1FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Fin2802: Investments
Spring, 2010Dragon Tang
Fin2802: Investments
Spring, 2010Dragon Tang
Lecture 15Financial Statement Analysis
March 18, 2010
Readings: Chapter 19Practice CFA Problem Sets: 6-
9,13,14,16
2FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Everyone gets sick sometime!Everyone gets sick sometime!
• Take your stocks to a doctor!
• Regular checkups will prevent big problems
3FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
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.
4FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Fundamental AnalysisFundamental Analysis
• Economics
• Finance
• Accounting
– How to interpret reported data?
5FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Financial StatementsFinancial Statements
• The Balance Sheet: Snapshot of Financial Condition
– Assets – Liabilities = Shareholders’ Equity
– Current vs long-term
• Income Statement: Summary of Profitability
– Revenue – Expenses = Net Income
– Expenses: raw material; salary; interest; tax
– EBIT=Earnings – Raw Material – Salary
• The Statement of Cash Flows: “Actual” Cash
– More reliable
– Activities: Operating; Investing; Financing
– Depreciation is not smoothed
6FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Accounting vs Economic EarningsAccounting vs Economic Earnings
• Economic earnings: Sustainable cash flow that can be paid out without impairing the productive capacity
• Accounting earnings: “Models” are used
• Accounting earnings are still useful
7FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Return on Equity (ROE)Return on Equity (ROE)
• ROE=Net profit/Equity
• Trend in ROE
• Watch out financial leverage:
ROA: Return on Assets=EBIT/Assets
Equity
DebtteInterestRaROAROATaxRateROE )()1(
8FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
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 ROEDu Pont System: Decomposition of ROE
x
ROA = Margin X Turnover
9FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
PracticePractice
An analyst applies the DuPont system of financial analysis to the following data for a company:
Leverage ration 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?
10FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Ratio AnalysisRatio Analysis• Asset utilization ratios: Efficiency
– Fixed-asset turnover=Sales/Fixed Assets
– Inventor turnover=cost of goods sold/average inventory
– Average collection period=(Account receivables/Sales)*365
• Liquidity and coverage ratios: Financial health– Current ratio=current assets/current liabilities
– Quick ratio=(cash+receivables)/current liabilities
– Interest coverage ratio=EBIT/interest expense
• Market price ratios: Relative Value– Market/Book ratio(P/B): “Safeness”
– Price-earnings ratio (P/E): No easy bargain
– E/P=ROE/(P/B)
• Choose a benchmark!
11FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Intel’s Financial Ratios Over TimeIntel’s Financial Ratios Over Time
12FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Economic Value Added (EVA)Economic Value Added (EVA)
EVA=(ROA-Capitalization Rate) Capital Invested
• Growth is not the whole picture!
• EVA can be positive or negative for firms that have positive earnings
13FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Key Financial Ratios of Growth Industries Inc.Key Financial Ratios of Growth Industries Inc.
14FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Growth Industries Statements of Cash FlowGrowth Industries Statements of Cash Flow
15FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Comparability ProblemsComparability Problems
• GAAP (Generally Accepted Accounting Principles) is not unique– Inventory valuation: LIFO vs FIFO
– Depreciation: Straight line vs Accelerated
– Real interest payments
• 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)
16FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Quality of Earnings:Areas of Accounting Choices
Quality of Earnings:Areas of Accounting Choices
• Allowance for bad debts
• Non-recurring items
• Reserves management
• Stock options
• Revenue recognition
• Off-balance sheet assets and liabilities
17
Figure 19.2 Comparative Accounting RulesFigure 19.2 Comparative Accounting Rules
FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
18FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Adjusted Versus Reported Price-Earnings RatiosAdjusted Versus Reported Price-Earnings Ratios
19FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Value InvestingValue Investing
• Benjamin Graham
• Pick value stocks (low P/B)
• Rule: stock price < net current-asset value
• Information sources: S&P’s Outlook and Value Line Investment Survey
20FIN 2802, Spring 10 - TangChapter 19: Financial Statement Analysis
Browne: Value Investing ChecklistBrowne: Value Investing Checklist
1. What is the outlook for pricing for products?2. Can the company sell more?3. Can the company increase profits on existing sales?4. Can the company control expenses?5. How much of the additional sales are net profits?6. How competitive is the company?7. Any one-time expenses?8. Any unprofitable operations?9. How well does the company meet expectations?10. Growth over the next five year11. Excess cash, competition strategies, acquisition value, stock
repurchases, insider trading activities