3. Financial statement analysis is defined as the
process of identifying financial strengths and
weaknesses of the firm by properly establishing
relationship between the items of the balance sheet
and the profit and loss account. Financial statements
are prepared to meet external reporting obligations
and also for decision making purposes. They play a
dominant role in setting the framework of managerial
decisions.
3
4. There are various methods or techniques that are
used in analyzing financial statements, among them
are horizontal or trend analysis, and vertical analysis
and ratios analysis, which are most widely used.
4
6. Horizontal Analysis or Trend Analysis:
Comparison of two or more year's financial data is known
as horizontal analysis, or trend analysis. Horizontal
analysis is facilitated by showing changes between years in
both dollar and percentage form.
Trend Percentage:
Horizontal analysis of financial statements can also be
carried out by computing trend percentages. Trend
percentage states several years' financial data in terms of a
base year. The base year equals 100%, with all other years
stated in some percentage of this base
6
7. Vertical Analysis:
Vertical analysis is the procedure of preparing and
presenting common size statements. Common size
statement is one that shows the items appearing on
it in percentage form as well as in dollar form. Each
item is stated as a percentage of some total of which
that item is a part. Key financial changes and trends
can be highlighted by the use of common size
statements.
7
8. Review of Financial Statements
Ratios
Types of Ratios
Examples
The DuPont Method
Summary
Strengths
Weaknesses
Ratios and Forecasting
8
9. Assessment of the firm’s past, present and future
financial conditions
Done to find firm’s financial strengths and
weaknesses
Primary Tools:
Financial Statements
Comparison of financial ratios to past, industry, sector
and all firms
9
10. Balance Sheet
Income Statement
Cash flow Statement
Statement of Retained Earnings
1
14. Ratio analysis - tool for measuring a firm’s liquidity,
profitability, and reliance on debt financing, as well as
the effectiveness of management’s resource
utilization.
The ratios analysis is the most powerful tool of
financial statement analysis. Ratios simply means one
number expressed in terms of another. A ratio is a
statistical yardstick by means of which relationship
between two or various figures can be compared or
measured. Ratios can be found out by dividing one
number by another number. Ratios show how one
number is related to another.
1
15. Financial Ratios:
Liquidity Ratios
Assess ability to cover current obligations
Leverage Ratios
Assess ability to cover long term debt obligations
Operational Ratios:
Activity (Turnover) Ratios
Assess amount of activity relative to amount of
resources used
Profitability Ratios
Assess profits relative to amount of resources used
Valuation Ratios:
Assess market price relative to assets or earnings
1
16. Activi t y Ra ti o s
Net sales
Inventory turnover
ratio indicates the
number of times
merchandise moves
through a business. Average of inventory
Net sales
Total asset turnover ratio
indicates how much in
sales each dollar invested
in assets generates.
Average of total assets
1
17. Liquidi ty R a ti o s
Total current assets
Current ratio compares
current assets to current
liabilities.
Total current liabilities
Acid-test (or quick) ratio Cash and equivalents
measures the ability of a + short-term investments
firm to meet its debt + accounts receivable
payments on short
notice.
Total current liabilities
1
18. P rofitabilit y R a ti o s
Profitability ratios measure the organization’s overall financial
performance by evaluating its ability to generate revenues in excess of
operating costs and other expenses.
1
19. Levera ge Ratios
• Leverage ratios measure the extent to which a firm relies on
debt financing.
• Total liabilities to total assets ratio > 50 percent indicates that a
firm is relying more on borrowed money than owners’ equity.
1
20. Standardize financial information for
comparisons
Evaluate current operations
Compare performance with past performance
Compare performance against other firms or
industry standards
Study the efficiency of operations
Study the risk of operations
2
21. A firm has resources
It converts resources into profits through
production of goods and services
sales of goods and services
Ratios
Measure relationships between resources and financial
flows
Show ways in which firm’s situation deviates from
Its own past
Other firms
The industry
All firms
2
30. Method to breakdown ROE into:
ROA and Equity Multiplier
ROA is further broken down as:
Profit Margin and Asset Turnover
Helps to identify sources of strength and weakness in
current performance
Helps to focus attention on value drivers
3
31. RO E
RO A E q u it y M u lt ip lie r
P r o f it M a r g in T o ta l A s s e t T u rn o v e r
3
32. RO E
RO A E q u i t y M u lt ip li e r
P r o f i t M a r g in T o ta l A s s e t T u rn o v e r
ROE = ROA × Equity Multiplier
Net Income Total Assets
= ×
Total Assets Common Equity
3
33. RO E
RO A E q u i t y M u lt ip li e r
P r o f i t M a r g in T o ta l A s s e t T u rn o v e r
ROA = Profit Margin × Total Asset Turnover
Net Income Sales
= ×
Sales Total Assets
3
34. RO E
RO A E q u i t y M u lt ip li e r
P r o f i t M a r g in T o ta l A s s e t T u rn o v e r
ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity
3
35. Net Income Sales Total Assets
ROE = × ×
Sales Total Assets Common Equity
= Profit Margin × Total Asset Turnover × Equity Multiplier
= ROA × Equity Multiplier
$1,666.00 $25,265.00 $11,471.00
ROE = × ×
$25,265.00 $11,471.00 $5,308.00
= 0.0659 × 2.2025 × 2.1611
= 0.1452 × 2.1611
= 31.39%
3
36. Ratios help to:
Evaluate performance
Structure analysis
Show the connection between activities and
performance
Benchmark with
Past for the company
Industry
Ratios adjust for size differences
3
37. A firm’s industry category is often difficult to identify
Published industry averages are only guidelines
Accounting practices differ across firms
Sometimes difficult to interpret deviations in ratios
Industry ratios may not be desirable targets
Seasonality affects ratios
3
38. Common stock valuation based on
Expected cashflows to stockholders
ROE and ρ are major determinants of cashflows to
stockholders
Ratios influence expectations by:
Showing where firm is now
Providing context for current performance
Current information influences expectations by:
Showing developments that will alter future
performance
3
39. Simplifies Financial Statements
Facilitates inter-firm comparison
Helps in Planning
Helps in investment decisions
Makes intra-firm comparison possible
3
40. Comparative study required
Ratios alone are not adequate
Problems of price level change
Lack of adequate standard
Limited use of single ratios
Personal bias
4
41. Annual reports
Via E mail, SEC or company websites
Published collections of data
Investment sites on the web
Examples
http://moneycentral.msn.com/investor
http://dell.com
http://www.marketguide.com
4
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Financial Statements summarize the results of the firm’s activities over the accounting period. Ratios provide a useful way to analyze financial statements and evaluate the firm’s performance over the period. Focusing on the ratios in the DuPont system helps structure the analysis and show the relationship between the firm’s operations, its capital structure and its profitability for investors. Using ratio analysis along with predictions about sustainable growth rates can help us predict future performance of the firm.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Ratios are compared to industry averages. There are 14 to 16 common ratios grouped into 4 types. Dun and Bradstreet and Robert Morris Associates give industry average ratios for hundreds of industries. We will describe the types of ratios and focus on several important financial ratios. Financial Statements 1. Financial statements report a firm’s position at a point in time and on operations over some past period 2. Investors use financial statements to predict future earnings/dividends 3. Management uses financial statements to help anticipate future conditions and as starting point for planning actions that will affect future event Financial ratios 1. Help evaluate a financial statement 2. Facilitate comparison of firms
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Balance Sheet Statement of financial position at specific point in time Income Statement Summarizes revenues and expenses over an accounting period Statement of Cash Flows Amount of cash generated during period is not what is shown on balance sheet Tells you what happened to cash generated during specified period Categories in Statement of Cash Flows (a) Operating activities (b) Investing activities (c) Financing activities Statement of Retained Earnings Reports how much of earnings retained in business rather than paid out in dividends over the life of the firm Retained earnings is claim against assets (a) Earnings retained to expand business (b) Do not represent cash
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Liquidity Ratios: Current Ratio Quick (Acid Test) Ratio Cash Ratio Net Working Capital to Total Assets Leverage Ratios: Total Debt Ratio Debt to Equity Ratio Equity Multiplier Long-term Debt Ratio Times Interest Earned Ratio Cash Coverage Ratio Activity (Turnover) Ratios: Inventory Turnover Days’ Sales in Inventory Receivables Turnover Days’ Sales in Receivables NWC Turnover Fixed Asset Turnover Total Asset Turnover Profitability Ratios: Profit Margin Return on Assets Return on Equity Valuation Ratios: Price to Earnings Market to Book
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Uses 1. Managers – to help analyze, control, improve a firm’s operations 2. Credit analysts – to help ascertain a company’s ability to pay its debts 3. Stock analysts – to determine a company’s efficiency, risk and growth potential
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Balance Sheet Statement of financial position at specific point in time Shows assets owned by the firm and sources of the money used to purchase those assets. Liquidity Order Assets: length of time typically to convert to cash Liabilities: how soon must be paid Characteristics Cash versus other assets Only cash represents actual money Noncash assets should produce cash in time Liabilities versus stockholders’ equity Both claims against assets Breakdown of common equity accounts Common stock Retained earnings Impacted by Inventory accounting Depreciation methods Position at one point in time
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Dell’s Balance Sheet: Assets the firm owns total more that $11 billion** , more short-term assets than long-term assets like plant and equipment. Those assets were purchased with money that came mainly from equity and short-term borrowing. Relatively little long-term debt.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Dell had more than $25 billion sales during the period. A large part of revenues went to pay for the raw materials that went into production. Depreciation reflects expenditure on a long-term asset which firm must expense over several years for tax purposes. It does not reflect an actual expenditure during this particular accounting period.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Used to study ability to cover current obligations Can firm raise cash to pay its current and upcoming bills on time? Basic Formulation: Liquid asset measures include: Current Assets Current Assets minus Inventories If industry average is 3.5, then Dell has fewer current assets per dollar of current liabilities than the norm If acid test ratio > 1, then Dell can meet all current liabilities even if sales cease
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Measure ability to cover long term debt How much debt has the firm issued? Can the firm afford to pay its long term interest and principal obligations? Basic formulation: Debt and debt service measures include: Total liabilities Long term debt Annual interest expenses Asset, profit or cash flow measures include: Total assets Total capitalization EAT, Profit... 1-Debt Ratio is fraction of firm owned by equity holders If industry average is 2.5 then revenues for Dell relative to interest expenses exceed industry norm
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Used to study operating profitability. How do profits compare to sales or assets? Basic Formulation: Profit measures include: Sales less costs Net Income Income Available to Common Stock Holders Sales/Asset measures include: Sales Total Assets Common Equity NOTE: Some books use: If yours does, use these equations AND adjust the DuPont Method accordingly by adding the the debt burden.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Used to study operating profitability. How do profits compare to sales or assets? Basic Formulation : Profit measures include: Sales less costs Net Income Income Available to Common Stock Holders Sales/Asset measures include: Sales Total Assets Common Equity
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Profitability is also affected by the firm’s ability to use its assets efficiently. Used to study operating efficiency. How do sales compare to the assets used in production? Basic Formulation: Assets include: All Assets Inventories Accounts Receivable If industry average is 1.25, then Dell gets more sales per dollar invested in assets than typical in the industry If industry average is 2, then Dell turns its inventory over more times on average than industry (Few assets are tied up in inventories)
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz DuPont Chart and Equation - Tie the Ratios Together Shows how profit margin, asset turnover ratio, and equity multiplier determine ROE Shows how expense control (profit margin), efficient use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity. Ties together all aspects of firm - production and financing.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders. The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative. Raising the s magnifying effect also raises the risk for stockholders.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each dollar of sales raises the Profit Margin. At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the dollar of sales produced with each dollar invested in assets. This is often thought of as sales volume. Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Dells ROE 31.39% is higher than the industry standard (24.1% average over the past 4 years). Where is Dell making these high profits? Dell’s ROE comes from: Dell’s profit margin is 6.59% The industry average over the preceding 4 years is only 3.69%. So, Dell is nearly twice as efficient as the industry average in generating profits from its sales. Dell’s sales-to-assets ratio is 2.20. The industry average over the preceding 4 years is 2.05. So, Dell is about average is generating sales from its assets. Dell’s equity multiplier is 2.16. The industry average over the preceding 4 years is 2.50. So, Dell is a little below average in its equity multiplier (using a little more equity and a little less debt than an average company in the industry.) Thus, we can conclude that Dell’s profitability comes from it’s operating efficiency!
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Knowing the absolute level of a single entry on the income statement or balance sheet doesn’t provide sufficient information to evaluate performance. Ratios help by focusing on relationships among entries on the financial statements. The ratios in the DuPont system show the connection between the firm’s operations, its capital structure and the returns for investors. Because a firm’s size affects financial statement values, it’s hard to evaluate performance using absolute levels. By controlling for differences in size to make comparisons ratios facilitate the evaluation of a firm’s performance.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Limitations 1. Large firms operate different divisions in different industries a. Difficult to develop meaningful industry averages b. More useful for small, narrowly focused firms 2. Firms want to be better than average a. Attaining average performance not necessarily good b. Best to focus on industry leaders’ ratios 3. Inflation may have distorted balance sheets a. Must consider effects when comparing over time 4. Seasonal factors distort ratio analysis a. Use monthly averages for season items such as inventory 5. Window dressing can make financial statements look better 6. Different accounting practices can distort comparisons a. Inventory valuation, depreciation methods 7. Difficult to generalize whether a ratio is “good” or “bad” a. High current ratio – strong liquidity or too much cash (nonearning) 8. Ratios can give “mixed” view of company a. Analyze net effects of a set of ratios
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Stock prices can be thought of as discounted present value of expected future dividends. Dividends are paid out of earnings. Therefore expectations of future dividends would be based on current earnings (ROE) and sustainable growth rate on earnings. Ratio analysis can help evaluate current performance as well as firm’s likelihood to be able to sustain performance. High current ROE that is the result of high Equity Multiplier implies higher risk for stockholders. High ROE that derives from high ROA is less risky and possibly more sustainable.
Financial Statement Analysis October 2000 C.J. Brown, M.M. Dutton and T.A. Rietz Annual Report Used by investors to help form expectations about future earnings and dividends Verbal Section Explain why things turned out the way they did Describes firms operating results during past year Discusses new developments that will affect future earnings Financial Statements Report what actually happened to assets, earnings, dividends Balance sheet Income statement Statement of retained earnings Statement of cash flows Advantages and Disadvantages of Data Sources The advantage of Annual reports is that give a great deal of information. They are available through the web now. The disadvantage is that they are not in a standard format and they are frequently affected by subtle differences in accounting rules. The advantage of published data on ratios is that they standardize the financial statements and compute ratios based on this information. The disadvantage is that this may hide important factors and the information my be far from current. The advantage of investment sites on the web is that they have the most current data. Some of them even standardize statements (e.g., Microsoft’s MoneyCentral). Of course, this has advantages and disadvantages.