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1 CHAPTER 5 ESSENTIALS of FINANCIAL STATEMENT ANALYSIS Adopted from Slides Authored by Brian Leventhal University of Illinois at Chicago University of.

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Presentation on theme: "1 CHAPTER 5 ESSENTIALS of FINANCIAL STATEMENT ANALYSIS Adopted from Slides Authored by Brian Leventhal University of Illinois at Chicago University of."— Presentation transcript:

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2 1 CHAPTER 5 ESSENTIALS of FINANCIAL STATEMENT ANALYSIS Adopted from Slides Authored by Brian Leventhal University of Illinois at Chicago University of Illinois at Chicago FINANCIAL REPORTING & ANALYSIS BY REVSINE – COLLINS – JOHNSON 2 nd Edition

3 2 I.Basic Approaches financial trends A.Time-series analysis helps identify financial trends over time for a single company or business unit.

4 3 single moment in time. B.Cross-sectional analysis helps identify similarities and differences across companies or business units at a single moment in time. I.Basic Approaches

5 4 time-series analysis In time-series analysis, the benchmark may be the change in performance or health each year.

6 5 I.Basic Approaches cross-sectional analysis In cross-sectional analysis, the benchmark may be the performance or health of a particular competitor or industry averages.

7 6 II.Quaker Oats Example Common size and trend statements B.Common size and trend statements provide a convenient way to organize financial statement information……… so that major financial components and changes are easily recognized.

8 7 1.Common size income statements recast each statement item as a percentage of sales for that period. 2.Trend statements recast each statement item as a percentage of that item in a base year. II.Quaker Oats Example

9 Comparative Income Statements ($ in millions) Sales $4,725.2 $ $5,015.7 $5,199.0 $5,954.0 Cost of Goods Sold 2, , , , ,294.4 Gross Profit 2, , , , ,659.6 Selling, G&A Exp. 1, , , , ,358.8 (Gains) losses on (2.3) ,486.3 (113.4) (1,053.5) divestitures, restructurings and asset impairment Interest Expense Other (revenues) exp Pre-tax income (1,064.3) ,220.5 Income taxes (133.4) Net Income (loss) (930.9)

10 II.Quaker Oats Example –Common Size % Sales Comparative Income Statements ($ in millions) Sales Cost of Goods Sold Gross Profit Selling, G&A Exp (Gains) losses on –2.2 –17.7 divest.,restructurings & asset impairment Interest Expense Other (revenues) exp Pre-tax income Income taxes Net Income (loss)

11 II.Quaker Oats Example –Trend (1995=100%) Comparative Income Statements ($ in millions) Sales Cost of Goods Sold Gross Profit Selling, G&A Exp (Gains) losses on divest.,restructurings & asset impairment Interest Expense Other (revenues) exp Pre-tax income Income taxes Net Income (loss)

12 11 III.Profitability, Competition, & Business Strategy A.Financial ratios are another powerful tool that analysts use in evaluating profit performance and assessing credit risk.

13 12 III.Profitability, Competition, & Business Strategy profit performance B. Most evaluations of profit performance begin with the Return on Assets (ROA) ratio: ROA = net operating profit after taxes average assets average assets

14 13 III.Profitability, Competition, & Business Strategy profit performance B. Most evaluations of profit performance begin with the return on assets (ROA) ratio: ROA = net operating profit after taxes average assets average assets 2.Analysts can isolate a companys sustainable operating profits by removing nonoperating or nonrecurring items from reported earnings.

15 14 III.Profitability, Competition, & Business Strategy profit performance B. Most evaluations of profit performance begin with the return on assets (ROA) ratio: ROA = net operating profit after taxes average assets average assets 3.After-tax interest expense is eliminated from the profit calculation so that operating profitability comparisons over time are not clouded by differences in financial structure.

16 15 III.Profitability, Competition, & Business Strategy profit performance B. Most evaluations of profit performance begin with the return on assets (ROA) ratio: ROA = net operating profit after taxes average assets average assets 4.Adjustments to eliminate distortions to both earnings and assets for items such as the capital and operating lease, for example mentioned earlier should be done.

17 16 III.Profitability, Competition, & Business Strategy increase C. A company can increase its ROA in two different ways: ROA = net operating profit after taxes average assets average assets 1.By increasing the operating profit margin. 2.By increasing the intensity of asset utilization. 3.In other words, ROA can be thought of as: Operating profit margin asset turnover

18 17 III.Profitability, Competition, & Business Strategy increase C. A company can increase its ROA in two different ways: ROA = net operating profit after taxes average assets average assets Operating profit margin asset turnover Net operating profit after taxes(NOPAT) Sales Average Assets

19 18 III.Profitability, Competition, & Business Strategy D. ROA and competitive advantage: Operating profit margin asset turnover Net operating profit after taxes(NOPAT) Sales Average Assets superior performance 5.There are only two strategies for achieving superior performance in any business: a.One strategy is product and service differentiation in order to focus customer attention on unique product or service attributes to gain customer loyalty and attractive profit margins.

20 19 III.Profitability, Competition, & Business Strategy D. ROA and competitive advantage: Operating profit margin asset turnover Net operating profit after taxes(NOPAT) Sales Average Assets superior performance 5.There are only two strategies for achieving superior performance in any business: Low-cost leadership b. Low-cost leadership focuses customer attention on product pricing. The goal is to under price the competition, achieve highest sales volumes, and still make a profit on each sale.

21 20 III.Profitability, Competition, & Business Strategy D. ROA and competitive advantage: Operating profit margin asset turnover Net operating profit after taxes(NOPAT) Sales Average Assets superior performance 5.There are only two strategies for achieving superior performance in any business: c.Few companies actually pursue one strategy to the exclusion of the other. Rather, they try to develop brand loyalty while controlling cost.

22 21 IV. Credit Risk & Capital Structure A.Credit risk refers to the ability and willingness of a borrower to pay its debt.

23 22 IV. Credit Risk & Capital Structure A.Credit risk refers to the ability and willingness of a borrower to pay its debt. 1.Ability to repay debt is determined by capacity to generate cash from operations, asset sales, or external financial markets in excess of cash needs.

24 23 IV. Credit Risk & Capital Structure A.Credit risk refers to the ability and willingness of a borrower to pay its debt. 2.Willingness to pay depends on which competing cash need is viewed as the most pressing at the moment.

25 24 IV. Credit Risk & Capital Structure A.Credit risk refers to the ability and willingness of a borrower to pay its debt. 3.The statement of cash flows is an important source of information for analyzing a companys credit risk. Financial ratios are also useful for this purpose.

26 25 IV. Credit Risk & Capital Structure B.Credit risk analysis using financial ratios typically involves an assessment of liquidity and solvency. 1.Liquidity refers to the companys short- term ability to generate cash for working capital needs and immediate debt repayment needs.

27 26 IV. Credit Risk & Capital Structure B.Credit risk analysis using financial ratios typically involves an assessment of liquidity and solvency. 2.Solvency refers to the long-term ability to generate cash internally or from external sources in order to satisfy plant capacity needs, fuel growth, and repay debt when due.

28 27 IV. Credit Risk & Capital Structure C.Short-term liquidity: Current = Current Assets Ratio Current Liabilities Ratio Current Liabilities 1. Reflects cash & other current assets that will be converted into cash in the normal operating cycle.

29 28 IV. Credit Risk & Capital Structure C.Short-term liquidity: Quick = Cash+ Receivables+Marketable Securities Ratio Current Liabilities Ratio Current Liabilities liquidity 2. Inventory is not included, providing a more short-run reflection of liquidity, since few businesses can instantaneously convert their inventories into cash.

30 29 a.This ratio tells users the proportion of yearly sales that the average receivables balance represents. This ratio will be correspondingly larger for firms with cash sales that are a larger proportion of total sales. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches. A/R Turnover = N e t S a l e s Average A/R Average A/R

31 30 b.This ratio tells users the average collection period for accounts receivable. This should be compared to the credit period allowed by the company. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches. Days Receivables = 365 D a y s Outstanding A/R Turnover

32 31 c.This ratio tells users the proportion of sales that the average inventory balance represents. A higher ratio may indicate: i. More efficient operations, or ii. Adoption of a low-cost leadership strategy. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches. Inventory Turnover =Cost of Goods Sold Ratio Average Inventory Ratio Average Inventory

33 32 d. This ratio tells users the average number of days that inventory is held in storage. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches. Days Inventory = 365 D a y s Held Inventory Turnover Held Inventory Turnover

34 33 e. This ratio, and its counterpart that follows, helps analysts understand the companys pattern of payment to suppliers. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches. Accounts Payable =Inventory Purchases Turnover Average A/P Turnover Average A/P

35 34 Show on average how long the company takes to payoff Accounts Payable. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches. Days A/P = 365 D a y s Days A/P = 365 D a y s Outstanding A/P Turnover

36 35 The level of concern is negatively correlated with the level of operating cash flow. IV. Credit Risk & Capital Structure Activity ratios 3.Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches Cash Inflow Vs Cash Outflow Mismatching Cash Inflow Vs Cash Outflow Mismatching Days Receivable Outstanding + Days Inventory Held Days Receivable Outstanding + Days Inventory Held - Days A/P Outstanding

37 36 IV. Credit Risk & Capital Structure D.Long-term solvency: 1.Debt ratios provide information about the amount of long-term debt in a companys financial structure.

38 37 2.Reflects the proportion of each asset dollar financed with long-term debt. IV. Credit Risk & Capital Structure D.Long-term solvency: Long-Term Debt = Long-Term Debt Long-Term Debt = Long-Term Debt to Total Assets Total Assets to Total Assets Total Assets

39 38 3.The adjustment to remove intangible assets is intended to removesoft assets, i.e., those that are difficult to value reliably. IV. Credit Risk & Capital Structure D.Long-term solvency: Long-Term Debt = Long-Term Debt Long-Term Debt = Long-Term Debt to Tangible Assets Total Tangible Assets to Tangible Assets Total Tangible Assets

40 39 4.Ability to generate a stream of inflows sufficient to make principal and interest payments. The interest coverage ratio is commonly used for this purpose. IV. Credit Risk & Capital Structure D.Long-term solvency: Interest = Operating Income before taxes & Interest Interest = Operating Income before taxes & Interest Coverage Interest Expense Coverage Interest Expense

41 40 5. The ability of a company to generate cash flows from operations in order to service both short-term and long-term borrowings. IV. Credit Risk & Capital Structure D.Long-term solvency: Operating Operating Cash Flows = Cash Flow from continuing operations to Total Avg. C/L + Long-Term Debt to Total Avg. C/L + Long-Term DebtLiabilities

42 41 V.Return on Equity & Financial Leverage Profitabilitycredit risk return A.Profitability and credit risk both influence the return that common shareholders earn on their investment in the company.

43 42 provided by shareholders B.Measures a companys performance in using capital provided by shareholders to generate earnings. Net Income Available to Net Income Available to Return on common shareholders Return on common shareholders Common Equity = Average Common (ROCE) Shareholders Equity Common Equity = Average Common (ROCE) Shareholders Equity V.Return on Equity & Financial Leverage

44 43 a.The common earnings leverage ratio shows the proportion of NOPAT that belongs to common shareholders. Net Income Available to Net Income Available to Return on common shareholders Return on common shareholders Common Equity = Average Common Common Equity = Average Common (ROCE) Shareholders Equity (ROCE) Shareholders Equity V.Return on Equity & Financial Leverage C. Components of ROCE: ROCE = ROA x Common earning lev. x Fin. structure lev. NOPAT AVG. Assets NI avail to CS NOPAT AVG. Assets AVG Common SE xx

45 44 finance assets b.The financial structure leverage ratio measures the degree to which the company uses common shareholders capital to finance assets. Net Income Available to Net Income Available to Return on common shareholders Return on common shareholders Common Equity = Average Common Common Equity = Average Common (ROCE) Shareholders Equity (ROCE) Shareholders Equity V.Return on Equity & Financial Leverage C. Components of ROCE: ROCE = ROA x Common earning lev. x Fin. structure lev. NOPAT AVG. Assets NI avail to CS NOPAT AVG. Assets AVG Common SE xx

46 45 VI.Earnings, Cash Earnings, or EBITDA? earnings A.There are several measures of earnings that may be used in press releases.

47 46 VI.Earnings, Cash Earnings, or EBITDA? earnings A. There are several measures of earnings that may be used in press releases. 1.GAAP earnings are those reported to the SEC using GAAP.

48 47 VI.Earnings, Cash Earnings, or EBITDA? earnings A. There are several measures of earnings that may be used in press releases. EBITDA 2.EBITDA is earnings before interest, taxes, depreciation, and amortization.

49 48 VI.Earnings, Cash Earnings, or EBITDA? earnings A. There are several measures of earnings that may be used in press releases. 3.Cash earnings is generally defined as earnings before goodwill amortization. Pro forma earnings is a variant that excludes a variety of costs that are routinely included in GAAP earnings. One popular operationalization is net income before goodwill amortization and one-time costs such as merger integration costs.

50 49 VI.Earnings, Cash Earnings, or EBITDA? earnings A. There are several measures of earnings that may be used in press releases. 3.Cash earnings is generally defined as earnings before goodwill amortization. b.Standard definitions for these benchmarks do not currently exist.

51 50 B.Analysts must be wary and look behind the numbers to see what is really going on! VI.Earnings, Cash Earnings, or EBITDA?


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