Financial Statement Analysis

1. 13 Financial Statement Analysis

2. Relationship to previous material • Focus has been: • What goes into 3 basic financial statements (Income Statement, Balance sheet, Statement of Cash Flows) • Now focus is: • How statements are analyzed by management, investors, and creditors

3. Objective of a Business • Create value for its shareholders while maintaining a sound financial position • Return on investment • Sound financial position • Other important objectives include: • Employee satisfaction • Social responsibility • Ethical considerations

4. Overview • GAAP does not define ratios • Multiple equally valid approaches to ratios and analysis • Managers (e.g. division manager, sales manager) should be measured to items that they control • Investors and top management are most interested in overall performance or broadest measures of performance: • Understanding less broad measures of performance may give additional insight into overall performance

5. Structure of analysis • From broadest to more specific levels • Principal value of financial analysis: • Suggests questions not answers: • Ratio comparisons start with supposition that all other things are equal

6. Categories of ratios which measure: • Overall performance • Profitability • Investment utilization • Financial condition • Dividend policy

7. Making comparisons • Finding the appropriate standard is difficult • A high ratio (e.g. current ratio, ROI) may be good or bad, it can’t be viewed in isolation: • Is a high CR good or bad? • Is a high ROI always good? • Values of ratios compared across time  longitudinal analysis, or trend analysis

8. Overall Measures • Return on assets (ROA) = (net income + interest*(1-tax rate))/ total assets: • How well management is using a pool of capital: • Before considering financing decisions • Measures how an enterprise uses its funds • May be used to evaluate individual business units in a large company when managers do not influence financing decision (i.e. how assets are financed)

9. Overall Measures • Return on shareholders’ equity (ROE) = Net income/shareholders’ equity: • Or, (net income -preferred dividends) / Common shareholders’ equity: • Common shareholders’ equity = total shareholders’ equity - preferred stock • Reflects return on funds invested by shareholders • Of interest to current and prospective shareholders

10. Overall Measures • Return on invested capital (ROIC) = (net income + interest(1-tax rate))/ invested capital: • Invested capital = permanent capital = capital employed = long-term liabilities + shareholders’ equity = working capital + non-current assets • Return on funds entrusted to the firm for relatively long time

11. Price/Earnings (PE) ratio • Measure of overall performance • Market price per share/EPS • Market price is not controlled by company, reflects all information available to the market • Reflects how investors judge future performance or prospects of the company • Commonly compared to other companies in same industry

12. Profitability measures • Profit margin = net income/net sales = a measure of overall profitability • Common size financial statements = Vertical analysis: • Express each item on the income statement as a percentage of net sales

13. Investment utilization measures • How well are assets managed • Profitability measures focus on Income Statement • Investment utilization measures involve balance sheet and income statement amounts

14. Investment turnover • Asset turnover = Sales revenue/total assets • Invested capital turnover = Sales revenue/invested capital • Equity turnover = Sales revenue/shareholders’ equity

15. Working capital measures • Days’ receivables = Receivables/(sales  365) • Days’ payables = operating payables/(pretax cash expenses  365): • Approximate pre-tax cash expenses = all expenses except taxes - depreciation expense

16. Working capital measures • Days’ inventory = inventory/(cost of goods sold  365): • Inventory turnover = cost of goods sold/inventory

17. Cash conversion cycle • Receivables conversion period (i.e. days’ receivables) + inventory conversion period (i.e. days’ inventory) - payment deferral period (i.e. days’ payables) = operating cycle - payment deferral period • A measure of liquidity: • Indicates time interval for which additional short-term financing might be needed to support a spurt in sales

18. Financial condition ratios • Liquidity • Solvency

19. Liquidity • Ability to meet current obligations: • Tests for size and relationship between current liabilities and current assets • Liquidity measures: • Current ratio = current assets/current liabilities • Acid Test (or quick) ratio = monetary current assets / current liabilities: • Monetary current assets = current assets - inventory - prepaid assets

20. Solvency • Ability to meet interest costs and repayment schedules associated with long-term debt • Solvency measures: • Debt/equity ratio = total liabilities/shareholders’ equity: • Alternatively, Debt/equity ratio = long-term liabilities/shareholders’ equity • Debt/capitalization ratio = long-term debt/total invested capital

21. Solvency Measures (Continued) • Total invested capital = long term debt + shareholders’ equity • Times interest earned = income before interest/interest expense • Ratio of Cash generated by operations to total debt

22. Dividend policy • Dividend yield = dividends per share/ market price per share • Dividend pay-out = dividends/net income • Provides info on how growth is financed: • Less dividends paid means more earnings are retained to fund growth

23. 13 End of Chapter 13