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CHAPTER 5 ESSENTIALS OF FINANCIAL STATEMENT ANALYSIS

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**Roadmap Two concepts Profitability analysis Credit risk analysis**

Cross-sectional vs. Time-series Common-size vs. Trend Statement Profitability analysis Credit risk analysis Return on equity and financial leverage analysis

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Basic Approaches A. Time-series analysis helps identify financial trends over time for a single company or business unit. B. Cross-sectional analysis helps identify similarities and differences across companies or business units at a single moment in time.

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**Common size and trend statements**

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.

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**Profitability, Competition, and Business Strategy**

A. Financial ratios are another powerful tool that analysts use in evaluating profit performance and assessing credit risk.

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Profitability, Competition, and Business Strategy Most evaluations of profit performance begin with the return on assets (ROA) ratio. ROA = NOPAT/Average Assets 1. A company’s sustainable operating profits are isolated by removing nonoperating or nonrecurring items from reported earnings.

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**Profitability, Competition, and Business Strategy**

2. 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. 3. Adjustments to eliminate distortions to both earnings & assets for items such as off-balance sheet operating leases.

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**Profitability, Competition, and Business Strategy**

A company can increase its ROA in two different ways: 1. By increasing the operating profit margin. 2. By increasing the intensity of asset utilization.

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**Profitability, Competition, and Business Strategy**

In other words, ROA can be thought of as: a. Oper. profit margin asset turnover , or b. NOPAT/SALES X SALES/AVG. ASSETS

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**Credit Risk and Capital Structure A**

Credit Risk and 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. 2. Willingness to pay depends on which competing cash need is viewed as the most pressing at the moment. 3. The statement of cash flows is an important source of information for analyzing a company’s credit risk. Financial ratios are also useful for this purpose.

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**Credit Risk and Capital Structure B**

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

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**Credit Risk and Capital Structure Short-term liquidity:**

Current Ratio = CA/CL reflects cash as well as amounts that will be converted into cash in the normal operating cycle.

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**Credit Risk and Capital Structure Short-term liquidity:**

Quick Ratio = (CA-INV)/CL Inventory is eliminated, providing a more short-run reflection of liquidity, since few businesses can instantaneously convert their inventories into cash.

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**Credit Risk and Capital Structure Short-term liquidity:**

A/R Turnover = Net Sales / Avg. A/R 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.

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**Credit Risk and Capital Structure Short-term liquidity:**

Days Receivable Out. = A/R Turnover This ratio tells users the average collection period for accounts receivable. This should be compared to the credit period allowed by the company.

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**Credit Risk and Capital Structure Short-term liquidity:**

Inventory Turnover Ratio = COGS / AVG.INV. 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.

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**Credit Risk and Capital Structure Short-term liquidity:**

Days Inventory Held = Days INV. TURNOVER This ratio tells users the average number of days that inventory is held in storage.

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**Credit Risk and Capital Structure Short-term liquidity:**

A/P Turnover = Inventory Purchases Avg. A/P. This ratio, and its counterpart that follows, helps analysts understand the company’s pattern of payment to suppliers.

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**Credit Risk and Capital Structure Short-term liquidity:**

Days A/P Outstanding = days A/P Turnover

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**Credit Risk and Capital Structure Short-term liquidity:**

+ days receivable outstanding + days inventory held - days accounts payable outstanding Difference to get a measure of the mismatching of cash inflows and outflows. The level of concern is negatively correlated with the level of operating cash flow.

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**Credit Risk and Capital Structure Long-term solvency:**

1. Debt ratios provide information about the amount of long-term debt in a company’s financial structure.

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**Credit Risk and Capital Structure Long-term solvency:**

2. L-Term Debt to Assets = Long-Term Debt Total Assets reflects the proportion of each asset dollar financed with long-term debt.

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**Credit Risk and Capital Structure Long-term solvency:**

3. L-T Debt to Tangible Assets = L-T Debt Total Tangible Assets The adjustment to remove intangible assets is intended to remove “soft” assets, i.e., those that are difficult to value reliably.

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**Credit Risk and Capital Structure Long-term solvency:**

4. Interest Coverage = Operating Income before taxes &Int. Exp Interest Expense While debt ratios are useful for understanding the financial structure of a company, they provide no information about its ability to generate a stream of inflows sufficient to make principal and interest payments. The interest coverage ratio is commonly used for this purpose.

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**Credit Risk and Capital Structure Long-term solvency:**

5. Operating Cash Flows to Total Liabilities = CFOPA Avg. CL +L-T Debt This ratio shows the ability of a company to generate cash flows from operations in order to service both short-term and long-term borrowings.

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**Return on Equity and Financial Leverage**

A. Profitability and credit risk both influence the return that common shareholders earn on their investment in the company.

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**Return on Equity and Financial Leverage**

B. Return on C/E (ROCE) = NI available to Common Shareholders Avg. Common SE This ratio measures a company’s performance in using capital provided by shareholders to generate earnings.

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**Return on Equity and Financial Leverage C. Components of ROCE:**

1. ROCE = ROA common earnings leverage financial structure leverage or

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**Return on Equity and Financial Leverage C. Components of ROCE:**

NOPAT X NI AVAIL. TO COMMON X AVG. ASSETS AVG. ASSETS NOPAT AVG. COMMON SE a. The common earnings leverage ratio shows the proportion of NOPAT that belongs to common shareholders. b. The financial structure leverage ratio measures the degree to which the company uses common shareholders’ capital to finance assets.

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**Roadmap Two concepts Profitability analysis Credit risk analysis**

Cross-sectional vs. Time-series Common-size vs. Trend Statement Profitability analysis Credit risk analysis Return on equity and financial leverage analysis

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