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1

Background

♦Financial statements aid in the process of

fundamental analysis ♦Fundamental analysts evaluate financial ratios as an aid to determine if a security is over- or under-priced ♦The efficient market theory suggests that publicly available financial statements offer nothing of value

– Professional security analysts have already discovered pertinent information and traded based on that information

2

Financial Statements

♦Large public firms issue quarterly financial

statements ♦Small firms may only issue annual statements ♦Closely-held corporations may not issue public financial statements ♦Main financial statements

– Balance sheet – Income and expense statement – Statement of cash flows

3

Balance Sheet

♦Represents historical value of firm’s assets,

liabilities and stockholders’ equity on the day the accounting period ends ♦Assets = Liability + Stockholders’ Equity

**♦Most firms end the fiscal year on December
**

31

– Stockholders’ Equity represents firm’s net worth (Book value of owners’ equity)

4

KO’s Balance Sheet

5

**Income & Expense Statement
**

♦Report the flows that occurred during

the accounting period ♦AKA profit and loss statement ♦Sales – Total Expenses = Income (Loss)

6

KO’s Income & Expense Statement

7

**Statement of Cash Flows
**

♦Cash flows are the net cash remaining

after all reinvestments have been deducted ♦Cash flow is not affected by

**♦Accounting income is more ambiguous
**

than a firm’s cash flows

8

– Accelerated depreciation rules – Arbitrary inventory valuation rules – Accrual methods of accounting

KO’s Statement of Cash Flows

9

KO’s Statement of Cash Flows

10

**KO’s Cash Flows
**

Cash flows provided by (used in): Operations Investment activities Free cash flow Cash flows used in: Financing Share repurchases Other financing activities Exchange Increase (Decrease) in cash KO uses its large cash flows for reinvesting within the firm, joint ventures, stock repurchases and cash dividends. 1997 4,033 (1,082) 2,951 1998 3,433 (1,557) 1,876 1999 3,883 (1,551) 2,332

(1,262) (1,833) (134) 304

(1,563) 230 (28) (89)

(15) (456) (28) (37)

KO generates tremendous cash flows from operations

11

**Sources of Financial Statements
**

♦ Publicly traded companies in the U.S. are required to

make full disclosure of their financial statements

– Usually a phone call or letter is all that is needed & firm will mail statements to you

• SEC’s Electronic Data Gathering Analysis and Retrieval (EDGAR) System has the information for free at www.sec.gov/edgarhp.htm

– Not user friendly

• EDGAR Online at www.edgar-online.com and FreeEDGAR at www.freeedgar.com are more user friendly but not all the data is free • Hoover’s On-Line at www.hoovers.com, PR Newswire at www.prnewswire.com and Yahoo!Finance at http://quotes.yahoo.com offer additional information

12

Common-Sized Financial Statements

**♦Express each item as a percentage of a
**

common base number

**♦Useful when comparing
**

– A firm over time – Different sized firms – Firms from different countries

– Such as Assets or Sales

13

KO’s Common-Sized Balance Sheet

14

KO’s Common-Sized Income & Expense Statement

15

**Analysis of Sales and Competition
**

♦KO manufactures syrups for the following

products

• • • • • • • • •

**– Coke Products (≈70% of total sales)
**

Classic Coke Diet Coke Decaffeinated Diet Coke Cherry Coke Diet Cherry Coke Sprite Fanta TAB Nestea •Diet Sprite •Mr. PiBB •Fresca •POWERaDE •Mello Yello •Lift •Barq’s •Specialty local drinks

– Non-Coke soft drinks (≈21% of total sales)

16

**Analysis of Sales and Competition
**

– Food Sales

• Fruit juices generate ≈9% of total sales

– Minute Maid juice – Hi-C – Fruitopia

**♦In the 1970s and 80s KO also sold
**

– – – –

Wines Discontinued these product lines to focus Straws on core business. Plastic cups Water conditioning equipment 17

**Analysis of Sales and Competition
**

♦KO products made up 18% of the nonalcoholic soft drinks purchased in the world in 1999 ♦Sales have grown at 6% annually for the last decade ♦EPS grew at 4.8% during the same period

18

**Analysis of Sales and Competition
**

♦KO sells its products in 200 countries

Only 21% are made in the U.S. where KO is headquartered.

19

**Analysis of Sales and Competition
**

♦Company strengths ♦Executives forecast a continuation of past

growth ♦Main competitor

– PepsiCo – Multinational diversification – Differentiated product line

**♦Only weak line is the ‘food products’ line
**

20

Financial Ratios

♦A financial ratio combines multiple values to

produce a new, meaningful value

– Used to quantify, summarize and interpret financial data – Solvency or liquidity ratio

• Measure firm’s ability to meet short-term obligations

♦Types of ratios

– Turnover ratios

• Measure rate of activity

– Coverage ratios

• Measure extent to which the firm’s earnings can cover debt-related expenses

21

Financial Ratios

– Leverage ratios

• Measure extent to which firm has been financed by creditors

– Profitability ratios

• Measures productivity of money invested in firm

**– Per share data
**

• Examines items that affect common stock’s market price per share

– Growth ratios

• Measures contribution of various items to firm’s development

**– Risk analysis ratios
**

• Measures variability

22

**Solvency (Liquidity) Ratios
**

♦ Current Ratio

– Formula

• Current Assets ÷ Current Liabilities

– Values

• 1997: 0.81 • 1998: 0.74 • 1999: 0.66

♦Quick Ratio

Quick ratio is more discriminating than Current Ratio—only includes the most liquid assets.

For every $1 in current liabilities the firm had $0.66 in current assets. KO did not quite have enough current assets to pay its bills.

–Formula

•(Current Assets – Inventory) ÷ Current Liabilities

–Values

•1997: 0.68 •1998: 0.64 •1999: 0.55

If the firm’s inventory becomes worthless, KO does not have enough liquid current assets to pay its bills.

23

**Solvency (Liquidity) Ratios
**

♦Even though KO has experienced huge

cash flows, the firm’s current and quick ratios are quite low ♦Thus, the solvency ratios did not tell the whole story

24

Turnover Ratios

♦Inactive assets might not be generating

earnings

– Turnover ratios help pinpoint the non-earning assets – Formula

• Annual credit sales ÷ Accounts receivable

– Values

• 1997: 11.51 • 1998: 11.29 • 1999: 11.02 Receivables turn over slightly less than once a month. Is this too low/high? Cannot be determined without knowing firm’s credit policy and industry customs.

♦Receivables Turnover Ratio

25

Turnover Ratios

♦ Collection Period

– Formula – Values

• 1997: 31.71 days • 1998: 32.32 days • 1999: 33.14 days • Accounts receivable ÷ Average day’s sales Acceptable value depends on product being sold and credit terms.

♦Inventory Turnover

–Formula –Values

•1997: 6.27 •1998: 6.25 •1999: 5.58 Need more information before we can evaluate these values. •Annual sales (at cost) ÷ Average Inventory (at cost)

26

Turnover Ratios

♦ Asset Turnover Ratio

– Formula

• Annual Sales ÷ Total Assets

– Values

• 1997: 1.11 • 1998: 0.98 • 1999: 0.92 Needs to be compared to competitors’ values.

**♦Equity Turnover Ratio
**

–Formula

•Annual Sales ÷ Equity

–Values

•1997: 2.58 •1998: 2.24 •1999: 2.08 Equity turns over faster than assets because firm uses financial leverage.

27

Coverage Ratios

♦ Times Interest Earned

– Values

•1997: 106.40 •1998: 85.64 •1999: 51.71 Some analysts use all debt-service charges, lease payment and cash dividends on preferred stock instead of interest payment alone. Some financial analysts prefer to use the pre-tax gross income – Formula instead of operating income • Annual operating income ÷ Annual interest payment

KO’s income can fall 98.07% (1 – (1/51.7 times) before it will be insufficient to cover the firm’s interest expense.

28

**A Cash Flow Ratio
**

♦ Two values from the Income & Expense Statement

can be used to define a company’s cash flow

– Earnings before interest and taxes (EBIT) – Depreciation/Amortization

• Allocates an asset’s cost over its useful life • A non-cash expense deducted from revenue • Reduces taxes

**♦ KO’s 1999 cash flow is
**

ratio

**♦ Can now calculate the Cash flow-to-long-term-debt
**

– 4,774 ÷ 854 = 5.59

– EBIT of $3,982 + Depreciation of $792 = $4,774

29

**Financial Leverage Ratios
**

♦ Total Debt to Total Asset Ratio

– Formula – Values

• 1997: 0.57 • 1998: 0.56 • 1999: 0.56 • Total debt ÷ Total assets

**♦ Total Debt to Total Equity
**

– Formula – Values

• 1997: 131.7 • 1998: 127.8 • 1999: 127.3 • Total debt ÷ Total equity

30

**Financial Leverage Ratios
**

♦ Long-term Debt to Equity

– Formula – Values

• 1997: 0.31 • 1998: 0.25 • 1999: 0.24 • Long-term debt ÷ Equity

**♦ Long-term Debt to Capitalization
**

– Formula – Values

• 1997: 0.24 • 1998: 0.20 • 1999: 0.19 • Long-term debt ÷ Capitalization Sum of permanent current liabilities, long-term debt, preferred stock and stockholders’ equity.

31

**Financial Leverage Ratios
**

♦Total Asset to Equity Ratio

– Formula

• Total assets ÷ Equity

– Values

• 1997: 231.7% • 1998: 227.8% • 1999: 227.3%

**♦Financial ratios are sometimes calculated
**

– Often more realistic and relevant

with market values rather than book values 32

Profitability Ratios

♦ Net Profit Margin

– Formula

• Net income ÷ Sales

– Values

• 1997: 0.22 or 22% • 1998: 0.19 or 19% • 1999: 0.12 or 12%

♦Return on Asset

–Formula

•Net income ÷ Total assets

An appropriate standard is needed to interpret a profit margin. A dollar’s worth of assets yielded about 11¢ of aftertax earnings in 1999.

–Values

•1997: 0.24 or 24% •1998: 0.18 or 18% •1999: 0.11 or 11%

33

Profitability Ratios

♦ Return on Equity (ROE)

– Formula

• Net income ÷ Equity

– Values

• 1997: 0.57 or 57% • 1998: 0.42 or 42% • 1999: 0.26 or 26%

If a firm has zero debt, its ROA and ROE are equal.

**♦Long-Term Capital’s Pretax Rate of Return
**

–Formula

•(Interest + Pretax earnings) ÷ Capitalization

–Values

•1997: 0.75 or 75% •1998: 0.58 or 58% •1999: 0.37 or 37%

If the rate does not exceed current interest rates, the firm is not earning enough to pay its debts.

34

**Per Share Data for Common Stock
**

♦Earnings Per Share (EPS)

• 1997: $1.67 • 1998: $1.43 • 1999: $0.98

– Formula • Net income ÷ # of common shares outstanding – Values

**♦ Cash Dividend Per Share
**

– Formula – Values

• 1997: $0.56 • 1998: $0.60 • 1999: $0.64 • Total corporate dividend ÷ # of common shares outstanding

35

**Per Share Data for Common Stock
**

♦ Payout Ratio

– Formula – Values

• 1997: 0.336 or 33.6% • 1998: 0.419 or 41.9% • 1999: 0.653 or 65.3% • Cash dividends per share ÷ EPS

♦Retention Rate

–Formula –Values

Measures the percentage of earnings the firm pays out as a dividend.

•Retained Earnings ÷ Net income •1997: 0.664 or 66.4% •1998: 0.581 or 58.1% •1999: 0.350 or 35.0%

Measures the percentage of earnings the firm retains.

36

**Per Share Data for Common Stock
**

♦Price-Earnings Ratio (P-E)

– Formula – Values

• 1997: Low of 32 to high of 47 • 1998: Low of 36 to high of 56 • 1999: Low of 48 to high of 72 • Market price per share ÷ EPS

37

**Analyzing and Interpreting Ratios
**

♦DuPont Analysis

– Allows for a thorough analysis of ROE

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

Equity Turnover Net profit margin

=

**Sales Total assets Net income × × Totalassets Equity Sales
**

Total asset turnover Financial leverage ratio Net profit margin

38

**KO’s DuPont Analysis
**

Year 1990 1991 1992 1993 1994 Asset Turnover 1.10 1.14 1.18 1.16 1.17 1.20 1.16 1.12 0.98 0.92 Financial Leverage 2.41 2.40 2.84 2.62 2.65 2.79 2.63 2.32 2.28 2.27 Profit Margin 13.50% 13.98% 12.73% 15.58% 15.78% 16.57% 18.70% 21.88% 18.78% 12.27% ROE 35.91% 38.17% 42.80% 47.47% 48.79% 55.38% 56.73% 56.76% 42.04% 25.52% Profit Margin rose and then fell over the decade. The increased use of financial leverage increased ROE through 1996.

Asset Turnover rose and then fell over the decade.

1995 1996 1997 1998 1999

39

Analysis of Growth

♦Common stock price appreciation depends

on various factors

– Growth financed internally depends on the amount of retained earnings – A corporation’s growth rate depends on the return on equity

• Growth rate = RR x ROE

Shows that multiple factors influence growth—one factor can rise and another fall and growth can remain unchanged. – Substituting the three-part DuPont ROE equation, we obtain

Growth rate = RR × Sales Total assets Net income × × Total assets Equity Sales

40

Risk Analysis

♦As a firm’s risk increases

– Investors demand higher interest rates (returns)

• Thus, the price of the firm’s bonds and stocks will drop (inverse relationship)

**♦How do you measure risk?
**

– Coefficient of variation

• Standard deviation ÷ average value • Rescales different-size standard deviations to make them easily comparable

41

Risk Analysis

♦Business risk

– Determined by volatility of operating income – Arises from fluctuations in sales and production costs – Arises due to the use of financial leverage (debt) 42

♦Financial risk

**Ratio Standards of Comparison
**

♦Cross-Sectional standards

– – – – – – Moody’s Standard & Poor’s Fitchs Value Line Duff and Phelps Dunn and Bradstreet

**– Compare a firm’s financial ratios to other firms or industry average
**

• Industry averages are published by companies such as

– Can reveal a firm’s strengths/weaknesses compared to other firms

43

**Ratio Standards of Comparison
**

♦Time-Series standards

– Compare a firm to its own ratios from other years

• Helps highlight trends/changes that have occurred

44

Potential Problems with Financial Analysis

♦Inflation distortions

– Can be a serious problem with the balance sheet

• Some fixed assets are reported at their historical costs

– After several years of high inflation historical costs can be irrelevant

**♦Vague definition of accounting income
**

– A firm can modify its accounting income depending upon certain actions

• Such as which depreciation method or inventory valuation technique is used

45

Potential Problems with Financial Analysis

♦Consolidated financial statements ♦Goodwill

– When a firm owns a subsidiary corporation accounting issues arise when considering minority interests – When a company merges, oftentimes ‘goodwill’ is then reflected on the consolidated balance sheet

• This intangible asset cannot be measured with precision

46

**The Bottom Line
**

♦ Financial ratios are computed using basic financial

statements like the balance sheet, income and expense statement and the statement of cash flows ♦ Financial ratios include

– – – – – – – – – solvency ratios coverage ratios turnover ratios profitability ratios cash flow ratios leverage ratios growth ratios per share data statistical risk analysis

47

**The Bottom Line
**

♦ Comparison of a firm’s ratios can be done on a ♦ Many additional ratios exist that were not covered in

this chapter

– Some analysts like to restate ratios – Some industries have ratios peculiar to that industry – Inflation – Different accounting methods – Mergers – Cross-sectional basis – Time-series basis

♦ Financial ratios can be distorted by

48

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