Financial Statement Analysis

The objective of these next few classes is to identify useful

diagnostic analytic techniques to determine firm and industry
attributes underlying the figures in financial statements.

It is not the figures per se which are important, but what they
represent in terms of trends, strengths and weaknesses.

Two approaches can be followed:

technical analysis (charting)
fundamental analysis (financial ratios)
 Charting (& EMH)
Assumes all information is impounded in past share prices
and that a study of past price performance will reveal clues
about future price performance
market
values
of shares
. .
.
of Co. X
. . .. . filter
upper (buy)

. .
.. . .. .
rules
.
....... extrapolate
trends
lower (sell)

t t

Use past prices to predict likely direction of shares

Basic Questions to Ask
1) Is the entity making any money
2) Is the management any good
3) Will the entity survive

To answer these questions we seek information from

sources about three areas:

profitability
Managerial
performance solvency
Sources of Information
Available

Annual Reports
Interim Reports
Prospectuses
Corporate Releases
Proxy and Listing documents
Bank Surveys
Newspapers (Media)

Need to watch the relative credibility

& timing of each of these sources
Common Size Statements

Sales 100%
To remove the potentially Cost of Goods Sold 40
distorting effect of size Gross Margin 60
we reduce all the dollar
magnitudes to a Operating Expenses
percentage of some base Wages 18%
Administration 10%
Utilities 5%
better Depreciation 5%
comparison Other Expenses 2% 40
over time Net Income 20%
 Comparison Between Companies
expressed first in dollar magnitudes

Company A ($Billion)

Cash 60 Accounts payable 120

Accounts receivable 140
Inventory 100 Debentures 900
Current assets 300
Common shares 500
Non-current assets 1700 Retained earnings 480
2000 2000
 Comparison Between Companies
expressed first in dollar magnitudes

Company B ($Billion)

Cash 130 Accounts payable 250

Accounts receivable 210
Inventory 500 Debentures 1150
Current assets 840
Common shares 100
Non-current assets 3160 Retained earnings 2500
4000 4000

Company B is twice the size of A in terms of book value,

but is bigger necessarily better?
Common-Sized Balance
Sheets
A% B% A% B%

Cash 3 3.25 Accts pay 6 6.25

Accts rec 7 5.25 Debentures 45 28.75
Inventory 5 12.5 C-stock 25 2.5
Non-current 85 79.0 Ret earnings 24 62.5
100 100 100 100

Which company is the best from an investment

point of view?
How do we diagnose the strengths & weaknesses
 Observations: A vs B

We examine line-by-line each component in the Balance Sheet

in an attempt to tease out the economic significance of each
company and make a relative assessment

Cash: there is virtually no difference in percentages,

but we might question whether there is too much or
not enough

Accounts receivable: which company appears to have

the better credit control facilities & why?
B
 More Observations

Inventory: which company probably follows JIT

which company has the better management
which company is more adaptable

A B;A;A
Non-Current Assets: which company is the oldest?
which company appears to be forward thinking
which company is responding to technological changes
Analysis of Liabilities

Accounts Payable: there is little to differentiate the two

companies on this liability, but do we have enough cash
on hand to meet this short-term obligation?

Debentures: which company Common Stock:

is the riskier & why? which Company
can issue a lot more
Equity?
Can it issue at
A a premium?
B
 What else & overall?
Retained earnings: which company is the more profitable
which company is the oldest
which company has been the better survivor

Summary: A
accounts receivable A better
Inventory B better
Non-current assets A better
BUT:
Debentures B less risky which company
Common stock B better is likely to be more
Retained earnings B better marketable on the
Stock Exchange
Which Company’s shares are more volatile B
Financial Ratio Analysis
Portray relationship of:
NUMERATOR X 100% = ratio value
DENOMINATOR

EXAMPLE: Net income = % Return on Investment

Total Assets

Relationship between two line items, one from the

Income Statement, the other from the Balance Sheet

EXAMPLE: CURRENT ASSETS = current ratio

CURRENT LIABILITIES
Advantages of Ratios

1. Simple to understand
2. Eliminate size effects
3. Indicate relationships
4. Single summary descriptors
5. Facilitate comparability
6. Enhances trend analysis
 Seeking Trends

.
Net income Upward trend
Total assets

. .. ..
..
.
.. ...... .
.. ...
Each point
is a financial
ratio value at
a point in time

time
Take “line of best fit” to identify trend of financial health
Ratio Cautions

Too many ratios (at least 79)

• Confusion if calculate too many
• Mixed signals
• Collinearity issues
•Multi-Collinearity
•Serial correlation
• Parsimonious set
• Factor analysis
Factor analysis results
area ratio
1 ROI EBIT/TA
2 Leverage LTD/TA
3 WC mgmt SALES/WC
4 Non-c mgnt SALES/FA
5 Lt solvency SALES/SH FUNDS
6 St solvency QA/QL
7 Inventory mgnt SALES/INVENTORY
8 Interest cover EBIT/INTEREST
9 Profit retention RE/NI
10 Credit policy SALES/ACC REC
 Financial Ratios Categoric Framework
Return on Investment

Profitability

Profit Margin Capital Turnover

Credit Policy
Financial
Analysis Inventory
of an Managerial
Entity’s Performance Administration
Financial
Statements Asset-Equity Structure

Short-Term

Solvency Cash Flow

Long-Term
CORPORATE FINANCIAL RATIOS
Profitability

a. Return on Investment
1. net income to total assets
2. net income to net worth
3. net income to working capital
4. net income to total debt
5. net income minus preferred dividends to common
owners’ equity
6. earnings before interest and taxes to total assets
7. gross profit to total assets
8. earnings per share to price per share
9. earnings per share
10. dividends to net income
11. dividends to cash flow
12. dividends per share
Profitability Ratios

Profitability

b. Profit Margin
13. net income to sales
14. gross profit to sales
c. Capital Turnover
15. sales to total assets
16. sales to net worth
17. sales to working
capital
18. sales to fixed assets
Managerial Performance
a. Credit Policy
19. accounts receivable to average daily sales
20. sales to accounts receivable
21. accounts payable to average purchases per
day
b. Inventory
22. sales to inventory
23. inventory to working capital
24. inventory to current assets
25. cost of sales to average goods inventory
26. inventory to total assets
27. days in period to inventory turnover
28. current liabilities to inventory
c. Administration
29. operating expenses plus cost of sales to
sales
30. operating expenses to gross margin
31. cost of sales to sales
32. operating expenses to total assets
Managerial Performance

d. Asset Equity Structure

33. current liabilities to total debt
34. working capital to net worth
35. retained earnings to total assets
36. debt to working capital
37. current liabilities to working capital
38. each current asset to total current
assets
39. net worth to total assets
40. fixed assets to net worth
41. fixed assets to debt
42. fixed assets to total assets
43. book value per share
44. total debt plus preferred stock to total
assets
45. debt to total assets
46. current liabilities to total assets
47. retained earnings to net income
Solvency
a. Short-Term Liquidity
48. current assets to current
liabilities
49. current liabilities to net worth
50. working capital to total assets
51. cash to total assets
52. quick assets to total assets
53. current assets to total assets
54. cash to sales
55. quick assets to sales
56. current assets to sales
57. cash to current liabilities
58. quick assets to current liabilities
59. no credit interval
60. basic defense interval
61. cash interval
62. reduced sales interval
63. reduced operation interval
Solvency
b. Long-Term Solvency
64. total debt to net worth
65. net worth to fixed assets
66. earnings before interest and taxes to interest
67. earnings before interest and taxes to fixed charges
68. total debt to total assets
69. market value of equity of book value of total debt
70. insubordinated debt to capital funds
c. Cash Flow
71. cash flow to total debt
72. cash flow to current liabilities
73. cash flow to sales
74. cash flow to total assets
75. cash flow to net worth
76. cash flow to current maturities of long-term debt
77. cash flow per common share
78. working capital to cash flow
79. annual funds flow to current liabilities
Groups of financial ratios

1. Profitability or efficiency (performance)

2. Liquidity
3. Gearing or leverage
4. Market value

Profitability:
Return on = EBIT
total assets Average TA

Return = NI for c-shareholders

on equity av c-shareholders’ equity
Inventory analysis

Inventory = COST OF GOODS SOLD

Turnover AVERAGE INVENTORY

usually, the higher the turnover the better

Turnover Rate for a Supermarket?
50 times

turnover rate for a gold shop?

2 times
Other Current Assets

Average
Collection = AVERAGE ACC RECEIVABLES
Period AVERAGE DAILY SALES

Tells us how long customers take to pay their bills

Payout ratio = DIVIDEND

NET INCOME

Is there a stable dividend maintenance policy?

Liquidity Ratios
Current Ratio = CURRENT ASSETS
CURRENT LIABILITIES

Quick Ratio = CA - INVENTORIES

(acid test) CURRENT LIABILITIES

Cash ratio = CASH + MARKETABLE SECURITIES

CURRENT LIABILITIES

Interval Measure = CA - INVENTORIES

Average daily expenditure from operations
= number of days of operations covered by available
liquid assets
Gearing (Leverage) ratios

Debt/Equity = LONG TERM DEBT

Ratio EQUITY

(higher the greater the risk)

Times Interest = EBIT (+DEPR’N)

Earned INTEREST

(higher the lower the risk)

Market Value Ratios
P-E Ratio = MARKET PRICE OF X’S SHARES
EPS

where EPS = Net Income

number of common shares

Dividend Yield = DIVIDENDS PER SHARE

MARKET PRICE OF X’S SHARES

the higher the market price the lower the yield

Financial ratio cautions

1. Ratio values need careful interpretation, especially in

relation to the nature of the industry
2. Values are sensitive to accounting policy changes
(different GAAP applications)
3 values sensitive to historical cost model
different years when assets acquired
4 watch carefully for same year ends
5 Watch carefully for same time period covered
 Cross sectional analysis
Yr 1 Yr 2 Yr 3 Yr 4
Co A %
Co B %
Co C %
Co D %
Co E %
Co F %
Select across a point in time & compare against a relevant standard

Choices: 1. Industry average

2. Average of similar-sized companies
3. Average/mode/median?
Time Series Analysis
ROI

.
A,B Which is better, Co. A or B?

OLS-regression
x/y
. ...
. .
t
. .... ...…
. .
.. ... .. .…. .. extrapolate
Trend analysis of past .. .. .. . . …
observations . .
predictions about: t
•Returns expected
•Solvency
•Success/failure