Bus 251 D1 & D2 (19-2)

Chapter 12
Financial
Statement Analysis

Lecture Notes
Anne Macdonald
 FINANCIAL STATEMENT ANALYSIS

Ratios provide CLUES not answers.

They suggest questions that should be asked.
Ratio results
will depend on: Environmental
factors
Changes to
Competitors’
company
actions
strategy

Company The Accounting

history / trends Company judgments

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 FINANCIAL STATEMENT ANALYSIS

Consolidated Financial Statement

Multinational corporation or group of companies

If more detailed
information is
Industry A Industry C Industry D available:
Investors may
want to consider
Country A Country B Country C applying ratio
analysis to
different product,
Product 2
Product 1 industry or
geographical
SEGMENTS.
Each segment may face different RISKS,
UNCERTAINTIES, POTENTIAL FOR GROWTH ….

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 FINANCIAL STATEMENT ANALYSIS

Ch.12 uses Saputo Inc., a Montreal based producer of dairy products

as an example. From their f/s for the fiscal year ended March 31st,
2017, possible segmentation could occur for:

Canada: Revenue (by sector)

Revenue
Retail
(geographically)
Foodservice
USA
Industrial

Canada
Overall: Revenue (by sector)

Retail
International
Foodservice

Industrial

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 FINANCIAL STATEMENT ANALYSIS

Before you start

e.g. Revenue
using ratios: recognition, capital
E.g. Income from discontinued
lines of business, restructuring
Is it a ‘clean’ opinion: asset valuation, …
costs, impairment or write-down
“…. These f/s present of capital assets, gain/loss on sale
fairly …” of capital assets, lawsuits …
Understand
significant
accounting Identify
policy transitory
Review choices
Auditors’ (non-
Understand the
company strategy, Report recurring)
competitive earnings
environment

Assess the
Review Know the What does
quality of
MD&A Company this mean?
earnings

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 FINANCIAL STATEMENT ANALYSIS

The quality of earnings is HIGH, when

Current Future
earnings Are highly correlated with earnings

Earnings = Cash from + Accruals Factors that reduce this correlation

operations ( the quality of earnings):
• Accounting estimates
There is little room for judgment, or • Accruals
measurement uncertainty with ‘Cash’.

IF: Cash from operations > Net income

(cash flow statement) (per accrual basis I/S)

THEN, The Quality of Earnings is HIGH (Net income is credible)

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 FINANCIAL STATEMENT ANALYSIS
Financial Statements: Ratios:
Balance Sheet Calculate and compare results:
Income statement
Cash flow statement
Notes to the F/S Internally (within External to
the company), to the company, to

Prior years’ results A company set Competitor’s General industry or

standard results environmental results
TREND analysis e.g. 30 days to
collect A/R CROSS SECTIONAL analysis

What are the difficulties with each of these suggestions?

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 Financial Statement Ratios
Net profit margin %
Basic EPS Profitability Gross profit margin %
Dividend payout Ratios Return on assets (ROA)
Dividend yield Return on equity (ROE)
Net free cash flow
Price/Earnings ratio

Equity Short-Term
Analysis Liquidity Current ratio
Ratios Ratios Quick ratio

Debt to equity ratio Activity A/R Turnover

Debt to assets ratio
Solvency Inventory Turnover
Interest coverage Ratios Ratios A/P Turnover
Cash flows to total
liabilities
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 FINANCIAL STATEMENT ANALYSIS
Ch.12 reviews many of the ratios seen earlier in the text. You
should be most familiar with:
Current ratio
Quick ratio
A/R turnover ratio
Inventory turnover ratio
Debt-to-Equity ratio or the Debt-to-Asset ratio
Earnings per share
Return on assets Also, understand how leverage connects the measures
Return on equity of ROA and ROE.

You don’t need to memorize the formulas.

You will be given a formula sheet (see the sample final).
Your focus should be on INTERPRETING the results, and knowing
WHEN to USE each ratio (what it measures – eg. The units of measure:
%?, times per year?, … ).
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 FINANCIAL STATEMENT ANALYSIS

The differences between ratios can be subtle:

Return on Equity (ROE) Return on Assets (ROA)
Has the company performed VS Has the company performed
well from the common well from management’s
shareholders’ perspective? perspective?

ROE = Net income - Preferred dividends (if any) ROA = Net income before interest expense
Avg common shareholders’ equity Average total assets
= Net + interest
This answers the question: income expense x [1 - tax rate]
How much additional wealth has the Average total assets
company generated for the common This answers the question:
shareholders this year, as a % of
these shareholders’ investment? How well did management use/manage
the assets owned by the company and
under management’s control.

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 FINANCIAL STATEMENT ANALYSIS
Ratio formulas must be used carefully.

Decide whether
Decide which
Identify relevant to exclude some
ratio (or ratios?)
F/S information. items, or include
to use.
other items.

Calculating more ratios is NOT always better:

• Ratios can send conflicting messages
• Choose a ratio that best measures whatever you are interested in
• Understand the trade-offs between ratios [e.g. You can increase the
inventory turnover ratio (sell inventory faster) by reducing the selling price.
However, this reduces the gross margin %, and thus the company’s
profitability.]

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 FINANCIAL STATEMENT ANALYSIS
Decide whether to
Decide which
Identify relevant exclude some
ratio (or ratios?)
F/S information. items, or include
to use.
other items.

Items that could be removed from Items that could be added into
the F/S: the F/S:
E.g. E.g.
‘Goodwill’, removed from Assets ‘Operating lease commitments’ added
‘Gain on sale of equipment’ (or other in to Liabilities
non-operating items) removed from Net Adjustments/estimates of future
Income changes in Net Income or Assets due
to:
• The impact of an expansion
But these can be • Supplier price increases
difficult to identify! • Changes to selling price or volume sold
….

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 FINANCIAL STATEMENT ANALYSIS

Price/Earnings Ratio = Market price per share This is the only ratio
which considers the
Earnings per share company’s share
price in the stock
market !

Be careful here. Remember What does this reflect?

“The amount what this includes: • The public’s expectations about
investors are • Net income for one period only future performance of the
willing to pay • May include transitory earnings
company, of competitors, of the
for $1 of economy in general ….
• The company may be changing
earnings.” (the future may not look like the past)
• Can be volatile

Investors may want to: Investors may want to:

• Remove transitory (non- • Normalize (average) share price
permanent) earnings. over a period of time.
• Normalize (average) earnings
over a period of years.

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 PRICE / EARNINGS RATIO

Price/Earnings Ratio A high ratio may indicate that investors think

= Market price per share the company has high growth potential, or that
Earnings per share (EPS) the company has a low level of risk.

Thinking Question:
Co. A and Co. B each have EPS of $1 this year.

Co A has a market price of $10/share Co B has a market price of $15/share

( P/E ratio of 10). ( P/E ratio of 15).
Possible explanations: • Co. B has better long-term strategies for
• Co. A is in a ‘slow growth’ industry, with growth than Co .A.
less upward potential. • Co. B had lower than usual net income
• Co. A has lower ‘quality of earnings’ than this year, reducing EPS.
Co. B. • Co. A and Co. B have the same EPS
• Co. A is evaluated by investors to be a only because they made different
more risky investment. accounting policy choices.
• Co. A at $10/share is a bargain – it is • Co. B at $15/share is overpriced
undervalued.
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 PRICE / EARNINGS RATIO
Amazon.com Inc.: A retailer? Or technology company?

Price-earnings ratio:
Between Jan 2017 and
Apr 2018, ranged from
150 times to over 300
times earnings

Was/is this an indication that Amazon shares are over priced?

Share price:
Increased from $700 to
more than $1400 during
this 15 month period.

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 PRICE / EARNINGS RATIO
Walmart Inc.: A more traditional retailer

Price-earnings ratio:
Between Jan 2017 and
Apr 2018, ranged from
15 times to about 27
times earnings

Compared to Amazon, are Walmart shares under-valued?

Share price:
Increased from $67 to
$88 during this 15 month
period (although with a
peak of over $100 in Jan
2018.

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 FINANCIAL STATEMENT ANALYSIS

Examples of P/E ratios (measured at Dec 31st each year)

2017 2016 2015 2014 2013

Saputo Inc. 20.0 27.8 21.5 24.1 18.5

Danone 24.0 21.0 40.5 29.8 17.8

Ford Motor Co. 6.7 6.7 7.7 5.8 5.3

Volkswagen AG 12.0 123.5 * 11.1 8.1 11.4

Facebook 34.2 44.4 105.3 73.0 133.3

* Net income and EPS were low

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 FINANCIAL STATEMENT ANALYSIS

Industry matters ….

Average P/E ratios for selected Average Debt-to-Equity ratios for selected
industries (2014) industries (2014)

P/E Ratio Debt-to Equity Ratio

Software Software

Gold Gold

Retailing Retailing

Telecommunications Telecommunications

Transportation Biotechnology

0 20 40 60 0 2 4 6

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