Module 3Module 3

Analyzing and Analyzing and Interpreting Interpreting

Financial Financial StatementsStatements

Common Questions that F/S Common Questions that F/S Analysis Can Help To Analysis Can Help To

AnswerAnswer CreditorCreditor

InvestorInvestor

ManageManagerr

Can the company pay the interest and Can the company pay the interest and principal on its debt? Does the company principal on its debt? Does the company reply too much on nonowner financing?reply too much on nonowner financing?

Does the company earn an acceptable Does the company earn an acceptable return on invested capital? Is the gross return on invested capital? Is the gross profit margin growing or shrinking? profit margin growing or shrinking? Does the company effectively use Does the company effectively use nonowner financing?nonowner financing?

Are costs under control? Are the Are costs under control? Are the company’s markets growing or company’s markets growing or shrinking? Do observed changes reflect shrinking? Do observed changes reflect opportunities or threats? Is the opportunities or threats? Is the allocation of investment across different allocation of investment across different assets too high or too low?assets too high or too low?

Ratio AnalysisRatio Analysis Examining various income statement and Examining various income statement and

balance sheet components in relation to balance sheet components in relation to one another facilitates financial statement one another facilitates financial statement analysis. This type of examination is called analysis. This type of examination is called ratio analysisratio analysis..

This module focuses on the disaggregation This module focuses on the disaggregation of Return Measures into of Return Measures into

1.1. Level I – RNOA and LEVLevel I – RNOA and LEV2.2. Level II – Profit Margins and TurnoverLevel II – Profit Margins and Turnover3.3. Level III – GPM, SGA, ART, INVT, PAT, APT, WCTLevel III – GPM, SGA, ART, INVT, PAT, APT, WCT4.4. As well as Liquidity and Solvency MeasuresAs well as Liquidity and Solvency Measures

Analysis StructureAnalysis Structure

Return on EquityReturn on Equity Return on equity (ROE) is computed as:Return on equity (ROE) is computed as:

ROE = Net Income / Average ROE = Net Income / Average

EquityEquity

Key DefinitionsKey Definitions

Observed Medians of Observed Medians of VariablesVariables

Level 1 Analysis – RNOA Level 1 Analysis – RNOA and Leverageand Leverage

Return on Net Operating Return on Net Operating AssetsAssets

(RNOA)(RNOA)RNOA = NOPAT / Average NOARNOA = NOPAT / Average NOA

where,where,

NOPAT is net operating profit after taxNOPAT is net operating profit after tax

NOA is net operating assetsNOA is net operating assets

Operating and Operating and Nonoperating Nonoperating

Assets/LiabilitiesAssets/Liabilities

Simplified Operating and Simplified Operating and Nonoperating Balance Nonoperating Balance

SheetSheet

NOPATNOPAT Net operating profit includes Net operating profit includes

Operating revenues lessOperating revenues less Operating expenses Operating expenses (COGS, SG&A, (COGS, SG&A, Taxes) Taxes)

Excluded are after-tax earnings Excluded are after-tax earnings from investments returns and from investments returns and interest expenses.interest expenses.

Operating/Nonoperating vs. Operating/Nonoperating vs. Core/TransitoryCore/Transitory

Financial Leverage and Financial Leverage and RiskRisk LEV is the other component of ROELEV is the other component of ROE

Given that increases in financial leverage Given that increases in financial leverage increase ROE, why are all companies not 100% increase ROE, why are all companies not 100% debt financed? debt financed?

The answer is because debt is risky. This The answer is because debt is risky. This increased risk increases the expected return increased risk increases the expected return that investors require to provide capital to the that investors require to provide capital to the firm. firm.

Higher financial leverage also results in a Higher financial leverage also results in a higher interest rate on the company’s debt. higher interest rate on the company’s debt. Standard & Poor’s and Moody’s Investor Standard & Poor’s and Moody’s Investor

Services ratings partly determine the debt’s Services ratings partly determine the debt’s interest rate—with lower quality ratings interest rate—with lower quality ratings yielding higher interest rates and vice-versa. yielding higher interest rates and vice-versa.

So, all else equal, higher financial leverage So, all else equal, higher financial leverage lowers a company’s debt rating and increases lowers a company’s debt rating and increases the interest rate it must pay. the interest rate it must pay.

Leverage and Income Leverage and Income VariabilityVariability

Level II Analysis – Margin Level II Analysis – Margin and Turnoverand Turnover

Margin vs. TurnoverMargin vs. Turnover

NOPAT MarginNOPAT Margin

Turnover of NOATurnover of NOA

Level 3 Analysis — Disaggregation of Level 3 Analysis — Disaggregation of

Margin and TurnoverMargin and Turnover

Gross Profit MarginGross Profit Margin

It allows a focus on average unit mark-upsIt allows a focus on average unit mark-ups A high gross profit margin is preferred to A high gross profit margin is preferred to

a lower one, which also implies that a a lower one, which also implies that a company has relatively more flexibility in company has relatively more flexibility in product pricing.product pricing.

Gross Profit MarginGross Profit Margin Two main factors determine gross profit Two main factors determine gross profit

margins:margins:1.1. CompetitionCompetition – as the level of competition – as the level of competition

intensifies, more substitutes become intensifies, more substitutes become available, which limits a company’s available, which limits a company’s ability to raise prices and pass along ability to raise prices and pass along price increases to customers.price increases to customers.

2.2. Product mixProduct mix – if the proportion of lower – if the proportion of lower price, higher volume products increases price, higher volume products increases relative to that of higher priced, lower relative to that of higher priced, lower volume products, then gross profit dollars volume products, then gross profit dollars may stay the same, but gross profit may stay the same, but gross profit margin declines.margin declines.

Operating Expense Operating Expense MarginMargin

Operating expense ratios (percents) are Operating expense ratios (percents) are used to examine the proportion of sales used to examine the proportion of sales consumed by each major expense consumed by each major expense category.category.

Expense ratios are calculated as follows:Expense ratios are calculated as follows:Operating expense percentage = Expense item/Net Operating expense percentage = Expense item/Net salessales

TurnoverTurnover Turnover measures relate to the Turnover measures relate to the

productivity of company assets. Such productivity of company assets. Such measures seek to answer the amount of measures seek to answer the amount of capital required to generate a specific capital required to generate a specific sales volume.sales volume.

Turnover ratios are calculated as follows:Turnover ratios are calculated as follows:Turnover = Sales volume/Average AssetsTurnover = Sales volume/Average Assets

As turnover increases, there is greater As turnover increases, there is greater cash inflow as cash outflow for assets to cash inflow as cash outflow for assets to support the current sales volume is support the current sales volume is reduced.reduced.

Accounts Receivable Accounts Receivable Turnover (ART)Turnover (ART)

Inventory Turnover (INVT)Inventory Turnover (INVT)

L-T Operating Asset L-T Operating Asset Turnover (LTOAT)Turnover (LTOAT)

Accounts Payable Turnover Accounts Payable Turnover (APT)(APT)

Net Operating Working Net Operating Working Capital Turnover (WOCT)Capital Turnover (WOCT)

Liquidity and Solvency Liquidity and Solvency MeasuresMeasures

LiquidityLiquidity refers to cash: how refers to cash: how much we have, how much is much we have, how much is expected, and how much can be expected, and how much can be raised on short notice. raised on short notice.

SolvencySolvency refers to the ability to refers to the ability to meet obligations; primarily meet obligations; primarily obligations to creditors, obligations to creditors, including lessors. including lessors.

Cash Operating CycleCash Operating Cycle Average Cash (Operating) Cycle - Average Cash (Operating) Cycle -

the period of time from cash to the period of time from cash to inventories to receivables to cash. inventories to receivables to cash.

Current and Quick RatioCurrent and Quick Ratio

Solvency RatiosSolvency Ratios

Flow RatiosFlow Ratios

Bankruptcy PredictionBankruptcy Prediction

Limitations of Ratio Limitations of Ratio analysisanalysis

Vertical and Horizontal Vertical and Horizontal AnalysisAnalysis

Vertical and Horizontal Vertical and Horizontal AnalysisAnalysis

Derivation of ROE Derivation of ROE DisaggregationDisaggregation