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Analysis of Financial Statements

Analysis of Financial Statements. Chapter 4. Outline. Why are ratios useful?. Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths. Ratio comparisons should be made through time and with competitors. Trend analysis.

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Analysis of Financial Statements

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  1. Analysis of Financial Statements Chapter 4

  2. Outline

  3. Why are ratios useful? • Ratios standardize numbers and facilitate comparisons. • Ratios are used to highlight weaknesses and strengths. • Ratio comparisons should be made through time and with competitors. • Trend analysis. • Peer (or industry) analysis.

  4. Major categories of ratios

  5. Liquidity

  6. Liquidity ratios

  7. Dell

  8. Operating cycle • Operating cycle: The length of time it takes for the investment of cash in inventory to be returned in the form of payments from customers. • The longer the operating cycle, the greater the need for liquidity

  9. Number of days Beg. Inv. + Purchases = COGS + End. Inv.

  10. Operating cycle Operating cycle = DSO + DSI Cash conversion cycle = DSO + DSI - DPO

  11. Dell Assumed all sales on credit

  12. Asset efficiency

  13. Turnovers

  14. Dell

  15. Relationships

  16. Profitability

  17. Profit margins

  18. Dell

  19. Financial leverage

  20. Debt management ratios

  21. Debt management ratios, cont. Fixed charges: Interest, preferred dividends, lease payments

  22. Dell

  23. Returns • The return on assets is the net profit relative to total assets • The return on equity is the net profit relative to equity:

  24. Returns, cont. • The return on invested capital is the net profit to invested capital: Invested capital = Debt + equity • The basic earning power ratio is the operating return on assets:

  25. Returns on assets and equity

  26. Returns on assets and equity

  27. Du Pont: Dell, FY2010

  28. Du Pont: Dell, 2006-2010

  29. Example: Borders Filed for bankruptcy 2011

  30. Problems with ROE • ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. • ROE does not consider risk. • ROE does not consider the amount of capital invested. • Might encourage managers to make investment decisions that do not benefit shareholders. • ROE focuses only on return and a better measure would consider risk and return.

  31. Example: KO

  32. Example: GM

  33. Multiples

  34. Analyzing the market value ratios • Price-earnings ratio (P/E): How much investors are willing to pay for $1 of earnings. • Market to book value of equity ratio (M/B): How much investors are willing to pay for $1 of book value equity. • Issues: • What is the meaning of the book value of equity? • What is the Molodovsky effect?

  35. Beyond ratios • Common size analysis • Qualitative analysis

  36. Common size analysis • Common size analysis provides a “big picture” of the changing relationships among accounts over time by standardizing the data. • Two forms: • Vertical: Each account as % of total • Horizontal: Each account as % of base year

  37. Vertical Example: Apple Assets

  38. Vertical example: Apple, cont. Liabilities and equity

  39. Horizontal example: Apple

  40. Issues

  41. (1) A single ratio is meaningless • Ratios must be put in context: in context of other firms, historical, and company-specific events. • A given value of a ratio is neither good or bad; rather, it helps paint a picture of the company’s health and performance.

  42. (2) Comparisons to industry ratios may be helpful • First challenge: identify the industry • Second challenge: identify comparables • Third challenge: construct industry ratios • Equal v. value weighted ratios

  43. (3) Trends break Analysis must be put in context of company-specific events, e.g.,: • M&A • Divestitures • Regulation change • Product line changes

  44. (4) Seasonality and FY choice can distort ratios • Companies select FY-end based on the low-point of their seasonal cycle. • Therefore, working capital accounts are likely at their lowest levels • Fix: Quarterly or monthly averages of accounts instead of FY balance sheet levels.

  45. (5) Window dressing • “Window dressing” techniques can make statements and ratios look better. • Compensation plans can result in distortions/dressing.

  46. (6) Different methods of accounting • Companies have some choices in accounting method (e.g., FIFO v. LIFO): • Makes comparisons difficult (across firms and across time) • Makes interpretation challenging (because may not have all the data).

  47. Qualitative analysis

  48. Qualitative factors • Are the firm’s revenues tied to one key customer, product, or supplier? • What percentage of the firm’s business is generated overseas? Which countries? • The firm’s competitive environment: degree of competitiveness • Future prospects / opportunities • Legal and regulatory environment • Product life cycle

  49. Sources of qualitative information • 10-K filings with the SEC • Annual reports • Press releases • Trade groups/associations • Government databases (e.g., Census, FTC, BEA)

  50. The end

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