1 CHAPTER 5 ESSENTIALS of FINANCIAL STATEMENT ANALYSIS Adopted from Slides Authored by Brian Leventhal University of Illinois at Chicago University of.

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CHAPTER 5

ESSENTIALS of FINANCIAL STATEMENT ANALYSIS

Adopted from Slides Adopted from Slides Authored by Authored by

Brian LeventhalBrian Leventhal University of Illinois at University of Illinois at

ChicagoChicago

FINANCIAL REPORTING & ANALYSISFINANCIAL REPORTING & ANALYSISBYBY

REVSINE – COLLINS – JOHNSON REVSINE – COLLINS – JOHNSON 22ndnd Edition Edition

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I. Basic Approaches

A. Time-series analysis helps identify financial trendsfinancial trends over time for a

single company or business unit.

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B. Cross-sectional analysis helps identify similarities and differences across companies or business units at a single single moment in moment in time. time.

I. Basic Approaches

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I. Basic Approaches

In time-series time-series analysisanalysis, the

benchmark may be the change in performance or health each

year.

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I. Basic Approaches

In cross-sectional cross-sectional analysisanalysis, the

benchmark may be the

performance or health of a particular

competitor or industry

averages.

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II. Quaker Oats Example 

B. Common size and trend Common size and trend statementsstatements provide a convenient way to organize financial statement information………

so that major financial

components and changes are

easily recognized.

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1. Common size income statements recast each statement item as a percentage of sales for that period.

2. Trend statements recast each statement item as a percentage of that item in a base year.

II. Quaker Oats Example

II. Quaker Oats Example

Comparative Income Statements($ in millions) 1999 1998 1997 1996 1995Sales $4,725.2 $4842.5 $5,015.7 $5,199.0 $5,954.0Cost of Goods Sold 2,136.8 2,374.4 2,564.9 2,807.5 3,294.4

Gross Profit 2,588.4 2,468.1 2,4580.8 2,391.5 2,659.6Selling, G&A Exp. 1,904.1 1,872.5 1,938.9 1,981.0 2,358.8(Gains) losses on (2.3) 128.5 1,486.3 (113.4) (1,053.5) divestitures, restructurings and asset impairmentInterest Expense 61.9 69.6 85.8 106.8 131.6Other (revenues) exp. 6.4 0.9 4.1 1.5 2.2 Pre-tax income 618.3 396.6 (1,064.3) 415.6 1,220.5Income taxes 163.3 112.1 (133.4) 167.7 496.5Net Income (loss) 455.0 284.5 (930.9) 247.9 724.0

II. Quaker Oats Example –Common Size % Sales

Comparative Income Statements($ in millions) 1999 1998 1997 1996

1995Sales 100.0 100.0 100.0 100.0

100.0 Cost of Goods Sold 45.5 49.0 51.1 54.0

55.3 Gross Profit 54.8 51.0 48.9 46.0 44.7

Selling, G&A Exp. 40.3 38.7 38.7 38.1 39.6

(Gains) losses on 0.0 2.7 29.6 –2.2 –17.7 divest.,restructurings & asset impairment

Interest Expense 1.3 1.4 1.7 2.1 2.2

Other (revenues) exp. 0.1 0.0 0.1 0.0 0.0

Pre-tax income 13.1 8.2 -21.2 8.0 20.5

Income taxes 3.5 2.3 -2.7 3.2 8.3

Net Income (loss) 9.6 5.8 -18.6 4.7 12.1

II. Quaker Oats Example –Trend(1995=100%)

Comparative Income Statements($ in millions) 1999 1998 1997 1996

1995Sales 79.4 81.3 84.2 87.3

100.0 Cost of Goods Sold 64.9 72.1 77.9 85.2

100.0 Gross Profit 97.3 92.8 92.1 89.9

100.0 Selling, G&A Exp. 80.7 79.4 82.2 84.0

100.0 (Gains) losses on 0.2 -12.2 -141.1 10.8

100.0 divest.,restructurings & asset impairment

Interest Expense 47.0 52.9 65.2 81.2 100.0

Other (revenues) exp.290.9 40.9 186.4 68.2 100.0

Pre-tax income 50.7 32.5 - 87.2 34.1 100.0

Income taxes 32.9 22.6 -26.9 33.8 100.0

Net Income (loss) 62.8 39.3 -128.6 34.2 100.0

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III. Profitability, Competition, & Business Strategy  A. Financial ratios are another

powerful tool that analysts use in evaluating profit performance and assessing credit risk.

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III. Profitability, Competition, & Business Strategy  B. Most evaluations of

profit performanceprofit performance begin with the Return on Assets (ROA) ratio:

ROA = ROA = net operating profit after taxesnet operating profit after taxes average assetsaverage assets

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III. Profitability, Competition, & Business Strategy  B. Most evaluations of

profit performanceprofit performance begin with the return on assets (ROA) ratio:

ROA = ROA = net operating profit after taxesnet operating profit after taxes average assetsaverage assets

2. Analysts can isolate a company’s sustainable operating profits by removing nonoperating or nonrecurring items from reported earnings.

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III. Profitability, Competition, & Business Strategy  B. Most evaluations of

profit performanceprofit performance begin with the return on assets (ROA) ratio:

ROA = ROA = net operating profit after taxesnet operating profit after taxes average assetsaverage assets

3. After-tax interest expense is eliminated from the profit calculation so that operating profitability comparisons over time are not clouded by differences in financial structure.

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III. Profitability, Competition, & Business Strategy  B. Most evaluations of

profit performanceprofit performance begin with the return on assets (ROA) ratio:

ROA = ROA = net operating profit after taxesnet operating profit after taxes average assetsaverage assets

4. Adjustments to eliminate distortions to both earnings and assets for items such as the capital and operating lease, for example mentioned earlier should be done.

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III. Profitability, Competition, & Business Strategy  C. A company can increaseincrease its

ROA in two different ways:ROA = ROA = net operating profit after taxesnet operating profit after taxes average assetsaverage assets

1. By increasing the operating profit margin.

2. By increasing the intensity of asset utilization.

3. In other words, ROA can be thought of as:

Operating profit marginOperating profit margin asset asset turnoverturnover

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III. Profitability, Competition, & Business Strategy  C. A company can increaseincrease its

ROA in two different ways:ROA = ROA = net operating profit after taxesnet operating profit after taxes average assetsaverage assets

Operating profit margin asset turnover

Net operating profit after taxes(NOPAT) Sales

S a l e sAverage Assets

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III. Profitability, Competition, & Business Strategy  D. ROA and competitive advantage:

Operating profit margin asset turnoverNet operating profit after

taxes(NOPAT) Sales

S a l e sAverage Assets

5. There are only two strategies for achieving superior performancesuperior performance in any business:a. One strategy is product and service differentiation in order to focus customer attention on “unique” product or service attributes to gain customer loyalty and attractive profit margins.

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III. Profitability, Competition, & Business Strategy  D. ROA and competitive advantage:

Operating profit margin asset turnoverNet operating profit after

taxes(NOPAT) Sales

S a l e sAverage Assets

5. There are only two strategies for achieving superior performancesuperior performance in any business:b. Low-cost leadershipLow-cost leadership focuses customer attention on product pricing. The goal is to under price the competition, achieve highest sales volumes, and still make a profit on each sale.

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III. Profitability, Competition, & Business Strategy  D. ROA and competitive advantage:

Operating profit margin asset turnoverNet operating profit after

taxes(NOPAT) Sales

S a l e sAverage Assets

5. There are only two strategies for achieving superior performancesuperior performance in any business:c. Few companies actually pursue one strategy to the exclusion of the other. Rather, they try to develop brand loyalty while controlling cost.

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IV. Credit Risk & Capital Structure  A. Credit risk refers to the

ability and willingness of a borrower to pay its debt.

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IV. Credit Risk & Capital Structure  A. Credit risk refers to the ability

and willingness of a borrower to pay its debt.

1. Ability to repay debt is determined by capacity to generate cash from operations, asset sales, or external financial markets in excess of cash needs.

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IV. Credit Risk & Capital Structure  A. Credit risk refers to the ability

and willingness of a borrower to pay its debt.

2. Willingness to pay depends on which competing cash need is viewed as the most pressing at the moment.

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IV. Credit Risk & Capital Structure  A. Credit risk refers to the ability

and willingness of a borrower to pay its debt.

3. The statement of cash flows is an important source of information for analyzing a company’s credit risk. Financial ratios are also useful for this purpose.

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IV. Credit Risk & Capital Structure  B. Credit risk analysis using financial

ratios typically involves an assessment of liquidity and solvency.

1. Liquidity refers to the company’s short-term ability to generate cash for working capital needs and immediate debt repayment needs.

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IV. Credit Risk & Capital Structure  B. Credit risk analysis using financial

ratios typically involves an assessment of liquidity and solvency.

2. Solvency refers to the long-term ability to generate cash internally or from external sources in order to satisfy plant capacity needs, fuel growth, and repay debt when due.

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IV. Credit Risk & Capital Structure  C. Short-term liquidity:

Current = Current = Current AssetsCurrent Assets Ratio Current LiabilitiesRatio Current Liabilities

1. Reflects cash & other current assets that will be converted into cash in the normal operating cycle.

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IV. Credit Risk & Capital Structure  C. Short-term liquidity:

Quick = Quick = Cash+ Receivables+Marketable SecuritiesCash+ Receivables+Marketable Securities

Ratio Current LiabilitiesRatio Current Liabilities

2. Inventory is not included, providing a more short-run reflection of liquidityliquidity, since few businesses can instantaneously convert their inventories into cash.

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a. This ratio tells users the proportion of yearly sales that the average receivables balance represents.

• This ratio will be correspondingly larger for firms with cash sales that are a larger proportion of total sales.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using

its assets by highlighting causes for cash flow mismatches.

A/R Turnover = A/R Turnover = N e t S a l e sN e t S a l e s Average A/RAverage A/R

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b. This ratio tells users the average collection period for accounts receivable.

• This should be compared to the credit period allowed by the company.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using

its assets by highlighting causes for cash flow mismatches.

Days Receivables’ = Days Receivables’ = 365 D a y s365 D a y sOutstanding A/R TurnoverOutstanding A/R Turnover

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c. This ratio tells users the proportion of sales that the average inventory balance represents.

• A higher ratio may indicate:• i. More efficient operations, or• ii. Adoption of a low-cost

leadership strategy.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using

its assets by highlighting causes for cash flow mismatches.

Inventory Turnover =Inventory Turnover =Cost of Goods Cost of Goods SoldSold Ratio Average Ratio Average InventoryInventory

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d. This ratio tells users the average number of days that inventory is held in storage.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using

its assets by highlighting causes for cash flow mismatches.

Days Inventory = Days Inventory = 365 D a y s 365 D a y s Held Inventory Held Inventory TurnoverTurnover

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e. This ratio, and its counterpart that follows, helps analysts understand the company’s pattern of payment to suppliers.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using

its assets by highlighting causes for cash flow mismatches.

Accounts Payable =Accounts Payable =Inventory Inventory Purchases Purchases Turnover Average Turnover Average A/PA/P

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Show on average how long the company takes to payoff Accounts Payable.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using

its assets by highlighting causes for cash flow mismatches.

Days A/P = Days A/P = 365 D a y s 365 D a y s Outstanding A/P TurnoverOutstanding A/P Turnover

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The level of concern is negatively correlated with the level of operating cash flow.

IV. Credit Risk & Capital Structure  3. Activity ratiosActivity ratios tell users how efficiently the company is using its assets by

highlighting causes for cash flow mismatches

Cash Inflow Vs Cash Outflow Cash Inflow Vs Cash Outflow MismatchingMismatching Days Receivable OutstandingDays Receivable Outstanding+ + Days Inventory Days Inventory HeldHeld

- - Days A/P OutstandingDays A/P Outstanding

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IV. Credit Risk & Capital Structure D. Long-term solvency:

1. Debt ratios provide information about the amount of long-term debt in a company’s financial structure.

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2. Reflects the proportion of each asset dollar financed with long-term debt.

IV. Credit Risk & Capital Structure D. Long-term solvency:

Long-Term Debt = Long-Term Debt = Long-Term Long-Term Debt Debt to Total Assets Total to Total Assets Total AssetsAssets

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3. The adjustment to remove intangible assets is intended to remove “soft” assets,

i.e., those that are difficult to value reliably.

IV. Credit Risk & Capital Structure D. Long-term solvency:

Long-Term Debt Long-Term Debt == Long-Term Long-Term

Debt Debt to Tangible Assets Total Tangible to Tangible Assets Total Tangible AssetsAssets

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4. Ability to generate a stream of inflows sufficient to make principal and interest payments.

The interest coverage ratio is commonly used for this purpose.

IV. Credit Risk & Capital Structure D. Long-term solvency:

Interest Interest ==Operating Income before taxes & Operating Income before taxes &

InterestInterest Coverage Interest ExpenseCoverage Interest Expense

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5. The ability of a company to generate cash flows from operations in order to service both short-term and long-term borrowings.

IV. Credit Risk & Capital Structure D. Long-term solvency:

Operating Operating

Cash Flows Cash Flows = = Cash Flow from continuing Cash Flow from continuing

operationsoperations to Total Avg. C/L + Long-Term to Total Avg. C/L + Long-Term DebtDebtLiabilitiesLiabilities

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V. Return on Equity & Financial Leverage 

A. ProfitabilityProfitability and credit riskcredit risk both influence the returnreturn that common shareholders earn on their investment in the company.

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B.Measures a company’s performance in using capital provided provided by shareholders by shareholders to generate earnings.

Net Income Net Income Available to Available to Return on Return on common common shareholdersshareholders Common Equity Common Equity = Average = Average Common Common (ROCE)(ROCE) Shareholders’ EquityShareholders’ Equity

V. Return on Equity & Financial Leverage

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a. The common earnings leverage ratio shows the proportion of NOPAT that belongs to common shareholders.

Net Income Available to Net Income Available to Return on Return on common shareholderscommon shareholders Common Equity Common Equity = = Average Common Average Common (ROCE)(ROCE) Shareholders’ Equity Shareholders’ Equity

V. Return on Equity & Financial LeverageC. Components of ROCE:

ROCE = ROA x Common earning lev. x Fin. structure lev.

NOPATNOPATAVG. AssetsAVG. Assets

NI avail to CSNI avail to CSNOPATNOPAT

AVG. AssetsAVG. AssetsAVG Common SEAVG Common SExx xx

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b. The financial structure leverage ratio measures the degree to which the company uses common shareholders’ capital to finance finance assetsassets.

Net Income Available to Net Income Available to Return on Return on common shareholderscommon shareholders Common Equity Common Equity = = Average Common Average Common (ROCE)(ROCE) Shareholders’ Equity Shareholders’ Equity

V. Return on Equity & Financial LeverageC. Components of ROCE:

ROCE = ROA x Common earning lev. x Fin. structure lev.

NOPATNOPATAVG. AssetsAVG. Assets

NI avail to CSNI avail to CSNOPATNOPAT

AVG. AssetsAVG. AssetsAVG Common SEAVG Common SExx xx

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VI.Earnings, Cash Earnings, or EBITDA? 

A. There are several measures of earningsearnings that may be used in press releases.

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VI.Earnings, Cash Earnings, or EBITDA?  A. There are several measures of

earningsearnings that may be used in press releases.

1. GAAP earnings are those reported to the SEC using GAAP.

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VI.Earnings, Cash Earnings, or EBITDA?  A. There are several measures of

earningsearnings that may be used in press releases.

2. EBITDAEBITDA is earnings before interest, taxes, depreciation, and amortization.

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VI.Earnings, Cash Earnings, or EBITDA?  A. There are several measures of

earningsearnings that may be used in press releases.

3. Cash earnings is generally defined as earnings before goodwill amortization.

Pro forma earnings is a variant that excludes a variety of costs that are routinely included in GAAP earnings.

One popular operationalization is net income before goodwill amortization and one-time costs such as merger integration costs.

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VI.Earnings, Cash Earnings, or EBITDA?  A. There are several measures of

earningsearnings that may be used in press releases.

3. Cash earnings is generally defined as earnings before goodwill amortization.

b. Standard definitions for these benchmarks do not currently exist.

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B. Analysts must be wary and look behind the numbers to see what is really going on!

VI.Earnings, Cash Earnings, or EBITDA?