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Financial Statement Analysis Techniques

ANALYSIS AND INTERPRETATION

OF FINANCIAL STATEMENTS

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Who analyzes financial statements?

– Internal users (i.e., management) – External users (emphasis of module)

• Examples: – Investors, creditors, regulatory agencies, – stock market analysts, auditors – Other relevant Stakeholders

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How the Information is Used

• What do internal users use it for? – Planning, evaluating and controlling company

operations • What do external users use it for?

– Assessing past performance and current financial position

– Making predictions about future profitability and solvency of the company

– Evaluating the effectiveness of management

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Methods of Financial Statement Analysis

• Horizontal Analysis (Time Series)

• Vertical Analysis (Cross Sectional)

• Common-Size Statements

• Trend Percentages

• Ratio Analysis

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Trend Analysis – Apple - 2005 2000 2001 2002 2003 2004 Sales Growth - -32.82% 7.07% 8.10% 33.38% Sustainable Growth Rate 19.14% -.64% 1.59% 1.63% 5.44% Liquidity Analysis

Current Ratio 2.81 3.39 3.25 2.50 2.63 Quick Asset Ratio 2.58 3.16 2.96 2.26 2.33 Inventory Turnover 176.27 375.27 91.98 80.34 59.60 Days supply of inventory 2.07 0.97 3.97 4.54 6.12 Accounts Receivable Turnover 8.38 11.51 10.16 8.10 10.70 Days supply of receivables 43.57 31.72 35.92 45.04 34.12 Working Capital Turnover 2.28 1.48 1.54 1.76 1.89

Profitability Analysis

Gross Profit Margin 27.13% 23.03% 27.92% 27.52% 27.29% Operating Expense ratio 20.59% 29.44% 27.62% 27.53% 23.35% Net Profit Margin 9.85% -0.47% 1.13% 1.11% 3.33% Asset Turnover 1.17 0.89 0.91 0.91 1.03 Return on Assets 11.55% -0.42% 1.03% 1.01% 3.43% Return on Equity 19.14% -0.64% 1.59% 1.63% 5.44%

Capital Structure Analysis

Debt to equity ratio 0.66 0.54 0.54 0.61 0.59 Times Interest Earned 53 -2.25 8.9 12.5 128.67 Debt Service Margin 2.89 .584 .28 .95 0

R&D Turnover 4.8% 8.0% 7.8% 7.6% 5.9%

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Cross Sectional Analysis – Apple 2005

Sales Growth Analysis 2001 2002 2003 2004 Apple -32.8% 7.0% 8.1% 33.4% Dell 26.2% -2.3% 13.6% 17.1% HP -7.5% 25.0% 29.0% 9.4% Gateway -35.8% -29.8% -18.4% 7.3% Competitor Avg -5.70% -2.37% 8.07% 11.27%

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

2001 2002 2003 2004

Apple Dell HP Gatew ay Competitor Avg

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Comparative Liquidity – Apple 2005 Current Ratio

2000 2001 2002 2003 2004 Apple 2.81 3.39 3.25 2.50 2.63 Dell 1.00 1.05 1.43 1.48 1.03 HP 1.61 1.48 1.53 1.53 1.51 Gateway 1.25 1.67 2.08 1.85 1.37 Competitor Avg 1.29 1.40 1.68 1.62 1.30

0

0.5

1

1.5

2

2.5

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3.5

4

2000 2001 2002 2003 2004

Apple Dell HP Gatew ay Competitor Avg

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Relative Leverage – Apple 2005 Debt to Equity Ratio

2000 2001 2002 2003 2004 Apple 0.66 0.54 0.54 0.61 0.59 Dell 2.17 1.88 1.43 1.16 2.08 HP .98 .95 1.36 1.39 1.03 Gateway 6.23 1.54 0.86 0.79 0.76 Competitor Avg 3.13 1.46 1.22 1.11 1.29

0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004

Apple Dell HP Gatew ay Competitor Avg

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Functional Aspects of Business Analyzed

• Liquidity Analysis – Assessment whether firm(s) have ability to satisfy

next period’s upcoming obligations – Ratios used:

• Current Ratio = CA/CL – Measurement as to extent the firm has sufficient current

resources exist to satisfy next period’s obligations. Presumes normal operating conditions

• Quick Asset Ratio (“Acid Test”) = (Cash-Like Assets)/CL – Eliminates Inventory, pre-paid expenses, Accruals, ets. – Focuses on “disaster planning” assessment

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Operating Efficiency Analysis (contributes to liquidity)

• Accounts Receivable Turnover (ARTO) – Sales ÷ Accounts Receivable

• Day’s Sales Outstanding (DSO) – 365 ÷ ARTO

• Inventory Turnover (ITO) – CGS ÷ Inventory

• Day’s Supply Inventory (DSI) – 365 ÷ DSI

• Working Capital Turnover (WCTO) – Sales ÷ (CA – CL)

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Operating Efficiency Analysis (continued)

• Cash to Cash Cycle (unlevered) = DSI + DSO

• What to look for: – Trends, outliers, industry structure and segmentation, hints and

indications of consistency with your assessment of KSF’s

• Presentation methods: – Provide both Tables and Graphs

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Profitability Analysis

• Always ask: “Profitability with respect to what?”

• Operational profitability (how is the firm performing?) – Gross Profit Margin (how profitable is basic product?)

– Operating Profit Margin (profitability of daily ops)

– Net Profit Margin (profitability of overall business)

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Profitability Analysis (Asset Returns)

• Measure any return in manner consistent with stock returns (Key)

– Return on Assets (ROA)t (Net Income)t ÷ (Total Assets)t-1

– Asset Turnover (ATO)t (ATO)t = (Sales)t ÷ (Total Assets)t-1

– DuPont Formula for ROA (ROA)t = (ATO)t × (Net Profit Margin)

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Profitability Analysis (Equity Returns)

– Return on Equity (ROE)t (ROE)t = (Net Income)t ÷ (Total Book Value Equity)t-1

(ROE)t = (ROA)t × (1 + (Liabilities ÷ Book Equity)t-1)

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Leverage and Capital Structure Risk

• Debt to Equity Ratio Total Liabilities ÷ Total Book Equity

• Times Interest Earned (TIE): TIE = EBIT ÷ Interest Expense

• Debt Service Margin (DSM)

(DSM)t = CFFOt ÷ (Current Maturities of Interest Bearing Obligations)t-1

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Leverage and Capital Structure Risk

Altman’s Z-Score (Credit Score)

+

+

+

+

=−

Assets TotalSales1.0

sLiabilitie of ValueBook Equity of ValueMarket 0.6

Assets TotalTaxes andInterest Before Earnings3.3

Assets TotalEarnings Retained1.4

Assets TotalCapital Working1.2scoreZ

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Potential Growth Rate Analysis

• Internal Growth Rate (IGR)

(IGR) = (ROA) × (1 - (DPSt ÷ EPSt))

• Sustainable Growth Rate (SGR) (SGR)t = (IGR)t × (1 + (Liabilitiest-1 ÷ BVEt-1))

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Project 2 – Perform Financial Analysis

• For Project 2, your group will need to perform a Financial Analysis of your firm and use competitors as benchmarks – Prepare tables and graphs – Analyze as separate sections: Liquidity and Operating Efficiency;

Profitability; Capital Structure (Leverage); Growth Potential – Write-up must draw specific conclusions and overall

performance conclusion for sections and components. Discuss industry trends, segmentation, and your company’s relative performance.

– Where possible, link ratio analysis write-up back to Project 1 conclusions regarding industry classification and KSF’s