Overview of Financial Analysis

o SPECIFY THE OBJECTIVES OF THE ANALYSIS

o Focus on who is the financial statement user

o The identity of the user helps define what information is needed

Financial

The company’s return on equity

has dipped considerably over

the last period

I had better

sell that stock ASAP!

Steps of a F/S Analysis1. Establish objectives of the analysis2. Study the industry and relate industry

climate to current and projected economic developments -

o a growth industry? o a dying industry? o a changing industry?

3. Develop knowledge of firm and quality of management

4. Evaluate financial statements using basic tools

5. Summarize findings6. Reach conclusions relevant to established

objectives

Potential Financial Statement Users:

oCreditorso InvestorsoManagersoWho else?

oWhat types of questions do each of these users seek answers to?

Data sourceso Financial statements (and notes)o Auditor’s reporto MD&Ao Supplementary scheduleso 10K and 10Q reports filed with SECo Computerized data bases

o Info on industry norms/ratioso Info on particular

companies/industries/mutual funds

o Articles in popular/business press o Websites

Tools for analysiso Common size financial

statementso Financial ratioso Trend analysiso Structural analysiso Industry comparisonso Common sense and

judgment

Financial Ratio Categories

o Liquidity Ratiosmeasure a firm’s ability to meet

cash needs as they arise

o Activity Ratiosmeasure the liquidity of specific

assets and the efficiency of managing assets

Ratio Categories (continued)

o Leverage Ratiosmeasure the extent of a firm’s

financing with debt relative to equity and its ability to cover interest and other fixed charges

o Profitability Ratiosmeasure the overall performance of a

firm and its efficiency in managing assets, liabilities and equity

Caution!o Ratios are valuable, BUT…..

o They do not provide answers in an of themselves and are not predictive

o They should be used with other elements of financial analysis

o There are no “rules of thumb” that apply to interpretation of ratios

Profitability Ratioso Gross Profit Margin

Gross Profit/Net Saleso Operating Profit Margin

Operating Profit/Net Saleso Net Profit Margin

Net Earnings/Net Saleso All measure firm’s ability to translate

sales dollars into profits

Profitability Ratios (continued)

o Return on Investment (or Return on Assets)Net Earnings/Total Assets

o Return on EquityNet Earnings/Stockholders’ Equity

o Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders

2005 KD Hatheway-Dial

Average Operating Average Operating AssetsAssets

Net Operating Net Operating IncomeIncome==

Return on Investment

ROROII

o Return on Investment (ROI)

o Net operating incomeo Income before interest and

taxeso Operating assets

oAssets held for operating purposes ONLY

o i.e. cash, accounts receivable, inventory, plant and equipment

Understanding ROI

2005 KD Hatheway-Dial

ROROII

== MargiMarginn

XX TurnovTurnoverer

==Operating Operating

MarginMargin

==TurnovTurnoverer

Net Operating Net Operating IncomeIncome

SalesSales

SalesSales

Average Operating Average Operating AssetsAssets

Understanding ROI

2005 KD Hatheway-Dial

12.512.5%%

== XX 2.52.5

==5%5%

==2.2.55

$10,000$10,000

$80,000$80,000$200,000$200,000

$200,000$200,000XX 1010

00

55%%

APPLYING ROI

2005 KD Hatheway-Dial

23.2523.25%%

== 8.4548.45455

XX 2.752.75

==8.4548.45455

==2.752.75

$18,600$18,600

$80,000$80,000$220,000$220,000

$220,000$220,000

10% Increased Sales without Any Increase in Operating Assets (assume 6% increase in operating expenses)

XX 101000

86% increase with 10% increase in sales

APPLYING ROI

2005 KD Hatheway-Dial

36.2536.25%%

== 14.5%14.5% XX 2.502.50

==14.5%14.5%

==2.502.50

$29,000$29,000

$80,000$80,000$200,000$200,000

$200,000$200,000

10% Decrease in operating expenses and no change in sales

XX 101000

190% increase with 10% decrease in operating expenses

APPLYING ROI

2005 KD Hatheway-Dial

13.9013.90%%

== 5.0%5.0% XX 2.782.78

==5.0%5.0%

==2.782.78

$10,000$10,000

$72,000$72,000$200,000$200,000

$200,000$200,000

10% Decrease in operating assets and no change in sales or operating expenses

XX 101000

11.2% increase with 10% decrease in operating assets

APPLYING ROI

2005 KD Hatheway-Dial

16.2516.25%%

== 6.8%6.8% XX 2.392.39

==6.86.8%%

==2.392.39

$14,300$14,300

$88,000$88,000$210,000$210,000

$210,000$210,000

10% increase in operating assets and 5% change in sales and 3% operating expenses

XX 101000

30% increase with 10% decrease in operating assets

Profitability Ratios (continued)

o Cash Flow MarginCash Flow from Operating

Activities /Net SalesMeasures ability to translate

sales into cash (with which to pay bills)

Profitability Ratios (continued)

o Cash Return on AssetsCash Flow from Operating

Activities /Total Assets

Useful comparison to return on investment

Indicates firm’s ability to generate cash from utilizing its assets

Liquidity Ratioso Current Ratio

Current Assets/Current LiabilitiesMeasures ability to meet short-term cash

needs

o Quick or Acid Test RatioCurrent Assets-Inventory/Current LiabilitiesMeasure ability to meet short-term cash

needs more rigorously

o Cash Flow Liquidity RatioCash+Marketable Securities+Cash Flow from

Operating Activities/Current LiabilitiesFocuses on ability of the firm to generate

operating cash flows as a source of liquidity

Activity Ratioso Average Collection Period

Accounts Receivable/Average Daily Sales

Helps gauge liquidity of accounts receivable (ability to collect cash from customers)

o Accounts Receivable TurnoverNet Sales/Accounts ReceivableAnother measure of efficiency of

firm’s collection and credit policies

Activity Ratios (continued)

o Inventory TurnoverCost of Goods Sold/InventoryMeasures efficiency of inventory

managemento Fixed Asset and Total Asset

TurnoverNet Sales/Net PP&E (Fixed Asset

T/O)Net Sales/Total Assets (Total

Asset T/O)Both assess effectiveness in

generating sales from investment in assets

Leverage: Debt Ratioso Debt Ratio

Total Liabilities/Total Assets

o Long-Term Debt to Total CapitalizationLong-term Debt/Long-term Debt +

Stockholders’ Equity

o Debt to Equity RatioTotal Liabilities/Stockholders’ Equity

o All three measure extent of firm’s financing with debt

Leverage: Coverage Ratios

o Proportion and amount of debt in capital structure is important to analyst

o Tradeoff between risk and return

o Use of debt involves risk -- commitment to fixed charges

o Fixed charges must be COVERED -- following are some ratios to assess coverage

Coverage Ratios (continued)

o Times Interest EarnedOperating Profit/Interest

ExpenseIndicates how well operating

earnings cover fixed interest charges

o Fixed Charge CoverageOperating Profit + Lease

Payments/Interest Expense + Lease Payments

Broader measure of how well operating earnings cover fixed charges

Coverage Ratios (continued)

o Cash Flow AdequacyCash Flow from Operating

Activities/ Average Annual Long-Term Debt Maturities

Measures firm’s 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

Other Ratioso Earnings per Common Share

Net Earnings/Average Common Shares Outstanding

Indicates return on a per share basis

o Price to EarningsMarket Price of Common

Stock/Earnings per Common ShareExpresses a multiple the stock market

places on earnings

Other Ratios (continued)o Dividend Payout

Dividends per Share/Earnings per Share

Shows percentage of earnings paid out to stockholders

o Dividend YieldDividends per Share/Market

Price of Common ShareShows rate earned by

shareholders from dividends relative to current stock price