CHAPTER 3

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CHAPTER 3

  1. 1. 3.1 CHAPTER 3 ANALYSIS OF FINANCIAL STATEMENTS RATIO ANALYSIS Primary goal of financial management is to maximize the stock price, not to maximize accounting measures such as net income or EPS. However, accounting data do influence stock prices---we need to evaluate the accounting information. Managers: improve performance. Lenders: evaluate the likelihood of collecting on loans. Stockholders: forecast earnings, dividends, and stock prices. Compari 1)Cross–sectional Analysis sons : (same industry) 2)Trend Analysis (past performance)
  2. 2. 3.2 I) LIQUIDITY RATIOS Ability to Meet Short-term Obligations: 1)Curren = Current t ratio assets Current liabilities = $ 1,000 = 3.2 $ 310 times Industry = 4.2 average times 2) Quick or = Current assets – acid Inventories test ratio Current liabilities = $385 = 1.2 $310 times Industry = 2.1 average times
  3. 3. 3.3 I) ASSET MANAGEMENT RATIOS Evaluating Inventories : 1)Inventor = Sales y Invento Turnover ries ratio = $3,000 = 4.9 $615 times Industry = 9.0 average times Evaluating Receivables : 2)Days Sales Outstanding (DSO) or Average Collection Period (ACP) = = Receivables Receivables Average Annual sales/ sales per day 360 = $375 = = 45
  4. 4. 3.4 $3,000/36 $375 days 0 $8.3 3 Industry = 36 average days Evaluating Fixed Assets : 3) Fixed = Assets Sales Turnover Net fixed assets = = 3.0 $3,000 times $1,000 Industry = 3.0 average times Evaluating Total Assets : 4) Total Assets = Sales Turnover Total assets
  5. 5. 3.5 = $3,000 = 1.5 $2,000 times Industry = 1.8 average times II)DEBT MANAGEMENT RATIOS The extent to which a firm uses debt financing or financial leverage has 3 implications : 1)Debt financing help stockholders control a firm with a limited investment. 2)Creditors look to equity or owner - supplied funds, to provide margin of safety (if equity small risks are borne by its creditors). 3) If firm earns more and finances by debt then ROE magnified or leveraged.
  6. 6. 3.6 Example of how the use of debt (or financial leverage) affects risk and return is in Table 3–1, P.95. EFFECTS OF FINANCIAL LEVERAGE ON STOCKHOLDERS’ RETURNS FIRM U (UNLEVERAGED) Current $ Debt $ assets 50 0 Fixed 50 Common 10 assets equity 0
  7. 7. 3.7 Total $ Total liabilities $ assets 100 and equity 10 0 EXPECT BAD ED CONDIT CONDIT IONS IONS (1) (2) Sales $ 100.00 $ 82.50 Operating costs 70.00 80.00 Operating $ 30.00 $ 2.50 income(EBIT) Interest 0.00 0.00 Earnings before $ 30.00 $ 2.50 taxes(EBT) Taxes(40%) 12.00 1.00 Net income(NI) $ 18.00 $ 1.50 ROEU = NI/Common 18.00% 1.50% equity
  8. 8. 3.8 = NI/$100 = FIRM L (LEVERAGED) Current $ 50 Debt $ assets 50 Fixed $ Common equity $ assets 50 50 Total $ Total liabilities $ assets 100 and equity 10 0 EXPECT BAD ED CONDIT CONDIT IONS IONS (1) (2) Sales $ 100.00 $ 82.50 Operating costs 70.00 80.00 Operating $ 30.00 $ 2.50 income(EBIT) Interest 7.50 7.50
  9. 9. 3.9 Earnings before $ 22.50 ($ 5.00) taxes(EBT) Taxes(40%) 9.00 (2.00) Net income(NI) $ 13.50 ($ 3.00) ROEU = NI/Common 27.00% (6.00% equity ) = NI/$50 = How the Firm is Financed: 1) Debt = Total ratio debt Total assets = $310 + = 53.2% $754 $2,00 0
  10. 10. 3.10 Industry = 40.0% average Ability to Pay Interest: 2) Time–interest–earned(TIE) ratio = EBIT Interest charges = $283.8 = 3.2 $88 times Industry = 6.0 average times Ability to Service Debt:
  11. 11. 3.11 3) EBITDA coverage ratio = EBITDA + Lease payments Interest charge + Loan payments + Lease Payments = $283.8 + $100 = 3.0 times + $28 $88 + $20 + $28 Industry = 4.3 times average III)PROFITABILITY RATIOS 1) Profit margin on sales (Net profit margin) = Net income available to common stockholders Sales = = 3.8% $113.5 $3,
  12. 12. 3.12 000 Industry = 5.0 % average Gross profit = Gross margin profit Sale = = $383.8 12.8% $3,00 0 2) Basic earning power ratio(BEP) = EBIT Total assets = $283.8 = 14.2% $2,000 Industry = 17.2% average
  13. 13. 3.13 3) Return on total assets(ROA) = Net income available to common stockholders Total assets = $113.5 = 5.7% $2,000 Industry = 9.0% average 4) Return on common equity(ROE) = Net income available to common stockholders Common equity = = 12.7 % $113.5 $896 Industry = 15.0 % average
  14. 14. 3.14 IV)MARKET VALUE RATIOS 1) Price/earnings (P/ E) ratio = Price per share Earnings per share = $23.00 = 10.1 $2.27 times Industry = 12.5 average times 2) Price/Cash = Price per flow Ratio share Cash flow per share = = 5.4 $23.00 times $4.27 Industr = 6.8
  15. 15. 3.15 y average times Book value per = Common share equity Shares outstanding = = $ $896 17.92 $5 0 3) Market/ = Market price per book ratio share Book value per share = = 1.3 $23.00 times $17.9 2 Industry = 1.7 average times
  16. 16. 3.16 Comparative and Trend Analysis (Fig. 3–1 P.105) Summary of Financial Ratio (Table 3–2 P. 106) DU PONT ANALYSIS Donaldson Brown (Du Pont’s CFO) developed Du Pont Equation He recognizes that company’s stock price depends on many things, including its ROE. ROE = (Profit margin) (Total assets turnover) (Equity multiplier) = Net income x Sales x Total assets Sales Total assets Common Equity
  17. 17. 3.17 ROE = Net = $ = 12.7 income 113.5 % Common $ 896 equity Du Pont ROE A = (3.8%) (1.5) = 12.7 (2.23) % ROE I = (5.0%) (1.8) = 15.0 (1.67) % Du Pont equation shows how the profit margin, the total assets turnover ratio, and the use of debt interest to determine ROE. From Du Pont equation, we saw that the average food products company (industry average) has : 1)Higher profit margin (5.0% : 3.8%) implies better control over expenses.
  18. 18. 3.18 2)Higher total asset turnover (1.8 : 1.5) implies using its assets more productively. 3)Allied Food Products has higher financial leverage (debt ratio 53.2% : 40% so equity multiplier 2.23 : 1.67) use of leverage increase its risk. So Du Pont equation highlights 3 important factors : 1)expense control 2)asset utilization and 3)debt utilization ROE (12.7%) can be calculated directly ROE = NI = $113.5 = 12.7% Common Equity $896
  19. 19. 3.19 But Du Pont equation shows how - the profit margin interact to - the total assets turnover determine ROE - the use of debt Fig. 3–2 P.107 : Modified Du Pont Chart Management can use the Du Pont system to analyze ways of improving performance. On the left or “profit margin” side: - Marketing can study the effects of raising sales prices (or lowering them to increase volume), moving into new products or markets with higher margins, and so on.
  20. 20. 3.20 - Cost accountants can study various expense items, and, working with engineers, purchasing agents, and other operating personnel seek ways to hold down costs. On the right or “turnover” side: - Financial analysts, working with both production and marketing investigate ways to reduce the investment in various type of assets. - Treasury staff can analyze the effects of alternative financing strategies seeking to hold down interest expense and risk of debt while still using leverage to increase ROE.
  21. 21. 3.21 As a result of such analysis, Allied’s president announced a series of moves designed to : - cut operating costs by > 20%/year - announced that the company intends to concentrate its capital in market where profit margins are reasonable high - if competition increases in certain of its product markets Allied will withdraw from those markets - Allied’s president (Jackson) recognizes that if competition drives profit margins too low in a particular market will be impossible to earn high ROE Allied may have to develop new products and shift capital into new areas
  22. 22. 3.22 COMPARATIVE RATIOS AND “BENCHMARKING” Benchmarking : compare ratios with those of a smaller set of leading companies called benchmark companies. Ex. P.110 Table 3–3 P.111 – ratios complied by Dun & Bradstreet (D & B) USE AND LIMITATONS OF RATIO ANALYSIS Ratio analysis is used by three main groups : (1) employ ratios to help Managers analyze, control, and : thus improve their firms’
  23. 23. 3.23 operations. (2)Credit such as bank loan officer analysts : or bond rating analysts, who analyze ratios to help ascertain a company’s ability to pay its debts. (3) Stock are interested in a analysts : company’s efficiency, risk, and growth prospects. Even ratio analysis can provide useful information concerning a company’s operations and financial condition, it does have limitations : (1)Many large firms operate different divisions in different industries – it's difficult to develop a meaningful set of
  24. 24. 3.24 industry averages for comparative purposes ; so ratio analysis is more useful for small, narrowly focused firm. (2)Most firms want to be better than average ; so merely attaining average performance is no particularly good : benchmarking helps in this regard. (3)Inflation may have badly distorted firm’s B/S – recorded values are often substantially different from “true” values. Also inflation affects both depreciation charges and inventory costs – profits are also affected judgement. (4)Seasonal factors can also distort a ratio analysis
  25. 25. 3.25 affects inventory (and receivables) – minimized by monthly average. (5)“Window dressing” techniques : make their financial statements look stronger. (6)Different accounting practices – distort comparisons i.e. depreciation methods, LIFO or FIFO. (7)Difficult to generalize : good or bad i.e. high quick ratio good or bad ? good more : bad excess liquidity cash or high fixed assets turnover. good : bad efficient undercapitalized (c afford to buy
  26. 26. 3.26 annot enough assets). (8)Some ratios are good and some are bad ; so overall good or bad ? * Financial statement analysis is useful, but analysts should be aware of the problems – so used intelligently and with good judgement.* PROBLEMS WITH ROE If a firm takes steps improve ROE, does it mean that shareholder wealth will also increase? Not necessary Because: (1)ROE does not consider risk. S - ROE 15%
  27. 27. 3.27 Which one is better? R - ROE 16% R more risky (2)ROE does not consider the amount of invested capital. 50% of $1 Which one is better? 30% of $1,000,000 ROE 45% (3)Manage large division ROE 35% (low risk) Profitable not accept if bonus depends on ROE. So EVA
  28. 28. 3.28 - END -

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