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
o
o
o
o
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:
oCreditors
oInvestors
oManagers
oWho else?
oWhat types of
questions do each of
these users seek answers to?
Data sources
o
o
o
o
o
o
Financial statements (and notes)
Auditor’s 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 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
oIncome before interest and taxes
o Operating assets
oAssets held for operating purposes
ONLY
oi.e. cash, accounts receivable,
inventory, plant and equipment
2005 KD Hatheway-Dial
Understanding ROI
ROI = Margin X Turnover
Operating
=
Margin
Net Operating Income
Sales
Turnover =
Sales
Average Operating Assets
2005 KD Hatheway-Dial
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