Financial Analysis PDF

Financial Analysis Introduction *[For whom ? ]* - **Ressources providers :** - Lenders : want to get reimbursed - Shareholders : want company growth - **Recipients of goods & services** - **Internal management** to assist in their decisions making capacity - Want to improve share...

Financial Analysis Introduction *[For whom ? ]* - **Ressources providers :** - Lenders : want to get reimbursed - Shareholders : want company growth - **Recipients of goods & services** - **Internal management** to assist in their decisions making capacity - Want to improve shareholder's value and personal benefit - **Regulators :** tax office, corporate regulator... *[Why ?]* By evaluating an entity's [financial past] (via financial analysis) users are in a better position to form an opinion as to the entity's *financial health, past, present and future*. *[What is needed ? ]* An annual report with : - What the company owes and owns (balance sheet) - What is earned last year (income statement) - What happened with the company's cash (cash flows statement) **Five aspects of the company's performance need to be investigated:** 1. Profitability, 2. Efficiency, 3. Liquidity, 4. Capital structure, 5. Market performance. Balance sheet The balance sheet is prepared on a particular date at the end of the accounting period, which depend of the firm's choice. In this course we will use the European balance sheet *[Non-Currents assets (long-term)]* It shows all the fixed assets of the company (aka) tangible assets. Such as : 1. **Property -- Plant & Equipment (PP&E).** These assets are **depreciated** over the period of time they benefits the company. PP&E are presented in a balance sheet as the - NET BOOK VALUE = original cost -- accumulated depreciation 2. **Others assets** Can include multitude of other noncurrent items such as: - Property held for sale - Long-term investments - **Intangible assets** - **Patents,** copyrights, trademarks, licenses, franchises - Goodwill : Arises when one company acquires another company for a price in excess of the [fair value] (FV) of the [net assets] acquired *[Currents assets ]* Current assets are cash or other **[assets expected to be converted into cash within *one year.* ]**Such as : [ ] 1. **Account receivable** 2. **Inventories :** Items held for sale or used in the manufacture of products that will be sold - Retail companies hold 1 type of inventory: finished goods - Manufacturing companies hold at least 3 types of inventories: [raw materials], [work-in-process], [finished goods] 3. **Prepaid expenses :** Insurance 4. **Cash and marketable securities** *[Equity ]* Ownership equity is the residual interest in assets that remains after deducting liabilities, but also represents **SHAREHOLDERS' MONEY** Also known variously as **[owners' equity]**, **[shareholders' equity]**, **[net worth]**, or simply [equity]. This usually includes: 1. **Paid up capital: common stock / ordinary shares** - Refers to the par value of the stock shares that have been issued by a company 2. **Additional paid-in capital** - Reflects the amount by which the original sales price of the stock shares exceeded par value (when shares have a par value) 3. **Retained earnings** - the sum a company has earned since its inception (net income), less any payments made to shareholders in the form of cash or stock dividends **Beginning retained earnings ± Net income (loss) -- Dividends = Ending retained** **earnings** 4. **Other equity accounts** - Preferred stock - Minority interests - Accumulated other comprehensive income/loss - Treasury stock *[Non-current liabilities ]* Obligations with [maturities beyond one year:] - Long-term debt: any type of bonds, bank loans, mortgages *[Current liabilities ]* Represent [claims against assets] by creditors **[Current Liabilities must be satisfied within one year]** or one operating cycle and include: 1. **Accounts Payable** 2. **Notes Payable / Short-term debt** 3. **Current Portion of Long-Term Debt** 4. **Accrued Liabilities/expenses** 5. **Unearned Revenue :** Result from prepayments received in advance for services or products 6. **Tax liabilities** Alternantive view of the Balance sheet *[Capital employed ]* Is how the capital is employed in the company's activities and how this capital is finance - Capital employed = non-current assets + WCR + cash Working capital requirement (BFR) = Inventory + AR -- AP WRC must be smallest as possible, even negative. This capital employed is financed by shareholders' equity and financial liabilities (**[invested capital]**) Invested capital = Equity + financial debt *[Managerial balance sheet]* The 3 cycle : - Investment cycle = LT fixed assets, Stable ressources - Operating cycle = Operating current assets, operating current liabilities - Cash cycle = cash holding, short term financial debt  NFL or Working Capital (WR) = LT stables resources -- LT assets Working capital requirement (WRC) = Inventory + AR -- AP Net Cash = WR -- WRC or Cash holding -- short term financial debt *[Consolidation ]* The purpose of Consolidation is to present the financial situation of a group of companies as if they formed one single entity. Consolidation is drawn up by any firm that : - controls other companies exclusively; or - exercises significant influence over them Scope of consolidation comprises the parent company and companies in which the parent company holds directly or indirectly [at least 20% of the voting rights] A subsidiary is **fully consolidated if it its parent holds over 50% of the voting rights**. When full consolidation takes place, Minority Interests appear in BS and the income statement The income statement Also called the **[Profit & Loss account (PnL)]** or [Statement of Earnings] It shows the details of revenues from sales, of the various expenses and thus gives the profit (or loss) for the accounting period (usually a year) Profit = Earnings = Income The measurement of accounting profit involves 2 steps: 1. **Identifying revenues for the period** - Revenue is recognized as soon as "the effort required to generate the sale is substantially complete and there is a reasonable certainty that payment will be received" -- not when cash is received ! - So [revenue ≠ cash] 2. **Matching the corresponding costs** **EBITDA = Earning Before Interest, Tax, Depreciation and Amortization (EBE)** - Gives a good view of the firm's profit capacity, regardless of its investment and depreciation policy **EBIT = Earning Before Interest & Tax (Résultat d'exploitation)** - Provides a basis for assessing the success of a company apart from its financing activities and separate from tax considerations **EBT = Earning before Taxes (Résultat courant avant impot)** **Net Income (Résultat net)** *[Common-size Income statement ]* - Expresses [each income statement item as a percentage of net sales] - Shows the relative magnitude of various expenses relative to sales, the profit percentages, and the relative importance of "other" revenues and expenses - Very useful analytical tool (structure and trends) Cash Flow Statement *[A Statement of Cash Flows shows :]* - what money (cash) came in (cash inflows e.g. sales receipts & loans) - what money (cash) went out (cash outflows e.g. payment for wages & electricity). - The difference between the two is called net cash flow. - The definition of cash not only includes cash on hand but also includes cash equivalents (i.e. highly liquid investments with short periods to maturity) CFS provides a link between successive Balance Sheets - reconciles the net increase or decrease in cash between the start and end of an accounting period *[The Statement of Cash Flows is divided into three main sections:]* 1. **Operating activities :** - day-to-day activities including receipts and payments (dividend and interest receipts are considered inflows) - The amount of cash flows from Operating Activities is a **key indicator** of the extent to which the operations of the entity have generated sufficient cash flows to : - maintain operations - repay loans - pay dividends - make new investments **[without] recourse to further finance (specifically external loans)** 2. **Investing activities** - activities relating to the acquisition &/or disposal of non-current assets & investments, (e.g. securities), that do not fall within the definition of cash - This cash flow represents the extent to which expenditures have been made for resources intended to generate future income and cash flows e.g.: - [Investments in] (outflow) non-current (long term assets) assets e.g. - Plant and equipment - Intangibles - Loans to others (outflow) - Proceeds (inflow) from the sale of the above 3. **Financing activities** - Activities that relate to changing the size &/or composition of the financial structure of the entity (e.g. equity & borrowings that do not fall within the definition of cash) - The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of capital to the entity. **Operating Cashflows** - Receipts from Customers - Payments to Suppliers and Employees - Interest Received - Interest Paid - Dividends Received - Tax Paid **Investing Cashflows** - Payment for Purchase of PPE - Proceeds From Sale of PPE - Payments for purchase of Subsidiaries **Financing Cashflows** - Proceeds from Issues - Proceeds From Borrowings - Repayment of Borrowings - Dividends Paid - Other Financing Cashflows **Net Increase/Decrease in Cash = Cash at the end of the period -- Cash at the beginning of the period** *[Reading a cash flow statement ]* 1. **Operating Cash flows (should be positive)** - \+ = Business cash flow are self funding - \- = Cashflows must be raised to keep business trading 2. **Investing cash Flows (should be negative)** - \+ = Disposed of more assets than acquired - \- = Acquired more assets than disposed (expansion) 3. **Financing Cash Flows (should be positive)** - \+ = Borrowings and/or contributed capital - \- = Repay loans, payments to owners Tools and Techniques There is 2 tools, such as : - Common-size financial statements - Financial ratios These 2 tools allows to analyze the financial health with two techniques - Trend analysis (evolution of the company over years) - Industry comparisons For that it necessary to look at any changes in the BS or the PnL not as an absolute figure but as percentage. A technique using relative quantitative data (ratios) in order to monitor, analyse & interpret the financial performance, condition, stability & growth potential of a firm over time. Ratios automatically adjust for firm size differences making inter-firm financial comparisons possible. There is 4+1 categories of ratios : 1. *[Profitability ratio]* Profitability ratios measure the overall performance as a return on sales or investment. - **Profit margins** - Gross margin = [\$\\ \\frac{\\text{gross}\\ \\text{profit}}{\\text{sales}}\$]{.math.inline} - Net profit margin = [\$\\ \\frac{\\text{net\\ profit\\ after\\ tax\\ }}{\\text{sales}}\$]{.math.inline} - EBITDA margin = [\$\\ \\frac{\\text{EBITDA}}{\\text{sales}}\$]{.math.inline} - EBIT margin = [\$\\ \\frac{\\text{EBIT}}{\\text{sales}}\$]{.math.inline} - **Return on Assets (ROA)** Tells you [how much was earned on each dollar tied up in the business] Basic measure of how efficiently a business allocates and manages its resources ROA = [\$\\ \\frac{\\text{Net\\ profit\\ after\\ tax\\ }}{\\text{Total\\ assets}}\$]{.math.inline} = ( [\$\\ \\frac{\\text{Net\\ profit\\ after\\ tax}}{\\text{Net\\ sales\\ }}\$]{.math.inline} x [\$\\ \\frac{\\text{Net\\ sales\\ }}{\\text{Total\\ assets}}\$]{.math.inline} ) = [\$\\ \\frac{\\text{Net\\ profit\\ margin}}{\\text{Asset\\ turnover\\ }}\$]{.math.inline} - **Return on Equity (ROE)** The ROE is a widely used indicator but has important limitations: - Value problem - ROE uses **book value**, **not market value**, of equity -- so this is the return to an investor that can buy the company's equity at its book value!! - Risk problem - What **risks** did/will the company take to generate its ROE ? You need to consider the leverage effect ROE = [\$\\ \\frac{\\text{Net}\\ \\text{profit}\\ \\text{after}\\ \\text{tax}\\ }{\\text{Equity}}\$]{.math.inline} = [\$\\ \\frac{\\text{Net}\\ \\text{profit}\\ \\text{after}\\ \\text{tax}\\ }{\\text{Net}\\ \\text{sales}\\ }\$]{.math.inline} x [\$\\frac{\\text{Net}\\ \\text{sales}\\ }{\\text{Total}\\ \\text{assets}\\ }\$]{.math.inline} x [\$\\frac{\\text{Total}\\ \\text{assets}}{\\text{Equity}}\$]{.math.inline} = ROE comes from - Earnings squeezed out of each dollar of sales - Sales generated from each dollar of assets - Assets bought with each dollar of equity The profit margin summarizes a company's income statement performance The asset turnover ratio summarizes the company's management of the asset side of its balance sheet The financial leverage ratio summarizes management of the liabilities side of the balance sheet - **Return on Invested Capital (ROIC)** This ratio takes into consideration all investments in the company on which a return must be earned (invested capital) ROIC = [\$\\ \\frac{EBIT\\ x\\ (1 - T)}{\\text{Invested\\ capital}}\$]{.math.inline} 2. *[Utilization (efficiency) ratio]* - **Total assets turnover** Total asset turnover assesses effectiveness in generating sales from investments in all assets : - The higher this ratio, the smaller the investment to generate sales - Ratio may be temporarily low due to extensive equipment modernization or assets acquired at year-end - Important to understand where any improvement/worsening is coming from... Total assets turnover = [\$\\ \\frac{\\text{Net\\ sales}}{\\text{Total\\ assets}}\$]{.math.inline} - **Fixed asset turnover** Assesses [effectiveness in generating sales from investments in fixed assets] -- very important for a capital-intensive firm A low turnover implies high [capital intensity] and [high operating leverage] Fixed asset turnover = [\$\\ \\frac{\\text{Net\\ sales}}{Net\\ porperty,\\ \\ \\ plant\\ \\&\\ equipement\\ }\$]{.math.inline} - **Working capital ratios**  Number of days of **Working Capital** or **Cash Conversion Cycle =** \+ average collection period \+ days inventory held \- days payable outstanding - Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing the changes in working capital - The lowest the figure the better for a company -- it means it transforms cash investment into cash from sales quicker 3. *[Leverage and Liquidity ratio]* - **Bankruptcy & Liquidation** When a company is unable to repay its debt, the debt holders can force the company into bankruptcy or liquidation. - **Liquidation** - the company ceases to exist. - It will [sell all the assets it owns] and pay the various claims to all creditors based on priority. The shareholders will receive the net proceeds from liquidation after all claims are paid out. - **Bankruptcy** - the company continues to function with restrictions. - the court will [appoint a receiver] who is in charge of overseeing the cash flows. There will be restrictions on how these cash flows are used. In some cases, the creditors may agree for reorganization of the capital structure. To prevent bankruptcy, lenders will impose covenants to the company = restrictions on what is can do. *[Liquidity ratio ]* - Current ratio = [\$\\frac{\\text{Current\\ assets}}{\\text{Current\\ liabilities}}\$]{.math.inline} \>1; Measure the firm\'s ability to meet maturing short term obligations. - Quick (acid-test) ratio = [\$\\frac{Current\\ assets - Inventory}{\\text{Current\\ liabilities}}\$]{.math.inline} \>1 ; Measures ability to meet short-term cash needs more rigorously by [eliminating inventory] - Cash ratio = [\$\\frac{cash\\ \\&\\ marketable\\ securities}{\\text{Current\\ liabilities\\ }}\$]{.math.inline} \>1 ; The question of how much cash and securities a company should carry is often closely related to the broader question of [how important liquidity is to the company] (operating expenses, loans, etc.) and [how best to provide it] *[Leverage ratio]* - Equity ratio = [\$\\ \\frac{\\text{Equity}}{\\text{Assets}}\$]{.math.inline} Debt to equity ratio = [\$\\frac{\\text{Total\\ debt}}{\\text{Equity}}\$]{.math.inline} - Debt ratio = [\$\\frac{\\text{Total\\ debt}}{\\text{Assets}}\$]{.math.inline} Long-term debt to capitalization = [\$\\frac{\\text{LT\\ debt}}{\\text{capital}}\$]{.math.inline} \< 50% *[Coverage ratio :]* - Times Interest earned ratio = [\$\\frac{\\text{EBIT}}{\\text{Interest\\ expenses}}\$]{.math.inline} \> 1 ; Indicates [how well operating earnings cover fixed interest expenses] - Debt reimbursement ratio = [\$\\frac{\\text{LMT\\ debt}}{\\text{EBITDA}}\$]{.math.inline} ; This ratio measures how long (in years) it will take the company to repay its LMT - Cash flow coverage = [\$\\frac{\\text{Operating\\ cash\\ flow}}{Interest - bearing\\ debt}\$]{.math.inline} ; This ratio measures leverage by comparing a firm's operating cash flow to the total value of financial liabilities 4. *[Market performance ratio]* These ratios are applicable to companies listed on organised exchanges. The ratios relate reported financial numbers to: - the number of shares on issue or - the market price of the share. - **Earnings per share (EPS)** = [\$\\frac{\\text{Net\\ Income}}{\\text{Average\\ number\\ of\\ shares\\ outstanding\\ }}\$]{.math.inline} - Provides the share investor with a common denominator to gauge investment returns - Growth rates in EPS are closely monitored by investment analysts and benchmarked against market and industry averages - **Dividend payout ratio** = [\$\\frac{Dividend\\ per\\ share\\ (DPS)}{Earnings\\ per\\ share\\ (\\ EPS)}\$]{.math.inline} - Relates cash dividends per share to earnings per share - This ratio helps understand a company's dividend policy and to what extent it retains its net earnings - **Dividend Yield** = [\$\\frac{Dividend\\ per\\ share\\ (DPS)}{\\text{Market\\ price\\ of\\ common\\ stock}}\$]{.math.inline} - Shows the relationship between cash dividends and market price - This ratio helps understand the return earned on an investment in shares - **Total return** = dividend yield + capital appreciation - **Price earnings ratio** = [\$\\frac{\\text{Marketing\\ price\\ of\\ common\\ stock}}{Earnings\\ per\\ share\\ (EPS)}\$]{.math.inline} - Relates earnings per common share to the market price at which the stock trades, expressing the "multiple" that the stock market places on a firm's earnings -- an indicator of investors' expectations - A key focus for the equity analyst Company valuation 1. *[Discounted cash flow ]* - Traditional descriptions of company equity valuation rely on the dividend discount model (DDM) method. - The value of a company's equity is computed based on forecasts of cash flows available to equity investors. (Dividends) - These forecasts are then discounted using the company's cost of equity capital Two models : - **Zero-growth model :** - Assumes that dividend D amount remains constant at all times - Since the dividend amount is constant, it is a perpetuity. - **Constant growth model :** - If earnings increase, dividends (usually a % of profit) will increase. - Assume that earnings and dividends grow at a constant rate of g% every year. - Assume that g \< k, where k is the required rate of return. **g = Growth rate = Retention x ROE** **k = required rate of return** 2. *[Present value of growth opportunities ]* - The value of the firm equals the value of the assets already in place, the **no-growth value of the firm**, - **Plus** the NPV of its future investments, - Which is called the **present value of growth opportunities** or **PVGO**. **Price = No-growth value per share + PVGO** Po = E1 / K + PVGO 3. *[Free cash flow model]* - FCF measures the level of cash available to a company\'s investors net of all required investments in working capital and fixed capital, including PPE, otherwise known as capital expenditures, plus any expenses required to remain a going concern.  - The higher the FCF the better the health of the company - Note : Negative FCF may not be a negative sign if the company is making significant investment. - **[The 3 equations should be the same]** - FCF = Cash Flow From Operating Activities - Capital Expenditures - FCF = Net Operating Profit After Tax - Net Investment in Operating Capital - FCF = Revenue - Operating Costs and Taxes - Required Investments in Operating Capital **[Methods of calculating growth in cash flows]** - 2 methods may be used - Extrapolate overall growth from past years - Use the individual components of FCF and estimate those. Much more accurate and useful, but much more complicated. Value = FCF x (1 + g ) / ( k -- g ) - g is the assumed growth rate - k is the WACC