Analysis of Financial Statements

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 Background
♦Financial statements aid in the process of
fundamental analysis
♦Fundamental analysts evaluate financial
ratios as an aid to determine if a security is
over- or under-priced
♦The efficient market theory suggests that
publicly available financial statements offer
nothing of value
– Professional security analysts have already
discovered pertinent information and traded
based on that information
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 Financial Statements
♦Large public firms issue quarterly financial
statements
♦Small firms may only issue annual
statements
♦Closely-held corporations may not issue
public financial statements
♦Main financial statements
– Balance sheet
– Income and expense statement
– Statement of cash flows

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 Balance Sheet
♦Represents historical value of firm’s assets,
liabilities and stockholders’ equity on the day
the accounting period ends
♦Assets = Liability + Stockholders’ Equity
– Stockholders’ Equity represents firm’s net worth
(Book value of owners’ equity)
♦Most firms end the fiscal year on December
31

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KO’s Balance Sheet

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 Income & Expense Statement
♦Report the flows that occurred during
the accounting period
♦AKA profit and loss statement
♦Sales – Total Expenses = Income
(Loss)

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KO’s Income & Expense Statement

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 Statement of Cash Flows
♦Cash flows are the net cash remaining
after all reinvestments have been
deducted
♦Cash flow is not affected by
– Accelerated depreciation rules
– Arbitrary inventory valuation rules
– Accrual methods of accounting
♦Accounting income is more ambiguous
than a firm’s cash flows
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KO’s Statement of Cash Flows

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KO’s Statement of Cash Flows

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 KO’s Cash Flows
Cash flows provided by (used in): 1997 1998 1999
Operations 4,033 3,433 3,883
Investment activities (1,082) (1,557) (1,551)
Free cash flow 2,951 1,876 2,332
Cash flows used in:
Financing
Share repurchases (1,262) (1,563) (15)
Other financing activities (1,833) 230 (456)
Exchange (134) (28) (28)
Increase (Decrease) in cash 304 (89) (37)

KO uses its large cash flows for KO generates

reinvesting within the firm, tremendous cash flows
joint ventures, stock from operations
repurchases and cash dividends.
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Sources of Financial Statements
♦ Publicly traded companies in the U.S. are required to
make full disclosure of their financial statements
– Usually a phone call or letter is all that is needed & firm
will mail statements to you
• SEC’s Electronic Data Gathering Analysis and Retrieval
(EDGAR) System has the information for free at
www.sec.gov/edgarhp.htm
– Not user friendly
• EDGAR Online at www.edgar-online.com and FreeEDGAR
at www.freeedgar.com are more user friendly but not all the
data is free
• Hoover’s On-Line at www.hoovers.com, PR Newswire at
www.prnewswire.com and Yahoo!Finance at
http://quotes.yahoo.com offer additional information

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Common-Sized Financial Statements
♦Express each item as a percentage of a
common base number
– Such as Assets or Sales
♦Useful when comparing
– A firm over time
– Different sized firms
– Firms from different countries

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KO’s Common-Sized Balance Sheet

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 KO’s Common-Sized
Income & Expense Statement

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Analysis of Sales and Competition
♦KO manufactures syrups for the following
products
– Coke Products (≈70% of total sales)
• Classic Coke
• Diet Coke
• Decaffeinated Diet Coke
• Cherry Coke
• Diet Cherry Coke
– Non-Coke soft drinks (≈21% of total sales)
• Sprite •Diet Sprite •Mello Yello
• Fanta •Mr. PiBB •Lift
• TAB •Fresca •Barq’s
• Nestea •POWERaDE •Specialty local drinks

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Analysis of Sales and Competition
– Food Sales
• Fruit juices generate ≈9% of total sales
– Minute Maid juice
– Hi-C
– Fruitopia

♦In the 1970s and 80s KO also sold

– Wines Discontinued these
– Straws product lines to focus
on core business.
– Plastic cups
– Water conditioning equipment
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Analysis of Sales and Competition
♦KO products made up 18% of the non-
alcoholic soft drinks purchased in the
world in 1999
♦Sales have grown at 6% annually for
the last decade
♦EPS grew at 4.8% during the same
period

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 Analysis of Sales and Competition
♦KO sells its products in 200 countries

Only 21% are

made in the
U.S. where
KO is
headquartered.

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Analysis of Sales and Competition
♦Company strengths
– Multinational diversification
– Differentiated product line
♦Executives forecast a continuation of past
growth
♦Main competitor
– PepsiCo
♦Only weak line is the ‘food products’ line

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 Financial Ratios
♦A financial ratio combines multiple values to
produce a new, meaningful value
– Used to quantify, summarize and interpret
financial data
♦Types of ratios
– Solvency or liquidity ratio
• Measure firm’s ability to meet short-term obligations
– Turnover ratios
• Measure rate of activity
– Coverage ratios
• Measure extent to which the firm’s earnings can cover
debt-related expenses
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 Financial Ratios
– Leverage ratios
• Measure extent to which firm has been financed by
creditors
– Profitability ratios
• Measures productivity of money invested in firm
– Per share data
• Examines items that affect common stock’s market
price per share
– Growth ratios
• Measures contribution of various items to firm’s
development
– Risk analysis ratios
• Measures variability
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 Solvency (Liquidity) Ratios
♦ Current Ratio
– Formula
• Current Assets ÷ Current Liabilities
– Values
• 1997: 0.81 For every $1 in current liabilities
• 1998: 0.74 the firm had $0.66 in current assets.
• 1999: 0.66 KO did not quite have enough
♦Quick Ratio current assets to pay its bills.
–Formula
Quick ratio is
•(Current Assets – Inventory) ÷ Current Liabilities
more
discriminating –Values
than Current
If the firm’s inventory becomes
•1997: 0.68
Ratio—only worthless, KO does not have
•1998: 0.64
includes the most enough liquid current assets to
•1999: 0.55
liquid assets. pay its bills.
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 Solvency (Liquidity) Ratios
♦Even though KO has experienced huge
cash flows, the firm’s current and quick
ratios are quite low
♦Thus, the solvency ratios did not tell
the whole story

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 Turnover Ratios
♦Inactive assets might not be generating
earnings
– Turnover ratios help pinpoint the non-earning
assets
♦Receivables Turnover Ratio
– Formula
• Annual credit sales ÷ Accounts receivable
– Values Receivables turn over slightly
• 1997: 11.51 less than once a month. Is this too
• 1998: 11.29 low/high? Cannot be determined
without knowing firm’s credit policy
• 1999: 11.02
and industry customs.

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 Turnover Ratios
♦ Collection Period
– Formula
• Accounts receivable ÷ Average day’s sales
– Values Acceptable value
• 1997: 31.71 days depends on product
• 1998: 32.32 days being sold and credit
• 1999: 33.14 days terms.

♦Inventory Turnover
–Formula
•Annual sales (at cost) ÷ Average Inventory (at cost)
–Values
•1997: 6.27 Need more information
•1998: 6.25 before we can evaluate
•1999: 5.58 these values.

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 Turnover Ratios
♦ Asset Turnover Ratio
– Formula
• Annual Sales ÷ Total Assets
– Values
• 1997: 1.11
Needs to be compared
• 1998: 0.98
to competitors’ values.
• 1999: 0.92
♦Equity Turnover Ratio
–Formula
•Annual Sales ÷ Equity
–Values
•1997: 2.58 Equity turns over
faster than assets
•1998: 2.24
because firm uses
•1999: 2.08 financial leverage.

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 Coverage Ratios
♦ Times Interest Earned
– Formula
• Annual operating income ÷ Annual interest payment
– Values
•1997: 106.40
•1998: 85.64
•1999: 51.71
KO’s income can fall
98.07% (1 – (1/51.7 times)
before it will be
insufficient to cover the
firm’s interest expense.
Some financial analysts prefer to
use the pre-tax gross income
instead of operating income
Some analysts use all
debt-service charges,
lease payment and
cash dividends on
preferred stock instead
of interest payment
alone.
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 A Cash Flow Ratio
♦ Two values from the Income & Expense Statement
can be used to define a company’s cash flow
– Earnings before interest and taxes (EBIT)
– Depreciation/Amortization
• Allocates an asset’s cost over its useful life
• A non-cash expense deducted from revenue
• Reduces taxes
♦ KO’s 1999 cash flow is
– EBIT of $3,982 + Depreciation of $792 = $4,774
♦ Can now calculate the Cash flow-to-long-term-debt
ratio
– 4,774 ÷ 854 = 5.59

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 Financial Leverage Ratios
♦ Total Debt to Total Asset Ratio
– Formula
• Total debt ÷ Total assets
– Values
• 1997: 0.57
• 1998: 0.56
• 1999: 0.56
♦ Total Debt to Total Equity
– Formula
• Total debt ÷ Total equity
– Values
• 1997: 131.7
• 1998: 127.8
• 1999: 127.3
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 Financial Leverage Ratios
♦ Long-term Debt to Equity
– Formula
• Long-term debt ÷ Equity
– Values
• 1997: 0.31
• 1998: 0.25
• 1999: 0.24
♦ Long-term Debt to Capitalization
– Formula
• Long-term debt ÷ Capitalization
– Values Sum of permanent current liabilities,
• 1997: 0.24 long-term debt, preferred stock and
• 1998: 0.20 stockholders’ equity.
• 1999: 0.19
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 Financial Leverage Ratios
♦Total Asset to Equity Ratio
– Formula
• Total assets ÷ Equity
– Values
• 1997: 231.7%
• 1998: 227.8%
• 1999: 227.3%

♦Financial ratios are sometimes calculated

with market values rather than book values
– Often more realistic and relevant

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 Profitability Ratios
♦ Net Profit Margin
– Formula
• Net income ÷ Sales
– Values An appropriate
• 1997: 0.22 or 22% standard is needed
• 1998: 0.19 or 19% to interpret a profit
• 1999: 0.12 or 12% margin.
♦Return on Asset
–Formula
A dollar’s worth of
•Net income ÷ Total assets
assets yielded
–Values
about 11¢ of after-
•1997: 0.24 or 24%
tax earnings in
•1998: 0.18 or 18%
1999.
•1999: 0.11 or 11%

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 Profitability Ratios
♦ Return on Equity (ROE)
– Formula
• Net income ÷ Equity
– Values If a firm has zero
• 1997: 0.57 or 57% debt, its ROA and
• 1998: 0.42 or 42% ROE are equal.
• 1999: 0.26 or 26%

♦Long-Term Capital’s Pretax Rate of Return

–Formula
•(Interest + Pretax earnings) ÷ Capitalization
–Values
If the rate does not exceed current
•1997: 0.75 or 75%
interest rates, the firm is not
•1998: 0.58 or 58%
•1999: 0.37 or 37%
earning enough to pay its debts.

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Per Share Data for Common Stock
♦Earnings Per Share (EPS)
– Formula
• Net income ÷ # of common shares outstanding
– Values
• 1997: $1.67
• 1998: $1.43
• 1999: $0.98
♦ Cash Dividend Per Share
– Formula
• Total corporate dividend ÷ # of common shares outstanding
– Values
• 1997: $0.56
• 1998: $0.60
• 1999: $0.64
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Per Share Data for Common Stock
♦ Payout Ratio
– Formula
• Cash dividends per share ÷ EPS
Measures the
– Values
percentage of
• 1997: 0.336 or 33.6%
earnings the
• 1998: 0.419 or 41.9%
firm pays out
• 1999: 0.653 or 65.3%
as a dividend.
♦Retention Rate
–Formula
•Retained Earnings ÷ Net income
–Values Measures the
•1997: 0.664 or 66.4% percentage of
•1998: 0.581 or 58.1% earnings the
•1999: 0.350 or 35.0% firm retains.

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Per Share Data for Common Stock
♦Price-Earnings Ratio (P-E)
– Formula
• Market price per share ÷ EPS
– Values
• 1997: Low of 32 to high of 47
• 1998: Low of 36 to high of 56
• 1999: Low of 48 to high of 72

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Analyzing and Interpreting Ratios
♦DuPont Analysis
– Allows for a thorough analysis of ROE
Net income
ROE =
Equity
Sales Net income
= ×
Equity   Sales
  
 
Equity Turnover Net profit margin

Sales Total assets Net income

= × ×
  assets
Total   Equity
       Sales
  
Total asset turnover Financial leverage ratio Net profit margin

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 KO’s DuPont Analysis
Asset Financial Profit Profit Margin
Year Turnover Leverage Margin ROE rose and then
1990 1.10 2.41 13.50% 35.91% fell over the
decade.
1991 1.14 2.40 13.98% 38.17%
1992 1.18 2.84 12.73% 42.80% The increased
use of
1993 1.16 2.62 15.58% 47.47% financial
1994 1.17 2.65 15.78% 48.79% leverage
Asset 1995 1.20 2.79 16.57% 55.38% increased ROE
Turnover through 1996.
1996 1.16 2.63 18.70% 56.73%
rose and
1997 1.12 2.32 21.88% 56.76%
then fell
over the 1998 0.98 2.28 18.78% 42.04%
decade. 1999 0.92 2.27 12.27% 25.52%

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 Analysis of Growth
♦Common stock price appreciation depends
on various factors
– Growth financed internally depends on the
amount of retained earnings
– A corporation’s growth rate depends on the
return on equity
• Growth rate = RR x ROE
Shows that multiple – Substituting the three-part DuPont ROE equation, we
factors influence obtain
growth—one factor Sales Total assets Net income
Growth rate = RR × × ×
can rise and another Total assets Equity Sales
fall and growth can
remain unchanged.
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 Risk Analysis
♦As a firm’s risk increases
– Investors demand higher interest rates
(returns)
• Thus, the price of the firm’s bonds and stocks
will drop (inverse relationship)
♦How do you measure risk?
– Coefficient of variation
• Standard deviation ÷ average value
• Rescales different-size standard deviations to
make them easily comparable

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 Risk Analysis
♦Business risk
– Determined by volatility of operating
income
– Arises from fluctuations in sales and
production costs
♦Financial risk
– Arises due to the use of financial leverage
(debt)

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Ratio Standards of Comparison
♦Cross-Sectional standards
– Compare a firm’s financial ratios to other firms
or industry average
• Industry averages are published by companies such as
– Moody’s
– Standard & Poor’s
– Fitchs
– Value Line
– Duff and Phelps
– Dunn and Bradstreet
– Can reveal a firm’s strengths/weaknesses
compared to other firms

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Ratio Standards of Comparison
♦Time-Series standards
– Compare a firm to its own ratios from
other years
• Helps highlight trends/changes that have
occurred

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Potential Problems with Financial Analysis

♦Inflation distortions
– Can be a serious problem with the balance sheet
• Some fixed assets are reported at their historical costs
– After several years of high inflation historical costs can
be irrelevant

♦Vague definition of accounting income

– A firm can modify its accounting income
depending upon certain actions
• Such as which depreciation method or inventory
valuation technique is used

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Potential Problems with Financial Analysis

♦Consolidated financial statements

– When a firm owns a subsidiary
corporation accounting issues arise when
considering minority interests
♦Goodwill
– When a company merges, oftentimes
‘goodwill’ is then reflected on the
consolidated balance sheet
• This intangible asset cannot be measured with
precision

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 The Bottom Line
♦ Financial ratios are computed using basic financial
statements like the balance sheet, income and
expense statement and the statement of cash flows
♦ Financial ratios include
– solvency ratios
– coverage ratios
– turnover ratios
– profitability ratios
– cash flow ratios
– leverage ratios
– growth ratios
– per share data
– statistical risk analysis
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 The Bottom Line
♦ Comparison of a firm’s ratios can be done on a
– Cross-sectional basis
– Time-series basis
♦ Many additional ratios exist that were not covered in
this chapter
– Some analysts like to restate ratios
– Some industries have ratios peculiar to that industry
♦ Financial ratios can be distorted by
– Inflation
– Different accounting methods
– Mergers

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