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# Chapter 3

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• www: Click on the web surfer to go to CNBC’s stock screener. Choose the “Advanced Search” option to show students the wide range of ratios that can be used for making investment decisions.
• The numbers in this sample balance sheet are based on the 1999 annual report for McGraw-Hill. The categories were condensed for simplicity.
• This sample income statement is based on information from the McGraw-Hill 1999 annual report.
• The firm is just barely able to cover current liabilities with it’s current assets. A short-term creditor might find this a bit disconcerting and may reduce the likelihood that they would lend money to the company. The ratio should be compared to the industry – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books. The quick ratio is a little lower than the current ratio, but overall inventory seems to be a small component of current assets. This company carries a very low cash balance. This may be an indication that they are aggressively investing in assets that will provide higher returns. We need to make sure that we have enough cash to meet our obligations, but too much cash reduces the return earned by the company.
• Note that these are often called leverage ratios. TE = total equity and TA = total assets, the numerator in the total debt ratio could also be found by adding all of the current and long-term liabilities. Another way to compute the D/E ratio if you already have the total debt ratio: D/E = Total debt ratio / (1 – total debt ratio) = .5863 / (1 - .5863) = 1.417 The EM is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.
• Even though the company is financed with over 58% debt, they have a substantial amount of operating income available to cover the required interest payments. Remember that depreciation is a non-cash deduction. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation to get an estimate of cash flow before taxes.
• Inventory turnover can be computed using either ending inventory or average inventory when you have both beginning and ending figures. It is important to be consistent with whatever benchmark you are using to analyze the company’s strengths or weaknesses. It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be understated and you might believe that the company is not performing as well as it is. On the other hand, if the balance sheet is prepared when inventory has been drawn down due to seasonal sales, then the inventory turnover would be overstated and the company may appear to be doing better than it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you may want to look at quarterly averages to get a better indication of turnover.
• Technically, the sales figure should be credit sales. This is often difficult to determine from the income statements provided in annual reports. If you use total sales instead of credit sales, you will overstate your turnover level. You need to recognize this bias when credit sales are unavailable, particularly if a large portion of the sales are cash sales. As with inventory turnover, you can use either ending receivables or an average of beginning and ending. You also run into the same seasonal issues as discussed with inventory. Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If the company offers a discount (1/10 net 30), then you would like to see days’ sales in receivables less than 30. If the company does not offer a discount (net 30), then you would like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is substantially larger than the net terms, then you first need to look for biases, such as seasonality in sales. If this does not provide an explanation for the difference, then the company may need to take another look at its credit policy (who it grants credit to and its collection procedures).
• Having a TAT of less than one is not a problem for most firms. Fixed assets are expensive and are meant to provide sales over a long period of time. This is why the matching principle indicates that they should be depreciated instead of immediately expensed. This is one of the ratios that will be used in the Du Pont identity.
• You can also compute the gross profit margin and the operating profit margin. Profit margin is one of the components of the Du Pont identity and is a measure of operating efficiency. It measures how well the firm controls the costs required to generate the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns almost \$0.11 for each dollar in sales. Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using. ROE will always be higher than ROA as long as the firm has debt. The greater the leverage the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximization. The Du Pont identity is used to identify factors that affect the ROE.
• Be sure and point out that the numbers in the tables are presented in thousands, so the BV of equity has to have the extra three zeros in order for the market-to-book ratio to work.
• Improving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong then we can look at fixed asset turnover and cash management. We can also improve our ROE by increasing our leverage – up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilize our interest tax credit effectively, but we don’t want to overdo it. The choice of leverage is discussed in more detail in chapter 13.
• Note that these ratios can be computed either on a per share basis or on an actual basis.
• This firm could grow assets at 6.71% without raising additional external capital. Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in chapter 13, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.
• Note that no new equity is issued. The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.
• The first three components come from the ROE and the Du Pont identity. It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value.
• SIC codes have been used many years to identify industries and allow for comparison with industry average ratios. The SIC codes are limited however and have not kept pace with a rapidly changing environment. Consequently, the North American Industry Classification System was introduced in 1997 to alleviate some of the problems with SIC codes. www: Click on the web surfer to go the NAICS home page. It provides information on the change to the NAICS and conversion between SIC and NAICS codes.
• www: The annual report was downloaded from the company’s web site and that is the hot link that is provided above. As time passes and the company produces new annual reports, the information may change, although it is linked directly to 1999, so hopefully it will still be available. If it isn’t, you can either update the ratios, or I have provided summary information in the Instructor’s manual for 1999. It would be a good exercise to have the students print the balance sheet and income statement for the latest year and work through these ratios in class. They could then compare the ratios to the table in the book. If you do this, be sure to point out that you should technically use benchmark data for the same time period.
• The industry number reported above is the median from the table. I also used the 25MM and over column to better match size. Liquidity ratio: Ethan Allan has an industry well above the median and it is right at the upper quartile. Is this good or bad? Short-term creditors like high current ratios, so the company should have little difficulty receiving short-term financing. However, short-term assets also tend to earn lower returns than do long-term assets, so the company may be passing up returns by holding more short-term assets. Finally, a high current ratio may be indicative of too much inventory or receivables problems. Quick ratio: Ethan Allan is still above the industry median, but below the upper quartile. This may be an indication of substantial amounts of inventory relative to the industry. Debt/Equity ratio: Ethan Allan is well below the industry average and has much less debt than 75% of the companies in the industry. Creditors like this, however, the firm may be foregoing valuable tax benefits associated with interest payments. Based on industry figures, Ethan Allan may have substantial unused debt capacity and might be able to increase shareholder wealth by taking on some additional debt. Times Interest Earned: This ratio is substantially higher than the industry median and is another indication that the company may have significant debt capacity available. Ethan Allan carries quite a bit of notes receivables. The interest received on the notes receivables can be used to offset interest expense paid on debt. This is another reason for the extremely high TIE.
• Inventory Turnover: The inventory turnover is substantially lower than the industry median and is right at the lower quartile. This is consistent with the high current ratio and the significant drop in the quick ratio relative to the current ratio. The company may want to examine its current inventory management policies to see if there are ways to maintain less inventory without incurring significant stock-out costs. This may also be a problem with a different accounting method than most firms in the industry or a different fiscal period (note that Ethan Allen’s fiscal year ends in June, but the data in the table is running April to March). Receivables are collected a little faster than the industry median, however, it is not outside the boundaries of the upper and lower quartiles. There is probably not much of a concern with the firm’s credit policy at this point. Total Asset Turnover: The company is a little below the industry median, but they are within the boundaries of the upper and lower quartiles. The problem with inventory seems to be mitigated somewhat by the efficient use of other assets. Profit margin before taxes (From Table 3.8): Ethan Allen’s profit margin is substantially higher than the median. This is generally good as long as the company is not foregoing necessary expenses just to increase the bottom line. ROA: The ROA is substantially higher than the upper quartile for the industry. This shows excellent return characteristics relative to the industry. The same comments hold for ROE. Note that ROA and ROE are computed using profit before taxes to be consistent with the numbers in the table.
• ### Chapter 3

1. 1. Chapter 3 Working With Financial Statements
2. 2. Key Concepts and Skills <ul><li>Know how to standardize financial statements for comparison purposes </li></ul><ul><li>Know how to compute and interpret important financial ratios </li></ul><ul><li>Know the determinants of a firm’s profitability and growth </li></ul><ul><li>Understand the problems and pitfalls in financial statement analysis </li></ul>
3. 3. Chapter Outline <ul><li>Standardized Financial Statements </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>The Du Pont Identity </li></ul><ul><li>Internal and Sustainable Growth </li></ul><ul><li>Using Financial Statement Information </li></ul>
4. 4. Standardized Financial Statements <ul><li>Common-Size Balance Sheets </li></ul><ul><ul><li>Compute all accounts as a percent of total assets </li></ul></ul><ul><li>Common-Size Income Statements </li></ul><ul><ul><li>Compute all line items as a percent of sales </li></ul></ul><ul><li>Standardized statements make it easier to compare financial information, particularly as the company grows </li></ul><ul><li>They are also useful for comparing companies of different sizes, particularly within the same industry </li></ul>
5. 5. Ratio Analysis <ul><li>Ratios also allow for better comparison through time or between companies </li></ul><ul><li>As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important </li></ul><ul><li>Ratios are used both internally and externally </li></ul>
6. 6. Categories of Financial Ratios <ul><li>Short-term solvency or liquidity ratios </li></ul><ul><li>Long-term solvency or financial leverage ratios </li></ul><ul><li>Asset management or turnover ratios </li></ul><ul><li>Profitability ratios </li></ul><ul><li>Market value ratios </li></ul>
7. 7. Sample Balance Sheet Numbers in thousands 4,088,797 Total Liab. & Equity 4,088,797 Total Assets 1,691,493 C/S 2,535,072 Net FA 871,851 LT Debt 1,553,725 Total CA 1,525,453 Total CL 199,375 Other CA 1,098,602 Other CL 295,255 Inventory 86,631 N/P 1,052,606 A/R 340,220 A/P 6,489 Cash
8. 8. Sample Income Statement Numbers in thousands, except EPS & DPS 2.17 EPS 1,738,125 Cost of Goods Sold 308,355 Depreciation 0.86 Dividends per share 425,764 Net Income 272,210 Taxes 697,974 Taxable Income 42,013 Interest Expense 739,987 EBIT 1,269,479 Expenses 3,991,997 Revenues
9. 9. Computing Liquidity Ratios <ul><li>Current Ratio = CA / CL </li></ul><ul><ul><li>1,553,725 / 1,525,453 = 1.02 times </li></ul></ul><ul><li>Quick Ratio = (CA – Inventory) / CL </li></ul><ul><ul><li>(1,553,725 – 295,225) / 1,525,453 = .825 times </li></ul></ul><ul><li>Cash Ratio = Cash / CL </li></ul><ul><ul><li>6,489 / 1,525,453 = .004 times </li></ul></ul>
10. 10. Long-term Solvency Measures <ul><li>Total Debt Ratio = (TA – TE) / TA </li></ul><ul><ul><li>(4,088,797 – 1,691,493) / 4,088,797 = .5863 times or 58.63% </li></ul></ul><ul><ul><li>The firm finances almost 59% of their assets with debt. </li></ul></ul><ul><li>Debt/Equity = TD / TE </li></ul><ul><ul><li>(4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times </li></ul></ul><ul><li>Equity Multiplier = TA / TE = 1 + D/E </li></ul><ul><ul><li>1 + 1.417 = 2.417 </li></ul></ul>
11. 11. Computing Coverage Ratios <ul><li>Times Interest Earned = EBIT / Interest </li></ul><ul><ul><li>739,987 / 42,013 = 17.6 times </li></ul></ul><ul><li>Cash Coverage = (EBIT + Depreciation) / Interest </li></ul><ul><ul><li>(739,987 + 308,355) / 42,013 = 24.95 times </li></ul></ul>
12. 12. Computing Inventory Ratios <ul><li>Inventory Turnover = Cost of Goods Sold / Inventory </li></ul><ul><ul><li>1,738,125 / 295,255 = 5.89 times </li></ul></ul><ul><li>Days’ Sales in Inventory = 365 / Inventory Turnover </li></ul><ul><ul><li>365 / 5.89 = 62 days </li></ul></ul>
13. 13. Computing Receivables Ratios <ul><li>Receivables Turnover = Sales / Accounts Receivable </li></ul><ul><ul><li>3,991,997 / 1,052,606 = 3.79 times </li></ul></ul><ul><li>Days’ Sales in Receivables = 365 / Receivables Turnover </li></ul><ul><ul><li>365 / 3.79 = 96 days </li></ul></ul>
14. 14. Computing Total Asset Turnover <ul><li>Total Asset Turnover = Sales / Total Assets </li></ul><ul><ul><li>3,991,997 / 4,088,797 = .98 times </li></ul></ul><ul><li>Measure of asset use efficiency </li></ul><ul><li>Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets </li></ul>
15. 15. Computing Profitability Measures <ul><li>Profit Margin = Net Income / Sales </li></ul><ul><ul><li>425,764 / 3,991,997 = .1067 times or 10.67% </li></ul></ul><ul><li>Return on Assets (ROA) = Net Income / Total Assets </li></ul><ul><ul><li>425,764 / 4,088,797 = .1041 times or 10.41% </li></ul></ul><ul><li>Return on Equity (ROE) = Net Income / Total Equity </li></ul><ul><ul><li>425,764 / 1,691,493 = .2517 times or 25.17% </li></ul></ul>
16. 16. Computing Market Value Measures <ul><li>Market Price = \$61.625 per share </li></ul><ul><li>Shares outstanding = 205,838,594 </li></ul><ul><li>PE Ratio = Price per share / Earnings per share </li></ul><ul><ul><li>61.625 / 2.17 = 28.4 times </li></ul></ul><ul><li>Market-to-book ratio = market value per share / book value per share </li></ul><ul><ul><li>61.625 / (1,691,493,000 / 205,838,594) = 7.5 times </li></ul></ul>
17. 17. Deriving the Du Pont Identity <ul><li>ROE = NI / TE </li></ul><ul><li>Multiply by 1 and then rearrange </li></ul><ul><ul><li>ROE = (NI / TE) (TA / TA) </li></ul></ul><ul><ul><li>ROE = (NI / TA) (TA / TE) = ROA * EM </li></ul></ul><ul><li>Multiply by 1 again and then rearrange </li></ul><ul><ul><li>ROE = (NI / TA) (TA / TE) (Sales / Sales) </li></ul></ul><ul><ul><li>ROE = (NI / Sales) (Sales / TA) (TA / TE) </li></ul></ul><ul><ul><li>ROE = PM * TAT * EM </li></ul></ul>
18. 18. Using the Du Pont Identity <ul><li>ROE = PM * TAT * EM </li></ul><ul><ul><li>Profit margin is a measure of the firm’s operating efficiency – how well does it control costs </li></ul></ul><ul><ul><li>Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets </li></ul></ul><ul><ul><li>Equity multiplier is a measure of the firm’s financial leverage </li></ul></ul>
19. 19. Payout and Retention Ratios <ul><li>Dividend payout ratio = Cash dividends / Net income </li></ul><ul><ul><li>0.86 / 2.17 = .3963 or 39.63% </li></ul></ul><ul><li>Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio </li></ul><ul><ul><li>1.31 / 2.17 = .6037 = 60.37% </li></ul></ul><ul><ul><li>Or 1 - .3963 = .6037 = 60.37% </li></ul></ul>
20. 20. The Internal Growth Rate <ul><li>The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. </li></ul>
21. 21. The Sustainable Growth Rate <ul><li>The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. </li></ul>
22. 22. Determinants of Growth <ul><li>Profit margin – operating efficiency </li></ul><ul><li>Total asset turnover – asset use efficiency </li></ul><ul><li>Financial leverage – choice of optimal debt ratio </li></ul><ul><li>Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm </li></ul>
23. 23. Why Evaluate Financial Statements? <ul><li>Internal uses </li></ul><ul><ul><li>Performance evaluation – compensation and comparison between divisions </li></ul></ul><ul><ul><li>Planning for the future – guide in estimating future cash flows </li></ul></ul><ul><li>External uses </li></ul><ul><ul><li>Creditors </li></ul></ul><ul><ul><li>Suppliers </li></ul></ul><ul><ul><li>Customers </li></ul></ul><ul><ul><li>Stockholders </li></ul></ul>
24. 24. Benchmarking <ul><li>Ratios are not very helpful by themselves; they need to be compared to something </li></ul><ul><li>Time-Trend Analysis </li></ul><ul><ul><li>Used to see how the firm’s performance is changing through time </li></ul></ul><ul><ul><li>Internal and external uses </li></ul></ul><ul><li>Peer Group Analysis </li></ul><ul><ul><li>Compare to similar companies or within industries </li></ul></ul><ul><ul><li>SIC and NAICS codes </li></ul></ul>
25. 25. Real World Example <ul><li>Ratios are figured using financial data from the 1999 Annual Report for Ethan Allen </li></ul><ul><li>Compare the ratios to the industry ratios in Table 3.9 in the book </li></ul><ul><li>Ethan Allen’s fiscal year end is June 30. </li></ul><ul><li>Be sure to note how the ratios are computed in the table so that you can compute comparable numbers. </li></ul><ul><li>Ethan Allan sales = \$762 MM </li></ul>
26. 26. Real World Example - II <ul><li>Liquidity ratios </li></ul><ul><ul><li>Current ratio = 2.433x; Industry = 1.4x </li></ul></ul><ul><ul><li>Quick ratio = .763x; Industry = .6x </li></ul></ul><ul><li>Long-term solvency ratio </li></ul><ul><ul><li>Debt/Equity ratio (Debt / Worth) = .371x; Industry = 1.9x. </li></ul></ul><ul><li>Coverage ratio </li></ul><ul><ul><li>Times Interest Earned = 70.6x; Industry = 3.4x </li></ul></ul>
27. 27. Real World Example - III <ul><li>Asset management ratios: </li></ul><ul><ul><li>Inventory turnover = 2.8x; Industry = 3.6x </li></ul></ul><ul><ul><li>Receivables turnover = 22.2x (16 days); Industry = 17.7x (21 days) </li></ul></ul><ul><ul><li>Total asset turnover = 1.6x; Industry = 2.2x </li></ul></ul><ul><li>Profitability ratios </li></ul><ul><ul><li>Profit margin before taxes = 17.4%; Industry = 3.1% </li></ul></ul><ul><ul><li>ROA (profit before taxes / total assets) = 27.6%; Industry = 5.8% </li></ul></ul><ul><ul><li>ROE = (profit before taxes / tangible net worth) = 37.9%; Industry = 17.6% </li></ul></ul>
28. 28. Quick Quiz <ul><li>How do you standardize balance sheets and income statements and why is standardization useful? </li></ul><ul><li>What are the major categories of ratios and how do you compute specific ratios within each category? </li></ul><ul><li>What are the major determinants of a firm’s growth potential? </li></ul><ul><li>What are some of the problems associated with financial statement analysis? </li></ul>
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