FINANCIAL STATEMENT ANALYSIS

Objectives of Analysis
The adequacy or otherwise of the profits earned The adequacy or otherwise of the financial strength Its ability to generate enough cash and cash equivalents, their timing and certainty The future growth outlook

Why Evaluate Financial Statements?

Internal uses
Performance evaluation compensation and comparison between divisions Planning for the future guide in estimating future cash flows

External uses
Creditors Suppliers Customers Stockholders, Analysts

The Tool Kit

Common-Size Analysis Common-Base or Trend Analysis Ratio Analysis

Ratio Analysis Five Major Categories

Liquidity ratios: Can we make required payments as they fall due? Asset Management: Do we have right amount of assets for the level of sales? (Activity ratios) Debt Management: Do we have the right mix of debt and equity? (Leverage ratios) Profitability: Do we have enough profits? Market Value: How the market is viewing the company?

Liquidity ratios
CR = CA / CL or CAs, loans and advances + ST Inv / CLs + provisions + ST debt QR Cash ratio = Cash / CL Interval Measure = CA / ADOE
ADOE = Total cost excluding depreciation and interest / 365

Solvency Ratios
Total Debt Ratio = TA TE / TA DER = TD / NW LTDR = LTD / LTD+TE Equity Multiplier = 1 + DER = TA / TE TIE = EBIT / Interest Cash Coverage Ratio = EBIT + Depreciation / Interest

Turnover Ratios
FATO = Sales / Fixed assets TATO = Sales / TA, Capital intensity. Debtor (Receivables) turnover = Sales / Receivables DSR (ACP) = 365 / DTO Inventory turnover = COGS / Inventory DSI = 365 / ITO Payables turnover = COGS / Payables DPO = 365/PTO NWC Turnover = Sales / NWC

Profitability Ratios
Profit margin = Net Income / Sales RoA = Net Income / TA RoE = Net Income / TE

Market Ratios
EPS P/E, PEG P/S Market / BV

The DuPont Model

Brings together: Profitability Efficiency Leverage

Deriving the Du Pont Identity

ROE = NI / TE Multiply by 1 and then rearrange
ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM

Multiply by 1 again and then rearrange

ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM

Du Pont Analysis

Net Income Return on equity = Sales

Sales Asset

Assets Shareholders Equity

Net Profit Margin

Total Asset Turnover

Equity Multiplier

Using the Du Pont Identity

ROE = PM * TAT * EM
Profit margin is a measure of the firms operating efficiency how well does it control costs Total asset turnover is a measure of the firms asset use efficiency how well does it manage its assets Equity multiplier is a measure of the firms financial leverage

Potential Problems
There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years Extraordinary events

 Comparison with industry averages is difficult if the firm operates many different divisions. Average performance is not necessarily good. Seasonal factors can distort ratios.

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 Window dressing techniques can make statements and ratios look better. Sometimes it is difficult to tell if a ratio value is good or bad. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

What are some qualitative factors analysts should consider when evaluating a companys likely future financial performance?
Are the companys revenues tied to a single customer? To what extent are the companys revenues tied to a single product? To what extent does the company rely on a single supplier?
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 What percentage of the companys business is generated overseas? What is the competitive situation? What does the future have in store? What is the companys legal and regulatory environment?

Non-Financial Measures of Operating Effectiveness

Innovation Customer Service Product Quality Reputation Good Employee Relations

Balanced Scorecard
Organisational Learning and Growth (Employee Training & Education, Innovation, Opportunities for Improvement, New Product Dev. Time) Business and Production Process Efficiency (Quality, Productivity, Cycle time) Customer Value (Customer Satisfaction and Loyalty) Financial Performance