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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 about Return on Equity?

- 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 profitable is this business?

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.

A word about ROA

- 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
- Easier to read
- 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

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