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Financial Statement
Analysis
1
Financial statement analysis involves the
• Selection,
• Evaluation, and
• Interpretation
of financial data and other pertinent information to assist in evaluating the
operating performance and financial condition of a company.
The operating performance of a company is a measure of how well a company has
used its resources to produce a return on its investment (as demonstrated in the profit
and loss statement).
The financial condition of a company is a measure of its ability to satisfy its obligations,
such as the payment of interest on its debt in a timely manner (as demonstrated in the
balance sheet & cash flow statement).
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What are the statements?
Financial statements are accounting reports issued by a firm periodically (usually
quarterly and annually) that present past performance information and a snapshot of
the firm’s assets and the financing of those assets
In a firm, generally three core financial statements can be found:
• Balance Sheet
• Income Statement (Profit and Loss Account) &
• Statement of Cash Flows
(US GAAP 10-K filing also requires the statement of stockholders’ equity).
Financial statements are required to be audited by a neutral third party, who checks and
ensures that the financial statements are prepared according to accounting bodies
guidelines/principles (such as GAAP or IFRS) and that the information contained is
reliable.
See the Appendix for general differences.
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Who uses financial statements?
Users of financial statements include:
•
•
•
•
Present and potential investors.
Financial managers within the firm.
Financial analysts.
Other interested outside parties (suppliers, trade creditors,
and customers).
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Who uses financial statements?
Investors.
• Investors are concerned with the inherent risk and the return their
investments provide. Investors include:
• Bondholders use the firm’s financial statements to assess the ability of
the company to make its debt payments.
• Stockholders use the statements to assess the firm’s profitability and
ability to make future dividend payments.
Managers.
Managers use financial statements to look at trends in their own business
and to compare their results with that of competitors.
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Who uses financial statements?
Financial Analyst
• Financial analysts gather financial information, analyze it, and
make recommendations.
• They read financial statements to determine a firm’s value and
project future earnings so that they can guide businesses and
individuals to help them with their investment decisions.
• Financial analyst examines a company’s performance in the
context of its industry (competitors) and economic environment to
arrive at a decision or recommendation.
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Who uses financial statements?
Financial Analyst
• Often, the decisions and recommendations are - whether to invest in
the company’s debt or equity securities and at what price.
• An investor in debt securities is concerned about the company’s ability
to pay interest and to repay the principal lent.
• An investor in equity securities is an owner with a residual interest in
the company and is concerned about its ability to pay dividends and
the likelihood that its share price will increase.
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Analysts typically have a specific economic decision in evaluating financial
reports. Examples of these decisions include the following:
■ Evaluating an equity investment for inclusion in a portfolio.
■ Evaluating a merger or acquisition candidate.
■ Evaluating a subsidiary or operating division of a parent company.
■ Deciding whether to make a venture capital or other private equity investment.
■ Determining a company’s creditworthiness to decide whether to extend a loan to the
company and, if so, what terms to offer.
■ Extending credit to a customer.
■ Examining compliance with debt covenants or other contractual arrangements.
■ Assigning a debt rating to a company or bond issue.
■ Valuing security (equity or debt) for recommending an investment to others.
■ Forecasting future net income and cash flow.
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These decisions demonstrate specific themes in financial analysis. In
general, analysts seek to examine a company's past and current
performance and financial position to form expectations about its future
performance and financial position.
Analysts are also concerned about factors affecting a company’s future
performance and financial position risks.
An examination of performance can include an assessment of a
company’s profitability (the ability to earn a profit from delivering goods
and services) and its ability to generate positive cash flows (cash receipts
over cash disbursements).
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Profit vs Cash Flow
Profit and cash flow are not equivalent.
Profit (or loss) represents the difference between the prices at which
goods or services are provided to customers and the expenses incurred to
provide those goods and services.
In addition, profit (or loss) includes other income (such as investment
income or income from selling items other than goods and services) minus
the expenses incurred to earn that income.
Overall, profit (or loss) equals income minus expenses, and its recognition
is primarily independent of when cash is received or paid. The example
below illustrates the distinction between profit (or loss) and cash flow.
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• Although profitability is important, so is a company’s ability to generate positive cash flow.
• Cash flow is important because, ultimately, the company needs cash to pay employees,
suppliers, and others in order to continue as a going concern.
• A company that generates positive cash flow from operations has more flexibility in funding
needed for investments and taking advantage of attractive business opportunities than an
otherwise comparable company without positive operating cash flow.
Source; CFA, 2019
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Profit vs Cash Flow
Additionally, a company needs cash to pay returns (interest and dividends)
to providers of debt and equity capital.
Therefore, the expected magnitude of future cash flows is important in
valuing corporate securities and in determining the company’s ability to
meet its obligations.
The ability to meet short-term obligations is generally referred to as
liquidity, and the ability to meet long-term obligations is generally
referred to as solvency.
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Profit vs Cash Flow
• Cash flow in any given period is not, however, a full measure of performance for that
period because, as shown in the previous example, a company may be obligated to
make future cash payments as a result of a transaction that generates positive cash
flow in the current period.
• Profits may provide helpful information about cash flows, past and future. If the
transaction of the example were repeated month after month, the long-term
average monthly cash flow of SD would equal €80,000, its monthly profit.
• Analysts typically evaluate not only past profitability but also forecast future
profitability.
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Overview of the session
Financial or Accounting Statements
• The Statement of Financial Position or Balance Sheet
• The Income Statement or Profit & Loss Account
• Cash Flow Statement
Financial Statement Analysis
• Standardizing Financial Statements
• Financial Ratio Analysis
• Benchmarking Financial Statement Analyses
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The Statement of Financial Position
What are the firm’s assets, and how are they funded?
The Accounting Equation
Shareholders’
Equity
+
Liabilities
≡
Assets
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The Statement of Financial Position
Why is it also called Balance Sheet?
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The Statement of Financial Position
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The Statement of Financial Position
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Case Study
Sky Plc (Financial Statements)
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Sky Plc (Balance Sheet)
Horizontal form
Assets
Non-Current Assets
Intangible Assets
Property, Plant and Equipment
Investments and Joint Ventures
Other Non-Current Assets
Current Assets
Inventories
Trade and Other Receivables
Short-Term Deposits
Cash and Cash Equivalents
Other Current Assets
Total Assets
£m
1,829
1,088
706
253
3,876
546
635
295
1,082
15
2,573
6,449
Equity and Liabilities
Non-Current Liabilities
Bank and Other Borrowings
Non-Current Trade and Other Payables
Other Non-Current Liabilities
£m
2,658
56
144
2,858
Current Liabilities
Borrowings
Trade and Other Payables
Other Current Liabilities
Total Liabilities
Total Equity
Total Equity and Liabilities
11
2,286
222
2,519
5,377
1,072
6,449
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Sky Plc (Balance Sheet) - Vertical form
Assets
Non-Current Assets
Intangible Assets
Property, Plant and Equipment
Investments and Joint Ventures
Other Non-Current Assets
Current Assets
Inventories
Trade and Other Receivables
Short-Term Deposits
Cash and Cash Equivalents
Other Current Assets
Total Assets
£m
1,829
1,088
706
253
3,876
546
635
295
1,082
15
2,573
6,449
Equity and Liabilities
Non-Current Liabilities
Bank and Other Borrowings
Non-Current Trade and Other Payables
Other Non-Current Liabilities
£m
2,658
56
144
2,858
Current Liabilities
Borrowings
Trade and Other Payables
Other Current Liabilities
Total Liabilities
Total Equity
Total Equity and Liabilities
11
2,286
222
2,519
5,377
1,072
6,449
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Sky Plc (Balance Sheet) - Vertical form
Assets
Non-Current Assets
Intangible Assets
Property, Plant and Equipment
Investments and Joint Ventures
Other Non-Current Assets
Current Assets
Inventories
Trade and Other Receivables
Short-Term Deposits
Cash and Cash Equivalents
Other Current Assets
Total Assets
£m
1,829
1,088
706
253
3,876
546
635
295
1,082
15
2,573
6,449
Equity and Liabilities
Non-Current Liabilities
Bank and Other Borrowings
Non-Current Trade and Other Payables
Other Non-Current Liabilities
£m
2,658
56
144
2,858
Current Liabilities
Borrowings
Trade and Other Payables
Other Current Liabilities
Total Liabilities
Total Equity
Total Equity and Liabilities
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2,286
222
2,519
5,377
1,072
6,449
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Three significant concerns when analysing financial position:
1. Liquidity.
2. Debt versus equity.
3. Value versus cost.
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1. Liquidity
Liquidity refers to the ease and quickness with which assets can be
converted to cash (without significant loss in value).
Current assets are the most liquid and include cash and assets that will be
turned into cash within a year from the date of the statement of financial
position.
Trade receivables are amounts yet to be collected from customers for goods
or services sold to them (after adjustment for potential bad debts).
Inventories are composed of raw materials to be used in production, work
in progress and finished goods.
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Non-current assets are the least liquid kind of assets.
Tangible non-current assets: property, plant and equipment.
Intangible non-current assets are the value of trademarks, patents or
goodwill. Goodwill is an accounting term that reflects the premium paid by
companies when they acquire other companies.
The greater the liquidity of a firm’s assets - the less likely the firm is to
experience problems meeting short-term obligations.
The greater the liquidity of a firm’s assets - the lower the opportunity to
invest in more profitable investment vehicles.
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2. Debt versus Equity
Shareholders’equity - claim against the firm’s assets that is residual.
The residual difference between assets and liabilities:
Assets - Liabilities ≡ Shareholder’s Equity
Shareholders’ equity increases when retained earnings are added.
Liabilities - obligations that require a payout within a stipulated period.
Bankruptcy: Bondholders can sue the firm if it defaults on its bond
contracts.
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3. Value versus Cost
The accounting value is the book value of the assets (both fixed and
current).
European Union - International Financial Reporting Standards
(IFRS).
IFRS uses theoretical market or fair value, the price at which willing
buyers and sellers would trade the assets.
Unfortunately, the tradable value of assets is likely to differ from their
accounting value - no liquid market allows the calculation of an asset’s
accounting fair value.
In these situations, the financial manager must estimate a fair value
from a similar asset or a theoretical model.
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Fair value
and market
value
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What would be the effect of revaluing the property to a figure of
£110,000 in the statement of financial position? Show the revised statement.
Revaluation of property from historical cost to fair value
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Quiz 1
Required:
(a) Prepare a statement of financial
position for the business as of 30
September 2018 using the standard
layout illustrated in the next slide.
(b) Comment on the business’s financial
position based on the statement prepared
in (a).
(c) Show the effect on the statement of
the financial position shown in (a) of a
decision to revalue the property to
£115,000 and to recognise that the net
realisable value of inventories at the yearend is £38,000.
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Template
Historical
Non-Current Assets
Plant and equipment
Property
Motor vehicles
Fixtures and fittings
Total Non-current Assets
Current Assets
Inventories
Trade recievables
Cash in hand
Total Current Assets
£
Non -current laibilities
Long-term borrowings
£
Total Non-current Liabilities
Current Liabilities
Trade payables
Short term payable
Total Current Liabilities
Equity
Opening balance
Retained earings
Revaluation gain/loss
Total equity
Total assets
Total laibilities and equities
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Net Working Capital
How to Calculate Net Working Capital
Current
Assets
Current
Liabilities
Net
Working
Capital
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The Income Statement
How has the firm performed over the previous period?
The Income Equation
Revenues
(Sales)
Expenses
(Costs)
Income
(Earnings)
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Sky Plc (Income Statement)
Income Statement
Revenue (Sales)
Operating Expenses (COGS)
Operating Profit
Income from Joint Ventures and Investments
Profit Before Interest and Taxation
Finance Costs (Interest)
Profit before Tax
Tax
Profit After Tax
Number of Shares
Earnings per Share (£)
£m
7,632
6,471
1,161
61
1,222
140
1,082
217
865
1,575.59
0.549
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When analysing an income statement, the financial manager
should keep in mind:
1. Non-cash Items
2. Time & Costs.
3. Taxes
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1. Non-cash items
Several non-cash items are expenses against revenues but do not
affect cash flow. The most important of these is depreciation or
capital allowances (part of operating expenses).
Depreciation reflects the accountant’s estimate of the cost of
equipment used up in the production process.
According to accountants, the equipment cost must be expensed over
the asset’s useful life.
From a financial perspective, the asset’s cost is the actual negative
cash flow incurred when the asset is acquired and not the accountant’s
smoothed yearly depreciation expense. More on cash flow later.
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2. Time and costs
Future Time: Short run and Long run.
The short run is the period in which:
• Certain equipment, resources and commitments of the firm are
fixed but long enough to vary output by using more labour and raw
materials.
• Some costs are fixed - that is, costs that will not change because of
fixed commitments. E.g. bond/bank interest, overhead and property
taxes.
• Some costs are variable - change with output. E.g. raw materials
and wages for employees in the production line.
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Long run: All costs are generally variable.
Product costs are the total production costs incurred during a
period – raw materials, direct labour and manufacturing
overheads – and are generally reported on the income statement
as the cost of goods sold.
Period costs are allocated to a time period called selling, general
and administrative expenses. One period cost would be the
company chief executive’s salary.
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3. Taxes
• Taxes can be one of the most significant cash outflows a firm
experiences.
• For example, for the year ending 2013, Royal Dutch Shell’s profit before
taxes was €26.9 billion. Its tax bill for this period was €17.1 billion or
about 63.6 per cent of its pre-tax earnings.
• The size of the tax bill is determined by: the tax code, set of rules, and
any deferred taxes from earlier years.
• Tax code is the result of political, not economic, forces. As a result, there
is no reason why it has to make economic sense.
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Corporate tax rates of few sample countries
https://home.kpmg/it/it/home/services/tax/tax-tools-and-resources/tax-rates-online.html
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Corporate taxes are generally not a simple arithmetic deduction from profit
before taxes.
Almost all countries in the world allow firms to carry forward losses or
defer taxes they have made in previous years to offset their tax bill in the
future. This is what happened to Royal Dutch Shell in 2013.
Although the corporate tax rate in the UK is much lower than 63.6 per cent,
Royal Dutch Shell would have had to pay tax in different jurisdictions,
many of which would have been greater than in the UK, as well as past
taxes deferred from earlier years.
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Taxes
Average vs Marginal Tax Rates
Average Tax
Rate
Tax paid/profit
before taxes
Marginal Tax
Rate
Tax (%) you pay
if you earn
one more unit
of currency.
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Average vs Marginal Tax Rates
The first €200,000 earned by Dutch firms (2023) pay 19 per cent tax; extra earnings pay
25.8 per cent tax. Suppose Dutch corporation has a taxable income of €400,000.
Tax Paid
19% × €200 +
25.8% × €200 =
€89.6
Tax Rates
Average: 89.6/400
= 22.4%
Marginal: 25.8%
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Which Tax Rate Should You Use in Financial Decisions?
Use the Marginal Tax
Rate since that is the
rate that you would be
taxed on any additional
income earned
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The Cash Flow Statement
Where has the cash come from and what has the firm
spent?
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Sky Plc (Cash Flow Statement)
Cash Flow Statement
£m
CF (O)
Cash Flow from Operating Activities
Cash Generated from Operations
Income from other activities
Tax Paid
Net Cash from Operating Activities
1,769
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-240
1,556
CF (I)
Cash Flow from Investing Activities
Purchase of Property, Plant & Equipment
Purchase of Intangible Assets
Decrease in Short-Term Deposits
Other Investments
Net Cash used in Investing Activities
-241
-302
300
-1
-244
NCF (F)
NCF (O)
Cash Flow from Financing Activities
Interest Paid
Dividends Paid
Purchase of Own Shares
Other Financing Activities
Net Cash used in Financing Activities
Net Increase in Cash and Cash Equivalents
-137
-485
-430
7
-1,045
267
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Some important observations can be drawn from our discussion of cash flow:
1. Operating cash flow measures the cash generated from operations, not counting cash
flows arising from investment expenditure or financing.
• It is usually positive; a firm is in trouble if operating cash flow is negative for a long
time because it is not generating enough cash to pay operating costs.
• The total cash flow of the firm includes adjustments for capital spending and new
financing. It will frequently be negative.
• When a firm grows rapidly, spending on inventory and non-current assets can be
higher than operating cash flow.
2. Profit is not cash flow. The profit made by Sky was £865 million, whereas cash flow
was only £267 million. The two numbers are not usually the same. Cash flow is more
revealing in determining a firm's economic and financial condition.
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Financial Statement Analysis
How to assess firm performance, risk and liquidity
Comparing Financial Statements: Size and Currency Bias
It is almost impossible to directly compare the financial statements
of two companies because of differences in size. For international
firms from two countries, the currencies of the stated financial
statements could be different.
Important to Compare Like for Like: Standardizing Statements
• Common-size Financial Statement
• Financial Ratio Analysis
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Standardizing statements
Standardise
Statements
Financial
Statements:
Common-size
Work with percentages instead of total monetary amounts.
The resulting financial statements are called common-size
statements.
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Non-standardized Sky Plc (Balance Sheet)
How much in
% do the
intangible
assets
constitute of
the total
assets?
1,829/6,449
= 28%
Assets
Non-Current Assets
Intangible Assets
Property, Plant and Equipment
Investments and Joint Ventures
Other Non-Current Assets
Current Assets
Inventories
Trade and Other Receivables
Short-Term Deposits
Cash and Cash Equivalents
Other Current Assets
£m
1,829
1,088
706
253
3,876
546
635
295
1,082
15
2,573
6,449
Total Assets
Equity and Liabilities
Non-Current Liabilities
Bank and Other Borrowings
Non-Current Trade and Other Payables
Other Non-Current Liabilities
£m
2,658
56
144
2,858
Current Liabilities
Borrowings
Trade and Other Payables
Other Current Liabilities
Total Liabilities
Total Equity
Total Equity and Liabilities
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2,286
222
2,519
5,377
1,072
6,449
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Work with percentages instead of total monetary amounts. The
resulting financial statements are called common-size statements.
Common-size Balance Sheet (Sky Plc)
Assets
Non-Current Assets
Intangible Assets
Property, Plant and Equipment
Investments and Joint Ventures
Other Non-Current Assets
Total Non-Current Assets
Current Assets
Inventories
Trade and Other Receivables
Short-Term Deposits
Cash and Cash Equivalents
Other Current Assets
Total Current Assets
Total Assets
%
28%
17%
11%
4%
60%
8%
10%
5%
17%
0%
40%
100%
Equity and Liabilities
Non-Current Liabilities
Bank and Other Borrowings
Non-Current Trade and Other Payables
Other Non-Current Liabilities
Total Non-Current Liabilities
Current Liabilities
Borrowings
Trade and Other Payables
Other Current Liabilities
Total Current Liabilities
Total Liabilities
Total Equity
Total Equity and Liabilities
%
41%
1%
2%
44%
0.2%
35%
3%
39%
83%
17%
100%
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Common-size Income Statement (Sky Plc)
Income Statement
Revenue
Operating Expenses
Operating Profit
Income from Joint Ventures and Investments
Profit Before Interest and Taxation
Finance Costs (Interest)
Profit before Tax
Tax
Profit After Tax
£m
7,632
6,471
1,161
61
1,222
140
1,082
217
865
%
100%
85%
15%
1%
16%
2%
14%
3%
11%
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How efficiently is the firm using it resources?
Ratio Analysis
The important financial ratios
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Ratio Analysis
Liquidity
Ratios
Financial
Leverage
Ratios
Profitability
Ratios
Turnover
Ratios
Market Value
Ratios
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Short-Term Solvency Ratios
Current ratio =
Quick ratio =
Cash ratio =
Current assets
Current liabilities
Current assets – Inventory
Current liabilities
Sky Plc
Short-term solvency or liquidity ratios
Current
Quick
Cash
1.02
0.80
0.43
times
times
times
Cash and Cash Equivalents
Current liabilities
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Long-Term Solvency Ratios
Total debt ratio =
Total assets – Total equity
Total assets
Debt–equity ratio = Total debt/Total equity
Equity multiplier = Total assets/Total equity
Times interest earned ratio =
Cash coverage ratio =
EBIT
Interest
Sky Plc
Financial Leverage or Long-Term Solvency Ratios
Total debt ratio
0.83
Debt to equity ratio
5.02
Equity Multiplier
6.02
Times interest earned
8.73
Cash coverage
11.64
Units
times
times
times
times
times
EBIT + Depreciation
Interest
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Asset Management Ratios
Inventory turnover =
Cost of goods sold
Days’ sales in inventory =
Receivables turnover =
Inventory
365 days
Inventory turnover
Asset Management or Turnover Ratios
Inventory turnover
Days' sales in inventory
Receivable turnover
Days' sales in receivables
Total asset turnover
11.85
31
12.02
30
1.18
times
days
times
days
times
Sales
Trade receivables
Days’ sales in receivables =
Total asset turnover =
Sky Plc
365 days
Receivables turnover
Sales
Total assets
The CGS should include materials used, labour costs,
managerial salaries and other costs of earning the
revenues. Depreciation is included in the figure if it is
being charged on assets directly related to the main
revenue stream. Otherwise, it is left out. In Sky’s case,
the depreciation would be charged for a reduction in
their satellite equipment’s value, so this figure should
be included in the cost of goods sold figure.
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Profitability Ratios
Profit margin =
Net income
Sales
Sky Plc
Return on assets =
Return on equity =
Net income
Total assets
Profitability Ratios
Profit margin
Return on assets
Return on equity
11.33%
13.41%
80.69%
Net income
Total equity
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Market Value Ratios
EPS =
Net income
Shares outstanding
PE ratio =
Price per share
Earnings per share
Market value or financial performance ratios
EPS
PE Ratio
Market-to-book ratio
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
Market value per share
times
times
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
Market-to-book-ratio =
£0.55
16.80
13.56
£1072
= £0.68
1,575.69
Book value per share
Book value per share is an accounting
number that reflects historical costs.
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Profitability Ratios
Profit margin
Return on assets
Return on equity
11.33%
13.41%
80.69%
• Why is there a significant difference
between ROA and ROE?
• What are the reasons?
The Du Pont Identity
ROE is Affected By
Operating Asset Use Financial
Efficiency Efficiency Leverage
61
𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑠𝑠𝑒𝑡𝑠
=
×
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑠𝑠𝑒𝑡𝑠
×
𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑅𝑂𝐴 ×
𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑅𝑂𝐴 ×
𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 1 +
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
+
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
= 𝑅𝑂𝐴 × 1 + 𝐷𝑒𝑏𝑡 − 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
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Profitability Ratios
Profit margin
Return on assets
Return on equity
11.33%
13.41%
80.69%
𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 1 + 𝐷𝑒𝑏𝑡 − 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜
𝑅𝑂𝐸 = 13.41% × 1 + 5.02 = 80.69%
Financial Leverage or Long-Term Solvency Ratios
Total debt ratio
0.83
Debt to equity ratio
5.02
Equity Multiplier
6.02
Times interest earned
8.73
Cash coverage
11.64
Units
times
times
times
times
times
The difference between ROE (80.69%)
and ROA (13.41%) can be substantial,
as shown for Sky plc.
This is because of the amount of debt
that the company has taken on, as
measured by the debt-equity ratio, also
determines the ROE in addition to
ROA.
63
𝑅𝑂𝐸 =
𝑅𝑂𝐸 =
𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑠𝑠𝑒𝑡𝑠
×
𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑠𝑠𝑒𝑡𝑠
𝑆𝑎𝑙𝑒𝑠
×
×
𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡𝑠
×
×
𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
ROA
𝑅𝑂𝐸 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 𝑃𝑀 × 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟(𝑇𝐴𝑇) × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟(EM)
Du Pont identity
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11/07/2023
For sky
𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡𝑠
×
×
𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝑅𝑂𝐸 = 𝑃𝑀 × 𝑇𝐴𝑇 × 𝐸𝑃
• Weakness in either operating or asset
use efficiency (or both) will show up in
a diminished return on assets, which
will translate into a lower ROE.
• The ROE could be leveraged up by
increasing the amount of debt in the
firm.
• However, notice that increasing debt
also increases interest expense, reducing
profit margins, which reduces ROE.
This 80.69% ROE is exactly what we had before.
The Du Pont identity implies that three things • More important, the use of debt
determine ROE:
financing has several other effects.
𝑅𝑂𝐸 = 11.33% × 1.18 × 6.02 = 80.69%
• If ROE is unsatisfactory by some
measure, then the Du Pont identity tells
you where to start looking for the
reasons.
1. Operating efficiency (profit margin)
2. Asset use efficiency (total asset turnover)
3. Financial leverage (equity multiplier)
65
The Dupont Identity: Proof
Return on equity =
=
ROE =
ROE =
Sales
Sales
×
Net income
Total equity
Net income
Assets
=
×
Net income
Net income
Assets
×
Sales
Net income
Total equity
×
Assets
Assets
Assets
Total equity
×
Assets
Total equity
×
Assets
Sales
Assets Total equity
Return on assets
= Profit margin × Total asset turnover × Equity multiplier
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11/07/2023
Using Financial
Statement Information: Choose a
Benchmark
Time Trend
Analysis
Look at the same ratio over a
number of years.
Peer Group
Analysis
Compare the ratio with similar
firms
Companies in the same
industry (Check SIC Code)
67
SIC Codes: Examples
C Manufacturing
K Financial and Insurance Activities
10 Manufacture of Food Products
64 Financial Service Activities, except
Insurance and Pension Funding
22 Manufacture of Rubber and Plastic
Products
65 Insurance, Reinsurance and Pension
Funding, except Compulsory Social
Security
24 Manufacture of Basic Metals
F Construction
41 Construction of Buildings
M Professional, Scientific and Technical
Services
69 Legal and Accounting Activities
42 Civil Engineering
72 Scientific Research and Development
43 Specialised Construction Activities
73 Advertising and Market Resarch
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Aspirant Analysis
Ratios
For the Fiscal Period Ending
Profitability
Return on Assets %
Return on Equity %
Net Income Margin %
Ebay
2021
Amazon
2021
8.0%
3.8%
130.6%
4.2%
28.8%
7.1%
Asset Turnover
Total Asset Turnover
Accounts Receivable Turnover
Inventory Turnover
0.5x
14.6x
NA
1.3x
20.8x
9.7x
2.0x
1.8x
1.1x
0.9x
Long Term Solvency
Total Debt/Equity
LT Debt/Equity
Total Liabilities/Total Assets
EBIT / Interest Exp.
96.5%
81.1%
63.3%
11.0x
100.9%
88.7%
67.1%
13.8x
Valuations
PE ratio
M/B ratio
15.25x
3.85x
63.74x
18.77x
Short Term Liquidity
Current Ratio
Quick Ratio
Source: Capital IQ
69
Financial Statement Analysis: Some Issues
Inappropriate
Peers
• Some companies operate in several industries
• Different Accounting Standards
Aspirant
Analysis
• You may want to compare your firm with the
best in the industry
• Choose similar firms at the top of the industry
Sources of
Information
• Financial Websites: Yahoo! Finance, Reuters,
FT.Com, ADVFN.com, Motley Fool
• Company Accounts: Download from website
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11/07/2023
Accounting
Manipulation or
Creative Accounting
•
•
•
•
•
•
Overstating revenues
Lowering depreciation
Delaying expenses
Capitalizing expenses
Masking liabilities
Using provisions to smooth
income
• Hiding losses
71
Quiz 2: Historical income statements and balance sheets for ABC Corp. are shown
below. Undertake a complete Common-size and Financial Ratio Analysis.
Balance Sheet ($ Million)
Income Statement ($ Million)
Year Ending Dec. 31,
2018
2019
2020
2021
Assets
Cash and Marketable Securities
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
$25.6
$99.4
$109.6
$96.7
$331.3
$23.0
$102.9
$108.0
$91.4
$325.3
$32.1
$107.3
$114.9
$103.7
$358.0
$28.4
$120.1
$116.8
$97.5
$362.8
Property, Plant and Equipment, Gross
Accumulated Depreciation
Property, Plant and equipment, Net
$680.9
$244.8
$436.1
$734.3
$296.8
$437.5
$820.8
$352.7
$468.1
$913.1
$427.9
$485.2
Other Non-Current Assets
Total Non-Current Assets
$203.2
$639.3
$205.1
$642.6
$407.0
$875.1
$456.3
$941.5
$970.6
$967.9
$1,233.1
$1,304.3
Liabilities and Shareholders' Equity
Accounts Payable
Short-Term Debt
Other Current Liabilities
Total Current Liabilities
$82.8
$39.1
$152.0
$273.9
$77.1
$29.7
$123.8
$230.6
$71.8
$79.8
$172.1
$323.7
$80.5
$110.3
$111.3
$302.1
Long-Term Debt
Deferred Income Taxes
Other Non-Current Liabilities
Total Liabilities
$163.5
$22.3
$100.6
$560.3
$145.0
$19.6
$80.1
$475.3
$201.8
$15.0
$115.0
$655.5
$218.1
$12.7
$94.5
$627.4
Paid-In Capital
Retained Earnings
Total Shareholders' Equity
$46.9
$363.4
$410.3
$46.1
$446.5
$492.6
$38.2
$539.4
$577.6
$44.8
$632.1
$676.9
$970.6
$967.9
$1,233.1
$1,304.3
Total Assets
Total Liabilities and Shareholders' Equity
Sales
Cost of Sales
Gross Operating Income
2018
$1,234.9
$679.1
$555.8
Year Ending Dec. 31,
2019
2020
$1,251.7
$1,300.4
$659.0
$681.3
$592.7
$619.1
2002
$1,334.4
$667.0
$667.4
Selling, General & Admn. Expenses
Depreciation
Other net (Income)/Expenses
EBIT
$339.7
$47.5
($11.8)
$180.4
$348.6
$52.0
($7.6)
$199.7
$351.2
$55.9
($7.0)
$219.0
$373.3
$75.2
($8.2)
$227.1
Interest (Income)
Interest Expense
Pre-Tax Income
($1.3)
$16.2
$165.5
($1.4)
$15.1
$186.0
($1.7)
$20.5
$200.2
($2.0)
$23.7
$205.4
Income Taxes
Net Income
$56.8
$108.7
$64.2
$121.8
$67.5
$132.7
$72.6
$132.8
$38.3
$70.4
$38.7
$83.1
$39.8
$92.9
$40.1
$92.7
Dividends
Addition to Retained Earnings
Other Data
Stock price (year-end)
Number of shares outstanding (millions)
2018
$55.50
48.0
2019
$65.30
47.3
2020
$55.70
46.8
2021
$51.40
46.2
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Short-term solvency or liquidity ratios
Current
Quick
Cash ratio
Identify the
following
financial ratios
Financial Leverage or Long-Term Solvency Ratios
Total debt ratio
Debt to equity ratio
Equity Multiplier
Times interest earned
Cash coverage
Asset Management or Turnover Ratios
Inventory turnover
Days' sales in inventory
Receivable turnover
Days' sales in receivables
Total asset turnover
Profitability or Operating Performance Ratios
Profit margin
Return on assets
Return on equity
Market value or financial performance ratios
EPS
PE Ratio
Market-to-book ratio
73
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11/07/2023
Homework
Find the most recent financial statements for Starbucks’ corporation (SBUX) using the
following sources:
a. From the company’s Web page www.starbucks.com. (Hint: Search for
“investor relations.”)
b. From the SEC Web site www.sec.gov. (Hint: Search for company filings in the
EDGAR database.)
c. From the Marketwatch Web site www.marketwatch.com.
d. From at least one other source. (Hint: Enter “SBUX 10K” at www.google.com.)
Each method will help find the same SEC filings. Yahoo! Finance also provides some
analysis such as charts and key statistics.
75
Appendix
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Different Accounting Standards
• US: Generally Accepted Accounting Principles (GAAP)
• As of 2018, over 180 jurisdictions, including EU, Australia, Brazil, Canada,
Russia, India, Hong Kong, Taiwan, and Singapore: International Financial
Reporting Standard (IFRS)
• China: Chinese Accounting Standards (CAS)
• Companies face tremendous accounting complexities when they operate
internationally.
• Investors also need help interpreting the financial statements of foreign
companies, which discourages them from investing abroad.
• However, as companies and capital markets become more global, interest
in harmonising accounting standards across countries has increased.
77
Difference between IFRS and US-GAAP
1. Treatment of inventory
IFRS: LIFO method is not allowed.
US-GAAP: Both LIFO and FIFO are allowed.
2. Intangibles
IFRS: The cost of the research phase is expensed as
incurred. Costs in the development phase may be
capitalised based on certain factors.
US-GAAP: Generally requires immediate expensing of
research and development expenditures, although some
exceptions exist.
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Difference between IFRS and US-GAAP
3. Rules vs Principles in the accounting process
IFRS: IFRS sets forth principles that companies should follow and
interpret to the best of their judgment. Companies enjoy some
leeway to make different interpretations of the same situation.
US-GAAP: the accounting process is prescribed in highly specific
rules and procedures, offering little room for interpretation. The
measures are devised to prevent opportunistic entities from
creating exceptions to maximise their profits.
4. Recognition of revenue
IFRS: revenue is recognised when the value or % of the value is
delivered.
US-GAAP: revenue is not recognised until the exchange of a good or
service has been completed.
79
Difference between IFRS and US-GAAP
5. Classification of liabilities
IFRS: No plain distinction between liabilities in IFRS, so
short-term and long-term liabilities may be grouped
together.
US-GAAP: Liabilities are classified into either current or
non-current liabilities, depending on the duration allotted for
the company to repay the debts. Debts that the company
expects to repay within the next 12 months are classified as
current liabilities, while debts whose repayment period
exceeds 12 months are classified as long-term liabilities.
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6. Fair Value Revaluations
IFRS: Allows revaluation of the following assets to fair value if fair
value can be measured reliably: inventories, property, plant &
equipment, intangible assets, and investments in marketable
securities. This revaluation may be either an increase or a decrease in
the asset’s value.
US-GAAP: Revaluation is prohibited except for marketable securities.
7. Fixed Assets
IFRS: Long-lived assets are initially valued at a cost but can later be
revalued up or down to market value. Any separate components of an
asset with different useful lives are required to be depreciated
separately under IFRS.
US-GAAP: Requires that long-lived assets, such as buildings, furniture
and equipment, be valued at historical cost and depreciated
appropriately.
81
8. Investment Property
IFRS: Includes the distinct category of investment property,
which is defined as property held for rental income or
capital appreciation. Investment property is initially
measured at cost and can be subsequently revalued to
market value.
US-GAAP: GAAP has no such separate category.
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