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Financial Statement Analysis: Understanding the Major Assessments and Value Investing Techniques

This chapter explores the major financial statements, accounting versus economic earnings, profitability measures, ratio analysis, economic value added, comparability problems, and value investing techniques. Learn how to analyze financial statements to make informed investment decisions.

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Financial Statement Analysis: Understanding the Major Assessments and Value Investing Techniques

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  1. CHAPTER 14 Financial Statement Analysis

  2. 14.1 THE MAJOR FINANCIAL STATEMENTS

  3. Income Statement • Four broad classes: • Cost of goods sold • General and administrative expenses • Interest expense • Taxes on earnings • Common Sizing

  4. Table 14.1 Consolidated Statement of Income

  5. Balance Sheet • Assets • Current • Long-term • Liability and stockholders’ equity • Common Sizing

  6. Table 14.2 Consolidated Balance Sheet

  7. Statement of Cash Flows • Recognizes only transactions in which cash changes hands

  8. Table 14.3 Consolidated Statement of Cash Flows

  9. 14.2 ACCOUNTING VERSUS ECONOMIC EARNINGS

  10. Accounting Versus Economic Earnings • Accounting earnings • Affected by several conventions regarding the valuation of assets • Economic earnings • Earnings above or below a trend line

  11. 14.3 PROFITABILITY MEASURES

  12. Past Versus Future ROE • Data from recent past may provide information regarding future performance • Analysts should always keep an eye on the future • Expectations of future dividends and earnings determine intrinsic value of stock

  13. Financial Leverage and ROE • The relationship among ROE, ROA, and leverage:

  14. 14.4 RATIO ANALYSIS

  15. Ratio Analysis • Purpose of Ratio Analysis • Uses • Trend analysis • Comparative analysis • Combination • Use by External Analysts • Important information for investment community • Important for credit markets

  16. Decomposition of ROE EBIT Sales Sales Assets Assets Equity Net Profit Pretax Profit Pretax Profit EBIT x ROE = x x x (1) x (2) x (3) x (4) x (5) Tax Burden Interest Burden x x Margin x Turnover x Leverage

  17. Type of Financial Ratios • Profitability Ratios • Turnover or Asset Utilization Ratios • Liquidity Ratios • Leverage Ratios • Market Price Ratios

  18. Profitability Ratios Net Profit Margin % Net Income Sales Operating Return on Assets % Earnings Before Int. & Taxes Total Assets

  19. Profitability Ratios (cont.) Return on Equity % Net Income Common Equity Operating Margin After Depreciation % Operating Profit Sales

  20. Activity or Management Efficiency Ratios Inventory Turnover Sales or Cost of Goods Sold Inventory Total Asset Turnover Sales Total Assets

  21. Activity or Management Efficiency Ratios (cont.) Average Collection Period Accounts Receivable Sales Per Day Days to Sell Inventory Inventory Sales Per Day

  22. Liquidity Ratios Current Ratio Current Assets Current Liabilities Quick Ratio Current Assets - Inventory Current Liabilities

  23. Leverage Ratios Times Interest Earned Earnings Before Int. & Taxes Interest Expense Fixed Charge Coverage Ratios Lease Payments Principal Repayments Preferred Dividends

  24. Leverage Ratios (cont.) Debt to Assets % Long Term Debt Assets Debt to Equity % Long Term Debt Shareholders Equity

  25. Market Price Ratios Price to Earnings Market Price of Stock Earnings Market-to-Book-Value Market Price of Stock Book Value Per Share

  26. Figure 14.1 DuPont Decomposition for Hewlett-Packard

  27. 14.5 ECONOMIC VALUE ADDED

  28. Economic Value Added • Approach to compare accounting profitability with the cost of capital • Definition • ROA-K (Capital Invested in the firm) • K = opportunity cost for capital • Ties accounting to return by investors

  29. Table 14.12 Economic Value Added, 2006

  30. 14.6 AN ILLUSTRATION OF FINANCIAL STATEMENT ANALYSIS

  31. Table 14.13 Key Financial Ratios of Growth Industries Inc.

  32. Table 14.14 Growth Industries Statement of Cash Flows

  33. 14.7 COMPARABILITY PROBLEMS

  34. Comparability Problems • Inventory valuation • LIFO and FIFO • Depreciation • Inflation and interest expense

  35. Quality of Earnings:Areas of Accounting Choices • Allowance for bad debts • Non-recurring items • Earnings smoothing • Stock options • Revenue recognition • Off-balance sheet assets and liabilities

  36. International Accounting Conventions • Reserving practices • Depreciation • Intangibles

  37. Figure 14.2 Adjusted Versus Reported Price-Earnings Ratios

  38. 14.8 VALUE INVESTING: THE GRAHAM TECHNIQUE

  39. Benjamin Graham • Graham believed careful analysis of a firm’s financial statements could turn up bargain stocks • He developed many different rules for determining the most important financial ratios

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