ac315 chapter 5 lecture

8/8/2019 Ac315 Chapter 5 Lecture

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CHAPTER 5

ESSENTIALS OF FINANCIAL

STATEMENT ANALYSIS


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Roadmap

Two concepts

Cross-sectional vs. Time-series

Common-size vs. Trend Statement

Profitability analysis

Credit risk analysis

Return on equity and financial leverage

analysis


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Basic ApproachesBasic Approaches

A. Time-series analysis helps identifyfinancial trends over time for a single

company or business unit.

B. Cross-sectional analysis helps identifysimilarities and differences across

companies or business units at a singlemoment in time.


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Common sizeand trend

statements 1. Common size income statements recast

each statement item as a percentage of sales

for that period.

2. Trend statements recast each statement

item as a percentage of that item in a base

year.


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Profitability, Competition, and

Business Strategy

A. Financial ratios are another

powerful tool that analysts use in

evaluating profit performance and

assessing credit risk.


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Business StrategyMost evaluations of profit

performancebegin with the return on

assets (ROA) ratio.

ROA = NOPAT/Average Assets

1. A companys sustainable operatingprofits are isolated by removingnonoperating or nonrecurring items fromreported earnings.


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Profitability, Competition, andBusiness Strategy

2. After-tax interest expense is eliminatedfrom the profit calculation so that operatingprofitability comparisons over time are notclouded by differences in financial structure.

3. Adjustments to eliminate distortions to bothearnings & assets for items such as off-balancesheet operating leases.


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Business Strategy

A company can increase its ROA intwo different ways:

1. By increasing the operating profitmargin.

2. By increasing the intensity of assetutilization.


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Business Strategy In other words, ROA can be thought of as:

a. Oper. profit margin v asset turnover ,or

b. NOPAT/SALES X SALES/AVG. ASSETS


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Credit Riskand CapitalCredit Riskand Capital

StructureStructureA. Credit riskrefers to theability and

willingness ofaborrower to pay its debt. 1. Ability to repay debt is determined by capacity

to generate cash from operations, asset sales, orexternal financial markets in excess of cash needs.

2. Willingness to pay depends on whichcompeting cash need is viewed as the most

pressing at the moment.

3. The statement of cash flows is an importantsource of information for analyzing a companyscredit risk. Financial ratios are also useful for this

purpose.


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StructureStructureB. Credit riskanalysisusing financialratios typically involvesan assessment of

liquidity and solvency.

1. Liquidity refers to the companys short-term ability to generate cash for workingcapital needs and immediate debt repaymentneeds.

2. Solvency refers to the long-term ability togenerate cash internally or from externalsources in order to satisfy plant capacityneeds, fuel growth, and repay debt when due.


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StructureStructureShort-term liquidity:

Current Ratio = CA/CL

reflects cash as well as amounts that will be

converted into cash in the normal

operating cycle.


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Inventory is eliminated, providing a moreshort-run reflection of liquidity, since fewbusinesses can instantaneously converttheir inventories into cash.



QuickRatio = (CA-INV)/CL


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A/R Turnover = Net Sales / Avg. A/R

This ratio tells users the proportion of yearlysales that the average receivables balance

represents. This ratio will be correspondinglylarger for firms with cash sales that are alarger proportion of total sales.


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Credit Riskand Capital StructureCredit Riskand Capital StructureShort-term liquidity:

Days Receivable Out. = 365 A/R Turnover

This ratio tells users the average collection

period for accounts receivable. This shouldbe compared to the credit period allowed bythe company.


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Inventory Turnover Ratio = COGS / AVG.INV.

This ratio tells users the proportion of sales that

the average inventory balance represents. Ahigher ratio may indicate:i. More efficient operations, orii. Adoption of a low-cost leadership

strategy.


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Days Inventory Held = 365Days

INV. TURNOVER

This ratio tells users the average number of

days that inventory is held in storage.


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A/P Turnover = Inventory PurchasesAvg. A/P.

This ratio, and its counterpart that follows, helpsanalysts understand the companys pattern ofpayment to suppliers.


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Credit Riskand Capital StructureCredit Riskand Capital Structure

Short-term liquidity:

Days A/P Outstanding = 365 days

A/P Turnover


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Short-term liquidity:

+ days receivable outstanding

+ days inventory held

- days accounts payable outstanding

Differenceto get a measure of the mismatching of cash inflows

and outflows. The level of concern is negativelycorrelated with the level of operating cash flow.


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Long-term solvency:

1. Debt ratios provide information about

the amount of long-term debt in a

companys financial structure.


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Long-term solvency:

2. L-Term Debt to Assets = Long-Term Debt

Total Assets

reflects the proportion of each asset dollar

financed with long-term debt.


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Long-term solvency:

3. L-T Debt to

Tangible Assets = L-T Debt

Total Tangible Assets

The adjustment to remove intangible assets is

intended to remove soft assets, i.e., those

that are difficult to value reliably.


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Long-term solvency:

4. Interest Coverage = Operating Incomebefore taxes &Int. Exp

Interest Expense

While debt ratios are useful for understanding thefinancial structure of a company, they provide no

information about its ability to generate a stream ofinflows sufficient to make principal and interestpayments. The interest coverage ratio iscommonly used for this purpose.


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Long-term solvency: 5. Operating Cash

Flows to Total Liabilities = CFOPAAvg. CL +L-T

Debt

This ratio shows the ability of a company togenerate cash flows from operations in order to

service both short-term and long-termborrowings.


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Return on Equity andReturn on Equity and

Financial LeverageFinancial Leverage A. Profitability and credit risk

both influence the return that

common shareholders earn on theirinvestment in the company.


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Return on Equity and

Financial Leverage

B. Return on C/E (ROCE) =

NI available to Common ShareholdersAvg. Common SE

This ratio measures a companys

performance in using capital provided byshareholders to generate earnings.


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Return on Equity and Financial

LeverageC. Components of ROCE:

1.ROCE = ROAv common earnings leverage v financialstructure leverage

or


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Return on Equity and Financial

LeverageC. Components of ROCE:

2. ROCE =NOPAT X NI AVAIL. TO COMMON X AVG. ASSETS

AVG. ASSETS NOPAT AVG. COMMONSE

a. The common earnings leverage ratio showsthe proportion of NOPAT that belongs to common

shareholders.b. The financial structure leverage ratiomeasures the degree to which the company usescommon shareholders capital to finance assets.


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Roadmap

Two concepts

Cross-sectional vs. Time-series

Common-size vs. Trend Statement

Profitability analysis

Credit risk analysis

Return on equity and financial leverage

analysis

ac315 chapter 5 lecture

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