Chapter 4 Analysis of Financial Statements
Ratio Analysis Notes <ul><li>When analyzing a firm, we compare financial  ratios  rather than dollar figures to diminish t...
Liquidity Ratios (MicroDrive p.124) <ul><li>Liquidity ratios measure the ability of to pay  short-term debts . </li></ul><...
<ul><li>What is the quick ratio for our firm?  </li></ul><ul><li>If the industry norm is 2.1, this is a(n)  unfavorable  c...
Asset Management Ratios <ul><li>Asset management ratios measure how efficiently management is using its  resources .  Thes...
<ul><li>What is the fixed assets turnover ratio for our firm?  </li></ul><ul><li>If the industry norm is 3.0, this is a(n)...
<ul><li>What is the total assets turnover ratio for our firm?  </li></ul><ul><li>If the industry norm is 1.8, this is a(n)...
<ul><li>What is the days sales outstanding (DSO) for our firm? (also known as the  average collection period ) </li></ul><...
Debt Management Ratios <ul><li>Debt management ratios measure the company’s use of  outside  (i.e., nonequity) financing. ...
<ul><li>What is the times interest earned (TIE) ratio for our firm? </li></ul><ul><li>If the industry norm is 6.0, this is...
<ul><li>What is the EBITDA coverage ratio for our firm?  </li></ul>
<ul><li>If the industry norm is 4.3, this is a(n)  unfavorable  comparison. </li></ul><ul><li>Like the TIE ratio, the EBIT...
Profitability Ratios <ul><li>Profitability ratios measure the  overall performance  of management. (also known as the  bot...
<ul><li>The basic earning power ratio focus is on profit before  financing costs , and is:  </li></ul><ul><li>If the indus...
<ul><li>What is the return on total assets ratio (ROA) for our firm?  </li></ul><ul><li>If the industry norm is 9.0%, this...
<ul><li>What is the return on equity ratio (ROE) for our firm?  </li></ul><ul><li>If the industry norm is 15.0%, this is a...
Market Value Ratios <ul><li>Market value ratios measure the market’s perception of the  quality  of the firm. </li></ul><u...
<ul><li>Caution: If a firm’s profitability is low, it will cause the P/E ratio to be artificially  high . </li></ul>
<ul><li>What is the price to cash flow ratio (P/CF) for our firm? </li></ul><ul><li>If the industry norm is 6.8, this is a...
<ul><li>What is the market to book ratio (M/B) for our firm?  </li></ul><ul><li>If the industry norm is 1.7, this is a(n) ...
Methods of Comparisons <ul><li>Comparing a firm’s ratios to its industry averages is called  cross-sectional  analysis or ...
Du Pont Analysis <ul><li>The Du Pont analysis refers to two formulas that show how selected ratios are  linked to each oth...
<ul><li>What are the Du Pont values for our firm?  </li></ul><ul><li>The analysis indicates that  insufficient volume  is ...
A broader example of how ratios are inter-connected <ul><li>What would be our revised balance sheet if we reduce DSO to 36...
<ul><li>The excess cash was used to reduce debt.  It also could have been used to: </li></ul><ul><li>-  increase  dividend...
Limitations of Ratio Analysis <ul><li>Ratio comparisons are less valid if your firm or the industry average firm operate i...
<ul><li>Ratio comparisons may be less valid if your company’s fiscal year and the fiscal year for the industry average fir...
<ul><li>Ratio comparisons in seasonal industries may be more distorted by the fact that the firms tend to close their book...
<ul><li>Variations in how the cost of items sold are recognized may further distort ratio comparisons.  </li></ul><ul><li>...
<ul><li>There is typically a trade-off between  risk  and  return .  While a high current ratio reflects greater liquidity...
Independent Reading <ul><li>What is the difference between the IASB and the FASB? (p. 131) </li></ul><ul><li>What are a co...
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Chapter 4

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  • Current ratio (2007) = 1000/310 = 3.2 Quick ratio (2007) = (1000-615)/310 = 1.2
  • Current ratio (2007) = 1000/310 = 3.2 Quick ratio (2007) = (1000-615)/310 = 1.2
  • Inventory turn (2007) = 3000/615 = 4.9 Fixed Assets turn (2007) = 3000/1000 = 3.0
  • Inventory turn (2007) = 3000/615 = 4.9 Fixed Assets turn (2007) = 3000/1000 = 3.0
  • TA turn (2007) = 3000/2000 = 1.5 DSO (2007) = 375 / (3000/365) = 46 days
  • TA turn (2007) = 3000/2000 = 1.5 DSO (2007) = 375 / (3000/365) = 46 days
  • Debt ratio (2007) = 1064 / 2000 = 53.2% TIE = 283.8 / 88 = 3.2
  • Debt ratio (2007) = 1064 / 2000 = 53.2% TIE = 283.8 / 88 = 3.2
  • EBITDA Coverage = (EBIT + Dep&amp;Amort + LeasePay) / (IntExp + LeasePay + LoanPay) = (283.8 + 100 + 28) / (88 + 20 + 28) = 411.8 / 136 = 3.0
  • EBITDA Coverage = (EBIT + Dep&amp;Amort + LeasePay) / (IntExp + LeasePay + LoanPay) = (283.8 + 100 + 28) / (88 + 20 + 28) = 411.8 / 136 = 3.0
  • PM = NI /Sales = 113.5 / 3000 = 3.8% BEP = EBIT / TA = 283.8 / 2000 = 14.2%
  • PM = NI /Sales = 113.5 / 3000 = 3.8% BEP = EBIT / TA = 283.8 / 2000 = 14.2%
  • ROA (2007) = 113.5 / 2000 = 5.7% ROE (2007) = 113.5 / 896 = 12.7%
  • ROA (2007) = 113.5 / 2000 = 5.7% ROE (2007) = 113.5 / 896 = 12.7%
  • P/E = 23 / 2.27 = 10.1 P/CF = 23 / 4.27 = 5.4
  • P/E = 23 / 2.27 = 10.1 P/CF = 23 / 4.27 = 5.4
  • P/E = 23 / 2.27 = 10.1 P/CF = 23 / 4.27 = 5.4
  • M/B = 23 / 17.92 = 1.3
  • ROE = PM x TATurn x EqMult EqMult – 1 / (1 – DebtRatio) Reflect (cost control) x (volume) x (debt leverage) Firm (2007) 12.7% = 3.8% x 1.5 x 2.23 Industry 15.0% = 5.0% x 1.8 x 1.67 Weaknesses: 1 st : volume 2 nd : cost control
  • ROE = PM x TATurn x EqMult EqMult – 1 / (1 – DebtRatio) Reflect (cost control) x (volume) x (debt leverage) Firm (2007) 12.7% = 3.8% x 1.5 x 2.23 Industry 15.0% = 5.0% x 1.8 x 1.67 Weaknesses: 1 st : volume 2 nd : cost control
  • A/R 375 Debt 1064 Other CA 625 PrefEquity 40 Net FA 1000 CommEquit 986 TA 2000 Tot Liab &amp;Eq 2000 Sales/day = 3000/365 = 8.22 Old Rec = 8.22 x 46 = 375 New Rec = 8.22 x 36 = 296 Reduction in Rec = 79 = Increase in cash A/R 296 Debt 985 Current ratio = 921/231 = 4.0 Other CA 625 PrefEquity 40 Debt ratio = 985 / 1921 = 51% Net FA 1000 CommEquit 986 if int exp = 10% new NI = 118.2 TA 1921 Tot Liab &amp;Eq 1921 PM = 118.2/3000 = 3.9% Increase dividends. Repurchase stock . Higher ROE, higher EPS. (favorable tax treatment for shareholders) Expand business . Higher profits. Note: Inventories also too high. Effect of reducing inventories?
  • A/R 375 Debt 1064 Other CA 625 PrefEquity 40 Net FA 1000 CommEquit 986 TA 2000 Tot Liab &amp;Eq 2000 Sales/day = 3000/365 = 8.22 Old Rec = 8.22 x 46 = 375 New Rec = 8.22 x 36 = 296 Reduction in Rec = 79 = Increase in cash A/R 296 Debt 985 Current ratio = 921/231 = 4.0 Other CA 625 PrefEquity 40 Debt ratio = 985 / 1921 = 51% Net FA 1000 CommEquit 986 if int exp = 10% new NI = 118.2 TA 1921 Tot Liab &amp;Eq 1921 PM = 118.2/3000 = 3.9% Increase dividends. Repurchase stock . Higher ROE, higher EPS. (favorable tax treatment for shareholders) Expand business . Higher profits. Note: Inventories also too high. Effect of reducing inventories?
  • Chapter 4

    1. 1. Chapter 4 Analysis of Financial Statements
    2. 2. Ratio Analysis Notes <ul><li>When analyzing a firm, we compare financial ratios rather than dollar figures to diminish the effects of differences in size (i.e., scale effects). </li></ul><ul><li>Industry averages are arithmetic medians , rather than means, to remove the distorting effects of outlier values. </li></ul>
    3. 3. Liquidity Ratios (MicroDrive p.124) <ul><li>Liquidity ratios measure the ability of to pay short-term debts . </li></ul><ul><li>What is the current ratio for our firm? </li></ul><ul><li>If the industry norm is 4.2, this is a(n) unfavorable comparison. </li></ul>
    4. 4. <ul><li>What is the quick ratio for our firm? </li></ul><ul><li>If the industry norm is 2.1, this is a(n) unfavorable comparison. </li></ul><ul><li>While the current ratio assumes that all current assets will be converted into cash within a year, the quick ratio assumes that inventories are illiquid. </li></ul>
    5. 5. Asset Management Ratios <ul><li>Asset management ratios measure how efficiently management is using its resources . These ratios are also known as efficiency or activity ratios. </li></ul><ul><li>What is the inventory turnover ratio? </li></ul><ul><li>If the industry norm is 9.0, this is a(n) unfavorable comparison. </li></ul>
    6. 6. <ul><li>What is the fixed assets turnover ratio for our firm? </li></ul><ul><li>If the industry norm is 3.0, this is a(n) favorable comparison. </li></ul><ul><li>Caution: If the fixed assets are older than average, this will cause the FA Turnover ratio to be artificially high . </li></ul>
    7. 7. <ul><li>What is the total assets turnover ratio for our firm? </li></ul><ul><li>If the industry norm is 1.8, this is a(n) unfavorable comparison. </li></ul><ul><li>Caution: If current assets are excessive, this will cause the TA Turn ratio to be artificially low . </li></ul>
    8. 8. <ul><li>What is the days sales outstanding (DSO) for our firm? (also known as the average collection period ) </li></ul><ul><li>If the industry norm is 36 days, this is a(n) unfavorable comparison. </li></ul><ul><li>Caution: If a company has excess inventories, it might be influenced to offer more lenient credit terms. </li></ul>
    9. 9. Debt Management Ratios <ul><li>Debt management ratios measure the company’s use of outside (i.e., nonequity) financing. (also known as leverage ratios) </li></ul><ul><li>What is the debt ratio for our firm? </li></ul><ul><li>If the industry norm is 40%, this is a(n) unfavorable comparison. </li></ul>
    10. 10. <ul><li>What is the times interest earned (TIE) ratio for our firm? </li></ul><ul><li>If the industry norm is 6.0, this is a(n) unfavorable comparison. </li></ul><ul><li>Note that the debt ratio focus is on the volume of debt, while the TIE focus is on ability to pay . </li></ul>
    11. 11. <ul><li>What is the EBITDA coverage ratio for our firm? </li></ul>
    12. 12. <ul><li>If the industry norm is 4.3, this is a(n) unfavorable comparison. </li></ul><ul><li>Like the TIE ratio, the EBITDA coverage ratio measures ability to pay , but the EBITDA coverage ratio assumes that more categories of fixed payments must be met (not just interest expense) </li></ul><ul><li>The EBITDA coverage ratio also assumes that payments are made out of cash profit , rather than book profit. </li></ul>
    13. 13. Profitability Ratios <ul><li>Profitability ratios measure the overall performance of management. (also known as the bottom line ) </li></ul><ul><li>The profit margin measures profit per dollar of sales , and is: </li></ul><ul><li>If the industry norm is 5.0%, this is a(n) unfavorable comparison. </li></ul>
    14. 14. <ul><li>The basic earning power ratio focus is on profit before financing costs , and is: </li></ul><ul><li>If the industry norm is 17.2%, this is a(n) unfavorable comparison. </li></ul><ul><li>Note: EBIT is also known as operating profit . </li></ul>
    15. 15. <ul><li>What is the return on total assets ratio (ROA) for our firm? </li></ul><ul><li>If the industry norm is 9.0%, this is a(n) unfavorable comparison. </li></ul>
    16. 16. <ul><li>What is the return on equity ratio (ROE) for our firm? </li></ul><ul><li>If the industry norm is 15.0%, this is a(n) unfavorable comparison? </li></ul>
    17. 17. Market Value Ratios <ul><li>Market value ratios measure the market’s perception of the quality of the firm. </li></ul><ul><li>What is the price earnings ratio (P/E) for our firm? </li></ul><ul><li>If the industry norm is 12.5, this is a(n) unfavorable comparison. </li></ul>
    18. 18. <ul><li>Caution: If a firm’s profitability is low, it will cause the P/E ratio to be artificially high . </li></ul>
    19. 19. <ul><li>What is the price to cash flow ratio (P/CF) for our firm? </li></ul><ul><li>If the industry norm is 6.8, this is a(n) unfavorable comparison. </li></ul><ul><li>Caution: If a firm is undergoing rapid expansion, its high depreciation charges will cause the P/CF ratio to be artificially low . </li></ul>
    20. 20. <ul><li>What is the market to book ratio (M/B) for our firm? </li></ul><ul><li>If the industry norm is 1.7, this is a(n) unfavorable comparison. </li></ul><ul><li>Note: Of the three market value ratios, the M/B is least subject to distortion. </li></ul>
    21. 21. Methods of Comparisons <ul><li>Comparing a firm’s ratios to its industry averages is called cross-sectional analysis or benchmarking . </li></ul><ul><li>Observing how a firm’s ratios change over time is called time series analysis or trend analysis. </li></ul><ul><li>A third approach is comparison to another firm of comparable size in the same industry. </li></ul>
    22. 22. Du Pont Analysis <ul><li>The Du Pont analysis refers to two formulas that show how selected ratios are linked to each other . </li></ul><ul><li>What are its components? </li></ul>
    23. 23. <ul><li>What are the Du Pont values for our firm? </li></ul><ul><li>The analysis indicates that insufficient volume is our firm’s greatest weakness, followed by cost control . </li></ul>
    24. 24. A broader example of how ratios are inter-connected <ul><li>What would be our revised balance sheet if we reduce DSO to 36 days, and use the additional cash to reduce short-term debt? </li></ul>
    25. 25. <ul><li>The excess cash was used to reduce debt. It also could have been used to: </li></ul><ul><li>- increase dividends </li></ul><ul><li>- repurchase stock ( tax treatment) </li></ul><ul><li>- expand business (future profit) </li></ul><ul><li>Note: Inventories also too high. If inventories are reduced, cash balances will increase . (Same effect as reducing receivables.) </li></ul>
    26. 26. Limitations of Ratio Analysis <ul><li>Ratio comparisons are less valid if your firm or the industry average firm operate in multiple industries . </li></ul><ul><li>The industry average may not be a(n) optimal goal. </li></ul><ul><li>Balance sheet values are based on historical costs and may not reflect market values. </li></ul>
    27. 27. <ul><li>Ratio comparisons may be less valid if your company’s fiscal year and the fiscal year for the industry average firm are different . </li></ul><ul><li>Management has considerable latitude in its ability to manipulate reported profits in the short-run . </li></ul>
    28. 28. <ul><li>Ratio comparisons in seasonal industries may be more distorted by the fact that the firms tend to close their books during the least active part of the season, when working capital items are typically lower . </li></ul>
    29. 29. <ul><li>Variations in how the cost of items sold are recognized may further distort ratio comparisons. </li></ul><ul><li>In an inflationary environment, companies that use FIFO (rather than LIFO) will report a lower cost of goods sold and a higher reported profit. </li></ul>
    30. 30. <ul><li>There is typically a trade-off between risk and return . While a high current ratio reflects greater liquidity, it also tends to result in lower profitability. </li></ul><ul><li>Profitability ratios are measures of book profit, and do not reflect the effect on shareholder wealth . A firm’s profits could be above average, and the stock price still fall if the reported profits are less than the market was expecting. </li></ul>
    31. 31. Independent Reading <ul><li>What is the difference between the IASB and the FASB? (p. 131) </li></ul><ul><li>What are a common-size balance sheet and a common-size income statement? (p. 137-139) </li></ul><ul><li>Is a company in a safer if (p.144-145): </li></ul><ul><li>- the bulk of its revenues are tied to one customer or many customers? </li></ul><ul><li>- it has a larger % of its business generated overseas or domestically? </li></ul>

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