Financial Statement Analysis and

Financial Models

Presented by

Maksudul Huq Kanan

Financial Statement Analysis

Financial statement analysis is a process of selecting,

evaluating, and interpreting financial data, along with other
pertinent information, in order to formulate an assessment
of a company’s present and future financial condition and
performance.
Financial Statement Analysis (Cont..)

 Financial statements provide the most

widely available data on public
corporations’ economic activities
 So, investors and other stakeholders rely on
financial reports to assess the plans and
performance of firms and corporate
managers.
Financial Statement Analysis (Cont..)

 Financial statement analysis is a valuable tool

since it enables the outside analysts create ‘inside
information’ there by gaining valuable insights
about current performance and future prospects.

 The assumption is managers have complete

information on a firm’s strategies and current state
of the art.
Financial Statement Analysis (Cont..)

 Financial statement analysis is also important in:

– Assessing management performance of a company
and whether projections of improvement or
sustainability are reasonable.
– Assessing the value of a company from historic
performance.
– Assessing the reasonableness of financial projections
provided by a company or the validity of earnings
projections
– Assessing whether the financial structure of a
company is of investment grade quality
Objectives of Financial Statement Analysis

 Financial statement analysis is like detective work – How can we use

information in financial statements to make assessments of various
issues. The financials should paint a picture of what has happened to
the company:
– How can we quickly review the income statement, balance sheet
and cash flow statement to determine how the stock market value
of a company compares to inherent value.
– How can we look the financial statements and assess risks
associated with a company and whether the company has
sufficient cash flow to pay off debt.
– Finance and valuation are about projecting the future -- how can
financial statement analysis be used in making projections.
– The problem in any financial analysis and valuation is that
measuring risk is very difficult
Financial Statement Analysis (Cont..)

Who analyzes financial statements?

– Internal users (i.e., management)
– External users
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
Financial Statement Analysis (Cont..)

 What do internal users use it for?

Planning, evaluating and controlling company
operations
 What do external users use it for?
Assessing past performance and current financial
position and making predictions about the future
profitability and solvency of the company as well
as evaluating the effectiveness of management
Financial Statement Analysis (Cont..)

Information is available from

– Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
– Reports filed with the government
Methods of Financial Statement Analysis

 Horizontal Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis
Horizontal Analysis

Using
Using comparative
comparative financial
financial
statements
statements to to calculate
calculate amount
amount
or
or percentage
percentage changes
changes in in aa
financial
financial statement
statement itemitem from
from
one
one period
period to
to the
the next
next
Vertical Analysis

For
For aa single
single financial
financial statement,
statement,
each
each itemitem isis expressed
expressed as as aa
percentage
percentage of of aa significant
significant total,
total,

e.g.,
e.g., all
all income
income statement
statement items
items
are
are expressed
expressed as
as aa percentage
percentage
of
of sales
sales
Common-Size Statements

Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and no
no absolute
absolute
amounts.
amounts.
Trend Percentages

Show
Show changes
changes overover time
time in in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of
of several
several years)
years)
Ratio Analysis

Expression of logical relationships between

items in a financial statement of a single
period (e.g., percentage relationship
between revenue and net income)
Basic Financial Statements
 Three types of financial statements are mandated by the
accounting and financial regulatory authorities:
1. Income statement – how much money you made last year?
 Revenue, expense, profits over a year or quarter.

1. Balance sheet – What’s your current financial situation?

a snap shot on a specific date of
 Assets (value of what the firm owns),
 Liabilities (value of firm’s debts), and
 Shareholder’s equity (the money invested by the
company owners)
1. Cash flow statement – How did the cash come and go?
cash received and cash spent by the firm over a period of
time
Income Statement
 Income Statement (Statement of Operations)
– Shows profitability for a period of time
– A summary statement of revenues, expenses, gains, and
losses.
– Must follow GAAP (financial accounting standards)
– Subject to much judgment by management.
– Traditionally, bottom-line earnings from income
statements represented primary stock price drivers.
– Currently, the move is on in the accounting profession
to distinguish appropriately between earnings and
“quality” earnings.
Sample Income Statement
 Sales
 Minus Cost of Goods Sold
 = Gross Profit
 Minus Operating Expenses
 Selling expenses
 General and Administrative expenses
 Depreciation and Amortization Expense
 = Operating income (EBIT)
 Minus Interest Expense
 = Earnings before taxes (EBT)
 Minus Income taxes
= Net income (EAT)/Income available for appreciation
Sample Income Statement
Income Statement of XYZ Corporation as on 31.12.2016
The Balance Sheet

 Determines Solvency Position of an organization on

a given date
– Assets (Resources): Future economic value owned or
controlled by the organization
 Current:--Cash and near cash assets
 Non-current—Relatively permanent assets used to
generate revenue
– Liabilities (Debts): Future claims by outsiders on
assets of the organization
 Current—Duein the near future
 Long-term—Due at least one year from the B/S date
– Stockholders’ Equity—Owners’ claim to organization
resources
The Balance Sheet
 The balance sheet provides a snapshot of the firm’s
financial position on a specific date. It is defined by:
Total Assets = Total Liabilities + Total Shareholder’s Equity
(Utilization of Fund) = (sources of funding)
 Total assets represents the resources owned by
the firm.
 Total liabilities represent the total amount of
money the firm owes its creditors.
 Total shareholders’ equity refers to the difference
in the value of the firm’s total assets and the
firm’s total liabilities.
Sample Balance Sheet
Statement of Cash Flows

 Summarizes cash inflows and (outflows) for

a period of time
– Includes all cash inflows (outflows) regardless of
source or use
– Categories of cash flows
 Operating Activities: Shows cash flows from operating
income (from income statement)
 Investing Activities: Shows cash flows to investments
and from sales of investments
 Financing Activities: Shows cash flows from borrowing
and sales of original equity issues and subsequent pay
back of loans, equity re-acquisitions, and dividends
Statement of Cash Flows
 The format for a traditional cash flow statement is as
follows:
Beginning Cash Balance
Plus: Cash Flow from Operating Activities
Plus: Cash Flow from Investing Activities
Plus: Cash Flow from Financing Activities
Equals: Ending Cash Balance
 Operating activities represent the company’s core business
including sales and expenses. Basically any activity that affects
net income for the period.
 Investing activities include the cash flows that arise out of the
purchase and sale of long-term assets such as plant and
equipment.
 Financing activities represent changes in the firm’s use of debt
and equity such as issue of new shares, payment of dividends.
Statement of Cash Flows
A. Operating Cash Flows
1) Net Income including int expense, int income and taxes
2) Depreciation
3) Deferred Taxes
4) Working Capital Changes
5) Minority Interest on Income Statement and Other Items
B. Investing Cash Flows
1) Capital Expenditure and Asset Purchases
2) Sale of Property, Plant, & Equipment
3) Inter-Corporate Investment
C. Financing Cash Flows
1) Dividend Payments
2) Proceeds from Equity or Debt Issuance
3) Equity Repurchased
4) Debt Principal Payments
STANDARDIZING STATEMENTS

One obvious thing we might want to do with a

company’s financial statements is to compare them to
those of other, similar companies. We would immediately
have a problem, however. It’s almost impossible to
directly compare the financial statements for two
companies because of differences in size.
To start making comparisons, one obvious thing we
might try to do is to somehow standardize the financial
statements. One common and useful way of doing this is
to work with percentages instead of amount. The
resulting financial statements are called common-size
statements.
Financial Ratio Analysis

Another way of avoiding the problems involved in

comparing companies of different sizes is to calculate
and compare financial ratios. Such ratios are ways of
comparing and investigating the relationships
between different pieces of financial information.
Financial ratio analysis is the use of relationships
among financial statement accounts to gauge the
financial condition and performance of a company.
Purpose of Ratio Analysis

 Evaluate management performance in three areas:

– Profitability
– Efficiency
– Risk
 Ratios are more informative than raw numbers
 Ratios provide meaningful relationships between
individual values in the financial statements
Purpose of Ratio Analysis

 Compare to other entities

 Examine a firm’s performance relative to:
– The aggregate economy
– Its industry or industries
– Its major competitors within the industry
– Its past performance (time-series analysis)
 Analysis helps you estimate the future performance of
the firm during subsequent business cycles
Categories of Financial Ratios

1. Internal liquidity (solvency)

2. Operating performance
– a. Operating efficiency
– b. Operating profitability
3. Risk analysis
– a. Business risk
– b. Financial risk

4. Growth analysis
5. External liquidity (marketability)
Internal Liquidity
 Internal liquidity (solvency) ratios indicate the ability to meet
future short-term financial obligations
 Current Ratio examines current assets and current liabilities
Current Assets
Current Ratio =
Current Liabilities
 Quick Ratio adjusts current assets by removing less liquid assets
Cash + Marketable Securities + Receivables
Quick Ratio =
Current Liabilities
 Cash Ratio is the most conservative liquidity ratio
Cash + Marketable Securities
Cash Ratio =
Current Liabilities
Internal Liquidity (Cont…)
 Receivables turnover examines the quality of accounts
receivable Net Annual Sales
Receivables Turnover =
Average Receivables
 Receivables turnover can be converted into an average
collection period
365
Average Receivables Collection Period =
Annual Turnover
 Inventory turnover relates inventory to sales or cost of
goods sold (CGS) Cost of Goods Sold
Inventory Turnover =
Average Inventory
Internal Liquidity (Cont…)
 Given the turnover values, you can compute the
average inventory processing time
Average Inventory Processing Period = 365/Annual Turnover
 Cash conversion cycle combines information from the
receivables turnover, inventory turnover, and accounts
payable turnover

Receivable Days
+Inventory Processing Days
-Payables Payment Period
Cash Conversion Cycle
Operating performance Ratio

 Ratios that measure how well management is

operating a business
– (1) Operating efficiency ratios
 Examine how the management uses its assets and capital,
measured in terms of sales dollars generated by asset or
capital categories
– (2) Operating profitability ratios
 Analyze profits as a percentage of sales and as a
percentage of the assets and capital employed
Operating Efficiency Ratios

 Total asset turnover ratio indicates the effectiveness of

a firm’s use of its total asset base (net assets equals
gross assets minus depreciation on fixed assets)
Net Sales
Total Asset Turnover =
Average Total Net Assets
 Net fixed asset turnover reflects utilization of fixed
assets
Net Sales
Fixed Asset Turnover =
Average Net Fixed Assets
Operating Profitability Ratios

 Operating profitability ratios measure

– 1. The rate of profit on sales (profit margin)
– 2. The percentage return on capital
 Gross profit margin measures the rate of profit on sales
(gross profit equals net sales minus the cost of goods sold)
Gross Profit
Gross Profit Margin =
Net Sales
 Operating profit margin measures the rate of profit on sales
after operating expenses (operating profit is gross profit
minus sales, general and administrative (SG + A) expenses)
Operating Profit
Operating Profit Margin =
Net Sales
Operating Profitability Ratios (Cont…)

 Net profit margin relates net income to sales

Net Income
Net Profit Margin =
Net Sales

 Return on total capital relates the firm’s earnings to all

capital in the enterprise
Net Income + Interest Expense
Return on Total Capital =
Average Total Capital
 Return on owner’s equity (ROE) indicates the rate of return
earned on the capital provided by the stockholders after
paying for all other capital used
Net Income
Return on Total Equity =
Average Total Equity
Operating Profitability Ratios (Cont…)

 Return on owner’s equity (ROE) can be computed for the

common- shareholder’s equity
Net Income - Preferred Dividend
Return on Owner' s Equity =
Average Common Equity

 DuPont analysis is a method of performance measurement

that was started by the DuPont Corporation in the 1920s.
With this method, assets are measured at their gross book
value rather than at net book value to produce a higher
return on equity (ROE). It is also known as DuPont identity.
Operating Profitability Ratios (Cont…)

 The DuPont System divides the ratio into several components that
provide insights into the causes of a firm’s ROE and any changes
in it Net Income Net Income Net Sales
ROE = = ×
Common Equity Net Sales Common Equity
Sales Sales Total Assets
= ×
Equity Total Assets Equity

Net Income Net Income Sales Total Assets

= × ×
Common Equity Sales Total Assets Common Equity

= Profit Margin X Total Asset Turnover X Financial Leverage

 An extended DuPont System provides additional insights
into the effect of financial leverage on the firm and
pinpoints the effect of income taxes on ROE
Operating Profitability Ratios (Cont…)

 We begin with the operating profit margin (EBIT

divided by sales) and introduce additional ratios to
derive an ROE value
EBIT Sales EBIT
× =
Sales Total Assets Total Assets
 This is the operating profit return on total assets. To
consider the negative effects of financial leverage, we
examine the effect of interest expense as a percentage
of total assets
EBIT Interest Expense Net Before Tax
− =
Total Assets Total Assets Total Assets
Operating Profitability Ratios (Cont…)

 We consider the positive effect of financial leverage

with the financial leverage multiplier
Net Before Tax (NBT) Total Assets Net Before Tax (NBT)
× =
Total Assets Common Equity Common Equity
 This indicates the pretax return on equity. To arrive at
ROE we must consider the tax rate effect.
Net Before Tax  Income Taxes  Net Income
× 100% − =
Common Equity  Net Before Tax  Common Equity
Operating Profitability Ratios (Cont…)

 In summary, we have the following five components of

return on equity (ROE)
EBIT
1. = Operating Profit Margin
Sales
Sales
2. = Total Asset Turnover
Total Assets
Interest Expense
3. = Interest Expense Rate
Total Assets
Total Assets
4. = Financial Leverage Multiplier
Common Equity
 Income Taxes 
5. 100% −  = Tax Retention Rate
 Net Before Tax 
Risk Analysis

 Risk analysis examines the uncertainty of income flows for the

total firm and for the individual sources of capital
– Debt, Preferred stock, Common stock
 Total risk of a firm has two components:
– Business risk
 The uncertainty of income caused by the firm’s industry
 Generally measured by the variability of the firm’s
operating income over time
– Financial risk
 Additional uncertainty of returns to equity holders due to
a firm’s use of fixed obligation debt securities
 The acceptable level of financial risk for a firm depends on
its business risk
Business Risk

 Variability of the firm’s operating income over time

 Standard deviation of the historical operating earnings series
 Two factors contribute to the variability of operating earnings
– Sales variability
 Earnings must be as volatile as sales
 Some industries are cyclical
– Operating leverage
 Production has fixed and variable costs
 Fixed production costs cause profit volatility with changes
in sales
 Fixed production costs are operating leverage
Financial Risk

 Bonds interest payments come before earnings are available

to stockholders
 These are fixed obligations
 Similar to fixed production costs, these lead to larger
earnings during good times, and lower earnings during a
business decline
 This debt financing increases the financial risk and
possibility of default
 Two sets of financial ratios help measure financial risk
– Balance sheet ratios
– Earnings or cash flow available to pay fixed financial charges
 Acceptable levels of financial risk depend on business risk
Financial Risk (Cont…)

 Proportion of debt (balance sheet) ratios

Total Long - Term Debt
Debt - Equity Ratio =
Total Equity

This may be computed with and without deferred taxes

 Long-term debt/total capital ratio indicates the proportion
of long-term capital derived from long-term debt capital
Total Long - Term Debt
L.T. Debt - Total L.T. Capital Ratio =
Total Long - Term Capital
Financial Risk (Cont…)

 Earnings or Cash Flow Ratios

– Relate the flow of earnings
– Cash available to meet the payments
– Higher ratio means lower risk
 Interest Coverage
Income Before Interest and Taxes (EBIT)
=
Debt Interest Charges

Net Income + Income Taxes + Interest Expense

=
Interest Expense
Financial Risk (Cont…)

 Firms may also have non-interest fixed payments due

for lease obligations
 The risk effect is similar to bond risk
 Bond-rating agencies typically add 1/3 lease payments
as the interest component of the lease obligations
 Total fixed charge coverage includes any non-
cancellable lease payments and any preferred
dividends paid out of earnings after taxes
Income Before Interest, Taxes, and Lease Payments
Fixed Charge Coverage =
Debt Interest + Lease Payments + Preferred Dividend/(1 - Tax Rate)
Financial Risk (Cont…)

 Cash flow ratios relate the flow of cash available from

operations to either interest expense, total fixed
charges, or the face value of outstanding debt
Traditional Cash Flow + Interest + 1/3 Lease Payments
Cash Flow Coverage =
Interest + 1 / 3 Lease Payments

Net Income + Depreciation Expense + Change in Deferred Tax

Cash Flow / Long - Term Debt =
Book Value of Long - Term Debt

Net Income + Depreciation Expense + Change in Deferred Tax

Cash Flow / Total Debt =
Total Debt
External Market Liquidity

 Market Liquidity is the ability to buy or sell an asset

quickly with little price change from a prior transaction
assuming no new information
 External market liquidity is a source of risk to investors
Determinants of Market Liquidity
 The value of shares traded
– This can be estimated from the total market value of
outstanding securities
– It will be affected by the number of security owners
– Numerous buyers and sellers provide liquidity
External Market Liquidity (Cont…)

 Trading turnover (percentage of outstanding shares

traded during a period of time)

 A measure of market liquidity is the bid-ask spread

Analysis of Growth Potential

 Creditors are interested in the firm’s ability to pay

future obligations
 Value of a firm depends on its future growth in
earnings and dividends
Determinants of Growth

 Resources retained and reinvested in the entity

 Rate of return earned on the resources retained
g = Percentage of Earnings Retained × Return on Equity
= RR x ROE
where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity
 ROE is a function of
– Net profit margin
– Total asset turnover
– Financial leverage (total assets/equity)
Comparative Analysis of Ratios

 Internal liquidity
– Current ratio, quick ratio, and cash ratio
 Operating performance
– Efficiency ratios and profitability ratios
 Financial
risk
 Growth analysis
Other Ratios
Other Ratios
Limitations of Financial Ratios

 Accounting treatments may vary among firms,

especially among MNCs
 Firms may have divisions operating in different
industries making it difficult to derive industry ratios
 Results may not be consistent
 Ratios outside an industry range may be cause for
concern
?
kanan3008@yahoo.com