corporate finance chapter 4.docx
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corporate finance chapter 4.docx
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corporatefinancechapter4
Chapter4
AnalyzingFinancialStatements
LearningObjectives
1.Explainthethreeperspectivesfromwhichfinancialstatementscanbeviewed.
2.Describecommon-sizefinancialstatements,explainwhytheyareused,andbeabletoprepareandusethemtoanalyzethehistoricalperformanceofafirm.
3.Discusshowfinancialratiosfacilitatefinancialanalysis,andbeabletocomputeandusethemtoanalyzeafirm’sperformance.
4.DescribetheDuPontsystemofanalysisandbeabletouseittoevaluateafirm’sperformanceandidentifycorrectiveactionsthatmaybenecessary.
5.Explainwhatbenchmarksare,describehowtheyareprepared,anddiscusswhytheyareimportantinfinancialstatementanalysis.
6.Identifythemajorlimitationsinusingfinancialstatementanalysis
I.ChapterOutline
4.1BackgroundforFinancialStatementAnalysis
A.Stockholders’Perspective
∙Shareholders’focuscentersonthevalueofthestocktheyhold.
∙Theirinterestinthefinancialstatementistogaugethecashflowsthatthefirmwillgeneratefromoperations,
∙Thisallowsthemtodeterminethefirm’sprofitability,theirreturnforthatperiod,andthedividendtheyarelikelytoreceive.
B.Managers’Perspective
∙Ononehand,management’sinterestinthefirm’sfinancialstatementissimilartothatofshareholders.
∙Agoodperformancebythefirmwillkeepthemanagementinthefirm,whileapoorperformancecancostthemtheirjobs.
∙Inaddition,managementgetsfeedbackontheirinvesting,financing,andworkingcapitaldecisionsbyidentifyingtrendsinthevariousaccountsthatarereportedinthefinancialstatements.
C.Creditors’Perspective
∙Creditorsorlendersareprimarilyconcernedaboutgettingtheirloansrepaidandreceivinginterestpaymentsontime.
∙Theirfocusison:
▪Amountofdebtthefirmhas.
▪Firm’sabilitytomeetshort-termobligations.
▪Firm’sabilitytogeneratesufficientcashflowstomeetalllegalobligationsfirstandstillhavesufficientcashflowstomeetdebtrepaymentandinterestpayments.
D.GuidelinesforFinancialStatementAnalysis
∙Identifywhoseperspectiveyouareusingtoanalyzeafirm—management,shareholder,orcreditor.
∙Useonlyauditedfinancialstatementsifpossible.
∙Performanalysisoverathree-tofive-yearperiod—trendanalysis.
∙Comparethefirm’sperformancetoitsdirectcompetitors—thatis,firmsthataresimilarinsizeandoffersimilarproducts.
∙Performabenchmarkanalysis.Thisinvolvescomparingittooneormoreofthemostrelevantcompetitors—AmericanAirwithDeltaorUnitedAirlines.
4.2Common-SizeFinancialStatements
Acommon-sizedbalanceiscreatedbydividingeachassetorliabilitybyabasenumberliketotalassetsorsales.Suchcommon-sizeorstandardizedfinancialstatementsallowonetocomparefirmsthataredifferentinsize.
A.Common-SizeBalanceSheets
∙Eachassetandliabilityitemonthebalancesheetisstandardizedbydividingitbytotalassets,
∙Thisresultsintheseaccountsbeingrepresentedaspercentagesoftotalassets.
B.Common-SizeIncomeStatements
∙Eachincomestatementitemisstandardizedbydividingitbythedollaramountofsales.
∙Eachincomestatementitemisnowindicatedasapercentageofsales.
4.3FinancialStatementAnalysis
A.Overview
∙Aratioiscomputedbydividingonebalancesheetorincomestatementitembyanother.
∙Avarietyofratioscanbecomputedtofocusonspecializedaspectsofthefirm’sperformance.
∙Thechoiceofthescaledeterminesthestorythatcanbegarneredfromtheratio.
∙Differentratioscanbecalculatedbasedonthetypeoffirmbeinganalyzedorthekindofanalysisbeingperformed.
∙Ratiosmaybecomputedtomeasureliquidity,efficiency,leverage,profitability,ormarket-valueperformance.
B.LiquidityRatios
∙Liquidityratiosmeasuretheabilityofthefirmtomeetshort-termobligationswithshort-termassetswithoutputtingthefirminfinancialtrouble.
∙Therearetwocommonlyusedratiostomeasureliquidity—currentratioandquickratio.
∙Currentratioiscalculatedbydividingthecurrentassetsbycurrentliabilities.
▪Ittellshowmanydollarsofcurrentassetsthefirmhasperdollarofcurrentliabilities.
▪Thehigherthenumber,themoreliquidthefirmandthebetteritsabilitytopayitsshort-termbills.
∙Quickratiooracid-testratioiscalculatedbydividingthemostliquidofcurrentassetsbycurrentliabilities.Inventorythatisnotveryliquidissubtractedfromtotalcurrentassetstodeterminethemostliquidassets.
▪Ittellsushowmanydollarsofliquidassetsthefirmhasperdollarofcurrentliabilities.
▪Thehigherthenumber,themoreliquidthefirmandthebetteritsabilitytopayitsshort-termbills.
∙Quickratioswilltendtobemuchsmallerthancurrentratiosformanufacturingfirmsorotherindustriesthathavealotofinventory,whileservicefirmsthattendnottocarrytoomuchinventorywillseenosignificantdifferencebetweenthetwo.
C.EfficiencyRatios
∙Thissetofratios,sometimescalledassetturnoverratios,measurestheefficiencywithwhichafirm’smanagementusestheassetstogeneratesales.
∙Whilemanagementcanusetheseratiostoidentifyareasofinefficiencythatrequireimprovement,creditorscanusesomeoftheseratiostodeterminethespeedwithwhichinventorycanbeconvertedtoreceivables,whichcanthenbeconvertedtocashandhelpthefirmtomeetitsdebtobligations.
∙Theseefficiencyratiosfocusoninventory,receivables,andtheuseoffixedandtotalassets.
∙Inventoryturnoverratioiscalculatedbydividingthecostofgoodssoldbyinventory.
▪Year-endinventorycanbeusedor,ifafirmexperiencessignificantchangesintheinventorylevelduringtheyear,theaverageinventorylevelcanbeused.
▪Itmeasureshowmanytimestheinventoryisturnedoverintosaleableproducts.
▪Themoretimesafirmcanturnovertheinventory,thebetter.
▪Toohighaturnoverortoolowaturnovercouldbeawarningsign.
∙Anotherratiothatbuildsontheinventoryturnoverratioisthedays’salesininventory.
▪Itmeasuresthenumberofdaysthefirmtakestoturnovertheinventory.
▪Thesmallerthenumber,thefasterthefirmisturningoveritsinventoryandthemoreefficientitis.
∙Accountsreceivablesturnoverratiomeasureshowquicklythefirmcollectsonitscreditsales.
▪Thehigherthefrequencyofturnover,thequickeritisconvertingitscreditsalesintocashflows.
∙Anothermeasureofthefirm’sefficiencyinthisregardisDaysSalesOutstanding.
▪Itmeasuresindaysthetimethefirmtakestoconvertitsreceivablesintocash.
▪Thefewerthedaysittakesthefirmtocollectonitsreceivables,themoreefficientthefirmis.
▪Recognize,however,thatanoverzealouscreditdepartmentmayturnoffthefirm’scustomers.
∙Totalassetturnoverratiomeasuresthelevelofsalesafirmisabletogenerateperdollaroftotalassets.
▪Thehigherthetotalassetturnover,themoreefficientlymanagementisusingtotalassets.
∙Fixedassetturnoverratiomeasuresthelevelofsalesafirmisabletogenerateperdollaroffixedassets.
▪Thehigherthefixedassetturnover,themoreefficientlymanagementisusingitsplantandequipment.
▪Thisratioismoresignificantforequipment-intensivemanufacturingindustryfirms,whilethetotalassetsturnoverratioismorerelevantforserviceindustryfirms.
D.LeverageRatios
∙Theabilityofafirmanditsownerstousetheirequitytogenerateborrowedfundsisreflectedintheleverageratios.
∙Financialleveragereferstotheuseoflong-termdebtinafirm’scapitalstructure.
∙Theuseofdebtincreasesshareholders’returnsthankstothetaxbenefitsprovidedbytheinterestpaymentsondebt.
∙Twosetsofratioscanbeusedtoanalyzeleverage—debtratiosthatquantifytheuseofdebtinthecapitalstructureandcoverageratiosthatmeasuretheabilityofthefirmtomeetitsdebtobligations.
∙Thefirstratio,totaldebtratio,iscalculatedbydividingtotaldebtbytotalassets.
▪Totaldebtincludesshort-termandlong-termdebt.
▪Thehighertheamountofdebt,thehigherthefirm’sleverage,andthemoreriskyitis.
∙Thesecondleverageratioisdebt-to-equityratio.
▪Itmeasurestheamountofdebtperdollarofequity.
∙Thethirdleverageratioiscalledtheequitymultiplierorleveragemultiplier.
▪Ittellsustheamountofassetsthatthefirmhasforeverydollarofequity.
▪Itservesasthebestmeasureofthefirm’sabilitytoleverageshareholders’equitywithborrowedfunds.
∙Ofthecoverageratios,thefirstoneistimesinterestearned.
▪Itmeasuresthenumberofdollarsinoperatingearningsthefirmgeneratesperdollarofinterestexpense.
▪Thehigherthenumber,thegreatertheabilityofthefirmtomeetitsinterestobligations.
∙Thesecondratioisthecashcoverageratio.
▪Itmeasurestheamountofcashafirmhastomeetitsinterestpayments.
E.ProfitabilityRatios
∙Theseratiosmeasurethefinancialperformanceofthefirm.
∙Grossprofitmarginmeasurestheamountofgrossprofitgeneratedperdollarofnetsales,whileoperatingprofitmarginmeasurestheamountofoperatingprofitgeneratedbythefirmforeachdollarofnetsales.Netprofitmarginmeasurestheamountofnetincomeaftertaxesgeneratedbythefirmforeachdollarofnetsales.
∙Ineachcase,thehighertheratio,themoreprofitablethefirm.
∙Whilemanagementandcreditorsarelikelytofocusontheseprofitabilitymeasures,shareholdersarelikelytoconcentrateontwoothers.
∙Thereturnonassets(ROA)ratiomeasurestheamountofnetincomeperdollaroftotalassets.
∙Avariationofthisratio,calledt
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