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Analysis of Financial Statements

Analysis of Financial Statements. Timothy R. Mayes, Ph.D. FIN 3300: Chapter 3. Common-size Income Statements. A common-size income statement restates all expenses as a percentage of sales

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Analysis of Financial Statements

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  1. Analysis of Financial Statements Timothy R. Mayes, Ph.D. FIN 3300: Chapter 3

  2. Common-size Income Statements • A common-size income statement restates all expenses as a percentage of sales • This allows the analyst to quickly and easily see which expenses have increased or decreased relative to sales

  3. Common-size Balance Sheets • A common-size balance sheet restates all assets and liabilities as a percentage of total assets • This allows the analyst to quickly and easily see which accounts have increased or decreased relative to total assets

  4. Financial Ratios • Financial ratios are the analyst’s microscope; they allow us to get a better view of the firm’s financial health than just looking at the raw financial statements • Ratios are used by both internal and external analysts • Internal uses • planning • evaluation of management • External uses • credit granting • performance monitoring • investment decisions

  5. Categories of Financial Ratios • Financial ratios are often divided into categories based on the information that they provide: • Liquidity • Efficiency • Leverage • Coverage • Profitability • Market valuation

  6. Liquidity Ratios • ‘Liquidity’ refers to the speed with which an asset can be converted to cash • Liquidity ratios describe the ability of a firm to meet its current obligations • There are three common liquidity ratios: • The Current Ratio • The Quick Ratio • The Cash Ratio

  7. The Current Ratio For EPI the current ratio in 1997 is:

  8. The Quick Ratio For EPI the quick ratio in 1997 is:

  9. The Cash Ratio For EPI the cash ratio in 1997 is:

  10. Efficiency Ratios • The efficiency ratios (A.K.A. assets utilization ratios) describe how well a firm is using its investment in various asset classes: • Inventory Turnover Ratio • Accounts Receivable Turnover Ratio • Average Collection Period • Fixed Asset Turnover Ratio • Total Asset Turnover Ratio

  11. The Inventory Turnover Ratio For EPI the inventory turnover ratio in 1997 is:

  12. The A/R Turnover Ratio For EPI the accounts receivable turnover ratio in 1997 is:

  13. The Average Collection Period For EPI the average collection period in 1997 is:

  14. The Fixed Asset Turnover Ratio For EPI the fixed asset turnover ratio in 1997 is:

  15. The Total Asset Turnover Ratio For EPI the total asset turnover ratio in 1997 is:

  16. Leverage Ratios • Leverage ratios describe the amount of debt that the firm has used to finance its investments in assets: • Total Debt Ratio • Long-term Debt Ratio • Debt to Equity • Long-term Debt to Equity

  17. The Total Debt Ratio For EPI the total debt ratio in 1997 is:

  18. The Long-term Debt Ratio For EPI the long-term debt ratio in 1997 is:

  19. The Debt to Equity Ratio For EPI the debt to equity ratio in 1997 is:

  20. The Long-term Debt to Equity Ratio For EPI the long-term debt to equity ratio in 1997 is:

  21. Coverage Ratios • Coverage ratios indicate the firm’s ability to pay certain expenses: • Times Interest Earned Ratio • Cash Coverage Ratio

  22. The Times Interest Earned Ratio For EPI the times interest earned ratio in 1997 is:

  23. The Cash Coverage Ratio For EPI the cash coverage ratio in 1997 is:

  24. The Fixed Charge Coverage Ratio • Note: SF Payments are Sinking Fund payments which are not tax deductible. Therefore, we must divide them by (1-t) to find out how much we need before taxes to meet this after-tax expense. Also, you must include preferred dividends in this number.

  25. Profitability Ratios • Profitability ratios provide a measure of the returns that a firm is generating: • Gross Profit Margin • Operating Profit Margin • Net Profit Margin • Return on Total Assets • Return on Equity • Return on Common Equity

  26. The Gross Profit Margin For EPI the gross profit margin in 1997 is:

  27. The Operating Profit Margin For EPI the operating profit margin in 1997 is:

  28. The Net Profit Margin For EPI the net profit margin in 1997 is:

  29. The Return on Total Assets For EPI the return on total assets in 1997 is:

  30. The Return on Equity For EPI the return on equity in 1997 is:

  31. The Return on Common Equity For EPI the return on common equity in 1997 is:

  32. Market Valuation Ratios • The market valuation ratios provide an indication of the relative under- or over-pricing of a firm’s stock: • Price/Earnings Ratio • Price/Book Ratio

  33. The Price/Earnings Ratio

  34. The Price/Book Ratio

  35. Rules for Memorizing Ratios • There can be an infinite number of financial ratios, but knowing a few basic rules will help you to memorize the formulas: The basic rule is that the name tells you how to calculate the ratio. • Any ‘margin’ ratio is something divided by sales • Any ‘turnover’ ratio is sales (or a variation of sales) divided by something • Any ‘return on’ ratio is net income (or a variation of net income) divided by something

  36. Using Financial Ratios • Calculating ratios is pointless unless you know how to use them • The most basic rule is: a single ratio provides very little information and may be misleading • With that in mind, there are at least 4 uses of ratios: • Trend analysis (internal and external) • Comparison to industry averages (internal and external) • Setting and evaluating company goals (internal) • Restrictive debt covenants (external)

  37. Trend Analysis of Ratios • Trend analysis involves the examination of ratios over time • The analyst tries to determine if the ratio is changing in a favorable, or unfavorable, direction • The chart shows EPI’s current ratio for two years (we really need more data)

  38. Comparing to Industry Averages • Industry average ratios provide a benchmark for comparison • We assume that if a ratio is too far from the average something is wrong • Industry ratios are available from Robert Morris Associates and Standard & Poor’s

  39. Company Goals and Debt Covenants • Company goals are often stated in terms of financial ratios • For example, it is common for management to set goals regarding the firm’s ROE • Debt covenants often contain restrictions on certain ratios • For example, a borrower might be required to maintain a debt to equity ratio of less than 1.0 and a current ratio greater than 2.0

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