McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statement

Analysis

K R SubramanyamJohn J Wild

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1CHAPTER

Overview of Financial Statement Analysis

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Business Analysis

Evaluate Prospects Evaluate Risks

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Information Sources for Business Analysis

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Credit Analysis

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Credit Analysis

Liquidity Ability to meet short-term obligations. Focus: • Current cash flows• Make up of current assets and liabilities• Liquidity of assets

SolvencyAbility to meet long-term obligations Focus:• Long-term profitability• Capital structure

Credit worthiness: Ability to honor credit obligations(downside risk)

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Equity Analysis

Technical analysis / Charting

• Patterns in price or volume history of a stock

• Predict future price movements

Fundamental Analysis Determine Intrinsic value

without reference to price

• Analyze and interpret key factors

– Economy– Industry– Company

Assessment of risk and potential

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Dynamics of Business ActivitiesBusiness Activities Time

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Business Activities

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Business Activities

Financing

Financing activities

• Owner (equity)

• Nonowner (liabilities)

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Investing activities

• Buying resources

• Selling resources

Investing = Financing

Business Activities

FinancingInvesting

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Operating ActivitiesRevenues and expenses from providing

goods and services

Business Activities

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Financial Statements Reflect Business Activities

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Financial Statements

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Balance Sheet

Total Investing = Total Financing = Creditor Financing + Owner Financing

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Income Statement

Revenues – Cost of goods sold = Gross ProfitGross profit – Operating expenses = Operating Profit

Colgate’s Profitability(in $billions)

$12.238 - $5.536 = $6.701 Gross Profit

$6.701 - $4.5411 = $2.160 Operating profit

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Statement of Cash Flows

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Additional Information(Beyond Financial Statements)

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Analysis Preview

Purpose:Evaluation of consecutive financial statements

Output : Direction, speed, & extent of any trend(s)

Types: Year-to-year Change Analysis Index-Number Trend Analysis

Comparative AnalysisYr2Yr1 Yr3

Analysis Preview1-25

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Analysis Preview

Purpose : Evaluation of internal makeup of financial statements Evaluation of financial statement accounts across companies

Output: Proportionate size of assets, liabilities, equity, revenues, & expenses

Common-Size Analysis

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Analysis Preview

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Analysis Preview

Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis)

Output: Mathematical expression of relation between two or more items

Cautions: Prior Accounting analysis is important Interpretation is key - long v/s short term & benchmarking.

Ratio Analysis

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Ratios Categories

1- Liquidity.2- Capital structure and Solvency.3- Return on investment.4- Operating Performance.5- Assets utilization.6- Market measures

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Ratios1- Liquidity. - Current Ratio. - Acid Test Ratio - Collection Period - Days to sell inventory.2- Capital Structure and Solvency - Total Debt to equity. - Long term debt to Equity. - Time interest Earned.

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Ratios Categories

3- Return on investment. - Return on Assets. - Return on common Equity.4- Operating Performance. - Gross profit Margin. - Operating Profit margin. - Net Profit margin.

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Ratios Categories

5- Assets utilization.- Cash turnover,- Account receivable turnover.- Inventory turnover.- Working Capital Turnover.- PPE turnover.- Total assets Turnover.

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Ratios Categories

6- Market measures - Price to Earnings. - Earning Yield. - Dividend Yield. - Dividend Payout Ratio. - Price to book

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Analysis Preview

Purpose: Estimate intrinsic value of a company (or stock)

Basis: Present value theory (time value of money)

ValuationValuation - an important goal of many types of business analysis

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Analysis Preview

Debt (Bond) Valuation

Bt is the value of the bond at time tIt +n is the interest payment in period t+nF is the principal payment (usually the debt’s face value)r is the investor’s required interest rate (yield to maturity)

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Analysis Preview

Equity Valuation

Vt is the value of an equity security at time tDt +n is the dividend in period t+nk is the cost of capitalE refers to expected dividends

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Analysis Preview Equity Valuation - Free Cash Flow to Equity

Model

FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures]k is the cost of capitalE refers to an expectation

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Analysis PreviewEquity Valuation - Residual Income Model

BVt is the book value at the end of period tRit+n is the residual income in period t + n [defined as

net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)]

k is the cost of capital E refers to an expectation