A 98 page summary of all the work covered in Investment management 314
Includes a summarized formula sheet of all the relevant formulas
Examples from chapter 11 and 14 are at the end, with detailed answers.
Investment management 314
Chapter 10: Analysis of financial statements
Major financial statements 10.1
Balance sheet:
- Indicates at a certain point in time, what resources (Assets) the firm controls and
how it has financed these assets
- Indicates current and fixed assets available at a point in time
- Financing is indicated by its mixture of current liabilities, long-term liabilities, and
owner’s equity
Income statement:
- Contains information on the profitability of the firm during some period of time, in
contrast to the balance sheet at a fixed point in time
- Indicates the flow of sales, expenses, and earnings during the time period
Cash flow statement:
- The cash flow statement integrates the prior 2 statements, indicating how the
balance sheet changes due to operating, investment and financing activities
- Analysists use these cash flow values to estimate the value of a firm and to evaluate
the risk and return of the firm’s bonds and stock
- The statement is broken up into three sections, the total of which is the net change
in the cash position (Equal to the difference between cash balance at the beginning and end on the
balance sheet)
- Cash flow from operating activities: The sources ad uses of cash that arise
from the normal operations of a firm
- Cash flow from investment activities: Change in gross plant and equipment
plus the change in the investment account
- Cash flow from financing activities: Financing sources minus financing uses
Measures of cash flow
1. Traditional cash flow
- Net income + depreciation expense
2. Free cash flow
- Represents the cash that a company is able to generate after laying out the
money required to maintain or expand its asset base
- It is usually EBIT(1 – tax rate) + Depreciation & Amortisation – Change in Net
Working Capital – Capital expenditure
3. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation)
- Very generous measure, does not consider any of the adjustment’s previously
mentioned
,Purpose of financial statement analysis
- Financial statement analysis seeks to evaluate management performance in several
important areas, including; profitability, efficiency, and risk.
- Although we analyse historical data, the ultimate goal is to provide insight that will
assist us in projecting future management performance
- It is the firms expected future performance that determines whether we should lend
money / invest in a firm
Analysis of financial ratios 10.2
- Numbers by themselves are of little value
- Ratios are intended to provide meaningful relationships between individual values
- These help to identify the strengths and weaknesses in a company’s financial health
so that corrective action may be initiated in a timely manner
Importance of relative financial ratios
Even a ratio by itself is of little value. Therefore, it is important to compare a firm’s
performance relative to:
- The aggregate economy
- Important as almost all firms are influenced by economic fluctuations
- E.g. It’s unreasonable to expect a firm’s profit margin to increase during a
recession; but a stable margin may be encouraging
- Past performance during different parts of the business cycle may help to
forecast how the firm will cope during similar conditions in the future
- Its industry or industries
- Different industries affect the firms within them differently, but the
relationship will always be significant
- E.g. During a recession, the question is not whether or not sales and margins
declined, but how bad the decline was compared to other similar firms
- Its major competitors within the industry
- Cross sectional analysis can be used to compare a firm to a subset of industry
firms comparable in size or characteristics.
- Inappropriate comparisons can arise when a multi-industry firm is evaluated
against ratios from a single industry
- Its past performance (Time-series analysis)
- Used to examine a firms relative performance over time to determine
whether it is progressing or declining
- Without considering the time-series trend can result in misleading conclusions
- E.g. An average rate of return of 10% can be the result of rate of return that
have increased from 5% - 15%, or the result of rates declining from 15% - 5%.
,In the following information, we divide the financial ratios into five major categories that
underscore the important economic characteristics of a firm. These five are:
1. Common size statements
2. Internal liquidity (Solvency)
3. Operating performance
- Operating efficiency
- Operating profitability
4. Risk analysis
- Business risk
- Financial risk
- External liquidity risk
5. Growth analysis
Computation of financial ratios 10.3
Common size statements:
- These normalise balance sheet and income statement items to allow easier
comparison of different-size firms
- A common size balance sheet expresses all balance sheet items as a percentage of
total assets
- A common-size income statement expresses all income statement items as a
percentage of sales
- Common size ratios are useful to quickly compare two different sized firms and to
examine trends over time within a single firm
Evaluating internal liquidity
Internal liquidity (Solvency) ratios are intended to indicate the ability of the firm to meet
future short-term financial obligations.
Internal liquidity ratios:
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒓𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
- Important that the ratio is within normal limits (Generally 2 > x > 1)
𝑪𝒂𝒔𝒉 + 𝑺𝒉𝒐𝒓𝒕 𝒕𝒆𝒓𝒎 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔 + 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔
𝑸𝒖𝒊𝒄𝒌 𝒓𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
- Some people question using the current ratio as inventory and other current assets
may not be very liquid
- The quick ratio relates current liabilities to only relatively liquid current assets
𝑪𝒂𝒔𝒉 𝒂𝒏𝒅 𝒎𝒂𝒓𝒌𝒆𝒕𝒂𝒃𝒍𝒆 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔
𝑪𝒂𝒔𝒉 𝒓𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
, 𝑵𝒆𝒕 𝒄𝒓𝒆𝒅𝒊𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔
- In addition to examining total liquid assets, it is useful to analyse the quality
(Liquidity) of the accounts receivable by calculating how often the firm’s receivables
turn over
- This implies an average collection period The faster these accounts are paid, the
sooner the firm gets the funds to pay off its own current liabilities
𝑪𝑶𝑺
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
- Indicates processing time
𝑪𝒂𝒔𝒉 𝒄𝒐𝒏𝒗𝒆𝒓𝒔𝒊𝒐𝒏 𝒄𝒚𝒄𝒍𝒆 = 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝒄𝒐𝒍𝒍𝒆𝒄𝒕𝒊𝒐𝒏 𝒅𝒂𝒚𝒔 + 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒑𝒓𝒐𝒄𝒆𝒔𝒔 𝒅𝒂𝒚𝒔 −
𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝒑𝒆𝒓𝒊𝒐𝒅
- A useful measure of overall internal liquidity
Evaluating operating performance 10.5
Operating performance ratios can be broken down into two categories
1. Operating efficiency ratios: They examine how the management uses its assets and
capital, measured by dollars of sales generated by various asset or capital categories
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑨𝒔𝒔𝒆𝒕𝒔
- Indicates the effectiveness of the firm’s use of its total asset base
- This ratio must be compared to that of other firms within an industry, as it varies
substantially between industries
- A high ratio compared to the industry norm may indicate too few assets for the
potential business (Sales), or it could be due to the use of fully depreciated assets
- A low ratio compared to the industry norm may indicate that the firm is tying up
capital in excess relative to the needs of the firm and compared to its competitors
Net fixed asset turnover: Reflects the firm’s utilisation of fixed assets. Can be broken into
two components
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝑭𝒊𝒙𝒆𝒅 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑭𝒊𝒙𝒆𝒅 𝒂𝒔𝒔𝒆𝒕𝒔
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝑻𝒂𝒏𝒈𝒊𝒃𝒍𝒆 𝒇𝒊𝒙𝒆𝒅 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑻𝒂𝒏𝒈𝒊𝒃𝒍𝒆 𝒂𝒔𝒔𝒆𝒕𝒔
- Goodwill is not included in TFAT
- Both must be compared to members of the same industry, should also consider the
effect of leased assets
- Low turnover can imply capital tied up in excessive fixed assets
- High turnover can indicate a lack of productive capacity to meet sales demand, or
the use of fully depreciated PPE
, 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝑬𝒒𝒖𝒊𝒕𝒚 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑬𝒒𝒖𝒊𝒕𝒚
- Important to consider the firm’s capital structure ratio, as firms can increase or
decrease their equity turnover ratio by changing its proportion of debt capital
2. Operating profitability ratios: They analyse the profits as a percentage of sales and
as a percentage of the assets and capital employed
𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕
𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
- Indicates the basic cost structure of the firm
- Analysis of this ratio over time shows the firm’s relative cost-price position
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
- The variability of the operating profit margin over time is a prime indicator of the
business risk for a firm
𝒑𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
(𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆)
𝑹𝑶𝑰𝑪 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝒄𝒂𝒑𝒊𝒕𝒂𝒍
- ROIC = Return On total Invested Capital
- This ratio relates the firm’s earnings to all the invested capital involved in the
enterprise
- Average total invested capital = Interest bearing debt + Shareholders equity
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒕𝒐𝒕𝒂𝒍 𝒆𝒒𝒖𝒊𝒕𝒚 =
𝑬𝒒𝒖𝒊𝒕𝒚
- This indicates a rate of return that management has earned on the capital provided
by stockholders after accounting for payments to all other capital suppliers
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 − 𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒐𝒘𝒏𝒆𝒓𝒔 𝒆𝒒𝒖𝒊𝒕𝒚 =
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚
- This ratio reflects the rate of return on the stockholders capital
- It should be consistent with the firm’s overall business risk
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑨𝒔𝒔𝒆𝒕𝒔
𝑹𝑶𝑬 = × ×
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑨𝒔𝒔𝒆𝒕𝒔 𝑬𝒒𝒖𝒊𝒕𝒚
𝑹𝑶𝑬 = 𝑷𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 × 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 × 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆
, Risk analysis 10.6
Business risk
Business risk: The uncertainty of operating income caused by the firm’s industry
- It is generally measured by the variability of the firm’s operating earnings/income
over time
- Sales variability: The prime determinate of operating earning’s variability
- Variability of sales is mainly caused by a firm’s industry and is largely outside
the control of management
- Operating leverage: The employment of fixed production costs
- The variability of a firm’s operating earnings also depends on its mixture of
production costs
Financial risk: The additional uncertainty of returns to equity holders due to a firm’s use of
fixed financial obligation securities
Relationship between business and financial risk
- The acceptable level of financial risk for a firm depends on its business risk
- If the firm has low business risk (I.e. stable operating earnings), investors are willing
to accept higher financial risk
Consideration of lease obligations
- Many firms lease facilities and equipment rather than borrow the funds and
purchase the asset
- The accounting for the lease obligation depends on the type of lease
- Capital lease: The value of the asset and the lease obligation is included on the
balance sheet as an asset and liability
- Operating lease: It is noted in the footnotes, but it is not specifically included in the
balance sheet
Capitalising operating leases
- This basically involves an estimate of the present value of a firm’s future lease
payments
- An analysist must estimate an appropriate discount rate (Typically the firm’s long-
term debt rate) and the firm’s future lease payment obligations as specified in a
footnote
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