commercial lenders. • The source is also lenders. • Industries are defined using NAICS system. • Data are organized by size (assets or sales). • Most ratios include upper/lower quartiles as well as average.

  31. Industry Averages • Dunn and Bradstreets • Focuses on publicly traded companies. • Industries are defined using SIC system. • Also used by SEC. • Data are clumped together (no size adjustments). • Most ratios include upper/lower quartiles as well as average. • But there are not many ratios covered.

  32. Dunn & Bradstreet Common Size Balance Sheet

  33. Dunn & Bradstreet Key Financial Ratios

  34. Excel Language • Logical operator IF • To have Excel automatically test cell addresses, use: • =IF(Logical test, Value if true, Value if false) • The logical test can use =, <, >, <>, <=, or >=. • E.g. =IF(A5>1,6,0). • Although the logical test usually uses values, it can use labels. • Value if true/false can be a value or a label. • Values are entered directly. • Labels are entered with quotation marks. • Blanks are entered as “”.

  35. Excel Language • Logical operator IF – continued • If the test is complex, either AND or OR should be used. • AND can be used if more than one logical test must be passed for the values to be applied. • OR can be used if at least one logical test must be passed for the values to be applied. • E.g. =IF(OR(A5>3, A5<-3), “Cool”, “Bummer”)

  36. Excel Language • Logical operator IF – continued • The IF statement can contain another, nested IF statement. • E.g. =IF(A5>2.65, “Great”, IF(A5<0.86, “Crap”, “Ok”) • If many nested IF statements are contemplated, then you should probably use a lookup table rather than a nested IF statement.

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