How to Analyse Financial StatementsThere is a
How to Analyse Financial Statements
There is a great deal of
valuable information in
financial statements.
But we must know how to
extract and refine it.
The process is like a doctor
diagnosing a patient's health.
The process is similar, but
our tools of analysis are not
quite the same.
Our tools of analysis are
financial ratios.
Financial Statement Analysis
When an unconscious patient arrives at the emergency room of
the hospital, what does the doctor do?
Answer: check the vital signs, like pulse, blood pressure,
temperature, etc.
Similarly, when we analyse financial statements, we check the
vital signs of the organization.
What are these vital signs? They include:
Short-term Liquidity
Profitability:
Profitability on Revenue
Profitability on Investment
Long-Term Asset Turnover
Long-term Leverage
For more, see the next slide.
Financial Vital Signs
Short-term Liquidity
Profitability:
On Revenue
On Investment
Long-Term Asset Turnover
Long-term Leverage
Market Performance
DuPont Analysis
Benchmarks (Yardsticks)
Data Sources
Short-term Liquidity
Short-term Liquidity means being able to
meet the payroll and pay the bills.
Organizations unable to meet the payroll
and pay the bills will soon collapse.
That is why our first step in financial
statement analysis is to test short-term
liquidity.
If an organization cannot survive the short
term, there is no need to examine its long
term signs.
Short-term Liquidity
Companies with a strong cash flow from
operations have good short term liquidity.
The cash flow statement shows the source
and uses of cash flows in a company.
Companies with good credit have bank
loans available for unexpected needs.
Assets on the balance sheet can be converted
to cash in an emergency.
Short-term Liquidity continued
Cash Flow Ratios
Cash from Operations/Net Income: represents cash
yield from Net Income. Trend should be reasonably
stable from period to period and above 100%.
Cash from Operations/Cash Used for Investing:
represents the extent to which expansion can be
financed from internally-generated cash from
operations. Trend should be reasonably stable from
period to period. Rapidly expanding companies will
need more cash than will be available from
operations. Most companies have had ratios above
1 in recent years.
Short-term Liquidity
Service companies differ from
manufacturing companies in their source of
liquidity.
Manufacturing companies have significant
inventory but service companies don’t.
Most manufacturing companies sell on
credit and have significant accounts
receivable.
Some service companies get paid in advance
or at time of provision of service.
Short-term Liquidity Manufacturing
Current Assets & Current Liabilities are items to be
received or paid in cash within a year.
As Current Assets turn into cash, the cash is used
to pay off Current Liabilities.
For short-term liquidity, Current Assets should be
greater than Current Liabilities.
We begin measuring short-term liquidity with the
Current Ratio.
Current Ratio = Current Assets/Current
Liabilities.
Current Ratio should usually be > 1 for
satisfactory liquidity – except for companies that
generate ample cash.
Short-term Liquidity: continued
The Quick Ratio.
Quick Ratio = (Current Assets, excluding
Inventory)/Current Liabilities.
Inventory can lose value fast through spoilage,
shrinkage, evaporation, obsolescence & etc.
Inventory cannot be sold off fast in a crunch –
except at fire sale prices.
So Quick Ratio conservatively – but realistically -
expects no value from inventory in an emergency.
Quick Ratio: should be > 1 for health for
companies that don’t have strong cash flow.
Short-term Liquidity: continued
Accounts Receivable Turnover.
Receivables Turnover = Sales/Accounts Receivable.
Example: Annual Sales = $120,000, Average Receivables =
$30,000.
Receivables Turnover = $120,000/$30,000 = 4 times per year
Can express as Days' Receivables on hand:
365 days/Receivables Turnover
Example continued: 365/4 = 91 days.
Receivables Turnover should be consistent;
With the firm's credit terms.
From period to period
Receivables Turnover measures the organization's efficiency in
collecting accounts receivable.
The faster the turnover the better the efficiency.
Short-term Liquidity: continued
Inventory Turnover.
Inventory Turnover = (Cost of Sales)/Inventory.
Example: Annual Cost of Sales = $100,000, Average Inventory =
$15,000.
Inventory Turnover = $100,000/$15,000 = 6.7 times per year
Can be expressed as Days' Inventory on hand:
365 days/Inventory Turnover
Example continued: 365/6.67 = 54.7 days.
Why is Cost of Sales the numerator, rather than Sales?
Sales are shown at selling price. Inventory is shown at cost.
To make numerator and denominator consistent, both should be at
cost.
Inventory Turnover measures the efficiency of inventory management.
Toyota and other Japanese firms using "just in time" inventory
showed the importance of speeding up inventory turnover.
A note of caution
Both the Current Ratio and the Quick Ratio can
be too high as well as too low.
When companies get into financial difficulty,
customer may stop paying bills – perhaps from
dissatisfaction with products
Inventory may include products that are no
longer able to be sold.
So a if the Current Ratio or Quick Ratio
increases dramatically, we should look to see
what is happening to inventory and receivables
Short-term Liquidity continued
Accounts Payable Turnover.
Payables Turnover = Cost of Sales/Accounts Payable.
Example: Annual Cost of Sales = $100,000, Average Payables =
$20,000.
Payables Turnover = $100,000/$20,000 = 5 times per year
Can be expressed as Days' Payables on hand:
365 days/Payables Turnover
Example continued: 365/5 = 73 days.
Why is Cost of Sales the numerator, rather than Sales?
Sales are at selling price. Payables are at cost, being amounts owed
to suppliers.
For consistency, both numerator and denominator should be at
cost.
Payables Turnover measures how promptly suppliers are
being paid – and whether cash discounts are being taken,
or lost.
Summary: Short-term Liquidity
Ratios measuring Short-term Liquidity:
Cash Flow Ratios
Current Ratio
Quick Ratio
Receivables Turnover & Days' Receivables
Inventory Turnover & Days' Inventory
Payables Turnover & Days' Payables
Profitability
Profitability is the most important factor in long term
corporate survival
Profits or Net Income are “the bottom line.”
On the income statement net income is the bottom line.
Businesses are formed and exist to generate returns
(profits or net income) for the owners.
Charities exist for people who want to give their money
to help others.
Good companies look to the long term to create value for
owners.
As we will see later in the course, long term value is
created when customers, employees and communities
all benefit.
Profitability
Profitability is measured in two different ways:
Profitability in Relation to Investment
Return on Equity ROE: Net Income/Equity. Shows profit
in relation to owner equity capital invested. Often the
first ratio to be considered. Some consider this
the most important ratio.
Return on Assets ROA: Net Income / Total Assets shows
what can be earned from the total of what is used in the
business
Raw Earning Power: EBIT/(LT Debt + Equity). Shows
earning power on total long-term capital invested,
regardless of type of financing.
Profitability
Profitability is measured in two different ways:
Profitability on Revenue
Profit Margin = Net Income/Sales or Net Income /
Revenue - Useful, and gives indication of pricing strategy
Gross profit ratio: Gross Profit/Sales
SG & A ratio: SG & A Expenses/Sales
EBIT ratio: EBIT/Sales – indication of cash flow
generation
Asset Turnover
Total Asset Turnover (TATO):
Total Asset Turnover = Total Revenue/Total
Assets
Measures capital intensity.
Capital intensity affects total amount of capital
needed
The faster the turnover of Total Assets, the lower
the total amount of capital that needs to be
invested in Total Assets.
Long-Term Leverage
Long-Term Leverage measures long-run risk.
Times Interest Earned (Interest Coverage):
Ratio of EBIT to Interest Expense.
Shows how much profit "cushion" there is to cover
interest payments.
Times Interest earned using Depreciation and
Amortization:
Ratio of EBITDA to Interest expense
Depreciation and Amortization are “non cash
charges” and available to provide cash to pay interest.
Long-Term Leverage
Long-Term Leverage measures long-run risk.
Debt to Equity Ratios:
Ratio of Long-Term Debt /LT Debt + Equity
Used in Weighted Average Cost of Capital work
Ratio of Debt / Total Assets
Ratio of Debt / Equity
Equity Multiplier: Total Assets / Equity
Used in DuPont Formula
More debt adds more risk, because debt repayment
must be made, whether times are good or bad.
More leverage makes the good times better, and the
bad times worse.
Stock Market Ratios
Market-based ratios reflect the investor view.
Price-Earnings Ratio P/E= Market Price per
Share/Earnings per Share.
Shows how much the market is paying per dollar of
current earnings.
Beta = a measure of common equity risk versus the entire
common equity market (which has Beta = 1.0)
Used in WACC work later in course
Market: Book Ratio.
Total Market Value of Equity/Book Value of Equity.
This is the ultimate measure of management success.
It shows how much the management has increased
the market value of the stock above the amount
invested by stockholders.
DuPont Analysis
So far, we have looked at ratios individually.
But DuPont Analysis is a way to see the
combined effect of the major ratios.
This is very important for business strategy.
The following slides explain how and why.
The DuPont Formula
Profit Margin x Total Asset Turnover x Equity
Multiplier = Return on Equity
NI = Net Income.
SA = Sales or Revenue
TA = Total assets
EQ = Total Equity (at book value)
ROE = NI/EQ
NI/SA x SA/TA x TA/EQ = NI/EQ
These 4 ratios encompass the elements of strategy
Pricing can be low and that requires that asset
turnover is high.
DuPont Analysis for Business Strategy
Long-term strategy goal: maintain strong
ROE.
DuPont analysis tells us exactly how to do
this.
Optimize one or more of the following:
NI/SA = profit on sales
SA/TA = total asset turnover (capital intensity)
TA/EQ = leverage
Profit on Sales
Ways to optimize profit on sales include:
Differentiate products to raise margins.
Revive and promote old products (Jell-O)
Promote the most profitable products.
Prune the least profitable products.
Cut costs of production.
Improve efficiency of operations
Outsource.
Total Asset Turnover
Ways to optimize total asset turnover are:
Adopt "just-in-time" inventory
Sell off obsolete inventory
Improve receivables collection efficiency
Sell and lease back property & plant
Slow down paying of accounts payable
Cut back on executive jets, corporate yachts
Seek out less capital intensive methods of
operation
Relocate operations to less expensive locations
Outsourcing
Leverage
Increase leverage, within safe limits:
Repurchase outstanding stock
Increase debt financing
Repurchase stock & issue more debt
Repurchase common stock & issue more
preferred stock
Benchmarking
In order to be meaningful, financial ratios
need to be compared with benchmark ratios.
Possible Benchmarks:
Same company, in earlier period
Competitor company, in same period
Group of competitor companies, in same period
An industry benchmark, such as The North
American Industry Classification System
(NAICS)
NAICS provides standard classifications for
industries, for example, see the next slide
Example of NAICS
NAICS code 2002
Includes NAICS Title: 21 Mining
211111 Crude Petroleum and Natural Gas Extraction
211112 Natural Gas Liquid Extraction
212111 Bituminous Coal and Lignite Surface Mining
212112 Bituminous Coal Underground Mining
212113 Anthracite Mining
These 6-digit codes describe standard industry classifications.
For more, see http://www.census.gov/eos/www/naics/
Sources of Industry Data
Most sources of industry data require purchase of a
subscription
However, the UMUC Library offers access to
several industry databases, such as Dun &
Bradstreet (D&B)
http://www.umuc.edu/library/resources/?cmd=createSubjectPages&temp
late_id=635&subjectIDs=7&submit=Write#Library_Databases
Sources that offer limited industry data free are:
Yahoo Finance
MSN Money
http://www.bizstats.com/corporations.asp?profType=ratios
Industry Data
One caution is that some companies operate in several
different industries.
For example, General Electric Company (GE) is a
diversified industrial corporation engaged in developing,
manufacturing and marketing a wide variety of products for
the generation, transmission, distribution, control and
utilization of electricity. On June 23, 2005, GE announced
reorganization of its 11 businesses into six industry-focused
businesses effective July 5, 2005. The six businesses are GE
Infrastructure, GE Industrial, GE Commercial Financial
Services, GE NBC Universal, GE Healthcare and GE
Consumer Finance.
It is difficult to find industry benchmarks for conglomerates
like GE. Benchmarks are easier for companies in one
industry.
Financial Ratio Calculation
Financial ratios have a numerator and a
denominator.
These numerators and denominators are
items from the Balance Sheet or the Income
Statement.
Example: Current Ratio = Current
Assets/Current Liabilities.
Continued on next slide ...
Financial Ratio Calculation
(continued)
Balance Sheets show financial position as of one
specific date.
But one specific date cannot represent an entire
accounting period – such as a year.
Therefore it is better to average beginning and
ending balance sheet amounts
In practice, for stable companies, we can
accomplish our learning goals without needing to
calculate these averages.
Please use Excel for all calculations
Please show calculations step by step.
Summary
Use financial ratios to
analyze:
Short-term solvency
Profitability
Long-term solvency
Use DuPont Analysis
to:
Devise strategy
Implement strategy.
Benchmarking
Industry comparisons