ACCT 610_Study Guide_part 2_Financial Statement Analysis_SV

2. Analysis of Financial Statements:

2) Financial Statement Analysis procedure：
– Horizontal and Vertical Analysis
– Ratio Analysis
– Dupont Analysis (A comprehensive analysis)
– Cash is King (Free cash flow and Cash conversion Cycle)

Ratio Analysis
1) Profitability—effective way to measure various levels of profits relative to _____________(using
Income statement)
a. Gross Margin = gross profit /net sales = _________________________________________
----Gross margin indicates _______________________
----hard to manipulate
----higher gross margin means a firm derives __________ (more/less) from a sale than that with
lower gross margin
---Exceptional measure of a company’s profitability at the ________ (highest/lowest) level.
An Example: Supermarket industry vs. High-tech companies
Note taking:

b. Operating Margin = Operating Income/net sales

Operating Income = ______________________________________________
(Think: What composes operating expenses? –
—answers question: ________________________________________________?).

An Example: Software industry is typically characterized by very _______ (high/low) gross margins
(because its ________________ tends to be very low. In software, however, there are much _________
(higher/lower) operating expenses, which usually involves a significant amount of research and
development. R&D tend to be a large part of a software company’s expenses structure,

c. Profit margin = Net income/net sales = (Operating income-interest expense-tax)/net sales

2) Return Analysis (An analysis of return to investment, sometimes considered as part of profitability
analysis—use both income statement & B/S)
a. Return on Assets = ___________________
b. Return on Equity (ROE) = ________________________—Represents profit generated per dollar of
shareholder’s investment.

3) Liquidity and Solvency

---Liquidity shows whether a company has sufficient liquid resources to cover its ____________
obligations. (This is something of particular interest to most ______________ that often base their
determination of a company’s creditworthiness on these ratios).
a. Current Ratio = _____________________
A ratio less than ______ indicates a big problem—not sufficient resources to cover its near-term
obligation. (What can the company do to improve its current ratio? –either
_________________________. However, issuing more short-term debt would leave the company
in a similarly weak position.
b. Quick ratio = _________________________________________________
(Primary difference between current ratio and quick ratio is that quick ratio excludes ________ as
___________ is often seen as not truly liquid.
c. Cash ratio = __________________________________
Here, both inventory and AR are excluded as both are problematic in converting into cash.
-----Long-term Solvency Analysis (leverage): useful in determining if the company is optimally
capitalized, i.e. optimal use of ___________)
a. Debt ratio (or debt-to-asset ratio) = ___________________
Answer the question: Compared to industry average, is the company _________ or
____________?
b. Debt-to-Equity ratio = __________________(a simple variation on the debt ratio).
c. Times interest earned ratio (also referred to as interest coverage ratio) = _______________
(Measures a company’s ability to pay interest—whether a firm has sufficient income to cover necessary
interest payments on debt outstanding).

4) Activity Analysis (Efficiency)

a. Accounts Receivable turnover days = 365/(credit sales/average accounts receivable)
---How long it takes the firm to collect cash from customers on account.
---the longer the AR remain outstanding, the more costly they become----why?
--must be compared with industry average (same for other turnover days)
b. Inventory turnover days = 365/(Cost of Goods sold/average inventory)
---measures how long it takes the firm to convert the inventory to sale.
---inventory is costly, why?
--the sooner the inventory turns, the better. (A good example:
c. Accounts payable turnover days = 365/(purchases/average accounts payable)
 Purchases = cost of goods sold + (Ending inventory-Beginning Inventory)
---How long it takes the company to pay off its outstanding payables.
---The longer the firm has to turn over its payables, the better off it is—However, if the number is
excessive, this might also suggests liquidity problem.
d. Cash conversion cycle = AR days + Inventory days- AP days

5) Valuation Analysis (related to price)

a. Price-to Earnings ratio (P/E) = (price per share)/(earnings per share)
----used to gauge the company’s relative value (ie. Probably ________ (overvalued/undervalued) if
company’s PE< industry PE)
---Calculate PE if: price of a stock: $33/share. Net income = $121,000, total shares outstanding: 110,000
(PE = _______, Industry PE = 25, Market average PE (Nasdaq) = 23, what does that mean? What do
investors pay higher than average price to purchase this company’s stock?)
---be aware that Earnings Per Share (EPS) can be manipulated.
---be aware that P/E ratio keeps changing (with the performance of the company).
--a related ratio: PEG ratio.
b. Price-to-book ratio = market price per share/book price per share
---book price: book value or owners equity on the balance sheet.
---a price-to-book ratio closer to _______ is usually considered as a buying opportunity.

Dupont Analysis (A comprehensive analysis—links performance with management ability)

(the above ratio analysis suggest that a company can do well by:
(1) _______________________________ (Profitability)
(2) ________________________________ (Efficiency)
(3) _______________________________ (Leverage ratio).
Question: Is there a ratio that combines/considers all these factors?
Yes! This Ratio is: _________________________ = Net Income/Owners equity
=

=
=
---Answers: Is the business doing better/worse (does a dollar from investor get more or less profit) and
why/what causes the firm doing better/worse)?
For Company ABC, Dupont Analysis shows that:

ABC Company Net Profit Asset

Financial
Margin: Net Turnover: ROE
Leverage: Total
Income /Total Sales/Total
Assets/Total
Sales Revenue Assets
2012 N/A 1.75 2.4 N/A
2013 0.066 1.65 1.68 18.3%
2014 20%
0.066 1.3 2.33
(assumed)

---Can be used to compare two companies:

Net Profit Asset

Margin Turnover Leverage ROE
C-123 0.02 5 1.3 0.13
C-890 0.2 0.5 1.3 0.13
---A note on ROE analysis (How interest rates affect ROE: how much debt/leverage is appropriate?)

Zerodebt HalfDebt
Total Asset 1,000,000 1,000,000
Total Equity 1,000,000 500,000
Total liability 0 500,000
EBIT 120,000 120,000
EBIT/total asset (ROA) 12% 12%
Scenario 1: borrow at 10% annual rate
EBIT 120,000 120,000
interest expense 0 50,000
EBT (earnings before Tax) 120,000 70,000
Tax expense
(40%) 48,000 28,000
Net Income 72,000 42,000
Total Equity 1,000,000 500,000
ROE 7.20% 8.40%
Scenario 2: borrow at 15% annual rate
EBIT 120,000 120,000
interest expense 0 75,000
EBT (earnings before Tax) 120,000 45,000
Tax expense
(40%) 48,000 18,000
Net Income 72,000 27,000
Total Equity 1,000,000 500,000
ROE 7.20% 5.40%
 (Source: Merton “Finance”)
Conclusion:

Cash Flow Analysis:

--Cash flow statement tells us the changes in cash flow and sources of these changes.
--Cash flow avoids the accrual accounting in recognizing revenue and expenses. (Why Cash flow from
operations differs from Net income from income statement)?