CF1 Lec3 Financial Analysis

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Introduction
Part 1
Part 2
Part 3
Summary
Lecture 3
FINANCIAL STATEMENTS ANALYSIS
Course: Corporate Finance 1
Lecturer: Hanh Nguyen LUU
1
PREVIOUS LECTURE REVISION
What are the 3 basic activities involved in conducting
a business?
Net
Goods & Services
earnings
o Operating activities
Reinvested Investment in
o Investing activities Producing Assets
Debt
o Financing activities payment
Debt Financing
Dividends
Equity Financing
2
PREVIOUS LECTURE REVISION
Match the Financial Statements with their functions
Summarize firm’s operating activities (revenues &

Balance sheet
expenses) over a given period
Reports all cash inflows and outflows occurred over a

Income statement
given period of time
Snapshot of firm’s assets & financing sources (equity

Statement of Cash flow
& liabilities) at a given point
3
Lecture 1: Introduction to Corporate Finance (Chapter 1)
Lecture 2: Financial Statements and Cash Flow (Chapter 2)
Lecture 3: Financial Statements Analysis (Chapter 3)
Overview Financial Statement Valuation Risk Management Short-term

Analysis Financial Decision
Corporate Finance
The Importance of Cash Flows
Financial Management
Goal
The Agency Problem
4
LECTURE OBJECTIVES
Ratio analysis provides a meaningful comparison of a company to its

industry;
Ratios can be used to measure profitability, asset utilization, liquidity,

and debt utilization;
The Du Pont system identifies the sources of return on assets and returns
on equity;
Trend analysis shows company performance over time
5
Financial Analysis
Ratio Analysis
Du Pont System
Limitations to Ratio Analysis
6
Financial Analysis
Ratio Analysis
Du Pont System
7
Financial Analysis Ratio Analysis Du Pont System Limitations to
Ratio Analysis
Purpose
1. Communicate financial information (within and outside firm)
2. Evaluate past performance and current financial situation
3. Assess future potentials and associated risks
4. Give recommendations to ensure business finance in good condition
Source of information for analysis

1. Released financial statements and firm’s press release
2. Report to the State Security Commission (listed firms)
3. Other sources: independent agent’s report, articles,…
Financial analysis involve

1. Trend/ Horizontal Analysis
2. Vertical Analysis
3. Ratio Analysis
8
Ratio Analysis
Why Evaluate Financial Statements?
Internal uses External uses

Performance evaluation –comparison between divisions Creditors
Planning for the future – guide in Shareholders
estimating future cash flows Governmental agencies
Other stockholders
9
Ratio Analysis
Steps in Analyzing Financial statements
Step 6: Value the

Step 5: Prepare firm
forecasted
Step 4: Analyze financial
current statements
Step 3: Assess the profitability and
quality of firm's risk
Step 2: Identify financial
company statements
Step 1: Identify strategies
industry and
economic
characteristics
10
Ratio Analysis
Standardizing statements
Hard to directly compare financial statements of 2 companies in different size/ in different years
Standardize by working with percentages  common-size statements
Make it easier to compare financial information
Common-size Balance Sheets

Expressing each item as percentage of Total Assets
Total change in different years has to be zero (total must add up to 100%)
Common-size Income Statements

Expressing each item as percentage of Total Sales
Indicate what happens to each unit of sales
11
Ratio Analysis
Common-size Balance Sheets
12
Ratio Analysis
Common-size Income Statements
13
Financial Analysis
Ratio Analysis
Du Pont System
14
Ratio Analysis
Categories
Short-term solvency/ Liquidity ratios
Long-term solvency/ Financial leverage ratios
Asset management/ Turnover ratios
Profitability ratios
Market value ratios
Question to ask
How it is computed?
What is it intended to measure?
What is the unit of measurement?
What might be a value telling us? How might such value be misleading?
How could this measure be improved? 15
Ratio Analysis
Liquidity ratios – Short-term solvency

Firm’s ability to pay its bills over the short-run without stress  ST creditors’ interest
Focus on Current Assets & Current Liabilities (book & market value likely similar)
Current ratio Quick ratio

Formula
Meaning Inventory: least liquid CA item

For each dollar of short-term debt, how many dollar of short-
For each dollar of ST debt, how many dollar of ST
term assets can be used for payment?
assets can be used to pay immediately?
Unit Unit of currency or times
Benchmark Compare with 1, previous year ratio, average ratio of the industry
If less than 1  negative net working capital
(not problem with large reserved of borrowing power)
16
Ratio Analysis
Exercise: Using information from ABC company’s Income Statement and Balance Sheet,
evaluate the firm’s financial situation.
17
Ratio Analysis
Exercise: Using information from ABC company’s Income Statement and Balance Sheet,
evaluate the firm’s financial situation.
18
Ratio Analysis
Exercise 3.1: Using information from ABC company’s Income Statement and Balance Sheet,
evaluate the firm’s liquidity situation
19
Ratio Analysis
Financial leverage ratios – Long-term solvency

Firm’s long-run ability to meet its obligation – financial leverage
Long-term Solvency Ratios Coverage Ratio

Total debt ratio Equity Multiplier Times interest earned Cash coverage
Formula
Meaning/ How much debt is Risk indicator that EBIT: not a measure of cash available to
Concerns How well a firm has
utilized to finance measures the portion of a pay interest
interest obligations
firm’s assets; company’s assets that is EBITDA: basic measure of firm’s ability to
covered by profits from
percentage of debt in financed by equity rather generate cash from operation  used to
business activities?
firm’s total capital? than by debt meet obligations
Unit Times
Benchmark Compare with previous year ratio, average ratio of the industry, comparable firm
20
Ratio Analysis
evaluate the firm’s leverage situation ABC Income statement and
Balance sheet
21
Ratio Analysis
Turnover ratios – Asset management

How efficiently or intensively a firm uses its assets to generate sales
Inventory ratios
Indicate how fast firm can sell products
Inventory turnover Days sales in Inventory

Formula
Meaning How many times firm sold off (turn over) the entire
inventory during the year How long it takes for inventory to stay in warehouse before
The higher the ratio, the more efficient inventory sale on average?
mangement
Unit Times Days
Benchmark Compare with previous year ratio, average ratio of the industry, competitors
(consider characteristics of firms business)
Often: the higher the better
Value can vary dramatically among firms in different industry
22
Ratio Analysis

Receivable ratios
Indicate how fast firm collect revenues on sales/ how fast firm can sell products
Receivables turnover Days sales in Inventory

Formula
Meaning How many times firm collect outstanding credit

How long it takes for firms to collect credit sales on average?
accounts and lent money again?
Unit Times Days
23
Ratio Analysis

Asset ratios
Indicate the efficiency of the firms’ asset management. How much dollar of revenues generated from one
dollar of sales?
Fixed Assets turnover Working capital turnover ratios Total Assets turnover
Formula
Unit Unit of currency of times

Can vary widely among different industries
24
Ratio Analysis
evaluate the firm’s asset management situation ABC Income statement and Balance
sheet
4850/
16.94 =
25
Ratio Analysis
Profitability ratios
Assess a firm’s ability to earn profits from its sales or operations, balance sheet assets, or shareholders' equity
How efficiently a firm generates profit and value for shareholders
Margin ratios Return ratios
Net profit margin EBITDA margin Return on Assets Return on Equity

Formula
Meaning How much operating

How much income generated
cash flows generated Profit per dollar of assets Profit per dollar of equity
from each dollar in sales?
from each dollar in sales?
Unit Times
Benchmark Compare with historical performance, average ratio of the industry (vary among different industries)
Notes Use accounting number (book value) rather than actual market value
Inappropriate to compare with interest in the financial market
26
Ratio Analysis
Market Value ratios

Based on market stock price, not on information on financial statements
Only apply for publicly traded firms
Price-Earnings ratio Market-to-Book ratio Enterprise value multiples

Formula
Meaning Total value of equity (not just common

How much investors are willing Estimate the value of the firm’s total business rather
stock)
to pay per dollar of current than just focusing on the value of its equity
Compares market value to cost of
earnings? Allows comparison of firms when there are
investment
High ratio  firm has significant differences in capital structure (interest expense),
Less than 1  firm not create value for
prospects for future growth taxes, or capital spending.
stockholders in general
Unit Unit of currency of times
27
Ratio Analysis
Cautions for doing Ratio Analysis
Ratios must be considered together; a single ratio by itself means relatively little.
Financial statements that are being compared should be dated at the same point in time.
Use audited financial statements when possible.
The financial data being compared should have been developed in the same way.
Be cautious of inflation distortions.
28
Financial Analysis
Ratio Analysis
Du Pont System
29
Ratio Analysis
Definition
The technique that breaks down ROA and ROE into related ratios to evaluate the impact of each part on the final result
Identify what steps need to be taken to improve financial position of the firm
Operating efficiency
Net income
Profit margin
Sales Return on Assets
Asset turnover
Total Assets Asset use efficiency Return on Equity
Equity multiplier
Total Equity Financial leverage 30
Ratio Analysis
Formula
ROE =
= ROA x Equity multiplier

=
= Profit margin x Total Asset turnover x Equity multiplier
Meaning
ROE is affected by 3 factors
Operating efficiency
Asset use efficiency
Financial leverage
Weakness in operating efficiency (reduction in profit margin) and/ or weakness in asset utilization (reduction in total
asset turnover)  ROA decrease  ROE decrease
31
Whether an increase in debt enhances ROE?
Ratio Analysis
Extended
DuPont
Chart
32
Ratio Analysis
Exercise 3.4: XYZ Corporation has the following financial information for the
previous year:
Sales: $8M, Profit Margin = 8%, Current Assets = $2M, Fixed Assets = $6M, Net Working
Capital = $1M, Long-term Debt = $3M
Compute the ROE using the DuPont Analysis.
Total Assets = Current Assets + Fixed Assets = 2M + 6M = $8M
Short-term debt = Current Assets - Net Working Capital = 2M - 1M = $1M
Total debt = Short-term debt + Long-term debt = 1M + 3M = 4M
Total Equity = Total Assets - Total Liabilities = 8M - 4M = $4M
ROE = Profit Margin * Total Assets Turnover * Equity Multiplier

= Net income/ Sales * Sales / Total Assets * Total Assets / Total equity
= 8% * 1 * 2
= 16%
33
Financial Analysis
Ratio Analysis
Du Pont System

34
Ratio Analysis
Limitations
o Historical basis of ratios
o No underlying theory to help identify which quantities to look at & guidance to set up benchmark
o Benchmarking is difficult for diversified firms
o Different accounting policies, different end of fiscal year, unusual transaction
o Manipulation of financial statements
o Inflation effects: numbers not comparable across period
o Cannot use to compare different industries
35
Search Menu
Introduction
Part 1
Part 2
Part 3
Summary
Key terms
o Liquidity ratios: current ratio, quick ratio
o Asset management ratios: inventory turnover, DSO, total asset turnover
o Debt management ratios: debt ratio, TIE
o Profitability ratios: profit margin, operating margin, ROA, ROE
o Market valuation ratio: M/B, P/E
o DuPont equation
36
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Introduction
Part 1
Part 2
Part 3
Summary
Thank you!
37

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What are the 3 basic activities involved in conducting

Match the Financial Statements with their functions

Summarize firm’s operating activities (revenues &

Reports all cash inflows and outflows occurred over a

Snapshot of firm’s assets & financing sources (equity

Lecture 2: Financial Statements and Cash Flow (Chapter 2)

Lecture 3: Financial Statements Analysis (Chapter 3)

Overview Financial Statement Valuation Risk Management Short-term

Ratio analysis provides a meaningful comparison of a company to its

Ratios can be used to measure profitability, asset utilization, liquidity,

Trend analysis shows company performance over time

Limitations to Ratio Analysis

Limitations to Ratio Analysis

Source of information for analysis

Financial analysis involve

Why Evaluate Financial Statements?

Internal uses External uses

Steps in Analyzing Financial statements

Step 6: Value the

Common-size Balance Sheets

Common-size Income Statements

Common-size Balance Sheets

Common-size Income Statements

Limitations to Ratio Analysis

Liquidity ratios – Short-term solvency

Current ratio Quick ratio

Meaning Inventory: least liquid CA item

Financial leverage ratios – Long-term solvency

Long-term Solvency Ratios Coverage Ratio

Turnover ratios – Asset management

Inventory turnover Days sales in Inventory

Turnover ratios – Asset management

Receivables turnover Days sales in Inventory

Meaning How many times firm collect outstanding credit

Turnover ratios – Asset management

Unit Unit of currency of times

Margin ratios Return ratios

Net profit margin EBITDA margin Return on Assets Return on Equity

Meaning How much operating

Market Value ratios

Price-Earnings ratio Market-to-Book ratio Enterprise value multiples

Meaning Total value of equity (not just common

Cautions for doing Ratio Analysis

Use audited financial statements when possible.

Be cautious of inflation distortions.

Sales Return on Assets

= ROA x Equity multiplier

= Profit margin x Total Asset turnover x Equity multiplier

Compute the ROE using the DuPont Analysis.

Total Assets = Current Assets + Fixed Assets = 2M + 6M = $8M

Short-term debt = Current Assets - Net Working Capital = 2M - 1M = $1M

Total debt = Short-term debt + Long-term debt = 1M + 3M = 4M

Total Equity = Total Assets - Total Liabilities = 8M - 4M = $4M

ROE = Profit Margin * Total Assets Turnover * Equity Multiplier

Limitations to Ratio Analysis

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