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Lecture 4-350 4-1

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  • 1. CHAPTER 4 Analysis of Financial Statements
    • Ratio Analysis
    • Usefulness of ratios.
    • Limitations of ratio analysis
  • 2. Last week we learned how to calculate free cash flow (FCF), which will be useful when we come to stock valuation.
    • This week we will talk about analyzing financial ratios.
    • The ratios I focus are relatively more important.
  • 3. Financial Ratios: Accounting data stated in relative terms
    • Why are financial ratios useful?
    • Ratios standardize numbers and facilitate comparisons.
    • Ratios are used to highlight weaknesses and strengths.
    • Ratios might be useful to predict future.
  • 4. Ratios are not to be read in isolation.
    • When Analyzing Financial Ratios, always examine:
      • Trends across time
      • Comparisons with other firms’ (industry average) ratios
  • 5. Balance Sheet: Assets
    • Cash
    • A/R
    • Inventories
    • Total CA
    • Gross FA
    • Less: Dep.
    • Net FA
    • Total Assets
    2002 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 2003E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152
  • 6. Balance sheet: Liabilities and Equity
    • Accts payable
    • Notes payable
    • Accruals
    • Total CL
    • Long-term debt
    • Common stock
    • Retained earnings
    • Total Equity
    • Total L & E
    2002 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592 2003E 436,800 300,000 408,000 1,144,800 400,000 1,721,176 231,176 1,952,352 3,497,152 “ E” means “estimates”.
  • 7. Income statement
    • Sales
    • COGS
    • Other expenses
    • EBITDA
    • Depr. & Amort.
    • EBIT
    • Interest Exp.
    • EBT
    • Taxes
    • Net income
    2002 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2003E 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584
  • 8. Other data
    • No. of shares
    • EPS
    • DPS
    • Stock price
    2003E 250,000 $1.014 $0.220 $12.17 2002 100,000 -$1.602 $0.110 $2.25
  • 9. What are some important ratios, and what questions do they answer?
    • Liquidity: Can the firm meet short term obligations?
    • Asset management: is the firm generating good revenue from assets? (Sales is important, at least from your marketing class:)
    • Profitability: Is the firm sufficiently profitable as reflected in PM, ROE, and ROA?
    • Debt management: is the firm using the right mix of debt and equity?
    • Market value: Do investors like the form’s earnings and future growth prospect as reflected in P/E and M/B ratios?
  • 10. How liquid is a firm?
    • Liquidity is the ability to meet maturing debt obligations.
      • Comparing cash and assets that can be converted into cash within the year with liabilities that are due within the year.
  • 11. Calculate D’Leon’s forecasted current ratio for 2003.
    • Current ratio = Current assets / Current liabilities
    • = $2,680 / $1,145
    • = 2.34
  • 12. Comments on current ratio
    • Expected to improve but still below the industry average.
    • Liquidity position is weak.
    2.70 2.30 1.20 2.34 Current ratio Ind. 2001 2002 2003
  • 13. Is Management Generating Adequate Sales on the Firm’s Assets?
    • How efficiently a firm is using its assets in generating sales
  • 14. Fixed asset and total asset turnover ratios vs. the industry average
    • FA turnover = Sales / Net fixed assets
    • = $7,036 / $817 = 8.61
    • TA turnover = Sales / Total assets
    • = $7,036 / $3,497 = 2.01
  • 15. Evaluating the FA turnover and TA turnover ratios
    • FA turnover projected to exceed the industry average.
    • TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).
    7.0 10.0 6.4 8.6 FA TO 2.6 2.3 2.1 2.0 TA TO Ind. 2001 2002 2003
  • 16. What is the inventory turnover vs. the industry average? Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10 6.1 4.8 4.70 4.1 Inventory Turnover Ind. 2001 2002 2003
  • 17. Comments on Inventory Turnover
    • Inventory turnover is below industry average.
    • D’Leon might have old inventory, or its control might be poor.
    • No improvement is currently forecasted.
  • 18. DSO is the average number of days after making a sale before receiving cash.
    • DSO = Receivables / Average sales per day
    • = Receivables / Sales/365
    • = $878 / ($7,036/365)
    • = 45.6
  • 19. Appraisal of DSO
    • D’Leon collects on sales too slowly, and is getting worse.
    • D’Leon has a poor credit policy.
    32.0 37.4 38.2 45.6 DSO Ind. 2001 2002 2003
  • 20. How is the Firm Financing Its Assets?
    • Does the firm finance assets more by debt or equity?
    • Debt Ratio
  • 21. Calculate the debt ratio.
    • Debt ratio (D/A)= Total debt / Total assets
    • = ($1,145 + $400) / $3,497
    • = 44.2%
    • It measures financial leverage.
    • (1) If a firm is profitable, borrowing appropriate debt can leverage up return on shareholder equity.
    • (2) Too much debt may increase risk of bankruptcy.
  • 22. How does the debt ratio compare with industry averages?
    • D/A is better than the industry average.
    50.0% 54.8% 82.8% 44.2% D/A Ind. 2001 2002 2003
  • 23. Is Management Generating Adequate Operating Profits on the Firm’s Assets?
    • Operating Profit Margin
    • Basic earning power (BEP)
    • Return on Assets
    • Return on equity
  • 24. Profitability ratios: Profit margin and Basic earning power
    • Profit margin (2003) = Net income / Sales
    • = $253.6 / $7,036 = 3.6%
    • BEP (2003) = EBIT / Total assets
    • = $492.6 / $3,497 = 14.1%
  • 25. Appraising profitability with the profit margin and basic earning power
    • Profit margin was very bad in 2002, but is projected to exceed the industry average in 2003. Looking good.
    • BEP removes the effects of taxes and financial leverage, and is useful for comparison of operating performance.
    • BEP projected to improve, yet still below the industry average. There is definitely room for improvement.
    3.5% 2.6% -2.7% 3.6% PM 19.1% 13.0% -4.6% 14.1% BEP Ind. 2001 2002 2003
  • 26. Profitability ratios: Return on assets and Return on equity
    • ROA = Net income / Total assets
    • = $253.6 / $3,497 = 7.3%
    • ROE = Net income / Total common equity
    • = $253.6 / $1,952 = 13.0%
  • 27. Appraising profitability with the return on assets and return on equity
    • Both ratios rebounded from the previous year, but are still below the industry average.
    • Note ROE=ROA*(total asset/total equity)=ROA/(1-total debt/total asset)=ROA/(1-debt ratio).
    • If ROA>0, the higher the debt ratio, the higher ROE.
    • If ROA<0, the higher the debt ratio, the lower ROE.
    • Wider variations in ROE illustrate the effect that leverage can have on profitability.
    9.1% 6.0% -5.6% 7.3% ROA 18.2% 13.3% -32.5% 13.0% ROE Ind. 2001 2002 2003
  • 28. Calculate the Price/Earnings and Market/Book ratios.
    • P/E = Price / Earnings per share
    • = $12.17 / $1.014 = 12.0
    • M/B = Mkt price per share / Book value per share
    • = $12.17 / ($1,952 / 250) = 1.56
    14.2 9.7 -1.4 12.0 P/E 2.4 1.3 0.5 1.56 M/B Ind. 2001 2002 2003
  • 29. Analyzing the market value ratios
    • P/E: How much investors are willing to pay for $1 of earnings. When investors believe that the earnings are “real”, or earnings will grow, the P/E ratios is generally high.
    • M/B: How much investors are willing to pay for $1 of book value equity. When investors believe that the growth prospect of the firm is good, M/B will be high.
    • For each ratio, generally the higher the number, the better.
    • However, higher ratios might also indicate that the stock is overvalued. (dot.com bubble.)
  • 30. The Du Pont system
    • Also can be expressed as:
    • ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
    • ROA = (NI/Sales) x (Sales/TA)
    • Focuses on:
      • Expense control (PM)
      • Asset utilization (TATO)
      • Debt utilization ( TA/Equity )
    • Shows how these factors combine to determine ROE.
  • 31. Potential problems and limitations of financial ratio analysis
    • Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.
    • “ Average” performance is not necessarily good, perhaps the firm should aim higher. Sometimes it is hard to tell if a ratio is “good” or “bad”.
    • Seasonal factors. (Macy, Marriot)
    • “ Window dressing” and “big baths” techniques can make statements and ratios look better.
  • 32. Window dressing
    • To get a smaller debt ratio
    12/31/2003 12/31/2004 1/6/2004 12/23/2003 Pay back debt Borrow new debt
  • 33. Big bath
    • Recognize more expense and charge in bad years to ensure a growing string of profits in the future, so investors might think the firm is making turnaround and growing.
  • 34. More issues regarding ratios
    • Different operating and accounting practices can distort comparisons.
    • Off sheet liabilities.
  • 35. To mitigate the limitation, 1. consider ratios together
    • For example, if a firm has negative ROA in recent years and debt ratio is high, the high debt ratio may indicate risk of default.
    • If a firm has been profitable in recent years, the high debt ratio may indicate that the firm is borrowing debt to expand business.
    • Thus it pays to consider ROA and debt ratio together.
  • 36. 2. Consider qualitative factors
    • Are the firm’s revenues tied to 1 key customer, product, or supplier?
    • Competition (will high profit attract competitors?)
    • Future prospects (does the firm spend any R&D?)
    • Legal and regulatory environment (is it a regulated industry?)