How to Analyse Financial How to Analyse Financial Statements Statements There is a great deal There is a great deal of valuable information of valuable information in financial in financial statements. statements. But we must know how to But we must know how to extract and refine it. extract and refine it. The process is like a The process is like a doctor diagnosing a doctor diagnosing a patient's health. patient's health. The process is similar, The process is similar, but our tools of but our tools of analysis are not quite analysis are not quite the same. the same. Our tools of analysis Our tools of analysis are financial ratios. are financial ratios.
Transcript
How to Analyse Financial How to Analyse Financial StatementsStatements
There is a great deal of There is a great deal of valuable information in valuable information in financial statements. financial statements.
But we must know how But we must know how to extract and refine it. to extract and refine it.
The process is like a The process is like a doctor diagnosing a doctor diagnosing a patient's health.patient's health.
The process is similar, The process is similar, but our tools of analysis but our tools of analysis are not quite the same.are not quite the same.
Our tools of analysis Our tools of analysis are financial ratios.are financial ratios.
Financial Statement Financial Statement AnalysisAnalysis When an unconscious patient arrives at the When an unconscious patient arrives at the
emergency room of the hospital, what does the emergency room of the hospital, what does the doctor do?doctor do? Answer: check the vital signs, like pulse, Answer: check the vital signs, like pulse, blood pressure, temperature, etc.blood pressure, temperature, etc. Similarly, when we analyse financial Similarly, when we analyse financial statements, we check the vital signs of the statements, we check the vital signs of the organization.organization. What are these vital signs? They include:What are these vital signs? They include:
Short-term LiquidityShort-term Liquidity
Profitability:Profitability:•Profitability on RevenueProfitability on Revenue•Profitability on InvestmentProfitability on Investment
Long-Term Asset TurnoverLong-Term Asset Turnover
Long-term LeverageLong-term LeverageFor more, see the next slide.For more, see the next slide.
Short-term LiquidityShort-term Liquidity Short-term Liquidity means being able Short-term Liquidity means being able
to meet the payroll and pay the bills.to meet the payroll and pay the bills. Organizations unable to meet the Organizations unable to meet the
payroll and pay the bills will soon payroll and pay the bills will soon collapse.collapse.
That is why our first step in financial That is why our first step in financial statement analysis is to test short-statement analysis is to test short-term liquidity.term liquidity.
If an organization cannot survive the If an organization cannot survive the short term, there is no need to short term, there is no need to examine its long term signs.examine its long term signs.
Short-term LiquidityShort-term Liquidity Current Assets & Current Liabilities Current Assets & Current Liabilities
are items to be received or paid in are items to be received or paid in cash within a year.cash within a year.
As Current Assets turn into cash, the As Current Assets turn into cash, the cash is used to pay off Current cash is used to pay off Current Liabilities. Liabilities.
For short-term liquidity, Current For short-term liquidity, Current Assets should be greater than Current Assets should be greater than Current Liabilities. Liabilities.
We begin measuring short-term We begin measuring short-term liquidity with the Current Ratio.liquidity with the Current Ratio. Current Ratio = Current Current Ratio = Current
Assets/Current Liabilities.Assets/Current Liabilities. Current Ratio should usually be > 1 Current Ratio should usually be > 1
for satisfactory liquidity – except for for satisfactory liquidity – except for companies that generate ample companies that generate ample cash.cash.
Same idea as Current RatioSame idea as Current Ratio But recognizes that inventory is a fickle But recognizes that inventory is a fickle
asset.asset. Inventory can lose value fast through Inventory can lose value fast through
spoilage, shrinkage, evaporation, spoilage, shrinkage, evaporation, obsolescence & other hazards.obsolescence & other hazards.
Inventory cannot be sold off fast in a Inventory cannot be sold off fast in a crunch – except at fire sale prices.crunch – except at fire sale prices.
So Quick Ratio conservatively – but So Quick Ratio conservatively – but realistically - expects no value from realistically - expects no value from inventory.inventory.
Quick Ratio: should be > 1 for health.Quick Ratio: should be > 1 for health.
Example: Annual Sales = $120,000, Average Example: Annual Sales = $120,000, Average Receivables = $30,000.Receivables = $30,000.
Receivables Turnover = $120,000/$30,000 = 4 Receivables Turnover = $120,000/$30,000 = 4 times per yeartimes per year
Can express as days' Receivables on hand: Can express as days' Receivables on hand: 365 days/Receivables Turnover 365 days/Receivables Turnover Example continued: 365/4 = 91 days.Example continued: 365/4 = 91 days.
Receivables Turnover should be consistent;Receivables Turnover should be consistent; With the firm's credit terms.With the firm's credit terms. From period to periodFrom period to period
Receivables Turnover measures the organization's Receivables Turnover measures the organization's efficiency in collecting accounts receivable.efficiency in collecting accounts receivable. The faster the turnover the better the efficiency.The faster the turnover the better the efficiency.
Inventory TurnoverInventory Turnover.. Inventory Turnover = (Cost of Sales)/Inventory.Inventory Turnover = (Cost of Sales)/Inventory.
Example: Annual Cost of Sales = $100,000, Average Example: Annual Cost of Sales = $100,000, Average Inventory = $15,000.Inventory = $15,000.
Inventory Turnover = $100,000/$15,000 = 6.7 times per Inventory Turnover = $100,000/$15,000 = 6.7 times per yearyear
Can be expressed as days' Inventory on hand: Can be expressed as days' Inventory on hand: 365 days/Inventory Turnover 365 days/Inventory Turnover Example continued: 365/6.67 = 54.7 days.Example continued: 365/6.67 = 54.7 days.
Why is Cost of Sales the numerator, rather than Sales?Why is Cost of Sales the numerator, rather than Sales? Sales are shown at selling price. Inventory is shown at Sales are shown at selling price. Inventory is shown at
cost.cost. To make numerator and denominator consistent, both To make numerator and denominator consistent, both
should be at cost.should be at cost. Inventory Turnover measures the efficiency of inventory Inventory Turnover measures the efficiency of inventory
management.management. Toyota and other Japanese firms using "just in time" Toyota and other Japanese firms using "just in time"
inventory showed the importance of speeding up inventory showed the importance of speeding up inventory turnover.inventory turnover.
Why is Cost of Sales the numerator, rather than Why is Cost of Sales the numerator, rather than Sales?Sales? Sales are at selling price. Payables are at cost, being Sales are at selling price. Payables are at cost, being
amounts owed to suppliers.amounts owed to suppliers. For consistency, both numerator and denominator For consistency, both numerator and denominator
should be at cost.should be at cost. Payables Turnover measures how promptly Payables Turnover measures how promptly
suppliers are being paid – and whether cash suppliers are being paid – and whether cash discounts are being taken, or lost.discounts are being taken, or lost.
Cash from Operations/Sales: represents Cash from Operations/Sales: represents cash yield from Sales. Watch trend period to cash yield from Sales. Watch trend period to period.period.
Cash from Operations/Average Total Assets: Cash from Operations/Average Total Assets: represents cash yield from Total Assets. represents cash yield from Total Assets. Watch trend period to period.Watch trend period to period.
Free Cash Flow/Sales: Free Cash Flow is Free Cash Flow/Sales: Free Cash Flow is Cash from Operations – Dividends – Net Cash from Operations – Dividends – Net Capital Expenditures. This is discretionary Capital Expenditures. This is discretionary cash. Watch trend period to period.cash. Watch trend period to period.
ProfitabilityProfitabilityProfitability is measured in two different ways:Profitability is measured in two different ways: Profitability on RevenueProfitability on Revenue
Gross profit ratio: Gross Profit/SalesGross profit ratio: Gross Profit/Sales SG & A ratio: SG & A Expenses/SalesSG & A ratio: SG & A Expenses/Sales EBIT ratio: EBIT/SalesEBIT ratio: EBIT/Sales Net Income ratio: Net Income/SalesNet Income ratio: Net Income/Sales Useful, but does not consider how much cash Useful, but does not consider how much cash
is invested. Therefore we should consider is invested. Therefore we should consider cash invested.cash invested.
Profitability in Relation to InvestmentProfitability in Relation to Investment Raw Earning Power: EBIT/(LT Debt + Equity). Raw Earning Power: EBIT/(LT Debt + Equity).
Shows earning power on total long-term Shows earning power on total long-term capital invested, regardless of type of capital invested, regardless of type of financing.financing.
Return on Equity: Net Income/Equity. Shows Return on Equity: Net Income/Equity. Shows profit in relation to owner equity capital profit in relation to owner equity capital invested.invested.
Asset TurnoverAsset TurnoverTotal Asset TurnoverTotal Asset Turnover: : Total Asset Turnover = Total Total Asset Turnover = Total
Revenue/Total AssetsRevenue/Total Assets Measures capital intensity.Measures capital intensity. Capital intensity affects total amount Capital intensity affects total amount
of capital neededof capital needed The faster the turnover of Total The faster the turnover of Total
Assets, the lower the total amount of Assets, the lower the total amount of capital that needs to be invested in capital that needs to be invested in Total Assets.Total Assets.
run riskrun risk..1.1. Times Interest Earned (Interest Coverage):Times Interest Earned (Interest Coverage):
Ratio of EBIT to Interest Expense.Ratio of EBIT to Interest Expense. Shows how much profit "cushion" there is to Shows how much profit "cushion" there is to
cover interest payments.cover interest payments.2.2. Debt to Equity Ratio:Debt to Equity Ratio:
Ratio of Long-Term Debt to LT Debt + EquityRatio of Long-Term Debt to LT Debt + Equity Shows "leverage" which is extent of reliance Shows "leverage" which is extent of reliance
on Debton Debt More debt adds more risk, because debt More debt adds more risk, because debt
repayment must be made, whether times are repayment must be made, whether times are good or bad.good or bad.
More leverage makes the good times better, More leverage makes the good times better, and the bad times worse.and the bad times worse.
Market RatiosMarket RatiosMarket-based ratios reflect the Market-based ratios reflect the
investor viewinvestor view..1.1. Price-Earnings Ratio = Market Price per Price-Earnings Ratio = Market Price per
Share/Earnings per Share.Share/Earnings per Share. Shows how much the market is paying per Shows how much the market is paying per
dollar of current earnings.dollar of current earnings. Market:Book RatioMarket:Book Ratio..
Total Market Value of Equity/Book Value of Total Market Value of Equity/Book Value of Equity.Equity.
This is the ultimate measure of management This is the ultimate measure of management success. success.
It shows how much the management has It shows how much the management has increased the market value of the stock above increased the market value of the stock above the amount invested by stockholders.the amount invested by stockholders.
Dupont AnalysisDupont Analysis So far, we have looked at ratios So far, we have looked at ratios
individually.individually. But Dupont Analysis is a way to see the But Dupont Analysis is a way to see the
combined effect of the major ratios.combined effect of the major ratios. This is very important for business This is very important for business
strategy.strategy. The following slides explain how and why. The following slides explain how and why.
The Dupont FormulaThe Dupont Formula NI/SA x SA/TA x TA/EQ x EQ/MV = EPNI/SA x SA/TA x TA/EQ x EQ/MV = EP
NI = Net Income. SA = SalesNI = Net Income. SA = Sales TA = Total assetsTA = Total assets EQ = Total Equity (at book value)EQ = Total Equity (at book value) ROE = NI/EQROE = NI/EQ MV = Total Market Value of StockMV = Total Market Value of Stock PS = Price per sharePS = Price per share EP = Earnings per Share to Price per EP = Earnings per Share to Price per
Share (the inverse of the Price/Earnings Share (the inverse of the Price/Earnings Ratio).Ratio).
NI/SA = profit on salesNI/SA = profit on sales SA/TA = total asset turnover (capital SA/TA = total asset turnover (capital
intensity)intensity) TA/EQ = leverageTA/EQ = leverage EQ/MV = equity at book to equity at EQ/MV = equity at book to equity at
market valuemarket value EP = earnings to price (inverse of P/E EP = earnings to price (inverse of P/E
ratio)ratio)
Dupont Analysis for Business Dupont Analysis for Business StrategyStrategy
Long-term strategy goal: Long-term strategy goal: maximize the firm's maximize the firm's Price/Earnings ratio.Price/Earnings ratio.
Dupont analysis tells us exactly Dupont analysis tells us exactly how to do this.how to do this.
Optimize one or more of the Optimize one or more of the following: following: NI/SA = profit on salesNI/SA = profit on sales SA/TA = total asset turnover SA/TA = total asset turnover
Profit on SalesProfit on SalesWays to optimize profit on sales Ways to optimize profit on sales
include:include: Differentiate products to raise Differentiate products to raise
margins.margins. Revive and promote old products Revive and promote old products
(Jell-O)(Jell-O) Promote the most profitable products.Promote the most profitable products. Prune the least profitable products.Prune the least profitable products. Cut costs of production.Cut costs of production. Improve efficiency of operationsImprove efficiency of operations Outsource.Outsource.
Total Asset TurnoverTotal Asset TurnoverWays to optimize total asset turnover Ways to optimize total asset turnover
are:are: Adopt "just-in-time" inventoryAdopt "just-in-time" inventory Sell off obsolete inventorySell off obsolete inventory Improve receivables collection Improve receivables collection
efficiencyefficiency Sell and lease back property & plantSell and lease back property & plant Slow down paying of accounts payableSlow down paying of accounts payable Cut back on executive jets, corporate Cut back on executive jets, corporate
yachtsyachts Seek out less capital intensive Seek out less capital intensive
methods of operationmethods of operation Relocate operations to less expensive Relocate operations to less expensive
locationslocations OutsourcingOutsourcing
LeverageLeverage
Increase leverage, within safe Increase leverage, within safe limits:limits:
debtdebt Repurchase common stock & Repurchase common stock &
issue more preferred stockissue more preferred stock
BenchmarkingBenchmarking In order to be meaningful, financial In order to be meaningful, financial
ratios need to be compared with ratios need to be compared with benchmark ratios.benchmark ratios.
Possible Benchmarks:Possible Benchmarks: Same company, in earlier periodSame company, in earlier period Competitor company, in same periodCompetitor company, in same period Group of competitor companies, in same Group of competitor companies, in same
periodperiod An industry benchmark, such as The An industry benchmark, such as The
North American Industry Classification North American Industry Classification System (NAICS) System (NAICS)
NAICS provides standard classifications for NAICS provides standard classifications for industries, for example, see the next slide industries, for example, see the next slide
Example of NAICSExample of NAICS
NAICS code 2002 NAICS code 2002 Includes NAICS Title: Includes NAICS Title: 21 21 Mining Mining 211111 211111 Crude Petroleum and Natural Gas Crude Petroleum and Natural Gas
Extraction Extraction 211112 211112 Natural Gas Liquid Extraction Natural Gas Liquid Extraction 212111 212111 Bituminous Coal and Lignite Surface Bituminous Coal and Lignite Surface
These 6-digit codes describe standard industry These 6-digit codes describe standard industry classifications. For more, see classifications. For more, see http://www.census.gov/epcd/naics02/http://www.census.gov/epcd/naics02/
Sources of Industry DataSources of Industry Data Most sources of industry data require Most sources of industry data require
purchase of a subscriptionpurchase of a subscription However, the UMUC Library offers However, the UMUC Library offers
access to several industry databases, access to several industry databases, such as Dun & Bradstreet (D&B) such as Dun & Bradstreet (D&B) http://www.umuc.edu/library/http://www.umuc.edu/library/
Two sources that offer limited Two sources that offer limited industry data free are:industry data free are: Yahoo FinanceYahoo Finance MSN MoneyMSN Money
Industry DataIndustry Data
One caution is that some companies operate in One caution is that some companies operate in several different industries.several different industries.
For example, General Electric Company (GE) is For example, General Electric Company (GE) is a diversified industrial corporation engaged in a diversified industrial corporation engaged in developing, manufacturing and marketing a developing, manufacturing and marketing a wide variety of products for the generation, wide variety of products for the generation, transmission, distribution, control and transmission, distribution, control and utilization of electricity. On June 23, 2005, GE utilization of electricity. On June 23, 2005, GE announced reorganization of its 11 businesses announced reorganization of its 11 businesses into six industry-focused businesses effective into six industry-focused businesses effective July 5, 2005. The six businesses are GE July 5, 2005. The six businesses are GE Infrastructure, GE Industrial, GE Commercial Infrastructure, GE Industrial, GE Commercial Financial Services, GE NBC Universal, GE Financial Services, GE NBC Universal, GE Healthcare and GE Consumer Finance. Healthcare and GE Consumer Finance.
It is difficult to find industry benchmarks for It is difficult to find industry benchmarks for conglomerates like GE. Benchmarks are easier conglomerates like GE. Benchmarks are easier for companies in one industry.for companies in one industry.
Financial Ratio Financial Ratio CalculationCalculation
Financial ratios have a numerator Financial ratios have a numerator and a denominator.and a denominator.
These numerators and These numerators and denominators are items from the denominators are items from the Balance Sheet or the Income Balance Sheet or the Income Statement.Statement.
Example: Current Ratio = Current Example: Current Ratio = Current Assets/Current Liabilities.Assets/Current Liabilities.
Continued on next slide ...Continued on next slide ...
Financial Ratio Financial Ratio Calculation (continued)Calculation (continued)
Balance Sheets show financial position as Balance Sheets show financial position as of one specific date.of one specific date.
But one specific date cannot represent an But one specific date cannot represent an entire accounting period – such as a year.entire accounting period – such as a year.
Therefore, when computing ratios, we Therefore, when computing ratios, we AVERAGE all Balance Sheet items in AVERAGE all Balance Sheet items in order to: order to: Avoid distortion, andAvoid distortion, and To represent an entire accounting To represent an entire accounting
period – such as a year, period – such as a year, Average = (Amount at beginning of Average = (Amount at beginning of
period + Amount at end of period)/2period + Amount at end of period)/2 ALWAYS be sure to average Balance ALWAYS be sure to average Balance
Sheet items when computing ratios. Sheet items when computing ratios.
SummarySummary Use financial Use financial
ratios to analyze:ratios to analyze: Short-term Short-term
