Overview of Financial

Statement Analysis

1
CHAPTER
Business Analysis

 Business analysis is the process of evaluating a

company’s economic prospects and risks for the purpose of
making business decisions
It includes analyzing a company’s business environment, its
strategies, and its financial position and performance.
 Financial statement analysis is an important component
of business analysis.
 Types of Business Analysis

• The goal of business analysis is to improve business

decisions by evaluating available information about a
company’s financial situation, its management, its
plans and strategies, and its business environment.

• Business analysis is an important part of the decisions

of security analysts, investment advisors, fund
managers, investment bankers, credit raters, corporate
bankers, and individual investors.
An internal financial analysis might be done:
• to evaluate the performance of employees to determine pay raises and bonuses.
• to compare the performance of different divisions.
• to prepare financial projections
• to evaluate the firm's financial performance in light of its competitors performance and determine how to
improve the firm's own operations.
External financial analysis is done by:
• banks and other lenders deciding to lend money.
• suppliers deciding to grant credit.
• credit-rating agencies determining credit worthiness.
• professional analysts who work for investment companies deciding to invest in the company.
• individual investors deciding to invest in the company.
 1-5

Component Processes of Business Analysis

btap nhóm ( bỏ prospestive & valuation)

An initial step in business analysis is to evaluate a
company’s business environment and strategies.

Business environment and strategy analysis consists of two

parts—industry analysis and strategy analysis
Business environment and strategy analysis requires
knowledge of both economic and industry forces.
 1-6

Industry Analysis
Industry analysis could be done using the framework (Michael Poster’s Five
Competitive Forces) including bargaining power with consumers and suppliers
and that actively compete among themselves and face threats from new
entrants and substitute products
 1-7

Strategic Analysis
Strategy analysis is the evaluation of both a company’s
business decisions and its success at establishing a
competitive advantage

What are future business prospects?

Are markets expected to grow?
What are firm’ strengths and
weaknesses?
What strategies has it taken, or does
it plan to take, in response to
business opportunities and threats?
 Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality
The quality of financial analysis depends on the reliability of financial
statements that in turn depends on the quality of accounting analysis
different inventory, depreciation methods
Comparability problems: arise when different companies adopt
different accounting for similar transactions or events. Comparability problems
also arise when a company changes its accounting over time

Manager estimation error

bóp méo
Distortion problems Earnings management Accounting
are deviations of accounting Risk
information from Distortion of business
the underlying economics.

Managers might manipulate financial statements

 Financial Analysis
Process to evaluate financial position and
performance using financial statements

Profitability analysis —Evaluate return

on investments Common tools

Risk analysis ——— Evaluate riskiness

& creditworthiness Ratio Cash
analysis flow
Sources and uses —Evaluate source & analysis
of funds analysis deployment of funds
 Prospective Analysis
Process to forecast future payoffs—
typically earnings, cash flows

Business Environment
The output of & Strategy Analysis
prospective
analysis is a Accounting Analysis
set of
expected
future payoffs Financial Analysis
used to
estimate
company
value Intrinsic Value
 Valuation


Valuation is a main objective of many
types of business calculate
analysis.intrinsic value

Valuation refers to the process of

converting forecasts of future payoffs into
an estimate of company value.
 Credit Analysis
Creditors lend funds to a
Creditors company in return for a
promise of repayment

Trade Creditors Non-trade Creditors

suppliers
• deliver goods or services
(debtholders)
to a company and expect • Provide major financing money
payment within a • Most long-term
reasonable period.
• Usually explicit interest
• Most trade credit is short
term, ranging from 30 to 60 • Bear risk of default
days
• Usually implicit interest
• Bear risk of default
 Credit Analysis
Credit worthiness: Ability to meet credit obligations
(downside risk)
trade creditors assess this nontrade creditors assess this

Liquidity Solvency
Ability to meet short- Ability to meet long-
term obligations term obligations
Focus: Focus:
• Current Financial • Long-term financial
conditions conditions
• Current cash flows • Long-term cash flows
• Liquidity of assets • Extended profitability
 Equity Analysis

 Equity investors  Intrinsic value is the

provide funds to a value of a company (or
company in return for the its stock) determined
risks and rewards of through fundamental
ownership analysis without
reference to its market
value (or stock price).
To determine intrinsic value, an analyst must forecast a
company’s earnings or cash flows and determine its risk.
This is achieved through a comprehensive, in-depth analysis
of a company’s business prospects and its financial
statements.
 Equity Analysis
Intrinsic Value
(or Fundamental Value)
Value of Company (or stock) without
reference to market value (or stock price)

look from the market

Intrinsic value > Market value Buy

Strategy

underprice

Intrinsic value < Market value Sell overprice

Intrinsic value = Market value Hold

btap nhóm: nên tránh diversified company, vì khó define industry của nó

Information Sources for

Business Analysis
Quantitative Qualitative
• Financial • Management
Discussion &
Statements Analysis
• Industry Statistics • Chairperson’s Letter
• Economic • Vision/Mission
Indicators Statement
• Regulatory filings • Financial Press
• Press Releases
• Trade reports
• Web sites
 Business Activities
Planning
Investing Activities Financial
Activities Activities

Operating Activities
Revenues and expenses from providing
goods and services

Operating activities represent the “carrying out” of the

business plan given its financing and investing activities.
Business Activities
Financing activities
• Owner (equity)
• Nonowner (liabilities)

Financing activities refer

to methods that companies
use to raise the money
There are two main
sources of external
financing—equity investors
Financing (also called owners
right side bal sheet
or shareholders) and
creditors (lenders).

to buy asset, by debt and eduity

 Business Activities
Investing activities
• Buying resources
• Selling resources
focus on asset
Investing activities
refer to a company’s
acquisition and
maintenance of Investing Financing
investments buy long term asset
for purposes of selling
products and providing
services, and for the
purpose of investing
excess cash.
Investing = Financing
Financial Statements Reflect Business Activities

Planning
Investing Financing
Current: Operating Current:
• Cash • Notes Payable
• Sales
Accounts Receivable • Accounts Payable
• Cost of Goods Sold
•

Inventories • Salaries Payable

• Selling Expense
•

Marketable Securities • Income Tax Payable

• Administrative Expense
•

Noncurrent: Noncurrent:
• Interest Expense

• Land, Buildings, & • Income Tax Expense

• Bonds Payable
Equipment • Common Stock
• Patents Net Income • Retained Earnings
• Investments
Liabilities & Equity
Income statement
Assets Cash Flow Balance Sheet

Balance Sheet Statement of Statement of

Cash Flows Shareholders’ Equity
 Financial Statements

• Balance Sheet
• Income Statement
• Statement of Shareholders’ Equity
• Statement of Cash Flows
 Kodak
Dec 31, 2001 (In millions, except per share data)

Liabilities and
Shareholders’ Equity
Assets
Current Assets CAN BE converted into money within 1 year Current Liabilities
Payables $ 3,276
Cash and cash equivalents $ 448
Short-term borrowings 1,378
Receivables 2,337
Accrued income taxes 544
Inventories 1,137
Current maturities of LTD 156
Deferred income tax charges 521
Total current liabilities 5,354
Other 240
Total current assets 4,683
Other Liabilities
Properties
Long-term borrowings 1,666
Land, buildings and equipment at cost 12,982
Post-employment liabilities 2,728
Less: Accumulated depreciation 7,323 720
Other long-term liabilities
Net properties 5,659
Total liabilities 10,468
Other Assets
Goodwill (net of accumulated
amortization of $920) 948 Shareholders' Equity
Other non-current assets tangible + intangible
2,072
Common stock, par value $2.50 per share,
Total Assets $ 13,362 950,000,000 shares authorized; issued
391,292,760 shares 978
Additional paid in capital 849
An accountant’s snapshot of Retained earnings 7,431
Accumulated other comprehensive loss (597)
the firm’s accounting value at 8,661
Treasury stock, as cost, 100,363,059 shares 5,767
a specific point in time Total shareholders' equity 2,894
Total liabilities and equity $ 13,362
 Balance Sheet

Total Investing = Total Financing

= Creditor Financing + Owner Financing

Kodak Financing

$13,362 = $10,468 + $2,894

 Income Statement
Kodak
For Year Ended Dec. 31, 2001 (In millions)

Sales $13,234
Cost of goods sold 8,670
Gross profit 4,564
Selling, general and administrative expenses 2,627
Research and development costs 779
Goodwill amortization 154
Restructuring costs and asset impairments 659
EARNINGS FROM OPERATIONS 345

Interest expense 219

Other income (charges) (18)
Earnings before income taxes 108
Provision for income taxes 32
NET EARNINGS 76
An income statement measures a company’s financial
performance for a specific period of time
 Statement of Cash Flows
Kodak
For year Ended Dec. 31, 2001 (In millions)
Cash flows from operating activities:
Net Earnings $ 76
Adjustments to reconcile to net cash provided by operating activities:
Depreciation and amortization 919
Restructuring costs 830
Provisions (benefit) for deferred income taxes (44)
(Increase) decrease in receivables 252
(Increase) decrease in inventories 461
(Decrease) increase in liabilities excluding borrowings (529)
Other items, net 100
Net cash provided by operating activities 2,065

Cash flow from Investing activities:

Additions to properties (743)
Acquisitions, net of cash acquired (306)
Marketable securities - sales 54
Marketable securities - purchases (52)
Net cash used in investing activities (1,047)

Cash flows from financing activities:

Net increase (decrease) in borrowings with original maturities of 90 days or less (695)
Proceeds from other borrowings 1,907
Repayment of other borrowings (1,355)
Dividends to shareholders (643)
Exercise of employee stock options 22
Stock repurchase programs (44)
Net cash provided by (used in) financing activities (808)
Effect of exchange rate changes on cash (8)
Net (decrease) increase in cash and cash equivalents 202
 Statement of Shareholders’ Equity
Kodak
For year ended Dec. 31, 2001
Accumulated
Additional Other
Common Pail In Retained Comprehensive Treasury
(In millions, except number of shares) Stock Capital Earnings Income (Loss) Stock Total
Shareholders’ Equity Dec 31, 2000 978 871 7,869 (482) (5,808) 3,428
Net earnings - - 76 - - 76
Other comprehensive income (loss):
Unrealized holding gains arising during
period ($34 million pre-tax) - - - (21) - (21)
Reclassification adjustment for gains included
in net earnings ($13 million pre-tax) - - - 8 - 8
Currency translation adjustment - - - (98) - (98)
Minimum pension liability adjustment
($7 million pre-tax) - - - (37) - (37)
Hedging gains (losses) - - - 33 33
Comprehensive loss - - - (115) - (115)
Cash dividends declared - - (514) - - (514)
Treasury stock repurchased (3,541,295 shares) - - - - (41) (41)
Treasury stock issued under employee plans
(1,393,105 shares) - (25) - - 82 57
Tax reductions – employee plans - 3 - - - 3
Shareholders’ Equity Dec 31, 2001 $978 $849 $7,431 $ (597) ($5,767) $2,894
 Statement of Cash Flows
Financial for Year Ended Dec. 31, 2001
Operating Cash flows $ 2,065
Statement Investing Cash flows
Financing Cash flows
(1,047)
(808)
Exchange rate changes on cash (8)
Links - Net Change in Cash $ 202
Cash Balance, Dec. 31, 1997 246
Kodak Cash Balance, Dec. 31, 1998 $ 448

Income Statement
Balance Sheet Balance Sheet
for Year Ended Dec. 31, 2001 Dec. 31, 2001
Dec. 31, 2000
Sales $13,234
Expenses (13,158) Assets
Assets
Net Earnings $ 76 Cash $ 448
Cash $ 246
Other Comprehensive Income (115) Non-Cash Assets 12,914
Non-Cash Assets 13,966
Comprehensive Income $ (39) Total Assets $13,362
Total Assets $14,212

Liabilities & Equity Statement of Shareholders’ Equity Liabilities & Equity

Total liabilities $ 10,784 for Year Ended Dec. 31, 2001 Total liabilities $10,468

Equity: Share Capital, Dec. 31, 1997 $ 1,849 Equity:

Share Capital 1,849 Adjustments/Stock Issue (22) Share Capital 1,827
Retained Earnings 7,387 Share Capital, Dec. 31, 1998 $ 1,827 Retained Earnings 6,834
Treasury Stock (5,808) Treasury Stock (5,767)
Total equity $ 3,428 Retained Earnings, Dec. 31, 1997 $ 7,387 Total equity $ 2,894
Add: Comprehensive Income (39)
Liabilities & Equity $14,212 Less: Dividends (514) Liabilities & Equity $13,362
Retained Earnings, Dec. 31, 1998 $ 6,834
(Point in time)

(Point in time)
Treasury Stock, Dec. 31, 1997 $ 5,808
Treasury Stock Issued 82
Treasury Stock Repurchased (41)
Treasury Stock, Dec. 31, 1998 $ 5,767

Dec. 31, 2000 (Period of time) Dec. 31, 2001

 Additional Information
(Beyond Financial Statements)

•Management Discussion & Analysis (MD&A)

•Management Report
•Auditor Report
•Notes to Financial Statements
•Supplementary Information
•Proxy Statement
•Social Responsibility Report
 1-42

Management’s Discussion & Analysis (MD&A)

• A portion of an organization's annual report that is written

for shareholders in which management explains how
the company performed the past year and projections for the coming
year. The report also highlights other aspects of the organization.
 1-43

Management Report
• The purposes of this report are to reinforce:
1. senior management's responsibilities for the company’s
financial and internal control system and
2. the shared roles of management, directors, and the auditor in
preparing financial statements.
 1-44

Auditor report
• An external auditor is an independent
certified public accountant hired by
management to provide an opinion on
whether or not the company’s financial
statements are prepared in conformity
with generally accepted accounting
principles.

• Financial statement analysis requires a

review of the auditor’s report to
ascertain whether the company
received an unqualified opinion.
Anything less than an unqualified
opinion increases the risk of analysis.
 1-45

Explanatory Notes to Financial Statements

• Explanatory notes that accompany financial reports play an important

part in financial statement analysis.

• Explanatory notes include information on:

1. accounting principles and methods employed,
2. detailed disclosures regarding individual financial statement items,
3. commitments
4. business combinations,
5. transactions with related parties,
6. stock option plans,
7. legal proceedings,
8. significant customers.
 Book Organization
Financial Statement Analysis

Part I Part II Part III

Introduction and Overview Accounting Analysis Financial Analysis

Chapter 3: Analyzing Chapter 7: Cash Flow

Chapter 1: Overview of Analysis
Financial Activities
Financial Statement Chapter 8: Return on
Chapter 4: Analyzing
Analysis Invested Capital
Investing Activities
Chapter 5: Analyzing Chapter 9: Profitability
Chapter 2: Financial Analysis
Investing Activities:
Reporting and Chapter 10: Prospective
Special topic
Analysis Analysis
Chapter 6: Analyzing
Chapter 11: Credit
Operating Activities
Analysis
Chapter 12: Equity
Analysis and Valuation
 Analysis Tools

1. Comparative financial statement analysis

2. Common-size financial statement analysis
3. Ratio analysis

5-39
 Analysis Tools
Yr1 Yr2 Yr3
Comparative Analysis (horizontal analysis)

Purpose: Evaluation of consecutive financial

statements from period to period
Output: Direction, speed, & any trend(s)
Types:  Year-to-year Change Analysis
 Index-Number Trend Analysis
Individuals conduct comparative financial statement analysis by reviewing
consecutive balance sheets, income statements, or statements of cash flows
from period to period.
The most important information often revealed from comparative financial
statement analysis is trend. A comparison of statements over several periods
can reveal the direction, speed, and trend
Comparative Analysis
Year-to-Year Change Analysis

 Comparing financial statements over relatively

short time periods—two to three years—is usually
performed with analysis of year-to-year changes in
individual accounts.
 It has the advantage of presenting changes in
absolute dollar amounts as well as in percentages.

5-41
 Analysis Tools
Year-to-Year Change Analysis

Kodak's Comparative Income Statements

Change Change
2001 2000
(in mil.) %
Sales $ 13,234 $13,994 $ (760) (5.4)%
Cost of goods sold 8,670 8,375 295 3.5
Gross profit $ 4,564 $ 5,619 $ (1,055) (18.8)
Operating Expenses:
Selling, general and admin. 2,781 2,665 116 4.4
Research and development 779 784 (5) (0.6)
Restructuring costs 659 (44) 703 -
Earnings from operations $ 345 $2,214 $(1,869) (84.4)
Interest Expense and other 237 82 155 189.0
Other income (charges) - - - -
Earnings before income taxes $ 108 $ 2,132 $ (2,024) (94.9)
Provision for income taxes 32 725 (693) (95.6)
Net earnings $ 76 $ 1,407 $ (1,331) (94.6)
 Analysis Tools
Year-to-Year Change Analysis

Computation of year-to-year changes is straightforward. Still, a few rules should be

noted.
When a negative amount appears in the base and a positive amount in the
next period (or vice versa), we cannot compute a meaningful percentage change.
When there is no amount for the base period, no percentage change is
computable
5-43
Comparative Analysis
Index-Number Trend Analysis
A useful tool for long-term trend comparisons is index-number trend analysis.
Analyzing data using index-number trend analysis requires choosing a
base period, for all items, with a preselected index number usually set to 100.
For index-number trend analysis, we need not analyze every item in
financial statements. Instead, we want to focus on significant items.

5-44
 Analysis Tools
Index-Number Trend Analysis

Comparative analysis also compares trends in related items.

 Analysis Tools
Common-Size Analysis (vertical analysis)
Purpose :  Evaluation of internal makeup
of financial statements
 Evaluation of financial statement accounts
across companies with different size
Output: Proportionate size of assets, liabilities, equity,
revenues, & expenses

Financial statement analysis can benefit from knowing what proportion of a group or
subgroup is made up of a particular account.
 Analysis tools
Common-Size Analysis (vertical analysis)
 How to prepare a common-size financial statement.
 For a common-size income statement, divide each
entry in the income statement by sales. 100%)
 For a common-size balance sheet, divide each entry in
the balance sheet by total assets.

 It helps to compare a firm’s financial statements

with those of other firms, even if the other firms
are not of equal size.
5-47
6
Table 7.1 H. J. Boswell Ltd
Cost of goods sold
are 75% of the
firm’s sales
resulting in a gross
profit of 25%

Operating expenses
are only 10.8% of
sales.
Income taxes are
4.1% of the firm’s
sales.
paying

After all expenses,

the firm generates
net income of 7.6%
of firm’s sales.
Table 7.2 H. J. Boswell Ltd

Total current assets increased

are 32.6% of all assets in 2015,
increasing from 27% in 2014.
However, total current liabilities
are 14.6% of total assets in 2015,
which is a decline from the
16.6% in 2014.

Total non-current liabilities

(long term debt) are 39.2% of
total assets in 2015, which is a
slight decrease from the 40.8%
in 2014.
10
 1-54

Exercise
 1-55

Exercise
2006 2005
Sales 100.0% 100.0%
Cost of goods sold 66.0 52.4
Gross profit 34.0% 47.6%
Operating expenses 21.0 19.4
Net income 13.0% 28.2%

bad control of cogs

Analysis and Interpretation: This situation appears to be unfavorable.
Both cost of goods sold and operating expenses are taking a larger
percent of each sales dollar in year 2006 compared to the prior year.
Also, even though sales volume increased, net income both
decreased in absolute terms and declined to only 13.0% of sales as
compared to 28.2% in the year before.
 1-56

Exercise
• Express the Mixon Company’s balance sheets in common-size
percents. (Round to the nearest one-tenth of a percent.)
 1-57

Exercise
Mixon Company
Common-Size Comparative Balance Sheet
December 31, 2004-2006

2006 2005* 2004*

Cash 5.9% 8.0% 9.9%
Accounts receivable, net 17.1 14.0 13.2
Merchandise inventory 21.5 18.5 14.2
Prepaid expenses 1.9 2.1 1.1

Plant assets, net 53.6 57.3 61.6

Total assets 100.0% 100.0% 100.0%

Accounts payable 24.9% 16.9% 13.2%

Long-term notes payable secured by
mortgages on plant assets 18.8 23.0 22.1
Common stock, $10 par value 31.4 36.5 43.6
Retained earnings 24.9 23.5 21.0
Total liabilities and equity 100.0% 100.0% 100.0%
*
Column does not equal 100.0 due to rounding.
 Analysis Tools
Ratio Analysis
Purpose : Evaluate relation between two or more
economically important items (one
starting point for further analysis)
Output: Mathematical expression of relation
between two or more items
Cautions:  Prior Accounting analysis is important
 Interpretation is key -- long vs short
term & benchmarking
Using financial ratios
Ratios can help us answer the following questions about the firm’s financial health:

12
Liquidity ratios
 Liquidity ratios address a basic question: How liquid is
the firm?

 A firm is financially liquid if it is able to pay its bills on

time. We can analyse a firm’s liquidity from two
perspectives:
1. Overall liquidity − analysed by comparing the firm’s
current assets to the firm’s current liabilities.
2. Liquidity of specific assets − analysed by examining the
timeliness in which the firm’s liquid assets (accounts
receivable and inventories) are converted into cash.

15
 Liquidity ratios: Current ratio
 The overall liquidity of a firm is analysed by computing the
current ratio and quick (acid-test) ratio.

 Current ratio: Current ratio compares a firm’s current (liquid)

assets to its current (short-term) liabilities.

 Current ratio = 0.95 times

 Peer –group current ratio =1.8 times các công ty cùng ngành có CR =1,8
co.s of the same industry 0.95<1.8:=> lower lididity comparing to other co.s
 The firm had $0.95 in current assets for every $1 it owed in current
liability.
16
 Liquidity ratios: Quick ratio
 Acid-test (Quick) ratio excludes the inventory from current assets
as inventory may not be very liquid.
TRỪ ĐI INVEN VÌ INVEN LESS LIQUID THAN OTHER CA

 What is the quick ratio for H.J. Boswell Ltd for 2015?
-> giảm quá nhiều => maybe kết luận cty đang giữ
 Quick ratio = 0.58 times quá nhiều inven
 Peer-group quick ratio = 0.94 times
 The firm has only $0.58 in current assets (less inventory) to cover $1 in
current liabilities.

17
Liquidity ratios: Individual asset ratios
 We can also measure the liquidity of the firm by
examining the liquidity of accounts receivable and
inventories to see how long it takes the firm to convert
its accounts receivables and inventories into cash.

 Useful ratios for this type of analysis include:

Average collection period measures the number of days it takes the firm
to collect its receivables.

Collection period = Average Accounts receivable

Sales/360
daily sales
Days’ sales in inventory the number of days the inventory sits unsold on
the firm’s shelves.

Days’ sales in inventory = Average inventory

Cost of Goods sold/360
18
 Can a firm have too much liquidity?
 Because the liquidity of a firm is defined in terms of its
ability to pay its bills on time, is it possible for a firm to
have too much liquidity?

The answer is YES

 A high investment in liquid assets will enable the firm

to repay its current liabilities in a timely manner.
However, excessive investments in liquid assets can
prove to be costly as liquid assets (such as cash)
generate minimal return.
nếu giữ quá nhiều cashs=> ko có interest (maybe từ bank)
quá nhiều receivables= customers keep your money and maynot pay back , money in cus account
21

high invent: high carrying cost, no money to invest in other investmnets , no return
Capital structure (solvency) ratios
Capital structure refers to the way a firm finances its
assets, using a combination of debt and equity.

Capital structure ratios address the important question:

How did the firm finance the purchase of its assets?

22
 Capital structure ratios (cont.)
Debt ratio measures the proportion of the firm’s assets that are financed by
borrowing or debt financing.
total debt

 What is the debt ratio for H. J. Boswell Ltd for 2015?

high lever=> high risk of financial distressbut high profitability
 Debt ratio = $1059.75 million ÷ $1971 million = 53.8%
 Peer group debt ratio= 35%
 The firm financed 53.8% of its assets with debt, compared with the
peer group average of 35% => it used more debt than the average of
other firms in the same industry.

23
 Capital structure ratios (cont.)
An alternative to the debt ratio is the debt to equity ratio, which compares
total liabilities to total equity.

Debt to equity ratio = Total liabilities

Total equity

 What is the debt to equity ratio for H. J. Boswell Ltd for 2015?

 Debt to equity ratio = $1059.75 million ÷ $911.25 million = 1.16

 The firm has 1.16 times as much debt as equity (which can also be
expressed as $1.16 of debt for every $1 of liabilities).

24
 Capital structure ratios (cont.)
 Interest coverage ratio (times interest earned) measures the ability of
the firm to service its debt or repay the interest on debt.
ebit trả cho int

 What will be the interest coverage ratio for H. J. Boswell for 2015?

 Interest coverage ratio = $382.5m ÷ $67.5m = 5.67 times

 Peer group interest coverage ratio= 7.0
 The firm can pay its total interest expense 5.67 times in 2015, so it could still pay
its interest expenses, but it has a lower interest coverage ratio than the peer
group.
25
 Asset management efficiency ratios
 Asset management efficiency ratios measure a firm’s effectiveness in
utilising its assets to generate sales.
 They are commonly referred to as turnover ratios as they reflect the
number of times a particular asset account balance turns over during a year.
 Total asset turnover ratio: represents the amount of sales generated per
dollar invested in firm’s assets.
Total asset Sales từ incomstat ( period)
=
turnover Average total assets từ balsheet (point)
 Total asset turnover = 1.37 times
 Peer group total asset turnover = 1.15 times
 The firm generated $1.37 in sales per dollar of assets in 2015
 It used assets more efficiently than its competitors.

26
Asset management efficiency ratios (cont.)
 Fixed asset turnover ratio: measures a firm’s efficiency in
utilising its non-current assets (such as property, plant and equipment).

Fixed asset Sales

turnover = Average Net property, plant
and equipment

 Fixed asset turnover = 2.03 times

 The firm generated $2.03 in sales per dollar invested in plant and
equipment.

27
Liquidity ratios: Accounts receivable turnover
ratio
Accounts receivable turnover ratio measures how many times receivables are
“rolled over” during a year.

Accounts receivable Sales

turnover = Average Accounts receivable

Example:
 Accounts receivable turnover = 16.67 times
 Peer-group receivable turnover = 14.6 times

 The firm’s accounts receivable were turning over 16.67 times per year,
compared to 14.6 times of the peer group
=> The firm’s accounts receivable is more liquid than peer group’ receivable.

19
Liquidity ratios: Inventory turnover ratio
Inventory turnover ratio measures how many times the company turns over its
inventory during the year. Shorter inventory cycles lead to greater liquidity since the
items in inventory are converted to cash more quickly.

Inventory Cost of goods sold

turnover = Average Inventory

 What will be the inventory turnover ratio for 2015 for H.J. Boswell Ltd?

 Inventory turnover ratio = $2025 ÷ $378 = 5.36 times

 Peer-group inventory turnover = 7.0 times

 The firm turned over its inventory 5.36 times per year, compared with 7.0 times
=> its inventory is more slowly than the average peer group firms or is less liquid.

20
Asset management efficiency ratios (cont.)
The following table summarises the efficiency of H.J.
Boswell Ltd’s management in utilising its assets to
generate sales.
Notice the assessment has been made by comparing H.J.
Boswell’s ratios have been to a benchmark (remember a
ratio by itself has no meaning – it is the comparison that
provides the meaning)
 Profitability ratios
Profitability ratios address a very fundamental question: Has
the firm earned adequate returns on its investments?

To answer this question, the analyst turns to two measures:

1. The firm’s profit margins to predict the ability to control
expenses
2. The firm’s rate of return on investments.

 Two fundamental determinants of a firm’s profitability and

return on investment:
 Cost control – How well has the firm controlled its costs relative
to each dollar of firm sales?
 Efficiency of asset utilisation – How effective is the firm in
using the assets to generate sales? 29
Cost control: Is the firm earning reasonable
profit margins?
 Ratios to help with analysing cost control include:
 Gross profit margin - measuring how well the firm’s
management controls its expenses to generate profits.
 Operating profit margin – measuring how much
profit is generated from each dollar of sales after
accounting for both costs of goods sold and operating
expenses.
 Net profit margin measures how much income is
generated from each dollar of sales after adjusting for all
expenses (including income taxes).

30
 Return on invested capital
 The return earned on a firm’s investments also depends on how much
money the firm has invested in assets in order to generate those revenues
and profits.
 Return on assets ratio (ROA) is the summary measure of operating
profitability. It takes into account the management’s success in controlling
expenses and its efficient use of assets.

Return on assets Net profit

=
(ROA) Average total assets
Return on assets (ROA) = 19.41% depend on purpose thì dùng 1 hay 2
 The firm generated $0.1941 of operating profits for every $1 of its invested
assets. EBIT

Return on assets Net profit + Interest (1-t)

=
(ROA) Average total assets 31
Is the firm providing a reasonable return on
the owner’s investment?
 Return on equity (ROE) ratio measures the accounting return on the
shareholders’ investment.

Return on equity Net profit

(ROE) = Average total equity

Return on common equity (ROE) ratio measures the accounting return on the
ordinary shareholders’ investment.

Return on common equity Net profit

(ROCE) = Average total ordinary equity

 Note: Ordinary equity is equal to total equity minus preference shares.

This is because we are trying to calculate the return on the investment by
ordinary shareholders, and the ordinary shareholders ‘own’ everything in the
equity section of the balance sheet except preference shares.
35
 The DuPont Identity identify the reason

 ROE = NI / TE decompose

 Multiply by 1 and then rearrange:

 ROE = (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA * EM
 Multiply by 1 again and then rearrange:
 ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
 ROE = PM * TAT * EM

Copyright © 2016 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Using the DuPont Identity
 ROE = Profit Margin * Total Asset Turnover * Equity Multiplier

 Profit margin is a measure of the firm’s operating efficiency –

how well it controls costs.
 Total asset turnover is a measure of the firm’s asset use
efficiency – how well it manages its assets.
 Equity multiplier is a measure of the firm’s financial leverage.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Using the DuPont method for decomposing
the ROE ratio

But both total asset turnover

Net profit margin is
and equity multiplier are
lower
higher

reason of higher return 38

 Market value ratios
Market value ratios address the question: How are the firm’s shares valued
in the stock market?

Price-earnings (P/E) Ratio: indicates how much investors are

currently willing to pay for $1 of reported earnings.
how much investors are willing to pay your stocks

 What will be the PE ratio for 2015 for H.J. Boswell Ltd if we assume the
firm’s share was selling for $32 per share at a time when the firm reported
its net income?
 P/E ratio = $32 ÷ $2.275 = 14.07
 The investors were willing to pay $14.07 for every dollar of earnings per
share that the firm generated. Why might that be? The P/E ratio will be higher for
companies expected to have better earnings growth
prospects and less risk.
39
Market value ratios

A market-to-book ratio
greater than 1 indicates
that the market value of
the firm’s shares is greater
than the book value or the
accumulated investment in
the firm’s equity and vice
versa.

40
Selecting a performance benchmark
There are two types of benchmarks that are commonly
used:
 Trend analysis – compares a firm’s financial statements
over time (time-series comparisons)
 Peer group comparisons – compares the subject firm’s
financial statements with that of “peer” firms.

41
Trend analysis
 Comparing a firm’s recent financial ratios with its past
financial ratios provides insight into whether the firm
is improving or deteriorating over time.

 This type of financial analysis is referred to as trend

analysis.

42
Peer firm comparison
 Peer groups often consist of firms from the same
industry. Industry average financial ratios can be
obtained from a number of financial databases and
internet sources (such as Yahoo finance and Google
finance).

43
 The limitations of ratio analysis

 There is no underlying theory, so there is no way to know which ratios are

most relevant.
 Benchmarking is difficult for diversified firms.
 An industry average is not necessarily a desirable target or norm.
 Globalization and international competition makes comparison more
difficult because of differences in accounting regulations.
 Firms use varying accounting procedures.
 Firms have different fiscal years.
 Financial ratios offer only clues.
 The results of financial analysis are no better than the quality of the
financial statements.
5-85
5-86
5-87
5-88
5-89
 Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis

Purpose: Estimate intrinsic value of a

company (or stock)
Basis: Present value theory (time value of
money)
Analysis Preview

Debt (Bond) Valuation

Bt is the value of the bond at time t

It +n is the interest payment in period t+n
F is the principal payment (usually the debt’s face value)
r is the investor’s required interest rate (yield to
maturity)
Analysis Preview

Equity Valuation

Vt is the value of an equity security at time t

Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends
 Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model

FCFt+n is the free cash flow in the period t + n [often

defined as cash flow from operations less capital
expenditures]
k is the cost of capital
E refers to an expectation
 Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period t

t

Rit+n is the residual income in period t + n [defined as

net income, NI, minus a charge on beginning
book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital
E refers to an expectation