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Financial Statement Analysis

Financial Statement Analysis. FIL 404 Prepared by Keldon Bauer. Ratio Analysis. Financial ratios are the vital signs of the business. They are used to assess the health of the business.

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Financial Statement Analysis

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  1. Financial Statement Analysis FIL 404 Prepared by Keldon Bauer

  2. Ratio Analysis • Financial ratios are the vital signs of the business. • They are used to assess the health of the business. • When they are off the norm, they should be taken together with all known information to get a correct diagnosis. • Norms should be seen as a normal range, not just one number.

  3. Ratio Analysis • Ratios also allow for better comparison through time or between companies. • As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important. • Ratios are used both internally and externally.

  4. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Asset management or efficiency ratios • Long-term solvency or financial leverage ratios • Debt coverage ratios • Profitability ratio • Market value ratios

  5. Liquidity Ratios • Relate short-term sources of and uses for cash. • Current Ratio:

  6. Liquidity Ratios • Quick (Acid Test) Ratio:

  7. Liquidity Ratios • Cash ratio:

  8. Efficiency Ratios • Purpose is to assess how well the firm is managing assets • Inventory turnover ratio (IT):

  9. Efficiency Ratios • Accounts receivable turnover (ART):

  10. Efficiency Ratios • Accounts payable turnover (APT):

  11. Efficiency Ratios • Total Asset Turnover (TAT):

  12. Leverage Ratios • Relate debt to equity sources of investment funds . • Debt Ratio: • Measures the proportion that liabilities are of total sources of funds

  13. Leverage Ratios • Debt-Equity Ratio: • Measures the proportion of debt to equity currently used to finance the firm.

  14. Coverage Ratios • Measure of ability to meet debt contracts. • Times Interest Earned (TIE) Ratio: • Measures how many times the interest expense could be covered by operating earnings.

  15. Coverage Ratios • EBITDA Ratio: • Conservatively estimates how many times the principal and interest payments could be made from operating cash flow.

  16. Profitability Ratios • What’s the bottom line? • Gross Profit Margin (GPM): • Measures how much profit is gained due to pricing.

  17. Profitability Ratios • Operating Profit Margin (OPM): • Measures how much profit can be pulled through ongoing operations.

  18. Profitability Ratios • Net Profit Margin (NPM): • Measures how much money from every dollar is pulled through as net profit.

  19. Basic Earnings Power • BEP removes effect of taxes and financial leverage. Useful for comparison.

  20. Profitability Ratios • Return on Total Assets (ROA): • This is a measure of the return on assets owned. • Therefore, it is a measure of return to all invested funds.

  21. Profitability Ratios • Return on Equity (ROE): • This is a measure of return to the equity holder (whether or not they get a dividend).

  22. Understanding the Analysis • Make sure you understand, and can communicate your analysis. • Ratios only make sense if the concept makes sense for your company. • Service companies have no inventory – inventory turnover makes no sense.

  23. Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TE) (TA / TA) • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange • ROE = (NI / TA) (TA / TE) (Sales / Sales) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM

  24. Market Value Ratios • Price-earnings ratio (P/E):

  25. Market Value Ratios • Price-Cash flow (P/CF) Ratio:

  26. Market Value Ratios • Dividend Yield: • Measures the return current shareholders would be earning from dividends if the most recent dividend history continues.

  27. Market Value Ratios • Market-to-Book Ratio: • Measures how much more value the stock market perceives in the company’s equity, than the accounting books would reflect.

  28. Common-Size Statements • Common-size financial statements are restatements as percentages of the traditionally largest number on the statement. • Common-size balance sheets are restated as percent of assets. • Common-size income statements are restated as percent of sales (or revenues).

  29. Creating Common Size Statements • The key to creating common size financial statements is the use of relative versus absolute addresses. • Excel interprets an address as relative (in position) to another address in a formula, unless you specify otherwise. • A1 is a relative address. • To specify an absolute address you simply use a $ in front of the absolute portion. • $A$1 means always A1. • The F4 key allows you to cycle through all options.

  30. Creating Common Size Statements • The item that is the basis for the common size, then typically gets an absolute address. • For example if sales are in C4, then creating a common size income statement would require you to punch in: • C4/C$4. • Then copying that formula down will create the common size income statement.

  31. Trend Analysis • Seeing how ratios change over time. • Are they getting better or worse over time? • Helps to determine the direction the firm is heading. • Show example. • Can be enhanced by graphing them.

  32. Trend Analysis

  33. Trend Analysis • You can also index the financial statements. • The figures in the earliest year are 100%, and those in subsequent years are percentages of the earliest year. • Be careful with the interpretation. • You are assuming that the first year was optimal. • High growth is miniscule accounts could be meaningless.

  34. Industry Averages • To compare the firm’s performance to that of similar firms, many use industry averages: • Risk Management Association (RMA) • Focuses on private companies. • The target audience is commercial lenders. • The source is also lenders. • Industries are defined using NAICS system. • Data are organized by size (assets or sales). • Most ratios include upper/lower quartiles as well as average.

  35. Industry Averages • Dunn and Bradstreets • Focuses on publicly traded companies. • Industries are defined using SIC system. • Also used by SEC. • Data are clumped together (no size adjustments). • Most ratios include upper/lower quartiles as well as average. • But there are not many ratios covered.

  36. Dunn & Bradstreet Common Size Balance Sheet

  37. Dunn & Bradstreet Key Financial Ratios

  38. Qualitative Factors • Are the company’s revenues tied to a single customer? • To what extent are the company’s revenues tied to a single product? • To what extent does the company rely on a single supplier?

  39. Qualitative Factors (Continued) • What percentage of the company’s business is generated overseas? • What is the competitive situation? • What does the future have in store? • What is the company’s legal and regulatory environment?

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