Financial Analysis

1
Financial Analysis

• Purpose
• Ratio Analysis
• Cash Flow Analysis

2
Purpose of Financial Analysis

• Assess Corporate Performance in the context of
  stated goals and strategy.
• Assess current financial position, including
  liquidity.

3
Tools of Financial Statement Analysis

• Ratio analysis
• Signal approach
• Cash Flow analysis

4
Ratio Analysis

• Tools for interpreting financial statements
• Often used to facilitate comparison via
  deflation.
• Common size financial statements- when the whole
  statement is converted to ratio form.

5
Ratio Analysis

• Financial ratios are typically grouped into four
  classes
• Profitability
• Liquidity ratios
• Solvency ratios
• Funds management ratios

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Profitability and growth-Strategic Areas of
Influence

• Operating management
• Investment management
• Financing strategy
• Dividend policies

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Drivers of Profit and Growth
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Ratios can be used

• To compare the same firm over several years
• To compare to other firms in the industry
• To compare to an absolute benchmark

9
Operating Management (managing revenues and
expenses)

• Return on equity (ROE) -- ROE (Net Income) /
  (Shareholders Equity)
• Return on Assets -- Income / (Total Assets)
• Return on sales (ROS) -- Net Income / Sales
• Gross Profit Margin- (Sales-COGS)/Sales
• Numerous variations of the above are computed in
  practice

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An Example-Return on Equity (ROE)

• Beginning balances, ending balances, average
  balances ?
• Often adjusted for preferred stock dividends
• Average for US industries is from 11 to 13 (PBH)

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The need for an analysis framework

• What do ROE, NPM, ROA, etc., mean as a group?
• What if they differ as to outcome (e.g., one firm
  has a higher NPM but lower ROE)?
• What story do they tell, collectively?
• How do they relate to each other?

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The Notion of Ratio Decomposition (Dupont
Analysis)

• ROE ROA Assets/equity (Financial leverage)
• ROA net income/ assets
• Financial leverage indicates the dollar of assets
  the firm is able to deploy for dollar invested by
  shareholders

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The Problem of mixed operating and non-operating
financial statement components

• What if a firm has a large block of assets and/or
  liabilities that are not involved in operations?
• What if net income includes numerous
  non-operating items?

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A Variation on the usual definition of ROA

• Operating ROA
• Focus is on operating return only -- excludes
  interest income
• (Net Income (Interest exp - Interest income)
  (1-tax rate)) / (Equity Debt - Cash and
  Short-tern investments)

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Decomposition Using Operating ROA

• ROE Operating ROA (RNOA) Spread x Leverage

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Operating/Nonoperating vs. Core/Transitory
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Level I-Based DecompositionExample ROE, RNOA
Leverage
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Financial Leverage and Risk

• Given that increases in financial leverage
  increase ROE, why are all companies not 100 debt
  financed?
• The answer is because debt is risky. This
  increased risk increases the expected return that
  investors require to provide capital to the firm.
  
• Higher financial leverage also results in a
  higher interest rate on the companys debt.

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Leverage and Income Variability
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Level II-Based DecompositionExample ROE, ROA
Leverage

• ROE ROA x assets/equity
• ROA net income/sales x sales/assets
• Therefore
• ROENet profit margin x
• asset turnover x
• leverage

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Level II Analysis of Operating Margin and
Operating Turnover
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Margin vs. Turnover
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Return on Sales (ROS)

• Shows profitability of firms operating
  activities
• Used extensively by Japanese management
• Indicates how much profit is generated per dollar
  of sales

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NOPAT Margin
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Turnover of NOA
here
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Level 3 Analysis Disaggregation of Operating
Margin and Operating Turnover
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Level III Analysis using the standard definition
of ROA
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Sustainable Growth Rate
Dividend payout
ROE
Fin Leverage
ROS
Asset Turnover
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Sustainable Growth 1

• ROE (1-Dividend payout ratio)

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Gross Profit Margin

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

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Gross Profit Margin

• Two main factors determine gross profit margins
• Competition The more competition, the lower
  margins tend to be.
• Product mix The greater the volume of low
  profit/high turnover goods, the lower the
  margins.
• Very relevant for comparisons within an industry
  -- not much outside

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Operating Expense Margin

• Operating expense ratios (percents) are used to
  examine the proportion of sales consumed by each
  major expense category.
• Expense ratios are calculated as follows
• Operating expense percentage Expense item/Net
  sales

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Drivers of Profit and Growth
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Investment Management

• Working Capital and Fixed Assets
• Receivables
• Inventory
• LT operating assets
• Payables

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Turnover

• Turnover measures relate to the productivity of
  company assets, i.e., how much capital is
  required to generate a specific sales volume?
• Turnover ratios are calculated as follows
• Turnover Sales volume/Average Assets
• As turnover increases, there is greater cash
  inflow as cash outflow for assets to support the
  current sales volume is reduced.

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Accounts Receivable Turnover (ART)
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Inventory Turnover (INVT)
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L-T Operating Asset Turnover (LTOAT)
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Accounts Payable Turnover (APT)
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Net Operating Working Capital Turnover (WOCT)
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Evaluating Financial Management

• Short-term evaluations
• Long-term evaluations

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Short-term evaluations 1

• Current ratio
• (Current assets) / (Current liabilities)

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Short-term evaluations 2

• Quick ratio
• (Cash Short-term investments Accounts
  Receivable) / (Current liabilities)

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Short-term evaluations 3

• Operating cash flow ratio
• (Cash flow from operations) / (Current
  liabilities)

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Long-term evaluations

• Debt is typically cheaper that equity
• Interest is tax deductible dividends are not
• Can impose discipline on management (explicit
  contracts)
• Easier to communicate proprietary information to
  private lenders than to public markets

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Standard ratios

• Liabilities-to-equity-ratio
• Debt-to-equity ratio
• Debt-to-capital
• Interest coverage

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Liabilities-to-equity

• (Total Liabilities) / (Shareholders equity)

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Debt-to-equity

• (Short-term debt Long-term debt) /
  (Shareholders equity)

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Interest coverage

• (Net income Interest expense Tax expense) /
  (Interest expense)

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Problems with Ratios

• Mis-specification of deflator (e.g., size)
• Accounting imperfections
• Problem of assumed linearity
• Ratio blow-up
• Negative numbers. What do they mean?
• Assumed 0 intercept.
• Omitted variables

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In Search of Fundamentals-Lev and Thiagarajans
Signals Approach

• Inventory
• Accounts receivable
• Capital Expenditure, RD
• Gross margin
• Sales and Administrative Expenses

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In Search of Fundamentals Lev and Thiagarajan
Signals Approach

• Effective tax
• Order backlog
• Labor force
• LIFO changes
• Audit qualifications

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Inventory

• Considered disproportionate increases in
  inventory as a negative signal
• Percentage Change in Inventory - Percentage
  Change in Sales

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Accounts Receivable

• Disproportionate increases considered negative
• Percentage Change in AR - Percentage Change in
  Sales

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Capital Expenditures RD

• Relative Decreases Considered negative
• Percentage change in industry - Percentage change
  in Firm

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Gross Margin

• Disproportionate decreases with respect to sales
  negative
• Percentage change in Gross Margin - Percentage
  change in sales

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Selling and Administrative

• Disproportionate increases to sales negative
• change in SA - change in sales

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Provision for doubtful accounts

• Increases less than the increases in accounts
  receivable is viewed as negative
• Change in Accounts receivable - Change in
  doubtful accounts

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Effective tax Rate

• Unusual decrease in effective tax rate considered
  negative
• PTE this year (Effective rate last year-
  effective rate this year)

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Order Backlog

• Unfilled orders is often viewed as a leading
  indicator
• change in sales - change in order backlog
• A negative signal is Good? or Bad?

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Labor Force Changes

• Labor force reductions are usually considered
  good news by analysts
• Defined as percentage change in sales per employee

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LIFO

• LIFO considered positive

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Audit Qualification

• Adverse opinion considered bad news

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Results

• Regression analysis with Excess Return as the
  dependent variable came out about as hypothesized
• Found that results are not constant for macro
  economic conditions

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From Business Activities to Financial Statements
Business Environment
Business Strategy
Accounting System
Accounting Environment
Accounting Strategy
Financial Statements
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Drivers of Profit and Growth
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Cash Flow Analysis- Based on Business Activities
Operating Activities Investment
Activities Financing Activities
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Cash Flow

• The Direct Method
• The Indirect Method

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Cash Flow -- Direct Method

• Recommended by the FASB
• Most companies use the Indirect Method

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Cash Flow -- Indirect Method - 1
Net Income
Add
Non-cash income items
Plus/Less
Adjustments for receivables inventories,
payables, taxes
Equals
Cash Flow from Operations
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Cash Flow -- Indirect Method - 2
Cash Flow from Operations
PLUS/LESS
Cash flow - Investment activities
PLUS/LESS
Cash flow - Financing activities
EQUALS
Change in cash and cash equivalents
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From Profit to Cash
Net Income
Cash Flow From Oper. bef. WC chgs, Inv Int
CF from op After Wc Changes before int
Noncash charges
/- Chg in Working Cap
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From Profit to Cash -- 2
Cash Flow From Operations
CF
Free Cash Flow
/- Interest
/- Chg Fixed Capital
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Free Cash Flow

• Jensen (1988) defines free cash flow as the cash
  left after managers have invested in all positive
  NPV projects
• He also asserts that managers will invest in
  negative NPV projects rather pay it out to
  shareholders
• The Free cash flow used in out context is the
  cash flow from operations plus the net investment
  cash flow

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Free cash Flow and Interest

• You may add interest back. Depends on the
  purpose of the Free Cash Flow. See p. 6-3.

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Free Cash Flow From Working Capital

• Adjust Working Capital from operations for
  changes in current accounts to get Cash Flow From
  Operations
• Add the net capital investment
• What you get is Free Cash Flow