Module 3Module 3

Analyzing and Analyzing and Interpreting Interpreting

Financial Financial StatementsStatements

Common Questions that F/S Common Questions that F/S Analysis Can Help To Analysis Can Help To

AnswerAnswer CreditorCreditor

InvestorInvestor

ManageManagerr

Can the company pay the interest and Can the company pay the interest and principal on its debt? Does the principal on its debt? Does the company reply too much on non-owner company reply too much on non-owner financing?financing?

Does the company earn an acceptable Does the company earn an acceptable return on invested capital? Is the gross return on invested capital? Is the gross profit margin growing or shrinking? profit margin growing or shrinking? Does the company effectively use non-Does the company effectively use non-owner financing?owner financing?

Are costs under control? Are the Are costs under control? Are the company’s markets growing or company’s markets growing or shrinking? Do observed changes shrinking? Do observed changes reflect opportunities or threats? Is the reflect opportunities or threats? Is the allocation of investment across allocation of investment across different assets too high or too low?different assets too high or too low?

Question?Question?

Is a Net Income of $100,000 Is a Net Income of $100,000 good?good?

Ratio AnalysisRatio Analysis

Examining various income statement and Examining various income statement and balance sheet components in relation to balance sheet components in relation to one another facilitates financial one another facilitates financial statement analysis. This type of statement analysis. This type of examination is called examination is called ratio analysisratio analysis..

This module focuses on the This module focuses on the disaggregation of Return Measures into disaggregation of Return Measures into

1.1. Level I – RNOA and LEVLevel I – RNOA and LEV

2.2. Level II – Profit Margins and TurnoverLevel II – Profit Margins and Turnover

3.3. Level III – GPM, OEM, ART, INVT, APT, etc.Level III – GPM, OEM, ART, INVT, APT, etc.

4.4. As well as Liquidity and Solvency MeasuresAs well as Liquidity and Solvency Measures

Profitability AnalysisProfitability Analysis

Return on Assets (ROA):Return on Assets (ROA):

ROA = Net Income / Average ROA = Net Income / Average AssetsAssets

For example, if we invest $100 in a For example, if we invest $100 in a savings account yielding $3 at year-savings account yielding $3 at year-end, the return on assets is 3%. end, the return on assets is 3%.

Disaggregating Return Disaggregating Return on Assetson Assets

Profit Margin, Asset Turnover, and Profit Margin, Asset Turnover, and Return on Assets for Selected Return on Assets for Selected

IndustriesIndustries

Operating vs. Operating vs. NonoperatingNonoperating

Operating expensesOperating expenses are the usual and are the usual and customary costs that a company incurs to customary costs that a company incurs to support its main business activitiessupport its main business activities

Nonoperating expensesNonoperating expenses relate to the relate to the company’s financing and investing company’s financing and investing activitiesactivities

Transitory vs. CoreTransitory vs. Core

Transitory itemsTransitory items are one-time are one-time events (e.g., not likely to recur)events (e.g., not likely to recur)

Core itemsCore items are likely to recur are likely to recur (persist) and are, therefore, more (persist) and are, therefore, more relevant for company valuationrelevant for company valuation

Operating/Nonoperating vs. Operating/Nonoperating vs. Core/TransitoryCore/Transitory

Analysis StructureAnalysis Structure

Return on Equity – Level Return on Equity – Level 11

Return on equity (ROE) is computed Return on equity (ROE) is computed as:as:

ROE = Net Income / Average ROE = Net Income / Average EquityEquity

Return on Net Operating Return on Net Operating AssetsAssets

(RNOA)(RNOA)

RNOA = NOPAT / Average NOARNOA = NOPAT / Average NOA

where,where,

NOPAT is net operating profit after taxNOPAT is net operating profit after tax

NOA is net operating assetsNOA is net operating assets

Financial Leverage and Financial Leverage and RiskRisk

LEV is the other component LEV is the other component of ROEof ROE

Is Debt a bad thing?Is Debt a bad thing? Given that increases in Given that increases in

financial leverage increase financial leverage increase ROE, why are all companies ROE, why are all companies not 100% debt financed?not 100% debt financed?

Leverage and Income Leverage and Income VariabilityVariability

Level II Analysis – Margin Level II Analysis – Margin and Turnoverand Turnover

Level 3 Analysis — Disaggregation of Level 3 Analysis — Disaggregation of

Margin and TurnoverMargin and Turnover

Gross Profit MarginGross Profit Margin

It allows a focus on average unit mark-It allows a focus on average unit mark-upsups

A high gross profit margin is preferred A high gross profit margin is preferred to a lower one, which also implies that a to a lower one, which also implies that a company has relatively more flexibility company has relatively more flexibility in product pricing.in product pricing.

Operating Expense Operating Expense MarginMargin

Operating expense ratios (percents) are Operating expense ratios (percents) are used to examine the proportion of sales used to examine the proportion of sales consumed by each major expense consumed by each major expense category.category.

Expense ratios are calculated as follows:Expense ratios are calculated as follows:Operating expense percentage = Expense Operating expense percentage = Expense item/Net salesitem/Net sales

TurnoverTurnover Turnover measures relate to the Turnover measures relate to the

productivity of company assets. Such productivity of company assets. Such measures seek to answer the amount measures seek to answer the amount of capital required to generate a of capital required to generate a specific sales volume.specific sales volume.

As turnover increases, there is greater As turnover increases, there is greater cash inflow as cash outflow for assets cash inflow as cash outflow for assets to support the current sales volume is to support the current sales volume is reduced.reduced.

Accounts Receivable Accounts Receivable Turnover (ART)Turnover (ART)

Inventory Turnover (INVT)Inventory Turnover (INVT)

Accounts Payable Turnover Accounts Payable Turnover (APT)(APT)

Liquidity and Solvency Liquidity and Solvency MeasuresMeasures

LiquidityLiquidity refers to cash: how refers to cash: how much we have, how much is much we have, how much is expected, and how much can be expected, and how much can be raised on short notice. raised on short notice.

SolvencySolvency refers to the ability to refers to the ability to meet obligations; primarily meet obligations; primarily obligations to creditors, obligations to creditors, including lessors. including lessors.

Current and Quick RatioCurrent and Quick Ratio

Solvency RatiosSolvency Ratios

Flow RatiosFlow Ratios

Vertical and Horizontal Vertical and Horizontal AnalysisAnalysis

Vertical and Horizontal Vertical and Horizontal AnalysisAnalysis

Limitations of Ratio Limitations of Ratio analysisanalysis