CHAPTER 3

Analysis of Financial Statements

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 Topics in Chapter

• Ratio analysis
• Ratios
• Common size statements
• Percent change statement
• DuPont equation
• Limitations of ratio analysis
• Qualitative factors

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Determinants of Intrinsic Value: Using Ratio
Analysis

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 Overview

• Ratios facilitate comparison of:

• One company over time
• One company versus other companies
• Ratios are used by:
• Lenders to determine creditworthiness
• Stockholders to estimate future cash flows and risk
• Managers to identify areas of weakness and strength

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 Income Statement
2019 2020E
Sales $6,000 $6,600
COGS except depr. 4,800 5,210
Other expenses 320 370
Deprec. 420 400
EBIT $ 460 $ 620
Int. expense 108 100
EBT $ 352 $ 520
Taxes (40%) 88 130
Net income $ 264 $ 390

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 Balance Sheets: Assets
2019 2020E
Cash $ 50 $ 60
S-T invest. 10 50
AR 520 530
Inventories 820 660
Total CA $1,400 $1,300
Net FA 3,500 3,700
Total
$4,900 $5,000
assets

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Balance Sheets: Liabilities & Equity
2019 2020E
Accts. payable $ 400 $ 330
Notes payable 250 100
Accruals 240 270
Total CL $ 890 $ 700
Long-term debt 1,100 1,100
Total liabilities $1,990 $1,800
Common stock 1,000 1,000
Ret. earnings 1,910 2,200
Total equity $2,910 $3,200
Total L&E $4,900 $5,000

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 Other Data
2019 2020E
EPS $2.64 $3.90
DPS $0.84 $1.00
Book value per
share $29.10 $32.00
Dividends $84 $100
Number of shares 100 100
Year-end stock
price $30.00 $49.00
Lease payments $20 $20
Tax rate 25% 25%

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 Profitability Ratios

• What is the company’s rate of return on sales?

• Profit margin
• Operating profit margin
• What is the company’s rate of return on assets?
• Basic earning power
• Return on assets
• Return on equity

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 Profit Margin

Net profit margin (PM):

2018 2019 2020E Ind.

Profit Margin 6.7% 4.4% 5.9% 7.2%

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 Operating Profit Margin

Operating profit margin:

2018 2019 2020E Ind.

Profit Margin 10.2% 7.7% 9.4% 10.4%

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 Basic Earning Power (BEP)

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 Basic Earning Power vs. Industry Average

• BEP removes effect of taxes and financial leverage.

Useful for comparison.
• Projected to be below average.
• Room for improvement.

2018 2019 2020E Ind.

Basic Earning
13.7% 9.4% 12.4% 15.6%
Power

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Return on Assets (ROA) and Return on Equity
(ROE) (1 of 2)

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Return on Assets (ROA) and Return on Equity
(ROE) (2 of 2)

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 ROA and ROE vs. Industry Averages

2018 2019 2020 Industry

ROA 9.0% 5.4% 7.8% 10.8%
ROE 13.5% 9.1% 12.2% 15.4%

• Both below industry average but improving.

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 Effects of Debt on ROA and ROE

• ROA is lowered by debt--interest expense lowers net

income, which also lowers ROA.
• However, the use of debt lowers equity, and if equity is
lowered more than net income, ROE would increase.

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 Asset Management Ratios

• How efficiently does the firm use its assets?

• How much does the firm have tied up in assets for each
dollar of sales?

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Inventory Turnover Ratio vs. Industry Average

2018 2019 2020E Ind.

Inventory
7.4 6.2 8.5 9.0
turnover

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 Comments on Inventory Turnover

• Inventory turnover:
• Improved from previous year
• Below industry average

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DSO: average number of days from sale until cash
received.

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 Appraisal of DSO

• Higher than 2018, but a little lower than industry.

2018 2019 2020E Ind.

Days Sales
26.5 31.6 29.3 28.0
Outstanding

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Fixed Assets and Total Assets Turnover Ratios
(1 of 2)

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 Fixed Assets and Total Assets Turnover Ratios
(2 of 2)
• Better than previous year.
• Not up to industry average. Caused by high fixed
assets relative to sales.
2018 2019 2020E Ind.
Fixed Asset
1.9 1.7 1.8 3.0
Turnover
Total Asset
1.348 1.224 1.320 1.5
Turnover

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 Liquidity Ratios

• Can the company meet its short-term obligations using

the resources it currently has on hand?

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Forecasted Current and Quick Ratios

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 Comments on Current and Quick Ratios

2018 2019 2020E Ind.

Current 2.1 1.6 1.9 2.5
Quick 1.0 0.7 0.9 1.9

• Expected to improve but still below the industry

average.
• Liquidity position is weak.
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 Debt Management Ratios

• Does the company have too much debt?

• Can the company’s earnings meet its debt servicing
requirements?

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 Leverage Ratios: Debt Ratio

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Leverage Ratios: Debt-to-Equity Ratio

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Leverage Ratios: Liabilities-to-Assets Ratio

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Leverage Ratios: Equity Multiplier

Equity multiplier = Total Assets

Common Equity
= $5,000
$3,200 = 1.5625

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 Times Interest Earned Ratio

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 EBITDA Coverage (EC)

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 Debt Management Ratios vs. Industry Averages
2018 2019 2020E Industry
Debt Ratio 20.8% 27.6% 24.0% 15.0%
Debt-to-equity 0.31 0.46 0.38 0.22
Liabilities-to-assets 33.1% 40.6% 36.0% 32.0%
Earnings Multiplier 1.49 1.68 1.56 1.47
Times Interest Earned 8.2 4.3 6.2 13.0
EBITDA Coverage Ratio 9.9 6.3 8.4 17.2
• Improved, but more debt than industry
• More risk than industry
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 Market Value Ratios

• Market value ratios incorporate the:

• High current levels of earnings and cash flow increase
market value ratios
• High expected growth in earnings and cash flow increases
market value ratios
• High risk of expected growth in earnings and cash flow
decreases market value ratios

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 Calculate and appraise the Price/Earnings (P/E)
ratio.
Price per share (P) = $49.00
Earnings per share (EPS) = $3.90

P/E = P/E = $49.00/$3.90 = 16.8

• P/E: How much investors will pay for $1 of earnings.

Higher is better.

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 Calculate and appraise the M/B ratio.

BVPS = Equity/ # Shares

= $3,200/100 = $32.00.
M/B = P/BVPS
M/B = $49.00/$32.00 = 1.53
• M/B: How much paid for $1 of book value. Higher is
better.

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 Comparison with Industry Averages

2018 2019 2020E Ind.

Price-to Earnings 13.6 11.4 12.6 16.8
Market-to-Book 1.8 1.0 1.5 2.7

• The P/E ratio and the M/B ratio indicate that the market
doesn’t value the company as highly as it does the
average firm in industry.

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Common Size Balance Sheets: Divide all items by
Total Assets
Assets 2018 2019 2020E Ind.
Cash 1.5% 1.0% 1.2% 1.5%
ST Inv. 2.5% 0.2% 1.0% 7.6%
AR 9.8% 10.6% 10.6% 13.2%
Invent. 15.2% 16.7% 13.2% 17.8%
Total CA 28.9% 28.6% 26.0% 40.0%
Net FA 71.1% 71.4% 74.0% 60.0%
TA 100.0% 100.0% 100.0% 100.0%

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Divide all items by Total Liabilities & Equity
Liab. & Eq. 2018 2019 2020E Ind.
AP 7.4% 8.2% 6.6% 6.8%
Notes pay. 1.2% 5.1% 2.0% 3.0%
Accruals 4.9% 4.9% 5.4% 10.2%
Total CL 13.5% 18.2% 14.0% 20.0%
LT Debt 19.6% 22.4% 22.0% 12.0%
Total Liab. 33.1% 40.6% 36.0% 32.0%
Total eq. 66.9% 59.4% 64.0% 68.0%
Total L&E 100.0% 100.0% 100.0% 100.0%

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 Analysis of Common Size Balance Sheets

• Computron has higher proportion of net fixed assets

than the industry.
• Computron’s total debt is 24% (the combined
percentages of notes payable and long-term bonds) of
its assets, which is higher than the industry’s combined
debt percentage of 20%.

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Common Size Income Statement: Divide all items
by Sales
2018 2019 2020E Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 78.2% 80.0% 78.9% 69.0%
Depr. 5.3% 5.3% 5.6% 3.3%
Other exp. 6.4% 7.0% 6.1% 17.3%
EBIT 10.2% 7.7% 9.4% 10.4%
Int. Exp. 1.2% 1.8% 1.5% 0.8%
8.9% 5.9% 7.9% 9.6%
Pre-tax earn.
2.2% 1.5% 2.0% 2.4%
Taxes (25%)
6.7% 4.4% 5.9% 7.2%
NI

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 Analysis of Common Size Income Statements

• Computron’s profit margin is less than the industry ratio

• Computron has lower Other Costs.
• But… it has much higher costs of goods sold

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Percentage Change Analysis: Cumulative Change
from First Year (2018)
Income St. 2018 2019 2020E
Sales 0.0% 9.1% 20.0%
COGS 0.0% 11.6% 21.2%
Depr. 0.0% 10.3% 27.6%
Other exp. 0.0% 20.0% 14.3%
EBIT 0.0% -17.9% 10.7%
Int. Exp. 0.0% 58.8% 47.1%
EBT 0.0% -28.5% 5.7%
Taxes 0.0% -28.5% 5.7%
NI 0.0% -28.5% 5.7%

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 Analysis of Percent Change Income Statement

• For 2019:
• Sales grew by 9% in 2019.
• Net income fell by 28.5%!
• For 2020 projections:
• Cumulative sales growth is 20%.
• Cumulative net income growth is 5.7%
• Improvement, but more work is needed

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Cumulative Percentage Change: Assets

Assets 2018 2019 2020E

Cash 0.0% -16.7% 0.0%
ST Invest. 0.0% -90.0% -50.0%
AR 0.0% 30.0% 32.5%
Invent. 0.0% 32.3% 6.5%
Total CA 0.0% 18.6% 10.2%
Net FA 0.0% 20.7% 27.6%
TA 0.0% 20.1% 22.5%

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Cumulative Percentage Change: Liabilities &
Equity
Liab. & Eq. 2018 2019 2020E

AP 0.0% 33.3% 10.0%

Notes pay. 0.0% 400.0% 100.0%
Accruals 0.0% 20.0% 35.0%
Total CL 0.0% 61.8% 27.3%
LT Debt 0.0% 37.5% 37.5%
Total eq. 0.0% 6.6% 17.2%
Total L&E 0.0% 20.1% 22.5%

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Analysis of Percent Change Balance Sheets: 2019

• Assets grew by 20.1% even though net income fell.

• Much of the asset growth was in accounts receivable
and inventories.
• Not collecting on credit sales
• Unsold product is piling up.
• Growth was funded with big increase in debt.

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 Analysis of Percent Change Balance Sheets:
Projections Compared with 2019
• Small cumulative increase in 2020E total assets (22.5%)
compared with 2019 change in total assets (20.1%)
• But big reduction in cumulative inventory growth (6.5% in
2020E vs. 32.3% in 2019)
• Big drop in cumulative notes payable growth in 2020E
relative to notes payable growth in 2019.

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 Explain the Extended DuPont Equation

• The DuPont equation focuses on:

• Expense control (Profit margin, PM)
• Asset utilization (Total asset turnover,TAT)
• Debt utilization (Equity multiplier, EM)
• It shows how these factors combine to determine the
return on equity (ROE).

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The Simple Version of the DuPont Equation

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The Extended DuPont Equation

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 ROE: (Profit margin)(TA turnover)(EM)

ROE2018 = (6.7%)(1.348)(1.495) = 13.5%

ROE2019 = (4.4%)(1.224)(1.684) = 9.1%

ROE2020E = (5.9%)(1.320)(1.563) = 12.2%

ROEInd = (7.2%)(1.5)(1.47) = 15.9%

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 Potential Problems and Limitations of Ratio
Analysis
• Comparison with industry averages is difficult if the firm
operates many different divisions.
• Seasonal factors can distort ratios.
• Window dressing techniques can make statements and
ratios look better.
• Different accounting and operating practices can distort
comparisons.

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 Qualitative Factors

• There is greater risk if:

• revenues tied to a single customer
• revenues tied to a single product
• reliance on a single supplier?
• High percentage of business is generated overseas?
• What is the competitive situation?
• What products are in the pipeline?
• What are the legal and regulatory issues?

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