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# Investments: Financial Statement Analysis (review)

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2. What questions are important in assessing the health of a firm? • Can the firm meet its debt obligations? • How well are assets being managed? • How profitable is the firm? • How risky is the firm? • What does the market think of the firm? •  Ratio Analysis: interpretation of accounting and market information to assess the health of companies.

3. Why do we use ratios? • We must consider things on a relative basis, not an absolute one. • e.g.: If one company has earnings of \$2,000,000 and another of \$1,000,000, which is better? • We can’t say because one company may be considerably bigger than the other. • By using ratios, we are able to compare a company to its peers. • There are no hard-and-fast rules here. We can and should be creative by creating our own ratios to investigate specific areas.

4. The DuPont Relationship • We begin any analysis by examining the factors that contribute to the Return on Equity (ROE). • Why? • Measures the return to shareholders • DuPont: ROE  NI / E = (NI / S)  (S / TA)  (TA / E ) = profit margin  asset turnover  leverage multiplier • Note that ROE = ROA  (TA / E ) • leverage multiplier = TA / E = TA / (TA - D) = 1 / (1 - debt ratio)

5. The DuPont approach is nice because it divides the firm into three tasks • expense management (measured by the profit margin) • asset management (measured by asset turnover) • debt management (represented by the debt ratio or leverage multiplier) • The DuPont Method • layered approach • examine the three components • dig deeper to identify possible weaknesses and strengths • dig deeper to find specific causes and hopefully to identify possible corrective action

6. factors of the profit margin • sales • cost of goods sold • SG&A expenses • R&D expenses • depreciation • interest • taxes • other expenses

7. factors of the asset turnover • sales • assets • current assets • cash • receivables • inventory • fixed assets • property • plant • equipment

8. factors of the leverage multiplier? • Since we are concerned with whether or not the firm can meet its debt obligations, the “factors” don’t really matter. • Instead… • current assets vs. current liabilities • current ratio • quick ratio • profits vs. debt payments • ROIC vs. after-tax interest • times-interest-earned • Ultimately, we must assess debt on a cash flow basis.

9. Tools • Common Size statements • express the balance sheet as a percentage of total assets • express the income statement as a percentage of sales • Indexed statements • express the financial statements from one period as a percentage of some base year. • See spreadsheet example

10. Profit Measures • Earnings (net income) • accounting profits • useful if not misleading (intentionally or otherwise), • problem: does not reflect cash flow • includes Depreciation as an expense • ignores Capital Expenditures • uses Sales instead of receipts • uses Cost of Goods Sold instead of disbursements • EBITDA • earnings without Depreciation, Interest, Taxes • looks at earnings without the effects of financing and accounting decisions • useful for understanding the ability to service debt • problem: still does not reflect cash flow

11. Free Cash Flow • measures the true cash flow of the firm in a given period, ignoring all financing-related cash flows and effects • Why ignore financing? • can be misleading due to fixed asset effects • e.g., firm with old, fully depreciated equipment vs. one that has bought new equipment during the period. • very useful when viewed over multiple periods • provides the basis for the DCF model

12. Building the Free Cash Flow Equation • How do earnings differ from cash flow? • Earnings include financing-related cash flows • adjust by using EBIT(1-T) (i.e., NOPAT) instead of earnings. • This is just net income assuming zero interest expense • Depreciation: subtracted, but is not a cash flow • adjust by adding depreciation • Capital Expenditures: ignored entirely • adjust by subtracting CapEx • Sales: recorded when made, not when cash is received. • adjust by subtracting the increase in receivables • Cost of Goods Sold: recorded when sold, not when the goods are paid for • adjust by subtracting the increase in inventory • and by subtracting the decrease in payables • Ignores cash needed for operations • adjust by subtracting the increase in operating cash • Note that most financial analysts ignore this effect entirely

13. Note the following • subtracting the increases in cash, inventory, and receivables  subtracting the increase in current assets. • adding the increase in payables  subtracting the decrease in current liabilities. • It follows that we subtract CA- CL. • Since Net Working Capital (NWC) is CA-CL, we subtract NWC. This gives us our final equation • The Free Cash Flow Equation

14. FCF yield = FCF / EV • EV  enterprise value = equity + preferred stock + debt – cash & equivalents • i.e., EV is the amount of capital the firm has currently invested • Why do we subtract cash & equivalents? • What happens if FCF yield < WACC? • company earns less than what it “owes” investors • higher sales  lower stock value!

15. Another Look at ROE • ROE = NI/E • NI = (EBIT-Interest)(1-t) = (EBIT-iD)(1-t) • t  effective tax rate • i  interest rate on debt • D  amount of outstanding debt • We can rearrange these equations to get an expression that is more helpful. • First, recall that the Return on Invested Capital is

16. The ROIC is entirely independent of capital structure. •  2ndterm of the last equation reflects the impact of capital structure on ROE. • The sign of the 2nd term tells us whether or not debt helps or hurts ROE.

17. What do we learn from this exercise? • i(1-t)<ROIC  taking on more debt will increase ROE. • i(1-t)>ROIC  taking on more debt will decrease ROE. • Implications • optimal strategy might be to use debt whenever the after-tax interest rate on marginal debt is below the ROIC and to use equity otherwise. • But…. • How far into the future should we look? One data point is hardly sufficient to draw strong conclusions. • The equation does not incorporate risk. • The equation ignores other important factors. • Revisiting our example…

18. Difficulties with Financial Statement Analysis • Information is always old. • Book values are reported instead of market values • We often must compare companies at different points in time. • Companies often use different terminology • Managers may have incentives to mislead • Financial statements often lack detail • Industry averages are often misleading • Should we include negative ratios in averages? • Should we include outliers in averages?

19. Other Comments • We should always consider the notes to the financial statements. • They give explanations for unusual items as well as notes that suggest an accounting explanation for a peculiarity. • We should always consider news stories on the company. • They often contain statements concerning the financial condition of the firm and/or comments on things to expect. • They provide updates since the date of the last financials.