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<ul><li>Ratio analysis </li></ul><ul><li>Du Pont system </li></ul><ul><li>Effects of improving ratios </li></ul><ul><li>Li...
<ul><li>Balance Sheet </li></ul><ul><li>Income Statement </li></ul><ul><li>Statement of Retained Earnings </li></ul><ul><l...
<ul><li>Compact Disclosure--student network </li></ul><ul><li>SEC.GOV for public companies </li></ul><ul><ul><li>EDGAR lib...
<ul><li>Cash </li></ul><ul><ul><li>Is cash cash? </li></ul></ul><ul><ul><li>Foreign currency translation & mark to market ...
Effects of Accounting Choices on Financial Statement Analysis LIFO & FIFO Appreciating value inventory units New units cos...
Inventory--appreciating value units FIFO  LIFO Balance sheet-- inventory over or understated? Income statement-- COGS over...
Effects of Accounting Choices on Financial Statement Analysis LIFO & FIFO Depreciating value inventory units New units cos...
Inventory--depreciating value units FIFO  LIFO Balance sheet-- inventory over or understated? Income statement-- COGS over...
<ul><li>Age  Depreciation </li></ul><ul><li>Land </li></ul><ul><li>Buildings </li></ul><ul><li>Equipment </li></ul>Effects...
<ul><li>Effects of Lease Financing </li></ul><ul><li>Capital Leases </li></ul><ul><li>Operating Leases </li></ul>Effects o...
<ul><li>Intangible Assets </li></ul><ul><ul><li>Goodwill </li></ul></ul><ul><ul><li>M&A </li></ul></ul>Effects of Accounti...
Mini Case Analysis
Mini Case Analysis Statement of Retained Earnings (1998) Balance of retained earnings, 12/31/97 $203,768  Add:  Net income...
Mini Case Analysis Statement of Cash Flows:  1998 <ul><li>OPERATING ACTIVITIES </li></ul><ul><li>Net Income (519,936) </li...
Mini Case Analysis Statement of Cash Flows:  1998 <ul><li>L-T INVESTING ACTIVITIES </li></ul><ul><li>Investments in fixed ...
Statement of Cash Flows:  1998 <ul><li>Summary: </li></ul><ul><li>Beginning cash 9,000  </li></ul><ul><li>Cash from operat...
What effect did the company’s expansion have on its net cash flow and net income for 1998? NCF 98 = NI + DEP = = NCF 97 = ...
<ul><li>The expansion was financed primarily with ______________ </li></ul><ul><li>The company __________________ which re...
What happens if fixed assets are depreciated over 7 years (as opposed to the current 10 years)? <ul><li>No effect on physi...
Other policies that can affect financial statements <ul><li>Inventory valuation methods. </li></ul><ul><li>Capitalization ...
Why are ratios useful?
<ul><li>Liquidity: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
<ul><li>Asset management: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
<ul><li>Debt management: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
<ul><li>Profitability: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
<ul><li>Market value: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
Mini Case Analysis--Compute Statement of Cash Flows:  1999 <ul><li>OPERATING ACTIVITIES </li></ul><ul><li>Net Income </li>...
Mini Case Analysis--Compute Statement of Cash Flows:  1999 <ul><li>L-T INVESTING ACTIVITIES </li></ul><ul><li>Investments ...
Mini Case Analysis--Compute Statement of Cash Flows:  1999 <ul><li>Summary: </li></ul><ul><li>Beginning cash 9,000  </li><...
Calculate the firm’s forecasted current and quick ratios for 1999. CR 99  =  =  =  QR 99  = =  = CA CL CA - Inv. CL
Comments on CR and QR 1999 1998 1997 Ind. CR 1.1x 2.3x 2.7x QR 0.4x 0.8x 1.0x
What is the inventory turnover ratio as compared to the industry average? Inv. turnover = =  =  Sales Inventories 1999 199...
<ul><li>Inventory turnover is _____ industry average. </li></ul><ul><li>Firm might have ___ inventory, or its control migh...
Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO = =  = ...
Appraisal of DSO <ul><li>Firm collects? </li></ul><ul><li>Credit policy? </li></ul>1999  1998  1997  Ind.    DSO   39.0  3...
Fixed Assets and Total Assets Turnover Ratios (More…) Fixed assets turnover Sales  Net fixed assets = =  =  Total assets t...
<ul><li>FA turnover is expected to ________________. </li></ul><ul><li>TA turnover?__________________ </li></ul>1999  1998...
Calculate the debt, TIE, and fixed charge coverage ratios. Total debt  Total assets Debt ratio =  EBIT  Int. expense TIE  ...
All three ratios reflect use of debt, but focus on different aspects. Fixed charge coverage = FCC = =  =  EBIT + Lease pay...
Debt situation? How do the debt management ratios compare with industry averages? 1999  1998  1997  Ind. D/A   95.4% 54.8%...
Profit Margin (PM) Profit margin story? 1999  1998  1997  Ind. PM   -8.9%  2.6%   3.5% PM  =  =  =  NI  Sales
BEP = =  =  Basic Earning Power (BEP) EBIT  Total assets (More…)
<ul><li>BEP removes effect of taxes and financial leverage.  Useful for comparison. </li></ul><ul><li>Projected to be?  </...
ROA = =  =  Return on Assets (ROA) and Return on Equity (ROE) Net income  Total assets (More…)
1999 1998  1997  Ind. ROA -18.1%   6.0% 9.1% ROE  -391.4%  13.3% 18.2% Story? ROE = =  = Net income  Common equity
<ul><li>ROA is ________by debt--interest expense ______ net income, which also ______ ROA. </li></ul><ul><li>However, the ...
Calculate and appraise the P/E and M/B ratios. (More…) Price =  $12.17. EPS =  =  =  P/E =  =  =  NI  Shares out. Price pe...
Com. equity  Shares out. BVPS = =  =  Mkt. price per share  Book value per share M/B  = =  =  (More…)
<ul><li>P/E: How much investors will pay for $1 of earnings.  High is good. </li></ul><ul><li>M/B: How much paid for $1 of...
(  )(  )(  )  = ROE Profit margin TA turnover Equity multiplier NI  Sales Sales TA TA  CE 1997 2.6%  x  2.3 x 2.2 = 13.3% ...
The Du Pont system focuses on: <ul><li>Expense control (PM) </li></ul><ul><li>Asset utilization (TATO) </li></ul><ul><li>D...
Simplified Firm Data A/R $  878 Debt $1,945 Other CA 1,802 Equity 1,552 Net FA 817 Total assets $3,497 L&E $3,497 Q.  How ...
Effect of reducing DSO from  44.9 days to 32 days: Old A/R =   = $878,000 New A/R =   =  625,376 Cash freed up =  Initiall...
New Balance Sheet What could be done with the new cash?  Effect on stock price and risk? Added cash $  253 Debt $1,945 A/R...
Potential use of freed up cash <ul><li>Repurchase stock .  </li></ul><ul><li>Expand business .  </li></ul><ul><li>Reduce d...
What are some potential problems and limitations of financial ratio analysis? <ul><li>Comparison with industry averages is...
<ul><li>Window dressing  techniques can make statements and ratios look better. </li></ul><ul><li>Different accounting and...
What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance...
What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance...
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3 - 1 Copyright © 2002 by James M. Johnson, Ph.D. All rights ...

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3 - 1 Copyright © 2002 by James M. Johnson, Ph.D. All rights ...

  1. 1. <ul><li>Ratio analysis </li></ul><ul><li>Du Pont system </li></ul><ul><li>Effects of improving ratios </li></ul><ul><li>Limitations of ratio analysis </li></ul><ul><li>Qualitative factors </li></ul>CHAPTER 3 Financial Statement Analysis
  2. 2. <ul><li>Balance Sheet </li></ul><ul><li>Income Statement </li></ul><ul><li>Statement of Retained Earnings </li></ul><ul><li>Statement of Cash Flows </li></ul>Financial Statement Analysis Financial Statements in 10Ks
  3. 3. <ul><li>Compact Disclosure--student network </li></ul><ul><li>SEC.GOV for public companies </li></ul><ul><ul><li>EDGAR library </li></ul></ul><ul><li>Company websites </li></ul><ul><li>www.corporateinformation.com </li></ul>Sources of Financial Statement Information
  4. 4. <ul><li>Cash </li></ul><ul><ul><li>Is cash cash? </li></ul></ul><ul><ul><li>Foreign currency translation & mark to market </li></ul></ul><ul><li>Short-term investments </li></ul>Effects of Accounting Choices on Financial Statement Analysis
  5. 5. Effects of Accounting Choices on Financial Statement Analysis LIFO & FIFO Appreciating value inventory units New units cost more over time Higher value units Lower value units LIFO FIFO
  6. 6. Inventory--appreciating value units FIFO LIFO Balance sheet-- inventory over or understated? Income statement-- COGS over or understated? Profit margin over or understated? Effects of Accounting Choices on Financial Statement Analysis
  7. 7. Effects of Accounting Choices on Financial Statement Analysis LIFO & FIFO Depreciating value inventory units New units cost less over time Lower value units Higher value units LIFO FIFO
  8. 8. Inventory--depreciating value units FIFO LIFO Balance sheet-- inventory over or understated? Income statement-- COGS over or understated? Profit margin over or understated? Effects of Accounting Choices on Financial Statement Analysis
  9. 9. <ul><li>Age Depreciation </li></ul><ul><li>Land </li></ul><ul><li>Buildings </li></ul><ul><li>Equipment </li></ul>Effects of Accounting Choices on Financial Statement Analysis
  10. 10. <ul><li>Effects of Lease Financing </li></ul><ul><li>Capital Leases </li></ul><ul><li>Operating Leases </li></ul>Effects of Accounting Choices on Financial Statement Analysis
  11. 11. <ul><li>Intangible Assets </li></ul><ul><ul><li>Goodwill </li></ul></ul><ul><ul><li>M&A </li></ul></ul>Effects of Accounting Choices on Financial Statement Analysis
  12. 12. Mini Case Analysis
  13. 13. Mini Case Analysis Statement of Retained Earnings (1998) Balance of retained earnings, 12/31/97 $203,768 Add: Net income, 1998 (519,936) Less: Dividends paid (11,000) Balance of retained earnings, 12/31/98 ($327,168)
  14. 14. Mini Case Analysis Statement of Cash Flows: 1998 <ul><li>OPERATING ACTIVITIES </li></ul><ul><li>Net Income (519,936) </li></ul><ul><li>Adjustments: </li></ul><ul><li>Depreciation 116,960 </li></ul><ul><li>Change in AR (280,960) </li></ul><ul><li>Change in inventories (572,160) </li></ul><ul><li>Change in AP 378,560 </li></ul><ul><li>Change in accruals 353,600 </li></ul><ul><li>Net cash provided by operations. </li></ul>(523,936)
  15. 15. Mini Case Analysis Statement of Cash Flows: 1998 <ul><li>L-T INVESTING ACTIVITIES </li></ul><ul><li>Investments in fixed assets (711,950) </li></ul><ul><li>FINANCING ACTIVITIES </li></ul><ul><li>Change in s-t investments 48,600 </li></ul><ul><li>Change in notes payable 520,000 </li></ul><ul><li>Change in long-term debt 676,568 </li></ul><ul><li>Payment of cash dividends (11,000) </li></ul><ul><li>Net cash from financing 1,234,168 </li></ul>
  16. 16. Statement of Cash Flows: 1998 <ul><li>Summary: </li></ul><ul><li>Beginning cash 9,000 </li></ul><ul><li>Cash from operations (523,936) </li></ul><ul><li>Investment in fixed assets (711,950) </li></ul><ul><li>Net cash from financing 1,234,168 </li></ul><ul><li>Equals: ending cash 7,282 </li></ul><ul><li>Change in cash for year: ( 1,718) </li></ul>
  17. 17. What effect did the company’s expansion have on its net cash flow and net income for 1998? NCF 98 = NI + DEP = = NCF 97 = = NI 98 - NI 97 = =
  18. 18. <ul><li>The expansion was financed primarily with ______________ </li></ul><ul><li>The company __________________ which reduced its financial strength and flexibility. </li></ul>How was the expansion financed?
  19. 19. What happens if fixed assets are depreciated over 7 years (as opposed to the current 10 years)? <ul><li>No effect on physical assets. </li></ul><ul><li>Fixed assets on balance sheet would _________. </li></ul><ul><li>Net income would __________. </li></ul><ul><li>Tax payments would _________. </li></ul><ul><li>Cash position would __________. </li></ul>
  20. 20. Other policies that can affect financial statements <ul><li>Inventory valuation methods. </li></ul><ul><li>Capitalization of R&D expenses. </li></ul><ul><li>Policies for funding the company’s retirement plan. </li></ul><ul><li>Lease financing </li></ul><ul><li>Merger accounting </li></ul>
  21. 21. Why are ratios useful?
  22. 22. <ul><li>Liquidity: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
  23. 23. <ul><li>Asset management: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
  24. 24. <ul><li>Debt management: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
  25. 25. <ul><li>Profitability: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
  26. 26. <ul><li>Market value: </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
  27. 27. Mini Case Analysis--Compute Statement of Cash Flows: 1999 <ul><li>OPERATING ACTIVITIES </li></ul><ul><li>Net Income </li></ul><ul><li>Adjustments: </li></ul><ul><li>Depreciation </li></ul><ul><li>Change in AR </li></ul><ul><li>Change in inventories </li></ul><ul><li>Change in AP </li></ul><ul><li>Change in accruals </li></ul><ul><li>Net cash provided by operations. </li></ul>
  28. 28. Mini Case Analysis--Compute Statement of Cash Flows: 1999 <ul><li>L-T INVESTING ACTIVITIES </li></ul><ul><li>Investments in fixed assets </li></ul><ul><li>FINANCING ACTIVITIES </li></ul><ul><li>Change in s-t investments </li></ul><ul><li>Change in notes payable </li></ul><ul><li>Change in long-term debt </li></ul><ul><li>Payment of cash dividends </li></ul><ul><li>Net cash from financing </li></ul>
  29. 29. Mini Case Analysis--Compute Statement of Cash Flows: 1999 <ul><li>Summary: </li></ul><ul><li>Beginning cash 9,000 </li></ul><ul><li>Cash from operations </li></ul><ul><li>Investment in fixed assets </li></ul><ul><li>Net cash from financing </li></ul><ul><li>Equals: ending cash 7,282 </li></ul><ul><li>Change in cash for year: ( 1,718) </li></ul>
  30. 30. Calculate the firm’s forecasted current and quick ratios for 1999. CR 99 = = = QR 99 = = = CA CL CA - Inv. CL
  31. 31. Comments on CR and QR 1999 1998 1997 Ind. CR 1.1x 2.3x 2.7x QR 0.4x 0.8x 1.0x
  32. 32. What is the inventory turnover ratio as compared to the industry average? Inv. turnover = = = Sales Inventories 1999 1998 1997 Ind. Inv. T. 4.5x 4.8x 6.1x
  33. 33. <ul><li>Inventory turnover is _____ industry average. </li></ul><ul><li>Firm might have ___ inventory, or its control might be ____. </li></ul><ul><li>Is improvement forecasted? </li></ul>Comments on Inventory Turnover
  34. 34. Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO = = = = 44.9 days. Receivables Sales/360
  35. 35. Appraisal of DSO <ul><li>Firm collects? </li></ul><ul><li>Credit policy? </li></ul>1999 1998 1997 Ind. DSO 39.0 36.8 32.0
  36. 36. Fixed Assets and Total Assets Turnover Ratios (More…) Fixed assets turnover Sales Net fixed assets = = = Total assets turnover Sales Total assets = = =
  37. 37. <ul><li>FA turnover is expected to ________________. </li></ul><ul><li>TA turnover?__________________ </li></ul>1999 1998 1997 Ind. FA TO 6.2x 10.0x 7.0x TA TO 2.0x 2.3x 2.6x
  38. 38. Calculate the debt, TIE, and fixed charge coverage ratios. Total debt Total assets Debt ratio = EBIT Int. expense TIE = = = (More…)
  39. 39. All three ratios reflect use of debt, but focus on different aspects. Fixed charge coverage = FCC = = = EBIT + Lease payments Interest Lease Sinking fund pmt. expense pmt. (1 - T) + +
  40. 40. Debt situation? How do the debt management ratios compare with industry averages? 1999 1998 1997 Ind. D/A 95.4% 54.8% 50.0% TIE -3.9x 3.3x 6.2x FCC -3.0x 2.4x 5.1x
  41. 41. Profit Margin (PM) Profit margin story? 1999 1998 1997 Ind. PM -8.9% 2.6% 3.5% PM = = = NI Sales
  42. 42. BEP = = = Basic Earning Power (BEP) EBIT Total assets (More…)
  43. 43. <ul><li>BEP removes effect of taxes and financial leverage. Useful for comparison. </li></ul><ul><li>Projected to be? </li></ul>1999 1998 1997 Ind. BEP -24.1% 14.2% 19.1%
  44. 44. ROA = = = Return on Assets (ROA) and Return on Equity (ROE) Net income Total assets (More…)
  45. 45. 1999 1998 1997 Ind. ROA -18.1% 6.0% 9.1% ROE -391.4% 13.3% 18.2% Story? ROE = = = Net income Common equity
  46. 46. <ul><li>ROA is ________by debt--interest expense ______ net income, which also ______ ROA. </li></ul><ul><li>However, the use of debt ______ equity, and if equity is ________ more than net income, ROE would </li></ul>Effects of Debt on ROA and ROE
  47. 47. Calculate and appraise the P/E and M/B ratios. (More…) Price = $12.17. EPS = = = P/E = = = NI Shares out. Price per share EPS
  48. 48. Com. equity Shares out. BVPS = = = Mkt. price per share Book value per share M/B = = = (More…)
  49. 49. <ul><li>P/E: How much investors will pay for $1 of earnings. High is good. </li></ul><ul><li>M/B: How much paid for $1 of book value. Higher is good. </li></ul><ul><li>P/E and M/B are high if ROE is high, risk is low. </li></ul>1999 1998 1997 Ind. P/E -0.4x 9.7x 14.2x M/B 1.7x 1.3x 2.4x
  50. 50. ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE 1997 2.6% x 2.3 x 2.2 = 13.3% 1998 -8.9% x 2.0 x 21.6 = -391.4% 1999 x x = Ind. 3.5% x 2.6 x 2.0 = 18.2% Explain the Du Pont System x x = ROE.
  51. 51. The Du Pont system focuses on: <ul><li>Expense control (PM) </li></ul><ul><li>Asset utilization (TATO) </li></ul><ul><li>Debt utilization (EM) </li></ul>It shows how these factors combine to determine the ROE.
  52. 52. Simplified Firm Data A/R $ 878 Debt $1,945 Other CA 1,802 Equity 1,552 Net FA 817 Total assets $3,497 L&E $3,497 Q. How would reducing DSO to 32 days affect the company? Sales $7,035,600 day 360 = = $19,543.
  53. 53. Effect of reducing DSO from 44.9 days to 32 days: Old A/R = = $878,000 New A/R = = 625,376 Cash freed up = Initially shows up as additional cash.
  54. 54. New Balance Sheet What could be done with the new cash? Effect on stock price and risk? Added cash $ 253 Debt $1,945 A/R 625 Equity 1,552 Other CA 1,802 Net FA 817 Total assets $3,497 Total L&E $3,497
  55. 55. Potential use of freed up cash <ul><li>Repurchase stock . </li></ul><ul><li>Expand business . </li></ul><ul><li>Reduce debt . </li></ul><ul><li>Pay a special cash dividend. </li></ul><ul><li>Buy another company </li></ul>(More…)
  56. 56. 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 is not necessarily good. </li></ul><ul><li>Seasonal factors can distort ratios. </li></ul>(More…)
  57. 57. <ul><li>Window dressing techniques can make statements and ratios look better. </li></ul><ul><li>Different accounting and operating practices can distort comparisons. </li></ul><ul><li>Sometimes it is difficult to tell if a ratio value is “good” or “bad.” </li></ul><ul><li>Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition. </li></ul>
  58. 58. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? <ul><li>Are the company’s revenues tied to a single customer ? </li></ul><ul><li>To what extent are the company’s revenues tied to a single product ? </li></ul><ul><li>To what extent does the company rely on a single supplier ? </li></ul>(More…)
  59. 59. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? <ul><li>What % of business is foreign? </li></ul><ul><li>What is the competitive situation ? </li></ul><ul><li>What does the future have in store? </li></ul><ul><li>What is the company’s legal and regulatory environment ? </li></ul>

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