BM410 - Investments
Financial Statement Analysis:
A Story in Numbers
Objectives
•
•
•
A. Understand the Key Responsibilities of an
Analyst in doing Securities Analysis
B. Identify sources of biases in conventional
accounting data
C. Understand (remember) Return on Equity
and how to calculate and use standard
financial ratios
A. Key Responsibilities of an Analyst
•
What are the key responsibilities of an
analyst?
1. Understand the company
2. Differentiate between accounting and
economic earnings
3. Differentiate between the past and the
future
4. Assess the quality of company management
5. Forecast earnings
Responsibilities (continued)
1. Understand the company (like you owned it
because you may)!
• Financial Statement Analysis helps the
analyst:
• Understand how the firm has done in the
past
• Help forecast how the firm will do in the
future
• It will not tell you to buy or sell a
stock, but it will help you estimate the
stock’s value
Responsibilities (continued)
• Tools Used by the Analyst
• Publicly available data
• Derived data from Financial Statements,
i.e. ratio analysis
• Your own knowledge and experience
• Interviews with management
• Research, competitor analysis, and
common sense
• Limitations
Responsibilities (continued)
2. Differentiate between Accounting and
Economic Earnings
• Accounting Earnings
• Earnings a firm has reported on its income
statement
• Affected by accounting conventions
regarding asset valuation, e.g. LIFO,
depreciation, etc.
• Tells (somewhat) what the firm actually
did. You must know the conventions
used to know what they did!!!!!!
Responsibilities (continued)
• Economic Earnings
• This is the real cash flow that a firm could pay
out forever in absence of any change in a firms
productive capacity
• These are your estimates what a firm could
do really do
• You must estimate economic earnings
• This is much harder to do
Responsibilities (continued)
3. Differentiate between the past and future
earnings and activities
• Accounting earnings are largely concerned over
what the firm did in the past
• Is the past indicative of the future?
• What has happened recently?
Responsibilities (continued)
 We are concerned with:
• What will happen this year in the:
• Company, Industry, World Economy
• Technology and the firms products and suppliers
• While Accounting is concerned with the past,
we are concerned with the future—WHAT
WILL HAPPEN THIS YEAR AND NEXT!
Responsibilities (continued)
 4. Assess the quality of company management
•
•
•
•
Can you trust them?
Are they competent?
Can they answer your questions?
Do they know what is happening in the world
economy and the industry?
• Do you have the confidence in them to run the
company in a way which best advances (your)
shareholder value?
Responsibilities (continued)
5. Forecast earnings
•
Build models to help understand relationships
between finance, marketing, operations, etc. and
earnings
• Understand each line item of the financial
forecast
• Use public and private data and personal
experience to make a line-by-line financial
forecast
• Compare forecasts to other analysts as a final
check on reasonableness
Responsibilities (continued)
 The value of a company is the present value
of its future earnings
•
Return on Equity is a key determinant of a
company’s growth in earnings (the other is its
payout ratio)
•
Return on Equity must be understood
thoroughly!
•
It’s a key part of valuation
Questions
•
Any questions on the responsibilities of an
analyst in doing securities analysis?
Assessment #1
•
You are visiting Dell Computer company as a
potential candidate for your portfolio.
Amazingly, your contact at Dell was a BM410
student from previous years. He has filled our
your entire spreadsheet in your format with
forecasts, assumptions, and totally written your
report for you. You have not yet written up the
report and you are in a hurry to get the report
out. What is your responsibility as an analyst?
Answer:
•
Even though he may have done a wonderful
job in analyzing the company and writing it up,
it is still your responsibility. You should go
over every entry, formula, assumption, and
forecast and make it your own. Relying on
some else’s knowledge of the company (you
need to know it yourself) is not only wrong
but can lead to major problems in the future.
B. Understand Sources of Bias in
Conventional Accounting Data
• Potential sources of biases:
• 1. Accounting Differences
• Inventory Valuation: FIFO, LIFO
• Depreciation: SL, SYD
• Treatment of leases, pension costs,
allowances for reserves
• 2. Inflation and interest expense
• Inflation accounting
• Accounting for interest expenses
• Expensed versus capitalized
Sources of Bias (continued)
• 3. International Accounting Conventions
• Accounting for Currency gains/losses
• Reserves, Intangibles, revenue recognition
• 4. International Accounting Standards
• Uses a principles-based system
• 5. US Accounting System
• Uses a rules-based system
C. Understand Ratio Analysis
and Return on Equity
• What is ratio analysis?
• Process of turning data into information
• A way of learning what a company is doing
• What is return on equity?
• The ratio of net profits to common equity, or
• How much earnings are generated by each dollar of
equity in the firm
• The process of understanding firm profitability and
sources of that profit
Return on Equity
(continued)
• Why is ROE important?
• The factors that affect earnings are the same
factors that affect ROE, including a firm’s:
• Taxes
• Interest on debt
• Profit margin
• Asset turnover
• Leverage
• ROE helps us understand earnings, and ratios help
us understand what affects ROE
Important Notice
• Whenever a financial ratio includes one item
from the income statement, which covers a
period of time, and the balance sheet, which is
a snapshot in time, the practice is to take the
average of the beginning and end-of-the-year
balance sheet (i.e., add them both and divide by
2).
ROE Decomposition
•
While there are many important ratios, five are critically
important to understanding earnings.
•
These five are commonly called the Dupont System by financial
analysts
• Memorize and use them!
Pretax Profit
Net Profit
ROE =
x
Pretax Profit
(1)
Tax
Burden
x
x
EBIT
(2)
Interest
Burden
x
x
EBIT
Sales
(3)
x
x
Assets
Sales
Assets
(4)
x Equity
x (5)
x Margin x Turnover x Leverage
ROE Decomposition (continued)
 1. Tax Burden (Net Profit / Pretax Profit)
•

A reflection of the government tax code and the
firm’s tax policies
• If different than comparable companies, ask
questions to find out why?
2. Interest Burden (Pretax Profit/EBIT or (EBIT
– Interest Expense)/EBIT)
•
The impact of interest costs on earnings
• The greater the interest burden, the more
susceptible the company to shocks in the
economy and industry
ROE Decomposition (continued)
 3. Operating (EBIT) Margin or ROS (EBIT /
Sales)
•
The operating profit per dollar of sales
• How efficient are they at turning sales into
profits?
 4. Asset Turnover (Sales/Assets)
•
The efficiency of asset utilization – sales generated
by each dollar of assets
• How well can they utilize their assets
ROE Decomposition (continued)
• 5. Leverage (Assets/Equity) or (1 +
Debt/Equity)
•
The ratio of assets over equity
• A reflection of how leveraged the firm is—how
much debt the firm is using
Key Points on ROE Analysis

Variations on a theme
•
•
•

ROA = EBIT/Assets = Operating Margin
(EBIT/Sales) x turnover (Sales/Assets) (3 x 4)
Compound leverage = interest x leverage
ROE = Tax burden x ROA x compound leverage
Relationship between ROE, ROA, and leverage
•
ROE = (1-tax rate)[ROA + (ROA-Interest rate) *
Debt/Equity]
Problem: Putting it all together (see p. 457)
Key Financial Ratios for Growth Industries
Year ROE TB IB M AT Lev CLF ROA PE PB
2001 7.5% .6 .65 30% .30 2.12 1.4 9% 8 .6
2002 6.1% .6 .47 30% .30 2.38 1.1 9% 6 .4
2003 3.0% .6 .20 30% .30 2.72 .6 9% 4 .1
Indus 8.6% .6 .80 30% .40 1.50 1.2 12% 8 .7
TB = Tax burden: net profit/Pre-tax profit, IB = interest burden:
pretax profit/EBIT, M = margin: EBIT/Sales, AT = asset
turnover: sales/assets, Lev = leverage: assets/equity, CLF =
compound leverage factor: IB*Lev
The CEO stated sales, assets and operating income are all
growing at 20% per year. 2003 was another great
year! What do you think?
Thoughts on:
• ROE
• Declining. Compared to the industry, it looks
particularly bad.
• PE / PB
• Low and falling. Investors are not looking
positively towards the firm’s future
• ROA
• Constant. Must mean an inappropriate use of
financial leverage
Putting it Together (continued) (see p. 469)
2001
2002
2003
Cash Flow from operating activities
Net income
$11,700 $10,143 $ 5,285
+ Depreciation
15,000 18,000 21,600
+ Decr. (incr.) in AR
(5,000) (6,000) (7,200)
+ Decr. (incr.) in inventories (15,000) (18,000) (21,600)
+ Incr. in Accounts Payable
6,000 7,200 8,640
Cash flow from investing activities
Investment in PP&E
(45,000) (54,000) (64,800)
Cash Flow from financing activities
Dividends paid
0
0
0
Short-term debt issued
42,300 54,657 72,475
Change in cash/marketable secur. 10,000 12,000 14,400
What’s the story here? (comment on NI, OCF, CFI, and
CFF)
Thoughts on:
• Net income
• Declining. Why? This is a major concern
• Operating Cash flow
• Cash is being generated by increased accounts
receivable, inventories, and accounts payable
• Cash Flow from Investing
• Earnings are declining, yet they are continuing to invest
heavily
• Cash Flow from Financing
• They are financing the investment from borrowings
 THERE ARE SOME REAL PROBLEMS HERE!
Questions, Answers and Miscellaneous
Slides
• Following are slides to review that may be
helpful in your study.
Problem 14-1
• The Crusty Pie company has a return on sales
higher than the industry average, yet its ROA is
the same as the industry average. How can you
explain this?
Answer 14-1
• What is the connection between ROA and
ROS?
Earnings =
Assets
ROA = ROS
Earnings
Sales
x
Sales
Assets
x Asset Turnover
• If ROA is equal to the industry and ROS is
higher than industry, then asset turnover must
be lower than the industry
Problem 14-2
• The ABC company has a profit margin on sales
below the industry average, yet its ROA is
above the industry average. What does this
imply about asset turnover?
Answer 14-2
• What is the connection between profit margin
on sales to return on assets?
Profit margin = ROA x (1/Asset Turnover)
EBIT = EBIT x Assets
Sales Assets
Sales
If profit margin is below, and ROA is above, then then
1/asset turnover must be higher and so asset
turnover is lower.
Problem 14-3
• Firm A and firm B have the same ROA, yet
firm A’s ROE is higher. How can you explain
this?
Answer 14-3
• What is the relationship between ROE and ROA?
Earnings = Earnings x Assets
Equity
Assets
Equity
ROE = ROA x leverage
• If the firms have the same ROA, but firms ROE is
higher, then firm A’s leverage or Assets/Equity must
be higher. The formula:
• *ROE = (1- tax rate) [(ROA + ROA – Interest Rate)
* Debt/Equity]
• This shows that assuming the same tax rates, they
must have different interest rates or debt/equity
ratios
Support for 14-3
ROE = Net Profit /Equity
= (EBIT – Interest – Taxes)/Equity
Net Profit = EBIT – Interest – Taxes
= ((1- tax rate)(EBIT – Interest))/Equity
EBIT – Interest – Taxes = (1- tax rate)(EBIT – Interest)
=(1- tax rate) ((ROA x assets – interest rate x debt))/Equity
Interest=interest rate x debt EBIT = ROA x Assets
= (1 - tax rate) [ROA x (Equity + Debt)/Equity
- Interest rates x (Debt/Equity)]
Assets = Equity + Debt
= (1 – tax rate)[ROA+(ROA–interest rate) (Debt/Equity)]
Problem 14-4
•
Which of the follow best explains a ratio of “net
sales to average net fixed assets” that exceeds the
industry average:
•
•
•
•
a. The firm added to its plant and equipment in the last
few years
b. The firm makes less efficient use of its assets than
other firms
c. The firm has a lot of old plant and equipment
d. The firms uses straight-line depreciation
Answer 14-4
•
Old plant and equipment. The firm is likely
to have older plant and equipment which
have a low book value due to depreciation,
making the ratio of sales to fixed asset higher.
Note:
• My purpose is not to review what you learned
in previous classes—I expect you to already
know that material. It is your responsibility to
know the rest of the ratios in the chapter and at
least have read about the new ratio’s in the
Apple Example from the TT05 – Financial
Ratios Reviewed.
Types of Financial Ratios
• Liquidity Ratios
• Strengths and weakness of the firms short-term
financial position
• Activity or Management Efficiency Ratios
• Managements ability to manage assets profitably
• Leverage Ratios
• Managements ability to use debt profitably
• Profitability Ratios
• Managements ability to generate earnings for the
shareholders
• Market Price Ratios
• Indications of firm value versus accounting or
Liquidity Ratios
• Current Ratio
• A measure of the firms ability to pay off current
liabilities by liquidating current assets, to avoid
insolvency in the short-term (the larger the better)
Current Assets
Current Liabilities
• Quick Ratio
• Similar to above, but only includes cash and
receivables, as some inventory may not be readily
convertible into cash (the larger the better)
Current Assets - Inventory
Current Liabilities
Activity or Management
Efficiency Ratios
• Inventory Turnover
• How often the inventory turns over each year (the
more it turns over generally, the higher the
earnings)
Sales or Cost of Goods Sold
Inventory
• Total Asset Turnover
• The ability of a company to minimize the level of
assets to support its level of sales (the greater the
number the better)
Sales
Total Assets
Activity or Management
Efficiency Ratios (continued)
• Average Collection Period
• How many days it takes to receive payment
from customers (the fewer days the better)
Accounts Receivable
Sales Per Day
• Days to Sell Inventory
• How many days it takes to sell current
inventory (the fewer the days the better)
Inventory
Sales Per Day
Leverage Ratios
• Times Interest Earned (interest coverage ratio)
• How many times interest expense can be covered
by current earnings (the more times the better)
Earnings Before Int. & Taxes
Interest Expense
• Fixed Charge Coverage Ratios
• How many times various fixed payments can be
made on current earnings (the greater the ratio of
earning to fixed payments, the better)
• Lease Payments
• Principal Repayments
• Preferred Dividends
Leverage Ratios (continued)
• Debt to Assets
• What percentage of your assets is represented by
debt (the higher the debt, the more risky the firm)
Long Term Debt
Assets
• Debt to Equity
• What percentage of owners equity is your debt (the
higher the debt, the more risky the firm)
Long Term Debt
Shareholders Equity
Profitability Ratios
• Net Profit Margin
• Percent of profit for each dollar of sales (the higher
the better)
Net Income
Sales
• Return on Assets
• Percent of income for each dollar of assets (the
higher the better)
Net Income
Total Assets
Profitability Ratios (continued)
• Return on Equity
• Percentage of return from each dollar of common
equity (the higher the better)
Net Income
Common Equity
• Operating Margin After Depreciation
• Percentage of return from each dollar of sales (the
higher the better)
Operating Profit
Sales
Market Price Ratios
• Price to Earnings
• A firms market capitalization divided by earnings or
Price per share / Earnings per share (diluted). It is
the price you are paying for each dollar of earnings
(the lower the better)
Market Price of Stock
Earnings
• Price to Book (Market-to-Book-Value)
• A firms market capitalization divided by owners
equity (PxS/BVpsxS). It is the price you are paying
for each dollar of equity (the lower the better)
Market Price of Stock
Book Value Per Share