CHAPTER 4 Analysis of Financial Statements

Ratio Analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors
3-1

Why are ratios useful?

Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths.

3-2

Trend analysis

Analyzes a firms financial ratios over time Can be used to estimate the likelihood of improvement or deterioration in financial condition.
3-3

What are the five major categories of ratios, and what questions do they answer?

Liquidity: Can we make required payments? Asset management: right amount of assets vs. sales? Debt management: Right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?
3-4

Liquidity ratios

Current ratio

Total CA/ total CL

Quick ratio

(CA-Inventories)/ CL

3-5

Asset Management (Turnover Ratios)

Inventory turnover

Sales/ inventories

DSO days sales outstanding

A/R Turnover = sales/ A/R DSO= 365/ A/R Turnover Operating cycle

Compare DSO with Co.s Credit policy

3-6

FA turnover

Sales/ NFA

TA turnover

Sales/ Total Assets

3-7

Debt Management Ratios

1. Debt ratio = Total Debt/ TA Debt taken to finance assets All liabilities taken High debt implications? Analysis? If ratio is high?

3-8

2. TIE = EBIT / Interest Expense Interest paying ability reflected If its 7x then ? If TIE low?

3-9

3. EBITDA Coverage = (EBITDA + Lease pmts) / Int. exp + lease pmts + principle amt

Overcomes limitations of TIE (significance of EBITDA Coverage ratio) One type of financial charge TIE does not a/c for regular retirement of loan etc
Ratio used by ST creditors
3-10

Profitability Ratios
1. Profit Margin = NI / Sales 2. BEP = EBIT / TA 3. ROA = NI / TA 4. ROE = NI / Total Common Equity

3-11

Effects of debt on ROA and ROE

ROA is lowered by debt--interest lowers NI, which also lowers ROA = NI/Assets. But use of debt also lowers equity, hence debt could raise ROE = NI/Equity.

3-12

Problems with ROE

ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance.
ROE does not consider risk. ROE does not consider the amount of capital invested. Might encourage managers to make investment decisions that do not benefit shareholders.

ROE focuses only on return. A better measure is one that considers both risk and return.
3-13

Market Value Ratios

1.

Price / Earning Ratio = Price per share Earnings per share

Analysis? Calculate EPS for P/E ratio If P/E = 12x then ? Is high P/E ratio a good sign?
Always high for which companies?
3-14

2.

Price / Cashflow Ratio = Price per share Cashflow per share

First calculate CF per share Analysis? If P/CF ratio = 8.12x then ? Comparison with industry average

3-15

3.

Market / Book Ratio = Market price per share Book value per share

What is BV ? Calculate BV per share for M/B ratio Ratio will be mostly greater than 1 Analysis?

3-16

Analyzing the market value ratios

P/E: How much investors are willing to pay for $1 of earnings. P/CF: How much investors are willing to pay for $1 of cash flow. M/B: How much investors are willing to pay for $1 of book value equity. For each ratio, the higher the number, the better. P/E and M/B are high if ROE is high and risk is low.
3-17

HOW DOES DEBT SUPPRESSES ROE IF BEP < i

Two firms with the same operating performance, EBIT. Only differ with respect to their use of debt (capital structure).
Firm U Capital structure 0:100 50:50 No debt Int Exp = $0 $20,000 in assets 40% tax rate Firm L Capital structure

$10,000 debt, i =12% Int Exp = $1200 $20,000 in assets 40% tax rate

3-18

FIRM U: UNLEVERAGED CAPITAL STRUCTURE 0:100 DEBT = $0

Scenario EBIT Interest EBT Taxes (40%) NI
O/E ROE

1 $2,000 0 $2,000 800 $1,200

20,000 6.0%

2 $3,000 0 $3,000 1,200 $1,800

20,000 9.0%

3 $4,000 0 $4,000 1,600 $2,400

20,000 12.0%
3-19

FIRM L: LEVERAGED CAPITAL STRUCTURE 50:50 DEBT = $10,000

Scenario EBIT Interest EBT Taxes (40%) NI O/E ROE 1 $2,000 1,200 $ 800 320 $ 480 10,000 4.8% 2 $3,000 1,200 $1,800 720 $1,080 10,000 10.8% 3 $4,000 1,200 $2,800 1,120 $1,680 10,000 16.8%
3-20

RATIO COMPARISON BETWEEN LEVERAGED AND UNLEVERAGED FIRMS

FIRM U
BEP ROE TIE

Bad
10.0% 6.0%

Avg
15.0% 9.0%

Good
20.0% 12.0%

FIRM L
BEP ROE TIE

Bad
10.0% 4.8% 1.67x

Avg
15.0% 10.8% 2.50x

Good
20.0% 16.8% 3.30x
3-21

THE EFFECT OF LEVERAGE (DEBT) ON PROFITABILITY AND DEBT COVERAGE (ABILITY TO MEET DEBT OBLIGATIONS)

For leverage to raise expected ROE, must have BEP > rd(weighted interest rate on loans). Why? If rd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = rdD). 3-22

Extended DuPont equation: Breaking down Return on equity

ROE = (Profit margin) x (TA turnover) x (Equity multiplier) = = 3.6% 13.0% x 2 x 1.8

2001 2002 2003E Ind.

PM 2.6% -2.7% 3.6% 3.5%

TA TO 2.3 2.1 2.0 2.6

EM 2.2 5.8 1.8 2.0

ROE 13.3% -32.5% 13.0% 18.2%

3-23

The Du Pont system

Also can be expressed as: ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) Focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (Eq. Mult.) Shows how these factors combine to determine ROE.
3-24

Qualitative factors to be considered when evaluating a companys future financial performance

Are the firms revenues tied to 1 key customer, product, or supplier? What percentage of the firms business is generated overseas? Competition Future prospects Legal and regulatory environment
3-25

Potential problems and limitations of financial ratio analysis

Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Average performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better.
3-26

More issues regarding ratios

Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is good or bad. Difficult to tell whether a company is, on balance, in strong or weak position.

3-27

Calculate and analyze various aspects of business (DLeon Company) with the help of Ratios using financial statements and other data provided in the following slides. Ratios for year 2001 and industry averages are provided.
3-28

Balance Sheet: Assets

Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

2003E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152

2002 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592

3-29

Balance sheet: Liabilities and Equity

2003E Accts payable 436,800 Notes payable 300,000 Accruals 408,000 Total CL 1,144,800 Long-term debt 400,000 Common stock 1,721,176 Retained earnings 231,176 Total Equity 1,952,352 Total L & E 3,497,152 2002 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592
3-30

Income statement
Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income

2003E 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584

2002 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)
3-31

Other data
No. of shares EPS DPS Stock price Lease pmts

2003E 250,000 $1.014 $0.220 $12.17 $40,000

2002 100,000 -$1.602 $0.110 $2.25 $40,000

3-32

Calculate DLeons forecasted current ratio for 2003.

Current ratio = Current assets / Current liabilities = $2,680 / $1,145 = 2.34x

3-33

Comments on current ratio

2003 Current ratio

2002 1.20x

2001 2.30x

Ind. 2.70x

2.34x

Expected to improve but still below the industry average. Liquidity position is weak.
3-34

What is the inventory turnover vs. the industry average?

Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10x
2002
4.70x

2003
Inventory Turnover 4.1x

2001
4.8x

Ind.
6.1x
3-35

Comments on Inventory Turnover

Inventory turnover is below industry average. DLeon might have old inventory, or its control might be poor. No improvement is currently forecasted.

3-36

DSO is the average number of days after making a sale before receiving cash. DSO = Receivables / Average sales per day = Receivables / Sales/365

= $878 / ($7,036/365)
= 45.6

3-37

Appraisal of DSO
2003 DSO 45.6 2002 38.2 2001 37.4 Ind. 32.0

DLeon collects on sales too slowly, and is getting worse. DLeon has a poor credit policy.
3-38

Fixed asset and total asset turnover ratios vs. the industry average FA turnover = Sales / Net fixed assets = $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

3-39

Evaluating the FA turnover and TA turnover ratios

2003 FA TO TA TO

2002 6.4x 2.1x

2001 10.0x 2.3x

Ind. 7.0x 2.6x

8.6x 2.0x

FA turnover projected to exceed the industry average. TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).
3-40

Calculate the debt ratio, TIE, and EBITDA coverage ratios. Debt ratio = Total debt / Total assets = ($1,145 + $400) / $3,497 = 44.2% TIE = EBIT / Interest expense = $492.6 / $70 = 7.0x

3-41

Calculate the debt ratio, TIE, and EBITDA coverage ratios.

EBITDA (EBITDA+Lease pmts) = coverage Int exp + Lease pmts + Principal pmts $609.6 + $40 = $70 + $40 + $0
= 5.9x

3-42

How do the debt management ratios compare with industry averages?

2003 D/A TIE EBITDA coverage

2002 -1.0x 0.1x

2001 54.8% 4.3x 3.0x

Ind. 50.0% 6.2x 8.0x

44.2% 82.8% 7.0x 5.9x

D/A and TIE are better than the industry average, but EBITDA coverage still trails the industry.
3-43

Profitability ratios: Profit margin and Basic earning power

Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6%

BEP = EBIT / Total assets = $492.6 / $3,497 = 14.1%

3-44

Appraising profitability with the profit margin and basic earning power
PM BEP

2003 3.6% 14.1%

2002 -2.7% -4.6%

2001 2.6% 13.0%

Ind. 3.5% 19.1%

Profit margin was very bad in 2002, but is projected to exceed the industry average in 2003. Looking good. BEP removes the effects of taxes and financial leverage, and is useful for comparison. BEP projected to improve, yet still below the industry average. There is definitely room for improvement.
3-45

Profitability ratios: Return on assets and Return on equity

ROA = Net income / Total assets = $253.6 / $3,497 = 7.3%

ROE = Net income / Total common equity = $253.6 / $1,952 = 13.0%

3-46

Appraising profitability with the return on assets and return on equity

ROA ROE

2003 2002 2001 7.3% -5.6% 6.0% 13.0% -32.5% 13.3%

Ind. 9.1% 18.2%

Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. Wide variations in ROE illustrate the effect that leverage can have on profitability.
3-47

Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

P/E

= Price / Earnings per share = $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share = $12.17 / [($253.6 + $117.0) 250] = 8.21x

3-48

Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

M/B = Mkt price per share / Book value per share = $12.17 / ($1,952 / 250) = 1.56x
2003 12.0x 8.21x 1.56x 2002 -1.4x -5.2x 0.5x 2001 9.7x 8.0x 1.3x Ind. 14.2x 11.0x 2.4x
3-49

P/E P/CF M/B

An example: The effects of improving ratios

A/R Other CA Net FA TA 878 1,802 817 3,497 Debt Equity 1,545 1,952 _____ Total L&E 3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firms DSO to 32 days affect the company?
3-50