Module 5

Financial Statement Analysis

 Financial Statement Analysis

• Financial Statement Analysis is the process of identifying the financial strengths and
weaknesses of the firm by properly establishing relationships between the items of the
balance sheet and the profit and loss account.

• It focuses on evaluation of past performance of the business firms in terms of

profitability, liquidity, solvency, operation efficiency and growth potentiality.

• Thus, it is an important means of assessing past performance and in forecasting and

planning future performance.

• There are two principal tools of financial analysis: Ratio analysis and cash flow analysis.

• The relationship between two accounting figures, expressed mathematically is known as

a financial ratio. Ratio analysis that compares a company’s present performance to its
past performance and/or to the performance of its peer provides the foundation for
making forecasts of future performance.

• Cash flow analysis allows the analyst to examine the firm’s liquidity and to assess the
management of operating, investment and financing cash flows.
 Financial Statement Analysis

The ratio Analysis involves comparison for a useful interpretation of the financial
statements. Standards of comparison may consist of :

Time series analysis: When financial ratios over a period of time are compared, it is known
as the time series analysis. It involves the comparison of present ratios with past ratios for
the same firm. It gives an indication of the direction of change and reflects whether the
firm’s financial performance has improved, deteriorated or remained constant over time.

Cross-sectional analysis: It compares ratios of one firm with some selected firms in the
same industry at the same point in time. This kind of a comparison indicates the relative
financial position and performance of the firm.

Industry analysis: To determine the financial condition and performance of a firm, its
ratios may be compared with average ratios of the industry of which the firm is a member.
This sort of analysis known as the industry analysis. It helps to ascertain the financial
standing and capability of the firm vis-à-vis other firms in the industry.

Proforma Analysis: Future ratios are developed from the projected or proforma financial
statements. The comparison of current or past ratios with future ratios shows the firm’s
relative strengths and weaknesses in the past and the future.
 Financial Statement Analysis

Types of Ratios

Based on the requirements of the various users, ratios are classifies into the following
categories:

• Liquidity Ratios
• Leverage Ratios
• Activity Ratios
• Profitability Ratios
 Financial Statement Analysis

Liquidity Ratio:

• The Liquidity ratios measure the ability of a firm to meet its short-term obligations and
reflect the short-term financial strength/solvency of a firm.
• Liquidity ratio helps the firm to maintain the proper balance between high liquidity and
lack of liquidity.
• The most common ratios, which indicate the extent of liquidity or lack of it are
Current Ratio
Quick Ratio
Cash Ratio
Net Working Capital Ratio
 Financial Statement Analysis

Leverage Ratios

• The long term solvency of a firm can be examined by using leverage or capital
structure ratios.
• The leverage or capital structure ratios may be defined as financial ratios which throw
light on the long-term solvency of a firm as reflected in its ability to assure the long-
term lenders with regard to
Periodic payment of interest during the period of the loan
Repayment of principal on maturity or in predetermined instalments at due
dates.

• Based on the above two aspects, there are two different but mutually dependent and
interrelated, types of leverage ratios.
• First, ratios which are based on the relationship between borrowed funds and owner’s
capital. These ratios are calculated from the balance sheet which are as follows:
a)debt-ratio, b) debt-equity ratio, c)equity-assets ratio

• The second type of capital structure ratios, called coverage ratios,

• a) Interest coverage ratio, b) dividend coverage ratio, c) total fixed charges coverage
ratio, d) cash flow coverage ratio and e) debt services coverage ratio.
 Financial Statement Analysis

Activity or Turnover Ratios

• Activity ratios are employed to evaluate the efficiency with which the firm manages
and utilizes its assets.
• These ratios are also called turnover ratios because they indicate the speed with
which assets are being converted or turned over into sales.
• Activity ratios, thus, involve a relationship between sales and assets. A proper balance
between sales and assets generally reflects that assets are managed well.
• Several activity ratios are calculated to judge the effectiveness of asset utilisation
Inventory Ratio
Debtors Ratio
Assets Turnover Ratio
Total Assets Turnover Ratio
Fixed Assets Turnover Ratio
Current Assets Turnover Ratio
Working Capital Turnover Ratio
 Financial Statement Analysis

Profitability Ratios
• Profitability Ratios are calculated to measure the operating efficiency of the company.
• Besides management of the company, creditors and owners are also interested in the
profitability of the firm.
• Generally two major types of profitability ratios are calculated:
profitability in relation to sales
profitability in relation to investment

• Several activity ratios are calculated to judge the effectiveness of asset utilisation
Gross Profit Margin
Net profit Margin
Net Margin based on NOPAT
Operating Expense Ratio
Return on Investment
Return on Equity
Earning per Share
Dividents per Share
Dividend-Payout Ratio
Price-Earnings Ratio
Market Value-to-Book Value Ratio
 Financial Statement Analysis

Drivers of a Firm’s Profitability and Growth

• The value of a firm is determined by its profitability and growth.

• The firm’s growth and profitability are influenced by its product market and financial
market strategies.
• Product market strategy is implemented through the firm’s competitive strategy,
operating policies and investment decisions.
• Financial market strategies are implemented through financing and dividend policies.
• Thus the four levers managers can use to achieve their growth and profit targets are
1. Operating management
2. Investment management
3. Financing strategy
4. Dividend policy
• The objective of ratio analysis is to evaluate the effectiveness of the firm’s policies in
each of these areas.
 Financial Statement Analysis

Growth and Profitability

Product Market Strategies Financial Market Policies

Operating
Operating Investment Financing
Management
Management Management Dividend Policy
Decisions

Managing
Managing Working Managing
Managing
Revenue & Capital Liabilities
Payout
Expenses &Fixed & Equity
Assets
 Financial Statement Analysis

Product market strategy of TJX and Nordstorm

• The efficiency of Product market strategies and Financial Market Strategies for the
two companies TJX and Nordstorm is analysed using the financial ratios of the
companies.

• TJX is the leading off-price apparel and home fashions retailer in the US and
worldwide. TJX pursue a cost leadership strategy, offering its customers a “rapidly
changing assortment of quality, brand-name and merchandise at prices generally 20%
to 60% below department and specialty store regular prices every day. “In order to
execute that strategy, the company has developed a low-cost, flexible business model
that has at its core a focus on opportunistic buying of merchandise.
 Financial Statement Analysis

Product Market strategy of TJX and Nordstorm

• Nordstorm is a high-end department store offering a wide variety of apparel, shoes and
accessories. Founded as a shoe store in Seattle, Washington, in 1901, the company
quickly became known for its broad selection of high-quality merchandise coupled with
exceptional customer service.
• Nordstorm’s success has historically been based on a competitive strategy of
differentiation that has sought to build loyalty in customers who have many retail
purchase options. The key elements of that strategy:
1.Providing exceptional customer service
2. Offering a broad selection of high-end, differentiated merchandise closely
targeted to local tastes
 Financial Statement Analysis

Financial Market Strategy of TJX and Nordstorm

• TJX and Nordstorm follow very different strategies when it comes to financing their
stores. TJX lease virtually all of its stores using off-balance sheet operating lease.

• In contrast, while Nordstorm also utilizes operating lease to some extent, the
company owns at least a portion of more than two-thirds of its store square footage
(land, buildings or both), and finances the owned portion with long term debt.

• These financing strategies impact many of the ratios that are calculated for these two
companies.
 Financial Statement Analysis

Operating Management Strategy of TJX and Nortdstorm

There is one more major differences between the TJX and Nordstorm relates to how each
executes its branded credit card offering.

TJX has chosen to outsource its credit card operations, giving up operational control and
potential earnings but also insulating itself from potential losses due to bad debt.

Nordstorm, on the other hand, views its in-house credit card operations as a strategic
advantage and part of its broader strategy of providing superior customer services. The
result of these business decision is seen primarily in Nordstorm’s much higher accounts
receivables balance as compared to TJX, and impacts many of the ratio calculations.
 Financial Statement Analysis

Cross-sectional Ratio Analysis of TJX and Nordstorm

Cross-sectional analysis of TJX and Nordstorm is performed where it compares TJX and
Nordstorm’s ratios for the fiscal year ending January 29, 2011 both on an “As Reported”
and “As Adjusted” basis.

Comparison of TJX with Nordstorm on an “As Reported” basis allows us to see the impact
of the different strategies, financial and operational decisions on the financial ratios of the
two companies.

Comparison on an “As Adjusted” basis removes the distortion caused by the differing
magnitude of their operating lease usage so that we can more clearly compare their true
operating performance.
 Financial Statement Analysis
Adjustment of other distortion in the financial statements of TJX and Nordstorm

• As a final consideration, it is important to ensure that the financial statements of the

company being analyzed do not include any additional data that will distort the
analysis. The major categories of such distortions include one-time write-offs of assets
and results from discontinued operations, including the gain or loss on the disposal of
such operations.

• For example, TJX sold its interest in Bob’s store in 2008. As a result, its 2008 income
statement contains a $ 34 million loss in the discontinued operations. Without
adjusting for this effect it would have been difficult to meaningfully use TJX’s 2008
results as a benchmark for performance in 2009 and beyond or to compare it to a
competitor such as Nordstorm.

• For the same reason, $ 3.6 million gain is excluded due to discontinued operations for
TJX in 2010, with this adjustment being included in the “As Adjusted” financial
statements for TJX.
 Financial Statement Analysis

Overall Profitability Analysis of TJX and Nordstorm

• The systematic analysis of a firm’s performance is started from the estimation of its
Return on Equity (ROE)

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
• ROE =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

• ROE provides an indication of how well managers are employing the funds invested by
the firm's shareholders to generate returns.

• In the long run, the value of the firm’s equity is determined by the relationship
between its ROE and its cost of equity capital. That is those firms that are expected
over the long run to generate ROEs in excess of the cost of equity capital should have
market values in excess of book value and vice versa.

• A comparison of ROE with the cost of capital is useful not only for analyzing the value of
the firm but also in considering the path of futures profitability.
 Financial Statement Analysis

Overall Profitability Analysis of TJX and Nordstorm

Table 1: ROE for TJX and Nordstorm

Year ended January 29, 2011 As reported As adjusted

TJX Nordtstorm TJX Nordstorm

ROE 46.5% 39.0% 55.4% 40.0%

Unadjusted ROE of Nordstorm , 39% trails the 46.5% earned by TJX in 2010. The
performance of both companies exceeded both historical trend of ROE in the economy
and cost of equity capital of firms.

However, when the ROE is calculated using adjusted financials the differential grows
significantly, reflecting the greater impact of the adjustment to TJX due to its much
larger use of operating leases.
 Financial Statement Analysis

Overall Profitability Analysis of TJX and Nordstorm

• TJX’s superior profitability performance relative to Nordstorm is reflected in the

difference between the market value of equity to book value ratios for the two
firms.
• As of January 29, 2011, TJX’s market to book ratio was 6.0 and Nordstorm’s rato
was 4.4. This differential in market valuation indicates the positive performance
of TJX compare to Nordstorm in the coming year.
 Financial Statement Analysis

Decomposing Profitability: Traditional Approach

Basically, a company’s ROE is affected by return on assets (ROA) and a measure of

financial leverage. ROA indicates that how profitably firm employs its assets while
financial leverage shows that how big the firm’s asset base is relative to shareholder’
investment.
Hence ROE can be decomposed into :

ROE = ROA * Financial Leverage

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑠𝑠𝑒𝑡𝑠

= *
𝐴𝑠𝑠𝑒𝑡𝑠 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
The ROA itself can be decomposed into:

ROA = ROS * Asset Turnover

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠

= *
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠

ROE = ROS * Asset turnover * Financial leverage

 Financial Statement Analysis
Decomposing Profitability: Traditional Approach

The decomposition of ROE into different ratios show us how an examination of the
building blocks of these ratios can yield a deeper understanding of how strategic,
investment and financing decisions made by the firm affect its ratios.

Table 2: Traditional Decomposition of ROE

Year ended January 29, 2011 As Reported As Adjusted

TJX Nordstorm TJX Nordstorm

Net profit margin (ROS) 6.1% 6.3% 7.3% 6.5%

*Asset turnover 2.94 1.47 1.84 1.36
=Return on assets(ROA) 18.0% 9.3% 13.4% 8.8%
*Financial leverage 2.58 4.19 4.12 4.55
=Return on equity (ROE) 46.5% 39.0% 55.4% 40.0%
 Financial Statement Analysis
Decomposing Profitability: Traditional Approach

• In comparing TJX to Nordstorm on an As Reported basis, a significantly higher asset

turnover is key to explaining how TJX, even with a slightly lower net profit margin
and a much lower financial leverage than Nordstorm, was able to post an overall
higher return on equity of 46.5% against 30.0% for Nordstorm.
• The possible reason of high performance of TJX could be:
1. TJX decision to outsource its credit card operation which results in much lower
Account Receivable balance when compared to Nordstorm who maintains its credit
card operation in house.
2. TJX’s more extensive use of off-balance sheet operating lease to finance its stores
(which reduces both overall reported asset and debt level).
• After adjusting for operating lease impact for both firms brings the asset turnover of
TJX closer to that of Nordstorm . However, the difference in credit card strategies
continues to drive a higher ROA for TJX.
• The increased ROE for TJX of 55.4% on an As Adjusted basis is basically due to
increased financial leverage resulting from the addition of long term debt to TJX’s
balance sheet.
• Finally, the higher adjusted ROS for TJX is the result of lower current expense
incurred as a result of the operating lease adjustment.
 Financial Statement Analysis

Limitations of Traditional Approach of Decomposing Profitability

• In the computation of ROA in traditional approach, the denominator includes the assets
claimed by all providers of capital to the firm, but the numerator includes only the
earnings available to equity holders.

• The assets themselves include both operating assets and financial assets such as cash
and short term investments.

• Further, net income includes income from operating as well as interest income and
expense, which are consequence of financing decisions.

• Often it is useful to distinguish between these two drivers of performance.

• Finally, the financial leverage ratio in this approach, does not recognize the fact that a
firm’s cash and short-term investments are in essence “negative debt” because they can
be used to pay down the debt on the company’s balance sheet.

• These issues are addressed by an alternative approach to decomposing ROE.

 Financial Statement Analysis

Decomposing Profitability: Alternative Approach

Definitions of Accounting Items Used in Ratio Analysis

Net interest expense after tax = (Interest expense – Interest income)* (1-Tax rate)

Net operating profit after taxes (NOPAT) = Net Income + Net interest expense after tax

Operating Working Capital = (Current assets – cash and marketable securities) –

(Current liabilities – Short-term debt and current portion
of long-term debt)
Net long-term assets = Total long-term assets – Non-interest- bearing long-term liabilities
Net debt = Total interest-bearing liabilities – Cash and marketable securities
Net assets = Operating working capital + Net long-term assets
Net Capital = Net debt + Shareholder’s equity
 Financial Statement Analysis
Decomposing Profitability: Alternative Approach

In alternative approach, the ROE is decomposed in following manner:

𝑁𝑂𝑃𝐴𝑇 (𝑁𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)

ROE = -
𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦

𝑁𝑂𝑃𝐴𝑇 𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑁𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
= * - *
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑂𝑃𝐴𝑇 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦) 𝑁𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
= *( )- *
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑂𝑃𝐴𝑇 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡) 𝑁𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
= * (1+ )- *
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
= Operating ROA + (Operating ROA – Effective interest rate after tax) * Net
Financial leverage
= Operating ROA + Spread * Net financial leverage
 Financial Statement Analysis
Decomposing Profitability: Alternative Approach

• Operating ROA is a measure of how profitably a company is able to deploy its operating
assets to generate operating profits. This would be a company’s ROE if it were financed
entirely with equity.

• Spread is the incremental economic effect from introducing debt into the capital
structure. This economic effect of borrowing is positive as long as the return on
operating assets is greater than the cost of borrowing.

• The ratio of net debt to equity provides a measure of this net financial leverage. A firm’s
spread times its net financial leverage, therefore, provides a measure of the financial
leverage gain to the shareholders.

• Operating ROA can be further decomposed into NOPAT margin and operating asset
turnover as follows:

𝑁𝑂𝑃𝐴𝑇 𝑆𝑎𝑙𝑒𝑠
Operating ROA = *
𝑆𝑎𝑙𝑒𝑠 𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
 Financial Statement Analysis

Distinguishing Operating and Financing Components in ROE Decomposition

Year ended January 29, 2011 As reported As adjusted

TJX Nordstorm TJX Nordstorm

Net operating profit margin (ROS) 6.2% 7.1% 8.1% 7.5%

• Net operating asset turnover 11.33 2.86 3.44 2.44
= Operating ROA 70.6% 20.4% 27.8% 18.4%
Spread 73.1% 16.1% 22.8% 14.2%
* Net financial leverage -0.33 1.16 1.21 1.52
= Financial leverage gain -24.1% 18.6% 27.6% 21.6%
ROE = Operating ROA +
Financial leverage gain 46.5% 39.0% 55.4% 40.0%
 Financial Statement Analysis
Decomposing Profitability: Alternative Approach

• Comparing the two firms on an as Reported basis, TJX’s dramatically higher operating
asset turnover as compared to Nordstorm’s is driven by its relatively low net assets that
result from its strategy of outsourcing its branded credit card (and thus not carrying a
high account receivables balance) and leasing virtually all of its stores (thus carrying
low net long-term assets relative to Nordstorm).

• The impact of the operating lease adjustment can be seen most strongly in net
operating asset turnover for TJX, which falls from 11.33 to 3.44 due to the greatly
increased asset base, bringing operating ROA down from 70.6% to 27.8%. This in turn
reduces the spread between TJX’s operating ROA and after tax interest cost from 73.1%
to 22.8 %.

• The change in net financial leverage from -0.33 on an As Reported basis to 1.21 on an
As Adjusted basis creates a positive financial leverage gain of 27.6% as compared to a -
24.1 % gain on as as Reported basis.

• It means that TJX’s use of additional leverage (adjustment made for the operating lease
) has actually helped through an increase in net operating profit margin, but primarily
by reversing a negative financial leverage gain, to create additional shareholder return
as seen in the higher As Adjusted ROE.