Chapter 14

Financial Statement Analysis

14-1

Income Statement

• Four broad types of accounts:– Cost of goods sold– General and administrative expenses– Interest expense– Taxes on earnings

• Common Size income statements– Divide each account by net sales– Eliminates size distortions

14-2

Balance Sheet• Assets

– Current– Long-term

• Liability (current and long term) and stockholders’ equity

• Common size balance sheet– Divide each account by total assets– Each account presented as a percent of the

total

14-3

Statement of Cash Flows• A financial statement showing a firm’s cash

receipts and cash payments during a specified period.– Recognizes transactions only if cash changes

hands. – “Undoes” much of accrual accounting to get at

cash changes– Does not allocate capital expenditures through

time via depreciation as income statement does

14-4

Statement of Cash Flows

Three main sections

• Cash flow related to operations CFO

• Cash flow related to investing CFI

• Cash flow related to financing CFF

• Allows the analyst to understand which of the firm’s activities are using and which generating cash.

14-5

Statement of Cash Flows

• Not all sources of cash are equally sustainable.– Would you rather invest in a firm that is primarily

generating cash through operations or through financing?

• It is difficult to evaluate whether the amount of cash flow related to investing is ‘good’ or ‘bad.’ What else would we need to know?– Rate of return on the investment

– Comparable data over time or from competitors

14-6

Accounting Versus Economic Earnings

• Accounting earnings– Earnings of a firm as reported on its income

statement

• Economic earnings– The real flow of cash that firm could pay out to

its stockholders without impairing its productive capacity.

14-7

Past Versus Future ROE

ROE = Net Profits / Equity

• Data from recent past may provide information regarding future ROE

• Analysts should always keep an eye on the future

• Expectations of future dividends and earnings determine intrinsic value of stock

14-8

Financial Leverage and ROE

(1 Tax rate) ( Interest rate)Debt

ROE ROA ROAEquity

• The relationship among ROE, ROA, and leverage:

• ROE = Net Profits / Equity

• ROA = EBIT / Total Assets

14-9

Ratio Analysis• Purpose of Ratio Analysis

– Understand the factors that affect performance

• Methods– Trend analysis– Comparative analysis– Combination of the two

• Use by External Analysts– Important information for investment community– Important for credit markets

14-10

DuPont Decomposition of ROE

Burden Burden

Leverage Turnover Margin Interest Tax

(5) (4) (3) (2) (1)

Equity

Assets

Assets

Sales

Sales

EBIT

EBIT

ProfitPretax

ProfitPretax

Profit NetROE

ROE can be decomposed into various ratios that reflect different aspects of a firm’s performance:

14-11

Type of Financial Ratios

• Ratio (1) Tax Burden (TB): – Measures the percentage of pretax profit that the firm keeps

after paying taxes

• Ratio (2) Interest Burden (IB):– Measures the percent of EBIT kept after paying interest expense– – This ratio is 1 if the firm has no debt

Burden Burden

Leverage Turnover Margin Interest Tax

(5) (4) (3) (2) (1)

Equity

Assets

Assets

Sales

Sales

EBIT

EBIT

ProfitPretax

ProfitPretax

Profit NetROE

EBIT

Expense InterestEBIT

EBIT

ProfitPretax

14-12

Type of Financial Ratios

• Ratio (3) Operating Profit Margin– Measures the percentage of sales revenue that remains after

subtracting cost of goods sold, selling and administrative expenses and depreciation

• Ratio (4) Asset Turnover Ratio (ATO)– Measures the efficiency of the firm at generating sales per dollar

invested in the assets– Note: Margin x ATO = ROA

Burden Burden

Leverage Turnover Margin Interest Tax

(5) (4) (3) (2) (1)

Equity

Assets

Assets

Sales

Sales

EBIT

EBIT

ProfitPretax

ProfitPretax

Profit NetROE

14-13

Type of Financial Ratios

• Ratio (5) Leverage ratio– Leverage ratio = 1 + Debt / Equity

– The leverage ratio is a measure of the percentage of debt in total capitalization.

– Note that it appears that using more debt as a percent of capital will increase ROE, but using more debt also reduces the interest burden ratio

Burden Burden

Leverage Turnover Margin Interest Tax

(5) (4) (3) (2) (1)

Equity

Assets

Assets

Sales

Sales

EBIT

EBIT

ProfitPretax

ProfitPretax

Profit NetROE

14-14

Type of Financial Ratios

• Ratio (5) Leverage ratio– Compound leverage factor (CLF) = Interest burden x Leverage– If the CLF > 1, the use of debt will increase ROE– If the CLF < 1, the use of debt will decrease ROE– CLF will be greater than 1 if ROA > Interest rate on debt– What does this imply about when firms should use more debt?

Burden Burden

Leverage Turnover Margin Interest Tax

(5) (4) (3) (2) (1)

Equity

Assets

Assets

Sales

Sales

EBIT

EBIT

ProfitPretax

ProfitPretax

Profit NetROE

14-15

Ratio Analysis using GIAsset Utilization Ratios (2010 data for GI)

1. Total Asset Turnover

2. Fixed Asset Turnover

3. Inventory Turnover

4. Average collection period or days sales in receivables

How will these ratios affect ROA and ROE?

AssetsFixed Avg.

Sales

Inventory Average

Sold Goods of Cost

365 Sales

sReceivable AccountsAvg.

606.216,000)/2($259,200

$144,000

AssetsAvg.

Sales303.

)/2000,324($518,400

$144,000

IndustryAverage

0.40

0.70

0.50

60 days

485.108,000)/2 29,6001($

$79,200

days 100.4365 $144,000

$36,000)/2($43,200

14-16

Ratio Analysis using GI

Market Price Ratios (2010 data for GI)

1.Market-to-Book

2.P/E ratio

3.ROE

Also

hareEarnings/s

stock Price

ValueBook atEquity

Income Net

97.300$5,285/1,0

$21.00

re Value/shaBook

stock Price1186.

000,1/128,177$

$21.00

IndustryAverage

.69

8.0

8.64%%98.2$177,128

,2855$

2.98%3.97

.1186

P/E

P/BROE

14-17

Figure 14.1 DuPont Decomposition for Hewlett-Packard

14-18

Table 14.10 Ratios for Major Industries

14-19

Economic Value Added• Concept: A firm adds value only if the return on its projects exceeds its required rate of

return• For example:

The effect of ROE and b on the Price/Book ratio for a stock with E1 = $1, Book value/share = $8.33 and k =12%:

• Bold numbers are the Price/Book ratios that result from the given Plowback ratio and ROE.

Plowback Ratio (b)

ROE 0% 25% 50% 75%

10% 1.00 0.95 0.86 0.67

12% 1.00 1.00 1.00 1.00

14% 1.00 1.06 1.20 2.00

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Economic Value Added

• Concept: A firm adds value only if the return on its projects exceeds its required rate of return

• Approach to compare accounting profitability with the cost of capital

• Definition– ROA-k (Capital Invested in the firm)– k = opportunity cost for capital or required return

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Table 14.11 Economic Value Added

14-22

Comparability ProblemsRatios must have a benchmark, but it can be difficult to compare data of different firms

• Different inventory valuation– LIFO and FIFO

• Depreciation problems– Accounting depreciation Economic depreciation– Different depreciation methods at different firms– In periods of inflation depreciation is understated in economic

terms and real economic income is overstated

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Comparability Problems• Inflation and interest expense

– Nominal interest rates include an inflation premium to compensate for erosion in the real value of the principal.

– Conceptually then, from an economic viewpoint part of interest expense is actually principal repayment.

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Fair Value Accounting

Fair value accounting uses market values rather than book values in the firm’s financial statements. – Market value is a truer picture of the current

value of the firm,– Market value is forward looking, book value is

backward looking– Trend is toward market value accounting

14-25

Fair Value Accounting

Financial Accounting Standards Board (FASB) Rule 157 classifies assets in one of three buckets:

– Level 1: Assets that are traded in active markets and should be valued at market prices

– Level 2: Asset that are not actively traded, but their values may be estimated from market data on similar assets

– Level 3: Assets that can only be valued with inputs that are difficult to observe.

•Level 2 and Level 3 assets may be valued using pricing models and the values may be ‘marked to model’

14-26

Quality of Earnings: Accounting Choices

Quality of earnings refers to the realism and sustainability of reported earnings,

• Allowance for bad debts must be realistic• Extraordinary and Non-recurring items are

sometimes pretty ordinary and common • Earnings smoothing is pervasive

– Revenue & expense recognition options– Engaging in contingent off-balance sheet assets

(certain leases) or liabilities (selling credit default swaps) that have unknowable effects on earnings

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International Accounting Conventions

• Reserving practices– Overseas firms have far more discretion in their ability to set

aside reserves for future contingencies (or not) than U.S. firms have.

– This means foreign firms’ earnings are more subject to managerial manipulation

• Depreciation– Foreign firms typically use accelerated depreciation on their

financial statements and U.S. firms don’t, so foreign firms have lower reported earnings, ceteris paribus.

• Intangibles– Treatment of intangibles varies widely between countries.

14-28

IFRS

The International Financial Reporting Standards (IFRS) have been adopted by the European Union and by over 100 countries.

• In 2007 the SEC began allowing foreign firms to list their securities in U.S. markets if they prepared their statements using IFRS

• In 2008 the SEC ruled that large U.S. multinational firms may start using IFRS rather than GAAP in 2010 and that all firms should use IFRS by 2014.

• IFRS standards are principle based rather than rules based

14-29

Value Investing: The Graham Technique Benjamin Graham

• Founder of modern fundamental analysis

• Graham believed careful analysis of a firm’s financial statements could turn up bargain stocks and his work was used by generations of analysts

• He developed many different rules for determining the most important financial ratios, as his ideas became popular they stopped working.

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