FINANCIAL STATEMENT ANALYSIS CHAPTER 13 1 Fundamental Analysis

FINANCIAL STATEMENT ANALYSIS CHAPTER 13 1

Fundamental Analysis n n n Finance (chapter 12): Valuation techniques ¨ Dividend discount model, P/E ratio ¨ Need input as dividends and earnings prospects Economics (chapter 11) (information from outside) ¨ macro level: market ¨ micro level: industries, firms Accounting (chapter 13) (information from inside) ¨ How to read reported data? ¨ How to use financial data as inputs into stock valuation

Financial Statement Analysis Objectives: • Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios. • Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis. • Measure a firm’s operating efficiency • Identify likely sources of biases in accounting data.

Income Statement n n Firm’s revenues and expenses during a specific period Typical format Sale - Operating expense COGS Depreciation Operating Income (EBIT) - Interest Earning before tax (EBT) - Tax Net Income (NI)

Table 14. 1 Consolidated Statement of Income

Balance Sheet n A snapshot of firm’s assets and liability at a given point in time Asset 1. Current Asset Cash Account receivable Inventory 2. Fixed asset Liabilities + Equity 1. Current liabilities Short term debt Account payable Note payable 2. Long-term debt 3. Equity Common stock Retained earning Total assets Total liabilities + equity

Table 14. 2 Consolidated Balance Sheet

Statement of cash flow n n n Net income: accounting profit Cash flow: cash available on hand Statement of cash flow: firm’s cash receipts and payments during a specific period

Table 14. 3 Consolidated Statement of Cash Flows

Return on Equity (ROE) n n n ROE=Net profit/Equity g = ROE × b To estimate g, need to estimate ROE Past ROE might not be good estimator of future ROE is linked with ROA and affected by firm’s financial policies Watch out financial leverage: ROA: Return on Assets=EBIT/Assets

Du Pont System: Decomposition of ROE = Net Profit Pretax Profit x (1) Tax Burden x x Pretax Profit x EBIT (2) Interest Burden x EBIT Sales (3) x x Sales Assets (4) x Assets Equity x (5) x Margin x Turnover x Leverage

Problem 7, Chapter 13, P. 456 An analyst applies the Du. Pont system of financial analysis to the following data for a company: Leverage ratio 2. 2 Total asset turnover 2. 0 Net profit margin 5. 5% Dividend payout ratio 31. 8% What is the company’s return on equity?

Ratio analyses n n n Liquidity Ratios Activity or Mgmt Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios

2002 Income statements Sale revenue Cost of goods sold Depreciation Selling and administrative expenses Operating income Interest expense Taxable income (40% tax rate) Net Income Balance Sheet (end of year) Cash and marketable securities Account receivables Inventories Net plant and equipment Total Asset Account payable Short-term debt Long-term debt Total Liabilities Shareholders’equity (1 mil shares outstanding) Market price per common share at year-end 50, 000 25, 000 75, 000 150, 000 30, 000 45, 000 75, 000 150, 000 2003 2004 2005 100, 000 55, 000 15, 000 30, 000 10, 500 7, 800 11, 700 120, 000 66, 000 18, 000 36, 000 19, 095 6, 762 10, 143 144, 000 79, 200 21, 600 43, 200 34, 391 3, 524 5, 285 60, 000 30, 000 90, 000 180, 000 36, 000 87, 300 75, 000 198, 300 161, 700 93. 60 72, 000 36, 000 108, 000 216, 000 432, 000 43, 200 141, 957 75, 000 260, 157 171, 843 61. 00 86, 400 43, 200 129, 600 259, 200 518, 400 51, 840 214, 432 75, 000 341, 272 177, 128 21. 00

Liquidity ratios n Current ratio = Current asset/ current liabilities 2003: current ratio = (60+30+90)/(36+87. 3) = 1. 46 2003 2004 2005 1. 46 1. 17 0. 97 ¨ Trend: decreasing ¨ poor standing relative to industry n 2005 industry average (IA) 2. 0 Quick ratio = (current asset-inventory)/current liability 2003: quick ratio = (60+30)/(36+87. 3) = 0. 73 2004 2005 0. 73 0. 58 0. 49 ¨ Trend: decreasing ¨ poor standing relative to industry 2005 industry average (IA) 1. 0

Management efficient ratios n n Inventory turnover = COGS (excluding depreciation) / average inventory ¨ How fast firm can sell inventory ¨ 2003: inventory turnover = (55 -15)/{(75+90)/2)}= 0. 485 ¨ 2003 2004 2005 IA 0. 485 0. 5 ¨ Slower in selling inventory total asset turnover = sale/average total asset ¨ 2003: TA turnover = 100/((300+360)/2) = 0. 30 ¨ 2003 2004 2005 IA 0. 30 0. 4

Management efficient ratios n n Average collection period (days receivable) = average AR/sales per day ¨ average time between date of sale and date payment received ¨ 2003: {(25+30)/2}/(100/365) = 100. 4 ¨ 2003 2004 2005 IA 100. 4 60 fixed asset turnover = sale/average of fixed asset 2003: ¨ 2003 ¨ 0. 606 100/{(150+180)/2}=0. 600 2004 2005 IA 0. 606 0. 7

Some comments on efficient management ratios n Total asset turnover of G. I. < industry average (0. 3<0. 4) fixed asset turnover < Industry average (0. 60 < 0. 7): inefficient in using fixed asset ¨ days receivable > industry average (100. 4 > 60): receive cash longer than average, poor receivable procedure ¨ Inventory turnover < industry average (0. 485<0. 5): turn inventory into sale slower than average, poor inventory management ¨

Leverage ratios n n n Interest coverage (times interest earned) = EBIT/Interest expense Leverage ratio: Assets/Equity = 1 + Debt/Equity Debt ratio = debt/equity

Profitability ratios n n n ROA = EBIT/(average total assets) ROE = NI/(average total equity) Return on sale (profit margin) = EBIT/Sales

Market price ratios n Market-to-book = price per share/ book value per share ¨ n Lower market-to-book stocks: safer stocks Price-to-earning (P/E) = market price per share / EPS ¨ Low P/E, more bargain

Comparability Problems n n n GAAP (Generally Accepted Accounting Principles) is not unique ¨ Inventory valuation: LIFO vs FIFO ¨ Depreciation: Straight line vs Accelerated Quality of earnings affected by: ¨ Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities GAAP vs IAS (International Accounting Standards)

Quality of Earnings: Areas of Accounting Choices n Allowance for bad debts: ¨ n Non-recurring items: ¨ n n Different companies have different estimates of reserve for future investment Stock options ¨ n Unusual income, does not happen regularly. Reserves management: ¨ n When companies sell goods using credit, need to have allowance for bad debts. This is the estimate. Different companies have different estimates Companies use stock options as bonus therefore it should be reported as expenses and need to price the options Revenue recognition Off-balance sheet assets and liabilities

Figure 13. 3 Adjusted Versus Reported Price-Earnings Ratios