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## Financial Analysis

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### Purpose Ratio Analysis Cash Flow Analysis Purpose of Financial Analysis Assess Corporate Performance in the context of stated goals and strategy. – PowerPoint PPT presentation

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Title: Financial Analysis

1
Financial Analysis
• Purpose
• Ratio Analysis
• Cash Flow Analysis

2
Purpose of Financial Analysis
• Assess Corporate Performance in the context of
stated goals and strategy.
• Assess current financial position, including
liquidity.

3
Tools of Financial Statement Analysis
• Ratio analysis
• Signal approach
• Cash Flow analysis

4
Ratio Analysis
• Tools for interpreting financial statements
• Often used to facilitate comparison via
deflation.
• Common size financial statements- when the whole
statement is converted to ratio form.

5
Ratio Analysis
• Financial ratios are typically grouped into four
classes
• Profitability
• Liquidity ratios
• Solvency ratios
• Funds management ratios

6
Profitability and growth-Strategic Areas of
Influence
• Operating management
• Investment management
• Financing strategy
• Dividend policies

7
Drivers of Profit and Growth
8
Ratios can be used
• To compare the same firm over several years
• To compare to other firms in the industry
• To compare to an absolute benchmark

9
Operating Management (managing revenues and
expenses)
• Return on equity (ROE) -- ROE (Net Income) /
(Shareholders Equity)
• Return on Assets -- Income / (Total Assets)
• Return on sales (ROS) -- Net Income / Sales
• Gross Profit Margin- (Sales-COGS)/Sales
• Numerous variations of the above are computed in
practice

10
An Example-Return on Equity (ROE)
• Beginning balances, ending balances, average
balances ?
• Often adjusted for preferred stock dividends
• Average for US industries is from 11 to 13 (PBH)

11
The need for an analysis framework
• What do ROE, NPM, ROA, etc., mean as a group?
• What if they differ as to outcome (e.g., one firm
has a higher NPM but lower ROE)?
• What story do they tell, collectively?
• How do they relate to each other?

12
The Notion of Ratio Decomposition (Dupont
Analysis)
• ROE ROA Assets/equity (Financial leverage)
• ROA net income/ assets
• Financial leverage indicates the dollar of assets
the firm is able to deploy for dollar invested by
shareholders

13
The Problem of mixed operating and non-operating
financial statement components
• What if a firm has a large block of assets and/or
liabilities that are not involved in operations?
• What if net income includes numerous
non-operating items?

14
A Variation on the usual definition of ROA
• Operating ROA
• Focus is on operating return only -- excludes
interest income
• (Net Income (Interest exp - Interest income)
(1-tax rate)) / (Equity Debt - Cash and
Short-tern investments)

15
Decomposition Using Operating ROA
• ROE Operating ROA (RNOA) Spread x Leverage

16
Operating/Nonoperating vs. Core/Transitory
17
Level I-Based DecompositionExample ROE, RNOA
Leverage
18
Financial Leverage and Risk
• Given that increases in financial leverage
increase ROE, why are all companies not 100 debt
financed?
• The answer is because debt is risky. This
increased risk increases the expected return that
investors require to provide capital to the firm.
• Higher financial leverage also results in a
higher interest rate on the companys debt.

19
Leverage and Income Variability
20
Level II-Based DecompositionExample ROE, ROA
Leverage
• ROE ROA x assets/equity
• ROA net income/sales x sales/assets
• Therefore
• ROENet profit margin x
• asset turnover x
• leverage

21
Level II Analysis of Operating Margin and
Operating Turnover
22
Margin vs. Turnover
23
Return on Sales (ROS)
• Shows profitability of firms operating
activities
• Used extensively by Japanese management
• Indicates how much profit is generated per dollar
of sales

24
NOPAT Margin
25
Turnover of NOA
here
26
Level 3 Analysis Disaggregation of Operating
Margin and Operating Turnover
27
Level III Analysis using the standard definition
of ROA
28
Sustainable Growth Rate
Dividend payout
ROE
Fin Leverage
ROS
Asset Turnover
29
Sustainable Growth 1
• ROE (1-Dividend payout ratio)

30
Gross Profit Margin
• A high gross profit margin is preferred to a
lower one, which also implies that a company has
relatively more flexibility in product pricing.

31
Gross Profit Margin
• Two main factors determine gross profit margins
• Competition The more competition, the lower
margins tend to be.
• Product mix The greater the volume of low
profit/high turnover goods, the lower the
margins.
• Very relevant for comparisons within an industry
-- not much outside

32
Operating Expense Margin
• Operating expense ratios (percents) are used to
examine the proportion of sales consumed by each
major expense category.
• Expense ratios are calculated as follows
• Operating expense percentage Expense item/Net
sales

33
Drivers of Profit and Growth
34
Investment Management
• Working Capital and Fixed Assets
• Receivables
• Inventory
• LT operating assets
• Payables

35
Turnover
• Turnover measures relate to the productivity of
company assets, i.e., how much capital is
required to generate a specific sales volume?
• Turnover ratios are calculated as follows
• Turnover Sales volume/Average Assets
• As turnover increases, there is greater cash
inflow as cash outflow for assets to support the
current sales volume is reduced.

36
Accounts Receivable Turnover (ART)
37
Inventory Turnover (INVT)
38
L-T Operating Asset Turnover (LTOAT)
39
Accounts Payable Turnover (APT)
40
Net Operating Working Capital Turnover (WOCT)
41
Evaluating Financial Management
• Short-term evaluations
• Long-term evaluations

42
Short-term evaluations 1
• Current ratio
• (Current assets) / (Current liabilities)

43
Short-term evaluations 2
• Quick ratio
• (Cash Short-term investments Accounts
Receivable) / (Current liabilities)

44
Short-term evaluations 3
• Operating cash flow ratio
• (Cash flow from operations) / (Current
liabilities)

45
Long-term evaluations
• Debt is typically cheaper that equity
• Interest is tax deductible dividends are not
• Can impose discipline on management (explicit
contracts)
• Easier to communicate proprietary information to
private lenders than to public markets

46
Standard ratios
• Liabilities-to-equity-ratio
• Debt-to-equity ratio
• Debt-to-capital
• Interest coverage

47
Liabilities-to-equity
• (Total Liabilities) / (Shareholders equity)

48
Debt-to-equity
• (Short-term debt Long-term debt) /
(Shareholders equity)

49
Interest coverage
• (Net income Interest expense Tax expense) /
(Interest expense)

50
Problems with Ratios
• Mis-specification of deflator (e.g., size)
• Accounting imperfections
• Problem of assumed linearity
• Ratio blow-up
• Negative numbers. What do they mean?
• Assumed 0 intercept.
• Omitted variables

51
In Search of Fundamentals-Lev and Thiagarajans
Signals Approach
• Inventory
• Accounts receivable
• Capital Expenditure, RD
• Gross margin

52
In Search of Fundamentals Lev and Thiagarajan
Signals Approach
• Effective tax
• Order backlog
• Labor force
• LIFO changes
• Audit qualifications

53
Inventory
• Considered disproportionate increases in
inventory as a negative signal
• Percentage Change in Inventory - Percentage
Change in Sales

54
Accounts Receivable
• Disproportionate increases considered negative
• Percentage Change in AR - Percentage Change in
Sales

55
Capital Expenditures RD
• Relative Decreases Considered negative
• Percentage change in industry - Percentage change
in Firm

56
Gross Margin
• Disproportionate decreases with respect to sales
negative
• Percentage change in Gross Margin - Percentage
change in sales

57
• Disproportionate increases to sales negative
• change in SA - change in sales

58
Provision for doubtful accounts
• Increases less than the increases in accounts
receivable is viewed as negative
• Change in Accounts receivable - Change in
doubtful accounts

59
Effective tax Rate
• Unusual decrease in effective tax rate considered
negative
• PTE this year (Effective rate last year-
effective rate this year)

60
Order Backlog
• Unfilled orders is often viewed as a leading
indicator
• change in sales - change in order backlog
• A negative signal is Good? or Bad?

61
Labor Force Changes
• Labor force reductions are usually considered
good news by analysts
• Defined as percentage change in sales per employee

62
LIFO
• LIFO considered positive

63
Audit Qualification

64
Results
• Regression analysis with Excess Return as the
dependent variable came out about as hypothesized
• Found that results are not constant for macro
economic conditions

65
From Business Activities to Financial Statements
Accounting System
Accounting Environment
Accounting Strategy
Financial Statements
66
Drivers of Profit and Growth
67
Cash Flow Analysis- Based on Business Activities
Operating Activities Investment
Activities Financing Activities
68
Cash Flow
• The Direct Method
• The Indirect Method

69
Cash Flow -- Direct Method
• Recommended by the FASB
• Most companies use the Indirect Method

70
Cash Flow -- Indirect Method - 1
Net Income
Non-cash income items
Plus/Less
payables, taxes
Equals
Cash Flow from Operations
71
Cash Flow -- Indirect Method - 2
Cash Flow from Operations
PLUS/LESS
Cash flow - Investment activities
PLUS/LESS
Cash flow - Financing activities
EQUALS
Change in cash and cash equivalents
72
From Profit to Cash
Net Income
Cash Flow From Oper. bef. WC chgs, Inv Int
CF from op After Wc Changes before int
Noncash charges
/- Chg in Working Cap
73
From Profit to Cash -- 2
Cash Flow From Operations
CF
Free Cash Flow
/- Interest
/- Chg Fixed Capital
74
Free Cash Flow
• Jensen (1988) defines free cash flow as the cash
left after managers have invested in all positive
NPV projects
• He also asserts that managers will invest in
negative NPV projects rather pay it out to
shareholders
• The Free cash flow used in out context is the
cash flow from operations plus the net investment
cash flow

75
Free cash Flow and Interest
• You may add interest back. Depends on the
purpose of the Free Cash Flow. See p. 6-3.

76
Free Cash Flow From Working Capital
• Adjust Working Capital from operations for
changes in current accounts to get Cash Flow From
Operations
• Add the net capital investment
• What you get is Free Cash Flow