Groslambert – Skema Business School
Analysis of financial statements
Bertrand Groslambert
[email protected]
Skema Business School
Portfolio Management
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Groslambert – Skema Business School
Course Outline

Introduction (lecture 1)



Modern Portfolio Theory (lectures 2-4)





The risk return framework Chap.1
Efficient capital markets Chap.6
The price of risk Chap.7,8
Asset pricing models Chap.9
Fundamental Analysis (lectures 5-8)






Presentation of portfolio management Chap.2,3,5
Introduction to Bloomberg
Analysis of financial statement Chap.10
Industry analysis Chap.12,13
Absolute and relative valuation analysis Chap.11, 14
Stock market valuation analysis Chap.12
Technical analysis (lecture 9) Chap.15
The asset management industry (lecture 10)



Portfolio management strategies Chap.16
The different types of investment companies Chap.24
Evaluation of portfolio performance Chap.25
NB: chapters refer to Reilly & Brown 8th and 9th ed.
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Financial Statements, what for?
Financial statements, by their nature, are
backward-looking, so why analyze the
statements?
 If market is not efficient, it may not yet have
incorporated these past results into security
prices
 This helps in estimating future returns

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Financial Statements, what for?

Stock valuation

Assigning credit quality ratings on bonds

Predicting insolvency (bankruptcy) of firms
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Analysis of Financial Statements






Major Financial Statements
Analysis of Financial Ratios
Computation of Financial Ratios
Evaluating Internal Liquidity
Evaluating Operating Performance
Risk Analysis
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Major Financial Statements

Corporate shareholder annual and quarterly reports must
include

Income statement
– Indicates the flow of sales, expenses, and earnings during the time period

Balance sheet

Statement of cash flows
– Indicates current and fixed assets available at a point in time
– Integrates the information on the balance sheet and income statement

Reports filed with the S.E.C.



10-K
10-Q
See Bloomberg FA and then Transparency to find the source
of data
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What’s the business model?
 What
do they do?
 How do they do?
 Who are their clients?
 Who their competitors?
 How is the market growing?
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What’s the business model?

Bloomberg DES
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What’s the business model?
Bloomberg DES => 5)Pharmacies and Drugstore
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What’s the business model?

Bloomberg DES => 5)Pharmacies and Drugstore => 5)Hierarchy (ICS)
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What’s the business model?

Bloomberg Industry Analysis BI
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Major Financial Statements

Bloomberg FA
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Income statement
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Balance sheet
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Walgreen balance sheet
Field
Assets
Cash & Near Cash Items
Short-Term Investments
Accounts & Notes Receivable
Inventories
Other Current Assets
Total Current Assets
LT Investments & LT Receivables
Net Fixed Assets
Gross Fixed Assets
Accumulated Depreciation
Other Long-Term Assets
Total Long-Term Assets
Total Assets
FY 2012
1297
0
2167
7036
260
10760
0
12038
17160
5122
10664
22702
33462
FY 2011
1556
0
2497
8044
225
12322
0
11526
15834
4308
3606
15132
27454
Field
Liabilities & Shareholders' Equity
Accounts Payable
Short-Term Borrowings
Other Short-Term Liabilities
Total Current Liabilities
Long-Term Borrowings
Other Long-Term Liabilities
Total Long-Term Liabilities
Total Liabilities
Total Preferred Equity
Minority Interest
Share Capital & APIC
Retained Earnings & Other Equity
Total Equity
Total Liabilities & Equity
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FY 2012
4384
1319
3019
8722
4073
2431
6504
15226
0
0
1016
17220
18236
33462
FY 2011
4810
13
3260
8083
2396
2128
4524
12607
0
0
914
13933
14847
27454
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Balance sheet

What’s behind these numbers?
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Balance sheet

Company news
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Balance sheet

Financed through LT Debt and Equity


Equity (treasury shares and retained earnings)
Long term and short term borrowings
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Cash flow statement
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Common size statements
Balance Sheet as a % of total assets
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Common size statements
Income Statement as a % of sales
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Walgreen: Sales and EPS
Bloomberg Graph GF

Sales and EPS
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How does Walgreen growth compare
with its main competitors?

Use the Bloomberg RV command
 Select
the custom tab and choose the relevant
indicators
 Select the comparable peers by choosing the
region

NB: This can also be done with the command
EQS
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Importance of
Relative Financial Ratios
Compare to other entities
 Examine a firm’s performance relative to:

 The
aggregate economy
 Its industry or industries
 Its major competitors within the industry
 Its past performance (time-series analysis)
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Financial ratios
Financial ratios cannot be used in isolation
 Financial ratios must be

 Compared
with historical trends
 Compared
with peers
– Relative value (RV in Bloomberg)
– One must define who are the peers
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Four Categories of Financial Ratios
1. Internal liquidity (solvency)
2. Operating performance


a. Operating efficiency
b. Operating profitability
3. Risk analysis



a. Business risk
b. Financial risk
c. External liquidity risky
4. Growth analysis
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Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate the ability to meet
future short-term financial obligations

Current Ratio examines current assets and current liabilities
Current Assets
Current Ratio 
Current Liabilitie s

Quick Ratio adjusts current assets by removing less liquid assets
Quick Ratio 

Cash  Marketable Securities  Receivable s
Current Liabilitie s
Cash Ratio is the most conservative liquidity ratio
Cash Ratio 
Cash  Marketable Securities
Current Liabilitie s
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Internal Liquidity (FA)
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Internal Liquidity
Industry comparison (RV)
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Financial Risk

Current ratio for various industries
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Evaluating Operating Performance

Ratios that measure how well management is
operating a business
 (1)
Operating efficiency ratios
– Examine how the management uses its assets and
capital, measured in terms of sales dollars generated
by asset or capital categories
 (2)
Operating profitability ratios
– Analyze profits as a percentage of sales and as a
percentage of the assets and capital employed
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Operating Efficiency Ratios

Total asset turnover ratio indicates the effectiveness of a firm’s
use of its total asset base
Total Asset Turnover 

Net fixed asset turnover reflects utilization of fixed assets
Fixed Asset Turnover 

Net Sales
Average Total Net Assets
Net Sales
Average Net Fixed Assets
Equity turnover examines turnover for capital component
Equity Turnover 
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Net Sales
Average Equity
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Operating Profitability Ratios

Gross profit margin measures the rate of profit on
sales
Gross Profit Margin 

Operating profit margin measures the rate of profit
on sales after operating expenses
Operating Profit Margin 

Gross Profit
Net Sales
Operating Profit
Net Sales
Net profit margin relates net income to sales
Net Profit Margin 
Net Income
Net Sales
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Operating Profitability Ratios

Return on total capital relates the firm’s earnings to all capital
in the enterprise
Return on Total Capital 
Net Income  Interest Expense
Average Total Capital
Return on Total Capital = Return on Invested Capital
Return on owner’s equity (ROE) indicates the rate of return
earned on the capital provided by the stockholders after paying
for all other capital used
Return on Total Equity 
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Net Income
Average Total Equity
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Walgreen
efficiency and profitability ratios
Name
Mkt Cap
Asset
Turnover
LF
Net Fixed
Asset
Turnover
LF
Average
WALGREEN CO
CVS CAREMARK CORP
RITE AID CORP
SHOPPERS DRUG MART CORP
27874,5
37927,1
63643,7
1482,3
8445,0
2,3
2,3
1,8
3,5
1,5
10,0
5,9
14,1
13,6
6,2
ROIC:Y
ROE:Y
9,9
10,4
7,7
12,2
12,9
9,1
11,7
14,5
Gross
Operating
Profit
Margin:Y Margin:Y Margin:Y
28,1
28,4
19,2
26,0
38,7
5,0
4,8
5,9
0,6
8,7
2,7
3,0
3,2
-1,4
5,9
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Operating Profitability Ratios

The DuPont System divides the ratio into
several components that provide insights into
the causes of a firm’s ROE and any changes
in it
ROE 
ROE 
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Net Income
Common Equity
Net Income
Sales
Total Assets


Sales
Total Assets Common Equity
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Dupont Analysis for Walgreen
Bloomberg: FA, ratio tab, Dupont tab

Why is Walgreen ROE down for the past 5 years?
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Comparing ROE vs ROA
 Paul
and Jacques start a new business each with
$10,000
 In addition Paul borrows $10,000 and Jacques
$2,000
 One year later, net incomes are respectively
Jacques $4,000 for Paul and $3,000 for Jacques
 Who was the best manager?
 Who generate the highest profitability?
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Comparing ROE vs ROA

Comparing ROE vs ROA
Paul
 ROE
:
 ROA :

Jacques
4,000 / 10,000 = 40%
3,000 / 10,000 = 30%
4,000 / 20,000 = 20%
3,000 / 12,000 = 25%
You are invited to join into their business.
Where would you put your money?
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Risk Analysis

Risk analysis examines the uncertainty of
income flows for the total firm and for the
individual sources of capital
 Debt
 Preferred
stock
 Common stock
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Risk Analysis

Total risk of a firm has two components:

Business risk
– The uncertainty of income caused by the firm’s
industry
– Generally measured by the variability of the firm’s
operating income over time

Financial risk
– Additional uncertainty of returns to equity holders
due to a firm’s use of fixed obligation debt securities
– The acceptable level of financial risk for a firm
depends on its business risk
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Business risk
Variability of the sales
 Variability of the earnings depends on

 the
variability of sales
and
 the proportion of fixed costs

Assignment: using Bloomberg create a
measure of business risk for your stock
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Financial Risk

Relationship between business risk and
financial risk
 Acceptable
level of financial risk for a firm
depends on its business risk
 Acceptable level of financial risk for a firm
depends on its industry and the proportion of fixed
assets
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Financial Risk

Proportion of debt (balance sheet) ratios indicate
what proportion of the firm’s capital is derived from
debt compared to other sources of capital, such as
preferred stock, common stock, and retained
earnings.
Debt/Equity Ratio 
Total Long - Term Debt
Total Equity
This may be computed with and without deferred taxes
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Financial Risk

Long-term debt/total capital ratio indicates the
proportion of long-term capital derived from
long-term debt capital
L.T. Debt / Total L.T. Capital Ratio

Total Long Term Debt
Total Long Term Capital
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Financial Risk

Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)
Total Interest Bearing Debt
Total Capital
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Financial Risk

Total Debt/Total Assets for various industries
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Financial Risk

Earnings or Cash Flow Ratios
 Relate
the flow of earnings
 Cash available to meet the payments
 Higher ratio means lower risk
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Financial Risk

Interest Coverage

Income Before Interest and Taxes (EBIT)
Debt Interest Charges

Net Income  Income Taxes  Interest Expense
Interest Expense
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Financial Risk

Cash flow ratios relate the flow of cash available from
operations to either interest expense, total fixed charges,
or the face value of outstanding debt




Cash flow coverage
Cash flow / Long-term Debt
Cash flow / Total Debt
Alternative Measures of Cash Flow


Cash flow from operation
Free cash flow
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Financial Risk

Net debt to EBITDA for various industries
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External Market Liquidity
External market liquidity is a source of risk to
investors
 Determinants of Market Liquidity

 The
dollar value of shares traded
– This can be estimated from the total market value of
outstanding securities
– It will be affected by the number of security owners
– Numerous buyers and sellers provide liquidity
A
measure of market liquidity is the bid-ask
spread
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External Market Liquidity

Walgreen volume
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Comparative Analysis of Ratios

Internal liquidity
 Current

ratio, quick ratio, and cash ratio
Operating performance
 Efficiency
ratios and profitability ratios
Risk Analysis
 Growth analysis (to be addressed in the Industry lecture)

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The Value of
Financial Statement Analysis
Groslambert – Skema Business School
Financial statements, by their nature, are
backward-looking
 An efficient market will have already
incorporated these past results into security
prices, so why analyze the statements?
 Analysis provides knowledge of a firm’s
operating and financial structure
 This helps in estimating future returns

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Specific Uses of Financial Ratios
1. Stock valuation
2. Identification of corporate variables affecting
a stock’s systematic risk (beta)
3. Assigning credit quality ratings on bonds
4. Predicting insolvency (bankruptcy) of firms
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Stock Valuation Models
Valuation models attempt to derive a value
based upon one of several cash flow or
relative valuation models
All valuation models are influenced by:


Expected growth rate of earnings, cash flows, or
dividends
Required rate of return on the stock
Financial ratios can help in estimating these
critical inputs
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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

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