Major Financial Statements

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Major Financial Statements

• Corporate shareholder annual and quarterly
  reports must include
• Balance sheet
• Income statement
• Statement of cash flows
• Reports filed with Securities and Exchange
  Commission (SEC)
• 10-K and 10-Q

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Statement of Cash Flows

• It has three sections
• Cash Flow from Operating Activities the sources
  and uses of cash that arise from the normal
  operations of a firm
• Cash Flow from Investing activities change in
  gross plant and equipment plus the change in the
  investment account
• Cash Flow from Financing activities financing
  sources minus financing uses

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Importance of Relative Financial Ratios

• Compare to other entities
• Examine a firms performance relative to
• The aggregate economy
• Its industry or industries
• Its major competitors within the industry
• Its past performance (time-series analysis)

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Comparing to A Firms Industry

• Most popular comparison
• Industries affect the firms within them
  differently, but the relationship is always
  significant
• The industry effect is strongest for industries
  with homogenous products
• Examine the industrys performance relative to
  aggregate economic activity

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Comparing to A Firms Major Competitors

• Industry averages may not be representative
• Select a subset of competitors to compare to
  using cross-sectional analysis, or
• Construct a composite industry average from
  industries the firm operates in

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Comparing to A Firms Historical Performance

• Determine whether it is progressing or declining
• Helpful for estimating future performance
• Consider trends as well as averages over time

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Five Categories of Financial Ratios

• 1. Internal liquidity (solvency)
• 2. Operating performance
• a. Operating efficiency
• b. Operating profitability
• 3. Risk analysis
• a. Business risk
• b. Financial risk

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Five Categories of Financial Ratios

• 4. Growth analysis

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Five Categories of Financial Ratios

• 5. External liquidity (marketability)

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Common Size Statements

• Normalize balance sheets and income statement
  items to allow easier comparison of different
  size firms
• A common size balance sheet expresses accounts as
  a percentage of total assets
• A common size income statement expresses all
  items as a percentage of sales

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Operating Profitability Ratios

• Return on owners equity (ROE) can be computed
  for the common- shareholders equity

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Operating Profitability Ratios
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Operating Profitability Ratios
This indicates the pretax return on equity. To
arrive at ROE we must consider the tax rate
effect.
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Operating Profitability Ratios
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Operating Profitability Ratios

• In summary, we have the following five components
  of return on equity (ROE)

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Operating Profitability Ratios
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Operating Profitability Ratios
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Operating Profitability Ratios
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Operating Profitability Ratios
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Operating Profitability Ratios
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The Expanded Du Pont system - Bloomberg and CFA
Style

• ROE EBIT/Sales x S/A x EBT/EBIT x A/Eq x
  EAT/EBT
• ROE O.P.M. x TATO x Interest Burden x EM x Tax
  Burden

It shows how these factors combine to determine
the ROE.
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Risk Analysis

• Total risk of a firm has two components
• Business risk
• The uncertainty of income caused by the firms
  industry
• Generally measured by the variability of the
  firms operating income over time
• Financial risk
• Additional uncertainty of returns to equity
  holders due to a firms use of fixed obligation
  debt securities
• The acceptable level of financial risk for a firm
  depends on its business risk

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Business Risk

• Variability of the firms operating income over
  time

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Business Risk

• Variability of the firms operating income over
  time
• Standard deviation of the historical operating
  earnings series

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Business Risk

• Two factors contribute to the variability of
  operating earnings
• Sales variability
• Earnings must be as volatile as sales
• Some industries are cyclical
• Operating leverage
• Production has fixed and variable costs
• Fixed production costs cause profit volatility
  with changes in sales
• Fixed production costs are operating leverage

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Financial Risk

• Bonds interest payments come before earnings are
  available to stockholders
• These are fixed obligations
• Similar to fixed production costs, these lead to
  larger earnings during good times, and lower
  earnings during a business decline
• This debt financing increases the financial risk
  and possibility of default

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Financial Risk

• Two sets of financial ratios help measure
  financial risk
• Balance sheet ratios
• Earnings or cash flow available to pay fixed
  financial charges
• Acceptable levels of financial risk depend on
  business risk

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Financial Risk

• Proportion of debt (balance sheet) ratios

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Financial Risk

• Proportion of debt (balance sheet) ratios
• This may be computed with and without deferred
  taxes

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Financial Risk

• Interest Coverage

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External Market Liquidity

• Market Liquidity is the ability to buy or sell an
  asset quickly with little price change from a
  prior transaction assuming no new information
• External market liquidity is a source of risk to
  investors

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External Market Liquidity

• Determinants of Market Liquidity
• The dollar value of shares traded
• This can be estimated from the total market value
  of outstanding securities
• It will be affected by the number of security
  owners
• Numerous buyers and sellers provide liquidity

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External Market Liquidity

• Trading turnover (percentage of outstanding
  shares traded during a period of time)

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External Market Liquidity

• A measure of market liquidity is the bid-ask
  spread

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Analysis of Growth Potential

• Creditors are interested in the firms ability to
  pay future obligations
• Value of a firm depends on its future growth in
  earnings and dividends

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Determinants of Growth

• Resources retained and reinvested in the entity
• Rate of return earned on the resources retained
• RR x ROE
• where
• g potential growth rate
• RR the retention rate of earnings
• ROE the firms return on equity

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Determinants of Growth

• ROE is a function of
• Net profit margin
• Total asset turnover
• Financial leverage (total assets/equity)

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Comparative Analysis of Ratios

• Internal liquidity
• Current ratio, quick ratio, and cash ratio
• Operating performance
• Efficiency ratios and profitability ratios
• Financial risk
• Growth analysis

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The Quality of Financial Statements

• Reflect reality rather than use accounting tricks
  or one-time adjustments to make things look
  better than they are

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The Quality of Financial Statements

• High-quality balance sheets typically have
• Conservative use of debt
• Assets with market value greater than book
• No liabilities off the balance sheet

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The Quality of Financial Statements

• High-quality income statements reflect repeatable
  earnings
• Gains from nonrecurring items should be ignored
  when examining earnings
• High-quality earnings result from the use of
  conservative accounting principles that do not
  overstate revenues or understate costs

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