Notes on Financial Statement Analysis and Ratio Analysis

LECTURE 4: ANALYSIS OF FINANCIAL STATEMENTS

• Course: FINA 320 Principles of Finance

Overview of Financial Ratio Analysis

• Essential tool for evaluating financial statements.

• Enables comparison of financial health among companies.

Ratio Analysis Components:

1. Liquidity Ratios

2. Asset Management Ratios

3. Debt Management Ratios

4. Profitability Ratios

5. Market Value Ratios

6. Tying Ratios Together: The DuPont Equation

7. Potential Misuses of ROE (Return on Equity)

8. Assessing Performance Using Financial Ratios

9. Uses and Limitations of Ratios

10. Looking Beyond the Numbers in Financial Analysis

Financial Statements and Reports

• Financial statements are crucial for assessing company financial health.

• Ratio analysis centers around these reports providing valuable insight.

Liquidity Ratios

• Focus on a firm's ability to meet short-term obligations and operational viability.

• Key Question: "Will the firm be able to pay off its debts as they come due?"

Definition of Liquid Assets

• Liquid Assets: Assets that can be rapidly converted to cash without significant value reduction.

Key Liquidity Ratios

1. Current Ratio

   • Formula: $Current Ratio = \frac{Current\,Assets}{Current\,Liabilities}$

   • Indicates coverage of current liabilities by current assets.

   • General Observations:

     • A decreasing current ratio may indicate financial struggles.

     • A high ratio reflects strong liquidity but may signal inefficiencies.

     • Industry averages serve as benchmarks but not strict targets.

2. Quick Ratio (Acid Test Ratio)

   • Formula: $Quick\,Ratio = \frac{Current\,Assets - Inventories}{Current\,Liabilities}$

   • A measure of a firm’s capacity to cover short-term obligations without selling inventory.

   • Inventories are the least liquid assets.

Example Calculation for Current and Quick Ratios

• Given: Current liabilities = $500 million, Current ratio = 2.0.

  • Total Current Assets = $Current\,Assets = Current\,Ratio \times Current\,Liabilities = 2.0 \times 500 = 1000\, million$

  • For Quick (Acid Test) Ratio = 1.6, determine inventory…

Asset Management Ratios

• Assess how efficiently a firm utilizes its assets concerning sales generation.

• Importance of Balance: Too many assets increase capital costs; too few may miss profitable opportunities.

Key Asset Management Ratios:

1. Inventory Turnover Ratio

   • Measures how often a company sells and replaces its stock of goods within a period.

2. Days Sales Outstanding (DSO)

   • Also known as Average Collection Period (ACP): Measures the average time to collect credit sales.

     • Implications of High DSO: Delayed cash inflows may increase financial risk and necessitate credit management improvements.

3. Total Assets Turnover

   • Indicates efficiency in using total assets to generate sales.

4. Fixed Assets Turnover

   • Measures how effectively the firm utilizes its fixed assets to generate sales.

Example Calculation for Inventory and DSO

• Firm data: Annual sales = $100 million, Cost of Goods = $80 million, Inventory = $20 million, Accounts Receivable = $30 million.

  • Calculation of Inventory Turnover Ratio and DSO…

Debt Management Ratios

• Indicate how a firm’s assets are financed and its capacity for long-term debt repayment.

• Highlights financial risk, focusing on the relationship between debt and equity.

Financial Leverage Effects on ROE

• Leverage can enhance ROE if earnings on assets surpass interest paid, but also raises risks.

• Review balance sheets and income statements to gauge the proportion of debt in financing strategy.

Key Debt Management Ratios

1. Total Debt to Total Capital

   • Measures the percentage of capital financed by debt holders.

2. Times Interest Earned (TIE)

   • Formula: $TIE = \frac{Operating\,Income}{Interest\,Expense}$

   • Indicates how well operating income can cover interest payments.

Profitability Ratios

• Showcase the overall profitability and efficiency of resource utilization.

Key Profitability Ratios

• Operating Margin: $Operating\,Margin = \frac{EBIT}{Sales}$

• Profit Margin: $Profit\,Margin = \frac{Net\,Income}{Sales}$

• Return on Total Assets (ROA): Measures firm’s return on assets utilized.

• Return on Common Equity (ROE): $ROE = \frac{Net\,Income}{Common\,Equity}$

  • Accounts for the efficiency of shareholder equity usage.

• Return on Invested Capital (ROIC): Represents returns provided to both investors (equity and debt holders).

• Basic Earning Power (BEP): Indicates the ability to generate EBIT before the effects of debt and taxes.

Example Profitability Scenarios

• Given: Sales = $20 billion, Net Income = $1 billion. Find various profitability ratios and analyze if reduced leverage would improve ROA…

Market Value Ratios

• Connect stock price to earnings and book values to assess their potential sustainability.

• High ratios indicate strong financial performance across liquidity, asset management, debt management, and profitability ratios.

Key Market Value Ratios

• Price/Earnings (P/E) Ratio: Indicates how much investors pay for $1 of earnings.

• Market/Book (M/B) Ratio: Compares stock price to its book value, revealing investor sentiment.

• Enterprise Value/EBITDA: Assesses market value of company total financial claims compared to operational earnings.

Example Interpretation of Ratios

• Industry comparison of ratios, providing insights into company standings relative to sector averages…