Essentials of Financial

Statement Analysis

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 5
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without the prior written consent of McGraw-Hill Education
 Financial Analysis Tools and
Approaches

Financial Analysis Tools Basic Approaches

 Time-series analysis
Cause-of-change analysis Helps identify trends for a single
company or business unit
 Cross-sectional analysis
Common-size statements Helps identify similarities and
differences across companies or
business units at a single point in
time
Trend statements
 Benchmark comparison
industry norms or predetermined
standards.
Financial ratios

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 Financial Statement Analysis and
Accounting Quality
 Analysts use financial statement information to see more clearly
the economic activities and condition of a company and its
prospects.
 However, financial statements do not always provide a complete
and faithful picture of a company’s activities and condition.

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 Getting Behind the Numbers at
Whole Foods Market

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 Cause-of-Change Analysis

One way to quantify the components of change is with a “cause-

of-change analysis”, which shows the effects of individual
changes on the change in net income.

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 Whole Foods Market:
Cause-of-Change Analysis 2015 vs. 2012

Let’s change sales from the 2012 level to the 2015 level, holding all
other inputs to the model constant at the 2012 level.

Hypothetical operating income that

would have been achieved if sales
had grown as they did, but operating
margin percentage remained
unchanged.

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 Common-Size Statements

 Financial analysts use common-size and trend statements of net

income to help spot changes in a company’s cost structure and profit
performance.
 Common-size income statements recast each statement item as a
percentage of sales.
 Common-size income statements show how much of each sales
dollar the company spent on operating expenses and other
business costs and how much of each sales dollar hit the bottom
line as profit.
 Common-size balance sheets recast each statement item as a
percentage of total assets.

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 Whole Foods Market:
Common-Size Income Statements

Each item is recast as percentage of sales.

29.1 cents of each 2015 sales dollar was spent on

selling, general, and administrative expenses.

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 Whole Foods Market:
Trend Income Statements

Each item is recast in percentage terms using a base year number.

Sales increased
substantially
Main reasons net
income fell:
• Increases in cost
of goods sold
• Increases in
selling, general,
and
administrative
Net income growth expenses
lagged sales growth

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 Whole Foods Market:
Common-Size Balance Sheets – Assets
Each item is recast as percentage of total assets.

Highlights
changes in
asset mix

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 Whole Foods Market:
Trend Balance Sheets – Assets
Each item is recast in percentage terms using a base year number.

Decrease
here
corresponds
with
increase
here

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 Whole Foods Market:
Common-Size Balance Sheets –
Liabilities and Stockholders’ Equity
Highlights changes in financial structure

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 Whole Foods Market:
Trend Balance Sheets – Liabilities
and Stockholders’ Equity

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 Whole Foods Market:
Common-Size and Trend Analysis
of Cash Flow Statements

Common-size cash flow statements are constructed by dividing

each cash flow item by sales for the year.

A major use of
operating cash
flows was for
development
costs and
capital
expenditures
for property,
plant, and
equipment.

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 Financial Ratios and Profitability Analysis
Operating profit margin
EBI refers to the
EBI company’s
earnings before
Sales
Return on assets interest
for a particular
period
EBI
ROA= X Asset turnover
Average assets
Average assets
represents the
Sales average book
Average assets value of total
assets over that
same time period

Before computing ROA, analysts may adjust the company’s reported earnings and asset
figures. The adjustments fall into three broad categories:
 Adjustments aimed at isolating a company’s sustainable profits by removing nonrecurring
items from reported income.
 An adjustment that eliminates after-tax interest expense from the profit calculation so that
profitability comparisons over time or across companies are not affected by differences in
financial structure.
 Adjustments for distortions related to accounting quality concerns.

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 Whole Foods Market:
Return on Assets
Before ROA is computed, adjustments are made to reported
earnings each year to eliminate interest expense, net of its related
tax savings. (Here, interest expense is immaterial.)

ROA grew from 9.7% in 2012 to more than 10% in 2013 and 2014 before
falling back to 9.3% in 2015.

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 How Can a Company Increase ROA?

A company can increase ROA in just two ways:

1. Increase the profit margin.
2. Increase the intensity of asset utilization (turnover rate).
Asset turnover

EBI EBI Sales

ROA =
Average assets Sales Average assets

Operating profit margin

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 Whole Foods Market:
ROA Decomposition

Whole Foods’ asset turnover improvement is due to gains in current asset

turnover, partially offset by reduced long-term asset turnover.

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 ROA and Competitive Advantage:
Grocery Industry

 Competition works to drive down ROA toward the competitive floor—that is, the
rate of return that would be earned in the economist’s “perfectly competitive”
industry.
 Companies that consistently earn an ROA above the floor are said to have a
competitive advantage.
 However, a high ROA stimulates more competition which can lead to an
eventual erosion of profitability and advantage.

Average ROA
is 4.8%

Different points
on the curve achieve
the 4.8% return with
different combinations
of margin and turnover

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 ROA and Competitive Advantage:
Grocery Industry
Average ROA
is 4.8%

Companies that
consistently earn
rates of return above
the floor have a
competitive
advantage.

 The ROAs of Whole Foods (WFM), SUPERVALU , and Fresh Market

(TFM) are above the curve, indicating ROAs above the industry average.

 Weis Markets (WMK) is just below the industry average ROA, due to its
lower turnover.

 Smart & Final Stores (SFS) is the lowest of the five companies shown on
both margin and turnover, resulting in a 3.3% ROA that lags well behind
the industry average.

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 Key Strategies for Achieving Superior
Performance

 Two key strategies for achieving superior performance in

any business:
 Product and service differentiation

 Focuses on “unique” products or services to gain brand loyalty and

attractive margins.
 People are willing to pay premium prices for things they value and
can’t get elsewhere.
 Differentiation can take several forms.
 Low-cost leadership
 Focuses on operating efficiencies, which permit the company to
underprice the competition, achieve high sales volumes, and still
make a profit on each sale.
 Companies can attain a low-cost position in various ways.

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 Return on Common Equity

 Return on common equity (ROCE) measures a company’s

performance in using capital provided by common shareholders to
generate earnings.
 ROCE explicitly considers how the company finances its assets.
 Interest charged on loans, and dividends declared on preferred stock,
are both subtracted in arriving at net income available to common
shareholders.

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 Return on Common Equity and
Financial Leverage

• ROCE is affected by both ROA and the degree of financial

leverage employed by the company.
• For firms with more financial leverage, the ups and downs in ROA
are exaggerated:
• When ROA is low at a highly levered firm, ROCE will be very
low, perhaps even negative.
• When ROA is high at a highly levered firm, ROCE will be very
high.

• In contrast, ROCE is not much more volatile than ROA for firms that
do not employ much financial leverage.

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 Components of ROCE

Return on assets (ROA)

EBI
Average assets
Return on common
equity (ROCE) X
Common earnings leverage
Net income available to
common shareholders Net income available to
common shareholders
Average common
shareholders’ equity EBI

X
Financial structure leverage
Average assets
Average common
shareholders’ equity

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 Profitability and Financial Leverage:
Good Earnings Year
Consider two companies with $2 million in assets:
• NoDebt raised all its capital from common shareholders
• HiDebt borrowed $1 million at 10% interest.
The two companies have identical operations, so their earnings before interest and
taxes (EBIT) are identical, as are their assets employed.

Good Earnings Year

 Both companies earn a ROA of 12% and NoDebt Company also earns a ROCE
of 12%.
 HiDebt’s ROCE is 18% because $180,000 of earnings is available to common
shareholders; leverage increased the return to HiDebt’s shareholders.

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 Liquidity, Solvency, and Credit Analysis:
Credit Risk

 Credit risk refers to the risk of nonpayment by the borrower.

 The lender risks losing interest payments and loan principal.
 A borrower’s ability to repay debt is driven by its capacity to
generate cash from operations, asset sales, or external
financial markets.
 Numerous and interrelated risks influence a company’s ability
to generate cash.

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 Liquidity, Solvency, and Credit Analysis:
Balancing Cash Sources and Needs

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 Short-Term Liquidity Ratios

Current assets
Current ratio =
Current liabilities
Liquidity
ratios Cash + Marketable securities + Receivables
Quick ratio =
Current liabilities
Short-term
liquidity Net credit sales
Accounts receivable turnover =
Average accounts receivable

Activity Cost of goods sold

Inventory turnover =
ratios Average inventory

Inventory purchases
Accounts payable turnover =
Average accounts payable

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 Liquidity Analysis:
Credit Risk Analysis: Short-Term Liquidity

• Even though both the current ratio and the quick ratio have been falling, Whole
Foods generates strong and predictable operating cash flows.

• Working capital activity ratios are essentially unchanged.

• Payments to suppliers occurred about 10 days after inventory was purchased

but it took about 22 days (17.2 + 4.9) to generate a sale and collect cash from
credit customers; this misalignment of operating cash flows is unlikely to cause
concerns.

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 Long-Term Solvency Ratios

Long-term debt
Long-term debt to assets =
Total assets
Debt ratios
Long-term debt
Long-term debt to tangible assets =
Total tangible assets

Long-term
solvency
Operating incomes before taxes and interest
Interest coverage =
Interest expense
Coverage
ratios
Operating cash flow Cash flow from continuing operations
to total liabilities = Average current liabilities + long-term debt

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 Long-Term Solvency:
Rite-Aid Corporation

An interest coverage ratio below 1 indicates that earnings are not even
sufficient to pay interest requirements.

• Rite Aid’s interest coverage ratio has grown over the period.
• Rite Aid’s cash flow coverage ratio and operating cash flow to total
liabilities ratio also increased over the period.

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 Cash Flow Analysis

 Although a company’s earnings are important, an analysis of its

cash flows is central to credit evaluations and lending decisions.
 Cash Flow from Operating Activities
 Generating cash from operations is essential to any company’s long-
term economic viability.
 Cash Flow from Investing Activities
 Changes in a company’s capital expenditures or fixed asset sales over
time must be analyzed carefully because they have implications for the
company’s future operating cash flows.
 Cash Flow from Financing Activities
 Determining the optimal debt level involves a trade-off between two
competing economic forces—taxes and costs of financial distress.

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 Financial Ratios and Default Risk

 A firm defaults when it fails to make

principal or interest payments.
 Lenders can then:
 Adjust the loan payment schedule.
 Increase the interest rate and require
loan collateral.
 Seek to have the firm declared
insolvent.
 Financial ratios play two roles in
credit analysis:
 They help quantify the borrower’s
credit risk before the loan is granted.
 Once granted, they serve as an early
warning device for increased credit
risk.

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 Summary
 Financial ratios, common-size statements and trend statements are powerful tools for:
 Tracking a company’s performance over time.
 Making comparisons among different companies.
 Assessing compliance with contractual benchmarks.
 There is no single “correct” way to compute many financial ratios.
 Not every analyst calculates these ratios in exactly the same way.? Sometimes it’s a
matter of personal taste or industry practice.
 At other times, it’s because the analyst is attempting to make the numbers more
comparable across companies or over time.
 Financial ratios don’t always provide the answers, but they can help you ask the right
questions.
 Is it the economics of the business or is it the accounting?
 Watch out for accounting distortions that can complicate your interpretation of financial ratios and other
comparisons.
 Remember that the analyst’s task is to “get behind the numbers”—that is, to develop a solid
understanding of the company’s economic activities and how industry fundamentals have shaped
where the company is today and where it will be tomorrow.

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