Module 3 - Analyzing and Interpreting Financial Statements

Ross School of Business Winter 2006 Module 3 Analyzing and Interpreting Financial Statements Ratio Analysis Examining various income statement and balance sheet components in relation to one another facilitates financial statement analysis. This type of examination is called ratio analysis. This module focuses on the disaggregation of Return Measures into Level 1 ? RNOA and LEV Level 2 ? Profit Margins and Turnover Level 3 ? GPM, SGA, ART, INVT, PAT, APT, WCT As well as Liquidity and Solvency Measures Analysis Structure Return on Equity Return on equity (ROE) is computed as: ROE = Net Income / Average Equity Key Definitions Observed Medians of Variables Level 1 Analysis ? RNOA and Leverage Return on Net Operating Assets (RNOA) RNOA = NOPAT / Average NOA where, NOPAT is net operating profit after tax NOA is net operating assets Operating and Nonoperating Assets/Liabilities Simplified Operating and Nonoperating Balance Sheet NOPAT Net operating profit includes Operating revenues less Operating expenses (COGS, SG&A, Taxes) Excluded are after-tax earnings from investments returns and interest expenses. Operating/Nonoperating vs. Core/Transitory Financial Leverage and Risk FLEV is the other component of ROE Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? Financial Leverage and Risk The answer is because debt is risky. This increased risk increases the expected return that investors require to provide capital to the firm. Higher financial leverage also results in a higher interest rate on the company?s debt. Standard & Poor?s and Moody?s Investor Services ratings partly determine the debt?s interest rate?with lower quality ratings yielding higher interest rates and vice-versa. So, all else equal, higher financial leverage lowers a company?s debt rating and increases the interest rate it must pay. Leverage and Income Variability Level 2 Analysis ? Margin and Turnover NOPAT Margin Turnover of NOA Level 3 Analysis ? Disaggregation of Margin and Turnover Gross Profit Margin It allows a focus on average unit mark-ups A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing. Operating Expense Margin Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category. Expense ratios are calculated as follows: Operating expense percentage = Expense item/Net sales Turnover Turnover measures relate to the productivity of company assets. Such measures seek to answer the amount of capital required to generate a specific sales volume. Turnover ratios are calculated as follows: Turnover = Sales volume/Average Assets As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced. Accounts Receivable Turnover (ART) Inventory Turnover (INVT) L-T Operating Asset Turnover (LTOAT) Accounts Payable Turnover (APT) Net Operating Working Capital Turnover (WOCT) Liquidity and Solvency Measures Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice. Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors. Cash Operating Cycle Average Cash (Operating) Cycle - the period of time from cash to inventories to receivables to cash. Current and Quick Ratio Solvency Ratios Flow Ratios Bankruptcy Prediction Vertical and Horizontal Analysis Vertical and Horizontal Analysis Derivation of ROE Disaggregation