OM FINAL

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

STANDARDIZED FINANCIAL STATEMENTS BALANCE SHEETS EXAMPLE COMMON-SIZE BALANCE SHEETS EXAMPLE INCOME STATEMENT EXAMPLE COMMON-SIZE INCOME STATEMENT EXAMPLE

STANDARDIZED FINANCIAL STATEMENTS

Common-Size Balance Sheets All accounts = percent of total assets (%TA)

Common-Size Income Statements All line items = percent of sales or revenue (%SLS)

Standardized statements are useful for: Comparing financial information year-to-year Comparing companies of different sizes, particularly within the same industry

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

STANDARDIZED FINANCIAL STATEMENTS BALANCE SHEETS EXAMPLE COMMON-SIZE BALANCE SHEETS EXAMPLE INCOME STATEMENT EXAMPLE COMMON-SIZE INCOME STATEMENT EXAMPLE

BALANCE SHEETS EXAMPLE

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

STANDARDIZED FINANCIAL STATEMENTS BALANCE SHEETS EXAMPLE COMMON-SIZE BALANCE SHEETS EXAMPLE INCOME STATEMENT EXAMPLE COMMON-SIZE INCOME STATEMENT EXAMPLE

COMMON-SIZE BALANCE SHEETS EXAMPLE

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

STANDARDIZED FINANCIAL STATEMENTS BALANCE SHEETS EXAMPLE COMMON-SIZE BALANCE SHEETS EXAMPLE INCOME STATEMENT EXAMPLE COMMON-SIZE INCOME STATEMENT EXAMPLE

INCOME STATEMENT EXAMPLE

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

STANDARDIZED FINANCIAL STATEMENTS BALANCE SHEETS EXAMPLE COMMON-SIZE BALANCE SHEETS EXAMPLE INCOME STATEMENT EXAMPLE COMMON-SIZE INCOME STATEMENT EXAMPLE

COMMON-SIZE INCOME STATEMENT EXAMPLE

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

WHY EVALUATE FINANCIAL STATEMENTS? BENCHMARKING PROBLEMS WITH FINANCIAL ANALYSIS CATEGORIES OF FINANCIAL RATIOS

WHY EVALUATE FINANCIAL STATEMENTS?

Internal uses Performance evaluation - compensation and comparison between divisions Planning for the future - guide in estimating future cash flows

External uses Creditors Suppliers Customers Stockholders

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

WHY EVALUATE FINANCIAL STATEMENTS? BENCHMARKING PROBLEMS WITH FINANCIAL ANALYSIS CATEGORIES OF FINANCIAL RATIOS

BENCHMARKING

Allow for better comparison through time or between companies

Used both internally and externally Time-Trend Analysis

How the firm’s performance is changing through time Internal and external uses

Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

WHY EVALUATE FINANCIAL STATEMENTS? BENCHMARKING PROBLEMS WITH FINANCIAL ANALYSIS CATEGORIES OF FINANCIAL RATIOS

SELECTED TWO-DIGIT SIC CODES

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

WHY EVALUATE FINANCIAL STATEMENTS? BENCHMARKING PROBLEMS WITH FINANCIAL ANALYSIS CATEGORIES OF FINANCIAL RATIOS

PROBLEMS WITH FINANCIAL ANALYSIS

Conglomerates–No readily available comparables

Global competitors–Different accounting procedures

Different fiscal year ends

Seasonal variations and one-time events: For firms in seasonal businesses (such as a retailer with a large Christmas season), this can lead to difficulties in comparing balance sheets because of fluctuations in accounts during the year.

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

WHY EVALUATE FINANCIAL STATEMENTS? BENCHMARKING PROBLEMS WITH FINANCIAL ANALYSIS CATEGORIES OF FINANCIAL RATIOS

CATEGORIES OF FINANCIAL RATIOS

Liquidity ratios or Short-term solvency

Financial leverage ratios or Long-term solvency ratios

Asset management or Turnover ratios

Profitability ratios

Market value ratios

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

INCOME STATEMENT

Revenues 51,407 Cost of goods sold 25,076 Gross profit 26,331 Selling, general, and administrative expenses 16,504 Operating income/Earnings before interest and taxes (EBIT) 9,827 Interest expense 629 Other nonoperating income, net 152 Earnings before income taxes/Taxable Income 9,350 Income tax 2,869 Net income 6,481

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

BALANCE SHEET–ASSETS

Cash, cash equiv., and marketable securities 5,469 Investment securities 423 Accounts receivable 4,062 Inventories 4,400 Deferred income taxes 958 Prepaid expenses and other receivables 1,803 Total current assets 17,115

Net property, plant, and equipment 14,108 Intangible assets 23,900 Other assets 1,925 Total assets 57,048

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

BS–LIABILITIES AND STOCKHOLDERS’ EQUITY

Accounts payable 3,617 Accrued and other liabilities 7,689 Taxes payable 2,554 Debt due in one year 8,287 Total current liabilities 22,147 Long-term debt 12,554 Deferred income taxes 2,261 Other noncurrent liabilities 2,808 Total liabilities 39,770

Convertible Class A preferred stock 1,526 Common shareholders’ equity 15,752 Total shareholders’ equity 17,278 Total liabilities and shareholders’ equity 57,048

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

LIQUIDITY RATIOS

The primary concern is the firm’s ability to pay its bills over the short run without undue stress. The ability to meet its short-term, immediate obligations.

Current ratio = Current assets

Current liabilities =

17, 115 22, 147

= 0.77

Quick ratio = Cash+Short-term marketable investments+Receivables

Current liabilities (1)

= 5, 469 + 423 + 4, 062

22, 147 = 0.45

Cash ratio = Cash+Short-term marketable investments

Current liabilities =

5, 469 + 423 22, 147

= 0.27

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

LIQUIDITY RATIOS’ MEANING

Current Ratio: One of the best-known and most widely used ratios.

Quick (or Acid-Test) Ratio: (1) Inventory is often the least liquid current asset. Some of the inventory may later turn out to be damaged, obsolete, or lost. (2) Relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory. Thus we use Quick (or Acid-Test) Ratio.

Cash Ratio: A very short-term creditor might be interested in the cash ratio.

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

SOLVENCY/FINANCIAL LEVERAGE RATIOS Solvency/Financial Leverage Ratios–ability to meets its debt obligations or financial leverage.

Total debt = Debt due in one year + Long-term debt + Deferred income taxes + Other noncurrent liabilities (2)

= 8, 287 + 12, 554 + 2, 261 + 2, 808 = 25, 910.

Total debt ratio = Debt-to-assets ratio = Total debt

Total assets =

25, 910

57, 048 = 0.45

Total equity = Total shareholders’ equity

Debt-to-equity ratio = Total debt

Total equity =

25, 910

17, 278 = 1.50

Financial leverage = Equity Multiplier = Total assets

Total equity =

57, 048

17, 278 = 3.30

Long-term debt-to-assets ratio = Long-term debt

Total assets =

12, 554

57, 048 = 0.22

Times interest earned ratio = Interest coverage ratio = Earnings before interest and taxes (EBIT)

Interest payments =

9, 827

629 = 15.62

Suppose the Cash flow from operations is 9,362.

Cash flow coverage ratio = Cash flow from operations + Interest payments + Income Tax

Interest payments =

9, 362 + 629 + 2, 869

629 = 20.45

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

ACTIVITY/ASSET MANAGEMENT RATIOS (I)

Activity/Asset Management Ratios–effectiveness in putting its asset investment to good use.

Inventory turnover = Cost of goods sold

(Average) inventory =

25, 076 4, 400

= 5.70

Receivables turnover = Total revenue

(Average) Accounts receivable =

51, 407 4, 062

= 12.66

Total asset turnover = Total revenue

(Average) total assets =

51, 407 57, 048

= 0.90

Capital Intensity = (Average) total assets

Total revenue =

57, 048 51, 407

= 1.11

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

ACTIVITY/ASSET MANAGEMENT RATIOS (II)

Number of days of inventory = 365

Inventory turnover =

Inventory

Cost of goods sold/365 =

4, 400

25, 076/365 = 64.05

Number of days of receivables = 365

Receivables turnover =

Accounts receivable

Revenue/365 =

4, 062

51, 407/365 = 28.84

Number of days of payables = 365

Payables turnover =

Accounts payable

Purchases*/365 =

3, 617

25, 836/365 = 51.10

*NOTE: Purchases=COGS+Ending inventory−Beginning inventory. Suppose the Inventory of 2003 is 3,640. Then Purchases= 25, 076 + 4, 400 − 3, 640 = 25, 836

Operating cycle = Number of days of inventory + Number of days of receivables = 64.05 + 28.84 = 92.89

Net operating cycle = Number of days of inventory + Number of days of receivables − Number of days of payables (3) = 64.05 + 28.84 − 51.10 = 41.79

Note that sometimes, we also use this formula

Payables turnover = COGS

Accounts payable =

25, 076

3, 617 = 6.93

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

ACTIVITY/ASSET MANAGEMENT RATIOS’ MEANING

Inventory Ratios: the higher this ratio is, the more efficiently we are managing inventory. It will take about Number of days of inventory to work off our current inventory. For example, in 2014, General Motors had a 94-day supply. It would have taken General Motors 94 days to deplete the available supply, or, equivalently, that General Motors had 94 days of vehicle sales in inventory. Mitsubishi had a 75-day supply of cars, while Ford had a mere 25-day supply. Historically, a 60-day supply of inventory has been considered normal in the automobile industry. This type of information is useful to auto manufacturers in planning future marketing and production decisions.

It might make more sense to use the average inventory in calculating turnover. It depends on the purpose of the calculation. If we are interested in how long it will take us to sell our current inventory, then using the ending figure is probably better.

If the total asset turnover is 0.64 times, this means for every dollar in assets, we generated $0.64 in sales. The capital intensity ratio, is simply the reciprocal of (that is, 1 divided by) total asset turnover. It can be interpreted as the dollar investment in assets needed to generate $1 in sales. High values correspond to capital-intensive industries (such as public utilities). The capital intensity is $l/0.64 = $1.56. That is, it takes $1.56 in assets to create $1 in sales.

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

PROFITABILITY RATIOS Profitability Ratios–ability to manage its expenses to generate profits from its sales.

Gross profit margin = Gross profit

Total revenue =

26, 331 51, 407

= 0.51

Operating profit margin = Operating income

Total revenue =

9, 827 51, 407

= 0.19

Profit margin = Net profit margin = Net income

Total revenue =

6, 481 51, 407

= 0.13

Pretax profit margin = Earnings before taxes

Total revenue =

9, 350 51, 407

= 0.18

Operating return on assets = Operating income

Total assets =

9, 827 57, 048

= 0.17

Return on assets = Net income Total assets

= 6, 481

57, 048 = 0.11

Return on equity = Net income Total equity

= 6, 481 17, 278

= 0.38

ROA and ROE should properly be called return on book assets and return on book equity.

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

DUPONT ANALYSIS

Return on equity = Net income Total equity

(4)

= Total assets Total equity

× Return on assets

= Financial leverage × Return on assets

= Total assets Total equity

× Net income Total assets

= Total assets Total equity

× Revenues

Total assets ×

Net income Revenues

= Financial leverage × Total asset turnover × Net profit margin

= Total assets Total equity

× Revenues

Total assets ×

Operating income Revenues

× Pre-tax Income

Operating income × (1 − TaxRate)

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

MARKET VALUE MEASURES b= Retention ratio = (Earnings − Cash dividends)/Net income. Dividend payout ratio = 1 − b = Cash dividends/Net income.

Price–earning (PE) ratio = Price per share

Earnings per share (EPS)

Price–sales ratio = Price per share Sales per share

Market-to-book ratio = Market value per share Book value per share

EBITDA ratio = Enterprise value

EBITDA

Enterprise value = Total market value of the stock (5)

+ Book value of all liabilities − Cash

EBITDA = EBIT + Depreciation & Amortization

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS

STANDARDIZED FINANCIAL STATEMENTS USING FINANCIAL STATEMENT INFORMATION

FINANCIAL RATIOS

EXAMPLES LIQUIDITY RATIOS SOLVENCY/FINANCIAL LEVERAGE RATIOS ACTIVITY/ASSET MANAGEMENT RATIOS PROFITABILITY RATIOS DUPONT ANALYSIS MARKET VALUE MEASURES

SUM. OF INTERNAL AND SUSTAINABLE GROWTH RATES

YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS