Financial Statement Analysis

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Financial Statement Analysis is the primary quantitative measurement of company performance.  It is not intended to be the only tool of evaluation, but it is a very important tool in such process.  The analysis is based upon externally presented financial statements (Financial Accounting) of companies.  Financial analysis will ordinarily involve comparisons within industry and individual company trend (year-by-year) and each analysis will normally involve parts of at least two financial statements.  The financial statement package according to generally accepted accounting principles (Financial Accounting Standards Board) includes the Balance Sheet, Income Statement, Cash Flow Statement, Statement of Changes in Owners' Equity (either as a separate financial statement or as a component of the Notes Section), and Notes to the Financial Statements.  As a graduate student you will need to review the makeup of each of these financial statements in order to develop meaningful interpretations about financial analyses derived from your assigned companies.  Financial analysis is a very important part of your capstone project.

Financial analysis can normally be divided into four categories as discussed below.

I. Profitability measures:  These are generally centered around income statement figures and indicate some measure of return on investment of the owners.

A. Return on investment (ROI); sometimes called return on assets (ROA)
1. General model

ROI = Return/ Investment (Average)

Return is frequently net income, although it can be other components of Net Income such as Operating Income.  Investment is most commonly average (beginning of year + end of year divided by 2) total assets.
This ratio gives the rate of return that is earned on the assets invested, and is
a key measure of profitability.

2. DuPont model (Provides a clue as to what caused changes in ROI)

ROI = Margin * Turnover
= Net income        *                  Sales
Sales                       Average total assets

The DuPont model breaks ROI down into two intermediate measures: sales margin and asset turnover.
Margin expresses the net income resulting from each dollar of sales (the efficiency of operations).  Turnover shows the effectiveness of utilization of assets to generate revenue.   These intermediate measures show the portion of ROI which is attributable to company efficiency and the part which is attributable to effective utilization of its assets to generate revenue.  An improvement in either of these components will improve the overall ROI.  The DuPont method is preferred for capstone presentation purposes as it indicates reasons for changes in ROI from year-to-year.

3. Variations of the general model use operating income, income before taxes, or some other intermediate income statement amount in the numerator and average operating assets in the denominator to focus on the rate of return from operations before taxes.

B. Return on equity (ROE)

1. General model

ROE = Net income / Average total owners' equity

This ratio gives the rate of return on that portion of the assets provided by the owners of the entity.  It is more meaningful than ROI because it gives us a return on the owners' investment.  The same measurement of return that is used in ROI should be used for ROE determinations.

2. A variation of the general model occurs when there is preferred stock. Net income is reduced by the amount of the preferred stock dividend requirement, and only common stockholders' equity is used in the denominator. This distinction is made because the ownership rights of the preferred and common stockholders differ.

3. A well-leveraged firm will have a much higher ROE than ROI (See Leverage ratios).

C. Price / Earnings ratio (P/E Ratio)

Price earnings ratio = Market price per share / Earnings per share
(or earnings multiple)

This ratio expresses the relative expensiveness of a share of a firm's common stock because it shows how much investors are willing to pay for the stock relative to earnings. Generally speaking, the greater a firm's ROI and rate of earnings growth, the lower the P/E ratio of its common stock will be.  In the case of the investor, lower is better (\$50/\$50 = 1).  If a company's stock has a high P/E ratio, it is normally overvalued.  Occasionally, the market corrects itself and share prices drop to more accurately reflect true values and earning potential.

D. Dividend yield

Dividend yield = Annual dividend per share / Average market price per share of stock

The dividend yield expresses part of the stockholder's ROI: the rate of return
represented by the annual cash dividend. The other part of the stockholder's total ROI comes from the change in the market value of the stock during the year; this is usually called the capital gain or loss.  Some investors will forego current return in favor of long-term capital gains.  Others prefer current return (for example, senior citizens).  This measure is more important for investors of mature and stable companies .

E. Dividend payout ratio

Dividend payout ratio = Annual dividend per share / Earnings per share
The dividend payout ratio expresses the proportion of earnings paid as dividends to common stockholders. It can be used to estimate dividends of future years if earnings can be estimated fairly accurately. Stockholders who expect future appreciation in stock values are willing to accept a low DPR.  Microsoft is an excellent example of this.

F. Preferred dividend coverage ratio

Preferred dividend coverage ratio = Net income / Preferred dividend requirement

The preferred dividend coverage ratio expresses the ability of the firm to meet its preferred stock dividend requirement.  Since preferred dividend payment is similar to debt, preferred stockholders must receive their dividends before any common dividends are paid. The higher this coverage ratio, the lower the probability that dividends on common stock will be discontinued because of low earnings and failure to pay dividends on preferred stock.

II. Liquidity measures

These measures reflect a Company's ability to pay current liabilities (generally, those due within a few months of the balance sheet date).

A. Working capital

Working capital = Current assets - Current liabilities (Note: this is a dollar amount, not a ratio; always note what the dollars are stated as, for example--\$50 million or \$50,000,000).

The relationship between current assets and current liabilities is a measure
of the firm's ability to meet its obligations as they come due.  Current Assets are cash and assets that will be converted into cash (inventory) ordinarily within one year or less and those assets that do not require an outflow of cash during an operating cycle for its use (supplies).  Current liabilities are those that are to be paid with current assets (generally within one year of the balance sheet date).

B. Current ratio

Current ratio = Current assets / Current liabilities

This ratio permits an evaluation of liquidity that is more comparable over time and between firms than the amount of working capital.  It is a comparison of growth in current liabilities compared to growth in current assets.

C. Acid-test ratio (A more rigorous test than the current ratio)

Acid-test ratio = Cash (including temporary cash investments) + Accounts
receivable / Current liabilities

By excluding inventories and other non-liquid current assets, this ratio gives a more conservative  assessment of the firm's bill-paying ability.

D.  Cash flow analysis

In 1987, the FASB issued SFAS 95.  This standard requires that a Statement of Cash Flows be included in Financial Statement Packages.  Some meaningful analyses of cash flows developed as a result.  One of the most useful measurements from the cash flow statement is "Cash Provided by Operations" or "Cash From Operating Activities" as it is sometimes called.  Integration of cash flow statement analyses is an increasingly important method of determination of quality of financial information reported on financial statements.  The student needs to consider cash flow analyses in determination of the 'Quality of Earnings' used in ROI and ROE measurements.

Sufficiency Ratios:   These ratios determine if a company generates enough cash flows from operations to fund some of its critical uses of cash.

1.   Cash flow adequacy = Cash from operations / (Long-term debt paid + purchases of property, plant and equipment + dividends paid)  This ratio measures the ability of companies to fund three critical success items from cash flow generated by operations.

2.   Long-term debt payment = Long-term debt payments / Cash from operations   This presents the ratio of cash flow generated from operations used to pay long-term debt payments.  If a company is heavily debt laden and this ratio is very low, this should sound a warning signal.

3.   Dividend payout = Dividends / Cash from operations  The same as (2) for dividend payments.

4.   Reinvestment = Purchase of property, plant and equipment / Cash from operations  This ratio compares the purchase of fixed (property, plant and equipment) to net cash from operating activities.  Some of the cash from operating activities should be reinvested in the purchase of new property, plant and equipment in growth companies, but the ratio should be less than one in all cases.

5.   Debt Coverage = Total Debt / Cash from operations   Gives a debt payback ratio.  This is one of the key indicators of healthy company growth.  Cash from operating activities is not subject to window dressing, as is net income, making it a much more tangible indicator of company well-being.  It is also a good indicator of stock price growth and/or deterioration.  Total debt includes both current and non-current liabilities.

6.   Depreciation-amortization impact = (Depreciation + amortization) / Cash from operations    Shows how much of cash flow is attributable to depreciation charges (non-cash expenses).   This amount of cash from operations should be reinvested in property, plant and equipment at a minimum.

Efficiency Ratios:  These measures determine the degree of efficiency of the company in generating cash flows from day-to-day operations.

1.   Cash flow to sales = Cash from operations / Sales   This is a cash basis sales margin and is useful in spotting excessive accounts receivable buildups.

2.   Operations Index = Cash from operations / Net Income    Over a long period of time it should be approximately equal.  However, consistently declining trends below one (1) should require additional investigation.  This measurement is an excellent indicator of 'quality of earnings' from year-to-year.  Inconsistent and extremely variable trends indicate earnings management.

3.   Cash flow return on assets = Cash from operations / Total assets  This is a cash basis ROI measurement and should be compared with regular ROI measurements.

Note that the most centrally important measurements of cash flow analysis include cash from operations or operating activities.  This cash flow is the life-blood of any type of organization.  Keep this in mind when performing cash flow analyses.

III. Activity measures (Control measures)

Basically, these measures involve the efficiency with which assets are managed or utilized in the generation of revenue and profits.

A. Turnover

1. Total asset turnover

Total asset turnover = Sales / Average total assets

Turnover shows the efficiency with which assets are used to generate sales. Refer also to the DuPont model under profitability measures.  This is also the second intermediate measurement in the DuPont model.

2. Variations include turnover calculations for accounts receivable, plant and equipment (or total operating assets as they are sometimes called).  Each variation uses sales in the numerator and the appropriate average amount in the denominator.

3. Inventory turnover

Inventory turnover = Cost of goods sold / Average inventories

Inventory turnover focuses on the efficiency of the firm's inventory management practices. Cost of goods sold is used in the numerator because inventories are carried at cost, not selling price.  An increasing trend in inventory turnover is good.

Days sales in inventory is an alternate presentation for this measure.

C. Number of days' sales in:

1. Accounts receivable

Number of days' sales in Accounts receivable = End of Year Accounts receivable / Average days' sales

Average days' sales = Annual sales / 365

This measure shows the average age of the accounts receivable, and reflects the efficiency of the firm's collection policies relative to its credit terms.

2. Inventory

Number of days' sales in inventory = End of Year Inventory / Average day's cost of goods sold

Average day's cost of goods sold = Annual cost of goods sold / 365

This measure shows the number of day's sales that could be made from the inventory on hand. The trend of this measure reflects management's ability to control inventories relative to sales.

IV. Financial leverage measures

These ratios Indicate the degree of the financing burden that is shared by creditors and owners.

Assets = Liabilities + Owners' Equity

/\ --------------> Financial leveraging is accomplished by increasing liabilities as a larger percentage of the total financing picture.  This process generates a higher ROE compared to ROI, but risk measurements must be included to detect too much financial leveraging.

A. Debt ratio

Debt ratio = Total liabilities / Total liabilities and owners' equity (Total Assets)  Determines the percentage of total assets that are financed by debt.

B. Debt / Equity ratio

Debt / Equity ratio = Total liabilities / Total owners' equity    A one to one type of financial leveraging measurement.

Each of these measures shows the proportion of debt in the capital structure. Note that a debt ratio of 50% is the same as a debt / equity ratio of 100%. These ratios reflect the risk caused by the interest and principal requirements of debt. Variations of these models involve the definition of total liabilities. Current liabilities and deferred taxes are excluded by some analysts because they are not interest bearing, and do not add as much risk as long-term debt. At the same time, a well leveraged firm provides higher ROEs in comparison to ROIs than a poorly leveraged firm.  The downside is the increasing amount of debt in capital structure increases risk involved and, accordingly, good financial leveraging must be balanced with acceptable resulting risk levels assumed by the companies.

C. Times interest earned

Times interest earned = Earnings before interest and taxes / Interest expense

This is a measure of the firm's ability to earn enough to cover its annual interest requirement, which is a fixed expense.  A declining trend signifies a company's becoming riskier.

D.  Times interest cash flow from operating activities coverage

Same as (C) except cash flow from operating activities is used as the numerator.

It is important to realize that trend is important in financial statement analysis. One year's financial statements are meaningless.  In most cases, effective use of financial statement analysis is enhanced by observing of trend over at least a three-year period.   Also, a company's results must be compared with industry trends to be meaningful.

This handout is intended to be a brief or review for you.  Please remember that you will need to consult other materials (texts, articles, etc.) in order to develop the necessary background for effective financial analysis.