Financial Statement Analysis:

A Story in Numbers

Investment Banking Internship

Objectives

• A. Understand the requirements for your Company Research Project, and know how and where to get company data

• B. Understand the Key Responsibilities of an Analyst in doing Securities Analysis

• C. Identify sources of biases in conventional accounting data

• D. Remember Return on Equity and how to calculate and use standard financial ratios

• E. Understand the types of financial ratios

A. Understand your Company Research Project

Keys to success on this internship• 1. Remember the overall objective

• This is a decision-making class. • Work accordingly

• 2. Start now and keep up with the schedule• Don’t put it off and don’t get behind!

• Work with me, the TAs, and PM students• Get ahead if you can

• 3. Read the PowerPoints and teaching tools• Read before class and ask questions in class!• It will be a good learning experience if you let it!

• You will get out of it what you put in

Questions

• Any questions on this internship project?

B. Key Responsibilities of an Analyst

What are the key responsibilities of an analyst?

1. Understand the company

2. Differentiate between accounting and economic earnings

3. Differentiate between the past and the future

4. Assess the quality of company management

5. Forecast earnings

Responsibilities (continued)

1. Understand the company (like you owned it because you may)!• Financial Statement Analysis helps the

analyst:• Understand how the firm has done in the

past• Help forecast how the firm will do in the

future• It will not tell you to buy or sell a

stock, but it will help you estimate the stock’s value

Responsibilities (continued)

• Tools Used by the Analyst• Publicly available data• Derived data from Financial Statements,

i.e. ratio analysis• Your own knowledge and experience• Interviews with management• Research, competitor analysis, and

common sense• Limitations

Responsibilities (continued)

2. Differentiate between Accounting and Economic Earnings

• Accounting Earnings• Earnings a firm has reported on its income

statement• Affected by accounting conventions regarding

asset valuation, e.g. LIFO, depreciation, etc.• Tells (somewhat) what the firm actually

did. You must know the conventions used to know what they did!!!!!!

Responsibilities (continued)

• Economic Earnings• This is the real cash flow that a firm could pay

out forever in absence of any change in a firms productive capacity

• These are your estimates what a firm could do really do

• You must estimate economic earnings• This is much harder to do

Responsibilities (continued)

3. Differentiate between the past and future earnings and activities

• Accounting earnings are largely concerned over what the firm did in the past

• Is the past indicative of the future?• What has happened recently?

Responsibilities (continued)

• We are concerned with:• What will happen this year in the:

• Company, Industry, World Economy• Technology and the firms products and

suppliers• While Accounting is concerned with the

past, we are concerned with the future—WHAT WILL HAPPEN THIS YEAR AND NEXT!

Responsibilities (continued)

4. Assess the quality of company management• Can you trust them?• Are they competent? • Can they answer your questions?• Do they know what is happening in the world

economy and the industry?• Do you have the confidence in them to run the

company in a way which best advances (your) shareholder value?

Responsibilities (continued)

5. Forecast earnings• Build models to help understand relationships

between finance, marketing, operations, etc. and earnings

• Understand each line item of the financial forecast

• Use public and private data and personal experience to make a line-by-line financial forecast

• Compare forecasts to other analysts as a final check on reasonableness

Responsibilities (continued)

The value of a company is the present value of its future earnings

• Return on Equity is a key determinant of a company’s growth in earnings (the other is its payout ratio)

• Return on Equity must be understood thoroughly!

• It’s a key part of valuation

Questions

• Any questions on the responsibilities of an analyst in doing securities analysis?

Assessment #1

• You are visiting Dell Computer company as a potential candidate for your portfolio. Amazingly, your contact at Dell was a BM410 student from previous years. He has filled our your entire spreadsheet in your format with forecasts, assumptions, and totally written your report for you. You have not yet written up the report and you are in a hurry to get the report out. What is your responsibility as an analyst?

Answer:

• Even though he may have done a wonderful job in analyzing the company and writing it up, it is still your responsibility. You should go over every entry, formula, assumption, and forecast and make it your own. Relying on some else’s knowledge of the company (you need to know it yourself) is not only wrong but can lead to major problems in the future.

C. Sources of Bias in conventional accounting data

• Accounting Differences• Inventory Valuation: FIFO, LIFO• Depreciation: SL, SYD• Treatment of leases, pension costs, allowances

for reserves

• Inflation and interest expense• Inflation accounting

• International Accounting Conventions• Accounting for Currency gains/losses• Reserves, Intangibles, revenue recognition

Sources of Bias (continued)

International Accounting Standards• Use a principle system

US Accounting System• Use a rules based system

D. Understand Ratio Analysis and Return on Equity

• What is ratio analysis?• Process of turning data into information• A way of learning what a company is doing

• What is return on equity?• The ratio of net profits to common equity, or• How much earnings are generated by each dollar of

equity in the firm• The process of understanding firm profitability and

sources of that profit

Return on Equity (continued)

• Why is ROE important?• The factors that affect earnings are the same

factors that affect ROE, including a firm’s:• Taxes• Interest on debt• Profit margin• Asset turnover• Leverage

• ROE helps us understand earnings, and ratios help us understand what affects ROE

Important Notice

• Whenever a financial ratio includes one item from the income statement, which covers a period of time, and the balance sheet, which is a snapshot in time, the practice is to take the average of the beginning and end-of-the-year balance sheet (i.e., add them both and divide by 2).

ROE Decomposition

ROE = Net Profit

Pretax Profit

xx

Pretax Profit

EBITxx

EBIT

Sales

Sales

Assetsxx xx

Assets

Equity

(1) x (2) x (3) x (4) x (5) (1) x (2) x (3) x (4) x (5)

x Margin x Turnover x Leverage Tax

Burden

Interest

Burden

xx

• While there are many important ratios, five are critically important to understanding earnings.

• These five are commonly called the Dupont System by financial analysts

• Memorize and use them!

ROE Decomposition (continued)

1. Tax Burden (Net Profit / Pretax Profit)• A reflection of the government tax code and the

firm’s tax policies• If different than comparable companies, ask

questions to find out why? 2. Interest Burden (Pretax Profit/EBIT or (EBIT

– Interest Expense)/EBIT)• The impact of interest costs on earnings

• The greater the interest burden, the more susceptible the company to shocks in the economy and industry

ROE Decomposition (continued)

3. Operating (EBIT) Margin or ROS (EBIT / Sales)

• The operating profit per dollar of sales• How efficient are they at turning sales into

profits? 4. Asset Turnover (Sales/Assets)

• The efficiency of asset utilization – sales generated by each dollar of assets

• How well can they utilize their assets

ROE Decomposition (continued)

• 5. Leverage (Assets/Equity) or (1 + Debt/Equity)

• The ratio of assets over equity• A reflection of how leveraged the firm is—how

much debt the firm is using

Key Points on ROE Analysis

Variations on a theme• ROA = EBIT/Assets = Operating Margin

(EBIT/Sales) x turnover (Sales/Assets) (3 x 4)• Compound leverage = interest x leverage• ROE = Tax burden x ROA x compound leverage

Relationship between ROE, ROA, and leverage• ROE = (1-tax rate)[ROA + (ROA-Interest rate) *

Debt/Equity]

E. Types of Financial Ratios

• Note:• My purpose is not to review what you learned in

previous classes—I expect you to already know that material. It is your responsibility to know the rest of the ratios and at least have read about the new ratio’s in the Apple Example from the TT05 – Financial Ratios Reviewed.

Types of Financial Ratios (continued)

• Liquidity Ratios• Strengths and weakness of the firms short-term financial

position• Activity or Mgmt Efficiency Ratios

• Managements ability to manage assets profitably• Leverage Ratios

• Managements ability to use debt profitably• Profitability Ratios

• Managements ability to generate earnings for the shareholders• Market Price Ratios

• Indications of firm value versus accounting or economic earnings

Liquidity Ratios

• Current Ratio• A measure of the firms ability to pay off current

liabilities by liquidating current assets, to avoid insolvency in the short-term (the larger the better)

Current AssetsCurrent Liabilities

• Quick Ratio• Similar to above, but only includes cash and

receivables, as some inventory may not be readily convertible into cash (the larger the better)

Current Assets - InventoryCurrent Liabilities

Activity or Management Efficiency Ratios

• Inventory Turnover• How often the inventory turns over each year (the

more it turns over generally, the higher the earnings)

Sales or Cost of Goods Sold

Inventory• Total Asset Turnover

• The ability of a company to minimize the level of assets to support its level of sales (the greater the number the better)

Sales

Total Assets

Activity or Management Efficiency Ratios (continued)

• Average Collection Period• How many days it takes to receive payment

from customers (the fewer days the better)Accounts Receivable Sales Per Day

• Days to Sell Inventory• How many days it takes to sell current

inventory (the fewer the days the better)Inventory

Sales Per Day

Leverage Ratios

• Times Interest Earned (interest coverage ratio)• How many times interest expense can be covered

by current earnings (the more times the better)Earnings Before Int. & Taxes

Interest Expense• Fixed Charge Coverage Ratios

• How many times various fixed payments can be made on current earnings (the greater the ratio of earning to fixed payments, the better)

• Lease Payments• Principal Repayments• Preferred Dividends

Leverage Ratios (continued)

• Debt to Assets• What percentage of your assets is represented by

debt (the higher the debt, the more risky the firm)

Long Term Debt

Assets• Debt to Equity

• What percentage of owners equity is your debt (the higher the debt, the more risky the firm)

Long Term Debt

Shareholders Equity

Profitability Ratios

• Net Profit Margin• Percent of profit for each dollar of sales (the

higher the better)Net Income Sales

• Return on Assets• Percent of income for each dollar of assets (the

higher the better) Net IncomeTotal Assets

Profitability Ratios (continued)

• Return on Equity• Percentage of return from each dollar of common

equity (the higher the better)

Net Income

Common Equity• Operating Margin After Depreciation

• Percentage of return from each dollar of sales (the higher the better)

Operating Profit

Sales

Market Price Ratios

• Price to Earnings• A firms market capitalization divided by earnings or Price

per share / Earnings per share (diluted). It is the price you are paying for each dollar of earnings (the lower the better)

Market Price of Stock

Earnings per share diluted • Price to Book (Market-to-Book-Value)

• A firms market capitalization divided by owners equity (PxS/BVpsxS). It is the price you are paying for each dollar of equity (the lower the better)

Market Price of Stock

Book Value Per Share diluted

Questions

Any Questions on Types of Financial Ratios?

Review Problems

1. Key Financial Ratios for Growth IndustriesYear ROE TB IB M AT Lev CLF ROA PE PB

2001 7.5% .6 .65 30% .30 2.12 1.4 9% 8 .6

2002 6.1% .6 .47 30% .30 2.38 1.1 9% 6 .4

2003 3.0% .6 .20 30% .30 2.72 .6 9% 4 .1

Indus 8.6% .6 .80 30% .40 1.50 1.2 12% 8 .7

TB = Tax burden: net profit/Pre-tax profit, IB = interest burden: pretax profit/EBIT, M = margin: EBIT/Sales, AT = asset turnover: sales/assets, Lev = leverage: assets/equity, CLF = compound leverage factor: IB*Lev

The CEO stated sales, assets and operating income are all growing at 20% per year. 2003 was another great year! What do you think?

Review Problems (continued)

• ROE• Declining. Compared to the industry, it looks

particularly bad.• PE / PB

• Low and falling. Investors are not looking positively towards the firm’s future

• ROA• Constant. Must mean an inappropriate use of

financial leverage

Review Problems (continued)

2004 2005 2006Cash Flow from operating activities

Net income $11,700 $10,143 $ 5,285+ Depreciation 15,000 18,000 21,600+ Decr. (incr.) in AR (5,000) (6,000) (7,200)+ Decr. (incr.) in inventories (15,000) (18,000) (21,600)+ Incr. in Accounts Payable 6,000 7,200 8,640

Cash flow from investing activitiesInvestment in PP&E (45,000) (54,000) (64,800)

Cash Flow from financing activitiesDividends paid 0 0 0Short-term debt issued 42,300 54,657 72,475

Change in cash/marketable secur. 10,000 12,000 14,400

What’s the story here? (comment on NI, OCF, CFI, and CFF)

Review Problems (continued)

• Net income• Declining. Why? This is a major concern

• Operating Cash flow• Cash is being generated by increased accounts

receivable, inventories, and accounts payable• Cash Flow from Investing

• Earnings are declining, yet they are continuing to invest heavily

• Cash Flow from Financing• They are financing the investment from borrowings

THERE ARE SOME REAL PROBLEMS HERE!

Review Problems (continued)

• Problem 14-1• The Crusty Pie company has a return on sales

higher than the industry average, yet its ROA is the same as the industry average. How can you explain this?

Review Problems (continued)

• What is the connection between ROA and ROS? Earnings = Earnings x Sales

Assets Sales Assets

ROA = ROS x Asset Turnover

• If ROA is equal to the industry and ROS is higher than industry, then asset turnover must be lower than the industry

Review Problems (continued)

• Problem 14-2• The ABC company has a profit margin on sales

below the industry average, yet its ROA is above the industry average. What does this imply about asset turnover?

Review Problems (continued)

• Answer 14-2• What is the connection between profit margin

on sales to return on assets?Profit margin = ROA x (1/Asset Turnover)

EBIT = EBIT x Assets

Sales Assets Sales

If profit margin is below, and ROA is above, then then 1/asset turnover must be higher and so asset turnover is lower.

Review Problems (continued)

• Problem 14-3• Firm A and firm B have the same ROA, yet

firm A’s ROE is higher. How can you explain this?

Review Problems (continued)

• Answer 14-3• What is the relationship between ROE and ROA?

Earnings = Earnings x Assets

Equity Assets Equity

ROE = ROA x leverage• If the firms have the same ROA, but firms ROE is

higher, then firm A’s leverage or Assets/Equity must be higher. The formula:

• *ROE = (1- tax rate) [(ROA + ROA – Interest Rate) * Debt/Equity]

• This shows that assuming the same tax rates, they must have different interest rates or debt/equity ratios

Review Problems (continued)

• Support for 14-3ROE = Net Profit /Equity = (EBIT – Interest – Taxes)/Equity

Net Profit = EBIT – Interest – Taxes = ((1- tax rate)(EBIT – Interest))/Equity

EBIT – Interest – Taxes = (1- tax rate)(EBIT – Interest) =(1- tax rate) ((ROA x assets – interest rate x

debt))/EquityInterest=interest rate x debt EBIT = ROA x Assets

= (1 - tax rate) [ROA x (Equity + Debt)/Equity - Interest rates x (Debt/Equity)]

Assets = Equity + Debt = (1 – tax rate)[ROA+(ROA–interest rate) (Debt/Equity)]

Review Problems (continued)

• Problem 14-4• Which of the follow best explains a ratio of “net

sales to average net fixed assets” that exceeds the industry average:

• a. The firm added to its plant and equipment in the last few years

• b. The firm makes less efficient use of its assets than other firms

• c. The firm has a lot of old plant and equipment

• d. The firms uses straight-line depreciation

Review Problems (continued)

• Answer 14-4• Old plant and equipment. The firm is likely to

have older plant and equipment which have a low book value due to depreciation, making the ratio of sales to fixed asset higher.