Financial AnalysisFinancial Analysis

PurposePurpose

Ratio AnalysisRatio Analysis

Cash Flow AnalysisCash Flow Analysis

Purpose of Financial AnalysisPurpose of Financial Analysis

Assess Corporate Performance in the Assess Corporate Performance in the context of stated goals and strategy.context of stated goals and strategy.

Assess current financial position, Assess current financial position, including liquidity. including liquidity.

Tools of Financial Statement Tools of Financial Statement AnalysisAnalysis

Ratio analysisRatio analysis Signal approachSignal approach Cash Flow analysisCash Flow analysis

Ratio Analysis Ratio Analysis

Tools for interpreting financial Tools for interpreting financial statementsstatements

Often used to facilitate comparison Often used to facilitate comparison via deflation. via deflation.

Common size financial statements- Common size financial statements- when the whole statement is when the whole statement is converted to ratio form. converted to ratio form.

Ratio AnalysisRatio Analysis

Financial ratios are typically grouped Financial ratios are typically grouped into four classesinto four classes• ProfitabilityProfitability• Liquidity ratiosLiquidity ratios• Solvency ratiosSolvency ratios• Funds management ratiosFunds management ratios

Profitability and growth-Profitability and growth-Strategic Areas of InfluenceStrategic Areas of Influence

Operating managementOperating management Investment managementInvestment management Financing strategyFinancing strategy Dividend policiesDividend policies

Drivers of Profit and GrowthDrivers of Profit and Growth

OperatingManagement

InvestmentManagement

FinancingManagement

DividendPolicy

ManagingRevenue and

Expenses

ManagingWorking

Capital andFixed Assets

ManagingLiabilities and

Equity

ManagingPayout

Product MarketStrategies

Financial MarketStrategies

Profitability andGrowth

Ratios can be used:Ratios can be used:

ToTo compare compare the same firm over the same firm over several yearsseveral years

To To comparecompare to other firms in the to other firms in the industryindustry

To To comparecompare to an absolute to an absolute benchmarkbenchmark

Operating Management Operating Management (managing revenues and expenses)(managing revenues and expenses)

Return on equity (ROE)Return on equity (ROE) -- ROE = (Net -- ROE = (Net Income) / (Shareholder’s Equity)Income) / (Shareholder’s Equity)

Return on AssetsReturn on Assets -- Income / (Total -- Income / (Total Assets)Assets)

Return on sales (ROS)Return on sales (ROS) -- Net Income / -- Net Income / SalesSales

Gross Profit Margin-Gross Profit Margin- (Sales-COGS)/Sales (Sales-COGS)/Sales Numerous variations of the above are Numerous variations of the above are

computed in practicecomputed in practice

An Example-Return on Equity An Example-Return on Equity (ROE)(ROE)

• Beginning balances, ending balances, average Beginning balances, ending balances, average balances ?balances ?

• Often adjusted for preferred stock dividendsOften adjusted for preferred stock dividends• Average for US industries is from 11 to 13% Average for US industries is from 11 to 13%

(PBH)(PBH)

The need for an analysis The need for an analysis frameworkframework

What do ROE, NPM, ROA, etc., mean What do ROE, NPM, ROA, etc., mean as a group? as a group?

What if they differ as to outcome What if they differ as to outcome (e.g., one firm has a higher NPM but (e.g., one firm has a higher NPM but lower ROE)?lower ROE)?

What story do they tell, collectively?What story do they tell, collectively? How do they relate to each other?How do they relate to each other?

The Notion of Ratio Decomposition The Notion of Ratio Decomposition (Dupont Analysis)(Dupont Analysis)

ROE = ROA * Assets/equity (Financial ROE = ROA * Assets/equity (Financial leverage)leverage)

ROA= net income/ assetsROA= net income/ assets

Financial leverage indicates the dollar of Financial leverage indicates the dollar of assets the firm is able to deploy for dollar assets the firm is able to deploy for dollar invested by shareholdersinvested by shareholders

The Problem of mixed operating and The Problem of mixed operating and non-operating financial statement componentsnon-operating financial statement components

What if a firm has a large block of What if a firm has a large block of assets and/or liabilities that are not assets and/or liabilities that are not involved in operations? involved in operations?

What if net income includes What if net income includes numerous non-operating items?numerous non-operating items?

A Variation on the usual definition of ROAA Variation on the usual definition of ROA

Operating ROAOperating ROA Focus is on operating return only -- Focus is on operating return only --

excludes interest income excludes interest income • (Net Income + (Interest exp - Interest (Net Income + (Interest exp - Interest

income) * (1-tax rate)) / (Equity + Debt - income) * (1-tax rate)) / (Equity + Debt - Cash and Short-tern investments)Cash and Short-tern investments)

Decomposition Using Decomposition Using Operating ROAOperating ROA

ROE= Operating ROA (RNOA) + ROE= Operating ROA (RNOA) + Spread x LeverageSpread x Leverage

Operating/Nonoperating vs. Operating/Nonoperating vs. Core/TransitoryCore/Transitory

Level I-Based DecompositionLevel I-Based DecompositionExample: ROE, RNOA & LeverageExample: ROE, RNOA & Leverage

Financial Leverage and RiskFinancial Leverage and Risk

Given that increases in financial Given that increases in financial leverage increase ROE, why are all leverage increase ROE, why are all companies not 100% debt companies not 100% debt financed? financed? • The answer is because debt is risky. The answer is because debt is risky.

This increased risk This increased risk increases the increases the expected returnexpected return that investors that investors require to provide capital to the firm. require to provide capital to the firm.

• Higher financial leverage also results Higher financial leverage also results in a higher interest rate on the in a higher interest rate on the company’s debt. company’s debt.

Leverage and Income VariabilityLeverage and Income Variability

Level II-Based DecompositionLevel II-Based DecompositionExample: ROE, ROA & LeverageExample: ROE, ROA & Leverage

ROE= ROA x assets/equityROE= ROA x assets/equity ROA= net income/sales x ROA= net income/sales x

sales/assetssales/assets Therefore:Therefore:

• ROE=Net profit margin x ROE=Net profit margin x

asset turnover x asset turnover x

leverageleverage

Level II Analysis of Operating Margin and Level II Analysis of Operating Margin and Operating TurnoverOperating Turnover

Margin vs. TurnoverMargin vs. Turnover

Return on Sales (ROS)Return on Sales (ROS)

Shows profitability of firm’s operating Shows profitability of firm’s operating activitiesactivities

Used extensively by Japanese Used extensively by Japanese managementmanagement

Indicates how much profit is Indicates how much profit is generated per dollar of salesgenerated per dollar of sales

NOPAT MarginNOPAT Margin

Turnover of NOATurnover of NOA

here

Level 3 Analysis — Disaggregation of Level 3 Analysis — Disaggregation of

Operating Margin and Operating TurnoverOperating Margin and Operating Turnover

Level III Analysis using the Level III Analysis using the standard definition of ROAstandard definition of ROA

Sustainable Growth RateSustainable Growth Rate

ROE

ROS Asset Turnover Fin Leverage

GOGS/ SalesGP/ SalesSG&A/SalesR&D/SalesOE/ SalesNon OE / SalesEBT / SalesTax Expenses / Sales

CA TurnoverWC TurnoverAR TirnoverInv TirnoverAP TurnoverDays RecDays PayPP&E Turnover

Current RatioQuick RatioCash RatioOper CF Ratio

Liab to EquityDebt to EquityDebt to Capital

Int Coverage

Dividend payout

Sustainable Growth 1Sustainable Growth 1

ROE * (1-Dividend payout ratio)ROE * (1-Dividend payout ratio)

Gross Profit MarginGross Profit Margin

A high gross profit margin is A high gross profit margin is preferred to a lower one, which also preferred to a lower one, which also implies that a company has implies that a company has relatively more flexibility in product relatively more flexibility in product pricing.pricing.

Gross Profit MarginGross Profit Margin Two main factors determine gross profit Two main factors determine gross profit

margins:margins:1.1. CompetitionCompetition – The more competition, the – The more competition, the

lower margins tend to be.lower margins tend to be.2.2. Product mixProduct mix – The greater the volume of low – The greater the volume of low

profit/high turnover goods, the lower the profit/high turnover goods, the lower the margins. margins.

Very relevant for comparisons within an Very relevant for comparisons within an industry -- not much outsideindustry -- not much outside

Operating Expense MarginOperating Expense Margin

Operating expense ratios (percents) are used to examine Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense the proportion of sales consumed by each major expense category.category.

Expense ratios are calculated as follows:Expense ratios are calculated as follows:

Operating expense percentage = Expense item/Net salesOperating expense percentage = Expense item/Net sales

Drivers of Profit and GrowthDrivers of Profit and Growth

OperatingManagement

InvestmentManagement

FinancingManagement

DividendPolicy

ManagingRevenue and

Expenses

ManagingWorking

Capital andFixed Assets

ManagingLiabilities and

Equity

ManagingPayout

Product MarketStrategies

Financial MarketStrategies

Profitability andGrowth

Investment ManagementInvestment Management

Working Capital and Fixed AssetsWorking Capital and Fixed Assets• Receivables Receivables • InventoryInventory• LT operating assetsLT operating assets• PayablesPayables

TurnoverTurnover

Turnover measures relate to the Turnover measures relate to the productivity of company assets, i.e., productivity of company assets, i.e., how much capital is required to how much capital is required to generate a specific sales volume?generate a specific sales volume?

Turnover ratios are calculated as Turnover ratios are calculated as follows:follows:

Turnover = Sales volume/Average AssetsTurnover = Sales volume/Average Assets As turnover increases, there is greater As turnover increases, there is greater

cash inflow as cash outflow for assets cash inflow as cash outflow for assets to support the current sales volume is to support the current sales volume is reduced.reduced.

Accounts Receivable Turnover (ART)Accounts Receivable Turnover (ART)

Inventory Turnover (INVT)Inventory Turnover (INVT)

L-T Operating Asset Turnover L-T Operating Asset Turnover (LTOAT)(LTOAT)

Accounts Payable Turnover (APT)Accounts Payable Turnover (APT)

Net Operating Working Capital Net Operating Working Capital Turnover (WOCT)Turnover (WOCT)

Evaluating Financial Evaluating Financial ManagementManagement

Short-term evaluations Short-term evaluations Long-term evaluationsLong-term evaluations

Short-term evaluations 1Short-term evaluations 1

Current ratioCurrent ratio• (Current assets) / (Current liabilities)(Current assets) / (Current liabilities)

Short-term evaluations 2Short-term evaluations 2

Quick ratioQuick ratio• (Cash + Short-term investments + (Cash + Short-term investments +

Accounts Receivable) / (Current Accounts Receivable) / (Current liabilities)liabilities)

Short-term evaluations 3Short-term evaluations 3

Operating cash flow ratioOperating cash flow ratio• (Cash flow from operations) / (Current (Cash flow from operations) / (Current

liabilities)liabilities)

Long-term evaluationsLong-term evaluations

Debt is typically cheaper that equityDebt is typically cheaper that equity Interest is tax deductible dividends Interest is tax deductible dividends

are notare not Can impose discipline on Can impose discipline on

management (explicit contracts)management (explicit contracts) Easier to communicate proprietary Easier to communicate proprietary

information to information to privateprivate lenders than lenders than to public marketsto public markets

Standard ratiosStandard ratios

Liabilities-to-equity-ratioLiabilities-to-equity-ratio Debt-to-equity ratioDebt-to-equity ratio Debt-to-capitalDebt-to-capital Interest coverageInterest coverage

Liabilities-to-equityLiabilities-to-equity

(Total Liabilities) / (Shareholders’ (Total Liabilities) / (Shareholders’ equity)equity)

Debt-to-equityDebt-to-equity

(Short-term debt + Long-term debt) / (Short-term debt + Long-term debt) / (Shareholders’ equity)(Shareholders’ equity)

Interest coverageInterest coverage

(Net income + Interest expense + (Net income + Interest expense + Tax expense) / (Interest expense)Tax expense) / (Interest expense)

Problems with RatiosProblems with Ratios

Mis-specification of deflator (e.g., size)Mis-specification of deflator (e.g., size) Accounting imperfectionsAccounting imperfections Problem of assumed linearityProblem of assumed linearity Ratio blow-upRatio blow-up Negative numbers. What do they Negative numbers. What do they

mean?mean? Assumed 0 intercept. Assumed 0 intercept. Omitted variablesOmitted variables

In Search of Fundamentals-In Search of Fundamentals-Lev and Thiagarajan’s Signals Lev and Thiagarajan’s Signals

ApproachApproach InventoryInventory Accounts receivableAccounts receivable Capital Expenditure, R&DCapital Expenditure, R&D Gross marginGross margin Sales and Administrative ExpensesSales and Administrative Expenses

In Search of Fundamentals: Lev and In Search of Fundamentals: Lev and Thiagarajan Signals ApproachThiagarajan Signals Approach

Effective taxEffective tax Order backlogOrder backlog Labor forceLabor force LIFO changesLIFO changes Audit qualificationsAudit qualifications

InventoryInventory

Considered disproportionate Considered disproportionate increases in inventory as a negative increases in inventory as a negative signalsignal

Percentage Change in Inventory - Percentage Change in Inventory - Percentage Change in SalesPercentage Change in Sales

Accounts ReceivableAccounts Receivable

Disproportionate increases Disproportionate increases considered negativeconsidered negative

Percentage Change in AR - Percentage Change in AR - Percentage Change in SalesPercentage Change in Sales

Capital Expenditures R&DCapital Expenditures R&D

Relative Decreases Considered Relative Decreases Considered negativenegative

Percentage change in industry - Percentage change in industry - Percentage change in FirmPercentage change in Firm

Gross MarginGross Margin

Disproportionate decreases with Disproportionate decreases with respect to sales negativerespect to sales negative

Percentage change in Gross Margin - Percentage change in Gross Margin - Percentage change in sales Percentage change in sales

Selling and AdministrativeSelling and Administrative

Disproportionate increases to sales Disproportionate increases to sales negativenegative

% change in S&A - % change in sales% change in S&A - % change in sales

Provision for doubtful accountsProvision for doubtful accounts

Increases less than the increases in Increases less than the increases in accounts receivable is viewed as accounts receivable is viewed as negativenegative

% Change in Accounts receivable - % % Change in Accounts receivable - % Change in doubtful accountsChange in doubtful accounts

Effective tax RateEffective tax Rate

Unusual decrease in effective tax Unusual decrease in effective tax rate considered negativerate considered negative

PTE this year * (Effective rate last PTE this year * (Effective rate last year- effective rate this year)year- effective rate this year)

Order BacklogOrder Backlog

Unfilled orders is often viewed as a Unfilled orders is often viewed as a leading indicatorleading indicator

% change in sales -% change in order % change in sales -% change in order backlogbacklog

A negative signal is Good? or Bad?A negative signal is Good? or Bad?

Labor Force ChangesLabor Force Changes

Labor force reductions are usually Labor force reductions are usually considered good news by analystsconsidered good news by analysts

Defined as percentage change in Defined as percentage change in sales per employeesales per employee

LIFOLIFO

LIFO considered positiveLIFO considered positive

Audit QualificationAudit Qualification

Adverse opinion considered bad Adverse opinion considered bad newsnews

ResultsResults

Regression analysis with Excess Regression analysis with Excess Return as the dependent variable Return as the dependent variable came out about as hypothesizedcame out about as hypothesized

Found that results are not constant Found that results are not constant for macro economic conditionsfor macro economic conditions

AccountingAccountingSystemSystem

Financial Financial StatementsStatements

Business Business ActivitiesActivities

Accounting Accounting StrategyStrategy

From Business Activities to Financial From Business Activities to Financial StatementsStatements

BusinessBusiness EnvironmentEnvironment

AccountingAccounting

EnvironmentEnvironment

BusinessBusiness StrategyStrategy

Drivers of Profit and GrowthDrivers of Profit and Growth

OperatingManagement

InvestmentManagement

FinancingManagement

DividendPolicy

ManagingRevenue and

Expenses

ManagingWorking

Capital andFixed Assets

ManagingLiabilities and

Equity

ManagingPayout

Product MarketStrategies

Financial MarketStrategies

Profitability andGrowth

Cash Flow Analysis- Cash Flow Analysis- Based on Business ActivitiesBased on Business Activities

Operating ActivitiesOperating Activities

Investment ActivitiesInvestment Activities

Financing ActivitiesFinancing Activities

Cash Flow Cash Flow

The Direct MethodThe Direct Method The Indirect MethodThe Indirect Method

Cash Flow -- Direct MethodCash Flow -- Direct Method

Recommended by the FASBRecommended by the FASB Most companies use the Indirect Most companies use the Indirect

MethodMethod

Cash Flow -- Indirect Method - 1Cash Flow -- Indirect Method - 1

Net Income

Plus/Less

Adjustments for receivablesinventories, payables, taxes

Equals

Cash Flow from Operations

Non-cash income items

Add

Cash Flow -- Indirect Method - 2Cash Flow -- Indirect Method - 2

Cash Flow from Operations

Cash flow - Investment activities

Cash flow - Financing activities

Change in cash and cashequivalents

PLUS/LESS

PLUS/LESS

EQUALS

From Profit to CashFrom Profit to Cash

Net Income

+ Noncash charges

CF from opAfter Wc Changesbefore int

+/- Chgin Working Cap

Cash FlowFrom Oper.bef. WC chgs,Inv & Int

From Profit to Cash -- 2From Profit to Cash -- 2

CF

+/- Interest

+/- Chg Fixed Capital

Cash Flow FromOperations

FreeCashFlow

Free Cash FlowFree Cash Flow

Jensen (1988) defines free cash flow as Jensen (1988) defines free cash flow as the cash left after managers have the cash left after managers have invested in all positive NPV projectsinvested in all positive NPV projects• He also asserts that managers will invest He also asserts that managers will invest

in negative NPV projects rather pay it out in negative NPV projects rather pay it out to shareholdersto shareholders

The Free cash flow used in out context The Free cash flow used in out context is the cash flow from operations plus is the cash flow from operations plus the net investment cash flowthe net investment cash flow

Free cash Flow and InterestFree cash Flow and Interest

You may add interest back. Depends You may add interest back. Depends on the purpose of the Free Cash on the purpose of the Free Cash Flow. See p. 6-3.Flow. See p. 6-3.

Free Cash Flow From Working Free Cash Flow From Working CapitalCapital

Adjust Working Capital from Adjust Working Capital from operations for changes in current operations for changes in current accounts to get Cash Flow From accounts to get Cash Flow From OperationsOperations

Add the net capital investmentAdd the net capital investment What you get is Free Cash FlowWhat you get is Free Cash Flow