Financial Statements Analysis Ratio Analysis

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Financial Statements AnalysisRatio Analysis
EBD 481, Fall 2007 Instructor
Galbraith Adapted from William Messier, Jr.,
Financial Ratios
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Financial Ratios

• The cornerstone of financial statement analysis
  is the use of ratios.
• In entrepreneurship used extensively in
  developing and analyzing business plan pro-formas
  and for purposes of valuation
• Financial ratios are generally grouped into four
  categories
• Short-term liquidity ratios
• Long-term solvency ratios
• Profitability ratios
• Market price and dividends ratios

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Financial Ratios

• Financial analysis using ratios is useful to
  investors because the ratios capture critical
  dimensions of the economic performance of the
  company.
• Managers use ratios to guide, measure, and reward
  workers.
• Often companies base employee bonuses on a
  specific financial ratio or a combination of some
  other performance measure and a financial ratio.

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Financial Ratios

• Short-term liquidity ratios

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Financial Ratios

• Long-term solvency ratios

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Financial Ratios

• Profitability ratios

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Financial Ratios

• Market price and dividend ratios

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Another important ratio for small business

• Discretionary Cash Flow/Sales
• Discretionary Cash Flow net income owners
  compensation non-cash expenses (most often
  depreciation)
• Why is this sometimes a better measure of
  performance than net-income for small firms?

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Evaluating Financial Ratios

• Financial ratios are evaluated using three types
  of comparisons.
• Time-series comparisons - comparisons of a
  companys financial ratios with its own
  historical ratios
• Benchmarks - general rules of thumb specifying
  appropriate levels for financial ratios
• Cross-sectional comparisons - comparisons of a
  companys financial ratios with the ratios of
  other companies or with industry averages

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Ratios

• Ratios mean different things to different groups.
• A creditor might think that a high current ratio
  is good because it means that the company has the
  cash to pay the debt.
• However, a manager might think that a high
  current ratio is undesirable because it could
  mean that the company is carrying too much
  inventory or is allowing its receivables to get
  too high.
• Because financial ratios may be interpreted
  differently by different users, the users of the
  financial ratios must understand the company and
  the business before drawing conclusions.

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Operating Performance andFinancial Performance

• Measures of profitability are affected by both
  financing and operating decisions.
• Financial management is concerned with where the
  company gets cash and how it uses that cash.
• Operating management is concerned with the
  day-to-day activities that generate revenues and
  expenses.
• Ratios that assess operating efficiency should
  not be affected by financial management
  performance.

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Operating Performance

• Rate of return on investment - evaluates the
  overall success of an investment by comparing
  what the investment returns with the amount of
  investment initially made

Rate of return on investment
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Operating Performance

• Income may be defined differently for alternative
  purposes.
• Net earnings
• Pretax income from operations
• Earnings before interest and taxes (EBIT)
• Invested capital may also be defined differently.
• Stockholders equity
• Total capital provided by both debt and equity
  sources

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Operating Performance

• Operating performance is best measured by pretax
  operating rate of return on total assets, often
  referred to as return on total assets.

Pretax operating rate of return on total assets
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Operating Performance

• The expanded expression of pretax operating rate
  of return on total assets highlights that
  operating income percentage and asset turnover
  will each increase the rate of return on assets.
• Using these two ratios allows manipulation of
  either one to determine what happens to the rate
  of return under different scenarios.

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Operating Performance

Operating Income
Operating Income on Sales

Sales
Pretax Return on Total Assets
x
Sales

Total Asset Turnover
Average Total Assets
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Operating Performance

• This decomposition of return on total assets can
  also be applied to the return on equity.
• This is often referred to as the DuPont analysis.

or
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Financial Performance

• Debt and equity financing must be balanced in
  order to achieve good financial performance.
• Firms must choose how much debt is appropriate.
• The firms must also choose how to split their
  debt between short-term debt and long-term debt.
• The prudent use of debt is a major part of
  intelligent financial management.
• Is there a difference in the appropriate use of
  debt by small entrepreneurial firms and larger
  corporations?

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• Is there a difference in the appropriate use of
  debt by small entrepreneurial firms and larger
  corporations?
• Higher interest rates paid by smaller firms
• More security needed by smaller firms
• Stricter qualification rules by banks
• Inability to access the bond market
• Personal guarantees by founders often required
• Need to maintain debt capacity for growth

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Financial Performance

• Short-term debt must be repaid or refinanced in a
  short period of time.
• If a company has trouble repaying the debt, it
  will also generally have trouble refinancing the
  debt.
• Naturally, lenders like healthy borrowers, not
  troubled borrowers.

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Financial Performance

• Long-term debt or equity are generally used to
  finance long-term investments.
• Debt financing is more attractive than equity
  financing because
• Interest payments are deductible for income tax
  purposes, but dividends are not deductible.
• The ownership rights to voting and profits are
  kept by the present shareholders.
• Then why do so many small companies prefer to
  raise money by equity (selling stock to friends
  and families)?

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Financial Performance
ROE
Return on Assets (Profitability)
Financial leverage
?
Liquidity
Net profit Margin
Asset turnover
?
Solvency
Sales
Total assets
Sales
Net income
/
/
Sales
Total cost
Current assets
Noncurrentassets


Land
Cash
Cost of goods sold
Building
Acc. Receivables
SGA
Equipment
Inventory
RD
Intangibles
Other
Interest expense
Others
Income taxes
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Trading on the Equity

• General comments about leveraging
• A debt-free, or unleveraged, company has
  identical return on assets (ROA) and return on
  equity (ROE).
• When a company has a ROA greater than the
  interest rate it is paying its lenders, ROE
  exceeds ROA.
• This is called favorable financial leverage.
• When a company is unable to earn at least the
  interest rate on the money borrowed, the return
  on equity will be lower than it would be for a
  debt-free company.
• The more stable the income, the less dangerous it
  is to trade on the equity.

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Economic Value Added

• The idea behind economic value added (EVA) is
  that a company must earn more than it must pay
  for capital if it is to increase in value.
• Capital is considered both debt and equity.
• The cost of capital in EVA is a weighted average
  of interest cost and the returns required by
  equity investors.
• If a company has positive EVA, the company is
  adding value if a company has negative EVA, the
  company is losing value and might be better off
  liquidating.

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Income tax effects

• Complicates analysis, but not really important
  for start-up companies.
• Why?