3.Financial Statement Analysis

Question 1

What is balance sheet

Answer 1

is a snapshot of the firm’s assets and liabilities at a given point in time.

Assets = Liabilities + Shareholders’ Equity

Question 2

What is goodwill

Answer 2

For example I buy macbook not only for its quality but also for the brand perception, reputation

Question 3

What is Liquidity?

Answer 3

When we speak of the liquidity of an asset, we mean
o the ability to convert it to cash quickly, AND
o without a significant loss in value.
• Firms that have a fair amount of liquid assets are less likely to experience financial distress.
• But liquid assets earn a lower return. Liquidity больше но зарабатываем меньше

Question 4

Trade off between liquidity and return

Answer 4

Basically, that means the lower risk you take the lower return you make. To make higher return with low risk then we should give up some liquidity. For instance, buying the real estate.
Or there’s another way to have a high return, but with high risk for instance buying stocks

Question 5

Book Value versus Market Value

Answer 5

• The balance sheet provides the book value of the assets, liabilities and equity.
• Market value is the price at which the assets, liabilities or equity can actually be bought or sold.
• Market value and book value are often very different. Why?
o Some assets do not even appear on the balance sheet.
o Under certain accounting rules, assets are listed at cost (e.g. US- GAAP, HGB).
o Even if assets are listed at fair value (e.g. IFRS) real market values are not available and must be estimated.
• Therefore, the “Total Assets” line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth.

Question 6

Net Working Capital

Answer 6

Net working capital measures the short-term liquidity of a company

Question 7

The Income Statement

Answer 7

Income (or Profit) = Revenue – Expenses during period

Question 8

Matching principle

Answer 8

Accounting requires to show revenue when it accrues and match the expenses required to generate the revenue.

Question 9

General structure of Income Statement

Answer 9

Turnover(or Revenue)
- COGS
=Gross Profit
- Marketing and sales expenses
- General and administrative expenses
= Operating Profit
\+ Non-opertating income
- Non.operating expenses
= EBIT
\+ FInancial income
- Financial expenses
= EBT
- Income Taxes
= Net Income, NP or EAT

Question 10

Non-Cash Items

Answer 10

Non-cash items are items on the income statement that represent costs but involve no cash outflow or inflow:

Question 11

Depreciation

Answer 11

Cost of machines used up in the production process

Question 12

Amortization

Answer 12

Reduction in the value of intangible assets

Question 13

Impairment

Answer 13

Reduction in the value of e.g. goodwill, shares

Question 14

Operating Cash Flow (OCF)

Answer 14

OCF is the cash flow that results from the day-to-day business of producing and selling.

Question 15

Net Capital Spending (NCS)

Answer 15

• NCS is sometimes called capital expenditure (CAPEX).
• NCS is money spent on fixed assets (additional assets and
replacements) less money received for the sale of fixed assets.

Question 16

Change in Net Working

Answer 16

• NWC is considered a good measure of both a company’s efficiency and its financial health.
• NWC = Current assets – Current liabilities
• The Change in NWC reflects the amounts invested in current assets
less the amounts financed by current liabilities.
Change in NWC = Ending NWC – Beginning NWC

Question 17

interest -finance expense
Sales – turnover or total operating revenue
Cogs- Cost of sales
EBIT- operating profit
Net income- profit for year, net profit

Question 18

Ratio Analysis
Liquidity Ratios
Current Ratio = CA / CL

Answer 18

o This ratio (CR) measures how much current liabilities are covered by current assets, assuming both can be converted to cash over the following 12 months.
o Rule of thumb: > 1 times (~ 1.5 – 2.5 times is considered healthy).
o High current ratio means high liquidity but also means a possible inefficient use of cash.

Question 19

Liquidity Ratios

Quick Ratio = (CA – Inventory) / CL

Answer 19

Quick ratio measures the ability of a business to pay its short-term liabilities by having assets that are already converted into cash
o Rule of thumb: > 1 time.

Question 20

Liquidity Ratios

Cash Ratio = Cash & cash equivalent / CL

Answer 20

o This ratio measures how much current liabilities are covered by cash or cash equivalent.
o Rule of thumb: ~ 0.2 times for the healthy company.
o For a start-up, this ratio should be higher e.g. between 0.3 and 0.5. o Too little cash (Cash Ratio &laquo_space;0.2) increases the risk of bankruptcy.
o Too much cash (Cash Ratio&raquo_space; 0.2) means too much-forgone interest.

Question 21

Financial Leverage Ratios

Total Debt Ratio

Answer 21

=TL/TA
o This ratio measures how much of the company’s assets is funded by
debt.
o Rule of thumb: < 0.7 times for healthy firm.
o This ratio takes into account all debts (current and non-current) of all maturities to all creditors.
o A low percentage (&laquo_space;0.7) means that the company is less dependent on leverage i.e. money borrowed from and/or owed to others. т
o In general, the higher the ratio, the more risks the company is considered to have taken on.

Question 22

Financial Leverage Ratios

Debt Equity Ratio

Answer 22

TL / TE
o This ratio indicates the proportion of debt and equity the company is
using to finance its assets.
o Rule of thumb: < 2 times.
o Similar to the Total Debt Ratio, a low percentage (&laquo_space;2) means that the company is using less leverage and has stronger equity position.
o A high Debt Equity Ratio means that the company has made an aggressive financing with debt. The company must therefore ensure that it generates sufficient operating profit to cover additional interest expenses.

Question 23

Financial Leverage Ratios

Equity Multiplier

Answer 23

= TA / TE = 1 + Debt Equity Ratio

o This ratio is useful in the consideration of Return of Equity (ROE).

Question 24

Financial Leverage Ratios

Times Interest Earned Ratio = EBIT / Interest

Answer 24

o This ratio (a.k.a Interest Coverage Ratio) indicates well the company
has its interest obligations covered.
o Rule of thumb: > 1 times.

Question 25

Financial Leverage Ratios

Cash Coverage Ratio = (EBIT + Depreciation) / Interest

Answer 25

o Like the Times Interest Earned ratio, this ratio measures the firm’s ability to pay its interest obligations from the cash generated from its operating activities.
o Rule of thumb: > 1 times.

Question 26

Asset Management Ratios

Inventory Turnover = COGS / Inventory

Answer 26

o This ratio measures how many times inventory is sold per year.
o Rule of thumb: Industry-dependent (however, the higher the ratio the more efficient the company is at managing its inventory).
o Generally, low inventory turnover means poor sales i.e. the company has excess stocks. This means a bad return on investment (i.e. buying too much) and trouble should the prices fall.

Question 27

Asset Management Ratios

Days’ Sales in Inventory (DSI) = 365 days / Inventory Turnover

Answer 27

o This ratio measures how long inventory is held before it is sold.
o Rule of thumb: Industry-dependent.
o Assuming the company is not running out of stock, the lower the Days’ Sales in Inventory, the more efficient the company is at managing its inventories.

Question 28

Asset Management Ratios

Receivables Turnover = Sales / Trade receivables

Answer 28

o This ratio measures how many times the company collects its
outstanding receivables during the year.
o Rule of thumb: > 12 times.

Question 29

Asset Management Ratios

Days’ Sales in Receivables (DSR) = 365 days / Receivables Turnover

Answer 29

o This ratio (also known as ‘Days Sales Outstanding’ or DSO) measures how fast (in days) the company collects cash on the sales and clears its credit accounts.
o Rule of thumb: ~ 30 days.
o The goal of business is to keep the Days’ Sales in Receivable as low as possible. The faster it is, the better the company is ultilising its assets.

Question 30

Asset Management Ratios

Total Asset Turnover (TAT) = Sales / Total Assets

Answer 30

o TAT measures how much sales in generated for every euro in assets.
o Rule of thumb: Industry-dependent.
o Generally, the higher the TAT the better. It means that the company is efficient at utilising its assets to generate sales.
o It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets.

Question 31

Profitability Ratios
Profit Margin (PM)

Answer 31

= (Net Income / Sales ) x 100%
o PM measures how much the company earns for every euro (dollar or
yen) in sales.
o Rule of thumb: Industry-dependent.
o PM indicates how well the company controls the costs that are required to generate the revenues.

Question 32

Profitability Ratios

Return on Assets (ROA)

Answer 32

= (Net Income / TA ) x 100%
o ROA measures profit per asset value or profit per every euro (dollar or
yen) of asset invested.
o Rule of thumb: Industry-dependent.
o ROA indicates how efficient the management is at using the company’s assets to generate profit.
o Generally, the higher the ROA the better. However, like PM, ROA can be very different for different industries e.g. capital-intensive businesses (with a large investment in fixed assets) are going to be more asset-heavy (hence low ROA) than technology or service businesses (hence high ROA).
o The management job is to make wise choice in allocating resources. Best managers make large profit from little investment in assets.

Question 33

Profitability Ratios

Return on Equity (ROE)

Answer 33

= (Net Income / TE ) x 100%
o ROE measures profit per equity value or profit per every euro (dollar or
yen) of equity invested.
o Rule of thumb: Industry-dependent (however, 15~20% are considered good).
o ROE indicates how well the company manages shareholders’ money and is therefore the most relevant profitability measure for shareholders.

Question 34

Market Value Ratios

Earnings Per Share (EPS) = Net Income* / Shares Outstanding

Answer 34

o EPS measures the earnings that every shareholder gets per share.
o Rule of thumb: company/industry-dependent (however, this needs to be at least greater than zero!).

Question 35

Market Value Ratios

Price Earnings Ratio (P/E) = Share Price / EPS

Answer 35

o PE ratio (P/E) indicates how much investors or the market is willing to pay per unit of current the earnings. This is sometimes referred to as ‘multiples’.
o Rule of thumb: company/industry-dependent (however, ~15-20 times for typical large companies).
o High P/E relative to the market means that either the company has a significant prospect for future growth OR it is currently being overvalued.
o Low P/E means either a “vote of no confidence” in the company OR the company is currently being overlooked by the market i.e. it is undervalued.

Question 36

Market Value Ratios

Market-to-Book ratio = Share Price / Book value per share ,where:

Answer 36

Book value per share = Total Equity / Shares Outstanding.
o Market-to-book ratio compares the market value of equity to the book value of equity and is often used by analysts as a measure of valuation for a stock.
o Rule of thumb: > 1 (~ 1.7 on average for the largest 30 US firms).
o Market to Book ratio compares the market value of the company’s
investments (numerator) with their historical costs (denominator).
o It is generally a bad sign if a company’s market-to-book ratio approaches 1.00 i.e. the company has not been successful in creating value for the shareholders.

Question 37

Limitations of Financial Ratios

Answer 37

• Like-with-like comparison
Care should be exercised that we are comparing companies like with
like e.g. same year, same industries, same periods.
• Rule of Thumb
Rules of thumb (R.O.T.) are just indicators. Different industries can differ from the R.O.T. Nevertheless, R.O.T. can be used in the first instance in the absence of other benchmarks. If the numbers are fairly different from the R.O.T. one should then investigate further e.g. compare previous years, same industry.
• Conglomerates
Conglomerates can be a problem. It could be difficult to assign an
industry to them. If possible, one should look at individual businesses
• International comparison
Sometimes major competitors and natural peer group are not in the same countries. This could be a problem as different accounting standards, taxes make it difficult to compare financial statements across borders.
• Line of business
Sometimes companies in the same line of business may not be comparable e.g. within the electricity generation business, there is hydro, renewable, coal etc. In such cases, further sub-categories of business may be required.
• One off event
Watch out for one off events e.g. one time profit from asset sales or one-off legal payout.
Seasonal business
Seasonal businesses can lead to difficulty in comparing financial positions e.g. trailing twelve months figures because of fluctuations in account during the year.
• Single financial factor
It is important not to rely on any one measure but to use it in conjunction with other measures e.g. a company may have a poor current ratio. But if it has a reasonable interest coverage and profit margin, it could still be an investable business.
• Internal strengths
Internal strengths such as the quality of staff,quality of products do not appear on the financial statements so they won’t show up in ratios.
• External factors
External factors such as economic or market environment are not reflected in the financial statements. When the market is very competitive, or the economy is in a downturn, it is OK for the ratios to suffer a bit.
• Future changes
Technological advances or changes in interest rates cannot be predicted by the financial statements, so they won’t show up in the ratios.
• Timing
Ratios only contain information about past and present. A business which has just started investing for growth will have lousy ratios until investments pay off. That doesn’t mean it is not worth investing.