Analysis of Financial Statements Chapter 4
Why are ratios useful? • Ratios standardize numbers and facilitate comparisons. • Ratios are used to highlight weaknesses and strengths. • Ratio comparisons should be made through time and with competitors. • Trend analysis. • Peer (or industry) analysis.
Operating cycle • Operating cycle: The length of time it takes for the investment of cash in inventory to be returned in the form of payments from customers. • The longer the operating cycle, the greater the need for liquidity
Number of days Beg. Inv. + Purchases = COGS + End. Inv.
Operating cycle Operating cycle = DSO + DSI Cash conversion cycle = DSO + DSI - DPO
Dell Assumed all sales on credit
Debt management ratios, cont. Fixed charges: Interest, preferred dividends, lease payments
Returns • The return on assets is the net profit relative to total assets • The return on equity is the net profit relative to equity:
Returns, cont. • The return on invested capital is the net profit to invested capital: Invested capital = Debt + equity • The basic earning power ratio is the operating return on assets:
Example: Borders Filed for bankruptcy 2011
Problems with ROE • ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. • ROE does not consider risk. • ROE does not consider the amount of capital invested. • Might encourage managers to make investment decisions that do not benefit shareholders. • ROE focuses only on return and a better measure would consider risk and return.
Analyzing the market value ratios • Price-earnings ratio (P/E): How much investors are willing to pay for $1 of earnings. • Market to book value of equity ratio (M/B): How much investors are willing to pay for $1 of book value equity. • Issues: • What is the meaning of the book value of equity? • What is the Molodovsky effect?
Beyond ratios • Common size analysis • Qualitative analysis
Common size analysis • Common size analysis provides a “big picture” of the changing relationships among accounts over time by standardizing the data. • Two forms: • Vertical: Each account as % of total • Horizontal: Each account as % of base year
Vertical Example: Apple Assets
Vertical example: Apple, cont. Liabilities and equity
(1) A single ratio is meaningless • Ratios must be put in context: in context of other firms, historical, and company-specific events. • A given value of a ratio is neither good or bad; rather, it helps paint a picture of the company’s health and performance.
(2) Comparisons to industry ratios may be helpful • First challenge: identify the industry • Second challenge: identify comparables • Third challenge: construct industry ratios • Equal v. value weighted ratios
(3) Trends break Analysis must be put in context of company-specific events, e.g.,: • M&A • Divestitures • Regulation change • Product line changes
(4) Seasonality and FY choice can distort ratios • Companies select FY-end based on the low-point of their seasonal cycle. • Therefore, working capital accounts are likely at their lowest levels • Fix: Quarterly or monthly averages of accounts instead of FY balance sheet levels.
(5) Window dressing • “Window dressing” techniques can make statements and ratios look better. • Compensation plans can result in distortions/dressing.
(6) Different methods of accounting • Companies have some choices in accounting method (e.g., FIFO v. LIFO): • Makes comparisons difficult (across firms and across time) • Makes interpretation challenging (because may not have all the data).
Qualitative factors • Are the firm’s revenues tied to one key customer, product, or supplier? • What percentage of the firm’s business is generated overseas? Which countries? • The firm’s competitive environment: degree of competitiveness • Future prospects / opportunities • Legal and regulatory environment • Product life cycle
Sources of qualitative information • 10-K filings with the SEC • Annual reports • Press releases • Trade groups/associations • Government databases (e.g., Census, FTC, BEA)