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6-1 Notes
CHAPTER 6
INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
I. Learning Objectives
1. Understand the relation between the expected return and risk of
investment alternatives and the role financial statement analysis plays in
providing information about returns and risk.
2. Understand the usefulness of the rate of return on assets (ROA) as a
measure of a firm’s operating profitability independent of financing and the
insights gained by disaggregating ROA into profit margin for ROA and the
total assets turnover ratios.
3. Understand the usefulness of the rate of the return on common
shareholders’ equity (ROCE) as a measure of profitability that incorporates
a firm’s financing decisions and the insights gained by disaggregating
ROCE into profit margin for ROCE, total assets turnover, and the capital
structure leverage ratios.
4. Understand the strengths and weaknesses of earnings per common share as
a measure of profitability.
5. Understand the distinction between short-term liquidity risk and long-term
liquidity risk and the financial statement ratios used to assess each.
6. Develop skills to interpret effectively the results of an analysis of
profitability and risk.
7. (Appendix) Develop skills to prepare pro forma financial statements.
8. (Appendix) Understand the usefulness of pro forma financial statements in
the valuation of a firm.
II. Organization of Class Sessions
The instructor faces several questions with respect to this chapter. First,
should the instructor cover the material on financial statement analysis after
Chapter 5, after Chapter 14, or not at all in the course? Inclusion of the
material after Chapter 5 provides a framework for using information from the
three financial statements covered in the first four chapters. Ratios organize
information from these three financial statements in a more usable form.
Notes 6-2
Thus, inclusion of the chapter after Chapter 5 serves as an effective
synthesizing device at this point. It also permits students to take a breath
from the conceptual and procedural emphasis of the first five chapters and
spend some time asking what the financial statements tell you. The main
difficulty with covering financial statement analysis at this point is that
students have not yet been exposed to various GAAP needed to analyze
financial statements of actual companies. Thus, the analysis might seem a bit
contrived to students. Coverage after Chapter 14 removes this concern. Some
accounting programs relegate financial statement analysis to another
accounting course or to a finance course and do not cover it at all in the initial
course.
A second issue concerns which of the various topics in Chapter 6 the
instructor wishes to cover: profitability analysis, risk analysis, pro forma
financial statements, and valuation. The first two topics logically fit together
and the last two logically fit together. We tend to cover the first three topics in
MBA courses and leave valuation to later courses. Inclusion of the material on
valuation in the chapter at least points students in the direction of using
financial statement information in assessing market prices of firms’ common
shares.
III. Lecture Outline
1. Understand the relation between the expected return and risk of
investment alternatives and the role financial statement analysis
plays in providing information about returns and risk.
A. The concepts of returns and risk are central to financial statement
analysis and valuation. We attempt to get students to understand
these concepts by placing the following investment alternatives on the
board or an overhead transparency:
Investment Alternative Risk Expected Return
B. We then have students identify the likely risks of each investment
alternative. The risks from investing in the U.S. government bond
relate primarily to changes in interest rates while the bond is
outstanding. The probability of the U.S. government defaulting on
the bond is low. The risks from investing in the common stock of an
electric utility involve changes in regulatory attitude of the state
6-3 Notes
C. We next have students suggest why the expected returns on the three
investments rank in the order shown. The response is that investors
D. Finally, we ask how an analysis of the financial statements helps the
investor to assess expected returns and risks. Students point out that
2. Understand the usefulness of the rate of return on assets (ROA) as
a measure of a firm’s operating profitability independent of
financing and the insights gained by disaggregating ROA into the
profit margin for ROA and the total assets turnover ratios.
A. Begin by raising the following question: Of what use to a user of
financial statements is a measure of profitability, like the rate of
return on assets (ROA) that excludes financing costs? ROA measures
a firm’s success in creating and selling goods and services, the
primary focus of its activities, and not on the supporting role of the
financing of those activities. Operating activities fall under the
responsibilities of manufacturing and marketing personnel, whereas
financing activities typically fall under the responsibilities of the
treasury function. A financial statement user desiring to assess the
success of a firm in its primary operating activity would want to
exclude financing costs. Also, firms in a particular industry probably
have similar operating policies but may have different financing
policies. Excluding financing costs permits an assessment of the
comparative operating performance of these firms.
B. Next, ask why the numerator of ROA adds back interest expense net
of tax savings from that interest expense. The obvious response is
that this adjustment eliminates financing costs. The more difficult
Notes 6-4
issue for students is understanding the mechanics of the adjustment.
Consider the following income statement data for a firm including
and excluding interest expense and related tax effects.
Net Income Net Income
Including Excluding
Interest Interest
Expense Expense
Sales ..................................................... $ 4,300,000 $ 4,300,000
Less: Expenses
Cost of Goods Sold ....................... (2,800,000) (2,800,000)
Selling and Administrative
Expenses .................................. (482,860) (482,860)
Interest Expense .......................... (100,000) --
Net Income before Income Taxes ........ 917,140 $ 1,017,140
Less Income Taxes at 30 Percent ........ (275,140) (305,140)
Net Income ........................................... $ 642,000 $ 712,000
The first column shows reported net income of $642,000. The second
column shows net income excluding interest expense of $100,000 and
excluding the tax savings from that interest expense of $30,000 (= .30
X $100,000). Thus, to convert net income to a measure that excludes
financing costs requires the following adjustment:
Net Income + Interest Expense – Tax Savings from = Numerator
Interest Expense of ROA
$642,000 + $100,000 – $30,000 = $712,000
Net Income + (1 – Tax Rate) (Interest Expense) = Numerator
of ROA
C. Third, place the disaggregation of ROA into profit margin and asset
turnover components on the board or a transparency. Ask the
following question: What types of actions might a firm take to
increase its profit margin? Responses include raising prices and
controlling costs. Then ask: What types of actions might a firm take
to improve its assets turnover? Responses include stricter control on
uncollectible accounts receivable, improved controls on the amount of
inventory on hand, and delayed purchasing of fixed assets. The point
to make is that actions to improve profit margin are largely, but not
totally, independent of actions to improve assets turnover. Some
firms have more flexibility to influence their profit margins (for
6-5 Notes
Example, branded food products) while other firms have more
flexibility to influence their assets turnover (for Example, grocery
stores).
D. Having discussed the rationale for, and calculation of, ROA, we then
work problems to illustrate its application. (Exercises 6.11, 6.12, 6.16
6.17, and 6.18) When we can spend only limited time on Chapter 6,
we assign Problem 6.27 because it permits a rich discussion in a
short period of time.
3. Understand the usefulness of the rate of return on common
shareholders’ equity (ROCE) as a measure of profitability that
incorporates a firm’s financing decisions and the insights gained
by disaggregating ROCE into profit margin ROCE, total assets
turnover, and the capital structure leverage ratios.
A. Begin by asking whether students agree or disagree with the
following statement: ROA excludes all financing cost while the rate
of return on common shareholders’ equity (ROCE) includes all
financing costs. This statement is correct with respect to ROA but
not with respect to ROCE. ROCE includes the cost of all financing
that is senior to the common shareholders but not the cost of common
shareholders’ capital. Then ask why it excludes the latter. The
answer relates to the residual nature of the common shareholders’
claim. The numerator of ROCE includes the portion of net income
left for the common shareholders and the denominator shows the
assets of a firm against which providers of capital that is senior to
the common shareholders do not have a claim. ROCE measures the
return to the common shareholders for the capital that they provided.
B. Next, ask under what conditions ROCE will exceed ROA. When ROA
exceeds the cost of financing senior to the common shareholders,
ROCE will exceed ROA. Common business terminology refers to this
phenomenon as financial leverage.
C. We show the disaggregation of ROCE into profit margin, assets
turnover, and leverage components on the board or an overhead
transparency to show how leverage enhances ROA to increase the
returns to the common shareholders.
D. Finally, we work several problems illustrating the calculation and
interpretation of ROCE and financial leverage. (Exercises 6.13, 6.14,
6.15 and 6.19)
4. Understand the strengths and weaknesses of earnings per
common share as a measure of profitability.
Notes 6-6
A. We show the following on the board or an overhead transparency:
Limited Brands May Department Stores
ROCE 29.3% 17.4%
EPS $1.36 $3.63
We ask which firm’s shareholders should be happier. This question
gets students to see that earnings per share (EPS) can give
misleading signals about profitability. One major problem is that the
number of shares outstanding in the denominator of EPS does not
give a good indication of the amount of capital provided by the
common shareholders.
B. We then ask why EPS is so widely used by security analysis if it is
subject to this weakness. The answer involves the ease in relating
per share earnings amounts to per share stock prices. If financial
periodicals reported a moving average market rate of return instead
of daily stock prices, perhaps investors would focus more on ROCE
than an EPS.
C. We assign Exercise 6.20 to illustrate problems with interpreting EPS.
5. Understand the distinction between short-term liquidity risk and
long-term liquidity risk and the financial statement ratios used to
assess each.
A. We begin by asking: What is the ultimate risk when one invests in a
firm? The response is that the firm goes bankrupt, is liquidated, and
the investor loses the full amount invested.
B. We then ask: Why do firms end up in bankruptcy? The simple
answer is that they run out of cash and find that they cannot obtain
additional cash from sources external to the firm. Assessing the
probability of running out of cash is the objective of risk analysis.
C. Next, we ask students to suggest a situation where a firm might have
significant risks of bankruptcy during the next six months but, if the
firm can get through that period, has a high probability of surviving
for the long term. Such a situation envisions large amounts of debt
coming due soon with inadequate cash resources to make the
payments, but high likelihood of generating significant cash flows in
the future (for Example, because of a new invention). Alternatively,
ask students to suggest a situation where a firm has a low probability
of bankruptcy during the next six months but a much higher
probability five years from now. Such a situation envisions
significant long-term debt coming due in five years and products in
6-7 Notes
the decline phase of their life cycle. These Examples should make
clear the need to assess both short-term and long-term liquidity risk.
D. We work several Problems illustrating the analysis of short-term
liquidity risk (Exercises 6.21 and 6.22) and long-term liquidity risk
(Exercises 6.23 and 6.24).
6. Develop skills to interpret effectively the results of an analysis of
profitability and risk.
Students can accomplish this learning objective most effectively by
using a full set of financial statements. Problems 6.27 and 5.29 work well
for this purpose and involve companies familiar to most students. Problem
6.28 extends the analysis to companies headquartered in other countries.
An alternative approach is to give students the full set of financial
statement ratios and have them do the interpretations (Problems 6.30 and
6.31). The difference between these approaches relates to whether the
instructor wishes to emphasize the calculation of the ratios. Problem 6.32
is a comprehensive review Problem involving balance sheet and income
statement relations for firms in twelve different industries. We find this
Problem works well with MBAs.
7. (Appendix) Develop skills to prepare pro forma financial
statements.
We find that this topic works well with MBAs. It cements
understanding of the three financial statements covered in Chapters 1 to 5
and the financial statement ratios in Chapter 6. When we cover pro forma
financial statements, we assign Problem 6.27 the previous class period.
Problem 6.27 requires students to analyze the past profitability and risk of
Target Corporation. We then assign Problem 6.33, which involves the
preparation of pro forma financial statements for Target. Problem 6.33
specifies the assumptions students should make in preparing pro forma
financial statements so students’ answers should be similar. The
instructor can spend some class time discussing the reasonableness of the
assumptions.
8. (Appendix) Understand the usefulness of pro forma financial
statements in the valuation of a firm.
We tend not to spend much class time on this complex topic. Our
purpose for including a brief discussion of it in the chapter is to
demonstrate the link between financial statements and market prices.
Notes 6-8
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