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CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES

Presenter’s name Presenter’s title dd Month yyyy

CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES Presenter’s name Presenter’s title dd Month yyyy

FINANCIAL ANALYSIS TOOLS:

DESCRIPTION

• Graphics • Regression • Common-Size Analysis • Financial Ratio Analysis

GRAPHICS: EXAMPLE

Operating Profit by Geographic Segment

22% 21% 19% 38% North America Latin America
22%
21%
19%
38%
North America
Latin America
  • Europe/South Pacific

  • Greater Asia/Africa

GRAPHICS: EXAMPLE

Greater Asia/Africa

Europe/South Pacific

Latin America

North America

2011 2010 2009 2008 2007 0 200 400 600 800 1000 1200 1400 1600
2011
2010
2009
2008
2007
0
200
400
600
800
1000
1200
1400
1600

$ millions

GRAPHICS: EXAMPLE

Operating profit margin

30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%

REGRESSION: EXAMPLE

GDP Change

14.0 12.0 10.0 f(x) = 0.12x + 5.82 R² = 0.27 8.0 6.0 4.0 2.0 0.0
14.0
12.0
10.0
f(x) = 0.12x + 5.82
R² = 0.27
8.0
6.0
4.0
2.0
0.0
-40.0
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
-2.0
-4.0

Sales Growth

COMMON-SIZE ANALYSIS

• Common-size analysis: Express financial data, including entire financial statements, in relation to a single financial statement item or base.

• Vertical common-size

  • - Balance sheet: Each item as a percent of total assets.

  • - Income statement: Each item as a percent of total net revenues.

  • - Cash flow: Each line as a percent of sales, assets, or total in and out.

  • - Highlights composition and identifies what’s important.

• Horizontal common-size

  • - Percentage increase or decrease of each item from the prior year or showing each year relative to a base year.

  • - Highlights items that have changed unexpectedly or have unexpectedly remained unchanged.

COMMON-SIZE BALANCE SHEET EXAMPLE:

SINGLE COMPANY, TWO PERIODS

Partial common-size balance sheet

COMMON-SIZE BALANCE SHEET EXAMPLE: SINGLE COMPANY, TWO PERIODS Partial common-size balance sheet

COMMON-SIZE BALANCE SHEET EXAMPLE:

CROSS-SECTIONAL, TWO COMPANIES, SAME TIME

Partial common-size balance sheet

Assets

Company 1 % of Total Assets

Company 2 % of Total Assets

Cash

38

12

Receivables

33

55

Inventory

27

24

Fixed assets net of depreciation

1

2

Investments

1

7

Total Assets

100

100

USE OF COMPARATIVE GROWTH INFORMATION: EXAMPLE

Sunbeam, Inc. 1997 vs.1996

Revenue +19% Receivables +38% Inventory +58%

Why are receivables growing so much faster than revenue? Why is inventory growing so much faster than revenue?

FINANCIAL RATIOS

• Ratios

  • - Express one number in relation to another.

  • - Standardize financial data in terms of mathematical relationships expressed as percentages, times, or days.

  • - Facilitate comparisons—trends and across companies.

• Ratios are interrelated

RATIO ANALYSIS

How profitable was Company X?

15.26%

A ratio is NOT the answer (except sometimes on

an exam). A ratio is an indicator—for example, an indicator of relative activity, profitability, liquidity, solvency.

RATIO ANALYSIS

How profitable was company X?

COMPANY X’S PROFITABILITY HAS IMPROVED. ITS NET PROFIT MARGIN WAS 15.3%, UP FROM 14.9% LAST YEAR.

A ratio is NOT the answer (except sometimes on an exam).

A ratio is an indicator—for example, an indicator of relative

activity, profitability, liquidity, solvency. Interpretation generally involves comparison. Furthermore, analysis will address the question of why.

RATIO ANALYSIS

How profitable was Company X?

COMPANY X WAS MORE PROFITABLE THAN COMPANY Y AS EVIDENCED BY ITS NET PROFIT MARGIN. COMPANY X’S MARGIN OF 15.3% WAS HIGHER THAN COMPANY Y’S MARGIN OF 12.0%.

A ratio is NOT the answer (except sometimes on an exam).

A ratio is an indicator—for example, an indicator of relative

activity, profitability, liquidity, solvency. Interpretation generally involves comparison. Furthermore, analysis will address the question of why.

USING FINANCIAL ANALYSIS TOOLS

Computation ≠ Analysis

• Analysis goes beyond collecting data and computing numbers.

• Analysis encompasses computations and interpretations. • Where practical, directly experience the company’s business. • Analysis of past performance:

What aspects of performance are critical to successfully competing in the industry?

How well did the company perform (relative to own history and relative to competitors)?

Why? What caused the performance? Does the performance reflect the company’s strategy?

USING FINANCIAL ANALYSIS TOOLS

• Not every ratio is relevant in every situation.

  • - Some ratios are irrelevant for certain companies.

  • - Some ratios are redundant.

  • - Industry-specific ratios can be as important as general financial ratios.

  • - Different users and questions (e.g., creditors, investors) focus on different ratios.

• Different sources categorize some ratios differently and include different ratios.

• Differences in accounting standards can limit comparability.

CATEGORIES OF FINANCIAL RATIOS

Category

Description

Activity

Activity ratios. How efficient are the firm’s operations and the firm’s management of assets?

Liquidity

Liquidity ratios. How well is the firm positioned to meet short-term obligations?

Solvency

Solvency ratios. How well is the firm positioned to meet long-term obligations?

Profitability

Profitability ratios. How and how much is the firm achieving returns on its investments?

Valuation

Valuation ratios. How does the firm’s performance or financial position relate to its market value?

PROFITABILITY AND OVERVIEW

Category

Description

Activity

Activity ratios. How efficient are the firm’s operations and the firm’s management of assets?

Liquidity

Liquidity ratios. How well is the firm positioned to meet short-term obligations?

Solvency

Solvency ratios. How well is the firm positioned to meet long-term obligations?

Profitability

Profitability ratios. How much and how is the firm achieving returns on its investments?

Valuation

Valuation ratios. How does the firm’s performance or financial position relate to its market value?

MEASURE OF PROFITABILITY:

RETURN ON EQUITY (ROE)

What rate of return has the firm earned on the shareholders’ equity it had available during the year?

The general form of the rate of return computation:

Rate of return =

Amount of return

Amount invested

Applied to shareholders’ equity:

ROE =

Net income

Average equity

DECOMPOSE ROE

 

Net income

 

ROE =

Average equity

 

Net income

 

Average assets

=

Average assets

×

Average equity

=

×

 

ROA

 

Leverage

DECOMPOSE ROE

ROE

=

ROA

×

Leverage

A company can increase its ROE

  • 1. With a business strategy, by increasing its ROA and/or

  • 2. With a financial strategy, by increasing its use of leverage as long as returns on the incremental investment exceed the cost of borrowing.

RETURN ON ASSETS

What rate of return has the firm earned on the assets it had available to use during the year?

The general form of this computation is the same:

Rate of Return =

Amount of return

Amount invested

Two variants of ROA computation:

Net income
Net income

(1)

ROA =

Average assets

(2)

ROA =

Net income adjusted for interest

Average assets

 

=

Net income + [Interest expense × (1 – Tax rate)]

   

Average assets

PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY

ROA =

Net income

Average assets

ROA =

Net income

 

Revenue

Revenue

×

Average assets

In other words, ROA can be thought of as:

PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY ROA = Net income Average assets ROA = Net income Revenue
PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY ROA = Net income Average assets ROA = Net income Revenue

Profit margin × Turnover (efficiency)

DECOMPOSING RETURN ON EQUITY

ROE =

Profit margin

×

Turnover

×

Leverage

 
 

Net income

 

Revenue

 

Average assets

ROE =

Revenue

×

Average assets

×

Average equity

DECOMPOSING RETURN ON EQUITY

Du Pont Analysis

What was the source of the firm’s return on equity?

To what extent

was it derived from selling a high margin product or keeping expenses low—deriving more profits from each $1 of sales? (return

on sales, net profit margin)

was it derived from generating higher sales from a lower investment in assets? (efficient use of assets, also known as

turnover or efficiency)

was it derived from investing a lower amount of equity—by using more debt in its capital structure? (financial leverage)

DECOMPOSING RETURN ON EQUITY:

STYLIZED COMPARATIVE ANALYSIS MINI-CASE

 

Averag

 

Co. A

Co. B

Co. C

e

Sales ($)

2,000

4,000

6,675

4,225

Net income (NI) ($)

200

200

200

200

Average assets ($)

1,000

2,000

1,500

1,500

Average equity ($)

1,000

1,000

1,000

1,000

Average liabilities ($)

0

1,000

500

500

ROE (NI/Equity)

Net profit margin (NI/Sales)

 

Turnover

 

(Sales/Assets)

Leverage

 

(Assets/Equity)

DECOMPOSING RETURN ON EQUITY:

STYLIZED COMPARATIVE ANALYSIS MINI-CASE

 

Co. A

Co. B

Co. C

Average

Sales ($)

2,000

4,000

6,675

4,225

NI ($)

200

200

200

200

Average assets ($)

1,000

2,000

1,500

1,500

Average equity ($)

1,000

1,000

1,000

1,000

Average liabilities ($)

0

1,000

500

500

ROE (NI/Equity)

20.0%

20.0%

20.0%

20.0%

Net profit margin (NI/Sales)

10.0%

5.0%

3.0%

4.7%

Turnover (Sales/Assets)

2

2

4.45

2.82

Leverage (Assets/Equity)

1

2

1.5

1.50

DECOMPOSING RETURN ON EQUITY:

COMPARATIVE

 

AAPL

HPQ

DELL

ROE

27.19% 21.50%

61.19%

 

Net profit

   

Net income/Sales

margin

14.88%

7.04%

4.06%

 

Asset

   

Sales/Average assets

turnover

1.00

1.17

2.26

Average assets/

Financial

   

Average equity

leverage

1.83

2.61

6.67

DUPONT ANALYSIS :

FURTHER DECOMPOSITION

• ROE = Net income/Average equity • Decompose ROE into five factors

ROE =

Net income

EBT

EBIT

EBT

×

EBIT

×

Revenue

   
   

Revenue

Average assets

 

×

Average assets

×

Average equity

PROFITABILITY: RETURN ON SALES (FROM THE COMMON-SIZE INCOME STATEMENT)

Gross profit margin = Gross profit/Revenue Measures the ability to translate sales into profit after consideration of cost of products sold.

Operating profit margin = Operating profit/Revenue Measures the ability to translate sales into profit after consideration of operating expenses.

Net profit margin = Net profit/Revenue Measures the ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes, and nonoperating items.

DISCUSSION BY CATEGORY

Category

Description

Activity

Activity ratios. How efficient are the firm’s operations and the firm’s management of assets?

Liquidity

Liquidity ratios. How well is the firm positioned to meet short-term obligations?

Solvency

Solvency ratios. How well is the firm positioned to meet long-term obligations?

Profitability

Profitability ratios. How much and how is the firm achieving returns on its investments?

Valuation

Valuation ratios. How does the firm’s performance or financial position relate to its market value?

ACTIVITY RATIOS

• Also known as asset utilization or operating efficiency ratios.

• How efficiently is the firm using its assets? How many dollars of sales was the firm able to generate from each dollar of assets? • Broadly

Asset turnover = Revenue/Average total assets

• Low or declining ratios could mean

  • - Sales are sluggish,

  • - A heavy investment in assets (inefficient? plant modernization to help in future? strategy shift?), and/or

  • - Asset mix changed. • Specifically, for fixed assets:

Fixed asset turnover = Revenue/Average net fixed assets • Can compute for any category of assets.

ACTIVITY RATIOS

Also known as asset utilization or operating efficiency ratios

 

Numerator

Denominator

Working capital turnover

Revenue

Average working capital

Fixed asset turnover

Revenue

Average net fixed assets

Total asset turnover

Revenue

Average total assets

OTHER COMMON ACTIVITY RATIOS

 

Numerator

Denominator

Inventory turnover

Cost of sales

Average inventory

Days of inventory on hand (DOH)

Number of days in period

Inventory turnover

Receivables turnover

Revenue

Average receivables

 

Number of days in

Receivables

Days of sales outstanding (DSO)

period

turnover

Payables turnover

Purchases

Average trade

payables

Number of days of payables

Number of days in period

Payables turnover

ACTIVITY RATIOS AND THE CASH CYCLE

(CASH CONVERSION CYCLE, A LIQUIDITY RATIO)

• Cash cycle: How long does it take for the firm to go from cash to cash?

  • - Service company: sell service → receive cash.

  • - Merchandising company: buy inventory → sell inventory → receive cash and pay for inventory.

  • - Manufacturing company: buy raw materials → make product → sell product → receive cash and pay for materials and labor.

• Cash conversion cycle (net operating cycle) = Days sales outstanding + Days inventory held – Number of days of payables

• Close link to liquidity

• Working capital (current assets minus current liabilities) reflects the investment required to support this cycle.

LIQUIDITY

• How well positioned is the firm to meet its near-term obligations?

Current ratio = Current assets/Current liabilities

Quick ratio = (Cash + Short-term marketable investments + Account receivables)/Current liabilities

Cash ratio = (Cash + Short-term marketable investments)/ Current liabilities

DISCUSSION BY CATEGORY

Category

Description

Activity

Activity ratios. How efficient are the firm’s operations and the firm’s management of assets?

Liquidity

Liquidity ratios. How well is the firm positioned to meet short-term obligations?

Solvency

Solvency ratios. How well is the firm positioned to meet long-term obligations?

Profitability

Profitability ratios. How much and how is the firm achieving returns on its investments?

Valuation

Valuation ratios. How does the firm’s performance or financial position relate to its market value?

SOLVENCY: HOW WELL POSITIONED IS THE FIRM TO MEET ITS LONGER-TERM LIABILITIES?

Debt ratios: How has the company financed itself? • Debt to total assets

• Debt to equity • Debt to total capital

}

Lower ratio –> safer. Higher cushion against potential creditor losses

Coverage ratios: Degree to which earnings or cash flow can decline without affecting firm’s ability to pay interest. • EBIT interest coverage = (EBT + Interest payments)/Interest payments • Fixed charge coverage = (EBIT + Lease payments)/(Interest payments + Lease payments)

COMMON SOLVENCY RATIOS

Solvency ratios

Numerator

Denominator

Debt ratios

Debt-to-assets ratio

Total debt

Total assets

Debt-to-capital ratio

Total debt

Total debt + Total

 

shareholders’ equity

Debt-to-equity ratio

Total debt

Total shareholders’ equity

Financial leverage ratio

Average total assets

Average total equity

 

Coverage ratios

Interest coverage

EBIT

Interest payments

Fixed charge

EBIT + Lease

Interest payments + Lease

coverage

payments

payments

DISCUSSION BY CATEGORY

Category

Description

Activity

Activity ratios. How efficient are the firm’s operations and the firm’s management of assets?

Liquidity

Liquidity ratios. How well is the firm positioned to meet short-term obligations?

Solvency

Solvency ratios. How well is the firm positioned to meet long-term obligations?

Profitability

Profitability ratios. How much and how is the firm achieving returns on its investments?

Valuation

Valuation ratios. How does the firm’s performance or financial position relate to its market value?

VALUATION RATIOS:

PRICE-TO-EARNINGS RATIO

P/E relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings.

P/E

 

Price

=

Earnings per share

High P/E indicates - Firm is valued highly by market, possibly because of growth expectations, or - That a firm may have very low earnings per share.

VALUATION RATIOS

Valuation ratios P/E P/CF P/S P/BV

Numerator Denominator

Price per share Price per share Price per share Price per share

Earnings per share Cash flow per share Sales per share Book value per share

DIVIDEND-RELATED QUANTITIES

Dividend payout ratio

 

Dividends per share

=

Earnings per share

Dividend yield

 

Dividends per share

=

Price

SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS

Ratio

Numerator

Denominator

EBIT and EBITDA interest coverage

EBIT or EBITDA

Gross interest (prior to deductions for capitalized interest or interest income)

FFO interest coverage

FFO plus interest paid minus operating lease adjustments

Gross interest (prior to deductions for capitalized interest or interest income)

FFO to debt

FFO

Total debt

Free operating cash flow to debt

CFO (adjusted) minus capital expenditures

Total debt

Discretionary cash flow to debt

CFO minus capital expenditures minus dividends paid

Total debt

SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS

Credit Ratio

Numerator

Denominator

Return on capital

EBIT

Average capital, where capital is equity plus noncurrent deferred taxes plus debt

Net cash flow to capital expenditures

FFO minus dividends

Capital expenditures

Debt to EBITDA

Total debt

EBITDA

Total debt to total debt plus equity

Total debt

Total debt plus equity

SEGMENT ANALYSIS EXAMPLE:

L’ORÉAL

SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

MODEL BUILDING:

EXAMPLES OF POSSIBLE USES OF RATIOS

Sales forecast (percent change from horizontal common-size income statement)

Expenses (from common-size income statement) Gross profit (gross profit margin) Operating profit (operating profit margin)

Assets (days receivable, days payable, PP&E turnover) Liabilities (leverage ratios)

Cash flow

RATIOS IN MODEL BUILDING

Forecast

Debt

Forecast

Cash Flow

Forecast Income and Taxes

Forecast

Interest

Expense

RATIOS IN MODEL BUILDING Forecast Debt Forecast Cash Flow Forecast Income and Taxes Forecast Interest Expense

Sales forecast

Expenses Gross Profit Operating Profit

Assets Liabilities

Cash Flow

SUMMARY: FINANCIAL ANALYSIS TOOLS

• Graphics facilitate comparisons, and regressions quantify statistical relationships. • Common-size analysis expresses financial data, including entire

financial statements, in relation to a single financial statement item or base. • Ratios, which express one number in relation to another, facilitate comparisons—trends and cross-sectional. • A ratio is an indicator of

  • - Activity

  • - Profitability

  • - Liquidity

  • - Solvency