Financial Statement Analysis

1. Financial Statement Analysis FIL 341 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. Asset Management Ratios • Purpose is to assess how well the firm is managing assets • Inventory turnover ratio (IT):

9. Asset Management Ratios • Accounts receivable turnover (ART):

10. Asset Management Ratios • Accounts payable turnover (APT):

11. Asset Management Ratios • Fixed asset turnover (FAT):

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

13. Leverage Ratios • Relate debt to equity sources of investment funds . • Debt Ratio:

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

15. 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.

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

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

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

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

20. Profitability Ratios • Basic earning power ratio (BEP):

21. 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.

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

23. Profitability Ratios • Return on Common Equity (ROCE): • This is a measure of return to all equity holders.

24. 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

25. Predicting Financial Distress • Altman’s Z was developed using a Probit model to estimate the probability that a firm would go into bankruptcy. • His model was not published. • Since 1968, private firms have duplicated his work to give us a similar model (only published this time).

26. Predicting Financial Distress • There are two models: • For publicly traded companies: • Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5 • For private firms: • Z = 0.717X1+0.847X2+3.107X3+0.42X4+0.998X5 • Z is a normally distributed variable, where: • Z<1.81 Bankruptcy is predicted within a year. • 1.81<Z<2.675 Financial distress, possible bankruptcy • Z>2.675 No financial distress predicted

27. Predicting Financial Distress • X1 = Net Working Capital /Total Assets • X2 = Retained Earnings/Total Assets • X3 = EBIT/Total Assets • X4 = Market Value of All Equity/Book Value of Total Liabilities • In the private firm model Book Value of Equity is substituted for Market Value of Equity • X5 = Sales/Total Assets • What does each variable measure?

28. 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.

29. Trend Analysis

30. 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.

31. 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.

32. Dunn & Bradstreet Common Size Balance Sheet

33. Dunn & Bradstreet Key Financial Ratios

34. Excel Language • Logical operator IF • To have Excel automatically test cell addresses, use: • =IF(Logical test, Value if true, Value if false) • The logical test can use =, <, >, <>, <=, or >=. • E.g. =IF(A5>1,6,0). • Although the logical test usually uses values, it can use labels. • Value if true/false can be a value or a label. • Values are entered directly. • Labels are entered with quotation marks. • Blanks are entered as “”.

35. Excel Language • Logical operator IF – continued • If the test is complex, either AND or OR should be used. • AND can be used if more than one logical test must be passed for the values to be applied. • OR can be used if at least one logical test must be passed for the values to be applied. • E.g. =IF(OR(A5>3, A5<-3), “Cool”, “Bummer”)

36. Excel Language • Logical operator IF – continued • The IF statement can contain another, nested IF statement. • E.g. =IF(A5>2.65, “Great”, IF(A5<0.86, “Crap”, “Ok”) • If many nested IF statements are contemplated, then you should probably use a lookup table rather than a nested IF statement.