FINANCIAL STATEMENT ANALYSIS
Annual report: report issued by a corporation to its stockholders
which contains basic financial statements and management’s
analysis of firm’s past operations and future prospects.
Balance sheet: snapshot of a firm’s financial position at one point
in time. Common size: percent of total assets. rev - cogs - exp - taxes
Income statement: summarizes a firm’s revenues, expenses and
taxes over a given period of time. Common size: percent of sales
Statement of retained earnings: shows how much of the firm’s
earnings were retained, rather than paid out as dividends (add
net income, less dividends).
Statement of cash flows: reports the impact of a firm’s activities
on cash flows over a given period of time.
Common base year statements: percent of base year
Book Values (BV): historical costs less accumulated depreciation,
determined by IFRS, GAAP. Market Values (MV): determined by
current trading values in the market.
MV of shareholders’ equity = market capitalization = share price x
number of outstanding shares
*MV vs BV: use Assets = Liabilities + Equity
Profits vs Cash Flows
- Profits subtract depreciation (a non-cash expense)
- Profits ignore cash expenditures on new fixed assets (expense is
capitalized)
z
- Profits record income and expenses at the time of sales, not
when cash exchanges actually occur
- Profits do not consider changes in working capital
Sources of Cash: decrease in assets/increase in equity & liabilities
Uses of Cash: increase in assets/decrease in equity & liabilities
Statement of cash flows:
1. Operating activities – includes net income and changes in most
current accounts (A/P, A/R, Inventory)
2. Investment activities – includes changes in fixed assets
3. Financing activities – includes changes in notes payable, longterm debt and equity accounts
Assets = Liabilities + Equity
CA + Net FA = CL + LT Debt + Common stock + RE
CA – CL + Net FA = LT Debt + Common stock + RE
Net working capital + Net FA = LT Debt + Common stock + RE
Cash + other CA – CL + Net FA = LT Debt + Common stock + RE
Since CL = non-interest bearing CL + interest bearing CL,
∆Cash = ∆CL - ∆CA other than cash - ∆Net FA + ∆LT Debt +
∆Common stock + ∆RE (+ Net Income – Dividends)
Operating Working Capital: stem from operating policies (A/R,
Inventory, A/P etc) and removed from financing decisions
- excludes non-operating working capital i.e. Notes Payable
Interest bearing liabilities: result of financing activities i.e. short
term loans, notes payables; Non-interest bearing: result of
operating activities i.e. accounts payables from suppliers
Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net
Capital Spending (NCS) – Changes in Net Operating Working
Capital (NOWC)
CFFA: cash flow generated from a firm’s operating assets after
taking into account all present investment needed for its ongoing operations. also referred to as Free Cash Flows
CFFA + Interest Tax Shield = Cash Flow to Creditors + Cash Flow to
Stockholders
Interest tax shield: reduction in the amount of tax paid. *do not
take into account interest tax shield: tax shield increases the
amount of cash flow available to creditors & shareholders
*Interest payments are deducted before calculation of Taxes:
reduces the amount of taxes paid. *Dividend payments not tax
deductible
When depreciation (expense) increases, net income decreases.
However, depreciation not part of cash flow but TAX is. EBIT
decreases, tax base and tax will decrease -> CFFA increases.
OCF = EBIT * (1 – Tax Rate) + Depreciation
NCS = Ending Net FA – Beg. Net FA + Depreciation
Changes in NOWC = Ending NOWC – Beg. NOWC
NOWC = Cash + AR + Inventory – AP or CA - non interestbearing-CL
Interest Tax Shield = Interest Paid * Tax Rate
Cash Flow to Creditors = Interest paid – Net New Borrowing (LT
Debt and Notes Payable, end - beg)
Cash Flow to Stockholders = Dividends Paid – Net New Equity
Raised (No RE) common stock and pay-in surplus, do not include RE
Cash Flow to Creditors & Stockholders = CFFA + Interest Tax Shield
Enterprise Value (cost of company’s operating assets) = Market
Value of Equity + Debt – Excess Cash
L IQUIDITY ( SHOT TERM SOLVENCY – ABILITY TO PAY BILLS IN SR/
CONVERT ASSETS TO CASH QUICKLY W / O SIGNIFICANT LOSS IN VALUE )
Current Ratio
Current Assets / Current Liabilities
(low: liquidity position weak)
Quick Ratio
[Current Assets – Inventory] / Current
Liabilities
Cash Ratio
Cash / Current Liabilities
NWC to Total
NWC / Total Assets
Asset
NWC = CA - CL
Interval Measure
Current Assets / Average Daily
Operating Cost [(COGS + Exp)/365]
L ONG T ERM S OLVENCY ( FINANCIAL LEVERAGE – EXTENT FIRM RELIES
ON DEBT VS EQUITY , HOW HEAVILY COMPANY IS IN DEBT )
Total Debt Ratio
Total Debt (CL + LT Debt) / Total Assets
Debt/Equity Ratio
(Total Assets – Total Equity) / Total
Equity
Equity Multiplier
Total Assets/Total Equity
(EM)
= 1 + Debt/Equity Ratio implies higher borrowing
(measures financial leverage)
Long-Term Debt
Long-term debt / (Long-term Debt +
Ratio
Total Equity)
Times Interest
EBIT(before interest & tax) / Interest
Earned Ratio
Cash Coverage
(EBIT + depreciation) / Interest
Ratio
A SSET M ANAGEMENT R ATIO ( TURNOVER / EFFICIENCY – HOW
PRODUCTIVELY THE FIRM IS USING ITS ASSETS )
Inventory
COGS/Inventory (how quickly inventory
Turnover
is produced & sold, high: old
inventory/poor control)
Days Sales in
365/Inventory Turnover
Inventory
Receivables
Sales/Receivables (success in managing
Turnover
collection from credit customers)
Day Sales
Account Receivables/Ave Daily Sales
Outstanding
(sales/365) OR 365/Rec Turnover
(ave no. of days after sale before
receiving cash, high: too slow, poor
credit policy)
Fixed Asset
Sales/Net Fixed Assets (how effective
Turnover
firm is in using assets to generate sales)
Total Asset
Sales/Total Assets (measures asset use
Turnover (TA TO)
efficiency; high: excessive current
assets)
P ROFITABILITY ( FIRMS RETURN ON INVESTMENTS , COMBINED EFFECT
OF LIQUIDITY , ASSET MANAGEMENT , DEBTS ON OPERATING RESULTS )
Profit Margin (PM)
Net Income/ Sales (measures firm’s
operating efficiency)
BEP (Basic Earning
EBIT/Total Assets
Power)
ROA
Net Income/Total Assets
ROE
*Net income/Total Common Equity
*if there is preferred dividend, deduct
M ARKET V ALUE R ATIOS ( HOW THE MARKET VALUES THE FIRM )
P/E
Share Price/Earnings per Share (how
much investors are willing to pay for $1
of earnings)
M/B
Market price per share/Book value per
(the higher the
share [total equity/no. of shares]
better)
(how much investors are willing to pay
for $1 of book value equity)
Dividends Payout
Dividends / Net Income
Ratio
Earnings per Share
Net Income / Outstanding Shares
Book to Market
Common Shareholder’s Equity / Market
Ratio
Capitalization
ROA is lowered by debt – interest expense lowers net income
Use of debt lowers equity – if equity is lowered more than net
income, ROE would increase.
Problems with ROE:
- ROE and shareholder wealth are correlated, but problems can
arise when ROE is the sole measure of performance
- ROE does not consider risk
- ROE does not consider amount of capital invested
- ROE might encourage managers to make investment decisions
that do not benefit shareholders
- ROE focuses only on return – better measure considers both risk
and return
DUPONT System - Return On Equity = Net Income / Total Equity =
Total Asset Turnover * Profit Margin * Equity Multiplier = Return
on Assets * Equity Multiplier
Limitations of ratio analysis:
- Comparison with industry averages is hard for diversified firms
- “Average” performance is not necessarily good
- Seasonal factors can distort ratios
- Different accounting practices can distort comparisons
- Different ratios give different signals hence difficult to tell if
company is in a strong or weak financial condition
*Comparing 2 exact same business, one with debt and one without,
one with debt will have lower income due to interest expense. ROA
of that with debt will be lower than without. But for ROE, can’t tell
since net income of one with debt is lower but equity is lower also)
TIME VALUE OF MONEY
*A dollar paid today is worth more than a dollar paid tomorrow:
lost earnings: can invest money to earn interest; loss of
purchasing power: presence of inflation; trade off depends on
rate of return
Present Value (PV): market value of cash flow to be received in
the future. Discounting: translate future value to value in present
Future Value (FV): value of cash flow in the future.
Compounding: translating a value to the future
Simple Interest – principal * interest
Compound Interest - FV = PV (1 + r) t | PV = FV/(1+r)n = FV(1/1+r)n
Annuity: series of cash flows in which the same cash flow takes
place each period for a set number of period
Ordinary Annuity – first cash flow occurs at end of period 1
Annuity due – first cash flow occurs at beginning of period 1
(worth more for same CF)
Perpetuity: set of equal payments paid forever at end of period 1
Growing perpetuity: set of payments which grow at constant rate
each period and continue forever; first cash flow at end of period
Interest: opportunity cost of funds and the uncertainty of
repayment of the amount borrowed (discount rate)
Multiple Cash Flows Timeline:
Effective Annual Rate (EAR): actual annual rate paid/received after
taking compounding that may occur during the year. If compounded
> 1 a year, stated rate different from EAR
&'( )
EAR = [ 1 +
] –1
)
Annual Percentage Rate (APR): annual rate
APR = period rate * number of periods per year
Period Rate = APR / number of periods per year
*never divide EAR to get period rate
*when comparing 2 investments with different compounding
periods, need to compute EAR and use for comparison
*always make sure interest rate and time period matches – must
change interest rate to match cash flow
*EAR is either equal or greater to APR (cannot be lower)
Assuming an Annual Percentage Rate (APR) of 10%,
If compounded annually, EAR = 10%
If compounded monthly, EAR = (1 + 0.1/12)12 = 1.1047 = 10.47%
Hence, more interested earned/paid when there are more
compounding periods.
To find implied interest rate: FV = PV(1+i)n à i = (FV/PV)1/n – 1
Types of Loans:
Pure Discount: no interim interest, principal & int. paid at maturity
Interest Only: interest paid throughout the loan period, principal
entirely paid at maturity
Fixed Principal Payments: interest for the period + fixed amount of
principal paid throughout loan period
Int payment =
i/r * beg bal
Ending bal = beg
bal – principal
payment
Amortized Loans: interest + portion of principal paid throughout loan
period (fixed amount paid each period, int decreases, prin. Increases)
Int payment =
i/r * beg bal
Principal paid =
total payment –
int paid
Ending bal = beg
bal – principal
paid
RISK AND RETURN
Investment Returns: measure the financial results of an investment
where returns may be historical or prospective
Dollar Terms: amount received (end of period) – amount invested
(beginning of period)
Percentage Terms:
PV of Annuity = PMT *
𝟏,𝑷𝑽 𝑭𝒂𝒄𝒕𝒐𝒓
𝒓
𝟏
𝟏
𝟏
= PMT * [ ∗ (𝟏 − (𝟏+𝒓)𝒏)]
𝒓
PV factor =
(𝟏:𝒓)𝒏
PV Annuity Due = PV of Annuity * (1+r)
𝟏
FV of Annuity = PV of Annuity * (1+r)n = PMT * [ 𝒓 ∗ [(𝟏 + 𝒓)𝒏 − 𝟏]]
FV Annuity Due = FV of Annuity * (1+r)
;<=>?@>A ;BC)<DE
PV of Perpetuity =
=
PV of Growing Perpetuity =
F>=GE ;BC)<DE
PV of Growing Annuity = C1 * [
FV of Growing Annuity = C1 * [
=,H
JKL N
I,(
)
JKM
[g = growth rate]
]
=,H
(I:=)N , (I:H)N
=,H
]
&)?ODE =<A<>P<@ (<D@) , &)?ODE >DP<GE<@ (Q<H>DD>DH)
&)?ODE >DP<GE<@ (Q<H>DD>DH)
Returns come in:
1. Any dividend or interest payment (income) received and
2. A capital gain or capital loss (due to a change in price)
Total Dollar Return = Dividend income + Capital gain/loss
Dividend Yield = Dividend / Beginning Period Share Price
Capital Gain Yield = Capital Gain / Beginning Period Share Price
Total percentage return = dividend yield + capital gains yield
*Capital gain: profit from the sale (not realised until sold)/increase in
value of capital assets i.e. share appreciates from $4 to $10
INFLATION
Nominal rate – does not account for inflation
Real rate of return – how much more you will be able to buy
1 + real return =
I:D?)>DBR =<EO=D
I:>DFRBE>?D =BE<
Real return ≈ nominal return – expected inflation
Expected returns: returns that take into account uncertainties that are present in different scenarios
– investor estimate the different return scenarios and probability of each scenario
Expected
Return
Possible Scenarios (if future possible
returns & probabilities given)
Historical
Arithmetic average
Sum of all
returns over a
period/time
Importance of financial markets: allow companies, governments and individuals to
increase their utility by matching borrowers with savers. Savers – have the ability to
invest in financial assets to defer consumption and earn a return to compensate them
for doing so. Borrowers – have better access to the capital that is available so that they
can invest in productive assets. Provides us with information about the returns that
are required for various levels of risk.
Risk Premium: excess return over the risk-free rate, equals required return - rate of
return available on risk free assets (i.e. treasury securities usually treasury bills,
sometimes treasury bonds for long term projects/company valuation)
EXPECTED PORTFOLIO RETURN
r – expected return of each stock
w – fraction of the portfolio’s dollar value invested in Stock i
Sum of (probability of each outcome) *
(expected return of each outcome)
Standard
Deviation
(measures
uncertainty
/TOTAL
RISK)
i.e. (0.30)(10%) + (0.10)(-10%) + (0.60)(25%)
Look at portfolio’s
return in each
scenario and the
probability of the
scenario occuring
Average annual return over last n years
*note that the PROBABILITY should be that of different economic situations and not different
percentage of portfolio invested in each asset
Determine if expected return is adequate by comparing to a benchmark – required rate of return on
the investment which is dependent on the risk of the investment
Risk: uncertainty associated with future possible outcomes
Investment risk: potential for investment return to fluctuate in value from year to year
Standard deviation measures total risk of an investment and dispersion around expected value.
The larger the standard deviation, the higher the probability that actual returns will be far away from
the expected return, the higher the risk.
Stand-alone risk: the risk an investor would face if he/she held only this one asset. Total risk.
Alternatively,
*standard deviation of portfolio can be derived in the same way as for a single asset
Standard deviation of a 2 stock portfolio:
When 2 stocks have negative
covariance which arises from negative
correlation between the stocks, can
provide return that is average of both
stocks but with much lower risk
COVARIANCE: how the two assets’ rates of return vary together over the same mean
time period
E(Ri) – expected return of i
pxy : correlation coefficient
between stock X and Y,
measures the extent to which
X and Y move together
Variance of portfolio depends on the correlation coefficients between the assets
included in the portfolio. Correlation coefficient standardizes the units of Cov measure
Coefficient of Variation (CV): standardised measure of dispersion about the expected value that
shows the risk per unit of return / measure of relative variability
CV =
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏
OR CV =
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
𝑴𝒆𝒂𝒏
RETURNS DISTRIBUTION:
- 2 stocks can be combined to form a
riskless portfolio if 𝜌 = -1
- risk is not reduced at all if the 2
stocks have 𝜌 = +1
- in generally, stocks have 𝜌 ≈ 0.65 so
risk is lowered but not eliminated,
𝜎 ≈ 35%
- ability to get rid of risks increases/
risk of portfolio decreases as 𝜌 -> -1
Risk-return Trade-off: There is reward for bearing risk; the greater the potential reward, the greater
the risk
Risk aversion: assumes investors dislike risk and require higher rates of return to encourage them to
hold riskier securities
DIVERSIFIABLE AND NON-DIVERSIFIABLE RISK:
Total Risk = Company-Specific Risk (Unsystematic Risk) + Market Risk (Systematic Risk)
Diversifiable: caused by random events i.e. lawsuits; good and bad events – effects
often eliminated
Non-Diversifiable: stem from factors that affect most firms i.e. recessions, inflation.
Market risk cannot be diversified by combining stocks into a portfolio, stocks will
generally move in same direction in varying degrees
*Stand-alone risk is not important to a well-diversified investor, no compensation for
unnecessary, diversifiable risk. Rational, risk-averse investors are concerned with 𝜎p
*If portfolio is well-diversified, the firm-specific risk is close to 0 and variance will come
from market risk (systematic & non-diversifiable)
ARITHMETIC AND GEOMETRIC MEAN;
Geometric mean: what investor actually earned per year on average. Mean holding
period return/average compound return
Arithmetic mean: what investor earned in a typical year/average return in a typical
year/observed average return/historical average return
Geometric:
Arithmetic:
OVERVIEW
Finance: determines value and making decisions based on that value assessment
Allocates resources including acquiring, investing and managing of resources
1. Investments
Study of financial transactions from the perspective of investors outside the firm
How do we assess the risk of various financial securities? How do we manage a
portfolio of financial securities to achieve a stated objective of the investor? How do
we evaluate portfolio performance?
2. Financial Markets and Intermediaries
Study of markets where financial securities i.e. stocks, bonds are bought and sold
Study of financial institutions that facilitate the flow of money from savers to
demanders of money
3. Corporate/Business Finance (Maximise Stock Price of the Firm)
Capital Budgeting: what long term investments to invest in? (increase size of pie, value
maximisation) Capital Structure: Where to get long-term financing for investments?
Should we fund with debt or equity? (how to slice the pie) Working Capital
Management: how we manage day to day finances?
Investment Vehicle Model: investor provides financing to the firm in exchange for
financial securities (various claims on firm’s cash flows) à firm invests funds in assets
à income generated by firm’s assets is distributed to the investors/reinvested
Balance Sheet Model: Accounting model; investment decisions on asset side, financing
decisions on liabilities and equity side
Treasurer: oversees cash/credit management, capital expenditures & financial
planning, Controller: oversees taxes, cost/financial accounting, data processing
2 Main Sources of External Financing:
Debt: Lenders (become corporation’s lenders), relationship determined by contract,
security and seniority (debt holders collect before equity holders in bankruptcy)
Equity: Shareholders’ ownership rights (residual claimants), Shareholders’ payoffs
(dividend per share and capital gain from sale of shares)
Goal of Financial Management: shareholder wealth/value maximization (stock price)
Stock prices determined by firm’s underlying ability to generate cash flows. Affected
by: Amount of cash flows expected by shareholders, Timing of the cash flow stream,
Riskiness of the cash flow stream [3 factors determine stock’s Intrinsic Value]
Intrinsic Value: estimate of stock’s “true” value based on accurate risk and return data
Market Price: actual selling price, perceived information seen by marginal investor
Agency Problem: conflict of interest between principal and agent. Direct costs:
expenditures that benefit management, monitoring costs. Indirect: lost opportunities
Addressing Agency Problem: Compensation plans that tie managers’ fortunes to
firm’s, monitoring, threat that poor performance will be fired, growing awareness of
importance of good corporate governance
Firm’s Sources of Funds: Money Markets – debt securities of less than 1 year traded:
inter-bank loans, bills; Capital Markets – equity and long-term debt claims traded;
Primary market – for government and corporations initially issued securities;
Secondary market – where existing financial claims are traded
Equity (residual claims): share issuance, retained earnings; Debt (contractual
obligations): bank borrowing, bond issuance