Financial Statement Analysis

Firm’s Disclosure of Financial Information

Financial Statements

• Accounting reports issued periodically to present past performance information and a snapshot of the firm’s assets and the financing of those assets

Generally Accepted Accounting Principle (GAAP)

• Provide a framework including a common set of rules and a standard format for public companies to use when they prepare their financial reports.

International Financial Reporting Standards

• Canada follows
• Most places follow except for US and Japan

Statement of Financial Position or Balance Sheet

Provides a snapshot of the firm’s financial position at a give point in time

Assets

• Cash, inventory, property, plant and equipment, and any other investments the company made

Current Assets

• Cash and other marketable securities
  • Short-term, low-risk investments
  • Easily sold and converted to cash
• Accounts Receivable
  • Amounts owed to a firm by customers who have purchased goods or services on credit
• Inventories
  • Raw materials, work in progress, and finished goods
• Other
  • Items such as prepaid expenses

Long Term Assets

• Assets that produce tangible benefits for more than one year
• Reduced through a yearly deduction called depreciation according to a schedule that depends on an asset’s life span

Liabilities

• Show the firm’s obligations to its creditors

Current Liabilities

Liabilities that will be satisfied within one year

• Accounts Payable
  • Amounts owed to suppliers for purchases with credit
• Notes payable and short-term debt
  • Loans that must be repaid in the next year
  • Repayment of long-term debt that will occur within the next year
• Accrual items
  • Items such as salary or taxes that are owed but have not yet been paid, and deferred or unearned revenue

Long-term Liabilities

Liabilities that will extend beyond one year

• Long term debt
  • A loan or debt obligation maturing of more than a year

Shareholder’s Equity

• Accounting measure of a firm’s net worth that represents the difference between the firm’s assets and its liabilities

Book value of equity (Liquidation Value)

• Net worth of the firm from an accounting perspective
• Assets - Liabilities = Equity
• Inaccurate assessment of the actual value of the firm’s equity

Market Capitalization

• Market price per share $\times$ number of s hares
• Does not depend on historical cost of assets

Market-to-Book Ratio

The ratio of a firm’s market capitalization to the book value of stockholders’ equity

• AKA Price-to-Book ratio

Statement of Cash Flows

Divided into three sections which correspond to the three major jobs of the financial manager

• Operating activities
• Investment activities
• Financing activities

Operating Activity

• Accounts receivable:
  • When a sale is recorded, but the cash has not yet been received, A/R must be deducted from net income
  • Represents increased lending and reduces available cash
• Accounts payable:
  • Increase borrowing, more cash available
• Inventory:
  • Increases to inventory are not recorded as a expense and do not contribute to net income
  • The cost of increasing inventory is a cash expense and must be deducted

Investment Activity

• Subtract the actual capital expenditure that the firm made
• Deduct other assets purchased or investments made by the firm, such as acquisitions

Financing Activity

• Dividends paid
• Cash received from sale of stock or spent repurchasing stock
• Changes to short-term and long-term borrowing

Income Statement Analysis

Profitability Ratios

Gross Margin

• Ratio of gross profit to revenues (sales)

Operating Margin

• How much a company earns before interest and taxes from each dollar of sales before interest and taxes are deducted

Net Profit Margin

• Fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses

Liquidity Ratios

Current Ratio

• Current assets / Current liabilities

Quick Ratio (acid-test ratio)

• better to use than current ratio as a measure of liquidity when firm cannot easily liquidate inventory
  • (current assets - inventory) / Current liabilities

Asset Efficiency

Asset Turnover

• Broad measure of efficiency
  • $\frac{\text{Sales}}{\text{Total Assets}}$
• Fixed asset turnover
  • $\frac{\text{Sales}}{\text{Fixed Assets}}$

Working Capital Ratios

Accounts Receivable Days

• Firm’s accounts receivable in terms of the number of days’ worth of sales that it represents

Inventory Days / Inventory Turnover

• Tells how efficiently a company turns its inventory into sales

Interest Coverage Ratios

Interest Coverage Ratio

• Measure of earnings divided by interest
• Assess how easily the firm will be able to cover its interest payments

Leverage Ratios

Extent to which firm relies on debt as a source of financing

Debt-equity ratio

• Debt / Equity

Debt-to-capital ratio

• Total debt / (total equity + total debt)

Net debt

• Total debt - excess cash & short-term investments

Debt-to-enterprise value ratio

• Net debt / (market value of debt + net debt)
• Net debt / Enterprise value

Equity Multiplier

• Total Assets / Book Value of Equity

Valuation Ratios

Price-earnings Ratio (P/E)

Used to assess whether a stock is over or under valued based on the idea that the value of a stock should be proportional to the earnings it can generate

• Market capitalization / Net income
• Share price / Earnings per share

PEG Ratio

Ratio of a firm’s P/E to its expected earnings growth rate

• Higher the PEG ratio, the higher the price relative to growth

Operating Returns

Return on Equity

Evaluating the firm’s return on investment by comparing its income to its investment

• Net income / Book value of equity

Return on Assets

Evaluating the firm’s return on investment by comparing its income to its assets

• Net income / Total assets

Return on invested capital (ROIC)

• EBIT(1 - tax rate) / (Book value of equity + Net debt)

Sarbanes-Oxly Act (SOX)

Improve the accuracy of financial information

• Requires that CEOs and CFOs certify the accuracy and appropriateness of their firm’s financial statements and increases the penalties against them if the financial statements later prove to be fraudulent