Agenda
Financial Statement Analysis
 Objectives of financial statement analysis
 Ratios and valuation
 ROE decomposition
 Residual income valuation model
 Limitations of ratio analysis
© 1999 by Robert F. Halsey
Objectives of Financial Reporting
Why do we issue financial statements?
According to the FASB, the purpose of financial reporting is to
provide information that is useful to investors and creditors
in order to predict the amount, timing and uncertainty of
future cash flows.
So, our target audience are investors and creditors, the
suppliers of capital to the firm. This is a trickle-down theory.
That is, if we supply useful information, then investors and
creditors will be able to accurately price company securities
(debt and equity) and capital will be efficiently allocated within
the economy.
© 1999 by Robert F. Halsey
Why do we want to predict the amount, timing and uncertainty
of future cash flows?
If I know the answer to these three variables, I can price any
security. I need to know the amount of the return (cash
flows) I will get on my investment, when I will realize this
return, and how certain I am of realizing those cash flows.
Investors and creditors are not the only parties interested in
financial information, of course. There are a number of other
users, including suppliers, regulatory and taxing authorities,
employees, competitors, and so on. But investors and
creditors are our primary audience.
© 1999 by Robert F. Halsey
Profitability Analysis
The starting point in financial statement analysis is the
evaluating the profitability of the company.
Any company can increase profitability by increasing the
amount of investment it is willing to make in earning assets.
So, just looking at the dollar amount of reported profits does
not tell us much. We need to evaluate profitability compared
to the level of investment.
This is done via the return on assets (ROA) ratio
© 1999 by Robert F. Halsey
Return on Assets (ROA) is computed as:
Net Income  Interest Expense  net of tax 
ROA 
Average Total Assets
 This formula relates operating performance to the
level of total assets.
 We add back after tax interest expense to measure
profitability before returns to investors and
creditors are subtracted (dividends are not an
expense so we do not need to add these back)
 The numerator, thus measures the return to all
providers of capital.
Our point of view here is the company as a whole,
not as an investor or creditor.
© 1999 by Robert F. Halsey
Neglecting for the moment the add-back of interest, ROA is
approximately to:
Sales
Net Income
ROA 

Sales
Average Total Assets
That is, ROA can be decomponsed algebraically into
Profitability (Net income / sales) , and
Turnover (Sales / Average total assets)
 We can, then, analyze trends in ROA as follows:
 Analyze profitability through analysis of gross
profit margins and expense control
 Analyze turnover through analysis of turnover of
accounts receivable, inventories and fixed assets
© 1999 by Robert F. Halsey
Another way to look at a company is from the viewpoint of the
shareholders. We do this through the return on equity ROE
ratio, computed as follows:
Net Income  Preferred Dividends
ROE 
Average Common Equity

Here, the point of view is the common shareholder. Net
income is already net of interest paid to creditors and we also
subtract the returns to preferred shareholders. The numerator,
therefore, is income available to common shareholders.
© 1999 by Robert F. Halsey
ROE can be decomposed in a similar way to ROA. If we ignore
the subtraction of dividends, ROA is approximately equal to,
Avg T A
ROE 
*
* Avg Equity
Sales AvgT A
NI
Sales
 PM * T urnover * Fin. Leverage
 ROA * Financial leverage
ROE is, therefore, roughly equivalent to ROA multiplied by the
firm’s financial leverage. Company managers can increase
return on equity by utilizing more borrowed capital in their
businesses. This debt, however, comes at a price. The firm is
more risky as a result since failure to make the required debt
payments can result in bankruptcy.
© 1999 by Robert F. Halsey
ROE can also be expressed as follows:
ROE = ROA + (FLEV * Spread)
where FLEV is financial leverage and
Spread = ROA – Interest rate on debt
This points out clearly the fact that firms can
increase ROE by taking more financial risk in the
form of debt. This is true so long as the return on
assets purchased with the debt is greater than the
interest rate on the debt. This concept is called
“trading on the equity.”
© 1999 by Robert F. Halsey
But, why should ROE be the focus of our
analysis?
The answer lies in modern valuation theory which
postulates that firm value can be expressed by
the following equation:
P = BV + PV(expected RI)
where,
P = stock price
BV = book value of stockholder’s equity
PV denotes present value
RI = residual income
This is the Residual Income Valuation Model.
© 1999 by Robert F. Halsey
Residual income (RI) is defined as,
RI = I - r * BV
where
I = reported net income
r = cost of equity capital (the return the
company’s shareholders require on
their investment)
BV = beginning book value
Residual income, then measures the excess
(deficiency) of profits compared with expected levels
of profitability
© 1999 by Robert F. Halsey
Residual income can also be expressed as follows:
RI = I - r * BV
= (ROE - r) * BV
where, ROE=I/BV
So, Shareholder value is increased as residual income
increases and residual income increases as ROE increases.
That is why we focus on ROE.
Also, note that a company can increase shareholder value by:
 Increasing profitability while holding investment constant
 Maintaining profitability with a lower investment base
 Some combination of the two.
© 1999 by Robert F. Halsey
These observations have the following implications for
managers:
 Performance evaluation should be based on
both reported profits and the level of
investment entrusted to the manager (whether at
the divisional level of the firm as a whole)
 Company managers should invest additional
capital in those divisions that can use it
effectively and re-deploy capital away from
those that can’t.
This concept is currently marketed by business
consultants under the name Economic Value Added
(EVA™) that you might have read about in the financial
press.
© 1999 by Robert F. Halsey
One of the most famous methods of disaggregating
ROE into its components is the DuPont method of
analysis:
Profit Margin
Gross Profit /Operating Exp.
X
Accounts receivable turn
ROE =
TA Turnover
X
Fin Leverage
© 1999 by Robert F. Halsey
Inventory turn
Fixed asset turn
Profit margin
The starting point in the analysis is the evaluation of
profitability. We look at two primary ratios:
1)
Gross Profit Margin =
Gross Profit / Sales
–
2)
This measures ability of the firm to mark up the cost
of its products or services into market prices
Operating expense percentage =
SG&A expenses / Sales
Where SG&A are selling, general and administrative
expenses (overhead).
– This measures how well the firm is able to control its
operating expenses
© 1999 by Robert F. Halsey
Turnover Ratios are the second step:
• Accounts Receivable Turnover ratio =
sales / average accounts receivable
– Indicator of collectability of accounts and effectiveness
of working capital management
• Inventory Turnover ratio =
cost of goods sold / average inventory
– Indicator of salability of inventory and effectiveness of
working capital management
• Plant Asset Turnover ratio =
sales / average plant assets
– Indicator of effective utilization of assets
© 1999 by Robert F. Halsey
These three ratios give us clues into the amount of
investment that is required to support a given level of
sales. Companies that can generate sales volume with
minimal investment will yield higher ROE’s than those
that cannot.
Receivable and inventory turnover ratios also give us
insight into the “quality” of those assets. As accounts
receivables take longer to collect (their turnover rate
declines), the risk of uncollectability increases. Also, as
inventories sit on the shelf for longer periods of time (theur
turnover decreases) there is a greater risk of
obsolescence, damage, etc which can reduce their market
value.
© 1999 by Robert F. Halsey
The last area of analysis is the firm’s leverage. Here we are
concerned with two possibilities:
 Is the firm leveraging itself enough? Firms can increase
ROE and, thus, stock price by increasing financial leverage.
Operating at too low a level of leverage does not effectively
utilize the firm’s equity and will not maximize shareholder value.
 Utilizing too much debt increases the risk of bankruptcy. As
this risk increases, shareholders will demand a higher
expected return. This will limit the number of possible projects
the firm can invest in since shareholder value is increased
only so long as ROA > r (the required return shareholders
expect). If the firm can’t grow, its stock price sill suffer.
This suggests a theoretical optimum amount of financial
leverage – just enough to that shareholder equity is maximized,
but not too much so that the risk of bankruptcy increases.
© 1999 by Robert F. Halsey
So, how do we measure whether the firm is taking on enough
debt? We can look at its competitors. Industries will find an
equilibrium level of financial leverage for the type of business
they are in. If the firm is operating at lower levels of leverage
than others in its industry, perhaps this is an indication that its
shareholder’s equity is not being effectively utilized.
And how do we assess the risk of bankruptcy for firms
operating with more financial leverage? The text describes
several ratios designed to give us clues whether the level of
financial leverage is too high. These are under the general
heading of Long-term liquidity (solvency) risk measures:
–Debt ratio (Debt/Total Assets or Debt/Equity)
–Cash flow from operations to total liabilities
–Times Interest Earned ratio (EBIT / I)
© 1999 by Robert F. Halsey
In addition to measuring the the ability of the firm to make
payments on its long-term debt, we are also interested in it’s
short-term debt paying ability. This is called liquidity
analysis.
Liquidity analysis is generally performed with three
ratios described in the text:
Current ratio = current assets / current liabilities
Quick ratio = quick assets / current liabilities
Cash flow from operations to current liabilities
All of these are designed to give us a feel for the degree to
which the firm is liquid. That is, does is have enough cash to
meet its obligations maturing in the near term or does it have
the ability to raise cash quickly from assets or operations.
© 1999 by Robert F. Halsey
Return on Common Equity Decomposition
International Business Machines Corporation
IBM provides a good
example of the ROE
decomposition:
During 94-97, its
ROE increased
dramatically, as did
its stock price.
All areas increased –
turnover, margins
and leverage.
© 1999 by Robert F. Halsey
Result
Return on
Equity
Fy94 .14
Fy95 .18
Fy96 .25
Fy97 .30
Determinants
TA Turnover
Fy94 .79
Fy95 .89
Fy96 .94
Fy97 .96
A/R Turn
Fy94 3.13
Fy95 3.20
Fy96 3.26
Fy97 3.34
Inv Turn
Fy94 4.98
Fy95 5.94
Fy96 6.85
Fy97 7.97
Profit Margin
Fy94 .05
Fy95 .06
Fy96 .07
Fy97 .08
Gross profit %
Fy94 .46
Fy95 .48
Fy96 .45
Fy97 .44
OP Margin
Fy94 .08
Fy95 .14
Fy96 .12
Fy97 .12
TA/TE
Fy94 3.46
Fy95 3.58
Fy96 3.75
Fy97 4.11
Market Price
Fy94 $ 36
Fy95 $ 46
Fy97 $ 76
Fy97 $105
Details
FA Turn
Fy94 3.75
Fy95 4.33
Fy96 4.47
Fy97 4.39
As another example of the ROE decomposition analysis, look at
the ratios relating to Dell and Compaq.
Dell’s ROE
ROE
PROF MARG TA TURN DEBT/TA increased
dramatically during
COMPAQ
the period while
92
10.8
5.2
1.4
0.0
Compaq’s was flat
93
19.8
6.4
2.0
0.0
94
95
96
97
27.4
19.0
24.4
23.8
8.0
5.3
7.3
7.5
2.1
2.1
2.0
2.0
4.9
3.8
2.9
0.0
92
93
94
95
96
97
31.6
-9.4
25.0
32.0
59.7
89.9
5.0
-1.2
4.3
5.1
6.8
7.7
2.7
2.8
2.5
2.8
3.0
3.4
6.1
8.8
7.1
8.1
1.5
3.8
DELL
© 1999 by Robert F. Halsey
Although their profit
margins were
similar, Dell’s asset
turnover was
considerably higher
(due primarily to
better inventory
management)
And its leverage
is higher.
Finally, there are several factors which limit the
effectiveness of financial statement Analysis:
 Firms have differing accounting principles, estimates,
and levels of conservatism. So, comparisons can be
difficult.
 Even within the same firm, its characteristics can
change over time due to mergers, new products,
management changes, etc. Also, if quarterly data is
analyzed, analysts must adjust for seasonal changes.
 Conglomerates are difficult to analyze. They are, in
essence, a blend of many different firms operating in
many different industries. And also, it is sometimes
difficult to compare these firms with industry averages
since they operate across industry lines.
© 1999 by Robert F. Halsey
It is very important to remember that ratios are not an end,
but a starting point to further probing.
The fact that a ratio increased or decreased is not
interesting. We must, then, attempt to discover why this
change took place. That is, what were the business factors
that led to the change manifested in the financial
statements?
Remember, the reality is the company itself, not its financial
statements. Does it have the right products at the right price?
Does it have the right amount of investment in order to
conduct its business? Is it utilizing the right amount of financial
leverage?
The amounts reported in the financial statements are a
representation of what is really happening with the business.
The task of the analyst is to understand the business factors that
give rise to the reported figures.
© 1999 by Robert F. Halsey
The End
© 1999 by Robert F. Halsey