Financial Statement Analysis

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Financial Statement Analysis

• FIL 404
• Prepared by Keldon Bauer

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Ratio Analysis

• Financial ratios are the vital signs of the
  business.
• They are used to assess the health of the
  business.
• When they are off the norm, they should be taken
  together with all known information to get a
  correct diagnosis.
• Norms should be seen as a normal range, not just
  one number.

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Ratio Analysis

• Ratios also allow for better comparison through
  time or between companies.
• As we look at each ratio, ask yourself what the
  ratio is trying to measure and why is that
  information important.
• Ratios are used both internally and externally.

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Categories of Financial Ratios

• Short-term solvency or liquidity ratios
• Asset management or efficiency ratios
• Long-term solvency or financial leverage ratios
• Debt coverage ratios
• Profitability ratio
• Market value ratios

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Liquidity Ratios

• Relate short-term sources of and uses for cash.
• Current Ratio

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Liquidity Ratios

• Quick (Acid Test) Ratio

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Liquidity Ratios

• Cash ratio

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Efficiency Ratios

• Purpose is to assess how well the firm is
  managing assets
• Inventory turnover ratio (IT)

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Efficiency Ratios

• Accounts receivable turnover (ART)

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Efficiency Ratios

• Accounts payable turnover (APT)

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Efficiency Ratios

• Total Asset Turnover (TAT)

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Leverage Ratios

• Relate debt to equity sources of investment funds
  .
• Debt Ratio
• Measures the proportion that liabilities are of
  total sources of funds

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Leverage Ratios

• Debt-Equity Ratio
• Measures the proportion of debt to equity
  currently used to finance the firm.

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Coverage Ratios

• Measure of ability to meet debt contracts.
• Times Interest Earned (TIE) Ratio
• Measures how many times the interest expense
  could be covered by operating earnings.

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Coverage Ratios

• EBITDA Ratio
• Conservatively estimates how many times the
  principal and interest payments could be made
  from operating cash flow.

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Profitability Ratios

• Whats the bottom line?
• Gross Profit Margin (GPM)
• Measures how much profit is gained due to
  pricing.

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Profitability Ratios

• Operating Profit Margin (OPM)
• Measures how much profit can be pulled through
  ongoing operations.

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Profitability Ratios

• Net Profit Margin (NPM)
• Measures how much money from every dollar is
  pulled through as net profit.

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Basic Earnings Power

• BEP removes effect of taxes and financial
  leverage. Useful for comparison.

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Profitability Ratios

• Return on Total Assets (ROA)
• This is a measure of the return on assets owned.
• Therefore, it is a measure of return to all
  invested funds.

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Profitability Ratios

• Return on Equity (ROE)
• This is a measure of return to the equity holder
  (whether or not they get a dividend).

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Understanding the Analysis

• Make sure you understand, and can communicate
  your analysis.
• Ratios only make sense if the concept makes sense
  for your company.
• Service companies have no inventory inventory
  turnover makes no sense.

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Deriving the Du Pont Identity

• ROE NI / TE
• Multiply by 1 and then rearrange
• ROE (NI / TE) (TA / TA)
• ROE (NI / TA) (TA / TE) ROA EM
• Multiply by 1 again and then rearrange
• ROE (NI / TA) (TA / TE) (Sales / Sales)
• ROE (NI / Sales) (Sales / TA) (TA / TE)
• ROE PM TAT EM

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Market Value Ratios

• Price-earnings ratio (P/E)

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Market Value Ratios

• Price-Cash flow (P/CF) Ratio

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Market Value Ratios

• Dividend Yield
• Measures the return current shareholders would be
  earning from dividends if the most recent
  dividend history continues.

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Market Value Ratios

• Market-to-Book Ratio
• Measures how much more value the stock market
  perceives in the companys equity, than the
  accounting books would reflect.

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Common-Size Statements

• Common-size financial statements are restatements
  as percentages of the traditionally largest
  number on the statement.
• Common-size balance sheets are restated as
  percent of assets.
• Common-size income statements are restated as
  percent of sales (or revenues).

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Creating Common Size Statements

• The key to creating common size financial
  statements is the use of relative versus absolute
  addresses.
• Excel interprets an address as relative (in
  position) to another address in a formula, unless
  you specify otherwise.
• A1 is a relative address.
• To specify an absolute address you simply use a
  in front of the absolute portion.
• A1 means always A1.
• The F4 key allows you to cycle through all
  options.

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Creating Common Size Statements

• The item that is the basis for the common size,
  then typically gets an absolute address.
• For example if sales are in C4, then creating a
  common size income statement would require you to
  punch in
• C4/C4.
• Then copying that formula down will create the
  common size income statement.

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Trend Analysis

• Seeing how ratios change over time.
• Are they getting better or worse over time?
• Helps to determine the direction the firm is
  heading.
• Show example.
• Can be enhanced by graphing them.

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Trend Analysis
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Trend Analysis

• You can also index the financial statements.
• The figures in the earliest year are 100, and
  those in subsequent years are percentages of the
  earliest year.
• Be careful with the interpretation.
• You are assuming that the first year was optimal.
• High growth is miniscule accounts could be
  meaningless.

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Industry Averages

• To compare the firms performance to that of
  similar firms, many use industry averages
• Risk Management Association (RMA)
• Focuses on private companies.
• The target audience is commercial lenders.
• The source is also lenders.
• Industries are defined using NAICS system.
• Data are organized by size (assets or sales).
• Most ratios include upper/lower quartiles as well
  as average.

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Industry Averages

• Dunn and Bradstreets
• Focuses on publicly traded companies.
• Industries are defined using SIC system.
• Also used by SEC.
• Data are clumped together (no size adjustments).
• Most ratios include upper/lower quartiles as well
  as average.
• But there are not many ratios covered.

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Dunn Bradstreet
Common Size Balance Sheet
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Dunn Bradstreet
Key Financial Ratios
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Qualitative Factors

• Are the companys revenues tied to a single
  customer?
• To what extent are the companys revenues tied to
  a single product?
• To what extent does the company rely on a single
  supplier?

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Qualitative Factors (Continued)

• What percentage of the companys business is
  generated overseas?
• What is the competitive situation?
• What does the future have in store?
• What is the companys legal and regulatory
  environment?