Principles of Business Finance Fin 510 Dr. Lawrence P. Shao Marshall University Spring 2002
<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 Analysis of Financial Statements
Balance Sheet: Assets 1999E 1998 Cash 85,632 7,282 AR 878,000 632,160 Inventories 1,716,480 1,287,360 Total CA 2,680,112 1,926,802 Gross FA 1,197,160 1,202,950 Less: Deprec. 380,120 263,160 Net FA 817,040 939,790 Total assets 3,497,152 2,866,592
Liabilities and Equity 1999E 1998 Accounts payable 436,800 524,160 Notes payable 600,000 720,000 Accruals 408,000 489,600 Total CL 1,444,800 1,733,760 Long-term debt 500,000 1,000,000 Common stock 1,680,936 460,000 Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832 Total L & E 3,497,152 2,866,592
<ul><li>Standardize numbers; facilitate comparisons </li></ul><ul><li>Used to highlight weaknesses and strengths </li></ul>Why are ratios useful?
<ul><li>Liquidity : Can we make required payments? </li></ul><ul><li>Asset management : Right amount of assets vs. sales? </li></ul>What are the five major categories of ratios, and what questions do they answer?
<ul><li>Debt management : 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 value : Do investors like what they see as reflected in P/E and M/B ratios? </li></ul>
Calculate D’Leon’s forecasted current and quick ratios for 1999. CR 99 = = = 1.85x . QR 99 = = = 0.67x . CA CL $2,680 $1,445 $2,680 - $1,716 $1,445 CA - Inv. CL
Comments on CR and QR <ul><li>Expected to improve but still below the industry average. </li></ul><ul><li>Liquidity position is weak. </li></ul>1999 1998 1997 Ind. CR 1.85x 1.1x 2.3x 2.7x QR 0.67x 0.4x 0.8x 1.0x
What is the inventory turnover ratio vs. the industry average? Inv. turnover = = = 4.10x. Sales Inventories $7,036 $1,716 1999 1998 1997 Ind. Inv. T. 4.1x 4.5x 4.8x 6.1x
<ul><li>Inventory turnover is below industry average. </li></ul><ul><li>D’Leon might have old inventory, or its control might be poor. </li></ul><ul><li>No improvement is currently forecasted. </li></ul>Comments on Inventory Turnover
Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO = = = = 44.9. Receivables Sales/360 $878 $7,036/360
Appraisal of DSO <ul><li>D’Leon collects too slowly, and is getting worse. </li></ul><ul><li>Poor credit policy. </li></ul>1999 1998 1997 Ind. DSO 44.9 39.0 36.8 32.0
F.A. and T.A. turnover vs. industry average Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets turnover Sales Total assets = = = 2.01x. $7,036 $3,497
<ul><li>FA turnover projected to exceed industry average. Good. </li></ul><ul><li>TA turnover not up to industry average. Caused by excessive current assets (A/R and Inv.) </li></ul>1999 1998 1997 Ind. FA TO 8.6x 6.2x 10.0x 7.0x TA TO 2.0x 2.0x 2.3x 2.6x
Calculate the debt, TIE, and fixed charge coverage ratios. Total debt Total assets Debt ratio = = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE = = = 5.8x. $510.6 $88
Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 1999 1998 1997 Ind. D/A 55.6% 95.4% 54.8% 50.0% TIE 5.8x -3.9x 3.3x 6.2x
Profit margin vs. industry average? Very bad in 1998, but projected to exceed industry average in 1999. Looking good. 1999 1998 1997 Ind. P.M. 3.6% -8.9% 2.6% 3.5% P.M. = = = 3.6%. NI Sales $253.6 $7,036
BEP = = = 14.6%. BEP vs. Industry Average? EBIT Total assets $510.6 $3,497
<ul><li>BEP removes effect of taxes and financial leverage. Useful for comparison. </li></ul><ul><li>Projected to be below average. </li></ul><ul><li>Room for improvement. </li></ul>1999 1998 1997 Ind. BEP 14.6% -24.1% 14.2% 19.1%
ROA = = = 7.3%. Return on Assets Net income Total assets $253.6 $3,497
1999 1998 1997 Ind. ROA 7.3% -18.1% 6.0% 9.1% ROE 16.3% -391.4% 13.3% 18.2% Both below average but improving. ROE = = = 16.3%. Net income Common equity $253.6 $1,552
<ul><li>ROA is lowered by debt--interest lowers NI, which also lowers ROA = NI/Assets. </li></ul><ul><li>But use of debt lowers equity, hence could raise ROE = NI/Equity. </li></ul>Effects of Debt on ROA and ROE
Calculate and appraise the P/E and M/B ratios. Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01
Com. equity Shares out. BVPS = = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B = = = 1.96x. $12.17 $6.21
<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 BV. 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 12.0x -0.4x 9.7x 14.2x M/B 1.96x 1.7x 1.3x 2.4x
( )( )( ) = ROE x x = ROE. Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE 1997 2.6% x 2.3 x 2.2 = 13.2% 1998 -8.9% x 2.0 x 21.6 = -391.4% 1999 3.6% x 2.0 x 2.3 = 16.3% Ind. 3.5% x 2.6 x 2.0 = 18.2%
The Du Pont system focuses on: <ul><li>Expense control (P.M.) </li></ul><ul><li>Asset utilization (TATO) </li></ul><ul><li>Debt utilization (Eq. Mult.) </li></ul>It shows how these factors combine to determine the ROE.
Effect of reducing DSO from 44.9 days to 32 days: Old A/R = 19,543 x 44.9 = 878,000 New A/R = 19,543 x 32.0 = 625,376 Cash freed up: 252,624 Initially shows up as additional cash.
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>Seasonal factors can distort ratios. </li></ul>
<ul><li>EVA takes into account the total cost of capital, which includes the cost of equity. </li></ul><ul><li>EVA is not a cash flow measure. It attempts to measure the true economic benefits and costs of a firm, division, or project. </li></ul>EVA Concepts
Economic Value Added (EVA) <ul><li>EVA = - </li></ul><ul><li>= - </li></ul><ul><li>= EBIT(1 - T) - After-Tax Cost of Capital </li></ul>Operating Income After Tax After-Tax Capital Costs Funds Available to Investors Cost of Capital Used
EVA 99 = ($510,640)(1 - 0.4) - $300,000 = $6,384. EVA 98 = (-$690,560)(1 - 0.4) - $275,000 = -$689,336. EVA 97 = ($209,100)(1 - 0.4) - $125,000 = $460. Jamison also has asked you to estimate D’Leon’s EVA. The after-tax total cost of capital = $125,000 in 1997, $275,000 in 1998, and will be $300,000 in 1999.
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 1 key customer? </li></ul><ul><li>To what extent are the company’s revenues tied to 1 key product? </li></ul><ul><li>To what extent does the company rely on a single supplier? </li></ul>