Financial Analysis

Purpose
Ratio Analysis
Cash Flow Analysis

Purpose of Financial Analysis

Assess Corporate Performance in the
context of stated goals and strategy.
Assess current financial position,
including liquidity.

Tools of Traditional
Financial Statement Analysis
Ratio analysis
Cash Flow analysis

Ratio Analysis
Tools for interpreting financial
statements
Often used to facilitate comparison
via deflation.
Common size financial statementswhen the whole statement is
converted to ratio form.

Ratio Analysis

Financial ratios are typically grouped

into four classes
Profitability
Liquidity ratios
Solvency ratios
Funds management ratios

Profitability and growthStrategic Areas of Influence

Operating management
Investment management
Financing strategy
Dividend policies

Drivers of Profit and Growth

Profitability and
Growth

Product Market
Strategies
Operating
Management

Investment
Management

Managing
Revenue and
Expenses

Managing
Working
Capital and
Fixed Assets

Financial Market
Strategies

Financing
Management

Managing
Liabilities and
Equity

Dividend
Policy

Managing
Payout

Ratios can be used:

To compare the same firm over
several years
To compare to other firms in the
industry
To compare to an absolute
benchmark

Operating Management
(managing revenues and expenses)

Return on equity (ROE) -- ROE = (Net

Income) / (Shareholders Equity)
Return on Assets -- Income / (Total
Assets)
Return on sales (ROS) -- Net Income /
Sales
Gross Profit Margin- (Sales-COGS)/Sales
Numerous variations of the above are
computed in practice

An Example-Return on Equity
(ROE)
Beginning balances, ending balances, average
balances ?
Often adjusted for preferred stock dividends
Average for US industries is from 11 to 13%
(PBH)

The need for an analysis

framework
What do ROE, NPM, ROA, etc., mean
as a group?
What if they differ as to outcome
(e.g., one firm has a higher NPM but
lower ROE)?
What story do they tell, collectively?
How do they relate to each other?

The Notion of Ratio Decomposition

(Dupont Analysis)

ROE = ROA * Assets/equity (Financial

leverage)
ROA= net income/ assets
Financial leverage indicates the dollar of
assets the firm is able to deploy for dollar
invested by shareholders

Sustainable Growth Rate

Dividend payout
ROE
ROS
GOGS/ Sales
GP/ Sales
SG&A/Sales
R&D/Sales
OE/ Sales
Non OE / Sales
EBT / Sales
Tax Expenses /
Sales

Asset Turnover
CA Turnover
WC Turnover
AR Tirnover
Inv Tirnover
AP Turnover
Days Rec
Days Pay
PP&E Turnover

Fin Leverage
Current Ratio
Quick Ratio
Cash Ratio
Oper CF Ratio
Liab to Equity
Debt to Equity
Debt to Capital
Int Coverage

Sustainable Growth 1

ROE * (1-Dividend payout ratio)

Gross Profit Margin

A high gross profit margin is

preferred to a lower one, which also
implies that a company has
relatively more flexibility in product
pricing.

Gross Profit Margin

Two main factors determine gross profit

margins:
1. Competition The more competition, the
lower margins tend to be.
2. Product mix The greater the volume of
low profit/high turnover goods, the lower the
margins.
Very relevant for comparisons within an
industry -- not much outside

Operating Expense Margin

Operating expense ratios (percents) are used to examine

the proportion of sales consumed by each major expense
category.
Expense ratios are calculated as follows:
Operating expense percentage = Expense item/Net sales

Drivers of Profit and Growth

Profitability and
Growth

Product Market
Strategies
Operating
Management

Investment
Management

Managing
Revenue and
Expenses

Managing
Working
Capital and
Fixed Assets

Financial Market
Strategies

Financing
Management

Managing
Liabilities and
Equity

Dividend
Policy

Managing
Payout

Investment Management

Working Capital and Fixed Assets

Receivables
Inventory
LT operating assets
Payables

Turnover
Turnover measures relate to the
productivity of company assets, i.e.,
how much capital is required to
generate a specific sales volume?
Turnover ratios are calculated as
follows:
Turnover = Sales volume/Average Assets
As turnover increases, there is greater
cash inflow as cash outflow for assets
to support the current sales volume is
reduced.

Accounts Receivable Turnover (ART)

Inventory Turnover (INVT)

L-T Operating Asset Turnover

(LTOAT)

Accounts Payable Turnover (APT)

Net Operating Working Capital

Turnover (WOCT)

Evaluating Financial
Management
Short-term evaluations
Long-term evaluations

Short-term evaluations 1

Current ratio
(Current assets) / (Current liabilities)

Short-term evaluations 2

Quick ratio
(Cash + Short-term investments +
Accounts Receivable) / (Current
liabilities)

Short-term evaluations 3

Operating cash flow ratio

(Cash flow from operations) / (Current
liabilities)

Long-term evaluations
Debt is typically cheaper that equity
Interest is tax deductible dividends
are not
Can impose discipline on
management (explicit contracts)
Easier to communicate proprietary
information to private lenders than
to public markets

Standard ratios
Liabilities-to-equity-ratio
Debt-to-equity ratio
Debt-to-capital
Interest coverage

Liabilities-to-equity

(Total Liabilities) / (Shareholders

equity)

Debt-to-equity

(Short-term debt + Long-term

debt) / (Shareholders equity)

Interest coverage

(Net income + Interest expense +

Tax expense) / (Interest expense)

Problems with Ratios

Mis-specification of deflator (e.g., size)
Accounting imperfections
Problem of assumed linearity
Ratio blow-up
Negative numbers. What do they
mean?
Assumed 0 intercept.
Omitted variables

From Business Activities to Financial

Statements
Business
Environment

Business
Activities

Business
Strategy
Accounting
System

Accounting
Accounting
Strategy

Environment
Financial
Statements

Drivers of Profit and Growth

Profitability and
Growth

Product Market
Strategies
Operating
Management

Investment
Management

Managing
Revenue and
Expenses

Managing
Working
Capital and
Fixed Assets

Financial Market
Strategies

Financing
Management

Managing
Liabilities and
Equity

Dividend
Policy

Managing
Payout

Cash Flow AnalysisBased on Business Activities

Operating Activities
Investment Activities
Financing Activities

Cash Flow
The Direct Method
The Indirect Method

Cash Flow -- Direct Method

Recommended by the FASB
Most companies use the Indirect
Method

Cash Flow -- Indirect Method - 1

Net Income
Add
Non-cash income items
Plus/Less

Adjustments for receivables

inventories, payables, taxes
Equals

Cash Flow from Operations

Cash Flow -- Indirect Method - 2

Cash Flow from Operations
PLUS/LESS

Cash flow - Investment activities

PLUS/LESS

Cash flow - Financing activities

EQUALS

Change in cash and cash

equivalents

From Profit to Cash

Net Income

+ Noncash
charges

+/- Chg
in Working Cap

Cash Flow
From Oper.
bef. WC chgs,
Inv & Int

CF from op
After Wc Changes
before int

From Profit to Cash -- 2

CF
+/- Interest

+/- Chg Fixed

Capital

Cash Flow
From
Operations

Free
Cash
Flow

Free Cash Flow

Jensen (1988) defines free cash flow

as the cash left after managers have
invested in all positive NPV projects
He also asserts that managers will invest
in negative NPV projects rather pay it out
to shareholders

The Free cash flow used in out context

is the cash flow from operations plus
the net investment cash flow

Free cash Flow and Interest

You may add interest back. Depends

on the purpose of the Free Cash
Flow. See p. 6-3.

Free Cash Flow From Working

Capital
Adjust Working Capital from
operations for changes in current
accounts to get Cash Flow From
Operations
Add the net capital investment
What you get is Free Cash Flow