FINANCIAL STATEMENT ANALYSIS Understanding the financial statements of a firm is critical since it is often the only source of information

with which we must make investment decisions; i.e., whether or not to loan the company money or invest some equity. There is a rationale behind the construction of the financial statements that helps us to interpret the information that is contained within them. Income Statements: Less Less Rent (epreciation Utilities )perating *ncome *nterest +,pense Ta,able *ncome Ta,es 0et *ncome Revenues !ost of "oods #old "ross %rofit #alaries &dvertising #elling ' &dministrative $anufacturing

Less Less

-inance "overnment .Ta, accounting/

The income statement is broken down by functional area. This allows us to more accurately determine where our strengths or weaknesses lie. Balance Sheets &s with the income statement, the balance sheet is constructed in a very methodical manner. )n the &sset side, the assets are listed in order from the most liquid to the least liquid. #imilarly, on the Liability ' +quity side, the accounts are listed in order from the most immediately due to the least.

!ash $arketable #ecurities &ccounts Receivable *nventory

&ccounts %ayable 1ages %ayable 2ank 0ote %ayable !urrent %ortion of L3T (ebt

%repaid +,penses Total !urrent &ssets %lant ' +quipment .&ccumulated (epr./ 0et %lant ' +quip. Total &ssets Statement of Cash Flows

Total !urrent Liabilities Long3Term (ebt !ommon #tock Retained +arnings Total Liabilities ' +quity

-rom a financial perspective, the #tatement of !ash -lows is the most important financial statement because it integrates the *ncome #tatement and 2alance sheet while ad4usting the accounting figures based upon accrual accounting into actual cash flow. -rom )perations %lus %lus %lus %lus 0et *ncome (epreciation &morti5ation )perating !ash -low !hanges in 0on3!ash !urrent &ssets !hanges in )perations3related !urrent Liabilities Total -rom )perations

-rom *nvesting &ctivities !hanges *n "ross -i,ed &ssets %lus !hanges in )ther 0on3!urrent &ssets Total -rom *nvesting &ctivities -rom -inancing &ctivities !hanges in 0on3)perations3related current liabilities %lus !hanges in Long3Term (ebt %lus !hanges in )ther !apital &ccounts .e,cept Retained +arnings/ Less (ividends %aid Total -rom -inancing &ctivities Total !hange in !ash %lus 2eginning !ash 2alance +nding !ash 2alance

COMMON SIZE INCOME STATEMENTS &ll *tems +,pressed as a %ercentage of Revenues.

COMMON SIZE BALANCE SHEETS &ll &ccounts +,pressed as a %ercentage of Total &ssets. 1hat6s the purpose of calculating !ommon3#i5ed statements7 purposes./ FINANCIAL RATIOS The financial statements are often the only information upon which to base an investment decision .as an equityholder or a lender/, so it is imperative that we be able to determine what economic information the statements contain. -inancial Ratios are used as tools to help us squee5e as much information as possible from the financial statements. *t must be kept in mind, however, that a financial ratio is only one number divided by another and only yields a number. The ratio takes on meaning when compared with other firms or industry averages .a static analysis/ or when compared with previous periods for trends to see if a firm6s position is improving or deteriorating .a dynamic analysis/. The ratios must also be taken together as a group 8 if a ratio appears to be 9higher: than it normally is, it can be due to the numerator being large )R the denominator being small. 2y looking at other ratios we can determine which is the case. Liquidity Ratios Liquidity ratios are designed to measure the e,tent to which our short3term, or liquid, assets e,ist to cover our short3term obligations. 1hile most ratios have definitions that vary .and, hence, one must be certain that the appropriate definition is being used for comparison purposes/, the definition of the !urrent Ratio is standard Current Ratio = Total Current Assets Total Current Liabilities .!omparison

The current ratio is looking at those assets that are e,pected to be converted into cash with one year, relative to those liabilities that come due within a year. & more stringent measure is the ;uick .or &cid Test/ Ratio. This ratio recogni5es that some current assets are more liquid than others. 1hile the book defines the quick ratio6s numerator as being the !urrent &ssets less *nventories, the general definition used in practice e,cludes other current assets that are not liquid in nature, such as prepaid e,penses.

The idea behind e,cluding inventories is twofold first, inventories are generally illiquid and can only be converted into cash by selling at steep discounts. #econdly, most companies sell inventories on credit, so they become an account receivable which must then be collected. 2y e,cluding inventories, the quick ratio is therefore recogni5ing the fact that they are one step further removed from becoming cash than other current assets. Monetary Current Assets Total Current Liabilities

Quick (Acid Test) Ratio =

FINANCIAL LEVERAGE The ne,t set of financial ratios is designed to e,amine the e,tent to which a company utili5es debt in the financing of its assets. The use of debt is referred to as financial leverage. -irst, let6s look at the effect of financial leverage on a firm. !onsider a company that has three different possible debt financing strategies, ranging from no debt to <=> debt. &lso, let6s assume that the interest rate on any debt employed is ?=> and that the firm has a ta, rate of @=>. *nterest Rate A ?=> Ta, Rate A @=> ? AAA = ?,=== 33333333 ?,=== B AAA D== D== 33333333 ?,=== C AAA <== ?== 33333333 ?,===

(+2T +;U*TE T)T&L &##+T#

#ince the effect of financing doesn6t appear until we go below the )perating *ncome .+2*T/ line, we can 4ump straight down to the operating income to analy5e the effect of financial leverage. &ssume that the +2*T is F?@= for the firm; then, the calculation of 0et *ncome, and the rate of return that the 0et *ncome represents on the equity invested, are as follows +2*T 3 *0T T&G. *0!. 3 T&G 0+T *0!)$+ R)+ A ?@= = 33333333 ?@= .DH/ 33333333 I@ I.@> ?@= .D=/ 33333333 <= .CH/ 33333333 D@ ?=.I> ?@= .<=/ 33333333 D= .B=/ 33333333 C= C=.=>

0otice that the Return on +quity is magnified by the use of debt, and that the more the debt that is employed, the greater the magnification. The profits of the firm can be greatly magnified through the use of debt. Leverage, however, is a two3edged sword. 0ot only are profits magnified, but also losses. !onsider the same firm when +2*T is only FH=

(+2T +;U*TE T)T&L &##+T# +2*T 3 *0T T&G. *0!. 3 T&G 0+T *0!)$+ R)+ A

? AAA = ?,=== 33333333 ?,=== H= = 33333333 H= .B@/ 33333333 CH C.H>

B AAA D== D== 33333333 ?,=== H= .D=/ 33333333 ?= .@/ 33333333 H ?.B>

C AAA <== ?== 33333333 ?,=== H= .<=/ 33333333 .C=/ ?B 33333333 .?I/ 3?I.=>

0ow the use of debt results in lower profitability. -inancial leverage magnifies both profits and losses 8 in other words, it magnifies the risk of the company. -inancial leverage will be looked at in more detail later. -or now, a basic understanding of the effect of leverage is sufficient; but let6s look at some of the ratios designed to measure the e,tent to which a company utili5es debt, and 4ust how well it can manage its debt. Levera e !So"ve#$y% Ratios The (ebt3to3&ssets Ratio looks at how much of a company6s assets are financed with debt; i.e., other people6s money. Debt / Asset Ratio = Total Debt Total Assets

& variation on the (ebt3to3&sset Ratio that is more commonly used in practice is the (ebt3to3+quity Ratio which simply e,presses the debt as a percentage of equity rather than total assets. The two measures are equivalent as indicated by the second part of the equation

Debt/"#uity Ratio =

Total Liabilities Net ort! D/A 1 - D/A

#ometimes it is desirable to break down the use of debt into short3term and long3term debt. 1hich type of debt do you think is more risky for the company to utili5e7 .To answer this, ask yourself whether you would prefer to buy a house using a one3year note that would have to be refinanced in twelve months, or a C=3year mortgage./ Current Liabs$ to Net ort! = Total Current Liabilities Net ort!

Just as in accounting where changes in current liabilities are included as a part of operating cash flows .since accounts payable and accruals such as wages payable arise from operations/, sometimes only the long3term portions of debt are considered. This is because oftentimes a company is viable in the long3run but faces short3term liquidity problems .consider when the (emocrats and Republicans shut down the federal government for a few days in ?<<K/. The capitali5ation ratio looks at the long3 term debt financing that a company uses Ca%itali&ation Ratio = Lon' - ter( Debt Lon' - ter( Ca%ital

1hile short3term solvency is obviously important, the long3term aspects are relevant for long3term debtLinvestment considerations. 1hile the preceding measures of the e,tent to which a company uses debt to finance its assets are important, what is probably of more concern is the ability of the company to service its debt. The following ratios look at the ability of the company to make debt service payments to its creditors. The most common of these, particularly when only the financial statements are available, is the Times *nterest +arned ratio Ti(es )nterest "arned = "*)T )nterest "+%ense

$ore important to many lenders is the ability of the company to not only make interest payments, but also to repay the principal of the loan. The (ebt #ervice !overage Ratio considers both interest and principal payments that are required. 0ote that the principal portion is 9grossed up: to account for ta, considerations. 1hy7 Debt ,er-ice Co-era'e = "*)T /rinci%al /y(t$ )nt$ "+%$ . 1- t

-inally, it is common for lenders .such as banks/ to look more toward the cash flow coverage of debt payments that a company can make. -or this reason, the )perating *ncome .+2*T/ has the non3cash charges of (epreciation and &morti5ation added back .4ust like they are in the )perating !ash -low section of the #tatement of !ash -lows/. Cas! Co-era'e = "*)T . De%reciation 0 A(orti&ation )nterest "+%ense "*)TDA )nterest "+%ense

Asset Ma#a e&e#t !'ti"i(atio#% Ratios &sset utili5ation ratios are designed to give insight into how effectively a company is managing its assets. -or many firms, inventories are its largest category of assets. 1hy is it bad to have too much inventory7 1hy is it bad to have too little7 )ne way to look at the amount of assets that a firm holds in relation to its level of sales is the inventory turnover ratio )n-entory Turno-er = Cost 12 3oods ,old )n-entory

The inventory turnover ratio can, alternatively, be stated as the &verage &ge of *nventory; i.e., how long on average does an inventory item sit in the warehouse before it is sold A-era'e A'e o2 )n-entory = )n-entory C13, / 456

The second ma4or category, at least of current assets, for most firms is the amount of money that is tied3up in &ccounts Receivable. The &verage !ollection %eriod .or (ays6 #ales )utstanding/ tells you how long, on average, it takes for a firm to collect the money due on a sale made on credit A-era'e Collection /eriod (Days7 ,ales 1utstandin') = Accounts Recei-able ,ales / 456

The final ma4or category of assets, particularly manufacturing firms, is that of %roperty, %lant ' +quipment, or -i,ed &ssets. The -i,ed &sset Turnover ratio looks at the amount of productive equipment that a firm has relative to the amount of sales that it is generating. *n one sense, this could be interpreted as a measure of the amount of capacity utili5ation that a firm has. 1hat problems do you see with this measure7

8i+ed Asset Turno-er =

,ales Net 8i+ed Assets

& final measure looks at all of the firm6s investment in assets relative to its sales level. This is the Total &sset Turnover ratio Total Asset Turno-er = ,ales Total Assets

)ro*ita+i"ity Ratios )ne of the best measures for evaluating management lies in their ability to control costs. Thus, profit margins are an important means of assessing this ability 3ross /ro2it Mar'in = 3ross /ro2it ,ales 1%eratin' )nco(e ,ales

1%eratin' /ro2it Mar'in =

Net /ro2it Mar'in =

Net )nco(e ,ales

&nother important factor has to do with the amount of profit being made relative to the investment in assets that support the operations and sales. 0ote that this ratio can be decomposed into the 0et %rofit $argin and the Total &sset Turnover. This has two important implications -irst, it illustrates that there are two ways to make money 8 have a high profit margin and a low turnover rate, or a low profit margin and a high turnover rate. #econdly, it provides us a means by which to determine where problems, or strengths, reside. *f the net R)& is low, is it because we are not controlling costs .in which case, is it in production, selling and administrative, or financing costs/, or is it because we have too many assets relative to sales .such as too much inventory, too long a collection period, too many unutili5ed fi,ed assets/. This approach to locating the source.s/ of the problems is known as the (u%ont method of analysis. Eour te,tbook gives you an e,ample of its implementation.

Net Return on Assets =

Net )nco(e Total Assets

= Net /ro2it Mar'in 9 Total Asset Turno-er Net )nco(e ,ales 9 ,ales Total Assets

-inally, equity investors are concerned with the rate of return that is being generated on their investment in the company. Return on "#uity = Net )nco(e Net ort! Net R1A 1- D / A Total Assets Total "#uity

= Net R1A 9

Mar,et Ratios The last group of ratios is designed to look at market3related measures of performance "arnin's %er ,!are (*asic) = Net )nco(e Total No$ o2 ,!ares 1utstandin' Net )nco(e Total /ossible ,!ares 1utstandin'

"arnin's %er ,!are (8ully Diluted) =

/rice / "arnin's Ratio = or / Di-$/"arn$ = " k, - '

Market /rice / s!are "arnin's %er ,!are

A#ot-er Liquidity Measure )ne problem with the !urrent and ;uick Ratios as measures of liquidity is the fact that they are predicated upon the liquidation of the current assets of the firm in order to satisfy the short3term liabilities. "enerally, however, one is not interested in liquidating a firm in order to cover its short3term obligations .e,cept in e,treme cases/. -or this reason, the cash cycle is often looked at in order to see the e,tent to which the ongoing operations of the firm cover short3term requirements .primarily in the area of accruals and payables/. *n order to calculate the cash cycle, we need to look at a measure of the short3term liability encompassed by the trade credit that our supplier provide to us A-era'e A'e o2 /ayables = Accounts /ayable C13, / 456

The cash cycle looks at how long a company has money tied3up in its operations. $oney is invested in inventories, which sit in the warehouse for a certain period of time and then are sold on credit which takes so3long to collect; but this length of time .known as the operating cycle/ is reduced by the fact that our suppliers do not require immediate payment for the inventories that we purchase. Cas! Cycle = A-era'e A'e o2 )n-entory . A-era'e Collection /eriod - A-era'e A'e o2 /ayables 1hile a short cash cycle is considered to be an efficient use of money, what are the dangers of having ?/ & low average age of inventory B/ & short average collection period C/ & long average payables period The firm6s cash cycle is looking at how long, and hence, how much, cash is tied up. (ecreasing the cash cycle decreases the amount of cash investment is required. &s will be seen when working capital is addressed, cash can be free3up by accelerating inflows .shortening the average collection period/ or delaying outflows .stretching out the average payables period/ as well as by liquidating assets such as inventory .and increasing inventory turnover which is the same as decreasing the average age of inventory/. I#dustry Avera es *ndustry averages are often used for comparison purposes. The two most popular sources of industry averages are R$&6s Annual Statement Studies and (un ' 2radstreet6s Key Business Ratios. R$& is an association of banks that pool loan data and (un ' 2radstreet is the well3known credit rating agency. *ndustry averages can

also be obtained from #tandard ' %oor6s and $oody6s, the two premier bond rating agencies.