Module 7

The Analysis of Financial StatementsThe Analysis of Financial StatementsBA 617BA 617

Module 7Module 7

Step OneStep One

Who is the user?Who is the user?

Different users have different information Different users have different information needs.needs.

Potential Financial Statement Potential Financial Statement Users:Users:

CreditorsCreditors

InvestorsInvestors

ManagersManagers

What types of questions do each of What types of questions do each of these users seek answers to?these users seek answers to?

CreditorsCreditors

Why does the firm want/need to borrow Why does the firm want/need to borrow funds?funds?

What is the firm’s capital structure? How What is the firm’s capital structure? How leveraged are they?leveraged are they?

How will they pay it back? What kind of How will they pay it back? What kind of cash flows are being generated by cash flows are being generated by operations?operations?

InvestorsInvestors

How has the firm performed/what are How has the firm performed/what are future expectations?future expectations?

How much RISK is inherent in the capital How much RISK is inherent in the capital structure?structure?

What are expected returns from the firm?What are expected returns from the firm?

What is firm’s competitive position? What is firm’s competitive position?

ManagersManagers

Need all info creditors and investors need Need all info creditors and investors need PLUS:PLUS:

What operating areas have contributed to What operating areas have contributed to success and which have not?success and which have not?

What are strengths/weaknesses of What are strengths/weaknesses of company’s financial position?company’s financial position?

What changes are indicated to improve What changes are indicated to improve future performance?future performance?

Caution!!!Caution!!!

Keep in mind: management PREPARES Keep in mind: management PREPARES financial statementsfinancial statements

Analyst should be alert to potential for Analyst should be alert to potential for management to influence reporting to management to influence reporting to make data more “appealing”make data more “appealing”

May want to supplement analysis with May want to supplement analysis with information apart from Annual Report information apart from Annual Report prepared by managementprepared by management

Steps 2 and 3Steps 2 and 3

Where to look for data...Where to look for data...

Financial statements (and notes)Financial statements (and notes)

Auditor’s reportAuditor’s report

MD&AMD&A

Supplementary schedulesSupplementary schedules

All of the above are in Annual Report -- All of the above are in Annual Report -- can also look further...can also look further...

Other Data SourcesOther Data Sources

10K and 10Q reports filed with SEC10K and 10Q reports filed with SEC

Computerized data basesComputerized data bases– Info on industry norms/ratiosInfo on industry norms/ratios– Info on particular companies/industries/mutual Info on particular companies/industries/mutual

fundsfunds

Articles in popular/business press Articles in popular/business press

Ever-expanding websitesEver-expanding websites

ValueLineValueLineUsername and PasswordUsername and Password

Available to Mercer students Available to Mercer students only!only!

USERID: 156339USERID: 156339

Password: stocksPassword: stocks

Great Analysis ToolGreat Analysis Tool

http://edgarscan.pwcglobal.com/recruit/other.htmlhttp://edgarscan.pwcglobal.com/recruit/other.html

Try out the benchmarking assistant!

More sources of infoMore sources of info

SIC ManualSIC Manual

Industry Averages and Comparison with Industry Averages and Comparison with CompetitorsCompetitors– The Dept of Commerce Financial ReportThe Dept of Commerce Financial Report– Robert Morris Associates Annual Statement StudiesRobert Morris Associates Annual Statement Studies– Standard & Poor’s Industry SurveysStandard & Poor’s Industry Surveys– Almanac of Business and Industrial Financial RatiosAlmanac of Business and Industrial Financial Ratios– D&B Industry Norms and Key Business RatiosD&B Industry Norms and Key Business Ratios

Compact DisclosureCompact Disclosure

Step 4Step 4

Basic ToolsBasic Tools

Common size financial statementsCommon size financial statements

Financial ratiosFinancial ratios

Trend analysisTrend analysis

Structural analysisStructural analysis

Industry comparisonsIndustry comparisons

Common sense and judgment (often the Common sense and judgment (often the hardest to use!)hardest to use!)

Common Size StatementsCommon Size Statements

Common size income statementCommon size income statement– expresses each income statement category expresses each income statement category

as a percentage of net salesas a percentage of net sales

Common size balance sheetCommon size balance sheet– expresses each item on balance sheet as a expresses each item on balance sheet as a

percentage of total assets or equitiespercentage of total assets or equities

Both statements facilitate structural Both statements facilitate structural analysis of the firmanalysis of the firm

Financial Ratio CategoriesFinancial Ratio Categories

Liquidity RatiosLiquidity Ratios– measure a firm’s ability to meet cash needs measure a firm’s ability to meet cash needs

as they ariseas they arise

Activity RatiosActivity Ratios– measure the liquidity of specific assets and measure the liquidity of specific assets and

the efficiency of managing assetsthe efficiency of managing assets

Ratio Categories (continued)Ratio Categories (continued)

Leverage RatiosLeverage Ratios– measure the extent of a firm’s financing with measure the extent of a firm’s financing with

debt relative to equity and its ability to cover debt relative to equity and its ability to cover interest and other fixed chargesinterest and other fixed charges

Profitability RatiosProfitability Ratios– measure the overall performance of a firm and measure the overall performance of a firm and

its efficiency in managing assets, liabilities its efficiency in managing assets, liabilities and equityand equity

Caution!!!!!!Caution!!!!!!

Ratios are valuable, BUT…..Ratios are valuable, BUT…..– They do not provide answers in an of themselves and They do not provide answers in an of themselves and

are not predictiveare not predictive– They should be used with other elements of financial They should be used with other elements of financial

analysisanalysis– There are no “rules of thumb” that apply to There are no “rules of thumb” that apply to

interpretation of ratiosinterpretation of ratios

KEEPING THIS IN MIND, LET’S TAKE A LOOK KEEPING THIS IN MIND, LET’S TAKE A LOOK AT SOME OF THE RATIOS….AT SOME OF THE RATIOS….

Liquidity RatiosLiquidity Ratios

Current RatioCurrent Ratio– Current Assets/Current LiabilitiesCurrent Assets/Current Liabilities– Measures ability to meet short-term cash needs Measures ability to meet short-term cash needs

Quick or Acid Test RatioQuick or Acid Test Ratio– Current Assets-Inventory/Current LiabilitiesCurrent Assets-Inventory/Current Liabilities– Measure ability to meet short-term cash needs Measure ability to meet short-term cash needs

more rigorouslymore rigorously

Liquidity Ratios (continued)Liquidity Ratios (continued)

Cash Flow Liquidity RatioCash Flow Liquidity Ratio– Cash+Marketable Securities+Cash Flow from Cash+Marketable Securities+Cash Flow from

Operating Activities/Current LiabilitiesOperating Activities/Current Liabilities– Focuses on ability of the firm to generate Focuses on ability of the firm to generate

operating cash flows as a source of liquidityoperating cash flows as a source of liquidity

Activity RatiosActivity Ratios

Average Collection PeriodAverage Collection Period– Accounts Receivable/Average Daily SalesAccounts Receivable/Average Daily Sales– Helps gauge liquidity of accounts receivable (ability to Helps gauge liquidity of accounts receivable (ability to

collect cash from customers)collect cash from customers)

Accounts Receivable TurnoverAccounts Receivable Turnover– Net Sales/Accounts ReceivableNet Sales/Accounts Receivable– Another measure of efficiency of firm’s collection and Another measure of efficiency of firm’s collection and

credit policiescredit policies

Activity Ratios (continued)Activity Ratios (continued)

Inventory TurnoverInventory Turnover– Cost of Goods Sold/InventoryCost of Goods Sold/Inventory– Measures efficiency of inventory managementMeasures efficiency of inventory management

Fixed Asset and Total Asset TurnoverFixed Asset and Total Asset Turnover– Net Sales/Net PP&E (Fixed Asset T/O)Net Sales/Net PP&E (Fixed Asset T/O)– Net Sales/Total Assets (Total Asset T/O)Net Sales/Total Assets (Total Asset T/O)– Both assess effectiveness in generating sales from Both assess effectiveness in generating sales from

investment in assetsinvestment in assets

Leverage: Debt RatiosLeverage: Debt Ratios

Debt RatioDebt Ratio– Total Liabilities/Total AssetsTotal Liabilities/Total Assets

Long-Term Debt to Total CapitalizationLong-Term Debt to Total Capitalization– Long-term Debt/Long-term Debt + Stockholders’ Long-term Debt/Long-term Debt + Stockholders’

EquityEquity

Debt to Equity RatioDebt to Equity Ratio– Total Liabilities/Stockholders’ EquityTotal Liabilities/Stockholders’ Equity

All three measure extent of firm’s financing with All three measure extent of firm’s financing with debtdebt

Leverage: Coverage RatiosLeverage: Coverage Ratios

Proportion and amount of debt in capital Proportion and amount of debt in capital structure is important to analyststructure is important to analyst

Tradeoff between risk and returnTradeoff between risk and return

Use of debt involves risk -- commitment to Use of debt involves risk -- commitment to fixed chargesfixed charges

Fixed charges must be COVERED -- Fixed charges must be COVERED -- following are some ratios to assess following are some ratios to assess coverage…...coverage…...

Coverage Ratios (continued)Coverage Ratios (continued)

Times Interest EarnedTimes Interest Earned– Operating Profit/Interest ExpenseOperating Profit/Interest Expense– Indicates how well operating earnings cover Indicates how well operating earnings cover

fixed interest chargesfixed interest charges

Fixed Charge CoverageFixed Charge Coverage– Operating Profit + Lease Payments/Interest Operating Profit + Lease Payments/Interest

Expense + Lease PaymentsExpense + Lease Payments– Broader measure of how well operating Broader measure of how well operating

earnings cover fixed chargesearnings cover fixed charges

Coverage Ratios (continued)Coverage Ratios (continued)

Cash Flow AdequacyCash Flow Adequacy– Cash Flow from Operating Activities/ Average Cash Flow from Operating Activities/ Average

Annual Long-Term Debt MaturitiesAnnual Long-Term Debt Maturities– Measures firm’s ability to cover long-term debt Measures firm’s ability to cover long-term debt

maturities each yearmaturities each year– Rationale is that over the long-run operating Rationale is that over the long-run operating

cash flows must be adequate to cover cash flows must be adequate to cover investing activities financed with debtinvesting activities financed with debt

Profitability RatiosProfitability Ratios

Gross Profit MarginGross Profit Margin– Gross Profit/Net SalesGross Profit/Net Sales

Operating Profit MarginOperating Profit Margin– Operating Profit/Net SalesOperating Profit/Net Sales

Net Profit MarginNet Profit Margin– Net Earnings/Net SalesNet Earnings/Net Sales

All measure firm’s ability to translate sales All measure firm’s ability to translate sales dollars into profitsdollars into profits

Profitability Ratios (continued)Profitability Ratios (continued)

Cash Flow MarginCash Flow Margin– Cash Flow from Operating Activities / Net Cash Flow from Operating Activities / Net

SalesSales– Measures ability to translate sales into cash Measures ability to translate sales into cash

(with which to pay bills!)(with which to pay bills!)

Profitability Ratios (continued)Profitability Ratios (continued)

Return on Investment (or Return on Return on Investment (or Return on Assets -- same thing, different words!)Assets -- same thing, different words!)– Net Earnings/Total AssetsNet Earnings/Total Assets

Return on EquityReturn on Equity– Net Earnings/Stockholders’ EquityNet Earnings/Stockholders’ Equity

Both measure overall efficiency of firm in Both measure overall efficiency of firm in managing investment in assets and managing investment in assets and generating return to stockholdersgenerating return to stockholders

Profitability Ratios (continued)Profitability Ratios (continued)

Cash Return on AssetsCash Return on Assets– Cash Flow from Operating Activities / Total Cash Flow from Operating Activities / Total

AssetsAssets– Useful comparison to return on investmentUseful comparison to return on investment– Indicates firm’s ability to generate cash from Indicates firm’s ability to generate cash from

utilizing its assetsutilizing its assets

Other Ratios You Hear About..Other Ratios You Hear About..

Earnings per Common ShareEarnings per Common Share– Net Earnings/Average Common Shares Net Earnings/Average Common Shares

OutstandingOutstanding– Indicates return on a per share basisIndicates return on a per share basis

Price to EarningsPrice to Earnings– Market Price of Common Stock/Earnings per Market Price of Common Stock/Earnings per

Common ShareCommon Share– Expresses a multiple the stock market places Expresses a multiple the stock market places

on earningson earnings

Other Ratios (continued)Other Ratios (continued)

Dividend PayoutDividend Payout– Dividends per Share/Earnings per ShareDividends per Share/Earnings per Share– Shows percentage of earnings paid out to Shows percentage of earnings paid out to

stockholdersstockholders

Dividend YieldDividend Yield– Dividends per Share/Market Price of Common Dividends per Share/Market Price of Common

ShareShare– Shows rate earned by shareholders from dividends Shows rate earned by shareholders from dividends

relative to current stock pricerelative to current stock price

Analyzing the CompanyAnalyzing the Company

Now that some of the “tools” of financial Now that some of the “tools” of financial analysis have been illustrated, where does analysis have been illustrated, where does one go from here?one go from here?

Step 5Step 5

Red FlagsRed Flags

Changes in top company managementChanges in top company management

Key financial ratios indicating deteriorating Key financial ratios indicating deteriorating trends and/or weaknesses relative to trends and/or weaknesses relative to industry competitorsindustry competitors

Cash flow from operations declining, Cash flow from operations declining, negative, volatile, or not tracking with net negative, volatile, or not tracking with net income.income.

Lack of profitability in key operating areas.Lack of profitability in key operating areas.

More Red FlagsMore Red Flags

Price to earnings ratio low relative to Price to earnings ratio low relative to competitorscompetitors

Firm’s earnings less than after-tax cost of Firm’s earnings less than after-tax cost of debtdebt

Declining operating profits when debt is Declining operating profits when debt is risingrising

Deteriorating trends in operating segmentsDeteriorating trends in operating segments

AccomplishmentsAccomplishments

Reviewed all the basic financial Reviewed all the basic financial statements and know what they arestatements and know what they are

Practiced the rudiments of financial Practiced the rudiments of financial analysisanalysis

If nothing else, hopefully gained an If nothing else, hopefully gained an appreciation of what information is appreciation of what information is available and how one might use it...available and how one might use it...

A Final NoteA Final Note

Financial analysis is only as good as the Financial analysis is only as good as the information upon which it is based -- information upon which it is based -- hence we need to be concerned about hence we need to be concerned about honest, straightforward, comprehensible honest, straightforward, comprehensible financial reportingfinancial reporting

Financial analysis is only valuable to me if Financial analysis is only valuable to me if it answers MY questions -- I need to it answers MY questions -- I need to THINK about what I need/would like to THINK about what I need/would like to know BEFORE I crunch numbersknow BEFORE I crunch numbers

A Final Final Note (really!)A Final Final Note (really!)

Analyzing financial information can be fun Analyzing financial information can be fun (as well as profitable)(as well as profitable)

You can never know too much about a You can never know too much about a company you plan to have a relationship company you plan to have a relationship with (as an investor, a creditor, a manager, with (as an investor, a creditor, a manager, an employee)an employee)