Financial Statement Analysis

Curriculum designed for use with the Iowa Electronic Markets

by

Cynthia J. Brown Marilyn M. Dutton Thomas A. Rietz

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Financial Statement Analysis: Lecture Outline

Review of Financial Statements Ratios

Types of Ratios Examples

The DuPont Method Ratios and Growth Summary

Strengths Weaknesses Ratios and Forecasting

Stock Price
Expected Cashflows NPV MVA EVA Market Conditions

Timing of Cashflows

Stock Price

Risk of Cashflows

Financial Analysis

Assessment of the firms past, present and future financial conditions Done to find firms financial strengths and weaknesses Primary Tools:
Financial Statements Comparison of financial ratios to past, industry, sector and all firms
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Financial Statements
Balance Sheet Income Statement Cashflow Statement Statement of Retained Earnings

Sources of Data

Annual reports
Via mail, SEC or company websites

Published collections of data

e.g., Dun and Bradstreet or Robert Morris

Investment sites on the web

Examples

http://moneycentral.msn.com/investor http://www.marketguide.com
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The Main Idea

Value for the firm comes from cashflows Cashflows can be calculated as:
(Revt - Costt - Dept)x(1-t) + Dept OR (Revt - Costt)x(1-t) + txDept OR Revtx(1-t) - Costtx(1-t) + txDept
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Review: Major Balance Sheet Items

Assets Current assets:

Cash & securities Receivables Inventories

Liabilities and Equity Current liabilities:

Payables Short-term debt

Fixed assets:
Tangible assets Intangible assets

Long-term liabilities Shareholders' equity

An Example: Dell Abbreviated Balance Sheet

Assets:
Current Assets: Non-Current Assets: Total Assets: $7,681.00 $3,790.00 $11,471.00 $5,192.00 $971.00 $5,308.00 $11,471.00

Liabilities:
Current Liabilities: LT Debt & Other LT Liab.: Equity: Total Liab. and Equity:

Review: Major Income Statement Items

Gross Profit = Sales - Costs of Goods Sold EBITDA = Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the firms cashflows and, thus, the value of the firms shares
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An Example: Dell Abbreviated Income Statement

Sales Costs of Goods Sold Gross Profit Cash operating expense EBITDA Depreciation & Amortization Other Income (Net) EBIT Interest EBT Income Taxes Special Income/Charges Net Income (EAT) $25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00

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Objectives of Ratio Analysis

Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations

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Rationale Behind Ratio Analysis

A firm has resources It converts resources into profits through

production of goods and services sales of goods and services

Ratios
Measure relationships between resources and financial flows Show ways in which firms situation deviates from

Its own past Other firms The industry All firms13

Types of Ratios

Financial Ratios:
Liquidity Ratios

Assess ability to cover current obligations Assess ability to cover long term debt obligations

Leverage Ratios

Operational Ratios:
Activity (Turnover) Ratios

Assess amount of activity relative to amount of resources used Assess profits relative to amount of resources used Assess market price relative to assets or earnings

Profitability Ratios

Valuation Ratios:

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Liquidity Ratio Examples: Dell

Current Ratio:
Current Ratio : Current As sets $7,681.00 1.48 Current Liabilitie s $5,192.00

Quick (Acid Test) Ratio:

Current As sets - Inventorie s $7,681.00 $391.00 1.40 Current Liabilitie s $1,107,000

Acid Test Ratio :

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Ratio Comparison: Current Ratio

2.5 2

Current Ratio

1.5 1 0.5 0

Jan-96 Dell Industry 2.08 1.80

Jan-97 1.66 1.80

Jan-98 1.45 1.90

Jan-99 1.72 1.60

Jan-00 1.48

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Leverage Ratio Examples: Dell

Debt Ratio:
Total Liabilitie s $6,163.00 Debt Ratio : 53.73% Total Assets $11,471.00

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Ratio Comparison: Debt Ratio

0.8 0.7 0.6

Debt Ratio

0.5 0.4 0.3 0.2 0.1 0

Jan-96 Dell Industry 54.70% 62.96%

Jan-97 73.07% 60.00%

Jan-98 69.70% 52.38%

Jan-99 66.25% 62.96%

Jan-00 53.73%

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Profitability Ratio Examples: Dell

Return on Assets (ROA):

ROA : Net Income $1,666.00 14.52% Total Assets $11,471.00

Return on Equity (ROE):

ROE : Net Income $1,666.00 31.39% Total Common Equity $5,308.00
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Profitability Ratio Examples: Dell

Net Profit Margin:

EBIT $2,451.00 Net Profit Margin : 6.59% Sales $25,265.00

Retention Ratio
EPS - Div $0.66 $0 Retention Ratio ( ) : 100% EPS $0.66
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Ratio Comparison: ROE

80% 70% 60% 50% 40% 30% 20% 10% 0%

ROE

Jan-96 Dell Industry 28.13% 22.30%

Jan-97 64.27% 30.60%

Jan-98 73.01% 25.50%

Jan-99 62.90% 18.00%

Jan-00 31.39%

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Ratio Comparison: ROA

25% 20%

ROA

15% 10% 5% 0%

Jan-96 Dell Industry 12.66% 6.80%

Jan-97 17.31% 10.90%

Jan-98 22.12% 7.20%

Jan-99 21.23% 5.70%

Jan-00 14.52%

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Ratio Comparison: Profit Margin

9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

Profit Margin

Jan-96 Dell Industry 5.14% 3.40%

Jan-97 6.68% 4.74%

Jan-98 7.66% 3.79%

Jan-99 8.00% 2.85%

Jan-00 6.59%

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Activity (Turnover) Ratio Examples: Dell

Total Asset Turnover Ratio:

Total Asset Turnover : Sales $25,265.00 2.20 Total Assets $11,471.00

Inventory Turnover Ratio:

Sales $25,265.00 Inventory Turnover : 64.62 Inventory $391.00
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Ratio Comparison: Asset Turnover

350% 300%

Asset Turnover

250% 200% 150% 100% 50% 0%

Jan-96 Dell Industry 2.47 2.00

Jan-97 2.59 2.30

Jan-98 2.89 1.90

Jan-99 2.65 2.00

Jan-00 2.20

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The DuPont System

Method to breakdown ROE into:

ROA and Equity Multiplier

ROA is further broken down as:

Profit Margin and Asset Turnover

Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers
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The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

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The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

ROE ROA Equity Multiplier Net Income Total Assets Total Assets Common Equity
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The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

ROA Profit Margin Total Asset Turnover Net Income Sales Sales Total Assets
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The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

ROE Profit Margin Total Asset Turnover Equity Multiplier Net Income Sales Total Assets Sales Total Assets Common Equity
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The DuPont System: Dell

ROE Net Income Sales Total Assets Sales Total Assets Common Equity Profit Margin Total Asset Turnover Equity Multiplier ROA Equity Multiplier

$1,666.00 $25,265.00 $11,471.00 ROE $25,265.00 $11,471.00 $5,308.00 0.0659 2.2025 2.1611 0.1452 2.1611 31.39%
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A Note on Sustainable Growth and Stock Returns

In the long run

Sustainable growth and long run capital gains (g) = ROE x

Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D1/P0):
r = g + D1/P0 = g + Do(1+g)/P0

Note: r & g must be quarterly if D is quarterly and annual if D is annual

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Example: Predicted Sustainable Growth for Dell

Based on the most recent numbers:

ROE = 31.39% & = 100% g = 0.3139 x 1 = 31.39% r = 0.3139 + 0/P = 31.39%

Based on 5 year averages:

ROE = 51.94% & = 100% g = 0.5194 x 1 = 51.94% r = 0.3139 + 0/P = 51.94%

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Summary of Financial Ratios

Ratios help to:

Evaluate performance Structure analysis Show the connection between activities and performance

Benchmark with
Past for the company Industry

Ratios adjust for size differences

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Limitations of Ratio Analysis

A firms industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios

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Ratios and Forecasting

Common stock valuation based on

Expected cashflows to stockholders ROE and are major determinants of cashflows to stockholders

Ratios influence expectations by:

Showing where firm is now Providing context for current performance

Current information influences expectations by:

Showing developments that will alter future performance
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How Might Ratios Help Me on the IEM?

Analysis of AAPL, IBM and MSFT, and comparisons to the S&P500 companies can help to:
Assess the (absolute and relative) financial state of each company Show each companys strengths and weaknesses Predict sustainable growth rate

Combined with current information, this can help to:

Assess likely future performance Predict future valuation and earnings growth Predict returns
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