Copyright (c) 2008 Thomson South-Western, a part of the
Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Chapter 5: Financial Analysis Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Key Concepts in Chapter 5 There are two primary tools in financial analysis:
Ratio analysis to assess how various line items in financial statements relate to each other and to measure relative performance.
Cash flow analysis to evaluate liquidity and the management of operating, investing, and financing activities as they relate to cash flow. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Determinants of Firm Value and Ratio Analysis Profitability and growth drive firm value. Managers can employ four levers to achieve growth and profit targets: Operating management Investment management Financing strategy Dividend policy
Ratio analysis seeks to evaluate the firms effectiveness in these areas. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Ratio Analysis Evaluating ratios requires comparison against some benchmark. Such benchmarks include: Ratios over time from prior periods (time series) Ratios of other firms in the industry (cross-sectional) Some absolute benchmark Effective ratio analysis must attempt to relate underlying business factors to the financial numbers The text illustrates ratio analysis by applying it to Wal-Mart stores.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Measuring Overall Profitability ROE is a comprehensive measure of and is a good starting point to systematically analyze firm performance.
ROE = Net Income / Shareholders equity Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Decomposing Profitability: Traditional Approach ROE = ROA * Financial leverage = Net income * Assets Assets Shareholders equity Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Decomposing Profitability: Alternative Approach The traditional approach has some limitations imposed by the composition of the denominator and numerator
An alternative approach computes ROE as ultimately being equal to: Operating ROA + Spread * Net financial leverage
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Detail of Alternative ROE Decomposition Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Wal-Mart and Target: Comparison of ROE Components Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Discussion of Results from Profitability Analysis Note the differences between key components of the traditional and alternative FY 2005 ROE decompositions:
Wal-Mart Traditional Wal-Mart Alternative Target Traditional Target Alternative Asset Turnover 2.61 41.6 1.63 2.59 ROA 9.3% 16.10% 7.50% 13.40% Financial Leverage 2.43 0.53 2.48 0.56 Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Assessing Operating Management: Income Statement Ratios Common-sized income statements facilitate comparisons of key line items across time and different firms. Additionally, the following ratios are also helpful: Gross profit margin EBITDA margin NOPAT margin Recurring NOPAT margin
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Gross Profit Margin Measures the profitability of sales, less direct costs of sales: Gross profit margin = Sales Cost of sales Sales
The gross profit margin is an indicator of: The price premium that a firms product commands in the market The efficiency of a firms procurement and/or production process Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy NOPAT and EBITDA Margins The NOPAT margin provides a comprehensive measure of operations: NOPAT margin = NOPAT Sales
The EBITDA margin eliminates the significant non-cash expenses of depreciation and amortization along with interest and taxes: EBITDA = Earnings before interest, taxes, depreciation, and amortization Sales Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy A Comparison of Key Income Statement Ratios for Wal-Mart and Target Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Decomposing Asset Turnover Asset management is a key indicator of how effective a firms management is.
Asset turnover may be broken into two primary components: 1. Working capital management 2. Long-term asset management Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Working Capital Management Working capital is the difference between current assets and current liabilities. Key ratios useful to analyzing the management of working capital include: Operating working capital to sales Operating working capital turnover Accounts receivable turnover Days receivables Inventory turnover Days inventory Accounts payable turnover Days payables Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Asset Management Ratios for Wal-Mart and Target Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Financial Leverage Analysis Borrowing allows a firm to access to capital, but increases the risk of ownership for equity holders. Analysis of leverage can be performed on both short- and long-term debts: Liquidity analysis relates to evaluating current liabilities Solvency analysis relates to longer term liabilities Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Liquidity Analysis There are several ratios useful to evaluate a firms liquidity, including: Current ratio Quick ratio Cash ratio Operating cash flow ratio Each of these ratios attempts to measure the ability of a firm to pay its current obligations. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Liquidity Analysis Knowing how the liquidity ratios are calculated allows the user to understand how to interpret them:
Current ratio = Current assets / Current liabilities Current liabilities
Quick ratio = Cash + Short-term investments + Accts. receivable Current liabilities
Cash ratio = Cash + Marketable securities Current liabilities
Operating cash flow ratio = Cash flows from operations Current liabilities Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Comparison of Wal-Mart and Target Liquidity Ratios Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Debt and Coverage Ratios Beyond short-term survival, solvency measures the ability of a firm to meet long-term obligations. Several useful ratios are used to analyze solvency. Three using only shareholders equity as a denominator are:
Liabilities-to-equity ratio = Total liabilities Shareholders equity
Debt-to-equity ratio = Short-term debt + Long-term debt Shareholders equity
Net-debt-to-equity ratio = Short-term debt + Long-term debt Cash and marketable securities Shareholders equity Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy More Debt and Coverage Ratios Two ratios that use debt as a proportion of total capital are: Debt-to-capital ratio =
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy More Debt and Coverage Ratios, contd. Two ratios that specifically address the ability to pay interest on debts are:
Interest coverage ratio (earnings basis) =
Net income + Interest expense + Tax expense Interest expense
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Comparison of Wal-Mart and Target Debt and Coverage Ratios Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Assessing the Sustainable Growth Rate A comprehensive measure of a firms ratios is the sustainable growth rate, which uses ROE:
ROE * (1 - Dividend payout ratio)
Where: Dividend payout ratio = Cash dividends paid Net income
Sustainable growth rate measures the ability of a firm to maintain its profitability and financial policies. Its components may be seen in Figure 5-2. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Sustainable Growth Rates For Wal-Mart and Target Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Cash Flow Analysis The ratio analysis previously discussed used accrual accounting.
Cash flow analysis can provide further insights into operating, investing, and financing activities.
All U.S. companies are required to include a statement of cash flows in their financial statements. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Analyzing Cash Flow Information A number of questions can be answered through analysis of the statement of cash flows. For example: Operating activities How strong is the firms internal cash flow generation? How well is working capital being managed?
Investing activities How much cash did the company invest in growth assets?
Financing activities What type of external financing does the company rely on? Did the company use internally generated funds for investments? Did the company use internally generated funds to pay dividends?
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Cash Flow Analysis Differences in reporting cash flow information allow for variation across firms that complicate comparisons. Analysts can make adjustments to net income to arrive at free cash flows, a commonly used metric for financial analysis. Table 5-11 in the next slide illustrates the various calculations using financial information from Wal-Mart and Target. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5: Financial Analysis Palepu & Healy Concluding Comments There are two primary tools in financial analysis:
Ratio analysis to assess how various line items in financial statements relate to each other and to measure relative performance.
Cash flow analysis to evaluate liquidity and the management of operating, investing, and financing activities as they relate to cash flow.
Both forms of analyses must be evaluated while considering whether firm performance is consistent with the strategic initiatives of management.