Analysis of Financial Statements

Published on February 2017 | Categories: Documents | Downloads: 49 | Comments: 0 | Views: 397
of 80
Download PDF   Embed   Report

Comments

Content

Course

: Z1462 Investment Analysis
and Portfolio Management
Effective Period : February 2016

Analysis of Financial
Statements
Session 5

Acknowledgement

These slides have been adapted from:
Frank K. Reilly & Keith C. Brown. (2012). Analysis
of Investments and Management of Portfolios. 10.
Cengage Learning. ISBN: 9780538482486

Chapter 10: Analysis of Financial
Statements
Analysis of Investments &
Management of Portfolios
10TH EDITION

Reilly

& Brown

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Major Financial Statements
• Corporate shareholder annual and quarterly
reports must include
– Balance sheet
– Income statement
– Statement of cash flows

• Reports filed with Securities and Exchange
Commission (SEC)
– 10-K
– 10-Q

10-4
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Generally Accepted Accounting Principles
(GAAP)
• Formulated by the Financial Accounting
Standards Board (FASB)
• Provides some choices of accounting
principles
• Financial statements footnotes must disclose
which accounting principles are used by the
firm

10-5
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet
• Shows resources (assets) of the firm and how it
has financed these resources
• Indicates current and fixed assets available at a
point in time
• Financing is indicated by its mixture of current
liabilities, long-term liabilities, and owners’ equity
• Exhibit 10.1 shows the balance sheet for
Walgreen Co. for 2006 through 2010

10-6
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 10.1

10-7
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Income Statement
• Contains information on the profitability of the firm
during some period of time, in contrast to the
balance sheet at a fixed point in time
• Indicates the flow of sales, expenses, and
earnings during the time period
• Exhibit 10.2 shows the income statement for
Walgreen Co. for years 2006 through 2010

10-8
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 10.2

10-9
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Statement of Cash Flows
• Shows the effects on the firm’s cash flow of
income flows and changes in various items on
the balance sheet (See Exhibit 10.3)
– Cash Flow from Operating Activities: the sources
and uses of cash that arise from the normal
operations of a firm
– Cash Flow from Investing Activities: change in
gross plant and equipment plus the change in the
investment account
– Cash Flow from Financing Activities: financing
sources minus financing uses
10-10
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Measures of Cash Flow
• Cash flow from operations
– Traditional cash flow equals net income plus
depreciation expense and deferred taxes
– Also adjust for changes in operating assets and
liabilities that use or provide cash

• Free cash flow recognizes that some
investing and financing activities are critical to
ongoing success of the firm and the following:
– Capital expenditures
– Disposition of properties and equipment
10-11
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Measures of Cash Flow
• EBITDA: The widely-used EBITDA (earnings
before interest, taxes, depreciation, and
amortization) measure of cash flow is
extremely liberal
– It does not consider any adjustments noted
previously, specifically the following:






Depreciation and amortization
Interest expense
Taxes
working capital
capital expenditures
10-12

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Purpose of
Financial Statement Analysis
• It seeks to evaluate the current management
performance and to provide insights that will
help project future management performance,
specifically in the following three areas:
– Profitability
– Efficiency
– Risk

10-13
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Financial Ratios
• Ratios are more informative that raw numbers
– Ratios provide meaningful relationships between
individual values in the financial statements

• Importance of relative financial ratios: Compare
a firm’s financial ratios to other entities





The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)

10-14
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Financial Ratios
• Comparison to the Aggregate Economy
– Most firms are influenced by economic expansions
and contractions in the business cycle
– Analysis helps you estimate the future performance
of the firm during subsequent business cycles

• Comparison to the Industry
– Most popular comparison
– Different industries affect the firms within them
differently, but the relationship is always significant
– The industry effect is strongest for industries with
homogenous products
10-15
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Financial Ratios
• Comparison to its Major Competitors
– Industry averages may not be representative
– Select a subset of competitors to compare to using
cross-sectional analysis, or
– Construct a composite industry average from
industries the firm operates in

• Comparison to its Own Historical Records
– Determine whether it is progressing or declining
– Helpful for estimating future performance
– Consider trends as well as averages over time
10-16
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Computation of Financial Ratios
• The Five Categories
– Common size statements
– Internal liquidity (solvency)
– Operating performance
 Operating efficiency
 Operating profitability

– Risk analysis
 Business risk
 Financial risk
 External liquidity risky

– Growth analysis
10-17
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Common Size Statements
• Normalize balance sheets and income statement
items to allow easier comparison of different size
firms
• Common size statements also give insight into a
firm’s financial condition
• A common size balance sheet expresses
accounts as a percentage of total assets (Exhibit
10.4 for Walgreen Co. from 2006 to 2010)
• A common size income statement expresses all
items as a percentage of sales (Exhibit 10.5 for
Walgreen Co. for 2006 through 2010)
10-18
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 10.5

10-19
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Internal liquidity (solvency) ratios indicate the
ability to meet future short-term financial
obligations
• They compare near-term financial obligations,
such as accounts payable or notes payable, to
current assets or cash flows that will be
available to meet these obligations.
• Current Ratio: Examines the relationship
between current assets and current liabilities
Current Assets
Current Ratio =
Current Liabilities
10-20
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Walgreens current ratio (in thousand of
dollars) were :
Current Assets
Current Ratio =
Current Liabilities
Current Ratio 2010 = 11,922 = 1.60
7,433
Current Ratio 2009 = 12,049 = 1.78
6,769
Current Ratio 2010 = 10,433 = 1.57
6,644
10-21
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Quick Ratio: Adjusts current assets by
removing less liquid assets

Quick Ratio 2010 = 4,330 = 0.58
7,433
Quick Ratio 2009 = 5,083 = 0.58
6,769
Quick Ratio 2008 = 2,970 = 0.45
6,644

10-22

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Cash Ratio: The most conservative liquidity
ratio
Cash Ratio = Cash and Marketable Securities
Current Liabilities
Cash Ratio 2010 = 1,880 = 0.25
7,433
Cash Ratio 2009 = 2,587 = 0.38
6,767
Cash Ratio 2010 = 443 = 0.07
6,644
10-23
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Receivables Turnover: Examines the quality
of accounts receivable

Receivable Turnover 2010 = 67,420
= 27.25x
Receivable Turnover 2009(2,450+2,496)
= 63,335
= 25.20x
(2,496+2,527)
Receivable Turnover 2008 = 67,420
= 24.78x
(2,450+2,496)

10-24

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Receivables turnover can be converted into
an average collection period
Average Receivable
Collection Period
Average Receivable

=

2010 Receivable
Average

27.25
= 365

= 14.48 days

2010 Receivable
Average

25.20
= 365

= 14.73 days

2010

365
Annual Turnover
= 365
= 13.39 days

24.78
10-25

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Inventory Turnover: Relates inventory to sales
or cost of goods sold (CGS)

Inventory Turnover = 48,444
= 6.84x
Inventory Turnover
= 45,722
2010
(7,378+6,789)/2
= 6.51x
2009
(6,789+7,249)/2
Inventory Turnover = 45,391
= 6.04x
2008
(7,249+6,790)/2

10-26

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Given the turnover values, you can compute
the average inventory processing time
Average Inventory

= 365

Processing Period 2010
Annual Inventory
Average Inventory
= 365 = 53.4
Turnover
days
Processing
2010 =6.84
AveragePeriod
Inventory
365 = 53.4
days
Processing
2010 =6.84
AveragePeriod
Inventory
365 = 53.4
days
10-27
Processing Period 2010
6.84

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Cash Conversion Cycle: Combines
information from the receivables turnover,
inventory turnover, and accounts payable
turnover.

10-28
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Cash Conversion Cycle: Combines information
from the receivables turnover, inventory
turnover, and accounts payable turnover.
Payable Turnover = 48,444
= 10.9x
2010
(4,585+4,308)/2
Inventory
Turnover
= 45,722
= 10.6x
2009
(4,308+4,289)/2
Inventory Turnover = 42,391
= 10.6x
2008
(4,289+3,733)/2
10-29
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Internal Liquidity
• Cash Conversion Cycle: Combines information
from the receivables turnover, inventory
turnover, and accounts payable turnover.
Payable payment Period = 365
Payable
Turnover
Payable payment Period
= 365
= 33.5 days
2010payment Period
10.9
Payable
= 365 = 34.4 days
2009payment
10.6
Payable
Period = 365 = 34.4 days
2008

10.6

10-30

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Operating Performance
• Ratios that measure how well management is
operating a business
– Operating Efficiency Ratios: Examine how the
management uses its assets and capital, measured
in terms of sales dollars generated by asset or
capital categories
– Operating Profitability Ratios: Analyze profits as a
percentage of sales and as a percentage of the
assets and capital employed

10-31
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Efficiency Ratios
• Total Asset Turnover: The total asset turnover
ratio indicates the effectiveness of a firm’s use of
its total asset base (net assets equals gross
assets minus depreciation on fixed assets)

10-32
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Efficiency Ratios
• Total Asset Turnover: The total asset turnover
ratio indicates the effectiveness of a firm’s use of
its total asset base (net assets equals gross
assets minus depreciation on fixed assets)
Total Asset Turnover = 67,420
2.62 times
2010
(26,275+25,142)/2
Total
Asset Turnover
= 63,335
2.66 times
(25,142+22,410)/2
Total2009
Asset Turnover
= 59,034
2.83 times
2008

=
=
=

(22,410+19,314)
10-33

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Efficiency Ratios
• Net Fixed Asset Turnover: Reflects utilization
of fixed assets

• Equity turnover examines turnover for capital
component

10-34
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Efficiency Ratios
• Net Fixed Asset Turnover: Reflects utilization
of fixed assets

Fixed Asset Turnover = 67,420
2.62 times
2010
(26,275+25,142)
Total
Asset Turnover
= 67,420
2.62 times
2010
(26,275+25,142)
Total Asset Turnover = 67,420
2.62 times
2010
(26,275+25,142)

=
=
=
10-35

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Efficiency Ratios
• Equity turnover examines turnover for capital
component
Equity Turnover = Net Sales
Equity Turnover
2010
Equity Turnover
2009
Equity Turnover
2008

=Average
67,420 Equity
= 4.69x
(14,400+14,376)/2
= 63,335
= 4.65x
(14,376+12,869)/2
= 59,034
= 4.93x
(12,869+11,104)/2
10-36

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• Operating profitability ratios measure
– The rate of profit on sales (profit margin)
– The percentage return on capital

10-37
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• Gross Profit Margin: Measures the rate of profit on
sales (gross profit equals net sales minus the cost
of goods sold)

• Net profit margin relates net income to sales

10-38
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• Operating Profit Margin: Measures the rate of
profit on sales after operating expenses
(operating profit is gross profit minus sales,
general and administrative (SG + A) expenses)

10-39
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• Return on Total Capital: Relates the firm’s
earnings to all capital in the enterprise

Return on Total Capital = 2,091 + 89
=
11.9%
2010
Return
on Total Capital =(18,536+18,123)/2
2,006 + 89
=
12.4%
2009
(18,536+18,123)/2
Return
on Total Capital =
2,157 + 11
=
15.0%
2008

(18,536+18,123)/2

10-40

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• Return on Owner’s Equity (ROE): Indicates the
rate of return earned on the capital provided
by the stockholders
Return on Owner’s Equity = Net Income-Preferred Div.
2010
Average Common Equity

Return on Owner’s Equity = 2,091 - 0
=
14.53%
2010
Return
on Owner’s Equity =(14,400+14,376)/2
2,006 - 0
=
14.73%
2009
(14,376+12,869)/2
Return on Owner’s Equity = 2,157 - 0
=
18.00%
2008
(12,869+11,104)/210-41

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• The DuPont System: It divides the ROE ratio
into several component ratios that provide
insights into the causes of a firm’s ROE and
any changes in it
x

Profit x Total Asset x Financial
Margin Turnover
Leverage
10-42
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• An extended DuPont System provides
additional insights into the effect of financial
leverage on the firm and pinpoints the effect
of income taxes on ROE
• We begin with the operating profit margin
(EBIT divided by sales) and introduce
additional ratios to derive an ROE value
• As shown on the next page, it involves four
equations to “reach” ROE
10-43
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
EBIT
Sales
EBIT


Sales Total Assets Total Assets
EBIT
Interest Expense Net Before Tax


Total Assets
Total Assets
Total Assets
Net Before Tax (NBT)
Total Assets
Net Before Tax (NBT)


Total Assets
Common Equity
Common Equity
Net Before Tax 
Income Taxes 
Net Income
  100% 
 
Common Equity 
Net Before Tax  Common Equity
10-44
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating Profitability Ratios
• In summary, there are five components of
return on equity (ROE)
1.
2.
3.

4.

EBIT
 Operating Profit Margin
Sales
Sales
 Total Asset Turnover
Total Assets
Interest Expense
 Interest Expense Rate
Total Assets
Total Assets
 Financial Leverage Multiplier
Common Equity

Income Taxes 

5.  100% 
  Tax Retention Rate
Net Before Tax 


10-45

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Analysis
• Risk analysis examines the uncertainty of income
flows for the total firm and for the individual
sources of capital
– Debt
– Preferred stock
– Common stock

10-46
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Analysis
• Total risk of a firm has two components:
– Business risk
 The uncertainty of income caused by the firm’s
industry
 Generally measured by the variability of the firm’s
operating income over time

– Financial risk
 Additional uncertainty of returns to equity holders
due to a firm’s use of fixed obligation debt securities
 The acceptable level of financial risk for a firm
depends on its business risk

10-47
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Business Risk
• Two factors contribute to the variability of
operating earnings
– Sales variability
 Sales variability is the prime determinant of
operating earnings variability
 The variability of sales is mainly caused by a firm’s
industry and is largely outside the
 control of management

– Operating leverage
 Greater operating leverage (caused by a higher
proportion of fixed production costs) makes the
operating earnings series more volatile relative to
the sales
10-48
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial Risk
• Bonds interest payments come before earnings
are available to stockholders
• These are fixed obligations
• Similar to fixed production costs, these lead to
larger earnings during good times, and lower
earnings during a business decline
• This debt financing increases the financial risk
and possibility of default

10-49
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial Risk
• Relationship between business risk and financial
risk
– Acceptable level of financial risk for a firm depends on
its business risk

• The three sets of financial ratios to measure
financial risk
– Balance sheet ratios
– Earnings and Cash Flow Coverage Ratios
– Cash Flow–Outstanding Debt Ratios

10-50
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet Ratios
• Proportion of Debt (Balance Sheet) Ratios:
Indicate what proportion of the firm’s capital is
derived from debt compared to other sources
of capital, such as preferred stock, common
stock, and retained earnings
• Debt-Equity Ratio
Total Long - Term Debt
Debt - Equity Ratio 
Total Equity
Debt-Equity Ratio = Non Current Liabilities+Deferred Taxes+PV of Lease
Obligations
Total Equity
10-51
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet Ratios
• Proportion of Debt (Balance Sheet) Ratios:
Indicate what proportion of the firm’s capital is
derived from debt compared to other sources
of capital, such as preferred stock, common
stock, and retained earnings
Debt-Equity Ratio =
4,124+318+20,340 =
172.1%
2010 Ratio
14,400
Debt-Equity
=
3,732+265+19,110 =
160.7%
14,376
Return2009
on Owner’s
Equity = 2,747+150+18,190
= 164.0%
2010

12,869

10-52

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet Ratios
• Long-Term Debt/Total Capital Ratio: Indicates
the proportion of long-term capital derived from
long-term debt capital

L.T. Debt / Total Capital Ratio
Total Long - Term Debt

Total Long - Term Capital

10-53
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet Ratios
• Long-Term Debt/Total Capital Ratio: Indicates
the proportion of long-term capital derived from
long-term debt capital
A
B
Long-term Debt = 24,7820
62,4%
2010
24,782 +14,400
Long-term Debt = 23,108
60.9%
2009 23,108 +14,376
Long-term Debt = 21,087
61,2%
2008 21,087 +12,869

= 62.5%
= 61.6%
= 62,1%

10-54
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Earnings or Cash Flow Ratios
• Earnings or Cash Flow Ratios: Relate the flow of
earnings or cash available to meet the required
interest and lease payments
• Interest Coverage Ratio
Income Before Interest and Taxes (EBIT)

Debt Interest Charges

• Fixed Financial Cost Coverage
Net Income  Income Taxes  Interest Expense

Interest Expense
10-55
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Earnings or Cash Flow Ratios
• Earnings or Cash Flow Ratios: Relate the flow of
earnings or cash available to meet the required
interest and lease payments
• Interest Coverage Ratio
Fixed Financial Cost Coverage =
2,091+1,282+85+1,424 = 3.24x
2010
Fixed Financial Cost Coverage =
2,006+1,158+83+1,338 = 3.23x
2009
Fixed Financial Cost Coverage =
2,157+1,273+11+1,273 = 3.67x
2008

85+1,424
83+1,338
11+1,273

10-56

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Earnings or Cash Flow Ratios
• Cash Flow Coverage Ratios: Relate the flow of
cash available from operations to either
interest expense, total fixed charges, or the
face value of outstanding debt
Cash Flow Coverage Ratio 
Traditiona l Cash Flow  Interest  1/3 Lease Payments
Interest  1 / 3 Lease Payments

10-57
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash Flow–Outstanding Debt Ratios
• Cash Flow–Long-Term Debt Ratio
Cash Flow / Long - Term Debt 
Net Income  Depreciati on Expense  Change in Deferred Tax
Book Value of Long - Term Debt

• Cash Flow–Total Debt Ratio
Cash Flow / Total Debt 
Net Income  Depreciati on Expense  Change in Deferred Tax
Total Debt

10-58
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash Flow–Outstanding Debt Ratios
• Cash Flow–Long-Term Debt Ratio
2010 =
3,744
4,124+20,340

= 15.3%

2010 =
4,111
3,732+19,110

= 18.0%

2010 =
3,039
2,747+18,190

= 14.5%

10-59
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

External Market Liquidity
• External Market Liquidity Defined
– External market Liquidity is the ability to buy or sell an
asset quickly with little price change from a prior
transaction assuming no new information
– External market liquidity is a source of risk to investors

10-60
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

External Market Liquidity
• Determinants of Market Liquidity
– The most important determinant of external market
– liquidity is the number of shares or the dollar value of
shares traded
– Trading turnover (percentage of outstanding shares
traded during a period of time)
– A measure of market liquidity is the bid-ask spread
– Certain corporate variables
 Total market value of outstanding securities
 Number of security owners

10-61
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

External Market Liquidity
• A very good measurethat is usually available is
trading turnover.
Trading Turnover = Number of shares Traded during the Year
Average Number of shares outstanding during
the year

• In addition, certain corporate variables are
correlated with these trading variables :
- Total market value of common shares
outstanding
- Number of security owners

10-62
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

External Market Liquidity
• A very good measurethat is usually available is
trading turnover.
Trading Turnover = Number of shares Traded during the Year
Average Number of shares outstanding during
the year

Trading Turnover = 1,027,156
107%
2010Turnover(938.605+988.561)/2
Trading
= 978,244
99%
2010Turnover(988.561+989.176)/2
Trading
= 1,027,156
94%
2010
(989.176+991.141)/2

=

=
=
10-63

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Growth Potential
• Importance of Growth Analysis
– Sustainable growth potential analysis examines ratio
that indicate how fast a firm should grow.
– Creditors are interested in the firm’s ability to pay
future obligations
– Value of a firm depends on its future growth in earnings
and dividends

10-64
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Growth Potential
• Determinants of Growth
– Resources retained and reinvested in the entity
– Rate of return earned on the resources retained

g  Percentage of Earnings Retained  Return on Equity
= RR x ROE

where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity

10-65
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of Growth Potential
• The sustainable growth potential analysis for
Walgreens begin with the retention rate (RR)
• Retention Rate = 1 – Dividends Declared
(RR)
Net Earnings
2010
= 1 - 541 = 0.74
2,091
2009
= 1 - 446 = 0.78
2,006
2008
= 1 - 376 = 0.83
2,157
10-66
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparative Analysis of Ratios
• Internal liquidity
– Current ratio, quick ratio, and cash ratio

• Operating performance
– Efficiency ratios and profitability ratios

• Risk Analysis
• Growth analysis

10-67
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis of
Non-U.S. Financial Statements
• Statement formats will be different
• Differences in accounting principles
• Ratio analysis will reflect local accounting
practices

10-68
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Quality of Financial Statements
• High-quality balance sheets typically have
– Conservative use of debt
– Assets with market value greater than book
– No liabilities off the balance sheet

• High-quality income statements reflect
– Repeatable earnings
– Uses of conservative accounting principles

• Footnotes
– Provide information on how the firm handles balances
sheet and income items
10-69
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Value of
Financial Statement Analysis
• Financial statements, by their nature, are
backward-looking
• An efficient market will have already incorporated
these past results into security prices, so why
analyze the statements?
• Analysis provides knowledge of a firm’s operating
and financial structure
• This aids in estimating future returns

10-70
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Specific Uses of Financial Ratios





Stock Valuation Models
Estimating the Ratings on Bonds
Predicting Insolvency (Bankruptcy)
Limitations of Financial Ratios

10-71
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Valuation Models
• Valuation models attempt to derive a value
based upon one of several cash flow or
relative valuation models
• All valuation models are influenced by:
– Expected growth rate of earnings, cash flows, or
dividends
– Required rate of return on the stock

• Financial ratios can help in estimating these
critical inputs

10-72
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Valuation Models
• Financial Ratios
1. Average debt/equity
2. Average interest coverage
3. Average dividend payout
4. Average return on equity
5. Average retention rate
6. Average market price to book value
7. Average market price to cash flow
8. Average market price to sales

10-73
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Valuation Models
• Variability Measures
1. Coefficient of variation of operating earnings
2. Coefficient of variation of sales
3. Coefficient of variation of net income
4. Systematic risk (beta)

• Nonratio Variables
1. Average growth rate of earnings

10-74
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Estimating the Ratings on Bond
• Financial Ratios
1. Long-term debt/total assets
2. Total debt/total capital
3. Net income plus depreciation (cash flow)/long term senior debt
4. Cash flow/total debt
5. Net income plus interest/interest expense (fixed charge coverage)
6. Cash flow/interest expense
7. Market value of stock/par value of bonds
8. Net operating profit/sales
9. Net income/owners’ equity (ROE)
10. Net income/total assets
11. Working capital/sales
12. Sales/net worth (equity turnover)

10-75
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Estimating the Ratings on Bond
• Variability Ratios
1. Coefficient of variation (CV) of net earnings
2. Coefficient of variation of return on assets

• Nonratio variables
1. Subordination of the issue
2. Size of the firm (total assets)
3. Issue size
4. Par value of all publicly traded bonds of the firm

10-76
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Predicting Insolvency (Bankruptcy)
• Financial Ratios
1. Cash flow/total debt
2. Cash flow/long-term debt
3. Sales/total assets
4. Net income/total assets
5. EBIT/total assets
6. Total debt/total assets
7. Market value of stock/book value of debt
8. Working capital/total assets
9. Retained earnings/total assets
10. Current ratio
11. Working capital/sales
10-77
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Limitations of Financial Ratios
• Accounting treatments may vary among firms,
especially among non-U.S. firms
• Firms may have have divisions operating in
different industries making it difficult to derive
industry ratios
• Results may not be consistent
• Ratios outside an industry range may be
cause for concern

10-78
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Internet Investments Online








http://www.walgreens.com
http://www.cvs.com
http://www.riteaid.com
http://www.longs.com
http://www.sec.gov
http://www.hoovers.com
http://www.dnb.com

10-79
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

THANK YOU

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close