Essentials of Financial Statement Analysis
Revsine/Collins/Johnson/Mittelstaedt: Chapter 5
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.
Learning objectives
1. How competitive forces and business strategies affect firms financial statements. 2. Why analysts worry about accounting quality. 3. How return on assets (ROA) is used to evaluate profitability. 4. How ROA and financial leverage combine to determine a firms return on equity (ROE). 5. How short-term liquidity risk and long-term solvency risk are assessed. 6. How to use the Statement of Cash Flows to assess credit and risk.
RCJM: Chapter 5 2009 2
Financial statement analysis:
Tools and approaches
Tools:
Approaches used with each tool:
1. Time-series analysis: the same firm over time (e.g., Wal-Mart in 2005 and 2006) 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2005). 3. Benchmark comparison: using industry norms or predetermined standards.
Common size statements
Trend statements
Financial ratios (e.g., ROA and ROE)
RCJM: Chapter 5
2009
Evaluating accounting quality
Analysts use financial statement information to get behind the numbers. However, financial statements do not always provide a complete and faithful picture of a companys activities and condition.
RCJM: Chapter 5
2009
How the financial accounting filter sometimes works
GAAP puts capital leases on the balance sheet, but operating leases are offbalance-sheet.
Managers have some discretion over estimates such as bad debt expense.
Managers have some discretion over the timing of business transactions such as when to buy advertising.
Managers can choose any of several different inventory accounting methods.
RCJM: Chapter 5
2009
Financial ratios and profitability analysis
Operating profit margin EBI Sales X Asset turnover Sales Average assets Analysts do not always use the reported earnings, sales and asset figures. Instead, they often consider three types of adjustments to the reported numbers: 1. Remove non-operating and nonrecurring items to isolate sustainable operating profits. 2. Eliminate after-tax interest expense to avoid financial structure distortions. 3. Eliminate any accounting quality distortions (e.g., off-balance operating leases).
6
Return on assets ROA= EBI Average assets
RCJM: Chapter 5
2009
How can ROA be increased?
There are just two ways: 1. Increase the operating profit margin, or 2. Increase the intensity of asset utilization (turnover rate).
ROA= EBI Average assets EBI Sales
Asset turnover
Sales Average assets
Operating profit margin
RCJM: Chapter 5
2009
ROA and competitive advantage:
Competition works to drive down ROA toward the competitive floor. Companies that consistently earn an ROA above the floor are said to have a competitive advantage. However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. Firm A and B earn the same ROA, but Firm A follows a differentiation strategy while Firm B is a low cost leader. Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA).
RCJM: Chapter 5 2009
Four hypothetical restaurant firms
Competitive ROA floor
Credit risk and capital structure:
Overview
Credit risk refers to the risk of default by the borrower. The lender risks losing interest payments and loan principal. A companys ability to repay debt is determined by its capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs. A companys willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment.
RCJM: Chapter 5
2009
Credit risk and capital structure:
Balancing cash sources and needs
RCJM: Chapter 5
2009
10
Credit risk:
Short-term liquidity ratios
Current ratio = Current assets Current liabilities Cash + Marketable securities + Receivables Current liabilities Net credit sales Average accounts receivable
Liquidity ratios
Quick ratio =
Short-term liquidity
Accounts receivable turnover =
Activity ratios
Inventory turnover =
Cost of goods sold Average inventory Inventory purchases Average accounts payable
Accounts payable turnover =
RCJM: Chapter 5
2009
11
Credit risk:
Long-term solvency
Long-term debt to assets = Long-term debt Total assets Long-term debt Total tangible assets
Debt ratios
Long-term debt to tangible assets =
Long-term solvency
Interest coverage = Operating incomes before taxes and interest Interest expense
Coverage ratios
Operating cash flow to total liabilities = Cash flow from continuing operations Average current liabilities + long-term debt
RCJM: Chapter 5
2009
12
Components of ROCE
Return on assets (ROA)
EBI Average assets X
Return on common equity (ROCE)
Net income available to common shareholders Average common shareholders equity
Common earnings leverage
Net income available to common shareholders EBI
Financial structure leverage
Average assets Average common shareholders equity
RCJM: Chapter 5 2009 13
Financial statement analysis and accounting quality
Financial ratios, common-size statements, and trend statements are extremely powerful tools. But they can be no better than the data from which they are constructed. Be on the lookout for accounting distortions when using these tools. Examples include:
Nonrecurring gains and losses Differences in accounting methods Differences in accounting estimates GAAP implementation differences Historical cost convention RCJM: Chapter 5 2009 14
Why do firms report EBITDA and pro forma earnings?
Impression management is the answer. Help investors and analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked. Mislead investors and analysts by changing the way in which profits are measured.
Analysts should remember: 1. There are no standard definitions for non-GAAP earnings numbers. 2. Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability. 3. EBITDA and pro forma earnings do not accurately measure firm cash flows.
Transform a GAAP loss into a profit. Show a profit improvement. Meet or beat analysts earnings forecasts.
2009
RCJM: Chapter 5
15
Summary
Financial ratios, common-size statements and trend statements are powerful tools. However:
There is no single correct way to compute financial ratios. Financial ratios dont provide the answers, but they can help you ask the right questions. Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons.
RCJM: Chapter 5
2009
16
