Chapter Nineteen
Financial Statement Analysis
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Financial Statement Analysis
• Financial statement analysis can be used
to discover mispriced securities.
• Financial accounting data are widely
available; however, accounting earnings
and economic earnings are not always the
same thing.
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Financial Statements
• Income Statement:
– Profitability over time
• Balance Sheet:
– Financial condition at a point in time
• Statement of Cash Flows:
– Tracks the cash implications of
transactions.
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Accounting Versus Economic Earnings
• Economic earnings
– Sustainable cash flow that can be paid to
stockholders without impairing productive
capacity of the firm
• Accounting earnings
– Affected by conventions regarding the
valuation of assets
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Table 19.1 Consolidated Statement of
Income for Home Depot, 2012
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Table 19.2 Consolidated Balance Sheet for
Home Depot, 2012
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Table 19.3 Statement of Cash Flows for
Home Depot, 2012
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Measuring Firm Performance
• Manager responsibilities:
– 1. Investment decisions
– 2. Financing decisions
• Ratios used to show efficiency and profitability of
these decisions:
– ROA- income earned per dollar deployed
– ROC- income earned per dollar invested (long term)
– ROE net income realized by shareholders per dollar
invested
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Measuring Firm Performance
• ROE is a key determinant of earnings
growth.
• Past profitability does not guarantee future
profitability.
• Security values are based on future
profits.
• Expectations of future dividends determine
today’s stock value.
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Financial Leverage and ROE
• ROE can differ from ROA because of
leverage.
• Leverage makes ROE more volatile.
• Let t=tax rate and r=interest rate, then:

Debt 
ROE  1  t ROA  ROA  r 

Equity 

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Financial Leverage and ROE

Debt 
ROE  1  t ROA  ROA  r 

Equity 

• If there is no debt or ROA = r, ROE will simply
equal ROA(1 - t).
• If ROA > r, the firm earns more than it pays
out to creditors and ROE increases.
• If ROA < r, ROE will decline as a function of
the debt-to-equity ratio.
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Table 19.5 Impact of Financial
Leverage on ROE
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Economic Value Added
• EVA is the difference between return on
assets (ROA) and the opportunity cost of
capital (k), multiplied by the capital invested
in the firm.
• EVA is also called residual income
• If ROA > k, value is added to the firm.
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Example 19.2 Intel
• In 2012, Intel’s cost of capital was 7.8%.
Its ROA was 13.9% and its capital base
was $56.34 billion.
• Intel’s EVA =
(0.139-0.078) x $56.34 billion = $3.44 billion
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Decomposition of ROE
DuPont Method
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡𝑠
𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 =
=
×
×
×
×
𝐸𝐵𝐼𝑇
𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡𝑠
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦
(2)
(4)
(3)
(5)
(1)
1.
2.
3.
4.
5.
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Tax Burden
Interest Burden
Margin
Turnover
Leverage
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Decomposition of ROE
ROA=EBIT/Sales x Sales/Assets
= margin x turnover
• Margin and turnover are unaffected by
leverage.
• ROA reflects soundness of firm’s
operations, regardless of how they are
financed.
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Decomposition of ROE
ROE=Tax burden x ROA x Compound leverage
factor
• Tax burden is not affected by leverage.
• Compound leverage factor= Interest
burden x Leverage
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Table 19.7 Ratio Decomposition Analysis
for Nodett and Somdett
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Choosing a Benchmark
• Compare the company’s ratios across
time.
• Compare ratios of firms in the same
industry.
• Cross-industry comparisons can be
misleading.
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Table 19.8 Differences between Profit Margin
and Asset Turnover across Industries
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Table 19.9 Summary of Key Financial Ratios
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Table 19.9 Summary of Key Financial Ratios
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Table 19.9 Summary of Key Financial Ratios
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Table 19.9 Summary of Key Financial Ratios
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Table 19.10 Summary of Key Financial Ratios
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Figure 19.3 DuPont Decomposition for
Home Depot
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Comparability Problems
• Accounting Differences
– Inventory Valuation
– Depreciation
• Inflation and Interest Expense
• Fair Value Accounting
• Quality of Earnings
• International Accounting Conventions
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International Accounting Differences
• Reserves – many other countries allow more
flexibility in use of reserves
• Depreciation – US allows separate tax and
reporting presentations
• Intangibles – treatment varies widely
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Figure 19.4 Adjusted Versus Reported
Price-Earnings Ratios
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The Graham Technique
• Rules for stock selection:
– Purchase common stocks at less than their
working-capital value.
– Give no weight to plant or other fixed assets.
– Deduct all liabilities in full from assets.
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