Chapter 3: Analysis of Financial Statements Flashcards
EBITDA
Earnings before interest, taxes, depreciation and amortization
intrinsic value of a firm
expected future free cash flows discounted at the weighted average cost of capital
Free Cash flow
FCF
= net operating profit after taxes - required investments of operating capital
Weighted average cost of capital
WACC
cost of debit and equity
- determined by:
market interest rates
market risk aversion
firm’s debt/equity mix
firm’s business risk
Components of financial statement analysis
- comparing a firm’s performance against that of other firms in the same industry
- evaluating trends in the firm’s financial position over time
users of financial analysis
managers
potential lenders
stockholders (potential stockholders)
Steps of financial analysis
- Gather data
- examine the statement of cash flows
- calculate and examine return on invested capital and free cash flow
- ratio analysis
Items of interest from statement of cash flows
- trends in net cash flow from operations over time
- large investment acquisitions
- financing section shows issuing debt or buying back stock (raising capital from investors or returning it to them)
NOPAT
Net operating profit after taxes
First measures calculated
Net Operating Profit after Taxes & total net operating capital
used to calculate
- operating profitability ratio
- capital requirement ratio
- return on invested capital
- free cash flow
Return on invested capital
ROIC
NOPAT/ total net operating capital
measure of firm’s overall performance
ROIC > WACC: company usually adding value
ROIC < WACC: usually means problems
Operating profitability ratio
OP
NOPAT / Sales
Capital Requirement ration
CR
= Total net operating capital/ sales
Profitability ratios
show the combined effects of liquidity, asset management, and debt on operating and financial results
Net profit margin
(aka profit margin on sales or profit margin)
show profit per dollar of sales
= Net income available to common stockholders / sales
Operating profit margin
= EBIT / Sales
shows how a company is performing with respect to operations before impact of interest expenses
Gross profit margin
a way to look at the components of operating costs
= (sales - cost of good sold including depreciation) / sales
identifies the gross profit per dollar of sales before other expenses deducted
Basic Earning Power ratio
BEP
= EBIT/ total assets
(EBIT = earnings before interest and taxes)
Return on total assets
ROA (or return on assets)
= (net income available to common stockholders) / total assets
Return on common equity
ROE (return on equity)
= (net income available to common stockholders)/ common equity
Asset management ratios
measure how effectively a firm manages its assets
(aka efficiency ratios)
Total assets turnover ratio
measures dollars in sales that are generated for each dollar tied up in assets
= sales/ total assets
Fixed assets turnover ratio
measures how effectively the firm uses its plant and equipment
= sales / net fixed assets
(can be influenced by inflation as fixed assets are reported at historical cost rather than replacement cost = older equipment yields higher ratio)
Days sales outstanding
DSO
aka average collection period (ACP)
= accounts receivable/ average daily sales
average length of time firm must wait after making a sale before receiving cash
(high accounts receivable can cause high levels of net operating working capital)
Inventory turnover ratio
= cost of goods sold (including depreciation) / inventories
depreciation included because virtually all depreciation associated with producing products?
(some sources define it as sales/ inventories)
Inventory turnover ratio
= cost of goods sold (including depreciation) / inventories
depreciation included because virtually all depreciation associated with producing products?
(some sources define it as sales/ inventories)
Number of times inventory is sold out and restocked (“turned over”) each year
low may mean holding too much inventory
Liquidity Ratios
Ratios that show the relationship of a firm’s cash and other current assets to its current liabilities
(firm’s short term ability to pay obligations)
Current ratio
= current assets / current liabilities
relevance of this ratio depends on perspective
creditors: high current ratio = current assets available to cover liabilities
Shareholders: high current ratio may mean too much money tied up in nonproductive assets
flag if wildly different from industry average
Quick ratio
aka acid test ratio
= (current assets - inventories) / current liabilities
or
= (cash + short term investments+ net accounts receivable)/ current liabilities
measurement of firm’s ability to pay off short-term obligations without relying on the sale of inventories
if below 1 would have to sell inventory to pay off current liabilities if they were all called
liquid asset
one that trades in an active market. Can be converted quickly to cash at the going price
Financial leverage
ratio of total assets to common equity
the extent to which a firm uses debt financing
shows the factor by which ROA is scaled up to determine ROE
is the magnifying effect that debt has on ROE and shareholder risk
implications of firm’s financial leverage
- financing part of a firm with debt means shareholders can control a firm with smaller equity investments
- shareholders returns magnified if assets generate higher pre-tax return than the interest rate on debt (conversely losses magnified if pre-tax ROA is below interest rate)
- if a company has high leverage a small decline in performance may cause the firm’s value to fall below it’s total debt
ergo creditor’s position riskier as leverage increases
Debt management ratios
aka leverage ratios
show:
- a firm’s use of debt relative to equity
- it’s ability to pay interest in principle
help judge likelihood of defaulting on deby
debt-to-assets ratio
aka debt ratio
= total debt/ total assets
percentage of funds provided by investors other than preferred or commDeon shareholders
Debt-to-equity ratio
= total debt / total common equity
(amount of debt for every dollar of equity)
market value of equity
= stock price x number of shares
market debt ratio
= total debt / (Total debt + market value of equity)
liabilities to assets ratio
shows the extent to which a firm’s assets are NOT supported by equity
= total liabilities / total assets
Equity multiplier
a set of rations that measure how effectively a firm is managing it’s assets (also asset management ratios)
= return on equity / return on assets
= (net income/ common equity) / (net income/ total asset)
the factor by which ROA is mulitipled to determine ROE
= 1/(1- liabilities-to-assets ratio)
Times interest earned ratio
TIE ratio aka interest coverage ratio
= EBIT / interest expense
measures extent to which operating income can decline before the firm is unable to meet its annual interest costs
uses EBIT because interest is paid with pre-tax dollars.
shortcomings of the TIE ratio
- interest not the only fixed financial charge. need to pay down debt/ lease payments
- EBIT is not all cash flow available to service debt (esp. if firm has high non-cash expenses)
EBITDA coverage ratio
Takes all “cash” earnings into account and all financial charges
= (EBITDA + lease payments) / (Interest + principal payments + lease payments)
must add back in lease payments because it has already been removed from EBITDA but is part of financial charges
of most use to relatively short-term lenders (period where depreciation-generated funds can be used to service debt instead of going back into the plant and equiptment
sinking fund
required annual payment designed to reduce the balance of a bond or preferred stock issue
Market value ratios
relate a company’s stock price to it’s earnings, cash flow, and book value per share.
measure the value of a company’s stock relative to another company
Price/Earnings ratio
P/E ratio
shows how much investors are willing to pay per dollar of reported profits
= price per share / earnings per share
compare to industry numbers
higher for firms with strong growth prospects
Price/Free cash flow ratio
P/FCP
= price per share / free cash flow per share
pertinent because stock price depends on a company’s ability to generate free cash flow)
Price/EBITDA ratio
= price / EBITDA
measure of operating performance that removes non-operating items (income/ taxes)
Market/ book ratio
M/B ratio
indicator of how investors regard the company
= market price per share / book value per share
(aka market value of equity / total common equity reported in FS)
Market value: forward looking (expectations of future cash flows)
Book value: past looking (historical investments/ earnings)
Book value per share
= Total common equity / shares outstanding
Market capitalization
aka Market cap
total market value of equity in a company
= price per share x total number of shares
Trend analysis
Examination of a single ratio over time
(can be compared against the trend in the industry on average)
Common size analysis
all income statement items are divided by sales and all balance sheet items are divided by total assets
thus a common size income statement shows each item as a percentage of sales and a common size balance sheet shows each item as a percentage of total assets
facilitates comparisons of financial statements over time and across companies
Percentage change analysis
calculates growth rates for all income statement items and all balance sheet accounts relative to a base year
DuPont equation
a formula showing that the rate of return on equity can be found as the profit margin multiplied by the product of total assets turnover and the equity multiplier
ROE = PM * total asset turnover * equity multiplier
helps show how managerial actions affecting profitability, asset efficiency and financial leverage interact to determine return on equity
Extended dupont equation
ROE = (net income / sales) * (sales/ total assets) * (Total assets / common equity)
(Same as ROE = Profit margin * total assets turnover * equity multiplier)
ROE in terms of asset profitability and leverage
ROE = (net income/ total assets) x (total assets / common equity) = ROA * equity multipler
Benchmarking
When a firm compares its rations to other leading (benchmark) companies in the same industry
Potential problems with ratio analysis
- industry averages are only somewhat meaningful to large firms that operate different divisions in different industries
- goals for high-level performance better set against industry leaders than average ratios
- inflation may distort firm’s balance sheets (historical cost vs replacement value)
- distortion from seasonal effects (when balance sheet inventory closes), minimized by using monthly averages for inventory calculations
- “window dressing” by firms
- distortion from different choices of accounting methods
Window dressing techniques
techniques employed by firms to make their financial statements look better than they really are
- manipulation of timing for assets and liabilities
qualitative questions for financial analysis
- to what extent are the company’s revenues tied to one key customer or key product?
- to what extent does the company rely on a single supplier?
- what percentage of the company’s business is generated overseas?
- what are the probable actions of current competitors and the likelihood of additional new competitors?
- do the company’s future prospects depend critically on the success of products currently in the pipeline or existing products?
- how do the legal and regulatory environments affect the company?
