Nyu Fsa 03 PDF

Financial Statement Analysis
Professor Julian Yeo
Class Notes 03: Reformulation of Financial Statements, Profitability Analysis and

Interpretation
In this document, we explore the difference between operating and non-operating assets,
liabilities, income, and expense and how to use this distinction to reformulate financial
statements. We outline the profitability framework and the accounting decomposition of ROE
and how to use the decomposition to evaluate firm performance. We also outline the types of
ratios used for to analyze factors other than firm profitability: growth prospects, short-term
liquidity risk, and long-term solvency risk.
Specifically, you will find:

1. The need to reformulate financial Statement
2. Overview of Financial Statement Analysis
3. Profitability Ratios
4. Other Common Ratios
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with current term students.
1.0. THE NEED TO REFORMULATE FINANCIAL STATEMENTS
Before we begin to perform our financial statement analysis, we need to reformulate the
financial statements to help us distinguish between operating and non-operating assets and
liabilities. The reformulation effectively aligns the financial statements with the activities
(operating, investing, and financing) of the business.
Simplified Operating/Nonoperating Balance Sheet
Assets Liabilities
Net Operating Assets (NOA) Current Operating Assets Current Operating Liabilities
(Assets – Liabilities) Long-Term Operating Assets Long-Term Operating Liabilities
Net Financial Obligations (NFO) Financial Assets Financial Obligations

(Liabilities – Assets) (Nonoperating) (Nonoperating)
Equity
Equity (NOA – NFO) Stockholders Equity
Total Assets Total Liabilities and Equity
As the diagram on the previous page indicates, non-operating assets and liabilities are primarily
financial in nature and include short and long-term investments in marketable securities and
borrowings of interest-bearing debt (short term notes and interest payable, current portion of
long-term debt, bonds and notes payable, and capitalized lease obligations), and stockholders’
equity.
GAAP Balance Sheet

Nonoperating (Financial) Items Highlighted
Current Assets Current Liabilities
Cash and Cash Equivalents Accounts Payable
Short-term Investments Accrued Liabilities
Accounts Receivable Short-term Notes and Interest Payable
Inventories Deferred Tax Liabilities
Prepaid Expenses Current Maturities of Long-term Debt
Deferred Tax Assets
Long-term Liabilities
Long-term Assets Bonds and Notes Payable
Long-term Investments in Securities Capitalized Lease Obligations
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Property, Plant, and Equipment, Net Pension and Other Postretirement Liabilities
Natural Resources Deferred Tax Liabilities
Equity Method Investments
Intangible Assets Minority Interest
Deferred Tax Assets
Capitalized Lease Assets
Other Long-term Assets Total Stockholders’ Equity
Simplified Operating/Nonoperating Income Statement
Operating Revenue OR
Operating Expense (OE )
Operating Income OI
Financial Expense FE
Financial Income (FI)
Net Financial Expense (NFE )
Earnings
Similar to nonoperating assets and liabilities, nonoperating revenues and expenses are also
primarily financial in nature and include interest income and expense, dividend income, hedging
gains or losses, debt retirement gains/losses.
The table below lists common operating/nonoperating income statement items and classifies
these items as core (persistent or sustainable) or transitory.
Core Transitory
Operating Sales, COGS, SG&A Expenses, R&D Operating Asset Write-Offs,
Expenses, Income Taxes Nonrecurring Restructuring Charges,
Gains/Losses from Operating Asset Sales
Nonoperating Dividend Income, Interest Income and Debt Retirement Gains/Losses,
Expense, Hedging Gains and Losses
To make sure that you are comfortable with the format of the reformulated statements, we will
review Class Exercise 3.1 Nike.
Implementation Issues
We will reformulate two sets of statements (Class Exercises 3.2 and 3.3) in class and discuss
implementation issues when reformulating our statements.
Balance sheet and correspondence line items on income statements need to be consistent
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 For example, if classify equity investment on the balance sheet as operating (in other
words, those equity investments are crucial in the operations of the business), the equity
income associated with the equity investment on the income statement must also be
classified as part of operating.
Dealing with imperfect information

 Often in the absence of perfect information, we will hold management accountable for
the assets and liabilities items on the Balance Sheet and classify them as operating. The
corresponding line items on the Income Statement will need to be consistent with the
Balance Sheet classifications.
Noncontrolling interest holders:

 Noncontrolling interest is included in stockholders’ equity under current GAAP.
 The income statement parses net income into that attributable to the parent company
shareholders and that attributed to noncontrolling interests.
 Treat noncontrolling interest holders as part of NFO (note: purely to separate out
nonoperating from operating). Net income attributed to noncontrolling interest is
included in NFE (note: NFE is confounded by financing activities as well as other non-
operating activities).
 While noncontrolling interests are treated as nonoperating, they represent an allocation of
net income to the parent company and the noncontrolling shareholders (already on an
after tax basis). Included in after tax NFE without needing to make tax shield
adjustment.
Treatment of Tax Shield

 Tax on operating profit = Tax expense + (pretax NFE * statutory tax rate) + (pretax non-
core expense item *statutory tax rate)
 The idea here is to compute Net Operating Profit After Tax (or Operating Income) as if
there is no leverage or non-core operating items.
 Tip: beware of whether item lies above or below the Income Tax Expense (or otherwise
known as Provision for Income Tax) line on the income statement. That way, you will
know whether the item you are dealing with is on a pre-tax or after-tax basis.
Discontinued Operations
 Discontinued operations are subsidiaries or business segments that the board of directors
has formally decided to divest.
 Companies must report discontinued operations on a separate line, below income from
continuing operations.
 If we include the net assets of discontinued operations as operating activities, it will
downward bias the RNOA calculations.
 Net income from discontinued operations should be treated as non-core operating as well.
Note: it is still part of operating activities, but we create a non-core category (especially
in the income statement)
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Preferred stock holders
 Preferred stock holders are more like debtholders from the common shareholder’s
perspective. The presence of preferred stock requires two adjustments
1. Preferred dividends should be included in NFE
2. Preferred stock must be subtracted from stockholders’ equity in CSE and classify
as NFO.
Dividends Payable
 Since we are conducting our analysis from the shareholder’s perspective, we cannot
technically owe ourselves money. This should be reclassified in CSE instead of leaving
it in NFO.
Capital Leases
• Essentially, the lessee is purchasing the asset by obtaining financing from the lessor.
Treat Leasedhold Assets as operating, and Leasehold Obligation as financing.
2.0. OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

Investors, creditors and other users of the financial statements are interested in evaluating the
firm’s profitability, growth prospects, short-term liquidity risk, and long-term solvency risk.
These dimensions have implications for equity valuation, credit evaluation, and the prediction of
financial distress.
An important tool in financial statement analysis is ratio analysis. Ratios summarize data in a
form that is relatively easy to understand, interpret, and compare.
Ratio analysis involves:

• Calculating ratios
• Examining the time-series behavior of the ratios (i.e., same firm over time)
• Comparing the ratios with those of similar firms (selected competitor firms or industry
averages) or with other benchmarks (e.g., estimates of the cost of capital)
Time-series analysis is useful for identifying trends and assessing the permanency of recent
changes in the ratios. Cross-sectional analysis is useful for evaluating the performance of a firm
relative to its competitors.
Ratio analysis is typically applied to historical data, but it can also be applied to forecasts,
primarily in order to evaluate the plausibility of the underlying forecasting assumptions.
Various ratios are used in evaluating each of the four dimensions (profitability, growth, short-
term liquidity risk, and long-term solvency risk). I next briefly discuss the more important ratios
from each group.
3.0. PROFITABILITY RATIOS

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There are two types of profitability ratios:
(1) Ratios used to analyze profitability given reported earnings and other financial
information
(2) Ratios used to evaluate the quality of reported earnings and other financial information
3.1. Ratios Used to Analyze Profitability Given Reported Earnings and Other Financial
Information
As the diagram below suggests, this analysis has four levels: shareholder profitability (level I),
profitability of assets versus the leverage effect (level II), profit margin versus asset turnover
(level III), and common size income statement and individual asset turnover ratios (level IV).
Return on Equity Decomposition
3.1.1. Level I: Shareholder Profitability
ROE = Return on Equity (otherwise known as ROCE, Return on Common Shareholder’s

Equity)
 Net Income ÷ Average Equity
 Net income is the return (dollar amount) on shareholders’ investment
 The book value of equity measures shareholders’ investment (capital contributions
and reinvested earnings)
 ROE, therefore, measures the rate of return on shareholders’ investment. It reflects
the extent of success in all business activities: operating, investing, and financing
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 Over time, profitability converges to “normal” levels, and so current profitability is
useful for predicting future changes in profitability and earnings
 Theoretically, book value of equity (the denominator of ROE) should be measured at
the beginning of the period. Yet most people use the balance at the end of the year or
alternatively use the average balance during the year (as we do). The logic here is
that, in some cases, a portion of the period’s earnings is related to new capital
contributions that are not reflected in the beginning balance of equity.
3.1.2. Level II: Profitability of Assets versus the Leverage Effect
The following ratios decompose ROE:
ROCE = Return from + Return from

Operating Activities Nonoperating Activities
= RNOA + (FLEV × Spread)
• RNOA = Return on Net Operating Assets

 NOPAT 1 ÷ Average NOA
 NFE = Net Financial Expense = (Financial Expenses – Financial Income)
 NOA = Operating Assets – Operating Liabilities
 RNOA effectively removes the effects of financing activities from the numerator and
the denominator.
• FLEV = Financial Leverage

 Average NFO 2 ÷ Average Equity
 NFO = Financial Obligations – Financial Assets
 Intuitively, FLEV is Liabilities ÷ Equity, except the operating liabilities (accounts
payable, etc.) are subtracted from the denominator of RNOA, instead of being
included in the numerator of FLEV.
• Spread = RNOA – NBC

 NBC = Net Borrowing Cost = NFE ÷ Average NFO
 NFE = Net Financial Expense = (Financial Expenses – Financial Income)
 Spread measures the extra return that accrues to shareholders due to the profitability
of operating assets over the cost of liabilities.
 ROE increases with FLEV as long as the firm can generate a return on investment in
its NOAs in excess of its NBC (i.e., as long as the Spread is positive).
1
NOPAT refers to “net operating profit after tax.”
2
NFO refers to “net financial obligations.”
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 The Spread determines the rate of increase in ROE with increases in leverage (i.e., the
more positive the Spread, the greater the rate by which ROE increases with FLEV).
• RNOA measures profitability from operating and investing activities, while ROE measures
profitability from all three activities: operating, investing, and financing. Thus, ROE –
RNOA reflects the effect of financing activities.
• Leverage increases financial risk, and should therefore be associated with higher profitability
on average.
• Profitability from operating and investing activities is typically more persistent and less
volatile than profitability from financing activities.
3.1.3. Level III: Profit Margin versus Asset Turnover
The following ratios decompose RNOA:
RNOA = Net Operating × Net Operating

Profit Margin Asset Turnover
= NOPM × NOAT
• NOPM = Net Operating Profit Margin

 NOPAT ÷ Sales
 NOPAT = Operating Income × (1 – [Tax Expense ÷ Pretax Income])
 NOPM reflects efficiency in controlling costs, product market strategies (e.g., product
differentiation), and accounting choices and distortions (more about this below)
• NOAT = Net Operating Asset Turnover

 Sales ÷ Average NOA
 NOA = Operating Assets – Operating Liabilities
 NOAT reflects asset utilization (e.g., just-in-time inventory), outsourcing, product
market strategies (e.g., cost leadership)
• When analyzing NOPM and NOAT, it is very important to be aware of the industry in which
the firm operates. Firms can produce a given level of RNOA with almost endless
combinations of NOPM and NOAT: capital-intensive industries need high NOPMs to offset
lower NOATs, while service companies often rely on high NOAT to offset lower NOPM.
• Percentage-wise, income is more variable than sales and assets. This is primarily due to
operating leverage. Therefore, changes in asset turnover are generally more persistent than
changes in profit margin.
3.1.4. Level IV: Common-size Income Statement and Individual Asset Turnover Ratios
This level pertains to the analysis of NOPM and NOAT.
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3.1.4.1. NOPM Drivers
 GPM = Gross Profit Margin ÷ Sales

 OPM = Operating Profit Margin ÷ Sales
 We can also examine various expense ratios such as COGS ÷ Sales, SG&A ÷ Sales,
R&D ÷ Sales, etc.
• These ratios are used to further analyze the profit margin. They are often presented as part of
a common-size income statement (common-size income statements are obtained by dividing
each line in the income statement by sales).
3.1.4.2. NOAT Drivers
• ART = Accounts Receivable Turnover

 Sales ÷ Average AR
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 Measures how many times in a period a firm collects its AR.
• INVT = Inventory Turnover

 COGS ÷ Average Inventory
 Measures how many times in a period a firm sells its inventory.
 Declines in INVT raise concerns about product demand as well as additional
inventory costs (i.e., storage, financing, insurance, theft, damage, etc.).
• APT = Accounts Payable Turnover

 COGS ÷ Average Accounts Payable
 Measures how many times in a period a firm pays its suppliers (the success in using
trade credit to finance inventory purchases).
 Managers want to use trade credit (which represents low-interest financing) to the
greatest extent possible, which tends to depress this ratio. 3
• LTOAT = Long-term Operating Asset Turnover

 Sales ÷ Average Long-term Operating Assets

• NOWCT = Net Operating Working Capital Turnover

 Sales ÷ Average Operating Working Capital
 OWC = Current Assets – Current Liabilities – Current FA + Current FL
 Measures the amount of operating working capital for each dollar of sales.
• The NOAT drivers are often expressed in an alternative format that reflects the amount of
days each asset or liability is held:
 Days in Accounts Receivable = 365 4 ÷ ART
 Days in Inventory = 365 ÷ INVT
 Days in Accounts Payable = 365 ÷ APT
4.0. OTHER RATIOS
4.1 Ratios Used to Evaluate the Overall Quality of Earnings and Other
Financial Information
3
It is wrong to think of accounts payable (trade credit) as zero-interest financing, even though no
interest is usually associated with AP. Suppliers who provide credit without interest usually
charge higher prices for goods/services supplied than would be the case if cash was paid.
4
365 assumes that you are analyzing AR annually. If you are analyzing AR quarterly, you
would use 90 in the numerator instead of 365.
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(Net Income – Cash from Operations) ÷ Net Income
• This ratio indicates the relative size of the noncash component of earnings (accruals).
• All else equal, analysts “prefer” cash earnings over accruals.
• Research suggests that accruals are indeed less persistent than cash from operations, although
there is substantial evidence that firms also manipulate cash from operations (e.g., through
sale of receivables, timing of sales and expenditures, and capitalization of expenditures).
• This ratio is not meaningful when earnings are negative or close to zero. In such cases, one
may scale accruals by assets or sales instead.
Unusual Items ÷ Sales
• Unusual items include restructuring charges, impairment charges, write-downs, other income
(expense), gains and losses.
• Unusual items are less likely to recur.
• Prior-year unusual items may facilitate overstatement of current earnings.
• The category “other income (expense)” includes small gains and losses and other one-time
items that are not material enough to be disclosed separately. However, for some companies,
this category may also include recurring items unrelated to core operations (e.g., share in
earnings of affiliated companies).
• Seemingly one-time items may actually recur (e.g., restructuring charges).
Expenses Recognized due to Conservatism ÷ Sales
• Include primarily R&D and some marketing expenses.

• Firms may increase reported earnings by cutting R&D; in general, changes in earnings due to
changes in R&D may have negative (rather than positive) correlation with value.
• Large changes in R&D may be due to expensing of purchased in-process R&D (in the
current or previous period) – such changes are not likely to persist.
… and there are many additional ratios in this group. We will discuss them as we cover the
specific line items in Part II.
The M Score (Beneish index)
●Utilize a collection of variables to calculate the likelihood of manipulation
1. Days Sales in Receivables Index

Re ceivablest Salest
DSRI t =
Re ceivablest −1 Salest −1
● Higher ratio may suggest an increase in sales on credit in an attempt to boost revenues
● Higher ratio may suggest inflated sales
2. Gross Margin Index
Gross Margin t −1 Salest −1
GMI t =
Gross Margin t Salest
=
(Salest −1 − COGSt −1 ) Salest −1
(Salest − COGSt ) Salest
● Declining margins suggests poorer prospects
● Firms with poor prospects are more likely to manipulate earnings
3. Asset Quality Index

1 − [(CurrentAssets t + PP & Et + Investmentst ) TotalAssetst ]
AQI t =
1 − [(CurrentAssets t -1 + PP & Et −1 + Investmentst −1 ) TotalAssetst −1 ]
● Can indicate over capitalization

● Over capitalization defers costs
4. Sales Growth Index

Salest
SGI t =
Salest −1
● Growth companies are considered more likely to manipulate earnings
● Capital needs make them more likely to manipulate to meet earnings targets
5. Depreciation Index
Depreciationt −1 (Depreciationt −1 + PPEt −1 )
DEPI t =
Depreciationt (Depreciationt + PPEt )
● A higher ratio suggest a slowing down of depreciation
● Raises the possibility that the firm increased the useful life estimate or adopted a new
depreciation method
6. Sales, General and Administrative Expenses Index

SG & At Salest
SGAI t =
SG & At −1 Salest −1
● The idea is that when sales grow disproportionally it is a bad signal
7. Leverage
LVGI t =
[(LongTermDebtt + CurrentLiabilitiest ) TotalAssetst ]
[(LongTermDebtt -1 + CurrentLiabilitiest −1 ) TotalAssetst −1 ]
● Higher leverage suggests higher debt contracting incentives to manipulate
8. TATA
Accrualst
TATAt =
TotalAssetst
● Total accruals to total assets
● All else equal, less accruals are better
Eight Variables:
M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI
+ 4.679*TATA – 0.327*LVGI
Five Variables:
M = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI
A score higher than -2.22 indicates a high likelihood of manipulation
4.2 Growth Ratios

Growth Ratio = Metric t /Metric t-1 -1
The following metrics are useful for the analysis of growth:
Past and Current Growth Rates in Revenue, Assets, Equity, and Earnings
• Past growth often predicts future growth.

• Due to conservative accounting practices and the revenue recognition principle, growth is
typically associated with lower reported profitability, so analyzing growth is also relevant for
interpreting profitability ratios.
4.3 Investment Intensity Ratios
• These ratios compare investments (e.g., business acquisitions, capital expenditures, R&D
expenditures, investments in working capital) with either revenue or assets.
• Unlike past growth rates, these ratios are forward-looking.
• The source of growth, internal (organic) versus external, has important value implications.
• The analysis of growth and its sources is also relevant for understanding life cycle effects.
4.4 SHORT-TERM LIQUIDITY RISK RATIOS

Liquidity risk is the risk that a firm will not have enough working capital to meet its short-term
obligations and will consequently default on these obligations. The following ratios are useful
for the analysis of liquidity risk:
Operating Cycle = Inventory Days + AR Days

Cash-to-Cash Cycle = Operating Cycle – AP Days
• The operating cycle measures the elapsed time from the purchase of inventory to ultimate
collection of the receivable generated from the sale of the inventory.
• The cash-to-cash cycle measures the amount of time the firm is “down” cash. In the diagram
below, the operating cycle is 120 days, AP days is 30, and the cash-to-cash cycle is 90 days.
90 days of operations must be financed (with debt or equity).
Day 0 Day 30 Day 90 Day 120

(Purchase Inventory) (Pay AP) (Sell Inventory) (Collect AR)
For a number of years, Dell had a negative cash-to-cash cycle (Dell collected cash from
customers before paying its suppliers). This means that Dell did not have to finance its
investment in inventory or AR with debt or equity. 100% of this investment is financed by
Dell’s suppliers at zero cost to Dell.
Current Ratio = Current Assets ÷ Current Liabilities
• The current ratio, therefore, indicates the ability of existing assets to settle existing liabilities
within the next year (or operating cycle).
Quick Ratio = Quick Assets ÷ Current Liabilities
• Some current assets are less liquid than others or are not expected to generate cash (e.g.,
inventory, prepaid expenses). Quick assets are highly liquid current assets such as cash,
marketable securities, and accounts receivable.
Working Capital Turnover Ratios
• These ratios indicate the degree of liquidity of different current assets and current liabilities.
• The ratios are calculated by comparing the end of year balance of the asset or liability with
the corresponding flow (sales, cost of goods sold, or purchases).
• The more important ratios in this group are AR turnover (or AR days), inventory turnover
(inventory days), and AP turnover (AP days).
Cash from Operations ÷ Current Liabilities
• This ratio indicates the ability of cash from operations to pay existing current liabilities.
4.5 LONG-TERM SOLVENCY RISK RATIOS

Solvency risk is the risk that a firm can not pay back its creditors’ future claims, even if the
firm’s assets are liquidated. The following ratios are useful for the analysis of solvency risk:
Common-size Balance Sheets
• A common-size balance sheet is prepared by dividing each balance sheet item by total assets.
• These ratios are useful for evaluating the maturity match of assets and liabilities.
Historical Variability of Net Income, Operating Cash Flow, and Sales
• Historical volatility predicts future volatility. All else equal, higher income or cash flow
variability implies higher likelihood of financial distress.
Operating Leverage = Fixed Costs ÷ Total Costs
• Fixed costs are those that cannot be adjusted when sales change. High operating leverage
implies low operating flexibility and hence high risk of incurring losses.
Capital Structure Ratios
• These ratios can be expressed in various forms, including debt-to-capital, debt-to-equity,

liabilities-to-assets, and liabilities-to-equity.
• The different ratios, however, may not indicate the same thing. Ratios that focus on debt
measure the company’s debt burden. In contrast, ratios that include all liabilities in the
numerator mix debt with operating liabilities. The two types of liabilities typically have
different implications for the firm’s stability. For example, firms with large balances of
accounts payable are often highly profitable (e.g., Dell).
Times Interest Earned = Earnings before Interest and Taxes ÷ Interest Expense
• This ratio reflects the income available to service the current debt burden. Management
prefers a high ratio, which reflects low default risk
Cash from Operations ÷ Total Liabilities
• This ratio indicates the ability of cash from operations to pay all existing liabilities.
Altman’s Z-Score
Z-Score = 1.2 * (working capital/total assets) + 1.4 *(retained earnings/total assets) + 3.3*
(EBIT/total assets) + 0.6* (market value of equity/total liabilities) + 0.99* (sales/total assets)
• Assess a company’s bankruptcy risk

• Altman model used to predict bankruptcy risk
• Shown to reasonably accurately predict bankruptcy for up to two years
o 95% accuracy in year 1
o 72% accurate in year 2
• Interpretation of Z-Scores
o Z-score > 3: Company is healthy and there is low bankruptcy potential in the short
term
o 2.99 > Z-score > 1.8: Gray area – company is exposed to some risk of bankruptcy,
caution is advised
o 1.8> Z-score: Company is in financial distress and there is high bankruptcy potential
in short term
APPENDIX
The relationship between ROE, RNOA and Leverage
NI
ROE = (1) 5
Equity
NI + int( net _ of _ taxsavings ) − int( net _ of _ taxsavings )

=
Equity
NI + int( net _ of _ taxsavings ) int( net _ of _ taxsavings)
= −
Equity Equity
NI + int( net _ of _ taxsavings ) − pref _ div NOA int( net _ of _ taxsavings ) NFO
= * − *
NOA Equity NFO Equity
NOA NFO
= RNOA * − NBC * (2)
Equity Equity
Where RNOA = NI + int( net _ of _ taxsavings )

NOA
int( net _ of _ taxsavings )
NBC =
NFO
NBC is commonly referred to as Net Borrowing Cost or Return to Debtholders.
Also, note that NOA=NFO+Equity, equation (2) can be rewritten as:

NFO NFO
= RNOA * (1 + ) − NBC * (3)
Equity Equity
Rearranging equation (3), it can be shown that
NFO
ROE = RNOA + ( RNOA − NBC ) (4)
Equity
Few observations
For a firm with no debt, ROE=RNOA.
For firms with leverage, the higher the leverage (i.e., NFO/CSE), the higher the ROE, provided that
(RNOA-NBC)>0.
5
For the ease of reading, the word ‘average’ before balance sheet items is dropped.
Now…
If a firm can increase its ROE by borrowing more, can it increase its’ share price by borrowing
more?
The quick answer is no. Why?

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Financial Statement Analysis

Professor Julian Yeo

Class Notes 03: Reformulation of Financial Statements, Profitability Analysis and

Specifically, you will find:

Simplified Operating/Nonoperating Balance Sheet

Net Financial Obligations (NFO) Financial Assets Financial Obligations

Equity (NOA – NFO) Stockholders Equity

Total Assets Total Liabilities and Equity

GAAP Balance Sheet

Simplified Operating/Nonoperating Income Statement

Dealing with imperfect information

Noncontrolling interest holders:

Treatment of Tax Shield

2.0. OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

Ratio analysis involves:

3.0. PROFITABILITY RATIOS

Return on Equity Decomposition

3.1.1. Level I: Shareholder Profitability

ROE = Return on Equity (otherwise known as ROCE, Return on Common Shareholder’s

3.1.2. Level II: Profitability of Assets versus the Leverage Effect

The following ratios decompose ROE:

ROCE = Return from + Return from

• RNOA = Return on Net Operating Assets

• FLEV = Financial Leverage

• Spread = RNOA – NBC

3.1.3. Level III: Profit Margin versus Asset Turnover

The following ratios decompose RNOA:

RNOA = Net Operating × Net Operating

• NOPM = Net Operating Profit Margin

• NOAT = Net Operating Asset Turnover

This level pertains to the analysis of NOPM and NOAT.

 GPM = Gross Profit Margin ÷ Sales

3.1.4.2. NOAT Drivers

• ART = Accounts Receivable Turnover

• INVT = Inventory Turnover

• APT = Accounts Payable Turnover

• LTOAT = Long-term Operating Asset Turnover

• NOWCT = Net Operating Working Capital Turnover

4.0. OTHER RATIOS

Unusual Items ÷ Sales

Expenses Recognized due to Conservatism ÷ Sales

• Include primarily R&D and some marketing expenses.

The M Score (Beneish index)

●Utilize a collection of variables to calculate the likelihood of manipulation

1. Days Sales in Receivables Index

3. Asset Quality Index

● Can indicate over capitalization

4. Sales Growth Index

6. Sales, General and Administrative Expenses Index

A score higher than -2.22 indicates a high likelihood of manipulation

4.2 Growth Ratios

The following metrics are useful for the analysis of growth:

• Past growth often predicts future growth.

4.3 Investment Intensity Ratios

4.4 SHORT-TERM LIQUIDITY RISK RATIOS

Operating Cycle = Inventory Days + AR Days

Day 0 Day 30 Day 90 Day 120

Current Ratio = Current Assets ÷ Current Liabilities

Quick Ratio = Quick Assets ÷ Current Liabilities

Working Capital Turnover Ratios

Cash from Operations ÷ Current Liabilities

4.5 LONG-TERM SOLVENCY RISK RATIOS

Common-size Balance Sheets