Week 3

Financial Statement Analysis

Chapter Overview

This chapter discusses the basic financial statements, the differences between accounting and economic income, return on equity (ROE), the decomposition of the ROE into component ratios for the purpose of financial analysis, other ratios relevant for financial analysis, and financial statement comparability problems.

LEARNING OBJECTIVES

After studying this chapter, the student should be able to analyze a firm using the basic financial statements to perform ratio analysis. The student should be able to identify the source of problems over time by decomposing the ROE using the DuPont procedure. The student should also be able to identify comparability problems across firms due to the varying generally accepted accounting principles available to the firm.

Presentation of Material

19.1 Major Financial Statements

The purpose of performing financial statement analysis is to use the firm’s accounting data in the security valuation process. An analyst can use the actual financial statements or use financial ratios constructed from the financial statements. Financial statement analysis can often lead the analyst to examine certain factors but it rarely gives the analyst a complete answer.

A distinction between economic and accounting earnings is also formed. Economic earnings are the sustainable cash flows that can be paid out to stockholders without impairing the productive capacity of the firm. Accounting earnings are affected by several conventions regarding the valuation of assets such as inventories.

A description of the basic financial statements is presented here. Analysts use common sized statements to make comparisons between firms. Indexed or trend statements are used to analyze changes over time. The statement of cash flows is used to identify where a firm got its funds and how the firm used the fund over the statement period. A set of sample statements, which students should be familiar, are provided in text.

19.2 Measuring Firm Performance

Manager responsibilities:

After establishing the basics of financial statements, students move to how this information measures firm performance. They learn a manager has two main responsibilities: investment decisions and financing decisions. Figure 19.1 further breaks down this decision-making process.

19.3 Profitability Measures

Common profitability measures are discussed. Students learn that ROE is a key determinant of earnings growth and is discussed in depth later in the chapter (the previous chapter as well). The concept of economic value added (EVA) is also introduced, calculating residual income in excess of the opportunity cost of capital.

19.4 Ratio Analysis

The DuPont system decomposes ROE (it might be useful to students to point out the origins of the DuPont system). The decomposition process allows an analyst to see what factors have the most significant influence on the summary measure. For example, analysis and comparison of the factors 3, 4 and 5 (from Equation 19.2) highlight profit margin on sales, total asset turnover and leverage (equity multiplier). When factors 3 and 4 are multiplied together, the analyst has a measure of EBIT/Assets. This measures the operational profit of the firm without the financial leverage. The decomposition is useful in highlighting relevant factors influencing overall profit. Decomposition of ROE is illustrated by several examples from the text. The examples are helpful in highlighting differences in industries in terms of generation of profit and the influence of leverage.

Ratio analysis is used to reduce the large number of individual statement items into meaningful relationships. Ratios are used to compare firms at a point in time and also to examine a firm’s performance over time. Ratios are used more extensively by external analysts than by managers of the firm. They are very important to the investment community and are present in most security analysis. They are used extensively for credit ratings. Table 19.10 lists and describes the major ratios. The table is broken into sections by type of ratios. Students interested in fundamental analysis should have a strong understanding of these ratios.

Leverage ratios are used to investigate the firm’s use of debt. Times-interest-earned and fixed-charge-coverage ratios are used to assess the firm’s ability to service debt. Asset utilization ratios measure how effective a firm is in generating sales using its assets. Liquidity ratios measure the firm’s ability to service short term debt. Market price ratios tie account measures to the market price of the stock.

19.5 Illustration of Financial Statement Analysis

This helpful example should be worked through with students. It will aid not only in the mechanics of ROE decomposition, but it will illustrate its usefulness in better evaluating a firm’s true success in over a given time period.

19.6 Comparability Problems

Since financial ratios are based on accounting data, an analyst must be aware of differences in accounting methods that could affect comparison of ratios. This section presents examples of the some of the key problems of comparability. Inventory valuation method is an important factor since it influences cost of goods sold. Firms can also choose different methods of depreciation. Depreciation affects reported income and reported asset values. Inflation can distort reported income and the balance sheet. Valuing with ambiguous worth at historical cost can skew the value of the firm. Supporters of fair value accounting believe marking-to-market can address this.

Differences in international accounting standards make comparisons of international firms difficult. One of the major factors that create differences is the ability to use reserves. Figure 19.4 shows how significant the effect on value can be for international firms.

Finally, students should understand that financial data is usually presented with a positive spin. Observing financials with a fair degree of skepticism (focused in several areas described in the text) can help uncover the quality of the earnings (i.e., the sustainability of these reported earnings)

19.7 Value Investing: The Graham Technique

With the publication of Security Analysis, Graham became an important thinker, writer, and teacher in the field of investment analysis. His influence on investment professionals remains very strong. He believed that one should purchase common stocks at less than their working-capital value, or net current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. Note to students that by 1976, given the rapid way in which information travels, he renounced his earlier views on security analysis and sided with the efficient market hypothesis and its advocates.

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