Investment analysis and portfolio management 8th reilly and brown chapter 010

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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K Reilly & Keith C Brown Chapter 10 Chapter 10 Analysis of Financial Statements Questions to be answered: • What are the major financial statements provided by firms and what specific information does each of them contain? • Why we use financial ratios to examine the performance of a firm and why is it important to examine performance relative to the economy and a firm’s industry? Chapter 10 Analysis of Financial Statements • What are the major categories for financial ratios and what questions are answered by the ratios in these categories? • What specific ratios help determine a firm’s internal liquidity, operating performance, risk profile, growth potential, and external liquidity? • How can the DuPont analysis help evaluate a firm’s return on equity over time? Chapter 10 Analysis of Financial Statements • What is a quality balance sheet or income statement? • Why is financial statement analysis done if markets are efficient and forward-looking? Chapter 10 Analysis of Financial Statements • What major financial ratios help analysts in the following areas: stock valuation, estimating and evaluating systematic risk, predicting the credit ratings on bonds, and predicting bankruptcy? Major Financial Statements • Corporate shareholder annual and quarterly reports must include – Balance sheet – Income statement – Statement of cash flows • Reports filed with Securities and Exchange Commission (SEC) – 10-K and 10-Q Generally Accepted Accounting Principles (GAAP) • Formulated by the Financial Accounting Standards Board (FASB) • Provides some choices of accounting principles • Financial statements footnotes must disclose which accounting principles are used by the firm Balance Sheet • Shows resources (assets) of the firm and how it has financed these resources • Indicates current and fixed assets available at a point in time • Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity Income Statement • Contains information on the profitability of the firm during some period of time • Indicates the flow of sales, expenses, and earnings during the time period Statement of Cash Flows • Integrates the information on the balance sheet and income statement • Shows the effects on the firm’s cash flow of income flows and changes in various items on the balance sheet Estimating Systematic Risk • Variability Measures Variance of operating earnings Coefficient of variation of operating earnings Coefficient of variation of operating profit margins Operating earnings beta (company earnings related to aggregate earnings) Estimating Systematic Risk • Nonratio Variables Asset size Market value of stock outstanding Estimating the Ratings on Bond • Financial Ratios Long-term debt/total assets Total debt/total capital Net income plus depreciation (cash flow)/long term senior debt Cash flow/total debt Net income plus interest/interest expense (fixed charge coverage) Cash flow/interest expense Estimating the Ratings on Bond Market value of stock/par value of bonds Net operating profit/sales Net income/owners’ equity (ROE) 10 Net income/total assets 11 Working capital/sales 12 Sales/net worth (equity turnover) Estimating the Ratings on Bond • Variability Ratios Coefficient of variation (CV) of net earnings Coefficient of variation of return on assets • Nonratio variables Subordination of the issue Size of the firm (total assets) Issue size Par value of all publicly traded bonds of the firm Predicting Insolvency (Bankruptcy) • Financial Ratios Cash flow/total debt Cash flow/long-term debt Sales/total assets Net income/total assets EBIT/total assets Total debt/total assets Financial Ratios and Insolvency (Bankruptcy) Market value of stock/book value of debt Working capital/total assets Retained earnings/total assets 10 Current ratio 11 Working capital/sales Limitations of Financial Ratios • Accounting treatments may vary among firms, especially among non-U.S firms • Firms may have have divisions operating in different industries making it difficult to derive industry ratios • Results may not be consistent • Ratios outside an industry range may be cause for concern Summary • Financial statement analysis help investors make decisions on investing in a firm’ s bonds or stock • A trend analysis of a firm’s financial ratios will be insightful • Financial ratios should be examined relative to the economy, the firm’s industry, and the firm’s main competitors Summary • The specific ratios can be divided into four categories: – – – – Internal liquidity Operating performance Risk analysis Growth analysis Summary • Analysts must consider differences in format and in accounting principle that cause different values for specific ratio when analyzing the financial statements for non-US firms Summary • Four major uses of financial ratios : – – – – Stock valuation Analysis of variables affecting a stock’s systematic risk Assigning credit ratings on bonds Predicting insolvency (bankruptcy) The Internet Investments Online http://www.walgreens.com http://www.cvs.com http://www.riteaid.com http://www.longs.com http://www.sec.gov http://www.hoovers.com http://www.dnb.com End of Chapter 12 –Analysis of Financial Statements Future topics Chapter 11 • An Introduction to Security Valuation ... ratios to examine the performance of a firm and why is it important to examine performance relative to the economy and a firm’s industry? Chapter 10 Analysis of Financial Statements • What are... DuPont analysis help evaluate a firm’s return on equity over time? Chapter 10 Analysis of Financial Statements • What is a quality balance sheet or income statement? • Why is financial statement analysis. .. markets are efficient and forward-looking? Chapter 10 Analysis of Financial Statements • What major financial ratios help analysts in the following areas: stock valuation, estimating and evaluating
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