Financial Statement Analysis:

1
Chapter 13

• Financial Statement Analysis
• A Story in Numbers
• or
• Uncovering the indicators of Value in a Company

2
Key Responsibilities of an Analyst in doing
Securities Analysis

• Understand the company
• Differentiate between accounting and economic
  earnings
• Differentiate between the past and the future
• Assess the quality of company management
• Forecast earnings

3
Responsibilities of an Analyst (contd)

• 1. Understand the company (like you owned it
  because you may)!
• Financial Statement Analysis helps the analyst
• Understand how the firm has done in the past
• Help forecast how the firm will do in the future
• It will not tell you to buy or sell a stock, but
  it will help you estimate the stocks value

4
Responsibilities of an Analyst (contd)

• Tools Used by the Analyst
• Publicly available data
• Derived data from Financial Statements, I.e.
  ratio analysis
• Your own knowledge and experience
• Interviews with management
• Research, competitor analysis, and common sense
• Limitations

5
Responsibilities of an Analyst (contd)

• 2. Differentiate between Accounting and Economic
  Earnings
• Accounting Earnings
• Earnings a firm has reported on its income
  statement
• Affected by accounting conventions regarding
  asset valuation, e.g. LIFO, depreciation, etc.
• Tells (somewhat) what the firm actually did. You
  must know the conventions used to know what they
  did!!!!!!

6
Responsibilities of an Analyst (contd)

• Economic Earnings
• The real cash flow that a firm could pay out
  forever in absence of any change in a firms
  productive capacity
• Estimates what a firm could do really do
• You must estimate economic earnings
• This is much harder to do

7
Responsibilities of an Analyst (contd)

• 3. Differentiate between the past and future
  earnings and activities
• Accounting earnings are largely concerned over
  what the firm did in the past
• Is the past indicative of the future?
• What has happened recently?

8
Responsibilities of an Analyst (contd)

• We are concerned with
• What will happen this year in the
• Company, Industry, World Economy
• Technology and the firms products and suppliers
• While Accounting is concerned with the past, we
  are concerned with the futureWHAT WILL HAPPEN
  THIS YEAR AND NEXT!

9
Responsibilities of an Analyst (contd)

• 4. Assess the quality of company management
• Can you trust them?
• Are they competent? Can they answer your
  questions?
• Do they know what is happening in the world
  economy and the industry?
• Do you have the confidence in them to run the
  company in a way which best advances (your)
  shareholder value?

10
Responsibilities of an Analyst (contd)

• 5. Forecast earnings
• Build models to help understand relationships
  between finance, marketing, operations, etc. and
  earnings
• Understand each line item of the financial
  forecast
• Use public and private data and personal
  experience to make a line-by-line financial
  forecast
• Compare forecasts to other analysts as a final
  check on reasonableness

11
Responsibilities of an Analyst (contd)

• The value of a company is the present value of
  its future earnings
• Return on Equity is a key determinant of a
  companys growth in earnings (the other is its
  payout ratio)
• Return on Equity must be understood thoroughly!
• Its a key part of valuation

12
3. Sources of Bias in conventional accounting data

• Accounting Differences
• Inventory Valuation FIFO, LIFO
• Depreciation SL, accelerated
• Treatment of leases, pension costs, allowances
  for reserves
• Inflation and interest expense
• Inflation accounting
• International Accounting Conventions
• Accounting for Currency gains/losses
• Reserves, Intangibles, revenue recognition

13
4. Understand Ratio Analysis and Return on Equity

• What is ratio analysis?
• Process of turning data into information
• A way of learning what a company is doing
• What is return on equity?
• The ratio of net profits to common equity, or
• How much earnings are generated by each dollar of
  equity in the firm
• The process of understanding firm profitability
  and sources of that profit

14
Return on Equity (continued)

• Why is ROE important?
• The factors that affect earnings are the same
  factors that affect ROE, including a firms
• Taxes
• Interest on debt
• Profit margin
• Asset turnover
• Leverage
• ROE helps us understand earnings, and ratios help
  us understand what affects ROE

15
Important Notice

• Whenever a financial ratio includes one item from
  the income statement, which covers a period of
  time, and the balance sheet, which is a snapshot
  in time, the practice is to take the average of
  the beginning and end-of-the-year balance sheet
  (i.e., add them both and divide by 2).

16
ROE Decomposition

• While there are many important ratios, five are
  critically important to understanding earnings.
• These five are commonly called the Dupont System
  by financial analysts
• Memorize and use them!

Assets Equity
Pretax Profit EBIT
EBIT Sales
Sales Assets
Net Profit Pretax Profit
x
x
ROE
x
x
(1) x (2) x
(3) x (4) x (5)
Tax Burden
Interest Burden
x
x Margin x Turnover x Leverage
17
ROE Decomposition (continued)

• 1. Tax Burden (Net Profit / Pretax Profit)
• A reflection of the government tax code and the
  firms tax policies
• If different than comparable companies, ask
  questions to find out why?
• 2. Interest Burden (Pretax Profit/EBIT or (EBIT
  Interest Expense)/EBIT)
• The impact of interest costs on earnings
• The greater the interest burden, the more
  susceptible the company to shocks in the economy
  and industry

18
ROE Decomposition (continued)

• 3. Operating (EBIT) Margin or ROS (EBIT / Sales)
• The operating profit per dollar of sales
• How efficient are they at turning sales into
  profits?
• 4. Asset Turnover (Sales/Assets)
• The efficiency of asset utilization sales
  generated by each dollar of assets
• How well can they utilize their assets

19
ROE Decomposition (continued)

• 5. Leverage (Assets/Equity) or (1 Debt/Equity)
• The ratio of assets over equity
• A reflection of how leveraged the firm ishow
  much debt the firm is using

20
Key Points on ROE Analysis

• Variations on a theme
• ROA EBIT/Assets Operating Margin (EBIT/Sales)
  x turnover (Sales/Assets) (3 x 4)
• Compound leverage interest x leverage
• ROE Tax burden x ROA x compound leverage
• Relationship between ROE, ROA, and leverage
• ROE (1-tax rate)ROA (ROA-Interest rate)
  Debt/Equity

21
Problem Putting it all together

• Key Financial Ratios for Growth Industries
• Year ROE TB IB M AT Lev CLF
  ROA PE PB
• 2001 7.5 .6 .65 30 .30 2.12
  1.4 9 8 .6
• 2002 6.1 .6 .47 30 .30 2.38
  1.1 9 6 .4
• 2003 3.0 .6 .20 30 .30 2.72
  .6 9 4 .1
• Indus 8.6 .6 .80 30 .40 1.50
  1.2 12 8 .7
• The CEO stated sales, assets and operating income
  are all growing at 20 per year. 2003 was
  another great year! What do you think?

22
Thoughts on

• ROE
• Declining. Compared to the industry, it looks
  particularly bad.
• PE/PB
• Low and falling. Investors are not looking
  positively towards the firms future
• ROA
• Constant. Must mean an inappropriate use of
  financial leverage

23
Putting it Together (continued)

• 2001 2002 2003
• Cash Flow from operating activities
• Net income 11,700
  10,143 5,285
• Depreciation 15,000
  18,000 21,600
• Decr. (incr.) in AR (5,000)
  (6,000) (7,200)
• Decr. (incr.) in inventories (15,000)
  (18,000) (21,600)
• Incr. in Accounts Payable 6,000
  7,200 8,640
• Cash flow from investing activities
• Investment in PPE (45,000)
  (54,000) (64,800)
• Cash Flow from financing activities
• Dividends paid
  0 0 0
• Short-term debt issued 42,300
  54,657 72,475
• Change in cash/marketable secur. 10,000
  12,000 14,400
• Whats the story here? (comment on NI, OCF, CFI,
  and CFF)

24
Thoughts on

• Net income
• Declining. Why?
• Operating Cash flow
• Cash is being generated by increased accounts
  receivable, inventories, and accounts payable
• Cash Flow from Investing
• Earnings are declining yet they are continuing to
  invest heavily
• Cash Flow from Financing
• They are financing the investment from borrowings
• THERE ARE SOME REAL PROBLEMS HERE!

25
Problem 13-1

• The Crusty Pie company has a return on sales
  higher than the industry average, yet its ROA is
  the same as the industry average. How can you
  explain this?

26
Answer 13-1

• What is the connection between ROA and ROS?
• Earnings Earnings x Sales
• Assets Sales Assets
• ROA ROS x Asset Turnover
• If ROA is equal to the industry and ROS is higher
  than industry, then asset turnover must be lower
  than the industry

27
Problem 13-2

• The ABC company has a profit margin on sales
  below the industry average, yet its ROA is above
  the industry average. What does this imply about
  asset turnover?

28
Answer 13-2

• What is the connection between profit margin on
  sales to return on assets?
• Profit margin ROA x (1/Asset Turnover)
• EBIT EBIT x Assets
• Sales Assets Sales
• If profit margin is below, and ROA is above, then
  then 1/asset turnover must be higher and so asset
  turnover is lower.

29
Problem 13-3

• Firm A and firm B have the same ROA, yet firm As
  ROE is higher. How can you explain this?

30
Answer 13-3

• What is the relationship between ROE and ROA?
• Earnings Earnings x Assets
• Equity Assets Equity
• ROE ROA x leverage
• If the firms have the same ROA, but firms ROE is
  higher, then firm As leverage or Assets/Equity
  must be higher. The formula
• ROE (1- tax rate) (ROA ROA Interest
  Rate)Debt/Equity
• This shows that assuming the same tax rates, they
  must have different interest rates or debt/equity
  ratios

31
Support for 13-3

• ROE Net Profit /Equity
• (EBIT Interest Taxes)/Equity
• Net Profit EBIT Interest Taxes
• ((1- tax rate)(EBIT Interest))/Equity
• EBIT Interest Taxes (1- tax rate)(EBIT
  Interest)
• (1- tax rate) ((ROA x assets interest
  rate x debt))/Equity
• Interestinterest rate x debt EBIT ROA x
  Assets
• (1 - tax rate) ROA x (Equity
  Debt)/Equity
• - Interest rates x (Debt/Equity)
• Assets Equity Debt
• (1 tax rate)ROA(ROAinterest rate)
  (Debt/Equity)

32
Problem 13-4

• Which of the follow best explains a ratio of net
  sales to average net fixed assts that exceeds
  the industry average
• a. The firm added to its plant and equipment in
  the last few years
• b. The firm makes less efficient use of its
  assets than other firms
• c. The firm has a lot of old plant and equipment
• d. The firms uses straight-line depreciation

33
Answer 13-4

• Old plant and equipment. The firm is likely to
  have older plant and equipment which have a low
  book value due to depreciation, making the ratio
  of sales to fixed asset higher.

34
Types of Financial Ratios

• Liquidity Ratios
• Strengths and weakness of the firms short-term
  financial position
• Activity or Mgmt Efficiency Ratios
• Managements ability to manage assets profitably
• Leverage Ratios
• Managements ability to use debt profitably
• Profitability Ratios
• Managements ability to generate earnings for the
  shareholders
• Market Price Ratios
• Indications of firm value versus accounting or
  economic earnings

35
Liquidity Ratios

• Current Ratio
• A measure of the firms ability to pay off current
  liabilities by liquidating current assets, to
  avoid insolvency in the short-term (the larger
  the better)
• Current Assets
• Current Liabilities
• Quick Ratio
• Similar to above, but only includes cash and
  receivables, as some inventory may not be readily
  convertible into cash (the larger the better)
• Current Assets - Inventory
• Current Liabilities

36
Activity or Management Efficiency Ratios

• Inventory Turnover
• How often the inventory turns over each year (the
  more it turns over generally, the higher the
  earnings)
• Sales or Cost of Goods Sold
• Inventory
• Total Asset Turnover
• The ability of a company to minimize the level of
  assets to support its level of sales (the greater
  the number the better)
• Sales
• Total Assets

37
Activity or Management Efficiency Ratios

• Average Collection Period
• How many days it takes to receive payment from
  customers (the fewer days the better)
• Accounts Receivable
• Sales Per Day
• Days to Sell Inventory
• How many days it takes to sell current inventory
  (the fewer the days the better)
• Inventory
• Sales Per Day

38
Leverage Ratios

• Times Interest Earned (interest coverage ratio)
• How many times interest expense can be covered by
  current earnings (the more times the better)
• Earnings Before Int. Taxes
• Interest Expense
• Fixed Charge Coverage Ratios
• How many times various fixed payments can be made
  on current earnings (the greater the ratio of
  earning to fixed payments, the better)
• Lease Payments
• Principal Repayments
• Preferred Dividends

39
Leverage Ratios

• Debt to Assets
• What percentage of your assets is represented by
  debt (the higher the debt, the more risky the
  firm)
• Long Term Debt
• Assets
• Debt to Equity
• What percentage of owners equity is your debt
  (the higher the debt, the more risky the firm)
• Long Term Debt
• Shareholders Equity

40
Profitability Ratios

• Net Profit Margin
• Percent of profit for each dollar of sales (the
  higher the better)
• Net Income
• Sales
• Return on Assets
• Percent of income for each dollar of assets (the
  higher the better)
• Net Income
• Total Assets

41
Profitability Ratios

• Return on Equity
• Percentage of return from each dollar of common
  equity (the higher the better)
• Net Income
• Common Equity
• Operating Margin After Depreciation
• Percentage of return from each dollar of sales
  (the higher the better)
• Operating Profit
• Sales

42
Market Price Ratios

• Price to Earnings
• A firms market capitalization divided by earnings
  or Price per share / Earnings per share. It is
  the price you are paying for each dollar of
  earnings (the lower the better)
• Market Price of Stock
• Earnings
• Price to Book (Market-to-Book-Value)
• A firms market capitalization divided by owners
  equity (PxS/BVpsxS). It is the price you are
  paying for each dollar of equity (the lower the
  better)
• Market Price of Stock
• Book Value Per Share