fin 303 vicentiu covrig 1 analysis of financial statements analysis of financial statements (chapter...

FIN 303Vicentiu Covrig

1

Analysis of financial statements

(chapter 4)


2

Ratio analysis: 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- Trend analysis- Peer (or Industry) analysis


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?


4

Balance Sheet: Assets

4-4

CashA/RInventories

Total CAGross FALess: Deprec.

Net FATotal Assets

20117,282

632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592

2012E85,632

878,0001,716,4802,680,1121,197,160 380,120 817,0403,497,152


5

Balance Sheet: Liabilities and Equity

4-5

Accts payableNotes payableAccruals

Total CLLong-term debtCommon stockRetained earnings

Total EquityTotal L & E

2011524,160636,808

489,6001,650,568

723,432460,000

32,592 492,5922,866,592

2012E436,800300,000

408,0001,144,800

400,0001,721,176 231,1761,952,3523,497,152


6

Income Statement

SalesCOGSOther expenses

EBITDADeprec. & amort.

EBITInterest exp.

EBTTaxesNet income

20116,034,0005,528,000

519,988 (13,988) 116,960 (130,948) 136,012 (266,960)

(106,784) (160,176)

2012E7,035,600

5,875,992 550,000

609,608 116,960

492,648 70,008

422,640 169,056 253,584


7

Other Data

4-7

No. of sharesEPSDPSStock priceLease pmts

2012E250,000

$1.014$0.220$12.17

$40,000

2011100,000-$1.602$0.110

$2.25$40,000


8

D’Leon’s Forecasted Current Ratio and Quick Ratio for 2012

4-8

2.34145,1$680,2$

sliabilitie Currentassets Current

ratio Current

48.0145,1$

)716,1$680,2($sliabilitie Current

)sInventorieassets (Current ratio Quick


9

Comments on Liquidity Ratios2012E 2011 2010 Ind.

Current ratio 2.34x 1.20x 2.30x 2.70x

Quick ratio 0.84x 0.39x 0.85x 1.00x

4-9

• Expected to improve but still below the industry average.

• Liquidity position is weak.


10

D’Leon’s Inventory Turnover vs. the Industry Average

2012E 2011 2010 Ind.

Inventory turnover 4.1x 4.70x 4.8x 6.1x

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

Inventory turnover is below industry average. D’Leon might have old inventory, or its control

might be poor.


11

DSO: 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

2012E 2011 2010 Ind.

DSO 45.6 38.2 37.4 32.0

• D’Leon has a poor credit policy.

• D’Leon collects on sales too slowly, and is getting worse.


12

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

4-12


13

Evaluating the FA Turnover (S/Net FA) and TA Turnover (S/TA) Ratios

2012E 2011 2010 Ind.

FA TO 8.6x 6.4x 10.0x 7.0x

TA TO 2.0x 2.1x 2.3x 2.6x

4-13

• FA turnover projected to exceed the industry average.

• TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).


14

Calculate the Debt Ratio and Times-Interest-Earned Ratio

Debt ratio = Total debt/Total assets

= ($1,145 + $400)/$3,497

= 44.2%

TIE = EBIT/Interest charges

= $492.6/$70 = 7.0x

4-14


15

D’Leon’s Debt Management Ratios vs. the Industry Averages2012E 2011 2010 Ind.

D/A 44.2% 82.8% 54.8% 50.0%

TIE 7.0x -1.0x 4.3x 6.2x

• D/A and TIE are better than the industry average.


16

As a short-term creditor concerned with a company’s ability to meet its financial obligation to you, which one of the following combinations of ratios would you most likely prefer?

Current Debt ratio TIE ratio a. 0.5 0.5 0.33 b. 1.0 1.0 0.50 c. 1.5 1.5 0.50 * d. 2.0 1.0 0.67

Exam type question


17

Profitability Ratios: Operating Margin, Profit Margin, and Basic Earning Power

4-17

Operating margin = EBIT/Sales = $492.6/$7,036 = 7.0% Profit margin = Net income/Sales = $253.6/$7,036 = 3.6%

Basic earning power = EBIT/Total assets = $492.6/$3,497 = 14.1%


18

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power

2012E 2011 2010 Ind.

Operating margin 7.0% -2.2% 5.6% 7.3%

Profit margin 3.6% -2.7% 2.6% 3.5%

Basic earning power 14.1% -4.6% 13.0% 19.1%

4-18


19

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power

Operating margin was very bad in 2011. It is projected to improve in 2012, but it is still projected to remain below the industry average.

Profit margin was very bad in 2011 but is projected to exceed the industry average in 2012. 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.

4-19


20

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%

4-20


21

Appraising Profitability with ROA and ROE

2012E 2011 2010 Ind.

ROA 7.3% -5.6% 6.0% 9.1%

ROE 13.0% -32.5% 13.3% 18.2%

4-21

• 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.


22

Effects of Debt on ROA and ROE Holding assets constant, if debt increases:

- Equity declines.- Interest expense increases – which leads to a

reduction in net income. ROA declines (due to the reduction in net

income). ROE may increase or decrease (since both

net income and equity decline).

4-22


23

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. Given these problems, reliance on ROE may

encourage managers to make investments that do not benefit shareholders. As a result, analysts have looked to develop other performance measures, such as EVA.


24

Calculate the Price/Earnings and Market/Book Ratios

P/E = Price/Earnings per share

= $12.17/$1.014 = 12.0x

M/B = Market price/Book value per share

= $12.17/($1,952/250) = 1.56x2012E 2011 2010 Ind.

P/E 12.0x -1.4x 9.7x 14.2x

M/B 1.56x 0.5x 1.3x 2.4x


25

Analyzing the Market Value Ratios P/E: How much investors are willing to

pay for $1 of earnings. 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.

4-25


26

The DuPont Equation

Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier).

4-26

)(TA/Equity (Sales/TA) (NI/Sales) ROE

multiplierEquity turnover

assets Total marginProfit ROE


27

DuPont Equation: Breaking Down Return on Equity

PM TA TO EM ROE

2010 2.6% 2.3 2.2 13.3%

2011 -2.7% 2.1 5.8 -32.5%

2012E 3.6% 2.0 1.8 13.0%

Ind. 3.5% 2.6 2.0 18.2%

4-27

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)

= 3.6% x 2 x 1.8

= 13.0%


28

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.


29

A firm that has an equity multiplier of 4.0 will have a debt ratio ofa. 4.00b. 3.00c. 1.00d. 0.75 *

Exam type questions


30

Exam type questionThe Merriam Company has determined that its return on equity is 15 percent.

Management is interested in the various components that went into this calculation. You are given the following information: total debt/total assets = 0.35 and total assets turnover = 2.8. What is the profit margin?

a. 3.48% *b. 5.42%c. 6.96%d. 2.45%


31

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. 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.


32

Learning objectives Given all the information needed, know how to calculate and interpret all the

financial ratios that are discussed in the notes, including DuPont analysis. For the exam, there will be a page attached to the exam paper with all the formulas from this chapter.

Discuss potential problems and limitations of financial ratio analysis, including problems with ROE

end of chapter problems 4-1 to 4-14, 4-22

fin 303 vicentiu covrig 1 analysis of financial statements analysis of financial statements (chapter...

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