FINANCIAL STATEMENT ANALYSIS Understanding the financial statements of a firm is critical since it is often the only source of information

with which we must make investment decisions; i.e., whether or not to loan the company money or invest some equity. There is a rationale behind the construction of the financial statements that helps us to interpret the information that is contained within them. Income Statements: Less: Less: Rent Depreciation Utilities Operating Income Interest Expense Taxable Income Taxes Net Income Revenues Cost of Goods Sold Gross Profit Salaries Advertising Selling & Administrative Manufacturing

Less: Less:

Finance Government (Tax accounting)

The income statement is broken down by functional area. This allows us to more accurately determine where our strengths or weaknesses lie.

Balance Sheets As with the income statement, the balance sheet is constructed in a very methodical manner. On the Asset side, the assets are listed in order from the most liquid to the least liquid. Similarly, on the Liability & Equity side, the accounts are listed in order from the most immediately due to the least.

Cash Marketable Securities Accounts Receivable Inventory Prepaid Expenses Total Current Assets Plant & Equipment (Accumulated Depr.) Net Plant & Equip. Total Assets Statement of Cash Flows

Accounts Payable Wages Payable Bank Note Payable Current Portion of L-T Debt Total Current Liabilities Long-Term Debt Common Stock Retained Earnings Total Liabilities & Equity

From a financial perspective, the Statement of Cash Flows is the most important financial statement because it integrates the Income Statement and Balance sheet while adjusting the accounting figures based upon accrual accounting into actual cash flow. From Operations: Net Income Plus: Depreciation Plus: Amortization Operating Cash Flow Plus: Changes in Non-Cash Current Assets Plus: Changes in Operations-related Current Liabilities Total From Operations From Investing Activities: Changes In Gross Fixed Assets Plus: Changes in Other Non-Current Assets Total From Investing Activities

From Financing Activities: Changes in Non-Operations-related current liabilities Plus: Changes in Long-Term Debt Plus: Changes in Other Capital Accounts (except Retained Earnings) Less: Dividends Paid Total From Financing Activities Total Change in Cash Plus: Beginning Cash Balance Ending Cash Balance COMMON SIZE INCOME STATEMENTS All Items Expressed as a Percentage of Revenues.

COMMON SIZE BALANCE SHEETS All Accounts Expressed as a Percentage of Total Assets. Whats the purpose of calculating Common-Sized statements? purposes.) FINANCIAL RATIOS The financial statements are often the only information upon which to base an investment decision (as an equityholder or a lender), so it is imperative that we be able to determine what economic information the statements contain. Financial Ratios are used as tools to help us squeeze as much information as possible from the financial statements. It must be kept in mind, however, that a financial ratio is only one number divided by another and only yields a number. The ratio takes on meaning when compared with other firms or industry averages (a static analysis) or when compared with previous periods for trends to see if a firms position is improving or deteriorating (a dynamic analysis). The ratios must also be taken together as a group if a ratio appears to be higher than it normally is, it can be due to the numerator being large OR the denominator being small. By looking at other ratios we can determine which is the case. (Comparison

Liquidity Ratios Liquidity ratios are designed to measure the extent to which our short-term, or liquid, assets exist to cover our short-term obligations. While most ratios have definitions that vary (and, hence, one must be certain that the appropriate definition is being used for comparison purposes), the definition of the Current Ratio is standard: Current Ratio = Total Current Assets Total Current Liabilities

The current ratio is looking at those assets that are expected to be converted into cash with one year, relative to those liabilities that come due within a year. A more stringent measure is the Quick (or Acid Test) Ratio. This ratio recognizes that some current assets are more liquid than others. While the book defines the quick ratios numerator as being the Current Assets less Inventories, the general definition used in practice excludes other current assets that are not liquid in nature, such as prepaid expenses. The idea behind excluding inventories is twofold: first, inventories are generally illiquid and can only be converted into cash by selling at steep discounts. Secondly, most companies sell inventories on credit, so they become an account receivable which must then be collected. By excluding inventories, the quick ratio is therefore recognizing the fact that they are one step further removed from becoming cash than other current assets. Monetary Current Assets Total Current Liabilities

Quick (Acid Test) Ratio =

FINANCIAL LEVERAGE The next set of financial ratios is designed to examine the extent to which a company utilizes debt in the financing of its assets. The use of debt is referred to as financial leverage. First, lets look at the effect of financial leverage on a firm. Consider a company that has three different possible debt financing strategies, ranging from no debt to 90% debt. Also, lets assume that the interest rate on any debt employed is 10% and that the firm has a tax rate of 40%. Interest Rate = 10% Tax Rate = 40% 1 === 0 1,000 -------1,000 2 === 500 500 -------1,000 3 === 900 100 -------1,000

DEBT EQUITY TOTAL ASSETS

Since the effect of financing doesnt appear until we go below the Operating Income (EBIT) line, we can jump straight down to the operating income to analyze the effect of financial leverage. Assume that the EBIT is $140 for the firm; then, the calculation of Net Income, and the rate of return that the Net Income represents on the equity invested, are as follows: EBIT - INT TAX. INC. - TAX NET INCOME ROE = 140 0 -------140 (56) -------84 8.4% 140 (50) -------90 (36) -------54 10.8% 140 (90) -------50 (20) -------30 30.0%

Notice that the Return on Equity is magnified by the use of debt, and that the more the debt that is employed, the greater the magnification. The profits of the firm can be greatly magnified through the use of debt. Leverage, however, is a two-edged sword. Not only are profits magnified, but also losses. Consider the same firm when EBIT is only $60:

DEBT EQUITY TOTAL ASSETS EBIT - INT TAX. INC. - TAX NET INCOME ROE =

1 === 0 1,000 -------1,000 60 0 -------60 (24) -------36 3.6%

2 === 500 500 -------1,000 60 (50) -------10 (4) -------6 1.2%

3 === 900 100 -------1,000 60 (90) -------(30) 12 -------(18) -18.0%

Now the use of debt results in lower profitability. Financial leverage magnifies both profits and losses in other words, it magnifies the risk of the company. Financial leverage will be looked at in more detail later. For now, a basic understanding of the

effect of leverage is sufficient; but lets look at some of the ratios designed to measure the extent to which a company utilizes debt, and just how well it can manage its debt. Leverage (Solvency) Ratios The Debt-to-Assets Ratio looks at how much of a companys assets are financed with debt; i.e., other peoples money. Debt / Asset Ratio = Total Debt Total Assets

A variation on the Debt-to-Asset Ratio that is more commonly used in practice is the Debt-to-Equity Ratio which simply expresses the debt as a percentage of equity rather than total assets. The two measures are equivalent as indicated by the second part of the equation:
Debt/Equity Ratio = Total Liabilities Net Worth D/A 1 - D/A

Sometimes it is desirable to break down the use of debt into short-term and long-term debt. Which type of debt do you think is more risky for the company to utilize? (To answer this, ask yourself whether you would prefer to buy a house using a one-year note that would have to be refinanced in twelve months, or a 30-year mortgage.) Current Liabs. to Net Worth = Total Current Liabilities Net Worth

Just as in accounting where changes in current liabilities are included as a part of operating cash flows (since accounts payable and accruals such as wages payable arise from operations), sometimes only the long-term portions of debt are considered. This is because oftentimes a company is viable in the long-run but faces short-term liquidity problems (consider when the Democrats and Republicans shut down the federal government for a few days in 1997). The capitalization ratio looks at the longterm debt financing that a company uses: Capitalization Ratio = Long - term Debt Long - term Capital

While short-term solvency is obviously important, the long-term aspects are relevant for long-term debt/investment considerations. While the preceding measures of the extent to which a company uses debt to finance its assets are important, what is probably of more concern is the ability of the

company to service its debt. The following ratios look at the ability of the company to make debt service payments to its creditors. The most common of these, particularly when only the financial statements are available, is the Times Interest Earned ratio: Times Interest Earned = EBIT Interest Expense

More important to many lenders is the ability of the company to not only make interest payments, but also to repay the principal of the loan. The Debt Service Coverage Ratio considers both interest and principal payments that are required. Note that the principal portion is grossed up to account for tax considerations. Why? Debt Service Coverage = EBIT Principal Pymt. Int. Exp. + 1- t

Finally, it is common for lenders (such as banks) to look more toward the cash flow coverage of debt payments that a company can make. For this reason, the Operating Income (EBIT) has the non-cash charges of Depreciation and Amortization added back (just like they are in the Operating Cash Flow section of the Statement of Cash Flows). Cash Coverage = EBIT + Depreciation & Amortization Interest Expense EBITDA Interest Expense

Asset Management (Utilization) Ratios Asset utilization ratios are designed to give insight into how effectively a company is managing its assets. For many firms, inventories are its largest category of assets. Why is it bad to have too much inventory? Why is it bad to have too little? One way to look at the amount of assets that a firm holds in relation to its level of sales is the inventory turnover ratio: Inventory Turnover = Cost Of Goods Sold Inventory

The inventory turnover ratio can, alternatively, be stated as the Average Age of Inventory; i.e., how long on average does an inventory item sit in the warehouse before it is sold:

Average Age of Inventory =

Inventory COGS / 365

The second major category, at least of current assets, for most firms is the amount of money that is tied-up in Accounts Receivable. The Average Collection Period (or Days Sales Outstanding) tells you how long, on average, it takes for a firm to collect the money due on a sale made on credit: Average Collection Period (Days' Sales Outstanding) = Accounts Receivable Sales / 365

The final major category of assets, particularly manufacturing firms, is that of Property, Plant & Equipment, or Fixed Assets. The Fixed Asset Turnover ratio looks at the amount of productive equipment that a firm has relative to the amount of sales that it is generating. In one sense, this could be interpreted as a measure of the amount of capacity utilization that a firm has. What problems do you see with this measure? Fixed Asset Turnover = Sales Net Fixed Assets

A final measure looks at all of the firms investment in assets relative to its sales level. This is the Total Asset Turnover ratio: Total Asset Turnover = Sales Total Assets

Profitability Ratios One of the best measures for evaluating management lies in their ability to control costs. Thus, profit margins are an important means of assessing this ability: Gross Profit Margin = Gross Profit Sales Operating Income Sales

Operating Profit Margin =

Net Profit Margin =

Net Income Sales

Another important factor has to do with the amount of profit being made relative to the investment in assets that support the operations and sales. Note that this ratio can be decomposed into the Net Profit Margin and the Total Asset Turnover. This has

two important implications: First, it illustrates that there are two ways to make money have a high profit margin and a low turnover rate, or a low profit margin and a high turnover rate. Secondly, it provides us a means by which to determine where problems, or strengths, reside. If the net ROA is low, is it because we are not controlling costs (in which case, is it in production, selling and administrative, or financing costs), or is it because we have too many assets relative to sales (such as too much inventory, too long a collection period, too many unutilized fixed assets). This approach to locating the source(s) of the problems is known as the DuPont method of analysis. Your textbook gives you an example of its implementation. Net Return on Assets = Net Income Total Assets

= Net Profit Margin * Total Asset Turnover Net Income Sales * Sales Total Assets

Finally, equity investors are concerned with the rate of return that is being generated on their investment in the company. Return on Equity = Net Income Net Worth Net ROA 1- D / A Total Assets Total Equity

= Net ROA *

Market Ratios The last group of ratios is designed to look at market-related measures of performance: Earnings per Share (Basic) = Net Income Total No. of Shares Outstanding Net Income Total Possible Shares Outstanding

Earnings per Share (Fully Diluted) =

Price / Earnings Ratio = or P Div./Earn. = E kS - g

Market Price / share Earnings per Share

Another Liquidity Measure One problem with the Current and Quick Ratios as measures of liquidity is the fact that they are predicated upon the liquidation of the current assets of the firm in order to satisfy the short-term liabilities. Generally, however, one is not interested in liquidating a firm in order to cover its short-term obligations (except in extreme cases). For this reason, the cash cycle is often looked at in order to see the extent to which the ongoing operations of the firm cover short-term requirements (primarily in the area of accruals and payables). In order to calculate the cash cycle, we need to look at a measure of the short-term liability encompassed by the trade credit that our supplier provide to us: Average Age of Payables = Accounts Payable COGS / 365

The cash cycle looks at how long a company has money tied-up in its operations. Money is invested in inventories, which sit in the warehouse for a certain period of time and then are sold on credit which takes so-long to collect; but this length of time (known as the operating cycle) is reduced by the fact that our suppliers do not require immediate payment for the inventories that we purchase. Cash Cycle = Average Age of Inventory + Average Collection Period - Average Age of Payables While a short cash cycle is considered to be an efficient use of money, what are the dangers of having: 1) A low average age of inventory 2) A short average collection period 3) A long average payables period The firms cash cycle is looking at how long, and hence, how much, cash is tied up. Decreasing the cash cycle decreases the amount of cash investment is required. As will be seen when working capital is addressed, cash can be free-up by accelerating inflows (shortening the average collection period) or delaying outflows (stretching out the average payables period) as well as by liquidating assets such as inventory (and increasing inventory turnover which is the same as decreasing the average age of

inventory). Industry Averages Industry averages are often used for comparison purposes. The two most popular sources of industry averages are RMAs Annual Statement Studies and Dun & Bradstreets Key Business Ratios. RMA is an association of banks that pool loan data and Dun & Bradstreet is the well-known credit rating agency. Industry averages can also be obtained from Standard & Poors and Moodys, the two premier bond rating agencies.