Chapter 5: Essentials of Financial

Statement Analysis
Learning objectives
1.Essentials

of financial statement analysis,

financial statement analysis tools and
approaches.
2.How

ROA is used to analyze profitability and the

insight to separate ROA to profit margin and
asset turnover rate.
3.How

ROA and financial leverage combine to

determine a firms return on equity (ROCE).
5-1

Learning objectives (contd.)

3.

Capital structure and credit risk: How

short-term liquidity risk and long-term
solvency risk are assessed and how to use
the statement of cash flows to assess
credit risk.

4.

Why do companies issue pro forma

earnings?

5-2

Qualitative Characteristics of
Accounting Information:

How do we define financial reporting quality?

Qualitative characteristics of accounting
Information:

Understandability
Decision usefulness
Reliability
Relevance
Consistency
Comparability
3

Attributes of High Quality

Financial Reporting

Financial reporting (earnings) quality has been

considered positively associated with the
following:
High persistence of earnings and cash flows
High predictive ability of earnings and cash
flows
High earnings response coefficient
Low level of earnings management
More voluntarily disclosure
Strong corporate governance
4

Manipulating Income and

Earnings Management

Earnings management: a practice that

earnings reported reflect more the desires of
management than the underlying financial
performance of the company. 1
Managers can sometimes exploit the flexibility
in GAAP to manipulate reported earnings in
ways that mask the companys underlying
performance.
Most managers prefer to report earnings that follow a
smooth, regular, upward path.2

1.

Arthur Levitt, former SEC chairman. 2.Bethany McLean, Hocus-Pocus: How IBM Grew 27% a Year, Fortune, June 26, 2000, p. 168.

What should the users be

aware of ?

Statement users must:

Understand current financial reporting
settings and standards.
Recognize that management may
manipulate the financial information.
Distinguish between reliable financial
statement information and poor quality
information.
6

Financial statement analysis

and accounting quality

The accounting distortions need to be

watched when analyzing statements.
Examples include:
1. Nonrecurring gains and losses
2. Differences in accounting methods.
3. Differences in accounting estimates.
4. GAAP implementation differences.
5. Historical cost convention.
7

Learning Objective:

Essentials of Financial Statement

Analysis

Analysis, Forecast and Vulation P

rocedure
Reviewing the Financial Statements:
s Review comparative financial

statements and audit opinion.

Adjusting and forecasting accounting
numbers:

Adjusting accounting numbers to

remove nonrecurring items, the
different choice in capital structures,
distortions from earnings
management, and significant
subsequent events from reported
net income.
9

Analysis

Assessing Profitability and

Creditworthiness:

Common size statements.

Trend statements
Financial ratio analysis: Use ratios to
assess liquidity, profitability and
solvency.
Credit analysis: Use ratios and cash
flow statement to determine the short
term and long term risk of default.

10

Forecast and Valuation

Comprehensive

Financial
statement forecasts (see Appendix B
of Chapter 6 )

Valuing

Equity Securities (see

Appendix A of Chapter 6):

a. Free cash-flow model

b. Abnormal earnings model
(residual income model).

11

Essentials of Financial Statement

Step 1: To be informed that financial statement
Analysis

analysis is a careful evaluation of the quality of a

companys reported accounting numbers.
Step 2: Then adjust the numbers to overcome
distortions caused by GAAP or by managers
accounting and disclosure choices.

Only then you can truly get behind the numbers and see whats really going on the
Company.

12

How the financial accounting

filter sometimes works
GAAP puts capital leases
on the balance sheet, but
operating leases are offbalance-sheet.

Managers have some

discretion over estimates
such as bad debt
expense.

Managers have some

discretion over the timing
of business transactions
such as when to buy
advertising.

Managers can choose

any of several different
inventory accounting
methods.

5-13

Tools:

Financial statement
analysis:

Tools and approachesApproaches used with each tool:

Common size statements

1.

Time-series analysis: the same firm

over time (e.g., Wal-Mart in 2008 and
2006)

Trend statements

2. Cross-sectional analysis: different

firms at a single point in time (e.g.,
Wal-Mart and Target in 2008).

Financial ratios
(e.g., ROA and ROCE)

3. Benchmark comparison: using

industry norms or predetermined
standards.

5-14

Financial analysis tools

1.

2.

3.

4.

Comparative Financial statements:

Statements are compared across years.
Common-size statements: Recast each
statement item as a percentage of a
certain item.
Trend statements: Recast each
statement item in percentage of a base
year number.
Financial ratios.
15

Basic Approaches
1.

2.

3.

Time-series analysis : Identify

financial trends over time for a single
company.
Cross-sectional analysis: Identify
similarities and differences across
companies at a single moment in time.
Benchmark comparison: measures a
companys performance against some
predetermined standard.
16

Getting behind the numbers:

Case Study: Krispy Kreme
Established in 1937.
Doughnuts,
Inc.

Today has more than 290

doughnut stores (companyowned plus franchised)
throughout the U.S.

Serves more than 7.5 million

doughnuts every day.

Strong earnings and

consistent sales growth.

17

Comparative Income
Statements:
Krispy Kremes Financials

Systemwide sales
Include sales from
company owned and
franchised stores.

Includes a $5.733 million

after-tax special charge
for business dispute

Includes a $9.1 million

charge to settle a
business dispute

Sales increased from $220.2 million in 1999 to $491.5 million in 2002.

Net income increased from $6 million in 1999 to $33.5 million in 2002.

18

Common Size Income

Statements:
Krispy Kremes Financials: Apply the analysis tool (Common Size
statement) to Income Statements

$393.7 operation expenses

$491.5 sales
* Not adjusted for distortions caused by special items.

Each statement item is computed as a percentage of sales.

19

Trend Income Statements:

Krispy Kremes Financials:

Apply the analysis tool (Trend

statement) to Income Statement

Base Year
$393.7 operating expenses in 2002
* Not adjusted for distortions caused by special items.

$194.5 operating expenses in 1999

Each statement item is calculated in percentage terms using a base year number.
20

Comparative Balance Sheets

Assets
Krispy Kremes Financials: Balance Sheet

Assets

21

Common Size Assets

Krispy Kremes Financials:

Apply the analysis tool

(Common Size statement) to assets

$3.2 cash
$105.0 assets

Each statement item is computed as a percentage of Total assets.

22

Trend Assets
Krispy Kremes Financials:

Apply the analysis tool (Trend

statement) to Balance sheet assets

$7 cash in 2000
$3.2 cash in 1999

Each statement item is calculated in percentage terms using a base year number.
23

Comparative Balance Sheets

Liability and Equity: Krispy Kremes
Financials

24

Common Size Liabilities and

Equity:
Krispy Kremes Financials:

Apply the analysis tool

(Common Size statement) to Balance sheet liabilities and equity

$13.1 accounts
payable
$105.0 total
liabilities and
equity

Each statement item is computed as a percentage of Total liabilities and equity.

25

Trend Liabilities and Equity

Krispy Kremes Financials:

Apply the analysis tool (Trend

statement) to Balance sheet liabilities and equity

$8.2 accounts
payable in 2000
$13.1 accounts
payable in 1999

Each statement item is calculated in percentage terms using a base year number.
26

Krispy Kremes Financials:

Abbreviated cash flow statements

27

Common Size Cash Flow

Statements:
Krispy Kremes Financials:

Apply the analysis tool

(Common Size statement) to Cash Flow Statements

$93.9 capital expenditures

$491.5 sales

Each statement item is computed as a percentage of Sales.

28

Trend Cash Flow Statements

Krispy Kremes Financials:

Apply the analysis tool (Trend

statement) to Cash Flow Statements

$93.9 capital expenditures in 2002

$10.5 capital expenditures in 1999

Each statement item is calculated in percentage terms using a base year number.
29

Krispy Kreme analysis:

Lessons learned

Informed financial statement analysis

begins with knowledge of the
company and its industry.

Common-size and trend statements

provide a convenient way to organize
financial statement information so that
major financial components and
changes are easily recognized.
30

Krispy Kreme analysis:

Lessons learned

Common-size and trend statement

techniques can be applied to all
financial statements and every
section of statements.
Financial statements help analysts
gain a sharper understanding of the
companys economic condition and
its prospects for the future.
31

Learning Objective:

Profitability Analysis

32

Financial ratios and profitability

analysis
Operating profit margin
EBI
Sales

Return on assets
ROA=

EBI
Average assets

NOPAT is net operating profit after taxes

Asset turnover
Sales
Average assets

Analysts do not always use the reported earnings, sales and asset figures.
Instead, they often consider three of adjustments to the reported numbers:

1. Remove non-operating and nonrecurring items to isolate

sustainable operating profits.
2. Eliminate after-tax interest expense to avoid financial structure
distortions.
3. Eliminate any accounting quality distortions (e.g., off-balance
operating leases).
33

Calculating Return on Assets

Eliminate
nonrecurring items
Eliminate interest
expense
Effective tax rate
34

How can ROA be

increased?
There
are just two ways:
1.

2.

Increase the operating

profit margin, or
Increase the intensity of
asset utilization
(turnover rate).
ROA=

EBI
Average assets

EBI
Sales

Asset turnover

Sales
Average assets

Operating profit margin

5-35

ROA, margin and turnover

A company earns $9 million of EBI on sales of $100
examples:
million with an asset base of $50 million.

Turnover improvement: Suppose assets can be reduced to $45

million without sacrificing sales or profits.

Margin improvement: Suppose expenses can be reduced so that

EBI becomes $10.

36

ROA Decomposition and Analysis

1.
2

How was Krispy Kreme able to increase its ROA from 7.1% to 12.1% over
this period?
1. The expanded store base, along with increased sales, allowed the fixed costs be
spread over a number of stores- The result was in an improved operating profit margin.
2. However, the asset based was considerably less productive in 2002 ( Asset turnover is
1.48) than it was in 1999 ( Asset turnover is 2.22) More stores meant more resources
( assets) tied up operating cash, receivables, etc.
37

Further decomposition of
Correspond to the common-size
ROA
Income statement items
Operating profit
margin
NOPAT
Sales
ROA = X
Sales
Average assets
Asset turnover

38

Usages of Decomposition of
ROA
The profit margin components can help the

analyst identity areas where cost reductions

have been achieved or where cost
improvements are needed.
The current asset turnover ratio helps the
analyst spot efficiency gains from improved
accounts receivable and inventory
management.
The long-term asset turnover ratio captures
information about property, plant, and
equipment utilization.
39

ROA and competitive

advantage:
Krispy Kreme

Wendys, Baja
Fresh, Caf
Express

S&P industry
survey or
other sources

Q: What was the key to Krispy Kremes success in 2002 ?

Answer: Krispy Kreme outperformed the competition by generating more sales per
40
asset dollar.

ROA and competitive

advantage:

Four
hypothetical
restaurant firms
Competitive
Advantage:
Companies that consistently earn an
ROA above the floor. (e.g., Firm C)

Competitive
ROA floor

However, a high ROA attracts more

competition which can lead to an
erosion of profitability and advantage.
Competition works to drive down ROA
toward the competitive floor.

Firm A and B earn the same ROA, but

Firm A follows a differentiation
strategy while Firm B is a low cost
leader.

Differences in business strategies give

rise to economic differences that are
reflected in differences in operating
margin, asset utilization, and profitability
(ROA).

41

Components of ROCE
Return on assets (ROA)
NOPAT

Return on common
equity (ROCE)

Average assets
X

Net income available to

common shareholders

Net income available to

common shareholders

Average common
shareholders equity

Net income available to

common shareholders =
Net income preferred
dividends

Common earnings leverage

NOPAT
X

Financial structure leverage

Average assets
Average common
shareholders equity

ROCE= ROA * Common earnings leverage* Financial Structure leverage

42

Return on equity and

financial leverage

Unchanged because of
Financial leverage

2005: No debt; all the earnings belong to shareholders.

2006: $1 million borrowed at 10% interest; ROCE
climbs to 20%.
2007: Another $1 million borrowed at 20% interest;
ROCE falls to only 15%.
43

Return on Equity and

financial leverage
Financial leverage is beneficial only
when the company earns (i.e.,
ROA) more than the incremental
after-tax cost of debt.
If the cost of debt is greater than the
earnings, increased leverage will
harm shareholders.

44

Return on Equity and

financial leverage (contd.)
The advantage of debt financing is
the tax deduction on interests.
The disadvantage is the increase of
the bankruptcy risk.
Both the cost of debt and the
bankruptcy probability need to be
considered in determining the capital
structure.
It is hard to determine the optimal
mix of capital and debt.

45

Profitability and financial

leverage:
Case Study

Leverage
Leveragehelps
helps
Leverage
Leverage neutral
neutral

Leverage hurts

46

Learning Objective:

Capital structure and

Assess Credit Risk

47

Credit risk and capital

structure:
Credit risk refers to the risk of default by the
Overview

borrower.
A companys ability to repay debt is
determined by its capacity to generate cash
from operations, asset sales, or external
financial markets in excess of its cash needs.
Financial ratios play two roles in credit
analysis:
They help quantify the borrowers credit risk
before the loan is granted.
Once granted, they serve as an early
warning device for increased credit risk.
48

Credit risk and capital

structure:
Balancing cash sources and needs

The cash flow statements contain information enabling a user to assess a

Companys credit risk, financial ratios are also useful for this purpose .
49

Traditional lending products

Short-term loans:
Seasonal lines of credit
Special purpose loans
(temporary needs)
Secured or unsecured

Long-term loans:
Mature in more than 1 year
Purchase fixed assets,
another company,
Refinance debt ,etc.
Often secured

Revolving loans
Like a seasonal credit line
Interest rate usually floats

Public Debt
Bonds, debentures, notes

Special features: Sinking

fund and call provisions

50

Evaluating the borrowers ability

to repay
Step 1:

Understand
the business

Step 2:

Evaluate
accounting quality

Step 3:

Evaluate current
profitability and health

Step 4:

Prepare pro forma

cash flow forecasts

Step 5:
Step 6:

Due diligence
Comprehensive risk
assessment

Business model and strategy

Key risks and successful factors
Industry competition
Spot potential distortions
Adjust reported numbers as needed
Examine ratios and trends
Look for changes in profitability, financial
conditions, or industry position.
Develop financial statement forecasts
Assess financial flexibility

Kick the tires

Likely impact on ability to pay
Assess loss if borrower defaults
Set loan terms
51

Credit risk: Short-term liquidity

Including Inventory

ratios
Current ratio =

Liquidity
ratios
Quick ratio =

Short-term
liquidity

Current assets

Cash + Marketable securities + Receivables

Current liabilities

Accounts receivable turnover =

Activity
ratios

Very immediate
liquidity

Current liabilities

Inventory turnover =

Average accounts receivable

Cost of goods sold

Average inventory

Accounts payable turnover =

Activity ratios tell us

How efficiently the company is using its assets.

Net credit sales

Inventory purchases
Average accounts payable

Liquidity refers to the companys short-term ability to generate cash for working
52
Capital needs and immediate debt repayment needs.

Receivables Turnover Ratio and

collection period
Receivables
Turnover =
Ratio

Net Sales
Average Accounts Receivable
This ratio measures how many
times a company converts its
receivables into cash each year.

Average Collection Period

Average
Collection
Period

365
Receivables Turnover Ratio

This ratio is an approximation of the

number of days the average accounts
receivable balance is outstanding. 53

Inventory Turnover Ratio and

Average Days in Inventory
Inventory
Turnover
Ratio

Cost of Goods Sold

Average Inventory

This ratio measures the number

of times merchandise inventory
is sold and replaced during the year.
Average Days in Inventory

Average =
365
Days in
Inventory Turnover Ratio
Inventory
This ratio indicates the number
of days it normally takes to sell inventory.
54

Credit risk:
Operating and cash conversion
cycles
Working capital ratios:
Days accounts receivable outstanding =

365 days
Accounts receivable turnover

(Days before cash is collected from the customer)

Days inventory held =

45 days

Operating
cycle 75
days
30 days

365 days

Cash
conversion
cycle 55
(75-20) days

Inventory turnover

Days accounts payable outstanding =

365 days

( 20 days)

Accounts payable turnover

( Days that suppliers are paid after inventory is purchased)

Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).
55

Credit risk:
Long-term solvency
Long-term debt to assets =

Debt ratios

Long-term debt

Including
Intangible assets

Total assets

Long-term debt to tangible assets =

Long-term debt
Total tangible assets

Long-term
solvency
Interest coverage =

Operating incomes before taxes and interest

Interest expense

Coverage
ratios
Operating cash flow
to total liabilities =

Cash flow from continuing operations

Average current liabilities + long-term debt

Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain
56
its productive capacity and still meet the interest and principal payment on its long-term debt.

Credit risk of Krispy Kreme :

Short-term liquidity and Long-term
solvency

57

Credit risk: Default Risk

A firm defaults when it fails

to make principal or
interest payments.

Lenders can then:

Adjust the loan payment
schedule.
Increase the interest
rate and require loan
collateral.
Seek to have the firm
declared insolvent.
Source: Moodys Investors Service (May 2000)

Default rates by Moodys credit rating, 1983-1999

58

Financial Ratios and Default

Risk
ROA and probability of default is negatively associated.
Return
on assets (ROA)
Profitability: Return on Assets Percentiles (excludes extraordinary items)

Source: Moodys Investors Service (May 2000)

59

Financial Ratios and Default

Risk
Quick Ratio and
probability of default is negatively associated.
Quick
Ratio
Liquidity: Quick Ratio Percentiles

Source: Moodys Investors Service (May 2000)

60

Credit analysis:
Case Study: G.T. Wilsons credit
A bank client for over 40 years.
risk

Owns 850 retail furniture stores throughout the U.S.

Increased competition and changing consumer
tastes caused the following changes in Wilsons
business strategy:
Expand product line to include high quality
furniture, consumer electronics, and home
entertainment systems.
Develop a credit card system to help customers
pay for purchases.
Open new stores in suburban shopping centers
and close unprofitable downtown stores.
61

Credit analysis:
Case Study: G.T. Wilsons credit
risk

Bank now has a $50 million secured

construction loan and a $200 million
revolving credit line which is up for
renewal with Wilson.
What do the Wilsons financial
statements tell us about its credit risk?
Should the bank renew Wilsons $200
million credit line?

62

Credit Analysis: Interpretation of cash flow

components

Negative free
cash flow

Increased
borrowing
Continued
dividend
payment

63

Credit Analysis : Selected financial

statistics

Declining
margin

Customers take
longer to pay,
but reserve is
smaller

Larger debt
burden

64

Credit analysis:
Recommendation

Wilson is a serious credit risk:

Inability to generate positive cash flows from
operations.
Extensive reliance on short-term debt
financing.
The company may be forced into bankruptcy
unless:
Other external financing sources can be
found.
Operating cash flows can be turned positive.
Update: Bankruptcy was declared shortly after
these financials were released.

65

Learning Objective:

Pro Forma Earnings

66

Pro Forma Earnings

Companies often voluntarily provide a
pro forma earnings number when
they announce annual or quarterly
earnings.
Pro forma earnings are
managements assessment of
permanent earnings.

67

Pro Forma Earnings

Many companies today are highlighting
a non-GAAP earnings in press releases,
in analyst conference calls, and in
annual reports.
The Sarbanes-Oxley Act Section 401
requires a reconciliation between pro
forma earnings and earnings
determined according to GAAP.

68

Financial statement analysis:

Non-GAAP earnings:
Pro forma earnings and EBITDA

Many companies today are

highlighting a non-GAAP
earnings in press releases, in
analyst conference call, and
in annual reports.
Sometimes these earnings
figures are called EBITDA
( earnings before interest,
income taxes,
depreciation, and
amortization)

Sometimes it is called
adjusted earnings.

Sometimes it is called
pro forma earnings.
69

Financial statement analysis:

Pro forma earnings at Amazon.com

Company
defined numbers
Computed
according to GAAP

70

When use the EBITDA or pro

forma earnings, analysts
There are no standard definitions for nonshould remember:
GAAP earnings numbers.

Non-GAAP earnings ignore some real

business costs and thus provide an
incomplete picture of company profitability.

EBITDA and pro forma earnings do not

accurately measure firm cash flows.
71

Why do firms report EBITDA

and pro forma earnings?

Help investors and analysts spot nonrecurring or non-cash revenue and

expense items that might otherwise be
overlooked.
Pro forma earnings could mislead
investors and analysts by changing the
way in which profits are measured.

Transform a GAAP loss into a profit.

Show a profit improvement.
Meet or beat analysts earnings forecasts.
72

Summary

Financial ratios, common-size statements

and trend statements are powerful tools.
However:
There is no single correct way to
compute financial ratios.
Financial ratios dont provide the
answers, but they can help you ask the
right questions.
Watch out for accounting distortions that
can complicate your interpretation of
financial ratios and other comparisons.
73

Summary of financial statement

analysis

How
to use financial ratios
Profitability:

ROA ( Return on assets)

Operating Profit Margin
ROCE ( Return on common stockholders equity)
Market Measures:
Earnings per share (EPS)
Price/ earnings ( Market price of common stock/
EPS)
Dividend payout ( Dividends per share/ EPS)
Dividend yield ( Dividends per share/ Market price
of common stock)

74

Summary of financial statement

analysis

How
to (use
financial
ratios
Liquidity
Evaluate
short-term
credit risk)
- Liquidity ratios: Current ratio and quick ratio
- Liquidity of working capital : Average collection
period, Days inventory held, days payable
outstanding, operating cycle days, cash
conversion cycle, etc.
- Operating Efficiency ( Activity ratios)
Accounts receivable turnover
Inventory turnover
Accounts payable turnover
75

Summary of financial statement

analysis
How to use financial ratios

Solvency ( Evaluate long-term credit

risk)
Coverage ratios: interest coverage,
operating cash flows to total liabilities
Debts ratios:
Debt/ Assets
Debt/ equity (Total liabilities/
Stockholders equity)

76

Whole Foods Market,

Comparative Income
Statement

5-77

Common
Size
statement
s

5-78

Business Segment
information

5-79

Comparative Balance Sheet

5-80

Comparative Balance Sheet

5-81

Common size and trend

analysis

5-82

Common size and trend

analysis (Exhibit 5.5
continued)

5-83

Common size and trend

analysis

5-84

Common size and trend

analysis (Exhibit 5.6
continued)

5-85

Comparative Cash Flows

5-86

Common size trend analysis

5-87