Financial Analysis

1. Financial Analysis Purpose Ratio Analysis Cash Flow Analysis

2. Purpose of Financial Analysis • Assess Corporate Performance in the context of stated goals and strategy. • Assess current financial position, including liquidity.

3. Tools of Traditional Financial Statement Analysis • Ratio analysis • Cash Flow analysis

4. Ratio Analysis • Tools for interpreting financial statements • Often used to facilitate comparison via deflation. • Common size financial statements- when the whole statement is converted to ratio form.

5. Ratio Analysis • Financial ratios are typically grouped into four classes • Profitability • Liquidity ratios • Solvency ratios • Funds management ratios

6. Profitability and growth-Strategic Areas of Influence • Operating management • Investment management • Financing strategy • Dividend policies

7. Profitability and Growth Product Market Strategies Financial Market Strategies Operating Management Investment Management Financing Management Dividend Policy Managing Working Capital and Fixed Assets Managing Revenue and Expenses Managing Liabilities and Equity Managing Payout Drivers of Profit and Growth

8. Ratios can be used: • To compare the same firm over several years • To compare to other firms in the industry • To compare to an absolute benchmark

9. Operating Management (managing revenues and expenses) • Return on equity (ROE) -- ROE = (Net Income) / (Shareholder’s Equity) • Return on Assets -- Income / (Total Assets) • Return on sales (ROS) -- Net Income / Sales • Gross Profit Margin- (Sales-COGS)/Sales • Numerous variations of the above are computed in practice

10. An Example-Return on Equity (ROE) • Beginning balances, ending balances, average balances ? • Often adjusted for preferred stock dividends • Average for US industries is from 11 to 13% (PBH)

11. The need for an analysis framework • What do ROE, NPM, ROA, etc., mean as a group? • What if they differ as to outcome (e.g., one firm has a higher NPM but lower ROE)? • What story do they tell, collectively? • How do they relate to each other?

12. The Notion of Ratio Decomposition (Dupont Analysis) • ROE = ROA * Assets/equity (Financial leverage) • ROA= net income/ assets • Financial leverage indicates the dollar of assets the firm is able to deploy for dollar invested by shareholders

13. CA Turnover WC Turnover AR Tirnover Inv Tirnover AP Turnover Days Rec Days Pay PP&E Turnover Current Ratio Quick Ratio Cash Ratio Oper CF Ratio Liab to Equity Debt to Equity Debt to Capital Int Coverage GOGS/ Sales GP/ Sales SG&A/Sales R&D/Sales OE/ Sales Non OE / Sales EBT / Sales Tax Expenses / Sales Sustainable Growth Rate Dividend payout ROE Fin Leverage ROS Asset Turnover

14. Sustainable Growth 1 • ROE * (1-Dividend payout ratio)

15. Gross Profit Margin • A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing.

16. Gross Profit Margin • Two main factors determine gross profit margins: • Competition – The more competition, the lower margins tend to be. • Product mix – The greater the volume of low profit/high turnover goods, the lower the margins. • Very relevant for comparisons within an industry -- not much outside

17. Operating Expense Margin • Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category. • Expense ratios are calculated as follows: Operating expense percentage = Expense item/Net sales

18. Profitability and Growth Product Market Strategies Financial Market Strategies Operating Management Investment Management Financing Management Dividend Policy Managing Working Capital and Fixed Assets Managing Revenue and Expenses Managing Liabilities and Equity Managing Payout Drivers of Profit and Growth

19. Investment Management • Working Capital and Fixed Assets • Receivables • Inventory • LT operating assets • Payables

20. Turnover • Turnover measures relate to the productivity of company assets, i.e., how much capital is required to generate a specific sales volume? • Turnover ratios are calculated as follows: Turnover = Sales volume/Average Assets • As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced.

21. Accounts Receivable Turnover (ART)

22. Inventory Turnover (INVT)

23. L-T Operating Asset Turnover (LTOAT)

24. Accounts Payable Turnover (APT)

25. Net Operating Working Capital Turnover (WOCT)

26. Evaluating Financial Management • Short-term evaluations • Long-term evaluations

27. Short-term evaluations 1 • Current ratio • (Current assets) / (Current liabilities)

28. Short-term evaluations 2 • Quick ratio • (Cash + Short-term investments + Accounts Receivable) / (Current liabilities)

29. Short-term evaluations 3 • Operating cash flow ratio • (Cash flow from operations) / (Current liabilities)

30. Long-term evaluations • Debt is typically cheaper that equity • Interest is tax deductible dividends are not • Can impose discipline on management (explicit contracts) • Easier to communicate proprietary information to private lenders than to public markets

31. Standard ratios • Liabilities-to-equity-ratio • Debt-to-equity ratio • Debt-to-capital • Interest coverage

32. Liabilities-to-equity • (Total Liabilities) / (Shareholders’ equity)

33. Debt-to-equity • (Short-term debt + Long-term debt) / (Shareholders’ equity)

34. Interest coverage • (Net income + Interest expense + Tax expense) / (Interest expense)

35. Problems with Ratios • Mis-specification of deflator (e.g., size) • Accounting imperfections • Problem of assumed linearity • Ratio blow-up • Negative numbers. What do they mean? • Assumed 0 intercept. • Omitted variables

36. Business Activities From Business Activities to Financial Statements Business Environment Business Strategy Accounting System Accounting Environment Accounting Strategy Financial Statements

37. Profitability and Growth Product Market Strategies Financial Market Strategies Operating Management Investment Management Financing Management Dividend Policy Managing Working Capital and Fixed Assets Managing Revenue and Expenses Managing Liabilities and Equity Managing Payout Drivers of Profit and Growth

38. Cash Flow Analysis- Based on Business Activities Operating Activities Investment Activities Financing Activities

39. Cash Flow • The Direct Method • The Indirect Method

40. Cash Flow -- Direct Method • Recommended by the FASB • Most companies use the Indirect Method

41. Cash Flow -- Indirect Method - 1 Net Income Add Non-cash income items Plus/Less Adjustments for receivables inventories, payables, taxes Equals Cash Flow from Operations

42. Cash Flow -- Indirect Method - 2 Cash Flow from Operations PLUS/LESS Cash flow - Investment activities PLUS/LESS Cash flow - Financing activities EQUALS Change in cash and cash equivalents

43. From Profit to Cash Net Income Cash Flow From Oper. bef. WC chgs, Inv & Int CF from op After Wc Changes before int + Noncash charges +/- Chg in Working Cap

44. From Profit to Cash -- 2 Cash Flow From Operations CF Free Cash Flow +/- Interest +/- Chg Fixed Capital

45. Free Cash Flow • Jensen (1988) defines free cash flow as the cash left after managers have invested in all positive NPV projects • He also asserts that managers will invest in negative NPV projects rather pay it out to shareholders • The Free cash flow used in out context is the cash flow from operations plus the net investment cash flow

46. Free cash Flow and Interest • You may add interest back. Depends on the purpose of the Free Cash Flow. See p. 6-3.

47. Free Cash Flow From Working Capital • Adjust Working Capital from operations for changes in current accounts to get Cash Flow From Operations • Add the net capital investment • What you get is Free Cash Flow