CH 19 Financial
Statement Analysis
Framework of Analysis
Fundamental Analysis
– Research to predict stock value that focuses on
such determinants as earnings and dividends
prospects, expectations for future interest rates,
and risk evaluation of the firm
Top-down approach (“Three-Step” Valuation
Approach
– Domestic and global economic analysis
– Industry analysis
– Company analysis
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Investment Process
3
FINANCIAL STATEMENT
ANALYSIS
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Financial Statement Analysis
Financial statement analysis can be used
to discover mispriced securities.
Financial accounting data are widely
available, but
– Accounting earnings and economic earnings
are not always the same thing!
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Financial Statements
Income Statement:
– Profitability over time
Balance Sheet:
– Financial condition at a point in time
Statement of Cash Flows:
– Tracks the cash implications of
transactions.
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Accounting Versus Economic Earnings
Economic earnings
– Sustainable cash flow that can be paid
to stockholders without impairing
productive capacity of the firm
Accounting earnings
– Affected by conventions regarding the
valuation of assets
Example: LIFO vs. FIFO
Depreciation expense
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Consolidated Statement of Income for
Home Depot, 2012
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Consolidated Balance Sheet for
Home Depot, 2012
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Statement of Cash Flows for
Home Depot, 2012
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Measuring Firm Performance
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Measuring Firm Performance
Manager responsibilities:
– 1. Investment decisions
– 2. Financing decisions
Ratios used to show efficiency and
profitability of these decisions:
– ROA- income earned per dollar deployed
– ROC- income earned per dollar invested (long
term)
– ROE net income realized by shareholders per
dollar invested
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Profitability Measures
ROE measures profitability for contributors
of equity capital.
– After-tax profit/book value of equity
ROA measures profitability for all
contributors of capital.
– EBIT/total assets
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Past vs. Future ROE
ROE is a key determinant of earnings growth.
– Firm’s growth rate = ROE x Retention Ratio
Past profitability does not guarantee future
profitability.
– Security values are based on future profits.
– Expectations of future dividends determine today’s
stock value.
ROA and ROE are linked, but their relationship is
affected by the firm’s financial policies.
– One should pay attention the firm’s debt-equity mix
and to the interest rate on its debt.
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Financial Leverage and ROE
ROE can differ from ROA because of leverage.
Leverage makes ROE more volatile.
Let t = tax rate and r = interest rate, then:

Debt 
ROE  1  t ROA  ROA  r 

Equity 

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Financial Leverage and ROE, cont’d
If there is no debt or ROA = r, ROE will
simply equal ROA(1 - t).
If ROA > r, the firm earns more than it pays
out to creditors and ROE increases.
If ROA < r, ROE will decline as a function of
the debt-to-equity ratio.

Debt 
ROE  1  t ROA  ROA  r 

Equity 

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Impact of Financial Leverage on ROE
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Economic Value Added
A firm should be viewed as successful only if
– The return on its projects is better than the rate investors
could expect to earn for themselves (on a risk-adjusted
basis) in the capital market.
EVA is the difference between return on assets
(ROA) and the opportunity cost of capital (k),
multiplied by the capital invested in the firm.
EVA is also called residual income
If ROA > k, value is added to the firm.
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Example: Intel
In 2012, Intel’s cost of capital was 7.8%.
Its ROA was 13.9% and its capital base
was $56.34 billion.
Intel’s EVA =
(0.139-0.078) x $56.34 billion = $3.44 billion
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Ratio Analysis:
Decomposition of ROE
DuPont Method
ROE =
Net Profit
x
Pretax Profit
Burden
x
EBIT
(1)
Tax
Pretax Profit
x
x
(2)
Interest
Burden
x
EBIT
Sales
(3)
x
x
Sales
Assets
(4)
x
Assets
Equity
x (5)
x Margin x Turnover x Leverage
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Decomposition of ROA
ROA= EBIT/Sales X Sales/Assets
= margin
X turnover
Margin and turnover are unaffected by
leverage.
ROA reflects soundness of firm’s
operations, regardless of how they are
financed.
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Decomposition of ROE
ROE
=Tax burden X ROA X Compound leverage factor
Tax burden is not affected by leverage.
Compound leverage factor= Interest
burden X Leverage
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Ratio Decomposition Analysis for
Nodett and Somdett
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Choosing a Benchmark
Compare the company’s ratios across time.
– Time-series analysis
Compare ratios of firms in the same industry.
– Peer group analysis
Cross-industry comparisons can be
misleading.
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Time-Series Analysis
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Time-Series Analysis
Op Income / Sales for Enron
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16
14
12
10
8
6
4
2
0
1984
1986
1988
1990
1992
1994
1996
1998
2000
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Peer Group Analysis
A. Profitability
1. Profit Margin ………………
2. Return on Assets …………..
Saxton
Company
Industry
Average
5.0%
12.5%
6.7%
10.0%
3. Return on Equity ………….. 20.0%
B. Asset Utilization
4. Receivables turnover …….
5. Average collection period….
6. Inventory turnover ………...
7. Fixed asset turnover ……….
8. Total asset turnover ……….
11.4
32.0
10.8
5.0
2.5
Conclusion
15.0%
Below average
Above average due
to high turnover
Good
10.0
36.0
7.0
5.4
1.5
Good
Good
Good
Below average
Good
C. Liquidity
9. Current ratio ………………
10. Quick Ratio ………………..
2.67
1.43
2.1
1.0
D. Debt Utilization
11. Debt to total assets ………..
12. Times interest earned …….
37.5%
11.0
33.0%
7.0
Good
Good
Slightly more debt
Good
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Peer Group Analysis
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Peer Group Analysis
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Differences between Profit Margin and
Asset Turnover across Industries
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Industry Differences
Industry Turnoverprofit margin tradeoff
Industries with high
turnover such as
groceries retail apparel
tend to have low profit
margins, while industries
with high margins such
as utilities tend to have
low turnover.
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Industry Differences
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Ratio Analysis
Which ratio measures the financial or credit risk?
Which ratio measures the company’s ability to service its fixed interest
payment?
Which ratio measures the company’s ability to pay off short-term
obligations like notes payables and accounts payables?
Which ratio measures how well the company generates revenues and
controls costs and expenses (i.e., overall operating effectiveness)?
Which ratio measures the company’s ability to deliver the shareholder’s
value?
Which ratio measures the company’s market price relative to $1 of
capital that was invested by shareholders?
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Comparability Problems
Accounting Differences
– Inventory Valuation
– Depreciation
Inflation and Interest Expense
Fair Value Accounting
Quality of Earnings
International Accounting Conventions
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International Accounting Differences
Reserves – many other countries allow
more flexibility in use of reserves
Depreciation – US allows separate tax
and reporting presentations
Intangibles – treatment varies widely
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Adjusted Versus Reported Price-Earnings
Ratios
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The Graham Technique
Rules for stock selection:
– Purchase common stocks at less than
their working-capital value.
– Give no weight to plant or other fixed
assets.
– Deduct all liabilities in full from assets.
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