Financial Statement Analysis

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Financial Statement Analysis
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What are the functions of financial statements?

• Provide information to owners and creditors about
  the firms current status and past financial
  performance
• Provide a convenient way for owners and creditors
  to set performance targets and impose
  restrictions on managers
• Provide a convenient way for a firms financial
  planning

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Types of financial statements

• Balance Sheet
• Income Statement
• Statement of Cash Flows

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The Balance Sheet

• The balance sheet shows a firms assets (what it
  owns) and liabilities (what it owes)
• The difference between a firms assets and
  liabilities is the firms net worth
• For corporations, net worth is called
  stockholders equity

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A typical balance sheet

• Assets
• Current Assets
• Cash short term securities
• Accounts Receivable
• Inventory
• Total Current Assets
• Fixed (long-term) assets
• Property/plant/equipment
• Investments
• Other assets
• Total Assets

• Liabilities Shareholder Equity
• Current Liabilities
• Accounts payable
• Short-term debt (due in one year)
• Accrued expenses
• Total Current Liabilities
• Long-term Liabilities
• Long-term debt
• Total Liabilities
• Shareholder Equity
• Common equity (paid in)
• Retained earnings
• Total liabilities shareholder equity

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Do financial analysts disagree with balance sheet
information?

• Main issue Book values vs. market values
• Balance sheets omit some economically significant
  assets called intangible assets, such as RD
• Intangible assets, such as goodwill, are not
  reported at market values
• Some economically significant liabilities are
  also omitted, e.g. pending lawsuits

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The Income Statement

• The income statement presents in a summary form
  the profitability of a firm over an annual period
• The income statement presents information on
• Revenues (sales)
• Cost of goods sold
• Operating expenses
• Financing costs of doing business
• Tax expenses

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A typical income statement

• Sales revenue
• - Cost of goods sold
• Gross margin
• - Operating expenses
• EBITDA
• - Depreciation Amortization
• EBIT (Operating income)
• - Interest payment
• Taxable income
• - Taxes
• Net Income

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How is net income allocated?

• Dividends
• Change in retained earnings
• Earnings per share
• Basic Net income / shares of common stock
  outstanding
• Diluted Adjusts for stock options and
  convertible debt

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Accounting vs. economic measures of earnings

• Accounting definition of earnings ignores
  unrealized gains or losses in market value of
  assets and liabilities
• Accrual accounting recognizes revenues and
  expenses in the period that they take place,
  which does not necessarily match the cash flows
  of a firm

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• The firms expenses are separated into operating,
  financing and capital
• Accounting depreciation does not attempt to
  measure economic depreciation (loss in an assets
  value)
• Inconsistencies in the application of this
  categorization of expenses (e.g., RD is treated
  as an operating expense)

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Statement of Cash Flows

• The statement of cash flows shows all the cash
  that flows in and out of a firm during a
  specified period of time
• Note that income statements show revenues and
  expenses
• Cash flow statements are useful because
• They show a firms cash position over time
• They avoid accounting judgments about revenues
  and expenses found in income statements

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A typical cash flow statement

• Cash flow from operations
• Net income
• Depreciation
• - Increase in accounts receivable
• - Increase in inventories
• Increase in accounts payable
• Total cash flow from operations
• Cash flow from investing activities
• - Investment in plant and equipment
• Cash flow from financing activities
• - Dividends paid
• Increase in short-term debt
• Change in cash and marketable securities

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Financial Ratio Analysis Evaluating a firms
performance

• Financial ratio analysis is a popular way of
  using information from financial statements to
  evaluate a firms performance
• Through the analysis of financial ratios, we can
  easily identify the strengths and weaknesses of a
  firm

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How are financial ratios used?

• Calculating financial ratios allows us to
• Examine the firms performance through time (e.g.
  last five years) and identify trends
• Compare the firms performance with other
  comparable firms (peer group) and identify the
  firms competitive advantage
• Some financial ratios (e.g. price-earnings ratio,
  market-to-book ratio) are useful in valuation
  analysis, such as valuing private firms

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Classification of financial ratios

• Profitability ratios
• Liquidity ratios
• Efficiency ratios
• Financial leverage ratios
• Market value ratios
• Payout policy ratios

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Profitability Ratios

• After-tax operating margin Measures the firms
  effectiveness in generating profits from
  operations
• (EBIT taxes)/Sales
• Return on assets Measures the firms operating
  effectiveness in generating profits from its
  assets
• (EBIT taxes)/Average Assets

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• Return on equity Measures the firms
  profitability from the perspective of the equity
  investor
• Net Income/Stockholders Equity
• Return on capital Measures the firms
  effectiveness in generating profits from the
  capital invested in the firm
• (EBIT taxes)/(BV Debt BV Equity)

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Liquidity Ratios

• Current ratio Compares current assets (cash,
  inventory, accounts receivable) to current
  liabilities (obligations due within one year)
• Current Assets/Current Liabilities
• Quick or Acid Test ratio Variant of current
  ratio that distinguishes current assets that can
  be converted quickly into cash (cash, marketable
  securities) from those that cannot (inventory,
  accounts receivable)
• (Cash Marketable Securities)/Current Liabilities

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Efficiency Ratios(Asset Management Ratios)

• Asset Turnover ratio Indicates how efficiently
  the firm is using its assets to generate sales
• Sales/Average Total Assets
• Accounts Receivable Turnover ratio Indicates how
  rapidly the firm is collecting its credit,
  measured by how many times accounts receivable
  are rolled over during a year
• Sales/Average Accounts Receivable

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• Inventory Turnover ratio Indicates the relative
  liquidity of inventories, measured by how many
  times the firms inventories are replaced during
  a year
• Cost of Goods Sold/Average Inventory
• Days Receivable Outstanding, Days Inventory Held
• 365/Receivable Turnover
• 365/Inventory Turnover

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Financial Leverage Ratios

• Times Interest Earned Ratio (Interest Coverage
  Ratio) Measures the firms capacity to meet
  interest payments from pre-debt, pre-tax earnings
• EBIT/Interest Expenses
• Debt Capitalization ratio Measures how much debt
  a firm is using as a proportion of its total
  capital (total value of debt plus equity)
• Debt/(Debt Equity)

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• Debt to Equity Ratio Measures debt as a
  proportion of the firms equity
• Debt/Equity
• The above two ratios can also be calculated by
  using only long-term debt
• Moreover, these ratios must be calculated using
  market instead of book values for debt and
  equity. Market-based debt ratios give a better
  indication of a firms ability to borrow

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Market Value Ratios

• Price to Earnings ratio (P/E) and Market to Book
  ratio Measure the relation between the
  accounting measures (value) of the firm and its
  market value
• Price per Share/Earnings per Share
• Price per Share/Book Value per Share

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Payout Policy Ratios

• Dividend Payout ratio It relates dividends paid
  to the earnings of the firm
• Dividends/Earnings
• Dividend Yield ratio It relates the dividend
  paid to the price of the stock
• Annual Dividends per Share/Price per Share

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The DuPont Analysis

• A useful way to understand the sources that drive
  a firms ROA and ROE
• We can disaggregate ROA as follows
• ROA (Net Profit Margin) ? (Total Asset
  Turnover)

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• Asset turnover and net profit margin (return on
  sales) drive ROA
• If a firm can reduce working capital without
  hurting its competitiveness, then asset turnover
  ? and ROA ?
• If a firm cuts back capital expenditures, then,
  in the short run, ROA ? because asset turnover ?
  (due to total assets ?) and return on sales ?
  (the latter because future depreciation ? and,
  thus, net income ?)
• But, this strategy, will probably hurt the firms
  competitiveness and, thus, ROA in the long run

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• Moreover, we can disaggregate ROE as follows
• ROE (ROA) ? (1 Debt Ratio)
• As we see, ROE can increase through an increase
  in ROA or the Debt Ratio

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• Financial analysts value more a firm that
  increases its ROE through higher ROA
• A firm that increases ROE by taking on more debt
  also increases the probability of being in
  financial distress (bankruptcy)

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Examples and Applications

• See handouts on Oracle Corp. distributed in class