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  • 1. ___________________________________ ___________________________________ ___________________________________ Chapter 3 ___________________________________ Working With Financial Statements ___________________________________ ___________________________________ ___________________________________ 3-1 ___________________________________ Key Concepts and Skills ___________________________________ Know how to standardize financial ___________________________________ statements for comparison purposes Know how to compute and interpret important ___________________________________ financial ratios ___________________________________ Know the determinants of a firm’s profitability and growth ___________________________________ Understand the problems and pitfalls in financial statement analysis ___________________________________ 1 3-2 ___________________________________ Chapter Outline ___________________________________ Standardized Financial Statements ___________________________________ Ratio Analysis ___________________________________ The Du Pont Identity Internal and Sustainable Growth ___________________________________ Using Financial Statement Information ___________________________________ ___________________________________ 2
  • 2. 3-3 ___________________________________ Standardized Financial Statements ___________________________________ Common-Size Balance Sheets ___________________________________ Compute all accounts as a percent of total assets Common-Size Income Statements ___________________________________ Compute all line items as a percent of sales Standardized statements make it easier to ___________________________________ compare financial information, particularly as the company grows ___________________________________ They are also useful for comparing companies of different sizes, particularly within the same industry ___________________________________ 3 3-4 ___________________________________ Ratio Analysis ___________________________________ Ratios also allow for better comparison ___________________________________ through time or between companies As we look at each ratio, ask yourself ___________________________________ what the ratio is trying to measure and ___________________________________ why that information is important Ratios are used both internally and ___________________________________ externally ___________________________________ 4 3-5 ___________________________________ Categories of Financial Ratios ___________________________________ Short-term solvency or liquidity ratios ___________________________________ Long-term solvency or financial leverage ratios ___________________________________ Asset management or turnover ratios ___________________________________ Profitability ratios Market value ratios ___________________________________ ___________________________________ 5
  • 3. 3-6 ___________________________________ Sample Balance thousands Numbers in Sheet ___________________________________ Cash 680,623 A/P 318,301 ___________________________________ A/R 1,051,438 N/P 4,613 ___________________________________ Inventory 300,459 Other CL 1,645,748 Other CA 415,310 Total CL 1,968,662 ___________________________________ Total CA 2,447,830 LT Debt 909,814 ___________________________________ Net FA 3,415,159 C/S 2,984,513 Total Assets 5,862,989 Total Liab. & Equity 5,862,989 ___________________________________ 6 3-7 ___________________________________ Sample Income Statement Numbers in thousands, except EPS & DPS ___________________________________ Revenues 5,250,538 Cost of Goods Sold 2,046,645 ___________________________________ Expenses 1,904,556 Depreciation & Amortization 124,647 ___________________________________ EBIT 1,174,690 Interest Expense 5,785 ___________________________________ Taxable Income 1,168,905 Taxes 412,495 ___________________________________ Net Income 756,410 EPS 3.92 ___________________________________ Dividends per share 1.20 7 3-8 ___________________________________ Computing Liquidity Ratios ___________________________________ Current Ratio = CA / CL ___________________________________ 2,447,830 / 1,968,662 = 1.24 times ___________________________________ Quick Ratio = (CA – Inventory) / CL (2,447,830 – 300,459) / 1,968,662 = 1.09 ___________________________________ times Cash Ratio = Cash / CL ___________________________________ 680,623 / 1,968,662 = .346 times ___________________________________ 8
  • 4. 3-9 ___________________________________ Computing Leverage Ratios ___________________________________ Total Debt Ratio = (TA – TE) / TA ___________________________________ (5,862,989 – 2,984,513) / 5,862,989 = .491 times or 49.1% ___________________________________ The firm finances slightly over 49% of their assets with debt. ___________________________________ Debt/Equity = TD / TE (5,862,989 – 2,984,513) / 2,984,513 = .964 times ___________________________________ Equity Multiplier = TA / TE = 1 + D/E 1 + .964 = 1.964 ___________________________________ 9 3-10 ___________________________________ Computing Coverage Ratios ___________________________________ Times Interest Earned = EBIT / Interest ___________________________________ 1,174,900 / 5,785 = 203 times ___________________________________ Cash Coverage = (EBIT + Depr. & Amort.) / Interest ___________________________________ (1,174,900 + 124,647) / 5,785 = 225 times ___________________________________ ___________________________________ 10 3-11 ___________________________________ Computing Inventory Ratios ___________________________________ Inventory Turnover = Cost of Goods Sold ___________________________________ / Inventory 2,046,645 / 300,459 = 6.81 times ___________________________________ Days’ Sales in Inventory = 365 / Inventory ___________________________________ Turnover 365 / 6.81 = 54 days ___________________________________ ___________________________________ 11
  • 5. 3-12 ___________________________________ Computing Receivables Ratios ___________________________________ Receivables Turnover = Sales / Accounts ___________________________________ Receivable 5,250,538 / 1,051,438 = 4.99 times ___________________________________ Days’ Sales in Receivables = 365 / ___________________________________ Receivables Turnover 365 / 4.99 = 73 days ___________________________________ ___________________________________ 12 3-13 ___________________________________ Computing Total Asset Turnover ___________________________________ Total Asset Turnover = Sales / Total ___________________________________ Assets 5,250,538 / 5,862,989 = .896 times ___________________________________ Measure of asset use efficiency ___________________________________ Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets ___________________________________ ___________________________________ 13 3-14 ___________________________________ Computing Profitability Measures ___________________________________ Profit Margin = Net Income / Sales ___________________________________ 756,410 / 5,250,538 = .1441 times or 14.41% Return on Assets (ROA) = Net Income / Total ___________________________________ Assets 756,410 / 5,862,989 = .1290 times or 12.90% ___________________________________ Return on Equity (ROE) = Net Income / Total Equity ___________________________________ 756,410 / 2,984,513 = .2534 times or 25.34% ___________________________________ 14
  • 6. 3-15 ___________________________________ Computing Market Value Measures ___________________________________ Market Price (12/31/04) = $91.54 per share ___________________________________ Shares outstanding = 189,813,459 PE Ratio = Price per share / Earnings per share ___________________________________ 91.54 / 3.92 = 23.35 times Market-to-book ratio = market value per share / ___________________________________ book value per share 91.54 / (2,984,513,000 / 189,813,459) = 5.82 times ___________________________________ ___________________________________ 15 3-16 ___________________________________ Table 3.5 ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ 16 3-17 ___________________________________ Deriving the Du Pont Identity ___________________________________ ROE = NI / TE ___________________________________ Multiply by 1 and then rearrange ___________________________________ ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM ___________________________________ Multiply by 1 again and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ___________________________________ ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM ___________________________________ 17
  • 7. 3-18 ___________________________________ Using the Du Pont Identity ___________________________________ ROE = PM * TAT * EM Profit margin is a measure of the firm’s ___________________________________ operating efficiency – how well does it control costs ___________________________________ Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage ___________________________________ its assets ___________________________________ Equity multiplier is a measure of the firm’s financial leverage ___________________________________ 18 3-19 ___________________________________ Payout and Retention Ratios ___________________________________ Dividend payout ratio (“b”) = Cash dividends / Net income ___________________________________ 1.20 / 3.92 = .3061 or 30.61% Retention ratio (“1 – b”) = Addn. to R/E / ___________________________________ Net income = (EPS – DPS) / EPS ___________________________________ (3.92 – 1.20) / 3.92 = .6939 = 69.39% Or: Retention ratio = 1 – Dividend Payout ___________________________________ Ratio 1 - .3061 = .6939 = 69.39% ___________________________________ 19 3-20 ___________________________________ The Internal Growth Rate ___________________________________ The internal growth rate tells us how much the firm can grow assets using retained ___________________________________ earnings as the only source of financing. ___________________________________ ROA × b ___________________________________ Internal Growth Rate = 1 - ROA × b ___________________________________ .1290 × .3061 = = .0411 1 − .1290 × .3061 ___________________________________ = 4.11% 20
  • 8. 3-21 ___________________________________ The Sustainable Growth Rate ___________________________________ 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. ___________________________________ ROE × b ___________________________________ Sustainable Growth Rate = 1 - ROE × b .2534 × .3061 ___________________________________ = = .0841 1 − .2534 × .3061 ___________________________________ = 8.41% 21 3-22 ___________________________________ Determinants of Growth ___________________________________ Profit margin – operating efficiency ___________________________________ Total asset turnover – asset use efficiency ___________________________________ Financial leverage – choice of optimal debt ratio ___________________________________ Dividend policy – choice of how much to pay to shareholders versus reinvesting in ___________________________________ the firm ___________________________________ 22 3-23 ___________________________________ Table 3.7 ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ 23
  • 9. 3-24 ___________________________________ Why Evaluate Financial Statements? ___________________________________ Internal uses ___________________________________ Performance evaluation – compensation and comparison between divisions ___________________________________ Planning for the future – guide in estimating future cash flows ___________________________________ External uses Creditors ___________________________________ Suppliers Customers ___________________________________ Stockholders 24 3-25 ___________________________________ Benchmarking ___________________________________ Ratios are not very helpful by themselves; they ___________________________________ need to be compared to something Time-Trend Analysis ___________________________________ Used to see how the firm’s performance is changing through time ___________________________________ Internal and external uses Peer Group Analysis ___________________________________ Compare to similar companies or within industries SIC and NAICS codes ___________________________________ 25 3-26 ___________________________________ Real World Example - I ___________________________________ Ratios are figured using financial data from the ___________________________________ 1/31/05 Annual Report for Hughes Supply, Inc. Hughes is in SIC 507, which is a component of ___________________________________ NAICS 444130 Compare the ratios to the median industry ratios ___________________________________ in Table 3.9 in the book (pp. 70 - 72) Hughes’ sales for the year ended January 5, ___________________________________ 2005 were 4.42 billion, so we compare it to the right-most column. ___________________________________ 26
  • 10. 3-27 ___________________________________ Real World Example - II ___________________________________ Liquidity ratios Current ratio = 2.36x; Industry = 1.8x ___________________________________ Quick ratio = 1.42x; Industry = .6x ___________________________________ Long-term solvency ratio Debt/Equity ratio (Debt / Worth) = 1.02x; ___________________________________ Industry = 1.4x. Coverage ratio ___________________________________ Times Interest Earned = 7.22x; Industry = 4.8x ___________________________________ 27 3-28 ___________________________________ Real World Example - III ___________________________________ Asset management ratios: ___________________________________ Inventory turnover = 5.34x; Industry = 4.2x Total asset turnover = 1.75x; Industry = 2.8x ___________________________________ Profitability ratios ___________________________________ ROE = (profit before taxes / tangible net worth) = 15.81%; Industry = 16.8% ___________________________________ ROA (profit before taxes / total assets) = 7.84%; Industry = 7.3% ___________________________________ 28 3-29 ___________________________________ Work the Web Example ___________________________________ The Internet makes ratio analysis much easier ___________________________________ than it has been in the past Click on the web surfer to go to ___________________________________ Moneycentral.com Choose a company and enter its ticker symbol ___________________________________ Click on “Financial Results” and “Key Ratios” to compare the firm to its industry and the S&P 500 for ___________________________________ various ratio categories Change the ratio category using the links to the left of the chart. ___________________________________ 29
  • 11. 3-30 ___________________________________ Quick Quiz ___________________________________ How do you standardize balance sheets and ___________________________________ income statements and why is standardization useful? ___________________________________ What are the major categories of ratios and how do you compute specific ratios within each category? ___________________________________ What are the major determinants of a firm’s growth potential? ___________________________________ What are some of the problems associated with financial statement analysis? ___________________________________ 30