1. Financial Statement Analysis
Chapter 14
Financial Statement Analysis
Describes the financial instruments traded in primary and secondary markets.
Discusses Market indexes. Discusses options and futures.
McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. Financial Statement Analysis
Chapter 14
Financial Statement Analysis
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3. 14.1 The Major Financial Statements
Income statement
Balance sheet
Statement of cash flows
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4. Income Statement Four broad types of accounts:
Cost of goods sold
General and administrative expenses
Interest expense
Taxes on earnings
Common Size income statements
Divide each account by net sales
Eliminates size distortions
Common size allows size free comparisons through time and across companies.
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5. Table 14.1 Consolidated Statement of Income
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6. Balance Sheet
Assets
Current
Long-term
Liability (current and long term) and stockholders’ equity
Common size balance sheet
Divide each account by total assets
Each account presented as a percent of the total
Common size statements are useful to understand the ‘big picture’ about a firm’s financials.
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7. Table 14.2 Consolidated Balance Sheet A
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8. Table 14.2 Consolidated Balance Sheet B
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9. Statement of Cash Flows
A financial statement showing a firm’s cash receipts and cash payments during a specified period.
Recognizes transactions only if cash changes hands.
“Undoes” much of accrual accounting to get at cash changes
Does not allocate capital expenditures through time via depreciation as income statement does
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10. Statement of Cash Flows
Three main sections
Cash flow related to operations
Cash flow related to investing
Cash flow related to financing
Allows the analyst to understand which of the firm’s activities are using and which generating cash.
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11. Statement of Cash Flows
Not all sources of cash are equally sustainable.
Would you rather invest in a firm that is primarily generating cash through operations or through financing?
It is difficult to evaluate whether the amount of cash flow related to investing is ‘good’ or ‘bad.’ What else would we need to know?
Rate of return on the investment
Comparable data over time or from competitors
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12. Table 14.3 Consolidated Statement of Cash Flows
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13. 14.2 Accounting Versus Economic Earnings
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14. Accounting Versus Economic Earnings
Accounting earnings
Earnings of a firm as reported on its income statement
Economic earnings
The real flow of cash that firm could pay out to its stockholders without impairing its productive capacity.
The two can differ, especially with the problems of earnings management, nevertheless stock prices do react to changes in announced earnings so there must be a relationship between accounting and economic earnings. 
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15. 14.3 Profitability Measures
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16. Past Versus Future ROE ROE = Net Profits / Equity
Data from recent past may provide information regarding future ROE
Analysts should always keep an eye on the future
Expectations of future dividends and earnings determine intrinsic value of stock
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17. Financial Leverage and ROE
The relationship among ROE, ROA, and leverage:
ROE = Net Profits / Equity
ROA = EBIT / Total Assets
The derivation of this equation is on the next slide, which is hidden.
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18. Financial Leverage and ROE
The derivation of this equation is as follows:
The derivation of this equation is as follows:
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19. Financial Leverage and ROE
Total Assets =$100 mil
Tax rate = 40%
Somedebt = $40 mil 8% 
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20. 14.4 Ratio Analysis 
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21. Ratio Analysis Purpose of Ratio Analysis Methods
Understand the factors that affect performance
Methods
Trend analysis
Comparative analysis
Combination of the two
Use by External Analysts
Important information for investment community
Important for credit markets 
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22. DuPont Decomposition of ROE
ROE can be decomposed into various ratios that reflect different aspects of a firm’s performance: 
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23. DuPont Decomposition of ROE
Ratio (1) Tax Burden (TB):
Measures the percentage of pretax profit that the firm keeps after paying taxes
Ratio (2) Interest Burden (IB):
Measures the percent of EBIT kept after paying interest expense
This ratio is 1 if the firm has no debt
Note the IB ratio is closely related to the times interest earned or TIE = EBIT / Interest expense. A high TIE indicates a low probability of bankruptcy. 1 – (1/TIE) = Maximum sustainable drop in EBIT that just allows the firm to cover its interest expense. With a TIE of 5 for instance, the firm could lose 1 – 1/5 = 80% of its EBIT and still just cover its interest expense.
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24. DuPont Decomposition of ROE
Ratio (3) Operating Profit Margin
Measures the percentage of sales revenue that remains after subtracting cost of goods sold, selling and administrative expenses and depreciation
Ratio (4) Asset Turnover Ratio (ATO)
Measures the efficiency of the firm at generating sales per dollar invested in the assets
Note: Margin x ATO = ROA
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25. DuPont Decomposition of ROE
Ratio (5) Leverage ratio
Leverage ratio = 1 + Debt / Equity
The leverage ratio is a measure of the percentage of debt in total capitalization.
Note that it appears that using more debt as a percent of capital will increase ROE, but using more debt also reduces the interest burden ratio
Note that the various debt ratios are all algebraically equivalent.
Knowing the Debt / Asset, one can find the Equity / Asset ratio because the two ratios must sum to 1. Taking the ratio of the two will give one the Debt / Equity ratio and adding 1 to that will give the leverage ratio.
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26. DuPont Decomposition of ROE
Compound leverage factor (CLF)
= Interest burden x Leverage
If the CLF > 1, the use of debt will increase ROE
If the CLF < 1, the use of debt will decrease ROE
CLF will be greater than 1 if ROA > Interest rate on debt
What does this imply about when firms should use more debt?
Firms should use more debt when they believe the ROA will be greater than the interest rate on the debt, this will result in positive leverage effects on ROE. Negative leverage effects on ROE will occur in low earning years. This is simply because of the fixed nature of the interest expense and this concept holds for any fixed cost.
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27. Sample ROE Decomposition
Compare two firms, Nodett and Somdett
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28. More on Ratios 
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29. Ratio Analysis using GI
Industry
Average
0.40
0.70
0.50
60 days
Asset Utilization Ratios (2010 data for GI)
Total Asset Turnover
Fixed Asset Turnover
Inventory Turnover
Average collection period or days sales in receivables
How will these ratios affect ROA and ROE?
Ask what it means if the Total Asset Turnover or ATO is less than the industry average. Normally when these ratios are higher ROA and ROE will be higher. All these ratios attempt to measure how efficiently the firm is using its assets to generate sales or a saleable product.
Asset utilization is lower than the typical firm because GI is not generating as many dollars of sales per dollar invested in fixed assets, because the firm’s cost of goods sold is not producing quite as much inventory and then the big reason, the average collection period (ACP) is 67% higher than the industry average.
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30. Ratio Analysis using GI
Industry
Average
2.0
1.0
0.70
Liquidity Ratios (2010 data for GI)
Current Ratio
Quick (Acid Test)
Cash ratio
All of these ratios indicate that GI is less liquid than the typical firm in the industry. If it doesn’t have a credit line it could have cash problems if there are unexpected contingencies or if sales and/or earnings slump. It is likely to face a drop in credit rating. The TIE is down as well. If you do the multiple year data you will find that all these ratios have been dropping. 
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31. Ratio Analysis using GI
Industry
Average
.69
8.0
8.64%
Market Price Ratios (2010 data for GI)
Market-to-Book
P/E ratio
ROE
Also:
There are 1,000,000 shares of stock outstanding, but we divide by $1,000 because all the numbers in Table 14.8 that we are using are in thousands of dollars.
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32. Figure 14.1 DuPont Decomposition for Hewlett-Packard
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33. Table 14.10 Ratios for Major Industries
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34. 14.5 Economic Value Added 
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35. Economic Value Added Plowback Ratio (b) ROE 0% 25% 50% 75% 10% 1.00
Concept: A firm adds value only if the return on its projects exceeds its required rate of return
For example: The effect of ROE and b on the Price/Book ratio for a stock with E1 = $1, Book value/share = $8.33 and k =12%:
Bold numbers are the Price/Book ratios that result from the given Plowback ratio and ROE.
Plowback Ratio (b)
ROE 0%
25%
50%
75%
10%
1.00
0.95
0.86
0.67
12%
14%
1.06
1.20
2.00
Presumably the required rate of return is the return investors could earn on their own in other investments of equal risk.
The main point of the table is that the P/B is improved by retaining earnings and reinvesting only if the ROE > k of 12%. The related point should also be made, namely that EPS growth can be generated simply by retaining earnings, but this does not mean the firm is adding value or maximizing shareholder wealth unless the return on the investment is greater than k.
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36. Economic Value Added K = 12% E1 = $1 Book Value $8.33
PLOUGH BACK RATIOS
Growth Rates 0%
25%
50%
75%
10%
0.0%
2.5%
5.0%
7.5%
12%
3.0%
6.0%
9.0%
14%
3.5%
7.0%
10.5%
Price
8.33
7.89
7.14
5.56
8.82
10.00
16.67
P/BV
1.00
0.95
0.86
0.67
1.06
1.20
2.00

37. Economic Value Added
Concept: A firm adds value only if the return on its projects exceeds its required rate of return
Approach to compare accounting profitability with the cost of capital
Definition
EVA = (ROA-k) x (Capital Invested in the firm)
k = opportunity cost for capital or required return
Presumably the required rate of return is the return investors could earn on their own in other investments of equal risk.
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38. Table 14.11 Economic Value Added
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39. 14.6 An Illustration of Financial Statement Analysis
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40. Table 14.12 Key Financial Ratios of Growth Industries (GI)
2010 annual report claimed that GI had a successful year, stating that as in the year before, sales, assets and operating income all continued to grow at 20%. Is the report correct?
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41. Table 14.13 GI Statement of Cash Flows
I believe there are some rounding problems in this table
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42. 14.7 Comparability Problems
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43. Comparability Problems
Ratios must have a benchmark, but it can be difficult to compare data of different firms
Different inventory valuation
LIFO and FIFO
Depreciation problems
Accounting depreciation  Economic depreciation
Different depreciation methods at different firms
In periods of inflation depreciation is understated in economic terms and real economic income is overstated
To add to the difficulty, U.S. Firms may report one depreciation method for reporting purposes on financial statements and actually use a different depreciation method for tax purposes.
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44. Comparability Problems
Inflation and interest expense
Nominal interest rates include an inflation premium to compensate for erosion in the real value of the principal.
Conceptually then, from an economic viewpoint part of interest expense is actually principal repayment. 
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45. Fair Value Accounting
Fair value accounting uses market values rather than book values in the firm’s financial statements.
Market value is a truer picture of the current value of the firm,
Market value is forward looking, book value is backward looking
Trend is toward market value accounting 
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46. Fair Value Accounting
Financial Accounting Standards Board (FASB) Rule 157 classifies assets in one of three buckets:
Level 1: Assets that are traded in active markets and should be valued at market prices
Level 2: Asset that are not actively traded, but their values may be estimated from market data on similar assets
Level 3: Assets that can only be valued with inputs that are difficult to observe.
Level 2 and Level 3 assets may be valued using pricing models and the values may be ‘marked to model’
Note that banks must mark to market some of their asset holdings. Bankers have fought mark to market rules for years, sometimes claiming it couldn’t be done, and other times claiming it shouldn’t be done. The financial crisis has exacerbated the debate. We learned from the S&L crisis of the 1980s and from Japan in the 1990s that you should have mark to market rules. Otherwise the financial statements are hiding losses in periods of distress. It may make sense to mark to a calculated fundamental value rather than market value if market value is at fire sale prices due to during periods when markets are not functioning properly.
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47. Quality of Earnings: Accounting Choices
Quality of earnings refers to the realism and sustainability of reported earnings,
Allowance for bad debts must be realistic
Extraordinary and Non-recurring items are sometimes pretty ordinary and common
Earnings smoothing is pervasive
Revenue & expense recognition options
Engaging in contingent off-balance sheet assets (certain leases) or liabilities (selling credit default swaps) that have unknowable effects on earnings
Remember that earnings are supposed to translate into cash flow and we are always trying to identify the trend in expected future cash flows.
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48. International Accounting Conventions
Reserving practices
Overseas firms have far more discretion in their ability to set aside reserves for future contingencies (or not) than U.S. firms have.
This means foreign firms’ earnings are more subject to managerial manipulation
Depreciation
Foreign firms typically use accelerated depreciation on their financial statements and U.S. firms don’t, so foreign firms have lower reported earnings, ceteris paribus.
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49. International Accounting Conventions
Intangibles
Treatment of intangibles varies widely between countries.
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50. Figure 14.2 Adjusted Versus Reported Price-Earnings Ratios
This data is from 1992 and it is way out of date, but it makes the point that the accounting method used can change the results substantially.
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51. IFRS
The International Financial Reporting Standards (IFRS) have been adopted by the European Union and by over 100 countries.
In 2007 the SEC began allowing foreign firms to list their securities in U.S. markets if they prepared their statements using IFRS
In 2008 the SEC ruled that large U.S. multinational firms may start using IFRS rather than GAAP in 2010 and that all firms should use IFRS by 2014.
IFRS standards are principle based rather than rules based
The IFRS standards will generally allow more flexibility in reporting standards
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52. 14.8 Value Investing: The Graham Technique
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53. Benjamin Graham Founder of modern fundamental analysis
Graham believed careful analysis of a firm’s financial statements could turn up bargain stocks and his work was used by generations of analysts
He developed many different rules for determining the most important financial ratios, as his ideas became popular they stopped working.
He still recommended buying stocks if their market value is less than their net working capital value.
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