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Major Financial Statements
Corporate shareholder annual and quarterlyreports must include
Balance sheet
Income statement
Statement of cash flows
Reports filed with Securities and ExchangeCommission (SEC)
10-K and 10-Q
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Measures of Cash Flow
Cash flow from operations
Traditional cash flow equals net income plus
depreciation expense and deferred taxes
Also adjust for changes in operating assets andliabilities that use or provide cash
Free cash flow recognizes that someinvesting and financing activities are critical
to ongoing success of the firm
Capital expenditures and dividends
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Measures of Cash Flow
EBITDA: measure of cash flow isextremely liberal.
It does not consider any adjustments noted
previously.
It adds back depreciation and amortization
along with both interest expense and taxes
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Comparison of a Firms Performance
Relative to the Aggregate Economy
Most firms are influenced by economicexpansions and contractions in the business
cycle
Analysis helps you estimate the future
performance of the firm during subsequent
business cycles
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Comparison of a Firms Performance
Relative toits Industry
Most popular comparison Industries affect the firms within them
differently, but the relationship is always
significant
The industry effect is strongest for
industries with homogenous products
Examine the industrys performance
relative to aggregate economic activity
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Comparison of a Firms Performance
Relative toits Major Competitors
Industry averages may not be representative Select a subset of competitors to compare to
using cross-sectional analysis, or
Construct a composite industry average
from industries the firm operates in
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Comparison of a Firms Performance
Relative to its Own Historical Track
Record
Determine whether it is progressing ordeclining
Helpful for estimating future performance
Consider trends as well as averages over
time
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Five Categories of Financial Ratios1. Common size statements
2. Internal liquidity (solvency)3. Operating performance
a. Operating efficiency
b. Operating profitability
4. Risk analysis
a. Business risk b. Financial risk
c. External liquidity risky
5. Growth analysis
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Evaluating Internal Liquidity
Cash Ratio is the most conservativeliquidity ratio
sLiabilitieCurrent
SecuritiesMarketableCashRatioCash
+
=
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Evaluating Internal Liquidity
Cash conversion cycle combines
information from the receivables turnover,
inventory turnover, and accounts payable
turnover
Receivable Days
+Inventory Processing Days-Payables Payment Period
Cash Conversion Cycle
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Operating Profitability Ratios
Gross profit margin measures the rate ofprofit on sales (gross profit equals net sales
minus the cost of goods sold)
SalesNet
ProfitGrossMarginProfitGross =
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Business Risk
Measured by variability of the firmsoperating income over time
Earnings variability is measured by standard
deviation of the historical operating
earnings series
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Business Risk Two factors contribute to the variability of
operating earnings Sales variability
Operating leverage
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Financial Risk
Bonds interest payments come beforeearnings are available to stockholders
These are fixed obligations
Similar to fixed production costs, these lead
to larger earnings during good times, and
lower earnings during a business decline
This debt financing increases the financial
risk and possibility of default
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Financial Risk
Relationship between business risk andfinancial risk
Acceptable level of financial risk for a firm
depends on its business risk
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Financial Risk
Long-term debt/total capital ratio indicatesthe proportion of long-term capital derived
from long-term debt capital
CapitalTerm-LongTotal
DebtTerm-LongTotal
RatioCapitalL.T.Total-DebtL.T.
=
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Financial Risk
Total debt ratios compare total debt (currentliabilities plus long-term liabilities) to total
capital (total debt plus total equity)
CapitalTotal
DebtInterestTotal
CapitalDebt/TotalBearing-InterestTotal
=
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Financial Risk
Earnings or Cash Flow Ratios Relate the flow of earnings
Cash available to meet the payments
Higher ratio means lower risk
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Financial Risk
Interest Coverage
ChargesInterestDebt
(EBIT)TaxesandInterestBeforeIncome=
ExpenseInterest
ExpenseInterestTaxesIncomeIncomeNet ++=
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Financial Risk
Firms may also have non-interest fixedpayments due for lease obligations
The risk effect is similar to bond risk
Bond-rating agencies typically add 1/3 lease
payments as the interest component of the
lease obligations
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Financial Risk
Total fixed charge coverage includes anynoncancellable lease payments and any
preferred dividends paid out of earnings
after taxes
Rate)Tax-1Dividend/(PreferredPaymentsLeaseInterestDebt
PaymentsLeaseandTaxes,Interest,BeforeIncome
CoverageChargeFixed
++
=
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Financial Risk
PaymentsLease3/1Interest
PaymentsLease1/3InterestFlowCashlTraditiona
CoverageFlowCash
+
++
=
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Financial Risk
DebtTerm-LongofValueBook
TaxDeferredinChangeExpenseonDepreciatiIncomeNet
DebtTerm-Long/FlowCash
++
=
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Financial Risk
DebtTotal
TaxDeferredinChangeExpenseonDepreciatiIncomeNet
DebtTotal/FlowCash
++
=
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Financial Risk
Alternative Measures of Cash Flow Cash flow from operation
Free cash flow
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External Market Liquidity
Market Liquidity is the ability to buy or sellan asset quickly with little price change
from a prior transaction assuming no new
information
External market liquidity is a source of risk
to investors
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External Market Liquidity
Determinants of Market Liquidity The dollar value of shares traded
This can be estimated from the total market
value of outstanding securities
It will be affected by the number of security
owners Numerous buyers and sellers provide liquidity
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External Market Liquidity
Trading turnover (percentage of outstandingshares traded during a period of time)
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External Market Liquidity
A measure of market liquidity is the bid-askspread
Certain corporate variables
Total market value of outstanding securities
(number of common shares outstanding times
the market price per share) Number of security owners
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Analysis of Growth Potential
Sustainable growth potential analysisexamines ratio that indicate how fast a firm
should grow.
Creditors are interested in the firms ability
to pay future obligations
Value of a firm depends on its futuregrowth in earnings and dividends
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Determinants of Growth Resources retained and reinvested in the
entity Rate of return earned on the resources
retained
= RR x ROE
where:g = potential growth rate
RR = the retention rate of earnings
ROE = the firms return on equity
EquityonReturnRetainedEarningsofPercentageg =
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Comparative Analysis of Ratios
Internal liquidity Current ratio, quick ratio, and cash ratio
Operating performance
Efficiency ratios and profitability ratios
Risk Analysis
Growth analysis
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Analysis of
Non-U.S. Financial Statements
Statement formats will be different Differences in accounting principles
Ratio analysis will reflect local accounting
practices
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The Quality of Financial
Statements
High-quality balance sheets typically have
Conservative use of debt
Assets with market value greater than book
No liabilities off the balance sheet
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The Quality of Financial
Statements High-quality income statements reflect repeatable
earnings Gains from nonrecurring items should be ignored
when examining earnings
High-quality earnings result from the use ofconservative accounting principles that do notoverstate revenues or understate costs
Footnotes Provide information on how the firm handles balances
sheet and income items
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The Value of
Financial Statement Analysis
Financial statements, by their nature, are
backward-looking
An efficient market will have already
incorporated these past results into security
prices, so why analyze the statements?
Analysis provides knowledge of a firmsoperating and financial structure
This aids in estimating future returns
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Specific Uses of Financial Ratios
1. Stock valuation
2. Identification of corporate variables
affecting a stocks systematic risk (beta)
3. Assigning credit quality ratings on bonds
4. Predicting insolvency (bankruptcy) of firms
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Stock Valuation Models
Valuation models attempt to derive a value basedupon one of several cash flow or relativevaluation models
All valuation models are influenced by: Expected growth rate of earnings, cash flows, or
dividends
Required rate of return on the stock
Financial ratios can help in estimating these critical
inputs
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Stock Valuation Models Financial Ratios
1. Average debt/equity2. Average interest coverage
3. Average dividend payout4. Average return on equity
5. Average retention rate
6. Average market price to book value
7. Average market price to cash flow
8. Average market price to sales
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Stock Valuation Models
Variability Measures
1. Coefficient of variation of operating earnings
2. Coefficient of variation of sales
3. Coefficient of variation of net income
4. Systematic risk (beta)
Nonratio Variables1. Average growth rate of earnings
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Estimating Systematic Risk
Financial Ratios
1. Dividend payout
2. Total debt/total assets
3. Cash flow/total debt
4. Interest coverage
5. Working capital/total assets6. Current Ratio
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Estimating Systematic Risk
Variability Measures
1. Variance of operating earnings
2. Coefficient of variation of operating earnings
3. Coefficient of variation of operating profit
margins
4. Operating earnings beta (company earningsrelated to aggregate earnings)
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Estimating Systematic Risk
Nonratio Variables
1. Asset size
2. Market value of stock outstanding
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Estimating the Ratings on Bond
Financial Ratios
1. Long-term debt/total assets
2. Total debt/total capital
3. Net income plus depreciation (cash flow)/long
term senior debt
4. Cash flow/total debt5. Net income plus interest/interest expense (fixed
charge coverage)
6. Cash flow/interest expense
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Estimating the Ratings on Bond
7. Market value of stock/par value of bonds
8. Net operating profit/sales
9. Net income/owners equity (ROE)10. Net income/total assets
11. Working capital/sales
12. Sales/net worth (equity turnover)
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Estimating the Ratings on Bond
Variability Ratios
1. Coefficient of variation (CV) of net earnings
2. Coefficient of variation of return on assets
Nonratio variables
1. Subordination of the issue
2. Size of the firm (total assets)3. Issue size
4. Par value of all publicly traded bonds of the firm
Predicting Insolvency
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Predicting Insolvency
(Bankruptcy)
Financial Ratios
1. Cash flow/total debt
2. Cash flow/long-term debt
3. Sales/total assets
4. Net income/total assets
5. EBIT/total assets6. Total debt/total assets
Financial Ratios and
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Financial Ratios and
Insolvency (Bankruptcy)
7. Market value of stock/book value of debt8. Working capital/total assets
9. Retained earnings/total assets10. Current ratio
11. Working capital/sales
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Limitations of Financial Ratios Accounting treatments may vary among firms,
especially among non-U.S. firms Firms may have have divisions operating in
different industries making it difficult to derive
industry ratios
Results may not be consistent
Ratios outside an industry range may be cause
for concern
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Summary
Financial statement analysis help investorsmake decisions on investing in a firm sbonds or stock.
A trend analysis of a firms financial ratioswill be insightful
Financial ratios should be examined relative
to the economy, the firms industry, and thefirms main competitors
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Summary
The specific ratios can be divided into four
categories:
Internal liquidity
Operating performance
Risk analysis
Growth analysis
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Summary
Analysts must consider differences in
format and in accounting principle that
cause different values for specific ratio
when analyzing the financial statements fornon-US firms
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Summary
Four major uses of financial ratios :
Stock valuation
Analysis of variables affecting a stocks
systematic risk Assigning credit ratings on bonds
Predicting insolvency (bankruptcy)
The Internet
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The Internet
Investments Onlinehttp://www.walgreens.com
http://www.cvs.com
http://www.riteaid.comhttp://www.longs.com
http://www.sec.govhttp://www.hoovers.com
http://www.dnb.com
