Financial Statement Analysis
Main Contents
The major financial statements
Standard financial ratios
Ratio decomposition analysis
Asset utilization ratios
Comparability problems
Accounting v.s,Economic earnings
The Major Financial Statements
Accounting data are useful in assessing the
economic prospects of the firm.
– An investor can use financial data as inputs into
stock analysis and estimate the intrinsic value of
common stocks.
There are three basic sources of data:
– The income statement
– The balance sheet
– The statement of cash flows
The Major Financial Statements
The income statement
– Table
– Is a summary of the profitability of the firm over a
period of time such as a year.
– Some terms
Revenue,expense,net earning or profit
Cost of goods sold,general and administrative expense,
interest expense,tax on earnings
Operating revenue,operating cost,operating income,
earning before interest & taxes (EBIT)
The Major Financial Statements
The balance sheet
– Table
– Provide a snapshot of the financial condition of the
firm at a particular time.
– Some terms:
Asset,liability,net worth or stockholder’s equity
Current asset,long-term asset
Current liability,long-term debt
Par value of stock,capital surplus(additional paid-in
capital),retained earnings
The Major Financial Statements
The statement of cash flows
– Table
– A statement showing a firm’s cash receipts and cash
payments generated by the firm’s operations,
investments and financial activities during a
specified period.
– Accrual method of accounting v.s,Transaction basic
method
– It provides evidence on the well-being of a firm.
Return On Equity (ROE)
Past ROE v.s,Future ROE
– ROE is one of the two basic factors in deter-mining
a firm’s growth rate of earnings.
A high ROE in the past does not necessarily imply a firm’s
future ROE will be high.
A declining ROE is evidence that the firm’s new
investments have offer a lower ROE than its past
investment.
It is expectations of future dividends and earnings that
determine the intrinsic value of a company’s stock.
Return On Equity (ROE)
Financial leverage and ROE
])()[1(
]T ) [ R O A-(1
r a t e )T a x -(1
E
D)(E
E q u i t y
d e b t )r a t eI n t e r e s t -A s s e t s( R O A
E q u i t y
T a x e s )-r a t e ) ( E B I TT a x -(1
E q u i t y
T a x e s-I n t e r e s t-E B I T
E q u i t y
p r o f i tN e t
E
D
E
D
iR O AR O A-T
i
R O E
Return On Equity (ROE)
An example
– Table
– Business risk,EBIT and ROA
– Financial risk,E and ROE
Some conclusions:
– If there is no debt or ROA= interest rate,its ROE
will simply equal (1-tax rate)*ROA
– If ROA exceeds the rate,the firm earns more on its
money than it pays out to creditors.
Return On Equity (ROE)
– Increase debt will make a positive
contribution to a firm’s ROE only if the
firm’s ROA exceeds the interest rate on the
debt.
– Financial leverage increases the risk of the
equity holder returns
Even if financial leverage increase the expected
ROE,it does not imply the market value of
equity will be higher.
Financial leverage increases the risk of the firm’s
equity as surely as it raises the expected ROE.
Ratio Analysis
Decomposition of ROE & Du Pont system
– Decomposition of ROE is helpful to under-
stand the factors affecting a firm’s ROE,
including its trend over time and its perfor-
mance relative to competitors.
LA T OR O SIBTB
E q u i t y
A s s e t s
A s s e t s
S a l e s
S a l e s
E B I T
E B I T
p r o f i tP r e t a x
p r o f i tP r e t a x
p r o f i tN e t
R O E
Ratio Analysis
An Example
– Table 13.6 on page 361
– ROS,operating profit per dollar of sales
– ATO,the efficiency of the firm’s use of asset
– TB,tax code and the policies pursed by firm
– IB,interest payments to debtholders
– L,the firm’s degree of financial leverage
Ratio Analysis
– Comparison of ROS and ATO usually is meaningful
only in evaluating firms in the same industry,Even
within an industry,ROS and ATO sometimes can
differ markedly among firms pursing different
marketing strategies.
LIBCL
A T OR O S R O A
CLR O ATB
LA T OR O SIBTB
R O E
Ratio Analysis
Turnover & other asset utilization ratios
– Fixed-asset turnover
– Inventory turnover
– Average collection period or days receivables
Liquidity and coverage ratios
– Current ratio
– Quick ratio or acid test ratio
– Interest coverage ratios or times interest earned
Ratio Analysis
Market price ratios
– Market-to-book-value ratio (P/B)
– Price/earnings ratio (P/E)
– Earning yield (E/P)
BP
R O E
R O E
/P
E
r a t i o P/ E r a t i o P / B
Comparability Problems
Inventory valuation
– LIFO v.s,FIFO
Depreciation
Inflation and interest expense
International accounting conventions
– Reserving practices,Depreciation,
Intangibles
Inflation accounting
Accounting Earnings Versus
Economic Earnings
Accounting earnings are earnings of a
firm as reported on its income statement.
– They are affected by several conventions
regarding the valuation of assets and by the
way some expenditure.
Economic earnings are real flows of cash
that a firm could pay out to shareholders
forever in the absence of any change in
the firm’s productive capacity
Accounting Earnings Versus
Economic Earnings
While different from economic earnings,
net income figure on the firm’s income
statement does convey considerable
information concerning a firm’s
prospects.
The deviation of actual earnings from
projected earnings is the driving force
behind abnormal stock returns.
Summary
A firm’s ROE is a key determinants of growth
of its earnings.
Decomposing a firm’s ROE ratio into the
product of several ratios and analyzing their
separate behavior over time and across
companies is very useful.
The primary focus of the security should be the
firm’s real economic earnings rather than its
reported earnings
Main Contents
The major financial statements
Standard financial ratios
Ratio decomposition analysis
Asset utilization ratios
Comparability problems
Accounting v.s,Economic earnings
The Major Financial Statements
Accounting data are useful in assessing the
economic prospects of the firm.
– An investor can use financial data as inputs into
stock analysis and estimate the intrinsic value of
common stocks.
There are three basic sources of data:
– The income statement
– The balance sheet
– The statement of cash flows
The Major Financial Statements
The income statement
– Table
– Is a summary of the profitability of the firm over a
period of time such as a year.
– Some terms
Revenue,expense,net earning or profit
Cost of goods sold,general and administrative expense,
interest expense,tax on earnings
Operating revenue,operating cost,operating income,
earning before interest & taxes (EBIT)
The Major Financial Statements
The balance sheet
– Table
– Provide a snapshot of the financial condition of the
firm at a particular time.
– Some terms:
Asset,liability,net worth or stockholder’s equity
Current asset,long-term asset
Current liability,long-term debt
Par value of stock,capital surplus(additional paid-in
capital),retained earnings
The Major Financial Statements
The statement of cash flows
– Table
– A statement showing a firm’s cash receipts and cash
payments generated by the firm’s operations,
investments and financial activities during a
specified period.
– Accrual method of accounting v.s,Transaction basic
method
– It provides evidence on the well-being of a firm.
Return On Equity (ROE)
Past ROE v.s,Future ROE
– ROE is one of the two basic factors in deter-mining
a firm’s growth rate of earnings.
A high ROE in the past does not necessarily imply a firm’s
future ROE will be high.
A declining ROE is evidence that the firm’s new
investments have offer a lower ROE than its past
investment.
It is expectations of future dividends and earnings that
determine the intrinsic value of a company’s stock.
Return On Equity (ROE)
Financial leverage and ROE
])()[1(
]T ) [ R O A-(1
r a t e )T a x -(1
E
D)(E
E q u i t y
d e b t )r a t eI n t e r e s t -A s s e t s( R O A
E q u i t y
T a x e s )-r a t e ) ( E B I TT a x -(1
E q u i t y
T a x e s-I n t e r e s t-E B I T
E q u i t y
p r o f i tN e t
E
D
E
D
iR O AR O A-T
i
R O E
Return On Equity (ROE)
An example
– Table
– Business risk,EBIT and ROA
– Financial risk,E and ROE
Some conclusions:
– If there is no debt or ROA= interest rate,its ROE
will simply equal (1-tax rate)*ROA
– If ROA exceeds the rate,the firm earns more on its
money than it pays out to creditors.
Return On Equity (ROE)
– Increase debt will make a positive
contribution to a firm’s ROE only if the
firm’s ROA exceeds the interest rate on the
debt.
– Financial leverage increases the risk of the
equity holder returns
Even if financial leverage increase the expected
ROE,it does not imply the market value of
equity will be higher.
Financial leverage increases the risk of the firm’s
equity as surely as it raises the expected ROE.
Ratio Analysis
Decomposition of ROE & Du Pont system
– Decomposition of ROE is helpful to under-
stand the factors affecting a firm’s ROE,
including its trend over time and its perfor-
mance relative to competitors.
LA T OR O SIBTB
E q u i t y
A s s e t s
A s s e t s
S a l e s
S a l e s
E B I T
E B I T
p r o f i tP r e t a x
p r o f i tP r e t a x
p r o f i tN e t
R O E
Ratio Analysis
An Example
– Table 13.6 on page 361
– ROS,operating profit per dollar of sales
– ATO,the efficiency of the firm’s use of asset
– TB,tax code and the policies pursed by firm
– IB,interest payments to debtholders
– L,the firm’s degree of financial leverage
Ratio Analysis
– Comparison of ROS and ATO usually is meaningful
only in evaluating firms in the same industry,Even
within an industry,ROS and ATO sometimes can
differ markedly among firms pursing different
marketing strategies.
LIBCL
A T OR O S R O A
CLR O ATB
LA T OR O SIBTB
R O E
Ratio Analysis
Turnover & other asset utilization ratios
– Fixed-asset turnover
– Inventory turnover
– Average collection period or days receivables
Liquidity and coverage ratios
– Current ratio
– Quick ratio or acid test ratio
– Interest coverage ratios or times interest earned
Ratio Analysis
Market price ratios
– Market-to-book-value ratio (P/B)
– Price/earnings ratio (P/E)
– Earning yield (E/P)
BP
R O E
R O E
/P
E
r a t i o P/ E r a t i o P / B
Comparability Problems
Inventory valuation
– LIFO v.s,FIFO
Depreciation
Inflation and interest expense
International accounting conventions
– Reserving practices,Depreciation,
Intangibles
Inflation accounting
Accounting Earnings Versus
Economic Earnings
Accounting earnings are earnings of a
firm as reported on its income statement.
– They are affected by several conventions
regarding the valuation of assets and by the
way some expenditure.
Economic earnings are real flows of cash
that a firm could pay out to shareholders
forever in the absence of any change in
the firm’s productive capacity
Accounting Earnings Versus
Economic Earnings
While different from economic earnings,
net income figure on the firm’s income
statement does convey considerable
information concerning a firm’s
prospects.
The deviation of actual earnings from
projected earnings is the driving force
behind abnormal stock returns.
Summary
A firm’s ROE is a key determinants of growth
of its earnings.
Decomposing a firm’s ROE ratio into the
product of several ratios and analyzing their
separate behavior over time and across
companies is very useful.
The primary focus of the security should be the
firm’s real economic earnings rather than its
reported earnings
