Post on 12-Jan-2016
CHAPTER THREECHAPTER THREE
Financial Statement Financial Statement AnalysisAnalysis
J. D. HanJ. D. Han
Learning ObjectivesLearning Objectives
1.1. How do we measure the health and the How do we measure the health and the prospect of a company?prospect of a company?
Unfortunately, one indicator does not give a Unfortunately, one indicator does not give a whole picture. whole picture.
2. What types of ratios are used in financial 2. What types of ratios are used in financial analysis?analysis?
3.3. What are the trade-offs among these ratios?What are the trade-offs among these ratios? Illustrate them with the DuPont system of Illustrate them with the DuPont system of
financial analysis of return on equity.financial analysis of return on equity.
3. 1 Learning Objectives3. 1 Learning Objectives
4.4.What kinds of distortions would inflation What kinds of distortions would inflation (changing prices) cause in the financial (changing prices) cause in the financial statement and on the income statement statement and on the income statement respectively?respectively?
5.5.Discuss some of the implications of foreign Discuss some of the implications of foreign exchange rates for Canadian companies exchange rates for Canadian companies with global operations.with global operations.
3.2 Ratio Analysis3.2 Ratio Analysis
Ratios are helpful for comparison Ratios are helpful for comparison purposespurposes
Ratios are divided into four Ratios are divided into four categories:categories:
1.1. Liquidity RatiosLiquidity Ratios
2.2. Leverage and Coverage RatiosLeverage and Coverage Ratios
3.3. Profitability and Activity RatiosProfitability and Activity Ratios
4.4. Market Value RatiosMarket Value Ratios
Liquidity Ratios: Liquidity Ratios: measuring a company’s short-term ability measuring a company’s short-term ability to pay its debtto pay its debt
Current Ratio = current Current Ratio = current assetsassets
current current liabilitiesliabilities
Most widely used liquidity ratioMost widely used liquidity ratio A value of > 2 is considered a crude A value of > 2 is considered a crude suitable measurement for suitable measurement for current ratiocurrent ratioWhat is ‘working capital’? What is ‘working capital’?
Liquidity RatiosLiquidity Ratios
Used to evaluate a business’ ability to Used to evaluate a business’ ability to meet current obligations when meet current obligations when inventory is considered to be a inventory is considered to be a concernconcern
Acid TestAcid Test
Quick ratio = current assets – Quick ratio = current assets – inventoriesinventories
current liabilitiescurrent liabilities
Liquidity RatiosLiquidity Ratios
Indicates an organization’s efficiency Indicates an organization’s efficiency of inventory managementof inventory management
inventory turnover signals efficient inventory turnover signals efficient managementmanagement
Inventory turnover = cost of goods Inventory turnover = cost of goods soldsold
average average inventoryinventory
Liquidity RatiosLiquidity Ratios
Indicates the average number of Indicates the average number of days that credit sales are days that credit sales are outstandingoutstanding
Avg. collection period = receivablesAvg. collection period = receivables avg. daily credit avg. daily credit
salessales
Leverage and Coverage Leverage and Coverage RatiosRatios
Common measure of a firm’s Common measure of a firm’s financial leveragefinancial leverage
Used as a safety margin that Used as a safety margin that shareholders are provided in the shareholders are provided in the event of liquidationevent of liquidation
Debt-to-equity = long-term debtDebt-to-equity = long-term debt shareholders’ shareholders’
equityequity
Leverage and Coverage Leverage and Coverage RatiosRatios
Broad measurement that looks at the Broad measurement that looks at the proportion of a firm’s total assets proportion of a firm’s total assets that are financed through debt and that are financed through debt and other liabilitiesother liabilities
Total debt-to-asset = total Total debt-to-asset = total debtdebt total total assetsassets
Leverage and Coverage Leverage and Coverage RatiosRatios
Measures the amount of assets a Measures the amount of assets a firm finances with debt or equityfirm finances with debt or equity
The The ratio, the proportion of ratio, the proportion of company’s assets financed through company’s assets financed through equity equity
Equity multiplier = Total assetsEquity multiplier = Total assets total equitytotal equity
Leverage and Coverage Leverage and Coverage RatiosRatios
Used to detect excessive leverageUsed to detect excessive leverage An indicator of the safety of a firm’s An indicator of the safety of a firm’s
periodic interest paymentsperiodic interest payments
Times interest earned = EBITTimes interest earned = EBIT interest interest chargescharges
Profitability and Activity Profitability and Activity Ratios:Ratios:
Different Measures of ProfitsDifferent Measures of Profits
Sales (revenues) – Cost of Goods sold Sales (revenues) – Cost of Goods sold ––Operating Expenses Operating Expenses = EBIT = EBIT = NOP= NOP
––Financing Charges Financing Charges =EBT =EBT––Income TaxesIncome Taxes =Net Profits =Net Profits
––Dividends on Preferred Shares= Profit Dividends on Preferred Shares= Profit available to common available to common
shareholdersshareholders
Profitability and Activity Profitability and Activity Ratios:Ratios:asses the overall managerial efficiency asses the overall managerial efficiency and profitabilityand profitability
Net operating margin = Net operating margin = EBITEBIT salessales
Gross operating margin = Gross operating margin = sales – sales – COGSCOGS salessales
Asset turnover = Asset turnover = salessales total assetstotal assets
Profitability RatiosProfitability Ratios
Broad measure of how well Broad measure of how well management is employing assets management is employing assets to earn profitsto earn profits
ROA = net profitROA = net profit total assetstotal assets
Profitability RatiosProfitability Ratios
Measures how well management Measures how well management serves shareholders’ interest by serves shareholders’ interest by determining the profit generation per determining the profit generation per dollar of equity invested in the firmdollar of equity invested in the firm
ROE = net profitROE = net profit shareholders’ equityshareholders’ equity
DuPont SystemDuPont System
Allows for analysis of critical components that Allows for analysis of critical components that influence ROE and help predict future trendsinfluence ROE and help predict future trends
The three ratios used in the DuPont system of The three ratios used in the DuPont system of financial analysis of return on equity are financial analysis of return on equity are Profitability, Leverage, and Asset Turnover.Profitability, Leverage, and Asset Turnover.
For instance, this shows that you can raise ROE For instance, this shows that you can raise ROE by decreasing the equity – what would be the by decreasing the equity – what would be the resultant problem or trade-offs between short-resultant problem or trade-offs between short-term and long-term welfares of the firm?term and long-term welfares of the firm?
ROE = net profit x sales x total assetsROE = net profit x sales x total assets sales total assets shareholders’ sales total assets shareholders’ equityequity
Market Value RatiosMarket Value Ratios
Most widely used market value ratioMost widely used market value ratio Reflects what investors are willing to Reflects what investors are willing to
pay for each dollar of reported pay for each dollar of reported annual common share earningsannual common share earnings
Price-Earnings Ratio = price per common Price-Earnings Ratio = price per common shareshare earning per common earning per common shareshare
Market Value RatiosMarket Value Ratios
Tobin’s q Ratio = Market Value of debt and Tobin’s q Ratio = Market Value of debt and equityequity
replacement costreplacement cost
Market-to-book ratio = Market Value of debt and Market-to-book ratio = Market Value of debt and equityequity
book value of assetsbook value of assets
The difference between the replacement cost and the book value is “depreciation”, both technical and physical.
3.3 Common-Size Analysis3.3 Common-Size Analysis
Involves converting dollar amounts Involves converting dollar amounts on the financial statements into on the financial statements into percentagespercentages
Helps compare financial statements Helps compare financial statements and identify trends that are not and identify trends that are not caused by the overall size of the caused by the overall size of the businessbusiness
Enables comparison of companies of Enables comparison of companies of different sizedifferent size
Market Value RatiosMarket Value Ratios
Indicates the percentage of earning paid to Indicates the percentage of earning paid to shareholders in the form of dividendsshareholders in the form of dividends
Dividend payout = common share Dividend payout = common share dividenddividend
common share common share earningsearnings
Dividend yield = dividend per common Dividend yield = dividend per common shareshare
price per common price per common shareshare Widely used market value ratioWidely used market value ratio Measures how much investors are willing Measures how much investors are willing to pay for a firm’s dividendto pay for a firm’s dividend
SummarySummary
1.1. The four categories of ratios used in The four categories of ratios used in financial analysis are:financial analysis are:
• Liquidity ratios highlight the firm’s short-Liquidity ratios highlight the firm’s short-term ability to meet financial obligations.term ability to meet financial obligations.
• Leverage ratios reflect the company’s long-Leverage ratios reflect the company’s long-term financing decisions, while coverage term financing decisions, while coverage ratios indicate its long-term ability to service ratios indicate its long-term ability to service outstanding debt.outstanding debt.
• Profitability and activity ratios portray the Profitability and activity ratios portray the earnings power of an enterprise and the earnings power of an enterprise and the efficiency with which its resources are used.efficiency with which its resources are used.
3.4 Effect of Inflation on 3.4 Effect of Inflation on Financial Statement Financial Statement
AnalysisAnalysis1)1) Effect on Balance SheetEffect on Balance Sheet
(1) Inflation makes Book and Market Values of (1) Inflation makes Book and Market Values of Asset diverge:Asset diverge:
Asset Value in the Book = Historical CostAsset Value in the Book = Historical Cost Inflation increases the Market Value of Asset – Inflation increases the Market Value of Asset –
the book value is below thi, being understated.the book value is below thi, being understated. For instance, the apparent ROA is For instance, the apparent ROA is
exaggerated. exaggerated.
(2) Real Value of Debt falls with inflation:(2) Real Value of Debt falls with inflation: Inflation decreases the Real Value of debtInflation decreases the Real Value of debt A falling inflation rate, and deflation increases A falling inflation rate, and deflation increases
the Real Value of debtthe Real Value of debt
3.4 Effect of Inflation on 3.4 Effect of Inflation on Financial Statement Financial Statement
AnalysisAnalysis2) Effects on Income Statement2) Effects on Income Statement
Inflation exaggerates the inventory Inflation exaggerates the inventory values, and thus earnings.values, and thus earnings.
Inflation understates the cost of Inflation understates the cost of depreciation.depreciation.
Overall, inflation overstates Overall, inflation overstates earnings.earnings.
3.6 International Considerations3.6 International Considerations When firms hold assets and liabilities When firms hold assets and liabilities
denominated in foreign currencies, the denominated in foreign currencies, the procedure for recognizing the gains or procedure for recognizing the gains or losses resulting from changes in foreign losses resulting from changes in foreign exchange rates becomes important.exchange rates becomes important.