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Chapter 4 Financial Statement Analysis and Forecasting Notes

4.1 Consistent Financial Analysis

•despite efforts to harmonize accounting standards, important differences in GAAP still persist

•these GAAP differences have forced users of financial statements to attempt an external reconciliation of GAAP

•this is important because users need to be able to compare statements of companies in the same industry from different countries

•the transition to International Financial Reporting Standards (IFRS) by 2011 will complicate issues in the short term

•on the other hand, as more countries adopt these standards, comparability should be enhanced in the long term

•aside from the use of different principles (i.e., different forms of GAAP) in preparing financial standards, an additional

complication arises because there are “generally accepted financial ratios”

4.2 A Framework for Financial Analysis

Return on Equity (ROE) and the DuPont System

•return on equity (ROE) return earned by equity holders on investment in firm; net income divided by shareholders’ equity

•ROE is not a “pure” financial ratio because it involves dividing an income statement (flow) item by a balance sheet (stock) item

•as a result, some people calculate the ROE as NI over the “average” SE—the average of the starting and ending SE

•this adjustment acknowledges that NI is earned throughout the year, so it makes sense to divide by an average of SE to recognize

that not all of those funds were invested throughout the year

•return on asset (ROA) net income divided by total assets

•if the ROE is multiplied by TA and divided by SE, the TA’s cancel out and produce the ROE

•leverage ratio total assets divided by shareholders’ equity; it measures how many dollars of total assets are supported by each

dollar of shareholders’ equity, or how many times the firm has leveraged capital provided by shareholders into total financing

•financial leverage the use of capital provided by shareholders to increase total financing

•net profit margin part of return on assets; net income divided by revenues

•turnover ratio art of return on assets; revenues divided by total assets

•ROA = NI / TA = NI / Revenues × Revenues / TA

•DuPont: ROE = NI /SE = NI / Revenues × Revenues / TA × TA / SE = Net profit margin × Turnover ratio × Leverage ratio

4.3 Leverage Ratios

•it is good when a firm is low risk and earns a healthy ROE, since it magnifies these high ROAs into even higher ROEs; but when

the firm loses money, the use of leverage magnifies ROEs on the downside as well

•there are basically three types: stock ratios, flow ratios, and other ratios

•stock ratios the amounts of debt outstanding at a particular time

•debt ratio total liabilities divided by total assets; just a rearrangement of leverage ratio

•invested capital the sum of interest-bearing debt and shareholders’ equity

•debt-equity (D/E) ratio debt divided by shareholders’ equity; it measures the use of interest-bearing debt

•times interest earned (TIE) earnings before interest and taxes divided by interest expense; also called the “coverage ratio”

•cash flow to debt ratio how long it would take to pay off debt from cash flow from operations (CFO); CFO divided by debt

4.4 Efficiency Ratios

•efficiency ratios ratios that measure how efficiently a dollar of revenues is turned into profits

•degree of total leverage (DTL) contribution margin divided by earnings before taxes

•break-even point (BEP) the level of revenues at which the firm covers all its operating and fixed costs; total operating and

fixed costs divided by the contribution margin ratio; CM ratio is just complement of VC as percentage of revenues

•gross profit margin revenues minus the cost of sales divided by revenues

•operating margin operating income (OI) divided by revenues

•operating income (OI) the earnings before interest and taxes (EBIT) figure

4.5 Productivity Ratios

•productivity ratios measurements of how productive the firm is in generating revenues from its assets

•receivables turnover ratio revenues dived by accounts receivables (AR)

•average collection period (ACP) accounts receivable dived by the average daily revenue; 365 divided by receivables turnover

•inventory turnover ratio the cost of sales (or revenue) divided by inventory

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