Working with Financial Statements

Chapter 3

Created by David Moore, PhD

Key Concepts

  1. Financial ratios
  2. Dupont Identity
  3. Benchmarking
  4. Issues with analyzing financial statements

Statement of Cash Flows

Summarizes the firm's sources and uses of cash over a specified period.
Cash Cash

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!!!)

Ratio Types

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

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

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

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

Asset Management

How efficiently a firm uses its assets to generate sales

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

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.

Performance: Profitability

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

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

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

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

Performance: Market

Focuses on stock market performance.

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

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

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

Enterprise value

Theoretical takeover value of the firm

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

Examples

Disney

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
  2. Peer group analysis

SIC Codes

SIC

Issues/Concern with Financial Statements Analysis

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

Key Learning Outcomes

  • Financial Ratios!!! Calculate and interpret.
  • Dupont Identity
  • Benchmarking
  • Issues with financial statements

Next time

Chapter 5: Introduction to Valuation