Chapter Two

Financial Statement Analysis

 REQUIRED INVESTMENTS IN
NET OPERATING PROFIT OPERATING CAPITAL
AFTER TAXES

FREE CASH FLOW (FCF)

WEIGHTED AVERAGE COST OF

MARKET INTEREST RATE CAPITAL

FIRMS DEB/EQUITY MIX

COST OF DEBT
COST OF EQUITY
MARKET RISK AVERSION FIRMS BUSINESS RISK
 Financial statement analysis

 Financial statement analysis involves

 (1) comparing a firm’s performance with that of other firms in
the same industry and
 (2) evaluating trends in the firm’s financial position over time.
 Managers use financial analysis
 to identify situations needing attention; potential lenders use
financial analysis to determine whether a company is
creditworthy; and stockholders use financial analysis to help
predict future earnings, dividends, and free cash flow.
 Financial analysis steps
 Gather Data
 Examine the Statement of Cash Flows
 Calculate and Examine the Return on Invested Capital
 Begin Ratio Analysis
Step-1-Gather Data
Step-2-Examine the Statement of Cash Flows

 Some financial analysis can be done

 The first step in with virtually no calculations.
financial analysis is to
 For example, we always look to the
gather data. statement of cash flows first,
particularly the net cash provided by
operating activities.
 Downward trends or negative net cash
 This can be accessed flow from operations almost always
from National Bank indicate problems
data base, investment  A quick look at the section on financing
research etc.. activities also reveals whether or not a
company is issuing debt or buying back
stock; in other words, is the company
raising capital from investors or
returning it to them?
Step-3-Calculate and Examine the Return
on Invested Capital
Step-4-Begin Ratio Analysis
 After examining the statement of
cash flows, we calculate the return  Financial ratios are
on invested capital (ROIC) designed to extract
important information
 The ROIC provides a vital measure
of a firm’s overall performance. If that might not be obvious
ROIC is greater than the company’s simply from examining a
weighted average cost of capital
(WACC), then the company usually firm’s financial statements.
is adding value.

 If ROIC is less than WACC, then the

company usually has serious
problems. No matter what ROIC
tells us about the firm’s overall
performance, it is important to
examine specific areas within the
firm, and for that we use ratios.
Liquidity Ratios Current Ratio
 This ratio is calculated by dividing current
 The company ability to assets by current liabilities. It indicates
the extent to which current liabilities are
satisfy shot term obligation covered by those assets expected to be
of a company. converted to cash in the near future.
 Current assets:
 Cash,
 Current ration  Marketable securities,
 Acid test ratio  Accounts receivable,
 And inventories.
 Current liabilities
 Accounts payable,
 Short-term notes payable,
 Current maturities of long-term
debt, accrued taxes, and other
accrued expenses (principally
wages).
Micro Drive Inc.: Balance Sheets and Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per Share Data)

Assets 2010 2009 Liability And Equity 2010 2009

Cash And Equivalent 10 15 Accounts Payable 60 30
Shot-tem Investments 0 65 Notes Payable 110 60
Accounts Receivable 375 315 Accruals 140 130
Inventories 615 415 Total Current Liabilities 310 220
Total Current Asset 1000 810 Long Term Bonds 754 754
Net Plant And Equipments 1000 870 Total Liability 1064 974
Preferred 40 40
Stock(400,000 Shares)

Common 130 130

Stock(50,000,000
Shares)
Retained Earrings 766 710
Total Common Equity 896 840
Total Assets 2000 1680 Total Liabilities And 2000 1680
Equity
 2010 2009
Net Sales 3000.0 2850.0
Operating Costs Excluding Depreciation And Amortization 2616.2 2497.0
Earning Before Interest, Taxes, Depreciation And Amortization (EBITDA) 383.8 353.0
Depreciation 100 90.0
Amortization 0.0 0.0
Depreciation And Amortization 100 90.0
Earnings Before Interest And Taxes (EBIT, Or Operating Income) 283.8 263
Less Interest 88.0 60
Earnings Before Taxes (EBT 195.8 203
Taxes (40%) 78.3 81.2
Net Income Before Preferred Dividends 117.5 121.8
Preferred Dividends 4.0 4.0
Net Income 113.5 117.8
Common Dividends 57.5 53.0
Addition To Retained Earnings 56.0 64.8
Per-share Data
Common Stock Price 23.0 26.0
Earnings Per Share (EPS) 2.27 2.36
Book Value Per Share (BVPS) 17.92 16.8
Cash Flow Per Share(CFPS) 4.27 4.16
Analysis current ratio…
1000/310 =3.2
Industry average=4.2

 Micro Drive has a lower current ratio than the

average for its industry. Is this good or bad?
Sometimes the answer depends on who is asking
the question
 Meaning to creditors

 For example, suppose a supplier is trying to decide whether to extend credit to

Micro Drive. In general, creditors like to see a high current ratio.
 If a company is getting into financial difficulty, it will begin paying its bills
(accounts payable) more slowly, borrowing from its bank, and so on, so its
current liabilities will be increasing.

 If current liabilities are rising faster than current assets then the current ratio
will fall, and this could spell trouble.

 Because the current ratio provides the best single indicator of the extent to
which the claims of short-term creditors are covered by assets that are
expected to be converted to cash fairly quickly, it is the most commonly used
measure of short-term solvency.
 Meaning to shareholders

 Now consider the current ratio from the perspective of a

shareholder. A high current ratio could mean that the company
has a lot of money tied up in nonproductive assets, such as excess
cash or marketable securities.

 Or perhaps the high current ratio is due to large inventory

holdings, which might well become obsolete before they can be
sold. Thus, shareholders might not want a high current ratio.
Quick (Acid Test) Ratio
 This ratio is calculated by deducting inventories from current assets
and dividing the remainder by current liabilities.

 Inventories are typically the least liquid of a firm’s current assets,

hence they are the assets on which losses are most likely to occur in
the event of liquidation.

 Therefore, a measure of the firm’s ability to pay off short-term

obligations without relying on the sale of inventories is important.
 Quick test=

(Current Assets – Inventories)/Current Liability

385/310=1.20
Industry Average=2.1

 The industry average quick ratio is 2.1, so Micro Drive

1.2 ratio is low in comparison with other firms in its
industry. Still, if the accounts receivable can be collected,
the company can pay off its current liabilities without
having to liquidate its inventory.
Asset Management Ratios
 Introduction
 The second group of ratios, the asset management ratios, measures how
effectively the firm is managing its assets.

 These ratios are designed to answer this question:

 Does the total amount of each type of asset as reported on the balance
sheet seem reasonable, too high, or too low in view of current and
projected sales levels?

 When they acquire assets, Micro Drive and other companies must borrow
or obtain capital from other sources. If a firm has too many assets, its
cost of capital will be too high, hence its profits will be depressed.

 On the other hand, if assets are too low, profitable sales will be lost.
Ratios that analyze the different types of assets are described in this
section.
The Inventory Turnover Ratio

 This ratio is calculated by dividing sales by inventories.

 Excess inventory is, of course, unproductive, and it represents an
investment with a low or zero rate of return.
 Micro Drive low inventory turnover ratio also makes us question
the current ratio.

• Inventory Turnover Ratio= Sales/Inventories

 Inventory turnover ratio=
$3000/615 = 4.90
Industry average =9.00

 As a rough approximation, each item of Micro Drive inventory is sold out and
restocked, or “turned over,” 4.9 times per year. Micro Drive turnover of 4.9
is much lower than the industry average of 9.0. This suggests that Micro Drive
is holding too much inventory.

 High levels of inventory add to net operating working capital (NOWC), which
reduces FCF, which leads to lower stock prices.

 In addition, Micro Drive low inventory turnover ratio makes us wonder

whether the firm is actually holding obsolete goods not worth their stated
value
 Evaluating Receivables:

 Days sales outstanding  Thus, the DSO represents the

(DSO), also called the average length of time that the
“average collection period” firm must wait after making a
(ACP), is used to appraise sale before receiving cash, which
accounts receivable, and it is the average collection period.
is calculated by dividing
accounts receivable by DSO= Receivables /Average
average daily sales to find sales per day
the number of days’ sales
375/8.2192=45.6 days
that are tied up in
receivables. Industry average =36 days
 Analysis's…

 Micro Drive sales terms call for payment within 30 days. The fact
that 46 days of sales are outstanding indicates that customers, on
average, are not paying their bills on time.

 As with inventory, high levels of accounts receivable cause high

levels of NOWC, which hurts FCF and stock price..
 The Fixed Assets Turnover Ratio
 The fixed assets turnover ratio measures how effectively the firm uses its plant
and equipment.

It is the ratio of sales to net fixed assets:

=$3,000/$1,000 = 3.0
Industry average =3.0
 Micro Drive ratio of 3.0 is equal to the industry average, indicating that the
firm is using its fixed assets about as intensively as are other firms in its
industry.

 Therefore, Micro- Drive seems to have about the right amount of fixed assets
in relation to other firms.
 A potential problem can exist when interpreting the fixed assets
turnover ratio. Recall from accounting that fixed assets reflect the
historical costs of the assets.

 Inflation has caused the current value of many assets that were
purchased in the past to be seriously understated. Therefore, if we
were comparing an old firm that had acquired many of its fixed
assets years ago at low prices with a new company that had
acquired its fixed assets only recently, we would probably find that
the old firm had the higher fixed assets turnover ratio.

 However, this would be more reflective of the difficulty

accountants have in dealing with inflation than of any inefficiency
on the part of the new firm. You should be alert to this potential
problem when evaluating the fixed assets turnover ratio.
The Total Assets Turnover Ratio

 The final asset management ratio, the total assets turnover ratio,
measures the turnover of all the firm’s assets; it is calculated by
dividing sales by total assets:

 Allied’s ratio is somewhat below the industry average, indicating

that the company is not generating a sufficient volume of business
given its total assets investment.

 Sales should be increased, some assets should be disposed of, or a

combination of these steps should be taken.
 $3;000/$2;000 =1.5
Industry average = 1.8

 Micro Drive ratio is somewhat below the industry average,

indicating that the company is not generating a sufficient volume
of business given its total asset investment.

 Sales should be increased, some assets should be sold, or a

combination of these steps should be taken.
Debt Management Ratios
 Introduction
 The extent to which a firm uses debt financing, or financial
leverage, has three important implications:

 By raising funds through debt, stockholders can maintain

control of a firm while limiting their investment.

 Creditors look to the equity, or owner-supplied funds, to

provide a margin of safety, so the higher the proportion of
the total capital that was provided by stockholders, the less
the risk faced by creditors.

 Ifthe firm earns more on investments financed with

borrowed funds than it pays in interest, the return on the
owners’ capital is magnified, or “leveraged.”
Example: Effects of Financial leverage on stockholders’ return
 Here we analyze two companies that are identical except for the way they are
financed. Firm U (for “unleveraged”) has no debt, whereas Firm L (for
“leveraged”) is financed with half equity and half debt that costs 15 percent.

 Both companies have $100 of assets and $100 of sales, and their expected
operating income (also called earnings before interest and taxes, or EBIT) is $30.

 Thus, both firms expect to earn $30, before taxes, on their assets. Of course,
things could turn out badly, in which case EBIT would be lower. Thus, in the
Balance Sheet Of Firm-U Partial View
Firm U (Unleveraged)

Current Assets $50 Debt $0

Fixed Assets 50 Common Equity 100

Total Assets $100 $100

Income statement of u partial view

Expected BAD condition

condition s
Sales $ 100.00 $ 82.50
Operating 70 80.00
costs
Operating income $30 $ 2.50
Interest 0.00 0.00
Earning before taxes(EBT) 30.00 $ 2.50

Taxes (40%) 12.00 1.00

Net income(NI) 18.00 $ 1.50
ROEu = NI/Common equity 18.00% 1.50%
=NI/$100
Balance Sheet Of L Partial View

Firm L(leveraged)

Current $50 Debt(interest= $50

Assets 15%)
Fixed Assets 50 Common 50
Equity
Total Assets $100 $100
 Income statement of L partial view

Expected condition BAD condition s

Sales $ 100.00 $ 82.50

Operating costs 70 70.00
Operating income $30 $ 12.50
Interest 7.5 7.50
Earning before $ 22.00 $ 5.00
taxes(EBT)
Taxes (40%) 9.00 (2.00)
Net income(NI) 13.50 ($ 3.00)
ROEL= NI/Common 27% (6.00%)
equity =NI/$50
 Even though both companies’ assets produce the same expected
EBIT, under normal conditions Firm L should provide its
stockholders with a return on equity of 27 percent versus only 18
percent for Firm U.

 This difference is caused by Firm L’s use of debt, which “leverages

up” its expected rate of return to stockholders.
 There are two reasons for the leveraging effect:
  Since interest is deductible, the use of debt lowers the tax bill and
leaves more of the firm’s operating income available to its investors.

 If operating income as a percentage of assets exceeds the interest

rate on debt, as it generally does, then a company can use debt to
acquire assets, pay the interest on the debt, and have something left
over as a “bonus” for its stockholders.

 For our hypothetical firms, these two effects combine to push Firm L’s
expected rate of return on equity up far above that of Firm U. Thus, debt
can “leverage up” the rate of return on equity.
 The ratio of total debt to total assets, generally called the
debt ratio, measures the percentage of funds provided by
creditors:

Total debt includes both current liabilities and long-term

debt.
 Creditors prefer low debt ratios because the lower the ratio,
the greater the cushion against creditors’ losses in the event
of liquidation.

 Stockholders,
on the other hand, may want more leverage
because it magnifies their return.
 Micro Drive debt ratio is 53.2% but its debt ratio in the previous
year was 47.6%,which means that creditors are now supplying
more than half the total financing.

 In addition to an upward trend, the level of the debt ratio is

well above the industry average.

 Creditors may be reluctant to lend the firm more money because

a high debt ratio is associated with a greater risk of bankruptcy.
Debt-to-equity Ratio

 The debt-to-equity ratio and the debt ratio contain the same information but
present that information slightly differently.

 The debt-to-equity ratio shows that Micro Drive has $1.14 of debt for
every dollar of equity, whereas the debt ratio shows that 53.2% of Micro
Drive financing is in the form of liabilities.

 We find it more intuitive to think about the percentage of the firm that is
financed with debt, so we usually use the debt ratio. However, the debt-to-
equity ratio is also widely used, so you should know how to interpret it.
Market debt ratio
 Sometimes it is useful to
express debt ratios in terms of
market values.

 It is easy to calculate the

market value of equity, which
is equal to the stock price
multiplied by the number of
shares. Micro Drive market
value of equity is $23(50) =
$1,150.

 Often it is difficult to estimate

the market value of liabilities,
so many analysts define the
market debt ratio as
 Micro Drive market debt ratio in the previous year was 38.1%.
The big increase was due to two major factors: Liabilities
increased and the stock price fell.

 The stock price reflects a company’s prospects for generating

future cash flows, so a decline in stock price indicates a likely
decline in future cash flows.

 Thus, the market debt ratio reflects a source of risk that is not
captured by the conventional book debt ratio.
Ability To Pay Interest: Times-interest-earned Ratio
 The ratio of earnings before interest and taxes (EBIT) to interest
charges; a measure of the firm’s ability to meet its annual interest
payments.
 The TIE ratio measures the extent to which operating income can
decline before the firm is unable to meet its annual interest costs.
 Failure to meet this obligation can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy.
 Note that earnings before interest and taxes, rather than net
income, is used in the numerator.

 Because interest is paid with pre-tax dollars, the firm’s ability to

pay current interest is not affected by taxes.
 Operating income of Micro Drive interest can pay company interest
expense 3.2 times. The industry average is 6, so Micro Drive is
covering its interest charges by a relatively low margin of safety.

 Thus, the TIE ratio reinforces the conclusion from our analysis of the
debt ratio that Micro Drive would face difficulties if it attempted to
borrow additional funds.
Profitability Ratios
 Profitability is the net result  Profit Margin On Sales
of a number of policies and
decisions.  This ratio measures net income
per dollar of sales; it is
 The ratios examined thus far calculated by dividing net
provide useful clues as to the income by sales.
effectiveness of a firm’s
operations, but the
profitability ratios show the
combined effects of liquidity,
asset management, and debt
on operating results.
 By dividing net income by sales. It gives the profit per dollar of sales:

Net profit margin =net income available to common

stockholders/sales=
• $113.50/$3000.00= 3.8%
 Industry average = 5.0%

 Net profit margin is below the industry average of 5%, but why is
this so? Is it due to inefficient operations, high interest expenses, or
both?
BASIC EARNING POWER (BEP)
 Instead of just comparing net income to sales, many
analysts also break the income statement into smaller
parts to identify the sources of a low net profit margin.

 For example, the operating profit margin is defined as -
the ability of the firm’s assets to generate operating
income; calculated by dividing EBIT by total assets.






 This ratio shows the raw earning power of the firm’s assets
before the influence of taxes and leverage, and it is useful for
comparing firms with different tax situations and different
degrees of financial leverage.

 Because of its low turnover ratios and low profit margin on

sales, Micro Drive is not getting as high a return on its assets as
is the average company in its industry.
RETURN ON TOTAL ASSETS
 The ratio of net income to total assets.
 The ratio of net income to total assets measures the
return on total assets (ROA) after interest and taxes



 $113.5/$2,000 = 5.7%
Industry average =9.0%

 Micro Drive 5.7% return is well below the 9% average for

the industry.
 This low return is due to

 the company’s low basic earning power and

 high interest costs resulting from its above-average use
of debt; both of these factors cause Micro Drive net
income to be relatively low.
 Return On Common Equity

 The ratio of net income to common equity; measures the

rate of return on common stockholders’ investment.

 Ultimately, the most important, or “bottom line,”

accounting ratio is the ratio of net income to common
equity, which measures the return on common equity (ROE):


 =$113.5/$896 = 12.7%
=Industry average = 15.0%

 Stockholders invest to earn a return on their money, and this

ratio tells how well they are doing in an accounting sense.

 Micro Drive’s 12.7% return is below the 15% industry average,

but not as far below as its return on total assets.
 Market Value Ratios
 Market value ratios relate a firm’s stock price to its earnings, cash
flow, and book value per share. Market value ratios are a way to
measure the value of a company’s stock relative to that of another
company.
 Sock Price /earning per share
 Stock Price / Cash Flow Ratio
 Stock price / book value per share
 Price/Earnings Ratio

 The price/earnings (P/E) ratio shows how much investors are

willing to pay per dollar of reported profits.

 Micro Drive stock sells for $23, so with an earnings per share
(EPS=113.5/50million) of $2.27 its P/E ratio is 10.1:
Price/earnings ratios

 Price/earnings ratios are higher for firms with strong growth

prospects, other things held constant, but they are lower for riskier
firms.

 Because Micro Drive P/E ratio is below the average, this suggests
that the company is regarded as being somewhat riskier than most,
as having poorer growth prospects, or both.

 In early 2009, the average P/E ratio for firms in the S&P 500 was
12.54, indicating that investors were willing to pay $12.54 for
every dollar of earnings.
Price/Cash Flow Ratio

 Stock prices depend on a company’s ability to generate cash flows.

 Consequently, investors often look at the price/cash flow ratio,
where cash flow is defined as net income plus depreciation and
amortization:

 Micro Drive price/cash flow ratio is also below the industry average,
once again suggesting that its growth prospects are below average,
its risk is above average, or both.
PRICE/EBITDA
 The price/EBITDA ratio is similar to the price/cash flow ratio, except
the price/EBITDA ratio measures performance before the impact of
interest expenses and taxes, making it a better measure of operating
performance.

 Micro Drive EBITDA per share is $383.8/50 = $7.676, so its

price/EBITDA is $23/$7.676 = 3.0.

 The industry average price/EBITDA ratio is 4.6, so we see again that

Micro Drive is below the industry average
 Market/Book Ratio
 The ratio of a stock’s market price to its book value gives another
indication of how investors regard the company.

 Companies with relatively high rates of return on equity generally

sell at higher multiples of book value than those with low returns.

 First, we find Micro Drive book value per share:

 Book value per share  Market/book ratio = M/B =
=Common  Market price per share/Book
equity/Shares value per share=
outstanding
=
 $23.00/$17.92 =1.3
 $896/50 = $17.92
 Industry average =1.7
 Now we divide the
 Investors are willing to pay
market price by the
relatively little for a dollar of
book value to get a
Micro Drive book value.
market/book
(M/B)ratio of 1.3
times:
 Since M/B ratios typically exceed 1.0, this means that investors are
willing to pay more for stocks than their accounting book values.

 The book value is a record of the past, showing the cumulative

amount that stockholders have invested, either directly by
purchasing newly issued shares or indirectly through retaining
earnings.

 In contrast, the market price is forward-looking, incorporating

investors’ expectations of future cash flows.

 For example, in early 2009 Alaska Air had a market/book ratio of

only 0.81, reflecting the airline industry’s problems, whereas Apple’s
market/book ratio was 3.45, indicating that investors expected
Apple’s past successes to continue.