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Chapter 2,3 Financial Statement Analysis

Chapter 2,3 Financial Statement Analysis. Taxes. Always changing Marginal vs. average tax rates Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income Other taxes. Example: Marginal Vs. Average Rates.

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Chapter 2,3 Financial Statement Analysis

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  1. Chapter 2,3 Financial Statement Analysis

  2. Taxes • Always changing • Marginal vs. average tax rates • Marginal – the percentage paid on the next dollar earned • Average – the tax bill / taxable income • Other taxes

  3. Example: Marginal Vs. Average Rates • Suppose your firm earns $4 million in taxable income. • What is the firm’s tax liability? • What is the average tax rate? • What is the marginal tax rate? • If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

  4. The Stockholders’ Report • The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP). • GAAP is authorized by the Financial Accounting Standards Board (FASB). • The four key financial statements required by the SEC for reporting to shareholders are the income statement, balance sheet, statement of retained earnings, and statement of cash flows.

  5. The Four Key Financial Statements The Income Statement • The income statement provides a financial summary of a company’s operating results during a specified period. • Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

  6. The Four Key Financial Statements The Balance Sheet • The balance sheet presents a summary of a firm’s financial position at a given point in time. • Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

  7. Market vs. Book Value • The balance sheet provides the book value of the assets, liabilities and equity. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decision-making process?

  8. The Four Key Financial Statements Statement of Retained Earnings • The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

  9. The Four Key Financial Statements Statement of Cash Flows • The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. • This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

  10. Consolidating International Financial Statements • FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets into dollars for consolidation with the parent company’s financial statements.

  11. 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

  12. Using Financial Ratios Types of Ratio Comparisons • Trend or time-series analysis • cross-sectional analysis • Combined Analysis

  13. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios

  14. Sample Balance Sheet Numbers in thousands

  15. Sample Income Statement Numbers in thousands, except EPS & DPS

  16. Computing Liquidity Ratios • Current Ratio = CA / CL • 1,553,725 / 1,525,453 = 1.02 times • Quick Ratio = (CA – Inventory) / CL • (1,553,725 – 295,225) / 1,525,453 = .825 times • Cash Ratio = Cash / CL • 6,489 / 1,525,453 = .004 times

  17. Computing Leverage Ratios • Total Debt Ratio = (TA – TE) / TA • (4,088,797 – 1,691,493) / 4,088,797 = .5863 times or 58.63% • The firm finances almost 59% of their assets with debt. • Debt/Equity = TD / TE • (4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times • Equity Multiplier = TA / TE = 1 + D/E • 1 + 1.417 = 2.417

  18. Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 1,738,125 / 295,255 = 5.89 times

  19. Computing Total Asset Turnover • Total Asset Turnover = Sales / Total Assets • 3,991,997 / 4,088,797 = .98 times • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

  20. Computing Profitability Measures • Profit Margin = Net Income / Sales • 425,764 / 3,991,997 = .1067 times or 10.67% • Return on Assets (ROA) = Net Income / Total Assets • 425,764 / 4,088,797 = .1041 times or 10.41% • Return on Equity (ROE) = Net Income / Total Equity • 425,764 / 1,691,493 = .2517 times or 25.17%

  21. Computing Market Value Measures • Market Price = $61.625 per share • Shares outstanding = 205,838,594 • PE Ratio = Price per share / Earnings per share • 61.625 / 2.17 = 28.4 times • Market-to-book ratio = market value per share / book value per share • 61.625 / (1,691,493,000 / 205,838,594) = 7.5 times

  22. See Table 3.5 for summary

  23. Using the Du Pont Identity • ROE = PM * TAT * EM • Profit margin is a measure of the firm’s operating efficiency – how well does it control costs • Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets • Equity multiplier is a measure of the firm’s financial leverage

  24. Payout and Retention Ratios • Dividend payout ratio = Cash dividends / Net income • 0.86 / 2.17 = .3963 or 39.63% • Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio • 1.31 / 2.17 = .6037 = 60.37% • Or 1 - .3963 = .6037 = 60.37%

  25. The Internal Growth Rate • The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

  26. The Sustainable Growth Rate • The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

  27. Determinants of Growth • Profit margin – operating efficiency • Total asset turnover – asset use efficiency • Financial leverage – choice of optimal debt ratio • Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

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