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Financial Statement Analysis
Relationship to previous material
· Focus has been:
· What goes into 3 basic financial statements (Income Statement, Balance sheet, Statement of Cash Flows).
· Now focus is:
· How statements are analyzed by management, investors, and creditors.
Objective of a Business
• Create value for its shareholders while maintaining a sound financial position. • Return on investment. • Sound financial position. • Other important objectives include:
– Employee satisfaction. – Social responsibility. – Ethical considerations.
· Investors and top management are most interested in overall performance or broadest measures of performance. sales manager) should be measured to items that they control. · Managers (e.g. · Multiple equally valid approaches to ratios and analysis. · Understanding less broad measures of performance may give additional insight into overall performance 1-4 . division manager.Overview · GAAP does not define ratios.
· Principal value of financial analysis: · Suggests questions not answers.Structure of analysis • From broadest to more specific levels.) 1-5 . · Ratio comparisons start with supposition that all other things are equal. (They rarely are.
Investment utilization. Dividend policy. Financial condition. 1-6 .Categories of ratios which measure: • • • • • Overall performance. Profitability.
Making comparisons · Finding the appropriate standard is difficult. or trend analysis. ROI) may be good or bad. It can’t be viewed in isolation. · Is a high CR good or bad? · Is a high ROI always good? · Values of ratios compared across time ® longitudinal analysis.g. 1-7 . current ratio. · A high ratio (e.
Overall Measures • Return on investment (ROI) = net income / investment · Possible definitions of investment: assets. net income -preferred dividends. net income + interest expense (1-tax rate). · Possible definitions of return: net income. invested capital. 1-8 . · Use income generated from pool of funds before considering cost of funds in pool. owners’ equity.
1-9 . · How well management is using a pool of capital . how assets are financed). · May be used to evaluate individual business units in a large company when managers do not influence financing decision (i.Return on assets (ROA) · (net income + interest*(1-tax rate))/ total assets.e. · Measures how an enterprise uses its funds. Some analysts ignore interest adjustment. · Before considering financing decisions.
(net income -preferred dividends) / Common shareholders’ equity. · Common shareholders’ equity = total shareholders’ equity .preferred stock. 1-10 . · Or. · Of interest to current and prospective shareholders.Return on shareholders’ equity (ROE) · Net income/shareholders’ equity. · Reflects return on funds invested by shareholders.
· Return on funds entrusted to the firm for relatively long time.Return on invested capital (ROIC) · (net income + interest(1-tax rate))/ invested capital · Invested capital = permanent capital = capital employed = long-term liabilities + shareholders’ equity = working capital + noncurrent assets. 1-11 .
(beginning + ending) ¸ 2). can use total tax rate or tax rate excluding deferred taxes. · To determine tax rate.Variations · Average or weighted average investment is more representative (e.g. · Tangible assets instead of total assets. 1-12 .
· ROE = (Pretax profit/sales revenue) X (sales revenues / total assets) X (Total assets/Shareholders’ equity) X (1.Tax rate) · How do we improve ROE? 1-13 . Asset TO & Leverage • ROE can be viewed as: Pretax margin percentage X Asset Turnover ratio X Financial leverage ratio X Tax retention rate.Relationship of ROE to Profit Margin.
• Reflects how investors judge future performance or prospects of the company. • Market price per share/EPS • Market price is not controlled by company. reflects all information available to the market. 1-14 .Price/Earnings (PE) ratio • Measure of overall performance. • Commonly compared to other companies in same industry.
• Is one a better company or investment than the other? Is one more profitable than the other? 1-15 .Earnings per share • Company ABC has an EPS of $5 per share. Company XYZ has an EPS of $10 per share.
1-16 . · Common size financial statements = Vertical analysis: · Express each item on the income statement as a percentage of net sales.Profitability measures · Profit margin = net income/net sales = a measure of overall profitability.
• Investment utilization measures involve balance sheet and income statement amounts. 1-17 . • Profitability measures focus on Income Statement.Investment utilization measures • How well are assets managed.
1-18 .Investment turnover · Asset turnover = Sales revenue/total assets. · Equity turnover = Sales revenue/shareholders’ equity. · Invested capital turnover = Sales revenue/invested capital.
Capital intensity · Less encompassing than investment turnover. 1-19 . · Capital intensity ratio = sales revenue/PPE = fixed asset turnover.
other non-cash expenses.Working capital measures · Days’ cash = cash/cash costs per day = cash/(cash expenses ¸ 365) · Cash expenses = total expenses depreciation . · Days’ receivables = Receivables/(sales ¸ 365) · Days’ inventory = inventory/(cost of goods sold ¸ 365) · Inventory turnover = cost of goods sold/inventory 1-20 .
Working capital measures · Days’ payables = operating payables/(pretax cash expenses ¸ 365).depreciation expense. · Working capital turnover = sales revenue/ working capital · Some analysts look at ratio of working capital to sales revenue (inverse of working capital turnover). · Approximate pre-tax cash expenses = all expenses except taxes . 1-21 .
1-22 . · A measure of liquidity.payment deferral period (i.e.e.e.Cash conversion cycle · Receivables conversion period (i. · Indicates time interval for which additional short-term financing might be needed to support a spurt in sales.payment deferral period. days’ receivables) + inventory conversion period (i. days’ payables) = operating cycle . days’ inventory) .
• Solvency.Financial condition ratios • Liquidity. 1-23 .
prepaid assets. 1-24 . · Tests for size and relationship between current liabilities and current assets. · Acid Test (or quick) ratio = monetary current assets / current liabilities · Monetary current assets = current assets inventory . · Liquidity measures: · Current ratio = current assets/current liabilities.Liquidity · Ability to meet current obligations.
· Solvency measures · Debt/equity ratio = total liabilities/shareholders’ equity · Alternatively.Solvency · Ability to meet interest costs and repayment schedules associated with long-term debt. 1-25 . · Debt/capitalization ratio = long-term debt/total invested capital. Debt/equity ratio = long-term liabilities/shareholders’ equity.
· Times interest earned = income before interest/interest expense · Ratio of Cash generated by operations to total debt 1-26 .Solvency Measures (Continued) · Total invested capital = long term debt + shareholders’ equity.
1-27 .Dividend policy • Dividend yield = dividends per share/ market price per share · Dividend pay-out = dividends/net income · Provides info on how growth is financed. · Less dividends paid means more earnings are retained to fund growth.
· Investor’s return on bonds kept to maturity: · Interest (adjusted for amortization of premium/discount). · Investor’s return on common stock: · Dividends + change in share price. · Function of expected future earnings. interest yield on bonds · Not a valid comparison. 1-28 . · Earnings reinvested in business.Dividend yield vs.
· May be misleading due to abnormally high or low beginning or ending year.Growth measures • Key accounting items for which growth is computed: sales. earnings per share. net income. · Average growth = (ågrowth per year for n years)/n · Compound growth rate = based on present value concepts. 1-29 .
Implied growth rate =Return on shareholders’ equity X Profit retention rate = ROE X (1 – Dividend payout) • Estimates potential to grow profits without an injection of new capital. 1-30 .
A feel for what is right or reasonable. • External benchmarks. Prior period’s results adjusted for changes in accounting methods.Bases for comparison · Experience. industry average 1-31 . · Budget. Competitor. A target developed within the company. Factors to be considered: · How carefully was budget constructed? · What circumstances are different now? · Historical standards.
Comments on Ratio Analysis • Helps paint a picture. • Try to overcome tendency to look at numbers rather than underlying reasons. 1-32 . • Starting point. identifies questions not answers.
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