Financial Statement Analysis and Financial Models

Financial Statement Analysis and Financial Models

Financial Statement Analysis and Financial Models from Maksudul Huq Chowdhury

Financial Statement Analysis and Financial Models

1. Financial Statement Analysis and Financial Models Presented by Maksudul Huq Kanan

2. Financial Statement Analysis Financial statement analysis is a process of selecting, evaluating, and interpreting financial data, along with other pertinent information, in order to formulate an assessment of a company’s present and future financial condition and performance.

3. Financial Statement Analysis (Cont..)  Financial statements provide the most widely available data on public corporations’ economic activities  So, investors and other stakeholders rely on financial reports to assess the plans and performance of firms and corporate managers.

4. Financial Statement Analysis (Cont..)  Financial statement analysis is a valuable tool since it enables the outside analysts create ‘inside information’ there by gaining valuable insights about current performance and future prospects.  The assumption is managers have complete information on a firm’s strategies and current state of the art.

5. Financial Statement Analysis (Cont..)  Financial statement analysis is also important in: – Assessing management performance of a company and whether projections of improvement or sustainability are reasonable. – Assessing the value of a company from historic performance. – Assessing the reasonableness of financial projections provided by a company or the validity of earnings projections – Assessing whether the financial structure of a company is of investment grade quality

6. Objectives of Financial Statement Analysis  Financial statement analysis is like detective work – How can we use information in financial statements to make assessments of various issues. The financials should paint a picture of what has happened to the company: – How can we quickly review the income statement, balance sheet and cash flow statement to determine how the stock market value of a company compares to inherent value. – How can we look the financial statements and assess risks associated with a company and whether the company has sufficient cash flow to pay off debt. – Finance and valuation are about projecting the future -- how can financial statement analysis be used in making projections. – The problem in any financial analysis and valuation is that measuring risk is very difficult

7. Financial Statement Analysis (Cont..) Who analyzes financial statements? – Internal users (i.e., management) – External users Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors

8. Financial Statement Analysis (Cont..)  What do internal users use it for? Planning, evaluating and controlling company operations  What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

9. Financial Statement Analysis (Cont..) Information is available from – Published annual reports (1) Financial statements (2) Notes to financial statements (3) Letters to stockholders (4) Auditor’s report (Independent accountants) (5) Management’s discussion and analysis – Reports filed with the government

10. Methods of Financial Statement Analysis  Horizontal Analysis  Vertical Analysis  Common-Size Statements  Trend Percentages  Ratio Analysis

11. Horizontal Analysis Using comparative financial statements to calculate amount or percentage changes in a financial statement item from one period to the next Using comparative financial statements to calculate amount or percentage changes in a financial statement item from one period to the next

12. Vertical Analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

13. Common-Size Statements Financial statements that show only percentages and no absolute amounts. Financial statements that show only percentages and no absolute amounts.

14. Trend Percentages Show changes over time in given financial statement items (can help evaluate financial information of several years) Show changes over time in given financial statement items (can help evaluate financial information of several years)

15. Ratio Analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

16. Basic Financial Statements  Three types of financial statements are mandated by the accounting and financial regulatory authorities: 1. Income statement – how much money you made last year?  Revenue, expense, profits over a year or quarter. 1. Balance sheet – What’s your current financial situation? a snap shot on a specific date of  Assets (value of what the firm owns),  Liabilities (value of firm’s debts), and  Shareholder’s equity (the money invested by the company owners) 1. Cash flow statement – How did the cash come and go? cash received and cash spent by the firm over a period of time

17. Income Statement  Income Statement (Statement of Operations) – Shows profitability for a period of time – A summary statement of revenues, expenses, gains, and losses. – Must follow GAAP (financial accounting standards) – Subject to much judgment by management. – Traditionally, bottom-line earnings from income statements represented primary stock price drivers. – Currently, the move is on in the accounting profession to distinguish appropriately between earnings and “quality” earnings.

18. Sample Income Statement  SalesSales  Minus Cost of Goods SoldMinus Cost of Goods Sold  = Gross Profit= Gross Profit  Minus Operating ExpensesMinus Operating Expenses  Selling expensesSelling expenses  General and Administrative expensesGeneral and Administrative expenses  Depreciation and Amortization ExpenseDepreciation and Amortization Expense  = Operating income (EBIT)= Operating income (EBIT)  Minus Interest ExpenseMinus Interest Expense  = Earnings before taxes (EBT)= Earnings before taxes (EBT)  Minus Income taxesMinus Income taxes = Net income (EAT)/Income available for appreciation= Net income (EAT)/Income available for appreciation

19. Sample Income Statement Income Statement of XYZ Corporation as on 31.12.2016

20. The Balance Sheet  Determines Solvency Position of an organization on a given date – Assets (Resources): Future economic value owned or controlled by the organization  Current:--Cash and near cash assets  Non-current—Relatively permanent assets used to generate revenue – Liabilities (Debts): Future claims by outsiders on assets of the organization  Current—Due in the near future  Long-term—Due at least one year from the B/S date – Stockholders’ Equity—Owners’ claim to organization resources

21. The Balance Sheet  The balance sheet provides a snapshot of the firm’s financial position on a specific date. It is defined by: Total Assets = Total Liabilities + Total Shareholder’s Equity (Utilization of Fund) = (sources of funding)  Total assets represents the resources owned by the firm.  Total liabilities represent the total amount of money the firm owes its creditors.  Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.

22. Sample Balance Sheet

23. Statement of Cash Flows  Summarizes cash inflows and (outflows) for a period of time – Includes all cash inflows (outflows) regardless of source or use – Categories of cash flows  Operating Activities: Shows cash flows from operating income (from income statement)  Investing Activities: Shows cash flows to investments and from sales of investments  Financing Activities: Shows cash flows from borrowing and sales of original equity issues and subsequent pay back of loans, equity re-acquisitions, and dividends

24. Statement of Cash Flows  The format for a traditional cash flow statement is as follows: Beginning Cash Balance Plus: Cash Flow from Operating Activities Plus: Cash Flow from Investing Activities Plus: Cash Flow from Financing Activities Equals: Ending Cash Balance  Operating activities represent the company’s core business including sales and expenses. Basically any activity that affects net income for the period.  Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment.  Financing activities represent changes in the firm’s use of debt and equity such as issue of new shares, payment of dividends.

25. Statement of Cash Flows A. Operating Cash Flows 1) Net Income including int expense, int income and taxes 2) Depreciation 3) Deferred Taxes 4) Working Capital Changes 5) Minority Interest on Income Statement and Other Items B. Investing Cash Flows 1) Capital Expenditure and Asset Purchases 2) Sale of Property, Plant, & Equipment 3) Inter-Corporate Investment C. Financing Cash Flows 1) Dividend Payments 2) Proceeds from Equity or Debt Issuance 3) Equity Repurchased 4) Debt Principal Payments

26. STANDARDIZING STATEMENTS One obvious thing we might want to do with a company’s financial statements is to compare them to those of other, similar companies. We would immediately have a problem, however. It’s almost impossible to directly compare the financial statements for two companies because of differences in size. To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements. One common and useful way of doing this is to work with percentages instead of amount. The resulting financial statements are called common-size statements.

27. Financial Ratio Analysis Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. Financial ratio analysis is the use of relationships among financial statement accounts to gauge the financial condition and performance of a company.

28. Purpose of Ratio Analysis  Evaluate management performance in three areas: – Profitability – Efficiency – Risk  Ratios are more informative than raw numbers  Ratios provide meaningful relationships between individual values in the financial statements

29. Purpose of Ratio Analysis  Compare to other entities  Examine a firm’s performance relative to: – The aggregate economy – Its industry or industries – Its major competitors within the industry – Its past performance (time-series analysis)  Analysis helps you estimate the future performance of the firm during subsequent business cycles

30. Categories of Financial Ratios 1. Internal liquidity (solvency) 2. Operating performance – a. Operating efficiency – b. Operating profitability 3. Risk analysis – a. Business risk – b. Financial risk 4. Growth analysis 5. External liquidity (marketability)

31. Internal Liquidity  Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations  Current Ratio examines current assets and current liabilities  Quick Ratio adjusts current assets by removing less liquid assets  Cash Ratio is the most conservative liquidity ratio sLiabilitieCurrent AssetsCurrent RatioCurrent = sLiabilitieCurrent sReceivableSecuritiesMarketableCash RatioQuick ++ = sLiabilitieCurrent SecuritiesMarketableCash RatioCash + =

32. Internal Liquidity (Cont…)  Receivables turnover examines the quality of accounts receivable  Receivables turnover can be converted into an average collection period  Inventory turnover relates inventory to sales or cost of goods sold (CGS) sReceivableAverage SalesAnnualNet TurnoversReceivable = TurnoverAnnual 365 PeriodCollectionsReceivableAverage = InventoryAverage SoldGoodsofCost TurnoverInventory =

33. Internal Liquidity (Cont…)  Given the turnover values, you can compute the average inventory processing time Average Inventory Processing Period = 365/Annual Turnover  Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover Receivable Days +Inventory Processing Days -Payables Payment Period Cash Conversion Cycle

34. Operating performance Ratio  Ratios that measure how well management is operating a business – (1) Operating efficiency ratios  Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories – (2) Operating profitability ratios  Analyze profits as a percentage of sales and as a percentage of the assets and capital employed

35. Operating Efficiency Ratios  Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets)  Net fixed asset turnover reflects utilization of fixed assets AssetsNetTotalAverage SalesNet TurnoverAssetTotal = AssetsFixedNetAverage SalesNet TurnoverAssetFixed =

36. Operating Profitability Ratios  Operating profitability ratios measure – 1. The rate of profit on sales (profit margin) – 2. The percentage return on capital  Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)  Operating profit margin measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative (SG + A) expenses) SalesNet ProfitGross MarginProfitGross = SalesNet ProfitOperating MarginProfitOperating =

37. Operating Profitability Ratios (Cont…)  Net profit margin relates net income to sales  Return on total capital relates the firm’s earnings to all capital in the enterprise  Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used SalesNet IncomeNet MarginProfitNet = CapitalTotalAverage ExpenseInterestIncomeNet CapitalTotalonReturn + = EquityTotalAverage IncomeNet EquityTotalonReturn =

38. Operating Profitability Ratios (Cont…)  Return on owner’s equity (ROE) can be computed for the common- shareholder’s equity  DuPont analysis is a method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value to produce a higher return on equity (ROE). It is also known as DuPont identity. EquityCommonAverage DividendPreferred-IncomeNet EquitysOwner'onReturn =

39. Operating Profitability Ratios (Cont…)  The DuPont System divides the ratio into several components that provide insights into the causes of a firm’s ROE and any changes in it = Profit Margin X Total Asset Turnover X Financial Leverage  An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE EquityCommon AssetsTotal AssetsTotal Sales Sales IncomeNet ××= EquityCommon IncomeNet Equity AssetsTotal AssetsTotal Sales Equity Sales ×= EquityCommon SalesNet SalesNet IncomeNet EquityCommon IncomeNet ROE ×==

40. Operating Profitability Ratios (Cont…)  We begin with the operating profit margin (EBIT divided by sales) and introduce additional ratios to derive an ROE value  This is the operating profit return on total assets. To consider the negative effects of financial leverage, we examine the effect of interest expense as a percentage of total assets AssetsTotal EBIT AssetsTotal Sales Sales EBIT =× AssetsTotal TaxBeforeNet AssetsTotal ExpenseInterest AssetsTotal EBIT =−

41. Operating Profitability Ratios (Cont…)  We consider the positive effect of financial leverage with the financial leverage multiplier  This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect. EquityCommon (NBT)TaxBeforeNet EquityCommon AssetsTotal AssetsTotal (NBT)TaxBeforeNet =× EquityCommon IncomeNet TaxBeforeNet TaxesIncome %100 EquityCommon TaxBeforeNet =      −×

42. Operating Profitability Ratios (Cont…)  In summary, we have the following five components of return on equity (ROE) MarginProfitOperating Sales EBIT .1 = TurnoverAssetTotal AssetsTotal Sales .2 = RateExpenseInterest AssetsTotal ExpenseInterest .3 = MultiplierLeverageFinancial EquityCommon AssetsTotal .4 = RateRetentionTax TaxBeforeNet TaxesIncome %100.5 =      −

43. Risk Analysis  Risk analysis examines the uncertainty of income flows for the total firm and for the individual sources of capital – Debt, Preferred stock, Common stock  Total risk of a firm has two components: – Business risk  The uncertainty of income caused by the firm’s industry  Generally measured by the variability of the firm’s operating income over time – Financial risk  Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities  The acceptable level of financial risk for a firm depends on its business risk

44. Business Risk  Variability of the firm’s operating income over time  Standard deviation of the historical operating earnings series  Two factors contribute to the variability of operating earnings – Sales variability  Earnings must be as volatile as sales  Some industries are cyclical – Operating leverage  Production has fixed and variable costs  Fixed production costs cause profit volatility with changes in sales  Fixed production costs are operating leverage

45. Financial Risk  Bonds interest payments come before earnings are available to stockholders  These are fixed obligations  Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline  This debt financing increases the financial risk and possibility of default  Two sets of financial ratios help measure financial risk – Balance sheet ratios – Earnings or cash flow available to pay fixed financial charges  Acceptable levels of financial risk depend on business risk

46. Financial Risk (Cont…)  Proportion of debt (balance sheet) ratios This may be computed with and without deferred taxes  Long-term debt/total capital ratio indicates the proportion of long-term capital derived from long-term debt capital EquityTotal DebtTerm-LongTotal RatioEquity-Debt = RatioCapitalL.T.Total-DebtL.T. CapitalTerm-LongTotal DebtTerm-LongTotal =

47. Financial Risk (Cont…)  Earnings or Cash Flow Ratios – Relate the flow of earnings – Cash available to meet the payments – Higher ratio means lower risk  Interest Coverage ChargesInterestDebt (EBIT)TaxesandInterestBeforeIncome = ExpenseInterest ExpenseInterestTaxesIncomeIncomeNet ++ =

48. Financial Risk (Cont…)  Firms may also have non-interest fixed payments due for lease obligations  The risk effect is similar to bond risk  Bond-rating agencies typically add 1/3 lease payments as the interest component of the lease obligations  Total fixed charge coverage includes any non- cancellable lease payments and any preferred dividends paid out of earnings after taxes =CoverageChargeFixed Rate)Tax-1Dividend/(PreferredPaymentsLeaseInterestDebt PaymentsLeaseandTaxes,Interest,BeforeIncome ++

49. Financial Risk (Cont…)  Cash flow ratios relate the flow of cash available from operations to either interest expense, total fixed charges, or the face value of outstanding debt =CoverageFlowCash PaymentsLease3/1Interest PaymentsLease1/3InterestFlowCashlTraditiona + ++ =DebtTerm-Long/FlowCash DebtTerm-LongofValueBook TaxDeferredinChangeExpenseonDepreciatiIncomeNet ++ =DebtTotal/FlowCash DebtTotal TaxDeferredinChangeExpenseonDepreciatiIncomeNet ++

50. External Market Liquidity  Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information  External market liquidity is a source of risk to investors Determinants of Market Liquidity  The value of shares traded – This can be estimated from the total market value of outstanding securities – It will be affected by the number of security owners – Numerous buyers and sellers provide liquidity

51. External Market Liquidity (Cont…)  Trading turnover (percentage of outstanding shares traded during a period of time)  A measure of market liquidity is the bid-ask spread

52. Analysis of Growth Potential  Creditors are interested in the firm’s ability to pay future obligations  Value of a firm depends on its future growth in earnings and dividends

53. Determinants of Growth  Resources retained and reinvested in the entity  Rate of return earned on the resources retained = RR x ROE where: g = potential growth rate RR = the retention rate of earnings ROE = the firm’s return on equity  ROE is a function of – Net profit margin – Total asset turnover – Financial leverage (total assets/equity) EquityonReturnRetainedEarningsofPercentageg ×=

54. Comparative Analysis of Ratios  Internal liquidity – Current ratio, quick ratio, and cash ratio  Operating performance – Efficiency ratios and profitability ratios  Financial risk  Growth analysis

55. Other Ratios

56. Other Ratios

57. Limitations of Financial Ratios  Accounting treatments may vary among firms, especially among MNCs  Firms may have divisions operating in different industries making it difficult to derive industry ratios  Results may not be consistent  Ratios outside an industry range may be cause for concern

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59. kanan3008@yahoo.com