Session 2 Financial analysis

Corporate Finance

Session 2: Financial analysis

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Session 2 Financial analysis

Topics

Measuring performance, efficiency, leverage, liquidity

Interpreting financial ratios

Case study ”Unidentified industries”

Expectations
This chapter introduces lots of concepts and requires a good intuitive
understanding of their uses and their limitations.

Reading
BMA 28

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Session 2 Financial analysis

Lowe’s Companies, Inc

Balance sheet ($mil)

2008 2007
Assets
Current assets
Cash and marketable securities 661 530
Accounts receivable 166 247
Inventories 8,209 7,611
Other current assets 215 298
Total current assets 9,251 8,686

Fixed assets
Tangible fixed assets
property plant and equipment 31,477 28,836
Less accumulated depreciation 8,755 7,475
Net tangible fixed assets 22,722 21,361

Long -term investments 253 509

Other long-term assets 460 313
Total assets 32,686 30,869

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Session 2 Financial analysis

Lowe’s Companies

Balance sheet ($ mil)

2008 2007
Liabilities and Shareholders’ Equity
Current liabilities
Debt due for repayment 1,021 1,104
Accounts payable 4,543 4,137
Other current liabilities 2,458 2,510
Total current liabilities 8,022 7,751

Long-term debt 5,039 5,576

Deferred income taxes 660 670
Other long-term liabilities 910 774
Total liabilities 14,631 14,771

Common stock and other paid-in capital 735 729

Retained earnings and capital surplus 17,320 15,369
Total shareholders' equity 18,055 16,098

Total liabilities and shareholders’ equity 32,686 30,869

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Session 2 Financial analysis

Lowe’s Companies

Income ($ mil)
2008
Net sales 48,230
Cost of goods sold 31,729
Selling, general, and administrative expenses 11,158
Depreciation 1,539
Earnings before interest and taxes (EBIT) 3,804
Interest expense 298
Taxable income 3,506
Tax 1,311
Net income 2,195

Dividends 491
Addition to retained earnings 1,704

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Session 2 Financial analysis

Finding Financial Statements

In the US, public companies report (quarterly and annual)
financial statements to their shareholders

Form 10-K reported to the SEC: annual statements

Form 10-Q: quarterly statements

Easily available online:

http://www.sec.gov/edgar/searchedgar/companysearch.html

Less detailed versions on yahoo.finance

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Session 2 Financial analysis

Lowe’s Company
Other Data (end of 2008)

1,470 million shares outstanding

Stock price =$18.19 per share

Market Capitalization
Total market value of equity
Market Capitalization=(Nb shares)*(Price per share)

Market Capitalization = $18.19 × 1,470 = $26,739 mil

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Session 2 Financial analysis

Lowe’s Company
EBIT= Total revenues - costs – depreciation
48,230 – 42,887 – 1,539 = $3,804 million

Net working capital

Net working capital = current assets - current liabilities

= 9,251 – 8,022 = $1,229 million

Net working capital measures the company’s potential reservoir of cash.

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Session 2 Financial analysis

Measures we will consider

• Performance (we skip EVA, Du Pont)
› Market-to-book
› ROC, ROE, ROA
• Efficiency
› Asset turnover
› Inventory turnover and inventory period
› Receivables turnover
› Average collection period
• Leverage
› Long-term debt ratio, long-term debt-equity ratio, total debt ratio
› Interest coverage
• Liquidity
› Quick ratio

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Session 2 Financial analysis

Lowe’s Company
Measuring Performance: Market-to-Book Ratio

Ratio of market value of equity to book value of equity.

market value of equity

Market-to-book ratio 
book value of equity Interpretation!?
$26, 739

$18, 055
 1.5

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Session 2 Financial analysis

Book Value versus Market Value

• The market value of an asset reflects its future expected cash-flows.

• Since the book value of an asset reflects its original cost, it might
deviate significantly from market value if the earning power of the asset
has increased or declined significantly since its acquisition.

• Given reasonably consistent accounting standards across firms, price-

book value ratios can be compared across similar firms for signs of
under- or overperformance, or for signs of under- or overvaluation.

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Session 2 Financial analysis

Measuring Profitability Interpretation!?

Lowe’s profitability measures

after tax interest + net income
Return on capital=
average total capital

=
(1- .35 ) ´ 298 + 2,195
= .103
23,094
after tax interest  net income
Return on assets=
total assets

=
1- .35   298  2,195
 .077
30,869
net income 2,195
Return on equity =   .136
equity 16,098
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Session 2 Financial analysis

Measuring Efficiency
Sales
Asset turnover ratio =
total assets at start of year

Sales
Asset turnover ratio =
OR Average total assets

For Lowe’s

Sales 48,230
Interpretation!?
Asset turnover ratio =   1.56
total assets at start of year 30,869

Sales
Asset turnover ratio =
Average total assets
OR 48,230
  1.52
(30,869  32,686) / 2

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Session 2 Financial analysis

Measuring Efficiency…

cost of goods sold

Inventory turnover ratio =
inventory at start of year
inventory at start of year
Inventory period=
daily cost of goods sold
 Efficient use of inventory?
sales
Receivable s Turnover =
receivable s at start of year

receivable s at start of year

Average collection period =
average daily sales
 How fast do customers pay?

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Session 2 Financial analysis

Measuring Leverage…

long term debt

Long term debt ratio =
long term debt + equity
Note: Long term debt includes all debt that is, well, long-term:
Bonds, long-term leases, bank loans, etc.

long term debt

Debt equity ratio =
equity
Note: Equity always refers to book equity, not market equity

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Measuring Leverage… and Liquidity

total liabilities
Total debt ratio=
total assets
 Leverage: Consider if short-term debt is not temporary!

EBIT
Times interest earned=
interest payments
 Leverage: How many times could EBIT cover
interest?

cash+marketable securities+receivables
Quick ratio=
current liabilities
 Liquidity: How “quick” are current assets relative to current liabilities
(Note: excludes inventory from current assets)

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Session 2 Financial analysis

Breakdown of ROA formula

• ROA can be decomposed into two parts:

after tax interest + net income

Return on assets =
total assets
sales after tax interest + net income
= *
assets sales
= asset turnover * operating profit margin
• Examples:
› Food chains tend to have high asset turnover but low margins
› Luxury hotels tend to have low asset turnover but high margins

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Session 2 Financial analysis

Unidentified Industries Case

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Dealing with identifiers

• What is an identifier, specifically a unique identifier?

• Examples? “TICKER” and “PERMNO”
• In financial data, identifiers values corresponding to an entity or
security.
• Identifiers are useful to:
› Filter data
› Merge datasets
› Track entities or securities through time

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The query results

are on the next
page, which
completes the
assignment.

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Session 2 Financial analysis

Identifiers (cont.)

• It’s complicated!
• Header vs. Historical Identifiers
› Headers are the most current identifiers.
› Historical identifiers have date ranges in which they are valid.
• Issue vs. Company Specific
› Understand if the identifier corresponds to the security or entity within
your data.
• Date Range of Different Datasets
› Understand if data ranges are associated with the identifiers or dataset.

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Session 2 Financial analysis

CRSP Permno/Permco (for US firms only)

1. Permno identifies securities.

› Permno is mapped to historical tickers, company names, etc., with
start and end dates in an event file.
› Permno is a 5 digit number.
2. Permco identifies companies.
› Permco is a number.
3. Permno and Permco do not change when a company changes
their name or ticker.
4. Never reassigned
In short, PERMNO and PERMCO are perfect identifiers

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Ticker

• Widely used and frequently recognizable

• Can change at any time and can be reused by a different
company
• One company can have multiple tickers.
• Usually 3 or 4 characters
• And – there are different “tickers”. For example there is a
Bloomberg “ticker”, an NYSE “ticker”, an I/B/E/S “ticker”…
• Ticker, in short, is a terrible identifier…

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Categorizing data: Industry Example

Helps to structure analyses.

Issue: are they given or a choice?

What is an “industry”?

Wikipedia says:

Can we do better than that?

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 Session 2 Financial analysis

How are “industries” defined?

• It’s complicated! Ugh…
› What if a firm changes over time?
› What if a firm does multiple things?
› What if an industry did not even exist last year?
› What about tech firms? Is Amazon a book store? A retailer? A computer processing
service firm? “Information Technology”? “Consumer Discretionary”?
• There are many! Important ones you will encounter include:
› SIC – Standard Industrial Classification. E.g. SIC code 2024 “ice cream and frozen
desserts”
› NAICS – North American Industry Classification System. E.g. NAICS code 6212
“offices of dentists”
› FAMA FRENCH 5/10/12/17/39/38/48/49. E.g. Fama French 37 “Chips” Electronic
Equipment
› NACE Statistical Classification of Economic Activities in the European Community.
E.g. NACE 07.21 “Mining of uranium and thorium ores”

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Fama/French 49 industries, all CRSP US firms with

publicly traded common stock, as of Dec2018
Date Fama and French 49 NFIRM Fama and French 49 NFIRM
Industries - Description Industries - Description
31DEC2018 AERO 16 INSUR 96 How to read this:
31DEC2018 AGRIC 6 LABEQ 53
31DEC2018 AUTOS 51 MACH 96 • “FUN” is
31DEC2018 BANKS 437 MEALS 59 Entertainment
31DEC2018 BEER 11 MEDEQ 124
31DEC2018 BLDMT 55 MINES 16 • “LABEQ” is Measuring
31DEC2018 BOOKS 17 OIL 136
31DEC2018 BOXES 10 OTHER 21 and Control
31DEC2018 BUSSV 163 PAPER 26
31DEC2018 CHEMS 66 PERSV 30
Equipment
31DEC2018 CHIPS 153 RLEST 30
31DEC2018 CLTHS 30 RTAIL 140
Full details:
31DEC2018 CNSTR 44 RUBBR 17 https://mba.tuck.dartmo
31DEC2018 COAL 8 SHIPS 9
31DEC2018 DRUGS 486 SMOKE 3 uth.edu/pages/faculty/k
31DEC2018 ELCEQ 48 SODA 10
31DEC2018 FABPR 5 SOFTW 281
en.french/Data_Library/
31DEC2018 FIN 104 STEEL 28 det_49_ind_port.html
31DEC2018 FOOD 41 TELCM 72
31DEC2018 FUN 46 TOYS 21
31DEC2018 GOLD 9 TRANS 68
31DEC2018 GUNS 7 TXTLS 7 Q: Why are there such
31DEC2018 HARDW 39 UTIL 76
31DEC2018 HLTH 51 WHLSL 96 large differences in
31DEC2018 HSHLD 38
TOTAL 3456
number of firms across
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industries?
Session 2 Financial analysis

Common Size Balance Sheet

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Common Size Income Statement

For S&P Composite Index Firms

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Financial Ratios
For S&P Composite Index Firms

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