Investments: Analysis
and Behavior
Chapter 10- Financial
Statement Analysis
©2008 McGraw-Hill/Irwin
Learning Objectives




Evaluate company profitability.
Assess and interpret the return on equity.
Determine a firm’s financial liquidity.
Compute valuation indicators
10-2
Investing versus Speculating

Stock investors own a small part of the
companies they hold.
 Business
ownership
 In the long run, the stock will perform as well (or as
poorly) as the underlying business.

Speculating
 Expectation
of short-term trading profits from shareprice fluctuations.
 Underlying business is irrelevant

So investors need to know about the
underlying business!
10-3
Financial Statements

Companies report their business
success/failure with quarterly and annual
(10-K) financial statements
 Balance

“Snapshot” of information at a specific point in time
 Income

Statement
“Video” of business activities over a specific time
period
 Cash

Sheet
Flow Statement
Change in the company’s cash position over a
specific period of time
10-4
Microsoft
10-5
10-6
Earning Profits

Net income (accounting profits)
 Difference
between revenues and
expenses, often expressed after taxes.

Earnings per share (EPS)
 Net
income divided by the number of
shares outstanding

Diluted earnings
 Net
income divided by the number of
shares outstanding after consideration
for the possible conversion of stock
options, buy-backs, etc.
10-7
10-8
10-9
Problems with Accounting Information

Historical cost versus market value

Economic costs versus accounting costs
 Depreciation
 Cash

flow versus earnings
Multiple ways under GAAP to treat various
assets, revenue, and costs
10-10
Assessing Performance Through
Financial Ratios

Profitability
Net Income
Net Profit Margin 
Total Sales
Net Income
Return on Equity 
Stockholde rs' Equity
Return on Assets 
Net Income
Total Assets
10-11
Using Microsoft’s financial statements in Tables
10.1 to 10.3, compute its net profit margin, ROE,
and ROA using net cash flow from operations
information for 2005.
Net Profit Margin 
Net Income $12,254

 0.3080  30.8%
Total Sales $39,788
Net Income
$12,254
Return on Equity 

 0.2547  25.5%
Stockholde r' s Equity
$48,115
Return on Assets 
Net Cash From Operations $16,605

 0.2345  23.5%
Total Assets
$70,815
10-12
Elements of ROE

Du Pont formula
 Why
has ROE changed?
ROE  Profit M arg in  Asset Turnover  Leverage Ratio

Net Income
Sales

Sales
Assets

Assets
Equity
 Total Asset
Turnover (TAT): ability to generate sales
from asset base
 Leverage: extent to which debt is used to capitalize
the company
10-13
In 2004 and 2005, Microsoft’s ROE was 10.9% and
25.5%, respectively. Why did Microsoft’s ROE increase
so dramatically over this year?
Solution:
Use the Du Pont system equation:
For 2004
ROE 
Net Income Sales Assets
$8,168 $36,835 $94,368





 0.222  0.388  1.261  0.1086  10.9%
Sales
Assets Equity $36,835 $94,368 $74,825
For 2005
ROE 
Net Income Sales Assets $12,254 $39,788 $70,815





 0.308  0.562  1.472  0.2548  25.5%
Sales
Assets Equity $39,788 $70,815 $48,115
First, Microsoft had a large increase in its profit margin. Second,
Microsoft paid a big dividend in November 2004 to distribute excess
cash to shareholders. This reduced the assets and equity in the
firm, which magnified its asset turnover ratio on leverage ratio.
10-14

Operating Efficiency
Receivable s Turnover 
SalesReven ue
Receivable s
Cost of Goods Sold
Inventory Turnover 
Inventory

More Leverage Variables
Debt to Equity 
Long - Term Debt
Total Equity
Long - Term Debt
Debt to Total Capital 
Total Capital
10-15
Compute the 2005 receivables turnover and
inventory turnover for Microsoft.
Solution:
Use the Balance Sheet and Income Statement
information:
Re venue
$39,788
Re ceivables Turnover 

 5.54
Accounts Re ceivable $7,180
Costof Re venue $6,200
Inventory Turnover 

 12.63
Inventories
$491
10-16
Financial Liquidity
Current Ratio 
Current Assets
Current Liabilitie s
current ratio < 1 would signal a potential problem
Quick Ratio 
Cash  Marketable Securities  Receivable s
Current Liabilitie s
EBIT
Interest Coverage 
Debt Interest Charge
10-17
Indications of Value

Stock price is not an indication of value
 i.e.,
Price-earnings ratio (P/E)
 Earnings
yield (E/P)
Figure 10.1 P/E Ratio of the Dow Jones Industrial Average
35
30
25
P/E Ratio

stock splits
20
15
10
5
0
1940
1945
1950
1955
1960
1965
Data source: Dow Jones and Company (http://w w w .djindexes.com/jsp/index.jsp).
1970
1975
1980
1985
1990
1995
2000
2005
10-18
Since the market P/E ratio can change dramatically over
time, relative P/E ratios are sometimes used:
firm P/E divided by benchmark P/E
Table 10.4 Compare Financial Ratios with Industry Averages
Market Cap
($Billion)
Net Profit
Margin
ROE %
289.43
30.8
22.5
0.000
5,059.60
9.5
13.4
0.017
Application Software
495.05
20.9
19.7
0.000
Internet Software &
Services
178.06
8.2
6.5
0.267
7.07
-1.4
0.0
0.003
Personal Computers
145.25
6.2
34.6
0.001
Wireless Communications
562.1
2.4
1.8
0.007
Microsoft
Technology Sector
Internet Service Providers
Source: Yahoo! Finance
Debt to
Equity
10-19

Price to book ratio
 Sometimes
Book to Market (B/M) issued.
 Low P/B (high B/M) firms are considered
value firms

Dividend yield
 Last
12 months of dividends / current
stock price
 Remember, dividends make up roughly
one third of a stock investor’s total
return!
10-20
Economic Value Added (EVA)

Economic wealth added to the firm

business profits less the compensation for debt and equity holders
EVA = Net Operating Profit after Taxes (NOPAT) – (Capital of the Firm × Cost of Capital)

In 2005, Microsoft’s EVA




NOPAT was $12.25 billion.
It is an all equity firm with market capitalization of about $275
billion.
Assuming a cost of capital of 14%.
Microsoft’s EVA is $–26.25 billion (= $12.25 - $275×0.14).

Even though Microsoft has an outstanding profit margin and ROE, it
has not been generating enough wealth to fully compensate its
stockholders for their capital. This may be why Microsoft stock has
languished within a range of $24 to $30 for three years.
10-21
Can Financial Statements Be Trusted?

Accounting scandals

Accounting restatements
 Changing
the numbers…
10-22
Figure 10.2 The Number of Firms Restating is Increasing
7.0%
Restatements
6.0%
Percent of listed companies
330
323
5.0%
270
4.0%
233
3.0%
2.0%
1.0%
Percent of Exchange Listed Companies
414
0.0%
2000
2001
2002
2003
2004
Source: 2004 Annual Review of Financial Reporting Matters, Huron Consulting Group
10-23