Financial Statement Analysis

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Financial Statement Analysis
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Objectives

• Review the components of the financial statement
  package.
• Discuss the information contained in the
  financial statements and how it can be used to
  evaluate a firm.
• Discuss the types of questions can financial
  ratios answer.
• Discuss the relationship between the notion of
  market efficiency and financial statement
  analysis.

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Introduction to Financial Statement Analysis

• A major source of information regarding a a
  firms operating performance and its resources is
  the firms financial statement package.
• Analyzing a set of financial statements involves
  using ratios of key financial statement items and
  other tools to gain insight into the
  profitability and risk of a firm.
• Financial statement analysis can help us to
  better understand the business risk and the
  financial risk of a firm.

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Principal Financial Statements

• Financial statements are intended to provide
  information on the operating performance and
  financial health of a business during a specified
  period of time.
• In the US, financial statements are required to
  adhere to GAAP (although GAAP does allow some
  flexibility).
• One goal is to make the financial statements of
  one firm comparable across time and to the
  financial statements of other firms.

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Principal Financial Statements, cont.

• GAAP requires firms to present balance sheets for
  the two most recent years and income statements
  and statements of cash flows for the three most
  recent years in a set of financial statements.
• In addition, firms are required to present notes
  to the financial statements that provide
  information on the accounting methods used by the
  firm to construct the financial statements.

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The Balance Sheet

• The balance sheet is a statement of financial
  position that presents details of the resources
  of a firm and the claims on those resources as of
  a specific point in time (i.e., on March 31,
  20XX).
• It is a static statement.
• The asset side of a balance sheet reports the
  effects of a firms past investment decisions
  while the liabilities and shareholders equity
  side reports the effects of a firms past
  financing decisions.

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The Balance Sheet, cont.

• The balance sheet is governed by the accounting
  identity
• Assets are resources that have the potential for
  providing a firm with future economic benefits.
• Liabilities are obligations to pay for benefits
  or services received in the past.
• Shareholders Equity represents a residual claim
  on the firm (in book value terms).

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The Balance Sheet, cont.

• It is important to note that most (if not all in
  some cases) assets and liabilities are reported
  on a firms balance sheet are at historical cost
  (less some adjustments).
• It is very rare that historical cost equals
  market value.
• Examples
• Machinery historical cost less depreciation
• Accounts Receivables historical value less an
  allowance for doubtful accounts
• Inventory lower of cost or market

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The Balance Sheet, cont.

• It is also important to note that the balance
  sheet may not report all assets and liabilities
  of a firm.
• Only assets and liabilities meeting certain
  criteria set out by GAAP are required to be
  reported on the balance sheet.
• The footnotes are a source of information for
  these other off-balance sheet assets and
  liabilities.

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The Balance Sheet Assets

• Assets are resources under a firms control that
  have the potential to provide the firm with
  future economic benefit(s).
• i.e., the ability to generate future cash inflows
  (accounts receivables, inventories, etc.) or
  decrease future cash outflows (i.e., prepayments,
  etc.)
• Assets are usually presented in order of their
  liquidity (cash, cash equivalents, accounts
  receivables, inventories, etc.).

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The Balance Sheet Assets, cont.

• Assets can be
• Monetary Assets
• cash, cash receivables, etc.
• Monetary assets are reported at the amount of
  cash the firm expects to receive in the future.
• Non-monetary
• inventories, PPE, etc.
• GAAP generally requires reporting non-monetary
  assets at their historical cost (historical cost
  is objective and verifiable).

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The Balance Sheet Assets, cont.

• Assets can be (cont.)
• Current Assets
• Cash and other assets (A/R, inventory,
  prepayments, etc.) expected to be converted into
  cash, sold, or consumed either in one year or in
  the operating cycle, whichever is longer.
• Non-current/Long-term Assets
• Assets not classified as current (PPE, some
  prepayments, etc.).

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The Balance Sheet Liabilities

• A liability represents a firms obligation to
  make payments of cash, goods, or services in a
  reasonably definite amount at a reasonably
  definite time in the future for benefits or
  services received in the past.
• Liabilities are generally monetary (require a
  payment of a fixed amount of cash) but can be
  non-monetary.

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The Balance Sheet Liabilities, cont.

• Liabilities can be
• Current Liabilities
• Obligations whose liquidation is reasonably
  expected to require the use of existing resources
  classified as current assets or the creation of
  other current liabilities.
• Non-current/Long-term Liabilities
• Obligations not classified as current.

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The Balance Sheet Shareholders Equity

• The shareholders equity in a firm is the firms
  owners residual interest or claim on the firm.
• The accounting identity can be re-written as
• Therefore, the valuation of assets and
  liabilities in the balance sheet determines the
  book value of the shareholders equity.

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The Balance Sheet Shareholders Equity, cont.

• The shareholders equity portion of the balance
  sheet is commonly presented in three parts.
• Capital Stock the par value of shares issued
• Additional Paid-In Capital excess amounts paid
  in (by shareholders) in excess of the par value
  of the shares issued
• Retained Earnings the firms undistributed
  earnings

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The Balance Sheet - Conclusion

• In summary, the balance sheet views resources
  from two perspectives
• As a list of the specific form in which the firm
  holds the resources (i.e., cash, inventory,
  etc.).
• As a list of the persons or entities that
  provided the funding to obtain those resources
  (and thus the persons who have a claim on those
  resources, i.e. debt holders and equity holders).
• ?The balance sheet presents the equality of
  investing and financing.

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The Income Statement

• The income statement is sometimes titled the
  Statement of Operations, Statement of Earnings,
  or the Statement of Income.
• The income statement presents details on the
  operating profitability of a firm over a
  particular time period (i.e., performance for the
  year ending on March 31, 20XX).
• It is a dynamic statement.

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The Income Statement, cont.

• GAAP requires publicly traded firms to use an
  accrual basis of accounting (as opposed to a cash
  basis) in measuring operating performance.
• Accrual basis accounting records revenues when
  they are earned and expenses when they are
  incurred (regardless of when actual cash flows
  occur).
• Cash basis accounting records revenues when cash
  is received and expenses when cash is paid.
• It is this accrual concept that links the balance
  sheet and the income statement.

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The Income Statement, cont.

• The bottom line
• Revenues measure the inflows of net assets from
  selling goods and providing services.
• Expenses measure the outflows of net assets that
  a firm uses in the process of generating
  revenues.
• Gains and losses arise from the sale of assets
  that arent directly related to the firms
  business.

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The Income Statement, cont.

• The goal of the income statement is to give a
  measure of operating performance that matches the
  firms outputs with the firms inputs.
• But, keep in mind, because the accrual basis of
  accounting is required
• revenues reflect sales for cash and sales for
  credit, and
• expenses reflect purchases made in cash and
  purchases made on credit.
• Therefore, net income includes cash and non-cash
  elements.

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The Statement of Cash Flows

• The statement of cash flows reports for a period
  of time the net cash flows (inflows less
  outflows) from three principal business
  activities of a firm
• (1) cash flows from operating activities
• (2) cash flows from investing activities
• (3) cash flows from financing activities
• As this statement reports on the actual cash
  flows for a period, it can be used to disentangle
  the effects of the accrual basis of accounting
  (where non-cash items affect reported net income).

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The Statement of Cash Flows, cont.

• Question Why is the statement of cash flows so
  important to a financial analyst?
• Answer Cash flows are vital to a firms
  survival. The statement of cash flows integrates
  the information contained in the balance sheet
  and income statement in a manner that allows an
  analyst to determine what the sources and uses of
  cash were for a firm for the specified time
  period.

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Cash Flows from Operating Activities

• This section of the statement of cash flows lists
  the sources and uses of cash that arise from the
  normal operations of a firm
• Operating activities involve the cash effects of
  transactions that enter into the determination of
  net income (i.e., income statement items).

Cash Flow from Operating Activities Net Income - Non-cash Revenues Non-cash Expenses - Changes in Net Working Capital
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Cash Flows from Investing Activities

• This section of the statement of cash flows lists
  the sources and uses of cash that arise from the
  investing activities of a firm (generally related
  to long-term assets).
• Investing activities include
• buying and selling debt of OTHER firms,
• collecting principal payments on debt of other
  firms,
• buying and selling securities of OTHER firms, and
• buying and selling property, plant, and equipment.

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Cash Flows from Financing Activities

• This section of the statement of cash flows lists
  the sources and uses of cash that arise from the
  financing activities of a firm (generally related
  to long-term liabilities and equity).
• Financing activities include
• sales and repurchases of the firms equity,
• dividends to the firms stockholders, and
• issuances and retirements of the firms debt.

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The Statement of Cash Flows, cont.

• The purpose of the statement of cash flows is to
  describe how the firm generated and used cash
  during the reporting period.
• The bottom line of the statement of cash flows
  reports the change in the firms cash balance
  from the beginning of the reporting period to the
  end of the reporting period.

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The Notes to the Financial Statements

• The notes to the financial statements generally
  explain the items presented in the main body of
  the statements.
• Examples of notes include
• descriptions of the accounting policies used in
  measuring the elements reported in the statements
  or
• explanations of uncertainties or contingencies.
• The notes to the financial statements are an
  integral part of the financial statements and
  should be viewed as such.

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Common Size Financial Statements

• Often, it may be difficult to compare two firms
  because they differ in size (in terms of sales
  levels or total asset levels).
• To resolve this problem, an analyst can create
  common size financial statements.
• A common size balance sheet states all numbers as
  a percentage of total assets.
• A common size income statement states all numbers
  as a percentage of sales.

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Common Size Financial Statements, cont.

• However, interpretation of common size financial
  statements must be made with care.
• One item in a common size statement is not
  independent of the other items (all items are
  presented as relative values to some base
  amount).
• The dollar amount of any one item might increase
  over the period but the items relative size can
  decrease at the same time.

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Percentage Change Statements

• A percentage change statement will present the
  percentage changes of individual items from the
  previous period to the current period.
• Again, care must be taken in interpreting the
  numbers in a percentage change statement. For
  instance,

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A Final (??) Comment on the Financial Statement
Package

• It is always important to remember who the
  authors of a financial statement package are (the
  firms managers) and what their
  incentives/motivations are (make the firm look
  good).
• Only the actual financial statements and
  accompanying notes are independently viewed by a
  team of auditors!
• More often than not, quarterly financial
  information is un-audited.

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Economic vs. Accounting Earnings

• Keep in mind that the financial statement package
  is only an approximation of reality though.
• If the world were certain, we could measure
  economic earnings as
• where the market value of net assets is equal to
  the present value of their future cash flows
  discounted at the risk-free rate.

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Economic vs. Accounting Earnings, cont.

• Unfortunately (or fortunately depending on your
  taste) we live in an uncertain world.
• We cannot say, with certainty, what will happen
  tomorrow most of the time.
• Therefore, we cannot say, with certainty, what an
  assets market price should be.
• In this world of uncertainty, no matter how we
  record earnings, they are only a proxy for
  economic income.

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Economic vs. Accounting Earnings, cont.

• Because of this uncertainty, analysts have
  developed different proxies for economic
  earnings.
• Distributable earnings the value of dividends
  that could be paid without changing the value of
  the firm.
• Sustainable income the level of income that can
  be maintained given the firms stock of capital
  investment.
• Permanent earnings the amount that can normally
  be earned given the firms assets.

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Economic vs. Accounting Earnings, cont.

• But, the accounting framework weve begun to
  describe gives us another measure Accounting
  Earnings.
• The accrual accounting system does not directly
  provide a measure equivalent to those previously
  discussed.
• It is the analysts task to use the accounting
  information to determine the numbers he/she
  wants/needs to value a firm.

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Financial Statement Analysis

• Financial statement analysis in general focuses
  on five primary categories
• the firms internal liquidity,
• the firms operating performance,
• an analysis of firm risk,
• an analysis of growth potential, and
• external market liquidity.
• The common approach is to start with ratio
  analysis.
• We will only highlight a handful of key ratios.

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Evaluating Internal Liquidity

• Internal liquidity ratios indicate the ability of
  the firm to meet future short-term financial
  obligations.
• The probability of financial distress decreases
  as the relative liquidity of a firms assets
  increases.
• Liquidity means nearness to cash, i.e., cash is
  the most liquid asset a firm can have, a machine
  might be very illiquid if it is difficult to sell
  to generate cash.
• The focus is on the current portion of the
  balance sheet.

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Evaluating Internal Liquidity The Current Ratio

• The current ratio is calculated as
• The analyst must consider how much inventory the
  company carries in assessing this ratio.
• Problem
• The effect on the current ratio of an equivalent
  increase in current assets and current
  liabilities depends on whether or not the current
  ratio was previously greater than or less than
  one.
• Can be greatly affected by economic conditions.

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Evaluating Internal Liquidity The Quick Ratio

• Sometimes, inventories and some other current
  assets may not be very liquid (i.e., easily
  converted into cash).
• Therefore, they shouldnt be considered in
  assessing a firms ability to meet its current
  obligations since they dont really add to this
  ability.
• The quick ratio is calculated as

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Evaluating Internal Liquidity The Cash Ratio

• An even more conservative measure is the cash
  ratio. This ratio assumes that only cash and
  marketable securities should be considered in
  evaluating a firms ability to meet its current
  obligations.
• The cash ratio is calculated as

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Evaluating Internal Liquidity Accounts
Receivables Turnover

• The rate at which A/R turn gives an indication of
  how quickly a firms receivables are converted
  into cash.
• The A/R turnover ratio is calculated as

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Evaluating Internal Liquidity Accounts
Receivables Turnover

• This rate implies an average A/R collection
  period
• i.e., if the Average A/R collection period is
  10, this implies that on average it takes the
  firm 10 days to collect cash from sales on
  credit.
• Potential problem Where do we get credit sales
  from?

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Evaluating Internal Liquidity Accounts
Receivables Turnover, cont.

• Firms might extend credit to induce sales, how
  might this affect receivables turnover?
• Firms make a trade-off in deciding the desirable
  receivables turnover rate.
• Receivables turnover too high strict credit
  policies, may be refusing credit to the
  creditworthy
• Receivables turnover too low lax credit
  policies, may be extending too much credit to the
  non-creditworthy.
• ?Large deviations from the industry average A/R
  collection period may be a red flag.

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Evaluating Internal Liquidity Inventory
Turnover

• The rate at which inventories turn gives an
  indication of how soon they will be sold.
• The inventory turnover ratio is calculated as

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Evaluating Internal Liquidity Inventory
Turnover, cont.

• This rate implies an average inventory processing
  time
• Question What would you expect Wal-Marts
  average processing time to be? What would you
  expect a jewelers average processing time to be?
• These ratios vary widely by industry. Be careful
  when comparing across industries.

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Evaluating Internal Liquidity Inventory
Turnover, cont.

• Increasing inventory turnover ratios might
  indicate more efficient inventory control
  systems.
• A JIT inventory system will increase the
  inventory turnover rate to infinity.
• Firms make a trade-off in deciding the desirable
  inventory turnover rate.
• Inventory turnover too high potential inventory
  shortages, may have to turn away customers and
  lose sales
• Inventory turnover too low excess inventory on
  hand, increased carrying costs, inventory
  obsolescence

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Evaluating Internal Liquidity Inventory
Valuation

• These ratios are affected by inventory valuation
  method.
• Three common inventory valuation methods
• Average cost values each unit of inventory at
  the same cost, a weighted average of all
  inventory units EVER purchased.
• First-In-First-Out (FIFO) assumes goods are
  sold in order of their purchase by the firm.
• Last-In-First-Out (LIFO) assumes goods are sold
  in reverse order of their purchase by the firm.

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Evaluating Internal Liquidity Inventory
Valuation, cont.

• What we are measuring is cost flow and NOT the
  actual flow of goods.
• Inventory valuation is a cost allocation
  mechanism.
• If input prices are
• Constant FIFO Average LIFO
• Rising FIFO lt Average lt LIFO
• Declining FIFO gt Average gt LIFO
• In making a comparison across firms, if the two
  firms dont use the same valuation method the
  comparison is NOT reasonable.

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Evaluating Internal Liquidity Inventory
Valuation, cont.

• FIFO has good balance sheet effects but poor
  income statement effects.
• On the B/S, inventory is listed closer to
  replacement cost.
• On the I/S, COGS reflects possibly old input
  prices.
• LIFO has good income statement effects but poor
  balance sheet effects.
• On the I/S, COGS reflects more recent input
  prices.
• On the B/S, inventory is listed at old
  replacement costs.

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Evaluating Internal Liquidity The Operating
Cycle

• The operating cycle is the sum of the number of
  days it takes for a firm to sell its inventory
  and convert the resulting receivables into cash.
• Weve already discussed the components of this.
  The operating cycle can be calculated as

Operating Cycle Average A/R Collection Period Average Inv. Processing Period
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Evaluating Internal Liquidity Accounts
Payables Turnover

• The rate at which A/P turn gives an indication
  of how quickly a firm pays for purchases on
  account.
• A/P turnover is calculated as

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Evaluating Internal Liquidity Accounts
Payables Turnover

• This rate implies an average A/P payment period
• But how do we calculate purchases?

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Evaluating Internal Liquidity The Cash
Conversion Cycle

• The cash conversion cycle represents, on average,
  the net time interval between the collection of
  cash receipts from product sales and the cash
  payments for the firms various resource
  purchases.
• The cash conversion cycle is defined as

Cash Conversion Cycle Operating Cycle - Average Payables Deferral Period
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Evaluating Operating Performance

• A study of operating performance attempts to the
  assess the managerial ability/competence by
  focusing on operating efficiency and operating
  profitability.
• Operating efficiency refers to how well
  management uses its assets and capital.
• Operating profitability refers to the returns
  management earns by using its assets and capital.

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Evaluating Operating Efficiency -Fixed Asset
Turnover

• Fixed asset turnover is defined as
• Fixed asset turnover indicates the extent to
  which a firm is utilizing existing property,
  plant, and equipment to generate sales.
• Should be used with caution. Might be better for
  year-to-year comparisons within the same company
  rather than for cross company comparisons.
• Affected by depreciation methods.

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Evaluating Operating Efficiency -Fixed Asset
Turnover, cont.

• Potential problems with the use of this ratio
• Sales growth is continuous (smooth) while fixed
  asset growth is lumpy, so, a time series of fixed
  asset turnovers may have a strange pattern.
• The accumulation of depreciation expense
  increases the fixed asset turnover by reducing
  the average fixed assets (in the denominator).
  Has there really been an increase in efficiency
  as would be implied by an increasing ratio?

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Evaluating Operating Efficiency -Fixed Asset
Turnover, cont.

• Possible interpretations
• Firms make investments in fixed assets in
  anticipation of higher sales in the future. Thus
  a low or decreased fixed asset turnover may
  indicate an expanding firm.
• On the other hand, a firm may cut back on capital
  expenditures if future sales outlooks are not
  good. Thus a high or increasing fixed asset
  turnover may indicate managerial pessimism.

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Evaluating Operating Efficiency -Depreciation

• Accounting and economic depreciation are two
  different things.
• Accounting depreciation allocates plant and
  equipment costs over the assets useful life.
• Economic depreciation relates to the real world
  usefulness of an asset.
• An asset might have little real economic value
  but still be carried on a firms books because it
  is not fully depreciated in the accounting sense.

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Evaluating Operating Efficiency -Depreciation,
cont.

• Firms have flexibility in choosing their
  depreciation method.
• Most use straight-line for financial reporting
  purposes.
• Virtually all (are required to) use accelerated
  methods for tax purposes.
• Straight-line depreciation allocates the cost of
  a depreciable asset evenly over the assets
  expected useful life.
• Accelerated methods allocate a larger portion of
  the depreciable assets cost in the earlier
  portion of the assets expected useful life.

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Evaluating Operating Efficiency -Total Asset
Turnover

• Total asset turnover is defined as
• Total asset turnover indicates the ability to
  manage the level of investment in assets for a
  particular level of sales.
• In other words, the ability to generate sales
  from a particular investment in assets.

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Evaluating Operating Profitability Gross Profit
Margin

• The gross profit margin is defined as
• The gross profit margin indicates the basic cost
  structure of the firm.
• This ratio varies widely by industry. It may not
  be reasonable to compare gross profit margins
  across dissimilar industries.
• Even a small change in the gross profit margin is
  likely to have a major impact on the bottom line.

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Evaluating Operating Profitability Operating
Profit Margin

• The operating profit margin is defined as
• The variability of the operating profit margin
  over time is an indicator of the business risk
  for a firm.
• Another option is to replace operating profit by
  earnings before interest, taxes, and depreciation
  (EBITDA).

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Evaluating Operating Profitability Net Profit
Margin

• The net profit margin is defined as
• The net profit margin measures how profitable a
  firms sales are after all expenses have been
  deducted.
• Since this factors in interest expense it may be
  more suitable to use for comparing the profit
  performance of different companies than the
  operating profit margin.

65
Evaluating Operating Profitability Return on
Total Capital/Assets

• Return on assets is defined as
• The return on assets indicates the return from
  operations independent of financing.
• In practice, different analysts may use different
  numbers in the numerator (EAT, EBIT, EBIAT, etc.).

66
Evaluating Operating Profitability Return on
Total Capital/Assets, cont.

• The return on assets might have two
  interpretations
• it measures a firms ability and efficiency in
  using its assets to generate profits or
• it reports the total return accruing to all who
  have provided the firm with capital (long- and
  short-term debt holders AND equity holders).

67
Evaluating Operating Profitability Return on
Owners Equity

• Considering all equity (includes preferred stock)
  the return on total equity is defined as
• Considering only common equity the return on
  owners equity is defined as
• ROE indicates the return that management has
  earned on the capital provided by the owner.

68
Evaluating Operating Profitability The Dupont
System

• ROE can be disaggregated into various components
  that can provide explanations for changes in ROE.
• Weve previously discussed two of these ratios,
  financial leverage will be discussed soon.

69
Risk Analysis

• Risk analysis examines the uncertainty of income
  flows for the total firm and for the individual
  sources of capital.
• In this sense, risk comes in two forms, business
  risk and financial risk.
• Business risk is the uncertainty of income caused
  by the firms industry/line of business.
• Financial risk/leverage is the uncertainty of
  returns to equity holders due to the firms use
  of fixed financing obligations.

70
Business Risk

• Business risk has two main components, sales
  variability and operating leverage.
• Sales variability is a prime determinant of
  earnings variability. Sales volatility can be
  measured by the coefficient of variation of
  sales.
• Operating leverage refers to the employment of
  fixed production costs. It can be measured as

71
Operating Leverage

• Operating leverage refers to the relative
  portions of fixed versus variable costs in the
  firms total cost structure.
• Greater operating leverage (a larger fixed cost
  portion) makes the operating earnings of a firm
  more volatile than sales.
• During slow periods, operating profits will
  decline by a larger percentage than sales.
• During expansionary periods, operating profits
  will increase by a larger percentage than sales.

72
Financial Leverage

• The employment of fixed financing costs is
  referred to as financial leverage.
• The financial leverage effect relates operating
  income to net income as follows
• Another measure of financial leverage is
• Although the two measures look different they
  reflect on the same issue.

73
Financial Risk Analysis The Debt to Equity Ratio

• The debt to equity ratio is defined as
• As the debt to equity ratio increases, earnings
  per share become more volatile and the
  probability of default increases.
• Recall the MM propositions which state that (in
  perfect markets) a firms WACC is constant.
• Question Should market values or book values be
  used?

74
Financial Risk Analysis Total Debt Ratio (Debt
to Assets Ratio)

• The total debt ratio (debt to assets ratio) is
  defined as
• This ratio measures the proportion of the firms
  assets that are financed with creditors funds.
• Note,

75
Financial Risk Analysis Interest Coverage

• The interest coverage ratio is defined as
• This ratio indicates how many times the fixed
  interest charges are earned based on the earnings
  available to pay these expenses.
• Obviously, a coverage ratio less than one
  indicates an inability to make necessary interest
  payments.

76
Financial Risk Analysis Cash Flow to Cap Ex
Ratio

• The cash flow to capital expenditures ratio is
  defined as
• This provides information about a firms ability
  to generate cash flow from operations in excess
  of the capital expenditures needed to maintain
  and build plant capacity.

77
Analysis of Growth Potential

• Investors are concerned about growth potential
  because a firms value depends on its ability to
  grow its earnings and dividends.
• Creditors are concerned about growth potential
  because a firms future success is a major
  determinant in its ability to pay future
  obligations.
• Growth depends on two factors, (1) the amount of
  resources retained and reinvested in the entity
  and (2) the rate of return earned on the retained
  resources.

78
Analysis of Growth Potential, cont.

• The firms growth potential is defined as
• This is sometimes called the sustainable growth
  rate. It assumes a constant debt to equity
  ratio.
• The retention rate is defined as
• We will use this growth rate later when trying to
  value the equity of firms.

79
External Market Liquidity

• Market liquidity is defined as the ability to buy
  or sell an asset quickly with little price change
  from the prior transaction.
• Liquidity relates to the ease with which one can
  convert an asset into cash or convert cash into
  an asset.
• Hence, shares of Microsoft are highly liquid
  while a stamp collection (or shares of Berkshire
  Hathaway Inc.) may not be.

80
External Market Liquidity, cont.

• High trading volumes and low bid-ask spreads
  imply liquidity.
• The bid-ask spread is the difference between the
  price paid to purchase a security and the price
  received for selling a security (bid lt ask).
• Another measure of liquidity is trading
  turnover.
• Trading turnover is the percentage of shares
  outstanding traded during a period of time.

81
The Pitfalls of Ratio Analysis

• Ratios provide a convenient way to analyze a firm
  from a financial perspective.
• This approach is not without problems though.
• A good analyst needs to be wary of some issues
  that can affect the interpretation of a set of
  financial ratios.

82
Financial Statements and Inflation

• Virtually no allowances are made for inflation in
  the actual statements themselves.
• Some mention of it may be found in the notes or
  in the Managements Discussion and Analysis but
  the numbers reported in the statements have no
  correction for inflation.
• The primary areas inflation may affect include
• interest expense,
• inventory valuation, and
• depreciation calculation.

83
Economic Assumptions of Ratio Analysis

• An implicit assumption in (most of) ratio
  analysis is that size is not important.
• ?We make a proportionality assumption.
• We know that this is assumption is not really
  reasonable though.
• Economies of scale (or other factors) often exist
  causing a nonlinear relationship between the
  numerator and denominator of a financial ratio.
• If output doubles, do we expect total costs to
  double? If output then doubles again, do we
  expect total costs to then double again? etc.

84
Benchmark Issues for Ratio Analysis

• A ratio, by itself, doesnt tell us much. We
  need to compare the ratio to something.
• Perhaps the same ratio for a competitor, perhaps
  the same ratio for the firm from last year, etc.
• The comparison must be an appropriate one.
• An appropriate benchmark is determined by the
  needs of the analyst.
• Lenders may wish to see certain firm traits or
  characteristics that an equity investor might not
  like.

85
Timing Issues for Ratio Analysis

• In the U.S., firms are only required to
  periodically report financial information (four
  times a year). Its worse outside of the U.S.
• The times when financial information is reported
  may not correspond to times of regular operations
  for a firm.
• Or, knowing that analysts use key ratios in
  making an investment recommendation, managers may
  have an incentive to try to manipulate the
  reported figures (to the extent that GAAP will
  allow).

86
Negative Numbers and Ratio Analysis

• Often times a ratio has little (if any) meaning
  if the numerator and denominator have a different
  sign (i.e., a positive numerator and a negative
  denominator or vice versa).
• Or, if both the numerator and denominator are
  negative a ratio may lead the analyst to a false
  conclusion.

87
Accounting Methods and Ratio Analysis

• As the numbers reported in the financial
  statement package are affected by various
  accounting methods employed, any ratios computed
  using those numbers are also affected by the
  various accounting methods employed.
• ?The analyst must try to disentangle the effects
  of accounting method choices on financial ratios
  and financial statement analysis in general.

88
Financial Statement Analysis vs. Efficient
Capital Markets

• A general description of an efficient market is
  one in which, on average, asset prices
  immediately reflect changes in underlying
  economic variables (i.e., market participants are
  smart/rational).
• Most (but not all) people/investors believe in
  some degree of market efficiency.
• By nature, the financial statement package
  contains historical information. So

89
Financial Statement Analysis vs. Efficient
Capital Markets, cont.

• Question If capital markets are believed to be
  efficient, why analyze a set of publicly
  available documents about a firm (that, by their
  very nature, contain stale information)?
• Possible answers
• (1) Someone must perform the analysis in order
  for the market to initially react to the
  information contained in the financial
  statements.
• (2) Markets might be efficient on average in the
  aggregate but temporarily inefficient at the
  individual firm level.

90
Financial Statement Analysis vs. Efficient
Capital Markets, cont.

• Possible answers, cont.
• (3) Financial statements may potentially be
  biased views (even in accordance with GAAP) of a
  firms performance if managers have incentives to
  make them so.
• ? The Quality of Earnings may actually be poor
  even if the firm reports profits.
• (4) There are other needs for financial
  statement analysis aside from investing in
  publicly traded common stocks (bank lending,
  credit analysis, etc.)