L06 - Financial Analysis

Understanding Financial Statements

Note: Sum of the parts Model not part of the exam

Balance Sheet

A balance sheet is a financial statement that reports a company’s assets, liabilities, and shareholders’ equity at a specific point in time. It encodes the fundamental accounting identity:

$$\text{Assets}=\text{Liabilities}+\text{Shareholders’ Equity}$$

Shareholders' Equity

Shareholders’ equity is the residual claim on assets after all liabilities are settled:

$$\text{Shareholders’ Equity}=\text{Total Assets}-\text{Total Liabilities}$$

It represents the book value of ownership in the firm.

Note: Equity is not a separate pool of cash — it is a derived quantity that forces the balance sheet identity to hold. If assets grow without a corresponding rise in liabilities, equity must increase, and vice versa.

Example of a Balance Sheet:

Left: Assets, Right: Liabilities

Current Assets: Term below 1 year, or even 30 days

• Cash: daily operating cash they have
• Receivables: outstanding payments
• Inventories: apples, water, whatever for supermarkets etc.. (Just In Time: limit amount of inventory I have)
  Fixed Assets:
• properties, plants, machines
• less accumulated depreciation → you can deduct depreciation of assets from taxable income → write off the cost of an asset over it’s useful life, reducing tax bill
• Net tangible fixed assets
• intangible assets: know-how, etc…

Current Liabilities: less than a year

• debt due for repayment
• accounts payable (pay as late as possible → gives you “funding” for nothing)
  • you have cash you can put to work → i.e. earn interest/profit from it. So if you repay later you get more
• Other current liabilities: short term loan, etc…
  Long term debt
• longer time loans, bonds, etc…
  Shareholder’s equity:
• Common Stock
  • face value of all issued shares ever (usually tiny nominal value)
• Additional paid-in-capital
  • IPO or issue shares → investors pay more than face value (difference between common stock value and initial share price you sold for)
• Retained earnings: money you keep (pay dividends, repurchase stock → but you keep some)
  • all cumulative profits ever earned - dividends
• Treasury Stock
  • take stock out of the market (buy back) → give more dividend to remaining stockholders
  • negative as buybacks reduce equity

Net working Capital: difference between current assets and current liabilities

• if < 0 usually sign of distress
• for retail (Kroger Co. from example) normal, as they basically sell inventory they haven’t paid the suppliers for.

Example (Constructing a Balance Sheet): Constructing the balance sheet for Galactic Enterprises:

Assets		Liabilities & Equity
Cash	$25,000	Accounts payable	$24,000
Accounts receivable	$35,000	Long-term debt	$130,000
Inventories	$30,000	Total Liabilities	$154,000
Net plant & equipment	$140,000	Shareholders’ equity	$76,000
Total Assets	$230,000	Total L + E	$230,000
Shareholders’ equity is the plug:

$$\text{Shareholders’ Equity}=\$230,000-\$154,000=\$76,000$$

This means that if Galactic Enterprises liquidated all assets at book value and repaid every creditor, $76,000 would remain for shareholders.

Aside (Depreciation)

The tax authority defines useful life of an asset.

For a laptop useful for 5 years, you can depreciate it total cost / total years = $200/year for example (straight line).

Then you can deduct this from your taxable income (i.e. if you have 5k taxable, you now only have 4.8k). This saves $60 per year at 30% tax rate.

EBITDA

EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) is a measure of a company’s core operating profitability, excluding the effects of financing decisions, tax environments, and non-cash accounting charges. It is computed as

$$\text{EBITDA}=\text{Revenue}-\text{COGS}-\text{Operating Expenses}$$

or equivalently, starting from net income:

$$\text{EBITDA}=\text{Net Income}+\text{Interest}+\text{Taxes}+\text{Depreciation}+\text{Amortisation}$$

where depreciation accounts for the gradual expensing of tangible assets and amortisation for intangible assets (e.g. patents, goodwill).

COGS: Cost of goods sold

Example: A firm reports net income of $40\text{m}$, interest expense $10\text{m}$, taxes $15\text{m}$, depreciation $8\text{m}$, and amortisation $2\text{m}$. Then

$$\text{EBITDA}=40+10+15+8+2=\$75\text{m}$$

If the enterprise value is \600\text{m}$,theEV/EBITDAmultipleis$8\times$.

Measuring Performance

Two key metrics are used to assess how much value a company has created for its shareholders.

Market Capitalisation

The market capitalisation of a firm is the total market value of its equity, computed as

$$\text{Market Cap}=\#\text{shares outstanding}\times \text{price per share}$$

It represents what the stock market currently believes the equity of the firm is worth.

Example: For Kroger Co. (fiscal year 2025), with 788 million shares outstanding at a price of $27.55 per share:

$$\text{Market Cap}=788\text{ M}\times \$27.55=\$21,709\text{ M}$$

Market Value Added (MVA)

Market Value Added is the difference between a firm’s market capitalisation and the book value of its equity:

$$\text{MVA}=\text{Market Cap}-{\text{Equity}}_{\text{book value}}$$

Read MVA:

• Positive MVA: indicates the firm has created value beyond what shareholders originally invested
• Negative MVA: indicates value destruction

The book value of equity is taken directly from the balance sheet — it reflects the historical accounting value of shareholders’ funds (paid-in capital + retained earnings − treasury stock).

Example: Kroger’s balance sheet (fiscal year 2025) reports total shareholders’ equity of $8,573 M. Combined with the market cap computed above:

$$\text{MVA}=\$21,709\text{ M}-\$8,573\text{ M}=\$13,136\text{ M}$$

This means the market values Kroger’s equity at roughly $13.1 billion more than its accounting book value, reflecting investor confidence in the firm’s future earning power.

Market / Book Ratio

Ratio between market capitalisation and book valuation.

EVA

Economic Value Added

Net income minus a charge for the cost of capital employed (also called residual income)
Residual Income: net dollar return after deducting cost of capital

$$\text{EVA}=\text{residual income}=(\text{after-tax interest + net income})-\text{(cost of capital )}\times \text{capital}$$ $$\text{EVA}=\left(\frac{\text{after-tax interest + net income}}{\text{total capital}}-\text{cost of capital}\right)\times \text{total capital}$$

Intuitive: measures whether a company is generating returns above and beyond what it’s capital actually costs: “after paying all suppliers of capital → did we destroy or create value”.

Total earnings: company generates value for

• debt-holders (banks, bondholders → they get interest payments)
• equity-holders (shareholders) → they get net income
  So total earnings = after-tax interest + net income

Total Capital: use the capital at the beginning of the period (this periods value was generated from the capital we had before that period)

Cost of capital: WACC (weighted average cost of capital) combines what debtholders and equity holders demand

After-tax Interest: you pay taxes on your income - interest expense (government subsidises debt).
Therefore, we need to “after-tax” it, to make sure we use the right values.
The $(1-0.21)$ factor is the after-tax adjustment using a 21% corporate tax rate.

Accounting Rates of Return

Three metrics measure how profitably a firm deploys its resources. All use after-tax figures to put debt and equity on the same footing. The tax rate used here is $t=0.21$ (US corporate rate).

Return on Capital (ROC)

Return on capital measures profitability relative to the funds provided by all capital suppliers (debt + equity):

$$\text{ROC}=\frac{(1-t)\cdot \text{Interest}+\text{Net Income}}{\text{Total Capital}}$$

The after-tax interest add-back neutralises the tax shield, so debt and equity are compared on equal terms. Total capital = long-term debt + shareholders’ equity (excludes operating liabilities).

Return on Assets (ROA)

Return on assets uses the same numerator but a broader denominator — all assets, regardless of how they are financed:

$$\text{ROA}=\frac{(1-t)\cdot \text{Interest}+\text{Net Income}}{\text{Total Assets}}$$

Because total assets $\ge$ total capital, ROA $\le$ ROC for the same firm.

Return on Equity (ROE)

Return on equity measures what flows to common shareholders per dollar of book equity:

$$\text{ROE}=\frac{\text{Net Income}}{\text{Equity}}$$

No interest add-back is needed because the numerator already belongs entirely to equity holders. Financial leverage typically pushes ROE above ROA.

Example (ROC, ROA, ROE):

Item	Value
Net income	\1{,}512$
Interest expense	\603$
Tax rate $t$	$21\%$
Total assets	\38{,}118$
Shareholders’ equity	\7{,}835$
Total capital (LT debt + equity)	\19{,}907$

$$\begin{array}{rl}\text{ROC}& =\frac{(1-0.21)\times 603+1,512}{19,907}=\frac{476.4+1,512}{19,907}\approx ==10.0\%==\\ \text{ROA}& =\frac{(1-0.21)\times 603+1,512}{38,118}=\frac{1,988.4}{38,118}\approx ==5.2\%==\\ \text{ROE}& =\frac{1,512}{7,835}\approx ==19.3\%==\end{array}$$

The gap between ROE ($19.3\%$) and ROC ($10.0\%$) illustrates the effect of financial leverage: equity holders bear concentrated risk, so their accounting return is amplified. ROA is lowest because it spreads the same earnings over all assets, including those funded by cheap operating liabilities like accounts payable.

Pro/Con with EVA and Accounting Rates of Return

Con:

• unlike market-value based measures, they show current performance and are not affected by the expectations about the future
• not every asset is shown
  • brand name
• in some industries EVA/ROI are negative
  • pharma research programs
• Balance sheet does not show current market value of firm’s assets
• Book equity is reduced when companies repurchase stocks
  • creates non-sense measure of EVA

Pro:

• Can be calculated for private companies (no observable market value)

Measuring Efficiency

Asset Turnover Ratio

The asset turnover ratio measures how efficiently a company uses its assets to generate sales.

$$\text{Asset turnover ratio}=\frac{\text{sales}}{\text{total assets at start of year}}=\frac{\$122,286}{\$38,118}=3.21$$

Profit Margin

The profit margin measures how much out of every dollar of sales a company actually keeps in earnings.

$$\text{Profit margin}=\frac{\text{net income}}{\text{sales}}=\frac{\$1,512}{\$122,286}=0.0124$$

Operating Profit Margin

The operating profit margin measures the earning power of operations, independent of how the company is financed (e.g., if it had no debt). After-tax interest is added back to net income to strip out financing effects.

$$\text{Operating profit margin}=\frac{\text{after-tax interest}+\text{net income}}{\text{sales}}=\frac{(1-0.21)\times \$603+1,512}{\$122,286}=0.0163$$

Inventory Turnover Ratio

The inventory turnover ratio tells how many times a year a company sells and replaces its entire stock of inventory.

$$\text{Inventory turnover ratio}=\frac{\text{cost of goods sold}}{\text{inventory at start of year}}=\frac{\$95,294}{\$6,846}=13.9$$

Inventory Period

The inventory period converts the turnover ratio into days — it tells exactly how long a specific item sits on the shelf before a customer buys it.

$$\text{Inventory period}=\frac{\text{inventory at start of year}}{\text{daily cost of goods sold}}=\frac{\$6,846}{\$95,294/365}=26.2\text{ days}$$

Receivables Turnover

The receivables turnover tells how many times per year a company collects its average accounts receivable (the money owed to them by customers).

$$\text{Receivables turnover}=\frac{\text{sales}}{\text{receivables at start of year}}=\frac{\$122,286}{\$1,589}=77.0$$

Accounts Receivable Period

The accounts receivable period converts the turnover into days — it tells exactly how long it takes, on average, to receive payment after a sale is made.

$$\text{Accounts receivable period}=\frac{\text{receivables at start of year}}{\text{average daily sales}}=\frac{\$1,589}{\$122,286/365}=4.7\text{ days}$$

Measuring Leverage

Long-Term Debt Ratio

The long-term debt ratio measures the proportion of a company’s long-term capital that consists of debt:

$$\text{Long-term debt ratio}=\frac{\text{long-term debt}}{\text{long-term debt}+\text{equity}}$$

A ratio of 0.59 (59%) means 59% of long-term capital is financed by debt.

Long-Term Debt–Equity Ratio

The long-term debt–equity ratio compares long-term debt directly to equity, and is a key measure of financial solvency:

$$\text{Long-term debt–equity ratio}=\frac{\text{long-term debt}}{\text{equity}}$$

Unlike the debt ratio, this is not bounded by 1 — a ratio above 1 means debt exceeds equity.

Total Debt Ratio

The total debt ratio measures what fraction of a company’s assets are financed by creditors rather than shareholders:

$$\text{Total debt ratio}=\frac{\text{total liabilities}}{\text{total assets}}$$

Times-Interest-Earned Ratio

The times-interest-earned ratio measures how easily a company can cover its interest expenses out of operating profits:

$$\text{Times-interest-earned}=\frac{\text{EBIT}}{\text{interest payments}}$$

where EBIT is earnings before interest and taxes. A higher ratio indicates a larger buffer against default.

Cash Coverage Ratio

The cash coverage ratio refines times-interest-earned by adding back depreciation — a non-cash expense that did not actually leave the bank account — to give a more accurate picture of cash available to service debt:

$$\text{Cash coverage ratio}=\frac{\text{EBIT}+\text{depreciation}}{\text{interest payments}}$$

Since depreciation is added back, the cash coverage ratio is always $\ge$ the times-interest-earned ratio. The gap between them reflects the size of non-cash charges relative to interest obligations.

The Du Pont System

The Du Pont System breaks down ROA (and ROE) into component ratios — asset turnover and operating profit margin:

$$\begin{array}{rl}\text{ROA}& =\frac{\text{after-tax interest}+\text{net income}}{\text{assets}}\\ & =\frac{\text{sales}}{\text{assets}}\times \frac{\text{after-tax interest}+\text{net income}}{\text{sales}}\\ & =\underset{\uparrow }{\underbrace{\text{Asset Turnover}}}\times \underset{\uparrow }{\underbrace{\text{Operating Profit Margin}}}\end{array}$$

we want a high asset turnover and high profit margin → increases total ROA.

Measuring Liquidity

• NWC to total assets

• Quick ratio: cash + marketable securities + receivables / current liabilites

  • measures how liquid you are

• Cash Ratio: cash + marketable securities / current liabilities

  • how much cash is part of your current liabilities