Economics 494

INVESTMENT ECONOMICS

Spring 2015
 
| HOME | SYLLABUS | CALENDAR | ASSIGNMENTS | ABOUT PROF. GIN |
 

C.  Financial Statement Analysis

1.  Major financial statements

a.  Income statement

  • Summary of the profitability of a firm over a period of time

  • Revenue - expenses = net earnings (profits)

  • Expenses:

(1) Cost of goods sold

(2) General and administrative expenses

(3) Interest expense

(4) Taxes on earnings

.

  • Should use economic earnings as opposed to accounting earnings

.

b.  Balance sheet

  • Financial condition of the firm at a particular moment

  • Assets = Liabilities + stockholders' equity

.

c. Statement of cash flows

  • Tracks cash implications of transactions

  • Accounts receivable and payable not counted

  • Depreciation not counted

  • Divided into cash flows from operations, from investments, and from financing activities

2. Measuring firm performance

  • Consider investment decisions and financing decisions

- Investment (capital budgeting) decisions - deals with use of capital

- Financing decisions - deals with sources of capital

.

.

.

.

.

.

.

.

.

3. Profitability measures

a. Return on assets (ROA)

.

.

.

b. Return on capital (ROC)

.

.

.

c. Return on equity (ROE)

.

.

.

  • Financial leverage - based on debt-equity mix

.

.

.

.

.

.

 d. Economic value added

  • Economic value added = (ROC - k) *capital invested

.

.

4.  Ratio analysis

a. Decomposition of ROE

.

.

.

.

(1) Tax-burden ratio

.

.

.

(2) Interest-burden ratio

.

.

.

  • Interest coverage ratio

.

.

.

(3) Profit margin or return on sales (ROS)

  • Operating profit per dollar of sales

.

.

.

(4) Total asset turnover (ATO)

  • Annual sales generated by each dollar of assets

  • Measure of efficiency

.

.

.

(5) Leverage ratio

  • Measure degree of financial leverage

.

.

  • Return on equity (ROE)

.

.

.

.

.

.

.

.

 b.  Turnover and other asset utilization ratios

  • Look at turnover for subcategories of assets

.

(1) Fixed-asset turnover ratio

  • Sales per dollar of money tied up in fixed assets

.

.

.

(2) Inventory turnover ratio

  • Measures speed at which inventory is turned over

.

.

.

(3) Days sales in receivables (average collection period)

  • Measures efficiency of management of accounts receivable

.

.

c.  Liquidity ratios

  • Liquidity - ability to convert assets to cash at short notice

.

(1) Current ratio

  • Ability to pay off current liabilities by liquidating current assets

.

.

.

(2) Quick ratio (acid test ratio)

  • Same as current ratio but inventory not counted as current assets

.

.

.

(3)  Cash ratio

  • Same as quick ratio but receivables not counted as current assets

.

.

.

d.  Market price ratios

(1) Market-book-value ratio (P/B)

.

.

.

(2) Price-earnings ratio (P/E)

.

.

.

  • Relationship between P/B and P/E

.

.

.

.

.

e. Benchmarks

(1) Compare with past values

  • Time series analysis

.

(2) Compare with other firms in industry