Module One

Jackie Channn

Chapter4AnalyzingFinancialStatements1.pdf

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Fundamentals of Corporate Finance Fourth Edition

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.

Chapter 4

Analyzing Financial Statements

Chapter 4: Analyzing Financial Statements

Learning Objectives

1. Explain the three perspectives from which financial statements can be viewed

2. Describe common-size financial statements, explain why they are used, and be able to prepare and use them to analyze the historical performance of a firm

3. Discuss how financial ratios facilitate financial analysis and be able to compute and use them to analyze a firm’s performance

4. Describe the DuPont system of analysis and be able to use it to evaluate a firm’s performance and identify corrective actions that may be necessary

5. Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis

6. Identify the major limitations in using financial statement analysis

Perspectives on Financial Statement Analysis

• Stockholders focus on net cash flows, risk, rate of return, and the market value of the firm’s stock

• Managers focus on rate of return, efficient use of assets, controlling costs, increasing net cash flows, increasing the market value of the firm’s stock, and job security

• Creditors focus on the predictability of revenues and expenses, the ability to meet short-term obligations, the ability to make loan payments as schedule, and avoidance of changes in risk

Guidelines for Financial Statement Analysis

• Understand which perspective: stockholder, manager, or creditor

• Use audited financial statements

• Use 3 to 5 years of statements to enable trend analysis

• Benchmark to competitors of similar size with similar products and services

Common-Size Financial Statements

• Common-size financial statements show the dollar amount of each item as a percentage of a reference value

o Common-size balance sheet may use total assets as the reference value; each item is expressed as a percentage of total assets

o Common-size income statement may use net sales as the reference value; each item is expressed as a percentage of net sales

Common-Size Balance Sheet

• The Common-Size Balance Sheet standardizes the amount in a balance sheet account by converting the dollar value of each item to its percentage of total assets

o Dollar values on a regular balance sheet provide information on the number of dollars associated with a balance sheet account

o Percentage values on a common-size balance sheet provide information on the relative size or importance of the dollars associated with a balance sheet account

Common-Size Income Statement

• The most useful way to prepare a common size income statement is to express each account as a percentage of net sales

• Each expense is interpreted as the cost incurred to generate $1 in sales

Financial Ratios and Firm Performance

• Financial ratios establish a common reference point across firms, even though the numerical value of the reference point will differ from firm-to-firm

o Ratios make it easier to compare the performance of large firms to that of small firms

o Ratios make it easier to compare the current and historical performance of a single firm as the firm changes over time (trend analysis)

Categories of Common Financial Ratios

• Liquidity ratios

• Efficiency ratios

• Leverage ratios

• Profitability ratios

• Market Value ratios

Short-Term Liquidity Ratios

• Liquidity ratios indicate a firm’s ability to pay short-term obligations with short-term assets without endangering the firm. In general, higher ratios are a favorable indicator

Equation 4.1

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Equation 4.2

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Efficiency Ratios (1 of 2) • Efficiency ratios indicate a firm’s ability to use assets to

produce sales. These are also called turnover ratios. In general, higher numbers are a favorable indicator. For Days Sales in Inventory, however, a lower number is favorable.

Equation 4.3

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 Equation 4.4

𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 365 𝑑𝑎𝑦𝑠

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Efficiency Ratios (2 of 2)

Equation 4.5

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

Equation 4.6

𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = 365 𝑑𝑎𝑦𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Asset Turnover Ratios

Equation 4.7

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equation 4.8

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

Leverage Ratios

• Leverage ratios indicate whether a firm is using the appropriate amount of debt financing. In general, higher ratios indicate greater potential return and greater bankruptcy risk. Equation 4.9

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equation 4.10

𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Equation 4.11

𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Coverage Ratios

• For the following ratios, a higher number generally indicates less bankruptcy risk and (possibly) lower potential return Equation 4.12

𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 = 𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

Equation 4.13

𝐶𝑎𝑠ℎ 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 = 𝐸𝐵𝐼𝑇𝐷𝐴

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

Profitability Ratios (1 of 2)

• Profitability ratios indicate whether a firm is generating adequate profit from its assets. In general, higher ratios indicate better performance.

Equation 4.14

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Equation 4.15

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝐸𝐵𝐼𝑇

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Profitability Ratios (2 of 2) Equation 4.16

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 Equation 4.17

𝐸𝐵𝐼𝑇 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐸𝑅𝑂𝐴 = 𝐸𝐵𝐼𝑇

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 Equation 4.18

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equation 4.19

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Market Value Indicators

• Market value ratios indicate how the market is valuing the firm’s equity. Higher ratios indicate greater shareholder wealth. Equation 4.20

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Equation 4.21

𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑎𝑡𝑖𝑜 = 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Equation 4.22

𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

The DuPont System

• Diagnostic tool for evaluating a firm’s financial health

• Uses related ratios that link the balance sheet and income statement

• Based on two equations that connect a firm’s ROA and ROE

• Used by management and shareholders to understand factors that drive ROE

ROA and ROE Equations Equation 4.23

𝑅𝑂𝐴 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Equation 4.24

𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

The DuPont Equation

Equation 4.25

𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

Equation 4.26

𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 ×

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Equations 4.25 and 4.26 show that ROE is driven by profitability, operating efficiency, and amount of leverage (debt)

Selecting a Benchmark

• A ratio or ratio analysis is relevant only when compared to an appropriate benchmark

o Trend Analysis – comparison to the firm’s historical performance

o Industry Analysis – comparison to the aggregate of firms in the same industry

• Standard Industrial Classification (SIC) System

• North American Industry Classification System (NAICS)

o Peer Group Analysis – comparison to a select group of firms in the same industry

Limitations of Financial Statement Analysis

• Weaknesses of financial statement analysis

o Not an exact science

o Relies on accounting data and historical costs

o Few guidelines or principles for determining whether a ratio is “high” or “low,” or is a reason for confidence or for concern

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