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financial statement analysis

Page history last edited by Brian D Butler 11 years, 5 months ago

 

 

 

Table of Contents:


 

 

Financial statement analysis 

 

- Profit & Risk analysis of a firm

 

1. past performance (look back)

2. project forward (pro forma statements for valuations)

 

Because most people prefer less risk, then you expect to see higher return for investing in shares of company compared to certificate of deposit.

 

Expected return from investing in a firm relates in part to the expected profitability of firm. Analyst studies the past earnings to understand operating performance and to estimate future profitability. But also need to analyze risk associated with return. Can they meet interest payments due (from long term borrowing)? Analysis of statements seeks to quantify the potential for profit and risk.

 


 

 

Overall health of a firm:

 

Tobin's Q ratio

 

The market-to-book value ratio, and the Tobin's Q ratio are both good indicators of the overall success of a firm if they are both over 1.0.

 

see:  http://en.wikipedia.org/wiki/Tobin%27s_q

 

 

 

Ratio Analysis: 

financial statement ratios 04.xls

 

Yes, I know "ratio analysis" sounds boring, but there really are some great insights you can get from looking at ratios.  For example...if you just try to look at the  balance sheet of a company...how can you tell how well (or how badly they are doing)?

 

What you need is some way to put the numbers into perspective...and believe it or not, ratios are the answer.

 

Its not easy to understand profitability & risk in absolute terms...instead, what you need are ratios.   For example, just try to look at an income statement and guess if the company is doing well.....You can not tell anything just by looking at net income.  Is this a large firm making small amounts of money, or a small firm making large amounts? Comparing net income to the amount of assets would give you a better understanding. Ratios make it easy to summarize and compare between firms.

 

But beware....ratios by themselves provide little information. Need to compare them with some standard.

 

 

Compare ratios to:

1. that companies Planned ratio

2. ratio in the previous period

3. similar firms ratios (example: sears vs walmart _v01.xls )

4. industry average ratios

 

First step: comparative statement analysis

make a comparison between income statement from year 1, 2, 3..etc. Put the statements next to each other in an excel sheet. Then do the same for Balance sheet, income statement

 

Next step: Time series analysis

compare ratios of same company over period of time

 

Third step: Cross-section analysis

compare ratios of company vs other company for specific period

Some ratios use income statement, others use balance sheet, and others relate between.

 

For help with analysis: http://www.ventureline.com/ (costs money to buy analysis), or http://www.bizminer.com/index.asp

 

 

Limitations of ratio analysis:

- differenet companies use different accounting standards.

- examples: inventory (LIFO vs FIFO), and assets (depreciation schedules differ)

- also, the statements only tell about the past, and not the future.

 

 

Profitability measures:

 

1. Net Profit Margin

2. Common size income statement – as a percent of sales – look for trends

3. Return on Assets (ROA) – earnings over assets

4. Return on Equity (ROE) – on common S.E. – earnings over equity

5. Earnings per share (EPS) – of common stock –earnings over # of shares

 

Net Profit Margin

net income / net sales

Measures the level of net income generated for each dollar of sales. Indicates the ability of a firm to absorb future cost increases or sales volumes declines.

 

 

 

 

 

 

 

 

Common size Income statement

Express individual expenses as % of sales.

See trends in COGS, and SGA as % of sales

 

Profit margin available to company

is represented by COGS / sales

- a decline in COGS / sales ratio might indicate worsening inventory controls, so look at the inventory turnover ratio...if its stable...then you know that the company might be having more trouble getting the higher margins. Maybe they are moving into less profitable businesses (potentially with higher turnover potential). Or maybe their product is becomming a commoditiy.

 

SGA vs Sales

if it is decreasing as sales volumes are increasing, then they might be benefiting from economies of scale. If they are outsourcing production or distribution, then they might have less overhead to manage these functions. Reduced product differentiation might lead to less advertising. Also, more brand awareness might do the same.

 

Rate of Return on Assets (ROA)

 

Measures performance of firm to use assets to generate earnings, without considering how the firm paid for those assets. It relates operating performance to investments (assets) without concern for finance. Answers the question of how well a firm has done in operations without considering financing activities.

 

ROA = return / assets

 

= (Net Income + Interest Expense - tax savings from interest) / Average total assets

  • to find tax savings from interest...just multiply interest expense by tax rate. Thats how much money you saved, and is the amount that has to be subtracted from interest.

 

This means you have to add back interest expense to net income, because you previously subtracted that interest expense in calculating the N.I., and if you don’t want to include financing activities in ROA, then you have to add it back.

 

But, because when you pay interest, you later get money back in (reduced) taxes…that means that not all of the interest expense was deducted in calculating net income….so, you only add back a portion of the interest expense (to net income when calculating ROA).

 

If interest expense was $100, then if tax rate was 35%, then you know that you saved income taxes of $100 x 35% = $35 and that you only expensed $65…so you add only $65 back to Net income when calculating ROA (not the full $100 of interest expenses).

 

Note: you do not add dividends because they do not affect the income statement.

 

If ROA is 9%, that means that for each $1.00 of assets used, the company earned $0.09 (before payments to suppliers of finance).

Goal = have turnover be as high as possible + profit margin as high as possible…leads to highest ROA

 

But some firms have little control over profit margin, such as firms selling commodities with high price pressure, so they can not raise prices. Then, these firms will need to improve turnover if they want better ROA. To do this, they will need to shorten inventory holding periods, or have better controls. If, on the other hand, another firm has high investments in PPE, they might not be able to improve the turnover ratio, and they will have to focus on the profit margin for ROA by doing things like improving brand loyalty.

 

 

 

Why use ROA?

 

1. Lenders (creditors) – have first claim on earnings and assets. Have contractual interest payments.. Want to be sure firm can return enough – more than the cost of financing.

2. Common shareholders – for determining leverage

 

Disaggregate ROA: Into product of other ratios.

 

Remember, that ROA = return / assets

 

= (Net Income + Interest Expense net taxes) / Average total assets

 

Disaggregate ROA

= Profit Margin * Turnover

= (Net income / sales) * (sales / assets)

(do sales create lots of earnings?) * (do assets create lots of sales?)

 

 

Profit margin for ROA

= Net Income / sales

= (Net Income + Interest Expense net taxes) / sales

- Profit margin measures firms ability to control expenses relative to sales

- And, to increase selling prices in relation to the expenses

 

Turnover = sales / assets

Note: you want turnover to be as high as possible.

- Turnover measures amount of sales compared to amount of assets. It also measures firms ability to control amount of assets for certain level of sales. The fewer assets they need, the bigger the turnover, and the more profitable the firm will be. Lower assets = higher ratio.

 

Total Asset turnover

Measures efficiency of resource use. Ability to generate sales through use of assets. Note that it can be significantly affected by depreciation method used, as well as the age of the assets.

 

Three types of turnover ratios:

Separate turnover ratios into three classes of assets – Accounts Receiveable (AR), Inventory, and fixed assets

 

A/R turnover ratios:

= sales revenue / average AR for period

Indicates how quickly a firm receives cash. For example, if AR turnover ration = 12.17 times per year (turnover), then the “days accounts receivable outstanding”= 365 / 12.17 = 30 days (average number of days to collect accounts receivable). Need to compare this actual # of days compared to the stated policy of the firm to see how effectively they manage their AR. But since many firms use AR to help generate sales, its important to also compare to sales trends.

 

Inventory turnover ratios:

= COGS / avg inventory for period

  • some people use sales / inventory…but not as correct.

 

Indicates how fast they sell their inventory, and how effectively the investment in inventory is managed. Note that it can be significantly affected by inventory methods used (LIFO vs FIFO, for example will give significantly different values).

 

 

The higher the ratio the better: the higher the COGS vs Inventory the better. For example, if the inventory turnover ratio was = 10 times per year, then we would know that 365 / 10 = 36.5 is the number of days that the inventory sat before selling. Since we want this # of days to be as small as possible, then we want the largest # of inventory turns per year as possible. To get this, we need COGS to be high compared to amount of inventory on hand. Note: in accounting, the COGS is = the value of the inventory that was sold duing this period. Note: also look at the common sized income statement and see how COGS as a % of sales is trending. If there are less COGS per sales, then you are becoming more efficient in selling. This might be because of more efficient inventory management and a higher inventory turnover ratio.

Note: firms prefer to sell as much as possible with as few assets tied up in inventory as possible. Reduced inventory means less money tied up in these assets, which likely means less financing required. But too little inventory might mean unhappy customers, so there has to be a balance.

 

Fixed Asset Turnover

= sales / avg PPE

Measures relation between sales and investment in fixed assets – PPE

Should be called “fixed asset productivity ratio”.

Measures level of sales from level of fixed assets

If you invest $1 in PPE…how many $ in sales does that yield? 5 or more?

 

If plant asset turnover is increasing, that might be because sales are growing faster than investments in new PPE, but it might also be becasue of outsourcing. If a company is outsourcing production, then they dont have to invest in PPE, and their fixed asset turnover ratio will seem larger.

 

 

 

Summary:

ROA – ability to use assets to generate earnings (independent of financing).

Profit margin ROA – relates expenses to sales

Turnover – how quickly they turn inventory / AR into sales, and how efficiently they turn PPE assets into sales.

 

ROE

= (Net income – dividends preferred stock) / avg common S.E.

Rate of return on common shareholders Equity (ROCE)

How good using financing assets to generate earnings?

Consider financing costs (unlike ROA, which does not)

Look at operating + investing + financing activities

 

Numerator- calculate amount of earnings available to common shareholders, by subtracting those to preferred. No need to adjust for interst because its already subtracted from Net income. DO NOT subtract dividends to common stockholders.

 

Denominator – includes all shareholders equity accounts (par value, additional paid in capital, retained earnings, etc.

 

Note: common stockholders have a “residual” claim on the earnings of a firm…after the contractual obligations to creditors and preferred stockholders are paid. So, ROA is required to first pay off creditors (interest payments) and preferred shareholders (dividends). If ROA exceeds the cost of interest + dividend (cost of borrowing), then the ROE will be larger than ROA.

 

ROE > ROA,

if, ROA > cost of borrowing

 

financial Leverage: financing with debt + preferred stock to increase the potential returns to common stock holders. Note: owners get a higher return for accepting higher risk (only getting paid after creditors and preferred shareholders). Using lower cost borrowed funds to earn higher rate of return on those funds and increasing the rate of return to owners.

 

How financial leverage works:

1. Firm borrows money from bank + preferred shareholders

2. invests in assets, generating ROA (before paying for financing).

3. creditors get interest payments, preferred shareholders get dividends

4. common shareholders have residual claim on extra earnings. As long as ROA exceeds #3, then common shareholders benefit from extra borrowing.

 

Leverage increases the return to common stock holders in good years, but can hurt in bad years. Works both ways…both help, or hurt.

 

Note: Insolvency is different than bankruptcy. Insolvency is a company that can not meet their immediate cash flow needs (pay interest, for example). Bankruptcy is a legal situation where liabilities exceed assets.

 

Average leverage for large manufacturing firms is between 30-60%

 

Disaggregating ROCE – return on common equity

 

Basic formula:

ROE = Net income – dividends on preferred stock / average common S.E

 

Disaggregate

ROE = Profit Margin * Turnover * leverage

 

Where,

Profit Margin for ROE = Net income – dividends on preferred / Sales

- This is almost the same as Profit Margin for ROA, except that we don’t add back interest net tax, and instead we subtract dividends on preferred stock

 

Turnover = sales / Average total assets

- This is exactly the same turnover ration from the ROA calculation

 

Leverage ratio:

 

Leverage = Average total assets / Average common S.E.

- Before multiplying by leverage, the formula is basically the same as ROA. So, in general, the ROE is basically like ROA, except that you also multiply by a leverage factor.

 

- If ROA = return / assets....and we now want ROE = return / equity....then we multiply ROA * assets / equity. (average)

 

- If liabilities = 0, then the leverage factor (assets / S.E) = 1, and the ROA = ROE, and there is no leverage factor. There is not an impact to earnings because of borrowing. But if you add debt (L), then assets / SE will increase because SE decreases in the denominator. This will lead to a larger leverage. A larger multiple, which will amplify earnings and losses.

 

Comparing ROA & ROE

If a company borrows more money to invest in PPE, and you want to know if the additional borrowing was a good idea or not….what you need to do is to look at the difference between ROA & ROE. If the ROE is above ROA, then it was likely a good idea. If the ROE is greater than ROA that suggests that the earnings on assets financed by the creditors was greater than the cost of the creditors’ financing. (Borrowed at a lower rate, and yielded a higher rate…making money on the spread).

 

 

Earnings per share

Third measure of profitability of firm

= (net income- dividends preferred) / shares outstanding

Note: same numerator as ROE above

Dilution – result of vonvertiable bonds, convertible preferred stock, and stock options

 

Criticism of EPS: does not consider amount of assets required. Two firms might have same EPS, but one uses 2x as many assets to generate those same earnings.

 

Price-Earnings Ratio:

P/E ratio - compares EPS to market price of stock

= market price per share / earnings per share

For example, “a stock is trading at 25 times earnings”

Be careful using PE ration when doing valuations of firms. Often included in the earnings are one-time events. They should only include normal ongoing earnings in the denominator.

 

 

Summary of Profitability measures

 

Best measures = ROA, ROE; because they related earnings to assets (or assets net of liabilities required to generate earnings).

 

 

 

 

 

 

Risk Analysis

 

Economy wide, industry wide, & company specific

 

Focus on liquidity of firm. Cash is king. Near cash is good enough

 

Short-term liquidity risk

 

Current Ratio

= current assets / current liabilities

  • current = within one year

Measures ability to meet short term obligations using short term assets

Analysts prefer >1

But be careful, there is a chance that a high current ratio might accompany a business recession, and a falling current ratio might go with profitable operations. Also beware that mgt can manipulate this ratio.

 

Note: because this ration includes inventory items, its value might depend heavily upon whether the firm uses FIFO or LIFO assumptions. The current ratio will be higher using FIFO than using LIFO (for the same firm). For that reason, perhaps the quick ratio (below) is better.

 

 

Quick ratio

“Acid test ratio”

 

Measures the ability to meet short term debt using the most liquid (quick) assets, excluding the amount of inventory in most cases

 

Is similar to the current ratio, but that the numerator only includes assets that could be quickly converted to cash. It might exclude either inventories or accounts receivable (or both) depending upon the company and industry. It is normal to see a quick ratio 50% of the current ratio. The normal practice is to exclude inventories, and include everything else, unless otherwise stated.

 

 

 

Note: weakness of both Current & Quick ratios is that they use Balance Sheet items at specific times. They might not reflect normal conditions. Management might be able to manipulate them. “window dressing”

 

Cash flows from operations vs. current Liabilities Ratio

= cash flow from operations / average current liabilities for year

Should be 40% or more

 

If the CFO/Current Liabilities are decreasing, it could be because the company is growing. If they have Accounts Payable (A/P) with only 30 days, but Accounts Receivable (A/R) of 60 days, and inventory turns at 90 days, then fast growth of the company might yield worsening CFO / current liabilities. Working capital needs increase as the company sees growth in sales. Another reason for a lower CFO/ Current Liabilities would be increased short term borrowing.

 

 

Working capital turnover ratios

working capital = current assets - current liabilities

note: there can be a decrease in working capital,but an increase in current ratio...how? if both current assets and liabilities decreased, but assets decreased a little faster.

 

 

1. Days Accounts receivable outstanding (365 / AR turnover ratio)

2. Days Accounts payables outstanding (365 / AP turnover ratio)

3. Days inventories held = (365/ inventory turnover ratio)

 

AR turnover ratio = sales / AR

AP turnover ratio = sales / AP

Inventory turnover ratio= sales / inventory…...or, better… = COGS / inventory

 

For example, if sales = 210,000 and inventory = 21,000, then you know that inventory turned over 10 times in year. With 365 days / 10 turns = 36.5 days inventories held

 

Note that inventory assumptions such as LIFO and FIFO will have dramatic affects on the inventory turnover ratio. A firm that uses LIFO will have higher COGS on the income statement, and lower inventory on their balance sheet. This means that the inventory turnover ratio will be significantly higher for a firm using LIFO. It will look like that firm is much better at turning over their inventory (and much better at managing it efficiently). This is not true. The same firm using FIFO will have a lower ratio.

 

 

LONG-term liquidity risk

 

- Need to generate profits over several years to avoid liquidation

- If profitable from operations, you can always get $ from creditors or owners

- Funds received from issuing bonds, or borrowing long term from bank have the lowest interest cost, but also require periodic payments and increase chance of insolvency

- the more stable the cash flows from operations, the more comfortable you should be with taking on debt.

- retailer like Wal-Mart has debt-equity of approximately 60% , with long term debt ratio of approx 40%. These are average for a retailer who uses long term finance for retail stores, but short term finance for inventories.

 

- want steady debt ratios and increasing profitability = risk of solvency is low

 

long term debt ratio

= long term debt / total of long term debt + equity

notice that the denominator is long term debt (not total debt) + all shareholders equity.

Some times, people call this the debt-equity ratio but it is not. Be careful

 

Debt- Equity ratio

Debt as a % of total financing.

= total liabilities (current and non-current) / total equities (liabilities + S.E. equities)

note: this one is confusing because on the surface, you would assume that it should just be debt to shareholders equity, but its not. Look at the denominator, and see that its actually debt to debt + equity. Be careful

 

 

Cash flow from operations vs. total Liabilities

 

 

- the problem with Debt/Eqity ratios is that they don’t mention how liquid are the assets needed to cover the various liabilities.

- similar to cash from operations vs. short term liabilities…but focuses on all liabilities, not just the current ones.

- should be 20% or more to be safe.

 

Interest Coverage Ratio - “Times Interest Earned” (TIE)

 

Measures ability to meet interest committments from current earnings. The higher the ratio, the safer it is for creditors.

 

Number of times that earnings covers the interest charges

= income before interest and income tax / interest expense

EBIT / interest expense

 

- measures long term liquidity risk

- should be more than 3.0 x

- but prefer stable ratio

 

- criticism of this ratio: it uses earnings, and not cash flows in numerator. If the ratio is low (3 or less), then you should switch to cash flows.

 

 

 

 

 

 

 

 

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