Transcript Document

Financial Statement Analysis
16.1 THE MAJOR FINANCIAL
STATEMENTS
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Balance Sheet
◦ Common Sized
◦ Trend or Indexed
Income Statement
◦ Common Sized
◦ Trend or Indexed
Statement of Cash Flows
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Four broad classes:
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Cost of goods sold
General and administrative expenses
Interest expense
Taxes on earnings
HP for example:
Operating revenue, Operating expense, Operating
income
EBIT: income earned if no debt or tax, measure of
profitability of the firm’s operations
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Assets
◦ Current
◦ Long-term
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Liability and stockholders’ equity
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Income statement and balance sheets are
based on accrual methods of accounting
Statement of cash flows tracks the cash
implications of transaction, recognizes only
transactions in which cash changes hands
◦ Example: if goods are sold now, with payment due
in 60 days. Income statement will treat the revenue
as generated when the sale occurs, balance sheet
will be immediately augmented by accounts
receivable, but the statement of cash flows will not
show an increase in available cash until the bill is
paid
16.2 ACCOUNTING VERSUS
ECONOMIC EARNINGS
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Economic earnings
◦ Sustainable cash flow that can be paid
to stockholders without impairing
productive capacity of the firm
Accounting earnings
◦ Affected by conventions regarding the
valuation of assets
16.3 PROFITABILITY MEASURES
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ROE: measures the profitability for
contributors of equity capital
ROE=Net income/equity
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ROA: measures the profitability for all
contributors of capital
ROA=EBIT/asset
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Leverage has a significant effect on
profitability measures
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Data from recent past may provide
information regarding future performance
Analysts should always keep an eye on the
future
Expectations of future dividends and earnings
determine intrinsic value of stock
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EXAMPLE
Noddet: all equity financed , total assets of
100 million, tax rate 40%
Somedett: 40 million debt, interest rate of 8%,
60 million equity.
Same sales, EBIT, ROA, but somedett’s ROE
exceeds that of nodett in normal and good
years, and is lower in bad years.
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Debt 
ROE = (1 - Tax rate)  ROA + (ROA - Interest rate)

Equity 
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ROE 
Net profit EBIT - Interest - Taxes (1 - Tax rate)(EBIT- Interest)
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Equity
Equity
Equity
 (ROA x Assets) - (Interest rate x Debt) 
 (1 - Tax rate) 

Equity
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Equity + Debt
Debt 
 (1 - Tax rate)  ROA x
 Interest rate x
Equity
Equity 
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Debt 
 (1 - Tax rate)  ROA + (ROA - Interest rate)
Equity 
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Calculate the ROE of somedett in a normal year
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Debt 
ROE = (1 - Tax rate)  ROA + (ROA - Interest rate)
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Equity
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40 
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 (1  40%) 0.1  (0.1  0.08)   6.8%
60 
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Increased debt will make a positive contribution to
a firm’s ROE only if ROA>interest rate on the debt
Higher ROE, not imply higher stock price. Financial
leverage increases the risk of the firm’s equity,
higher discount rate will offset the higher
expected earnings
16.4 RATIO ANALYSIS
ROE =
Net Profit
x
Pretax Profit
Burden
x
EBIT
(1)
Tax
Pretax Profit
x
x
(2)
Interest
Burden
x
EBIT
Sales
(3)
x
x
Sales
Assets
(4)
x
x
Assets
Equity
(5)
x Margin x Turnover x Leverage
ROE =tax burden  interest burden  margin  turnover  leverage
tax burden= NI/pretax profit=NI/(EBIT-I)
interest burden=pretax profit/EBIT=(EBIT-I)/EBIT
operating profit margin (return on sales)=EBIT/sales
total asset turnover=sales/asset
leverage=A/E=1+D/E
ROE =tax burden  interest burden  margin  turnover  leverage
ROA=Margin  Turnover
Compound leverage factor=interest burden  leverage
ROE=tax burden  ROA  Compound leverage factor
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Profitability Ratios
Turnover or Asset Utilization Ratios
Liquidity Ratios
Leverage Ratios
Market Price Ratios
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One item from income statement, another
from a balance sheet, take the average of the
beginning and end-of-year balance sheet
figures
Fixed asset turnover=sales/ave fixed assets
Inventory turnover=COGS/ave inventory
Average collection period=365*ave Accounts
receivable / sales
Net Profit Margin %
Net Income
Sales
Operating Return on Assets %
Earnings Before Int. & Taxes
Total Assets
Return on Equity %
Net Income
Common Equity
Inventory Turnover
Sales or Cost of Goods Sold
Inventory
Total Asset Turnover
Sales
Total Assets
Average Collection Period
Accounts Receivable
Sales Per Day
Days to Sell Inventory
Inventory
Sales Per Day
Current Ratio
Current Assets
Current Liabilities
Quick Ratio
Current Assets - Inventory
Current Liabilities
Times Interest Earned
Earnings Before Int. & Taxes
Interest Expense
Fixed Charge Coverage Ratios
Lease Payments
Principal Repayments
Preferred Dividends
Debt to Assets %
Long Term Debt
Assets
Debt to Equity %
Long Term Debt
Shareholders Equity
Price to Earnings
Market Price of Stock
Earnings
Market-to-Book-Value
Market Price of Stock
Book Value Per Share
16.5 ECONOMIC VALUE ADDED
 Difference
between return on
assets (ROA) and the opportunity
cost of capital (k)
ROA-K (Capital Invested in the firm)
 EVA
is also called residual income
 EVA can be positive or negative
for firms that have positive
earnings
15.6 AN ILLUSTRATION OF FINANCIAL
STATEMENT ANALYSIS
16.5 COMPARABILITY
PROBLEMS
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Inventory valuation
◦ LIFO and FIFO
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Depreciation
Inflation and interest expense
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Allowance for bad debts
Non-recurring items
Earnings smoothing
Stock options
Revenue recognition
Off-balance sheet assets and liabilities
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Reserving practices
Depreciation
Intangibles
16.6 VALUE INVESTING: THE GRAHAM
TECHNIQUE
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Graham believed careful analysis of a firm’s
financial statements could turn up bargain
stocks
He developed many different rules for
determining the most important financial
ratios
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Accounting Differences
◦ Inventory Valuation
◦ Depreciation
Inflation and Interest Expense
Fair Value Accounting
Quality of Earnings
International Accounting Conventions
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Reserves – many other countries allow
more flexibility in use of reserves
Depreciation – US allows separate tax
and reporting presentations
Intangibles – treatment varies widely
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Careful analysis of a firm’s financial
statements could turn up bargain stocks
Purchase common stocks at less then
their working-capital value
Give no weight to plant or other fixed
assets
Deduct all liabilities in full from assets