Financial Statement Analysis

1

Financial Statement Analysis EMBA Program, Fall
2008 Robert L. Vigeland
2
Financial Statement Analysis

• Objective to evaluate a companys prospects and
  risks for the purpose of making better business
  decisions

3
Decisions and decision makers

• Creditors
• Should we extend trade credit to this customer?
  What credit limit?
• Should we lend to this company? At what interest
  rate? What terms?

4
Decisions and decision makers

• Equity investors
• Is the companys stock priced appropriately?
• What are the companys prospects for future
  profitability?
• What are the risks?

5
Decisions and decision makers

• Managers
• How do we compare with others in our industry?
• Should we acquire or divest?
• Should we repurchase our own stock?
• Should we change the dividend payout?

6
Decisions and decision makers

• Auditors
• Is our client a going concern?
• What is the likelihood that the financial
  statements are materially misstated?

7
Decisions and decision makers

• Directors
• How is management performing?
• What is the likelihood that the financial
  statements are materially misstated?
• Are managers fairly compensated?

8
Decisions and decision makers

• Regulatory bodies
• What is the likelihood that the financial
  statements are materially misstated?
• Are the companys rates appropriate?
• Did the company pay an appropriate amount of
  taxes?

9
Decisions and decision makers

• Unions
• Can the company afford to pay us more or increase
  our benefits?
• Are managers fairly compensated?
• What is the likelihood of bankruptcy?

10
Components

• Accounting analysis
• Do the companys financial statements reflect
  reality?
• Financial analysis
• Using the financial statements to assess
  financial position and performance and assess
  future performance
• Prospective analysis

11
Accounting analysis

• Comparability issues
• Accounting distortions
• Estimation errors
• Earnings management
• Distortions caused by accounting standards
• Uncertainty about accounting distortions creates
  accounting risk

12
Financial analysis

• Profitability analysis
• What is the companys return on investment? What
  is driving the companys profitability?
• Risk analysis
• Is the company able to meet its commitments?
• Analysis of sources and uses of funds

13
Prospective analysis

• Valuation models are based on future earnings or
  cash flows
• The result of prospective analysis is the
  projection of future earnings or cash flows that
  can be used in these models to estimate a
  companys value

14
Comparative analysis

• Comparative analysis involves comparing
  consecutive financial statements from period to
  period for evidence of favorable or unfavorable
  trends
• This may be done by
• Year-to-year change analysis
• Index number trend analysis

15
Comparative analysis
16
Comparative analysis

• It is often easier to make a comparative analysis
  using index numbers, i.e., all amounts expressed
  relative to a base period (here, 2001).

17
Comparative analysis
18
Common sized statements

• Facilitate comparisons of firms of different
  sizes
• Help understand the fundamental economic
  characteristics of different industries and
  different firms in the same industry

19
Common sized statements

• We will compare the statements of BNSF (ticker
  BNI) with those of Union Pacific (ticker UNP), a
  primary competitor in the railroad industry.

20
Common-sized balance sheet
21
Common-sized balance sheet
22
Common-sized income statement
23
Ratio analysis

• Ratio analysis
• Ratios allow the analyst to assess firm
  performance on various dimensions
• Ratio definitions are not standardized
• Not all analysts are interested in the same ratios

24
Ratio analysis

• Profitability analysis
• Return on investment
• Operating performance
• Asset utilization
• Credit analysis
• Liquidity
• Capital structure and solvency

25
Return on investment

• An analysis of return on investment assesses the
  profitability of the company in light of capital
  invested.
• The capital markets will only provide capital if
  the returns are adequate given the risk.

26
ROE

• Return on equity (ROE) is a popular summary
  measure of a companys income in relation to the
  average stockholders investment.
• ROE Net income
• Average stockholders equity

27
ROE
28
ROE BNI vs. UPN
29
ROE

• Return on equity has two components
• Operating return return on net operating assets
• Nonoperating return
• We will focus on the operating return. The
  non-operating return is a function of a companys
  capital structure and investments in
  non-operating assets.

30
RNOA

• Return on net operating assets measures the
  return from operating activities on the net
  investment in operating assets.
• Net operating profit, after taxes NOPAT
• Average net operating assets NOA

31
RNOA illustrated
32
RNOA BNI vs. UPN
33
RNOA BNI vs. UPN
34
Disaggregating RNOA

• RNOA NOPAT/Average NOA
• NOPAT/Sales Sales/Average NOA
• NOPM NOAT
• Profit margin Asset
  turnover

35
Disaggregating RNOA
36
Operating performance

• In analyzing operating performance, we evaluate
  profit margins from operating activities.

37
Operating performance

• Operating profit margin captures the relationship
  between operating profit and revenues.
• Operating profit / Revenues

38
Operating performance
39
Operating performance

• Net profit margin captures the relationship
  between net profit and revenues.
• Net income / Revenues

40
Operating performance
41
Asset utilization

• To evaluate asset utilization, we examine the
  relationship between revenues and the companys
  investment in assets.

42
Asset utilization

• Cash turnover ratio captures the relationship
  between revenues and the companys average cash
  balance
• Revenues / Average cash

43
Asset utilization
44
Asset utilization

• Receivables turnover ratio measures the
  efficiency of receivables management
• Revenues / average accounts receivable

45
Asset utilization
46
Asset utilization

• Sales to materials and supplies captures the
  relationship between revenues and materials and
  supplies
• Revenues / average materials supplies

47
Asset utilization
48
Asset utilization

• Fixed Asset Turnover Ratio measures how
  efficiently the firm manages its investment in
  PPE
• Revenues / average fixed assets

49
Asset utilization
50
Asset utilization

• Total asset turnover ratio measures overall
  relationship between revenues and assets
• Revenues / average total assets

51
Asset utilization
52
Liquidity Analysis

• Liquidity analysis attempts to assess the ability
  of a company to meet its short-term obligations.

53
Liquidity Analysis

• Current ratio captures the relationship between
  current assets to current liabilities
• Current assets / current liabilities

54
Liquidity Analysis
55
Liquidity Analysis

• Quick (acid-test) ratio focuses on the
  relationship between the most liquid assets
  (cash, marketable securities, receivables) and
  current liabilities
• Quick assets / current liabilities

56
Liquidity Analysis
57
Liquidity Analysis

• The collection period focuses on the average
  period of time receivables are outstanding. The
  longer receivables are outstanding, the less
  liquid the company.
• Average receivables/(Sales/365)

58
Liquidity Analysis
59
Solvency Analysis

• Capital structure and solvency analysis attempts
  to assess the companys ability to meet its
  long-term obligations

60
Solvency Analysis

• Total liabilities to equity captures the
  relationship between financing provided by
  creditors and financing provided by owners.
• Total liabilities/Shareholders equity

61
Solvency Analysis
62
Solvency Analysis

• Long-term debt to equity captures the
  relationship between financing provided by
  long-term creditors and financing provided by
  owners.
• Long-term liabilities/Equity

63
Solvency Analysis
64
Solvency Analysis

• Times interest earned ratio measures the extent
  to which earnings cover interest
• EBIT / Interest expense

65
Solvency Analysis
66
Market measures

• The price to earnings ratio captures expectations
  of earnings growth. Investors would be willing to
  pay more for a dollar of current earnings as
  earnings are expected to grow.
• P/E Stock price/earnings per share

67
Market measures
68
Market measures

• The price to book ratio captures the companys
  ability to earn more than the required return.
  Managers create value by earning more than
  stockholders required return.
• Stock price/book value per share

69
Market measures
70
Du Pont Analysis

• Du Pont system of ratio analysis shows that ROE
  is influenced by margin, turnover, and leverage
• ROE
• Income/sales Sales/assets
  Assets/equity
• Margin Turnover Leverage

71
Du Pont Analysis