Overview of Financial Analysis

1. Overview of Financial Analysis • SPECIFY THE OBJECTIVES OF THE ANALYSIS • Focus on who is the financial statement user • The identity of the user helps define what information is needed I had better sell that stock ASAP! The company’s return on equity has dipped considerably over the last period Financial

2. Steps of a F/S Analysis • Establish objectives of the analysis • Study the industry and relate industry climate to current and projected economic developments - • a growth industry? • a dying industry? • a changing industry? • Develop knowledge of firm and quality of management • Evaluate financial statements using basic tools • Summarize findings • Reach conclusions relevant to established objectives

3. Potential Financial Statement Users: • Creditors • Investors • Managers • Who else? • What types of questions do each of these users seek answers to?

4. Data sources • Financial statements (and notes) • Auditor’s report • MD&A • Supplementary schedules • 10K and 10Q reports filed with SEC • Computerized data bases • Info on industry norms/ratios • Info on particular companies/industries/mutual funds • Articles in popular/business press • Websites

5. Tools for analysis • Common size financial statements • Financial ratios • Trend analysis • Structural analysis • Industry comparisons • Common sense and judgment

6. Financial Ratio Categories • Liquidity Ratios measure a firm’s ability to meet cash needs as they arise • Activity Ratios measure the liquidity of specific assets and the efficiency of managing assets

7. Ratio Categories (continued) • Leverage Ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges • Profitability Ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity

8. Caution! • Ratios are valuable, BUT….. • They do not provide answers in an of themselves and are not predictive • They should be used with other elements of financial analysis • There are no “rules of thumb” that apply to interpretation of ratios

9. Profitability Ratios • Gross Profit Margin Gross Profit/Net Sales • Operating Profit Margin Operating Profit/Net Sales • Net Profit Margin Net Earnings/Net Sales • All measure firm’s ability to translate sales dollars into profits

10. Profitability Ratios (continued) • Return on Investment (or Return on Assets) Net Earnings/Total Assets • Return on Equity Net Earnings/Stockholders’ Equity • Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders

11. Return on Investment • Return on Investment (ROI) • Net operating income • Income before interest and taxes • Operating assets • Assets held for operating purposes ONLY • i.e. cash, accounts receivable, inventory, plant and equipment Net Operating Income = ROI Average Operating Assets 2005 KD Hatheway-Dial

12. Understanding ROI ROI = Margin X Turnover Operating Margin Net Operating Income = Sales Sales = Turnover Average Operating Assets 2005 KD Hatheway-Dial

13. Understanding ROI 5% 12.5% = X 2.5 $10,000 5% 100 X = $200,000 $200,000 = 2.5 $80,000 2005 KD Hatheway-Dial

14. APPLYING ROI 10% Increased Sales without Any Increase in Operating Assets (assume 6% increase in operating expenses) 23.25% = 8.4545 X 2.75 86% increase with 10% increase in sales $18,600 8.4545 100 X = $220,000 $220,000 = 2.75 $80,000 2005 KD Hatheway-Dial

15. APPLYING ROI 10% Decrease in operating expenses and no change in sales 36.25% = 14.5% X 2.50 190% increase with 10% decrease in operating expenses $29,000 14.5% 100 X = $200,000 $200,000 = 2.50 $80,000 2005 KD Hatheway-Dial

16. APPLYING ROI 10% Decrease in operating assets and no change in sales or operating expenses 13.90% = 5.0% X 2.78 11.2% increase with 10% decrease in operating assets $10,000 5.0% 100 X = $200,000 $200,000 = 2.78 $72,000 2005 KD Hatheway-Dial

17. APPLYING ROI 10% increase in operating assets and 5% change in sales and 3% operating expenses 16.25% = 6.8% X 2.39 30% increase with 10% decrease in operating assets $14,300 6.8% 100 X = $210,000 $210,000 = 2.39 $88,000 2005 KD Hatheway-Dial

18. Profitability Ratios (continued) • Cash Flow Margin Cash Flow from Operating Activities /Net Sales Measures ability to translate sales into cash (with which to pay bills)

19. Profitability Ratios (continued) • Cash Return on Assets Cash Flow from Operating Activities /Total Assets Useful comparison to return on investment Indicates firm’s ability to generate cash from utilizing its assets

20. Liquidity Ratios • Current Ratio Current Assets/Current Liabilities Measures ability to meet short-term cash needs • Quick or Acid Test Ratio Current Assets-Inventory/Current Liabilities Measure ability to meet short-term cash needs more rigorously • Cash Flow Liquidity Ratio Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities Focuses on ability of the firm to generate operating cash flows as a source of liquidity

21. Activity Ratios • Average Collection Period Accounts Receivable/Average Daily Sales Helps gauge liquidity of accounts receivable (ability to collect cash from customers) • Accounts Receivable Turnover Net Sales/Accounts Receivable Another measure of efficiency of firm’s collection and credit policies

22. Activity Ratios (continued) • Inventory Turnover Cost of Goods Sold/Inventory Measures efficiency of inventory management • Fixed Asset and Total Asset Turnover Net Sales/Net PP&E (Fixed Asset T/O) Net Sales/Total Assets (Total Asset T/O) Both assess effectiveness in generating sales from investment in assets

23. Leverage: Debt Ratios • Debt Ratio Total Liabilities/Total Assets • Long-Term Debt to Total Capitalization Long-term Debt/Long-term Debt + Stockholders’ Equity • Debt to Equity Ratio Total Liabilities/Stockholders’ Equity • All three measure extent of firm’s financing with debt

24. Leverage: Coverage Ratios • Proportion and amount of debt in capital structure is important to analyst • Tradeoff between risk and return • Use of debt involves risk -- commitment to fixed charges • Fixed charges must be COVERED -- following are some ratios to assess coverage

25. Coverage Ratios (continued) • Times Interest Earned Operating Profit/Interest Expense Indicates how well operating earnings cover fixed interest charges • Fixed Charge Coverage Operating Profit + Lease Payments/Interest Expense + Lease Payments Broader measure of how well operating earnings cover fixed charges

26. Coverage Ratios (continued) • Cash Flow Adequacy Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities Measures firm’s ability to cover long-term debt maturities each year Rationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt

27. Other Ratios • Earnings per Common Share Net Earnings/Average Common Shares Outstanding Indicates return on a per share basis • Price to Earnings Market Price of Common Stock/Earnings per Common Share Expresses a multiple the stock market places on earnings

28. Other Ratios (continued) • Dividend Payout Dividends per Share/Earnings per Share Shows percentage of earnings paid out to stockholders • Dividend Yield Dividends per Share/Market Price of Common Share Shows rate earned by shareholders from dividends relative to current stock price