Essentials of Financial
Statement Analysis
Revsine/Collins/Johnson: Chapter 5
Learning objectives
1. How competitive forces and business strategies affect firms’ financial
statements.
2. Why analysts worry about accounting quality.
3. How return on assets (ROA) is used to evaluate profitability.
4. How ROA and financial leverage combine to determine a firm’s return
on equity (ROE).
5. How short-term liquidity risk and long-term solvency risk are assessed.
6. Why EBITDA can be a misleading indicator of profitability and cash
flow.
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Financial statement analysis:
Tools and approaches
Tools:
Approaches used with each tool:
Common size statements
Trend statements
Financial ratios
(e.g., ROA and ROE)
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1. Time-series analysis: the same firm
over time (e.g., Wal-Mart in 2005 and
2006)
2. Cross-sectional analysis: different
firms at a single point in time (e.g.,
Wal-Mart and Target in 2005).
3. Benchmark comparison: using
industry norms or predetermined
standards.
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Evaluating accounting “quality”
 Analysts use financial statement information to “get behind the
numbers”.
 However, financial statements do not always provide a complete
and faithful picture of a company’s activities and condition.
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How the financial accounting “filter”
sometimes works
GAAP puts capital leases
on the balance sheet, but
operating leases are “offbalance-sheet”.
Managers have some
discretion over estimates
such as “bad debt
expense”.
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Managers have some
discretion over the timing
of business transactions
such as when to buy
advertising.
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Managers can choose
any of several different
inventory accounting
methods.
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Evaluating accounting “quality”:
The message for analysts
 The first step to informed financial statement analysis is a careful
evaluation of the quality of a company’s reported accounting
numbers.
 Then adjust the numbers to overcome distortions caused by
GAAP or by managers’ accounting and disclosure choices.
 Only then can you truly “get behind the numbers” and see what’s
really going on in the company.
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Getting behind the numbers:
Krispy Kreme Doughnuts, Inc.
 Established in 1937.
 Today has more than 290
doughnut stores (companyowned plus franchised)
throughout the U.S.
70%
65%
60%
50%
40%
31%
30%
20%
10%
 Serves more than 7.5 million
doughnuts every day.
0%
Compnay
stores
Sales to
franchisees
Royalties
Revenue sources in 2002
 Strong earnings and consistent
sales growth.
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Krispy Kreme’s Financials:
Comparative Income Statements
Includes a $5.733 million
after-tax special charge
for business dispute
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Includes a $9.1 million
charge to settle a
business dispute
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Krispy Kreme’s Financials:
Common size income statements
$393.7 operation expenses
$491.5 sales
* Not adjusted for distortions caused by “special items”.
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Krispy Kreme’s Financials:
Tend income statements
$393.7 operating expenses in 2002
* Not adjusted for distortions caused by “special items”.
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$194.5 operating expenses in 1999
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Krispy Kreme’s Financials:
Business segment information
Sell flour mix,
doughnut
making
equipment,
and supplies to
franchised
stores
* Not adjusted for distortions caused by “special items”.
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Krispy Kreme’s Financials:
Business segments (common size)
* Not adjusted for distortions caused by “special items”.
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Krispy Kreme’s Financials:
Balance sheet assets
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Krispy Kreme’s Financials:
Common size assets
$3.2 cash
$105.0 assets
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Krispy Kreme’s Financials:
Trend assets
$7 cash in 2000
$3.2 cash in 1999
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Krispy Kreme’s Financials:
Balance sheet liabilities and equity
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Krispy Kreme’s Financials:
Common size liabilities and equity
$13.0 accounts
payable
$105.0 total
liabilities and
equity
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Krispy Kreme’s Financials:
Trend liabilities and equity
$8.2 accounts
payable in 2000
$13.1 accounts
payable in 1999
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Krispy Kreme’s Financials:
Abbreviated cash flow statements
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Krispy Kreme’s Financials:
Common size cash flow statements
$93.9 capital expenditures
$491.5 sales
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Krispy Kreme’s Financials:
Trend cash flow statements
$93.9 capital expenditures in 2002
$10.5 capital expenditures in 1999
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Krispy Kreme analysis:
Lessons learned
1. Informed financial statement analysis begins with knowledge of
the company and its industry.
2. Common-size and trend statements provide a convenient way to
organize financial statement information so that major financial
components and changes are easily recognized.
3. Financial statements help analysts gain a sharper understanding
of the company’s economic condition and its prospects for the
future.
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Financial ratios and profitability
analysis
Operating profit margin
NOPAT
Sales
Return on assets
ROA=
NOPAT
Average assets
X
NOPAT is net operating profit after taxes
Asset turnover
Sales
Average assets
Analysts do not always use the reported earnings, sales and asset figures. Instead, they
often consider three types of adjustments to the reported numbers:
1. Remove non-operating and nonrecurring items to isolate sustainable operating profits.
2. Eliminate after-tax interest expense to avoid financial structure distortions.
3. Eliminate any accounting quality distortions (e.g., off-balance operating leases).
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Calculating ROA for Krispy Kreme
Eliminate
nonrecurring items
Eliminate interest
expense
Effective tax rate
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How can ROA be increased?
There are just two ways:
1. Increase the operating profit margin, or
2. Increase the intensity of asset utilization (turnover rate).
Assets turnover
Operating profit margin
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ROA, margin and turnover:
An example
 A company earns $9 million of NOPAT on sales of $100 million
with an asset base of $50 million.
 Turnover improvement: Suppose assets can be reduced to $45
million without sacrificing sales or profits.
 Margin improvement: Suppose expenses can be reduced so that
NOPAT becomes $10.
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Krispy Kreme:
ROA decomposition
How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over this period?
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Further decomposition of ROA
Operating profit
margin
NOPAT
Sales
ROA = X
Sales
Average assets
Asset turnover
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ROA and competitive advantage:
Krispy Kreme
Wendy’s, Baja Fresh,
Café Express
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S&P industry survey
or other sources
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ROA and competitive advantage:
Four hypothetical restaurant firms

Competition works to drive down
ROA toward the competitive floor.
Competitive
ROA floor

Companies that consistently earn an
ROA above the floor are said to have
a competitive advantage.

However, a high ROA attracts more
competition which can lead to an
erosion of profitability and advantage.

Firm A and B earn the same ROA,
but Firm A follows a differentiation
strategy while Firm B is a low cost
leader.

Differences in business strategies
give rise to economic differences that
are reflected in differences in
operating margin, asset utilization,
and profitability (ROA).
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Credit risk and capital structure:
Overview
 Credit risk refers to the risk of default by the borrower.
 The lender risks losing interest payments and loan principal.
 A company’s ability to repay debt is determined by it’s capacity to
generate cash from operations, asset sales, or external financial
markets in excess of its cash needs.
 A company’s willingness to repay debt depends on which of the
competing cash needs management believes is most pressing at
the moment.
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Credit risk and capital structure:
Balancing cash sources and needs
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Credit risk:
Short-term liquidity ratios
Current ratio =
Liquidity
ratios
Quick ratio =
Current assets
Current liabilities
Cash + Marketable securities + Receivables
Current liabilities
Short-term
liquidity
Accounts receivable turnover =
Activity
ratios
Inventory turnover =
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Average accounts receivable
Cost of goods sold
Average inventory
Accounts payable turnover =
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Net credit sales
Inventory purchases
Average accounts payable
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Credit risk:
Operating and cash conversion cycles
Working capital ratios:
Days accounts receivable outstanding =
365 days
45 days
Accounts receivable turnover
Operating
cycle 75
days
Days inventory held =
Cash
conversion
cycle 55
days
Inventory turnover
Days accounts payable outstanding =
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30 days
365 days
365 days
( 20 days)
Accounts payable turnover
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Credit risk:
Operating and cash conversion cycle example
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Credit risk:
Short-term liquidity at Krispy Kreme
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Credit risk:
Long-term solvency
Long-term debt to assets =
Long-term debt
Total assets
Debt ratios
Long-term debt to tangible assets =
Long-term debt
Total tangible assets
Long-term
solvency
Interest coverage =
Operating incomes before taxes and interest
Interest expense
Coverage
ratios
Operating cash flow
to total liabilities =
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Cash flow from continuing operations
Average current liabilities + long-term debt
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Credit risk:
Long-term solvency at Krispy Kreme
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Credit risk:
Financial ratios and default risk

A firm defaults when it fails to make
principal or interest payments.

Lenders can then:




Adjust the loan payment schedule.
Increase the interest rate and require
loan collateral.
Seek to have the firm declared
insolvent.
Financial ratios play two roles in
credit analysis:


They help quantify the borrower’s
credit risk before the loan is granted.
Once granted, they serve as an early
warning device for increased credit
risk.
Default rates by Moody’s credit rating, 1983-1999
Source: Moody’s Investors Service (May 2000)
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Default frequency:
Return on assets (ROA)
Profitability: Return on Assets Percentiles (excludes extraordinary items)
Source: Moody’s Investors Service (May 2000)
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Default frequency:
Debt-to-tangible assets and interest coverage
Solvency: Debt-to-Tangible Assets and Interest Coverage Percentiles
Source: Moody’s Investors Service (May 2000)
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Default frequency:
Quick ratio
Liquidity: Quick Ratio Percentiles
Source: Moody’s Investors Service (May 2000)
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Return on equity and financial
leverage

2005: No debt, so all the earnings belong to shareholders.

2006: $1 million borrowed at 10% interest, but ROCE climbs to 20%.

2007: Another $1 million borrowed at 20% interest, and ROCE falls to only 15%.
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Components of ROCE
Return on assets (ROA)
NOPAT
Average assets
Return on common
equity (ROCE)
X
Common earnings leverage
Net income available to
common shareholders
Net income available to
common shareholders
Average common
shareholders’ equity
NOPAT
X
Financial structure leverage
Average assets
Average common
shareholders’ equity
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Profitability and financial leverage:
Nodebt and Hidebt example
Leverage
Leveragehelps
helps
Leverage neutral
Leverage hurts
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Financial statement analysis and
accounting quality
 Financial ratios, common-size statements, and trend statements
are extremely powerful tools.
 But they can be no better than the data from which they are
constructed.
 Be on the lookout for accounting distortions when using these
tools. Examples include:
Nonrecurring
gains and losses
Differences in
accounting methods
Differences in
accounting estimates
GAAP implementation
differences
Historical
cost convention
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Financial statement analysis:
Pro forma earnings at Amazon.com
Company
defined numbers
Computed
according to GAAP
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Why do firms report EBITDA and “pro
forma” earnings?
 Impression management is the
answer.
Analysts should remember:
 Help investors and analysts spot
non-recurring or non-cash
revenue and expense items that
might otherwise be overlooked.
 Mislead investors and analysts
by changing the way in which
profits are measured.



2. Non-GAAP earnings ignore
some real business costs and
thus provide an incomplete
picture of company profitability.
3. EBITDA and pro forma earnings
do not accurately measure firm
cash flows.
Transform a GAAP loss into a
profit.
Show a profit improvement.
Meet or beat analysts’ earnings
forecasts.
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1. There are no standard definitions
for non-GAAP earnings numbers.
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GAAP earnings, pro forma earnings,
and EBITDA
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Summary
 Financial ratios, common-size statements and trend statements
are powerful tools.
 However:



There is no single “correct” way to compute financial ratios.
Financial ratios don’t provide the answers, but they can help you ask
the right questions.
Watch out for accounting distortions that can complicate your
interpretation of financial ratios and other comparisons.
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