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# Chapter 4: Analysis of Financial Statements

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### Chapter 4: Analysis of Financial Statements

1. 1. Chapter 4: Analysis of Financial Statements I. Ratio analysis A. Analysis of financial statements can be used to predict future earnings and dividends B. Analysis of financial statements is starting point for planning actions that will improve future performance C. Ratio analysis: Calculates and interprets financial ratios to analyze firm’s performance II. The different types of ratios A. Two liquidity ratios 1. Liquid asset =asset that can be converted to cash quickly without having to reduce asset’s price very much 2. Liquidity ratios: ratios that show the relationship of a firm’s cash and other current assets to its current liabilities 3. Current ratio a. Indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future b. Formula: current assets current ratio = cuurent liabilities 4. Quick Ratio or Acid Test Ratio a. Inventories least liquid of firm’s current assets and are assets on which assets most likely to occur in event of liquidation. Firm’s ability to pay-off short-term obligations without relying on sale of inventories is important b. Formula: current assets - inventory quick (acid-test) ratio = current liabilities B. Four asset management ratios 1. Asset management ratios = set of ratios that measure how effectively firm manages its assets 2. Inventory turnover ratio Sales Inventory turnover ratio = Inventory 3. Days sales outstanding (DSO) = average collection period = ACP a. Indicates the average length of time the firm must wait after making a sale before it receives cash b. Formula: Receivables Receivables DSO = days sales outstanding = = Average sales per day Annual sales 365 4. Fixed assets turnover ratio a. Measures how effectively the firm uses its plant and equipment b. Formula: Chapter 4: Analysis of Financial Statements Page 1
2. 2. sales fixed assets turnover ratio = net fixed assets 5. Total assets turnover ratio sales total assets turnover ratio = total assets C. Debt management ratios 1. Total debt to total assets total debt debt ratio = total assets 2. Times-interest-earned (TIE) ratio a. Measures firm’s ability to meet its annual interest payments b. Formula EBIT times-interest-earned (TIE) ratio = interest charges 3. EBITDA coverage ratio a. Ratio whose numerator includes all cash flows available to meet fixed financial charges and whose denominator includes all fixed financial charges b. Formula: EBITDA + lease payments EBITDA coverage ratio = interest + principal payments + lease payments D. Four profitability ratios 1. Profitability ratios = group of ratios that show combined effects of liquidity, asset management, and debt on operating results 2. Profit margin on sales net income profit margin on sales = sales 3. Return on total assets (ROA) net income return on total assets = ROA = total assets 4. Basic earning power (BEP) ratio a. Ratio indicates the ability of firm’s assets to generate operating income b. Formula EBIT basic earning power (BEP) ratio = total assets 5. Return on common equity a. Measures rate of return on common stockholders’ investment b. Formula: net income return on common equity = ROE = common equity 6. An important digression: The effect of leverage on ROE a. The concept of leverage i. Financial debt = use of debt financing ii. Three important implications of using debt financing Chapter 4: Analysis of Financial Statements Page 2
3. 3. ● By raising funds through debt, stockholders can control a firm with limited amount of equity investment ● The higher the proportion of total capital provided by stockholders, the less risk faced by creditors. ● If firm earns more on its assets than the interest it pays on debt, then using debt “leverages” or magnifies the return on equity (ROE) b. Example: A leveraged and unleveraged firm Table 4-1: Effects of Financial Leverage on Stockholder Returns FIRM U [UNLEVERAGED (NO DEBT)] Current assets \$50 Debt \$0 Fixed assets 50 Common Equity 100 Total assets \$100 Total Liabilities & Equity \$100 Business Conditions Good Expected Bad Sales Revenue \$150.0 \$100.0 \$75.0 Operating costs Fixed 45.0 45.0 45.0 Variable 60.0 40.0 30.0 Total operating costs 105.0 85.0 75.0 Operating Income (EBIT) \$45.0 \$15.0 \$0.0 Interest (Rate = 10%) 0.0 0.0 0.0 Earnings before taxes (EBT) \$45.0 \$15.0 \$0.0 Taxes (rate = 40%) 18.0 6.0 0.0 Net income \$27.0 \$9.0 \$0.0 ROE 27.0% 9.0% 0.0% FIRM L [LEVERAGED (SOME DEBT)] Current assets \$50 Debt \$50 Fixed assets 50 Common Equity 50 Total assets \$100 Total Liabilities & Equity \$100 Business Conditions Good Expected Bad Sales Revenue \$150.0 \$100.0 \$75.0 Operating costs Fixed 45.0 45.0 45.0 Variable 60.0 40.0 30.0 Total operating costs 105.0 85.0 75.0 Operating Income (EBIT) \$45.0 \$15.0 \$0.0 Interest (Rate = 10%) 5.0 5.0 5.0 Earnings before taxes (EBT) \$40.0 \$10.0 -\$5.0 Taxes (rate = 40%) 16.0 4.0 0.0 Net income \$24.0 \$6.0 -\$5.0 ROE 48.0% 12.0% -10.0% c. Results: Chapter 4: Analysis of Financial Statements Page 3
4. 4. i. Because interest is deductible, use of debt lowers tax bill and leaves more of the firm’s operating income available to investors ii. Use of debt require firms to balance higher expected returns against increased risk E. Three market value ratios 1. Set of ratios that relate stock price to its earnings, cash flow and book value per share 2. Price/Earnings Ratio = P/E Ratio a. Shows the dollar amount investors will pay for \$1 of current earnings b. Formula: price per share price/earnings (P/E) ratio = earnings per share 3. Price/cash flow ratio a. Shows the dollar amount investors will pay for \$1 of cash flow b. Formula: price per share price/cash flow = cash flow per share 4. Market/Book Ratio a. Book value per share: common equity book value per share = shares outstanding b. market/book ratio: market price per share market/book ratio = M/B = book value per share III.Book’s example of Allied Food Products A. Review financial statements developed in Chapter 3: Tables 3 – 1, 3 – 2, 3 – 3, 3 – 4 Chapter 4: Analysis of Financial Statements Page 4
5. 5. TABLE 4-2: Allied Food Products: Summary of Financial Ratios (Millions of Dollars) Liquidity Ratios 2004 Industry Ratio Formula Calculation Comment Value Average current assets \$1,000 Current Ratio = 3.2x 3.7x 4.2x Poor cuurent liabilities \$310 current assets - inventory \$385 Quick = 1.2x 1.8x 2.2x Poor current liabilities \$310 Asset Management 2004 Industry Ratio Formula Calculation Comment Value Average Inventory Sales \$3,000 = 4.9x 6.9x 10.9x Poor Turnover Inventory \$615 Days sales Receivables \$375 = 46 days 40.3 days 36 days Poor outstanding Annual sales 365 \$8.2192 Fixed asset sales \$3,000 = 3.0x 3.3x 2.8x OK turnover net fixed assets \$1,000 Total assets sales \$3,000 Somewhat = 1.5x 1.7x 1.8x turnover total assets \$2,000 Low Debt Management 2004 Industry Ratio Formula Calculation Comment Value Average Total debt to total debt \$1,060 High = 53.0% 47.6% 40.0% total assets total assets \$2,000 (risky) Times-interest-earned EBIT \$283.8 Low = 3.2x 4.4x 6.0x (TIE) interest charges \$88.0 (risky) EBITDA EBITDA + lease payments \$383.8 + \$28 \$411.8 Low = = 3.0x 3.5x 4.3x Coverage* interest + principal payments + lease payments \$88 + \$20 + \$28 \$136 (risky) * Assumes lease payments = \$28 million and principal payments = \$20 million Chapter 4: Analysis of Financial Statements Page 5
6. 6. TABLE 4-2 (Continued): Allied Food Products: Summary of Financial Ratios (Millions of Dollars) Profitability 2004 Industry Ratio Formula Calculation Comment Value Average net income \$117.5 Profit margin on sale = 3.9% 4.3% 5.0% Poor sales \$3,000 Return on total asset net income \$117.5 = 5.9% 7.3% 9.0% Poor (ROA) total assets \$2,000 Basic earning power EBIT \$283.8 15.7 = 14.2% 18.0% Poor (BEP) total assets \$2,000 % Return on common net income \$117.5 13.8 equity = 12.5% 15.0% Poor common equity \$940 % (ROE) Market Value Ratios 2004 Industry Ratio Formula Calculation Comment Value Average price per share \$23.00 Price/earnings (P/E) = 9.8x 10.7x 11.3x Low earnings per share \$2.35 price per share \$23.00 Price/cash flow = 5.3x 6.13x 5.4x Low cash flow per share \$4.35 market price per share \$23.00 Market/book (M/B) = 1.2x 1.5x 1.7x Low book value per share \$18.80 IV. Benchmarking: cross-sectional and trend comparisons A. Trend analysis 1. = analysis of a firm’s financial ratios over time 2. Used to estimate the likelihood of improvement or deterioration in its financial condition B. Cross-sectional analysis: compare company’s financial ratios with a group of “benchmark” companies Chapter 4: Analysis of Financial Statements Page 6
7. 7. V. Tying ratios together: The Du Pont Equation A. Basic Du Pont Equation 1. ROA is the product of the profit margin and the total asset turnover 2. Formula Net Income Net Income Sales ROA = = × Total Assets Sales Total Assets 3. Book’s 2005 Allied Food Example ROA = 3.9% × 1.5 = 5.9% B. ROA and ROE 1. If a company were financed only by common equity → no debt → no liabilities → assets = equity Net Inocme Net Income ROA = = = ROE Total Assets Common Equity 2. Define the equity multiplier a. Definition: Total Assets Equity Multiplier = Common Equity b. Firms with more leverage → ↑ debt and ↓ equity → ↑ equity multiplier c. Book’s 2005 Allied Food example: equity multiplier = (\$2,000)/(\$940) = 2.13 3. Extended Du Pont equation Net Income Sales Total Assets a. ROE = × × Sales Total Assets Common Equity b. ROE = (profit margin) × (total assets turnover) × (equity multipler) c. Book’s 2005 Allied Food Example: ROE = (3.9%)(1.5)(2.13) = 12.5% VI. Uses and limitations of ratio analysis A. Comparison with industry averages more difficult for conglomerate firms that operate many divisions in different industries B. “Average” performance is not necessarily good → Perhaps firm should have higher goal and focus on industry leader’s ratios → Benchmarking will help in this area C. Inflation distorts balance sheets and income statements and comparisons of ratios across time must be done with care D. Seasonal factors can distort ratios E. Firms may employ “window dressing techniques” to make their financial statements look better than they really are F. Different accounting and operating practices can distort comparisons of ratios Chapter 4: Analysis of Financial Statements Page 7
8. 8. G. It is difficult to determine whether a given ratio value is good or bad 1. A high current ratio may imply excellent liquidity (which is good) or excessive cash (which is bad because it is a nonearning asset) 2. A high fixed asset turnover ratio may indicate a firm that uses its fixed assets efficiently or a firm that is short cash and doesn’t have capital for needed investments H. Some of the firm’s ratios may look strong while some of its ratios look poor 1. Makes it difficult to determine overall position of firm 2. Statistical methods (discriminate analysis) have been used to determine the net effect of a set of ratios and determine which ones predict financial distress VII. Problems with ROE A. ROE and shareholder wealth are positively correlated but problems can anise when ROE is the sole measure of performance B. Types of problems 1. ROE does not consider risk 2. ROE does not consider the amount of invested capital 3. Managers attempts to maximize ROE will ignore other profitable investments Chapter 4: Analysis of Financial Statements Page 8