ESSENTIALS of FINANCIAL STATEMENT ANALYSIS

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CHAPTER 5
FINANCIAL REPORTING ANALYSIS BY REVSINE
COLLINS JOHNSON 2nd Edition

• ESSENTIALS of FINANCIAL STATEMENT ANALYSIS

Adopted from Slides Authored by Brian Leventhal
University of Illinois at Chicago
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I. Basic Approaches

• A. Time-series analysis helps identify financial
  trends over time
  for a
  single company
  or
  business unit.

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I. Basic Approaches

• B. Cross-sectional analysis helps identify
  similarities and differences across
  companies or business
  units at a
  single moment in
  time.

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I. Basic Approaches
In time-series analysis, the benchmark may be the
change in performance or health each year.
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I. Basic Approaches
In cross-sectional analysis, the benchmark may be
the performance or health of a particular
competitor or industry averages.
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II. Quaker Oats Example 

• B. Common size and trend statements provide a
  convenient way to organize financial statement
  information
  so that major
  financial
  components and
  changes are easily
  recognized.

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II. Quaker Oats Example

• 1. Common size income statements recast
  each statement item as a percentage of sales for
  that period.
• 2. Trend statements recast each statement item as
  a percentage of that item in a base year.

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II. Quaker Oats Example

• Comparative Income Statements
• ( in millions) 1999 1998
  1997 1996 1995
• Sales 4,725.2 4842.5
  5,015.7 5,199.0 5,954.0
• Cost of Goods Sold 2,136.8 2,374.4
  2,564.9 2,807.5 3,294.4 Gross Profit
  2,588.4 2,468.1 2,4580.8 2,391.5
  2,659.6
• Selling, GA Exp. 1,904.1 1,872.5
  1,938.9 1,981.0 2,358.8
• (Gains) losses on (2.3) 128.5
  1,486.3 (113.4) (1,053.5)
• divestitures,
• restructurings and
• asset impairment
• Interest Expense 61.9 69.6
  85.8 106.8 131.6
• Other (revenues) exp. 6.4 0.9
  4.1 1.5 2.2
• Pre-tax income 618.3 396.6
  (1,064.3) 415.6 1,220.5
• Income taxes 163.3 112.1
  (133.4) 167.7 496.5
• Net Income (loss) 455.0 284.5
  (930.9) 247.9 724.0

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II. Quaker Oats Example Common Size Sales
Comparative Income Statements ( in millions)
1999 1998 1997 1996
1995 Sales
100.0 100.0 100.0 100.0
100.0 Cost of Goods Sold 45.5 49.0
51.1 54.0 55.3 Gross
Profit 54.8 51.0
48.9 46.0 44.7 Selling, GA Exp.
40.3 38.7 38.7
38.1 39.6 (Gains) losses on
0.0 2.7 29.6 2.2
17.7 divest.,restructurings

asset impairment Interest Expense
1.3 1.4 1.7
2.1 2.2 Other (revenues) exp. 0.1
0.0 0.1 0.0
0.0 Pre-tax income 13.1
8.2 -21.2 8.0
20.5 Income taxes 3.5
2.3 -2.7 3.2 8.3 Net
Income (loss) 9.6 5.8
-18.6 4.7 12.1
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II. Quaker Oats Example Trend(1995100)
Comparative Income Statements ( in millions)
1999 1998 1997
1996 1995 Sales
79.4 81.3 84.2 87.3
100.0 Cost of Goods Sold 64.9
72.1 77.9 85.2 100.0
Gross Profit 97.3
92.8 92.1 89.9 100.0
Selling, GA Exp. 80.7 79.4
82.2 84.0 100.0 (Gains)
losses on 0.2 -12.2
-141.1 10.8 100.0 divest.,restructuri
ngs
asset
impairment Interest Expense 47.0
52.9 65.2 81.2 100.0
Other (revenues) exp.290.9 40.9
186.4 68.2 100.0 Pre-tax income
50.7 32.5 - 87.2
34.1 100.0 Income taxes
32.9 22.6 -26.9 33.8
100.0 Net Income (loss) 62.8
39.3 -128.6 34.2 100.0
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III. Profitability, Competition, Business
Strategy 

• A. Financial ratios are another powerful tool
  that analysts use in evaluating profit
  performance and assessing credit risk.

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III. Profitability, Competition, Business
Strategy 

• B. Most evaluations of
  profit performance begin with the
  Return on Assets (ROA) ratio

ROA net operating profit after taxes
average assets
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III. Profitability, Competition, Business
Strategy 

• B. Most evaluations of
  profit performance begin with the
  return on assets (ROA) ratio

ROA net operating profit after taxes
average assets
2. Analysts can isolate a companys sustainable
operating profits by removing nonoperating or
nonrecurring items from reported earnings.
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III. Profitability, Competition, Business
Strategy 

• B. Most evaluations of
  profit performance begin with the
  return on assets (ROA) ratio

ROA net operating profit after taxes
average assets
3. After-tax interest expense is eliminated from
the profit calculation so that operating
profitability comparisons over time are not
clouded by differences in financial structure.
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III. Profitability, Competition, Business
Strategy 

• B. Most evaluations of
  profit performance begin with the
  return on assets (ROA) ratio

ROA net operating profit after taxes
average assets
4. Adjustments to eliminate distortions to both
earnings and assets for items such as the capital
and operating lease, for example mentioned
earlier should be done.
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III. Profitability, Competition, Business
Strategy 

• C. A company can increase its ROA in two
  different ways

ROA net operating profit after taxes
average assets

• By increasing the operating profit margin.
• By increasing the intensity of asset
  utilization.
• In other words, ROA can be thought of as
• Operating profit margin ? asset turnover

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III. Profitability, Competition, Business
Strategy 

• C. A company can increase its ROA in two
  different ways

ROA net operating profit after taxes
average assets
Operating profit margin ? asset turnover
Net operating profit after taxes(NOPAT)
Sales
S a l e s Average Assets
?
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III. Profitability, Competition, Business
Strategy 

• D. ROA and competitive advantage

Operating profit margin ? asset turnover
5. There are only two strategies for achieving
superior performance in any business
a. One strategy is product and service
differentiation in order to focus customer
attention on unique product or service
attributes to gain customer loyalty and
attractive profit margins.
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III. Profitability, Competition, Business
Strategy 

• D. ROA and competitive advantage

Operating profit margin ? asset turnover
5. There are only two strategies for achieving
superior performance in any business
b. Low-cost leadership focuses customer
attention on product pricing. The goal is to
under price the competition, achieve highest
sales volumes, and still make a profit on each
sale.
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III. Profitability, Competition, Business
Strategy 

• D. ROA and competitive advantage

Operating profit margin ? asset turnover
5. There are only two strategies for achieving
superior performance in any business
c. Few companies actually pursue one strategy to
the exclusion of the other.
Rather, they try to develop brand loyalty
while controlling cost.
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IV. Credit Risk Capital Structure 

• A. Credit risk refers to the ability and
  willingness of a borrower to
  pay its debt.

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IV. Credit Risk Capital Structure 

• A. Credit risk refers to the ability and
  willingness of a borrower to pay its debt.

1. Ability to repay debt is determined by
capacity to generate cash from operations, asset
sales, or external financial markets
in excess of cash needs.
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IV. Credit Risk Capital Structure 

• A. Credit risk refers to the ability and
  willingness of a borrower to pay its debt.

• 2. Willingness to pay depends on which competing
  cash need is viewed as the most pressing at the
  moment.

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IV. Credit Risk Capital Structure 

• A. Credit risk refers to the ability and
  willingness of a borrower to pay its debt.

• 3. The statement of cash flows is an important
  source of information for analyzing a companys
  credit risk.
  
  
• Financial ratios are also
  useful for this purpose.

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IV. Credit Risk Capital Structure 

• B. Credit risk analysis using financial ratios
  typically involves an assessment of liquidity and
  solvency.

1. Liquidity refers to the companys short-term
ability to generate cash for working capital
needs and immediate debt repayment needs.
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IV. Credit Risk Capital Structure 

• B. Credit risk analysis using financial ratios
  typically involves an assessment of liquidity and
  solvency.

2. Solvency refers to the long-term ability to
generate cash internally or from external sources
in order to satisfy plant capacity needs,
fuel growth,
and
repay debt
when due.
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IV. Credit Risk Capital Structure 

• C. Short-term liquidity

Current Current Assets Ratio Current
Liabilities
1. Reflects cash other current assets that will
be converted into cash in the normal operating
cycle.
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IV. Credit Risk Capital Structure 

• C. Short-term liquidity

Quick Cash ReceivablesMarketable Securities
Ratio Current Liabilities
2. Inventory is not included, providing a more
short-run reflection of liquidity, since
few businesses can
instantaneously convert
their inventories into cash.
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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches.

A/R Turnover N e t S a l e s
Average A/R

• This ratio tells users the proportion of yearly
  sales that the average receivables balance
  represents.
• This ratio will be correspondingly larger for
  firms with cash sales that are a larger
  proportion of total sales.

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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches.

Days Receivables 365 D a y s Outstanding
A/R Turnover

• This ratio tells users the average collection
  period for accounts receivable.
• This should be compared to the credit period
  allowed by the company.

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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches.

Inventory Turnover Cost of Goods Sold
Ratio Average Inventory

• This ratio tells users the proportion of sales
  that the average inventory balance represents.
• A higher ratio may indicate
• i. More efficient operations, or
• ii. Adoption of a low-cost
  leadership strategy.

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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches.

Days Inventory 365 D a y s
Held Inventory Turnover
d. This ratio tells users the average number of
days that inventory is held in storage.
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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches.

Accounts Payable Inventory Purchases
Turnover Average A/P
e. This ratio, and its counterpart that
follows, helps analysts understand the companys
pattern of payment to suppliers.
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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches.

Days A/P 365 D a y s
Outstanding A/P Turnover
Show on average how long the company takes to
payoff Accounts Payable.
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IV. Credit Risk Capital Structure 

• 3. Activity ratios tell users how efficiently the
  company is using its assets by highlighting
  causes for cash flow mismatches

Cash Inflow Vs Cash Outflow Mismatching
Days Receivable Outstanding Days Inventory
Held - Days A/P Outstanding
The level of concern is negatively correlated
with the level of operating cash flow.
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IV. Credit Risk Capital Structure 

• D. Long-term solvency
• 1. Debt ratios provide information about the
  amount of long-term debt in a companys
  financial structure.

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IV. Credit Risk Capital Structure 
D. Long-term solvency
Long-Term Debt Long-Term Debt to Total
Assets Total Assets

• 2. Reflects the proportion of each asset dollar
  financed with
  long-term debt.

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IV. Credit Risk Capital Structure 
D. Long-term solvency
Long-Term Debt Long-Term Debt to
Tangible Assets Total Tangible Assets

• 3. The adjustment to remove intangible assets is
  intended to remove
  soft assets,
  
• i.e., those that are difficult
  to value reliably.

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IV. Credit Risk Capital Structure 
D. Long-term solvency
Interest Operating Income before taxes
Interest Coverage Interest Expense

• Ability to generate a stream of inflows
  sufficient to make principal and interest
  payments.
• The interest coverage ratio is
  commonly used for this purpose.

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IV. Credit Risk Capital Structure 
D. Long-term solvency
Operating Cash Flows Cash Flow from
continuing operations to Total Avg.
C/L Long-Term Debt Liabilities
5. The ability of a company to generate cash
flows from operations in order to service both
short-term and
long-term borrowings.
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V. Return on Equity Financial Leverage 

• A. Profitability and credit risk both influence
  the return that common shareholders earn on their
  investment in the company.

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V. Return on Equity Financial Leverage
Net Income Available to
Return on common shareholders
Common Equity Average Common (ROCE)
Shareholders Equity
B. Measures a companys performance in using
capital provided by
shareholders to
generate earnings.
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V. Return on Equity Financial Leverage
C. Components of ROCE
Net Income Available to
Return on common
shareholders Common Equity Average
Common (ROCE)
Shareholders Equity
ROCE ROA x Common earning lev. x Fin.
structure lev.
a. The common earnings leverage ratio shows the
proportion of NOPAT that belongs to common
shareholders.
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V. Return on Equity Financial Leverage
C. Components of ROCE
Net Income Available to
Return on common
shareholders Common Equity Average
Common (ROCE)
Shareholders Equity
ROCE ROA x Common earning lev. x Fin.
structure lev.
b. The financial structure leverage ratio
measures the degree to which the company uses
common shareholders capital to finance assets.
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VI. Earnings, Cash Earnings, or EBITDA? 

• A. There are several measures of earnings that
  may be used in press releases.

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VI. Earnings, Cash Earnings, or EBITDA? 

• A. There are several measures of
  earnings that may be used in press releases.

1. GAAP earnings are those reported to the SEC
using GAAP.
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VI. Earnings, Cash Earnings, or EBITDA? 

• A. There are several measures of
  earnings that may be used in press releases.

2. EBITDA is earnings before interest, taxes,
depreciation, and amortization.
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VI. Earnings, Cash Earnings, or EBITDA? 

• A. There are several measures of
  earnings that may be used in press releases.

3. Cash earnings is generally defined as earnings
before goodwill amortization.

• Pro forma earnings is a variant that excludes a
  variety of costs that are routinely included in
  GAAP earnings.
• One popular operationalization is net income
  before goodwill amortization and one-time costs
  such as merger integration costs.

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VI. Earnings, Cash Earnings, or EBITDA? 

• A. There are several measures of
  earnings that may be used in press releases.

3. Cash earnings is generally defined as earnings
before goodwill amortization.
b. Standard definitions for these benchmarks do
not currently exist.
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VI. Earnings, Cash Earnings, or EBITDA?

• B. Analysts must be wary and
  look behind
  the numbers to see what is
  really going on!