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 companys 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 a growth industry? a dying industry? a changing industry?

o
o o o

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 o o o Financial statements (and notes) Auditors report MD&A Supplementary schedules 10K and 10Q 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 firms 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 firms 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 firms 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
ROI = Margin X Turnover Operating = Margin Turnover = Net Operating Income Sales

Sales Average Operating Assets

2005 KD Hatheway-Dial

Understanding ROI
12.5% = 5% X 2.5 $10,000 $200,000

5% = 2.5 =

X 100

$200,000 $80,000

2005 KD Hatheway-Dial

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 = 2.75

$18,600 $220,000

X 100

$220,000 $80,000

2005 KD Hatheway-Dial

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%

$29,000 $200,000

X 100

2.50

$200,000 $80,000

2005 KD Hatheway-Dial

APPLYING ROI
10% Decrease in operating assets and no change in sales or operating expenses
13.90% = 5.0% 5.0% = X 2.78 $10,000 $200,000 X 100
11.2% increase with 10% decrease in operating assets

2.78

$200,000 $72,000

2005 KD Hatheway-Dial

APPLYING ROI
10% increase in operating assets and 5% change in sales and 3% operating expenses
16.25% = 6.8% 6.8% = 2.39 = X 2.39 X 100
30% increase with 10% decrease in operating assets

$14,300 $210,000

$210,000 $88,000

2005 KD Hatheway-Dial

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 firms 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 firms 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 firms 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 firms 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