2. Financial Statement Analysis (Ch.

2)

Understanding key financial statements

Assessing a firm’s financial health using financial ratios

Firms’ Disclosure of Financial Information

Financial statements are accounting reports issued

periodically to present past performance and a snapshot
of the firm’s assets and the financing of those assets.

Investors, financial analysts, managers, and other

interested parties such as creditors rely on financial
statements to obtain reliable information about a
corporation.
 Firms’ Disclosure of Financial Information

Generally Accepted Accounting Principles (GAAP)

- Set by the Financial Accounting Standards Board (FASB) to provide a
common set of rules and a standard format for public companies’ reports.

International Financial Reporting Standards (IFRS)

- Set by the International Accounting Standards Board (IASB)
• Since 2005 all publicly traded European Union companies are required to follow
IFRS.
• Accepted by all major stock exchanges around the world except U.S. and Japan.
• In 2010, the US SEC affirmed its support of a single standard, with IFRS as the
preferred method.

Financial statements

Balance sheet
Income statement
The Statement of Cash Flows
Other Financial Statement Information
- Management Discussion and Analysis
• A preface to the financial statements in which the company’s management
discusses the recent year’s performance
- Statement of Changes in Shareholders’ Equity
- Notes to the Financial Statements

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 The Balance Sheet

Balance sheet - Financial statement that shows the value of the

firm’s assets and liabilities at a particular time.
(a snapshot of the firm!!)

- Assets: The left-hand side

• Current assets (e.g., cash, accounts receivable, inventory, …)
• Fixed assets (PPE)
– Tangible (e.g., Land, Property, Plants,…)
– Intangible (e.g., Trademark, Patents, …)

- Liabilities and Owners’ equity: The right-hand side

• Current liabilities (e.g., accounts payable, notes, …)
• Long-term debts (e.g., loans, bonds, …)
• Shareholders’ equity

Assets = Liabilities + Shareholders’ equity

The Balance Sheet

Global Corporation
Balance Sheet

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 Market versus Book Value

Stockholders’ Equity
- Book value of equity
- Net worth from an accounting perspective
- Assets – Liabilities = Equity
- True value of assets may be different from book value

Market capitalization
- Market price per share times number of shares
- Does not depend on historical cost of assets.

Market versus Book Value

Problem:
If Global has 3.6 million shares outstanding, and these shares
are trading for a price of $10 per share, what is Global’s market
capitalization?

How does the market capitalization compare to Global’s book

value of equity?

What are the possible sources of market values that do not

appear in the balance sheet?

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 Income Statement

Income Statement
Financial statement that shows the revenues and expenses, and
the difference between the two, which is the firm’s profit over a
period of time.
- Sometimes called the profit and loss statement, or “P&L.”

The Income Statement

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 Income Statement

Earnings Calculations
- Revenues (net sales)
- Cost of Sales = Gross Profit
- Operating Expenses = Operating Income
- +/- Other Income = Earnings Before Interest and Taxes
- +/- Interest income (expense) = Pretax Income
- - Taxes
- = Net Income

Note: Financial analysts often compute a firm’s earnings before interest, taxes, depreciation,
and amortization (EBITDA) because depreciation and amortization are not cash flows, this
subtotal reflects the cash a firm has earned from operations.

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The Statement of Cash Flows

The Statement of Cash Flows

Financial statement that determines how much cash the firms
has generated, and how that cash has been allocated, during a
set period.

- Operating activities
- Investment activities
- Financing activities

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 The Statement of Cash Flows

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Financial Ratios Analysis

Financial ratios are the relationships determined from a

firm’s financial information and used for comparison
purposes.

Questions related to the ratio analysis

How is it computed?
What is it intended to measure, and why might we be
interested?
What is the unit of measurement?
What might a high or low value be telling us? How might
such values be misleading?
How could this measure be improved?

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 Type of Financial Ratios

Leverage (gearing) ratios show how heavily the company

is in debt.

Liquidity ratios measure how easily the firm can lay its
hands on cash.

Efficiency (turnover) ratios measure how productively the

firm is using its assets.

Profitability ratios are used to measure the firm’s return on

its investments.

Valuation ratios can be calculated directly only for publicly

traded companies
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Leverage Ratios

total debt
Debt - equity ratio (gearing ratio) =
total equity

or
total debt total debt
Debt - capital ratio = =
total capital total debt + equity

total debt
Debt - assets ratio =
total assets

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 Leverage Ratios: coverage ratios

EBIT EBITDA
Interest coverage ratio = or
interest interest

Lenders often assess firm’s leverage by computing an interest coverage ratio.

It assesses how easily the firm will be able to cover its interest payments.

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Liquidity Ratios

Current assets
Current ratio =
Current liabilitie s

Current assets - Inventory

Quick ratio =
Current liabilities

• A higher current or quick ratio implies less risk of the firm experiencing
a cash shortfall in the near future.

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 Liquidity Ratios

Working capital * Working capital

=
to total assets ratio Total assets

• It measures the firm’s potential reservoir of cash

How to compute Working Capital?

(Anglo-Saxon) :
Net working capital = Current assets – Current liabilities

(Franco-Saxon) :
Operating Working Capital « Besoin en Fonds de Roulement (BFR) » =
A/C Receivable + Inventory – A/C Payable

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Efficiency Ratios

Sales
Asset turnover ratio =
Total assets
• It measures how much in sales that each dollar of assets produced

Accounts receivable
Collection period = × 365 *
Sales
• It measures the speed with which customers pay their bills.
• It expresses accounts receivable in terms of daily sales

* In practice, we can use 360 days as well

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 Efficiency Ratios

Inventory
Inventory days = × 365
Cost of goods sold
inventory
~ × 365
sales

Accounts payable
Payable period = × 365
Cost of goods sold
accounts payable
~ × 365
sales

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Profitability Ratios: profit margin

Gross profit
Gross margin =
Sales

Operating profit (EBIT)

Operating margin =
Sales

Net income
Net margin =
Sales

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 Profitability Ratios: profitability

Net income EBIT

Return on assets (ROA) = or
Total assets total assets

Operating ROA

Net income
Return on equity (ROE) =
Total equity

EBIT × (1 - Tax rate) EBIT x (1 - Tax rate)

Return on capital employed (ROCE)* = =
Equity + Net Debt * * Fixed assets + Working capital

*= Return on invested capital (ROIC)

** Net debt = Total debt – cash – marketable securities

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The DuPont Identity

• A breakdown of ROA into component ratios

Sales Net income

ROA = x
Assets Sales

Asset turnover Profit margin

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 The DuPont Identity

Net income Sales

ROE = ×
Sales Equity
Net income Sales Assets
ROE = × ×
Sales Assets Equity

Profit margin Asset turnover Equity Multiplier

(=>leverage)

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The DuPont Identity

Problem:
The following table contains information about Wal-Mart (WMT) and
Nordstrom (JWN). Compute their respective ROEs and then determine how
much Wal-Mart would need to increase its profit margin in order to match
Nordstrom’s ROE. WMT keeps its turnover and equity multiplier fixed.

Profit margin Asset turnover Equity multiplier

Wal-Mart (WMT) 3.6% 2.4 2.6
Nordstrom 7.7% 1.7 2.4

Solution:
• We can compute the ROE of each company by multiplying together its profit
margin, asset turnover, and equity multiplier.
• In order to determine how much Wal-Mart would need to increase its margin
to match Nordstrom’s ROE, we can set Wal-Mart’s ROE equal to
Nordstrom’s, keep its turnover and equity multiplier fixed, and solve for the
profit margin.

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 The DuPont Identity

• Using the DuPont Identity, we have:

– ROEWMT = 3.6% x 2.4 x 2.6 = 22.5%
– ROEJWN = 7.7% x 1.7 x 2.4 = 31.4%
• Now, using Nordstrom’s ROE, but Wal-Mart’s asset turnover and equity multiplier,
we can solve for the margin that Wal-Mart needs to achieve Nordstrom’s ROE:
– 31.4% = Margin x 2.4 x 2.6
– Margin = 31.4% / 6.24 = 5.0%
• Wal-Mart would have to increase its profit margin from 3.6% to 5% in order to
match Nordstrom’s ROE.
• It would be able to achieve Nordstrom’s ROE even with a lower margin than
Nordstrom (5.0% vs. 7.7%) because of its higher turnover and slightly higher
leverage.

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Valuation Ratios

Share price Market capitaliza tion

P/E Ratio = =
Earnings per share Net income
• It gauges the market value of the firm whether a share is over- or under-valued,
based on the idea that the value of a share should be proportional to the level of
earnings it can generate for its shareholders.
• P/E ratios can vary widely across industries and tend to be higher for industries with
high growth rates.

Market value of equity + Debt - Cash *

Entreprise value/operating income =
Operatingincome
* Cash + marketable securities

Market value of equity

Market - to - Book ratio =
Book valueof equity
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