Key Financial Statements and Ratios Analysis
Financial Statement Analysis
Financial statements provide crucial insights into a company’s financial health and performance. Here’s a breakdown of key statements and concepts:
Key Financial Statements
- Balance Sheet: Shows a company’s assets, liabilities, and equity at a specific point in time.
- Income Statement: Reports a company’s revenues, expenses, and profits over a period.
- Statement of Cash Flows: Tracks the movement of cash both into and out of a company over a period.
- Statement of Stockholders’ Equity: Details changes in stockholders’ equity over a period.
Key Financial Formulas and Concepts
- Stockholders’ Equity: Paid-in Capital + Retained Earnings
- Stockholders’ Equity: Total Assets – Total Liabilities
- Working Capital: Current Assets – Current Liabilities
- Total Debt: Short-Term Debt + Long-Term Debt
- Total Liabilities: Total Debt + (Accounts Payable + Accruals)
- Depreciation: A non-cash expense reflecting the decline in value of tangible assets.
- Amortization: A non-cash expense reflecting the decline in value of intangible assets.
- EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization
- Free Cash Flow (FCF): Cash available for distribution to investors or reinvestment.
- Net Operating Profit After Taxes (NOPAT): Profit generated from operations if the company had no debt.
- Market Value Added (MVA): Market value of equity – Book value of equity
- Economic Value Added (EVA): NOPAT – Capital costs
Taxation Concepts
- Progressive Tax: Tax rate increases with income.
- Marginal Tax Rate: Tax rate on the last dollar of income.
- Average Tax Rate: Taxes paid / Taxable income
- Capital Gain: Profit from selling an asset for more than its purchase price.
- Capital Loss: Loss from selling an asset for less than its purchase price.
Financial Ratio Analysis
Financial ratios help assess a company’s performance and financial health across different areas:
Liquidity Ratios
Measure a company’s ability to meet short-term obligations:
- Current Ratio: Current Assets / Current Liabilities
- Quick Ratio (Acid Test): (Current Assets – Inventories) / Current Liabilities
Asset Management Ratios
Measure how efficiently a company uses its assets:
- Inventory Turnover Ratio: Cost of Goods Sold / Inventories
- Days Sales Outstanding (DSO): Accounts Receivable / Average Sales per Day
- Fixed Assets Turnover Ratio: Sales / Net Fixed Assets
- Total Assets Turnover Ratio: Sales / Total Assets
Debt Management Ratios
Measure a company’s ability to manage its debt:
- Total Debt to Total Capital: Total Debt / Total Capital
- Times-Interest-Earned (TIE) Ratio: EBIT / Interest Charges
Profitability Ratios
Measure a company’s profitability:
- Operating Margin: Operating Income / Sales
- Profit Margin: Net Income / Sales
- Return on Total Assets (ROA): Net Income / Total Assets
- Return on Common Equity (ROE): Net Income / Common Equity
- Return on Invested Capital (ROIC): After-Tax Operating Income / Total Invested Capital
- Basic Earning Power (BEP) Ratio: EBIT / Total Assets
Market Value Ratios
, which give an idea of what investors think about the firm and its future prospects. – Liquid asset: An asset that can be converted to cash quickly without having to reduce the asset’s price very much. – Liquidity ratios: Ratios that show the relationship of a firm’s cash and other current assets to its current liabilities. – Current ratio: This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. – Quick, or acid test, ratio: This ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities. – Asset management ratios: A set of ratios that measure how effectively a firm is managing its assets. – Inventory turnover ratio: This ratio is calculated by dividing cost of goods sold by inventories. It indicates how many times inventory is turned over during the year. – Days Sales Outstanding Ratio: This ratio is calculated by dividing accounts receivable by average sales per day. It indicates the average length of time the firm must wait after making a sale before it receives cash. – Fixed assets turnover ratio: The ratio of sales to net fixed assets. It measures how effectively the firm uses its plant and equipment. – Total assets turnover ratio: This ratio is calculated by dividing sales by total assets. It measures how effectively the firm uses its total assets. – Debt management ratios: A set of ratios that measure how effectively a firm manages its debt. – Total debt to total capital: The ratio of total debt to total capital; it measures the percentage of the firm’s capital provided by debtholders. – Times-interest-earned (TIE) ratio: The ratio of earnings before interest and taxes (EBIT) to interest charges; a measure of the firm’s ability to meet its annual interest payments. – Profitability ratios: A group of ratios that show the combined effects of liquidity, asset management, and debt on operating results. – Operating margin: This ratio measures operating income, or EBIT, per dollar of sales; it is calculated by dividing operating income by sales. – Profit margin: This ratio measures net income per dollar of sales and is calculated by dividing net income by sales. – Return on total assets (ROA): The ratio of net income to total assets; it measures the rate of return on the firm’s assets. – Return on common equity (ROE): The ratio of net income to common equity; it measures the rate of return on common stockholders’ investment. – Return on invested capital (ROIC): The ratio of after-tax operating income to total invested capital; it measures the total return that the company has provided for its investors. – Basic earning power (BEP) ratio: This ratio indicates the ability of the firm’s assets to generate operating income; it is calculated by dividing EBIT by total assets. – Price/earnings (P/E) ratio: The ratio of the price per share to earnings per share; shows the dollar amount investors will pay for $1 of current earnings. – Enterprise value/EBITDA (EV/EBITDA) ratio: The ratio of a firm’s enterprise value relative to its EBITDA. – Weighted average cost of capital, WACC: A weighted average of the component costs of debt, preferred stock, and common equity. – After-tax cost of debt: The relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC. – Retained earnings breakpoint: The amount of capital raised beyond which new common stock must be issued. – Modified IRR (MIRR): The discount rate at which the present value of a project’s cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm’s cost of capital. – Payback period: The length of time required for an investment’s cash flows to cover its cost. – Incremental cash flows: Cash flows that will occur if and only if the firm takes on a project. – Sunk cost: A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. – Externalities: Effects on the firm or the environment that are not reflected in the project’s cash flows. – Cannibalization: The situation when a new project reduces cash flows that the firm would otherwise have had. – Stand-alone risk: The risk an asset would have if it were a firm’s only asset and if investors owned only one stock. It is measured by the variability of the asset’s expected returns. – Corporate, or within-firm, risk: Risk considering the firm’s diversification, but not stockholder diversification. It is measured by a project’s effect on uncertainty about the firm’s expected future returns. – Market, or beta, risk: Considers both firm and stockholder diversification. It is measured by the project’s beta coefficient. – risk-adjusted cost of capital: The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital. – Sensitivity analysis: Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant. – Base-case NPV: The NPV when sales and other input variables are set equal to their most likely (or base-case) values. – Monte Carlo simulation: A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes. – Replacement chain (common life) approach: A method of comparing projects with unequal lives that assumes that each project can be repeated as many times as necessary to reach a common life. The NPVs over this life are then compared, and the project with the higher common-life NPV is chosen. – Equivalent annual annuity (EAA) method: A method that calculates the annual payments that a project will provide if it is an annuity. When comparing projects with unequal lives, the one with the higher equivalent annual annuity (EAA) should be chosen.
