Chapter 10

Major Financial Statements

• Corporate shareholder annual and quarterly reports must include– Balance sheet– Income statement– Statement of cash flows

• Reports filed with Securities and Exchange Commission (SEC)– 10-K and 10-Q

Statement of Cash Flows

It has three sections: Cash Flow from Operating Activities – the

sources and uses of cash that arise from the normal operations of a firm

Cash Flow from Investing activities – change in gross plant and equipment plus the change in the investment account

Cash Flow from Financing activities– financing sources minus financing uses

Importance of Relative Financial Ratios

• Compare to other entities

• Examine a firm’s performance relative to:– The aggregate economy– Its industry or industries– Its major competitors within the industry– Its past performance (time-series analysis)

Comparing to A Firm’s Industry

• Most popular comparison

• Industries affect the firms within them differently, but the relationship is always significant

• The industry effect is strongest for industries with homogenous products

• Examine the industry’s performance relative to aggregate economic activity

Comparing to A Firm’s Major Competitors

• Industry averages may not be representative

• Select a subset of competitors to compare to using cross-sectional analysis, or

• Construct a composite industry average from industries the firm operates in

Comparing to A Firm’s Historical Performance

• Determine whether it is progressing or declining

• Helpful for estimating future performance

• Consider trends as well as averages over time

Five Categories of Financial Ratios

1. Internal liquidity (solvency)

2. Operating performance– a. Operating efficiency– b. Operating profitability

3. Risk analysis– a. Business risk– b. Financial risk


4. Growth analysis


5. External liquidity (marketability)

Common Size Statements

• Normalize balance sheets and income statement items to allow easier comparison of different size firms

• A common size balance sheet expresses accounts as a percentage of total assets

• A common size income statement expresses all items as a percentage of sales

Operating Profitability Ratios

• Return on owner’s equity (ROE) can be computed for the common- shareholder’s equity

EquityCommon Average

Dividend Preferred-IncomeNet Equity sOwner'on Return


Assets Total

EBIT

Assets Total

Sales

Sales

EBIT

Assets Total

Tax BeforeNet

Assets Total

ExpenseInterest

Assets Total

EBIT

EquityCommon

(NBT)Tax BeforeNet

EquityCommon

Assets Total

Assets Total

(NBT)Tax BeforeNet


Assets Total

EBIT

Assets Total

Sales

Sales

EBIT

Assets Total

Tax BeforeNet

Assets Total

ExpenseInterest

Assets Total

EBIT

EquityCommon

(NBT)Tax BeforeNet

EquityCommon

Assets Total

Assets Total

(NBT)Tax BeforeNet

This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect.


Assets Total

EBIT

Assets Total

Sales

Sales

EBIT

Assets Total

Tax BeforeNet

Assets Total

ExpenseInterest

Assets Total

EBIT

EquityCommon

(NBT)Tax BeforeNet

EquityCommon

Assets Total

Assets Total

(NBT)Tax BeforeNet

EquityCommon

IncomeNet

Tax BeforeNet

Taxes Income%100

EquityCommon

Tax BeforeNet


In summary, we have the following five components of return on equity (ROE)

Operating Profitability RatiosMarginProfit Operating

Sales

EBIT .1


Sales

EBIT .1

TurnoverAsset TotalAssets Total

Sales .2


Sales

EBIT .1


Sales .2

Rate ExpenseInterest Assets Total

ExpenseInterest .3


Sales

EBIT .1


Sales .2


ExpenseInterest .3

Multiplier Leverage FinancialEquityCommon

Assets Total .4


Sales

EBIT .1


Sales .2


ExpenseInterest .3

Multiplier Leverage FinancialEquityCommon

Assets Total .4

RateRetention Tax Tax BeforeNet

Taxes Income%100 .5

The Expanded Du Pont system - Bloomberg and CFA Style:

• ROE = EBIT/Sales x S/A x EBT/EBIT x A/Eq x EAT/EBT

• ROE = O.P.M. x TATO x Interest Burden x EM x Tax Burden

It shows how these factors combine to determine the ROE.

Risk Analysis• Total risk of a firm has two components:

– Business risk• The uncertainty of income caused by the firm’s

industry• Generally measured by the variability of the firm’s

operating income over time

– Financial risk• Additional uncertainty of returns to equity holders

due to a firm’s use of fixed obligation debt securities• The acceptable level of financial risk for a firm

depends on its business risk

Business Risk

• Variability of the firm’s operating income over time

Business Risk

• Variability of the firm’s operating income over time

• Standard deviation of the historical operating earnings series

Business Risk

• Two factors contribute to the variability of operating earnings– Sales variability

• Earnings must be as volatile as sales• Some industries are cyclical

– Operating leverage• Production has fixed and variable costs• Fixed production costs cause profit volatility with changes

in sales• Fixed production costs are operating leverage

Financial Risk

• Bonds interest payments come before earnings are available to stockholders

• These are fixed obligations

• Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline

• This debt financing increases the financial risk and possibility of default

Financial Risk

• Two sets of financial ratios help measure financial risk– Balance sheet ratios– Earnings or cash flow available to pay fixed

financial charges

• Acceptable levels of financial risk depend on business risk

Financial Risk

• Proportion of debt (balance sheet) ratios

Financial Risk

• Proportion of debt (balance sheet) ratios

This may be computed with and without deferred taxes

Equity Total

Debt Term-Long TotalRatioEquity -Debt

Financial Risk

• Interest Coverage

ChargesInterest Debt

(EBIT) Taxes andInterest Before Income

ExpenseInterest

ExpenseInterest Taxes Income IncomeNet

External Market Liquidity

• Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information

• External market liquidity is a source of risk to investors


Determinants of Market Liquidity

• The dollar value of shares traded– This can be estimated from the total market

value of outstanding securities– It will be affected by the number of security

owners– Numerous buyers and sellers provide liquidity


• Trading turnover (percentage of outstanding shares traded during a period of time)


• A measure of market liquidity is the bid-ask spread

Analysis of Growth Potential

• Creditors are interested in the firm’s ability to pay future obligations

• Value of a firm depends on its future growth in earnings and dividends

Determinants of Growth• Resources retained and reinvested in the entity• Rate of return earned on the resources retained

= RR x ROEwhere:g = potential growth rateRR = the retention rate of earningsROE = the firm’s return on equity

Equityon Return Retained Earnings of Percentage g

Determinants of Growth

• ROE is a function of– Net profit margin– Total asset turnover– Financial leverage (total assets/equity)

Comparative Analysis of Ratios

• Internal liquidity– Current ratio, quick ratio, and cash ratio

• Operating performance– Efficiency ratios and profitability ratios

• Financial risk

• Growth analysis

The Quality of Financial Statements

• Reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are


• High-quality balance sheets typically have – Conservative use of debt– Assets with market value greater than book– No liabilities off the balance sheet


• High-quality income statements reflect repeatable earnings

• Gains from nonrecurring items should be ignored when examining earnings

• High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

Chapter 10

Business

operating profitability

financial risk bonds

operating performance

risk analysis total

categories of financial

sets of financial ratios

operating activities

business risk variability