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Financial Analysis. Purpose Ratio Analysis Cash Flow Analysis. Purpose of Financial Analysis. Assess Corporate Performance in the context of stated goals and strategy. Assess current financial position, including liquidity. . Tools of Traditional Financial Statement Analysis.

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financial analysis

Financial Analysis

Purpose

Ratio Analysis

Cash Flow Analysis

purpose of financial analysis
Purpose of Financial Analysis
  • Assess Corporate Performance in the context of stated goals and strategy.
  • Assess current financial position, including liquidity.
ratio analysis
Ratio Analysis
  • Tools for interpreting financial statements
  • Often used to facilitate comparison via deflation.
  • Common size financial statements- when the whole statement is converted to ratio form.
ratio analysis1
Ratio Analysis
  • Financial ratios are typically grouped into four classes
    • Profitability
    • Liquidity ratios
    • Solvency ratios
    • Funds management ratios
profitability and growth strategic areas of influence
Profitability and growth-Strategic Areas of Influence
  • Operating management
  • Investment management
  • Financing strategy
  • Dividend policies
drivers of profit and growth

Profitability and

Growth

Product Market

Strategies

Financial Market

Strategies

Operating

Management

Investment

Management

Financing

Management

Dividend

Policy

Managing

Working

Capital and

Fixed Assets

Managing

Revenue and

Expenses

Managing

Liabilities and

Equity

Managing

Payout

Drivers of Profit and Growth
ratios can be used
Ratios can be used:
  • To compare the same firm over several years
  • To compare to other firms in the industry
  • To compare to an absolute benchmark
operating management managing revenues and expenses
Operating Management (managing revenues and expenses)
  • Return on equity (ROE) -- ROE = (Net Income) / (Shareholder’s Equity)
  • Return on Assets -- Income / (Total Assets)
  • Return on sales (ROS) -- Net Income / Sales
  • Gross Profit Margin- (Sales-COGS)/Sales
  • Numerous variations of the above are computed in practice
an example return on equity roe
An Example-Return on Equity (ROE)
  • Beginning balances, ending balances, average balances ?
  • Often adjusted for preferred stock dividends
  • Average for US industries is from 11 to 13% (PBH)
the need for an analysis framework
The need for an analysis framework
  • What do ROE, NPM, ROA, etc., mean as a group?
  • What if they differ as to outcome (e.g., one firm has a higher NPM but lower ROE)?
  • What story do they tell, collectively?
  • How do they relate to each other?
the notion of ratio decomposition dupont analysis
The Notion of Ratio Decomposition (Dupont Analysis)
  • ROE = ROA * Assets/equity (Financial leverage)
  • ROA= net income/ assets
  • Financial leverage indicates the dollar of assets the firm is able to deploy for dollar invested by shareholders
sustainable growth rate

CA Turnover

WC Turnover

AR Tirnover

Inv Tirnover

AP Turnover

Days Rec

Days Pay

PP&E Turnover

Current Ratio

Quick Ratio

Cash Ratio

Oper CF Ratio

Liab to Equity

Debt to Equity

Debt to Capital

Int Coverage

GOGS/ Sales

GP/ Sales

SG&A/Sales

R&D/Sales

OE/ Sales

Non OE / Sales

EBT / Sales

Tax Expenses / Sales

Sustainable Growth Rate

Dividend payout

ROE

Fin Leverage

ROS

Asset Turnover

sustainable growth 1
Sustainable Growth 1
  • ROE * (1-Dividend payout ratio)
gross profit margin
Gross Profit Margin
  • A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing.
gross profit margin1
Gross Profit Margin
  • Two main factors determine gross profit margins:
    • Competition – The more competition, the lower margins tend to be.
    • Product mix – The greater the volume of low profit/high turnover goods, the lower the margins.
  • Very relevant for comparisons within an industry -- not much outside
operating expense margin
Operating Expense Margin
  • Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category.
  • Expense ratios are calculated as follows:

Operating expense percentage = Expense item/Net sales

drivers of profit and growth1

Profitability and

Growth

Product Market

Strategies

Financial Market

Strategies

Operating

Management

Investment

Management

Financing

Management

Dividend

Policy

Managing

Working

Capital and

Fixed Assets

Managing

Revenue and

Expenses

Managing

Liabilities and

Equity

Managing

Payout

Drivers of Profit and Growth
investment management
Investment Management
  • Working Capital and Fixed Assets
    • Receivables
    • Inventory
    • LT operating assets
    • Payables
turnover
Turnover
  • Turnover measures relate to the productivity of company assets, i.e., how much capital is required to generate a specific sales volume?
  • Turnover ratios are calculated as follows:

Turnover = Sales volume/Average Assets

  • As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced.
evaluating financial management
Evaluating Financial Management
  • Short-term evaluations
  • Long-term evaluations
short term evaluations 1
Short-term evaluations 1
  • Current ratio
    • (Current assets) / (Current liabilities)
short term evaluations 2
Short-term evaluations 2
  • Quick ratio
    • (Cash + Short-term investments + Accounts Receivable) / (Current liabilities)
short term evaluations 3
Short-term evaluations 3
  • Operating cash flow ratio
    • (Cash flow from operations) / (Current liabilities)
long term evaluations
Long-term evaluations
  • Debt is typically cheaper that equity
  • Interest is tax deductible dividends are not
  • Can impose discipline on management (explicit contracts)
  • Easier to communicate proprietary information to private lenders than to public markets
standard ratios
Standard ratios
  • Liabilities-to-equity-ratio
  • Debt-to-equity ratio
  • Debt-to-capital
  • Interest coverage
liabilities to equity
Liabilities-to-equity
  • (Total Liabilities) / (Shareholders’ equity)
debt to equity
Debt-to-equity
  • (Short-term debt + Long-term debt) / (Shareholders’ equity)
interest coverage
Interest coverage
  • (Net income + Interest expense + Tax expense) / (Interest expense)
problems with ratios
Problems with Ratios
  • Mis-specification of deflator (e.g., size)
  • Accounting imperfections
  • Problem of assumed linearity
  • Ratio blow-up
  • Negative numbers. What do they mean?
  • Assumed 0 intercept.
  • Omitted variables
from business activities to financial statements

Business

Activities

From Business Activities to Financial Statements

Business

Environment

Business

Strategy

Accounting

System

Accounting

Environment

Accounting

Strategy

Financial

Statements

drivers of profit and growth2

Profitability and

Growth

Product Market

Strategies

Financial Market

Strategies

Operating

Management

Investment

Management

Financing

Management

Dividend

Policy

Managing

Working

Capital and

Fixed Assets

Managing

Revenue and

Expenses

Managing

Liabilities and

Equity

Managing

Payout

Drivers of Profit and Growth
cash flow analysis based on business activities
Cash Flow Analysis- Based on Business Activities

Operating Activities

Investment Activities

Financing Activities

cash flow
Cash Flow
  • The Direct Method
  • The Indirect Method
cash flow direct method
Cash Flow -- Direct Method
  • Recommended by the FASB
  • Most companies use the Indirect Method
cash flow indirect method 1
Cash Flow -- Indirect Method - 1

Net Income

Add

Non-cash income items

Plus/Less

Adjustments for receivables

inventories, payables, taxes

Equals

Cash Flow from Operations

cash flow indirect method 2
Cash Flow -- Indirect Method - 2

Cash Flow from Operations

PLUS/LESS

Cash flow - Investment activities

PLUS/LESS

Cash flow - Financing activities

EQUALS

Change in cash and cash

equivalents

from profit to cash
From Profit to Cash

Net Income

Cash Flow

From Oper.

bef. WC chgs,

Inv & Int

CF from op

After Wc Changes

before int

+ Noncash

charges

+/- Chg

in Working Cap

from profit to cash 2
From Profit to Cash -- 2

Cash Flow

From

Operations

CF

Free

Cash

Flow

+/- Interest

+/- Chg Fixed

Capital

free cash flow
Free Cash Flow
  • Jensen (1988) defines free cash flow as the cash left after managers have invested in all positive NPV projects
    • He also asserts that managers will invest in negative NPV projects rather pay it out to shareholders
  • The Free cash flow used in out context is the cash flow from operations plus the net investment cash flow
free cash flow and interest
Free cash Flow and Interest
  • You may add interest back. Depends on the purpose of the Free Cash Flow. See p. 6-3.
free cash flow from working capital
Free Cash Flow From Working Capital
  • Adjust Working Capital from operations for changes in current accounts to get Cash Flow From Operations
  • Add the net capital investment
  • What you get is Free Cash Flow