Investments:
Financial Statement Analysis
(review)
Professor Scott Hoover
Business Administration 365
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What questions are important in assessing
the health of a firm?
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Can the firm meet its debt obligations?
How well are assets being managed?
How profitable is the firm?
How risky is the firm?
What does the market think of the firm?
 Ratio Analysis: interpretation of accounting
and market information to assess the health of
companies.
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Why do we use ratios?
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We must consider things on a relative basis, not an
absolute one.
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e.g.: If one company has earnings of $2,000,000 and
another of $1,000,000, which is better?
 We can’t say because one company may be
considerably bigger than the other.
By using ratios, we are able to compare a company to
its peers.
There are no hard-and-fast rules here. We can
and should be creative by creating our own ratios
to investigate specific areas.
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The DuPont Relationship
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We begin any analysis by examining the factors
that contribute to the Return on Equity (ROE).
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Why?
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Measures the return to shareholders
DuPont:
ROE  NI / E = (NI / S)  (S / TA)  (TA / E )
= profit margin
 asset turnover
 leverage multiplier
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Note that ROE = ROA  (TA / E )
leverage multiplier = TA / E
= TA / (TA - D)
= 1 / (1 - debt ratio)
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The DuPont approach is nice because it divides
the firm into three tasks
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expense management (measured by the profit margin)
asset management (measured by asset turnover)
debt management (represented by the debt ratio or
leverage multiplier)
The DuPont Method
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layered approach
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examine the three components
dig deeper to identify possible weaknesses and strengths
dig deeper to find specific causes and hopefully to identify
possible corrective action
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factors of the profit margin
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sales
cost of goods sold
SG&A expenses
R&D expenses
depreciation
interest
taxes
other expenses
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factors of the asset turnover
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sales
assets
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current assets
 cash
 receivables
 inventory
fixed assets
 property
 plant
 equipment
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factors of the leverage multiplier?
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Since we are concerned with whether or not the firm can
meet its debt obligations, the “factors” don’t really
matter.
Instead…
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current assets vs. current liabilities
 current ratio
 quick ratio
profits vs. debt payments
 ROIC vs. after-tax interest
 times-interest-earned
Ultimately, we must assess debt on a cash flow basis.
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Tools
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Common Size statements
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Indexed statements
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express the balance sheet as a percentage of total assets
express the income statement as a percentage of sales
express the financial statements from one period as a
percentage of some base year.
See spreadsheet example
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Profit Measures
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Earnings (net income)
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accounting profits
useful if not misleading (intentionally or otherwise),
problem: does not reflect cash flow
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includes Depreciation as an expense
ignores Capital Expenditures
uses Sales instead of receipts
uses Cost of Goods Sold instead of disbursements
EBITDA
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earnings without Depreciation, Interest, Taxes
looks at earnings without the effects of financing and
accounting decisions
useful for understanding the ability to service debt
problem: still does not reflect cash flow
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Free Cash Flow
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measures the true cash flow of the firm in a given
period, ignoring all financing-related cash flows and
effects
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can be misleading due to fixed asset effects
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Why ignore financing?
e.g., firm with old, fully depreciated equipment vs. one that
has bought new equipment during the period.
very useful when viewed over multiple periods
provides the basis for the DCF model
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Building the Free Cash Flow Equation
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How do earnings differ from cash flow?
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Earnings include financing-related cash flows
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adjust by using EBIT(1-T) (i.e., NOPAT) instead of earnings.
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This is just net income assuming zero interest expense
Depreciation: subtracted, but is not a cash flow
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adjust by adding depreciation
Capital Expenditures: ignored entirely
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adjust by subtracting CapEx
Sales: recorded when made, not when cash is received.
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adjust by subtracting the increase in receivables
Cost of Goods Sold: recorded when sold, not when the goods are
paid for
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adjust by subtracting the increase in inventory
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and by subtracting the decrease in payables
Ignores cash needed for operations
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adjust by subtracting the increase in operating cash
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Note that most financial analysts ignore this effect entirely
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Note the following
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subtracting the increases in cash, inventory, and
receivables  subtracting the increase in current
assets.
adding the increase in payables  subtracting the
decrease in current liabilities.
It follows that we subtract CA- CL.
Since Net Working Capital (NWC) is CA-CL, we
subtract NWC. This gives us our final equation
The Free Cash Flow Equation
FCF  NOPAT  NWC  CapEx  D & A  Other Effects
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FCF yield = FCF / EV
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EV  enterprise value
= equity + preferred stock + debt – cash & equivalents
i.e., EV is the amount of capital the firm has currently
invested
Why do we subtract cash & equivalents?
What happens if FCF yield < WACC?
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company earns less than what it “owes” investors
higher sales  lower stock value!
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Another Look at ROE
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ROE = NI/E
NI = (EBIT-Interest)(1-t) = (EBIT-iD)(1-t)
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t  effective tax rate
i  interest rate on debt
D  amount of outstanding debt
We can rearrange these equations to get an expression
that is more helpful.
First, recall that the Return on Invested Capital is
EBIT 1  t 
ROIC 
DE
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ROE 
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EBIT
 iD 1  t 
E
EBIT 1  t 
iD 1  t 

E
E
EBIT 1  t  D  E
iD 1  t 


DE
E
E
iD 1  t 
D

ROIC  
 1 
E
E

D
ROIC  ROIC  i 1  t 
E
The ROIC is entirely independent of capital structure.
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 2nd term of the last equation reflects the impact of
capital structure on ROE.
The sign of the 2nd term tells us whether or not debt helps
or hurts ROE.
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What do we learn from this exercise?
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i(1-t)<ROIC  taking on more debt will increase ROE.
i(1-t)>ROIC  taking on more debt will decrease ROE.
Implications
 optimal strategy might be to use debt whenever the
after-tax interest rate on marginal debt is below the
ROIC and to use equity otherwise.
 But….
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How far into the future should we look? One data point is
hardly sufficient to draw strong conclusions.
The equation does not incorporate risk.
The equation ignores other important factors.
Revisiting our example…
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Difficulties with Financial Statement Analysis
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Information is always old.
Book values are reported instead of market values
We often must compare companies at different points in
time.
Companies often use different terminology
Managers may have incentives to mislead
Financial statements often lack detail
Industry averages are often misleading
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Should we include negative ratios in averages?
Should we include outliers in averages?
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Other Comments
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We should always consider the notes to the
financial statements.
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They give explanations for unusual items as well as
notes that suggest an accounting explanation for a
peculiarity.
We should always consider news stories on the
company.
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They often contain statements concerning the financial
condition of the firm and/or comments on things to
expect.
They provide updates since the date of the last
financials.
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