Chapter 13

Financial
Statement
Analysis

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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.

13-2
 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.

13-3

Overview

GAAP does not define ratios.

Multiple equally valid approaches to ratios and
analysis.
Managers (e.g. division manager, sales
manager) should be measured to items that they
control.
Investors and top management are most
interested in overall performance or broadest
measures of performance.
Understanding less broad measures of performance
may give additional insight into overall performance
13-4
 Structure of analysis
From broadest to more specific levels.
Principal value of financial analysis:
Suggests questions not answers.
Ratio comparisons start with supposition that all
other things are equal. (They rarely are.)

13-5

Categories of ratios which

measure:
Overall performance.
Profitability.
Investment utilization.
Financial condition.
Dividend policy.

13-6
 Making comparisons
Finding the appropriate standard is
difficult.
A high ratio (e.g. current ratio, ROI) may
be good or bad. It cant 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, or trend analysis.
13-7

Overall Measures
Return on investment (ROI) = net income /
investment
Possible definitions of investment: assets,
owners equity, invested capital.
Possible definitions of return: net income, net
income -preferred dividends, net income +
interest expense (1-tax rate).
Use income generated from pool of funds
before considering cost of funds in pool.

13-8
 Return on assets (ROA)
(net income + interest*(1-tax rate))/ total
assets.
How well management is using a pool of
capital .
Before considering financing decisions. Some
analysts ignore interest adjustment.
Measures how an enterprise uses its funds.
May be used to evaluate individual business units
in a large company when managers do not
influence financing decision (i.e. how assets are
financed).
13-9

Return on shareholders
equity (ROE)
Net income/shareholders equity.
Or, (net income -preferred dividends) /
Common shareholders equity.
Common shareholders equity = total
shareholders equity - preferred stock.
Reflects return on funds invested by
shareholders.
Of interest to current and prospective
shareholders.

13-10
 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 + non-
current assets.
Return on funds entrusted to the firm for
relatively long time.

13-11

Variations
Average or weighted average investment
is more representative (e.g. (beginning +
ending) 2).
Tangible assets instead of total assets.
To determine tax rate, can use total tax
rate or tax rate excluding deferred taxes.

13-12
 Relationship of ROE to Profit
Margin, Asset TO & Leverage
ROE can be viewed as:
Pretax margin percentage X Asset Turnover ratio
X Financial leverage ratio X Tax retention rate.
ROE =
(Pretax profit/sales revenue) X (sales revenues /
total assets) X (Total assets/Shareholders
equity) X (1- Tax rate)
How do we improve ROE?

13-13

Price/Earnings (PE) ratio

Measure of overall performance.
Market price per share/EPS
Market price is not controlled by company;
reflects all information available to the
market.
Reflects how investors judge future
performance or prospects of the company.
Commonly compared to other companies in
same industry.
13-14
 Earnings per share
Company ABC has an EPS of $5 per
share, Company XYZ has an EPS of $10
per share.
Is one a better company or investment
than the other? Is one more profitable
than the other?

13-15

Profitability measures
Profit margin = net income/net sales = a
measure of overall profitability.
Common size financial statements =
Vertical analysis:
Express each item on the income statement
as a percentage of net sales.

13-16
 Investment utilization
measures
How well are assets managed.
Profitability measures focus on Income
Statement.
Investment utilization measures involve
balance sheet and income statement
amounts.

13-17

Investment turnover
Asset turnover = Sales revenue/total
assets.
Invested capital turnover = Sales
revenue/invested capital.
Equity turnover = Sales
revenue/shareholders equity.

13-18
 Capital intensity
Less encompassing than investment
turnover.
Capital intensity ratio = sales revenue/PPE
= fixed asset turnover.

13-19

Working capital measures

Days cash = cash/cash costs per day =
cash/(cash expenses 365)
Cash expenses = total expenses -
depreciation - other non-cash expenses.
Days receivables = Receivables/(sales
365)
Days inventory = inventory/(cost of
goods sold 365)
Inventory turnover = cost of goods
sold/inventory 13-20
 Working capital measures
Days payables = operating
payables/(pretax cash expenses 365).
Approximate pre-tax cash expenses = all
expenses except taxes - 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).
13-21

Cash conversion cycle

Receivables conversion period (i.e. days
receivables) + inventory conversion period
(i.e. days inventory) - payment deferral
period (i.e. days payables) = operating
cycle - payment deferral period.
A measure of liquidity.
Indicates time interval for which additional
short-term financing might be needed to
support a spurt in sales.
13-22
 Financial condition ratios
Liquidity.
Solvency.

13-23

Liquidity
Ability to meet current obligations.
Tests for size and relationship between
current liabilities and current assets.
Liquidity measures:
Current ratio = current assets/current
liabilities.
Acid Test (or quick) ratio = monetary current
assets / current liabilities
Monetary current assets = current assets -
inventory - prepaid assets.
13-24
 Solvency
Ability to meet interest costs and
repayment schedules associated with
long-term debt.
Solvency measures
Debt/equity ratio = total
liabilities/shareholders equity
Alternatively, Debt/equity ratio = long-term
liabilities/shareholders equity.
Debt/capitalization ratio = long-term debt/total
invested capital.
13-25

Solvency Measures
(Continued)
Total invested capital = long term debt +
shareholders equity.
Times interest earned = income before
interest/interest expense
Ratio of Cash generated by operations to
total debt

13-26
 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.

13-27

Dividend yield vs. interest

yield on bonds
Not a valid comparison.
Investors return on bonds kept to maturity:
Interest (adjusted for amortization of
premium/discount).
Investors return on common stock:
Dividends + change in share price.
Function of expected future earnings.
Earnings reinvested in business.

13-28
 Growth measures

Key accounting items for which growth

is computed: sales, net income,
earnings per share.
Average growth = (growth per year for
n years)/n
Compound growth rate = based on
present value concepts.
May be misleading due to abnormally high
or low beginning or ending year.
13-29

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.

13-30
 Bases for comparison

Experience. A feel for what is right or

reasonable.
Budget. A target developed within the
company. Factors to be considered:
How carefully was budget constructed?
What circumstances are different now?
Historical standards. Prior periods results
adjusted for changes in accounting methods.
External benchmarks. Competitor, industry
average
13-31

Comments on Ratio Analysis

Helps paint a picture.
Try to overcome tendency to look at
numbers rather than underlying reasons.
Starting point; identifies questions not
answers.

13-32
 Chapter 13

End of
Chapter 13

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.