Corporate Finance: Financial Statement Analysis

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Corporate FinanceFinancial Statement Analysis

• Professor Scott Hoover
• Business Administration 221

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• 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
  companies.

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• 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
  peers.
• To adjust for differences in size, etc., we use
  ratios.
• 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.

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• 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
  multiplier
• Note that ROE ROA ? (TA / E )
• leverage multiplier TA / E 1 /
  (1 D/TA)

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• The DuPont approach is nice because it divides
  the firm into three tasks
• expense management (measured by the profit
  margin)
• 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.

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

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• 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

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• 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 -
  inventory)/CL
• 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.

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• Activity (Asset Management) Ratios
• total asset turnover ? sales / total assets
  S/TA
• higher asset turnover ? more effective use of
  assets.
• BUTmay imply that the company has old assets.
• inventory turnover ? cost of goods sold /
  inventory
• higher inventory turnover ? more effective use of
  inventory.
• 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.

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• collection period ? receivables / credit sales
  per day receivables / (credit sales/n)
• higher collection period ? lower quality of
  sales
• 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
  purchases/n)
• 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

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PayablesPeriod
CollectionPeriod
GoodsAcquired
GoodsPaid For
GoodsSold
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.

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• Debt Management Ratios
• debt ratio ? total debt / total assets
• Note that we prefer to use the market value of
  equity in the calculation DR
  debt/(debtMV(equity)
• 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
  equity
• 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

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

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• 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.

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• 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

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• 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
  E/P.

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• 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.

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

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• Difficulties with Financial Statement Analysis
• The information we consider is always old.
• We rely on book values, which can be quite
  misleading.
• 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
  averages.
• 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.

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• 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
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• 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.

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• 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
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• ROE a bit low
• Debt ratio about average.
• Net profit margin about average.
• Total asset turnover significantly below
  average.
• Fixed asset turnover looks okay.
• Inventory turnover in days well above industry
  average.
• 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
  earnings.
• 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.

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• 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.