LECTURE 3

Financial statement analysis

Fundamental concepts
Economic data: forward-looking, needed for valuation
Accounting data: backward-looking, an account of historical performance  for
valuation it can be useful to compare companies, asses how they run and compare
ratios

Financial statements for equity valuation

1. Income statement
 Summary of profitability through record of revenues and expenses

Expenses classes
- Cost of sales
- General expenses
- Interest expenses (interest paid on loans)
- Taxes (money paid to government when profit is made)

Operating income
- the difference between operating revenues and costs, with the
latter being all costs incurred in the course of generating
revenues including depreciation

EBIT (operating income/profit)

- operating income plus non-recurring revenues less non-
recurring expenses
- Earnings before income and tax

Taxable Income
- EBIT less net interest expenses

Net Income
- the “bottom line” is calculated by subtracting taxes from taxable
income

Common-Size - all items are expressed as a percentage of total revenue in order to

enable comparisons across firms of different sizes.
 2. Balance Statement

 Point in time view of the financial position of a firm by listing assets

and liabilities

Current Assets - real and financial assets that may be converted to cash
within one year.

Fixed Assets - these are tangible and intangible assets, with the latter
being difficult to value.

Current Liabilities - debts or accounts that must be paid within one year.

Long-Term Debt - all liabilities that are due in more than one year.

Shareholders’ Equity - comprised of:

(i) shares issued at par value
(ii) additional paid-in capital
(iii) retained earnings (cumulative reinvested profits).

Equity= Total Assets−Total Liabilities

Assets = Equity + total liabilities

Common-Size - all items are expressed as a percentage of total assets in order to

enable comparisons across firm of different sizes.
 3. Cash Slow Statements

 Record of cash receipts and payments = actual cash flow position

cash flows reported separately for:

(i) operations;
(ii) investments; and
(iii) financing.

Accrual versus Actual - the income statement and balance sheet are based on
accrual (matching revenue and expenses to the period they relate to) accounting
while the cash flow statement is based on “actual accounting”.

Adjustments to Net Income - adjustments to income that have not been realised in
cash, which
mainly due to:
(i) changes in working capital; and
(ii) depreciation or impairment expenses.

Utility - if a firm has to resort to financing to maintain productive capacity and pay
dividends consistently, this is a sign for concern regarding prospects for the firm's
operations.

 economic earnings: the sustainable cash flow that can be paid out to
shareholders
without impairing the productive capacity of the firm, which is vital for valuation.

 Accounting earnings: They may not accurately reflect economic earnings due to
asset valuation and expense recognition rules, but they still provide valuable
insights, as shown by share price reactions to earnings announcements.

Measuring Firms performance

Firm managers have two board responsibilities
1. Investment decisions = the use of capital (profitability)
2. Financial decisions = the source of capital (sufficient supply, liquidity and
manageable leverage for prospective growth)
Profitability measures

1. Return on assets
 EBIT or operating costs/ total assets
 profitability ratio that measures how efficiently a company uses its
assets to generate profit
 A higher ROA means the company is using its assets more efficiently
to generate profit

2. Return on capital
 EBIT/long term capital
 Operating income per unit of long-term capital deployed
 measure how efficiently a company generates profit from its capital.
 A higher ROC indicates better efficiency in using capital to generate profit

3. Return on equity
 measures the profitability of a company relative to the equity invested by its
shareholders. Essentially, it shows how effectively a company uses its equity
to generate profits.
 Det income/shareholders equity
 Net income per unit of currency invested by shareholders
  ROE indicates how much profit a company is generating with the money
invested by its shareholders. A higher ROE means that the company is
efficiently using equity to generate profits

 ROE is a key determinant of earnings growth

 Past profitability does not guarantee future profitability
 Security values are based on future profits
 Expectations of future dividends determine today’s stock value

Financial leverage
Leverage refers to the use of borrowed money (debt) to increase the potential return
on investment. There are two measures:
The relationship between ROE,ROA and Leverage

Where:
p = interest rate on debt
t = tax rate

1. If ROA>p, the firm earns more than it pays out to creditors and ROE
increases.
 leverage boosts ROE
 2. If ROA<p, the firm earns less than it pays out, ROE will decline as a function
of the debt-to-equity ratio
 leverage reduces ROE

Example

 Nodett: A firm that is 100% equity-financed (no debt).

 Somdett: A firm that is partly debt-financed (40% debt, 60% equity).

Both firms have the same business operations and risks—meaning their revenue,
operating costs, and EBIT (Earnings Before Interest and Taxes) are identical.
However, because Somdett has debt, it must pay interest on that debt, affecting its
net profits and ultimately its ROE.

Observations

1. ROA (Return on Assets) is the same for both firms.

o ROA = EBIT / Total Assets
o Since both firms have the same EBIT and assets, their ROA is
identical.
2. ROE (Return on Equity) differs because of leverage.
o ROE = Net Profit / Equity
o Since Somdett has less equity (because part of its assets are financed
by debt), any profit or loss is magnified for its shareholders.
3. Leverage amplifies ROE—positively or negatively.
o When the firm’s ROA is greater than the interest rate on debt,
Somdett’s ROE is higher than Nodett’s.
o When the firm’s ROA is lower than the interest rate on debt,
Somdett’s ROE is lower than Nodett’s.
Economic value added
 A firm should be viewed as successful only if the return on its projects is
better than the rate investors could expect to earn for themselves (on a risk-
adjusted basis) in the capital market
 To account for this opportunity cost, we might measure the success of the firm
using the difference between the return on capital, ROC, and the opportunity
cost of capital, k
 Economic value added is the spread between ROC and k multiplied by the
capital invested in the firm
- Firms return in excess of its opportunity costs

 If ROA > k, value is added to the firm

Decomposition of ROE

DuPont composition: enables you to focus on factors which influence performance of

ROE

1. TB = Tax Burden
2. IB = Interest burden

- The higher the degree of financial leverage, the lower the

interest burden ratio
3. ROS = return on sales or profit margin
4. ATO = asset turn over
5. Leverage ratio: 1 + D/E
 financial leverage helps boost ROE only if ROA is greater than the interest
rate on the firm’s debt
Other Asset Utilisation Turnover ratios
1. Fixed asset turnover

Formula:

 Purpose:
Measures the efficiency with which a company uses its fixed assets (such as
property, plant, and equipment) to generate sales.
 Interpretation:
A higher ratio indicates more efficient utilization of fixed assets to generate
revenue.

2. Inventory Ratio (ITO)

Formula:

 Purpose:
Measures how quickly a company turns over its inventory.
 Interpretation:
A higher ratio indicates faster inventory turnover, which typically signals good
inventory management and product demand.
 Note:
Both Cost of Sales and Inventory should be valued at cost.

3. Days sales in receivables/ collection period

Formula:

 Purpose:
Measures the average number of days it takes for a company to collect
payment from its customers.
 Interpretation:
A lower DSR indicates quicker collections, improving liquidity. A higher DSR
 means the company is taking longer to collect payments, potentially affecting
cash flow.

4. Income vs Balance sheet quantities

 Purpose:
When a ratio includes data from both the income statement and the balance
sheet, it’s common to average the balance sheet quantity over the period
covered by the income statement.
o Example: For a ratio involving accounts receivable, the average
accounts receivable over the period should be used to calculate the
ratio more accurately.

Liquidity Ratios

These ratios assist one to understand whether a firm has access to cash to pay
scheduled and unforeseen obligations.

1. Current ratio - reflects the ability of the firm to pay off its current liabilities by
liquidating

2. Quick/Acid Test Ratio - similar to the Current Ratio except for the exclusion of
inventories:

3. Cash Ratio - similar to the Quick Ratio except for the exclusion of accounts
receivable

4. Interest Coverage Ratio - also referred to as times interest earned, and

closely related to the Interest-Burden Ratio
Market price ratios
compare a company's stock price to its earnings, book value, sales, or cash flows.
These ratios are important because they help investors, analysts, and financial
managers assess a company's valuation, growth potential, and investment
attractiveness

Market-to-Book Value Ratio - the market price of a firm’s share divided by its book
value per share:

Price-Earnings Ratio - also referred to as the “P/E Multiple”, it is the ratio of a firm’s
share market price to its earnings per share:

Earnings per share

Comparability problems

Comparing financial statements of different companies can be challenging due to

varying methodologies for dealing with the following issues:

○ Inventory Valuation (for e.g., LIFO versus FIFO).

○ Depreciation and Impairments.
○ Inflation and Interest Expenses.
○ Fair Value or Mark-to-Market Accounting.
○ Accounting Practices affecting Earnings Quality.
○ International Accounting Conventions.