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Business Finance. BA303 Michael Dimond. Module G: Financial Statement Analysis. Understanding financial statements. Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity. Meaningful Ratio Analysis.

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Presentation Transcript

BA303

Michael Dimond

Understanding financial statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Shareholders’ Equity
Meaningful Ratio Analysis
• Analysis means to break something down to understand it.
• Ratio analysis should be used to answer a specific question or set of questions.
• If you were examining the financial statements for a company, you might start with this basic question:

“Is this a good use of investors’ money?”

• What financial ratio would answer this question?

• How do you compute Return on Equity (ROE)?
Analyzing ROE
• ROE = NI ÷ Equity and answers the question, “is this a good use of investors’ money?”
• If you were to break this down, there are three basic questions to answer:

How efficiently are assets being used?

How much does financial leverage help the investors?

• What financial ratios would answer these questions?

Profit Margin (PM)

Total Asset Turnover (TAT)

Equity Multiplier (EM)

Drivers of ROE
• Profit Margin (PM) = NI ÷ Sales and answers the question, “How profitable is this business?”
• Total Asset Turnover (TAT) = Sales ÷ Total Assets and answers the question, “How efficiently are assets being used?”
• Equity Multiplier (EM) = Total Assets ÷ Equity and answers the question, “How much does financial leverage help the investors?”
The DuPont Identity
• ROE is directly driven by profitability, efficiency and leverage.
• ROE = PM x TAT x EM

How does that work?

• The numerators and denominators cancel to reduce the equation to NI ÷ Equity
A note about the text’s version of ROE & DuPont
• The author uses Earnings Available to Common Shareholders for ROE computations. While this is not terribly incorrect, it isn’t really correct either.
• Net Income ÷ Equity = ROE
• Earnings Available to Common Shareholders ÷ (Equity – Preferred Equity) = Return on Common Equity (ROCE, not ROE)
• The purpose of analysis is to answer important questions.
• If the question is how hard the investors’ money is working, compute ROE
• To find how hard common shareholders’ money is working, compute ROCE
• Never mix & match. ROCE uses Earnings Available to Common Shareholders and Common Equity. ROE uses Net Income and Total Equity.
• Notice the author computes ROA as Earnings Available to Common Shareholders ÷ Total Assets. What is wrong with this?
• ROE & ROA are sometimes very manipulated figures, used by managers to prove a point. Always compute your own figures for analysis.
• ROA = Return on Assets
• What’s the difference between Equity & Assets?
• Leverage
• What’s the difference between ROE & ROA?
• Leverage
• ROE = PM x TAT x EM
• EM represents leverage
• ROA = PM x TAT
• No leverage
Digging Deeper with Financial Ratios
• How would you analyze profitability, efficiency and leverage?
• How do profitability, efficiency and leverage relate?
• What affects profitability?
• What drives sales?
• What is the composition of assets?
• How were assets paid for?
• How are liabilities managed?
• Where shall we begin?
Common-Size Financial Statements
• Shows each line item as a percent of an appropriate total.
• Common-size balance sheet
• % of Total Assets
• Shows the composition of assets
• Liabilities & equity items are also shown as % of total assets
• Debt Ratio = Total Liabilities ÷ Total Assets
• Common-size income statement
• % of Sales
• PM = Net Income as % of Sales
We don’t make a common-size CF Statement

There are other ways to examine relevant information which would be more helpful

Vertical & Horizontal Analysis
• Vertical Analysis compares figures as a percent of a relevant total (“common size” financial statements)
• Horizontal Analysis compares the same figure over a series of periods (showing % change or % growth)
Measuring growth
• Financial figures change from year to year
• To find the % change (“% growth”) over a 1-year period, divide the difference of the two figures by the first year’s value:
• [ending – beginning] / [beginning]

OR

• [ending] / [beginning] - 1
• Measuring growth over more than one period means we need to find the average growth during that time.
CAGR: Compound Annual Growth Rate
• The CAGR is the result of compounded increase over time at a specific average rate
• (133.1/100)^(1/3)-1=0.10
• It can be tested by plugging the result into a compounding formula using the same figures
• 100*(1+0.10)^3=133.10
• It can be figured using the TVM functions on your calculator
• PV = -100 FV = 133.10 n = 3 PMT = 0 solve for I = 10%
• What if you were given a series of % changes instead of dollar figures?
• Year 1: 10% increase, Year 2: 12% increase, Year 3: 8% increase
• You need to find the Geometric Average Growth over the three year period
Geometric Average vs Arithmetic Average
• Arithmetic Average only shows the “typical” result
• Geo Avg = [(1+20%)*(1+-16.67%)* (1+20%)*(1+16.67%)]^(1/4) -1 = 8.78%
• CAGR also shows the result of compounding
• (14/10)^(1/4) – 1 = 0.878 = 8.78%
• The price didn’t increase 8.78% each year, but we end up with the same final value if we compound it by 8.78% every year.
• 5 years means 4 periods of compounding, so we find the 4th root ( ^1/4 power)
Categories of Financial Ratios
• Most finance texts group ratios into categories like these:
• Profitability ratios
• Efficiency (or Activity) ratios
• Liquidity ratios
• Debt ratios
• Market ratios
• It is usually more helpful to think of the questions to be answered rather than just crunching a bunch of numbers.
• Uses critical thinking
• Less time consuming
• Uses fewer resources
Profitability Ratios
• PM = Net Income ÷ Sales (Sometimes called “Net Profit Margin”).
• This also is the bottom line on a common-size income statement
• The author makes a distinction for Earnings Available to Common Shareholders.
• Gross Margin = Gross Profit ÷ Sales
• Gross Profit = Sales – COGS
• Also called the “Gross Profit Margin”
• Operating Margin = Operating Profit ÷ Sales
• Also called the “Operating Profit Margin”
Efficiency Ratios
• TAT = Sales ÷ Total Assets
• How hard do specific assets work?
• Inventory Turnover
• Inventory Turnover = Sales ÷ Inventory
• The label “Inventory Turnover” is also used for COGS ÷ Avg. Inventory
• These two ratios answer different questions:
• How hard is inventory working? (Sales/Inventory)
• How many times/year is inventory replaced? (COGS/Average Inventory)
• How would you convert this into “Days in Inventory?”
• Average Collection Period or AR Conversion Period
• Days to Collect AR = Avg. Accts Receivable ÷ Avg. Daily Sales
• Average Daily Sales = Sales ÷ 365
• The sales figure should exclude sales paid for in cash, use only sales creating AR
Efficiency Ratios
• Average Payment Period
• Days to Pay AP = Avg. AP ÷ Avg Daily Purchases
• Avg Daily Purchases = Purchases ÷ 365
• Purchases = COGS + Ending Inventory – Beginning Inventory
• If you know how long it takes a company to sell inventory, how long it takes to collect accounts receivable and how long to pay its bills, you can compute how long their business takes to function
• Operating Cycle: Days in Inventory + Days in Receivables
• Cash Cycle: Days in Inventory + Days in Receivables – Days in Payables
Efficiency Ratios
• There is an easy and consistent way to compute and understand the components of the cash cycle.
• Each of the “Days in…” figures represents a year divided by the appropriate turnover rate:
• Days in Inventory = 365 ÷ Inventory Turnover Rate
• Days in Receivables = 365 ÷ Receivables Turnover Rate
• Days in Payables = 365 ÷ Payables Turnover Rate
• This means the turnover rates can be simplified to these:
• Inventory Turnover Rate = COGS ÷ Avg. Inventory
• Receivables Turnover Rate = Sales ÷ Avg. Receivables
• Payables Turnover Rate = Purchases ÷ Avg. Payables
• …and the days in each can be computed as:
• Days in Inventory = 365 ÷ (COGS ÷ Avg. Inventory)
• Days in Receivables = 365 ÷ (Sales ÷ Avg. Receivables)
• Days in Payables = 365 ÷ (Purchases ÷ Avg. Payables)
Liquidity Ratios
• The Current Ratio
• Pretty much useless in my opinion, but memorize it anyway.
• Current Assets ÷ Current Liabilities
• Liquidity means something can be converted into cash immediately without significant loss of value. Current Assets includes inventory. Is inventory really liquid?
• Quick Ratio (also called the “Acid Test”)
• Answers the question, “how well can this firm meet its short-term obligations?”
• [Current Assets – Inventory] ÷ Current Liabilities
Debt Management Ratios
• Debt ratio = Total Liabilities ÷ Total Assets
• Also called “Debt to Total Capital” ratio
• Debt-to-Equity ratio = Total Liabilities ÷ Total Equity
• EM (from DuPont) = 1 + D/E
• Times Interest Earned ratio = EBIT ÷ Interest
• NOTE: The book has a typo on page 78. It claims TIE = EBIT ÷ Tax, which is not correct.
• TIE can be altered to cover any financial obligations.
• TIE = EBIT ÷ Interest
• :. TIE = (EBT + Interest) ÷ Interest
• (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts) = Fixed Payment Coverage
• (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts + Principal Repayments/(1-t)) = Fixed Payment Coverage
Market Value Ratios
• Price-to-Earnings ratio = Share Price ÷ Earnings per Share
• Earnings per Share (EPS) = Earnings Available to Common Shareholders ÷ Number of Shares of Common Stock
• If there is no preferred equity (or an insignificant amount), EPS can be NI ÷ Number of Shares
• Because the Numerator and Denominator are both “per share,” the PE ratio can be computed as Market Capitalization ÷ Total Earnings Available
• Market-to-Book ratio = Price per Share ÷ Book Value per Share
• Book Value per Share = Common Equity on Balance Sheet ÷ Number of Shares
• Common Equity = All equity except preferred equity
• Again, because the Numerator and Denominator are both “per share,” the MB ratio can be computed as Market Capitalization ÷ Total Common Equity
Other useful analysis
• Dividends & Retained Earnings
• d: Dividend Payout Ratio = Dividends ÷ Net Income
• b: Retention Ratio = 1 – d

Also called the “plowback ratio.” Why do you think that name is used?

• Growth Limitations
• SGR: Sustainable Growth Rate = b x ROE = b x PM x TAT x EM
• IGR: Internal Growth Rate = b x ROA = b x PM x TAT
• Breakeven
• BE = Total Fixed Costs ÷ Contribution Margin
• Contribution Margin = Price per unit – Variable Costs per unit
• Operating, Accounting, and Financial breakevens all exist. The definition of “Fixed Costs” changes.
• Degree of Operating Leverage
• Looks a lot like an elasticity formula: %Δ Op. Income ÷ %ΔSales
• As firm approaches breakeven, DOL gets larger
• A point estimate of DOL can be computed as Gross Profit ÷ Operating Income