SM Analysis of Financial Statements

Potential problems and limitations of financial ratio analysis

Comparison with industry averages is difficult if the firm operates many different divisions. "Average" performance is not necessarily good. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is "good" or "bad." Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in strong or weak financial condition.

Analyzing liquidity

Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due. A second meaning includes the concept of converting an asset into cash with little or no loss in value. Three important liquidity measures - 1. Net working capital (NWC) = Current assets - Current liabilities 2. Current ratio (CR) = Current assets / Current liabilities 3. Quick (acid test) ratio (QR) = (Current assets - Inventory) / Current liabilities **You want your ratio to be greater than 1.

Five major categories of ratios

Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? Debt management: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Why are ratios useful?

Standardize numbers; facilitate comparisions. Used to highlight weaknesses and strengths.

Qualitative factors analysts should consider when evaluating a company's likely future financial performance

Are the company's revenues tied to a single customer? To what extent are the company's revenues tied to a single product? To what extend does the company rely on a single supplier? What percentage of the company's business is generated overseas? What is the competitive situation? What does the future have in store? What is the company's legal and regulatory environment?

Analyzing activity

Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency. Five important activity measures - 1. Inventory turnover (IT) = Costs of goods sold / Inventory a. How quickly you can sell your inventory. If it's high, it's better. Compare it to competitors. 2. Average collection period (ACP) = Accounts receivable / (Annual sales / 360) 3. Average payment period (APP) = Accounts payable / (Annual purchases / 360) a. If the number is higher than means you aren't making payments on your purchases. Compare to similar firms. 4. Fixed asset turnover (FAT) = Sales / Net fixed assets a. If number is higher it means you're making good sales. 5. Total asset turnover (TAT) = Sales / Total assets a. Fixed assets are assets that are tied down (plant, equipment). How efficient are my plants? If the number is high, your fixed assets are efficient.

DuPont system of analysis

An integrative approach used to dissect a firm's financial statements and assess its financial condition. It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE. The firm's return is broken into three components - 1. A profitability measure (net profit margin). 2. An efficiency measure (total asset turnover). 3. A leverage measure (financial leverage multiplier).

Analyzing debt

Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners. Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock. Measures of debt - (1) Degree of indebtedness and (2) Ability to service debts. Four important debt measures - 1. Debt-ratio (DR) = Total liabilities / total assets 2. Debt-equity ratio (DER) = Long-term debt / Stockholders' equity a. You want a higher ratio because that means there's company growth. 3. Times interest earned ratio (TIE) = Earnings before interest and taxes / Interest a. Ability to pay back money, want it to be greater than 1. 4. Fixed payment coverage ratio (FPC) = (Earnings before interest and taxes + Lease payments) / (Interest + Lease payments + (Principal payments + Preferred stock dividends) * (1 / (1-T)))

The use of financial ratios

Financial Ratio are used as a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm's operations and status. Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status. Interested parties - Shareholders, creditors, and management. Word of caution regarding ratio analysis - a. A single ratio rarely tells enough to make a sound judgement. b. Financial statements used in ratio analysis must be from similar points in time. c. Audited financial statements are more reliable that unaudited statements. d. The financial data used to compute ratios must be developed in the same manner. e. Inflation can distort comparisons. Groups of financial ratios - Liquidity, activity, debt, and profitability.

Analyzing profitability

Profitability Measures assess the firm's ability to operate efficiently and are of concern to owners, creditors, and management. A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm's profitability relative to sales. Seven basic profitability measures - 1. Gross profit margin (GPM) = Gross profits / Sales 2. Operating profit margin (OPM) = Operating profits (EBIT) / Sales 3. Net profit margin (NPM) = Net profit after taxes / Sales 4. Return on total assets (ROA) = Net profit after taxes / Total assets a. You want to know if you're using your assets effectively. The number should be bigger. 5. Return on equity (ROE) = Net profit after taxes / Stockholders' equity 6. Earnings per share (EPS) = Earnings available for common stockholders / Number of shares of common stock outstanding 7. Price per earnings ratio = Market price per share of common stock / Earnings per share a. Use to compare businesses and see what to invest in.