Financial Statement Analysis

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Financial Statement Analysis

• Objective to evaluate a companys prospects and
  risks for the purpose of making better business
  decisions

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Decisions and decision makers

• Creditors
• Should we extend trade credit to this customer?
  What credit limit?
• Should we lend to this company? At what interest
  rate? What terms?

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Decisions and decision makers

• Equity investors
• Is the companys stock priced appropriately?
• What are the companys prospects for future
  profitability?
• What are the risks?

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Decisions and decision makers

• Managers
• How do we compare with others in our industry?
• Should we acquire or divest?
• Should we repurchase our own stock?
• Should we change the dividend payout?

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Decisions and decision makers

• Auditors
• Is our client a going concern?
• What is the likelihood that the financial
  statements are materially misstated?

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Decisions and decision makers

• Directors
• How is management performing?
• What is the likelihood that the financial
  statements are materially misstated?
• Are managers fairly compensated?

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Decisions and decision makers

• Regulatory bodies
• What is the likelihood that the financial
  statements are materially misstated?
• Are the companys rates appropriate?
• Did the company pay an appropriate amount of
  taxes?

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Decisions and decision makers

• Unions
• Can the company afford to pay us more or increase
  our benefits?
• Are managers fairly compensated?
• What is the likelihood of bankruptcy?

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Issues in ratio analysis

• Comparability issues
• Accounting distortions
• Estimation errors
• Earnings management
• Distortions caused by accounting standards
• Uncertainty about accounting distortions creates
  accounting risk

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Comparative analysis

• Comparative analysis involves comparing
  consecutive financial statements from period to
  period for evidence of favorable or unfavorable
  trends
• This may be done by
• Year-to-year change analysis
• Index number trend analysis

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Comparative analysis
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Comparative analysis

• It is often easier to make a comparative analysis
  using index numbers, i.e., all amounts expressed
  relative to a base period (here, 2002).

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Comparative analysis
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Common sized statements

• Facilitate comparisons of firms of different
  sizes
• Help understand the fundamental economic
  characteristics of different industries and
  different firms in the same industry

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Common sized statements

• We will compare the statements of BNSF with those
  of some competitors, both in the railroad
  industry and in the capital market
• UNP Union Pacific
• NSC Norfolk Southern Corp.
• CSX CSX Corp.
• MSFT Microsoft Corp.

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Common-sized balance sheet
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Common-sized balance sheet
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Common-sized income statement
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Ratio analysis

• Ratio analysis
• Ratios allow the analyst to assess firm
  performance on various dimensions
• Ratio definitions are not standardized
• Not all analysts are interested in the same ratios

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Ratio analysis

• Activity analysis
• Short-term (operating) activity
• Long-term (investing) activity
• Liquidity analysis
• Solvency analysis
• Profitability analysis

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Activity analysis

• To evaluate how efficiently a company is
  utilizing its assets, we typically examine the
  relationship between the companys revenues and
  its investment in assets.

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Activity analysis

• Receivables turnover ratio measures the
  efficiency of receivables management
• Revenues / average accounts receivable

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Activity analysis
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Activity analysis

• Sales to materials and supplies captures the
  relationship between revenues and materials and
  supplies (inventory for MSFT)
• Revenues / average materials supplies

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Activity analysis
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Activity analysis

• Fixed Asset Turnover Ratio measures how
  efficiently the firm manages its investment in
  PPE
• Revenues / average fixed assets

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Activity analysis
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Activity analysis

• Total asset turnover ratio measures overall
  relationship between revenues and assets
• Revenues / average total assets

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Activity analysis
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Liquidity analysis

• Liquidity analysis attempts to assess the ability
  of a company to meet its short-term obligations.

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Liquidity analysis

• Current ratio captures the relationship between
  current assets to current liabilities
• Current assets / current liabilities

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Liquidity analysis
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Liquidity analysis

• Quick (acid-test) ratio focuses on the
  relationship between the most liquid assets
  (cash, marketable securities, receivables) and
  current liabilities
• Quick assets / current liabilities

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Liquidity analysis
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Liquidity analysis

• The collection period focuses on the average
  period of time receivables are outstanding. The
  longer receivables are outstanding, the less
  liquid the company.
• Average receivables/(Sales/360)

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Liquidity analysis
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Solvency analysis

• Capital structure and solvency analysis attempts
  to assess the companys ability to meet its
  long-term obligations

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Solvency analysis

• Total liabilities to equity captures the
  relationship between financing provided by
  creditors and financing provided by owners.
• Total liabilities/Shareholders equity

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Solvency analysis
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Solvency analysis

• Long-term debt to equity captures the
  relationship between financing provided by
  long-term creditors and financing provided by
  owners.
• Long-term liabilities/Equity

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Solvency analysis
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Solvency analysis

• Times interest earned ratio measures the extent
  to which earnings cover interest
• EBIT / Interest expense

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Solvency analysis
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Return on investment

• An analysis of return on investment assesses the
  profitability of the company in light of capital
  invested.
• The capital markets will only provide capital if
  the returns are adequate given the risk.

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Return on investment

• Return on assets measures the return accruing to
  all providers of capital, independent of source
• Income before interest, net of taxes
• Average total assets

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Return on investment
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Return on investment

• Return on common equity measures the
  profitability relative to the common
  stockholders equity
• Net income / average common equity

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Return on investment
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Operating performance

• In analyzing operating performance, we evaluate
  profit margins from operating activities.

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Operating performance

• Operating profit margin captures the relationship
  between operating profit and revenues.
• Operating profit / Revenues

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Operating performance
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Operating performance

• Net profit margin captures the relationship
  between net profit and revenues.
• Net income / Revenues

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Operating performance
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Du Pont Analysis

• Du Pont system of ratio analysis shows that ROE
  is influenced by margin, turnover, and leverage
• ROE
• Income/sales Sales/assets
  Assets/equity
• Margin Turnover Leverage

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Du Pont Analysis