Essentials of Financial Statement Analysis Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 5

Learning objectives How cause of change analysis and common-size and trend statements illuminate financial statement patterns and shed light on business activities. How competitive forces and business strategies affect firms’ financial statements. How return on assets (ROA) is used to evaluate profitability. How return on equity (ROCE) can be used to assess the effect of financial leverage on profitability. How short-term liquidity risk and long-term solvency risk are assessed. How to use the Statement of Cash Flows to assess credit and risk. How to interpret the results of an analysis of profitability and risk. How to prepare and analyze business segment disclosures. 5-2

Financial statement analysis: Tools and approaches Approaches used with each tool: Time-series analysis: the same firm over time (e.g., Wal-Mart in 2012 and 2010) Common size statements Trend statements 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2012). Financial ratios (e.g., ROA and ROCE) 3. Benchmark comparison: using industry norms or predetermined standards. 5-3

Evaluating accounting “quality” Analysts use financial statement information to “get behind the numbers”. However, financial statements do not always provide a complete and faithful picture of a company’s activities and condition. 5-4

How the financial accounting “filter” sometimes works GAAP puts capital leases on the balance sheet, but operating leases are “off-balance-sheet”. Managers can choose any of several different inventory accounting methods. Managers have some discretion over estimates such as “bad debt expense”. Managers have some discretion over the timing of business transactions such as when to buy advertising. 5-5

Whole Foods Market: Comparative Income Statement 5-6

Whole Foods Market: Simple Financial Model Representation of Net Income 5-7

Whole Foods Market: Cause-of-Change Analysis 5-8

Whole Foods Market: Common-Size Statements 5-9

Whole Foods Market: Trend Statements 5-10

Whole Foods Market: Store Analysis 5-11

Whole Foods Market: Comparative Balance Sheet 5-12

Whole Foods Market: Comparative Balance Sheet 5-13

Whole Foods Market: Common-Size Analysis of Assets 5-14

Whole Foods Market: Trend Analysis of Assets 5-15

Whole Foods Market: Common-Size Analysis of Liabilities and Shareholders’ Equity 5-16

Whole Foods Market: Trend Analysis of Liabilities and Shareholders’ Equity 5-17

Whole Foods Market: Comparative Cash Flow Statements 5-18

Whole Foods Market: Common-Size and Trend Analysis of Selected Cash Flow Items 5-19

Financial ratios and profitability analysis Operating profit margin EBI Sales Return on assets ROA= EBI Average assets X Asset turnover Sales Average assets Analysts do not always use the reported earnings, sales and asset figures. Instead, they often consider three types of adjustments to the reported numbers: Remove non-operating and nonrecurring items to isolate sustainable operating profits. Eliminate after-tax interest expense to avoid financial structure distortions. Eliminate any accounting quality distortions (e.g., off-balance operating leases). 5-20

How can ROA be increased? There are just two ways: Increase the operating profit margin, or Increase the intensity of asset utilization (turnover rate). Asset turnover ROA = EBI Average assets Sales Operating profit margin 5-21

ROA and competitive advantage: Grocery industry Competition works to drive down ROA toward the competitive floor. Companies that consistently earn an ROA above the floor are said to have a competitive advantage. However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. Average ROA is 4.6% Different points on the curve have different combinations of margin and turnover Both Harris Teeter Supermarkets (HTSI) and Safeway, Inc. (SWY) both earned about the average industry return of 4.6% but Harris did it with higher margins and lower turnover than Safeway Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA). 5-22

Profitability and financial leverage Good earnings year: ROCE is higher for HiDebt because leverage increased the return to shareholders due to the after-tax interest payment of only 6% (10% x (1-40%) Neutral earnings year: Leverage neither helps nor harms shareholders Bad earnings year: After-tax interest charges wipe out earnings, and ROCE is 0% for HiDebt 5-23

Components of ROCE Return on assets (ROA) Return on common EBI Average assets X Return on common equity (ROCE) Common earnings leverage Net income available to common shareholders EBI Net income available to common shareholders Average common shareholders’ equity Financial structure leverage Average assets Average common shareholders’ equity 5-24

Financial statement analysis and accounting quality Financial ratios, common-size statements, and trend statements are extremely powerful tools. But they can be no better than the data from which they are constructed. Be on the lookout for accounting distortions when using these tools. Examples include: Nonrecurring gains and losses Differences in accounting methods Differences in accounting estimates GAAP implementation differences Historical cost convention 5-25

Liquidity, Solvency, and Credit Analysis: Overview Credit risk refers to the risk of nonpayment by the borrower. The lender risks losing interest payments and loan principal. A borrower’s ability to repay debt is driven by its capacity to generate cash from operations, asset sales, or external financial markets. A company’s willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment. 5-26

Liquidity, Solvency, and Credit Analysis: Balancing cash sources and needs Figure 5.4 5-27

Liquidity Analysis: Short-term liquidity ratios Current ratio = Current assets Current liabilities Quick ratio = Cash + Marketable securities + Receivables Liquidity ratios Short-term liquidity Accounts receivable turnover = Net credit sales Average accounts receivable Inventory turnover = Cost of goods sold Average inventory Accounts payable turnover = Inventory purchases Average accounts payable Activity ratios 5-28

Liquidity Analysis: Comparison of Operating and cash conversion cycle 5-29

Liquidity Analysis: Credit Risk Analysis: Short-Term Liquidity 5-30

Liquidity Analysis: Long-term solvency Long-term debt to assets = Long-term debt Total assets Long-term debt to tangible assets = Total tangible assets Coverage ratios Debt ratios Long-term solvency Interest coverage = Operating incomes before taxes and interest Interest expense Operating cash flow to total liabilities Cash flow from continuing operations Average current liabilities + long-term debt = 5-31

Credit risk: Financial ratios and default risk A firm defaults when it fails to make principal or interest payments. Lenders can then: Adjust the loan payment schedule. Increase the interest rate and require loan collateral. Seek to have the firm declared insolvent. Financial ratios play two roles in credit analysis: They help quantify the borrower’s credit risk before the loan is granted. Once granted, they serve as an early warning device for increased credit risk. Default Rates among public companies by S&P credit rating: 1981-2008 5-32

Default frequency: Probability of default within five years among public companies: 1980-1999 5-33

Summary Financial ratios, common-size statements and trend statements are powerful tools. However: There is no single “correct” way to compute financial ratios. Financial ratios don’t provide the answers, but they can help you ask the right questions. Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons. 5-34