FINA2010 Financial Management

Lecture 2: Financial Statement Analysis

Instructor: Prof. Jangwoo Lee

CUHK Business School

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 Some Housekeeping Items
• Group Formation: email group info to the TA
by the 27th of January

• Assignment Due: Lecture 4 (6 Feb – 9 Feb)

•Midterm Exam: at LSK-LT5 from 19:00

to 20:30 on the 22nd of February.

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 Last Lecture
• Forms of business organization: sole
proprietorship, partnership, corporation

• Goal of financial management: maximize the

current stock price

• Financial management: capital budgeting,

capital structure, working capital management
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 Lecture Outline
• Financial Statements
– Balance Sheet
– Income Statement
– Statement of Cash Flows
• Ratio Analysis
• The Du Pont Identity
• Potential Problems with Financial Statement
Analysis

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 Learning Objectives
• Explain and list the type of information found
in financial statements
• Be able to compute and interpret important
financial ratios
• Be able to compute and interpret the Du Pont
Identity

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 The Annual Report
• An annual report is a report issued annually by a
corporation to the public. It contains basic financial
statements as well as management’s analysis of the
firm’s past operations and future prospects.
• Example: Hyatt Hotel Corporations: visit
http://investors.hyatt.com/investor-relations/financia
l-reporting/annual-reports/default.aspx
for its annual reports for the past a few years.

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 Financial Statements
• The importance of financial statements
– Stockholders
– Bondholders
– Regulators
– Competitors
– Employees…

Financial statements (or financial

report) are a formal record of the
financial activities and position of a
business, person, or other entity.
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 Luckin
Scandal
• Attention from international investors such as
BlackRock Inc. and support from banks
including Credit Suisse Group AG. Luckin went
public in the U.S. in May 2019, raising $561
million.

• In January 2020, just before the novel

coronavirus began roiling China’s economy,
Luckin’s stock reached $50 a share, almost
triple its offer price.

FINA 2010 8
 Luckin
Scandal
• On the last day of Jan 2020, a research
firm Muddy Waters shorted the stock,
and provided an 89-page report showing
that Luckin was inflating the number of
items sold per day by 69% in the third
quarter of 2019 and 88% in the fourth.
• Since all orders are placed through its
app, each has a sequential pickup
number. But Luckin, the document said,
seemed to be intentionally skipping
numbers during the day to give the
appearance of higher volume.
• As auditors from EY reviewed Luckin’s
2019 accounts, they found evidence that
some managers had been fabricating
transactions.
FINA 2010 9
 Luckin
Scandal

FINA 2010 10
 Financial Statements
• Balance Sheet: provides a snapshot of a firm’s
assets and liabilities at a given point in time.
• Income Statement: summarizes a firm’s
revenues and expenses over a given period of
time.
• Statement of Cash Flows: reports the impact of
a firm’s activities on cash flows over a given
period of time.

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 The Balance Sheet
What a
firm owns

< 1 year

What a
< 1 year
firm owes

Liquidity Seniority

• Net working capital is usually positive in a healthy firm.

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Examples of Current Assets / Current Liabilities

• Current Assets • Current Liabilities

-Cash and cash -Notes Payable
equivalents. -Accounts Payable
-Accounts receivable. -Short-Term Loan
-Inventory.

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Sample Balance Sheet
• Balance Sheet
Identity: Assets =
Liabilities +
Shareholders’ Equity
(Resources must
equal Claims)
• Value of items:
generally at original
cost (also known as
historical cost, book
value)

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 Leverage: Debt VS. Equity
• Creditors: first claim to the firm’s cash flow.
• Equity holders: the residual value.
– Shareholders’ equity = Assets − Liabilities
• The use of debt in a firm’s capital structure is called
financial leverage.
– The more debt a firm has (as a percentage of assets), the
greater is its degree of financial leverage.
• Financial leverage increases the potential reward to
shareholders, as well as the potential financial distress
and business failure.
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 Example: High vs. Low Leverage
• Firm A: 100$; 70$ debt &30 $equity
• Firm B: 100$; 50$ debt & 50 $ equity
• Debtholders require an interest of 10%
• Good economy: both A & B make an operating
profit of 150$
• Bad economy: both A & B make an operating profit
of 70$
• What can equity holders of A & B get in the good
and bad economy? (Ignore taxes)
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 Example: High vs. Low Leverage
• In Firm A, debtholders get first 77$
• In Firm B, debtholders get first 55$

• Good economy: both A & B make 150$

• A: 150$-77$=73$
• B: 150$-55$=95$

• Bad economy: both A & B make 70$

• A: All 77$ goes to debtholders
• B: 70$ - 55$ = 15$
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 Sample Income Statement

• EBIT – “Operating Profit”

• Both interests and depreciation can affect tax payments!

• Earnings per share (EPS) = Net income/Total shares outstanding
• Dividends per share = Total dividends/Total shares outstanding
• ∆Retained earnings = Net income − Dividends
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Retained Earnings

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 Statement of Cash Flows
• Sources of cash (activities that bring in cash):
– decreases in assets (other than cash)
– increases in equity and liabilities

• Uses of cash (activities that involve cash

outflows):
– increases in assets (other than cash)
– decreases in equity and liabilities

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 Quick Review MCQ
• A firm has $2,100 in net income, a tax rate of
35 percent, and interest expense of $700. What
is EBIT?
A. $3,535
B. $4,100
C. $6,700
D. $3,931
E. $4,520
• Answer: 2,100/(1 − 35%) + 700 = $3,931
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 Quick Review MCQ
• Which of the following is a source of cash?
A. The purchase of new fixed assets.
B. Dividends paid.
C. A decrease in long-term debt.
D. A decrease in inventory.
E. The repurchase of outstanding common stock.

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 Quick Review MCQ
• Your firm has total assets of $4,900, fixed assets of
$3,200, long-term debt of $2,900, and short-term
debt of $1,400. What is the amount of net working
capital?

A. -$100
B. $300
C. $600
D. $1,700
E. $1,800
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Use of Financial Statements

Standardization

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Standardized Financial Statements
• Common-Size Balance Sheets
– Compute all accounts as a percent of total assets
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Standardized statements make it easier to compare
financial information, particularly as the company
grows.
• They are also useful for comparing companies of
different sizes, particularly within the same industry.

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Normal VS. Common Size Balance Sheet

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 Ratio Analysis
• Ratios allow for better comparison through time or
between companies.
• Ratios are used both internally and externally.
• Time Trend Analysis (over time)
– Used to see how the firm’s performance is changing
through time
• Peer Group Analysis (with others)
– Compare to similar companies or within industries
– Standard Industrial Classification (SIC) and North
American Industry Classification System (NAICS) codes
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 What information is valuable?
• Four (types of) ratios
– Liquidity
– Long-term solvency
– Asset management
– Profitability
• Pay attention to the unit.(times, days, percent)

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 1. Liquidity Ratios
• Short-term solvency (liquidity) ratios indicate a firm’s
ability to meet its maturing short-term obligations.
• Can we make required payments as they become
due?
What are the short-term obligations for
hospitality/financial industry?

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Computing Liquidity Ratios
• Current ratio = Current
assets/Current liabilities =
708/540 = 1.31 times
• Quick ratio = (Current assets –
Inventory)/Current liabilities =
(708 − 422)/540 = 0.53 times
• Cash ratio = Cash/Current
liabilities = 98/540 = 0.18 times
• Net working capital (NWC) to
total assets = NWC/TA = (708 –
540)/3,588 = 4.7%

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 2. Long-term Solvency Ratios
• Long-term solvency (financial leverage) ratios show
how heavily the company is in debt.
• Do we have the right mix of debt and equity?
• Financial leverage relates to the extent that a firm
relies on debt financing rather than equity.
• Generally, the more debt a firm has, the more likely it
is the firm will become unable to fulfill its contractual
obligations.
• Measure two aspects of leverage: level of
indebtedness and the ability to service this debt

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Computing Long-term Solvency Ratios
• Total debt ratio = (Total assets –
Total equity)/Total assets = (3,588
– 2,591)/3,588 = 0.28 times
• Debt-equity ratio
= Total debt/Total equity
= 0.28/(1 – 0.28) = 0.39 times
• Equity multiplier
= Total assets/Total equity
= 1/(1 – 0.28) = 1.39 times
= 1 + Debt-equity ratio
• Long-term debt ratio = Long-term
debt/(Long-term debt + Total
equity) = 457/(457 + 2,591) = 0.15
times
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Computing Long-term Solvency Ratios

• Times interest earned (TIE)

ratio = EBIT/Interest =
691/141 = 4.9 times
– Also known as interest
coverage ratio

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 Quick Review MCQ
• If a firm has a debt-equity ratio of 1.0, then its
total debt ratio must be which one of the
following?

A. 0.0
B. 0.5
C. 1.0
D. 1.5
E. 2.0
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 3. Asset Management Ratios
• Asset management (turnover/efficiency/asset utilization)
ratios measure how effectively the firm’s assets are being
managed.
• Is the sales high enough for our assets?
• Inventory turnover ratios measure how quickly inventory is
produced and sold.
• Receivable turnover ratios provide information on the
success of the firm in managing its collection from credit
customers.
• Asset turnover ratios show how effective the firm is in using
its assets to generate sales.

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Inventory Turnover

• Inventory turnover = Cost of

goods sold/Inventory =
1,344/422 = 3.2 times

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Receivable Turnover

• Receivables turnover =
Sales/Accounts receivable =
2,311/188 = 12.3 times

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Asset Turnover

• NWC turnover = Sales/NWC =

2,311/(708 − 540) = 13.8 times
• Fixed asset turnover = Sales/Net
fixed assets = 2,311/2,880 = 0.8
times
• Total asset turnover = Sales/Total
assets = 2,311/3,588 = 0.64 times
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 4. Profitability Ratios
• Profitability ratios measure how successfully a
business earns a return on its investment.
• Do sales prices exceed unit costs, and are sales
high enough?
• Show the combined effects of liquidity, asset
management, and debts on operating results.

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Computing Profitability Ratios

• Profit margin = Net income/Sales

= 363/2,311 = 15.71%
• Basic earning power = EBIT/Total
assets = 691/3,588 = 19.26%

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Computing Profitability Ratios

• Return on assets (ROA) = Net

income/Total assets = 363/3,588
= 10.12%
• Return on equity (ROE) = Net
income/Total equity = 363/2,591
= 14.01%

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 More on ROA and ROE
• ROA is lowered by debt: interest expense
lowers net income, which also lowers ROA.
• However, the use of debt lowers equity, and if
equity is lowered more than net income, ROE
would increase.
• ROE is often used as a measure of how well
management is attaining the goal of owner
wealth maximization.

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 The DuPont System
ROE Decomposition
• Some profitability and efficiency measures can
be linked in useful ways.
• These relationships are often referred to as the
Du Pont system in recognition of the chemical
company that popularized them.
• Du Pont Identity: ROE = PM × TAT × EM
– where ROE is return on equity; PM is profit margin;
TAT is total asset turnover; EM is equity multiplier

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DuPont Identity Derivation

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Three Ratios of the DuPont Identity
• ROE = PM × TAT × EM
• Profit margin (PM) is a measure of the firm’s operating
efficiency – how well does it control costs
• Total asset turnover (TAT) is a measure of the firm’s
asset use efficiency – how well does it manage its
assets
• Equity multiplier (EM) is a measure of the firm’s
financial leverage
• Example on Lucky Corp.: ROE = PM × TAT × EM =
15.71% × 0.64 × 1.39 = 14%
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 Expanded DuPont Analysis

• Why Google’s ROE is so much higher?

– Asset utilization (higher total asset turnover)
• What accounts for the increase in Yahoo!’s ROE?
– Operating efficiency (higher profit margin)

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 Why Evaluate Financial Statements?
• Internal uses
– Performance evaluation: compensation and comparison
between divisions
– Planning for the future: guide in estimating future cash
flows
• External uses: firm’s financial health
– Creditors (E.g., assess overall creditworthiness)
– Suppliers (E.g., grant/extend credit)
– Customers (E.g., long-term business)
– Stockholders (E.g., profitability, growth)
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 Potential Problems with Financial Statement Analysis

• Different ratios may give different signals, difficult to tell the

financial condition of a company.
• Benchmarking (with industry averages) is difficult for diverse
firms (firms operate many different divisions).
• Globalization and international competition makes
comparison more difficult due to different accounting and
operating practices.
• Different fiscal years and seasonal factors can distort ratios.
• Extraordinary events can give misleading signals.
• Window dressing techniques can make statements and ratios
look better.

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 Quick Review MCQ
• Financial leverage refers to:
A. The amount of debt used in a firm’s capital
structure.
B. The ratio of retained earnings to shareholders’
equity.
C. The ratio of paid-in surplus to shareholders’ equity.
D. The ratio of cost-of-goods-sold to total sales.
E. The amount of receivables present in the firm’s
asset structure.

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 Quick Review MCQ
• Ratios that measure how efficiently a firm’s
management uses its assets in operations to
generate bottom line net income are known
as:
A. Asset management ratios.
B. Leverage ratios.
C. Liquidity ratios.
D. Market value ratios.
E. Profitability ratios.
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 Summary
• The main financial statements in the annual
report: Balance Sheet, Income Statement, and
Statement of Cash Flows
• Four major categories of ratios: liquidity, long-
term solvency, asset management, and
profitability
• Du Pont Identity: ROE = PM × TAT × EM

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 Information on the Web
• The Internet makes ratio analysis much easier
than it has been in the past.
• Go to https://finance.yahoo.com/
– Enter the ticker symbol of a company, e.g., ‘AAPL’
for Apple Inc., ‘0005.HK’ for HSBC Holdings
– Click on ‘Financials’ and ‘Statistics’ to see what
information is available

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