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Corporate Finance: Financial Statement Analysis


Corporate Finance: Financial Statement Analysis Professor Scott Hoover Business Administration 221 – PowerPoint PPT presentation

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Title: Corporate Finance: Financial Statement Analysis

Corporate FinanceFinancial Statement Analysis
  • Professor Scott Hoover
  • Business Administration 221

  • What questions are important in assessing the
    health of a firm?
  • Can the firm meet its debt obligations?
  • How well are assets being managed?
  • How risky is the firm?
  • How profitable is the firm?
  • What does the market think of the firm?
  • ? Ratio Analysis interpretation of accounting
    and market information to assess the health of

  • Why do we use ratios?
  • We must consider things on a relative basis, not
    an absolute one.
  • e.g. If one company has earnings of 2,000,000
    and another of 1,000,000, which is better?
  • We cant say because one company may be
    considerably bigger than the other.
  • We evaluate a company by comparing it to its
  • To adjust for differences in size, etc., we use
  • Note that there are no hard-and-fast rules here.
    We can and should be creative and create our own
    ratios to investigate potential problems or
    identify strengths.

  • The DuPont Relationship
  • We begin any analysis by examining the factors
    that contribute to the ROE. Why?
  • DuPont ROE ? NI / E (NI / S) ? (S / TA) ?
    (TA / E ) profit margin
    ? asset turnover ? leverage
  • Note that ROE ROA ? (TA / E )
  • leverage multiplier TA / E 1 /
    (1 D/TA)

  • The DuPont approach is nice because it divides
    the firm into three tasks
  • expense management (measured by the profit
  • asset management (measured by asset turnover)
  • debt management (measured by the debt ratio or
    leverage multiplier)
  • The DuPont Method
  • layered approach
  • examine the three components
  • identify possible weaknesses and strengths
  • dig deeper to find more specific causes
  • dig deeper to identify possible corrective
    action, etc.

  • factors of the profit margin
  • sales
  • cost of goods sold
  • selling, general, and administrative costs
  • research and development expense
  • depreciation
  • interest
  • taxes
  • other expenses

  • factors of the asset turnover
  • sales
  • current assets
  • cash
  • receivables
  • inventory
  • fixed assets
  • property
  • plant
  • equipment
  • factors of the leverage multiplier
  • current liabilities
  • long-term liabilities
  • shareholder's equity

  • Ratios
  • Liquidity Ratios
  • current ratio ? current assets / current
    liabilities CA/CL
  • higher current ratio ? greater ability to cover
    short-term debt obligations
  • current ratio too high ? firm may be holding
    too much cash, etc. That money might be invested
    to earn a higher rate of return.
  • acid test ratio (aka, quick ratio) ? (CA -
  • higher quick ratio ? the greater is the ability
    to cover short-term debt obligations without
    selling off inventory.
  • As before, if the quick ratio is too high, the
    firm may be wasting money.

  • Activity (Asset Management) Ratios
  • total asset turnover ? sales / total assets
  • higher asset turnover ? more effective use of
  • BUTmay imply that the company has old assets.
  • inventory turnover ? cost of goods sold /
  • higher inventory turnover ? more effective use of
  • We sometimes use inventory turnover in days ?
    inventory / (COGS/n)
  • n is the number of days in the reporting period.
  • fixed-asset turnover ? sales / net property,
    plant and equipment
  • higher fixed asset turnover ? more effective use
    of fixed assets.
  • BUTmay imply that the company has old assets.

  • collection period ? receivables / credit sales
    per day receivables / (credit sales/n)
  • higher collection period ? lower quality of
  • Note that we often do not have credit sales, so
    we proxy by using actual sales
  • days sales in cash ? (cash marketable
    securities) / (sales/n)
  • higher days sales in cash ? greater ability to
    handle unexpected short-term needs.
  • BUTlower return due to uninvested capital
  • payables period ? payables / (credit
  • higher payables period ? lesser need for
    short-term capital
  • Note that we often do not have credit
    purchases, so we proxy by using actual cost of
    goods sold

GoodsPaid For
MoneyReceivedFor Goods
InventoryTurnoverin Days
  • The time between paying for goods and receiving
    money for them is ITDCP-PP
  • The greater is this number, the greater the
    opportunity cost because the companys money is
    tied up rather than being invested.

  • Debt Management Ratios
  • debt ratio ? total debt / total assets
  • Note that we prefer to use the market value of
    equity in the calculation DR
  • example 100 initial investment in a project
    that pays off 120, all equity firm
  • return to shareholders is 20
  • example same, but 50 debt (6 interest), 50
  • 50 ? 1.06 53 goes to debtholders
  • 67 left for shareholders ? (67-50) / 50 34
  • Other benefits of higher debt
  • greater control (less shares outstanding)
  • interest tax deduction
  • Drawbacks of higher debt
  • greater risk of bankruptcy
  • must appease debtholders

  • times-interest earned ? EBIT / interest expense
  • higher times-interest-earned ratio ? the higher
    the profits beyond what is necessary to pay
  • BUT a firm with too little debt may have a high
    TIE ? we must be cautious in interpreting the
  • current ratio
  • quick ratio

  • Profitability Ratios
  • gross margin ? (sales COGS)/sales
  • higher gross margin ? efficient control of costs
    or efficient generation of sales
  • net profit margin ? net profits after taxes (net
    income) / sales ? NI / S
  • higher net profit margin ? higher fraction of
    revenues kept as profits.
  • return on equity (ROE) ? NI / E
  • higher ROE ? more profitable use of firm equity.
  • A profitable high-debt firm will tend to have a
    high ROE (since equity is low), so we must be
    cautious in interpreting the ratio.

  • return on invested capital (ROIC) EBIT?(1-T) /
    (interest-bearing debt equity).
  • higher ROIC ? greater overall efficiency.
  • The profitability ratios are often difficult to
    interpret. Why?
  • incentives to make their taxable incomes low
  • incentives to make earnings appear high.
  • ? We must always look at notes to the financial
    statements, new reports, etc. to see if any
    unusual accounting events are happening.
  • We can examine other measures of profitability
    such as EBITDA and free cash flow

  • Market Value Ratios
  • price to earnings ? market share price / earnings
    per share
  • higher P/E ratio ? better market opinion of the
    future prospects of the firm.
  • BUTP/Es for firms with extremely low earnings
    can be misleading.
  • One rule of thumb ignore P/E when profit margin
    is less than some arbitrary value (4 perhaps?)
  • Mathematically, it is more reasonable to look at

  • market to book ? market value of equity / book
    value of equity
  • higher market to book ratio ? better market
    opinion of the current state of the firm.
  • BUTM/B may be high if assets are old.
  • M/B lt 1 is a special case. Why?
  • Two main explanations
  • 1. Book value of assets (and hence book value of
    equity) is misleading
  • 2. The company has a high risk of bankruptcy.

  • Other tools
  • Common Size statements
  • express the balance sheet as a percentage of
    total assets
  • express the income statement as a percentage of
  • Indexed statements
  • express the financial statements from one period
    as a percentage of the previous period.

  • Difficulties with Financial Statement Analysis
  • The information we consider is always old.
  • We rely on book values, which can be quite
  • We are often forced to compare companies at
    different points in time.
  • Different accounting firms use different
    terminology, sometimes making it difficult to
    interpret the financial statements.
  • We must be careful in calculating industry
  • Should we include negative ratios in averages?
  • Should we include outliers in averages (P/E very
    high for example)?
  • Firm managers may have incentives to mislead
    (agency problems).
  • Financial statements often do not have the level
    of detail necessary to fully evaluate problems.

  • Very Simple Example

Ratio firm industry average
current ratio 2.2 3.6
quick ratio 1.8 2.9
total asset turnover 2.1 2.2
fixed asset turnover 4.2 4
collection period 22 days 24 days
inventory turnover 10 days 9 days
payables period 18 days 17 days
debt ratio 40 30
TIE ratio 6.4 6
profit margin 9 8
ROA 16 18
ROE 26.5 24.5
P/E 16 15
market to book 2.4 2.3
  • ROE looks okay
  • Debt ratio a bit higher than average.
  • TIE is slightly above average
  • current ratio is below average but above 1.
  • quick ratio is below average but above 1.
  • conclusion The firm did not have trouble
    covering its interest over the past year (TIE
    ok), but may struggle a bit over the coming year
    (CR and QR below average)
  • Profit margin a bit above average.
  • Total asset turnover nearly average.
  • Price to earnings and Market to book look okay
  • No other ratios are significantly different from
    the industry average.
  • Overall conclusion The firm (perhaps) has a
    little too much debt, but it is probably not a
    big deal.

  • Another Very Simple Example

ratio firm industry average
current ratio 3.2 3.6
quick ratio 1.4 2.9
total asset turnover 1.3 2.2
fixed asset turnover 4.2 4
collection period 22 days 24 days
inventory turnover 19 days 11 days
payables period 19 days 21 days
debt ratio 30 30
TIE ratio 6.4 6
profit margin 9 8
ROA 12 20
ROE 16.7 24
P/E 16 15
market to book 1.2 2.3
  • ROE a bit low
  • Debt ratio about average.
  • Net profit margin about average.
  • Total asset turnover significantly below
  • Fixed asset turnover looks okay.
  • Inventory turnover in days well above industry
  • Collection period about average.
  • Current ratio a bit low. Quick ratio well
    under average.
  • Price to earnings okay. This tells us that the
    current price is in line with last year's
  • Market to book well under average.
  • Overall conclusion The firm appears to have an
    inventory control problem (too much inventory on
    hand). The problem might be a serious one.

  • Final Comments
  • We should always consider the notes to the
    financial statements.
  • ..give explanations for unusual items as well as
    notes that suggest an accounting explanation for
    a peculiarity.
  • We should always consider news stories, press
    releases, etc.
  • often contain statements concerning the
    financial condition of the firm and comments on
    what to expect.
  • give information on the firm since the date of
    the last financials.
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