Chapter 10

Investment
by

Dr. Kumail Rizvi, CFA, FRM

Chapter 10
Analysis of Financial Statements
Questions to be answered:
What are the major financial statements
provided by firms and what specific
information does each of them contain?
Why do we use financial ratios to examine the
performance of a firm and why is it important
to examine performance relative to the
economy and a firms industry?

Chapter 10
Analysis of Financial Statements
What are the major categories for financial ratios
and what questions are answered by the ratios in
these categories?
What specific ratios help determine a firms
internal liquidity, operating performance, risk
profile, growth potential, and external liquidity?
How can the DuPont analysis help evaluate a
firms return on equity over time?

Chapter 10
Analysis of Financial Statements
What is a quality balance sheet or income
statement?
Why is financial statement analysis done if
markets are efficient and forward-looking?

Chapter 10
Analysis of Financial Statements
What major financial ratios help analysts in the
following areas: stock valuation, estimating and
evaluating systematic risk, predicting the credit
ratings on bonds, and predicting bankruptcy?

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 and 10-Q

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

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

Income Statement
Contains information on the profitability of
the firm during some period of time
Indicates the flow of sales, expenses, and
earnings during the time period

Statement of Cash Flows

Integrates the information on the balance
sheet and income statement
Shows the effects on the firms cash flow of
income flows and changes in various items
on the balance sheet

Statement of Cash Flows

It has three sections:
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

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
Capital expenditures and dividends

Measures of Cash Flow

EBITDA: measure of cash flow is
extremely liberal.
It does not consider any adjustments noted
previously.
It adds back depreciation and amortization
along with both interest expense and taxes

Purpose of
Financial Statement Analysis
Evaluate management performance in three
areas:
Profitability
Efficiency
Risk

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 to other entities
Examine a firms performance relative to:

The aggregate economy

Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)

Comparison of a Firms Performance

Relative 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 of a Firms Performance

Relative to
its Industry
Most popular comparison
Industries affect the firms within them
differently, but the relationship is always
significant
The industry effect is strongest for
industries with homogenous products
Examine the industrys performance
relative to aggregate economic activity

Comparison of a Firms Performance

Relative 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 of a Firms Performance

Relative to its Own Historical Track
Record
Determine whether it is progressing or
declining
Helpful for estimating future performance
Consider trends as well as averages over
time

Five Categories of Financial Ratios

1. Common size statements
2. Internal liquidity (solvency)
3. Operating performance
a. Operating efficiency
b. Operating profitability

4. Risk analysis
a. Business risk
b. Financial risk
c. External liquidity risky

Five Categories of Financial Ratios

5. Growth analysis

Common Size Statements

Normalize balance sheets and income
statement items to allow easier comparison
of different size firms
A common size balance sheet expresses
accounts as a percentage of total assets
A common size income statement expresses
all items as a percentage of sales

Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate
the ability to meet future short-term
financial obligations
Current Ratio examines current assets and
current liabilities
Current Assets
Current Ratio
Current Liabilitie s

Evaluating Internal Liquidity

Quick Ratio adjusts current assets by
removing less liquid assets
Cash Marketable Securities Receivable s
Quick Ratio
Current Liabilitie s

Evaluating Internal Liquidity

Cash Ratio is the most conservative
liquidity ratio
Cash Marketable Securities
Cash Ratio
Current Liabilitie s

Evaluating Internal Liquidity

Receivables turnover examines the
quality of accounts receivable
Net Annual Sales
Receivable s Turnover
Average Receivable s

Receivables turnover can be converted into

an average collection period
365
Average Receivable s Collection Period
Annual Turnover

Evaluating Internal Liquidity

Inventory turnover relates inventory to sales
or cost of goods sold (CGS)
Cost of Goods Sold
Inventory Turnover
Average Inventory

Given the turnover values, you can compute

the average inventory processing time
Average Inventory Processing Period = 365/Annual
Inventory Turnover

Evaluating Internal Liquidity

Cash conversion cycle combines
information from the receivables turnover,
inventory turnover, and accounts payable
turnover

Receivable Days
+Inventory Processing Days
-Payables Payment Period
Cash Conversion Cycle

Evaluating Operating
Performance
Ratios that measure how well management
is operating a business
(1) Operating efficiency ratios
Examine how the management uses its assets and
capital, measured in terms of sales dollars generated
by asset or capital categories

(2) Operating profitability ratios

Analyze profits as a percentage of sales and as a
percentage of the assets and capital employed

Operating Efficiency Ratios

Total asset turnover ratio indicates the
effectiveness of a firms 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

Operating Efficiency Ratios

Net fixed asset turnover reflects utilization
of fixed assets
Net Sales
Fixed Asset Turnover
Average Net Fixed Assets

Operating Efficiency Ratios

Equity turnover examines turnover for
capital component
Net Sales
Equity Turnover
Average Equity

Operating Profitability Ratios

Operating profitability ratios measure
1. The rate of profit on sales (profit margin)
2. The percentage return on capital

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

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

Operating Profitability Ratios

Net profit margin relates net income to sales
Net Income
Net Profit Margin
Net Sales

Operating Profitability Ratios

Common size income statement
It lists all expense and income items as a
percentage of sales and provide useful insights
regarding the trends in cost figures and profit
margins

Operating Profitability Ratios

Return on total capital relates the firms
earnings to all capital in the enterprise
Net Income Interest Expense
Return on Total Capital
Average Total Capital

Operating Profitability Ratios

Return on owners equity (ROE) indicates
the rate of return earned on the capital
provided by the stockholders after paying
for all other capital used
Net Income
Return on Total Equity
Average Total Equity

Operating Profitability Ratios

Return on owners equity (ROE) can be
computed for the common- shareholders
equity

Net Income - Preferred Dividend

Return on Owner' s Equity
Average Common Equity

Operating Profitability Ratios

The DuPont System divides the ratio into
several components that provide insights
into the causes of a firms ROE and any
changes in it
Net Income
Net Income
Net Sales
ROE

Common Equity
Net Sales Common Equity
Sales
Sales
Total Assets

Equity Total Assets

Equity

Operating Profitability Ratios

Net Income

Common Equity
Net Income
Sales
Total Assets

Sales
Total Assets Common Equity

Profit
Margin

Total Asset
x Turnover

Financial
x Leverage

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

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

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

This is the operating profit return on total

assets. To consider the negative effects of
financial leverage, we examine the effect of
interest expense as a percentage of total
assets

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets

We consider the positive effect of financial

leverage with the financial leverage multiplier

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

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
This indicates the pretax return on equity. To arrive
at ROE we must consider the tax rate effect.

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

Operating Profitability Ratios

In summary, we have the following five
components of return on equity (ROE)

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales
Sales
2.
Total Asset Turnover
Total Assets

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales
Sales
2.
Total Asset Turnover
Total Assets
Interest Expense
3.
Interest Expense Rate
Total Assets

Operating Profitability Ratios

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

Operating Profitability Ratios

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

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

Risk Analysis
Total risk of a firm has two components:
Business risk
The uncertainty of income caused by the firms
industry
Generally measured by the variability of the firms
operating income over time

Financial risk
Additional uncertainty of returns to equity holders
due to a firms use of fixed obligation debt securities
The acceptable level of financial risk for a firm
depends on its business risk

Business Risk
Variability of the firms operating income
over time

Business Risk
Measured by variability of the firms
operating income over time
Earnings variability is measured by standard
deviation of the historical operating
earnings series

Business Risk
Two factors contribute to the variability of
operating earnings
Sales variability
Operating leverage

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

Financial Risk
Relationship between business risk and
financial risk
Acceptable level of financial risk for a firm
depends on its business risk

Financial Risk
Proportion of debt (balance sheet) ratios
indicate what proportion of the firms
capital is derived from debt compared to
other sources of capital, such as preferred
stock, common stock, and retained earnings.

Financial Risk
Proportion of debt (balance sheet) ratios
Total Long - Term Debt
Debt - Equity Ratio
Total Equity

This may be computed with and without

deferred taxes

Financial Risk
Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital

Financial Risk
Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital
L.T. Debt - Total L.T. Capital Ratio
Total Long - Term Debt

Total Long - Term Capital

Financial Risk
Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)

Financial Risk
Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)
Total Interest - Bearing Debt/Total Capital
Total Interest Debt

Total Capital

Financial Risk
Earnings or Cash Flow Ratios
Relate the flow of earnings
Cash available to meet the payments
Higher ratio means lower risk

Financial Risk
Interest Coverage
Income Before Interest and Taxes (EBIT)

Debt Interest Charges

Net Income Income Taxes Interest Expense

Interest Expense

Financial Risk
Firms may also have non-interest fixed
payments due for lease obligations
The risk effect is similar to bond risk
Bond-rating agencies typically add 1/3 lease
payments as the interest component of the
lease obligations

Financial Risk
Total fixed charge coverage includes any
noncancellable lease payments and any
preferred dividends paid out of earnings
after taxes

Financial Risk
Total fixed charge coverage includes any
noncancellable lease payments and any
preferred dividends paid out of earnings
after taxes
Fixed Charge Coverage
Income Before Interest, Taxes, and Lease Payments
Debt Interest Lease Payments Preferred Dividend/( 1 - Tax Rate)

Financial Risk
Cash flow ratios relate the flow of cash
available from operations to either interest
expense, total fixed charges, or the face
value of outstanding debt

Financial Risk
Cash Flow Coverage
Traditiona l Cash Flow Interest 1/3 Lease Payments
Interest 1 / 3 Lease Payments

Financial Risk
Cash Flow / Long - Term Debt
Net Income Depreciati on Expense Change in Deferred Tax
Book Value of Long - Term Debt

Financial Risk
Cash Flow / Total Debt
Net Income Depreciati on Expense Change in Deferred Tax
Total Debt

Financial Risk
Alternative Measures of Cash Flow
Cash flow from operation
Free cash flow

External Market Liquidity

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

External Market Liquidity

Determinants of Market Liquidity
The dollar value of shares traded
This can be estimated from the total market
value of outstanding securities
It will be affected by the number of security
owners
Numerous buyers and sellers provide liquidity

External Market Liquidity

Trading turnover (percentage of outstanding
shares traded during a period of time)

External Market Liquidity

A measure of market liquidity is the bid-ask
spread
Certain corporate variables
Total market value of outstanding securities
(number of common shares outstanding times
the market price per share)
Number of security owners

Analysis of Growth Potential

Sustainable growth potential analysis
examines ratio that indicate how fast a firm
should grow.
Creditors are interested in the firms ability
to pay future obligations
Value of a firm depends on its future
growth in earnings and dividends

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 firms return on equity

Determinants of Growth
ROE is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)

Comparative Analysis of Ratios

Internal liquidity
Current ratio, quick ratio, and cash ratio

Operating performance
Efficiency ratios and profitability ratios

Risk Analysis
Growth analysis

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

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

The Quality of Financial

Statements
High-quality income statements reflect repeatable
earnings
Gains from nonrecurring items should be ignored
when examining earnings
High-quality earnings result from the use of
conservative accounting principles that do not
overstate revenues or understate costs
Footnotes
Provide information on how the firm handles balances
sheet and income items

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 firms
operating and financial structure
This aids in estimating future returns

Specific Uses of Financial Ratios

1. Stock valuation
2. Identification of corporate variables
affecting a stocks systematic risk (beta)
3. Assigning credit quality ratings on bonds
4. Predicting insolvency (bankruptcy) of firms

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

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

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

Estimating Systematic Risk

Financial Ratios
1. Dividend payout
2. Total debt/total assets
3. Cash flow/total debt
4. Interest coverage
5. Working capital/total assets
6. Current Ratio

Estimating Systematic Risk

Variability Measures
1. Variance of operating earnings
2. Coefficient of variation of operating earnings
3. Coefficient of variation of operating profit
margins
4. Operating earnings beta (company earnings
related to aggregate earnings)

Estimating Systematic Risk

Nonratio Variables
1. Asset size
2. Market value of stock outstanding

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

Estimating the Ratings on Bond

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)

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

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

Financial Ratios and

Insolvency (Bankruptcy)
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

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

Summary
Financial statement analysis help investors
make decisions on investing in a firm s
bonds or stock.
A trend analysis of a firms financial ratios
will be insightful
Financial ratios should be examined relative
to the economy, the firms industry, and the
firms main competitors

Summary
The specific ratios can be divided into four
categories:

Internal liquidity
Operating performance
Risk analysis
Growth analysis

Summary
Analysts must consider differences in
format and in accounting principle that
cause different values for specific ratio
when analyzing the financial statements for
non-US firms

Summary
Four major uses of financial ratios :
Stock valuation
Analysis of variables affecting a stocks
systematic risk
Assigning credit ratings on bonds
Predicting insolvency (bankruptcy)

The Internet
Investments Online
http://www.walgreens.com
http://www.cvs.com
http://www.riteaid.com
http://www.longs.com
http://www.sec.gov
http://www.hoovers.com
http://www.dnb.com

End of Chapter 12
Analysis of Financial
Statements

Future topics
Chapter 11
An Introduction to Security Valuation