class 5-6
TRANSCRIPT
Ratio analysisDu Pont systemEffects of improving ratiosLimitations of ratio analysis
CHAPTER 7 Analysis of Financial Statements
Balance Sheet: Assets
1999E 1998Cash 85,632 7,282AR 878,000 632,160Inventories 1,716,480 1,287,360 Total CA 2,680,112 1,926,802Gross FA 1,197,160 1,202,950Less: Deprec. 380,120 263,160 Net FA 817,040 939,790Total assets 3,497,152 2,866,592
Liabilities and Equity
1999E 1998Accounts payable 436,800 524,160Notes payable 600,000 720,000Accruals 408,000 489,600 Total CL 1,444,800 1,733,760Long-term debt 500,000 1,000,000Common stock 1,680,936 460,000Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832Total L & E 3,497,152 2,866,592
Income Statement
1999E 1998Sales 7,035,600 5,834,400COGS 5,728,000 5,728,000Other expenses 680,000 680,000Depreciation 116,960 116,960 Tot. op. costs 6,524,960 6,524,960 EBIT 510,640 (690,560)Interest exp. 88,000 176,000 EBT 422,640 (866,560)Taxes (40%) 169,056 (346,624)Net income 253,584 (519,936)
Other Data
1999E 1998
Shares out. 250,000 100,000
EPS $1.014 ($5.199)
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000
• Financial analysis focuses on cash flows• Accounting income may differ from cash
flow– Net cash flow = net income - non cash
revenues + non cash charges
• One major non cash charge is depreciation– Net cash flow = NI + depreciation
Accounting Income vs. Cash Flow
• Operating cash flow– Represents funds available to pay both debt
holders and share holders– Operating cash flow =
• EBIT * (1 - tax rate) + depreciation
• Net cash flow = operating cash flow - interest * (1 - tax rate)
Accounting Income vs. Cash Flow
(523,936)
Statement of Cash Flows (1998)
OPERATING ACTIVITIES Net income (519,936)Add (Sources of cash): Depreciation 116,960 Increase in A/P 378,560 Increase in accruals 353,600Subtract (Uses of cash): Increase in A/R (280,960) Increase in inventories (572,160)
Net cash provided by ops.
L-T INVESTING ACTIVITIES Investment in fixed assets (711,950)
FINANCING ACTIVITIES Increase in notes payable 520,000 Increase in long-term debt 676,568 Payment of cash dividends (11,000) Net cash from financing 1,185,568
NET CHANGE IN CASH (50,318)
Plus: Cash at beginning of year 57,600Cash at end of year 7,282
• Net cash from operations = -$523,936, mainly because of negative NI.
• The firm borrowed $1,185,568 to meet its cash requirements.
• Even after borrowing, the cash account fell by $50,318.
What can you conclude about D’Leon’s financial condition from its
statement of CFs?
What effect did the company’s expansion have on its net cash flow
and operating cash flow?
NCF98 = NI + DEP = ($519,936) + $116,960= ($402,976).
NCF97 = $87,960 + $18,900 = $106,860.OCF98 = EBIT(1 - T) + DEP
= (-$690,560)(0.6) + $116,960= ($297,376).
OCF97 = ($209,100)(0.6) + $18,900= $144,360.
Ratio Analysis• Why are financial ratios useful?
– Standardized numbers, facilitate comparisons– Used to highlight strengths and weaknesses
• Benchmarking– Comparing a company’s financial ratios with those
of a set of benchmark companies– Gives a way for the company to assess its
performance
Calculation of Ratios
• Issues to consider– When dealing with balance sheet numbers,
we may have a problem because those numbers represent the state of the company at a certain point in time• Often will use, when available, average numbers
over the year
Calculation of Ratios
• The Impact of Leverage– Risk sharing– Higher returns– Affect on ratios?
• Any ratio involving income (profitability ratios) will be impact by a company’s leverage choice
• Makes comparisons difficult• What is the difference between two identical companies that
use different leverage?
Limitations of Ratio Analysis
• Use data reported on financial statements– Seasonal factors can distort ratios.– “Window dressing” techniques can make
statements and ratios look better.– Different operating and accounting practices
distort comparisons.
Limitations of Ratio Analysis
• Making comparisons can be difficult– Comparison with industry averages is
difficult if the firm operates many different divisions.
– “Average” performance not necessarily good.
– Sometimes hard to tell if a ratio is “good” or “bad.”
• Liquidity: Can we make required payments as they fall due?
• Asset management: Do we have the right amount of assets for the level of sales?
What are the five major categories of ratios, and what
questions do they answer?
(More…)
• Debt management: Do we have the 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?
Calculate D’Leon’s forecasted current and quick ratios for 1999.
CR99 = = = 1.85x.
QR99 =
= = 0.67x.
CACL
$2,680$1,445
$2,680 - $1,716$1,445
CA - Inv.CL
Expected to improve but still below the industry average.
Liquidity position is weak.
Comments on CR and QR
1999 1998 1997 Ind.
CR 1.85x 1.1x 2.3x 2.7x
QR 0.67x 0.4x 0.8x 1.0x
What is the inventory turnover ratio vs. the industry average?
Inv. turnover =
= = 4.10x.
SalesInventories
$7,036$1,716
1999 1998 1997 Ind.
Inv. T. 4.1x 4.5x 4.8x 6.1x
• Inventory turnover is below industry average.
• D’Leon might have old inventory, or its control might be poor.
• No improvement is currently forecasted.
Comments on Inventory Turnover
ReceivablesAverage sales per day
DSO is the average number of days after making a sale before receiving
cash.
DSO =
= = = 44.9. ReceivablesSales/360
$878$7,036/360
Appraisal of DSO
D’Leon collects too slowly, and is getting worse.
Poor credit policy.
1999 1998 1997 Ind.DSO 44.9 39.0 36.8 32.0
F.A. and T.A. turnover vs. industry average
Fixed assetsturnover
Sales Net fixed assets=
= = 8.61x.$7,036$817
Total assetsturnover
Sales Total assets=
= = 2.01x.$7,036$3,497
FA turnover projected to exceed industry average. Good.
TA turnover not up to industry average. Caused by excessive current assets (A/R and Inv.)
1999 1998 1997 Ind.FA TO 8.6x 6.2x 10.0x 7.0xTA TO 2.0x 2.0x 2.3x 2.6x
Calculate the debt and TIE ratios.
Total debt Total assetsDebt ratio =
= = 55.6%.$1,445 + $500$3,497
EBIT Int. expense TIE =
= = 5.8x.$510.6$88
Too much debt, but projected to improve.
How do the debt management ratios compare with industry averages?
1999 1998 1997 Ind.D/A 55.6% 95.4% 54.8% 50.0%TIE 5.8x -3.9x 3.3x 6.2x
Very bad in 1998, but projected to exceed industry average in 1999. Looking good.
Profit margin vs. industry average?
1999 1998 1997 Ind.P.M. 3.6% -8.9% 2.6% 3.5%
P.M. = = = 3.6%. NI Sales
$253.6$7,036
BEP =
= = 14.6%.
BEP vs. Industry Average?
EBIT Total assets
$510.6 $3,497
• BEP removes effect of taxes and financial leverage. Useful for comparison.
• Projected to be below average.• Room for improvement.
1999 1998 1997 Ind.BEP 14.6% -24.1% 14.2% 19.1%
Return on Assets
ROA =
= = 7.3%.
Net income Total assets
$253.6 $3,497
ROE =
= = 16.3%.
Net income Common equity
$253.6 $1,552
1999 1998 1997 Ind.ROA 7.3% -18.1% 6.0% 9.1%ROE 16.3% -391.4% 13.3% 18.2%
Both below average but improving.
• ROA is lowered by debt--interest lowers NI, which also lowers ROA = NI/Assets.
• But use of debt lowers equity, hence could raise ROE = NI/Equity.
Effects of Debt on ROA and ROE
Calculate and appraise the P/E and M/B ratios.
Price = $12.17.
EPS = = = $1.01.
P/E = = = 12x.
NI Shares out.
$253.6250
Price per shareEPS
$12.17$1.01
Com. equity Shares out.BVPS =
= = $6.21.$1,552250
Mkt. price per share Book value per share
M/B =
= = 1.96x.$12.17$6.21
P/E: How much investors will pay for $1 of earnings.
M/B: How much paid for $1 of BV.
1999 1998 1997 Ind.P/E 12.0x -0.4x 9.7x 14.2xM/B 1.96x 1.7x 1.3x 2.4x
The Du Pont system focuses on:
• Expense control (P.M.)• Asset utilization (TATO)• Debt utilization (Eq. Mult.)
It shows how these factors combine to determine the ROE.
The Du Pont Equations:
• ROA = PM * TATO =– (NI/Sales)*(Sales/TA)
• ROE = ROA * Equity Multiplier =– (NI/TA)*(TA/Common Equity)
• ROE = PM*TATO*EM– ROE = (NI/Sales)*(Sales/TA)*(TA/CE)
( )( )( ) = ROE
x x = ROE.
Profitmargin
TAturnover
Equitymultiplier
NI Sales
SalesTA
TA CE
1997 2.6% x 2.3 x 2.2 = 13.2%1998 -8.9% x 2.0 x 21.6 = -391.4%1999 3.6% x 2.0 x 2.3 = 16.3%Ind. 3.5% x 2.6 x 2.0 = 18.2%
Simplified D’Leon Data
A/R 878 Debt 1,945Other CA 1,802 Equity 1,552Net FA 817Total assets $3,497 L&E $3,497
Q. How would reducing DSO to 32 days affect the company?
Sales $7,035,600 day 360
= = $19,543.
Effect of reducing DSO from 44.9 days to 32 days:
Old A/R = 19,543 x 44.9 = 878,000
New A/R = 19,543 x 32.0 = 625,376
Cash freed up: 252,624
Initially shows up as additional cash.
What could be done with the newcash? Effect on stock price and risk?
New Balance Sheet
Added cash $ 253 Debt $1,945A/R 625 Equity 1,552Other CA 1,802Net FA 817Total assets $3,497 Total L&E $3,497