978-0324651140 Chapter 6 Lecture Note

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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