Chapter

13
Financial Statement Analysis

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Relationship to previous material

Focus has been:
What goes into 3 basic financial statements (Income Statement, Balance sheet, Statement of Cash Flows).

Now focus is:

How statements are analyzed by management, investors, and creditors.

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Objective of a Business
Create value for its shareholders while maintaining a sound financial position. Return on investment. Sound financial position. Other important objectives include:
Employee satisfaction. Social responsibility. Ethical considerations.
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Overview
GAAP does not define ratios. Multiple equally valid approaches to ratios and analysis. Managers (e.g. division manager, sales manager) should be measured to items that they control. Investors and top management are most interested in overall performance or broadest measures of performance.
Understanding less broad measures of performance may give additional insight into overall performance
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Structure of analysis
From broadest to more specific levels. Principal value of financial analysis:
Suggests questions not answers.
Ratio comparisons start with supposition that all other things are equal. (They rarely are.)

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Categories of ratios which measure:

Overall performance. Profitability. Investment utilization. Financial condition. Dividend policy.

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Making comparisons
Finding the appropriate standard is difficult. A high ratio (e.g. current ratio, ROI) may be good or bad. It cant be viewed in isolation.
Is a high CR good or bad? Is a high ROI always good?

Values of ratios compared across time longitudinal analysis, or trend analysis.

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Overall Measures
Return on investment (ROI) = net income / investment
Possible definitions of investment: assets, owners equity, invested capital. Possible definitions of return: net income, net income -preferred dividends, net income + interest expense (1-tax rate). Use income generated from pool of funds before considering cost of funds in pool.
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Return on assets (ROA)

(net income + interest*(1-tax rate))/ total assets.
How well management is using a pool of capital .
Before considering financing decisions. Some analysts ignore interest adjustment. Measures how an enterprise uses its funds. May be used to evaluate individual business units in a large company when managers do not influence financing decision (i.e. how assets are financed).
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Return on shareholders equity (ROE)

Net income/shareholders equity.
Or, (net income -preferred dividends) / Common shareholders equity.
Common shareholders equity = total shareholders equity - preferred stock. Reflects return on funds invested by shareholders. Of interest to current and prospective shareholders.
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Return on invested capital (ROIC)

(net income + interest(1-tax rate))/ invested capital
Invested capital = permanent capital = capital employed = long-term liabilities + shareholders equity = working capital + noncurrent assets. Return on funds entrusted to the firm for relatively long time.

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Variations
Average or weighted average investment is more representative (e.g. (beginning + ending) 2). Tangible assets instead of total assets. To determine tax rate, can use total tax rate or tax rate excluding deferred taxes.

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Relationship of ROE to Profit Margin, Asset TO & Leverage

ROE can be viewed as: Pretax margin percentage X Asset Turnover ratio X Financial leverage ratio X Tax retention rate. ROE = (Pretax profit/sales revenue) X (sales revenues / total assets) X (Total assets/Shareholders equity) X (1- Tax rate)
How do we improve ROE?

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Price/Earnings (PE) ratio

Measure of overall performance. Market price per share/EPS Market price is not controlled by company; reflects all information available to the market. Reflects how investors judge future performance or prospects of the company. Commonly compared to other companies in same industry.
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Earnings per share

Company ABC has an EPS of $5 per share, Company XYZ has an EPS of $10 per share. Is one a better company or investment than the other? Is one more profitable than the other?

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Profitability measures
Profit margin = net income/net sales = a measure of overall profitability. Common size financial statements = Vertical analysis:
Express each item on the income statement as a percentage of net sales.

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Investment utilization measures

How well are assets managed. Profitability measures focus on Income Statement. Investment utilization measures involve balance sheet and income statement amounts.

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Investment turnover
Asset turnover = Sales revenue/total assets. Invested capital turnover = Sales revenue/invested capital. Equity turnover = Sales revenue/shareholders equity.

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Capital intensity
Less encompassing than investment turnover. Capital intensity ratio = sales revenue/PPE = fixed asset turnover.

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Working capital measures

Days cash = cash/cash costs per day = cash/(cash expenses 365)
Cash expenses = total expenses depreciation - other non-cash expenses.

Days receivables = Receivables/(sales 365) Days inventory = inventory/(cost of goods sold 365)
Inventory turnover = cost of goods sold/inventory
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Working capital measures

Days payables = operating payables/(pretax cash expenses 365).
Approximate pre-tax cash expenses = all expenses except taxes - depreciation expense.

Working capital turnover = sales revenue/ working capital

Some analysts look at ratio of working capital to sales revenue (inverse of working capital turnover).

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Cash conversion cycle

Receivables conversion period (i.e. days receivables) + inventory conversion period (i.e. days inventory) - payment deferral period (i.e. days payables) = operating cycle - payment deferral period. A measure of liquidity.
Indicates time interval for which additional short-term financing might be needed to support a spurt in sales.
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Financial condition ratios

Liquidity. Solvency.

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Liquidity
Ability to meet current obligations.
Tests for size and relationship between current liabilities and current assets.

Liquidity measures:
Current ratio = current assets/current liabilities. Acid Test (or quick) ratio = monetary current assets / current liabilities
Monetary current assets = current assets inventory - prepaid assets.
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Solvency
Ability to meet interest costs and repayment schedules associated with long-term debt. Solvency measures
Debt/equity ratio = total liabilities/shareholders equity
Alternatively, Debt/equity ratio = long-term liabilities/shareholders equity. Debt/capitalization ratio = long-term debt/total invested capital.
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Solvency Measures (Continued)

Total invested capital = long term debt + shareholders equity. Times interest earned = income before interest/interest expense Ratio of Cash generated by operations to total debt

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Dividend policy
Dividend yield = dividends per share/ market price per share Dividend pay-out = dividends/net income Provides info on how growth is financed.
Less dividends paid means more earnings are retained to fund growth.

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Dividend yield vs. interest yield on bonds

Not a valid comparison. Investors return on bonds kept to maturity:
Interest (adjusted for amortization of premium/discount).

Investors return on common stock:

Dividends + change in share price.
Function of expected future earnings. Earnings reinvested in business.

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Growth measures
Key accounting items for which growth is computed: sales, net income, earnings per share. Average growth = (growth per year for n years)/n Compound growth rate = based on present value concepts.
May be misleading due to abnormally high or low beginning or ending year.
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Implied growth rate

=Return on shareholders equity X Profit retention rate = ROE X (1 Dividend payout) Estimates potential to grow profits without an injection of new capital.

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Bases for comparison

Experience. A feel for what is right or reasonable. Budget. A target developed within the company. Factors to be considered:
How carefully was budget constructed? What circumstances are different now?

Historical standards. Prior periods results adjusted for changes in accounting methods. External benchmarks. Competitor, industry average
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Comments on Ratio Analysis

Helps paint a picture. Try to overcome tendency to look at numbers rather than underlying reasons. Starting point; identifies questions not answers.

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