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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
Five Categories of Financial Ratios
4. Growth analysis
Five Categories of Financial Ratios
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
Operating Profitability Ratios
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
Operating Profitability Ratios
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.
Operating Profitability Ratios
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
Operating Profitability Ratios
In summary, we have the following five components of return on equity (ROE)
Operating Profitability RatiosMarginProfit Operating
Sales
EBIT .1
Operating Profitability RatiosMarginProfit Operating
Sales
EBIT .1
TurnoverAsset TotalAssets Total
Sales .2
Operating Profitability RatiosMarginProfit Operating
Sales
EBIT .1
TurnoverAsset TotalAssets Total
Sales .2
Rate ExpenseInterest Assets Total
ExpenseInterest .3
Operating Profitability RatiosMarginProfit Operating
Sales
EBIT .1
TurnoverAsset TotalAssets Total
Sales .2
Rate ExpenseInterest Assets Total
ExpenseInterest .3
Multiplier Leverage FinancialEquityCommon
Assets Total .4
Operating Profitability RatiosMarginProfit Operating
Sales
EBIT .1
TurnoverAsset TotalAssets Total
Sales .2
Rate ExpenseInterest Assets Total
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
External Market Liquidity
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
External Market Liquidity
• Trading turnover (percentage of outstanding shares traded during a period of time)
External Market Liquidity
• 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
The Quality of Financial Statements
• High-quality balance sheets typically have – Conservative use of debt– Assets with market value greater than book– No liabilities off the balance sheet
The Quality of Financial Statements
• 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