Chapter 10 - Frank Reily - Investment Analysis

Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 10
Chapter 10
Analysis of Financial Statements
Questions to be answered:
What are the major financial statements
provided by firms and what specific
information does each of them contain?
Why do we use financial ratios to examine the
performance of a firm and why is it important
to examine performance relative to the
economy and a firms industry?
Chapter 10
What are the major categories for financial
ratios and what questions are answered by the
ratios in these categories?
What specific ratios help determine a firms
internal liquidity, operating performance, risk
profile, growth potential, and external
liquidity?
How can the DuPont analysis help evaluate a
firms return on equity over time?
Chapter 10
What are some of the major differences
between U.S. and non-U.S. financial
statements and how do these differences affect
the financial ratios?
What is a quality balance sheet or income
statement?
Why is financial statement analysis done if
markets are efficient and forward-looking?
Chapter 10
What major financial ratios help analysts in
the following areas: stock valuation,
estimating and evaluating systematic risk,
predicting the credit ratings on bonds, and
predicting bankruptcy?
Major Financial Statements
Corporate shareholder annual and quarterly
reports must include
Balance sheet
Income statement
Statement of cash flows
Reports filed with Securities and Exchange
Commission (SEC)
Generally Accepted Accounting
Principles (GAAP)
Formulated by the Financial Accounting
Standards Board (FASB)
Provides some choices of accounting
principles
Financial statements footnotes must
disclose which accounting principles are
used by the firm
Balance Sheet
Shows resources (assets) of the firm and
how it has financed these resources
Indicates current and fixed assets available
at a point in time
Financing is indicated by its mixture of
current liabilities, long-term liabilities, and
owners equity
Income Statement
Contains information on the profitability of
the firm during some period of time
Indicates the flow of sales, expenses, and
earnings during the time period
Statement of Cash Flows
Integrates the information on the balance
sheet and income statement

Shows the effects on the firms cash flow of
income flows and changes in various items
on the balance sheet

Statement of Cash Flows
It has three sections:
Cash Flow from Operating Activities the
sources and uses of cash that arise from the
normal operations of a firm
Cash Flow from Investing activities change in
gross plant and equipment plus the change in
the investment account
Cash Flow from Financing activities financing
sources minus financing uses

Cash flow statement (Indirect Method)
Net Income: xx
Add: All non cash Expenses xx
Change in operating activities xx
Change in investing activities xx
Change in financing activities xx
Cash flow during the year xx
Add cash at the beginning xx
Cash flow at the end of the period xx

Problem Cash flow statement (Indirect Method)
ABC Company Balance Sheet for year ended

Assets 2004 2003
Cash 25,000 20,000
N/R 20,000 25,000
MKT Sec 35,000 30,000
A/R 15,000 10,000
Inventory 20,000 30,000
Prepaid Rent 10,000 15,000
Office Supplies 3,000 2,000
Fixed Asset 100,000 100,000
Acc Depr (40,000) (20,000)
Total Assets 188,000 212,000
Liabilities and Equity
A/P 10,000 20,000
N/P 13,000 7,000
ST Loan 10,000 30,000
LT Loan 30,000 35,000
CS 100,000 100,000
RE 25,000 20,000
Total liabilities and Equity 188,000 212,000
Problem Cash flow statement (Indirect Method)
ABC Company
Income Statement
Sales 250000
CoGS -160000
Op Exp -65000
Depr -20000
NI 5000
Interpretation
Operating activities of the cash flow shows the trend of
the productivity and capability of generating revenue thus
having proper access and efficient management of
liquidity along with working capital. It also speaks how
well your business operation is with respect to liquidity
and profitability and contributing the level of efficiency
towards management of operating activities i.e. utilization
of current assets and current liabilities.
Investing activities reveal the facts of company current
and future investment strategies in medium to long term
fixed assets uses and disposal, This also communicates
efficiency in terms of better investments for future thus
translating and promising more profitable future cashflow
for the anticipated growth of the company.

Financing cash flows explained how efficiently company
is using its financing line to better utilize and generate the
excellence of production and revenue of the business (i.e.
operating segment) and acquisition and disposal of assets
for the business growth through better financial
investment decision. All three segments of cash flow
statement have the strong correlation among them and
translates the companys future prospects to the company
based on operation, investments and financing domain.
This also reflect how efficiently company utilize its
financing resources for short to long term depending upon
the nature and requirement of business along with various
economic factors assumptions are considered.

Alternative Measures of Cash Flow
Cash flow from operations
Traditional cash flow equals net income plus
depreciation expense and deferred taxes
Also adjust for changes in operating assets and
liabilities that use or provide cash
Free cash flow recognizes that some
investing and financing activities are critical
to ongoing success of the firm
Capital expenditures and dividends
Purpose of
Financial Statement Analysis
Evaluate management performance in three
areas:
Profitability
Efficiency
Risk
Analysis of Financial Ratios
Ratios are more informative that raw
numbers
Ratios provide meaningful relationships
between individual values in the financial
statements
Importance of
Relative Financial Ratios
Compare to other entities
Examine a firms performance relative to:
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)
Comparing to
The Aggregate Economy
Most firms are influenced by economic
expansions and contractions in the business
cycle
Analysis helps you estimate the future
performance of the firm during subsequent
business cycles
Comparing to
A Firms Industry
Most popular comparison
Industries affect the firms within them
differently, but the relationship is always
significant
The industry effect is strongest for
industries with homogenous products
Examine the industrys performance
relative to aggregate economic activity
Comparing to
A Firms Historical Performance
Determine whether it is progressing or
declining
Helpful for estimating future performance
Consider trends as well as averages over
time
Five Categories of Financial Ratios
1. Internal liquidity (solvency)
2. Operating performance
a. Operating efficiency
b. Operating profitability
3. Risk analysis
a. Business risk
b. Financial risk
Six Categories of Financial Ratios
4. Growth analysis
Six Categories of Financial Ratios
5. External liquidity (marketability)
Common Size Statements
Normalize balance sheets and income
statement items to allow easier comparison
of different size firms
A common size balance sheet expresses
accounts as a percentage of total assets
A common size income statement expresses
all items as a percentage of sales
Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate
the ability to meet future short-term
financial obligations
Current Ratio examines current assets and
current liabilities
s Liabilitie Current
Assets Current
Ratio Current =
Quick Ratio adjusts current assets by
removing less liquid assets

s Receivable Securities Marketable Cash
Ratio Quick
+ +
=
Cash Ratio is the most conservative
liquidity ratio
Securities Marketable Cash
Ratio Cash
+
=
Receivables turnover examines the
quality of accounts receivable
s Receivable Average
Sales Annual Net
Turnover s Receivable =
Receivables turnover can be converted into
an average collection period

Turnover Annual
365
Period Collection s Receivable Average =
Inventory turnover relates inventory to sales
or cost of goods sold (CGS)
Inventory Average
Sold Goods of Cost
Turnover Inventory =
Given the turnover values, you can compute
the average inventory processing time
Average Inventory Processing Period = 365/Annual
Turnover

Cash conversion cycle combines
information from the receivables turnover,
inventory turnover, and accounts payable
turnover
Receivable Days
+Inventory Processing Days
-Payables Payment Period
Cash Conversion Cycle
Evaluating Operating
Performance
Ratios that measure how well management
is operating a business
(1) Operating efficiency ratios
Examine how the management uses its assets and
capital, measured in terms of sales dollars generated
by asset or capital categories
(2) Operating profitability ratios
Analyze profits as a percentage of sales and as a
percentage of the assets and capital employed
Operating Efficiency Ratios
Total asset turnover ratio indicates the
effectiveness of a firms use of its total asset
base (net assets equals gross assets minus
depreciation on fixed assets)
Assets Net Total Average
Sales Net
Turnover Asset Total =
Operating Efficiency Ratios
Net fixed asset turnover reflects utilization
of fixed assets
Assets Fixed Net Average
Sales Net
Turnover Asset Fixed =
Operating Profitability Ratios
Operating profitability ratios measure
1. The rate of profit on sales (profit margin)
2. The percentage return on capital
Gross profit margin measures the rate of
profit on sales (gross profit equals net sales
minus the cost of goods sold)
Sales Net
Profit Gross
Margin Profit Gross =
Operating profit margin measures the rate
of profit on sales after operating expenses
(operating profit is gross profit minus sales,
general and administrative (SG + A)
expenses)
Sales Net
Profit Operating
Margin Profit Operating =
Net profit margin relates net income to sales
Sales Net
Income Net
Margin Profit Net =
Return on total capital relates the firms
earnings to all capital in the enterprise
Capital Total Average
Expense Interest Income Net
Capital Total on Return
+
=
Return on owners equity (ROE) indicates
the rate of return earned on the capital
provided by the stockholders after paying
for all other capital used
Equity Total Average
Income Net
Equity Total on Return =
Return on owners equity (ROE) can be
computed for the common- shareholders
equity
Equity Common Average
Dividend Preferred - Income Net
Equity s Owner' on Return =
The DuPont System divides the ratio into
several components that provide insights
into the causes of a firms ROE and any
changes in it
Equity Common
Sales Net
Sales Net
Income Net
Equity Common
Income Net
ROE = =
Equity
Assets Total
Assets Total
Sales
Equity
Sales
=
Equity Common
Assets Total
Assets Total
Sales
Sales
Income Net
Equity Common
Income Net
=
=
Profit Total Asset Financial
Margin Turnover Leverage
=
x x
An extended DuPont System provides
additional insights into the effect of
financial leverage on the firm and pinpoints
the effect of income taxes on ROE
Assets Total
EBIT
Assets Total
Sales
Sales
EBIT
=
Assets Total
Tax Before Net
Assets Total
Expense Interest
Assets Total
EBIT
=
Equity Common
(NBT) Tax Before Net
Equity Common
Assets Total
Assets Total
(NBT) Tax Before Net
=
Equity Common
Income Net
Tax Before Net
Taxes Income
% 100
Equity Common
Tax Before Net
=
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In summary, we have the following five
components of return on equity (ROE)
Margin Profit Operating
Sales
EBIT
. 1 =
Turnover Asset Total
Assets Total
Sales
. 2 =
Rate Expense Interest
Assets Total
Expense Interest
. 3 =
Multiplier Leverage Financial
Equity Common
Assets Total
. 4 =
Rate Retention Tax
Tax Before Net
Taxes Income
% 100 . 5 =
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Risk Analysis
Risk analysis examines the uncertainty of
income flows for the total firm and for the
individual sources of capital
Debt
Preferred stock
Common stock
Risk Analysis
Total risk of a firm has two components:
Business risk
The uncertainty of income caused by the firms
industry
Generally measured by the variability of the firms
operating income over time

Financial risk
Additional uncertainty of returns to equity holders
due to a firms use of fixed obligation debt securities
The acceptable level of financial risk for a firm
depends on its business risk
Business Risk
Variability of the firms operating income
over time
Standard deviation of the historical
operating earnings series
Business Risk
Two factors contribute to the variability of
operating earnings
Sales variability
Earnings must be as volatile as sales
Some industries are cyclical
Operating leverage
Production has fixed and variable costs
Fixed production costs cause profit volatility with
changes in sales
Fixed production costs are operating leverage
Financial Risk
Bonds interest payments come before
earnings are available to stockholders
These are fixed obligations
Similar to fixed production costs, these lead
to larger earnings during good times, and
lower earnings during a business decline
This debt financing increases the financial
risk and possibility of default
Financial Risk
Two sets of financial ratios help measure
financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed
financial charges
Acceptable levels of financial risk depend
on business risk
Financial Risk
Proportion of debt (balance sheet) ratios

This may be computed with and without
deferred taxes
Equity Total
Debt Term - Long Total
Ratio Equity - Debt =
Financial Risk
Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital
Financial Risk
Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)
Financial Risk
Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)
Capital Total
Debt Interest Total
Capital Debt/Total Bearing - Interest Total
=
Financial Risk
Earnings or Cash Flow Ratios
Relate the flow of earnings
Cash available to meet the payments
Higher ratio means lower risk
Financial Risk
Interest Coverage
Charges Interest Debt
(EBIT) Taxes and Interest Before Income
=
Expense Interest
Expense Interest Taxes Income Income Net + +
=
Financial Risk
Firms may also have non-interest fixed
payments due for lease obligations
The risk effect is similar to bond risk
Bond-rating agencies typically add 1/3 lease
payments as the interest component of the
lease obligations
External Market Liquidity
Market Liquidity is the ability to buy or sell
an asset quickly with little price change
from a prior transaction assuming no new
information
External market liquidity is a source of risk
to investors
Determinants of Market Liquidity
The dollar value of shares traded
This can be estimated from the total market
value of outstanding securities
It will be affected by the number of security
owners
Numerous buyers and sellers provide liquidity
Trading turnover (percentage of outstanding
shares traded during a period of time)
A measure of market liquidity is the bid-ask
spread
Analysis of Growth Potential
Creditors are interested in the firms ability
to pay future obligations
Value of a firm depends on its future
growth in earnings and dividends
Determinants of Growth
Resources retained and reinvested in the
entity
Rate of return earned on the resources
retained

= RR x ROE
where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firms return on equity

Equity on Return Retained Earnings of Percentage g =
Determinants of Growth
ROE is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)
Comparative Analysis of Ratios
Internal liquidity
Current ratio, quick ratio, and cash ratio
Operating performance
Efficiency ratios and profitability ratios
Financial risk
Growth analysis
The Quality of Financial
Statements
Reflect reality rather than use accounting
tricks or one-time adjustments to make
things look better than they are
Statements
High-quality balance sheets typically have
Conservative use of debt
Assets with market value greater than book
No liabilities off the balance sheet
Statements
High-quality income statements reflect
repeatable earnings
Gains from nonrecurring items should be
ignored when examining earnings
High-quality earnings result from the use of
conservative accounting principles that do
not overstate revenues or understate costs
The Value of
Financial Statement Analysis
Financial statements, by their nature, are
backward-looking
An efficient market will have already
incorporated these past results into security
prices, so why analyze the statements?
Analysis provides knowledge of a firms
operating and financial structure
This aids in estimating future returns
Stock Valuation Models
Valuation models attempt to derive a value based
upon one of several cash flow or relative
valuation models
All valuation models are influenced by:
Expected growth rate of earnings, cash flows, or
dividends
Required rate of return on the stock
Financial ratios can help in estimating these critical
inputs
Financial Ratios
1. Average debt/equity
2. Average interest coverage
3. Average dividend payout
4. Average return on equity
5. Average retention rate
6. Average market price to book value
7. Average market price to cash flow
8. Average market price to sales
Variability Measures
1. Coefficient of variation of operating earnings
2. Coefficient of variation of sales
3. Coefficient of variation of net income
4. Systematic risk (beta)
Nonratio Variables
1. Average growth rate of earnings
Financial Ratios and Systematic
Risk
Financial Ratios
1. Dividend payout
2. Total debt/total assets
3. Cash flow/total debt
4. Interest coverage
5. Working capital/total assets
6. Current Ratio
Risk
Variability Measures
1. Variance of operating earnings
2. Coefficient of variation of operating earnings
3. Coefficient of variation of operating profit
margins
4. Operating earnings beta (company earnings
related to aggregate earnings)
Risk
Nonratio Variables
1. Asset size
2. Market value of stock outstanding
Financial Ratios and Bond
Ratings
Financial Ratios
1. Long-term debt/total assets
2. Total debt/total capital
3. Net income plus depreciation (cash flow)/long
term senior debt
5. Net income plus interest/interest expense (fixed
charge coverage)
6. Cash flow/interest expense
Ratings
7. Market value of stock/par value of bonds
8. Net operating profit/sales
9. Net income/owners equity (ROE)
10. Net income/total assets
11. Working capital/sales
12. Sales/net worth (equity turnover)
Ratings
Variability Ratios
1. Coefficient of variation (CV) of net earnings
2. Coefficient of variation of return on assets
Nonratio variables
1. Subordination of the issue
2. Size of the firm (total assets)
3. Issue size
4. Par value of all publicly traded bonds of the firm
Financial Ratios and
Insolvency (Bankruptcy)
Financial Ratios
2. Cash flow/long-term debt
3. Sales/total assets
4. Net income/total assets
5. EBIT/total assets
6. Total debt/total assets
Financial Ratios and
Insolvency (Bankruptcy)
7. Market value of stock/book value of debt
8. Working capital/total assets
9. Retained earnings/total assets
10. Current ratio
11. Cash/current liabilities
12. Working capital/sales

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