Chapter 4 Organization and Functioning of Securities Markets

Financial Statement Analysis

Tom Rourke FINA 4397 - Financial Statement Analysis

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Objectives

• Review the components of the financial statement package.

• Discuss the information contained in the financial statements and how it can be used to evaluate a firm.

• Discuss the types of questions can financial ratios answer.

• Discuss the relationship between the notion of market efficiency and financial statement analysis.


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Introduction to Financial Statement Analysis

• A major source of information regarding a a firm’s operating performance and its resources is the firm’s financial statement package.

• Analyzing a set of financial statements involves using ratios of key financial statement items and other tools to gain insight into the profitability and risk of a firm.

• Financial statement analysis can help us to better understand the business risk and the financial risk of a firm.


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Principal Financial Statements

• Financial statements are intended to provide information on the operating performance and financial health of a business during a specified period of time.

• In the US, financial statements are required to adhere to GAAP (although GAAP does allow some flexibility).– One goal is to make the financial statements of one

firm comparable across time and to the financial statements of other firms.


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Principal Financial Statements, cont.

• GAAP requires firms to present balance sheets for the two most recent years and income statements and statements of cash flows for the three most recent years in a set of financial statements.

• In addition, firms are required to present notes to the financial statements that provide information on the accounting methods used by the firm to construct the financial statements.


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The Balance Sheet

• The balance sheet is a statement of financial position that presents details of the resources of a firm and the claims on those resources as of a specific point in time (i.e., on March 31, 20XX).– It is a “static” statement.

• The asset side of a balance sheet reports the effects of a firm’s past investment decisions while the liabilities and shareholders’ equity side reports the effects of a firm’s past financing decisions.


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The Balance Sheet, cont.

• The balance sheet is governed by the accounting identity:

• Assets are resources that have the potential for providing a firm with future economic benefits.

• Liabilities are obligations to pay for benefits or services received in the past.

• Shareholders’ Equity represents a residual claim on the firm (in book value terms).

Equity rs'ShareholdesLiabilitieAssets


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• It is important to note that most (if not all in some cases) assets and liabilities are reported on a firm’s balance sheet are at historical cost (less some adjustments).

• It is very rare that historical cost equals market value.

• Examples:– Machinery: historical cost less depreciation– Accounts Receivables: historical value less an

allowance for doubtful accounts– Inventory: lower of cost or market


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• It is also important to note that the balance sheet may not report all assets and liabilities of a firm.– Only assets and liabilities meeting certain criteria set

out by GAAP are required to be reported on the balance sheet.

– The footnotes are a source of information for these other off-balance sheet “assets” and “liabilities.”


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The Balance Sheet – Assets

• Assets are resources under a firm’s control that have the potential to provide the firm with future economic benefit(s).– i.e., the ability to generate future cash inflows

(accounts receivables, inventories, etc.) or decrease future cash outflows (i.e., prepayments, etc.)

• Assets are usually presented in order of their “liquidity” (cash, cash equivalents, accounts receivables, inventories, etc.).


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The Balance Sheet – Assets, cont.

• Assets can be – Monetary Assets

• cash, cash receivables, etc.• Monetary assets are reported at the amount of

cash the firm expects to receive in the future.– Non-monetary

• inventories, PP&E, etc.• GAAP generally requires reporting non-monetary

assets at their historical cost (historical cost is objective and verifiable).


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The Balance Sheet – Assets, cont.

• Assets can be (cont.)– Current Assets

• Cash and other assets (A/R, inventory, prepayments, etc.) expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer.

– Non-current/Long-term Assets• Assets not classified as current (PP&E, some

prepayments, etc.).


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The Balance Sheet – Liabilities

• A liability represents a firm’s obligation to make payments of cash, goods, or services in a reasonably definite amount at a reasonably definite time in the future for benefits or services received in the past.

• Liabilities are generally monetary (require a payment of a fixed amount of cash) but can be non-monetary.


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The Balance Sheet – Liabilities, cont.

• Liabilities can be – Current Liabilities

• Obligations whose liquidation is reasonably expected to require the use of existing resources classified as current assets or the creation of other current liabilities.

– Non-current/Long-term Liabilities• Obligations not classified as current.


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The Balance Sheet – Shareholders’ Equity

• The shareholders’ equity in a firm is the firm’s owners’ residual interest or claim on the firm.

• The accounting identity can be re-written as

• Therefore, the valuation of assets and liabilities in the balance sheet determines the book value of the shareholders’ equity.

sLiabilitie-AssetsEquity rs'Shareholde


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The Balance Sheet – Shareholders’ Equity, cont.

• The shareholders’ equity portion of the balance sheet is commonly presented in three parts.– Capital Stock: the par value of shares issued– Additional Paid-In Capital: excess amounts paid in (by

shareholders) in excess of the par value of the shares issued

– Retained Earnings: the firm’s undistributed earnings


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The Balance Sheet - Conclusion

• In summary, the balance sheet views resources from two perspectives:– As a list of the specific form in which the firm holds

the resources (i.e., cash, inventory, etc.).– As a list of the persons or entities that provided the

funding to obtain those resources (and thus the persons who have a claim on those resources, i.e. debt holders and equity holders).

The balance sheet presents the equality of investing and financing.


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The Income Statement

• The income statement is sometimes titled the Statement of Operations, Statement of Earnings, or the Statement of Income.

• The income statement presents details on the operating profitability of a firm over a particular time period (i.e., performance for the year ending on March 31, 20XX).– It is a “dynamic” statement.


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The Income Statement, cont.

• GAAP requires publicly traded firms to use an accrual basis of accounting (as opposed to a cash basis) in measuring operating performance.– Accrual basis accounting records revenues when they

are earned and expenses when they are incurred (regardless of when actual cash flows occur).

– Cash basis accounting records revenues when cash is received and expenses when cash is paid.

• It is this accrual concept that links the balance sheet and the income statement.


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• The bottom line:

• Revenues measure the inflows of net assets from selling goods and providing services.

• Expenses measure the outflows of net assets that a firm uses in the process of generating revenues.

• Gains and losses arise from the sale of assets that aren’t directly related to the firm’s business.

ossesExpenses/L – ainsRevenues/G Income Net


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• The goal of the income statement is to give a measure of operating performance that matches the firm’s outputs with the firm’s inputs.

• But, keep in mind, because the accrual basis of accounting is required– revenues reflect sales for cash and sales for credit,

and– expenses reflect purchases made in cash and

purchases made on credit.

• Therefore, net income includes cash and non-cash elements.


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The Statement of Cash Flows

• The statement of cash flows reports for a period of time the net cash flows (inflows less outflows) from three principal business activities of a firm:(1) cash flows from operating activities(2) cash flows from investing activities(3) cash flows from financing activities

• As this statement reports on the actual cash flows for a period, it can be used to disentangle the effects of the accrual basis of accounting (where non-cash items affect reported net income).


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The Statement of Cash Flows, cont.

• Question: Why is the statement of cash flows so important to a financial analyst?

• Answer: Cash flows are vital to a firm’s survival. The statement of cash flows integrates the information contained in the balance sheet and income statement in a manner that allows an analyst to determine what the sources and uses of cash were for a firm for the specified time period.


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Cash Flows from Operating Activities

• This section of the statement of cash flows lists the sources and uses of cash that arise from the normal operations of a firm:

• Operating activities involve the cash effects of transactions that enter into the determination of net income (i.e., income statement items).

Cash Flow from Operating Activities

= Net Income -Non-cash Revenues

+Non-cash Expenses

-Changes in Net Working

Capital


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Cash Flows from Investing Activities

• This section of the statement of cash flows lists the sources and uses of cash that arise from the investing activities of a firm (generally related to long-term assets).

• Investing activities include:– buying and selling debt of OTHER firms,– collecting principal payments on debt of other firms,– buying and selling securities of OTHER firms, and– buying and selling property, plant, and equipment.


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Cash Flows from Financing Activities

• This section of the statement of cash flows lists the sources and uses of cash that arise from the financing activities of a firm (generally related to long-term liabilities and equity).

• Financing activities include:– sales and repurchases of the firm’s equity,– dividends to the firm’s stockholders, and– issuances and retirements of the firm’s debt.


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The Statement of Cash Flows, cont.

• The purpose of the statement of cash flows is to describe how the firm generated and used cash during the reporting period.

• The “bottom line” of the statement of cash flows reports the change in the firm’s cash balance from the beginning of the reporting period to the end of the reporting period.


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The Notes to the Financial Statements

• The notes to the financial statements generally explain the items presented in the main body of the statements.

• Examples of notes include:– descriptions of the accounting policies used in

measuring the elements reported in the statements or– explanations of uncertainties or contingencies.

• The notes to the financial statements are an integral part of the financial statements and should be viewed as such.


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Common Size Financial Statements

• Often, it may be difficult to compare two firms because they differ in size (in terms of sales levels or total asset levels).

• To resolve this problem, an analyst can create “common size” financial statements.– A common size balance sheet states all numbers as a

percentage of total assets.– A common size income statement states all numbers

as a percentage of sales.


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Common Size Financial Statements, cont.

• However, interpretation of common size financial statements must be made with care.– One item in a common size statement is not

independent of the other items (all items are presented as relative values to some base amount).

– The dollar amount of any one item might increase over the period but the item’s relative size can decrease at the same time.


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Percentage Change Statements

• A percentage change statement will present the percentage changes of individual items from the previous period to the current period.

• Again, care must be taken in interpreting the numbers in a percentage change statement. For instance,

... A/R Cash AssetsCurrent %%%


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A Final (??) Comment on the Financial Statement Package

• It is always important to remember who the authors of a financial statement package are (the firm’s managers) and what their incentives/motivations are (make the firm look good).– Only the actual financial statements and

accompanying notes are independently viewed by a team of auditors!

– More often than not, quarterly financial information is un-audited.


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Economic vs. Accounting Earnings

• Keep in mind that the financial statement package is only an approximation of reality though.

• If the world were certain, we could measure economic earnings as

where the market value of net assets is equal to the present value of their future cash flows discounted at the risk-free rate.

assets net sfirm' the of value market

flow cash net earningseconomic


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Economic vs. Accounting Earnings, cont.

• Unfortunately (or fortunately depending on your taste) we live in an uncertain world.– We cannot say, with certainty, what will happen

tomorrow most of the time.

• Therefore, we cannot say, with certainty, what an asset’s market price should be.

• In this world of uncertainty, no matter how we record earnings, they are only a proxy for economic income.


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• Because of this uncertainty, analysts have developed different proxies for economic earnings.– Distributable earnings – the value of dividends that

could be paid without changing the value of the firm.– Sustainable income – the level of income that can

be maintained given the firm’s stock of capital investment.

– Permanent earnings – the amount that can normally be earned given the firm’s assets.


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• But, the accounting framework we’ve begun to describe gives us another measure – Accounting Earnings.

• The accrual accounting system does not directly provide a measure equivalent to those previously discussed.– It is the analyst’s task to use the accounting

information to determine the numbers he/she wants/needs to value a firm.


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Financial Statement Analysis

• Financial statement analysis in general focuses on five primary categories:– the firm’s internal liquidity,– the firm’s operating performance,– an analysis of firm risk,– an analysis of growth potential, and– external market liquidity.

• The common approach is to start with ratio analysis.– We will only highlight a handful of key ratios.


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Evaluating Internal Liquidity

• Internal liquidity ratios indicate the ability of the firm to meet future short-term financial obligations.

• The probability of financial distress decreases as the relative liquidity of a firm’s assets increases.– Liquidity means “nearness to cash,” i.e., cash is the

most liquid asset a firm can have, a machine might be very illiquid if it is difficult to sell to generate cash.

• The focus is on the current portion of the balance sheet.


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Evaluating Internal Liquidity – The Current Ratio

• The current ratio is calculated as:

• The analyst must consider how much inventory the company carries in assessing this ratio.

• Problem: – The effect on the current ratio of an equivalent

increase in current assets and current liabilities depends on whether or not the current ratio was previously greater than or less than one.

– Can be greatly affected by economic conditions.

sLiabilitie Current

AssetsCurrentRatio Current


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Evaluating Internal Liquidity – The Quick Ratio

• Sometimes, inventories and some other current assets may not be very liquid (i.e., easily converted into cash).– Therefore, they shouldn’t be considered in assessing

a firm’s ability to meet its current obligations since they don’t really add to this ability.

• The quick ratio is calculated as:

sLiabilitie Current

sReceivableSecurities MarketableCashRatio Quick


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Evaluating Internal Liquidity – The Cash Ratio

• An even more conservative measure is the cash ratio. This ratio assumes that only cash and marketable securities should be considered in evaluating a firm’s ability to meet its current obligations.

• The cash ratio is calculated as:

sLiabilitie Current

Securities MarketableCashRatio Cash


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Evaluating Internal Liquidity – Accounts Receivables Turnover

• The rate at which A/R turn gives an indication of how quickly a firm’s receivables are converted into cash.

• The A/R turnover ratio is calculated as:

sReceivable AccountAverage

Sales CreditTurnover A/R


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Evaluating Internal Liquidity – Accounts Receivables Turnover

• This rate implies an average A/R collection period:

i.e., if the Average A/R collection period is 10, this implies that on average it takes the firm 10 days to collect cash from sales on credit.

• Potential problem: Where do we get credit sales from?

Turnover A/R

365Period Collection A/RAverage


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Evaluating Internal Liquidity – Accounts Receivables Turnover, cont.

• Firms might extend credit to induce sales, how might this affect receivables turnover?

• Firms make a trade-off in deciding the desirable receivables turnover rate.– Receivables turnover too high – strict credit policies,

may be refusing credit to the creditworthy– Receivables turnover too low – lax credit policies,

may be extending too much credit to the non-creditworthy.

Large deviations from the industry average A/R collection period may be a red flag.


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Evaluating Internal Liquidity – Inventory Turnover

• The rate at which inventories turn gives an indication of how soon they will be sold.

• The inventory turnover ratio is calculated as:

Inventory Average

Sold Goods of CostTurnover Inventory


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Evaluating Internal Liquidity – Inventory Turnover, cont.

• This rate implies an average inventory processing time:

• Question: What would you expect Wal-Mart’s average processing time to be? What would you expect a jeweler’s average processing time to be?

• These ratios vary widely by industry. Be careful when comparing across industries.

Turnover Inv.

365Period Processing Inv. Average


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Evaluating Internal Liquidity – Inventory Turnover, cont.

• Increasing inventory turnover ratios might indicate more efficient inventory control systems.– A JIT inventory system will increase the inventory

turnover rate to infinity.• Firms make a trade-off in deciding the desirable

inventory turnover rate.– Inventory turnover too high – potential inventory

shortages, may have to turn away customers and lose sales

– Inventory turnover too low – excess inventory on hand, increased carrying costs, inventory obsolescence


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Evaluating Internal Liquidity – Inventory Valuation

• These ratios are affected by inventory valuation method.

• Three common inventory valuation methods:– Average cost – values each unit of inventory at the

same cost, a weighted average of all inventory units EVER purchased.

– First-In-First-Out (FIFO) – assumes goods are sold in order of their purchase by the firm.

– Last-In-First-Out (LIFO) – assumes goods are sold in reverse order of their purchase by the firm.


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Evaluating Internal Liquidity – Inventory Valuation, cont.

• What we are measuring is cost flow and NOT the actual flow of goods.– Inventory valuation is a cost allocation mechanism.

• If input prices are– Constant: FIFO = Average = LIFO– Rising: FIFO < Average < LIFO– Declining: FIFO > Average > LIFO

• In making a comparison across firms, if the two firms don’t use the same valuation method the comparison is NOT reasonable.


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Evaluating Internal Liquidity – Inventory Valuation, cont.

• FIFO has good balance sheet effects but poor income statement effects.– On the B/S, inventory is listed closer to replacement

cost. – On the I/S, COGS reflects possibly old input prices.

• LIFO has good income statement effects but poor balance sheet effects.– On the I/S, COGS reflects more recent input prices. – On the B/S, inventory is listed at old replacement

costs.


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Evaluating Internal Liquidity – The Operating Cycle

• The operating cycle is the sum of the number of days it takes for a firm to sell its inventory and convert the resulting receivables into cash.

• We’ve already discussed the components of this. The operating cycle can be calculated as

Operating Cycle

=Average A/R

Collection Period+

Average Inv. Processing

Period


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Evaluating Internal Liquidity – Accounts Payables Turnover

• The rate at which A/P “turn” gives an indication of how quickly a firm pays for purchases on account.

• A/P turnover is calculated as:

Payables AccountAveragePurchases

Turnover A/P


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Evaluating Internal Liquidity – Accounts Payables Turnover

• This rate implies an average A/P payment period:

• But how do we calculate purchases?

Turnover A/P365

Period Payment A/PAverage

Inv. Beginning - Inv. Ending COGS Purchases


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Evaluating Internal Liquidity – The Cash Conversion Cycle

• The cash conversion cycle represents, on average, the net time interval between the collection of cash receipts from product sales and the cash payments for the firm’s various resource purchases.

• The cash conversion cycle is defined as:

Cash Conversion Cycle

=Operating

Cycle-

Average Payables Deferral Period


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Evaluating Operating Performance

• A study of operating performance attempts to the assess the managerial ability/competence by focusing on operating efficiency and operating profitability.

• Operating efficiency refers to how well management uses its assets and capital.

• Operating profitability refers to the returns management earns by using its assets and capital.


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Evaluating Operating Efficiency -Fixed Asset Turnover

• Fixed asset turnover is defined as:

• Fixed asset turnover indicates the extent to which a firm is utilizing existing property, plant, and equipment to generate sales.– Should be used with caution. Might be better for

year-to-year comparisons within the same company rather than for cross company comparisons.

– Affected by depreciation methods.

AssetsFixed Average

Sales NetTurnover AssetFixed


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Evaluating Operating Efficiency -Fixed Asset Turnover, cont.

• Potential problems with the use of this ratio:– Sales growth is continuous (smooth) while fixed asset

growth is lumpy, so, a time series of fixed asset turnovers may have a strange pattern.

– The accumulation of depreciation expense increases the fixed asset turnover by reducing the average fixed assets (in the denominator). Has there really been an increase in efficiency as would be implied by an increasing ratio?


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Evaluating Operating Efficiency -Fixed Asset Turnover, cont.

• Possible interpretations:– Firms make investments in fixed assets in anticipation

of higher sales in the future. Thus a low or decreased fixed asset turnover may indicate an expanding firm.

– On the other hand, a firm may cut back on capital expenditures if future sales outlooks are not good. Thus a high or increasing fixed asset turnover may indicate managerial pessimism.


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Evaluating Operating Efficiency -Depreciation

• Accounting and economic depreciation are two different things.– Accounting depreciation allocates plant and

equipment costs over the asset’s useful life.– Economic depreciation relates to the real world

usefulness of an asset.– An asset might have little real economic value but still

be carried on a firm’s books because it is not fully depreciated in the accounting sense.


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Evaluating Operating Efficiency -Depreciation, cont.

• Firms have flexibility in choosing their depreciation method.– Most use straight-line for financial reporting purposes. – Virtually all (are required to) use accelerated methods

for tax purposes.

• Straight-line depreciation allocates the cost of a depreciable asset evenly over the asset’s expected useful life.

• Accelerated methods allocate a larger portion of the depreciable asset’s cost in the earlier portion of the asset’s expected useful life.


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Evaluating Operating Efficiency -Total Asset Turnover

• Total asset turnover is defined as:

• Total asset turnover indicates the ability to manage the level of investment in assets for a particular level of sales.– In other words, the ability to generate sales from a

particular investment in assets.

AssetsTotal Average

Sales NetTurnover AssetTotal


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Evaluating Operating Profitability –Gross Profit Margin

• The gross profit margin is defined as:

• The gross profit margin indicates the basic cost structure of the firm.– This ratio varies widely by industry. It may not be

reasonable to compare gross profit margins across dissimilar industries.

• Even a small change in the gross profit margin is likely to have a major impact on the bottom line.

Sales Net

Sold Goods of Cost-Sales Net

Sales Net

Profit GrossMargin Profit Gross


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Evaluating Operating Profitability –Operating Profit Margin

• The operating profit margin is defined as:

• The variability of the operating profit margin over time is an indicator of the business risk for a firm.

• Another option is to replace operating profit by earnings before interest, taxes, and depreciation (EBITDA).

Sales Net

ExpensesA &SG - Profit Gross

Sales Net

Profit OperatingMargin Profit Operating


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Evaluating Operating Profitability –Net Profit Margin

• The net profit margin is defined as:

• The net profit margin measures how profitable a firm’s sales are after all expenses have been deducted.

• Since this factors in interest expense it may be more suitable to use for comparing the profit performance of different companies than the operating profit margin.

Sales Net

Income NetMargin Profit Net


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Evaluating Operating Profitability –Return on Total Capital/Assets

• Return on assets is defined as:

• The return on assets indicates the return from operations independent of financing.

• In practice, different analysts may use different numbers in the numerator (EAT, EBIT, EBIAT, etc.).

AssetsTotal Average

Expense InterestIncome NetROA


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Evaluating Operating Profitability –Return on Total Capital/Assets, cont.

• The return on assets might have two interpretations:– it measures a firm’s ability and efficiency in using its

assets to generate profits or– it reports the total return accruing to all who have

provided the firm with capital (long- and short-term debt holders AND equity holders).


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• Considering all equity (includes preferred stock) the return on total equity is defined as:

• Considering only common equity the return on owner’s equity is defined as:

• ROE indicates the return that management has earned on the capital provided by the owner.

Equity Total Average

Income NetEquity Total on Return

Evaluating Operating Profitability –Return on Owner’s Equity

Equity Common Average

Dividends Preferred-Income NetROE


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Evaluating Operating Profitability –The Dupont System

• ROE can be disaggregated into various components that can provide explanations for changes in ROE.

• We’ve previously discussed two of these ratios, financial leverage will be discussed soon.

Leverage Financial Turnover AssetTotal Margin Profit

Equity Common Avg

AssetsTotal Avg

AssetsTotal Avg

Sales Net

Sales Net

Income Net

Equity Common Avg

Sales Net

Sales Net

Income Net

Equity Common Avg

Income Net ROE


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Risk Analysis

• Risk analysis examines the uncertainty of income flows for the total firm and for the individual sources of capital.

• In this sense, risk comes in two forms, business risk and financial risk.– Business risk is the uncertainty of income caused by

the firm’s industry/line of business.– Financial risk/leverage is the uncertainty of returns to

equity holders due to the firm’s use of fixed financing obligations.


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Business Risk

• Business risk has two main components, sales variability and operating leverage.– Sales variability is a prime determinant of earnings

variability. Sales volatility can be measured by the coefficient of variation of sales.

– Operating leverage refers to the employment of fixed production costs. It can be measured as:

sales%

profits% DOL


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Operating Leverage

• Operating leverage refers to the relative portions of fixed versus variable costs in the firm’s total cost structure.

• Greater operating leverage (a larger fixed cost portion) makes the operating earnings of a firm more volatile than sales.– During slow periods, operating profits will decline by a

larger percentage than sales.– During expansionary periods, operating profits will

increase by a larger percentage than sales.


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Financial Leverage

• The employment of fixed financing costs is referred to as financial leverage.

• The financial leverage effect relates operating income to net income as follows:

• Another measure of financial leverage is:

• Although the two measures look different they reflect on the same issue.

income netincome operating

leverage financial

equity common averageassets total average

leverage financial


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Financial Risk Analysis –The Debt to Equity Ratio

• The debt to equity ratio is defined as:

• As the debt to equity ratio increases, earnings per share become more volatile and the probability of default increases.

• Recall the M&M propositions which state that (in perfect markets) a firm’s WACC is constant.

• Question: Should market values or book values be used?

Equity Total

Debt TotalRatioEquity to Debt


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Financial Risk Analysis –Total Debt Ratio (Debt to Assets Ratio)• The total debt ratio (debt to assets ratio) is

defined as:

• This ratio measures the proportion of the firm’s assets that are financed with creditors’ funds.

• Note,

AssetsTotal

Debt TotalRatio Debt Total

AssetsTotalDebt Total

-1

AssetsTotalDebt Total

Equity Total

Debt Total


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Financial Risk Analysis –Interest Coverage

• The interest coverage ratio is defined as:

• This ratio indicates how many times the fixed interest charges are earned based on the earnings available to pay these expenses.

• Obviously, a coverage ratio less than one indicates an inability to make necessary interest payments.

Expense Interest

Expense InterestTaxes IncomeIncome Net

Expense Interest

EBITCoverage Interest


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Financial Risk Analysis –Cash Flow to Cap Ex Ratio

• The cash flow to capital expenditures ratio is defined as:

• This provides information about a firm’s ability to generate cash flow from operations in excess of the capital expenditures needed to maintain and build plant capacity.

esExpenditur Capital

Operations Continuing fromFlow CashEx Flow/Cap Cash Operating


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Analysis of Growth Potential

• Investors are concerned about growth potential because a firm’s value depends on its ability to grow its earnings and dividends.

• Creditors are concerned about growth potential because a firm’s future success is a major determinant in its ability to pay future obligations.

• Growth depends on two factors, (1) the amount of resources retained and reinvested in the entity and (2) the rate of return earned on the retained resources.


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Analysis of Growth Potential, cont.

• The firm’s growth potential is defined as:

• This is sometimes called the sustainable growth rate. It assumes a constant debt to equity ratio.

• The retention rate is defined as:

• We will use this growth rate later when trying to value the equity of firms.

equity on returnrate retentiong

taxes after Income Operating

declared dividends-1rate retention


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External Market Liquidity

• Market liquidity is defined as the ability to buy or sell an asset quickly with little price change from the prior transaction.– Liquidity relates to the ease with which one can

convert an asset into cash or convert cash into an asset.

• Hence, shares of Microsoft are highly liquid while a stamp collection (or shares of Berkshire Hathaway Inc.) may not be.


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External Market Liquidity, cont.

• High trading volumes and low bid-ask spreads imply liquidity.– The bid-ask spread is the difference between the

price paid to purchase a security and the price received for selling a security (bid < ask).

• Another measure of liquidity is trading turnover.– Trading turnover is the percentage of shares

outstanding traded during a period of time.


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The Pitfalls of Ratio Analysis

• Ratios provide a convenient way to analyze a firm from a financial perspective.

• This approach is not without problems though.– A good analyst needs to be wary of some issues that

can affect the interpretation of a set of financial ratios.


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Financial Statements and Inflation

• Virtually no allowances are made for inflation in the actual statements themselves.– Some mention of it may be found in the notes or in

the “Management’s Discussion and Analysis” but the numbers reported in the statements have no “correction” for inflation.

• The primary areas inflation may affect include– interest expense,– inventory valuation, and– depreciation calculation.


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Economic Assumptions of Ratio Analysis

• An implicit assumption in (most of) ratio analysis is that size is not important.We make a proportionality assumption.

• We know that this is assumption is not really reasonable though.– Economies of scale (or other factors) often exist

causing a nonlinear relationship between the numerator and denominator of a financial ratio.

– If output doubles, do we expect total costs to double? If output then doubles again, do we expect total costs to then double again? etc.


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Benchmark Issues for Ratio Analysis

• A ratio, by itself, doesn’t tell us much. We need to compare the ratio to something.– Perhaps the same ratio for a competitor, perhaps the

same ratio for the firm from last year, etc.– The comparison must be an appropriate one.

• An appropriate benchmark is determined by the needs of the analyst.– Lenders may wish to see certain firm traits or

characteristics that an equity investor might not like.


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Timing Issues for Ratio Analysis

• In the U.S., firms are only required to periodically report financial information (four times a year). It’s worse outside of the U.S.

• The times when financial information is reported may not correspond to times of regular operations for a firm.

• Or, knowing that analysts use key ratios in making an investment recommendation, managers may have an incentive to try to manipulate the reported figures (to the extent that GAAP will allow).


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Negative Numbers and Ratio Analysis

• Often times a ratio has little (if any) meaning if the numerator and denominator have a different sign (i.e., a positive numerator and a negative denominator or vice versa).

• Or, if both the numerator and denominator are negative a ratio may lead the analyst to a false conclusion.


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Accounting Methods and Ratio Analysis

• As the numbers reported in the financial statement package are affected by various accounting methods employed, any ratios computed using those numbers are also affected by the various accounting methods employed.

The analyst must try to disentangle the effects of accounting method choices on financial ratios and financial statement analysis in general.


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Financial Statement Analysis vs. Efficient Capital Markets

• A general description of an efficient market is one in which, on average, asset prices immediately reflect changes in underlying economic variables (i.e., market participants are smart/rational).– Most (but not all) people/investors believe in some

degree of market efficiency.

• By nature, the financial statement package contains historical information. So …


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Financial Statement Analysis vs. Efficient Capital Markets, cont.

• Question: If capital markets are believed to be efficient, why analyze a set of publicly available documents about a firm (that, by their very nature, contain “stale” information)?

• Possible answers:(1) Someone must perform the analysis in order for the market to initially react to the information contained in the financial statements.(2) Markets might be efficient on average in the aggregate but temporarily inefficient at the individual firm level.


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Financial Statement Analysis vs. Efficient Capital Markets, cont.

• Possible answers, cont.

(3) Financial statements may potentially be biased views (even in accordance with GAAP) of a firm’s performance if managers have incentives to make them so.

The Quality of Earnings may actually be poor even if the firm reports profits.

(4) There are other needs for financial statement analysis aside from investing in publicly traded common stocks (bank lending, credit analysis, etc.)

Documents

Chapter 4 Organization and Functioning of Securities Markets