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Analysis
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
Financial
Statement Analysis
Financial Statements
A Possible Framework for Analysis
Balance Sheet Ratios
Income Statement and Income
Statement/Balance Sheet Ratios
Trend Analysis
Common-Size and Index Analysis
Examples of External Uses
of Statement Analysis
Trade Creditors -- Focus on the
liquidity of the firm.
Bondholders -- Focus on the
long-term cash flow of the firm.
Shareholders -- Focus on the
profitability and long-term health of
the firm.
Examples of Internal Uses
of Statement Analysis
Plan -- Focus on assessing the current
financial position and evaluating
potential firm opportunities.
Control -- Focus on return on investment
for various assets and asset efficiency.
Understand -- Focus on understanding
how suppliers of funds analyze the firm.
Primary Types of
Financial Statements
Balance Sheet
A summary of a firms financial position on
a given date that shows total assets = total
liabilities + owners equity.
Income Statement
A summary of a firms revenues and
expenses over a specified period, ending
with net income or loss for the period.
Basket Wonders Balance
Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Cash and C.E. $ 90 a. How the firm stands on
Acct. Rec.c 394 a specific date.
Inventories 696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10 customers.
Current Assetse d. Future expense items
$1,195 Fixed Assets (@Cost) f
already paid.
1030 Less: Acc. Depr. g
e. Cash/likely convertible
(329) Net Fix. Assets $ 701
to cash within 1 year.
Investment, LT 50 Other
Assets, LT 223 Total f. Original amount paid.
Assets b $2,169 g. Acc. deductions for
wear and tear.
Basket Wonders Balance
Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets =
Acct. Payablec 94 Liabilities + Equity.
Accrued Taxes d 16 Other b. What BW owed and
Accrued Liab. d 100 ownership position.
Current Liab. e $ 500 c. Owed to suppliers for
Long-Term Debt f 530 goods and services.
Shareholders Equity d. Unpaid wages, salaries,
Com. Stock ($1 par) g 200 etc.
Add Pd in Capital g 729 e. Debts payable < 1 year.
Retained Earnings h 210 f. Debts payable > 1 year.
Total Equity $1,139 g. Original investment.
Total Liab/Equitya,b $2,169 h. Earnings reinvested.
Basket Wonders
Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2007a
Net Sales $ 2,211 Cost of a. Measures profitability
Goods Sold b 1,599 over a time period.
Gross Profit $ 612 SG&A b. Received, or receivable,
Expenses c 402 from customers.
EBITd $ 210 c. Sales comm., adv.,
Interest Expensee 59 officers salaries, etc.
EBT f $ 151 Income d. Operating income.
Taxes 60 EATg $ e. Cost of borrowed funds.
91 Cash Dividends f. Taxable income.
38 Increase in RE $ g. Amount earned for
53
shareholders.
Use of Financial Ratios
Current Assets
Liquidity Ratios
Current Liabilities
Total Debt
Financial Leverage
Shareholders Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is $1,030 = .90
financed by debt. $1,139
Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89
BW has average debt utilization
relative to the industry average.
Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Total-Assets
Total Debt
Financial Leverage
Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2007
of the firms assets
that are supported by $1,030 = .47
debt financing. $2,169
Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 .47 .47
2006 .47 .47
2005 .45 .47
BW has average debt utilization
relative to the industry average.
Financial Leverage Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)
An analysis of percentage
financial statements where all
balance sheet items are divided
by total assets and all income
statement items are divided by
net sales or revenues.
Basket Wonders Common
Size Balance Sheets
Basket Wonders Common
Size Balance Sheets
Basket Wonders Common
Size Income Statements
Index Analyses
Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
Determining Standard
Deviation (Risk Measure)
n
= ( Ri - R )2( Pi )
i=1
Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
How to Determine the Expected
Return and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining Standard
Deviation (Risk Measure)
n
=
i=1
( Ri - R ) ( Pi )
2
= .01728
= .1315 or 13.15%
Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = / R
CV of BW = .1315 / .09 = 1.46
Determining Standard
Deviation (Risk Measure)
n
=
i=1
( R i - R )
2
(n)
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
Determining Portfolio
Expected Return
m
RP = ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
portfolio.
Determining Portfolio
Standard Deviation
m m
P =
j=1 k=1
Wj Wk jk
jk = j k r jk
j is the standard deviation of the jth
asset in the portfolio,
k is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between the
jth and kth assets in the portfolio.
Correlation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.
RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(
.6 8%)
8%
RP = (3.6%) + (4.8%)
4.8% = 8.4%
Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW BW,BW WBW WD BW,D
Row 2 WD WBW D,BW WD WD D,D
Unsystematic risk
Total
Risk
Systematic risk
Unsystematic risk
Total
Risk
Systematic risk
EXCESS RETURN
ON MARKET PORTFOLIO
Characteristic Line
What is Beta?
EXCESS RETURN
ON MARKET PORTFOLIO
Security Market Line
Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
Security Market Line
Rj = Rf + j(RM - Rf)
Required Return
RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
Security Market Line
Obtaining Betas
Can use historical data if past best represents the
expectations of the future
Can also utilize services like Value Line, Ibbotson
Associates, etc.
Adjusted Beta
Betas have a tendency to revert to the mean of 1.0
Can utilize combination of recent beta and mean
2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate
Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%.
10% A stock analyst following
the firm has calculated that the firm beta is
1.2.
1.2 What is the required rate of return on
the stock of Basket Wonders?
BWs Required
Rate of Return
Intrinsic $0.50
=
Value 10.8% - 5.8%
= $10
Direction of
Movement Direction of
Movement
Rf Stock Y (Overpriced)