Download Ind.

CHAPTER 4
Analysis of Financial
Statements




Ratio Analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
4-1
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2010E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
2009
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
4-2
Balance sheet:
Liabilities and Equity
2010E
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
2009
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-3
Income statement
Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes
Net income
2010E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2009
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-4
Other data
No. of shares
EPS
DPS
Stock price
Lease pmts
2010E
250,000
$1.014
$0.220
$12.17
$40,000
2009
100,000
-$1.602
$0.110
$2.25
$40,000
4-5
Why are ratios useful?



Ratios standardize numbers and
facilitate comparisons.
Ratios are used to highlight
weaknesses and strengths.
Ratio comparisons should be made
through time and with competitors


Peer (or Industry) analysis
Trend analysis
4-6
Ratios facilitate comparisons
Firm A (RM)
Sales
5,000,000
T. Assets 3,500,000
Firm B (RM)
4,850,000
3,200,000
4-7
Turnover ratio
Firm A
5,000,000 = 1.428x
3,500,000
Industry analysis
Firm B
1.52x
Firm B
4,850,000 = 1.52x
3,200,000
Industry
1.729x
4-8
Trend Analysis
Turnover ratio firm’s B
1.256
1.276
1.325
1.346
1.426
1.457
Year
2000
2001
2002
2003
2004
2005
4-9
1.5
1.45
1.4
1.35
Series1
1.3
1.25
1.2
1.15
1
2
3
4
5
6
4-10
What question do they answer?

Liquidity Ratio: Can we make required
payments?
4-11
Calculate forecasted current ratio and
quick ratio for 2010.
Current ratio =
=
=
Quick ratio =
=
=
Current assets / Current liabilities
$2,680 / $1,145
Industry
2.34x
2.70x
(CA – Inventories) / CL
($2,680 – $1,716) / $1,145
0.84x
Industry
1.0x
4-12
Comments on liquidity ratios
2010E
2009
2008
Ind.
Current Ratio
2.34x
1.20x
2.30x
2.70x
Quick Ratio
0.84x
0.39x
0.85x
1.00x


Expected to improve but still below the
industry average.
Liquidity position is weak.
4-13
What question do they answer?

Asset management ratios: right
amount of assets vs. sales?
4-14
What is the inventory turnover
vs. the industry average?
Inv. turnover
Inventory
Turnover
= Sales / Inventories
= $7,036 / $1,716
= 4.10x
2010E
2009
2008
Ind.
4.1x
4.70x
4.8x
6.1x
4-15
Comments on
Inventory Turnover


Inventory turnover is below industry
average.
Company might have overstocked of
inventory or insufficient sales
4-16
DSO is the average number of days after
making a sale before receiving cash.
DSO = Receivables / Avg sales per day
= Receivables / (Annual sales/365)
= $878 / ($7,036/365)
= 45.6 days
4-17
Appraisal of DSO
DSO


2010E
2009
2008
Ind.
45.6
38.2
37.4
32.0
Company collects on sales too slowly,
and is getting worse.
Company has a poor credit policy.
4-18
Fixed assets and total assets 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
4-19
Evaluating the FA turnover and
TA turnover ratios


2010E
2009
2008
Ind.
FA TO
8.6x
6.4x
10.0x
7.0x
TA TO
2.0x
2.1x
2.3x
2.6x
FA turnover projected to exceed the industry
average.
TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).
4-20
what question do they answer?

Debt management: Right mix of debt
and equity?
4-21
Effects of Financial Leverage on Stockholder
Returns
Current assets
Fixed assets
FIRM U [UNLEVERAGED (NO DEBT)]
$50
Debt
50
Common Equity
Total Assets
$100
Total liabilities and equity
Good
Sales revenues
Operating costs
Fixed
Variable
Total Operating costs
Operating income (EBIT)
Interest (Rate = 10%)
Earnings before taxes (EBT)
Taxes (Rate = 40%)
Net income (NI)
ROEu
$0
100
150.0
45.0
60.0
105.0
45.0
0.0
45.0
18.0
27.0
27.0%
BUSINESS
CONDITIONS
Expected
100.0
45.0
40.0
85.0
15.0
0.0
15.0
6.0
9.0
9.0%
$100
Bad
75.0
45.0
30.0
75.0
0.0
0.0
0.0
0.0
0.0
0.0%
4-22
FIRM L [UNLEVERAGED (SOME DEBT)]
Current assets
$50
Fixed assets
50
Total Assets
$100
Debt
$50
Common Equity
50
Total liabilities and equity
Good
Sales revenues
Operating costs
Fixed
Variable
Total Operating costs
Operating income (EBIT)
Interest (Rate = 10%)
Earnings before taxes (EBT)
Taxes (Rate = 40%)
Net income (NI)
ROEL
150.0
45.0
60.0
105.0
45.0
5.0
40.0
16.0
24.0
48.0%
BUSINESS
CONDITIONS
Expected
100.0
45.0
40.0
85.0
15.0
5.0
10.0
4.0
6.0
12.0%
$100
Bad
75.0
45.0
30.0
75.0
0.0
5.0
-5.0
0.0
-5.0
-10.0%
4-23
Leverage( debt) and the advantages ?



Imagine that the company have RM 50
million to pay for the new building
It is insufficient to buy the building for the
company expansion plan, so the company
use that money as a deposit on the loan and
get a loan for the rest of the money due.
If the building price is RM250 M, and the
company put down RM50 M, the company
can use the loan to leverage that cash so the
4-24
company can afford the building.
Leverage( debt) and the advantages ?



In this case the loan covers 80% of the
purchase price.
The company now can use any cash the
company earn beyond the monthly loan
repayment to pay other company’s
expenditure.
The real benefits of leverage is seen when
the building price goes up over time.
4-25
Leverage( debt) and the advantages ?


Suppose the building value increases by
20% to RM300 M at which point the
company sell it and pay back the loan of RM
200 M.
The company capital now has doubled from
RM 50 M to RM 100M
4-26
Calculate the debt to equity ratio, debt
ratio, times-interest-earned coverage
ratios.
Debt to Equity= Total debt / Total equity
= ($1,145 + $400) / 1,721 +231
Ind.
= 0.79
0.83
4-27
Calculate the debt to equity ratio, debt
ratio, times-interest-earned coverage
ratios.
Debt ratio = Total debt / Total assets
= ($1,145 + $400) / $3,497 Ind.
= 44.2%
50%
TIE
= EBIT / Interest expense
= $492.6 / $70 = 7.0x
Ind.
6.2%
4-28
How do the debt management ratios
compare with industry averages?

2006E
2005
2004
Ind.
D/A
44.2%
82.8%
54.8%
50.0%
TIE
7.0x
-1.0x
4.3x
6.2x
D/E
0.79
4.79
1.21
0.81
D/E, D/A and TIE are compatible with the
industry
4-29
What questions do they answer?

Profitability ratios: These ratios enable
the investors to evaluate the firm’s
profit with respect to a given level of
sales, a certain level of assets, or the
owners’ investments?
4-30
Profitability ratios:
Profit margin and Basic earning power
Profit margin = Net income / Sales
= $253.6 / $7,036 = 3.6%
Ind.
3.5%
BEP
= EBIT / Total assets
= $492.6 / $3,497 = 14.1%
Ind.
19.1%
4-31
Profitability ratios:
Return on assets and Return on equity
ROA = Net income / Total assets
= $253.6 / $3,497 = 7.3%
Ind.
9.1%
ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
Ind.
18.2%
4-32
Appraising profitability with the return
on assets and return on equity

2010E
2009
2008
Ind.
ROA
7.3%
-5.6%
6.0%
9.1%
ROE
13.0%
-32.5%
13.3%
18.2%
Both ratios rebounded from the previous
year, but are still below the industry
average. More improvement is needed.
4-33
Problems with ROE

ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.

ROE could not capture accounting manipulation
risk.
4-34
High ROE
Net income
Capital structure policy
ROE= Net Income
Common equity
Equity
Liability
High risk of financial
distress
4-35
Market value ratios

A set of ratios that relate the firm’s
stock price to its earnings, cash flow,
and book value per share.
4-36
Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.
Share price= $12.17, Earnings= $253,584 # 0f shares= 250,000
P/E
= Price / Earnings per share
= $12.17 / $1.014 = 12.0x
Ind.
14.2x
P/CF = Price / Cash flow per share
= $12.17 / [($253.6+$117.0) ÷ 250]
Ind.
= 8.21x
11.0x
4-37
Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.
M/B = Market price / Book value per share
= $12.17 / ($1,952 / 250) = 1.56x Ind.
2.4x
2010E
2009
2008
Ind.
P/E
12.0x
-1.4x
9.7x
14.2x
P/CF
8.21x
-5.2x
8.0x
11.0x
M/B
1.56x
0.5x
1.3x
2.4x
4-38
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.
4-39
The Du Pont system
Equity
Profit
Total assets
ROE  margin  turnover 
multiplier
ROE  (NI/Sales)  (Sales/TA)  (TA/Equity)

Focuses on expense control (PM), asset
utilization (TA TO), and debt utilization
(Equity multiplier.)
4-40
Extended DuPont equation:
Breaking down Return On Equity
ROE =
=
=
(NI / Sales) x (Sales/TA) x (TA/Equity)
3.6%
13.0%
x
2
x
1.8
PM
TA TO
EM
ROE
2008
2009
2010E
2.6%
-2.7%
3.6%
2.3
2.1
2.0
2.2
5.8
1.8
13.3%
-32.5%
13.0%
Ind.
3.5%
2.6
2.0
18.2%
Ind.
18.2%
4-41
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.
“Window dressing” techniques can make
statements and ratios look better.
Different operating and accounting practices
can distort comparisons.
4-42
Electronic
1) Firm A
Firm B
N. Income
= RM1m
T. Assets
= RM4m
Return on = 1m
Total asset
4m
= 0.25 ≈ 25%
Subs A
Subs B
N. Income
= RM5m
T. Assets
= RM15m
Subs C
Return on = 5m
total asset 15m
= 0.33 ≈ 33%
4-43
2)
ROE
ROA
Firm A
13%
5.9%
Industry average
13.2%
5.9%
4-44
3) Window Dressing
ROE
Firm A
12.6%
Firm B
ROE = Net income
Equity
10.5%
; A= L+E
4-45
Different accounting practice
Sales
COGS
Depreciation
Net income
Firm A
xxx
(xx)
(x)
xx
straight line method
Firm B
xxx
(xx)
(xx)
x
Accelerated method
4-46
Potential problems and limitations
of financial ratio analysis

It is difficult to generalize about whether a
particular ratio is good or bad.


For example, a high current ratio may indicate a
strong liquidity position (which is good) or excessive
cash ( which is bad) because excess cash is non
earning assets.
Example 2, high fixed turnover ratio may indicate
either the firm uses its assets efficiently, or that it is
short of cash and cannot afford to make the needed
investment in fixed assets.
4-47
Potential problems and limitations
of financial ratio analysis


Inflation can badly distort many firms’ balance
sheet data. Thus the recorded values are often
substantially different from “true” values
Seasonal factors can distort ratio analysis. For
example the inventory turnover ratio for a
food processor will be radically different if the
balance sheet figure used for inventory is the
one just before versus just after the close of
the canning season.
4-48