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FINANCIAL STATEMENT ANALYSIS

This note provides a brief review of basic financial statements and of common techniques for their analysis. I. REVIEW OF BASIC FINANCIAL STATEMENTS The Balance Sheet A balance sheet describes the assets and liabilities of a firm at a single point in time. Given the conventions of generally accepted accounting procedures, total assets must equal total liabilities plus equity. A basic balance sheet is given below.
AJAX WHOLESALE CO. - BALANCE SHEET Dec. 31, 2005 ASSETS Cash Marketable Securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accum. Depreciation Net Fixed Assets TOTAL ASSETS 215,000 -95,000 120,000 240,000 30,000 10,000 45,000 35,000 120,000 LIABILITES AND EQUITY Accounts Payable Notes Payable to Bank Other Current Liabilities Total Current Liabilities Long-term Debt Common Stock ($.10 par) Additional Paid in Capital Retained Earnings TOTAL LIAB. & EQUITY 10,000 25,000 3,000 38,000 102,000 5,000 50,000 45,000 240,000

Current assets are those assets that have a maturity of a year or less (most are converted into cash within a year). Current liabilities are debts that must be paid within one year. Net working capital is defined as total current assets minus total current liabilities. Shareholders equity is usually reported using three separate accounts: 1) common stock, 2) additional paid in capital, and 3) retained earnings. The first two equity accounts are used to report the total amount received by the firm (over its life) from the sale of common stock. The last one (retained earnings) is used to report the accumulated earnings that have been retained in the firm over its life. The total equity of the firm is the combination of the three accounts. If Ajax Wholesale Co. were to sell one additional share of common stock for $2, then $0.10 (the par value) would be added to the common stock account and the remainder ($1.90) would be added to additional paid in capital. The number of shares outstanding at any time is equal to the common stock amount divided by the par value. In the case of Ajax, we see that there are 50,000 shares outstanding ($5,000/ $0.10 = 50,000 shares). Balance sheet amounts are reported at book value. Except for fixed assets (which are reduced by depreciation), book value is usually equal to original cost. Book values can be very misleading, especially for fixed assets, long-term debt, and equity. Book values often understate true value (market value). This is an important limitation of balance sheets.

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The Income Statement An income statement describes the revenue (sales, etc.) and expenses of a firm over a period of time. A typical income statement is given below.
AJAX WHOLESALE CO INCOME STATEMENT (For year ended Dec. 31, 2003) Sales (all for credit) Cost of Goods Sold Gross Profit Wages and Salary Other Administrative Exp. Depreciation Expense Interest Expense Income Before Taxes Taxes Income After Taxes $600,000 -350,000 250,000 - 85,000 - 45,000 - 35,000 - 10,000 75,000 - 35,000 40,000

An income statement starts with revenue (sales) and then deducts a variety of expenses and costs. If there is anything left at the end, it is called net profit, income after taxes or net income (all the same). Expenses and costs are deducted in a given order: first the costs of production, then operating expenses, then interest expense, then taxes. Operating income is generally defined as sales less all operating costs and expenses (pre-tax expenses and costs directly resulting from the production and sale of the product and the normal operation of the business). Interest expense is not an operating expense. Operating income for Ajax is $85,000. The income statement measures revenue and expenses using accrual accounting. Revenues and expenses are reported for the period in which a transaction is undertaken, rather than for the period in which the cash is actually received or paid. Suppose, for example, that Ajax Co. sold a widget for $50,000 on December 15 of 2005 but did not get paid for the widget until the following January 15. The income statement would include the $50,000 in 2005 sales. Because firms use accrual accounting, profit is not the same thing as cash flow (actual receipts of cash). Financial analysts are often more interested in cash flow than in profit. For this reason, analysts often focus on cash flow rather than measures of profit. Financial statements are not holy. They do not reveal divine truth. They are prepared according to generally accepted accounting procedures (GAAP). Quite often, GAAP allows many alternative ways of accounting for a particular transaction, with the choice being made by the firm's management. Therefore, some firms try to "manage" their financial statements in order to hide problems or merely present the most attractive financial picture possible. Be skeptical. Do not trust. Comparing financial statement between two or more U.S. firms is difficult since they may have used different GAAP in calculating and reporting income. Despite their weaknesses, financial statements are usually the best source of information we have about a firm.

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Taxes Corporations pay federal income tax each year based on taxable income. Most also pay state income tax. The federal Internal Revenue Service (IRS) requires that corporations use special accounting procedures to calculate taxable income. In a sense, firms must keep two sets of books, one for reporting income to the public using GAAP and another for reporting income to the IRS. Small corporations (with little taxable income) have lower federal income tax rates (as low as 15% for taxable income below $50,000). Most large corporations have a 35% federal tax rate for most taxable income. State income tax rates may add another 5% to 10%. Since income tax rates are progressive over some range, one must distinguish between the average tax rate and the marginal tax rate. The average tax rate is calculated as the total tax divided by total taxable income. The marginal tax rate is simply the tax rate applied to one additional dollar of income. Example: Corporations pay 15% tax on the first $50,000 of taxable income, 25% on the next $25,000 and 34% on taxable income of from $75,001 to $100,000. What is the average and marginal tax rate for a corporation with $80,000 of taxable income? Tax = $50,000(.15) + $25,000(.25) + $5,000(.34) = $15,450. Average tax rate = $15,450/$80,000 = .193 = 19.3% Marginal tax rate = 34% (i.e., $0.34 additional tax if taxable income increased by $1) All regular interest income and interest expense is recognized in calculating the taxable income of a corporation. The exception is interest paid by municipalities (city, county and state governments). Interest on municipal debt is free from federal income tax. Thus, wealthy individuals often buy municipal bonds or notes (lend money to municipalities) because they don’t have to pay taxes on the interest income. As a result, interest rates paid by municipalities tend to be low. Only about 30% of dividend income received by a corporation is recognized in calculating taxable income (70% to 75% is excluded). Dividends paid by a corporation are not deductible in calculating taxable income. All dividends received by individuals represent taxable income. In a sense, corporate income is subject to double taxation. The corporation itself pays taxes on its profits. When the remaining profits are distributed to shareholders as dividends, the shareholders must then pay personal income tax on the dividends they receive. Example: Suppose Acme Co. has $100,000 in taxable income and a 40% average tax rate, resulting in a tax of $40,000 and $60,000 in after tax income. Assume that the $60,000 is paid out as a dividend to the owner, who is in the 35% tax bracket. He would pay personal taxes of $21,000 = (.35)$60,000, leaving him $39,000 in after tax income. In this example, the $100,000 in corporate taxable income produces $39,000 in after-tax income to the owner. Total taxes paid = $61,000 ($40,000 + 21,000). The combined effective tax rate is thus 61% ($61,000/$100,000). Cash Flow Although the news media and many individual investors seem to focus on profit, many financial analysts consider cash flow to be far more important. Cash flow refers to actual receipts or expenditures of cash. Unlike measures of profit (which are based on accrual methods of accounting), the definition of cash flow is clean and unambiguous. You either get a dollar or you don’t.

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Cash flow from operations (operating cash flow) for a period of time is measured as total cash revenue less total cash operating expenses on an after-tax basis. Although a traditional income statement is prepared using accrual methods of accounting, it can be used to estimate operating cash flow with a few adjustments. An income statement deducts depreciation expense and interest expense, which is appropriate in measuring profit, but not for measuring operating cash flow. Depreciation is a non-cash expense – it is not paid to anyone. And interest expense is a financing expense, not an operating expense. Different analysts use different methods of measuring/approximating operating cash flow. A simple approximation is to start with net profit after taxes and add back depreciation and amortization expense and interest expense: Operating Cash Flow = Net Profit after taxes + Depreciation Expense + Interest Expense. If a firm is growing, then a portion of operating cash flow may have to be plowed back into the business in order to make capital investments or to increase net working capital (NWC). What’s left is called cash flow from assets or free cash flow. If operating cash flow is measured as noted above, then we can measure free cash flow as follows: Free Cash Flow = Operating Cash Flow – Net capital expenditures – increase in NWC Free cash flow is the amount that is available to pay any interest and principal payments that are due to creditors and dividends to shareholders. Some Self-Test Questions Use the following financial statements to answer the questions below.
ACME CO. INCOME STATEMENT Year Ended Dec. 31 Sales (all credit) Cost of Goods Sold Gross Profit Rent Expense Wages and Salaries Depreciation Expense Interest Expense Taxable Income Taxes Net Income $700,000 -370,000 330,000 -70,000 -180,000 -50,000 -10,000 20,000 -8,000 12,000 ACME CO. BALANCE SHEET - Dec. 31 ASSETS: Cash Accounts Receivable Net Fixed Assets Total Assets LIABILITIES AND EQUITY: Accounts Payable Long-term Debt Common Stock ($2 par) Additional Paid in Capital Retained Earnings Total Liab. + Equity $20,000 90,000 30,000 140,000 $20,000 40,000 30,000 22,000 28,000 140,000

Using the financial statements given above for Acme, how many shares of common stock are outstanding? (15,000 shares) Using the financial statements given above for Acme, what is the book value of common equity? ($80,000) What are the earnings per share (eps) for Acme? ($.80)

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Using the financial statements given above, what is the total of Acme’s current assets? ($110,000) Using the financial statements given above, what is Acme’s net working capital? ($90,000) Using the financial statements given above, what is the cash flow from operations? ($72,000) Refer to the financial statements above for Acme Co. Suppose Acme had net capital expenditures of $20,000 during the year and increased net working capital by $10,000. What was their free cash flow for the year? ($42,000)

II. ANALYSIS OF FINANCIAL STATEMENTS
This section reviews some of the common ratios used to measure the performance of business firms. Some Common Financial Ratios The most popular approach to measuring the financial condition of a firm is to use the balance sheet and/or income statement to construct financial ratios. These ratios are then usually tracked over time to identify trends or they are compared to industry averages. The financial ratios described below can be divided into groups based upon the underlying characteristic or dimension that they measure. The main groups are: 1) leverage ratios, 2) liquidity ratios, 3) efficiency ratios, 4) profitability ratios, and 5) market-value ratios. The first four groups use financial statements alone to measure current or historic performance. The last group (market-value ratios) uses stock market data to measure anticipated future performance. Liquidity Ratios The liquidity of an asset is a measure of how easily and quickly the asset can be converted into cash. Cash is the ultimate liquidity at it is immediately available to pay bills, buy assets, etc. Marketable securities are less liquid than cash, but still very liquid and are often counted as cash on the balance sheet. Accounts receivable are less liquid and inventory is generally the least liquid of the current assets. At the other extreme, fixed assets are generally very illiquid (have low liquidity). Liquid firms (firms with many assets easily converted into cash) are able to more quickly respond to changing conditions and are usually able to pay their bills on time. Illiquid firms are often unable to pay current obligations and have a higher risk of insolvency. Current Ratio. The current ratio (the ratio of current assets to current liabilities) measures the ability of a firm to meet current payment obligations using liquid assets. Current liabilities are those liabilities that must be paid within one year. Current assets are those assets that will normally be converted into cash within one year. In a sense, the current ratio is a ratio of the ability to pay over the need to pay. A higher current ratio implies greater safety and lower risk. Current Ratio = Current Assets___ Current Liabilities Quick (or Acid Test) Ratio. The quick ratio (sometimes called the acid test ratio) is a slight variation on the current ratio. The main current assets are cash, marketable securities, accounts receivable and

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inventory. Of these, inventory is the least liquid. The quick ratio is similar to the current ratio, except inventory is not used in the numerator. Thus, the quick ratio is a more conservative (safer) measure of liquidity. A higher quick ratio implies greater safety. Quick Ratio = Current Assets other than inventory___ Current Liabilities

Leverage Ratios Most leverage ratios measure the extent to which a firm uses borrowed money (debt) to finance its operations. Since the use of debt increases the possibility of bankruptcy, firms with high leverage ratios (heavy use of debt financing) are considered risky. Total Debt Ratio. The total debt ratio is the ratio of total liabilities (debt) to total Assets. Total liabilities can be measured directly (just add all liabilities on the balance sheet) or can be calculated as total assets less total equity. A higher ratio means greater risk. Total debt ratio = Total Assets – Total Equity____

Total Assets Times Interest Earned. While the total debt ratio uses items from the balance sheet that measure “stocks,” the times-interest-earned ratio (also called interest coverage) uses information from the income statement to measure "flows." This ratio is the ratio of earnings before interest and taxes (EBIT) to interest expense. Times Interest Earned = EBIT _____ Interest Expense

The interpretation of this ratio is simple. EBIT (earning before interest and taxes) is the most that the firm has available from current operations to pay interest. Time interest earned is, therefore, a ratio of the ability to pay to the need to pay. The higher the ratio, the greater the margin of safety for creditors. In this case, a high ratio means low risk.

Cash Coverage. The cash coverage ratio is similar to the times interest earned ratio. The difference is that it uses pre-tax operating cash flow in the numerator, rather than operating income.
Cash Coverage = EBIT + Depreciation Expense _____ Interest Expense Efficiency Ratios Efficiency ratios measure how efficiently individual assets are being utilized. Exact interpretation depends on the individual ratio. Inventory Turnover Ratio. The inventory turnover ratio (the ratio of cost of goods sold to inventory) indicates how efficiently inventory is being managed. An inventory turnover ratio of 4 indicates that inventory "turns over" four times during a year - an items stays in inventory an average of 1/4 of a year

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before it is sold. A low turnover ratio might indicate that a firm is carrying too much inventory for the volume of sales, suggesting that future purchases of inventory be deferred. Most firms strive to increase their turnover ratio. Inventory Turnover Ratio = Cost of Goods Sold___ Inventory Days' sales in Inventory. The days' sales in inventory ratio is closely related to inventory turnover. It measures the average time an item remains in inventory before being sold. An inventory turnover ratio of x corresponds to a days' sales in inventory ratio of 365/x. Firms attempt to reduce the days sales in inventory ratio in order to improve the efficiency and liquidity of the firm. Inventory_ Days Sales in Inventory = __ Cost of goods sold/365 Accounts Receivable Turnover. The accounts receivable turnover ratio is calculated as annual sales divided by accounts receivable. The ratio is interpreted in a manner similar to the inventory turnover. Accounts Receivable Turnover = ___ Accounts Receivable Sales

Average Collection Period. The average collection period (sometimes called the days' sales in accounts receivable) measures the average time it takes to collect accounts receivable. For obvious reasons, firms attempt to minimize the average collection period. Average Collection Period = Accounts Receivable _ Average Daily Credit Sales

The average daily sales is often estimated using annual sales divided by 365. Total Asset Turnover Ratio. The total asset turnover ratio (the ratio of annual sales to total assets) measures the revenue generated per dollar of assets. To some extent, this ratio measure capacity utilization. A firm with a high asset turnover ratio (for the industry) is fully utilizing its assets. For such a firm, additional sales growth might first require an expansion of assets. A high asset turnover ratio is desirable. Asset Turnover Ratio = Annual Sales___ Total Assets Profitability Ratios Profitability ratios measure overall firm performance by relating some measure of profit to either sales or assets. “Margin” ratios have sales in the denominator and some measure of profit in the numerator – they measure profit as a percent of sales. “Return on” ratios have some measure of profit in the numerator (usually net profit) and either assets or equity in the denominator.

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Net Profit Margin. The net profit margin measures the percent of each sales dollar that goes to profit (i.e., net profit as a percent of sales). Net Profit Margin = Net Profit After Taxes Sales The average net profit margin varies from industry to industry. For example, it is generally much higher for jewelry retailers than for grocery stores. In general, industries with a high average profit margin tend to have a lower asset turnover ratio and vise versa. Other things being equal, a business would prefer a higher profit margin. Other profit margins are also popular and frequently used. For example, the gross profit margin is gross profit as a percent of sales. However, if used alone, the term “profit margin” generally refers to the net profit margin. Return on Assets (ROA). The rate of return on assets is defined as net profit expressed as a percent of total assets. Return on Assets = Net Profit After Taxes Total Assets This ratio must be interpreted with caution. It represents a true rate of return only if net profit is constant each year and the book value of total assets is a true measure of their current value. Due to conservative principles of accounting, the book value of total assets often understates their current value, which causes the return on asset ratio to appear better than it really is. Return on Equity (ROE). The rate of return on equity is similar to the return on assets, except that equity (rather than assets) is used in the denominator. Return on Equity = Net Profit After Taxes Common Equity If a corporation has preferred stock outstanding, then the numerator should be net profit available for common stock (i.e., total net profit less preferred dividends). Like the ROA, the ratio must be interpreted with caution, since the book value of common equity often understates the true value. Market-Value Ratios Market-value ratios generally use the market value of the firm's common stock as a substitute for the book value of equity. Since the market value of equity reflects investor expectations of future performance, these ratios focus on the future rather than the past or present. Price-Earnings Ratio. The price-earnings (P/E) ratio looks at the relationship between current earnings and the market price of the firm's common stock. Stock price per share Earnings per share _ _ _

Price-Earnings Ratio

=

_

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Since the market price of the stock reflects anticipated future earnings, the P/E ratio reflects market expectations regarding future earnings growth. Stocks with a high P/E have a high expected growth rate in earnings. Stocks with a low P/E tend to be more stable companies with limited growth opportunities. A very low P/E may reflect an anticipated decline in earnings. The Du Pont System The Du Pont System focuses upon one or two overall measures of firm performance and attempts to highlight the factors that influence these performance measures. The Du Pont system can be quite detailed, but we will look at only one simple part of the Du Pont System. Consider the rate of return on assets (ROA), which is calculated as net profit divided by total assets. This ratio can be decomposed into two factors. ROA = Sales Assets × Net profit Sales

The first factor is the asset turnover ratio and the second is the net profit margin. Many different combinations of these two ratios may lead to the same ROA. By decomposing the ROA into its component parts, it is often possible to determine why the ROA of a firm is high or low. In general, industries that tend to have a high (low) profit margin often tend to have a low (high) asset turnover ratio. The Rate of return on equity (ROE) is another good measure of overall firm performance. The ROE, which is calculated as net profit divided by total equity, can be decomposed into three factors as follows:

ROE

=

Sales Assets

×

Net profit Sales

×

. _ Assets Total Equity

If the ROE of a firm is below the industry average, a comparison of the three factors noted above with their respective industry average might highlight the reason for the low ROE and suggest corrective action.
Relative Financial Statements

Relative financial statements are often used to help identify trends over time. On the income statement, each revenue and expense item is expressed as a percent of sales (which has a value of 100%). On the balance sheet, every asset, liability and equity account is expressed as a percent of total assets. This very simple analytic approach facilitates the identification of possibly harmful trends when comparing financial statements from successive years and facilitates comparison between firms and industries.

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Using Financial Statements • The financial analysis of a company often involves ratio analysis, but few of the ratios described above can be interpreted in isolation. It is often difficult to determine what is a "good" ratio value and what is a "bad" ratio value. Two popular approaches are used to interpret the ratios of a particular company: 1) comparison with historic trends, and 2) comparison with industry averages. The analysis of financial ratios for a single year is often difficult or unproductive. For example, suppose that XYZ Company has a current ratio of 2.5. What does this mean? Is it good or bad? One way to try to answer these questions is to compare the current value with that of the past three to five years. In this way, trends can be identified which may signal problems in need of attention. Another popular way to evaluate financial ratios is to compare the ratios for a particular firm with those of a "typical" firm in the same industry. Fortunately, industry average ratios are published by a number of sources and are available in almost any library. You can also find Industry average ratios for many key industries at http://www.bizstats.com. Meaningful financial statement analysis requires meaningful financial statements. However, financial statements are often prepared using questionable accounting procedures. Even when they are prepared according to the strictest standards, normal financial statements are limited by the fact that they measure historic costs, rather than current value. While historic cost might be of interest to some, most financial decisions call for information on current values. For current assets and current liabilities, historic cost is often a good estimate of current value. The same is seldom true for fixed assets and shareholder’s equity. Therefore, any ratios based on fixed assets, total assets or shareholder’s equity should be viewed cautiously.

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Some Self-Test Questions
Calculate the following ratios using the 2005 Balance Sheet and Income Statement for Ajax Wholesale Co.: Net Working Capital, Current Ratio, Quick Ratio, Total Debt Ratio, Times Interest Earned, Cash Coverage, Inventory Turnover, Accounts Receivable Turnover, days sales in inventory, Average Collection Period, Total Asset Turnover, Net Profit margin, Rate of Return on Assets, Rate of Return on Common Equity, Earnings per Share, and the Price-Earnings Ratio. AJAX WHOLESALE CO INCOME STATEMENT (2005) Sales (all for credit) $600,000 Cost of Goods Sold -350,000 Gross Profit 250,000 Wages and Salary - 85,000 Other Administrative Exp. - 45,000 Depreciation Expense - 35,000 Interest Expense - 10,000 Income Before Taxes 75,000 Taxes - 35,000 Income After Taxes 40,000 AJAX WHOLESALE CO. BALANCE SHEET Dec. 31, 2005 ASSETS Cash Marketable Securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accum. Depreciation Net Fixed Assets TOTAL ASSETS 215,000 -95,000 120,000 240,000 30,000 10,000 45,000 35,000 120,000 LIABILITES AND EQUITY Accounts Payable Notes Payable to Bank Other Current Liabilities Total Current Liabilities Long-term Debt Common Stock ($.10 par) Additional Paid in Capital Retained Earnings TOTAL LIAB. & EQUITY 10,000 25,000 3,000 38,000 102,000 5,000 50,000 45,000 240,000

The market price of Ajax Co. common stock is $8 per share. Answers: net working capital = 120,000 - 38,000 = 82,000 Current ratio = 120,000/38,000 = 3.157 Quick ratio = 85,000/38,000 = 2.237 Total debt ratio = 140,000/240,000 = .583 Times interest earned = 8.5 Cash Coverage = 120,000/1,000 = 12 Inventory turnover = 350,000/35,000 = 10 Accounts Receivable Turnover = 600,000/45,000 = 13.33 Days sales in inventory = 36.5 days

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Average collection period = 27.4 days Total Asset turnover = 2.502 Net Profit Margin = 6.7% Return on Assets = 16.7% Return on Equity = 40% Earnings per share = $0.80 P/E = 10

Prepare relative financial statements for Ajax Wholesale company based on the financial statements given above. AJAX WHOLESALE CO INCOME STATEMENT (2005) Sales (all for credit) 100.00 Cost of Goods Sold -58.33 Gross Profit 41.67 Wages and Salary - 14.17 Other Administrative Exp. - 7.50 Depreciation Expense - 5.83 Interest Expense - 1.67 Income Before Taxes 12.50 Taxes - 5.83 Income After Taxes 6.67 AJAX WHOLESALE CO. BALANCE SHEET Dec. 31, 2005 ASSETS Cash Marketable Securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accum. Depreciation Net Fixed Assets TOTAL ASSETS 89.58 -39.58 50.00 100.00 12.50 4.17 18.75 14.58 50.00 LIABILITES AND EQUITY Accounts Payable Notes Payable to Bank Other Current Liabilities Total Current Liabilities Long-term Debt Common Stock ($.10 par) Additional Paid in Capital Retained Earnings TOTAL LIAB. & EQUITY 4.17 10.42 1.25 15.83 42.50 2.08 20.83 18.75 100.00

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