Lecture 05 Financial Statement Analysis

Question 1

What is financial statement analysis?

Answer 1

• Financial statement analysis (FSA) is the investigation of relationships between various items on the balance sheet and the income statement.
• The objective of FSA is to understand how companies generate returns on their investors’ capital.
  To this end, FSA evaluates companies’ profitability, operational efficiency, liquidity and capital structure.
• FSA relies on accounting data. You cannot do it well without a good understanding of financial accounting.

Question 2

What are return rates?

Answer 2

The main object of interest to an investor is the return on invested capital.

Return is defined as the profit (or loss) accruing to the investor in a given period, divided by the amount of capital deployed to generate that profit.

Return rates can be disaggregated into various component ratios that speak to different aspects of a company’s operations and its financing.

Question 3

What is the return rate taxonomy?

Answer 3

1. Return on Equity
2. Return on Net Operating Assets + Financing Return = Return on Equity
3. Net Operating Profit Margin * Net Operating Asset Turnover = Return on Net Operating Assets
4. Financing Margin * Financial Leverage = Financing Return

Question 4

What is the formula for return on equity?

Answer 4

ROE = net income/average owners’ equity

Question 5

What is the problem with using ROE as a metric of success?

Answer 5

ROE conflates the successfulness of the business model with the financing choices (capital structure) of the company.

Question 6

How do we isolate the operational aspect of the ROE?

Answer 6

The return on net operating assets (RNOA) is the component of ROE that isolates the operational aspects.

Question 7

What is the RNOA?

Answer 7

The return on net operating assets (RNOA) is defined as:

RNOA = Net Operating Profit After Tax (NOPAT)/Average Net Operating Assets (NOA)

RNOA measures profitability of the business model, independent of how the company is financed.

The net operating income after tax (NOPAT) in the numerator excludes any income and expense related to financing activities (such as interest).

The net operating assets (NOA) in the denominator comprise all sources of capital, including both debt and equity.

Question 8

How do we choose line items to calculate return rates?

Answer 8

• Line items can be omitted, modified or replaced, depending on the objectives of our analysis. Two principles should be kept in mind.
• Predictability. The income figure should be reasonably representative of what to expect long-term, given the company’s current business model.
• Consistency. If we remove an income item, we should also remove its underlying assets and liabilities (if any), and vice versa.
• It is useful to compare different scenarios and assumptions.

Question 9

What are the candidates for modification/removal from the income statement for analyzing return?

Answer 9

Possible (but not necessary) choices for removal or modification include:
* discontinued operations (will not be there in the future);
non-recurring items (e.g., impairments; but consider carefully if the item in question is truly singular or merely infrequent);
* volatile items (e.g., unrealized gains or losses from fair value changes);
* equity method investment income (also remove underlying investment asset; consider degree of integration into company’s business model);
* minority (non-controlling) interest (also omit related equity balance; note how the removal would affect the interpretation of the results);
* income taxes (ideally, would like to use what appears to be the company’s long-term average tax rate).

Question 10

How do we regroup the income for financial statement analysis?

Answer 10

Classify all income statement items you end up using as either
operating, including all revenues, expenses, and other items connected to activities around providing goods and services to customers; or as
financing, including all income and expenses arising from the company’s financial investments and its financial obligations (debt).

Question 11

How do we regroup the capital for financial statement analysis?

Answer 11

Remove any balance sheet items related to items removed from the income statement (e.g., assets of discontinued operations).
Adjust equity capital accordingly, if necessary.

Regroup the remaining assets and liability items into
operating, including all balances that arise as a result of the company’s activities when providing goods and services to customers; and
financing, including all financial investments on the asset side and all debt and debt-like positions on the liability side.

Question 12

What are the approaches for dealing with taxes for financial statement analysis?

Answer 12

Possible approaches to calculating income tax for our analysis purposes:

• ignore the reported tax expense and instead use the statutory rates in effect in the company’s main operating jurisdictions; or
• use a tax rate computed from tax expense relative to pre-tax income, averaged over sufficiently many periods to even out fluctuations; or
• use the reported tax expense of the period and apportion it between operating and financial income.

Under the apportionment approach, it is common to use
tax on financial income = financial income × statutory tax rate
and allocate the remainder to tax on operating income.

Question 13

What is the modified dupont formula?

Answer 13

ROE = RNOA + financing margin * financial leverage
Equivalent to:
ROE = RNOA + (RNOA - net financig rate) * financial leverage

Question 14

What is the formula for the net financing rate?

Answer 14

Net financial expense after tax/average net debt

Question 15

What is the formula for financial leverage?

Answer 15

Average net debt/average equity

Question 16

How can we disaggregate RNOA further?

Answer 16

RNOA = NOPAT/sales * sales/average NOA
where NOPAT/sales =Net Operating Profit Margin
and sales/average NOA = Net Operating Asset Turnover

NOPAT - Net Operating Profit After Tax

Question 17

What is the relationship between NOPM and NOAT?

Answer 17

They are inversely proportional for most businesses.

Question 18

What is the formula for inventory turnover?

Answer 18

Inventory Turnover = COGS/Average Inventory

Inventory turnover measures the speed of selling physical goods, once procured or produced. The higher the ratio, the faster goods get sold.

Question 19

What is the formula for days inventory outstanding?

Answer 19

days inventory outstanding = days per period/inventory turnover

The inverse of the turnover ratio is the average time an inventory item remains in stock, commonly measured in days.

Question 20

What is the formula for receivables turnover?

Answer 20

receivables turnover = sales revenue/average receivables

Receivables turnover measures the speed of collecting outstanding balances from customers. The higher the ratio, the faster the collection.

Question 21

What is the formula for days receivables outstanding?

Answer 21

days receivable outstanding = days per period/receivables turnover

The inverse of the turnover ratio is the average collection period, commonly measured in days.

Question 22

What is the formula for payables turnover?

Answer 22

Payables turnover = purchases/average payables

Payables turnover measures the speed of paying outstanding balances to vendors. The lower the ratio, the longer the company takes to pay.

Question 23

What is the formula for days payable outstanding?

Answer 23

days payable outstanding = days per period/payables turnover

The inverse of the turnover ratio is the average payment period, commonly measured in days

Question 24

What is the formula for the operating cycle?

Answer 24

operating cycle = inventory days + receivable day - payable days

The working capital turnover ratios can be combined into what is often referred to as the (net) operating cycle (or cash cycle or trade cycle).

The operating cycle statistic is incomplete because it omits critical parts of companies’ operations (e.g., procurement activities).
The statistic becomes more meaningful if:
* receivables and payables are mostly related to customers and vendors;
* sales are mostly in the form of physical goods; and
* the company follows a single, homogeneous business model.

Question 25

What is the formula for the current ratio?

Answer 25

current ratio = current assets/current liabilities

The current ratio is the ratio of current assets to current liabilities

• To assess whether the level is adequate or inadequate, compare it to
• the company’s current ratio values in prior years; and
• the current ratios of competitors in the same industry.
• Very low values indicate impending financial distress.
• Very high values imply unused resources that are not invested profitably.

Question 26

What is the quick ratio?

Answer 26

quick ratio = cash + marketable securities (+ receivables)/current liabilities

• Sometimes receivables are omitted.
• Regarding interpretation, apply the same guidance as for the current ratio.

Question 27

What is solvency analysis?

Answer 27

A company is considered solvent if its asset value is sufficient to cover its liabilities.

Question 28

What is interest coverage?

Answer 28

interest coverage = EBIT/interest cost

Question 29

What are some common types of financial leverage calculations?

Answer 29

Financial leverage refers to the proportion of insider (equity) capital to outsider capital. Leverage can be measured in various ways, such as:

assets/equity
liabilities/equity
debt (financial liabilities)/equity

(Unlike the ROE breakdown analysis, solvency analysis generally uses gross debt instead of net debt.)

Question 30

What is a common size financial statement?

Answer 30

One can expand the analysis further, to any financial statement ratio that one finds insightful given the business model of one’s company of interest.

To make the process easier, it is often helpful to standardize the balance sheet and income statement, such that,
* on the income statement, all amounts are expressed in percent of revenue; and
* on the balance sheet, all amounts are expressed in percent of assets.
This standardized format is also called common-size financial statements.

Evaluation based on common-size statements is called vertical analysis.

Question 31

What are some common analysis of time trends?

Answer 31

• The counterpart to vertical analysis is horizontal analysis, the comparison of a given line item or ratio across time.
• Amounts are typically standardized by expressing them in percent of a given reference year’s value.
• Horizontal analysis is useful to assess growth or decline patterns.
• Horizontal analysis can also identify large changes that limit comparability across time (e.g., major acquisitions or disposals).

Question 32

What are some guidelines good to remember for financial statement analysis?

Answer 32

• Financial statement analysis must be customized uniquely for each company. Not all ratios make sense in all cases.
• Besides the ratios we discussed, there are many industry-specific ones (e.g., seat-kilometers in airlines, or sales per square-meter in retail).
• You need to choose what to include in your analysis and which amounts to omit, modify or re-allocate. Try and compare different scenarios.
• Details matter. Read the footnotes and management’s discussion.
• Explain your choices carefully, with reference to the data provided.
• To evaluate your results, compare them to the company’s own history (but beware of substantive changes in the business model, e.g., after large acquisitions); and
• peer firms in the same (or a related) industry.