Overview of Financial Analysis I had better sell
Overview of Financial Analysis I had better sell that stock ASAP! o SPECIFY THE OBJECTIVES OF THE ANALYSIS o Focus on who is the financial statement user o The identity of the user helps define what information is needed The company’s return on equity has dipped considerably over the last period Financial
Steps of a F/S Analysis 1. 2. Establish objectives of the analysis Study the industry and relate industry climate to current and projected economic developments o o o 3. 4. 5. 6. a growth industry? a dying industry? a changing industry? Develop knowledge of firm and quality of management Evaluate financial statements using basic tools Summarize findings Reach conclusions relevant to established objectives
Potential Financial Statement Users: o Creditors o Investors o Managers o Who else? o What types of questions do each of these users seek answers to?
Data sources o o o Financial statements (and notes) Auditor’s report MD&A Supplementary schedules 10 K and 10 Q reports filed with SEC Computerized data bases o Info on industry norms/ratios o Info on particular companies/industries/mutual funds o Articles in popular/business press o Websites
Tools for analysis o Common size financial statements o Financial ratios o Trend analysis o Structural analysis o Industry comparisons o Common sense and judgment
Financial Ratio Categories o Liquidity Ratios measure a firm’s ability to meet cash needs as they arise o Activity Ratios measure the liquidity of specific assets and the efficiency of managing assets
Ratio Categories (continued) o Leverage Ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges o Profitability Ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity
Caution! o Ratios are valuable, BUT…. . o They do not provide answers in an of themselves and are not predictive o They should be used with other elements of financial analysis o There are no “rules of thumb” that apply to interpretation of ratios
Profitability Ratios o Gross Profit Margin Gross Profit/Net Sales o Operating Profit Margin Operating Profit/Net Sales o Net Profit Margin Net Earnings/Net Sales o All measure firm’s ability to translate sales dollars into profits
Profitability Ratios (continued) o Return on Investment (or Return on Assets) Net Earnings/Total Assets o Return on Equity Net Earnings/Stockholders’ Equity o Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders
Return on Investment o Return on Investment (ROI) Net Operating Income ROI = Average Operating Assets o Net operating income o Income before interest and taxes o Operating assets o Assets held for operating purposes ONLY o i. e. cash, accounts receivable, inventory, plant and equipment 2005 KD Hatheway-Dial
Understanding ROI = Margin X Turnove r Operating = Margin Turnove = r 2005 KD Hatheway-Dial Net Operating Income Sales Average Operating Assets
Understanding ROI 12. 5% = 2005 KD Hatheway-Dial 5% X 2. 5 5% = $10, 000 $200, 000 2. 5 = $200, 000 $80, 000 X 100
APPLYING ROI 10% Increased Sales without Any Increase in Operating Assets (assume 6% increase in operating expenses) 23. 25% = 8. 4545 X 2. 75 86% increase with 10% increase in sales 8. 4545 = $18, 600 $220, 000 = $220, 000 $80, 000 2. 75 2005 KD Hatheway-Dial X 100
APPLYING ROI 10% Decrease in operating expenses and no change in sales 36. 25% = 14. 5% X 2. 50 190% increase with 10% decrease in operating expenses 14. 5% 2. 50 2005 KD Hatheway-Dial = $29, 000 $200, 000 = $200, 000 $80, 000 X 100
APPLYING ROI 10% Decrease in operating assets and no change in sales or operating expenses 13. 90% = 5. 0% X 2. 78 11. 2% increase with 10% decrease in operating assets 5. 0% 2. 78 2005 KD Hatheway-Dial = $10, 000 $200, 000 = $200, 000 $72, 000 X 100
APPLYING ROI 10% increase in operating assets and 5% change in sales and 3% operating expenses 16. 25% = 6. 8% X 2. 39 30% increase with 10% decrease in operating assets 6. 8% = $14, 300 $210, 000 2. 39 = $210, 000 $88, 000 2005 KD Hatheway-Dial X 100
Profitability Ratios (continued) o Cash Flow Margin Cash Flow from Operating Activities /Net Sales Measures ability to translate sales into cash (with which to pay bills)
Profitability Ratios (continued) o Cash Return on Assets Cash Flow from Operating Activities /Total Assets Useful comparison to return on investment Indicates firm’s ability to generate cash from utilizing its assets
Liquidity Ratios o Current Ratio Current Assets/Current Liabilities Measures ability to meet short-term cash needs o Quick or Acid Test Ratio Current Assets-Inventory/Current Liabilities Measure ability to meet short-term cash needs more rigorously o Cash Flow Liquidity Ratio Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities Focuses on ability of the firm to generate operating cash flows as a source of liquidity
Activity Ratios o Average Collection Period Accounts Receivable/Average Daily Sales Helps gauge liquidity of accounts receivable (ability to collect cash from customers) o Accounts Receivable Turnover Net Sales/Accounts Receivable Another measure of efficiency of firm’s collection and credit policies
Activity Ratios (continued) o Inventory Turnover Cost of Goods Sold/Inventory Measures efficiency of inventory management o Fixed Asset and Total Asset Turnover Net Sales/Net PP&E (Fixed Asset T/O) Net Sales/Total Assets (Total Asset T/O) Both assess effectiveness in generating sales from investment in assets
Leverage: Debt Ratios o Debt Ratio Total Liabilities/Total Assets o Long-Term Debt to Total Capitalization Long-term Debt/Long-term Debt + Stockholders’ Equity o Debt to Equity Ratio Total Liabilities/Stockholders’ Equity o All three measure extent of firm’s financing with debt
Leverage: Coverage Ratios o Proportion and amount of debt in capital structure is important to analyst o Tradeoff between risk and return o Use of debt involves risk -commitment to fixed charges o Fixed charges must be COVERED -- following are some ratios to assess coverage
Coverage Ratios (continued) o Times Interest Earned Operating Profit/Interest Expense Indicates how well operating earnings cover fixed interest charges o Fixed Charge Coverage Operating Profit + Lease Payments/Interest Expense + Lease Payments Broader measure of how well operating earnings cover fixed charges
Coverage Ratios (continued) o Cash Flow Adequacy Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities Measures firm’s ability to cover longterm debt maturities each year Rationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt
Other Ratios o Earnings per Common Share Net Earnings/Average Common Shares Outstanding Indicates return on a per share basis o Price to Earnings Market Price of Common Stock/Earnings per Common Share Expresses a multiple the stock market places on earnings
Other Ratios (continued) o Dividend Payout Dividends per Share/Earnings per Share Shows percentage of earnings paid out to stockholders o Dividend Yield Dividends per Share/Market Price of Common Share Shows rate earned by shareholders from dividends relative to current stock price
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