Financial Statement Analysis

Asset Turnover Ratio

Is a measure of a company's ability to use its assets to generate sales or revenue AND is a calculation of the amount of sales or revenue generated per dollar of assets. Formula is Sales or Revenues/Total Assets, higher number is preferable (because it means its using its assets efficiently to make money) Comparatives needs to be between companies within the same industry. Asset turnover is usually calculated annually for fiscal/calendar year. Total assets or calculated average of assets at the beginning and end of the year

Solvency

the ability to pay interest as it comes due and to repay the balance of a debt due at its maturity.

Liquidity

the ability to pay obligations expected to become due within the next year or operating cycle

Quick Ratio

(Current Assets - Inventory) / Current Liabilities

Free Cash Flow to Firm (FCFF)

A firms operating decisions (specifically excludes finance decisions), generates sales, yields cash (a/r) from sales, reducing cash by paying bills = net cash flow left over. Left overs goes to Lenders or Owners/share holders. FCF = Earnings before interest taxes * (1-Tax rate) + Depreciation - Capital Expenditures - Increase net working capital (Non Cash Current Assets) - Non interest bearing current liabilities = Free Cash Flow OR Earnings before interest taxes * (1-Tax rate) - Increase in Net Fixed Assets (NFA=Gross FA - Acc Depr) - Increase net working capital (Non Cash Current Assets)

Profit Margin

A ratio that measures how much income is kept in a company as compared to the total revenue, measure of profitability. Formula: Revenue minus All expenses, interest, taxes Divided by Revenue. Giving an outcome of a profit percentage of every dollar, or the company keeps what percentage of every dollar in revenue. Find the ratio because more revenue or more net profit does not indicate that they have a higher profit margin. It is a measure of efficiency, but growing revenue without sacrificing profit margin sometimes doesn't work. Sometimes company's sacrificing profit margins by giving consumers a cheaper price so that Revenue could increase.

Economic Value Added (EVA)

A variation of profit, profit does not take into consideration there is a cost to capital. To measure investments or return in comparison to the cost that it is for the capital to generate that return. Formula: EVA = Net Operating Profit After Taxes (NOPAT aka Expected Return) minus (Total Assets minus current liabilities aka Invested Capital) X Weighted Average Cost of Capital (WACC) Question: Does the investment exceed that cost of capital and if so, by how much. A superior method of looking at profit.

Average Collection Period

Accts Rec / Daily Credit Sales

Trend Analysis (another form of a horizontal analysis)

Again analyze a company from one year to another year. What direction a business is taking. Are accounts increasing, decreasing and at what rate. Basing everything on the base year (100%). What happend from the base year to the current year or the year before, etc.

Trend Percentage

Analysis year dollar amount divided by the Base year dollar amount. Example: Base year 100%, if revenue increased by 2%, then our trend percentage would be 102% reflecting that Revenues are 102% this year of our base year.

Horizontal Analysis

Analyzing information for the same company but analyzing the information from one year compared with another year. Using period data to complete the analysis to determine Dollar Changes and Percentage Changes. Numerator will be the dollar change between a base year and analysis year/Base period dollar amount. 1st - Difference between years 2nd - Amt of change/dollar amount of base year

The three major important financial statement components

Balance Sheet, Income Statement, Statement of Cash Flows

Inventory Turnover

COGS / Inventory An efficiency ratio that shows how quickly a company uses up its supply of goods over a given time frame. Formula: Market Value of Sales / Ending Inventory OR Cost of Goods Sold (COGS-Income Stmt) / Average Inventory (Balance Sheet). Average Inventory is more accurate because it accounts for seasonal fluctuations, specific to retail businesses. Comparatively low inventory turnover means that a company has poor sales or too much inventory. Inventory that sits too long can deteriorate or loose value. High inventory turnover can indicate strong sales, but it can also indicate that the company doesn't have an effective inventory purchasing plan in place.

AR Turnover

Credit Sales / AR

Current Ratio

Current Assets/Current Liabilities Use in Liquidity ratios $assets: $liab

Interpret the contents of: income statement

Describes revenues and expenses, measures results of a firm's operations over a specified period, shows profits and loss for the period

Potential problems and limitations of Financial Ratio Analysis

Difficult to compare averages...may differ between divisions, average performance is not necessarily good, seasonal factors will distort ratios

Ratio Analysis

Expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another.

Leverage Ratios

Firms in capital-intensive industries must always keep a close eye on their debt. Debt can actually increase shareholder returns, high levels strain a companies credit ratings and weaken the ability to finance.

Example of non cash on Income Statement

Good Will, Depreciation, Non-Cash item (write-off on bad debts, or credit losses)

Return on Investment (ROI)

Helps investors evaluate the performance of an investment and compare it to the performance of their other investments

Income Statement

How much a company might earn in a given period, Revenue/Sales, minus Costs of Goods Sold = Gross Profit. Less Operating Expenses = Operating Profit. Assets of a company are generating the Operating Profit. Minus Interest = Pretax Income. Minus Taxes = Net Income (goes to the owners of the company)

How would you analyze a company to invest in

How one company compares to another similar company

Earnings per Share (EPS)

Is a measurement of a company's profit. Formula: Profit minus dividends / # of shares outstanding. Its better to have a higher EPS than a higher profit. Can use EPS to compare other companies/industries

Gross Margin

Is a rough gauge of how profitable its operations are, measures how much sales revenue the company retains after all the direct costs associated with making a product or providing a service are accounted for. OH are not direct costs. The greater the business margin, the more money it will have to invest in other important areas. Generally quoted as a percentage of the company sales. Formula: Revenue minus COGS = Difference which you / Revenue = Gross Margin. Extremely useful as a yardstick to make sure that a company is operating with maximum efficiency. Best used for comparing companies within the same industry with similar revenue numbers/business models

Warning signs of a troubled company

Key signals, declining stock prices; long periods of time where cash payments exceed a company's cash receipts (warehouse is full of inventory that isn't selling or too much cash is being spent on unnecessary expenditures); Debt levels, high interest repayment places high pressure on distressed companies. A high total debt-to-equity ratio generally means higher risk of a company failing. When a company's debit exceeds peers or its own historical amounts, the company could face liquidity problems; Rumors of SEC investigations; Insider actions-red flag owners selling off their shares; Key executives leaving the company

Debt to EBITDA (Equity Before Interest, Taxes, Interest, Depreciation, Amortization)

Measures a company's ability to pay off its incurred debt.

Liquidity Ratios

Measures short term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Relate the current assets and link them to the current liabilities Use the Balance Sheet Liquidity-the ability to pay obligations expected to become due within the next year or operating cycle. When working capital is positive, there is greater likelihood that the company will pay its liabilities. Working Capital (Excess of Current Assets)=Current Assets - Current Liabilities.

Solvency Ratio

Measures the ability of the company to survive over a long period of time Debt to equity ratios; Debt to total asset ratios Use the Balance Sheet Total Liab/Total Assets Measures the percentage of total financing provided by creditors rather than stockholders. Ratio means that every dollar of assets was financed by ? cents of debt.

Profitability Ratio

Measures the income or operating success of a company for a given period of time - Income statement Revenue - Expenses = Net Income Use the Income Statement

Earnings per Share (EPS)

Measures the net income earned on each share of common stock. Net Income - Preferred Stock Div _______________________________________________ Average Common share Outstanding

Financial Ratios

Measures the relative health or sickness of a business, results will allow an appraisals of the position of the business, identify trouble spots needing attention, make projections and forecasts about the course of future operations.

Retained Earnings RE

Money generated from the operations of the company that is plowed back (or retained) in the business. Represents the amount of the company's earnings that was not paid out as dividends to stockholders.

Cash Flow from Operations - Indirect Method

Net Cash provided (+) or used (-) by the firm's core business. Core business-Operations, using Net Income then adjust for accruals to convert to cash basis. Such as non cash transactions like depreciation, loss on sale of equipment, and use a comparative balance sheets of different years. Look for AR, Inventory, AP...looking at those changes to make adjustments. Example: Net Income, add back Depreciation expense, add Loss on Sale of Equip, add/subtract increases or decreases between years of AR, Inventory, and AP. Take into consideration the account and how it effects things. So an decrease in AR would be a positive adj, and increase in Inventory would be a negative adj (because used cash to increase inventory), and an increase in AP is a positive adj (because we increased our AP), = Net cash Provided by Operating Activities.

Cash Flow from Investing

Net cash provided (or used) by the purchase or sale of fixed assets, securities, investments. Gains to cash from investing is a positive figure, whereas a purchases are a negative figure.= Net cashed (used) or provided by Investing Activities.

Cash Flows from Financing

Net cash provided (or used/repaid to) debt holders (borrow/repay) and equity holders (stock/dividends). Does not include interest expense...see operating section.Sources of cash is positive, dividends are cash out flow, bonds paid out (redeemed) is also a cash out flow = Net cash provided or used by financing activities.

Return on Equity (Book Value)

Numerator (Net Income) / Denominator (Book Value of Equity) Using Assets less debt = Equity

Return on Asset (ROA)

Numerator (Operating Profit) / denominator (assets) Based on Operating Profit

Equity (Stockholders, Shareholders, Owners)

Ownership interest, the residual interest in the assets of an entity that remains after deducting its liabilities. Assets = Liab + S/E or Assets - Liab = S/E Examples: Common Stock, Preferred Stock (Par Value/Stock issue) APIC, Treasury Stock (buy back it's own stock-Contra equity-reduces equity), Retained Earnings (profits kept not paid out as dividends)

Asset

Probable future economic benefit & obtained or controlled by a particular entity, as a result of past transactions or events (A/R, Current assets, Investments, PPE, Intangibles, Other/def tax asset)

Liabilities

Probable future sacrifices of economic benefits, arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events - Debt/borrow, salaries payable, general payables, Unearned revenue (that you owe a probable future sacrifice) or a contingent liability/lawsuit

Dividend

Profits paid out to shareholders that is not invested or needed to run the business, can be increased or decreased dependent upon how the business performs

Vertical Analysis

Relationship of each item on a financial statement to a base amount on the same financial statement. Such as an Income Statement, each item on the statement is expressed as a percentage of net sales. Balance sheet, each account amount is expressed as a percentage of the total assets amount and/or the total liabilities + Owner's Equity Amount. Use the Total Liab & Equity when doing a vertical analysis of Liab and Equity.

components of return on equity

Return on Equity has three ratio components. The three ratios that make up Return on Equity are: 1. Profit Margin = Net Income / Sales Profit - Margin measures the percent of profits you generate for each dollar of sales. 2. Asset Turnover = Sales / Assets - Asset Turnover reflects the level of capital we have tied-up in assets and how much sales we can squeeze out of our assets. 3. Financial Leverage = Assets / Equity - Financial Leverage is a measure of how much we use equity and debt to finance our assets.

Interpret the contents of: statement of cash flows

Show changes in the balance sheet, reports the cash generated and used during a specific time period.

Interpret the contents of: balance sheet

Snapshot of the firms assets, financing of the assets at a given point, lists assets, liabilities and equities

Balance Sheet

Statement of Net Worth

Book Value

Tells an investor how much a company is worth if it ceased operating today, sold all its assets and paid off all its debt. Formula: Tangible Assets (anything that can be sold) minus Liabilities = Book Value

SG&A Expenses

The costs associated with selling a firm's products and the costs incurred in running the firm's daily business operations. The SG&A is reported on the Income Statement. The direct costs making the product are expenses that fall under the Costs of Goods Sold. If the SG&A amount is high as a percentage of sales or as a percentage of net income compared to competitors, it's possible too much money is being spent on SG&A. This item can be compared to publicly owned companies to gauge effectiveness. SG&A should be as low as possible, while maintaining high sales.

Cash Conversion Cycle (Net Operating Cycle)

The number of days it takes a business to convert its production inputs into cash receipts. The calculation is commonly used by analysts to measure the time between: a company's initial investment in working capital and the company's cash collection. CCC = DSI (Days Sale of Inventory) + DSO (Days Sale Outstanding - DPO (Days Payable Outstanding) Shorter cash conversion cycle means only needs to finance its accts receivable and/or inventory for a short period of time, which can indicate higher liquidity and effective management of inventory and credit sales. Longer cash conversion cycle means it takes longer to sell its product and/or accts receivable payments from customers, or possibly that it's paying bills too quickly. Example: 60 days to sell 30 to receive pymt 45 to pay suppliers. 60+30-45=45 days cash conversion, paying suppliers later or receiving payment earlier will shorten the cash conversion cycle.

Building a Statement of Cash Flow

Use Net Cash Provided (+) by Operations PLUS Net Cash Used (-) from Investing PLUS Net Cash Provided (+) by Financing = Net Increase/Decrease in Cash Cash Flow Operations Cash Flow Investing Cash Flow Financing

Obtaining useful conclusions using ratios

Use industry comparisons and trend analysis

Example of cash on Income Statement

Variable costs, Salaries, Costs of Goods Sold, Increase in long-term debt (the firm took on new loans)

Items listed on the balance sheet

are listed from the most liquid to the least liquid

balance sheet equation

assets=liabilities+owner's equity assets employed are financed thru borrowing or own money

Major purpose of: Balance Sheet

is a snapshot of the firm's assets and the financing of those assets at a given point in time. It is a listing of all the assets, liabilities, and equity of the firm

depreciation

is a term used for tax and accounting purposes that describes the method a company uses to account for the declining value of its assets.(is common example of a noncash expense that is included in net income calculations but not in cash flow calculations).

amortization

refers to the process of allocating the cost of an intangible asset over a period of time. It also refers to the repayment of loan principal over time.

statement of cash flow

typically breaks out a company's cash sources and uses for the period into three categories: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. It is not the same as net income, which includes transactions that did not involve actual transfers of money. This all equates to change in cash.

standardizing financial information

undergo the same processes so that the disclosed information is relevant, reliable, comparable and consistent.