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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,#,Lecture Presentation Software,to accompany,Investment Analysis and Portfolio Management,Seventh Editionby,Frank K. Reilly & Keith C. Brown,Chapter 10,Chapter 10AnalysisofFinancialStatements,Questionstobeanswered,:,:,What arethemajorfinancial statementsprovidedbyfirmsand whatspecificinformationdoeseach of themcontain?,Whydoweuse financialratiostoexaminetheperformanceofafirm andwhyisitimportant to examineperformancerelativetothe economyand afirms industry?,Chapter 10AnalysisofFinancialStatements,What arethemajorcategoriesforfinancial ratiosandwhatquestionsare answered by theratiosinthesecategories?,What specific ratioshelp determinea firm,sinternalliquidity, operatingperformance,riskprofile,growthpotential,andexternalliquidity?,Howcan theDuPontanalysishelpevaluatea firm,sreturnonequity overtime?,Chapter 10AnalysisofFinancialStatements,What aresome of themajordifferencesbetween U,.,.S.and non-U.S,.,. financialstatements andhowdothesedifferencesaffect thefinancialratios?,What is a,“,“quality,”,” balancesheetorincome statement?,Whyisfinancial statementanalysisdone if marketsare efficientandforward-looking?,Chapter 10AnalysisofFinancialStatements,What major financialratioshelpanalystsinthefollowing areas:stockvaluation, estimatingand evaluatingsystematicrisk,predicting thecreditratingsonbonds,and predictingbankruptcy?,MajorFinancialStatements,Corporateshareholderannual andquarterlyreportsmustinclude,MajorFinancialStatements,Corporateshareholderannual andquarterlyreportsmustinclude,Balance sheet,MajorFinancialStatements,Corporateshareholderannual andquarterlyreportsmustinclude,Balance sheet,Incomestatement,MajorFinancialStatements,Corporateshareholderannual andquarterlyreportsmustinclude,Balance sheet,Incomestatement,Statementofcashflows,MajorFinancialStatements,Corporateshareholderannual andquarterlyreportsmustinclude,Balance sheet,Incomestatement,Statementofcashflows,Reports filed withSecuritiesandExchangeCommission,(,(SEC),MajorFinancialStatements,Corporateshareholderannual andquarterlyreportsmustinclude,Balance sheet,Incomestatement,Statementofcashflows,Reports filed withSecuritiesandExchangeCommission,(,(SEC),10-K and10-Q,GenerallyAcceptedAccountingPrinciples,(GAAP),Formulated by theFinancialAccountingStandardsBoard,(,(FASB,),),Providessome choicesofaccountingprinciples,Financialstatementsfootnotesmustdisclosewhichaccounting principlesare usedbythe firm,Balance Sheet,Showsresources,(,(assets)ofthe firmand howithasfinancedtheseresources,Indicatescurrentandfixedassets availableata point in time,Financingisindicated by itsmixture of currentliabilities, long,-,-termliabilities,and ownersequity,IncomeStatement,Containsinformationontheprofitabilityofthefirmduringsomeperiodoftime,Indicatesthe flowofsales, expenses,andearningsduring thetime period,StatementofCashFlows,Integrates theinformationonthebalancesheetandincome statement,Showstheeffectsonthefirms cashflowofincomeflowsand changesinvariousitemsonthebalancesheet,StatementofCashFlows,Ithasthreesections,:,:,Cash FlowfromOperatingActivities thesources anduses of cashthatarisefrom thenormaloperationsofa firm,Cash FlowfromInvestingactivities changeingrossplantandequipment plusthe changeintheinvestmentaccount,Cash FlowfromFinancingactivities financingsources minus financinguses,AlternativeMeasuresofCash Flow,Cash flowfromoperations,Traditionalcash flowequals netincomeplusdepreciationexpenseanddeferredtaxes,Also adjustforchangesinoperatingassets andliabilitiesthat useorprovide cash,Free cashflowrecognizes thatsomeinvestingand financingactivities arecriticaltoongoing successofthe firm,Capital expendituresanddividends,Purpose ofFinancialStatement Analysis,Evaluatemanagement performance in three areas:,Profitability,Efficiency,Risk,AnalysisofFinancialRatios,Ratiosare moreinformativethatrawnumbers,Ratiosprovidemeaningful relationshipsbetweenindividual valuesinthefinancial statements,Importance ofRelativeFinancialRatios,Compare to other entities,Examine afirms performance relative to:,Theaggregate economy,Itsindustryorindustries,Itsmajorcompetitorswithin theindustry,Itspastperformance,(,(time-seriesanalysis,),),ComparingtoTheAggregateEconomy,Most firms areinfluenced by economic expansionsand contractionsinthebusinesscycle,Analysishelpsyouestimatethe futureperformanceofthefirmduringsubsequentbusinesscycles,ComparingtoAFirms Industry,Most popularcomparison,Industries affectthefirmswithin themdifferently, buttherelationship is alwayssignificant,Theindustryeffect is strongestforindustrieswith homogenousproducts,Examine theindustrys performance relative to aggregateeconomicactivity,ComparingtoAFirms Major Competitors,Industryaveragesmaynot be representative,Selectasubsetofcompetitorstocomparetousingcross-sectionalanalysis, or,Constructacompositeindustryaveragefrom industriesthe firmoperatesin,ComparingtoAFirms HistoricalPerformance,Determinewhetheritisprogressingordeclining,Helpful forestimating futureperformance,Considertrendsaswellasaveragesover time,Five CategoriesofFinancial Ratios,1.Internalliquidity,(,(solvency),2.Operatingperformance,a.Operatingefficiency,b.Operatingprofitability,3.Risk analysis,a.Businessrisk,b.Financialrisk,SixCategoriesofFinancialRatios,4.Growthanalysis,SixCategoriesofFinancialRatios,5.Externalliquidity,(,(marketability,),),CommonSizeStatements,Normalizebalancesheetsand incomestatementitemstoalloweasier comparisonofdifferent sizefirms,A commonsize balancesheetexpresses accounts as apercentageoftotalassets,A commonsize incomestatementexpresses allitemsasa percentageofsales,Evaluating Internal Liquidity,Internalliquidity,(,(solvency)ratiosindicatethe abilitytomeetfutureshort,-,-termfinancialobligations,Current Ratio examines currentassets andcurrent liabilities,Evaluating Internal Liquidity,QuickRatioadjusts currentassets by removing lessliquid assets,Evaluating Internal Liquidity,Cash Ratio is themost conservativeliquidityratio,Evaluating Internal Liquidity,Receivablesturnoverexaminesthequalityofaccountsreceivable,Receivablesturnovercanbeconverted intoanaveragecollection period,Evaluating Internal Liquidity,Inventoryturnoverrelatesinventorytosalesorcostofgoodssold (CGS,),),Giventheturnovervalues,youcan computethe averageinventory processingtime,Average InventoryProcessing Period,=,= 365/AnnualTurnover,Evaluating Internal Liquidity,Cash conversioncyclecombinesinformationfromthereceivablesturnover, inventoryturnover,and accounts payableturnover,Receivable Days,+Inventory ProcessingDays,-PayablesPaymentPeriod,Cash ConversionCycle,Evaluating OperatingPerformance,Ratiosthatmeasure howwell managementisoperating abusiness,(1)Operating efficiencyratios,Examine howthemanagementuses itsassetsand capital, measured in terms of sales dollarsgenerated by asset or capitalcategories,(2)Operating profitabilityratios,Analyze profitsasapercentage of sales andasa percentageofthe assetsandcapitalemployed,OperatingEfficiencyRatios,Totalassetturnoverratioindicatesthe effectivenessofafirmsuse of itstotalassetbase (netassets equalsgrossassetsminusdepreciation on fixed assets),OperatingEfficiencyRatios,Netfixedassetturnoverreflectsutilizationoffixedassets,OperatingProfitabilityRatios,Operatingprofitabilityratiosmeasure,1.Therateofprofitonsales,(,(profitmargin,),),2.Thepercentagereturnoncapital,OperatingProfitabilityRatios,Grossprofitmargin measures therate of profitonsales,(,(grossprofit equalsnetsalesminusthe costofgoodssold),OperatingProfitabilityRatios,Operatingprofit marginmeasurestherateofprofitonsalesafteroperating expenses (operatingprofit is gross profitminussales,generalandadministrative,(,(SG +A)expenses,),),OperatingProfitabilityRatios,Netprofit marginrelates netincometosales,OperatingProfitabilityRatios,Returnontotalcapitalrelates thefirmsearningstoall capitalinthe enterprise,OperatingProfitabilityRatios,Returnonowner,sequity,(,(ROE)indicates therate of returnearnedonthe capitalprovidedbythe stockholdersafterpayingfor allothercapital used,OperatingProfitabilityRatios,Returnonowner,sequity,(,(ROE)can be computed forthecommon-shareholders equity,OperatingProfitabilityRatios,TheDuPont Systemdivides theratiointo severalcomponentsthat provideinsightsintothecauses of afirms ROEandany changesinit,OperatingProfitabilityRatios,Profit Total Asset Financial,Margin Turnover Leverage,=,x,x,OperatingProfitabilityRatios,AnextendedDuPontSystem provides additionalinsightsintotheeffect of financialleverageonthefirmandpinpoints theeffectofincome taxes on ROE,OperatingProfitabilityRatios,AnextendedDuPontSystem provides additionalinsightsintotheeffect of financialleverageonthefirmandpinpoints theeffectofincome taxes on ROE,Webeginwith theoperatingprofit margin,(,(EBITdivided by sales)andintroduce additionalratios to deriveanROEvalue,OperatingProfitabilityRatios,OperatingProfitabilityRatios,This is theoperatingprofit returnontotalassets,.,.Toconsiderthenegativeeffectsoffinancialleverage, we examinethe effectofinterestexpense as apercentageoftotalassets,OperatingProfitabilityRatios,OperatingProfitabilityRatios,Weconsiderthepositiveeffect of financialleveragewith thefinancialleveragemultiplier,OperatingProfitabilityRatios,OperatingProfitabilityRatios,This indicatesthepretax returnonequity,.,.ToarriveatROE we mustconsiderthe taxrate effect.,OperatingProfitabilityRatios,OperatingProfitabilityRatios,Insummary,wehave thefollowingfivecomponents of returnonequity,(,(ROE),OperatingProfitabilityRatios,OperatingProfitabilityRatios,OperatingProfitabilityRatios,OperatingProfitabilityRatios,OperatingProfitabilityRatios,Risk Analysis,Risk analysis examines theuncertaintyofincomeflowsfor thetotalfirm andforthe individualsourcesofcapital,Debt,Preferredstock,Commonstock,Risk Analysis,Totalrisk of afirmhastwo components,:,:,Businessrisk,Theuncertaintyofincome causedbythefirms industry,Generallymeasuredbythe variability of thefirmsoperating incomeover time,Financialrisk,Additional uncertainty of returnstoequity holdersdue to afirms useoffixedobligation debtsecurities,Theacceptableleveloffinancialriskforafirm dependsonits business risk,BusinessRisk,Variabilityofthefirms operatingincomeovertime,BusinessRisk,Variabilityofthefirms operatingincomeovertime,Standarddeviationofthe historicaloperating earnings series,BusinessRisk,Twofactorscontribute to thevariabilityofoperatingearnings,Salesvariability,Earningsmust be as volatile as sales,Some industriesare cyclical,Operatingleverage,Production hasfixedandvariablecosts,Fixedproduction costs cause profitvolatility withchangesinsales,Fixedproduction costs areoperatingleverage,FinancialRisk,Bondsinterestpaymentscome beforeearningsareavailable to stockholders,Thesearefixedobligations,Similar to fixed productioncosts, these leadtolarger earnings duringgood times,andlowerearningsduring abusinessdecline,This debtfinancing increasesthefinancial riskand possibility of default,FinancialRisk,Twosetsoffinancialratios helpmeasurefinancialrisk,Balance sheet ratios,Earningsorcash flowavailable to payfixedfinancialcharges,Acceptable levelsoffinancialriskdependonbusinessrisk,FinancialRisk,Proportion of debt,(,(balancesheet,),) ratios,FinancialRisk,Proportion of debt,(,(balancesheet,),) ratios,FinancialRisk,Proportion of debt,(,(balancesheet,),) ratios,This maybecomputedwith andwithout deferred taxes,FinancialRisk,Long-termdebt/totalcapital ratio indicatestheproportionoflong-termcapitalderived fromlong-term debtcapital,FinancialRisk,Long-termdebt/totalcapital ratio indicatestheproportionoflong-termcapitalderived fromlong-term debtcapital,FinancialRisk,Totaldebt ratioscompare total debt,(,(currentliabilitiespluslong-termliabilities,),) to total capital,(,(total debtplustotalequity,),),FinancialRisk,Totaldebt ratioscompare total debt,(,(currentliabilitiespluslong-termliabilities,),) to total capital,(,(total debtplustotalequity,),),FinancialRisk,EarningsorCash FlowRatios,Relatethe flowofearnings,Cash availabletomeet thepayments,Higherratiomeanslowerrisk,FinancialRisk,InterestCoverage,FinancialRisk,InterestCoverage,FinancialRisk,InterestCoverage,FinancialRisk,Firmsmayalsohave non-interestfixedpaymentsduefor lease obligations,Theriskeffectissimilartobond risk,Bond-ratingagenciestypicallyadd 1,/,/3leasepaymentsastheinterestcomponent of theleaseobligations,FinancialRisk,Totalfixedchargecoverageincludesany noncancellable lease payments andanypreferred dividendspaid outofearningsaftertaxes,FinancialRisk,Totalfixedchargecoverageincludesany noncancellable lease payments andanypreferred dividendspaid outofearningsaftertaxes,FinancialRisk,Cash flowratios relatetheflowofcash availablefrom operationstoeither interest expense, total fixed charges, or theface value of outstanding debt,FinancialRisk,FinancialRisk,FinancialRisk,ExternalMarketLiquidity,MarketLiquidity is theability to buyorsell an asset quicklywithlittlepricechange fromapriortransactionassumingnonewinformation,Externalmarketliquidity is asource of risktoinvestors,ExternalMarketLiquidity,DeterminantsofMarket Liquidity,Thedollar value of sharestraded,This canbeestimatedfromthetotalmarket value of outstanding securities,Itwill be affected by thenumberofsecurityowners,Numerousbuyersand sellersprovideliquidity,ExternalMarketLiquidity,Trading turnover (percentage of outstanding sharestradedduring aperiod of time,),),ExternalMarketLiquidity,A measureofmarket liquidityisthebid-askspread,AnalysisofGrowthPotential,Creditorsare interestedinthe firm,sability to payfutureobligations,Valueofa firmdependsonitsfuture growthinearningsanddividends,DeterminantsofGrowth,Resourcesretainedand reinvestedinthe entity,Rate of returnearnedonthe resourcesretained,= RR xROE,where:,g =potential growthrate,RR,=,= theretentionrateofearnings,ROE,=,=thefirms returnonequity,DeterminantsofGrowth,ROEisafunctionof,Netprofit margin,Totalassetturnover,Financialleverage,(,(total assets/equity,),),ComparativeAnalysisofRatios,Internalliquidity,Current ratio,quickratio,and cashratio,Operatingperformance,Efficiency ratiosandprofitabilityratios,Financialrisk,Growthanalysis,AnalysisofNon-U,.,.S.Financial Statements,Statementformatswill be different,Differencesinaccounting principles,Ratioanalysiswill reflectlocalaccountingpractices,TheQualityofFinancialStatements,Reflect realityrather thanuse accountingtricks or one-time adjustments to makethings lookbetter thantheyare,TheQualityofFinancialStatements,High-qualitybalancesheetstypically have,Conservativeuse of debt,Assetswithmarketvaluegreaterthan book,Noliabilitiesoffthe balancesheet,TheQualityofFinancialStatements,High-qualityincome statementsreflectrepeatable earnings,Gainsfrom nonrecurringitemsshouldbeignoredwhen examiningearnings,High-qualityearningsresult fromthe useofconservativeaccountingprinciples thatdonot overstaterevenuesorunderstate costs,TheValueofFinancialStatementAnalysis,Financialstatements,bytheirnature,arebackward,-,-looking,Anefficientmarket willhavealready incorporatedthesepast resultsintosecurityprices, so whyanalyze thestatements?,Analysisprovidesknowledgeofafirmsoperating andfinancialstructure,This aidsinestimatingfuturereturns,SpecificUses of FinancialRatios,1.Stockvaluation,2.Identificationofcorporatevariables affectinga stockssystematicrisk (beta),3.Assigningcredit qualityratingsonbonds,4.Predicting insolvency,(,(bankruptcy,),) of firms,StockValuationModels,Valuationmodels attempttoderive avaluebasedupononeofseveralcash floworrelativevaluation models,Allvaluation modelsareinfluencedby:,Expectedgrowthrateofearnings,cashflows,or dividends,Requiredrate of returnonthestock,Financialratios canhelp in estimatingthesecriticalinputs,StockValuationModels,FinancialRatios,1.Average debt,/,/equity,2.Average interest coverage,3.Average dividend payout,4.Average returnonequity,5.Average retentionrate,6.Average marketpricetobook value,7.Average marketpricetocash flow,8.Average marketpricetosales,StockValuationModels,VariabilityMeasures,1.Coefficientofvariationofoperating earnings,2.Coefficientofvariationofsales,3.Coefficientofvariationofnet income,4.Systematic risk,(,(beta,),),NonratioVariables,1.Average growthrate of earnings,FinancialRatios andSystematic Risk,FinancialRatios,1.Dividendpayout,2.Totaldebt/total assets,3.Cash flow,/,/totaldebt,4.Interestcoverage,5.Working capital,/,/totalassets,6.Current Ratio,FinancialRatios andSystematic Risk,VariabilityMeasures,1.Varianceofoperatingearnings,2.Coefficientofvariationofoperating earnings,3.Coefficientofvariationofoperating profitmargins,4.Operatingearningsbeta,(,(companyearningsrelated to aggregateearnings),FinancialRatios andSystematic Risk,NonratioVariables,1.Assetsize,2.Marketvalueofstockoutstanding,FinancialRatios andBond Ratings,FinancialRatios,1.Long-termdebt/totalassets,2.Totaldebt/total capital,3.Netincome plusdepreciation (cash flow,),)/longtermseniordebt,4.Cash flow,/,/totaldebt,5.Netincome plusinterest,/,/interestexpense,(,(fixedcharge coverage),6.Cash flow,/,/interestexpense,FinancialRatios andBond Ratings,7.Marketvalueofstock,/,/par value of bonds,8.Netoperating profit/sales,9.Netincome/ownersequity (ROE,),),10.Net income/totalassets,11.Workingcapital/sales,12.Sales,/,/net worth (equityturnover,),),FinancialRatios andBond Ratings,VariabilityRatios,1.Coefficientofvariation,(,(CV)ofnetearnings,2.Coefficientofvariationofreturn on assets,Nonratiovariables,1.Subordination of theissue,2.Size of thefirm (totalassets,),),3.Issuesize,4.Parvalueofall publicly tradedbondsofthefirm,FinancialRatios andInsolvency,(,(Bankruptcy),FinancialRatios,1.Cash flow,/,/totaldebt,2.Cash flow,/,/long-term debt,3.Sales/totalassets,4.Netincome/total assets,5.EBIT/total assets,6.Totaldebt/total assets,FinancialRatios andInsolvency,(,(Bankruptcy),7.Marketvalueofstock,/,/bookvalueofdebt,8.Working capital,/,/totalassets,9.Retainedearnings/totalassets,10.Currentratio,11.Cash/current liabilities,12.Workingcapital/sales,LimitationsofFinancialRatios,Accounting treatmentsmay varyamongfirms, especiallyamongnon-U,.,.S.firms,Firmsmayhavehave divisionsoperatingindifferent industriesmaking it difficulttoderiveindustryratios,Results maynotbeconsistent,Ratiosoutsideanindustryrangemaybecausefor concern,TheInternetInvestmentsOnline,EndofChapter12,AnalysisofFinancialStatements,FuturetopicsChapter 11,SecurityValuationProcess,TheoryofValuation,ValuationofAlternativeInvestments,Estimating theRequiredRate of ReturnandExpectedGrowth Rates,
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