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1 John V. Balanquit johnthecpa.wikispaces.com
Financial Statement Analysis John V. Balanquit johnthecpa.wikispaces.com

2 Learning Objectives Why return on equity is one of the key financial ratios used for assessing a firm’s performance, and how it can be used to provide information about three areas of a firm’s operations Why outsiders and insiders are concerned with a company’s ratios related to leverage, efficiency, productivity, liquidity and value How to calculate, interpret, and evaluate the key ratios related to leverage, efficiency, productivity, liquidity, and value Why financial forecasts provide critical information for both management and external parties How to prepare financial forecasts by using the percentage of sales approach How external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth rates.

3 Financial Statement Analysis and Forecasting
The DuPont System Financial Statement Analysis and Forecasting

4 A Framework for Financial Analysis Return on Equity (ROE) and DuPont System
The DuPont System gives a framework for the analysis of financial statements through the decomposition of the Return on Equity ratio (See Figure 4 -2 that illustrates the constituent parts of ROE ) [4-1]

5 Framework for Financial Analysis Du Pont System
4 - 2 FIGURE GOOD OR BAD? LEVERAGE RATIOS EFFICIENCY RATIOS PRODUCTIVITY RATIOS ROE

6 A Framework for Financial Analysis DuPont System and Decomposition of ROE
As Figure 4 – 2 illustrates, ROE is a function of: Corporate use of leverage (use of debt) Efficiency ratios (ability of the firm to control costs in relationship to sales) Productivity ratios (the degree to which the firm can generate sales in relationship to assets employed) [4-1]

7 A Framework for Financial Analysis Return on Equity (ROE) and DuPont System
ROE is not a pure ratio because it involves dividing an income statement item (flow) by a balance sheet (stock) item. Instead of using ending SE, many argue you should use average SE (beginning SE plus ending SE divided by 2) because SE changes over the year as income is earned and retained earnings grow. [4-1]

8 A Framework for Financial Analysis Return on Equity (ROE)
[4- 7] ROA Leverage ROE when decomposed shows that it is a function of the return earned on assets and of the leverage used by the firm.

9 A Framework for Financial Analysis Return on Total Assets
ROA shows the ratio of income to assets that have been used to produce them. ROA can be further decomposed as shown and the following slide [4-2]

10 A Framework for Financial Analysis Return on Assets (ROA)
ROA is the product of the net profit margin and the sales to total asset ratio: The sales cancel and we are left with NI / TA [4- 6]

11 A Framework for Financial Analysis Leverage Ratio
If ROA is multiplied by TA and divided by SE, the TA’s cancel out and produces ROE. TA / SE is the leverage ratio It measures how many dollars of total assets are supported by each dollar of Shareholders Equity. [4-3]

12 DuPont System The DuPont system provides a good starting point for any financial analysis It shows that financial strength comes from many sources (profitability, asset utilization, leverage) It reinforces the concept that good financial analysis requires looking at each ratio in the context of the other Whenever you are presented with financial statements it is important that you look at a sample of ratios from each major category to identify areas of strength and weakness (Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans)

13 A Framework for Financial Analysis Return on Equity (ROE) and the DuPont System

14 Interpreting Ratios A ratio is just one number over another number – by itself, there is little ‘information’ To judge whether a ratio is ‘good’ or ‘bad’ requires that it be compared to something else such as: The company’s own ratios over time to ascertain trends Other comparable companies or industry averages (Table 4 -2 illustrates Rothmans DuPont ratios over time)

15 A Framework for Financial Analysis Interpreting Ratios
Do you see trends here? What factors are driving the trend in ROE?

16 A Framework for Financial Analysis Interpreting Ratios
Do you see trends here? What factors are driving the trend in ROE? How do these results compare to Rothmans on the previous slide?

17 Financial Statement Analysis and Forecasting
Leverage Ratios Financial Statement Analysis and Forecasting

18 Leverage Leverage = magnification
Financial leverage occurs when a firm uses sources of financing that carry a fixed cost (such as long-term debt), and uses this to generate greater returns that result in magnified returns to shareholders. Leverage means magnification of either profits or losses.

19 Leverage Ratios Include: Debt ratio Debt to equity ratio
Times interest earned ratio Cash flow to debt ratio

20 Leverage Ratios Debt Ratio
Is a stock ratio indicating the proportion of total assets financed by debt at a particular point in time (the balance sheet date) [4- 8]

21 Leverage Ratios Debt-Equity Ratio
Is a stock ratio indicating the proportion that total debt represents in relationship to the shareholders equity (common stock and retained earnings) at the balance sheet date. [4- 9]

22 Leverage Ratios Times Interest Earned (TIE)
Is an income statement (flow) ratio indicating the number of times the firm’s pre-tax income exceeds its fixed financial obligations to its lenders (debt holders) [4- 10]

23 Leverage Ratios Cash Flow to Debt Ratio
Measures how long it would take to payoff a firm’s debt (D) [4- 11]

24 Leverage Ratios Cash Flow to Debt Ratio
Which firm exhibits greater use of leverage? Which exhibits greater capacity to take on and service debt?

25 Financial Statement Analysis and Forecasting
Efficiency Ratios Financial Statement Analysis and Forecasting

26 Efficiency Ratios Efficiency ratios measure how efficiently a dollar of sales is turned into profits. Gives insight to the firm’s cost structure Whether problems exist with variable costs or fixed costs (overhead) or both

27 Efficiency Ratios Include: Degree of total leverage Break-even point
Gross profit margin Operating margin

28 Efficiency Ratios Interpreting Ratios
The focus of efficiency ratios is with the income statement. This example demonstrates the leverage effect of using fixed costs in lieu of variable costs in the cost structure. Sales varied by +/- of 10% yet profits varied by +/- 40%.

29 Efficiency Ratios Degree of Total Leverage Ratio
An income statement ratio that measures the exposure of profits to changes in sales. The greater the DTL, the greater leverage effect. [4- 12]

30 Efficiency Ratios Break Even Point
Estimates the volume of units that must be produced and sold in order for the firm to cover all costs both fixed and variable. The break even point tends to increase as the use of fixed costs increases. [4- 13]

31 Efficiency Ratios Gross Profit Margin
Demonstrates the percentage of sales that are available to cover fixed (period) costs and financing expenses after variable costs have been paid. A declining gross profit margin raises concerns about the firm’s ability to control variable costs such as direct materials and direct labour. [4- 14]

32 Efficiency Ratios Operating Margin
Operating margin measures the cumulative effect of both variable and period costs on the ability of the firm to turn sales into operating profits to cover, interest, taxes, depreciation and amortization (EBITDA). [4- 15]

33 Efficiency Ratios Interpreting Ratios
Which firm is able to produce a greater percentage of sales as profits? Which firm is able to produce strong and consistent profitability?

34 Financial Statement Analysis and Forecasting
Productivity Ratios Financial Statement Analysis and Forecasting

35 Productivity Ratios Measure the ability of the firm to generate sales from the assets that it employs. Excessive investment in assets with little or no increase in sales reduces the rate of return on both assets and equity (ROA) and (ROE)

36 Productivity Ratios Include: Receivables turnover
Average collection period (ACP) Inventory turnover Average days sales in inventory (ADSI) Fixed asset turnover

37 Productivity Ratios Receivables Turnover
Measures the sales generated by every dollar of receivables. [4- 16]

38 Productivity Ratios Average Collection Period
Estimates the number of days it takes a firm to collect on its accounts receivable. If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate. [4- 17]

39 Productivity Ratios Inventory Turnover
Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year. A ratio that involves both ‘stock’ and ‘flow’ values Is strongly a function of ending inventory value…managers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.) [4- 18]

40 Productivity Ratios Inventory Turnover
When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales. Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost. [4- 19]

41 Productivity Ratios Average Days Sales in Inventory (ADSI)
Estimates the number of days of sales tied up in inventory (based on ending inventory values) [4- 20]

42 Productivity Ratios Fixed Asset Turnover
Estimates the number of dollars of sales produced by each dollar of net fixed assets. [4- 21]

43 Productivity Ratios Interpreting Ratios
Which firm has been improving its efficiency ratios to a greater degree?

44 Financial Statement Analysis and Forecasting
Liquidity Ratios Financial Statement Analysis and Forecasting

45 Liquidity Ratios Measure the ability of the firm to meet its maturing financial obligations through liquid (cash and near cash) resources Include: Working capital ratio Current ratio Quick (acid-test) ratio

46 Liquidity Ratios Working Capital Ratio
Measures the percentage of total assets that is invested in current assets. Helps to analyze capital intensity as well as corporate liquidity. [4- 22]

47 Liquidity Ratios Current Ratio
Measures the number of dollars of current assets for each dollar of current liabilities. Helps to estimate the capacity of the firm to meet its maturing financial obligations. [4- 23]

48 Liquidity Ratios Quick Ratio
Recognizing that inventories may be less liquid than other current assets, and in some cases, when liquidated quickly result in cash flows that are less than book value, the quick ratio gives a clearer indication of the firm’s ability to meet its maturing financial obligations out of current, liquid assets. [4- 24]

49 Liquidity Ratios Interpreting Ratios
Which firm has greater liquidity and capacity to meet its financial obligations?

50 Financial Statement Analysis and Forecasting
Valuation Ratios Financial Statement Analysis and Forecasting

51 Valuation Ratios Used to assess how the market is valuing the firm (share price) in relationship to assets and current earnings, profits and dividends Include: Equity book value per share (BVPS) Dividend yield Dividend payout Price-earnings (P/E) ratio Forward (P/E) ratio Market-to-book (M/B) ratio EBITDA multiple

52 Valuation Ratios Interpreting Ratios – Book Value per Share
Expresses shareholders’ equity on a per share basis. [4- 25]

53 Valuation Ratios Interpreting Ratios – Dividend Yield
Expresses dividend payout as a percentage of the current share price. Can be compared to other investment instruments such bonds (current yield) or with other dividend-paying companies. [4- 26]

54 Valuation Ratios Interpreting Ratios – Dividend Payout Ratio
Expresses dividends as a percentage of earnings on a per share basis. [4- 27]

55 Valuation Ratios Interpreting Ratios – Trailing P/E Ratio
Earnings multiple based on the most recent earnings. Often used in estimating the value of a stock. A stock trading at a P/E multiple of 10 will take ten years at current earnings to recover the price of the stock. A stock trading at a P/E multiple of 100 will take 100 years at current annual earnings to recover the price of the stock. [4- 28]

56 Valuation Ratios Interpreting Ratios – Forward P/E Ratio
Earnings multiple based on forecast earnings per share. Often used in estimating the value of a stock especially with companies with rapid growth in earnings per share. Low P/E shares are regarded as value stocks High P/E shares are regarded as growth stocks [4- 29]

57 Valuation Ratios Interpreting Ratios – Market to Book Ratio
Estimates the dollars of Share Price per dollar of book value per share. Given historical cost accounting as the basis for book value per share, the degree to which market value per share exceeds BVPS indicates the value that has been added to the company by management. [4- 30]

58 Valuation Ratios Interpreting Ratios – EBITDA Multiple
Total enterprise value is an estimate of the total market value of the firm (market value of equity plus market value of debt) EBITDA multiple expresses total enterprise value for each dollar of operating income (EBITDA)

59 Valuation Ratios Interpreting Ratios
Can you draw any conclusions for the comparative valuation ratio data summarized in this table?

60 Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

61 Common Size Statements
A common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages. A common size financial statement helps to compare entries in a firm’s financial statements, even if the firms are not of equal size. How to prepare a common size financial statement? For a common size income statement, divide each entry in the income statement by the company’s sales. For a common size balance sheet, divide each entry in the balance sheet by the firm’s total assets.

62 Whole Foods Market, Comparative Income Statement
5-62

63 Common Size statements
5-63

64 Business Segment information
5-64

65 Comparative Balance Sheet
5-65

66 Comparative Balance Sheet
5-66

67 Common size and trend analysis
5-67

68 Common size and trend analysis (Exhibit 5.5 continued)
5-68

69 Common size and trend analysis
5-69

70 Common size and trend analysis (Exhibit 5.6 continued)
5-70

71 Comparative Cash Flows
5-71

72 Common size trend analysis
5-72

73 The Limitations of Ratio Analysis
Picking an industry benchmark can sometimes be difficult. Published peer-group or industry averages are not always representative of the firm being analyzed. An industry average is not necessarily a desirable target or norm. Accounting practices differ widely among firms. Many firms experience seasonal changes in their operations. Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios. The results of financial analysis are dependent on the quality of the financial statements.


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