Chapter 14 investments financial statement analysis

Statement of Cash Flows• A financial statement showing a firm’s cash receipts and cash payments during a specified pe riod.. Statement of Cash FlowsThree main sections • Cash flow relate

Chapter 14

Financial Statement Analysis

14.1 The Major Financial Statements

 Income statement

 Balance sheet

 Statement of cash flows

14-2

Income Statement

• Four broad types of accounts:

- Cost of goods sold

- General and administrative expenses

- Interest expense

- Taxes on earnings

• Common Size income statements

- Divide each account by net sales

- Eliminates size distortions

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Table 14.1 Consolidated Statement of Income

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Balance Sheet

• Assets

- Current: Converted into cash within 1 year

- Long-term

• Liability (current and long term) and stockholders’ equity

• Common size balance sheet

- Divide each account by total assets

- Each account presented as a percent of the total

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Table 14.2 Consolidated Balance Sheet A

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Table 14.2 Consolidated Balance Sheet B

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Statement of Cash Flows

• A financial statement showing a firm’s cash receipts and cash payments during a specified pe riod.

- Recognizes transactions only if cash changes hands

- “Undoes” much of accrual accounting to get at cash changes

- Does not allocate capital expenditures through time via depreciation as income statement does

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Statement of Cash Flows

Three main sections

• Cash flow related to operations

• Cash flow related to investing

• Cash flow related to financing

• Allows the analyst to understand which of the firm’s activities are using and which generating cash.

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Statement of Cash Flows

• Not all sources of cash are equally sustainable.

• Would you rather invest in a firm that is primarily generating cash through operations or through financing?

• It is difficult to evaluate whether the amount of cash flow related to investing is ‘good’ or ‘bad.’ What else woul

d we need to know?

• Rate of return on the investment

• Comparable data over time or from competitors

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Table 14.3 Consolidated Statement of Cash Flows

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14.2 Accounting Versus Economic Earnings

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Accounting Versus Economic Earnings

14.3 Profitability Measures

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Past Versus Future ROE

ROE = Net Profits / Equity

• Data from recent past may provide information regarding future ROE

• Analysts should always keep an eye on the future

• Expectations of future dividends and earnings determine intrinsic value of stock

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Financial Leverage and ROE

• Pay careful attention to the firm’s debt-equity mix and to the interest rate on its debt

• The relationship among ROE, ROA, and leverage:

• ROE = Net Profits / Equity

• ROA = EBIT / Total Assets

• If ROA > the borrowing rate, the firm earns more on its money than it pays out to creditors

• If ROA< the interest rate paid on debt, ROE will decline by an amount that depends on the debt/equit

y

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(1 Tax rate) ( Interest rate) Debt

Equity

Financial Leverage and ROE

14.4 Ratio Analysis

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Ratio Analysis

• Purpose of Ratio Analysis

- Understand the factors that affect performance

- Trend analysis

- Comparative analysis

- Combination of the two

• Use by External Analysts

- Important information for investment community

- Important for credit markets

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DuPont Decomposition of ROE

ROE can be decomposed into various ratios that reflect different aspects of a firm’s performance:

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Burden

Burden

Leverage Turnover

Margin

Interest

Tax

(5)

(4)

(3)

(2)

(1)

Assets

Sales Sales

EBIT EBIT

Profit

Pretax Profit

Pretax

Profit

Net ROE

Type of Financial Ratios

• Ratio (1) Tax Burden (TB):

- Measures the percentage of pretax profit that the firm keeps after paying taxes

• Ratio (2) Interest Burden (IB):

- Measures the percent of EBIT kept after paying interest expense

-

- This ratio is 1 if the firm has no debt

- Closely related to the interest coverage ratio, defined as EBIT/Interest expense

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EBIT

Expense Int erest

EBIT EBIT

Prof it Pret ax = −

Burden

Burden

Leverage Turnover

Margin

Interest

Tax

(5) (4)

(3)

(2)

(1)

Assets

Sales Sales

EBIT EBIT

Profit

Pretax Profit

Pretax

Profit Net

Type of Financial Ratios

• Ratio (3) Operating Profit Margin

- Measures the percentage of sales revenue that remains after subtracting cost of

goods sold, selling and administrative expenses and depreciation.

• Ratio (4) Asset Turnover Ratio (ATO)

- Measures the efficiency of the firm at generating sales per dollar invested in assets.

- Note: Margin x ATO = ROA

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Burden

Burden

Leverage Turnover

Margin

Interest

Tax

(5) (4)

(3)

(2)

(1)

Assets

Sales Sales

EBIT EBIT

Profit

Pretax Profit

Pretax

Profit Net

Type of Financial Ratios

• Ratio (5) Leverage ratio

- Leverage ratio = (Equity + Debt) / Equity = 1 + (Debt / Equity)

- The leverage ratio is a measure of the percentage of debt in total capitalization

- Note that it appears that using more debt as a percent of capital will

increase ROE, but using more debt also reduces the interest burden ratio

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Burden

Burden

Leverage Turnover

Margin

Interest

Tax

(5) (4) (3)

(2)

(1)

Equity

Assets Assets

Sales Sales

EBIT EBIT

Profit

Pretax Profit

Pretax

Profit Net

Type of Financial Ratios

• Ratio (5) Leverage ratio

- Compound leverage factor (CLF) = Interest burden x Leverage

- If the CLF > 1, the use of debt will increase ROE

- If the CLF < 1, the use of debt will decrease ROE

- CLF will be greater than 1 if ROA > Interest rate on debt

- What does this imply about when firms should use more debt?

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Burden

Burden

Leverage Turnover

Margin

Interest

Tax

(5) (4) (3)

(2)

(1)

Equity

Assets Assets

Sales Sales

EBIT EBIT

Profit

Pretax Profit

Pretax

Profit Net

Sample ROE Decomposition

Compare two firms, Nodett and Somdett

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More on Ratios

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Table 14.8 Growth Industries (GI) financial statements ($thousands)

Ratio Analysis using GI

Asset Utilization Ratios (2010 data for GI): Evaluate efficiency

1.Total Asset Turnover

2.Fixed Asset Turnover

3.Inventory Turnover

4.Average collection period or days sales in receivables

Industry Average

• Lower fixed-asset turnover and investor turnover

• Higher average days receivables.

 Higher investment in working capital and thus lower ROA

 Have problems with excess plant capacity along with poor inventory and receivables management practices

Assets Fixed

Avg.

Sales

Inventory Average

Sold Goods

of Cost

365 Sales

s Receivable Accounts

Avg.

×

606.216,000)/2($259,200

$144,000

=+

Assets Avg.

)/2000,324($518,400

$144,000

=+

485.108,000)/229,600

1($

$79,200

=+

days100.4

365

$144,000

$36,000)/2($43,200

=

×+

Ratio Analysis using GI

Liquidity Ratios (2010 data for GI): Evaluate riskiness

1.Current Ratio

2.Quick Ratio

3.Cash ratio

IndustryAverage

2.0

1.0

0.70

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• The decline in the liquidity ratios combined with the decline in coverage ratio.

 GI’s credit rating is likely to decline and experience relatively poor credit risk

s Liabilitie Current

s Receivable Securities

Marketable

s Liabilitie Current

Securities Marketable

Cash +

49

$266,272

$129,600-

$259,200

=

s Liabilitie Current

Assets

272 , 266

$

$259,200

=

324

$266,272

$43,200

$86,400

=+

Ratio Analysis using GI

Market Price Ratios (2010 data for GI)

.69

8.0

8.64%

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• Lower P/B and P/E, which mean lower growth opportunity

• Lower ROE, which is not a good firm.

 However, distinguish between good firms and good investments.

Firm with low ROEs can be good investments if the price is low enough

hare Earnings/s

stock Price

Value Book

at Equity

Income Net

97.300

$5,285/1,0

$21.00

=

e Value/shar Book

stock

000,1/128,177

$

$21.00

=

%98.2

$177,128

,2855

P/B ROE

B P

ROE P

E eld EarningsYi

/ )

/

Figure 14.1 DuPont Decomposition for Hewlett-Packard

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Choosing a Benchmark

Table 14.10 Ratios for Major Industries

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Choosing a Benchmark

14.7 Value Investing: The Graham Technique

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Benjamin Graham

• Founder of modern fundamental analysis

• Graham believed careful analysis of a firm’s financial statements could turn up bargain stocks and his work was used by generatio

ns of analysts

• He developed many different rules for determining the most important financial ratios, as his ideas became popular they stopped working

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