Financial Statement Analysis

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Analysis of Financial Statements and Stock Valuations.

The Field of Finance
• Financial Management – Analyze and forecast a firm’s performance – Evaluate investment opportunities • Financial Markets and Institutions – The flow of funds through institutions – Markets in which financial assets are sold – Impact of interest rates on that flow of funds • Investments – Locate, select, and manage money-producing assets.

Assets

Liabilities
Equity

 Liabilities and equity represent sources of funds.  Assets represent uses of funds.

Balance Sheet
Assets Liabilities Equity

 Liabilities and equity represent sources of funds.  Assets represent uses of funds.  Liabilities represent a debt claim.  Equity represents an ownership claim.

Investments
• Looks at financial analysis from perspective of investor – Stockholders are owners of the firm

– Bondholders are creditors of the firm

Investments
 Looks at financial analysis from perspective of investor  Stockholders are owners of the firm  Bondholders are creditors of the firm

 From an investor’s perspective, what matters is the rate of return on a security  Risk-return tradeoff: Investors prefer high expected returns and low risk.

Investments
 Looks at financial analysis from perspective of investor  Stockholders are owners of firm  Bondholders are creditors of firm  From investor’s perspective, what matters is the rate of return on a security  Risk-return tradeoff: Investors prefer high expected returns and low risk.  From the firm’s perspective this rate of return represents a cost of funds.

Ratio Analysis
• Financial managers use ratios to interpret the raw numbers on financial statements. • Relative measures allow comparison over time and to other firms. • Ratios are used by financial managers, other business managers, creditors, and investors.

Ratio Analysis

Five Categories of Ratios
• • • • • Profitability ratios Liquidity ratios Debt ratios Asset activity ratios Market value ratios

Ratio Analysis
Profitability Ratios
• Measure the overall effectiveness of the firm’s management.
– Gross Margin Ratio - Gross Profit/Sales – Operating Profit Margin - Operating Income/Sales

– Net Profit Margin - Net Profit/Sales
– Return on Assets - Net Income/Total Assets – Return on Equity - Net Income/Common equity

Ratio Analysis
Profitability Ratios: Example GPM

Gross Profit Margin =

Gross Profit Sales

How effective is the firm at generating revenue in excess of its cost of goods sold?

Balance Sheet Excalibur Corporation Cash Accounts Receivable Inventories Plant & Equipment Less:Acc. Depr. Net Fixed Assets Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 $175 430 625 $1,230 $2,500 (1,200) $1,300 $2,530 Accounts Payable S-T Notes Payable $115 115 $230 $600

Current Assets

Current Liabilities

Total Assets

Bonds Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700

Total Liabilities and Owners Equity

$2,530

Gross Profit Margin

=

Gross Profit Sales

Gross Profit Margin = $575 = 39.7% $1,450

Ratio Analysis
Liquidity Ratios


Measure the ability of the firm to meet its short-term financial obligations.

Current Assets Current Ratio = Current Liabilities

Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

Ratio Analysis
Liquidity Ratios


Measure the ability of the firm to meet its short-term financial obligations.

Acid-Test Ratio =

Current Assets - Inventory Current Liabilities

What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

Balance Sheet Excalibur Corporation Cash Accounts Receivable Inventories Plant & Equipment Less:Acc. Depr. Net Fixed Assets $175 430 625 $1,230 $2,500 (1,200) $1,300 $2,530 Accounts Payable S-T Notes Payable $115 115 $230 $600

Current Assets

Current Liabilities

Total Assets

Current Assets - Inventory Acid-Test Ratio = Current Liabilities

Long-term Debt Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700

Total Liabilities and Owners Equity

$2,530

$1,230 -$625 Acid-Test Ratio = = 2.63x $230

Ratio Analysis
Debt Ratios
Debt to Equity Ratio Total Debt Common Equity

What is the proportion of debt relative to equity financing for the firm?

Ratio Analysis
Debt Ratios

Operating Income Times Interest Earned Ratio = Interest Expense What is the firm’s ability to repay interest payments from their income?

Balance Sheet Excalibur Corporation Cash Accounts Receivable Inventories Plant & Equipment Less:Acc. Depr. Net Fixed Assets Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 $175 430 625 $1,230 $2,500 (1,200) $1,300 $2,530 Accounts Payable S-T Notes Payable $115 115 $230 $600

Current Assets

Current Liabilities

Total Assets

Total Liabilities and Times Operating Owners Equity Income $2,530 Interest = Interest Expense Earned Ratio

Long-term Debt Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700

TIE Ratio =

$330 = 5.50x $60

Ratio Analysis
Asset Activity Ratios

Sales Inventory Turnover Ratio = Inventory Is inventory translating into sales for the firm?

Balance Sheet Excalibur Corporation Cash Accounts Receivable Inventories Plant & Equipment Less:Acc. Depr. Net Fixed Assets Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 $175 430 625 $1,230 $2,500 (1,200) $1,300 $2,530 Accounts Payable S-T Notes Payable $115 115 $230 $600

Current Assets

Current Liabilities

Total Assets

Total Liabilities and Inventory Owners Equity

Long-term Debt Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 $2,530

Sales Turnover = Inventory Ratio

Inventory Turnover = $1450 = 2.3x $625

Ratio Analysis
Asset Activity Ratios
Sales Total Asset Turnover Ratio = Total Assets
How effective is the firm in using all assets to generate sales?

Ratio Analysis
Market Value Ratios
Market Price per Share Earnings per Share

Price to Earnings Ratio =

How much are investors willing to pay per dollar of earnings of the firm?

(Indicator of investor’s attitudes toward future prospects of the firm.)

Balance Sheet Excalibur Corporation

Additional Info: 100 shares $20.00 per share

Cash Accounts Receivable Inventories Plant & Equipment Less:Acc. Depr. Net Fixed Assets

Current Assets

Total Assets

$175 430 625 $1,230 $2,500 (1,200) $1,300 $2,530

Accounts Payable S-T Notes Payable

Current Liabilities

Long-term Debt Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700

$115 115 $230 $600

Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62

Total Liabilities and Owners Equity

$2,530

P/E Ratio

Market Price/Share EPS

P/E ratio =

$20.00 = 12.35x $162/100

Ratio Analysis
Market Value Ratios
Market Price per Share Book Value per Share

Market to Book Ratio =

How much are investors willing to pay per dollar of book value?

Balance Sheet Excalibur Corporation

Additional Info: 100 shares $20.00 per share
Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62

Cash Accounts Receivable Inventories Plant & Equipment Less:Acc. Depr. Net Fixed Assets

Current Assets

Total Assets

$175 430 625 $1,230 $2,500 (1,200) $1,300 $2,530

Accounts Payable S-T Notes Payable

Current Liabilities

Long-term Debt Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700

$115 115 $230 $600

Total Liabilities and Owners Equity

$2,530

Market Price/Share to = Common Equity/ # shares Book

M/B =

$20.00 $1,700/100

= 1.18x

EBITDA
• EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. • It is often of great interest to financial analysts. • It measures the amount of cash thrown off from the operations of the company.

Ratio

Industry

Excalibur

Profitability Gross Profit Margin 39.7% Operating Profit Margin Net Profit Margin Return on Assets Return on Equity

38% 20% 12% 9.0% 13.4% 22.8% 11.2% 6.4% 9.5%

Excalibur is good at keeping operating costs down, but not as good at total costs. ROA and ROE are low mainly due to productivity problems.

Summary of Excalibur Corporation Ratios
Ratio
Liquidity Current Ratio Acid-Test Ratio

Industry

Excalibur

5.00x 3.00x

5.35x 2.63x

Looking at the current ratio it appears that Excalibur is more liquid than the industry.... however when looking at Acid Test (a better measure) they are not as liquid indicating that inventory levels are probably too high.

Ratio

Industry

Excalibur
33% 5.50x

Debt Debt Ratio Times Interest Earned Debt to Equity 48%

35% 7.00x 49%

While the debt ratio is close to the industry average, Excalibur is not able to cover interest payments as easily as the industry. This indicates Excalibur may have too much debt relative to what they can realistically afford.

Ratio
Market Value Price Earnings Market to Book

Industry
18.0 2.5

Excalibur
12.35 1.18

Excalibur’s Investors are not willing to pay as much per rupee of earnings or per rupee of book value as they are for shares in other firms in the industry. This signals that they consider the firm’s prospects to be worse than the average. However, the firm is still selling for more than its liquidation value.

Relationships Among Ratios: The Du Pont System
• Ratio Analysis generally involves an examination of related

ratios. • Comparison of these relationships over time helps to identify the company’s strengths and weaknesses.

Relationships Among Ratios: The Du Pont System
The Du Pont Equation
Return Net = Profit x on Assets Margin
Net Inc. = Assets Net Inc. Sales

Total Asset Turnover
Sales Assets

x

Relationships Among Ratios: The Du Pont System
The Modified Du Pont Equation
Return Net = Profit x on Equity Margin
Net Inc. = Equity Net Inc. Sales

Total Asset Turnover
Sales Assets

Equity x Multiplier x
Assets Equity

x

Significance of some ratios
• Return on Capital Employed
– Reflects management quality over the long term

• Free cash flow generation
– Reflects ability of the business to throw cash from operations; ultimately the true test of success

• Operating Leverage V/s Financial Leverage ratios
– Fixed cost over fixed plus variable operating costs

• Working capital management
– Net working capital

Industry or Sector Research
• Unique features of each industry
– – – – – – – – – – Capital Intensive Labour intensive Skills dependent Location dependent Degree of Value addition Regulatory influence Foreign Exchange influence Logistics and freight impacts Seasonality Cyclycality

Industry Research - contd.
• A Top down approach v/s bottom up • An appreciation on the macro economic scenario • Needs a close watch on key economic variables, ministry statements, revenue collections and trends • Politically sensitive • Broad brush surges and dips

Valuation of Common Stocks Dividend Discount Model

Factors that affect the value of a firm’s stock price:
• Cash flows – Necessary to pay the bills – Not the same as sales or profits • Timing of cash flows – Cash received sooner is better than cash received later • Risk – Definite cash inflows are generally preferred to uncertain cash inflows

Valuing Common Stock
P0 = PV of ALL expected dividends discounted at investor’s Required Rate of Return
0 1 2 3 

P0

D1

D2

D3

D

P0 =

D1 (1+ ks )

+

D2 (1+ ks )2

D3 + (1+ ks )3

+···

Not like Preferred Stock since D0 = D1 = D2 = D3 = DN , therefore the cash flows are no longer an annuity.

Valuing Common Stock
P0 = PV of ALL expected dividends discounted at investor’s Required Rate of Return
0 1 2 3 

P0

D1

D2

D3

D

P0 =

D1 (1+ ks )

+

D2 (1+ ks )2

D3 + (1+ ks )3

+···

Investors do not know the values of D1, D2, .... , DN. The future dividends must be estimated.

Risk and Rates of Return
• Risk is the potential for unexpected events to occur. • If two financial alternatives are similar except for their degree of risk, most people will choose the less risky alternative because they are risk averse i.e. they don’t like risk. • Risk averse investors will require higher rates of return as compensation for taking on higher levels of risk.

Risk and Rates of Return
• Risk of a company's stock can be separated into two parts:
– Firm Specific Risk - Risk due to factors within the firm

Stock price will most likely fall if a major government contract is discontinued unexpectedly.
– Market related Risk - Risk due to overall market conditions

Stock price is likely to rise if overall stock market is doing well.

Risk and Rates of Return
• Risk of a company's stock can be separated into two parts:
– Firm Specific Risk - Risk due to factors within the firm – Market related Risk - Risk due to overall market conditions

• Diversification: If investors hold stock in many companies, the firm specific risk will tend to cancel out. • Even if investors hold many stocks, cannot eliminate the market related risk

Risk and Rates of Return
• Risk and Diversification – If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated

Risk and Rates of Return
• Risk and Diversification – If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated

Variability of Returns

Market Related Risk # of stocks in Portfolio

Risk and Rates of Return
• Risk and Diversification – If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated

Variability of Returns Firm Specific Risk

# of stocks in Portfolio

Risk and Rates of Return
• Risk and Diversification – If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated

Variability of Returns

Total Risk # of stocks in Portfolio

Risk and Rates of Return
• Market risk is the risk of the overall market, so to measure we need to compare individual stock returns to the overall market returns. • A proxy for the market is usually used: An index of stocks such as the BSE 500 • Market risk measures how individual stock returns are affected by this market • Regress individual stock returns on the returns of the market index

Risk and Rates of Return
• Market Risk is measured by Beta – Beta is the slope of the regression (characteristic) line

Risk and Rates of Return
• Market Risk is measured by Beta (b) – Beta is the slope of the regression (characteristic) line
PepsiCo 15% Return
10% 5%

S&P Return
5% 10% 15%

-15% -10%

-5%
-5% -10% -15%

Slope = 1.1 = Beta (b)

Risk and Rates of Return
• Interpreting Beta – Beta = 1 Market Beta = 1 Company with a beta of 1 has average risk – Beta < 1 Low Risk Company Return on stock will be less affected by the market than average – Beta > 1 High Market Risk Company Stock return will be more affected by the market than average

Portfolio construction
• • • • Initial Objectives Aggressive v/s conservative Concentrated v/s diversified % allocation and impact on overall return on portfolio • How much cash? • Trading costs and return erosion

Portfolio construction

“More money can be made by optimal asset allocation than by stock picks”

Performance Evaluation of Portfolios
• Is return the only criteria?
– What is the risk undertaken by the fund manager to achieve the return? – How do you quantify risk? – Returns over which period? – What is consistency – Does diversification count or is concentration the answer? – Is the fund bigger than the fund manager? – Fund manager style

Portfolio Risk • Measured by standard Deviation of the portfolio or Beta • Usually compared to a visible and transparent benchmark • Higher SD indicates higher risk • Optimal event - Highest risk adjusted return

Performance measures - Sharpe Ratio
• In this model, performance of a fund is evaluated on the basis of Sharpe Ratio, which is a ratio of returns generated by the fund over and above risk free rate of return and the total risk associated with it. According to Sharpe, it is the total risk of the fund that the investors are concerned about. So, the model evaluates funds on the basis of reward per unit of total risk. Symbolically, it can be written as: • Sharpe Index (Si) = (Ri - Rf)/Si • Where, Si is standard deviation of the fund. • While a high and positive Sharpe Ratio shows a superior riskadjusted performance of a fund, a low and negative Sharpe Ratio is an indication of unfavorable performance.

Performance Measures - Treynor ratio
• Developed by Jack Treynor, this performance measure evaluates funds on the basis of Treynor's Index. This Index is a ratio of return generated by the fund over and above risk free rate of return (generally taken to be the return on securities backed by the government, as there is no credit risk associated), during a given period and systematic risk associated with it (beta). Symbolically, it can be represented as:


• •

Treynor's Index (Ti) = (Ri - Rf)/Bi.
Where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the fund. All risk-averse investors would like to maximize this value. While a high and positive Treynor's Index shows a superior risk-adjusted performance of a fund, a low and negative Treynor's Index is an indication of unfavorable performance

Performance measures - Jensen’s alpha
• This measure, invented by Michael Jensen, involves evaluation of the returns that the fund has generated vs. the returns actually expected out of the fund given the level of its systematic risk. The surplus between the two returns is called Alpha, which measures the performance of a fund compared with the actual returns over the period. Required return of a fund at a given level of risk (Bi) can be calculated as: Ri = Rf + Bi (Rm - Rf) Where, Rm is average market return during the given period. After calculating it, alpha can be obtained by subtracting required return from the actual return of the fund. Higher alpha represents superior performance of the fund and vice versa. Limitation of this model is that it considers only systematic risk not the entire risk associated with the fund and an ordinary investor can not mitigate unsystematic risk, as his knowledge of market is primitive.

• •



Equity Mutual Fund - An application of Portfolio Theory • • • • Diversified Professionally Managed Liquid Affordable

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