ACCT week 4

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Chapter 3

Financial Statement Analysis Tools

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis Tools Covered in this Chapter

In this chapter will see:

How to calculate many financial ratios

How to use financial ratios to make predictions about potential bankruptcy

How to calculate the economic profit (as opposed to net income) that a firm earned in a period

Financial Ratios

Financial ratios are simply comparisons of two financial statement items

These comparisons help us to draw conclusions about the financial health of the firm that aren’t immediately obvious by looking at the raw values (e.g., net income may be positive, but what matters is how large it is relative to sales, assets, or equity)

We will calculate five categories of ratios:

Liquidity ratios

Efficiency ratios

Leverage ratios

Coverage ratios

Profitability ratios

Liquidity Ratios

Liquidity ratios describe the ability of a firm to meets its short-term obligations by comparing current assets to current liabilities

Current assets will be converted to cash which will then be used to retire current liabilities

For both ratios, higher values are indicative of a higher probability of being able to pay off short-term debts

Efficiency Ratios

Efficiency ratios, also called asset management ratios, provide information about how well the company is using its assets to generate sales

Leverage Ratios (1 of 2)

Leverage ratios describe the degree to which the firm uses debt in its capital structure

Leverage Ratios (2 of 2)

Generally, lower leverage ratios are preferred though a reasonable amount of debt is usually considered to be a good thing

Coverage Ratios

Coverage ratios describe the quantity of funds available to “cover” certain expenses, particularly interest expense (though this is not the only one)

We generally prefer higher coverage ratios as that indicates a level of debt that is easy for the firm to service

Profitability Ratios (1 of 2)

Profitability ratios measure how profitable a firm is relative to sales, total assets, or equity

Profitability Ratios (2 of 2)

Without exception, higher profitability ratios are preferred over lower ones

E P I’s Financial Ratios

The image to the right shows the calculations of all financial ratios that we discussed

These values were calculated using the financial statements given in Chapter 2

DuPont Analysis

DuPont analysis refers to a method of decomposing the return on equity into its components to better understand the R O E and why it may have changed (or why it is different than that of some other firm)

There are two versions of DuPont analysis:

Using Financial Ratios

Financial ratios can be analyzed in three ways:

Trend Analysis

Comparing to Industry Averages

Compared to Company Goals and Debt Covenants

Additionally, ratios can be used in valuation analysis and for financial distress prediction

Financial Distress Prediction (Z-Scores)

In 19 68, Edward Altman first used discriminant analysis to classify firms into one of three categories: bankruptcy predicted, possible bankruptcy, and no financial distress

Today, this model would be considered to be a “machine learning” model alongside other classification methods (e.g., k-means or support vector machines)

We covered two Z-Score models:

The Original Z-Score Model

The Z-Score Model for Private Firms

The Original Z-Score Model

The original Z-Score model was for publicly traded firms:

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5

where

Z-Score Model for Private Firms

Altman also estimated a model for privately held firms to allow for the fact that you cannot calculate the market value of equity for a private firm

This model is very similar, but the coefficients changed (note that X4 has been redefined):

Z = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5

where

Economic Profit Measures of Performance

Economic profit is the profit earned in excess of the firm’s costs, including its implicit opportunity costs (primarily its cost of equity, which is ignored by accounting profit)

Definition of Economic Profit:

Note that economic profit is often referred to as Economic Value Added (E V A), which is a trademark of Stern Stewart and Company