Overview of Financial Analysis

1
Overview of Financial Analysis

• SPECIFY THE OBJECTIVES OF THE ANALYSIS
• Focus on who is the financial statement user
• The identity of the user helps define what
  information is needed

I had better sell that stock ASAP!
The companys return on equity has dipped
considerably over the last period
Financial
2
Steps of a F/S Analysis

• Establish objectives of the analysis
• Study the industry and relate industry
  climate to current and projected economic
  developments -
• a growth industry?
• a dying industry?
• a changing industry?
• Develop knowledge of firm and quality of
  management
• Evaluate financial statements using basic tools
• Summarize findings
• Reach conclusions relevant to established
  objectives

3
Potential Financial Statement Users

• Creditors
• Investors
• Managers
• Who else?
• What types of questions do each of
  these users seek answers to?

4
Data sources

• Financial statements (and notes)
• Auditors report
• MDA
• Supplementary schedules
• 10K and 10Q reports filed with SEC
• Computerized data bases
• Info on industry norms/ratios
• Info on particular companies/industries/mutual
  funds
• Articles in popular/business press
• Websites

5
Tools for analysis

• Common size financial statements
• Financial ratios
• Trend analysis
• Structural analysis
• Industry comparisons
• Common sense and judgment

6
Financial Ratio Categories

• Liquidity Ratios
• measure a firms ability to meet cash needs as
  they arise
• Activity Ratios
• measure the liquidity of specific assets and the
  efficiency of managing assets

7
Ratio Categories (continued)

• Leverage Ratios
• measure the extent of a firms financing with
  debt relative to equity and its ability to cover
  interest and other fixed charges
• Profitability Ratios
• measure the overall performance of a firm and its
  efficiency in managing assets, liabilities and
  equity

8
Caution!

• Ratios are valuable, BUT..
• They do not provide answers in an of themselves
  and are not predictive
• They should be used with other elements of
  financial analysis
• There are no rules of thumb that apply to
  interpretation of ratios

9
Profitability Ratios

• Gross Profit Margin
• Gross Profit/Net Sales
• Operating Profit Margin
• Operating Profit/Net Sales
• Net Profit Margin
• Net Earnings/Net Sales
• All measure firms ability to translate sales
  dollars into profits

10
Profitability Ratios (continued)

• Return on Investment (or Return on Assets)
• Net Earnings/Total Assets
• Return on Equity
• Net Earnings/Stockholders Equity
• Both measure overall efficiency of firm in
  managing investment in assets and generating
  return to stockholders

11
Return on Investment

• Return on Investment (ROI)
• Net operating income
• Income before interest and taxes
• Operating assets
• Assets held for operating purposes ONLY
• i.e. cash, accounts receivable, inventory, plant
  and equipment

Net Operating Income

ROI
Average Operating Assets
2005 KD Hatheway-Dial
12
Understanding ROI
ROI

Margin
X
Turnover
Operating Margin
Net Operating Income

Sales
Sales

Turnover
Average Operating Assets
2005 KD Hatheway-Dial
13
Understanding ROI
5
12.5

X
2.5
10,000
5
100
X

200,000
200,000

2.5
80,000
2005 KD Hatheway-Dial
14
APPLYING ROI
10 Increased Sales without Any Increase in
Operating Assets (assume 6 increase in operating
expenses)
23.25

8.4545
X
2.75
86 increase with 10 increase in sales
18,600
8.4545
100
X

220,000
220,000

2.75
80,000
2005 KD Hatheway-Dial
15
APPLYING ROI
10 Decrease in operating expenses and no change
in sales
36.25

14.5
X
2.50
190 increase with 10 decrease in operating
expenses
29,000
14.5
100
X

200,000
200,000

2.50
80,000
2005 KD Hatheway-Dial
16
APPLYING ROI
10 Decrease in operating assets and no change in
sales or operating expenses
13.90

5.0
X
2.78
11.2 increase with 10 decrease in operating
assets
10,000
5.0
100
X

200,000
200,000

2.78
72,000
2005 KD Hatheway-Dial
17
APPLYING ROI
10 increase in operating assets and 5 change in
sales and 3 operating expenses
16.25

6.8
X
2.39
30 increase with 10 decrease in operating assets
14,300
6.8
100
X

210,000
210,000

2.39
88,000
2005 KD Hatheway-Dial
18
Profitability Ratios (continued)

• Cash Flow Margin
• Cash Flow from Operating Activities /Net Sales
• Measures ability to translate sales into cash
  (with which to pay bills)

19
Profitability Ratios (continued)

• Cash Return on Assets
• Cash Flow from Operating Activities /Total Assets
• Useful comparison to return on investment
• Indicates firms ability to generate cash from
  utilizing its assets

20
Liquidity Ratios

• Current Ratio
• Current Assets/Current Liabilities
• Measures ability to meet short-term cash needs
• Quick or Acid Test Ratio
• Current Assets-Inventory/Current Liabilities
• Measure ability to meet short-term cash needs
  more rigorously
• Cash Flow Liquidity Ratio
• CashMarketable SecuritiesCash Flow from
  Operating Activities/Current Liabilities
• Focuses on ability of the firm to generate
  operating cash flows as a source of liquidity

21
Activity Ratios

• Average Collection Period
• Accounts Receivable/Average Daily Sales
• Helps gauge liquidity of accounts receivable
  (ability to collect cash from customers)
• Accounts Receivable Turnover
• Net Sales/Accounts Receivable
• Another measure of efficiency of firms
  collection and credit policies

22
Activity Ratios (continued)

• Inventory Turnover
• Cost of Goods Sold/Inventory
• Measures efficiency of inventory management
• Fixed Asset and Total Asset Turnover
• Net Sales/Net PPE (Fixed Asset T/O)
• Net Sales/Total Assets (Total Asset T/O)
• Both assess effectiveness in generating sales
  from investment in assets

23
Leverage Debt Ratios

• Debt Ratio
• Total Liabilities/Total Assets
• Long-Term Debt to Total Capitalization
• Long-term Debt/Long-term Debt Stockholders
  Equity
• Debt to Equity Ratio
• Total Liabilities/Stockholders Equity
• All three measure extent of firms financing with
  debt

24
Leverage Coverage Ratios

• Proportion and amount of debt in capital
  structure is important to analyst
• Tradeoff between risk and return
• Use of debt involves risk -- commitment to fixed
  charges
• Fixed charges must be COVERED -- following are
  some ratios to assess coverage

25
Coverage Ratios (continued)

• Times Interest Earned
• Operating Profit/Interest Expense
• Indicates how well operating earnings cover fixed
  interest charges
• Fixed Charge Coverage
• Operating Profit Lease Payments/Interest
  Expense Lease Payments
• Broader measure of how well operating earnings
  cover fixed charges

26
Coverage Ratios (continued)

• Cash Flow Adequacy
• Cash Flow from Operating Activities/ Average
  Annual Long-Term Debt Maturities
• Measures firms ability to cover long-term debt
  maturities each year
• Rationale is that over the long-run operating
  cash flows must be adequate to cover investing
  activities financed with debt

27
Other Ratios

• Earnings per Common Share
• Net Earnings/Average Common Shares Outstanding
• Indicates return on a per share basis
• Price to Earnings
• Market Price of Common Stock/Earnings per Common
  Share
• Expresses a multiple the stock market places on
  earnings

28
Other Ratios (continued)

• Dividend Payout
• Dividends per Share/Earnings per Share
• Shows percentage of earnings paid out to
  stockholders
• Dividend Yield
• Dividends per Share/Market Price of Common Share
• Shows rate earned by shareholders from dividends
  relative to current stock price