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FINANCIAL STATEMENT ANALYSIS

CHAPTER 13

Fundamental Analysis

Finance (chapter 12): Valuation techniques Dividend discount model, P/E ratio Need input as dividends and earnings prospects

Economics (chapter 11) (information from outside) macro level: market micro level: industries, firms

Accounting (chapter 13) (information from inside) How to read reported data? How to use financial data as inputs into stock valuation

Financial Statement AnalysisFinancial Statement Analysis

Objectives:

• Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios.

• Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis.

• Measure a firm’s operating efficiency

• Identify likely sources of biases in accounting data.

Income Statement

Firm’s revenues and expenses during a specific period Typical formatSale

- Operating expense

COGS

Depreciation

Operating Income (EBIT)

- Interest

Earning before tax (EBT)

- Tax

Net Income (NI)

Table 14.1 Consolidated Statement of Income

Balance Sheet

A snapshot of firm’s assets and liability at a given point in time

Asset Liabilities + Equity

1. Current Asset 1. Current liabilities

Cash Short term debt

Account receivable Account payable

Inventory Note payable

2. Fixed asset 2. Long-term debt

3. Equity

Common stock

Retained earning

Total assets Total liabilities + equity

Table 14.2 Consolidated Balance Sheet

Statement of cash flow

Net income: accounting profit Cash flow: cash available on hand Statement of cash flow: firm’s cash receipts and payments

during a specific period

Table 14.3 Consolidated Statement of Cash Flows

Return on Equity (ROE)

ROE=Net profit/Equity g = ROE × b To estimate g, need to estimate ROE Past ROE might not be good estimator of future ROE ROE is linked with ROA and affected by firm’s financial

policies Watch out financial leverage:

ROA: Return on Assets=EBIT/Assets

Equity

DebtteInterestRaROAROATaxRateROE )()1(

ROE = Net Profit

Pretax Profit

x

Pretax Profit

EBITx

EBIT

Sales

Sales

Assetsx x

Assets

Equity

(1) x (2) x (3) x (4) x (5)

x Margin x Turnover x Leverage Tax

Burden

Interest

Burden

Du Pont System: Decomposition of ROE

x

Problem 7, Chapter 13, P. 456

An analyst applies the DuPont system of financial analysis to the following data for a company:

Leverage ratio 2.2

Total asset turnover 2.0

Net profit margin 5.5%

Dividend payout ratio 31.8%

What is the company’s return on equity?

Ratio analyses

Liquidity Ratios Activity or Mgmt Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios

2002 2003 2004 2005Income statements

Sale revenue 100,000 120,000 144,000Cost of goods sold 55,000 66,000 79,200Depreciation 15,000 18,000 21,600Selling and administrative expenses 15,000 18,000 21,600Operating income 30,000 36,000 43,200Interest expense 10,500 19,095 34,391Taxable income (40% tax rate) 7,800 6,762 3,524Net Income 11,700 10,143 5,285

Balance Sheet (end of year)Cash and marketable securities 50,000 60,000 72,000 86,400Account receivables 25,000 30,000 36,000 43,200Inventories 75,000 90,000 108,000 129,600Net plant and equipment 150,000 180,000 216,000 259,200Total Asset 300,000 360,000 432,000 518,400Account payable 30,000 36,000 43,200 51,840Short-term debt 45,000 87,300 141,957 214,432Long-term debt 75,000 75,000 75,000 75,000Total Liabilities 150,000 198,300 260,157 341,272Shareholders’equity (1 mil shares outstanding) 150,000 161,700 171,843 177,128Market price per common share at year-end 93.60 61.00 21.00

Liquidity ratios

Current ratio = Current asset/ current liabilities

2003: current ratio = (60+30+90)/(36+87.3) = 1.462003 2004 2005 2005 industry average (IA)

1.46 1.17 0.97 2.0 Trend: decreasing poor standing relative to industry

Quick ratio = (current asset-inventory)/current liability

2003: quick ratio = (60+30)/(36+87.3) = 0.732003 2004 2005 2005 industry average (IA)

0.73 0.58 0.49 1.0 Trend: decreasing poor standing relative to industry

Management efficient ratios

Inventory turnover = COGS (excluding depreciation) / average inventory How fast firm can sell inventory 2003: inventory turnover = (55-15)/{(75+90)/2)}= 0.485 2003 2004 2005 IA

0.485 0.485 0.485 0.5 Slower in selling inventory

total asset turnover = sale/average total asset 2003: TA turnover = 100/((300+360)/2) = 0.30 2003 2004 2005 IA

0.30 0.30 0.30 0.4

Management efficient ratios

Average collection period (days receivable)

= average AR/sales per day average time between date of sale and date payment received 2003: {(25+30)/2}/(100/365) = 100.4 2003 2004 2005 IA

100.4 100.4 100.4 60 fixed asset turnover = sale/average of fixed asset

2003: 100/{(150+180)/2}=0.600 2003 2004 2005 IA

0.606 0.606 0.606 0.7

Some comments on efficient management ratios

Total asset turnover of G.I. < industry average (0.3<0.4) fixed asset turnover < Industry average (0.60 < 0.7): inefficient in

using fixed asset days receivable > industry average (100.4 > 60): receive cash longer

than average, poor receivable procedure Inventory turnover < industry average (0.485<0.5): turn inventory into

sale slower than average, poor inventory management

Leverage ratios

Interest coverage (times interest earned) = EBIT/Interest expense

Leverage ratio:

Assets/Equity = 1 + Debt/Equity Debt ratio = debt/equity

Profitability ratios

ROA = EBIT/(average total assets) ROE = NI/(average total equity) Return on sale (profit margin) = EBIT/Sales

Market price ratios

Market-to-book = price per share/ book value per share Lower market-to-book stocks: safer stocks

Price-to-earning (P/E) = market price per share / EPS Low P/E, more bargain

Comparability Problems GAAP (Generally Accepted Accounting Principles) is

not unique Inventory valuation: LIFO vs FIFO Depreciation: Straight line vs Accelerated

Quality of earnings affected by: Allowance of bad debt; nonrecurring items; stock

option; revenue recognition; off-balance-sheet assets and liabilities

GAAP vs IAS (International Accounting Standards)

Quality of Earnings:Areas of Accounting ChoicesQuality of Earnings:Areas of Accounting Choices

Allowance for bad debts: When companies sell goods using credit, need to have allowance for bad debts. This is the estimate.

Different companies have different estimates

Non-recurring items: Unusual income, does not happen regularly.

Reserves management: Different companies have different estimates of reserve for future investment

Stock options Companies use stock options as bonus therefore it should be reported as expenses and need to price the

options

Revenue recognition Off-balance sheet assets and liabilities

Figure 13.3 Adjusted Versus Reported Price-Earnings Ratios