1. ANALYSIS OF FINANCIAL STATEMENTS
Chapter 14
ANALYSIS OF FINANCIAL STATEMENTS

2. Major Financial Statements
Corporate shareholder annual and quarterly reports must include:
Balance sheet
Income statement
Statement of cash flows
Reports filed with Securities and Exchange Commission (SEC)
10-K and 10-Q

3. Generally Accepted Accounting Principles
GAAP are formulated by the Financial Accounting Standards Board (FASB)
Provides some flexibility of accounting principles
Can be good for firms in different situations
Can represent a challenge for analysis
Financial statements footnotes must disclose which accounting principles are used by the firm

4. Balance Sheet
Shows resources (assets) of the firm and how it has financed these resources (liabilities and equity)
Indicates current and fixed assets available at a point in time (snapshot)
Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity

5. Income Statement
Contains information on the profitability of the firm during some period of time
Indicates the flow of sales, expenses, and earnings during the time period

6. Statement of Cash Flows
Integrates the information on the balance sheet and income statement
Shows the effects on the firm’s cash flow of income statement items and changes in various items on the balance sheet
Three sections show cash flows from
Operating activities
Investing activities
Financing activities

7. Alternative Measures of Cash Flow
Cash flow from operations
Traditional cash flow equals net income plus depreciation expense and deferred taxes
Also adjust for changes in operating assets and liabilities that use or provide cash
Free cash flow recognizes that some investing and financing activities are critical to ongoing success of the firm
Modifies cash flow from operations to reflect necessary capital expenditures and projected divestitures

8. Purpose of Financial Statement Analysis
Evaluate management performance in
Profitability
Efficiency
Risk
Although financial statement information is historical, it is used to project future performance

9. Analysis of Financial Ratios
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers
Helps control for different sizes of firms
Ratios provide meaningful relationships between individual values in the financial statements

10. Importance of Relative Financial Ratios
In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks
Examine a firm’s performance relative to:
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its own past performance (time-series analysis)

11. Comparing to the Industry Norms
Most popular comparison
Industries affect the firms within them differently, but the relationship is always significant
The industry effect is strongest for industries with homogenous products
Can also examine the industry’s performance relative to aggregate economic activity

12. Comparing to the Firm’s Major Competitors
Industry averages may not be representative
A firm may operate in several distinct industries
Several approaches:
Select a subset of competitors for the comparison group
Construct a composite industry average from the different industries in which the firm operates

13. Comparing to the Firm’s Own Past Performance
Determine whether it is progressing or declining
Helpful for estimating future performance
Consider trends as well as averages over time

14. Five Categories of Financial Ratios
Common size statements
Internal liquidity (solvency)
Operating performance
Operating efficiency
Operating profitability
Risk analysis
Business risk
Financial risk
External liquidity risk
Growth analysis

15. Common Size Statements
Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales

16. Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
Current Ratio examines current assets and current liabilities
Quick Ratio adjusts current assets by removing less liquid assets
Cash ratio relates cash (ultimate liquid asset) to current liabilities

17. Evaluating Internal Liquidity
Receivables turnover examines the management of accounts receivable
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Cash conversion cycle is a good overall measure of liquidity and indicates the net delay between cash inflow and cash outflow

18. Evaluating Operating Performance
Operating efficiency ratios
Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales
Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales
Net fixed asset turnover reflects utilization of fixed assets. This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales

19. Operating Profitability Ratios
Operating profitability ratios measure
The rate of profit on sales (profit margin)
The percentage return on capital
Examine how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit
Gross profit margin measures the rate of return after cost of goods sold

20. Operating Profitability Ratios
Operating profit margin measures the rate of profit on sales after operating expenses
Operating profit is sometimes called Earnings before interest and taxes (EBIT)
Net profit margin relates net income to sales
Since Net Sales is in the denominator of all of the three previous ratios, the common size income statement gives all of these ratios at once

21. Operating Profitability Ratios
Return on total capital relates the firm’s earnings to all capital invested in the business
Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used
The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight

22. Operating Profitability Ratios
An extended DuPont System provides additional insights into ROE
The extended DuPont System shows that there are five components of return on equity (ROE):
Operating profit margin
Total asset turnover
Interest expense rate
Financial leverage multiplier
Tax retention rate

23. Risk Analysis
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into two basic sources:
Business risk: The uncertainty in a firm’s operating income, highly influenced by industry factors
Financial risk: The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily through employing leverage).
External liquidity analysis considers another aspect of risk from an investor’s perspective

24. Business Risk Variability of the firm’s operating income over time
Can be measured by calculating the standard deviation of operating income over time or the coefficient of variation
In addition to measuring business risk, we want to explain its determining factors.

25. Business Risk Two primary determinants of business risk
Sales variability
The main determinant of earnings variability
Cost Variability and Operating leverage
Production has fixed and variable costs
Greater fixed production costs cause greater profit volatility with changes in sales
Fixed costs represent operating leverage
Greater operating leverage is good when sales are high and increasing, but bad when sales fall

26. Financial Risk
Interest payments are deducted before we get to net income
These are fixed obligations
Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline
Fixed financing costs are called financial leverage
The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high

27. Financial Risk
Two sets of financial ratios help measure financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial charges
Acceptable levels of financial risk depend on business risk
A firm with considerable business risk should likely avoid lots of debt financing

28. Financial Risk Proportion of debt (balance sheet) ratios
Long-term debt can be related to:
Equity (L-t D/Equity)
How much debt does the firm employ in relation to its use of equity?
Total Capital [L-t D/(L-t D +Equity)]
How much debt does the firm employ in relation to all long-term sources of funds?
Total debt can be related to:
Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]
Assessment of overall debt load, including short-term

29. Financial Risk Earnings or Cash Flow Ratios
Relate operating income (EBIT) to fixed payments required from debt obligations
Higher ratio means lower risk
Interest Coverage or Times Interest Earned Ratio
May also want to calculated coverage ratios that reflect other fixed charges

30. Financial Risk Cash flow ratios
Fixed financing costs such as interest payments must be paid in cash, so these ratios use cash flow rather than EBIT to assess the ability to meet these obligations
Relate the flow of cash available from operations to:
Interest expense
Total fixed charges
The face value of outstanding debt

31. External Liquidity Risk
Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information
External market liquidity is a source of risk to investors

32. Analysis of Growth
Growth Rates can be calculated for balance sheet accounts and for income statement items
Sustainable growth potential can be analyzed
Important to both creditors and owners
Creditors interested in ability to pay future obligations
For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends
g = ROE x Retention rate
The retention rate is one minus the firm’s dividend payout ratio
Anything that impacts ROE (profitability, asset management, and leverage) would also be a determinant of future growth

33. Analysis of Non-U.S. Financial Statements
Statement formats will be different
Differences in accounting principles
Ratio analysis will reflect local accounting practices

34. The Quality of Financial Statements
“Quality financial statements” reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are
High-quality balance sheets typically have
Conservative use of debt
Assets with market value greater than book
No liabilities off the balance sheet

35. The Quality of Financial Statements
High-quality income statements
Reflect repeatable earnings
Gains from nonrecurring items should be ignored when examining earnings
High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

36. The Value of Financial Statement Analysis
Financial statements, by their nature, are backward-looking
An efficient market will have already incorporated these past results into security prices, so why analyze the statements?
Analysis provides knowledge of a firm’s operating and financial structure
This aids in estimating future returns

37. Uses of Financial Ratios
Stock valuation
Identification of corporate variables affecting a stock’s systematic risk (beta)
Assigning credit quality ratings on bonds
Predicting insolvency (bankruptcy) of firms

38. Financial Ratios and Stock Valuation Models
Stock valuation often considers discounted cash flow analysis
Estimate cash flows
Estimate an appropriate discount rate
A number of financial ratios can be useful in arriving at estimates for each of these inputs
Price ratio analysis for a stock
Sometimes we estimate the value of a stock through various price ratios such as P/E
Would need to estimate variables such as expected growth rate of earnings and dividends

39. Financial Ratios and Systematic Risk
A firm’s systematic risk (as measured by beta) is related to a number of financial statement variables

40. Financial Ratios and Bond Ratings
Changes in bond ratings are linked to changes in various financial statement variables
Predicting such changes in ratings before they occur can increase the return on a bond or stock portfolio

41. Financial Ratios and Insolvency (Bankruptcy)
Certainly, analysts and investors are concerned with the possibility of bankruptcy
A number of variables have a rather strong relationship to the bankruptcy experience of firms in the past
Can use financial statement analysis to identify firms where insolvency is a likely outcomes

42. Limitations of Financial Ratios
Always consider relative financial ratios
Accounting treatments may vary among firms, especially among non-U.S. firms
Firms may have have divisions operating in different industries making it difficult to derive industry ratios
Are the results consistent?
Ratios outside an industry range may be cause for concern