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Chapter 14 ANALYSIS OF FINANCIAL STATEMENTS Chapter 14 Questions Questions to be answered: What are the major financial statements provided by firms and what specific information does each of them contain?

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## Chapter 14

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**Chapter 14**ANALYSIS OF FINANCIAL STATEMENTS**Chapter 14 Questions**Questions to be answered: • What are the major financial statements provided by firms and what specific information does each of them contain? • Why do we use financial ratios to examine the performance of a firm, and why is it important to examine performance relative to the economy and to a firm’s industry?**Chapter 14 Questions**• What are the major categories for financial ratios and what questions are answered by the ratios in these categories? • What specific ratios help determine a firm’s internal liquidity, operating performance, risk profile, growth potential, and external liquidity? • How can the DuPont analysis help evaluate a firm’s return on equity over time?**Chapter 14 Questions**• What is “quality” balance sheet or income statement? • Why is financial statement analysis done if markets are efficient and forward-looking? • What major financial ratios help analysts in the following areas: stock valuation, estimating and evaluating systematic risk, predicting the credit ratings on bonds, and predicting bankruptcy?**Analyzing Financial Statements**• We will be considering asset valuation. • Financial asset values are a function of two variables: • Discount rate ( the required rate of return) • Expected future cash flows • Financial statement analysis can be useful in estimating both of these valuation inputs.**Major Financial Statements**• Corporate shareholder annual and quarterly reports must include: • Balance sheet • Income statement • Statement of cash flows • Reports filed with Securities and Exchange Commission (SEC) • 10-K and 10-Q**Generally Accepted Accounting Principles**• GAAP are formulated by the Financial Accounting Standards Board (FASB) • Provides some flexibility of accounting principles • Can be good for firms in different situations • Can represent a challenge for analysis • Financial statements footnotes must disclose which accounting principles are used by the firm**Balance Sheet**• Shows resources (assets) of the firm and how it has financed these resources • Indicates current and fixed assets available at a point in time • Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity**Income Statement**• Contains information on the profitability of the firm during some period of time • Indicates the flow of sales, expenses, and earnings during the time period**Statement of Cash Flows**• Integrates the information on the balance sheet and income statement • Shows the effects on the firm’s cash flow of income statement items and changes in various items on the balance sheet • Three sections show cash flows from • Operating activities • Investing activities • Financing activities**Alternative 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 and liabilities that use or provide cash • Free cash flow recognizes that some investing and financing activities are critical to ongoing success of the firm • Modifies cash flow from operations to reflect necessary capital expenditures and projected divestitures**Purpose of Financial Statement Analysis**• Evaluate management performance in • Profitability • Efficiency • Risk • Although financial statement information is historical, it is used to project future performance**Analysis of Financial Ratios**• Ratios can often be more informative that raw numbers • Puts numbers in perspective with other numbers • Helps control for different sizes of firms • Ratios provide meaningful relationships between individual values in the financial statements**Importance of Relative Financial Ratios**• In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks • Examine a firm’s performance relative to: • The aggregate economy • Its industry or industries • Its major competitors within the industry • Its own past performance (time-series analysis)**Comparing to the Aggregate Economy**• Most firms are influenced by economic expansions and contractions in the business cycle • Analysis helps you estimate the future performance of the firm during subsequent business cycles**Comparing to the Industry Norms**• 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 • Can also examine the industry’s performance relative to aggregate economic activity**Comparing to the Firm’s Major Competitors**• Industry averages may not be representative • A firm may operate in several distinct industries • Several approaches: • Select a subset of competitors for the comparison group • Construct a composite industry average from the different industries in which the firm operates**Comparing to the Firm’s Own Past Performance**• Determine whether it is progressing or declining • Helpful for estimating future performance • Consider trends as well as averages over time**Six Categories of Financial Ratios**• Common size statements • Internal liquidity (solvency) • Operating performance • Operating efficiency • Operating profitability • Risk analysis • Business risk • Financial risk • External liquidity risk • Growth analysis**Common Size Statements**• Normalize balance sheets and income statement items to allow easier comparison of different size firms • A common size balance sheet expresses accounts as a percentage of total assets • A common size income statement expresses all items as a percentage of sales**Evaluating Internal Liquidity**• Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations • Current Ratio examines current assets and current liabilities**Evaluating Internal Liquidity**• Quick Ratio adjusts current assets by removing less liquid assets**Evaluating Internal Liquidity**• Cash ratio relates cash (ultimate liquid asset) to current liabilities**Evaluating Internal Liquidity**• Receivables turnover examines the management of accounts receivable Receivables turnover can be converted into an average collection period**Evaluating Internal Liquidity**• Inventory turnover relates inventory to sales or cost of goods sold (CGS) Given the turnover values, you can compute the average inventory processing time**Evaluating Internal Liquidity**• Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover CCC = Receivables Collection Period + Inventory Processing Period - Payables Payment Period**Evaluating Operating Performance**• Ratios that measure how well management is operating a business • Operating efficiency ratios • Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales • Operating profitability ratios • Examine how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit**Operating Efficiency Ratios**• Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales**Operating Efficiency Ratios**• Net fixed asset turnover reflects utilization of fixed assets • This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales**Operating Profitability Ratios**• Operating profitability ratios measure • The rate of profit on sales (profit margin) • The percentage return on capital**Operating Profitability Ratios**• Gross profit margin measures the rate of return after cost of goods sold • What proportion of the sales dollar is left after cost of goods sold? • Is the firm buying inputs (inventory and direct labor) at good prices?**Operating Profitability Ratios**• Operating profit margin measures the rate of profit on sales after operating expenses • Operating profit is sometimes called Earnings before interest and taxes (EBIT) • Operating income can be thought of as the “bottom line” from operations**Operating Profitability Ratios**• Net profit margin relates net income to sales • Shows the combined effect of operating profitability and the firm’s financing decisions (since net income is after interest and tax payments)**Common Size Income Statement**• Since Net Sales is in the denominator of all of the three previous ratios, the common size income statement gives all of these ratios at once • It also allows us to focus on any categories of expenses that are out of line with the appropriate benchmark**Operating Profitability Ratios**• Return on total capital relates the firm’s earnings to all capital invested in the business**Operating Profitability Ratios**• Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used**Operating Profitability Ratios**• Return on owner’s equity (ROE) can be computed for the based only on the common shareholder’s equity • Deducts preferred dividends, which are a priority claim on net income**Operating Profitability Ratios**• The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight**Profit Total Asset Financial**Margin Turnover Leverage x x = Operating Profitability Ratios**Operating Profitability Ratios**• An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE • We begin with the operating profit margin (EBIT divided by sales) and introduce additional ratios to derive an ROE value**Operating Profitability Ratios**This is the operating profit return on total assets. To consider the negative effects of financial leverage, we examine the effect of interest expense as a percentage of total assets**Operating Profitability Ratios**We consider the positive effect of financial leverage with the financial leverage multiplier**Operating Profitability Ratios**This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect.**Operating Profitability Ratios**• In summary, we have the following five components of return on equity (ROE): • Operating profit margin • Total asset turnover • Interest expense rate • Financial leverage multiplier • Tax retention rate**Risk Analysis**• Risk analysis examines the uncertainty of income for the firm and for an investor • Total firm risks can be decomposed into two basic sources: • Business risk: The uncertainty in a firm’s operating income, highly influenced by industry factors • Financial risk: The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily through employing leverage). • External liquidity analysis considers another aspect of risk from an investor’s perspective**Business Risk**• Variability of the firm’s operating income over time • Can be measured by calculating the standard deviation of operating income over time or the coefficient of variation • In addition to measuring business risk, we want to explain its determining factors.**Business Risk**Two primary determinants of business risk • Sales variability • The main determinant of earnings variability • Cost Variability and Operating leverage • Production has fixed and variable costs • Greater fixed production costs cause greater profit volatility with changes in sales • Fixed costs represent operating leverage • Greater operating leverage is good when sales are high and increasing, but bad when sales fall**Financial Risk**• Interest payments are deducted before we get to net income • These are fixed obligations • Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline • Fixed financing costs are called financial leverage • The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high**Financial Risk**• Two sets of financial ratios help measure financial risk • Balance sheet ratios • Earnings or cash flow available to pay fixed financial charges • Acceptable levels of financial risk depend on business risk • A firm with considerable business risk should likely avoid lots of debt financing

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