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by: Greg Flatley PhD


Greg Flatley PhD
GPA 3.85


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Class Notes
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This 8 page Class Notes was uploaded by Greg Flatley PhD on Thursday October 22, 2015. The Class Notes belongs to ENGR 191B at University of California Santa Barbara taught by Staff in Fall. Since its upload, it has received 54 views. For similar materials see /class/226925/engr-191b-university-of-california-santa-barbara in Applied Science at University of California Santa Barbara.




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Date Created: 10/22/15
OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS 1 Equity Investment Here look at risk vs return take into account in ation recessions etc Credit Extension Look at nancial statements to determine the short term cash generating ability Corporate bond Investment Here look at the longrun viability of the rm based on nancial statements and the economic factors SupplierCustomer health Use nancial statements to assess the health of key suppliers or customers to whom you extend credit Competitor analyses Analyze nancial statements to determine market share pricing product miXetc Businesses can be seen as having three main activities Operating Producing and or distributing a good or service Financing Raising capital to fund operations thru common stock bonds preferred stock or bank nancing Investing Investing the capital in Property Plant amp Equipment PPE Financial Statement Analysis is used to see how well a rm is doing these three activities Data Issues in FSA Need to keep in mind several data issues when begin comparing the performance of a rm to either its historical performance or that of other similar firms Speci cally the data issues to consider are l 59 Nonrecurring Income Restated nancial statements Reporting Periods Account Classi cation 5 Accounting Principles Technigues Trend Analysis Common size Cross Sectional Analysis ROA Return on Assets How well able to generate a return from the assets they used independent of the nancing used ROA Net Income 1 lTax Rate 1 Interest Expense Average Total Assets Income from continuing operations Tax Rate ltax rate interest expense gives you the true quotaftertaxquot cost of the debt Average assets can either be an average of the level at the beginning and end of each year or can be an average of total assets levels for each qtr used if it uctuates greatly Important to look at ROA in context of what is average for that specific industry Breaking ROA Down ROA Pro t Margin X Asset Turnover Net income interest expense lt X Sales Sales Avg Total Assets When you look at ROA this way you can then begin to determine whether the difference in ROA between two rms stems from a higher lower pro t margin or is a result of a higher lower Asset Turnover Rate From an economic perspective there is a risk return tradeoff Following this theory high risk rms should have high ROAs Pro t Margin Asset Turnover amp Business Strategy Firms can choose to follow one of two alternative strategies for a product 1 Product differentiation or 2 Low Cost Leadership look at differences in pro t margins and assets turnovers between rms in the same industry Result from choice of 1 Product differentiation Brand Loyalty 2 Low Cost Leadership economies of scale or production efficiencies See this in the Retailing industry Pro t Margin Asset Turnover Specialty Retailers 525 19 Department Stores 358 23 Grocery Stores 150 50 exception is gourmet specialty groceries Steps in an ROA analysis When comparing two or more similar rms 1 Compare each rms ROA to the other rms and to the industry average 2 Then look at the pro t margins vs the industry A Examine internal strategic reasons for this Higher pro t margin brand loyalty Higher Asset turnover lowcost leadership B External factors which would affect the pro t marginasset turnover mix such as 0 degree of competition 0 regulation 0 entry barriers Other Reasons for Differences in ROA There are two main economic reasons for differences in Pro tability ROA between industries or firms or same rm over different time periods 1 operating leverage ampor 2 Stage in Product Life Cycle Operating Leverage Operating leverage amount of xed costs a rm has to cover the higher the degree of operating leverage the greater the variability of net income and thus ROA because the xed costs are spread over a greater of units when sales increase so margins increase and xed costs are spread over a reduced of units when sales drop so the pro t margin shrinks quite dramatically Cyclical businesses with a high degree of operating leverage will exhibit the greatest variation in ROAs from year to year Cyclical businesses without high degrees of fixed costs will have less uctuation in ROA because they don t have the xed costs to magnify the effect of the cyclical business During rst two stages in lifecylce objective is to gain market acceptance amp market share therefore focus is on 0 product development RampD costs 0 market development amp penetration advert amp promo costs 0 increasing capacity capital expenditures Costs tend to be high here ROA tends to be low here due to high investment upfront and not having realized the increased revenues from these efforts yet Operating income lags the expenditures for RampD and advertising by several cycles so see high costs and low profitability in the early years as all the capital and longer term investment into a product is being made Maturity Phase Many firms begin to enter that industry as the see the revenue potential Competition increases and price competition becomes a major factor here cost cutting becomes a major emphasis and ROAs hit their highest level have the increased revenue from the effects of earlier advertising and RampD and many efficiciencies from economies of scale and the learning curve effect and not many expenditures are being made See a trend towards Improved capacity utilization More efficient production Decline phase Firms exit the industry as sales decline and profit opportunities diminish ROA profits will drop ROCE Return on Common Shareholder s Equity ROE ROCE the portion of the return which is allocable to the common shareholders ROCE Net Income Preferred Dividends Average Common Shareholder s Equity Common Shareholder s equity Total Shareholder s Equity par value of preferred stock Comparing ROA t0 ROCE ROA total return on the assets of the firms This return is then allocated to l the bondholders 2 the preferred shareholders and then 3 lastly the common shareholders The return allocated to the common shareholders is a residual and is the ROCE The ROCE can be gt lt or to the firms overall ROA If the firm used financia leverage correctly where financial leverage is incurring the fixed cost of debt and preferred stock ot magnify earnings then the ROCE will exceed the ROA This means the xed return the rm pays its creditors and preferred shareholders is less than the overall ROA and thus the ROCEgtROA Earnings Per Common Share Common Shareholders often also look at Earnings Per Share when assessing a firms39 profitability EPS Net Income Pref Stock Dividends Weighted Avg Common Shares Outstanding only works if the firm has a simple capital structure ie doesn t have convertible bonds or convertible preferred stock Example Firm has a net income of 10500 It had 5000 shares of common stock issued at the beginning of the year At the end of the third quarter 34 of the way thru the year it repurchased 1000 shares of common which is now held as treasury stock reducing the number of shares outstanding to 4000 shares by the end of the year note this transaction will show up in the Treasury Stock Common Account It paid out 700 in preferred stock dividends will show up in the income statement There are no stock options or warrants outstanding and the preferred stock is not convertible EPS 10500700 98004750 75 5000 25 4000 EPS 206 Risk Analysis Firm specific risk Firms generate cash ows from operations investing and financing There are two risk concerns when it comes to cash ow 1 What is the firms short term ability to generate cash for working capital amp day to day operations This ties in with the cash flow from operations Short term liquidity risk ratios are used 2 What is the firms ability to repay its long term debt and interest on that debt This ties in with cash ow from financing and investment I Long term debt ratios are used The cash flows from these various sources fluctuates according to the product lifecycle Short term liguiditu assessment technigues 1 Current ratio current assetscurrent liabilities Tends towards 10 2 Quick ratio limits numerator to only those assets quickly convertible to cash Cashz Marketable Securities amp receivables current liabilities Tends towards 05 Closely correlated to the Current Ratio 3 Operating Cash flow to Current Liabilities Ratios Overcomes the problems found with using current ratios or quick ratios cash ows from continuing operations Average Current Liabilities Can also look at turnovers Ability to generate cash in the short term from operations Collecting A R amp Selling goods from inventory Paying A P is a drain on Short term cash ows A R turnover Sales Avg AR Inv Turnover COGS Avg Inventory A P Turnover Purchases Avg AP purchases COGS Ending inventory Beginning inventory Firm can still be in a good short term liquidity position becuase they have the ability to generate a lot of cash in the short term as indicated by turnover ratios Ability to Service Debt I Amount of Debt DebtEquity ratio Longterm DebtAssets Ratio II Can also look at the ability of the firm to pay the interest on its debt interest coverage ratio net income interest exp Income tax expense Interest Expense III Also need to consider the firms ability to generate cash ow from operations to service debt Two ratios used here Operating cash ow to total liabilities ratio Cash ow from continuing operations Avg Total Liabilities 20 or more is common 2 Operating cash ow to Capital Expenditures Ratio cash ow from continuing operations Capital expenditures


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