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
Analysis of Financial Statements
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
Analysis of Financial Statements
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
Analysis of Financial Statements
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

Major Financial Statements

Corporate shareholder annual and quarterly
reports must include
Balance sheet

Major Financial Statements

Corporate shareholder annual and quarterly
reports must include
Balance sheet
Income statement

Major Financial Statements

Corporate shareholder annual and quarterly
reports must include
Balance sheet
Income statement
Statement of cash flows

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)

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)
10-K and 10-Q

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

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 than 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 Major Competitors
Industry averages may not be representative
Select a subset of competitors to compare to
using cross-sectional analysis, or
Construct a composite industry average
from industries the firm operates in

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
Current Assets
Current Ratio
Current Liabilitie s

Evaluating Internal Liquidity

Quick Ratio adjusts current assets by
removing less liquid assets
Cash Marketable Securities Receivable s
Quick Ratio
Current Liabilitie s

Evaluating Internal Liquidity

Cash Ratio is the most conservative
liquidity ratio
Cash Marketable Securities
Cash Ratio
Current Liabilitie s

Evaluating Internal Liquidity

Receivables turnover examines the
quality of accounts receivable
Net Annual Sales
Receivable s Turnover
Average Receivable s

Receivables turnover can be converted into

an average collection period
365
Average Receivable s Collection Period
Annual Turnover

Evaluating Internal Liquidity

Inventory turnover relates inventory to sales
or cost of goods sold (CGS)
Cost of Goods Sold
Inventory Turnover
Average Inventory

Given the turnover values, you can compute

the average inventory processing time
Average Inventory Processing Period = 365/Annual
Turnover

Evaluating Internal Liquidity

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)
Net Sales
Total Asset Turnover
Average Total Net Assets

Operating Efficiency Ratios

Net fixed asset turnover reflects utilization
of fixed assets
Net Sales
Fixed Asset Turnover
Average Net Fixed Assets

Operating Profitability Ratios

Operating profitability ratios measure
1. The rate of profit on sales (profit margin)
2. The percentage return on capital

Operating Profitability Ratios

Gross profit margin measures the rate of
profit on sales (gross profit equals net sales
minus the cost of goods sold)
Gross Profit
Gross Profit Margin
Net Sales

Operating Profitability Ratios

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)
Operating Profit
Operating Profit Margin
Net Sales

Operating Profitability Ratios

Net profit margin relates net income to sales
Net Income
Net Profit Margin
Net Sales

Operating Profitability Ratios

Return on total capital relates the firms
earnings to all capital in the enterprise
Net Income Interest Expense
Return on Total Capital
Average Total Capital

Operating Profitability Ratios

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
Net Income
Return on Total Equity
Average Total Equity

Operating Profitability Ratios

Return on owners equity (ROE) can be
computed for the common- shareholders
equity

Net Income - Preferred Dividend

Return on Owner' s Equity
Average Common Equity

Operating Profitability Ratios

The DuPont System divides the ratio into

several components that provide insights
into the causes of a firms ROE and any
changes in it
Net Income
Net Income
Net Sales
ROE

Common Equity
Net Sales Common Equity
Sales
Sales
Total Assets

Equity Total Assets

Equity

Operating Profitability Ratios

Net Income

Common Equity
Net Income
Sales
Total Assets

Sales
Total Assets Common Equity

Profit
Margin

x Total Asset x Financial

Turnover

Leverage

Operating Profitability Ratios

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

Operating Profitability Ratios

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
We begin with the operating profit margin
(EBIT divided by sales) and introduce
additional ratios to derive an ROE value

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

This is the operating profit return on total

assets. To consider the negative effects of
financial leverage, we examine the effect of
interest expense as a percentage of total
assets

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets

We consider the positive effect of financial

leverage with the financial leverage multiplier

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets
Net Before Tax (NBT)
Total Assets
Net Before Tax (NBT)

Total Assets
Common Equity
Common Equity

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets
Net Before Tax (NBT)
Total Assets
Net Before Tax (NBT)

Total Assets
Common Equity
Common Equity
This indicates the pretax return on equity. To arrive
at ROE we must consider the tax rate effect.

Operating Profitability Ratios

EBIT
Sales
EBIT

Sales Total Assets Total Assets

EBIT
Interest Expense Net Before Tax

Total Assets
Total Assets
Total Assets
Net Before Tax (NBT)
Total Assets
Net Before Tax (NBT)

Total Assets
Common Equity
Common Equity
Net Before Tax
Income Taxes
Net Income
100%

Common Equity
Net Before Tax Common Equity

Operating Profitability Ratios

In summary, we have the following five
components of return on equity (ROE)

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales
Sales
2.
Total Asset Turnover
Total Assets

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales
Sales
2.
Total Asset Turnover
Total Assets
Interest Expense
3.
Interest Expense Rate
Total Assets

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales
Sales
2.
Total Asset Turnover
Total Assets
Interest Expense
3.
Interest Expense Rate
Total Assets
Total Assets
4.
Financial Leverage Multiplier
Common Equity

Operating Profitability Ratios

EBIT
1.
Operating Profit Margin
Sales
Sales
2.
Total Asset Turnover
Total Assets
Interest Expense
3.
Interest Expense Rate
Total Assets
Total Assets
4.
Financial Leverage Multiplier
Common Equity

Income Taxes
5. 100%
Tax Retention Rate
Net Before Tax

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

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

Financial Risk
Proportion of debt (balance sheet) ratios
Total Long - Term Debt
Debt - Equity Ratio
Total Equity

Financial Risk
Proportion of debt (balance sheet) ratios
Total Long - Term Debt
Debt - Equity Ratio
Total Equity

This may be computed with and without

deferred taxes

Financial Risk
Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital

Financial Risk
Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital
L.T. Debt - Total L.T. Capital Ratio
Total Long - Term Debt

Total Long - Term 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)
Total Interest - Bearing Debt/Total Capital
Total Interest Debt

Total Capital

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

Financial Risk
Interest Coverage
Income Before Interest and Taxes (EBIT)

Debt Interest Charges

Financial Risk
Interest Coverage
Income Before Interest and Taxes (EBIT)

Debt Interest Charges

Net Income Income Taxes Interest Expense

Interest Expense

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

Financial Risk
Total fixed charge coverage includes any
noncancellable lease payments and any
preferred dividends paid out of earnings
after taxes

Financial Risk
Total fixed charge coverage includes any
noncancellable lease payments and any
preferred dividends paid out of earnings
after taxes
Fixed Charge Coverage
Income Before Interest, Taxes, and Lease Payments
Debt Interest Lease Payments Preferred Dividend/( 1 - Tax Rate)

Financial Risk
Cash flow ratios relate the flow of cash
available from operations to either interest
expense, total fixed charges, or the face
value of outstanding debt

Financial Risk
Cash Flow Coverage
Traditiona l Cash Flow Interest 1/3 Lease Payments
Interest 1 / 3 Lease Payments

Financial Risk
Cash Flow / Long - Term Debt
Net Income Depreciati on Expense Change in Deferred Tax
Book Value of Long - Term Debt

Financial Risk
Cash Flow / Total Debt
Net Income Depreciati on Expense Change in Deferred Tax
Total Debt

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

External Market Liquidity

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

External Market Liquidity

Trading turnover (percentage of outstanding
shares traded during a period of time)

External Market Liquidity

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: of Earnings Retained Return on Equity
g Percentage
g = potential growth rate
RR = the retention rate of earnings
ROE = the firms return on equity

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

Analysis of
Non-U.S. Financial Statements
Statement formats will be different
Differences in accounting principles
Ratio analysis will reflect local accounting
practices

The Quality of Financial

Statements
Reflect reality rather than use accounting
tricks or one-time adjustments to make
things look better than they are

The Quality of Financial

Statements
High-quality balance sheets typically have
Conservative use of debt
Assets with market value greater than book
No liabilities off the balance sheet

The Quality of Financial

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

Specific Uses of Financial Ratios

1. Stock valuation
2. Identification of corporate variables
affecting a stocks systematic risk (beta)
3. Assigning credit quality ratings on bonds
4. Predicting insolvency (bankruptcy) of firms

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

Stock Valuation Models

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

Stock Valuation Models

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

Financial Ratios and Systematic

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)

Financial Ratios and Systematic

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
4. Cash flow/total debt
5. Net income plus interest/interest expense (fixed
charge coverage)
6. Cash flow/interest expense

Financial Ratios and Bond

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)

Financial Ratios and Bond

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
1. Cash flow/total debt
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

Limitations of Financial Ratios

Accounting treatments may vary among firms,
especially among non-U.S. firms
Firms may have have divisions operating in
different industries making it difficult to derive
industry ratios
Results may not be consistent
Ratios outside an industry range may be cause
for concern

The Internet
Investments Online

www.walgreens.com
www.cvs.com
www.riteaid.com
www.longs.com
www.sec.gov/edgarhp.htm
www.hoovers.com
www.dnb.com

End of Chapter 12
Analysis of Financial
Statements

Future topics
Chapter 11

Security Valuation Process

Theory of Valuation
Valuation of Alternative Investments
Estimating the Required Rate of
Return and Expected Growth Rates