Without financial statement analysis, finance statements would be comprised of primarily historical data. The analysis converts the data into information that is useful to understanding the company and its valuation. Analysis may be cross-sectional or trend. Cross-sectional analysis compares a company against its competitors, an industry, or a benchmark (like the group of companies that make up the S&P 500). A trend analysis studies one company over time (years, quarters, months) to understand patterns. Within each broad type of analysis, a number of company characteristics can be examined. Recall the discussion of industry analysis, accounting analysis, and financial analysis. Industry analysis focuses on industry characteristics, such as entry barriers and market share; accounting analysis examines how accounting policy decisions made by the company affect its earnings quality. Financial analysis looks at a company s balance sheet and income statement together to better understand its sources of profits and returns. In many cases, analysis examines a component of one statement scaled (or divided) by a component on another statement. In this way, for example, profit relative to assets or sales is understood. For example, it is less significant if a company with $100 million in sales earns $1 million in profits (1% profit) than a company that earns $1 million in profits on $20 million in sales (5%). Analysis done in this way produces ratios. Some of the most common ratios used in financial analysis are ROE (return on equity), ROA (return on assets), turnover (sales divided by assets), and leverage (assets divided by total debt). The figure below defines each ratio and shows how these most common ratios are related to each other: ROE = ROA x Leverage ROA = Margin x Turnover In which: Leverage = Average total assets / Average total equity Margin = Net income / Sales Turnover = Sales / Average total assets If the definitions are written out, the relationships can be seen more clearly: 1
Net income / Average equity = Net income / Sales x Sales / Average assets x Average assets / Average equity This means that Return on Assets is a product of the size of profit (margin) times how frequently those profits are made (turnover). Return on Equity is Return on Assets magnified by the degree of leverage. More leverage results in a higher return on equity (given equal ROA). An example will demonstrate these ratios and the power of leverage. Recall that for 2008, Lava bikes earned $82,900 in income and at December 21, 2008, Lava had $149,015 in total assets and $87,900 in total equity. Assume Lava Bikes has the following financial statements at the end of its second year of operation. Lava Bikes Income Statement For the year ended December 31, 2009 Revenues $650,000 Cost of Sales $390,000 Gross Margin $260,000 General and Admin Expenses $94,600 Depreciation $10,500 Interest $3,000 Total Expenses $180,100 Income before taxes $151,600 Tax Expense $57,300 Net Income $94,300 Lava Bikes Balance Sheet December 31, 2009 Cash $83,600 Accounts Receivable, net $67,900 Inventory $37,590 2
Total Current Assets $189,150 Plant & Equipment, Net of accumulated depreciation of ($10,500) $57,490 Total Assets $246,640 Accounts Payable $31,540 Current Debt $8,450 Total Current Liabilities $39,990 Long-term Debt $24,450 Total Liabilities $64,440 Common Stock $10,000 Retained Earnings $172,200 Total Equity $182,200 Total Liabilities and Equity $246,640 From these statements, plus those from Unit 1, the following can be computed: Average total assets = ($149,015 + $246,640) / 2 = $197,827.50 Average equity = ($87,900 + $182,200) /2 = $135,050 Note that one averages the quantities from the two balance sheets to get a better understanding of the assets and equity in place during the year (year 2) when the income was earned. It presents a more accurate computation of turnover and leverage if it is based on the average resources available versus a beginning balance or ending balance only. Putting these computations together with the net income and sales from the year 2 income statement, the following are the computations for ROA and ROE: ROA = Return on Assets = Margin x Turnover = Net income / Sales x Sales / Average Assets = 3
($94,300 / $650,000) x ($650,000 / $197,827.5) = 14.5% x 3.29 = 47.6% Asset utilization analysis focuses on the turnover ratio (sales / assets). After the primary ratio is computed, further asset utilization analysis examines sales relative to specific categories of assets, such as current assets or long-term tangible assets. ROE = ROA x Leverage = ROA x Average Assets / Average Equity =47.6% x (197,827.5 / 135,050) = 47.6% x 1.46 =69.7% Capital structure analysis focuses on the leverage ratio (assets / equity). Again, after the primary ratio is computed, further capital structure analysis focus on the structure of the leverage. How does one interpret these results? Lava Bikes has a profit margin of 14.5% and turns its assets into sales 3.29 times per year. Together, that results in a return on assets of 47.6%. This means for every dollar of assets, in 2009, Lava earned 47.6 cents. Lava can improve its ROA by either increasing its profit margin or increasing its turnover. Leverage measures the amount of debt financing. Return on equity is magnified by leverage. In this case, Lava has assets of 1.46 times equity (or 32% liabilities). At 69.7%, Lava earns 69.7 cents on every dollar of equity invested. If leverage is higher, Lava will have even greater return on equity. Recall that accounting analysis focuses on accounting policies and choices. Earnings management is one type of accounting analysis. Earnings management analysis specifically focuses on the quality of the earnings number. Net income may be artificially higher because of an accounting change, an unusual one-time gain on the sale of a plant or division, or the realization of past accounting decisions such as a LIFO liquidation. Examination of earnings management happens through the review of income statements for unusual or one-time items and a review of the notes to financial statements. The notes will explain accounting policy decisions made. When one conducts an analysis, where does one find financial statements of companies and industries? Most publicly held companies publish their financial statements and filings to the SEC on their 4
company Web sites. Industry data can be collected from sources such as hoovers.com and Dun and Bradstreet. These sources collect information and compute ratios. Note that the ratio computations of other sources will be similarly computed but not always exactly computed as above (for example, they may not use averages). Sources such as Dun and Bradstreet will also have credit and summary information on some private companies. External users usually have their favorites for industry and company specific information. 5