Financial Analysis Overview - Chapter 3

Chapter 3 - Evaluation of Financial Performance

• Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability.
• The goal of financial analysis is to identify the major strengths and weaknesses of a business, assess its viability and health, and analyze problem areas.
• Credit managers use financial analysis to decide whether to extend credit.
• Security analysts use financial analysis to assess whether to invest.
• Bankers use financial analysis for deciding to grant loans.

Overview of Financial Analysis

• Financial analysis involves examining three main financial statements: balance sheet, income statement, and statement of cash flows.
• The balance sheet shows what a firm owns—its assets—and how it's financed—its liabilities and equity.
• The income statement explains how a firm turns its revenues into income and operating expenses.
• The statement of cash flows shows where cash comes from and goes to.
• Financial statements, such as the income statement and balance sheet, can be converted to "common size" statements (income statement or balance sheet) by dividing by sales (income statement) or assets (balance sheet).

Financial Statements

• A balance sheet presents a snapshot of a firm's assets and liabilities at a specific point in time.
• Assets are what a firm owns.
• Liabilities represent the firm's obligations through debt.
• Equity shows the owners' stake in the company's assets.
• Equity represents the sourced funds through financing through stock or reinvesting earnings.
• Higher up assets/liabilities are typically more liquid.

Income Statement

• An income statement summarizes a firm's financial performance over a period of time.
• The income statement begins with sales, which subtract the cost of goods sold to arrive at gross profit.
• Operating expenses are subtracted from gross profit to arrive at earnings before interest and taxes (EBIT).
• Interest expense is deducted next to arrive at earnings before taxes (EBT).
• Taxes are then subtracted, resulting in earnings after taxes, which are also known as net income.

Ratio Analysis

• Ratio analysis involves comparing lines from financial statements to other parts of financial statements or industry averages. This makes it possible to see if a company is performing well within its industry.
• For example, ratios can be used to compare two firms or the same firm over time.
• Ratios need to be considered in context of the firm and its competitors.

Liquidity Ratios

• Liquidity ratios indicate a company's ability to meet short-term obligations.
• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Current Assets – Inventory) / Current Liabilities
• Cash Ratio = Cash / Current Liabilities

Asset Management Ratios

• Asset management ratios assess how efficiently a firm uses its assets.
• Average Collection Period = Accounts Receivable / (Annual Credit Sales / 365)
• Inventory Turnover = Cost of Goods Sold / Average Inventory
• Fixed Asset Turnover = Sales / Net Fixed Assets
• Total Asset Turnover = Sales / Total Assets

Leverage Ratios

• Leverage ratios measure the extent to which a firm relies on debt financing.
• Debt Ratio = Total Debt / Total Assets
• Debt to Equity = Total Debt / Total Equity
• Times Interest Earned (TIE) = EBIT / Interest Expense

Profitability Ratios

• Profitability ratios measure a firm's ability to generate income.
• Gross Profit Margin = Gross Profit / Sales
• Net Profit Margin = Net Income / Sales
• Return on Assets (ROA) = Net Income / Total Assets
• Return on Equity (ROE) = Net Income / Total Equity

Market Ratios

• Market ratios evaluate a firm's market performance.
• Price-earnings ratio (PE) = Market Price per Share / Earnings Per Share.
• Price-to-sales ratio = Market Price per Share / Sales per Share.
• Market-to-book ratio = Market Price/Book Value per Share.
• Enterprise Value to EBITDA (EV/EBITDA) = Enterprise Value/ EBITDA

Dividend Policy Ratios

• Dividend payout ratio = Dividends Per Share / Earnings Per Share
• Dividend yield = Dividend per Share / Price per Share

The DuPont Equation

• This equation breaks down a company's return on equity (ROE) into components such as net profit margin, total asset turnover rate, and equity multiplier. This equation helps to see how different parts influence the company's return.

Note on Benchmarking

• Ratios are most effective when compared to a benchmark, such as industry averages or prior performance.
• Comparing ratios to a benchmark is effective, as it allows for the measurement of performance against other firms within the same industry.
• Benchmark performance can be compared for a better outlook of a company's current situation.