Chapter 10: Analysis of Financial

Statements

Analysis of Investments &

Management of Portfolios
10TH EDITION

Reilly & Brown

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 Major Financial Statements
• Corporate shareholder annual and quarterly
reports must include
– Balance sheet
– Income statement
– Statement of cash flows
• Reports filed with Securities and Exchange
Commission (SEC)
– 10-K
– 10-Q

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 Generally Accepted Accounting Principles
(GAAP)
• Formulated by the Financial Accounting
Standards Board (FASB)
• Provides some choices of accounting
principles
• Financial statements footnotes must disclose
which accounting principles are used by the
firm

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 Balance Sheet
• Shows resources (assets) of the firm and how it
has financed these resources
• Indicates current and fixed assets available at a
point in time
• Financing is indicated by its mixture of current
liabilities, long-term liabilities, and owners’ equity
• Exhibit 10.1 shows the balance sheet for
Walgreen Co. for 2006 through 2010

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 Income Statement
• Contains information on the profitability of the firm
during some period of time, in contrast to the
balance sheet at a fixed point in time
• Indicates the flow of sales, expenses, and
earnings during the time period
• Exhibit 10.2 shows the income statement for
Walgreen Co. for years 2006 through 2010

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 Exhibit 10.2

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 Statement of Cash Flows
• Shows the effects on the firm’s cash flow of
income flows and changes in various items on
the balance sheet (See Exhibit 10.3)
– Cash Flow from Operating Activities: the sources
and uses of cash that arise from the normal
operations of a firm
– Cash Flow from Investing Activities: change in
gross plant and equipment plus the change in the
investment account
– Cash Flow from Financing Activities: financing
sources minus financing uses

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 Measures of Cash Flow
• Cash flow from operations
– Traditional cash flow equals net income plus
depreciation expense and deferred taxes
– Also adjust for changes in operating assets and
liabilities that use or provide cash
• Free cash flow recognizes that some
investing and financing activities are critical to
ongoing success of the firm and the following:
– Capital expenditures
– Disposition of properties and equipment

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 Measures of Cash Flow
• EBITDA: The widely-used EBITDA (earnings
before interest, taxes, depreciation, and
amortization) measure of cash flow is
extremely liberal
– It does not consider any adjustments noted
previously, specifically the following:
 Depreciation and amortization
 Interest expense
 Taxes
 working capital
 capital expenditures

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 Purpose of
Financial Statement Analysis
• It seeks to evaluate the current management
performance and to provide insights that will
help project future management performance,
specifically in the following three areas:
– Profitability
– Efficiency
– Risk

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 Analysis of Financial Ratios
• Ratios are more informative that raw numbers
– Ratios provide meaningful relationships between
individual values in the financial statements
• Importance of relative financial ratios: Compare
a firm’s financial ratios to other entities
– The aggregate economy
– Its industry or industries
– Its major competitors within the industry
– Its past performance (time-series analysis)

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 Analysis of Financial Ratios
• Comparison to the Aggregate Economy
– Most firms are influenced by economic expansions
and contractions in the business cycle
– Analysis helps you estimate the future performance
of the firm during subsequent business cycles
• Comparison to the Industry
– Most popular comparison
– Different industries affect the firms within them
differently, but the relationship is always significant
– The industry effect is strongest for industries with
homogenous products

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 Analysis of Financial Ratios
• Comparison to its Major Competitors
– Industry averages may not be representative
– Select a subset of competitors to compare to using
cross-sectional analysis, or
– Construct a composite industry average from
industries the firm operates in
• Comparison to its Own Historical Records
– Determine whether it is progressing or declining
– Helpful for estimating future performance
– Consider trends as well as averages over time

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 Computation of Financial Ratios
• The Five Categories
– Common size statements
– Internal liquidity (solvency)
– Operating performance
 Operating efficiency
 Operating profitability
– Risk analysis
 Business risk
 Financial risk
 External liquidity risky
– Growth analysis

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 Common Size Statements
• Normalize balance sheets and income statement
items to allow easier comparison of different size
firms
• Common size statements also give insight into a
firm’s financial condition
• A common size balance sheet expresses
accounts as a percentage of total assets (Exhibit
10.4 for Walgreen Co. from 2006 to 2010)
• A common size income statement expresses all
items as a percentage of sales (Exhibit 10.5 for
Walgreen Co. for 2006 through 2010)
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 Exhibit 10.5

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 Evaluating Internal Liquidity
• Internal liquidity (solvency) ratios indicate the
ability to meet future short-term financial
obligations
• They compare near-term financial obligations,
such as accounts payable or notes payable, to
current assets or cash flows that will be
available to meet these obligations.
• Current Ratio: Examines the relationship
between current assets and current liabilities
Current Assets
Current Ratio=
Current Liabilities
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 Evaluating Internal Liquidity
• Quick Ratio: Adjusts current assets by
removing less liquid assets

Cash+Marketable Securities+Receivables
Quick Ratio=
Current Liabilities
• Cash Ratio: The most conservative liquidity
ratio
Cash+ Marketable Securities
Cash Ratio=
Current Liabilities

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 Evaluating Internal Liquidity
• Receivables Turnover: Examines the quality
of accounts receivable
Net Annual Sales
R eceivables Turnover=
Average Receivables
• Receivables turnover can be converted into
an average collection period

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 Evaluating Internal Liquidity
• Inventory Turnover: Relates inventory to
sales or cost of goods sold (CGS)
Cost of Goods Sold
I nventory Turnover=
Average Inventory
• Given the turnover values, you can compute
the average inventory processing time

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 Evaluating Internal Liquidity
• Cash Conversion Cycle: Combines
information from the receivables turnover,
inventory turnover, and accounts payable
turnover.

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 Evaluating Operating Performance
• Ratios that measure how well management is
operating a business
– Operating Efficiency Ratios: Examine how the
management uses its assets and capital, measured
in terms of sales dollars generated by asset or
capital categories
– Operating Profitability Ratios: Analyze profits as a
percentage of sales and as a percentage of the
assets and capital employed

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 Operating Efficiency Ratios
• Total Asset Turnover: The total asset turnover
ratio indicates the effectiveness of a firm’s use of
its total asset base (net assets equals gross
assets minus depreciation on fixed assets)

Net Sales
Total Asset Turnover=
Average Total Net Assets

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 Operating Efficiency Ratios
• Net Fixed Asset Turnover: Reflects utilization
of fixed assets
Net Sales
¿ Asset Turnover= Asset ¿
Average Net ¿
• Equity turnover examines turnover for capital
component

Net Sales
Equity Turnover=
Average Equity

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 Operating Profitability Ratios
• Operating profitability ratios measure
– The rate of profit on sales (profit margin)
– The percentage return on capital

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 Operating Profitability Ratios
• Gross Profit Margin: Measures the rate of profit on
sales (gross profit equals net sales minus the cost
of goods sold)
Gross Profit
Gross Profit Margin=
Net Sales

• Net profit margin relates net income to sales

Net Income
Net Profit Margin=
Net Sales
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 Operating Profitability Ratios
• Operating Profit Margin: Measures the rate of
profit on sales after operating expenses
(operating profit is gross profit minus sales,
general and administrative (SG + A) expenses)

Operating Profit
Operating Profit Margin=
Net Sales

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 Operating Profitability Ratios
• Return on Total Capital: Relates the firm’s
earnings to all capital in the enterprise
Net Income+ Interest exp .
Return on Total Capital=
Average Total Capital
• Return on Owner’s Equity (ROE): Indicates the
rate of return earned on the capital provided
by the stockholders

Net Income − Preferred÷.

′
Return on Owne r s Equity=
AverageCommon Equity
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 Operating Profitability Ratios
• The DuPont System: It divides the ROE ratio
into several component ratios that provide
insights into the causes of a firm’s ROE and
any changes in it

¿ Profit
x
Total Asset
Margin Turnover
x
Financial
Leverage

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 Operating Profitability Ratios
• An extended DuPont System provides
additional insights into the effect of financial
leverage on the firm and pinpoints the effect
of income taxes on ROE
• We begin with the operating profit margin
(EBIT divided by sales) and introduce
additional ratios to derive an ROE value
• As shown on the next page, it involves four
equations to “reach” ROE

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 Operating Profitability Ratios
EBIT Sales EBIT
 
Sales Total Assets Total Assets

EBIT Interest Expense Net Before Tax

 
Total Assets Total Assets Total Assets

Net Before Tax (NBT) Total Assets Net Before Tax (NBT)
 
Total Assets Common Equity Common Equity
Net Before Tax  Income Taxes  Net Income
 100 %  
Common Equity  Net Before Tax  Common Equity

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 Operating Profitability Ratios
• In summary, there are five components of
return on equity (ROE)
EBIT
1.  Operating Profit Margin
Sales
Sales
2.  Total Asset Turnover
Total Assets
Interest Expense
3.  Interest Expense Rate
Total Assets
Total Assets
4.  Financial Leverage Multiplier
Common Equity
 Income Taxes 
5 .  100 %    Tax Retention Rate
 Net Before Tax 
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 Risk Analysis
• Risk analysis examines the uncertainty of income
flows for the total firm and for the individual
sources of capital
– Debt
– Preferred stock
– Common stock

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 Risk Analysis
• Total risk of a firm has two components:
– Business risk
 The uncertainty of income caused by the firm’s
industry
 Generally measured by the variability of the firm’s
operating income over time
– Financial risk
 Additional uncertainty of returns to equity holders
due to a firm’s use of fixed obligation debt securities
 The acceptable level of financial risk for a firm
depends on its business risk

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 Business Risk
• Two factors contribute to the variability of
operating earnings
– Sales variability
 Sales variability is the prime determinant of
operating earnings variability
 The variability of sales is mainly caused by a firm’s
industry and is largely outside the
 control of management
– Operating leverage
 Greater operating leverage (caused by a higher
proportion of fixed production costs) makes the
operating earnings series more volatile relative to
the sales
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 Financial Risk
• Bonds interest payments come before earnings
are available to stockholders
• These are fixed obligations
• Similar to fixed production costs, these lead to
larger earnings during good times, and lower
earnings during a business decline
• This debt financing increases the financial risk
and possibility of default

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 Financial Risk
• Relationship between business risk and financial
risk
– Acceptable level of financial risk for a firm depends on
its business risk
• The three sets of financial ratios to measure
financial risk
– Balance sheet ratios
– Earnings and Cash Flow Coverage Ratios
– Cash Flow–Outstanding Debt Ratios

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 Balance Sheet Ratios
• Proportion of Debt (Balance Sheet) Ratios:
Indicate what proportion of the firm’s capital is
derived from debt compared to other sources
of capital, such as preferred stock, common
stock, and retained earnings
• Debt-Equity Ratio
Total Long - Term Debt
Debt - Equity Ratio 
Total Equity

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 Balance Sheet Ratios
• Proportion of Debt (Balance Sheet) Ratios:
Indicate what proportion of the firm’s capital is
derived from debt compared to other sources
of capital, such as preferred stock, common
stock, and retained earnings
• Debt-Equity Ratio

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 Balance Sheet Ratios
• Long-Term Debt/Total Capital Ratio: Indicates
the proportion of long-term capital derived from
long-term debt capital

L.T. Debt / Total Capital Ratio

Total Long - Term Debt

Total Long - Term Capital

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 Balance Sheet Ratios
• Total Debt-Total Capital Ratios: Compare total
debt (current liabilities plus long-term liabilities) to
total capital (total debt plus total equity)

Total Debt - Total Capital Ratio

Total Interest - Bearing Debt

Total Invested Capital

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 Earnings or Cash Flow Ratios
• Earnings or Cash Flow Ratios: Relate the flow of
earnings or cash available to meet the required
interest and lease payments
• Interest Coverage Ratio

Income Before Interest and Taxes (EBIT)


Debt Interest Charges
Net Income  Income Taxes  Interest Expense

Interest Expense

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 Earnings or Cash Flow Ratios
• Cash Flow Coverage Ratios: Relate the flow of
cash available from operations to either
interest expense, total fixed charges, or the
face value of outstanding debt

Cash Flow Coverage Ratio 

Traditiona l Cash Flow  Interest  1/3 Lease Payments
Interest  1 / 3 Lease Payments

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 Cash Flow–Outstanding Debt Ratios
• Cash Flow–Long-Term Debt Ratio
Cash Flow / Long - Term Debt 
Net Income  Depreciati on Expense  Change in Deferred Tax
Book Value of Long - Term Debt

• Cash Flow–Total Debt Ratio

Cash Flow / Total Debt 
Net Income  Depreciati on Expense  Change in Deferred Tax
Total Debt

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 External Market Liquidity
• External Market Liquidity Defined
– External market Liquidity is the ability to buy or sell an
asset quickly with little price change from a prior
transaction assuming no new information
– External market liquidity is a source of risk to investors

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 External Market Liquidity
• Determinants of Market Liquidity
– The most important determinant of external market
– liquidity is the number of shares or the dollar value of
shares traded
– Trading turnover (percentage of outstanding shares
traded during a period of time)
– A measure of market liquidity is the bid-ask spread
– Certain corporate variables
 Total market value of outstanding securities
 Number of security owners

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 Analysis of Growth Potential
• Importance of Growth Analysis
– Sustainable growth potential analysis examines ratio
that indicate how fast a firm should grow.
– Creditors are interested in the firm’s ability to pay future
obligations
– Value of a firm depends on its future growth in earnings
and dividends

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 Analysis of Growth Potential
• Determinants of Growth
– Resources retained and reinvested in the entity
– Rate of return earned on the resources retained

g = Percentage of Earnings Retained´ Return on Equity

= RR x ROE
where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity

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 Comparative Analysis of Ratios
• Internal liquidity
– Current ratio, quick ratio, and cash ratio
• Operating performance
– Efficiency ratios and profitability ratios
• Risk Analysis
• Growth analysis

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 Analysis of
Non-U.S. Financial Statements
• Statement formats will be different
• Differences in accounting principles
• Ratio analysis will reflect local accounting
practices

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 The Quality of Financial Statements
• High-quality balance sheets typically have
– Conservative use of debt
– Assets with market value greater than book
– No liabilities off the balance sheet
• High-quality income statements reflect
– Repeatable earnings
– Uses of conservative accounting principles
• Footnotes
– Provide information on how the firm handles balances
sheet and income items

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 The Value of
Financial Statement Analysis
• Financial statements, by their nature, are
backward-looking
• An efficient market will have already incorporated
these past results into security prices, so why
analyze the statements?
• Analysis provides knowledge of a firm’s operating
and financial structure
• This aids in estimating future returns

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 Specific Uses of Financial Ratios
• Stock Valuation Models
• Estimating the Ratings on Bonds
• Predicting Insolvency (Bankruptcy)
• Limitations of Financial Ratios

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 Stock Valuation Models
• Valuation models attempt to derive a value
based upon one of several cash flow or
relative valuation models
• All valuation models are influenced by:
– Expected growth rate of earnings, cash flows, or
dividends
– Required rate of return on the stock
• Financial ratios can help in estimating these
critical inputs

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 Stock Valuation Models
• Financial Ratios
1. Average debt/equity
2. Average interest coverage
3. Average dividend payout
4. Average return on equity
5. Average retention rate
6. Average market price to book value
7. Average market price to cash flow
8. Average market price to sales

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 Stock Valuation Models
• Variability Measures
1. Coefficient of variation of operating earnings
2. Coefficient of variation of sales
3. Coefficient of variation of net income
4. Systematic risk (beta)
• Nonratio Variables
1. Average growth rate of earnings

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 Estimating the Ratings on Bond
• Financial Ratios
1. Long-term debt/total assets
2. Total debt/total capital
3. Net income plus depreciation (cash flow)/long term senior debt
4. Cash flow/total debt
5. Net income plus interest/interest expense (fixed charge coverage)
6. Cash flow/interest expense
7. Market value of stock/par value of bonds
8. Net operating profit/sales
9. Net income/owners’ equity (ROE)
10. Net income/total assets
11. Working capital/sales
12. Sales/net worth (equity turnover)

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 Estimating the Ratings on Bond
• Variability Ratios
1. Coefficient of variation (CV) of net earnings
2. Coefficient of variation of return on assets
• Nonratio variables
1. Subordination of the issue
2. Size of the firm (total assets)
3. Issue size
4. Par value of all publicly traded bonds of the firm

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 Predicting Insolvency (Bankruptcy)
• Financial Ratios
1. Cash flow/total debt
2. Cash flow/long-term debt
3. Sales/total assets
4. Net income/total assets
5. EBIT/total assets
6. Total debt/total assets
7. Market value of stock/book value of debt
8. Working capital/total assets
9. Retained earnings/total assets
10. Current ratio
11. Working capital/sales

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 Limitations of Financial Ratios
• Accounting treatments may vary among firms,
especially among non-U.S. firms
• Firms may have have divisions operating in
different industries making it difficult to derive
industry ratios
• Results may not be consistent
• Ratios outside an industry range may be
cause for concern

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 The Internet Investments Online
• [Link]
• [Link]
• [Link]
• [Link]
• [Link]
• [Link]
• [Link]

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