Lecture 6 - Analyzing Financial Statements

Analyzing Financial Statements

Horizontal Analysis
Show Income statement columns for comparable periods. Calculate % increase in an additional column. If you do it for many years, it’s called trend analysis.

Vertical Analysis
Calculate each balance sheet and income statement line as a percentage of Sales. You can trend that out also, combining vertical and horizontal analysis.

Ratio Analysis
Know these ratios! They will be on the final exam! No cheat sheet allowed.

Go to finance.yahoo.com and got to investing – stock investing – stock screener.

Current Ratio = current assets / current liabilities
You would typically want this to be > 1.0
Some companies can have < 1 and still be well run – Walmart and Dell.

Quick Ratio = Very current assets / current liabilities
This is a greater test of whether a company is liquid or not. This ratio will not be on the final exam, but it’s mentioned because Benjamin Graham uses it.
This is calculated by not including prepaid expenses or inventory.

Receivables Turnover = Net Credit Sales / Avg Accts Receivables
Days in Receivables = 365 / Receivables Turnover

Inventory Turnover = COGS / Avg Inventory
Days in Inventory = 365 / Inventory Turnover

Payables Turnover = (COGS +/- in/decrease in inventory) / Avg Accts Payable
Numerator is essentially the purchases

Profitability Ratios

Profit Margin = Net Income / Net Sales
Walmart has small profit margin, but makes it up in large sales volume.
Manufacturing companies like Boeing have much higher profit margins

Asset Turnover = Net Sales / Avg Total Assets

Return on Assets = Net Income / Avg Total Assets

Return on Equity = Net Income / Avg Equity

Equity is almost always lower than assets, so ROE is higher than ROA.
Many ppl would make adjustments to the Net Income numerator in the last two ratios.

Solvency Ratios

Debt to Equity = Total Debt / Avg Total Equity
Utility companies and Lehmann Brothers have high D2E ratio. Many industries have a standard for this ratio that is “expected”.

Interest Coverage = Income before Interest and Taxes / Interest Expense
This measures how capable the firm is of paying off its debt.
Banks certainly look at this ratio when lending.

Cash Flow Adequacy Ratios

Skip the first three: Cash Flow Yield, Cash Flow to Sales, Cash Flow to Assets

Free Cash Flow = Cash Flow from Operations – Dividends – Net Capital Expenditures
Cash Flow from Operations is somewhat difficult to compute. But it is on the statement of cash flows.
Subtract out dividends to keep shareholders happy.
Subtract out maintenance of plant and property so operations can continue in the future.
The rest is not subject to prior commitments. It’s up to managerial discretion on how to spend it.
Not really a ratio. It’s a cash flow computation.

Cash flow can come from 3 sources: Operations, investing, financing.

Next two are not in the book:

EBIT = Earnings before interest and taxes

Net Income + Interest Paid + Taxes
The numerator from Interest Coverage.
Interest = how to finance – high debt or low debt
Taxes = how company is organized – partnership, S corp, etc
This is raw earnings.

EBITDA = Earnings before interest, taxes, depreciation and amortization
Amortization is like depreciation for intangibles. Depreciation and amortization are an expense on the income statement that doesn’t represent a current cash flow. These are non-cash charges that are added back to net income to calculate EBITDA.

These last two, EBIT and EBITDA, are also not ratios.

Market Strength Ratios

Price/Earnings Ratio = Stock Price / Earnings per Share
High ratio indicates that the market values it highly. Others, like Benjamin Graham, target low PE ratio in the hopes that the market will value the company in the future.

Dividend Yield = Dividend / Stock Price
Compare this yield to the interest yield in the bank or other debt instruments.