CHAPTER 17
Financial statement analysis II
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© 2005 Peter Walton and Walter Aerts
Contents
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Introduction – Framing of financial
statement analysis
Quality of earnings
Analytical techniques
Strategic ratio analysis
Z scores
Shareholder value
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Framing of financial statement
analysis
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Accounting numbers are not the only
input into the assessment of a
company’s prospects
Figure 17.1 provides an overview of
relevant framing factors
Increasing use of investor briefings by
companies
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© 2005 Peter Walton and Walter Aerts
Fig. 17.1 Rating pyramid
Sovereign macro-economic analysis
Industry sector analysis
Regulatory environment (national and global)
Competitive trends in sector
Market position
Quantitative analysis financial statements past performance future
projections
Qualitative analysis management strategic direction financial flexibility
Rating
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© 2005 Peter Walton and Walter Aerts
Quality of earnings
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Is profit (and profit growth) sustainable?
What is the impact of short term conditions ?
What is the impact of ‘creative’ accounting
changes ?
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Changes in accounting policies
Changes in accounting estimates
Changes in consolidation scope
Changes in interest %
Exceptional sale of assets or business segments
Other extraordinary operations
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© 2005 Peter Walton and Walter Aerts
Quality of earnings (cont.)
Some analysts will compare, in a longitudinal fashion,
operating profit to net operating cash flow to identify and
analyse the effect of ‘accruals’- games on operating
earnings.
Quality of operating earnings =
Net operating cash flow
Net operating profit
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© 2005 Peter Walton and Walter Aerts
Discontinuing operations
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A discontinuing operation is a clearly
distinguishable component of a group’s
business, that
(a) Is disposed of or terminated pursuant to a single plan
(b) Represents a separate major line of business or geographical
area of operations, and
(c) Can be distinguished operationally and for financial reporting
purposes.
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Requires major additional disclosures
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Income statement / Cash Flow Statement / Notes
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© 2005 Peter Walton and Walter Aerts
IFRS 5 - Presentation of Discontinued Operations in the
Income Statement (Extract)
XYZ GROUP - INCOME STATEMENT FOR THE YEAR ENDED 31
DECEMBER 20-2
(illustrating the classification of expenses by function)
(in thousands of currency units)
Continuing operations
20-2
Revenue
X
Cost of sales
(X)
Gross profit
X
Other income
X
Distribution costs
(X)
Administrative expenses
(X)
Other expenses
(X)
Finance costs
(X)
Share of profit of associates
X
Profit before tax
X
Income tax expense
(X)
Profit for the period from continuing operations
X
20-1
X
(X)
X
X
(X)
(X)
(X)
(X)
X
X
(X)
X
continues
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© 2005 Peter Walton and Walter Aerts
IFRS 5 - Presentation of Discontinued Operations in the
Income Statement (Extract) – cont.
Discontinued operations
Profit for the period from discontinued
operations1
X
X
Profit for the period
X
X
X
X
X
X
X
X
Attributable to:
Equity holders of the parent
Minority interest
1 The required analysis would be given in
the notes
Source: IFRS 5 – Non-current assets held for sale and discontinued operations, Guidance on implementing
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Analytical techniques
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Common accounting base
Common size
Ebitda
Objectives of analysis
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© 2005 Peter Walton and Walter Aerts
Common accounting base
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Adapt financial statement data for
differences in accounting rules among
companies, e.g.
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Accounting for R&D costs
Depreciation rules
Goodwill treatment
Revaluation of fixed assets
Set up comparable pro-forma
statements for cross-sectional analysis
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© 2005 Peter Walton and Walter Aerts
Common size
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Common size financial statements
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Resize components of balance sheet as a % of
total assets
Express components of income statement as a %
of sales
They allow a straightforward internal or
structural analysis of a company’s
financial position and performance
Useful for comparisons in time and in
space
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Ebitda
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‘Earnings before interest, taxation,
depreciation and amortization’
Proxy for net operating cash flow
Cleans operating result for non-cash
costs and non-cash revenues
Robust measure for comparison of
performance in time and space
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Objectives of analysis
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Investors and creditors as predominant users
of financial statements
Broadly, both investor and creditor will use
the same indicators, but the relative
importance of specific indicators will be
different and will be contingent on the type of
investor (and creditor) decisions to be made
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Strategic ratio analysis
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Sustainable growth
ROI decomposition
Financial leverage
Operational gearing
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Recap ratio analysis
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Understand accounting principles
Develop a consistent analysis
framework
Constraints of an historical perspective
Garbage in, garbage out
Take into account trends and industry
comparisons
Take into account worldwide variations
in accounting rules
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© 2005 Peter Walton and Walter Aerts
Strategic analysis
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Elements of strategic analysis:
 Phase in life cycle of company and products
 Nature of market
• Difficult entry <> large margins
• Easy entry <> margins usually very low
 Nature of products
• Niche products (low volume, high price)
• Bulk (high volume, low margins)
 ….
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Develop (combinations of) ratios which will
give insights to a company’s strategic
positioning
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Sustainable growth
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Look at growth of key items of financial
statements
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Trend analysis
Differentiate organic and acquired growth
Sustainable growth =
ROE x (1 – Dividend payout ratio)

Dividend payout = Dividend / Earnings attributable to
shareholders
= indicator of internally generated growth potential if
the company’s profitability, dividend payout and level
of debt financing are kept constant
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Growth analysis
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Periodic growth of sales as point of departure
Link with profit growth ?
Differentiate between organic and acquired
growth
Identify regional or geographic location of
growth
Differentiate growth potential by business
segment
Impact on cash flow ?
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
ROI decomposition
There is a conventional relationship between management
performance ratios which links return on investment, profit margin
and asset turnover as follows:
Profit margin * Asset turnover = ROI
If we apply this reasoning to the ROA (return on assets) ratio, we
arrive at the following algebraic equality:
Profit before
interest
Sales
*
Sales
Total assets
=
Profit before
interest
Total assets
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
ROI decomposition (2)
Assume: ROA decreases over a number of periods

Cause? Asset turnover, Profit margin or both ?
Assume: Asset turnover drops => Cause? Sales, assets or
both?
Potential causes:
(1)
(2)
Due to competition, sales decrease and one is not able to adjust
inventory levels accordingly
Recent investments in IT were necessary to support current
competitive position
Assume: Profit margin decreases => Cause ?
Increasing operating expenses, decreasing market
share, decreasing sales prices, …
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Financial leverage
Taking the analysis one step further, the return on equity can be analytically
linked to the return on assets ratio with the introduction the concept of
financial leverage.
ROA * Financial leverage = ROE
Starting with the ROA (return on assets) ratio, we arrive at the following
algebraic equality:
Profit before
interest
Total assets
*
Total assets
Equity
=
Profit before
interest
Equity
Alternatively, we can start from the original ROE definition and get the following:
Net profit for the period
*
Total assets
Total assets
=
Equity
Net profit for the period
Equity
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Final leverage coefficient
A related, but somewhat different, concept is the financial
leverage coefficient ratio, defined as ROE divided by ROA:
Financial leverage coefficient = ROE% / ROA%
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Table 17.1 Financial leverage effect at
different debt/equity ratios
Total assets = 1,000
ROA = 10%
After-tax cost of debt = 7%
Debt /Equity
Profit before interest
Cost of debt
Net profit
ROE
Financial leverage
coefficient
100%
150%
300%
100
100
100
35
42
52.5
65
58
47.5
13%
14.5%
19%
13%/10% = 1.30
1.45
1.90
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
The DuPont model
Combining ROI decomposition and financial leverage brings us to
the following overall model (also called the DuPont model):
ROE = Net profit margin * Asset turnover * Financial leverage
or:
Net profit for
the period
=
Equity
Net profit for
the period
Sales
Sales
* Total assets *
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Total assets
Equity
Operational gearing
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Volatility of profit as a function of changes in
sales (taking into account the cost structure)
Operational gearing is the % change in profit
as sales changes 1%
Based on the traditional difference between
fixed and variable costs
Operational gearing =
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
(Sales – variable costs) / EBT
or
(Earnings before tax + fixed costs) / EBT
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Fig. 17.2 Operational gearing
Value
Sales
Costs = Fixed + Variable Costs
Break-even
Volume
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Fig. 17.2 Operational gearing (cont.)
Value
Sales
Costs = Fixed + Variable Costs
Break-even
Volume
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Fig. 17.2 Operational gearing (cont.)
Value
Sales
Costs = Fixed + Variable Costs
Break-even
Volume
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Different cost structures
Sales
Fixed
costs
Variable
costs
PbT
Operational
gearing
Co. A
100
20
70
10
3:1
Co.B
100
70
20
10
8:1
If sales increase by 10%, profit before tax of company A increases
by 30% and profit of company B by 80%
A decrease in sales will have a more dramatic effect in company B
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Operational gearing indicators
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Operational gearing =
 (Sales
– variable costs) / EBT
 (Earnings before tax + fixed costs) / EBT
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Proxy in external analysis:
 LT
assets / Total assets
 LT assets / Current assets
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© 2005 Peter Walton and Walter Aerts
Investigate link between ratios
and cash flows
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Cash from operations
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Changes in working capital
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Days credit given and net working capital
Investment outflows
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ROCE, profit margins and growth
Capital intensity, age assets and depreciation
regime
Free cash flow
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Should be positive if company in stable position
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© 2005 Peter Walton and Walter Aerts
Z-scores
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Failure prediction models: ratios are used as
input for more sophisticated models, taking
into account the simultaneous impact of
several factors
How measured ?
2 samples with mutual matching of which one
with failed companies - data consist of
financial ratios relative to years before failure
=> ratios which discriminate best between
two groups are used as input for failure
prediction models
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Shareholder value
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Focus on present (discounted) value of
forecast earnings
Time value of money and present value
calculations
Forecast cash flows
Discount rate
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© 2005 Peter Walton and Walter Aerts
Present value
The essence of present value is that a rational person
will prefer to have a receipt sooner rather than later
because the money can be used to generate more
money.
For example, if a company has a choice of receiving
$1,000 now or $1,000 in a year’s time, it would prefer to
have the cash now because it could be invested and
earn a return. If the money was put into risk free
securities where it could earn 15 per cent, then $1,000
now would be worth $1,150 in a year’s time.
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© 2005 Peter Walton and Walter Aerts
Present value (cont.)
Extending that, the $1,000 to be received after a year is
worth $1,000/1.15 (or $870) today, because $870
invested today at 15 per cent would yield $1,000 in a
year’s time. Similarly, $1,000 to be received in two years’
time is worth $1,000/(1.15*1.15) = $756 at present (i.e.
compound interest at 15 per cent for two years would
be $244).
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts