Financial Analysis

1. Financial Analysis Purpose Ratio Analysis Cash Flow Analysis

2. Purpose of Financial Analysis • Assess Corporate Performance in the context of stated goals and strategy. • Assess current financial position, including liquidity.

3. Tools of Financial Statement Analysis • Ratio analysis • Signal approach • Cash Flow analysis

4. Ratio Analysis • Tools for interpreting financial statements • Often used to facilitate comparison via deflation. • Common size financial statements- when the whole statement is converted to ratio form.

5. Ratio Analysis • Financial ratios are typically grouped into four classes • Profitability • Liquidity ratios • Solvency ratios • Funds management ratios

6. Profitability and growth-Strategic Areas of Influence • Operating management • Investment management • Financing strategy • Dividend policies

7. Profitability and Growth Product Market Strategies Financial Market Strategies Operating Management Investment Management Financing Management Dividend Policy Managing Working Capital and Fixed Assets Managing Revenue and Expenses Managing Liabilities and Equity Managing Payout Drivers of Profit and Growth

8. Ratios can be used: • To compare the same firm over several years • To compare to other firms in the industry • To compare to an absolute benchmark

9. Operating Management (managing revenues and expenses) • Return on equity (ROE) -- ROE = (Net Income) / (Shareholder’s Equity) • Return on Assets -- Income / (Total Assets) • Return on sales (ROS) -- Net Income / Sales • Gross Profit Margin- (Sales-COGS)/Sales • Numerous variations of the above are computed in practice

10. An Example-Return on Equity (ROE) • Beginning balances, ending balances, average balances ? • Often adjusted for preferred stock dividends • Average for US industries is from 11 to 13% (PBH)

11. The need for an analysis framework • What do ROE, NPM, ROA, etc., mean as a group? • What if they differ as to outcome (e.g., one firm has a higher NPM but lower ROE)? • What story do they tell, collectively? • How do they relate to each other?

12. The Notion of Ratio Decomposition (Dupont Analysis) • ROE = ROA * Assets/equity (Financial leverage) • ROA= net income/ assets • Financial leverage indicates the dollar of assets the firm is able to deploy for dollar invested by shareholders

13. The Problem of mixed operating and non-operating financial statement components • What if a firm has a large block of assets and/or liabilities that are not involved in operations? • What if net income includes numerous non-operating items?

14. A Variation on the usual definition of ROA • Operating ROA • Focus is on operating return only -- excludes interest income • (Net Income + (Interest exp - Interest income) * (1-tax rate)) / (Equity + Debt - Cash and Short-tern investments)

15. Decomposition Using Operating ROA • ROE= Operating ROA (RNOA) + Spread x Leverage

16. Operating/Nonoperating vs. Core/Transitory

17. Level I-Based DecompositionExample: ROE, RNOA & Leverage

18. Financial Leverage and Risk • Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? • The answer is because debt is risky. This increased risk increases the expected return that investors require to provide capital to the firm. • Higher financial leverage also results in a higher interest rate on the company’s debt.

19. Leverage and Income Variability

20. Level II-Based DecompositionExample: ROE, ROA & Leverage • ROE= ROA x assets/equity • ROA= net income/sales x sales/assets • Therefore: • ROE=Net profit margin x asset turnover x leverage

21. Level II Analysis of Operating Margin and Operating Turnover

22. Margin vs. Turnover

23. Return on Sales (ROS) • Shows profitability of firm’s operating activities • Used extensively by Japanese management • Indicates how much profit is generated per dollar of sales

24. NOPAT Margin

25. Turnover of NOA here

26. Level 3 Analysis — Disaggregation of Operating Margin and Operating Turnover

27. Level III Analysis using the standard definition of ROA

28. CA Turnover WC Turnover AR Tirnover Inv Tirnover AP Turnover Days Rec Days Pay PP&E Turnover Current Ratio Quick Ratio Cash Ratio Oper CF Ratio Liab to Equity Debt to Equity Debt to Capital Int Coverage GOGS/ Sales GP/ Sales SG&A/Sales R&D/Sales OE/ Sales Non OE / Sales EBT / Sales Tax Expenses / Sales Sustainable Growth Rate Dividend payout ROE Fin Leverage ROS Asset Turnover

29. Sustainable Growth 1 • ROE * (1-Dividend payout ratio)

30. Gross Profit Margin • A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing.

31. Gross Profit Margin • Two main factors determine gross profit margins: • Competition – The more competition, the lower margins tend to be. • Product mix – The greater the volume of low profit/high turnover goods, the lower the margins. • Very relevant for comparisons within an industry -- not much outside

32. Operating Expense Margin • Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category. • Expense ratios are calculated as follows: Operating expense percentage = Expense item/Net sales

33. Profitability and Growth Product Market Strategies Financial Market Strategies Operating Management Investment Management Financing Management Dividend Policy Managing Working Capital and Fixed Assets Managing Revenue and Expenses Managing Liabilities and Equity Managing Payout Drivers of Profit and Growth

34. Investment Management • Working Capital and Fixed Assets • Receivables • Inventory • LT operating assets • Payables

35. Turnover • Turnover measures relate to the productivity of company assets, i.e., how much capital is required to generate a specific sales volume? • Turnover ratios are calculated as follows: Turnover = Sales volume/Average Assets • As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced.

36. Accounts Receivable Turnover (ART)

37. Inventory Turnover (INVT)

38. L-T Operating Asset Turnover (LTOAT)

39. Accounts Payable Turnover (APT)

40. Net Operating Working Capital Turnover (WOCT)

41. Evaluating Financial Management • Short-term evaluations • Long-term evaluations

42. Short-term evaluations 1 • Current ratio • (Current assets) / (Current liabilities)

43. Short-term evaluations 2 • Quick ratio • (Cash + Short-term investments + Accounts Receivable) / (Current liabilities)

44. Short-term evaluations 3 • Operating cash flow ratio • (Cash flow from operations) / (Current liabilities)

45. Long-term evaluations • Debt is typically cheaper that equity • Interest is tax deductible dividends are not • Can impose discipline on management (explicit contracts) • Easier to communicate proprietary information to private lenders than to public markets

46. Standard ratios • Liabilities-to-equity-ratio • Debt-to-equity ratio • Debt-to-capital • Interest coverage

47. Liabilities-to-equity • (Total Liabilities) / (Shareholders’ equity)

48. Debt-to-equity • (Short-term debt + Long-term debt) / (Shareholders’ equity)

49. Interest coverage • (Net income + Interest expense + Tax expense) / (Interest expense)

50. Problems with Ratios • Mis-specification of deflator (e.g., size) • Accounting imperfections • Problem of assumed linearity • Ratio blow-up • Negative numbers. What do they mean? • Assumed 0 intercept. • Omitted variables