CHAPTER 19
Financial Statement Analysis
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McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Financial Statement Analysis
• Financial statement analysis can be
used to discover mispriced securities.
• Financial accounting data are widely
available, but
– Accounting earnings and economic
earnings are not always the same thing!
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Financial Statements
• Income Statement:
– Profitability over time
• Balance Sheet:
– Financial condition at a point in time
• Statement of Cash Flows:
– Tracks the cash implications of
transactions.
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Table 19.1 Consolidated Statement of
Income for Hewlett-Packard, 2009
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Table 19.2 Consolidated Balance Sheet for
Hewlett-Packard, 2009
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Table 19.3 Statement of Cash Flows for
Hewlett-Packard, 2009
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Accounting Versus Economic Earnings
• Economic earnings
– Sustainable cash flow that can be paid
to stockholders without impairing
productive capacity of the firm
• Accounting earnings
– Affected by conventions regarding the
valuation of assets
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Profitability Measures
• ROE measures profitability for
contributors of equity capital.
– After-tax profit/book value of equity
• ROA measures profitability for all
contributors of capital.
– EBIT/total assets
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Past vs. Future ROE
• ROE is a key determinant of earnings
growth.
• Past profitability does not guarantee future
profitability.
• Security values are based on future
profits.
• Expectations of future dividends determine
today’s stock value.
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Financial Leverage and ROE
• ROE can differ from ROA because of
leverage.
• Leverage makes ROE more volatile.
• Let t=tax rate and r=interest rate, then:

Debt 
ROE  1  t ROA  ROA  r 

Equity

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Financial Leverage and ROE

Debt 
ROE  1  t ROA  ROA  r 

Equity

• If there is no debt or ROA = r, ROE will
simply equal ROA(1 - t).
• If ROA > r, the firm earns more than it pays
out to creditors and ROE increases.
• If ROA < r, ROE will decline as a function
of the debt-to-equity ratio.
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Table 19.5 Impact of Financial
Leverage on ROE
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Decomposition of ROE
DuPont Method
ROE =
Net Profit
x
Pretax Profit
Burden
x
EBIT
(1)
Tax
Pretax Profit
x
x
(2)
Interest
Burden
x
EBIT
Sales
(3)
x
x
Sales
Assets
(4)
x
Assets
Equity
x (5)
x Margin x Turnover x Leverage
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Decomposition of ROE
ROA=EBIT/Sales X Sales/Assets
= margin X turnover
• Margin and turnover are unaffected by
leverage.
• ROA reflects soundness of firm’s
operations, regardless of how they are
financed.
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Decomposition of ROE
ROE=Tax burden X ROA X Compound leverage
factor
• Tax burden is not affected by leverage.
• Compound leverage factor= Interest
burden X Leverage
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Table 19.6 Ratio Decomposition Analysis
for Nodett and Somdett
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Choosing a Benchmark
• Compare the company’s ratios across
time.
• Compare ratios of firms in the same
industry.
• Cross-industry comparisons can be
misleading.
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Table 19.7 Differences between Profit Margin
and Asset Turnover across Industries
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Table 19.9 Summary of Key Financial
Ratios
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Table 19.9 Summary of Key Financial
Ratios
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Table 19.9 Summary of Key Financial
Ratios
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Table 19.9 Summary of Key Financial
Ratios
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Table 19.9 Summary of Key Financial
Ratios
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Figure 19.1 DuPont Decomposition for
Hewlett-Packard
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Economic Value Added
• EVA is the difference between return on
assets (ROA) and the opportunity cost of
capital (k), multiplied by the capital
invested in the firm.
• EVA is also called residual income
• If ROA > k, value is added to the firm.
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Example 19.4 Wal-Mart
• In 2009, Wal-Mart’s cost of capital was
5.9%. Its ROA was 9.6% and its capital
base was $115 billion.
• Wal-Mart’s EVA =
(0.096-0.059) x $115 billion = $4.25 billion
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Comparability Problems
• Accounting Differences
– Inventory Valuation
– Depreciation
• Inflation and Interest Expense
• Fair Value Accounting
• Quality of Earnings
• International Accounting Conventions
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International Accounting Differences
• Reserves – many other countries allow
more flexibility in use of reserves
• Depreciation – US allows separate tax
and reporting presentations
• Intangibles – treatment varies widely
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Figure 19.2 Adjusted Versus Reported
Price-Earnings Ratios
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The Graham Technique
• Rules for stock selection:
– Purchase common stocks at less than
their working-capital value.
– Give no weight to plant or other fixed
assets.
– Deduct all liabilities in full from assets.
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