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Questions
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 to a firms industry?
Questions.
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?
Questions.
What is quality balance sheet or income statement? Why is financial statement analysis done if markets are efficient and forward-looking? 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?
Financial statement analysis can be useful in estimating both of these valuation inputs.
Can be good for firms in different situations Can represent a challenge for analysis 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
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
Modifies cash flow from operations to reflect necessary capital expenditures and projected divestitures
Ratios provide meaningful relationships between individual values in the financial statements
The aggregate economy Its industry or industries Its major competitors within the industry Its own past performance (time-series analysis)
Select a subset of competitors for the comparison group Construct a composite industry average from the different industries in which the firm operates
3. Operating performance Operating efficiency Operating profitability 4. Risk analysis Business risk Financial risk External liquidity risk
5. Growth analysis
Given the turnover values, you can compute the average inventory processing time
Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales Examine how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit
The rate of profit on sales (profit margin) The percentage return on capital
Is the firm buying inputs (inventory and direct labor) at good prices? Gross Profit Gross Profit Margin Net Sales
Shows the combined effect of operating profitability and the firms financing decisions (since net income is after interest and tax payments)
Net Profit Margin Net Income Net Sales
It also allows us to focus on any categories of expenses that are out of line with the appropriate benchmark
Profit Margin
Financial x Leverage
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
We consider the positive effect of financial leverage with the financial leverage multiplier
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.
Net Before Tax (NBT) Total Assets Total Assets Common Equity
Net Before Tax Common Equity 100%
Operating profit margin Total asset turnover Interest expense rate Financial leverage multiplier Tax retention rate
Risk Analysis
Risk analysis examines the uncertainty of income for the firm and for an investor Total firm risks can be decomposed into two basic sources:
Business risk: The uncertainty in a firms operating income, highly influenced by industry factors Financial risk: The added uncertainty in a firms net income resulting from a firms financing decisions (primarily through employing leverage).
External liquidity analysis considers another aspect of risk from an investors perspective
Business Risk
Variability of the firms operating income over time Can be measured by calculating the standard deviation of operating income over time or the coefficient of variation In addition to measuring business risk, we want to explain its determining factors.
Business Risk
Two primary determinants of business risk Sales variability
Financial Risk
Interest payments are deducted before we get to net income
Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline
The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high
Financial Risk
Two sets of financial ratios help measure financial risk
Balance sheet ratios Earnings or cash flow available to pay fixed financial charges
A firm with considerable business risk should likely avoid lots of debt financing
Financial Risk
Proportion of debt (balance sheet) ratios Long-term debt can be related to:
How much debt does the firm employ in relation to its use of equity?
How much debt does the firm employ in relation to all long-term sources of funds?
Financial Risk
Earnings or Cash Flow Ratios
Relate operating income (EBIT) to fixed payments required from debt obligations Higher ratio means lower risk
Financial Risk
Interest Coverage or Times Interest Earned Ratio
Measures the number of times Interest payments are covered by EBIT Interest Coverage = EBIT/Interest Expense
May also want to calculated coverage ratios that reflect other fixed charges
Financial Risk
Cash flow ratios
Fixed financing costs such as interest payments must be paid in cash, so these ratios use cash flow rather than EBIT to assess the ability to meet these obligations Relate the flow of cash available from operations to:
Interest expense Total fixed charges The face value of outstanding debt
Determinants of Growth
Sustainable Growth Model
What is the rate of return on equity (which gives the maximum possible growth)? How much of that growth is put to work through earnings retention (rather than being paid out in dividends)? The retention rate is one minus the firms dividend payout ratio Anything that impacts ROE would also be a determinant of future growth
Determinants of Growth
ROE (recall the DuPont equation) is a function of
Net profit margin Total asset turnover Financial leverage (total assets/equity)
High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs
Analysis provides knowledge of a firms operating and financial structure This aids in estimating future returns
A number of financial ratios can be useful in arriving at estimates for each of these inputs
Sometimes we estimate the value of a stock through various price ratios such as P/E
Would need to estimate variables such as expected growth rate of earnings and dividends
Predicting such changes in ratings before they occur can increase the return on a bond or stock portfolio