Financial Statement Analysis Financial Statement Analysis John V. Balanquit...

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Financial Statement Analysis

John V. Balanquit

johnthecpa.wikispaces.com

Learning Objectives

1. Why return on equity is one of the key financial ratios used for assessing a firm’s performance, and how it can be used to provide information about three areas of a firm’s operations

2. Why outsiders and insiders are concerned with a company’s ratios related to leverage, efficiency, productivity, liquidity and value

3. How to calculate, interpret, and evaluate the key ratios related to leverage, efficiency, productivity, liquidity, and value

4. Why financial forecasts provide critical information for both management and external parties

5. How to prepare financial forecasts by using the percentage of sales approach

6. How external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth rates.

The DuPont System

Financial Statement Analysis and Forecasting

A Framework for Financial AnalysisReturn on Equity (ROE) and DuPont System

• The DuPont System gives a framework for the analysis of financial statements through the decomposition of the Return on Equity ratio

(See Figure 4 -2 that illustrates the constituent parts of ROE )

Equity rs'Shareholde

IncomeNet Equity on Return

Framework for Financial AnalysisDu Pont System

4 - 2 FIGURE

GOOD OR BAD?

LEVERAGE RATIOS

EFFICIENCY RATIOS

PRODUCTIVITY RATIOS

A Framework for Financial AnalysisDuPont System and Decomposition of ROE

• As Figure 4 – 2 illustrates, ROE is a function of:– Corporate use of leverage (use of debt)– Efficiency ratios (ability of the firm to control costs in relationship to

sales)– Productivity ratios (the degree to which the firm can generate sales in

relationship to assets employed)

A Framework for Financial AnalysisReturn on Equity (ROE) and DuPont System

• ROE is not a pure ratio because it involves dividing an income statement item (flow) by a balance sheet (stock) item.

• Instead of using ending SE, many argue you should use average SE (beginning SE plus ending SE divided by 2) because SE changes over the year as income is earned and retained earnings grow.

A Framework for Financial AnalysisReturn on Equity (ROE)

[4- 7]

Leverage

ROE when decomposed shows that it is a function of the return earned on assets and of the leverage used by the firm.

A Framework for Financial AnalysisReturn on Total Assets

• ROA shows the ratio of income to assets that have been used to produce them.

• ROA can be further decomposed as shown and the following slide

Assets Total

IncomeNet Assetson Return

A Framework for Financial AnalysisReturn on Assets (ROA)

• ROA is the product of the net profit margin and the sales to total asset ratio:

• The sales cancel and we are left with NI / TA

NIROA [4- 6]

A Framework for Financial AnalysisLeverage Ratio

• If ROA is multiplied by TA and divided by SE, the TA’s cancel out and produces ROE.

• TA / SE is the leverage ratio

• It measures how many dollars of total assets are supported by each dollar of Shareholders Equity.

Assets Total Leverage

Leverage

DuPont System

• The DuPont system provides a good starting point for any financial analysis– It shows that financial strength comes from many sources

(profitability, asset utilization, leverage)– It reinforces the concept that good financial analysis requires

looking at each ratio in the context of the other– Whenever you are presented with financial statements it is

important that you look at a sample of ratios from each major category to identify areas of strength and weakness

(Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans)

A Framework for Financial AnalysisReturn on Equity (ROE) and the DuPont System

Return on Equity 3/31/2006 3/31/2005 3/31/2004 3/31/2003(1) Net Sales 652,271 636,771 620,104 575,469(2) Pretax Income 274,829 261,345 252,683 240,197(3) Net Income 99,464 92,997 90,277 86,678(4) Total assets 449,075 528,528 496,757 429,965(5) Shareholders' equity 113,860 193,708 168,497 130,537Pretax margin % (2/1) 42.13% 41.04% 40.75% 41.74%× Tax retent % (3/2) 36.19% 35.58% 35.73% 36.09%=profit margin % (3/1) 15.25% 14.60% 14.56% 15.06%× Asset Utilization % (1/4) 145.25% 120.48% 124.83% 133.84%= ROA % (3/4) 22.15% 17.60% 18.17% 20.16%× Leverage % (4/5) 394.41% 272.85% 294.82% 329.38%=ROE % (3/5) 87.36% 48.01% 53.58% 66.40%

Source: Data from E-Trade Canada

Table 4-1 E-Trade Canada's Rothman's Dupont ROE Analysis

Interpreting Ratios

• A ratio is just one number over another number – by itself, there is little ‘information’

• To judge whether a ratio is ‘good’ or ‘bad’ requires that it be compared to something else such as:– The company’s own ratios over time to ascertain

trends– Other comparable companies or industry averages

(Table 4 -2 illustrates Rothmans DuPont ratios over time)

A Framework for Financial AnalysisInterpreting Ratios

Rothmans (March 31)

2004 2005 2006

ROE 0.5358 0.4801 0.8736ROA 0.1817 0.1760 0.2215Net profit margin 0.1456 0.1460 0.1525Turnover 1.2483 1.2048 1.4525Leverage 2.9482 2.7285 3.9441

Table 4-2 Rothman's Dupont Ratios

Do you see trends here?

What factors are driving the trend in ROE?

A Framework for Financial AnalysisInterpreting Ratios

Altria (December 31)

2003 2004 2005

ROE 0.3670 0.3066 0.2922ROA 0.0957 0.0926 0.0967Net profit margin 0.1132 0.1051 0.1066Turnover 0.8455 0.8816 0.9065Leverage 3.8352 3.3095 3.0232

Table 4-3 Altria's Dupont Ratios

Do you see trends here?

What factors are driving the trend in ROE?

How do these results compare to Rothmans on the previous slide?

Leverage Ratios

Leverage

• Leverage = magnification• Financial leverage occurs when a firm uses

sources of financing that carry a fixed cost (such as long-term debt), and uses this to generate greater returns that result in magnified returns to shareholders.

• Leverage means magnification of either profits or losses.

Leverage Ratios

• Include:– Debt ratio– Debt to equity ratio– Times interest earned ratio– Cash flow to debt ratio

Leverage RatiosDebt Ratio

• Is a stock ratio indicating the proportion of total assets financed by debt at a particular point in time (the balance sheet date)

Assets Total

sLiabilitie Total ratioDebt TA

TL[4- 8]

Leverage RatiosDebt-Equity Ratio

• Is a stock ratio indicating the proportion that total debt represents in relationship to the shareholders equity (common stock and retained earnings) at the balance sheet date.

Debt Total ratioy Debt/Equit SE

D[4- 9]

Leverage RatiosTimes Interest Earned (TIE)

• Is an income statement (flow) ratio indicating the number of times the firm’s pre-tax income exceeds its fixed financial obligations to its lenders (debt holders)

ExpenseInterest

Taxes andInterest Before Earnings

EarnedInterest Times

[4- 10]

Leverage RatiosCash Flow to Debt Ratio

• Measures how long it would take to payoff a firm’s debt (D)

Debt Total

Operations from FlowCash /

ratiodebt toflowCash

[4- 11]

Leverage RatiosCash Flow to Debt Ratio

2004 2005 2006 2003 2004 2005

Leverage 2.9482 2.7285 3.9441 3.8352 3.3095 3.0232Debt ratio 0.6608 0.6335 0.7465 0.7393 0.6978 0.6692D/E ratio 0.8902 0.7729 1.3152 0.9785 0.7482 0.6703TIE 46.7842 36.1270 42.7356 13.7035 12.9082 14.3405Cash flow to debt 1.5037 1.0823 1.2235 0.4408 0.4739 0.4621

Table 4-4 Leverage Ratios

Rothmans (March 31) Altria (December 31)

Which firm exhibits greater use of leverage?

Which exhibits greater capacity to take on and service debt?

Efficiency Ratios

Efficiency ratios measure how efficiently a dollar of sales is turned into profits.

• Gives insight to the firm’s cost structure • Whether problems exist with variable costs or fixed costs

(overhead) or both

Efficiency Ratios

• Include:– Degree of total leverage– Break-even point– Gross profit margin– Operating margin

Efficiency RatiosInterpreting Ratios

Sales 120 132 108Contribution margin (40%) 48 53 43Fixed cost 31 51 31Interest 5 5 5Tax 6 8.5 3.5Net income 6 8.5 3.5

Net profit margin 5.0% 6.4% 3.2%

Table 4-5 Profit Margin and Sales Variability

The focus of efficiency ratios is with the income statement. This example demonstrates the leverage effect of using fixed costs in lieu of variable costs in the cost structure.

Sales varied by +/- of 10% yet profits varied by +/- 40%.

Efficiency RatiosDegree of Total Leverage Ratio

• An income statement ratio that measures the exposure of profits to changes in sales.

• The greater the DTL, the greater leverage effect.

Taxes Before Earnings

Marginon Contributi

Leverage Total of Degree

[4- 12]

Efficiency RatiosBreak Even Point

• Estimates the volume of units that must be produced and sold in order for the firm to cover all costs both fixed and variable.

• The break even point tends to increase as the use of fixed costs increases.

Marginon Contributi

Costs Fixed

Point Even Break

[4- 13]

Efficiency RatiosGross Profit Margin

• Demonstrates the percentage of sales that are available to cover fixed (period) costs and financing expenses after variable costs have been paid.

• A declining gross profit margin raises concerns about the firm’s ability to control variable costs such as direct materials and direct labour.

Sold Goods ofCost -Sales

Margin Profit Gross

[4- 14]

Efficiency RatiosOperating Margin

• Operating margin measures the cumulative effect of both variable and period costs on the ability of the firm to turn sales into operating profits to cover, interest, taxes, depreciation and amortization (EBITDA).

Income OperatingNet

Margin Operating

[4- 15]

Efficiency RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Net profit margin 0.1456 0.1460 0.1525 0.1132 0.1051 0.1066Gross profit margin 0.4261 0.4305 0.4426 0.3519 0.3348 0.3286Operating margin 0.4102 0.4155 0.4263 0.1938 0.1867 0.1696

Table 4-6 Efficiency Ratios

Which firm is able to produce a greater percentage of sales as profits?

Which firm is able to produce strong and consistent profitability?

Productivity Ratios

• Measure the ability of the firm to generate sales from the assets that it employs.

• Excessive investment in assets with little or no increase in sales reduces the rate of return on both assets and equity (ROA) and (ROE)

Productivity Ratios

• Include:– Receivables turnover– Average collection period (ACP)– Inventory turnover– Average days sales in inventory (ADSI)– Fixed asset turnover

Productivity RatiosReceivables Turnover

• Measures the sales generated by every dollar of receivables.

Receivable Accounts

turnover sReceivable

[4- 16]

Productivity RatiosAverage Collection Period

• Estimates the number of days it takes a firm to collect on its accounts receivable.

• If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate.

turnoversReceivable

Turnover sReceivable

365 Period Collection Average

[4- 17]

Productivity RatiosInventory Turnover

• Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.

• A ratio that involves both ‘stock’ and ‘flow’ values• Is strongly a function of ending inventory value…

managers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.)

Turnover Inventory INV

[4- 18]

Productivity RatiosInventory Turnover

• When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.

• Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost.

Turnover Inventory INV

[4- 19]

Productivity RatiosAverage Days Sales in Inventory (ADSI)

• Estimates the number of days of sales tied up in inventory (based on ending inventory values)

turnoverInventory

(ADSI)inventory in sales days Average

[4- 20]

Productivity RatiosFixed Asset Turnover

• Estimates the number of dollars of sales produced by each dollar of net fixed assets.

AssetsFixedNet

SalesNFA

Turnover Asset Fixed [4- 21]

Productivity RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Turnover 1.2483 1.2048 1.4525 0.8455 0.8816 0.9065Receivables turnover 19.3825 19.8254 55.3006 NA 15.5735 18.2529ACP 18.8314 18.4108 6.6003 NA 23.4372 19.9968Inventory turnover (using sales) 3.1170 3.0349 3.1597 8.5241 8.9244 9.2455ADSI 117.0988 120.2692 115.5165 42.8197 40.8991 39.4788Fixed asset turnover 11.0158 9.2087 8.5490 5.0613 5.4959 5.8673

Table 4-7 Productivity Ratios

Which firm has been improving its efficiency ratios to a greater degree?

Liquidity Ratios

4 - 45

Liquidity Ratios

• Measure the ability of the firm to meet its maturing financial obligations through liquid (cash and near cash) resources

• Include:– Working capital ratio– Current ratio– Quick (acid-test) ratio

Liquidity RatiosWorking Capital Ratio

• Measures the percentage of total assets that is invested in current assets.

• Helps to analyze capital intensity as well as corporate liquidity.

AssetsTotal

AssetsCurrentTA

Ratio Capital Working[4- 22]

Liquidity RatiosCurrent Ratio

• Measures the number of dollars of current assets for each dollar of current liabilities.

• Helps to estimate the capacity of the firm to meet its maturing financial obligations.

RatioCurrent

sLiabilitieCurrent

AssetsCurrentCL

[4- 23]

Liquidity RatiosQuick Ratio

• Recognizing that inventories may be less liquid than other current assets, and in some cases, when liquidated quickly result in cash flows that are less than book value, the quick ratio gives a clearer indication of the firm’s ability to meet its maturing financial obligations out of current, liquid assets.

RatioQuick

sLiabilitieCurrent

sInventorieAssetsCurrentCL

[4- 24]

Liquidity RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Current ratio 2.8868 2.9310 2.4756 NA 1.0987 0.9856Quick ratio 1.4981 1.5092 1.0037 NA 0.4877 0.4442Working capital ratio 0.8414 0.8235 0.7800 NA 0.2548 0.2388

Table 4-8 Liquidity Ratios

Which firm has greater liquidity and capacity to meet its financial obligations?

Valuation Ratios

• Used to assess how the market is valuing the firm (share price) in relationship to assets and current earnings, profits and dividends

• Include:– Equity book value per share (BVPS)– Dividend yield– Dividend payout– Price-earnings (P/E) ratio– Forward (P/E) ratio – Market-to-book (M/B) ratio– EBITDA multiple

Valuation RatiosInterpreting Ratios – Book Value per Share

• Expresses shareholders’ equity on a per share basis.

Shares ofNumber

Equity rs'Shareholde SharePer ValueBook [4- 25]

Valuation RatiosInterpreting Ratios – Dividend Yield

• Expresses dividend payout as a percentage of the current share price.

• Can be compared to other investment instruments such bonds (current yield) or with other dividend-paying companies.

Shareper Price

SharePer Dividend Yield Dividend

DPS [4- 26]

Valuation RatiosInterpreting Ratios – Dividend Payout Ratio

• Expresses dividends as a percentage of earnings on a per share basis.

Shareper Earnings

SharePer Dividend Payout Dividend

DPS [4- 27]

Valuation RatiosInterpreting Ratios – Trailing P/E Ratio

• Earnings multiple based on the most recent earnings.• Often used in estimating the value of a stock.

• A stock trading at a P/E multiple of 10 will take ten years at current earnings to recover the price of the stock.

• A stock trading at a P/E multiple of 100 will take 100 years at current annual earnings to recover the price of the stock.

Shareper Earnings

Price Share ratio earnings-Price

P [4- 28]

Valuation RatiosInterpreting Ratios – Forward P/E Ratio

• Earnings multiple based on forecast earnings per share.

• Often used in estimating the value of a stock especially with companies with rapid growth in earnings per share.

• Low P/E shares are regarded as value stocks• High P/E shares are regarded as growth stocks

Shareper Earnings Estimated

Price Share ratio earnings-Price Forward

P [4- 29]

Valuation RatiosInterpreting Ratios – Market to Book Ratio

• Estimates the dollars of Share Price per dollar of book value per share.

• Given historical cost accounting as the basis for book value per share, the degree to which market value per share exceeds BVPS indicates the value that has been added to the company by management.

Shareper ValueBook

Price Share ratiobook -to-Market

P [4- 30]

Valuation RatiosInterpreting Ratios – EBITDA Multiple

• Total enterprise value is an estimate of the total market value of the firm (market value of equity plus market value of debt)

• EBITDA multiple expresses total enterprise value for each dollar of operating income (EBITDA)

EBITDA

onamortizati andon depreciati taxes,interest, before Earnings

Value Enterprise Total multipleEBITDA

Valuation RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Dividend yield 0.0474 0.0438 0.1333 0.0485 0.0462 0.0410Dividend payout 0.6063 0.7664 1.8621 0.5841 0.6184 0.6132P/E 12.7799 17.5109 13.9655 12.0398 13.3991 14.9739M/B 6.8451 8.3685 12.0682 4.4208 4.0979 4.6319EBITDA multiple 4.8535 6.3545 5.2095 7.8436 8.8194 9.7774Dividend yield (excl. special dividend) N/A N/A 0.0593 N/A N/A N/ADividend payout (excl. special dividend) N/A N/A 0.8276 N/A N/A N/A

Table 4-10 Value Ratios

Can you draw any conclusions for the comparative valuation ratio data summarized in this table?

Copyright

Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

Common Size Statements

A common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages.

A common size financial statement helps to compare entries in a firm’s financial statements, even if the firms are not of equal size.

How to prepare a common size financial statement? For a common size income statement, divide each

entry in the income statement by the company’s sales.

For a common size balance sheet, divide each entry in the balance sheet by the firm’s total assets.

Whole Foods Market,Comparative Income Statement

Common Size statements

Business Segment information

Comparative Balance Sheet

Common size and trend analysis

Common size and trend analysis (Exhibit 5.5 continued)

Common size and trend analysis

Common size and trend analysis (Exhibit 5.6 continued)

Comparative Cash Flows

Common size trend analysis

The Limitations of Ratio Analysis

1. Picking an industry benchmark can sometimes be difficult.

2. Published peer-group or industry averages are not always representative of the firm being analyzed.

3. An industry average is not necessarily a desirable target or norm.

4. Accounting practices differ widely among firms.

5. Many firms experience seasonal changes in their operations.

6. Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios.

7. The results of financial analysis are dependent on the quality of the financial statements.

Financial Statement Analysis Financial Statement Analysis John V. Balanquit...

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