The Analysis of Financial Statements Ratios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison - CEO, R.E.C. Inc. (C) 2007 Prentice Hall, Inc. 5-1 Objectives of Analysis Objectives will vary depending on the perspective of the financial statement user specific questions that are addressed by the analysis Remember--the identity of the user helps define what information is needed (C) 2007 Prentice Hall, Inc. 5-2 Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds (C) 2007 Prentice Hall, Inc. 5-3 Investors An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation (C) 2007 Prentice Hall, Inc. 5-4 Tools and Techniques These include: Common-size financial statements Financial ratios Trend analysis Industry comparisons Most important: Common sense and judgment (C) 2007 Prentice Hall, Inc. 5-5 Common-Size Financial Statements Express each account on the balance sheet as a percentage of total assets income statement as a percentage of net sales (C) 2007 Prentice Hall, Inc. 5-6 Key Financial Ratios Standardize financial data in terms of mathematical relationships expressed in the form of Percentages Times Days (C) 2007 Prentice Hall, Inc. 5-7 Key Financial Ratios (cont.) Liquidity (Short-term liquidity) Activity Leverage (Long-term solvency) Profitability Market (C) 2007 Prentice Hall, Inc. 5-8 Liquidity Ratios: Short-Term Solvency Current Ratio Measures ability to meet short-term cash needs Current assets Current liabilities (C) 2007 Prentice Hall, Inc. 5-9 Liquidity Ratios: Short-Term Solvency (cont.) Quick or Acid-Test Ratio Measures ability to meet short-term cash needs more rigorously by eliminating inventory (Cash+short-term investments + A/R) current liabilities Current assets - Inventory Current liabilities (C) 2007 Prentice Hall, Inc. 5-10 Liquidity Ratios: Short-Term Solvency (cont.) Cash Flow Liquidity Ratio Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash + Marketable securities + CFO * Current liabilities *Cash flow from operating activities (C) 2007 Prentice Hall, Inc. 5-11 Liquidity Ratios Short term liquidity Current Ratio Quick Ratio Cash Flow Liquidity (C) 2007 Prentice Hall, Inc. 2007 1,13 0,48 0,76 2006 1,18 0,52 0,57 2005 1,43 0,68 1,21 2004 2,04 0,86 1,61 2003 1,65 0,40 0,92 5-12 Activity Ratios: Asset Liquidity, Asset Management Efficiency Accounts Receivable Turnover Another measure of efficiency of firm’s collection and credit policies Credit sales, net Average trade receivable s, net 365 receivable turnover (C) 2007 Prentice Hall, Inc. 5-13 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Inventory Turnover Another measure of firm’s efficiency in managing its inventory Cost of goods sold average inventorie s 365 inventory turnover (C) 2007 Prentice Hall, Inc. 5-14 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Payables Turnover Another way to gain insight into a firm’s pattern of payment to suppliers COGS in inventorie s Average trade payables 365 payable turnover (C) 2007 Prentice Hall, Inc. 5-15 Cash Conversion Cycle or Net Trade Cycle The normal cycle of a firm that consists of: Buying or manufacturing inventory, with some purchases on credit Selling inventory, with some sales on credit Collecting the cash (C) 2007 Prentice Hall, Inc. 5-16 Cash Conversion Cycle or Net Trade Cycle (cont.) Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing: Key balance sheet accounts that affect cash flow from operating activities Accounts Receivable Inventory Accounts Payable (C) 2007 Prentice Hall, Inc. 5-17 Cash Conversion Cycle or Net Trade Cycle (cont.) Calculated as follows: Average collection period Plus Days inventory held Minus Days payable outstanding Equals Cash conversion or net trade cycle (C) 2007 Prentice Hall, Inc. 5-18 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Fixed Asset Turnover Assesses effectiveness in generating sales from investments in fixed assets Net sales Net property, plant, equipment (Average) (C) 2007 Prentice Hall, Inc. 5-19 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Total Asset Turnover Assesses effectiveness in generating sales from investments in all assets Net sales Total assets (Average) (C) 2007 Prentice Hall, Inc. 5-20 Activity Ratios- Summary Receivable Turnover Inventory Turnover Payable Turnover Fixed Asset Turnover Total Asset Turnover Net Sales/Average Trade Receivables COGS/Average Inventories Purchases/Average Trade Payables Net Sales/Average PP&E Net Sales/Average Total Assets Average collection period Average days in inventory Avergae payment period 365/receivable turnover 365/inverntory turnover 365/payable turnover Net Trade Period collection period + days in inventory - (C) 2007 Prentice Hall, Inc. 5-21 Activity Ratios- Summary Activity Ratios Receivable Turnover Inventory Turnover Payable Turnover PPE Turnover Asset Turnover 2007 10,62 4,84 17,75 1,13 0,71 2006 10,67 4,98 14,21 0,96 0,60 2005 11,40 6,08 13,90 0,91 0,58 2004 15,55 6,57 25,24 0,98 0,63 Collection Period Days in inventory Payment period 34,37 75,48 20,57 34,21 73,33 25,68 32,00 59,99 26,26 23,47 55,52 14,46 Cash cycle 89,29 81,86 65,74 64,54 (C) 2007 Prentice Hall, Inc. 5-22 Leverage Ratios: Debt Financing and Coverage Debt Ratio Considers the proportion of all assets that are financed with debt Total liabilities Total assets (C) 2007 Prentice Hall, Inc. 5-23 Leverage Ratios: Debt Financing and Coverage (cont.) Long-term Debt to Total Capitalization Reveals the extent to which long-term debt is used for the firm’s permanent financing (both longterm debt and equity) Long–term debt Long-term debt + Stockholders’ equity (C) 2007 Prentice Hall, Inc. 5-24 Leverage Ratios: Debt Financing and Coverage (cont.) Debt to Equity Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) Total liabilities Stockholders’ equity (C) 2007 Prentice Hall, Inc. 5-25 Leverage Ratios: Debt Financing and Coverage (cont.) Times Interest Earned Indicates how well operating earnings cover fixed interest expenses Operating profit Interest expense (C) 2007 Prentice Hall, Inc. 5-26 Leverage Ratios: Debt Financing and Coverage (cont.) Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes CFO + interest paid + taxes paid Interest paid (C) 2007 Prentice Hall, Inc. 5-27 Leverage Ratios: Debt Financing and Coverage (cont.) Fixed Charge Coverage Broader measure of how well operating earnings cover fixed charges Operating profit + Rent expense Interest expense + Rent expense *Rent expense = operating lease payments (C) 2007 Prentice Hall, Inc. 5-28 Leverage Ratios: Debt Financing and Coverage (cont.) Cash Flow Adequacy Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year Cash flow from operating activities Capital expenditures + debt repayments + dividends paid (C) 2007 Prentice Hall, Inc. 5-29 Leverage Ratios: Debt Financing and Coverage Summary Solvency Ratios Debt Ratio LT Debt to Capital Debt to equity Times interest earned Cash interest coverage Long-term Liquidity Debt ratio L/T Debt to Capitalization debt to equity Times interest earned (C) 2007 Prentice Hall, Inc. Total liabilities/Total assets Total liabilities/Total equity Oper. Income/Interest expense CFO + interest paid + tax paid)/Interest paid 2007 0,43 0,28 0,86 4,79 2006 0,43 0,29 0,83 3,84 2005 0,38 0,26 0,67 11,57 2004 0,29 0,19 0,43 8,63 5-30 Profitability Ratios: Overall Efficiency and Performance Gross Profit Margin Measures ability to translate sales into profit after consideration of cost of products sold Gross profit Net sales (C) 2007 Prentice Hall, Inc. 5-31 Profitability Ratios: Overall Efficiency and Performance (cont.) Operating Profit Margin Measures ability to translate sales into profit after consideration of operating expenses Operating profit Net sales (C) 2007 Prentice Hall, Inc. 5-32 Profitability Ratios: Overall Efficiency and Performance (cont.) Net Profit Margin Measures ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes and nonoperating items Net earnings Net sales (C) 2007 Prentice Hall, Inc. 5-33 Profitability Ratios: Overall Efficiency and Performance (cont.) Cash Flow Margin Measures ability to translate sales into cash (with which to pay bills!) Cash flow from operating activities Net sales (C) 2007 Prentice Hall, Inc. 5-34 Profitability Ratios: Overall Efficiency and Performance (cont.) Return on Equity (ROE) Measures rate of return on stockholders’ investment Net earnings Stockholders’ equity (Average) (C) 2007 Prentice Hall, Inc. 5-35 Profitability Ratios: Overall Efficiency and Performance (cont.) Return on Total Assets (ROA) or Return on Investment (ROI) Measures overall efficiency of firm in managing investment in assets and generating profits (C) 2007 Prentice Hall, Inc. Net earnings Total assets (Average) 5-36 Relating the Ratios —The Du Pont System Is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios The Du Pont System helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity (C) 2007 Prentice Hall, Inc. 5-37 Relating the Ratios —The Du Pont System (cont.) The summary ratios used are the following: (1) Net profit margin (2) Total asset turnover Net income Net sales Net sales X Total assets (3) Return on investment (4) Financial leverage Net income Total assets Total assets (C) 2007 Prentice Hall, Inc. (3) Return on investment Net income = Total assets (5) Return on equity Net income X Stockholder equity = Stockholder equity 5-38 Profitability Ratios: Overall Efficiency and Performance (cont.) Cash Return on Assets Measures firm’s ability to generate cash from the utilization of its assets Useful comparison to ROA Cash flow from operating activities Total assets (Average) (C) 2007 Prentice Hall, Inc. 5-39 Profitability Ratios-Summary Profitability Ratios Gross Margin Operating Margin Net Profit Margin Return on Assets Return on Equity Cash Return on Assets (C) 2007 Prentice Hall, Inc. Gross profit/Sales revenue Operating Income/Sales revenue Net Income/Sales Revenue Net income/Average total assets Net income/Average total equity CFO/Average total assets 5-40 Profitability Ratios-Summary Profitability Gross margin % Operating Margin Net Profit Margin ROA = ROE = Cash Return on Assets (C) 2007 Prentice Hall, Inc. 2007 27,36% 15,18% 7,91% 5,60% 10,99% 14,15% 2006 27,14% 10,99% 5,45% 3,25% 5,99% 7,63% 2005 27,80% 15,78% 9,98% 5,76% 9,37% 16,58% 2004 30,83% 18,61% 12,61% 7,94% 11,96% 5-41 Market Ratios Four market ratios of particular interest to the investor are 1. 2. 3. 4. Earnings per common share Price-to-earnings Dividend payout Dividend yield (C) 2007 Prentice Hall, Inc. 5-42 Market Ratios (cont.) Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Net earnings Average shares outstanding (C) 2007 Prentice Hall, Inc. 5-43 Market Ratios (cont.) Price-to-Earnings Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings Market price of common stock Earnings per share (C) 2007 Prentice Hall, Inc. 5-44 Market Ratios (cont.) Dividend Payout Determined by the formula cash dividends per share divided by earnings per share Dividends per share Earnings per share (C) 2007 Prentice Hall, Inc. 5-45 Market Ratios (cont.) Dividend Yield Shows the relationship between cash dividends and market price Dividends per share Market price of common stock (C) 2007 Prentice Hall, Inc. 5-46 Market Ratios Market Ratios Price earnings ratio price to book value (C) 2007 Prentice Hall, Inc. 2007 12,73 1,35 2006 46,67 1,34 2005 16,93 1,49 2004 11,16 1,28 5-47 Financial Analysis Credit Analysis Equity Analysis Creditors What is the borrowing cause? What is the firm’s capital structure? What will be the source of debt repayment? (C) 2007 Prentice Hall, Inc. 5-49 Credit Rating Business Risk Industry characteristics Company position Management Financial Risk Financial characteristics Financial Policy Profitability Capital Structure Cash Flow Protection Financial flexibility (C) 2007 Prentice Hall, Inc. 5-50 Standard & Poor’s rating method 1. 2. 3. 4. 5. 6. 7. 8. EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt % Free operating cash flow/Total debt % Return on capital % Operating income/Sales Long-term debt/Capital Total debt/Capital (C) 2007 Prentice Hall, Inc. 5-51 Standard and Poors Corporate Ratings (C) 2007 Prentice Hall, Inc. 5-52 Financial distress The deterioration in a company’s financial condition such that its ability to repay debt is impaired (C) 2007 Prentice Hall, Inc. 5-53 Prediction of financial distress Univariate models Beaver (1966) relied on Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio No-credit (defensive) interval (C) 2007 Prentice Hall, Inc. 5-54 Prediction of financial distress Multivariate models Altman Z-score (Current assets – current liabilities)/total assets (weight-1,2) Retained earnings/Total assets (weight-1,4) EBIT/Total assets (weight-3,3) Preferred and common stock market value/Book value of liabilities (weight-0,6) Sales/Total assets (weight-1,0) (C) 2007 Prentice Hall, Inc. 5-55 Altman Z-score Z> 2,99 Not in financial distress Z< 1,81 In financial stress 2,99>Z>1,81 Uncertain (C) 2007 Prentice Hall, Inc. 5-56 Altman Z score Anadolu Cam Altman Z-score Ratio 1 Ratio 2 Ratio 3 Ratio 4 Ratio 5 Altman Z-score (C) 2007 Prentice Hall, Inc. 2006 0,04 0,11 0,04 1,60 0,55 1,85 A. Cam 2005 2004 0,08 0,14 0,12 0,10 0,07 0,12 2,27 2,97 0,51 0,61 2,36 3,08 5-57 Additional considerations Mezzanine items Could be debt or equity Off-balance-sheet liabilities Operating leases Contingent liabilities Environmental liabilities (C) 2007 Prentice Hall, Inc. 5-58 Equity Analysis Buy-side Work for an institutional investors (mutual fund) Make internal recommendations regarding the purchase of equity securities Might review reports of sell-side analysts Sell-side Work for brokerage firms Issue reports for retail and institutional customers (C) 2007 Prentice Hall, Inc. 5-59 Valuation Current value V0 is a function of Present value of next year’s cash flow, Required rate of return, r Expected constant growth rate, g CF1 V0 (C) 2007 Prentice Hall, Inc. CF1 rg 5-60 Equity Analysis Provides information regarding 1. The future cash flow generating ability of the firm 2. The growth (or lack thereof) of those cash flows 3. The risk of those cash flows, and 4. The risk-free rate commanded by the market (C) 2007 Prentice Hall, Inc. 5-61 Top-Down Analysis Begin at highest (economy) level Allocation between domestic and international equities Market sectors Industries (within a sector) End with evaluation of specific companies (C) 2007 Prentice Hall, Inc. 5-62 Bottom-Up Analysis Begin with individual companies Screen large data bases for attractive characteristics Look for key strengths Compustat, Bloomberg, Baseline Search for a combination of characteristics (C) 2007 Prentice Hall, Inc. 5-63 Five Steps of a Financial Statement Analysis Step 1 Establish objectives of the analysis Who are you and why are you interested in this company? What questions would you like to have answered? What info is vital to the decision at hand? (C) 2007 Prentice Hall, Inc. 5-64 Five Steps of a Financial Statement Analysis (cont.) Step 2 Study the industry in which the firm operates and relate industry climate to current and projected economic developments (C) 2007 Prentice Hall, Inc. 5-65 Five Steps of a Financial Statement Analysis (cont.) Step 3 Develop knowledge of the firm and the quality of management How well does this firm appear to be run? Are they taking advantage of opportunities? Are they innovative, forward-looking, etc? (C) 2007 Prentice Hall, Inc. 5-66 Five Steps of a Financial Statement Analysis (cont.) Step 4 Evaluate financial statements–tools include: Common-size financial statements Key financial ratios Trend analysis Comparison with industry competitors (C) 2007 Prentice Hall, Inc. 5-67 Five Steps of a Financial Statement Analysis (cont.) Step 4 Evaluate financial statements–areas include: Short-term liquidity Operating efficiency Capital structure and long-term solvency Profitability Market ratios Segmental analysis (when relevant) (C) 2007 Prentice Hall, Inc. 5-68 Five Steps of a Financial Statement Analysis (cont.) Step 5 Summarize findings based on analysis Reach conclusions about the firm relevant to your established objectives (C) 2007 Prentice Hall, Inc. 5-69 Financial Statements An Overview Map (C) 2007 Prentice Hall, Inc. 5-70