Overview of Financial Analysis

I had better sell that stock ASAP!

o SPECIFY THE OBJECTIVES OF THE ANALYSIS o Focus on who is the financial statement user o The identity of the user helps define what information is needed
The companys return on equity has dipped considerably over the last period

Financial

Steps of a F/S Analysis

1. Establish objectives of the analysis 2. Study the industry and relate industry climate to current and projected economic developments o o o a growth industry? a dying industry? a changing industry?

1. Develop knowledge of firm and quality of management 2. Evaluate financial statements using basic tools 3. Summarize findings 4. Reach conclusions relevant to established objectives

Potential Financial Statement Users: o Creditors o Investors o Managers o Who else? o What types of questions do each of these users seek answers to?

Data sources
o o o o o o Financial statements (and notes) Auditors report MD&A Supplementary schedules 10K and 10Q reports filed with SEC Computerized data bases
o Info on industry norms/ratios o Info on particular companies/industries/mutual funds

o Articles in popular/business press o Websites

Tools for analysis

o Common size financial statements o Financial ratios o Trend analysis o Structural analysis o Industry comparisons o Common sense and judgment

o Liquidity Ratios

Financial Ratio Categories

measure a firms ability to meet cash needs as they arise

o Activity Ratios
measure the liquidity of specific assets and the efficiency of managing assets

o Leverage Ratios

Ratio Categories (continued)

measure the extent of a firms financing with debt relative to equity and its ability to cover interest and other fixed charges

o Profitability Ratios
measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity

Caution!
o Ratios are valuable, BUT..
o They do not provide answers in an of themselves and are not predictive o They should be used with other elements of financial analysis o There are no rules of thumb that apply to interpretation of ratios

Profitability Ratios
o Gross Profit Margin Gross Profit/Net Sales o Operating Profit Margin Operating Profit/Net Sales o Net Profit Margin Net Earnings/Net Sales o All measure firms ability to translate sales dollars into profits

Profitability Ratios (continued)

Net Earnings/Total Assets

o Return on Investment (or Return on Assets) o Return on Equity

Net Earnings/Stockholders Equity

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

Return on Investment
o Return on Investment (ROI) Net Operating
RO = I

Income Average Operating Assets

o Net operating income o Income before interest and taxes o Operating assets o Assets held for operating purposes ONLY o i.e. cash, accounts
2005 KD Hatheway-Dial

Understanding ROI
RO = Margi X Turnov I n er Operating = Margin Turnov = er Net Operating Income Sales Sales Average Operating Assets

2005 KD Hatheway-Dial

Understanding ROI
12.5 = % 5% = 2. = 5 5 % X 2.5 $10,000 $200,000 $200,000 $80,000

X 10 0

2005 KD Hatheway-Dial

APPLYING ROI
10% Increased Sales without Any Increase in Operating Assets (assume 6% increase in operating expenses) 23.25 = 8.454 X 2.75 % 86% increase with 5 10% increase in
sales

8.454 = 5 2.75 =

$18,600 $220,000 $220,000 $80,000

X 10 0

2005 KD Hatheway-Dial

APPLYING ROI
10% Decrease in operating expenses and no change in sales 36.25 = 14.5% X 2.50 % 190% increase with 10% decrease in operating
expenses

14.5% = 2.50 =

$29,000 $200,000 $200,000 $80,000

X 10 0

2005 KD Hatheway-Dial

APPLYING ROI
10% Decrease in operating assets and no change in sales or operating expenses 13.90 = 5.0% X 2.78 % 11.2% increase with 10% decrease in operating
assets

5.0%

$10,000 $200,000 $200,000 $72,000

X 10 0

2.78 =

2005 KD Hatheway-Dial

APPLYING ROI
10% increase in operating assets and 5% change in sales and 3% operating expenses 16.25 = 6.8% X 2.39 % 30% increase with 10% decrease in operating
assets

6.8 = %

$14,300 $210,000 $210,000 $88,000

X 10 0

2.39 =

2005 KD Hatheway-Dial

Profitability Ratios (continued)

o Cash Flow Margin
Cash Flow from Operating Activities /Net Sales Measures ability to translate sales into cash (with which to pay bills)

o Cash Return on Assets

Profitability Ratios (continued)

Cash Flow from Operating Activities /Total Assets Useful comparison to return on investment Indicates firms ability to generate cash from utilizing its assets

Liquidity Ratios
o Current Ratio
Current Assets/Current Liabilities Measures ability to meet short-term cash needs

o Quick or Acid Test Ratio

Current Assets-Inventory/Current Liabilities Measure ability to meet short-term cash needs more rigorously

o Cash Flow Liquidity Ratio

Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities Focuses on ability of the firm to generate operating cash flows as a source of

Activity Ratios
o Average Collection Period
Accounts Receivable/Average Daily Sales Helps gauge liquidity of accounts receivable (ability to collect cash from customers)

o Accounts Receivable Turnover

Net Sales/Accounts Receivable Another measure of efficiency of firms collection and credit policies

o Inventory Turnover

Activity Ratios (continued)

Cost of Goods Sold/Inventory Measures efficiency of inventory management

o Fixed Asset and Total Asset Turnover

Net Sales/Net PP&E (Fixed Asset T/O) Net Sales/Total Assets (Total Asset T/O) Both assess effectiveness in generating sales from investment in assets

Leverage: Debt Ratios

o Debt Ratio
Total Liabilities/Total Assets

o Long-Term Debt to Total Capitalization

Long-term Debt/Long-term Debt + Stockholders Equity

o Debt to Equity Ratio

Total Liabilities/Stockholders Equity

o All three measure extent of firms financing with debt

Leverage: Coverage Ratios

o Proportion and amount of debt in capital structure is important to analyst o Tradeoff between risk and return o Use of debt involves risk -commitment to fixed charges o Fixed charges must be COVERED -- following are some ratios to assess

o Times Interest Earned

Coverage Ratios (continued)

Operating Profit/Interest Expense Indicates how well operating earnings cover fixed interest charges

o Fixed Charge Coverage

Operating Profit + Lease Payments/Interest Expense + Lease Payments Broader measure of how well operating earnings cover fixed charges

o Cash Flow Adequacy

Coverage Ratios (continued)

Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities Measures firms ability to cover long-term debt maturities each year Rationale is that over the longrun operating cash flows must be adequate to cover investing activities financed with debt

Other Ratios
o Earnings per Common Share
Net Earnings/Average Common Shares Outstanding Indicates return on a per share basis

o Price to Earnings
Market Price of Common Stock/Earnings per Common Share Expresses a multiple the stock market places on earnings

Other Ratios (continued)

o Dividend Payout
Dividends per Share/Earnings per Share Shows percentage of earnings paid out to stockholders

o Dividend Yield
Dividends per Share/Market Price of Common Share Shows rate earned by shareholders from dividends relative to current stock price