Chapter 13 Financial Statement Analysis
Learning Objectives After studying this chapter, you should be able to: • Locate and use the many sources of information about company performance. • Analyze the components of a company using trend analysis and other techniques. • Use the basic financial ratios to guide your thinking. • Evaluate corporate performance using ROA, ROE, and EVA. • Calculate EPS under complex circumstances. • Adjust for nonrecurring items.
Sources of InformationAbout Companies • Financial statement analysis - using financial statements to assess a company’s performance • Information about publicly traded companies comes in many forms and may be found in many places. • Annual reports • SEC filings and databases • Company press releases • Articles that appear in the financial press
Sources of InformationAbout Companies • The annual report is important to investors because of its completeness and its reliability due to the audit performed by an independent auditor. • The annual report includes: • Financial statements • Footnotes to the financial statements • A summary of accounting principles used • Management’s discussion and analysis of the financial results • The auditor’s report • Comparative financial data for a series of years • Narrative information about the company
Sources of InformationAbout Companies • Publicly traded companies must also prepare reports for the Securities and Exchange Commission (SEC). • Form 10-K - presents financial statement data in greater detail than the financial statements in annual reports • Form 10-Q - includes quarterly financial statements that provide more timely but less complete information than annual reports
Sources of InformationAbout Companies • Company press releases provide the basis for articles in the financial press such as The Wall Street Journal and Business Week. • Services such as Value Line, Moody’s Investors Services, Standard and Poor’s Industrial Surveys, and Dun & Bradstreet provide useful information to investors.
Sources of InformationAbout Companies • The Internet is changing the way that people make investments. • Many investors now buy and sell securities without the help of a broker. • Much of the market information is available electronically, usually for free from various sources.
Sources of InformationAbout Companies • Large investors often require pro forma statements which are carefully formulated expressions of predicted results. • Any investor should take the time to gather as much information about potential investments as possible. • There are many sources of information for investors to use.
Objectives of FinancialStatement Analysis • Although different investors demand different returns, they all use financial statement analysis for common reasons. • To predict their expected returns • To assess the risks associated with those returns • Financial statement analysis focuses on past performance to predict future performance.
Objectives of FinancialStatement Analysis • Creditors want to know about short-term liquidity and long-term solvency. • Short-term liquidity - an organization’s ability to meet current payments as they become due • Long-term solvency - an organization’s ability to generate enough cash to repay long-term debts as they mature
Objectives of FinancialStatement Analysis • Equity investors are more concerned with returns in the form of dividends and increased market price of the stock. • These investors are naturally more interested in profitability. • Profits spur both dividends and increased stock prices.
Evaluating Trends and Components of the Business • Evaluating trends and components of a business are two ways of looking at financial information. • Trend analysis involves comparing financial trends from one year to another. • Evaluating components of a business can be done in more than one way. • Relationships among elements of the financial statements may be examined. • Components may also be thought of as separate business units or segments. These components may be examined.
Trend Analysis • Trends are predictable patterns that have been observed in the past and are expected to continue into the future. • A pattern must be identified, and expectations of whether the trend will continue must be formed. • Trends can be shown as changes in amounts from year to year or as percentage changes from year to year.
Trend Analysis • The dollar amount of the change is simply the current year minus the previous year. • The percentage change is computed as follows:
Trend Analysis STELLAR CORPORATION Income Statements for the Years Ended December 31, 2002 and 2001 Increase % Increase 2002 2001 (Decrease) (Decrease) Sales $98,600 $89,500 $9,100 10.2% Expenses: Wages expense 45,800 42,900 2,900 6.8 Rent expense 12,000 12,000 0 0.0 Utilities expense 6,500 6,450 50 0.8 Depreciation expense 5,000 5,900 (900) (15.3) Total expenses 69,300 67,250 2,050 3.0 Net Income $29,300 $22,250 $7,050 31.7 ============= ============= ===========
Trend Analysis • Changes in dollar amounts and percentage terms help to expose patterns. • Understanding these patterns is most important. • The answers to why items changed tell a lot about how a company is run, how it will perform in the future, and whether or not it would be a good investment. • Analysts generally look at several years’ worth of financial information to discover trends.
Common-Size Statements • Common-size statements - financial statements expressed in component percentages • The income statement is expressed as a percentage of sales. • This makes it easy to compare percentages to those of other companies because percentages are a common index. • The balance sheet is expressed as a percentage of total assets. • This is often referred to as component percentages because they measure each component as a percentage of the total.
Common-Size Statements • For the income statement, sales is set at 100% and each other element is expressed as a percentage of the sales figure. • For the balance sheet, the total assets amount is set at 100%, and each other element is expressed as a percentage of the total assets figure.
Common-Size Statements STELLAR CORPORATION Income Statements for the Years Ended December 31, 2002 and 2001
Management’s Discussionand Analysis • Management’s discussion and analysis - a required section of the annual report that concentrates on explaining the major changes in the income statement, liquidity, and capital resources • Management’s discussion often includes a discussion of trends and analysis of components.
Segment Reporting • Many large companies are involved in more than one type of business activity or market. • Each individual type of business activity or market may be considered a segment. • The FASB requires information on a business segment to be reported based on the way it is reported to management. • The information is reported consistent with the way the company manages the business.
Segment Reporting • When analyzing segment data, two things should be considered. • Evaluating segment data forces us to ask important questions that help us to truly understand the business. • Truly understanding the business means not only understanding what is sold and how much is made but also interpreting how financial reports summarize dynamic changes in the business.
Financial Ratios • The cornerstone of financial statement analysis is the use of ratios. • Financial ratios are sometimes grouped into four categories: • Short-term liquidity ratios • Long-term solvency ratios • Profitability ratios • Market price and dividends ratios
Financial Ratios Short-term liquidity ratios
Financial Ratios Long-term solvency ratios
Financial Ratios Profitability ratios
Financial Ratios Market price and dividend ratios
Evaluating Financial Ratios • Financial ratios are evaluated using three types of comparisons. • Time-series comparisons - comparisons of a company’s financial ratios with its own historical ratios • Benchmarks - general rules of thumb specifying appropriate levels for financial ratios • Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages
Ratios • Financial analysis using ratios is useful to investors because the ratios capture critical dimensions of the economic performance of the company. • Managers use ratios to guide, measure, and reward workers. • Often companies base employee bonuses on a specific financial ratio or a combination of some other performance measure and a financial ratio.
Ratios • Ratios mean different things to different groups. • A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt. • However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.
Ratios • Because financial ratios may be interpreted differently by different users, the users of the financial ratios must understand the company and the business before drawing conclusions.
Operating Performance andFinancial Performance • Measures of profitability are affected by both financing and operating decisions. • Financial management is concerned with where the company gets cash and how it uses that cash. • Operating management is concerned with the day-to-day activities that generate revenues and expenses. • Ratios that assess operating efficiency should not be affected by financial management performance.
Operating Performance • Rate of return on investment - evaluates the overall success of an investment by comparing what the investment returns with the amount of investment initially made Rate of return on investment
Operating Performance • Income may be defined differently for alternative purposes. • Net earnings • Pretax income from operations • Earnings before interest and taxes (EBIT) • Invested capital may also be defined differently. • Stockholders’ equity • Total capital provided by both debt and equity sources
Operating Performance • Operating performance is best measured by pretax operating rate of return on total assets, often referred to as return on total assets. Pretax operating rate of return on total assets
Operating Performance • The right side of the previous equation is actually composed of two more important ratios. • This equation may also be expressed as: Pretax operating rate of return on total assets Operating income percentage on sales Total asset turnover =
Operating Performance • The expanded expression of pretax operating rate of return on total assets highlights that operating income percentage and asset turnover will each increase the rate of return on assets. • Using these two ratios allows manipulation of either one to determine what happens to the rate of return under different scenarios.
Operating Performance Operating Income Operating Income % on Sales ¸ Sales Pretax Return on Total Assets x Sales ¸ Total Asset Turnover Average Total Assets
Operating Performance • This decomposition of return on total assets can also be applied to the return on equity. • This is often referred to as the DuPont analysis. or
Financial Performance • Debt and equity financing must be balanced in order to achieve good financial performance. • Firms must choose how much debt is appropriate. • The firms must also choose how to split their debt between short-term debt and long-term debt. • The prudent use of debt is a major part of intelligent financial management.
Financial Performance • Short-term debt must be repaid or refinanced in a short period of time. • If a company has trouble repaying the debt, it will also generally have trouble refinancing the debt. • Naturally, lenders like healthy borrowers, not troubled borrowers.
Financial Performance • Long-term debt or equity are generally used to finance long-term investments. • Debt financing is more attractive than equity financing because: • Interest payments are deductible for income tax purposes, but dividends are not deductible. • The ownership rights to voting and profits are kept by the present shareholders.
Trading on the Equity • Capitalization (capital structure) - the total of a company’s long-term financing • Owners’ equity plus long-term debt • Trading on the equity (financial leverage, leveraging) - using borrowed money at fixed interest rates with the objective of enhancing the rate of return on common equity
Trading on the Equity • There are costs and benefits to the shareholders from leveraging. • Costs: • Interest payments • Increased risk • Benefits: • Larger returns to the common shareholders, as long as overall income is large enough to cover the increased interest payments
Trading on the Equity • General comments about leveraging: • A debt-free, or unleveraged, company has identical return on assets (ROA) and return on equity (ROE). • When a company has a ROA greater than the interest rate it is paying its lenders, ROE exceeds ROA. • This is called favorable financial leverage. • When a company is unable to earn at least the interest rate on the money borrowed, the return on equity will be lower than it would be for a debt-free company. • The more stable the income, the less dangerous it is to trade on the equity.
Economic Value Added • The idea behind economic value added (EVA) is that a company must earn more than it must pay for capital if it is to increase in value. • Capital is considered both debt and equity. • The cost of capital in EVA is a weighted average of interest cost and the returns required by equity investors. • If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.
Income Tax Effects • If all things are equal, debt financing is less costly to a corporation than equity financing because interest payments are deductible for income tax purposes. • Dividends paid on stock are not deductible. • Also, dividend rates on stock are generally higher than interest rates on debt because of the increased risk associated with stock.
Income Tax Effects • General comments on debt financing versus equity financing: • Because interest is deductible for income tax purposes, net income attributable to common shareholders can be higher if debt is used because taxes are lower. • Book net income is higher if equity financing is used because there are no interest payments to be deducted as expenses. • Failure to pay interest is an act of bankruptcy, which gives creditors the right to control the company; failure to pay dividends has less severe consequences.
Measuring Safety • Investors in debt securities want assurance that the company in which they have invested will be able to make the scheduled interest and principal payments. • These investors want to avoid the trouble of recovering their investments through bankruptcy of the company. • They would much rather a steady stream of income from a healthy company.
Measuring Safety • Interest coverage (times interest earned) - a ratio that focuses on the interest-paying ability of a company