# 1 Investments: Financial Statement Analysis (review) Professor Scott Hoover Business Administration 365.

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1 Investments: Financial Statement Analysis (review) Professor Scott Hoover Business Administration 365

2 What questions are important in assessing the health of a firm?  Can the firm meet its debt obligations?  How well are assets being managed?  How profitable is the firm?  How risky is the firm?  What does the market think of the firm?   Ratio Analysis: interpretation of accounting and market information to assess the health of companies.

3  Why do we use ratios? We must consider things on a relative basis, not an absolute one.  e.g.: If one company has earnings of \$2,000,000 and another of \$1,000,000, which is better?  We can’t say because one company may be considerably bigger than the other. By using ratios, we are able to compare a company to its peers.  There are no hard-and-fast rules here. We can and should be creative by creating our own ratios to investigate specific areas.

4 The DuPont Relationship  We begin any analysis by examining the factors that contribute to the Return on Equity (ROE). Why?  Measures the return to shareholders  DuPont: ROE  NI / E = (NI / S)  (S / TA)  (TA / E ) = profit margin  asset turnover  leverage multiplier Note that ROE = ROA  (TA / E ) leverage multiplier = TA / E = TA / (TA - D) = 1 / (1 - debt ratio)

5  The DuPont approach is nice because it divides the firm into three tasks expense management (measured by the profit margin) asset management (measured by asset turnover) debt management (represented by the debt ratio or leverage multiplier)  The DuPont Method layered approach  examine the three components  dig deeper to identify possible weaknesses and strengths  dig deeper to find specific causes and hopefully to identify possible corrective action

6  factors of the profit margin sales cost of goods sold SG&A expenses R&D expenses depreciation interest taxes other expenses

7  factors of the asset turnover sales assets  current assets  cash  receivables  inventory  fixed assets  property  plant  equipment

8  factors of the leverage multiplier? Since we are concerned with whether or not the firm can meet its debt obligations, the “factors” don’t really matter. Instead…  current assets vs. current liabilities  current ratio  quick ratio  profits vs. debt payments  ROIC vs. after-tax interest  times-interest-earned Ultimately, we must assess debt on a cash flow basis.

9  Tools Common Size statements  express the balance sheet as a percentage of total assets  express the income statement as a percentage of sales Indexed statements  express the financial statements from one period as a percentage of some base year. See spreadsheet example

10 Profit Measures  Earnings (net income) accounting profits useful if not misleading (intentionally or otherwise), problem: does not reflect cash flow  includes Depreciation as an expense  ignores Capital Expenditures  uses Sales instead of receipts  uses Cost of Goods Sold instead of disbursements  EBITDA earnings without Depreciation, Interest, Taxes looks at earnings without the effects of financing and accounting decisions useful for understanding the ability to service debt problem: still does not reflect cash flow

11  Free Cash Flow measures the true cash flow of the firm in a given period, ignoring all financing-related cash flows and effects  Why ignore financing? can be misleading due to fixed asset effects  e.g., firm with old, fully depreciated equipment vs. one that has bought new equipment during the period. very useful when viewed over multiple periods provides the basis for the DCF model

12  Building the Free Cash Flow Equation How do earnings differ from cash flow?  Earnings include financing-related cash flows  adjust by using EBIT(1-T) (i.e., NOPAT) instead of earnings.  This is just net income assuming zero interest expense  Depreciation: subtracted, but is not a cash flow  adjust by adding depreciation  Capital Expenditures: ignored entirely  adjust by subtracting CapEx  Sales: recorded when made, not when cash is received.  adjust by subtracting the increase in receivables  Cost of Goods Sold: recorded when sold, not when the goods are paid for  adjust by subtracting the increase in inventory  and by subtracting the decrease in payables  Ignores cash needed for operations  adjust by subtracting the increase in operating cash  Note that most financial analysts ignore this effect entirely

13  Note the following subtracting the increases in cash, inventory, and receivables  subtracting the increase in current assets. adding the increase in payables  subtracting the decrease in current liabilities.  It follows that we subtract  CA-  CL.  Since Net Working Capital (NWC) is CA-CL, we subtract  NWC. This gives us our final equation  The Free Cash Flow Equation

14 FCF yield = FCF / EV  EV  enterprise value = equity + preferred stock + debt – cash & equivalents  i.e., EV is the amount of capital the firm has currently invested  Why do we subtract cash & equivalents? What happens if FCF yield < WACC?  company earns less than what it “owes” investors  higher sales  lower stock value!

15 Another Look at ROE  ROE = NI/E  NI = (EBIT-Interest)(1-t) = (EBIT-iD)(1-t) t  effective tax rate i  interest rate on debt D  amount of outstanding debt  We can rearrange these equations to get an expression that is more helpful.  First, recall that the Return on Invested Capital is

16 The ROIC is entirely independent of capital structure.   2 nd term of the last equation reflects the impact of capital structure on ROE.  The sign of the 2 nd term tells us whether or not debt helps or hurts ROE.

17  What do we learn from this exercise? i(1-t)ROIC  taking on more debt will decrease ROE. Implications  optimal strategy might be to use debt whenever the after-tax interest rate on marginal debt is below the ROIC and to use equity otherwise.  But….  How far into the future should we look? One data point is hardly sufficient to draw strong conclusions.  The equation does not incorporate risk.  The equation ignores other important factors. Revisiting our example…

18  Difficulties with Financial Statement Analysis Information is always old. Book values are reported instead of market values We often must compare companies at different points in time. Companies often use different terminology Managers may have incentives to mislead Financial statements often lack detail Industry averages are often misleading  Should we include negative ratios in averages?  Should we include outliers in averages?

19 Other Comments  We should always consider the notes to the financial statements. They give explanations for unusual items as well as notes that suggest an accounting explanation for a peculiarity.  We should always consider news stories on the company. They often contain statements concerning the financial condition of the firm and/or comments on things to expect. They provide updates since the date of the last financials.