Analysis of Financial Statements

Size: px

Start display at page:

Download "Analysis of Financial Statements"

Mitchell Baker
6 years ago
Views:

1 Question 1: What are the key elements in the primary financial statements that are used by executives for firm analysis? The three key financial statements that business executives and financial analysts use are the following: Income statement: This lists revenue, expenses, and profits of a corporation for any given time period (e.g., a calendar year). Cash flow statement: This lists sources of cash inflow and outflow for a company over a given period. Balance sheet: This gives accounting of a firm s assets, liabilities, and owner s equity for a given time period. Question 2: How do you analyze the income statement? The following will analyze a hypothetical income statement to help answer this question: Fiscal Year Results (in thousands of U.S. dollars) Year 1 Year 2 Year 3 Net Sales 340, , ,000 Cost of Goods Sold 162, , ,000 Gross Profit 178, , ,000 Gross Profit Margin 52.35% 53.61% 54.12% Revenue (net sales) increased 5.88% in the second year and 18.06% in the third year. An increasing growth rate in revenue is good, especially if the sources of revenue are strong and have good longterm prospects. Cost of goods sold increased by 3.09% and 16.77% in the second and third years, respectively. Note that the cost of goods sold increased less than revenue; because of this, gross operating margin increased from 52.35% in the first year to 54.12% in the third year. Gross operating margin is found by dividing gross operating income (revenue cost of goods sold) by revenue. Depreciation 29,000 33,000 42,000 Selling Expenses 52,000 55,000 63,000 General and Administrative 45,000 46,000 49,000 Total Operating Expenses 126, , ,000 1

2 Depreciation, selling expenses, and general and administrative expenses make up the operating expenses. Operating expenses increased by 6.35% and 14.93% in Years 2 and 3 respectively, as follows: Operating Income 52,000 59,000 76,000 Operating Profit Margin 15.29% 16.39% 17.88% Interest Expense 12,000 15,000 20,000 Income Before Taxes 40,000 44,000 56,000 Income Taxes 13,000 14,000 15,000 Net Income 27,000 30,000 41,000 Net Profit Margin 7.94% 8.33% 9.65% Operating income is gross profit operating expenses. Operating income increased 13.4% and 28.81% in Years 2 and 3 respectively, both of which are faster than revenue growth. When operating income is growing faster than revenue growth, operating profit margin will increase, which is what happened in this example. Operating profit margin increased from 15.29% in the first year to 17.88% in the third year. Subtracting interest expense and income taxes from operating income results in net income. Increasing net income is an important goal for most companies. In this example, net income increased by 11.11% and 36.67%. Net income increased faster than revenue growth, so net income margin increased. Net income margin is found by dividing net income by revenue. Question 3: How do you analyze balance sheets? The balance sheet shown can illustrate how financial analysts evaluate balance sheets: 2

3 (in thousands of U.S. dollars) Assets Period Ending Dec. 31, 2012 Period Ending Dec. 31, 2013 % Change Cash and Cash Equivalents 9,100 9, % Accounts Receivable 8,250 8, % Inventories 55,000 60, % Prepaid Expenses 8,500 8, % Deferred Income Taxes 7,000 7, % Total Current Assets 87,850 94, % Property, Plant, & Equipment 85,000 90, % Intangible Assets 25,000 36, % Total Assets 197, , % Current assets increased by 7.97%, driven by a 9.09% increase in inventories. This could be a positive or negative, depending on the reason for increased inventory. If sales were increasing rapidly and the company had to replenish inventory to keep pace with sales, then this would be viewed as positive. On the other hand, if sales were flat or declining and inventory was increasing, then the firm would be buying goods that would take a longer time to sell, tying up cash in inventory that could be used for something else. Total assets increased by 6.82%, with a $5 million increase in property plant and equipment. This could be caused by increased sales and the company s expansion of its production capabilities. Liabilities and Equity Current Portion of Long-Term Debt 1,500 1, % Accounts Payable 35,000 37, % Other Current Liabilities 8,000 8, % Total Current Liabilities 44,500 47, % Long-Term Debt 45,000 47, % Other Long-Term Liabilities 5,000 5, % 3

4 Total Liabilities 94,500 99, % Equity 103, , % The increase in accounts payable is the major driver of the increase in short-term liabilities. This could be related to increased sales and, therefore, the increase in the amount owed to vendors. The increase in total liabilities was largely derived from the increase in long-term debt. This is likely related to increased property, plant, and equipment (meaning that the company may have used long-term debt to finance the production expansion). Shareholder s equity increased by $8 million, or roughly 8%. Because assets increased by $13.5 million and liabilities increased by only $5.35 million, shareholder s equity increased by the difference, or $8.15 million. It is difficult to judge this value without considering net income because financial analysts look at the return on equity (net income / equity) to determine the meaning of the equity value (in addition to how it was derived). Question 4: How do analysts and executives analyze the cash flow statement? An example statement of cash flow is shown in the following table: (in thousands of U.S. dollars) Period Ending Dec. 31, 2011 Period Ending Dec. 31, 2012 Period Ending Dec. 31, 2013 Cash From Operating Activities Net Income 27,000 30,000 41,000 Depreciation 29,000 33,000 42,000 Other 6,900 7,300 7,600 Total 62,900 70,300 90,600 Cash from operating activities is the cash that is provided by the business. For most companies, this is the largest source of cash inflow. To get cash from operating activities, start with net income, add back noncash items (e.g., depreciation and amortization), and subtract any operating activities that used cash. Note the amount of deprecation relative to net income. In asset-intensive companies, depreciation is a large component of cash flow. 4

5 Cash Used in Investing Activities Capital Expenditures (24,000) (25,000) (30,000) Cash used in financing activities Cash used for principal payments (15) (25) (30) Cash from debt issues 0 1,500 2,450 Cash to pay dividends (6,750,) (7,500) (10,250) Total (6,765) (6,025) (7,830) Increase (decrease) in cash 32,135 39,275 52,770 The only item on this cash flow statement for investing activities is the capital expenditures that the company made. For most companies, capital expenditures are the largest component of investing activities (other items might be included, such as cash used to acquire a company or cash received from selling assets). Cash that is used for financing is debt and equity. The firm paid down the debt outstanding with the cash for principal payments. The company received cash from the debt that it issued. The company used cash to pay dividends to stockholders. Question 5: How do you perform cash flow analysis on a project? Cash flow analysis on a project is performed by analyzing the benefits of a project relative to its cost. This is done in the context of cash flow. The cash flows are evaluated on a present-value basis. To begin the analysis of a capital project, start with items found on the income statement. These include the revenue that the project generates, operating expenses that will be incurred due solely to this project, and depreciation (which is typically the capital that is required for the project depreciated over some time of the project life). Subtract operating expenses and depreciation from revenue to derive operating income. To find net income, take into account taxes and interest expense. If there is no interest expense with a project, it may indicate that the company does not plan to issue debt to finance this project. Once net income is determined, add back noncash items such as depreciation to derive cash flow. 5

6 Find the present value (PV) of the cash flow by discounting the noncash items at the appropriate discount rate. The final step in deriving project cash flows is to sum up the PV cash flows over the life of the project. By doing this, you can quickly glance at the project and determine when the PV cash flows become positive. Question 6: How are decisions made on capital projects? Given that discounted cash flows have been determined for a project, most companies examine the net present value (NPV) and modified internal rate of return (MIRR) on a project to help guide decision making. Given that a project has a positive NPV, it will be viewed more favorably than projects that do not. If the company had unlimited funds, it would take on all positive net present value projects (by definition, a positive NPV project adds value to the firm). However, companies do not have unlimited funds. They use a second metric, the MIRR, to help rank projects and determine which are the best to undertake. Question 7: How do project cash flows impact financial statements? Project cash flows impact financial statements in the following key areas: Projects that increase revenue will increase revenue on the income statement. Projects that increase operating expense and depreciation will drag down operating income on income statements. As long as revenuegenerating projects generate incremental revenue faster than projects that increase operating cost and depreciation, operating income will increase on the income statement otherwise, it will not. Because companies are looking at many projects over a given time period, they typically view them collectively in a portfolio. Net income on the income statement is impacted by net income from projects. If, in a portfolio view, projects are collectively generating net income over a given time period, net income for the company should increase as well. Capital expenditure to purchase assets hits two financial statements: the balance sheet and the statement of cash flow. When a firm purchases an asset (e.g., a plant), it increases the value of the assets on the balance sheet (property, plant, and equipment). The capital 6

7 expenditures are recorded as a cash outflow on the cash flow statement under the cash used for investing section. Thus, as firms take on more capital projects, they will increase assets (and likely shareholder equity) and decrease the net cash balance. Depreciation that appears on capital projects also appears on the statement of cash flows. Question 8: What are financial ratios, and how do they work? Financial ratios are used by financial analysts to look at key metrics of a firm, compare them to a benchmark (typically industry performance), and quickly make decisions about the company s financial performance. The following are some of the major financial ratios, how they are calculated, and what they mean: Operating margin: This is calculated by dividing operating income by revenue. It indicates how well a company is generating profit from its business operations. The data for this metric are found on the income statement. Total asset turnover: This is a measure of the assets that are needed for every sales dollar; it is calculated by dividing net sales (revenue) by total assets. Firms with low total asset turnover indicate that they require large amounts of assets to generate sales, and firms with high total asset turnovers are indicative of lower required assets for every dollar of sales. The data to calculate this metric can be found on the balance sheet (total assets) and income statement (sales). Current ratio: This measures how well a company is managing its current assets with respect to its current liabilities. To calculate this measure, divide current assets by current liabilities (both of which can be found on the balance sheet). Companies with current ratios greater than one have sufficient short-term assets on their balance sheet to cover short-term liabilities. Companies with current ratios less than one may face liquidity problems because they do not have sufficient short-term assets to cover short-term liabilities. Interest coverage ratio: This indicates how much income a firm generates to cover its interest expense. To calculate the value, divide operating income by interest expense. A firm with an interest coverage ratio less than one is not generating enough income from its business to cover its interest expense thus, it may have to dip into cash reserves simply to pay interest expense. The data that are needed to calculate this measure can be found on the income 7

8 statement. Price-to-earnings ratio (PE): This is a market measure. This measure is calculated by dividing the company s stock price by its earnings (generally, the previous year s earnings). High PE ratios are indicative of companies with a bright (fast-growing) long-term earnings outlook, and firms with low PE ratios are typically more mature firms with slower growth prospects. The data for this metric can be found in the stock exchange (stock price) and income statement (earnings, such as net income). Earnings per share (EPS): This is a measure of the earnings that a company generates relative to the number of shares outstanding. Public companies typically set EPS estimates on a quarterly and annual basis, closely followed by Wall Street analysts. Companies that do not meet their earnings targets typically see their stock price decline. Generally speaking, companies like to increase their EPS in a consistent manner year after year (e.g., increase EPS 10% per year). Earnings are found on the income statement, and outstanding shares are found on the balance sheet. Return on equity (ROE): This measures how much income a firm is generating relative to equity. It is measured by dividing net income by shareholder s equity. ROE is a key metric that determines if owners of the company are being compensated appropriately for their ownership of the firm. If shareholders require a 12% return, they would like to see the company generate a 12% ROE. The data that are needed to calculate ROE can be found on the income statement (net income) and the balance sheet (equity). Question 9: How do you influence financial ratios? The following are some suggestions to positively influence select financial ratios: To increase operating margin, firms can increase revenue faster than expenses. To enhance total asset turnover, companies can generate revenues from sources that are less asset-intensive, or increase leverage on existing assets. The current ratio can be influenced by effectively managing the components that make up current assets while reducing the growth rate in the components that comprise current liabilities. Earnings per share (EPS) can be increased by growing net income and 8

9 keeping the shares outstanding constant or by reducing the shares outstanding while keeping earnings constant (generally not an option for publicly traded companies because shareholders want earnings to increase). ROE can be positively influenced by increasing net income at a rate that exceeds the rate of growth in equity. If firms can leverage existing assets to a higher degree, thus not requiring additional assets and not driving up equity, they can increase sales and income. Because net income will be increasing while equity is staying constant, this will increase ROE. Question 10: How are financial statements related to ratio analysis? Financial statements and financial ratios are intertwined. The data that are needed to calculate financial ratios can be found on financial statements; however, the more important point is how financial statements change, and what that means to financial ratios. The performance of an organization can be visualized by the changes in its financial statements. Organizations that perform well typically reflect this good performance on their financial statements. For example, a drug company might introduce a blockbuster drug that generates significant revenue and income. This would be reflected on the income statement and cash flow statement. Furthermore, it would be reflected in key ratios such as operating margin, interest coverage ratio, PE ratio, EPS, and ROE. The example highlights the truth that a single, major change in a business will ripple through to many financial statements and ratios. Understanding how to analyze the changes in ratios, including what each primary statement element and ratio means about the firm, is key to being a good financial analyst. 9

WEEK 10 Analysis of Financial Statements

WEEK 10 Analysis of Financial Statements Learning Objectives 1. Organize a systematic financial statements analysis using common-size financial statements and ratio analysis. 2. Recognize the potential