Financial Analysis

(C) 2007 Prentice Hall, Inc.(C) 2007 Prentice Hall, Inc.

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The Analysis of The Analysis of Financial StatementsFinancial StatementsRatios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison

- CEO, R.E.C. Inc.


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Objectives of AnalysisObjectives of Analysis

Remember--the identity of the user helps Remember--the identity of the user helps define what information is needed define what information is needed

Objectives will vary depending on the Objectives will vary depending on the perspective of theperspective of the financial statement userspecific questions that are addressed

by the analysis


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CreditorsCreditors

A creditor is ultimately concerned A creditor is ultimately concerned with the ability of an existing or with the ability of an existing or prospective borrower to make prospective borrower to make interest and principal payments interest and principal payments on borrowed funds on borrowed funds


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InvestorsInvestors

An investor attempts to arrive at an An investor attempts to arrive at an estimation of a company’s future estimation of a company’s future earnings stream in order to earnings stream in order to attach a value to the securities attach a value to the securities being considered for purchase or being considered for purchase or liquidation liquidation


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Tools and TechniquesTools and Techniques

Common-size financial statementsCommon-size financial statements

Financial ratiosFinancial ratios

Trend analysisTrend analysis

Industry comparisonsIndustry comparisons

These include:These include:

Most important:Most important:Common sense and judgment


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Common-Size Common-Size Financial StatementsFinancial Statements

Express each account on the Express each account on the balance sheetbalance sheet as a percentage as a percentage

of total assets of total assets income statementincome statement as a as a

percentage of net sales percentage of net sales


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Key Financial RatiosKey Financial Ratios

Standardize financial data in terms Standardize financial data in terms of mathematical relationships of mathematical relationships expressed in the form of expressed in the form of

PercentagesPercentages

TimesTimes

DaysDays


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Key Financial RatiosKey Financial Ratios (cont.)(cont.)

Liquidity (Short-term liquidity)Liquidity (Short-term liquidity) ActivityActivity Leverage (Long-term solvency) Leverage (Long-term solvency) ProfitabilityProfitability MarketMarket


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency

Measures ability to meet short-Measures ability to meet short-term cash needs term cash needs

Current RatioCurrent Ratio

Current assetsCurrent assets

Current liabilitiesCurrent liabilities


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency (cont.) (cont.)

Measures ability to meet short-term cash needs Measures ability to meet short-term cash needs

more rigorously by eliminating inventorymore rigorously by eliminating inventory

Quick or Acid-Test Ratio

Current assets - InventoryCurrent assets - Inventory


(Cash+short-term investments + A/R)

current liabilities


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency (cont.) (cont.)

Focuses on ability of the firm to Focuses on ability of the firm to generate operating cash flows generate operating cash flows as a source of liquidityas a source of liquidity

Cash Flow Liquidity Ratio

*Cash flow from operating

activities

Cash + Marketable securities + Cash + Marketable securities + CFO *CFO *



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Liquidity RatiosLiquidity Ratios

Short term liquidity 2007 2006 2005 2004 2003Current Ratio 1,13 1,18 1,43 2,04 1,65 Quick Ratio 0,48 0,52 0,68 0,86 0,40 Cash Flow Liquidity 0,76 0,57 1,21 1,61 0,92


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Liquidity, Asset Management EfficiencyManagement Efficiency

Another measure of efficiency of firm’s Another measure of efficiency of firm’s collection and credit policiescollection and credit policies

Accounts Receivable TurnoverAccounts Receivable Turnover

net s,receivable tradeAverage

net sales,Credit

turnoverreceivable

365


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.)(cont.)

Another measure of firm’s efficiency Another measure of firm’s efficiency in managing its inventoryin managing its inventory

Inventory Turnover

sinventorie average

sold goods ofCost

turnoverinventory

365


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.) (cont.)

Another way to gain insight into a firm’s Another way to gain insight into a firm’s pattern of payment to supplierspattern of payment to suppliers

Payables Turnover

payables tradeAverage

sinventoriein COGS

turnoverpayable

365


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Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle

Buying or manufacturing Buying or manufacturing inventory, with some purchases inventory, with some purchases on crediton credit

Selling inventory, with some sales Selling inventory, with some sales on crediton credit

Collecting the cash Collecting the cash

The normal cycle of a firm that The normal cycle of a firm that consists of:consists of:


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Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle (cont.)(cont.)

Key balance sheet accounts that affect Key balance sheet accounts that affect cash flow from operating activitiescash flow from operating activities

Accounts ReceivableAccounts Receivable InventoryInventory Accounts PayableAccounts Payable

Helps the analyst understand why Helps the analyst understand why cash cash flow generation has flow generation has improved or improved or deteriorated by deteriorated by analyzing:analyzing:


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Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle (cont.)(cont.)

Average collection periodAverage collection periodPlusPlus

Days inventory heldDays inventory heldMinusMinus

Days payable outstandingDays payable outstandingEqualsEquals

Cash conversion or net trade cycleCash conversion or net trade cycle

Calculated as follows:Calculated as follows:


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.)(cont.)

Assesses effectiveness in generating Assesses effectiveness in generating sales from investments in fixed sales from investments in fixed assetsassets

Fixed Asset Turnover

Net salesNet sales

Net property, plant, equipmentNet property, plant, equipment(Average)(Average)


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.) (cont.)

Assesses effectiveness in generating sales Assesses effectiveness in generating sales from investments in all assetsfrom investments in all assets

Total Asset Turnover

Net salesNet sales

Total assetsTotal assets(Average)(Average)


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Activity RatiosActivity Ratios- - SummarySummaryReceivable Turnover Net Sales/Average Trade ReceivablesInventory Turnover COGS/Average InventoriesPayable Turnover Purchases/Average Trade PayablesFixed Asset Turnover Net Sales/Average PP&ETotal Asset Turnover Net Sales/Average Total Assets

Average collection period 365/receivable turnover Average days in inventory 365/inverntory turnoverAvergae payment period 365/payable turnover

Net Trade Period collection period + days in inventory -


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Activity RatiosActivity Ratios- - SummarySummary

Activity Ratios 2007 2006 2005 2004Receivable Turnover 10,62 10,67 11,40 15,55 Inventory Turnover 4,84 4,98 6,08 6,57 Payable Turnover 17,75 14,21 13,90 25,24 PPE Turnover 1,13 0,96 0,91 0,98 Asset Turnover 0,71 0,60 0,58 0,63

Collection Period 34,37 34,21 32,00 23,47 Days in inventory 75,48 73,33 59,99 55,52 Payment period 20,57 25,68 26,26 14,46

Cash cycle 89,29 81,86 65,74 64,54


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Leverage Ratios: Leverage Ratios: Debt Financing and Debt Financing and CoverageCoverage

Considers the proportion of all assets Considers the proportion of all assets that are financed with debtthat are financed with debt

Debt Ratio

Total liabilitiesTotal liabilities

Total assetsTotal assets


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Leverage Ratios: Leverage Ratios: Debt Financing and Coverage Debt Financing and Coverage (cont.) (cont.)

Reveals the extent to which long-Reveals the extent to which long-term debt is used for the firm’s term debt is used for the firm’s permanent financing (both permanent financing (both long-term debt and equity)long-term debt and equity)

Long-term Debt to Total Capitalization

Long–term debtLong–term debt

Long-term debt + Stockholders’ Long-term debt + Stockholders’ equityequity


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage

(cont.)(cont.)

Measures the riskiness of the firm’s Measures the riskiness of the firm’s capital structure in terms of the capital structure in terms of the relationship between the funds relationship between the funds supplied by creditors (debt) and supplied by creditors (debt) and investors (equity)investors (equity)

Debt to Equity

Total liabilitiesTotal liabilities

Stockholders’ equityStockholders’ equity


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(cont.)(cont.)

Indicates how well operating earnings Indicates how well operating earnings cover fixed interest expensescover fixed interest expenses

Times Interest Earned

Operating profitOperating profit

Interest expenseInterest expense


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(cont.)(cont.)

Measures how many times interest Measures how many times interest payments can be covered by payments can be covered by cash flow from operations cash flow from operations before interest and taxesbefore interest and taxes

Cash Interest Coverage

CFO + interest paid + taxes paidCFO + interest paid + taxes paid

Interest paidInterest paid


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(cont.)(cont.)

Broader measure of how well operating Broader measure of how well operating earnings cover fixed chargesearnings cover fixed charges

Fixed Charge Coverage

*Rent expense = operating lease payments

Operating profit + Rent expenseOperating profit + Rent expense

Interest expense + Rent expenseInterest expense + Rent expense


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage (cont.)(cont.)

Measures firm’s ability to cover capital Measures firm’s ability to cover capital expenditures, long-term debt expenditures, long-term debt payments and dividends each yearpayments and dividends each year

Cash Flow Adequacy

Cash flow from operating activitiesCash flow from operating activities

Capital expenditures + debt Capital expenditures + debt repayments + dividends paidrepayments + dividends paid


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Leverage Ratios: Debt Financing Leverage Ratios: Debt Financing and Coverage Summaryand Coverage Summary

Solvency RatiosDebt Ratio Total liabilities/Total assets LT Debt to CapitalDebt to equity Total liabilities/Total equity Times interest earned Oper. Income/Interest expense Cash interest coverage CFO + interest paid + tax paid)/Interest paid

Long-term Liquidity 2007 2006 2005 2004Debt ratio 0,43 0,43 0,38 0,29 L/T Debt to Capitalization 0,28 0,29 0,26 0,19 debt to equity 0,86 0,83 0,67 0,43 Times interest earned 4,79 3,84 11,57 8,63


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Profitability Ratios: Profitability Ratios: Overall Efficiency and Overall Efficiency and PerformancePerformance

Measures ability to translate sales Measures ability to translate sales into profit after consideration of into profit after consideration of cost of products soldcost of products sold

Gross Profit Margin

Gross profitGross profit

Net salesNet sales


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Profitability Ratios: Profitability Ratios: Overall Efficiency and PerformanceOverall Efficiency and Performance (cont.)(cont.)

Measures ability to translate sales Measures ability to translate sales into profit after consideration of into profit after consideration of operating expensesoperating expenses

Operating Profit Margin

Operating profitOperating profit

Net salesNet sales


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Measures ability to translate sales Measures ability to translate sales into profit after consideration into profit after consideration of all expenses and revenues, of all expenses and revenues, including interest, taxes and including interest, taxes and nonoperating itemsnonoperating items

Net Profit Margin

Net earningsNet earnings

Net salesNet sales


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Measures ability to translate sales into Measures ability to translate sales into cash (with which to pay bills!)cash (with which to pay bills!)

Cash Flow Margin

Cash flow from operating Cash flow from operating activitiesactivities

Net salesNet sales


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Measures rate of return on Measures rate of return on stockholders’ investmentstockholders’ investment

Return on Equity (ROE)


Stockholders’ equityStockholders’ equity(Average)


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Measures overall efficiency of firm Measures overall efficiency of firm in managing investment in in managing investment in assets and generating profitsassets and generating profits

Return on Total Assets (ROA) or Return on Investment (ROI)


Total assetsTotal assets(Average)


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Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System

Is helpful to complete the evaluation of Is helpful to complete the evaluation of a firm by considering the a firm by considering the interrelationship among the individual interrelationship among the individual ratios ratios The Du Pont System helps the analyst The Du Pont System helps the analyst see how the firm’s decisions and see how the firm’s decisions and activities over the course of an activities over the course of an accounting period interact to produce accounting period interact to produce an overall return to the firm’s an overall return to the firm’s

shareholders, the return on equityshareholders, the return on equity


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Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System

(cont.)(cont.)The summary ratios used are the following:

(1)Net profit margin

(2)Total asset turnover

(3)Return on investment

(3)Return on investment

(4)Financial leverage

(5)Return on equity

Net income Net sales Net incomeNet income Net sales Net income

Net sales X Total assets = Total assetsNet sales X Total assets = Total assets

Net income Total assets Net Net income Total assets Net incomeincome

Total assets X Stockholder equity = Stockholder Total assets X Stockholder equity = Stockholder equityequity


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Measures firm’s ability to generate Measures firm’s ability to generate cash from the utilization of its cash from the utilization of its assetsassets

Useful comparison to ROAUseful comparison to ROA

Cash Return on Assets

Cash flow from operating Cash flow from operating activitiesactivities

Total assetsTotal assets(Average)


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Profitability Ratios-SummaryProfitability Ratios-Summary

Profitability RatiosGross Margin Gross profit/Sales revenue Operating Margin Operating Income/Sales revenueNet Profit Margin Net Income/Sales RevenueReturn on Assets Net income/Average total assets Return on Equity Net income/Average total equity Cash Return on Assets CFO/Average total assets


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Profitability Ratios-SummaryProfitability Ratios-Summary

Profitability 2007 2006 2005 2004Gross margin % 27,36% 27,14% 27,80% 30,83%Operating Margin 15,18% 10,99% 15,78% 18,61%Net Profit Margin 7,91% 5,45% 9,98% 12,61%ROA = 5,60% 3,25% 5,76% 7,94%ROE = 10,99% 5,99% 9,37% 11,96%Cash Return on Assets 14,15% 7,63% 16,58%


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Market RatiosMarket Ratios

1.1. Earnings per common shareEarnings per common share2.2. Price-to-earningsPrice-to-earnings3.3. Dividend payoutDividend payout4.4. Dividend yieldDividend yield

Four market ratios of particular interest to the investor are


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Market RatiosMarket Ratios (cont.) (cont.)

Provides the investor with a Provides the investor with a common denominator to common denominator to gauge investment returnsgauge investment returns

Earnings per Common Share


Average shares outstandingAverage shares outstanding


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Relates earnings per common share to the Relates earnings per common share to the market price at which the stock trades, market price at which the stock trades, expressing the “multiple” that the stock expressing the “multiple” that the stock market places on a firm’s earningsmarket places on a firm’s earnings

Price-to-Earnings

Market price of common stockMarket price of common stock

Earnings per shareEarnings per share


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Determined by the formula cash Determined by the formula cash dividends per share divided by dividends per share divided by earnings per shareearnings per share

Dividend Payout

Dividends per shareDividends per share

Earnings per shareEarnings per share


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Shows the relationship between cash Shows the relationship between cash dividends and market pricedividends and market price

Dividend Yield

Dividends per shareDividends per share

Market price of common stockMarket price of common stock


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Market RatiosMarket Ratios

Market Ratios 2007 2006 2005 2004Price earnings ratio 12,73 46,67 16,93 11,16price to book value 1,35 1,34 1,49 1,28

Financial AnalysisFinancial Analysis

Credit AnalysisCredit Analysis Equity AnalysisEquity Analysis


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CreditorsCreditors

What is the borrowing cause?What is the borrowing cause? What is the firm’s capital What is the firm’s capital

structure?structure? What will be the source of debt What will be the source of debt

repayment?repayment?


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Credit RatingCredit Rating Business RiskBusiness Risk

Industry characteristicsIndustry characteristics Company positionCompany position ManagementManagement

Financial RiskFinancial Risk Financial characteristicsFinancial characteristics Financial PolicyFinancial Policy ProfitabilityProfitability Capital StructureCapital Structure Cash Flow ProtectionCash Flow Protection Financial flexibilityFinancial flexibility


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Standard & Poor’s rating Standard & Poor’s rating methodmethod

1.1. EBIT interest coverageEBIT interest coverage

2.2. EBITDA interest coverageEBITDA interest coverage

3.3. Funds from operations/Total debt %Funds from operations/Total debt %

4.4. Free operating cash flow/Total debt %Free operating cash flow/Total debt %

5.5. Return on capital %Return on capital %

6.6. Operating income/SalesOperating income/Sales

7.7. Long-term debt/CapitalLong-term debt/Capital

8.8. Total debt/CapitalTotal debt/Capital


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Standard and Poors Standard and Poors Corporate RatingsCorporate Ratings


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Financial distressFinancial distress

The deterioration in a The deterioration in a company’s financial condition company’s financial condition such that its ability to repay such that its ability to repay debt is impaireddebt is impaired


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Prediction of financial Prediction of financial distressdistressUnivariate modelsUnivariate models

Beaver (1966) relied onBeaver (1966) relied on Cash flow to total debtCash flow to total debt Net income to total assetsNet income to total assets Total debt to total assetsTotal debt to total assets Working capital to total assetsWorking capital to total assets Current ratioCurrent ratio No-credit (defensive) intervalNo-credit (defensive) interval


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Prediction of financial Prediction of financial distressdistressMultivariate modelsMultivariate models

Altman Z-scoreAltman Z-score (Current assets – current liabilities)/total (Current assets – current liabilities)/total

assets (weightassets (weight-1,2-1,2)) Retained earnings/Total assets (weightRetained earnings/Total assets (weight--

1,1,4)4) EBIT/Total assets (weightEBIT/Total assets (weight--33,,3)3) Preferred and common stock market Preferred and common stock market

value/Book value of liabilities (weightvalue/Book value of liabilities (weight--00,,6)6) Sales/Total assets (weightSales/Total assets (weight-1,-1,0)0)


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Altman Z-scoreAltman Z-score

Z> 2,99 Z> 2,99 Not in financial Not in financial distressdistress

Z< 1,81 Z< 1,81 In financial stressIn financial stress 2,99>Z>1,81 2,99>Z>1,81 UncertainUncertain


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Altman Z score Altman Z score Anadolu Anadolu CamCam

Altman Z-score 2006 2005 2004Ratio 1 0,04 0,08 0,14 Ratio 2 0,11 0,12 0,10 Ratio 3 0,04 0,07 0,12 Ratio 4 1,60 2,27 2,97 Ratio 5 0,55 0,51 0,61 Altman Z-score 1,85 2,36 3,08

A. Cam


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Additional considerationsAdditional considerations

Mezzanine itemsMezzanine items Could be debt or equityCould be debt or equity

Off-balance-sheet liabilitiesOff-balance-sheet liabilities Operating leasesOperating leases Contingent liabilitiesContingent liabilities Environmental liabilitiesEnvironmental liabilities


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Equity AnalysisEquity Analysis

Buy-sideBuy-side Work for an institutional investors (mutual Work for an institutional investors (mutual

fund)fund) Make internal recommendations regarding Make internal recommendations regarding

the purchase of equity securitiesthe purchase of equity securities Might review reports of sell-side analystsMight review reports of sell-side analysts

Sell-sideSell-side Work for brokerage firmsWork for brokerage firms Issue reports for retail and institutional Issue reports for retail and institutional

customerscustomers


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ValuationValuation

Current value Current value VV00 is a function ofis a function of Present value of next year’s cash Present value of next year’s cash

flow, flow, CFCF11

Required rate of return, Required rate of return, rr Expected constant growth rate, Expected constant growth rate, gg

10

CFV

r g


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Equity AnalysisEquity Analysis

Provides information regardingProvides information regarding1.1. The future cash flow generating The future cash flow generating

ability of the firmability of the firm2.2. The growth (or lack thereof) of The growth (or lack thereof) of

those cash flowsthose cash flows3.3. The risk of those cash flows, andThe risk of those cash flows, and4.4. The risk-free rate commanded The risk-free rate commanded

by the marketby the market


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Top-Down AnalysisTop-Down Analysis

Begin at highest (economy) Begin at highest (economy) levellevel

Allocation between domestic and Allocation between domestic and international equitiesinternational equities

Market sectorsMarket sectors Industries (within a sector)Industries (within a sector) End with evaluation of specific End with evaluation of specific

companiescompanies


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Bottom-Up AnalysisBottom-Up Analysis

Begin with individual Begin with individual companiescompanies

Look for key strengthsLook for key strengths

Screen large data bases for Screen large data bases for attractive characteristicsattractive characteristics

Compustat, Bloomberg, BaselineCompustat, Bloomberg, Baseline

Search for a combination of Search for a combination of characteristicscharacteristics


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Five Steps of a Financial Five Steps of a Financial Statement AnalysisStatement Analysis

Who are you and why are you Who are you and why are you interested in this company?interested in this company?

What questions would you like to What questions would you like to have answered?have answered?

What info is vital to the decision at What info is vital to the decision at hand? hand?

Establish objectives of the analysis

Step 1


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Five Steps of a Financial Five Steps of a Financial Statement AnalysisStatement Analysis (cont.)(cont.)

Study the industry in which the firm Study the industry in which the firm operates and relate industry operates and relate industry climate to current and projected climate to current and projected economic developments economic developments

Step 2Step 2


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How well does this firm appear to be run?How well does this firm appear to be run? Are they taking advantage of Are they taking advantage of

opportunities?opportunities? Are they innovative, forward-looking, etc?Are they innovative, forward-looking, etc?

Step 3

Develop knowledge of the firm and the quality of management


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Common-size financial statementsCommon-size financial statements Key financial ratiosKey financial ratios Trend analysisTrend analysis Comparison with industry competitorsComparison with industry competitors

Step 4

Evaluate financial statements–tools include:


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Short-term liquidityShort-term liquidity Operating efficiencyOperating efficiency Capital structure and long-term Capital structure and long-term

solvencysolvency ProfitabilityProfitability Market ratiosMarket ratios Segmental analysis (when relevant)Segmental analysis (when relevant)

Step 4 Evaluate financial statements–areas include:


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Reach conclusions about the Reach conclusions about the firm relevant to your firm relevant to your established objectives established objectives

Step 5

Summarize findings based on analysis


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Financial StatementsFinancial StatementsAn OverviewAn OverviewMap

Financial Analysis

Economy & Finance

Transcript of Financial Analysis