Chapter 14 investments financial statement analysis

Chapter 14
Financial Statement Analysis
14.1 The Major Financial Statements

Income statement

Balance sheet

Statement of cash flows
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Income Statement
•
Four broad types of accounts:
- Cost of goods sold
- General and administrative expenses
- Interest expense
- Taxes on earnings
•
Common Size income statements
- Divide each account by net sales
- Eliminates size distortions
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Table 14.1 Consolidated Statement of Income
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Balance Sheet
•
Assets
- Current: Converted into cash within 1 year.
- Long-term
•
Liability (current and long term) and stockholders’ equity

•
Common size balance sheet
- Divide each account by total assets
- Each account presented as a percent of the total
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Table 14.2 Consolidated Balance Sheet A
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Table 14.2 Consolidated Balance Sheet B
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Statement of Cash Flows
•
A financial statement showing a firm’s cash receipts and cash payments during a specified pe
riod.
- Recognizes transactions only if cash changes hands.
-
“Undoes” much of accrual accounting to get at cash
changes.
- Does not allocate capital expenditures through time via depreciation as income statement does.
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Statement of Cash Flows
Three main sections
•
Cash flow related to operations
•
Cash flow related to investing
•
Cash flow related to financing
•
Allows the analyst to understand which of the firm’s activities are using and which generating cash.
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Statement of Cash Flows
•
Not all sources of cash are equally sustainable.
•
Would you rather invest in a firm that is primarily generating cash through operations or through financing?
•
It is difficult to evaluate whether the amount of cash flow related to investing is ‘good’ or ‘bad.’ What else woul
d we need to know?
•
Rate of return on the investment
•
Comparable data over time or from competitors
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Table 14.3 Consolidated Statement of Cash Flows
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14.2 Accounting Versus Economic Earnings
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Accounting Versus Economic Earnings
•
Accounting earnings
•
Earnings of a firm as reported on its income statement
•
Economic earnings
•
The real flow of cash that firm could pay out to its stockholders without impairing its productive capacity.
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14.3 Profitability Measures
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Past Versus Future ROE

ROE = Net Profits / Equity
•
Data from recent past may provide information regarding future ROE
•
Analysts should always keep an eye on the future
•
Expectations of future dividends and earnings determine intrinsic value of stock
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Financial Leverage and ROE
•
Pay careful attention to the firm’s debt-equity mix and to the interest rate on its debt.
•
The relationship among ROE, ROA, and leverage:
•
ROE = Net Profits / Equity
•
ROA = EBIT / Total Assets
•
If ROA > the borrowing rate, the firm earns more on its money than it pays out to creditors.
•
If ROA< the interest rate paid on debt, ROE will decline by an amount that depends on the debt/equit
y.
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(1 Tax rate) ( Interest rate)
Debt
ROE ROA ROA
Equity
 
= − + −
 

 
Financial Leverage and ROE
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Nodett: All equity nanced; Total assets of $100M; 40%
of corporate tax.
Somdett: 40% debt nancing of $100M assets; Interest rate of
8%
14.4 Ratio Analysis
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Ratio Analysis
•
Purpose of Ratio Analysis
- Understand the factors that affect performance
•
Methods
- Trend analysis
- Comparative analysis
- Combination of the two
•
Use by External Analysts
- Important information for investment community
- Important for credit markets
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DuPont Decomposition of ROE
ROE can be decomposed into various ratios that reflect different aspects of a firm’s
performance:
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Burden Burden
Leverage Turnover Margin Interest Tax
(5) (4) (3) (2) (1)

Assets
Sales
Sales
EBIT
EBIT
ProfitPretax
ProfitPretax
ProfitNet
ROE
××××
××××
××××=
Equity
Assets
Type of Financial Ratios
•
Ratio (1) Tax Burden (TB):
- Measures the percentage of pretax profit that the firm keeps after paying taxes
•
Ratio (2) Interest Burden (IB):
- Measures the percent of EBIT kept after paying interest expense
-
-
This ratio is 1 if the firm has no debt
- Closely related to the interest coverage ratio, defined as EBIT/Interest expense
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EBIT
Expense InterestEBIT
EBIT
ProfitPretax −

=
Burden Burden
Leverage Turnover Margin Interest Tax
(5) (4) (3) (2) (1)
Assets
Sales
Sales
EBIT
EBIT
ProfitPretax
ProfitPretax
ProfitNet
ROE
××××
××××
××××=
Equity
Assets
Type of Financial Ratios
•
Ratio (3) Operating Profit Margin
-
Measures the percentage of sales revenue that remains after subtracting cost of
goods sold, selling and administrative expenses and depreciation.
•
Ratio (4) Asset Turnover Ratio (ATO)
-
Measures the efficiency of the firm at generating sales per dollar invested in assets.
- Note: Margin x ATO = ROA
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Burden Burden
Leverage Turnover Margin Interest Tax
(5) (4) (3) (2) (1)
Assets
Sales
Sales
EBIT
EBIT
ProfitPretax
ProfitPretax
ProfitNet
ROE
××××
××××
××××=
Equity
Assets
Type of Financial Ratios
•
Ratio (5) Leverage ratio
- Leverage ratio = (Equity + Debt) / Equity = 1 + (Debt / Equity)
-
The leverage ratio is a measure of the percentage of debt in total capitalization.
-
Note that it appears that using more debt as a percent of capital will
increase ROE, but using more debt also reduces the interest burden ratio
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Burden Burden
Leverage Turnover Margin Interest Tax
(5) (4) (3) (2) (1)

Equity
Assets
Assets
Sales
Sales
EBIT
EBIT
ProfitPretax
ProfitPretax
Profit Net
ROE
××××
××××
××××=
Type of Financial Ratios
•
Ratio (5) Leverage ratio
- Compound leverage factor (CLF) = Interest burden x Leverage
- If the CLF > 1, the use of debt will increase ROE
- If the CLF < 1, the use of debt will decrease ROE
- CLF will be greater than 1 if ROA > Interest rate on debt
- What does this imply about when firms should use more debt?
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Burden Burden
Leverage Turnover Margin Interest Tax
(5) (4) (3) (2) (1)
Equity
Assets
Assets
Sales

Sales
EBIT
EBIT
ProfitPretax
ProfitPretax
Profit Net
ROE
××××
××××
××××=
Sample ROE Decomposition
Compare two firms, Nodett and Somdett
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