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Chapter 3 Power Point Slides

  1. 1. Chapter 3 Analysis of Financial Statements: Financial Statements and Reports Ratio Analysis Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777
  2. 2. Financial Statements and Reports <ul><li>The Income Statement </li></ul><ul><li>The Balance Sheet </li></ul><ul><li>Statement of Cash Flows </li></ul><ul><li>Statement of Retained Earnings </li></ul>
  3. 3. Computron: Income Statement
  4. 4. Computron: Balance Sheet: Assets
  5. 5. Computron: Liabilities and Equity
  6. 6. Computron: Statement of Cash Flows (2000)
  7. 7. Computron: Statement of Cash Flows (continued)
  8. 8. What Can You Conclude about Computron’s Financial Condition from its Statement of Cash Flows? <ul><li>Net operating cash flow is ($73,780) </li></ul><ul><ul><li>Operations are draining cash </li></ul></ul><ul><li>Had to borrow $126,180 in long- and short-term debt to cover cash outlays, pay for fixed asset additions, and to pay dividends </li></ul><ul><li>Despite borrowing, cash account still fell $5,600 in 2000 </li></ul>
  9. 9. Statement of Retained Earnings Balance of retained earnings Dec. 31, 1999 $203,786 2000 Net Income 44,220 2000 dividends to stockholders (22,000) Balance of retained earnings Dec. 31, 2000 $225,988
  10. 10. Computron: Additional Data
  11. 11. Ratio Analysis <ul><li>An analysis of a firm’s ratios is generally the first step in financial analysis </li></ul><ul><li>The ratios are designed to show relationships between financial statement accounts within firms and between firms </li></ul>
  12. 12. What is the Purpose of Ratio Analysis? <ul><li>Give idea of how well the company is doing </li></ul><ul><li>Standardize numbers; facilitate comparisons </li></ul><ul><li>Used to highlight weaknesses and strengths </li></ul>
  13. 13. <ul><li>Liquidity: Can we make required payments? </li></ul><ul><li>Asset mgt.: Right amount of assets vs. sales? </li></ul><ul><li>Debt mgt.: Right mix of debt and equity? </li></ul><ul><li>Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? </li></ul><ul><li>Market values: Do investors like what they see as reflected in P/E and M/B ratios? </li></ul>What Are the Five Major Categories of Ratios? What Questions Do They Answer?
  14. 14. Industry Average Data (2000)
  15. 15. What are Computron’s Current and Quick ratios?
  16. 16. Comment on Computron’s Liquidity Position <ul><li>Ratios held steady but slightly below ind. avg. </li></ul><ul><li>Inventories are the least liquid of Computron’s assets and they are the assets that suffer losses in the event of a forced sale. </li></ul><ul><li>The quick ratio shows that even if receivables are collected in full, Computron still needs to raise case from sale of inventories to meet obligations. </li></ul>
  17. 17. Note that the $1,290,000 in current assets is made up of... $ 52,000 in cash $402,000 in accts rec $836,000 in inventories $1,290,000 total Cur Lia - Cash - Acc Rec = Inventory needed to be liquidated to meet current liabilities Thus, cur. lia minus cash = $540,200 - $52,000 = $488,200 and $488,200 - accts rec = $488,200 - $402,000 = $86,200 in inventory… That would have to be liquidated in order to meet current liabilities
  18. 18. What is Computron’s Inventory Turnover Ratio?
  19. 19. Comments on Computron’s Inventory Turnover <ul><li>Compares poorly with industry. </li></ul><ul><li>Continuing on a downward trend. </li></ul><ul><li>May be holding excess inventories, or </li></ul><ul><li>May be holding old/obsolete inventory. </li></ul>
  20. 20. What is Computron’s Days Sales Outstanding Ratio?
  21. 21. Comments on Computron’s Days Sales Outstanding Ratio <ul><li>Looks bad. </li></ul><ul><li>Higher than industry average. </li></ul><ul><li>Getting higher!! </li></ul>
  22. 22. What is Computron’s Fixed Assets and Total Assets Turnover Ratios?
  23. 23. Comments on Computron’s Fixed Assets Turnover and Total Assets Turnover <ul><li>Fixed assets turnover has improved. </li></ul><ul><li>However, total asset turnover remains the same and below industry average. </li></ul><ul><li>As we saw before, Computron may have excess inventories and receivables. </li></ul>
  24. 24. Calculate the Debt, TIE, and Fixed Charge Coverage Ratios. Debt Ratio = Total debt Total assets TIE = EBIT Int. expense
  25. 25. FCC = EBIT + Lease payments + S.F. Pmts. Interest + Lease + Sinking fund pmt. expense pmt. (1-T) All three ratios reflect use of debt, but focus on different aspects. Fixed Charge Coverage Ratio
  26. 26. Comments on Computron’s Debt Management <ul><li>Debt ratio is above industry and going higher. </li></ul><ul><li>Computron would find it difficult to borrow. </li></ul><ul><li>TIE and FCC below industry average and falling--indicates Computron has high use of debt. </li></ul>
  27. 27. If you are in the 30% tax bracket, you have to earn $1.43 before tax in order to put $1.00 into your pocket $1.43 – 30%($1.43) = $1.00 Or $1.00/(1-Tax Rate) = $1.00/(1-.30) = $1.43 “ Amount/(1-T) “ is frequently used in Finance
  28. 28. Calculate Computron’s Profitability Ratios-- Profit Margin, ROA, and ROE Low and Falling!
  29. 29. Computron’s ROA, and ROE
  30. 30. Comments on Computron’s ROA and ROE <ul><li>Both ROA and ROE substantially below industry average. </li></ul><ul><li>Company stock probably not doing well. </li></ul>
  31. 31. Calculate Computron’s Market Value Ratios - - Price/Earnings Ratio and Market/Book Value Ratio EPS = Net Income / Shares Outstanding
  32. 32. Computron’s Market/Book Value Ratio
  33. 33. Book Value = Common Equity / shares outstanding
  34. 34. Comments on Computron’s Market Value Ratios <ul><li>P/E rose from 1999 to 2000--good? </li></ul><ul><li>NO! because earnings dropped! </li></ul><ul><li>M/B well below industry average. </li></ul><ul><li>Investors view Computron as riskier than other companies in the industry. </li></ul>
  35. 35. Summary of Ratio Analysis: The Du Pont Equation
  36. 36. DU PONT Equation Provides Overview of: <ul><li>Firm’s profitability (measured by ROA) </li></ul><ul><li>Firm’s expense control (measured by profit margin) </li></ul><ul><li>Firm’s asset utilization (measured by total asset turnover) </li></ul>
  37. 37. <ul><li>Expense control is poor and trending downward. </li></ul><ul><li>Asset utilization is below average but not getting worse. </li></ul><ul><li>Combination = ROA that is very low and falling. </li></ul>Computron’s DU PONT Equation
  38. 38. Sales per day amount to: $3,850,000/ 360 = $10,694 Accounts Receivable are now $402,000, or 37.6 days sales $10,694 * 37.6 = $402,094.40 or $402,094.40 / $10,694 = 37.6 If DSO can be reduced to 27.6 days without affecting sales… Then accounts receivable would be: $10,694 * 27.6 = $295,154 Compared to the current accounts receivable this would mean a collection (cash inflow) of: $402,000 - $295,154 = $106,846
  39. 39. What are Some Potential Problems and Limitations of Financial Ratio Analysis? <ul><li>Comparison with industry averages is difficult if the firm operates many different divisions. </li></ul><ul><li>“ Average” performance not necessarily good. </li></ul><ul><li>Inflation distorts balance sheets. </li></ul>
  40. 40. <ul><li>Seasonal factors can distort ratios. </li></ul><ul><li>Window dressing” techniques can make statements and ratios look better. </li></ul><ul><li>Different operating and accounting practices distort comparisons. </li></ul>What are Some Potential Problems and Limitations of Financial Ratio Analysis?
  41. 41. <ul><li>Sometimes hard to tell if a ratio is “good” or “bad.” </li></ul><ul><li>Difficult to tell whether company is, on balance, in strong or weak position. </li></ul>What are Some Potential Problems and Limitations of Financial Ratio Analysis?
  42. 42. End of Chapter 3 Analysis of Financial Statements
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