Essentials of

Financial Statement
Analysis

Revsine/Collins/Johnson/Mittelstaedt: Chapter 5

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, All

 Learning objectives
1. How competitive forces and business strategies affect firms’ financial
statements.

2. Why analysts worry about accounting quality.

3. How return on assets (ROA) is used to evaluate profitability.

4. How ROA and financial leverage combine to determine a firm’s return

on equity (ROE).

5. How short-term liquidity risk and long-term solvency risk are assessed.

6. How to use the Statement of Cash Flows to assess credit and risk.

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 Financial statement analysis:
Tools and approaches
Tools: Approaches used with each tool:

1. Time-series analysis: the same firm over

time (e.g., Wal-Mart in 2005 and 2006)
Common size statements

2. Cross-sectional analysis: different firms

Trend statements at a single point in time (e.g., Wal-Mart
and Target in 2005).

3. Benchmark comparison: using industry

Financial ratios norms or predetermined standards.
(e.g., ROA and ROE)

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 Evaluating accounting
“quality”
 Analysts use financial statement information to “get behind the
numbers”.

 However, financial statements do not always provide a complete

and faithful picture of a company’s activities and condition.

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 How the financial accounting
“filter” sometimes works
GAAP puts capital leases
on the balance sheet, but
operating leases are “off-
balance-sheet”.

Managers have some Managers have some Managers can choose

discretion over estimates discretion over the timing any of several different
such as “bad debt of business transactions inventory accounting
expense”. such as when to buy methods.
advertising.

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 Whole Foods Market,
Comparative Income
Statement

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 Common Size statements

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 Business Segment information

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 Comparative Balance Sheet

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 Common size trend analysis

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 Comparative Cash Flows

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 Common size trend analysis

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 Financial ratios and
profitability analysis
Operating profit margin

EBI
Sales
Return on assets
EBI
ROA= X Asset turnover
Average assets
Sales
Average assets

Analysts do not always use the reported earnings, sales and asset figures. Instead, they
often consider three types 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).

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 How can ROA be increased?
There are just two ways:

1. Increase the operating profit

margin, or

2. Increase the intensity of asset

utilization (turnover rate). Asset turnover

EBI EBI Sales

ROA=
Average assets Sales Average assets

Operating profit margin

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 ROA and competitive
advantage:
Four hypothetical restaurant firms
 Competition works to drive down
ROA toward the competitive floor. Competitive
ROA floor
 Companies that consistently earn an
ROA above the floor are said to have
a competitive advantage.

 However, a high ROA attracts more

competition which can lead to an
erosion of profitability and advantage.

 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).

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 Credit risk and capital
structure:
Overview
 Credit risk refers to the risk of default by the borrower.

 The lender risks losing interest payments and loan principal.

 A company’s ability to repay debt is determined by it’s capacity to

generate cash from operations, asset sales, or external financial
markets in excess of its cash needs.

 A company’s willingness to repay debt depends on which of the

competing cash needs management believes is most pressing at
the moment.

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 Credit risk and capital
structure:
Balancing cash sources and needs

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 Credit risk:
Short-term liquidity ratios

Current assets
Current ratio =
Current liabilities
Liquidity
ratios Cash + Marketable securities + Receivables
Quick ratio =
Current liabilities
Short-term
liquidity Net credit sales
Accounts receivable turnover =
Average accounts receivable

Activity Cost of goods sold

Inventory turnover =
ratios Average inventory

Inventory purchases
Accounts payable turnover =
Average accounts payable

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 Credit risk:
Operating and cash conversion cycle
example

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 Credit risk:
Long-term solvency

Long-term debt
Long-term debt to assets =
Total
Debt ratios assets
Long-term debt
Long-term debt to tangible assets =
Total tangible assets

Long-term
solvency
Operating incomes before taxes and interest
Interest coverage =
Interest expense
Coverage
ratios
Operating cash flow Cash flow from continuing operations
to total liabilities = Average current liabilities + long-term debt

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 Credit risk:
Financial ratios and 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.

 Financial ratios play two roles in

credit analysis:
 They help quantify the borrower’s
credit risk before the loan is granted. Default rates by Moody’s credit rating, 1983-1999
 Once granted, they serve as an early
warning device for increased credit
risk.
Source: Moody’s Investors Service (May 2000)

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 Default frequency:
Return on assets (ROA)

Profitability: Return on Assets Percentiles (excludes extraordinary items)

Source: Moody’s Investors Service (May 2000)

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 Default frequency:
Debt-to-tangible assets and interest
coverage

Solvency: Debt-to-Tangible Assets and Interest Coverage Percentiles

Source: Moody’s Investors Service (May 2000)

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 Default frequency:
Quick ratio

Liquidity: Quick Ratio Percentiles

Source: Moody’s Investors Service (May 2000)

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 Return on equity and financial
leverage
 2005: No debt, so all the earnings belong
to shareholders.

 2006: $1 million borrowed at 10%

interest, but ROCE climbs to 20%.

 2007: Another $1 million borrowed at 20%

interest, and ROCE falls to only 15%.

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 Components of ROCE
Return on assets (ROA)
EBI
Average assets
Return on common
equity (ROCE) X
Common earnings leverage
Net income available to
common shareholders Net income available to
common shareholders
Average common
shareholders’ equity EBI

X
Financial structure leverage
Average assets
Average common
shareholders’ equity

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 Profitability and financial
leverage:
Nodebt and Hidebt example

Leverage neutral

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 Financial statement analysis
and accounting quality
 Financial ratios, common-size statements, and trend statements
are extremely powerful tools.

 But they can be no better than the data from which they are
constructed.

 Be on the lookout for accounting distortions when using these

tools. Examples include:
Nonrecurring
gains and losses
Differences in
accounting methods
Differences in
accounting estimates
GAAP implementation
differences
Historical
cost convention

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 Why do firms report EBITDA
and “pro forma” earnings?
 Impression management is the Analysts should remember:
answer.
1. There are no standard definitions
 Help investors and analysts spot for non-GAAP earnings numbers.
non-recurring or non-cash
revenue and expense items that 2. Non-GAAP earnings ignore
might otherwise be overlooked. some real business costs and
thus provide an incomplete
 Mislead investors and analysts picture of company profitability.
by changing the way in which
profits are measured. 3. EBITDA and pro forma earnings
 Transform a GAAP loss into a do not accurately measure firm
profit.
cash flows.
 Show a profit improvement.
 Meet or beat analysts’ earnings
forecasts.

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 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 don’t 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.

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