Investments: Analysis and
Behavior
Chapter 10 – Financial Statement Analysis
Learning Objectives




Evaluate company profitability.
Assess and interpret the return on equity.
Determine a firm’s financial liquidity.
Compute valuation indicators
Investing versus Speculating
 Stock investors own a small part of the companies
they hold.
– Business ownership (see page 294)
– 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
 Investors need to know about the underlying
business!
Financial Statements
 Companies report their business success/failure
with quarterly and annual (10-K) financial
statements
– Balance Sheet
• “Snapshot” of information at a specific point in time
• Examines financial well-being
• Current Assets
 Cash , short-term investments, accounts receivable,
and inventory
• Current Liability
 Short-term obligations including accounts payable,
accrued compensation (compensation not yet paid),
and income taxes
Financial Statements
Income Statement
• “Video” of business activities over a specific time period
• Report of business inflows and outflows during a given period
• Gives an ongoing view of dynamic change
Cash Flow Statement
• Change in the company’s cash position over a specific period of
time
• Often examined in addition to an income statement, because of
accounting errors or bias that can appear in income statements
Financial Statements
 Financial statements are a clear and concise summary report
on the business activities of a firm
 Modern business activities sometimes need further
clarification – Footnotes
– Additional disclosure and detail of the firm’s business activities
– Used to augment, clarify, and supplement line-item disclosures
– Interestingly, in annual reports, the number of pages of footnotes often
exceed the number of pages devoted to financial statements
Table 10.1 Balance Sheet Information for Microsoft Corp.
Table 10.1 Balance Sheet Information for Microsoft Corp.
(cont)
Earnings
 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.
– Investors should focus on this when the use of
stock options is significant
– Usually lower than EPS
Table 10.2 Income Statement Information for Microsoft
Corp.
Table 10.3 Cash Flow Statement
Information for Microsoft Corp.
Problems with Accounting Information
 Historical cost versus market value
– Historical  actual cash cost for an asset
– Market  current amount that must be paid for an asset
 Economic costs versus accounting costs
– Depreciation
– Cash flow versus earnings
 Multiple ways under GAAP (standard framework and
guidelines for financial accounting) to treat various
assets, revenue, and costs.
– Accounting errors are common.
– Firms sometimes abuse accrual accounting flexibility.
Simplified View of Economic
and Accounting Profit
Assessing Performance Through
Financial Ratios
Profitability
Net Income
Net Profit Margin 
Total Sales
Net Income
Return on Equity 
Stockholde rs' Equity
Stockholders’ Equity – Book value of a company; Capital received from investors; Assets
minus liabilities
Return on Assets 
Net Income
Total Assets
Net Income – Slides 10 and 11; Total Sales – Slide 10; Stockholders’ Equity – Slide 8;
Total Assets - Slide s 7 and 8
Bankruptcy
 Relates to going out of business or recovering from
crippling debt
 Chapter 11
– Used to reorganize and attempt to become profitable again
– Management continues to run day-to-day business operations
– Important business decisions must be approved by the bankruptcy
court
 Chapter 7
– A company stops all operations and goes out of business
– A trustee is appointed to liquidate company assets
– Proceeds are used to pay off debts
15
Profitability – The most useful indicator of business
quality is a consistently high level of this
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 2007.
net income $14,065
Net profit margin 

 0.2751  27.5%
total sales
$51,122
net income
$14,065
Return on equity 

 0.4523  45.2%
stockholde r' s equity $31,097
net cash from operations $17,796
Return on sssets 

 0.2817  28.2%
total assets
$63,171
Net Income – Slides 10 and 11; Total Sales – Slide 10; Stockholders’ Equity – Slide 8;
Total Assets - Slide s 7 and 8
Elements of ROE
– Despite its limitations, many investors continue to regard
return on equity as the best single indicator of corporate
profitability, because it reflects the company’s use of both
operating leverage and financial leverage
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
• The book value of total assets divided by stockholder’s equity
In 2006 and 2007, Microsoft’s ROE was 31.4% and 45.2%,
respectively. Why did Microsoft’s ROE increase so
dramatically over this year?
Solution:
Use the Du Pont system equation:
For 2006
ROE 
net income sales assets $12,599 $44,282 $69,597





 0.285  0.636  1.735  0.314  31.4%
sales
assets equity $44,282 $69,597 $40,104
For 2007
ROE 
net income sales assets $14,065 $51,122 $63,171





 0.275  0.809  2.031  0.452  45.2%
sales
assets equity $51,122 $63,171 $31,097
First, Microsoft had a large increase in its profit margin. Microsoft has been
repurchasing its stock ($19 billion in 2006 and $27 billion in 2007). This
has the effect of decreasing assets because cash is spent to buy the shares.
This reduced the assets and equity in the firm, thereby magnifying its asset
turnover ratio and leverage ratio.
 Operating Efficiency
– A key determinant of profitability
– Management needs to know whether factories are running
at or near capacity
SalesReven ue
Receivable s Turnover 
Receivable s
Inventory Turnover 
Debt to Equity 
Cost of Goods Sold
Inventory
Long - Term Debt
Total Equity
Leverage Measures
A firm can magnify its business risk by
borrowing money
– Financial Leverage
• Amount of debt used
• It can increase a firm’s risk by magnifying the size of
profits and losses
– Operating Leverage
• Measure of business risk taken through the use of fixed
cost production
Long - Term Debt
Debt to Total Capital 
Total Capital
Financial Liquidity
 An important determinant of creditworthiness and
investment merit
 Key Considerations
– Does the firm have enough money to pay its short term
debts?
– How comfortable is the firm in making required interest
payments?
Market Capitalization
 Market value of a firm (in terms of common stock)
 The most common size measure
Stocks are often grouped by industry or sector to
describe companies that face a similar competitive
environment. Classifying firms by their size is also
common because academic research has documented
that size is an important determinant of risk.
Indications of Value
 Stock price is not an indication of value
– i.e., stock splits
Figure 10.1 P/E Ratio of the Dow Jones Industrial Average
50
45
40
35
P/E Ratio
30
25
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
Indications of Value
 Price-earnings ratio (P/E)
– The most common valuation yardstick used to measure
relative value
– Earnings yield (E/P)
 Price-book ratio (P/B)
– Shows the relationship between a stock’s current price and
its accounting net worth
 Dividend Yield
– Shows the amount of dividend income
– Expresses dividend income as a percentage of the amount
paid for a stock
– Helps determine an investor’s total return
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
Can Financial Statements Be Trusted?
 Accounting scandals
 Accounting restatements
– Changing the numbers…
– Back-dating executive options
 Accounting bias can be a problem
 Earnings management problem