Lecture 1

Basic Financial Analysis

Look at Lecture 1 Supplementary Material.xls

Objective
Learn to use a firms financial statements to assess its historical performance and current financial standing.

Financial analysts rely on key financial ratios that summarize the firms financial strengths and weaknesses.
These ratios are no substitute for a crystal ball, but do help you to ask the right questions. These tools are useful for various analysts, including: managers worried about problems with their strategies lenders screening loan applications investors seeking to monitor the firms activities
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Setting
We want to assess the current financial standing of the Executive Paper Corporation. Largely a backward looking exercise, but suggestive of future events. Perhaps you are a financial analyst with the firm and are helping develop a 5-year financial plan.

Or perhaps you work for a rival firm that is contemplating a takeover bid.
Or perhaps you are a banker trying to decide whether to give a loan or not. From last years annual report (2012), we observe the firms income statement and balance sheet.
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EPC's Balance Sheet as of Dec 2012 Assets

Dec 2011 Dec 2012 Change

Cash & ST Securities

Receivables Inventory Total current assets Gross PPE Less accum. depreciation

65,000
90,000 85,000 240,000 200,000 60,000

71,125
95,000 95,000 261,125 250,475 66,000

6,125
5,000 10,000 21,125 50,475 6,000

Net fixed assets

Total assets

140,000
380,000

184,475
445,600

44,475
65,600
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EPC's Balance Sheet as of Dec 2012 - Liabilities & Equity

Dec 2011 Payables Accrued expenses Total current liabilities Long-term debt Total Liabilities Common stock 55,000 11,000 66,000 100,000 166,000 25,000 Dec 2012 60,000 3,000 63,000 50,000 113,000 28,000 Change 5,000 -8,000 -3,000 -50,000 -53,000 3,000

Retained earnings
Total shareholders' equity Total liabilities and equity

189,000
214,000 380,000

304,600
332,600 445,600

115,600
118,600 65,600
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EPC's Income Statement for 2012 Revenues Costs Depreciation EBIT Interest @ 10% Taxable income Tax @ 40% Net income Dividends (1/3 of NI) Addition to retained earnings 765,000 460,000 6,000 299,000 10,000 289,000 115,600 173,400 57,800 115,600

Earnings per share ($) Dividend per share ($)

1.08 0.36
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Other financial information for EPC:

Dec 2011 Market value of equity 250,000

Dec 2012 375,000

Number of shares Share price ($) Number of Employees

100,000 2.5 50,000

160,000 2.3 50,000

Liquidity Ratios for 2012

NWC to Assets Ratio = NWC / Total BV Assets = 0.44

Current Ratio = Current Assets / Current Liabilities = 4.14

Quick (or Acid-Test) Ratio =

Cash Ratio = Cash & Equiv. / Current Liabilities = 1.13

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Leverage Ratios for 2012

Book Leverage = Debt / Total BV of Assets = 0.25 Market Leverage = Book Debt-Equity Ratio = Debt / BV of Equity = 0.34

Market Debt-Equity Ratio = Debt / MV of Equity = 0.30

Interest Coverage = Principal Coverage = (EBIT + Dep.) / Debt = 2.70 Fraction of Debt that is Long Term = 0.44
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Profitability Ratios for 2012

Net Profit Margin = Net Income / Revenues = 0.23 Return on Assets (ROA) = Net Income / Assets = 0.39

Return on Equity (ROE) = Net Income / Equity = 0.52

Payout or Retention Ratios for 2012

Payout Ratio =

Retention Ratio =
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Market-Value Ratios for 2012

Price-Earnings Ratio (PE) = Stock Price / EPS = 2.13 Dividend Yield = Market-to-Book Equity Ratio (M/B) = Market Equity / Book Equity = 1.13

Productive Efficiency Ratios for 2012

Sales-to-Assets Ratio = Sales / Assets = 1.72
Sales per employee = Sales / Employees = 15.3
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DuPont Analysis / System

ROE = Net Income / Equity
= (Net Income / Sales) (Sales / Assets) (Assets / Equity) = Net Profit Mg Asset Turnover Equity Multiplier = 0.23 1.72 1.34 0.53

Key questions:
what accounts for the ROE dynamics over time for the firm? time series dimension what accounts for the difference in ROE of firm A and B? cross sectional dimension
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DuPont Analysis: RIM case

Research in Motion Return on Equity (ROE) RIM APPLE RIM APPLE RIM APPLE RIM APPLE 2010 16% 35% 0.17 0.21 0.39 1.06 2.42 1.54 2011 6% 42% 0.06 0.24 0.37 1.13 2.50 1.54

Net Income / Sales Sales / Assets Assets / Equity

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Application: Financial Ratios & the Z-Score

Variable X1 X2 X3 X4 X5 Definition Weight NWC / Assets 1.2 Retained Earnings / Assets 1.4 EBIT / Assets 3.3 Market value of equity / Book value of liabilities 0.6 Sales / Assets 1.0

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Z > 2.99 - Safe Zone 1.8 < Z < 2.99 - Grey Zone Z < 1.80 - Distress Zone
Online Z-score calculator: http://www.creditguru.com/CalcAltZ.shtml Altman, E., 1968, Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy, Journal of Finance 23: 189209. 14

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The Operating Cycle & the Cash Cycle

Raw material purchased
Order Stock Placed Arrives

Finished goods sold

Cash received

Inventory period Accounts payable period

Firm receives invoice

Accounts receivable period

Time

Cash paid for materials

Operating cycle Cash cycle

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Operating Cycle and Cash Cycle

OC = IP + ARP (each measured in days) CC = OC APP = IP + ARP APP (each measured in days) The cash cycle determines the need for short-term finance! What comes to mind if you see a firm with a trend towards a: longer inventory period? longer collection period? longer payables period? OC = IP + ARP (note that X = Xt Xt-1)

CC = OC APP = IP + ARP APP

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Operating & Cash Cycles for 2012

Inventory Turnover (per year) = COGS / Avg. Inventory = 5.1 Inventory Period (days) = 365 / Inventory Turnover = 71.4 Receivables Turnover (per year) = Sales / Avg. Receivables = 8.3 Collection Period (days) = 365 / Receivables Turnover = 44.1

Payables Turnover (per year) = COGS / Avg. Payables = 8.0

Payables Period (days) = 365 / Payables Turnover = 44.6

Operating Cycle =
Cash Cycle =
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Tracing Sources & Uses of Cash

Balance Sheet in year t Current Assets (CA) Current Liabilities (CL)

Cash
Marketable Securities Accounts Receivable

Accounts Payable
Notes Payable Accrued Expenses

Inventories
Net PPE (NPPE)

Long-Term Debt (LTD)

Common Stock (S) Retained Earnings (RE)

Cash = LTD + S + RE + CL CA (excl. cash) NPPE

Cash = LTD + S + RE + CL CA (excl.cash) NPPE
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Deriving Cash
Cash = LTD + S + RE + CL CA (excl. cash) NPPE RE = NI Dividends RE = NI Dividends + Depreciation Depreciation = OCF Dividends Depreciation (OCF = NI + Dep.)

Cash = LTD + S + CL CA (excl. cash) NPPE Depreciation + OCF Dividends

(Recall GPPE = NPPE + Depreciation) Cash = LTD + S + CL CA (excl. cash) GPPE + OCF Dividends
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Deriving Cash
Cash = LTD + S + CL CA (excl. cash) GPPE + OCF Dividends

For reporting purposes, firms present the information about the change in cash using the Statement of Cash Flows
Cash = CF from operating activities + CF from investing + CF from financing CF from operating activities =

CF from investing =
CF from financing =
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Sources and Uses of Cash

Cash = LTD + S + CL CA (excl. cash) GPPE +OCF Dividends , where OCF = NI + Dep. Cash = Sources of cash Uses of cash
Sources of cash: Long-term debt issued New equity issued Increases in CL items Decreases in CA items (excl. cash) Decreases in fixed assets Operating Cash Flow Uses of cash: Long-term debt reduced Equity retired Decreases in CL items Increases in CA items (excl. cash) Increases in fixed assets Dividends
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Sources and Uses of Cash: Examples

Increase (decrease) in receivables Increase (decrease) accounts payable

Increase (decrease) in inventory

Increase (decrease) prepayments Increase (decrease) notes payable

Pay dividends
Increase (decrease) accrued expenses Increase (decrease) taxes payable

Increase (decrease) in fixed assets

Why is tracing the change in a firms cash useful?
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EPCs Sources & Uses of Cash for 2012

Sources of Cash: Increase in Payables Issuance of Common Stock Operating Cash Flow (NI + Dep.) Total sources Uses of Cash: Increase in Receivables Increase in Inventory Increase in GPPE Decrease in Accrued Expenses Retirement of Long-Term Debt Dividend Payments Total uses

5,000 3,000 179,400 187,400

2.7% 1.6% 95.7% 100.0%

5,000 10,000 50,475 8,000 50,000 57,800 181,275

2.8% 5.5% 27.8% 4.4% 27.6% 31.9% 100.0%

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Summary & Conclusions

Financial statements can be used to construct financial ratios that broadly describe a firms current and past financial situation and provide hints about future developments. From accounting data we can trace the sources & uses of cash, which provides further detail about a firms operations. These tools are quite simple, but powerful if used in conjunction with additional information, such as sales forecasts, industry reports, or macroeconomic conditions. They are mostly useful for an initial diagnostic of the firms financial condition. More importantly, they point to things you need to worry about in more detail (like initial medical exams!). For example, credit rating agencies assign credit scores largely based on this type of financial ratios (and some additional info).
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