Analysis of Financial Statements

Fundamental Analysis and Financial Ratios

Fundamental Analysis Overview

  • Definition: Relies on financial statements and other information about a company to predict the future of its stock price.

  • Key Areas of Focus:

    • The firm’s management team.

    • Product markets.

    • The firm’s current and future competitive conditions.

    • The firm’s current and future company conditions.

Financial Ratios Categories

  • Short Term Liquidity Ratios: Assess a firm's ability to meet immediate obligations.

  • Capital Structure and Long-term Solvency Ratios: Evaluate the firm's debt financing and long-term financial health.

  • Return on Investment Ratios: Measure the efficiency of generating profits from invested capital.

  • Operating Performance Ratios: Gauge the effectiveness of a firm's core operations.

  • Asset Utilization Ratios: Indicate how efficiently a company uses its assets to generate sales.

  • Market Measures: Relate a firm's stock price to its earnings and book value.

Comparability & Limitations of Financial Statements

  • Comparability Issues: Can arise due to the flexibility allowed under International Financial Reporting Standards (IFRS) and/or U.S. Generally Accepted Accounting Principles (US GAAP).

  • Specific Areas of Flexibility:

    • Accounting for inventories.

    • Depreciation methods.

    • Adjusting for the effects of inflation.

Statement of Cash Flows

  • Purpose: Answers critical questions regarding a company's cash movements.

  • Questions Addressed:

    1. How were the funds provided by operations used within the business?

    2. Where did the funds come from to maintain dividends, especially in the face of potential losses?

    3. How did the business obtain funds to repay debt?

    4. What were the sources of working capital, and how were these funds utilized?

    5. How did the company finance a large investment project?

  • Importance: This statement is crucial for analyzing cash inflows and outflows to determine future cash flows.

Return on Stockholders’ Equity (ROE)

  • Significance: An essential component when making stock investment decisions.

  • Definitions:

    • Earnings available to common shareholders: Profits after taxes less any preferred dividends.

    • ROE Formula:
      extROE=extReturnontotalassetsimesextAsset/equityratioext{ROE} = ext{Return on total assets} imes ext{Asset/equity ratio}

The Effects of Financial Leverage on ROE

  • Importance: ROE is a critical measure in determining a company’s growth rate of earnings.

  • Impact of Capital Structure: Capital structure significantly affects ROE.

  • Basic ROE Formula:
    extROE=racextNetprofitextEquityext{ROE} = rac{ ext{Net profit}}{ ext{Equity}}

  • Leverage-Adjusted ROE Formula: extROE=(1−extt)[extROA+(extROA−extr)imesextDebt/extEquity]ext{ROE} = (1 - ext{t}) [ ext{ROA} + ( ext{ROA} - ext{r}) imes ext{Debt} / ext{Equity}]

    • Where:

      • exttext{t} = tax rate

      • extROAext{ROA} = Return on Assets

      • extrext{r} = interest rate on debt

  • Equation Dissection:

    • No Debt: If there is no debt, then extROE=extROA(1−extt)ext{ROE} = ext{ROA}(1 - ext{t}).

    • ROA Equals Interest on Debt: If the Return on Assets (extROAext{ROA}) equals the interest rate on the debt (extrext{r}), then extROE=extROA(1−extt)ext{ROE} = ext{ROA}(1 - ext{t}).

    • ROA Greater Than Interest on Debt: If ROA > interest on debt, ROE increases with increasing Debt/Equity ratio.

    • ROA Less Than Interest on Debt: If ROA < interest on debt, ROE declines with increasing Debt/Equity ratio.

    • Positive Contribution to ROE: Increasing debt will make a positive contribution to ROE only if extROAext{ROA} is greater than the interest on this debt.

The Dupont ROE Decomposition

  • Origin: First employed by Du Pont de Nemours & Company to value a company.

  • Significance: Serves as an excellent starting point for financial analysis.

  • Decomposition Formula: extROE=racextNetIncomeextEquity=racextNIextPretaxIncimesracextPretaxInc.extEBITimesracextEBITextSalesimesracextSalesextAssetsimesracextAssetsextEquityext{ROE} = rac{ ext{Net Income}}{ ext{Equity}} = rac{ ext{NI}}{ ext{Pretax Inc}} imes rac{ ext{Pretax Inc.}}{ ext{EBIT}} imes rac{ ext{EBIT}}{ ext{Sales}} imes rac{ ext{Sales}}{ ext{Assets}} imes rac{ ext{Assets}}{ ext{Equity}}

    • This formula breaks down ROE into five components:

      1. Tax Burden

      2. Interest Burden

      3. Operating Profit Margin

      4. Asset Turnover Ratio

      5. Leverage Ratio

(1) Tax Burden

  • Formula:
    racextNetIncomeextPretaxIncomerac{ ext{Net Income}}{ ext{Pretax Income}}

  • Measurement: Measures the portion of income remaining after tax as a fraction of pre-tax income.

  • Insight: Reveals the impact of taxes on ROE.

  • Characteristic: Unaffected by the business cycle.

(2) Interest Burden

  • Formula:
    racextPretaxIncomeextEBIT=racextEBIT−extInterestExpenseextEBITrac{ ext{Pretax Income}}{ ext{EBIT}} = rac{ ext{EBIT} - ext{Interest Expense}}{ ext{EBIT}}

  • Measurement: Represents the portion of income remaining after interest payments, as a fraction of Earnings Before Interest and Taxes (EBIT).

  • Variability: Will vary according to how well a company is operating.

  • Indicator: In a good year, this ratio will be high because fixed interest payments have less of an impact on operating profits.

(3) Operating Profit Margin

  • Formula:
    racextEBITextSalesrac{ ext{EBIT}}{ ext{Sales}}

  • Measure: A familiar measure of operating performance.

  • Scope: Includes both the profitability of the business concept and management’s ability.

  • Efficiency: Measures operational efficiency, independent of financing decisions.

  • Indicator: The higher the ratio, the more efficient the company in its operations.

(4) Asset Turnover Ratio

  • Formula:
    racextSalesextAssetsrac{ ext{Sales}}{ ext{Assets}}

  • Indication: Indicates how effectively a firm’s assets are deployed to generate sales.

  • Interpretation of High Ratio: A high ratio suggests efficient use of assets, but it could also be a sign of asset impairment or a function of depreciation policy.

  • Interpretation of Low Ratio: A low ratio often indicates overcapacity within the firm.

  • Characteristic: Independent of capital structure.

(5) Leverage Ratio

  • Formula:
    racextAssetsextEquityrac{ ext{Assets}}{ ext{Equity}}

  • Alternative Expression: Can also be expressed as:
    racextDebt+extEquityextEquity=racextDebtextEquity+1rac{ ext{Debt} + ext{Equity}}{ ext{Equity}} = rac{ ext{Debt}}{ ext{Equity}} + 1

  • Impact of Debt: As debt increases, the leverage ratio also increases, thereby having an impact on calculated ROE.

  • Combined Effect: Since items (2) Interest Burden and (5) Leverage Ratio are both affected by capital structure, their combined effect is important.

  • Compound Leverage Factor: This combined measure is known as the Compound Leverage Factor.

    • Formula for Compound Leverage Factor:
      extCompoundLeverageFactor=racextPretaxIncomeextEBITimesracextAssetsextEquityext{Compound Leverage Factor} = rac{ ext{Pretax Income}}{ ext{EBIT}} imes rac{ ext{Assets}}{ ext{Equity}}

Uses of ROE Analysis (Dupont Decomposition)

  • As an absolute measure of a firm’s performance over time.

  • As a comparative measure of firms within the same industry.

Alternative Dupont Model Statement

  • You may also see the Dupont model stated as: extROE=racextEBIT−extINTextSalesimes(1−extt)imesracextSalesextAssetsimesracextAssetsextEquityext{ROE} = rac{ ext{EBIT} - ext{INT}}{ ext{Sales}} imes (1 - ext{t}) imes rac{ ext{Sales}}{ ext{Assets}} imes rac{ ext{Assets}}{ ext{Equity}}

    • Where extINText{INT} is Interest Expense.

Summary of Financial Statement Analysis

  • Purpose: Financial Statement Analysis rarely leads to definitive answers but rather raises further questions for investigation.

  • Scope: This topic is extensive; this overview provides initial thoughts on how to approach company analysis.

Book Value Per Share (BPS)

  • Definition: Book value per share is an important determinant of earnings.

  • Ways to Increase BPS:

    1. Retained earnings: Reinvesting profits back into the company.

    2. Buy back company stock: Purchasing shares at prices less than book value per share.

    3. Sell stock at a price above book value per share: Often occurs during mergers or new equity issuances.

Profit Margin Ratios

  • Gross Profit Margin: Measures the productive efficiency of a firm over time and as compared to industry competitors.

  • Net Operating Margin: Shows the percentage of sales dollars not consumed in the generation of sales, indicating operational efficiency before interest and taxes.

Short-Term Liquidity Ratios

  • Purpose: Used to evaluate a firm’s ability to meet short-term obligations without undue stress.

  • Focus: Many of these ratios focus on a firm’s liquidity and, although crude, can give a general assessment of working capital.

  • Examples:

    • Current ratio

    • Acid-test ratio (or Quick Ratio)

    • Accounts receivable turnover ratio

    • Inventory turnover

Solvency Ratios

  • Purpose: Determine the extent to which the company is trading on its equity (i.e., using debt financing).

  • Leverage Risk: The more stable the industry and the firm’s earnings, the more leverage risk the firm can accept.

  • Interpretation of High Ratio: A higher ratio indicates greater financial leverage with debt.

  • Debt Type: Firms tend to use mostly short-term debt, but long-term solvency ratios are still applied.

  • Impact of Leasing: Firms with more leasing activities could show lower reported financial leverage on their balance sheets.

Coverage Ratios

  • Purpose: Used to test the adequacy of cash flows generated through earnings to meet debt and lease obligations.

  • Data Source: Relies on historical data for assessment.

Asset Turnover

  • Formula:
    extAssetTurnover=racextNetsalesexttotalassetsext{Asset Turnover} = rac{ ext{Net sales}}{ ext{total assets}}

  • Insights: Can reveal the weaknesses and strengths of a company by showing how efficiently assets generate sales.

  • Analytical Techniques:

    • Vertical Analysis: Expresses each expense item as a percentage of net sales (racextExpenseextNetSalesrac{ ext{Expense}}{ ext{Net Sales}}).

    • Horizontal Analysis: Compares an expense in a given year to the same expense in a base year (racextExpenseingivenyearextExpenseinbaseyearrac{ ext{Expense in given year}}{ ext{Expense in base year}}).

  • Benefit: These analyses help a firm track its expenses versus growth. For example, an expansion requires significant cash infusion before sales begin to pick up.

Accounts Receivable Analysis

  • Definition: Monies due from customers for goods or services delivered.

  • High A/R Turnover: Could mean that credit terms are tight, indicating efficient collection.

  • Increases in Days’ Sales in Accounts Receivable: Could indicate more liberal credit terms or customer non-payment issues.

  • Cost Implications: It is costly for a firm to carry an above-average amount of receivables due to lost interest and potential bad debt.

  • Causes for A/R Increase (Year-to-Year):

    • Poor economy.

    • Poor collection job by the company.

    • Excessively liberal credit terms.

  • Risk Signals: These issues are signs of danger to the firm’s growth and viability.

  • Money Costs: There are direct money costs associated with carrying accounts receivable (e.g., funding costs).

Inventory Analysis

  • Definition: A firm’s store of raw materials and finished and semi-finished products.

  • Low Inventory Turnover Ratio: Indicates that inventory may be too high, incurring carrying expenses. Excess inventory may foreshadow a slowdown in production or demand.

  • High Inventory Turnover Ratio (Relative to Industry): Suggests low inventory levels, which could lead to missed sales opportunities or production bottlenecks.

  • High Inventories (Manufacturing Firms): More common for manufacturing firms; service firms cannot