Chapter 10

Analysis of Financial Statements

Financial Statements• Corporate shareholder annual and quarterly

reports must include– Balance sheet (Exhibit 10.1)– Income statement (Exhibit 10.2)– Statement of cash flows (Exhibit 10.3)

• Reports filed with Securities and Exchange Commission (SEC)– 10-K and 10-Q

• All reports must be prepared using GAAP

Common Size Statements

• Normalize balance sheets and income statement items to allow easier comparison of different size firms

• Common size balance sheet: all accounts are expressed as a percentage of total assets

• Common size income statement: all accounts are expressed as a percentage of sales

Analysis of Financial Ratios

• Ratios are more informative than raw numbers

• Ratios provide meaningful relationships between individual values in the financial statements

• Ratios help investors evaluate management performance in terms of profitability, efficiency and risk.

Importance of Relative Financial Ratios

• Enable comparison of a firm’s performance to– The aggregate economy– Its industry or industries– Its major competitors within the industry– Its past performance (time-series analysis)

Five Categories of Financial Ratios

1. Internal liquidity (solvency)

2. Operating efficiency and profitability

3. Business and financial risk analysis

4. Growth analysis

5. External liquidity (marketability)

Internal Liquidity

• Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations– Current Ratio– Quick Ratio– Cash Ratio– Inventory Turnover

• All internal liquidity ratios should be compared with industry numbers

Current Ratio (CR)

• Examines current assets and current liabilities

• A current ratio above 1 is usually best, but a high current ratio isn’t optimal

sLiabilitieCurrent

AssetsCurrent RatioCurrent

Quick Ratio (QR)

• Adjusts current assets by removing less liquid assets

• QR is less or equal to CR

• If QR is much lower than CR, it could signal an inventory problem

sLiabilitieCurrent

sReceivableSecurities MarketableCashRatioQuick

Cash Ratio

• The most conservative liquidity ratio

• A cash ratio of 1 suggests that the firm has enough on hand to meet all current obligations in the coming year

• Usually less than 1

sLiabilitieCurrent

Securities MarketableCashRatioCash

Inventory Turnover (ITO)• Measures efficiency in inventory

management

• Usually higher is better

• Time series comparisons also work well for ITO

Inventory Average

Sold Goods ofCost TurnoverInventory

Average Collection Period (ACP)• Compare to credit terms offered

• Varies dramatically depending on product and industry

• Should be close to the norm for the industry

Receivable Accounts AverageSales

365ACP

Operating Performance• Measure how well management is operating

the business– (1) Operating efficiency ratios

• Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories (total asset turnover and fixed asset turnover)

– (2) Operating profitability ratios• Analyze profits as a percentage of sales and as a

percentage of the assets and capital employed (profit margins and returns on capital)

Total Asset Turnover (TAT)

• Meaures the effectiveness of a firm’s use of its total asset base

• Higher is better

• May be distorted by inflation

Assets Total Average

SalesTurnover Asset Total

Fixed Asset Turnover (FAT)

• Measures efficiency of plant and equipment use

• Higher is better

• May be distorted by inflation

Assets Fixed Average

SalesTurnover Asset Fixed

Profit Margins• Higher is better for all profit margins

• Can be computed on a gross, operating, or net basis– Gross profit equals sales minus the cost of

goods sold – Operating profit is gross profit minus selling,

general and administrative (SG + A) expenses– Net profit is what is left after all expenses are

covered

Sales

Profit Net MarginProfitNet

Return on Equity (ROE)

• Meaures the rate of return earned on the capital provided by the stockholders after paying for all other capital used

• Higher is better

Equity Total Average

IncomeNet Equity Totalon Return

ROE Decomposition

Equity Common

Assets Total

Assets Total

Salesx

Sales

Income NetROE

LeverageinancialFxATTxNPMROE

Return on Assets (ROA)

• Meaures the rate of return earned on the firm’s assets

• Higher is better

Assets Total Average

Income NetAssets Total on Return

Risk Analysis

• Total risk of a firm has two components:– Business risk

• The uncertainty of income caused by the firm’s industry• Generally measured by the variability of the firm’s

operating income over time or the standard deviation of the historical operating earnings series

– Financial risk• Additional uncertainty of returns to equity holders due to

a firm’s use of fixed obligation debt securities• The acceptable level of financial risk for a firm depends

on its business risk

Business Risk• Two factors contribute to the variability of

operating earnings– Sales variability

• Earnings are generally as volatile as sales

• Some industries are cyclical

– Operating leverage• Production has fixed and variable costs

• Fixed production costs cause profit volatility with changes in sales

• Fixed production costs are operating leverage

Debt Ratios

• Higher ratios suggest increased financial risk

Equity Total

Debt Term-Long TotalRatioEquity -to-Debt

(Capital) Assets Total

Debt TotalRatio Debt

Earnings Ratios

• Higher ratios suggest lower risk

• The Fixed Charge Coverage takes into account non-interest fixed obligations

Expense Interest

(EBIT) Taxes and Interest before EarningsCoverageInterest

Rate) Tax-1Dividend/( PreferredPayments LeaseInterest Debt

Payments Lease and Taxes, Interest, Before Income

Coverage Charge Fixed

Cash Flow Ratios

• Cash flow ratios relate the flow of cash available from operations to either interest expenseor the face value of outstanding debt

• Higher suggests lower risk

• 1/3 of a lease payment is used as a measure of interest expense on a lease

Cash Flow Ratios

Debt Total

Tax Deferred in ChangeExpense onDepreciatiIncome Net

Debt Total / Flow Cash

Payments Lease 3/1Interest

Payments Lease 1/3InterestFlow Cash lTraditiona

Coverage Flow Cash

Analysis of Growth Potential

• Creditors are interested in the firm’s ability to pay future obligations

• Value of a firm depends on its future growth in earnings and dividends

• We will discuss these computations in Chapters 11 and 15.

External Market Liquidity

• The dollar value of shares traded

• Trading turnover (percentage of outstanding shares traded during a period of time)

• The bid-ask spread is a measure of market liquidity

Financial Statement Quality

• High-quality balance sheets typically have – Conservative use of debt– Assets with market value greater than book– No liabilities off the balance sheet

Financial Statement Quality

• 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

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

Uses of Ratio Analysis

1. Stock valuation

2. Identification of corporate variables affecting a stock’s systematic risk (beta)

3. Assigning credit quality ratings on bonds

4. Predicting insolvency (bankruptcy) of firms

5. Management of the firm

Stock Valuation Models

Valuation models attempt to derive a value based upon one of several cash flow or relative valuation models

All valuation models are influenced by:• Expected growth rate of earnings, cash flows, or

dividends• Required rate of return on the stock

Financial ratios can help in estimating these critical inputs

Limitations of 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

• Foreign firms may follow different reporting formats and different accounting principles