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FINAN303
Principles of Finance
Spring 2016
Statement Analysis
1. Purposes of Financial Statement Analysis (Home Depot)
a. Why do we care?
i. Examine data for obvious trends and patterns
ii. Attempts to illuminate strengths and weaknesses
iii. Often identifies the next question(s) to ask
2. Users
a.
b.
c.
d.
Internal users
Lenders
Stockholders
Competitors
i. Finance can be used effectively as a competitive weapon
3. Some Caveats
a. We’re going to discuss how to calculate a wide range of numbers. In, and of
themselves, these numbers mean very little and must be put into some context.
b. The context
i. Across time
ii. In comparison to industries and peer firms
iii. It is good tradecraft to do both
4. Peer Firms and Industries
a. Some industries are very diverse
i. Retailing
b. Many firms operate in multiple industries
i. Johnson & Johnson
c. Some firms really don’t have peers
i. General Electric
d. Even some comparisons that appear to “make sense” can be problematic
i. Coca-Cola versus Pepsi
5. Basic Financial Analysis Tools
a. Common size financial statements
b. Financial ratios
6. Common Size Financial Statements
a. Currency values are transformed into percentages
b. Rationale is that percentages make it easier to make comparisons and spot trends
c. Two types of common size statements
i. Horizontal
ii. Vertical
7. Horizontal Common Size Statements
a. The percent change in each balance sheet and income statement account is calculated
from period to period
i. Sales (2010) = $150 million
ii. Sales (2009) = $120 million
iii. Percent change = (New-Old)/Old = ($150-$120)/$120 = 25%
Office: MBEB 2210
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FINAN303
Principles of Finance
Spring 2016
8. Vertical Common Size Statements
a. On the income statement, currency values are transformed into percentages of
revenue (or sales)
b. On the balance sheet, currency values are transformed into percentages of total
assets
c. Revenue (2010) = $150 million
d. Cost of goods = $90 million
i. Cost of goods (as a percent of revenue) = $90/$150 = 60%
9. Financial Ratios
a. Generally a financial ratio is one number divided by another
b. There is not universal agreement over how specific ratios are calculated; the key is
consistency from year to year and from firm to firm
c. Financial ratios are just numbers have to be compared to some benchmark
10. Categories of Ratios
a. Liquidity ratios
i. Ability to meet short term obligations
b. Activity or efficiency ratios
i. How well the firm utilizes and manages assets
c. Leverage and coverage ratios
i. Use of borrowed funds and ability to cover fixed financial charges
d. Profitability ratios
i. Gives an indication of the firms overall effectiveness
e. Miscellaneous ratios and ratios based on market values
11. Liquidity Ratios
a. Current ratio: current assets/current liabilities (CL)
b. Quick ratio: (current assets - inventory)/CL
c. Cash ratio: cash & short term investments/CL
12. Activity/Efficiency Ratios
a. Total asset turnover: sales/total assets
b. Fixed asset turnover: sales/net fixed assets
c. Receivables turnover: sales/accounts receivable
d. Days sales outstanding: accounts receivable/daily sales
e. Inventory turnover: sales/inventory
f. Average age: 365/inventory turnover
13. Leverage and Coverage Ratios
a. Total debt ratio: total liabilities/total assets
b. Debt to equity: debt/equity
c. Equity multiplier: assets/equity
d. Times interest earned: EBIT/interest
14. Profitability Ratios
a. Profit margins
i. Gross margin: gross income/revenue
ii. Operating margin: operating income/revenue
Office: MBEB 2210
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FINAN303
Principles of Finance
Spring 2016
iii. Net margin: net income/revenue
15. Rates of return
a. Return on assets (ROA): net income/total assets
b. Return on equity (ROE): net income/equity
16. ROE Breakdown (DuPont formula)
a. Breaks down ROE initially into three components
b. ROE = Asset turnover x Net margin x Equity multiplier
c. Each ratio can be broken down further
d. The purpose is to identify the key drivers of profitability and to note whether or not
these key drivers have changed over time
i. Asset turnover = Focuses on asset utilization
ii. Net Margin = Focuses on expense control
iii. Equity Multiplier = Focuses on debt utilization
17. Other Ratios
a. Dividend payout ratio: dividends/net income
b. Retention rate: 1 – dividend payout ratio
c. Sustainable growth rate: ROE x retention rate
d. Price to earnings ratio: stock price/earnings per share
e. Dividend yield: dividend/stock price
f. Market value added: Market value of equity – Book value of equity
g. Economic value added: Net income – (r * Equity)
i. where r is the required rate of return on equity
Office: MBEB 2210
3
[email protected]