Chapter 14 - financial statement analysis Flashcards
income statement
shows a firm’s revenues and expenses during a specified period
classes of expenses
- Cost of goods sold: the direct cost attributable to producing the product sold by the firm
- SG&A: corresponds to overhead expenses, salaries, advertising, and other costs of operating the firm that is not directly attributable to production
- Interest expense on the firm’s debt
- Taxes owed to federal and local governments
operating income
difference between operating revenues and operating expenses
other income (expenses)
from other, primarily nonrecurring, sources is then added (subtracted) to obtain earnings before interest and taxes (EBIT)
EBIT
Measures profitability abstracting from the interest burden attributable to debt financing and taxes
common size IS
all items are expressed as a percentage of total revenue
economic earnings
The real flow of cash that a firm could pay out without impairing its productive capacity
accounting earnings
- Earnings of a firm as reported on its income statement
- Affected by several conventions regarding the valuation of assets such as inventories (LIFO vs. FIFO) and by the way some expenditures sich as capital investments are recognized over time (depreciation expenses)
balance sheet
An accounting statement of a firm’s financial position at a particular time
fundamental accounting equation
Assets = Liabilities + Equity
assets
items that will bring future financial benefits
current assets
cash and other items sich as AR or inventories that will be converted into cahs within one year
Long-term (fixed) assets
- Tangible fixed assets: items such as property, plant, or equipment
- Intangible assets: hard to value
Goodwill
when one firm purchases another for a premium over its BV
liabilities
financial obligations
current liabilities
accounts payable and debts due within one year
shareholder’s equity
- different between total assets and total liabilities
- Net worth or book value
- Divided into par value of stock, capital surplus (additional paid-in capital), and retained earnings
- Par value + capital surplus represents the proceeds realized from the sale of the stock tp the public
treasury stock
Stock that has been repurchased by the company and is held in its treasury
issued shares
Shares that have been issued by the company
outstanding shares
Shares that have been issued by the company and are held by investors
cash flow statement
shows a firm’s cash receipts and cash payments during a specified period
cash flow from operations
- Starts with net income, adjusts for non-cash items, and changes in working capital
- Adds back depreciation expense
cash flow from investing
Investments in the assets necessary for the firm to maintain or enhance its productive capacity
cash flow from financing
issuance/redemption of outstanding securities or debt
- dividends
Financial manager responsibilities
- Investment (capital budgeting) decisions: pertain to the firm’s use of capital
- financing decisions: firm’s sources of capital
Investment (capital budgeting) decisions
- pertain to the firm’s use of capital
Profitability of projects?
- ROA, ROE, ROC, economic value added
- Turnover ratios
- Profit margins
financial decisions
- firm’s sources of capital
- Debt ratios, coverage ratios
- Current, quick, and cash ratios
- NWC
return on assets (ROA)
- Earnings before interest and taxes divided by total assets
- ROA = EBIT / TA
- Operating income / TA
return on invested capital (ROIC)
- EBIT divided by long-term capital
- ROC = EBIT / long-term capital
- Operating earnings per dollar of long-term capital
long-term capital
shareholder’s equity + long-term debt
return on equity (ROE)
- The ratio of net profits to common equity
- ROE = NI / shareholder’s equity
- NI realized by shareholders per dollar they have invested in the firm
what does debt/equity mix affect
ROE
ROE, ROA relationship
ROE = (1-tax rate) x [ROA+(ROA-interest rate)x(debt/equity)]
If ROA exceeds borrowing rate…
- the firm earns more in its investments than it pays out to creditors
- Surplus earnings are available to the equityholders, which increases ROE
If ROA is less than the interest rate paid on debt…
then ROE will decline by an amount that depends on the debt/equity ratio
Economic value added (residual income)
- A measure of the dollar value of a firm’s return in excess of its opportunity cost
- (ROC - CoC) x capital invested in the firm
- Plowing back funds into the firm increases share value only if the firm earns a higher RoR on those funds than the opportunity cost of capital
opportunity CoC
market capitalization rate
DuPont system
Decomposition of profitability measures into component ratios
ROE (decomposed) =
(NI/equity) = (NI/pretax profit) x (pretax profit/EBIT) x (EBIT/sales) x (sales/assets) x (assets/equity)
Operating profits margin (return on sales)
ratio of operating profits per dollar of sales, (EBIT/sales)
asset turnover (ATO)
The annual sales generated by each dollar of assets, (sales/assets)
Tax burden ratio
NI/pretax profit
what ratios do not depend on leverage
- operating profit margin
- asset turnover
what ratios are not affected by capital structure?
- tax burden ratio
- operating profit margin
- asset turnover
what ratios are affected by capital structure?
- interest burden ratio
- leverage ratio
interest-burden ratio
- Pretax profits/EBIT = (EBIT-interest expense)/EBIT
- Higher the financial leverage, the lower the IB raito
interest coverage ratio (times interest earned)
- A financial leverage measure arrived at by dividing EBIT by interest expense
- Interest coverage = EBIT/interest expense
- High coverage ratio indicates that annual earnings are significantly greater than annual interest obligations
leverage ratio
Measure of debt financing, (assets/equity)
compound leverage factor
interest burden x leverage ratio
inventory turnover ratio
COGS/average inventory
days sales in receivables (average collection period)
- Accounts receivable per dollar of daily sales
Average level of AR expressed as a multiple of daily sales - (Average AR/sales) x 365
- Number of days’ worth of sales tied up in AR
- Average leg between the date of sale and the date payment is received
liquidity
The ability to convert assets into cash at short notice
current ratio
- Current assets/current liabilities
- Ability to pay off CL by liquidating in CA
Quick (acid test) ratio
- A measure of liquidity similar to the current ratio except for exclusion of inventories
- (cash + marketable securities + receivables) / CL
cash ratio
- Ratio of cash and marketable securities to current liabilities
- Cash ratio = (cash + marketable securities) / CL
Market-to-book-value ratio (P/B)
Market price / book value per share
price/earnings ratio (P/E)
- ratio of a stock’s price to its earnings per share
- How much the market is willing to pay for a dollar of earnings
- Market views the firm as having attractive growth opportunities
ROE =
= earnings/BV = (market price/BV) / (market price/earnings)
comparability problems
GAAP manipulability, inflation, capitalization of leases and other expenses, treatment of pension costs, and allowances for reserves
LIFO
- last-in, first-out accounting method of valuing inventories
- If costs rise, accurately measures the COGS today, but underestimates the current value of the remaining inventory
- Lower reported profit and balance sheet value of inventories
- Lower estimate of TA and BV of equity
FIFO
- first-in, first-out accounting method of valuing inventories
- More realistic estimate of economic earnings (real sustainable CF) because of up-to-date prices for COGS
- Induces BS distortions when it values investment in inventories at original cost
- Investment base in which return is earned is undervalued, during inflation
economic depreciation
amount the firm must reinvest to sustain its real CF at the current level
accounting depreciation
- portion of the original acquisition cost of an asset that is allocated to each period over an arbitrarily specified life of the asset
- Reported in financial earnings
depreciation for tax vs reporting
- tax purposes: currently allows the entire investment to be written off immediately
- reporting purposes: firms are more likely to depreciate an investment smoothly over some assumed lifetime, using SL depreciation
- Most firms use accelerated depreciation for tax purposes and SL depreciation in financial statements
- Because conventional depreciation is based on the historical cost, measured depreciation in periods of inflation is understated relative to replacement cost, and real economic income is correspondingly overstated
inflation and interest expense
- Nominal interest rates include an inflation premium that compensates the lender for inflation-induced erosion in the real value of principal
- Mismeasurement of real interest means that inflation results in an understatement of real income
Fair value accounting (mark-to-market)
Use of current market values rather than historic cost in the firm’s financial statements
Allowance for bad debt
- Most firms sell goods using trade credit and must make an allowance for bad debt
- Unrealistically low allowance overstates the payments the firm is likely to receive and therefor reduces the quality of reported earnings
- Rising average collection period on AR could be evidence of potential problems with future collections
nonrecurring items
- Some items that affect earnings should not be expected to recur regularly
- Asset sales, effects of accounting changes, interest rate movements, or unusual investment income
earnings smoothing
E.x. “Releasing” earnings by reversing transactions and thereby creating the appearance of steady earnings growth
revenue recognition
- GAAP accounting allows firms to recognize a sale before it is paid
- Sometimes it can be hard to know when to recognize
how can you detect the quality of earnings using AR?
If AR increases faster than sales, or becomes a larger % of total assets, beware of these practices
contingent liabilities
might have to pay in the future
differences in international reserving practices
- Some countries allow firms considerably more discretion in setting aside reserves for future contingencies than the US
- Additions to reserves result in a charge against income, so reported earnings are subject to managerial discretion
differences in international depreciation practices
- In the US, firms typically have separate accounts for tax and reporting purposes
- Accelerated depreciation for tax, Sl depreciation for reporting
- Most other countries do not allow dual sets of accounts
- And use accelerated depreciation which results in lower reported earnings
International financial reporting standards (IFRS)
A principles-based set of accounting rules adopted by about 100 countries around the world, including the European Union
“Principles-based”
general approaches for the preparation of financial statements
