FINANCIAL STATEMENT ANALYSIS:
Understanding the financial statements of a firm is critical since it is often the only source of information with which we must make investment decisions; i.e., whether or not to loan the company money or invest some equity. There is a rationale behind the construction of the financial statements that helps us to interpret the information that is contained within them.
Income Statements:
Revenues
Less:
Cost of Goods Sold
Manufacturing
Gross Profit
Less:
Salaries
Advertising
Rent
Selling & Administrative
Depreciation
Utilities
Operating Income
Less:
Interest Expense
Finance
Taxable Income
Less:
Taxes
Government (Tax accounting)
Net Income
The income statement is broken down by functional area. This allows us to more accurately determine where our strengths or weaknesses lie.
Balance Sheets
As with the income statement, the balance sheet is constructed in a very methodical manner. On the Asset side, the assets are listed in order from the most liquid to the least liquid. Similarly, on the Liability & Equity side, the accounts are listed in order from the most immediately due to the least.
Cash Accounts Payable
Marketable Securities Wages Payable
Accounts Receivable Bank Note Payable
Inventory Current Portion of L-T Debt
Prepaid Expenses
Total Current Assets Total Current Liabilities
Plant & Equipment Long-Term Debt
(Accumulated Depr.) Common Stock
Net Plant & Equip. Retained Earnings
Total Assets Total Liabilities & Equity
Statement of Cash Flows:
From a financial perspective, the Statement of Cash Flows is the most important financial statement because it integrates the Income Statement and Balance sheet while adjusting the accounting figures based upon accrual accounting into actual cash flow.
From Operations:
Net Income
Plus: Depreciation
Plus: Amortization
Operating Cash Flow
Plus: Changes in Non-Cash Current Assets
Plus: Changes in Operations-related Current Liabilities
Total From Operations
From Investing Activities:
Changes In Gross Fixed Assets
Plus: Changes in Other Non-Current Assets
Total From Investing Activities
From Financing Activities:
Changes in Non-Operations-related current liabilities
Plus: Changes in Long-Term Debt
Plus: Changes in Other Capital Accounts
(except Retained Earnings)
Less: Dividends Paid
Total From Financing Activities
Total Change in Cash
Plus: Beginning Cash Balance
Ending Cash Balance
COMMON SIZE INCOME STATEMENTS
All Items Expressed as a Percentage of Revenues.
COMMON SIZE BALANCE SHEETS
All Accounts Expressed as a Percentage of Total Assets.
What’s the purpose of calculating Common-Sized statements? (Comparison purposes.)
Financial Rations:
The financial statements are often the only information upon which to base an investment decision (as an equity holder or a lender), so it is imperative that we be able to determine what economic information the statements contain. Financial Ratios are used as tools to help us squeeze as much information as possible from the financial statements. It must be kept in mind, however, that a financial ratio is only one number divided by another and only yields a number. The ratio takes on meaning when compared with other firms or industry averages (a static analysis) or when compared with previous periods for trends to see if a firm’s position is improving or deteriorating (a dynamic analysis). The ratios must also be taken together as a group – if a ratio appears to be “higher” than it normally is, it can be due to the numerator being large OR the denominator being small. By looking at other ratios we can determine which is the case.
Liquidity Ratios:
Liquidity ratios are designed to measure the extent to which our short-term, or liquid, assets exist to cover our short-term obligations. While most ratios have definitions that vary (and, hence, one must be certain that the appropriate definition is being used for comparison purposes), the definition of the Current Ratio is standard:
The current ratio is looking at those assets that are expected to be converted into cash with one year, relative to those liabilities that come due within a year. A more stringent measure is the Quick (or Acid Test) Ratio. This ratio recognizes that some current assets are more liquid than others. While the book defines the quick ratio’s numerator as being the Current Assets less Inventories, the general definition used in practice excludes other current assets that are not liquid in nature, such as prepaid expenses.
The idea behind excluding inventories is twofold: first, inventories are generally liquid and can only be converted into cash by selling at steep discounts. Secondly, most companies sell inventories on credit, so they become an account receivable which must then be collected. By excluding inventories, the quick ratio is therefore recognizing the fact that they are one step further removed from becoming cash than other current assets.
Financial Leverage
The next set of financial ratios is designed to examine the extent to which a company utilizes debt in the financing of its assets. The use of debt is referred to as financial leverage. First, let’s look at the effect of financial leverage on a firm. Consider a company that has three different possible debt financing strategies, ranging from no debt to 90% debt. Also, let’s assume that the interest rate on any debt employed is 10% and that the firm has a tax rate of 40%.
Interest Rate = 10%
Tax Rate = 40%
1 2 3
=== === ===
DEBT 0 500 900
EQUITY 1,000 500 100
–‑‑‑‑‑‑ –‑‑‑‑‑‑ –‑‑‑‑‑‑
TOTAL ASSETS 1,000 1,000 1,000
Since the effect of financing doesn’t appear until we go below the Operating Income (EBIT) line, we can jump straight down to the operating income to analyze the effect of financial leverage. Assume that the EBIT is $140 for the firm; then, the calculation of Net Income, and the rate of return that the Net Income represents on the equity invested, are as follows:
EBIT 140 140 140
‑ INT 0 (50) (90)
–‑‑‑‑‑‑ –‑‑‑‑‑‑ –‑‑‑‑‑‑
TAX. INC. 140 90 50
‑ TAX (56) (36) (20)
‑‑‑‑‑‑ –‑‑‑‑‑‑ –‑‑‑‑‑‑
NET INCOME 84 54 30
ROE = 8.4% 10.8% 30.0%
Notice that the Return on Equity is magnified by the use of debt, and that the more the debt that is employed, the greater the magnification. The profits of the firm can be greatly magnified through the use of debt.
Leverage, however, is a two-edged sword. Not only are profits magnified, but also losses. Consider the same firm when EBIT is only $60:
1 2 3
=== === ===
DEBT 0 500 900
EQUITY 1,000 500 100
–‑‑‑‑‑‑ –‑‑‑‑‑‑ –‑‑‑‑‑‑
TOTAL ASSETS 1,000 1,000 1,000
EBIT 60 60 60
‑ INT 0 (50) (90)
–‑‑‑‑‑‑ –‑‑‑‑‑‑ –‑‑‑‑‑‑
TAX. INC. 60 10 (30)
‑ TAX (24) (4) 12
–‑‑‑‑‑‑ –‑‑‑‑‑‑ –‑‑‑‑‑‑
NET INCOME 36 6 (18)
ROE = 3.6% 1.2% ‑18.0%
Now the use of debt results in lower profitability. Financial leverage magnifies both profits and losses – in other words, it magnifies the risk of the company. Financial leverage will be looked at in more detail later. For now, a basic understanding of the effect of leverage is sufficient; but let’s look at some of the ratios designed to measure the extent to which a company utilizes debt, and just how well it can manage its debt.
Leverage (Solvency) Ratios:
The Debt-to-Assets Ratio looks at how much of a company’s assets are financed with debt; i.e., other people’s money.
A variation on the Debt-to-Asset Ratio that is more commonly used in practice is the Debt-to-Equity Ratio which simply expresses the debt as a percentage of equity rather than total assets. The two measures are equivalent as indicated by the second part of the equation:
Sometimes it is desirable to break down the use of debt into short-term and long-term debt. Which type of debt do you think is more risky for the company to utilize? (To answer this, ask yourself whether you would prefer to buy a house using a one-year note that would have to be refinanced in twelve months, or a 30-year mortgage.)
Just as in accounting where changes in current liabilities are included as a part of operating cash flows (since accounts payable and accruals such as wages payable arise from operations), sometimes only the long-term portions of debt are considered. This is because oftentimes a company is viable in the long-run but faces short-term liquidity problems (consider when the Democrats and Republicans shut down the federal government for a few days in 1997). The capitalization ratio looks at the long-term debt financing that a company uses:
While short-term solvency is obviously important, the long-term aspects are relevant for long-term debt/investment considerations.
While the preceding measures of the extent to which a company uses debt to finance its assets are important, what is probably of more concern is the ability of the company to service its debt. The following ratios look at the ability of the company to make debt service payments to its creditors. The most common of these, particularly when only the financial statements are available, is the Times Interest Earned ratio:
More important to many lenders is the ability of the company to not only make interest payments, but also to repay the principal of the loan. The Debt Service Coverage Ratio considers both interest and principal payments that are required. Note that the principal portion is “grossed up” to account for tax considerations. Why?
Finally, it is common for lenders (such as banks) to look more toward the cash flow coverage of debt payments that a company can make. For this reason, the Operating Income (EBIT) has the non-cash charges of Depreciation and Amortization added back (just like they are in the Operating Cash Flow section of the Statement of Cash Flows).
Asset Management (Utilization) Ratios:
Asset utilization ratios are designed to give insight into how effectively a company is managing its assets. For many firms, inventories are its largest category of assets. Why is it bad to have too much inventory? Why is it bad to have too little? One way to look at the amount of assets that a firm holds in relation to its level of sales is the inventory turnover ratio:
The inventory turnover ratio can, alternatively, be stated as the Average Age of Inventory; i.e., how long on average does an inventory item sit in the warehouse before it is sold:
The second major category, at least of current assets, for most firms is the amount of money that is tied-up in Accounts Receivable. The Average Collection Period (or Days’ Sales Outstanding) tells you how long, on average, it takes for a firm to collect the money due on a sale made on credit:
The final major category of assets, particularly manufacturing firms, is that of Property, Plant & Equipment, or Fixed Assets. The Fixed Asset Turnover ratio looks at the amount of productive equipment that a firm has relative to the amount of sales that it is generating. In one sense, this could be interpreted as a measure of the amount of capacity utilization that a firm has. What problems do you see with this measure?
A final measure looks at all of the firm’s investment in assets relative to its sales level. This is the Total Asset Turnover ratio:
Profitability Ratios
One of the best measures for evaluating management lies in their ability to control costs. Thus, profit margins are an important means of assessing this ability:
Another important factor has to do with the amount of profit being made relative to the investment in assets that support the operations and sales. Note that this ratio can be decomposed into the Net Profit Margin and the Total Asset Turnover. This has two important implications: First, it illustrates that there are two ways to make money – have a high profit margin and a low turnover rate, or a low profit margin and a high turnover rate. Secondly, it provides us a means by which to determine where problems, or strengths, reside. If the net ROA is low, is it because we are not controlling costs (in which case, is it in production, selling and administrative, or financing costs), or is it because we have too many assets relative to sales (such as too much inventory, too long a collection period, too many unutilized fixed assets). This approach to locating the source(s) of the problems is known as the DuPont method of analysis. Your textbook gives you an example of its implementation.
Finally, equity investors are concerned with the rate of return that is being generated on their investment in the company.
Market Ratios
The last group of ratios is designed to look at market-related measures of performance:
Another Liquidity Measure
One problem with the Current and Quick Ratios as measures of liquidity is the fact that they are predicated upon the liquidation of the current assets of the firm in order to satisfy the short-term liabilities. Generally, however, one is not interested in liquidating a firm in order to cover its short-term obligations (except in extreme cases). For this reason, the cash cycle is often looked at in order to see the extent to which the ongoing operations of the firm cover short-term requirements (primarily in the area of accruals and payables). In order to calculate the cash cycle, we need to look at a measure of the short-term liability encompassed by the trade credit that our supplier provide to us:
The cash cycle looks at how long a company has money tied-up in its operations. Money is invested in inventories, which sit in the warehouse for a certain period of time and then are sold on credit which takes so-long to collect; but this length of time (known as the operating cycle) is reduced by the fact that our suppliers do not require immediate payment for the inventories that we purchase.
While a short cash cycle is considered to be an efficient use of money, what are the dangers of having:
- A low average age of inventory
- A short average collection period
- A long average payables period
The firm’s cash cycle is looking at how long, and hence, how much, cash is tied up. Decreasing the cash cycle decreases the amount of cash investment is required. As will be seen when working capital is addressed, cash can be free-up by accelerating inflows (shortening the average collection period) or delaying outflows (stretching out the average payables period) as well as by liquidating assets such as inventory (and increasing inventory turnover which is the same as decreasing the average age of inventory).
Industry Averages :
Industry averages are often used for comparison purposes. The two most popular sources of industry averages are RMA’s Annual Statement Studies and Dun & Bradstreet’s Key Business Ratios. RMA is an association of banks that pool loan data and Dun & Bradstreet is the well-known credit rating agency. Industry averages can also be obtained from Standard & Poor’s and Moody’s, the two premier bond rating agencies.
