Financial Statement Analysis

Created by David Moore, PhD

Reference Material: Wall Street Prep Accounting Crash Course (Chapter 51)

Key Concepts

  1. Common-size Financial Statements
    • Vertical vs Horizontal
  2. Financial Ratios
  3. Dupont Identity
  4. Benchmarking
  5. Issues with analyzing financial statements

What Is Financial Statement Analysis?

Process of analyzing financial statements for decision making purposes
  • External: Understand overall health
  • Internal: Monitoring tool

General Issue

How do we compare Financial Statements?

  • Size is a major issue
  • Solution
    • Standardize financial statements
      • Vertical
      • Horizontal
    • Financial Ratios

Common-Size Statements

Express all items/accounts in percentage terms
  • Balance Sheet
    • Vertical:Express as a percent of total assets
    • Horizontal:Express as a percent of base or last year
  • Income Statement
    • Vertical:Express as a percent of Sales
    • Horizontal:Express as a percent of base or last year
  • Vertical: Within same period for the same company
  • Horizontal:Across reporting periods (base-year or growth)

Common Size Balance Sheet

Vertical Analysis

2017 2018 Common-Size
Cash 84 146 146/3636=4.0%
A/R 165 188 188/3636=5.2%
Inventory 393 422 422/3636=11.6%
PPE 2731 2880 2880/3636=79.2%
Total Assets 3373 3636 3636/3636=100%

Common Size Balance Sheet

Horizontal Analysis

2017 2018 Common-Size
Cash 84 146 146/84-1=73.8%
A/R 165 188 188/165-1=13.9%
Inventory 393 422 422/393-1=7.4%
PPE 2731 2880 2880/2731-1=5.5%
Total Assets 3373 3636 3636/3373-1=7.8%

Common Size Income Statement

Vertical Analysis

2018 Common-Size
Sales 2311 2311/2311=100.0%
Cost of Goods Sold 1344 1344/2311=58.2%
Depreciation 276 276/2311=11.9%
EBIT 691 691/2311=29.9%
Net Interest Expense 141 141/2311=6.1%
Taxable Income 550 550/2311=23.8%
Taxes 116 116/2311=5.0%
Net Income 435 435/2311=18.8%

What the Common-Size Reveals

  • Large or drastic changes
  • Strategy
  • Used as part of Overall Financial statement analysis

Caveats

  • Quarterly Data and Horizontal
    • Use same fiscal quarter
  • Horizontal can be misleading due to base year selection
  • Best if Vertical and horizontal are used in conjunction.
  • Can also compare intra-industry

Ratio Analysis

Overview

  • Why study ratios?
  • There are a lot of financial ratios; CFA exam has 40!
  • We will cover commonly used ratios
  • Not all ratios created from same data, i.e., be careful!

Takeaway: It is trivial to calculate ratios, I want you to understand what the ratios mean (Interpret them!!!)

Ask Yourself

  • How is the ratio computed?
  • What is the ratio trying to measure and why?
  • What is the unit of measurement?
  • Does the sign make sense?
  • What does the value indicate?
  • How can we improve the company's ratio?

Ratio Types

  • Liquidity or Short-term solvency
  • Asset Management or Turnover
  • Financial leverage or Long-term Solvency
  • Performance
    • Profitability
    • Market Value


Click here for a full list and description of financial ratios.

Short-term solvency

Measure the firm's ability to pay its bills over the short run without undue stress

$Current Ratio=\frac{Current Assets}{Current Liabilities}$

$Quick Ratio=\frac{Current Assets - Inventory}{Current Liabilities}$

$Cash Ratio=\frac{Cash}{Current Liabilities}$

$Interval Measure=\frac{CA}{Average Daily Operating Costs}$
This is just a sample of ratios for this category

Asset Management

How efficiently a firm uses its assets to generate sales

$Inventory Turnover=\frac{Cost of Goods Sold}{Inventory}$

$Days' Sales In Inventory=\frac{365 days}{Inventory Turnover}$

This is just a sample of ratios for this category

Long-term Solvency

Typically referred to as financial leverage ratios. Measures the firm's ability to meet long-term obligations
$Total Debt Ratio=\frac{Total Assets - Total Equity}{Total Assets}$

$Debt\text{-}Equity Ratio=\frac{Total Debt}{Total Equity}$

$Equity Multiplier=\frac{Total Assets}{Total Equity}$

$Cash Coverage Ratio=\frac{EBIT + Depreciation}{Interest}$
Sidenote: Typically analysts are only concerned with long-term debt.
This is just a sample of ratios for this category

Performance: Profitability

Focuses on bottom line(profits/return). as well as stock market performance.

$Profit Margin=\frac{Net Income}{Sales}$

$Return on Equity(ROE)=\frac{Net Income}{Total Equity}$

$Return on Assets(ROA)=\frac{Net Income}{Total Assets}$

This is just a sample of ratios for this category

Performance: Market

Focuses on stock market performance.

$Earnings Per Share=\frac{Net Income}{Shares Outstanding}$

$PE Ratio=\frac{Price Per Share}{Earnings Per Share}$

$Market\text{-}To\text{-}Book Ratio=\frac{Market Value}{Book Value}$

This is just a sample of ratios for this category

Enterprise value

Theoretical takeover value of the firm

$Enterprise Value=Market Cap + Book Value Of Liabilities - Cash$

Dupont Identity

Decompose ROE into component parts.

$ROE=Profit Margin \text{ x } Total Asset Turnover \text{ x } Equity Multiplier$
Dupont

Why analyze financial statements?

  • Market data can be difficult to get
  • Comparison tool: Internal vs external uses

Benchmarking

Ratio in isolation does not paint entire picture, therefore; compare to "something". Benchmarking is finding that something.

Common Benchmarks

  1. Time trend analysis (Horizontal)
  2. Peer group analysis (Vertical/Intra Industry)

SIC Codes

SIC

Issues/Concern with Financial Statements Analysis

  • No theory
  • Conglomerates
  • Globalization
  • Different accounting procedures
  • Fiscal-year ends and seasonality
  • One-time events

Financial Statement Analysis in practice

SIC

Ratios Tell A Story

California Choppers Case

Key Learning Outcomes

  • Common-size: vertical vs horizontal
  • Financial Ratios!!! Calculate and interpret.
  • Dupont Identity
  • Benchmarking
  • Issues with analysis

Next time

Financial Statement Modeling