13 Financial Statement Analysis
Relationship to previous material • Focus has been: • What goes into 3 basic financial statements (Income Statement, Balance sheet, Statement of Cash Flows). • Now focus is: • How statements are analyzed by management, investors, and creditors.
Objective of a Business • Create value for its shareholders while maintaining a sound financial position. • Return on investment. • Sound financial position. • Other important objectives include: • Employee satisfaction. • Social responsibility. • Ethical considerations.
Overview • GAAP does not define ratios. • Multiple equally valid approaches to ratios and analysis. • Managers (e.g. division manager, sales manager) should be measured to items that they control. • Investors and top management are most interested in overall performance or broadest measures of performance. • Understanding less broad measures of performance may give additional insight into overall performance
Structure of analysis • From broadest to more specific levels. • Principal value of financial analysis: • Suggests questions not answers. • Ratio comparisons start with supposition that all other things are equal. (They rarely are.)
Categories of ratios which measure: • Overall performance. • Profitability. • Investment utilization. • Financial condition. • Dividend policy.
Making comparisons • Finding the appropriate standard is difficult. • A high ratio (e.g. current ratio, ROI) may be good or bad. It can’t be viewed in isolation. • Is a high CR good or bad? • Is a high ROI always good? • Values of ratios compared across time longitudinal analysis, or trend analysis.
Overall Measures • Return on investment (ROI) = net income / investment • Possible definitions of investment: assets, owners’ equity, invested capital. • Possible definitions of return: net income, net income -preferred dividends, net income + interest expense (1-tax rate). • Use income generated from pool of funds before considering cost of funds in pool.
Return on assets (ROA) • (net income + interest*(1-tax rate))/ total assets. • How well management is using a pool of capital . • Before considering financing decisions. Some analysts ignore interest adjustment. • Measures how an enterprise uses its funds. • May be used to evaluate individual business units in a large company when managers do not influence financing decision (i.e. how assets are financed).
Return on shareholders’ equity (ROE) • Net income/shareholders’ equity. • Or, (net income -preferred dividends) / Common shareholders’ equity. • Common shareholders’ equity = total shareholders’ equity - preferred stock. • Reflects return on funds invested by shareholders. • Of interest to current and prospective shareholders.
Return on invested capital (ROIC) • (net income + interest(1-tax rate))/ invested capital • Invested capital = permanent capital = capital employed = long-term liabilities + shareholders’ equity = working capital + non-current assets. • Return on funds entrusted to the firm for relatively long time.
Variations • Average or weighted average investment is more representative (e.g. (beginning + ending) 2). • Tangible assets instead of total assets. • To determine tax rate, can use total tax rate or tax rate excluding deferred taxes.
Relationship of ROE to Profit Margin, Asset TO & Leverage • ROE can be viewed as: Pretax margin percentage X Asset Turnover ratio X Financial leverage ratio X Tax retention rate. • ROE = (Pretax profit/sales revenue) X (sales revenues / total assets) X (Total assets/Shareholders’ equity) X (1- Tax rate) • How do we improve ROE?
Price/Earnings (PE) ratio • Measure of overall performance. • Market price per share/EPS • Market price is not controlled by company; reflects all information available to the market. • Reflects how investors judge future performance or prospects of the company. • Commonly compared to other companies in same industry.
Earnings per share • Company ABC has an EPS of $5 per share, Company XYZ has an EPS of $10 per share. • Is one a better company or investment than the other? Is one more profitable than the other?
Profitability measures • Profit margin = net income/net sales = a measure of overall profitability. • Common size financial statements = Vertical analysis: • Express each item on the income statement as a percentage of net sales.
Investment utilization measures • How well are assets managed. • Profitability measures focus on Income Statement. • Investment utilization measures involve balance sheet and income statement amounts.
Investment turnover • Asset turnover = Sales revenue/total assets. • Invested capital turnover = Sales revenue/invested capital. • Equity turnover = Sales revenue/shareholders’ equity.
Capital intensity • Less encompassing than investment turnover. • Capital intensity ratio = sales revenue/PPE = fixed asset turnover.
Working capital measures • Days’ cash = cash/cash costs per day = cash/(cash expenses 365) • Cash expenses = total expenses - depreciation - other non-cash expenses. • Days’ receivables = Receivables/(sales 365) • Days’ inventory = inventory/(cost of goods sold 365) • Inventory turnover = cost of goods sold/inventory
Working capital measures • Days’ payables = operating payables/(pretax cash expenses 365). • Approximate pre-tax cash expenses = all expenses except taxes - depreciation expense. • Working capital turnover = sales revenue/ working capital • Some analysts look at ratio of working capital to sales revenue (inverse of working capital turnover).
Cash conversion cycle • Receivables conversion period (i.e. days’ receivables) + inventory conversion period (i.e. days’ inventory) - payment deferral period (i.e. days’ payables) = operating cycle - payment deferral period. • A measure of liquidity. • Indicates time interval for which additional short-term financing might be needed to support a spurt in sales.
Financial condition ratios • Liquidity. • Solvency.
Liquidity • Ability to meet current obligations. • Tests for size and relationship between current liabilities and current assets. • Liquidity measures: • Current ratio = current assets/current liabilities. • Acid Test (or quick) ratio = monetary current assets / current liabilities • Monetary current assets = current assets - inventory - prepaid assets.
Solvency • Ability to meet interest costs and repayment schedules associated with long-term debt. • Solvency measures • Debt/equity ratio = total liabilities/shareholders’ equity • Alternatively, Debt/equity ratio = long-term liabilities/shareholders’ equity. • Debt/capitalization ratio = long-term debt/total invested capital.
Solvency Measures (Continued) • Total invested capital = long term debt + shareholders’ equity. • Times interest earned = income before interest/interest expense • Ratio of Cash generated by operations to total debt
Dividend policy • Dividend yield = dividends per share/ market price per share • Dividend pay-out = dividends/net income • Provides info on how growth is financed. • Less dividends paid means more earnings are retained to fund growth.
Dividend yield vs. interest yield on bonds • Not a valid comparison. • Investor’s return on bonds kept to maturity: • Interest (adjusted for amortization of premium/discount). • Investor’s return on common stock: • Dividends + change in share price. • Function of expected future earnings. • Earnings reinvested in business.
Growth measures • Key accounting items for which growth is computed: sales, net income, earnings per share. • Average growth = (growth per year for n years)/n • Compound growth rate = based on present value concepts. • May be misleading due to abnormally high or low beginning or ending year.
Implied growth rate =Return on shareholders’ equity X Profit retention rate = ROE X (1 – Dividend payout) • Estimates potential to grow profits without an injection of new capital.
Bases for comparison • Experience. A feel for what is right or reasonable. • Budget. A target developed within the company. Factors to be considered: • How carefully was budget constructed? • What circumstances are different now? • Historical standards. Prior period’s results adjusted for changes in accounting methods. • External benchmarks. Competitor, industry average
Comments on Ratio Analysis • Helps paint a picture. • Try to overcome tendency to look at numbers rather than underlying reasons. • Starting point; identifies questions not answers.
13 End of Chapter 13