Topic 4 – Fundamental Analysis

Major Financial Statements

Balance
Sheet

Financial
Statements
Income Cash Flow
Statement
Statement

10-2
Balance Sheet
• Shows resources (Assets) of the firm and how it has
financed these resources (Liabilities & Equity)

Current Current
Liabilities Owner’
Assets s
Fixed Non-Current
Liabilities Equity
Assets

The balance sheet presents the STOCKS AT THE END of the

period

10-4
Balance Sheet
ABC Company 2014 2015
Balance Sheet
ASSETS 2014 2015
Cash and Equivalents $ 67 $ 193
Accounts Receivable, Net 10 8
Inventory 248 314
Other Current Assets 40 51
Total Current Assets 365 566
Gross PP&E 528 738
Accumulated Depreciation 144 190
Net PP&E 384 548
Current Intangible Assets 28 33
Total Assets $ 777 $ 1,147

Assets LIABILITIES & EQUITY 2014 2015

Fixed Accounts Payable Non-Current $ 115 $ 158
Taxes Payable 33 32
Assets Other Current Liabilities
Liabilities 103 137
Total Current Liabilities 251 327
Long-term Debt 18 81
Other Liabilities 42 62
Total Liabilities 311 470
Total Stockholder's Equity 466 677
Total Liabilities and Equity $ 777 $ 1,147

10-4
 Income Statement
• Contains information on the profitability of the firm
over a period of time

Profit Income Expense

The income statement presents the FLOWS OVER the period

10-5
Income Statement

Income Statement 2014 2015

Sales $ 1,934 $ 2,519
Cost of Goods Sold 1,190 1,499
Gross Profit 744 1,020
Selling, General, and Admin Exp 454 576
Operating Income before Depr 290 444
Current
Depreciation and Amortization 52 70
Operating Profit 238 374
Interest Expense
Assets 1 4
Fixed
Other Gains and Losses Non-Current 0 (1)
Pretax Income
Assets Liabilities 237 371
Income Tax Expense 92 141
Net Income $ 145 $ 230

10-4
Statement of Cash Flows
• Records the amount of cash and cash equivalent
entering and leaving the firm

Operating • Day-to-day Operation

• Main Products/Services
Activities
• Borrow Money
Financing • Pay Dividends

Activities • Buy Equipment/Buildings

• Buy Stock/Bonds
Investing
10-6
Activities
Statement of Cash Flows
Statement of Cash Flows 2014 2015
Operations
Net Income $ 145 $ 230
Depreciation and Amortization 52 70
Other Gains and Losses 0 (1)
Chg. in Accounts Receivable, Net (4) 2
Chg. in Inventory (4) (66)
Chg. in Other Current Assets (11) (11)
Chg. in Accounts Payable 21 43
Chg. in Taxes Payable 18 (1)
Chg. in Other Current Liabilities 28 34
Chg. in Other Liabilities 5 21
Current Net Cash from Operations 250 321

Investing
Assets Acquisition of PP&E (198) (234)
Fixed Non-Current
Change in Intangible Assets (3) (5)

Assets Liabilities
Net Cash from Investing Activities (201) (239)

Financing
Net Proceeds from Issuing Debt (3) 63
Dividends (17) (19)
Net Cash from Financing Activities (20) 44

Change in cash 29 126

10-4
Purpose of Financial Statement Analysis

Financial
Statement
Analysis

Evaluate
Predict
Current
Future
Management
Management
Performance
Performance
Profitability
Efficiency
Risk

10-7
Analysis of Financial Ratios
• Ratios are more informative that raw numbers

o Ratios provide a meaningful relationship

between individual values in the financial
statements

o They are used in the comparative analysis

Example: 100$ debt matters more in a firm with total asset of 120$ than that
with total assets of 10000$?

10-8
Relative Financial Ratios
• Comparison to the Aggregate Economy
o Most firms are influenced by economic expansions
and contractions in the business cycle
o Estimate future performance of the firm
Vietjet Air 2015 2016 2017 2018 2019 2020

Net margin 5.9% 9.1% 12.0% 10.0% 7.5% 0.4%

Asset Turnover 2.01 1.71 1.64 1.51 1.15 0.39

x Leverage (Assets/Equity) 5.61 4.24 2.99 2.78 3.28 3.02

ROE 75.2% 72.6% 66.2% 43.3% 26.3% 0.5%

             
GDP growth 7% 6.69% 6.94% 7.08% 7.02% 2.91%

10-10
 Relative Financial Ratios (cont)
• Comparison to the Industry
oDifferent industries affect the firms within them
differently
oThe industry effect is strongest for industries with
homogenous products
Net margin 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Target 4.7% 4.5% 3.4% 3.8% 4.3% 4.2% 4.5% 3.8% 3.4% 4.5% 3.8% 3.5% 3.8% 4.2%
Costco 1.7% 1.8% 1.5% 1.7% 1.7% 1.8% 2.0% 1.9% 2.1% 2.0% 2.1% 2.3% 2.3% 2.4%
Walmart 3.6% 3.5% 3.4% 3.7% 3.8% 3.7% 3.8% 3.5% 3.5% 3.1% 2.9% 2.1% 1.5% 2.9%

Google 25.3% 19.4% 27.6% 29.0% 25.7% 25.1% 23.7% 20.6% 21.8% 21.6% 20.3% 22.5% 21.2% 22.1%
Facebook (90.2%) (20.6%) 29.5% 30.7% 26.9% 1.0% 19.1% 23.6% 20.6% 37.0% 44.8% 39.6% 26.1% 33.9%
Microsoft 27.5% 29.3% 24.9% 30.0% 33.1% 23.0% 28.1% 25.4% 13.0% 22.5% 26.4% 27.4% 31.3% 31.0%

10-12
 Relative Financial Ratios (cont)
• Comparison to its Major Competitors
o Select a subset of competitors to compare to
using cross-sectional analysis.
Gross Margin 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Facebook 73.2% 54.4% 71.3% 75.0% 76.8% 73.2% 76.2% 82.7% 84.0% 86.3% 86.6% 83.2% 81.9% 80.6%
Microsoft 79.1% 80.8% 79.2% 80.2% 77.7% 76.2% 73.8% 68.8% 64.7% 64.0% 64.5% 65.2% 65.9% 67.8%
Google 59.9% 60.4% 62.6% 64.5% 65.2% 62.7% 60.4% 61.6% 62.4% 61.1% 58.9% 56.5% 55.6% 53.6%

10-13
 Relative Financial Ratios (cont)
• Comparison to its Own Historical Records
o Determine whether it is progressing or declining

o Helpful for estimating future performance

o Consider trends as well as averages over time

Useful source of information to estimate the future growth under
some assumptions, e.g. sales growth if the firm’s market share remains the
same
Net margin 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Target 4.7% 4.5% 3.4% 3.8% 4.3% 4.2% 4.5% 3.8% 3.4% 4.5% 3.8% 3.5% 3.8% 4.2%
Costco 1.7% 1.8% 1.5% 1.7% 1.7% 1.8% 2.0% 1.9% 2.1% 2.0% 2.1% 2.3% 2.3% 2.4%
Walmart 3.6% 3.5% 3.4% 3.7% 3.8% 3.7% 3.8% 3.5% 3.5% 3.1% 2.9% 2.1% 1.5% 2.9%

10-14
Specific Uses of Financial Ratios

• Study the driver of the firm’s performance (this week)

• Stock Valuation Model (later next week)

• Estimating the Ratings on Bonds, e.g. Fitch & Moody

• Predicting the firm’s probability of Bankruptcy, e.g. Altman

Z-score

10-55
Case Overview -
ABC
Objective: we will use the case study to interpret the financial ratios of the firm

• Specialty retailer of fashionable clothes and

accessories for dogs
• Most locations are in shopping malls and on “hip”
shopping streets
o 1226 stores in US, Canada, and UK

o Owns most of its stores; no franchises

10-15
Case Overview – ABC
(cont)
• Strategy
o Reputation as a fashion trend-setter in good
quality clothes at reasonable prices
• Designers work two-years in advance to create a stylish
but basic “look”
o Deep inventory of a limited number of items
• New collection of styles every two months; older stock
is sold quickly by slashing prices

10-16
Case Overview – ABC
(cont)
• Strong brand name
o Extensive advertising and promotional campaigns
o Celebrity endorsements
o Stores also have the same “look” with frequent rearranging
of displays

• Stable management team

o Most still around from founding of company
• High growth in sales and earnings
o Despite struggles in industry, labelled as “nation’s hottest
retailer” by a major business magazine
o Most growth is due to new store openings
10-19
Case Overview – ABC
(cont)
• Threats of competition
o Major retailers and other specialty clothing chains have
plans to introduce
o Similar lines of dog clothing

10-21
Case Overview – ABC
(cont)
• Future goals and plans
o Maintain at least 30% ROE and 11% ROS
o 20% sales growth
• New store openings and enlargement of some
existing stores
o Capital expenditures of $200 million per year
• Expansion into Europe and Asia
o Keep focus on core competencies in dog fashion
• But studying possible expansion into cat and ferret
markets
o Consider launching its own credit card
• Spur growth in sales and earn financing income 10-22
 ROE Dupont
Analysis
How to improve the firm’s ROE? What ways are more sustainable?
Why do we use the average for balance sheet items?
How much return
Return on Equity (ROE) is generated for
Net Income/ Avg. Shareholders’ Equity
the
shareholders?

How effectively Return on Assets (ROA) Financial Leverage

are resources
Net Income/ Avg. Total Assets Avg. Total Assets/
(assets) used
to generate
Avg. Total Shareholder’s Equity
profits? How much debt is used
to finance total assets?

Return on Sales (ROS) Asset Turnover

Net Income/ Sales Sales/ Avg. Total Assets

ROE = Net Income/ Sales X Sales/ Assets X Assets/ Equity

= Profitability X Efficiency X Leverage

How much profit is earned How much sales are How much debt is used to finance
on each dollar sales? generated using total assets?
the available
assets?
 ABC firm

The main drivers of ABC ROE are

+ improvement in the ROS
+ sustainably high asset turnover

Is there any way to improve the ABC’s ROE?

+ increase financial leverage?
+ increase ROS and asset turnover? How?

10-23
Profit Margin Ratios

• What are the drivers of profitability?

o Decompose Return on Sales by income

statement line item.

• Gross Margin = Sales − Cost of Goods Sold

Sales

• SG&A-to-Sales = SG&A Expense

Sales
*SG&A: Selling, General and Administrative Expenses

10-29
Profit Margin Ratios (cont)

• Operating Margin = Operating Income (EBIT)

Sales
EBIT = sales - COGS - SG&A - depreciation = EBITDA - depreciation

• Interest Expense-to-Sales = InterestSales

Expense
EBT = EBIT - interest expense

• Effective Tax Rate = Pre−taxIncome Taxes

Income (EBT)
The effective tax rate may be different from public tax rate on firms’ profit, e.g.
20% in Vietnam. This is because in some cases, we can have reduction in tax
payments from previous years’ losses, i.e. loss carryforward.
See https://www.investopedia.com/terms/l/losscarryforward.asp

10-30
Profit Margin Ratios (cont)
• What are the drivers of ABC profitability?

10-28
Asset Turnover Ratios
• The efficiency in using the firm’s asset to generate
sales

• Accounts Receivable (A/R) Turnover = Sales

Average A/R
how well we are at collecting credit from (cash owed by) customers

• Inventory Turnover = Cost of Goods Sold

Average Inventory
how many times we sell and replace inventory

10-32
Asset Turnover Ratios (cont)

Purchases
• Accounts Payable (A/P) Turnover = Average A/P
o Purchases = Ending Inventory + COGS –
Beginning Inventory
How well we are paying off accounts payable

• Fixed Asset Turnover = Sales

Avg. Net PP&E
How well we use fixed asset to generate sales

10-33
Asset Turnover Ratios (cont)
• What are the drivers of ABC asset turnover?

10-28
Days Outstanding Ratios (Aside)

• Days Sales Outstanding = 365 × Average

Sales
A/R
Average Inventory
• Days Inventory = 365 × Cost of Goods Sold

Average
• Days Payable = 365 × Purchases
A/P
Days sales outstanding: how many days to collect payment after a sale has
been made
Days inventory: how many days to produce and sell final goods from inventory
Days payable: how many days to pay its bills/invoices to trade creditors

10-35
 Days Outstanding Ratios (Aside)
• Net Trade Cycle = Days Receivable + Days Inventory -
Days Payable

o Represents the gap between cash outflows and

cash inflows that we have to bridge with short-term
borrowing
How long the cash is tied up in the trade cycle before coming back out as cash
again.
positive net trade cycle: the days a firm needs to funds with a line of credit
negative net trade cycle: the firm is paid for its products before it pays to vendor
for material supply

10-36
Common Liquidity Ratios

Short-term Long-term

• Current Ratio • Debt to Equity

• Interest
• Quick Ratio • Long-term Debt to
• CFO to Coverage
• Cash Interest Equity
Current • Long-term Debt to
Coverage
Liabilities Tangible Assets

10-38
Long-term Debt Ratios
• How does the company finance the firm’s asset?

• Debt to Equity = Total Liabilities

Total Stockholders’ Equity
total liabilities include total (short- & long-term) debt, account payables, etc.

• Long-Term-Debt to Equity = Total Total Long−Term Debt

Stockholders’ Equity
• Long-Term Debt to Tangible Assets =

Total Long−Term Debt intangible assets: may not

Total Assets − Intangible liquid as other assets
Assets because it is hard to value

10-44
Short-term Liquidity Ratios
•Does the company have enough cash coming in to cover short-term
obligations?

o Ideally, ratios would be over 1

• Current Assets
Current Ratio = Current Liabilities

• Quick Ratio = Cash + Receivables

Current Liabilities
The Quick ratio only considers the most liquid short-term assets

10-40
Interest Coverage Ratios

Interest Coverage =
Operating Income before Depreciation
Interest Expense

10-41
Common Size Statements

Easier Comparison Of Different Size Firms

Insight Into A Firm’s Financial Condition

Balance Sheet: % Of Total Assets

Income Statement: % Of Sales

10-45
Risk Analysis
What risk can explain the variation of the firm’s ROE?

Business Risk Financial Risk

• Caused By Use
• Caused By The
Of Fixed
Firm’s Industry
• Variability Of Obligation & Debt
Securities
Operating Income

10-47
Business Risk

Business Risk

Profitability Asset turnover

• Caused By Firm’s • Higher % Of Fixed

Industry Costs
• Outside Of • More Volatile
Management Operating
Control, e.g. Earnings
COVID-19
10-48
Reference(s)

o Reilly, FK & Brown, KC 2011, Investment Analysis & Portfolio

Management, 10th edn, South-Western Cengage Learning,
Mason, Ohio.
o Bodie, Z, Kane, A & Marcus, AJ 2013,
Essentials of investments, 9th edn, McGraw-
Hill/Irwin, New York.
o Jones, CP 2010, Investments Principles and Concepts, 11th
edn, International student version, Wiley, Hoboken, N.J.

RMIT University Vietnam 57