Introduction to financial statement analysis
Chapter Two
Introduction to financial statement analysis
Answers to Concept Check questions
1. What is the role of the auditor?
2. What are the four financial statements that all public companies must produce?
3. What is depreciation designed to capture?
4. The book value of a company’s assets usually does not equal the market value of those assets. What are some reasons for this difference?
5. What does a high debt–equity ratio tell you?
6. What is a firm’s enterprise value?
7. What do a firm’s earnings measure?
8. What is meant by ‘dilution’?
9. How can a financial manager use the DuPont Identity to assess the firm’s ROE?
10. How do you use the P/E ratio to gauge the market value of a firm?
11. Why does a firm’s net profit not correspond to cash earned?
12. What are the components of the statement of cash flows?
The components of the statement of cash flows are:
• Cash from operating activities
• Cash from investing activities
• Cash from financing activities
13. Where do off-balance sheet transactions appear in a firm’s financial statements?
14. What information do the notes to financial statements provide?
15. Describe the transactions Enron used to increase its reported earnings.
16. What is CLERP 9?
Answers to Review Questions
1. Why do firms disclose financial information?
2. Who reads financial statements? List at least three different categories of people. For each category, provide an example of the type of information they might be interested in and discuss why.
3. What four financial statements can be found in a firm’s annual report? What checks are there on the accuracy of these statements?
4. What is the purpose of the balance sheet?
5. How can you use the balance sheet to assess the health of the firm?
6. What is the purpose of the income statement?
7. How are the balance sheet and the income statement related?
8. What is the DuPont Identity and how can a financial manager use it?
Return on equity
? Net profit margin
?A sset turnover ?
Equity multiplier
Net income Net income Sales Assets
? ? ?
Shareholder equity Sales Assets Shareholder equity
The DuPont Identity is useful to managers, as it identifies three drivers that the manager can use to affect ROE.
9. How does the statement of cash flows differ from the income statement?
10. Can a firm with positive net profit run out of cash? Explain.
11. What can you learn from management’s discussion or the notes to the financial statements?
12. How did accounting fraud contribute to the collapse of Enron and HIH Insurance?
Firms’ disclosure of financial information
1. Find the most recent financial statements for Qantas (ASX:QAN) using the following sources:
a. From the company’s web page: www.qantas.com.au. (Hint: search for ‘investors’.)
b. From the ASX website: www.asx.com.au. (Hint: click on announcements to search for the release of the annual report.)
c. From the Yahoo! Finance website: au.finance.yahoo.com.
d. From at least one other source. (Hint: enter ‘Qantas annual report’ at www.google.com.)
2. Consider the following potential events that might have occurred to Global on 30 December 2017. For each one, indicate which line items in Global’s balance sheet would be affected and by how much. Also indicate the change to Global’s book value of equity.
a) Global used $20 million of its available cash to repay $20 million of its long-term debt.
b) A warehouse fire destroyed $5 million worth of uninsured inventory.
c) Global used $5 million in cash and $5 million in new long-term debt to purchase a $10 million building.
d) A large customer owing $3 million for products it already received declared bankruptcy, leaving no possibility that Global would ever receive payment.
e) Global’s engineers discover a new manufacturing process that will cut the cost of its flagship product by over 50%.
f) A key competitor announces a radical new pricing policy that will drastically undercut Global’s prices
3. What was the change in Global’s book value of equity from 2016 to 2017 according to Table 2.1? Does this imply that the market price of Global’s shares increased in 2017? Explain
4. Find the 2016 annual report for Billabong International Limited (ASX:BBG) online. Using figures for the consolidated company, answer the following questions from its balance sheet:
a. How much cash did Billabong have at the end of the 2015/16 year?
b. What were Billabong’s total assets?
c. What were Billabong’s total liabilities?
d. What was the book value of Billabong’s equity?
5. In June 2016, BHP Billiton Limited (ASX:BHP) had a book value of equity of $80.7 billion,
5.32 billion shares outstanding and a market price of $18.65 per share. BHP also had cash of $13.8 billion and total debt of $79.1 billion.
a. What was BHP’s market capitalisation? What was its market-to-book ratio?
b. What was BHP’s book debt–equity ratio? What was its market debt–equity ratio?
c. What was BHP’s enterprise value?
6. In June 2016, Newcrest Mining Limited (ASX:NCM), Australia’s largest gold producer, had cash of $71 million, current assets of $1079 million and current liabilities of $900 million. It also had inventories of $732 million.
a. What was Newcrest Mining’s current ratio?
b. What was Newcrest Mining’s quick ratio?
7. In June 2016, St Barbara Limited (ASX:SBM), Australia’s third-largest gold producer, had a quick ratio of 2.77 and a current ratio of 3.85. What can you say about the asset liquidity of Newcrest Mining relative to St Barbara?
8. In June 2016, the following information was true about Origin Energy Limited (ASX:ORG) and AGL Energy Limited (ASX:AGL), both Australian energy retailers. Values (except price per share) are in millions.
a. What is the market-to-book ratio of each company?
b. What conclusions do you draw from comparing the two ratios?
9. Find the 2016 annual report for Billabong International Limited (ASX:BBG) online. Using figures for the consolidated company, answer the following questions from the income statement:
a. What was Billabong’s revenue for 2016? By what percentage did revenue grow from 2015?
b. What were Billabong’s operating and net profit margins in 2016? How do they compare with its margins in 2015?
c. What was Billabong’s diluted EPS (excluding extraordinary items) in 2016? What number of shares was this EPS based on?
10. *Suppose that in 2017, Global launched an aggressive marketing campaign that boosted sales by 15%. However, its operating margin fell from 5.57% to 4.50%. Suppose that it had no other income, interest expenses were unchanged, and taxes were the same percentage of pre-tax profit as in 2016.
11. Suppose a firm’s tax rate is 30%.
a. What effect would a $10 million operating expense have on this year’s earnings? What effect would it have on next year’s earnings?
b. What effect would a $10 million capital expense have on this year’s earnings if the capital is depreciated at a rate of $2 million per year for five years? What effect would it have on next year’s earnings?
12. You are analysing the leverage of two firms and you note the following (all values are in millions of dollars):
a. What is the market debt–equity ratio of each firm?
b. What is the book debt–equity ratio of each firm?
c. What is the interest coverage ratio of each firm?
d. Which firm will have more difficulty meeting its debt obligations?
13. For 2016, Fantastic Furniture (ASX:FAN) and Nick Scali Furniture (ASX:NCK) had the following information (all values are in millions of dollars):
a. What is each company’s accounts receivable days?
b. What is each company’s inventory turnover?
c. Which company is managing its accounts receivable and inventory more efficiently?
14. *Quisco Systems has 6.5 billion shares outstanding and a share price of $18.00. Quisco is considering developing a new networking product in-house at a cost of $500 million. Alternatively, Quisco can acquire a firm that already has the technology for $900 million worth (at the current price) of Quisco shares. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.80.
a. Suppose Quisco develops the product in-house. What impact would the development cost have on Quisco’s EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco’s tax rate is 30% and the number of shares outstanding is unchanged.
b. Suppose Quisco does not develop the product in-house but instead acquires the technology. What effect would the acquisition have on Quisco’s EPS this year? (Note that acquisition expenses do not appear directly on the income statement. Assume the acquired firm has no revenue or expenses of its own, so that the only effect on EPS is due to the change in the number of shares outstanding.)
c. Which method of acquiring the technology has a smaller impact on earnings? Is this method cheaper? Explain.
15. In December 2016, American Airlines (AAL) had a market capitalisation of $23.6 billion, debt of $47.5 billion, cash of $0.3 billion and revenue of $40.2 billion. Delta Airlines (DAL) had a market capitalisation of $36.6 billion, debt of $39.0 billion, cash of $2.8 billion and revenue of $39.6 billion. (All values in US dollars.)
a. Compare the market capitalisation-to-revenue ratio (also called the price-to-sales ratio) for American Airlines and Delta Airlines.
b. Compare the enterprise value-to-revenue ratio for American Airlines and Delta Airlines
c. Which of these comparisons is more meaningful? Explain
16. *Find the 2016 annual report for The Reject Shop Limited (ASX:TRS) online.
a. Calculate The Reject Shop’s net profit margin, total asset turnover and equity multiplier.
b. Verify the DuPont Identity for The Reject Shop’s ROE.
c. If The Reject Shop’s managers wanted to increase its ROE by one percentage point, how much higher would their asset turnover need to be?
17. Repeat the analysis from parts (a) and (b) of the previous problem for JB Hi-Fi (ASX:JBH). Based on the DuPont Identity, what explains the difference between the two firms’ ROEs?
18. Find the 2016 annual report for Billabong International Limited (ASX:BBG) online. Using figures for the consolidated company, answer the following questions from its cash flow statement:
a. How much cash did Billabong generate from operating activities in 2016?
b. What was Billabong’s depreciation expense in 2016? (Hint: look on the income statement or in the notes.)
c. How much cash was invested in new fixed assets and capital expenditures?
d. What was Billabong’s net result from financing activities? Did Billabong raise cash or spend cash through financing activities?
19. See the cash flow statement here (indirect method) for Allied Foods Ltd (all values in thousands of dollars) (see MyLab Finance for the data in Excel format):
a. What were Allied Foods’ cumulative earnings over these four quarters? What were its cumulative cash flows from operating activities?
b. What fraction of the cash from operating activities was used for investment over the four quarters?
c. What fraction of the cash from operating activities was used for financing activities over the four quarters?
a. Allied Foods’ cumulative earnings over these 4 quarters was $918.268 million. Its cumulative cash flows from
20. Suppose your firm receives a $5 million order on the last day of the year. You fill the order with $2 million worth of inventory. The customer picks up the entire order the same day and pays $1 million up-front in cash; you also issue a bill for the customer to pay the remaining balance of $4 million within 40 days. Suppose your firm’s tax rate is 0% (i.e. ignore taxes). Determine the consequences of this transaction for each of the following:
a. revenue;
b. earnings;
c. receivables;
d. inventory;
e. cash.
21. Nokela Industries purchases a $40 million cyclo-converter. The cyclo-converter will be depreciated by $10 million per year over four years, starting this year. Suppose Nokela’s tax rate is 30%.
a. What impact will the cost of the purchase have on earnings for each of the next four years?
b. What impact will the cost of the purchase have on the firm’s cash flow for the next four years?
Accounting manipulation
22. Find the 2016 annual report for Billabong International Limited (ASX:BBG) online.
a. Which auditing firm certified these financial statements?
b. Which officers of Billabong certified the financial statements?
1. Download the annual income statements, balance sheets and cash flow statements for the last four financial years from MarketWatch (www.marketwatch.com). Enter each company’s share symbol and then go to ‘Financials’. Copy and paste the financial statements into Excel.
2. Find historical share prices for each firm from Yahoo! Finance (http://finance.yahoo.com). Enter your share symbol, click on ‘Historical Prices’ in the left column, and enter the proper date range to cover the last day of the month corresponding to the date of each financial statement. Use the closing share prices (not the adjusted close). To calculate the firms’ market capitalisation at each date, we multiply the firms’ historic share prices by the number of shares outstanding. (See ‘Basic Shares Outstanding’ on the income statement you downloaded in step 1.)
3. For each of the four years of statements, calculate the following ratios for each firm: Valuation ratios P/E ratio (for EPS, use diluted EPS total) Market-to-book ratio Enterprise value-to-EBITDA (For debt, include long-term and short-term debt; for cash, include marketable securities) Profitability ratios Operating margin (use operating income after depreciation) Net profit margin ROE.
4. Obtain industry averages for each firm from Microsoft at http://money.msn.com/investing. Enter the share symbol on top of the home page and then click on ‘Analysis’. Various ratios, along with industry ratios, can be found by clicking on ‘Key Statistics’, ‘Profitability’, ‘Price Ratios’, and further down, ‘Financial Health’ and ‘Management Effectiveness’.
a. Compare each firm’s ratios with the available industry ratios for the most recent year. (Ignore the ‘Company’ column, as your calculations will be different.)
b. Analyse the performance of each firm versus the industry and comment on any trends in each individual firm’s performance. Identify any strengths or weaknesses you find in each firm.
5. Examine the market-to-book ratios you calculated for each firm. Which, if either, of the two firms can be considered ‘growth firms’ and which, if either, can be considered ‘value firms’?
6. Compare the valuation ratios across the two firms. How do you interpret the difference between them?
7. Consider the enterprise value of each firm for each of the four years. How have the values of each firm changed over the time period?
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