1. FINANCIAL STATEMENT ANALYSIS
CHAPTER 13

2. Fundamental Analysis Finance (chapter 12): Valuation techniques
Dividend discount model, P/E ratio
Need input as dividends and earnings prospects
Economics (chapter 11) (information from outside)
macro level: market
micro level: industries, firms
Accounting (chapter 13) (information from inside)
How to read reported data?
How to use financial data as inputs into stock valuation

3. Financial Statement Analysis
Objectives:
Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios.
Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis.
Measure a firm’s operating efficiency
Identify likely sources of biases in accounting data.

4. Income Statement Firm’s revenues and expenses during a specific period
Typical format Sale
- Operating expense
COGS
Depreciation
Operating Income (EBIT)
- Interest
Earning before tax (EBT)
- Tax
Net Income (NI)

5. Table 14.1 Consolidated Statement of Income

6. Balance Sheet
A snapshot of firm’s assets and liability at a given point in time
Asset Liabilities + Equity
1. Current Asset 1. Current liabilities
Cash Short term debt
Account receivable Account payable
Inventory Note payable
2. Fixed asset Long-term debt
3. Equity
Common stock
Retained earning
Total assets Total liabilities + equity

7. Table 14.2 Consolidated Balance Sheet

8. Statement of cash flow Net income: accounting profit
Cash flow: cash available on hand
Statement of cash flow: firm’s cash receipts and payments during a specific period

9. Table 14.3 Consolidated Statement of Cash Flows

10. Return on Equity (ROE) ROE=Net profit/Equity g = ROE × b
To estimate g, need to estimate ROE
Past ROE might not be good estimator of future ROE
ROE is linked with ROA and affected by firm’s financial policies
Watch out financial leverage:
ROA: Return on Assets=EBIT/Assets

11. Du Pont System: Decomposition of ROE
Net Profit
Pretax Profit x
EBIT
Sales
Assets
Equity
(1) x (2) x (3) x (4) x (5)
x Margin x Turnover x Leverage
Tax
Burden
Interest x

12. Problem 7, Chapter 13, P. 456
An analyst applies the DuPont system of financial analysis to the following data for a company:
Leverage ratio 2.2
Total asset turnover 2.0
Net profit margin 5.5%
Dividend payout ratio 31.8%
What is the company’s return on equity?

13. Ratio analyses Liquidity Ratios Activity or Mgmt Efficiency Ratios
Leverage Ratios
Profitability Ratios
Market Price Ratios

14.
Income statements
Sale revenue , , ,000
Cost of goods sold 55,000 66,000 79,200
Depreciation ,000 18,000 21,600
Selling and administrative expenses 15,000 18,000 21,600
Operating income ,000 36,000 43,200
Interest expense ,500 19,095 34,391
Taxable income (40% tax rate) 7,800 6,762 3,524
Net Income ,700 10,143 5,285
Balance Sheet (end of year)
Cash and marketable securities 50,000 60,000 72,000 86,400
Account receivables 25,000 30,000 36,000 43,200
Inventories 75,000 90, , ,600
Net plant and equipment 150, , , ,200
Total Asset , , , ,400
Account payable 30,000 36,000 43,200 51,840
Short-term debt 45,000 87, , ,432
Long-term debt 75,000 75,000 75,000 75,000
Total Liabilities , , , ,272
Shareholders’equity (1 mil shares outstanding) 150, , , ,128
Market price per common share at year-end

15. Liquidity ratios Current ratio = Current asset/ current liabilities
industry average (IA)
Trend: decreasing
poor standing relative to industry
Quick ratio = (current asset-inventory)/current liability
2003: quick ratio = (60+30)/( ) = 0.73

16. Management efficient ratios
Inventory turnover = COGS (excluding depreciation) / average inventory
How fast firm can sell inventory
2003: inventory turnover = (55-15)/{(75+90)/2)}= 0.485 IA
Slower in selling inventory
total asset turnover = sale/average total asset
2003: TA turnover = 100/(( )/2) = 0.30

17. Management efficient ratios
Average collection period (days receivable)
= average AR/sales per day
average time between date of sale and date payment received
2003: {(25+30)/2}/(100/365) = 100.4 IA
fixed asset turnover = sale/average of fixed asset
2003: 100/{( )/2}=0.600

18. Some comments on efficient management ratios
Total asset turnover of G.I. < industry average (0.3<0.4)
fixed asset turnover < Industry average (0.60 < 0.7): inefficient in using fixed asset
days receivable > industry average (100.4 > 60): receive cash longer than average, poor receivable procedure
Inventory turnover < industry average (0.485<0.5): turn inventory into sale slower than average, poor inventory management

19. Leverage ratios
Interest coverage (times interest earned) = EBIT/Interest expense
Leverage ratio:
Assets/Equity = 1 + Debt/Equity
Debt ratio = debt/equity

20. Profitability ratios ROA = EBIT/(average total assets)
ROE = NI/(average total equity)
Return on sale (profit margin) = EBIT/Sales

21. Market price ratios
Market-to-book = price per share/ book value per share
Lower market-to-book stocks: safer stocks
Price-to-earning (P/E) = market price per share / EPS
Low P/E, more bargain

22. Comparability Problems
GAAP (Generally Accepted Accounting Principles) is not unique
Inventory valuation: LIFO vs FIFO
Depreciation: Straight line vs Accelerated
Quality of earnings affected by:
Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities
GAAP vs IAS (International Accounting Standards)

23. Quality of Earnings: Areas of Accounting Choices
Allowance for bad debts:
When companies sell goods using credit, need to have allowance for bad debts. This is the estimate. Different companies have different estimates
Non-recurring items:
Unusual income, does not happen regularly.
Reserves management:
Different companies have different estimates of reserve for future investment
Stock options
Companies use stock options as bonus therefore it should be reported as expenses and need to price the options
Revenue recognition
Off-balance sheet assets and liabilities

24. Figure 13.3 Adjusted Versus Reported Price-Earnings Ratios