how
good or bad is the firm’s performance
how
weak or strong is the firm’s financial condition
have
both things improved or worsened over time
what
are the underlying reasons for these changes?
Objective of financial statement
analysis:
|
how
good or bad is the firm’s performance |
|
how
weak or strong is the firm’s financial condition |
|
have
both things improved or worsened over time |
|
what
are the underlying reasons for these changes? |
Using various financial ratios we can compute the numbers
that tell us how good or bad the firm’s performance is, or how weak or strong
its financial condition is.
The key part of financial statement analysis is to understand
WHY.
Why did the firm do better or worse, what contributed to the
performance?
Computing the ratios is trivial; interpreting them is the key
issue.
Financial statements do tell the complete story: not only how
the firm did, but how it came to do well or badly, as the case may be.
But it's far from easy to read the statements and extract the full story.
Financial statement analysis is much more of an art than a science!
Not only do we compare this years’ statements to previous
years, we also compare the firm to its competitors. The full picture doesn’t begin to emerge till you make both
comparisons.
|
what
do you think when you see a firm’s profitability ratios declining over
time? |
|
what
if you then find the competitors’ ratios declined even more? |
Different types of Financial Ratios:
I
LEVERAGE RATIOS
|
How
much debt is firm using? |
|
How
safe or unsafe is it for this firm to be carrying this much debt? |
e.g. Leverage Ratio = Total
Assets/Equity
|
Should
it be high or low? |
 |
Too
high => flirting with
bankruptcy |
|
Too
low => not using interest deductions to save on taxes |
|
=>
should be neither too high nor too low |
Issues relevant for leverage ratios
include:
o
short-term
debt (not whether to include, but how to treat? How much of the short-term debt you see on the balance sheet
is permanent financing, how much temporary?
o
Book
value ratios become more and more inaccurate as firm slides into financial
distress
o
As
your financial condition weakens, book value of debt doesn’t change
o
Market
value drops drastically
o
Market
value ratio tells true story; book value ratio is very different
II
LIQUIDITY RATIOS
|
How
much working capital is firm using? |
|
Are
current assets sufficient to meet current liabilities? (ability to pay bills
in short-term) |
e.g. Current Ratio = C.A./C.L.
o
Is
higher necessarily better?
o
Depends
on whose point of view you consider. Always
better for creditors; their money is safer.
But for s/h, higher ratio could indicate inefficient use of assets (e.g.
C.A. excessively high; too much idle cash)
Issues relevant for liquidity
ratios include:
o
Book
value of current liabilities are more reliable than they are for long-term debt
o
But
short-term assets and liabilities more susceptible to window-dressing than
long-term assets or liabilities
o
Also
change more in response to economic conditions; numbers you see on the balance
sheet can quickly become outdated
III
EFFICIENCY RATIOS
|
How
efficiently the firm uses various types of assets |
|
How
efficiently assets are deployed to generate sales, profits, etc |
e.g. Sales-to-assets = Sales/(Avg. Total Assets)
|
Measures
sales generated per $ of assets |
|
Higher
does mean more efficient |
|
But
it could also mean something more: maybe it is higher than competitors
because firm is pretty much working at 100% of capacity and competitors have
lower capacity utilization |
=> even though last year you
have been more efficient than your competitors, your competitive position for
the future may be weaker. They can
increase sales without new investment; you can increase sales only by first
making new investment (to add capacity)
IV
PROFITABILITY RATIOS
e.g. Net profit margin = (EBIT – TAX)/Sales
|
Numerator
is not net income but N.I. + Interest |
|
Interest
is paid out of profits; this way we also take into account the profits that
were generated and used to pay interest |
|
Many
ratios have built in biases that must be remembered when making comparisons.
Net profit margin will always be artificially higher for a high-debt
firm. Take two firms that are
identical except for their debt. Both
use their assets the same way to generate the same cashflows. They have the
same EBIT. The high debt one
has larger interest deductions and so pays lower taxes => it will have
higher net profit margin (even though the firms are otherwise identical) |
V.
MARKET VALUE RATIOS
|
How
highly is the firm valued in the market relative to key numbers from the
financial statements (EPS or Book value of equity) |
|
Captures
investors’ expectations about firm’s future growth |
e.g. Market-to-book ratio = (Stock price)/(BV per share)
|
What
does such a ratio reflect? Consider
what makes it greater than 1 |
|
Take
the example we used in Lecture 2 of a firm that starts with $2m in cash and
then finds a $1m investment. |
|
Initially,
MV = BV = 2m => ratio is 1 |
|
After
the investment, BV remains $2m, MV becomes 2.4m => ratio is 1.2 |
Thus
positive NPV investment makes market value exceed BV
Numerator
of ratio captures value, denominator captures cost
But
again, a built in bias creates distortions over time
|
Numerator
is market value today |
|
Denominator
is the total capital invested or reinvested by s/h over time |
|
Value
today is being divided by past investment |
|
Just
by time value of money, value may grow over time even if there is no more
positive NPV investment |
|
If you see this firm’s ratio increasing over time, is it due to new positive NPV investment or these time value effects? |