Chapter 4

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  • Why not compare $ figures instead of ratios? Larger firms should make bigger profits; ratios adjust for size difference What kind of averages are industry norms? Arithmetic medians For all of the ratio problems in the following slides, see I/S and B/S on pages 70 and 73.
  • Group measures the ability of the firm to pay its short-term debts Comparison to industry norm of 4.2 is unfavorable Comparison to industry norm of 1.0 is favorable
  • Group measures the ability of the firm to pay its short-term debts Comparison to industry norm of 4.2 is unfavorable Comparison to industry norm of 1.0 is favorable
  • Also called ‘efficiency’ ratios Group measures how efficiently management is using the firm’s resources (i.e., its assets) Comparison to industry norm of 9.0 is unfavorable
  • Also called ‘efficiency’ ratios Group measures how efficiently management is using the firm’s resources (i.e., its assets) Comparison to industry norm of 9.0 is unfavorable
  • Comparison to industry norm of 36 (days) is unfavorable
  • Comparison to industry norm of 36 (days) is unfavorable
  • Comparison to industry norm of 3.0 is in line with industry (neither favorable nor unfavorable)
  • Comparison to industry norm of 3.0 is in line with industry (neither favorable nor unfavorable)
  • Comparison to industry norm of 1.8 is unfavorable
  • Comparison to industry norm of 1.8 is unfavorable
  • Also called ‘leverage’ ratios Group measures the extent to which the firm uses outside funding (i.e., borrowed funds) Comparison to industry norm of 40% is unfavorable Focuses on the level of debt
  • Also called ‘leverage’ ratios Group measures the extent to which the firm uses outside funding (i.e., borrowed funds) Comparison to industry norm of 40% is unfavorable Focuses on the level of debt
  • Also called ‘leverage’ ratios Group measures the extent to which the firm uses outside funding (i.e., borrowed funds) Comparison to industry norm of 40% is unfavorable Focuses on the level of debt
  • Comparison to industry norm of 6.0 is unfavorable Focuses on ability to carry debt
  • Comparison to industry norm of 6.0 is unfavorable Focuses on ability to carry debt
  • Comparison to industry norm of 4.3 is unfavorable More comprehensive than TIE
  • Comparison to industry norm of 4.3 is unfavorable More comprehensive than TIE
  • Group measures the ‘bottom line’ … the overall performance of management Comparison to industry norm of 5.0% is unfavorable
  • Group measures the ‘bottom line’ … the overall performance of management Comparison to industry norm of 5.0% is unfavorable
  • Compared to industry norm of 17.2% is unfavorable
  • Comparison to industry norm of 9.0% is unfavorable
  • Comparison to industry norm of 15.0% is unfavorable
  • Group measures the market’s reaction to firm’s performance Comparison to industry norm of 12.5 is unfavorable Comparison looks worse when you consider that earnings are low
  • Group measures the market’s reaction to firm’s performance Comparison to industry norm of 12.5 is unfavorable Comparison looks worse when you consider that earnings are low
  • Comparison to industry norm of 6.8 is unfavorable
  • Comparison to industry norm of 6.8 is unfavorable
  • Comparison to industry norm of 1.7 is unfavorable
  • Trend analysis refers to how ratios change over time For example: Profit margin 05 = 3.9% Profit margin 04 = 4.1% The profit margin is worsening
  • Shows how ROE is linked to three other ratios: ROE = (PM)(TATurn)(FinLevMult) ROE = (NPM)(TAT)(FLM) Firm (12.5%) = (3.9) (1.5) (2.13) Norm (15.0%) = (5.0) (1.8) (1.67) Which component has the greatest deviation from industry norms? PM = (3.9-5.0)/5.0 = (22%) TATurn = (1.5-1.8)/1.8 = (17%) FinLevMult= (2.13-1.67)/1.67 = 28%
  • Shows how ROE is linked to three other ratios: ROE = (PM)(TATurn)(FinLevMult) ROE = (NPM)(TAT)(FLM) Firm (12.5%) = (3.9) (1.5) (2.13) Norm (15.0%) = (5.0) (1.8) (1.67) Which component has the greatest deviation from industry norms? PM = (3.9-5.0)/5.0 = (22%) TATurn = (1.5-1.8)/1.8 = (17%) FinLevMult= (2.13-1.67)/1.67 = 28%
  • Shows how ROE is linked to three other ratios: ROE = (PM)(TATurn)(FinLevMult) ROE = (NPM)(TAT)(FLM) Firm (12.5%) = (3.9) (1.5) (2.13) Norm (15.0%) = (5.0) (1.8) (1.67) Which component has the greatest deviation from industry norms? PM = (3.9-5.0)/5.0 = (22%) TATurn = (1.5-1.8)/1.8 = (17%) FinLevMult= (2.13-1.67)/1.67 = 28%
  • Shows how ROE is linked to three other ratios: ROE = (PM)(TATurn)(FinLevMult) ROE = (NPM)(TAT)(FLM) Firm (12.5%) = (3.9) (1.5) (2.13) Norm (15.0%) = (5.0) (1.8) (1.67) Which component has the greatest deviation from industry norms? PM = (3.9-5.0)/5.0 = (22%) TATurn = (1.5-1.8)/1.8 = (17%) FinLevMult= (2.13-1.67)/1.67 = 28%
  • Benchmarking – comparing a firm’s ratios to a select set of competitors
  • Multiple-industry concerns : The industry norm may reflect a firm in several industries Who says the average firm is doing the best job ?
  • Inflation distorts balance sheet items, especially fixed assets (e.g., timber land purchased 50 years ago) Seasonal factors distort comparisons (when do firms ‘close the books’?) Beware of window dressing in reports
  • Inflation distorts balance sheet items, especially fixed assets (e.g., timber land purchased 50 years ago) Seasonal factors distort comparisons (when do firms ‘close the books’?) Beware of window dressing in reports
  • Accounting practices may vary, distorting financial ratio comparisons (e.g., FIFO vs LIFO) A deviation from the norm may be good or bad (e.g., a high current ratio indicates good liquidity, but lowers profitability)
  • Accounting practices may vary, distorting financial ratio comparisons (e.g., FIFO vs LIFO) A deviation from the norm may be good or bad (e.g., a high current ratio indicates good liquidity, but lowers profitability)
  • Profitability ratios do not reflect the effect on shareholder wealth (a firm could have high profits and suffer stock price declines)
  • Profitability ratios do not reflect the effect on shareholder wealth (a firm could have high profits and suffer stock price declines)
  • Profitability ratios do not reflect the effect on shareholder wealth (a firm could have high profits and suffer stock price declines)
  • Chapter 4

    1. 1. Chapter 4 Analysis of Financial Statements
    2. 2. Ratio Analysis Notes <ul><li>When analyzing companies, we compare ratios rather than dollar figures to adjust for differences in size . </li></ul><ul><li>Industry averages are arithmetic medians (not arithmetic means ) to avoid distortions caused by extreme outliers . </li></ul>
    3. 3. Liquidity Ratios (Refer to financial statements, p.70,73) <ul><li>The liquidity group of ratios measures the ability of the company to pay short-term debts </li></ul><ul><li>What is the current ratio for Allied Food Products for 2005? </li></ul>
    4. 4. <ul><li>The current ratio assumes that all current assets will be turned into cash within a year. </li></ul><ul><li>If the industry norm is 4.2, then Allied Foods appears to have below-average level of liquidity, and a weaker -than-average ability to pay short-term debts. </li></ul>
    5. 5. <ul><li>What is the quick ratio for AFP? </li></ul><ul><li>The quick ratio assumes that all current assets except for inventories will be turned into cash within a year. </li></ul><ul><li>If the industry norm is 1.0, this ratio suggests above -average liquidity for Allied Foods. </li></ul>
    6. 6. Asset Management Ratios <ul><li>The asset management group of ratios measures how efficiently management is using the company’s resources . </li></ul><ul><li>Two other names for this group are efficiency or activity group. </li></ul>
    7. 7. <ul><li>What is the inventory turnover ratio for AFP? </li></ul><ul><li>If the industry norm is 9.0, then Allied Foods appears to be much less efficient than average. Note that this could be due to low sales or excessive inventories. </li></ul>
    8. 8. <ul><li>The days sales outstanding (DSO) measures the average time between when a sale is made and when collection occurs . </li></ul><ul><li>Another name for this measure is average collection period . </li></ul>
    9. 9. <ul><li>What is the days sales outstanding (DSO) for AFP? </li></ul><ul><li>If the industry norm is 36 days, Allied Foods is less efficient than average in making its collections. </li></ul><ul><li>This might be an attempt to offer more attractive terms to their customers to sell off excess inventory . </li></ul>
    10. 10. <ul><li>What is the fixed assets turnover ratio for AFP? </li></ul><ul><li>If the industry norm is 3.0, Allied Foods appears to have average efficiency in generating sales. </li></ul>
    11. 11. <ul><li>Note: If Allied Foods fixed assets are older than average, this would artificially inflate the FA Turnover measure, causing it to be distorted . </li></ul>
    12. 12. <ul><li>What is the total assets turnover ratio for AFP? </li></ul><ul><li>If the industry norm is 1.8, Allied Foods appears to be less efficient than average in generating sales. </li></ul>
    13. 13. <ul><li>Note: If inventories were high, this would cause TA Turnover to be low . </li></ul>
    14. 14. Debt Management Ratios <ul><li>The debt management group of ratios measures the company’s use of debt funding . </li></ul><ul><li>Another name for this group is the leverage group. </li></ul>
    15. 15. <ul><li>What is the debt ratio for AFP? </li></ul><ul><li>If the industry norm is 40%, this indicates that Allied Foods is riskier than average. </li></ul>
    16. 16. <ul><li>Note: If a company uses only short-term debt to fund increases in inventories, it will cause the debt ratio to rise . </li></ul><ul><li>Example (not Allied Foods) of a company buying $100 more in inventory, and funding it with an increase in short-term debt: </li></ul><ul><li>before: C.R. = 200/100 = 2.0 </li></ul><ul><li>after: C.R. = </li></ul>
    17. 17. <ul><li>What is the times interest earned (TIE) ratio for AFP? </li></ul><ul><li>If the industry norm is 6.0, Allied Foods appears to have a weaker -than-average ability to carry its debt. </li></ul>
    18. 18. <ul><li>Note: If Allied Foods has a debt ratio that is above average, it not only carries a higher -than-average amount of debt, its higher risk also means that it likely pays a higher -than-average interest rate on each dollar of debt. </li></ul><ul><li>Both of these effects will cause interest expense to be high , and the TIE ratio to be low . </li></ul>
    19. 19. <ul><li>What is the EBITDA coverage ratio for AFP? </li></ul>
    20. 20. <ul><li>If the industry norm is 4.3, Allied Foods appears to have a less -than-average ability of Allied Foods to make its fixed financial payments. </li></ul><ul><li>Note: Like the TIE ratio, the EBITDA Coverage ratio assumes the company must make fixed financial payments . But since the EBITDA Coverage ratio assumes the firm must meet a broader array of fixed financial charges, it is considered to be more comprehensive. </li></ul>
    21. 21. Profitability Ratios <ul><li>The profitability group of ratios measures the overall performance of management (but this is only in an accounting sense). </li></ul>
    22. 22. <ul><li>What is the net profit margin for Allied Foods? </li></ul><ul><li>If the industry norm is 5.0%, Allied Foods appears to be less profitable per dollar of sales. </li></ul>
    23. 23. <ul><li>What is the basic earning power ratio for AFP? </li></ul><ul><li>If the industry norm is 17.2%, Allied Foods appears to be less profitable. </li></ul>
    24. 24. <ul><li>What is the return on total assets ratio (ROA) for AFP? </li></ul><ul><li>If the industry norm is 9.0%, Allied Foods appears to be less profitable than average. </li></ul>
    25. 25. <ul><li>What is the return on equity ratio (ROE) for AFP? </li></ul><ul><li>If the industry norm is 15.0%, Allied Foods appears to be less profitable than average. </li></ul>
    26. 26. Market Value Ratios <ul><li>The market value group of ratios measures how the company is viewed by the market . </li></ul>
    27. 27. <ul><li>What is the price earnings ratio (P/E) for AFP? </li></ul><ul><li>P/E = Price/EPS </li></ul><ul><li>= 23/2.35 = 9.8 </li></ul><ul><li>If the industry norm is 12.5, Allied Foods is viewed unfavorably by the market. </li></ul>
    28. 28. <ul><li>What is the price to cash flow ratio (P/CF) for AFP? </li></ul><ul><li>If the industry norm is 6.8, Allied Foods is viewed unfavorably by the market. </li></ul>
    29. 29. <ul><li>Note: If a company’s profitability is low , it will artificially inflate (distort) the P/E ratio. </li></ul><ul><li>Note: If a firm is actively expanding, its CF will be high (due to the high depreciation charges on new equipment), which can cause the P/CF ratio to be low . </li></ul>
    30. 30. <ul><li>What is the market to book ratio (M/B) for AFP? </li></ul><ul><li>If the industry norm is 1.7, Allied Foods is viewed unfavorably by the market. (Note: Unlike P/E and P/CF, the M/B ratio is not as easily distorted.) </li></ul>
    31. 31. Methods of Comparisons <ul><li>When we compare the firm’s ratios to industry averages, this is called cross-sectional analysis. </li></ul><ul><li>When we examine how a firm’s ratios change over time, this is called time-series analysis. </li></ul><ul><li>One other method of ratio analysis is to compare our firm to another comparable firm … same size, same industry. </li></ul>
    32. 32. Du Pont Analysis <ul><li>The Du Pont analysis shows how ROE is the product of three other ratios. </li></ul><ul><li>The Du Pont equation is: </li></ul><ul><li>where </li></ul><ul><li>PM – reflects cost control </li></ul><ul><li>TATurn – reflects volume </li></ul><ul><li>FLM – reflects debt leverage </li></ul>
    33. 33. <ul><li>Note: FLM = 1 / (1 – DR) </li></ul><ul><li>Note that ROE can be increased through more a higher PM (more efficient cost control ), greater TA Turnover (earn the PM on more sales dollars), or a higher financial leverage multiplier (higher debt ratio). </li></ul>
    34. 34. <ul><li>What are the Du Pont values for AFP and the industry? </li></ul>
    35. 35. <ul><li>What does the analysis indicate are AFP’s greatest weaknesses ? </li></ul>
    36. 36. Sources of Industry Norms <ul><li>Value Line </li></ul><ul><li>Dun & Bradstreet </li></ul><ul><li>Moody’s Industrial Manual </li></ul><ul><li>Robert Morris Associates </li></ul><ul><li>Various trade publications </li></ul><ul><li>Various internet sources </li></ul>
    37. 37. Limitations of Ratio Analysis <ul><li>The comparison to industry averages would be less valid if your firm operates in just one industry, and the industry average firm operates in multiple industries. </li></ul><ul><li>Are matching the industry averages necessarily optimal goals? Who says being average should be our goal? </li></ul>
    38. 38. <ul><li>Fixed asset items may be worth more or less than indicated by the balance sheet. For example, land recorded at historical cost and bought many years ago should be worth much more than its book value. </li></ul><ul><li>Do all of the industry firms close their books at the same time of the year? No. If you are comparing a firm that closed its books on Dec31 to an industry-average firm that closed its books on Jun30, you would be comparing different time periods. </li></ul>
    39. 39. <ul><li>Does management have the ability to manipulate reported profits in the short-run … all within GAAP? Yes. </li></ul><ul><li>Managers commonly manipulate reported expenses (such as pension contributions) to try to smooth earnings and make them look more stable . </li></ul>
    40. 40. <ul><li>In seasonal industries, firms tend to close their books during the least active part of the season? </li></ul><ul><li>During the slowest part of the season, balance sheet figures like inventories and receivables may be well below their values during the active portion of the year. </li></ul>
    41. 41. <ul><li>Do all firms in an industry follow the same accounting procedures (e.g., FIFO vs LIFO)? No. </li></ul><ul><li>If you have two identical firms during an inflationary period and Firm A uses LIFO (i.e., the latest cost figure) while Firm B uses FIFO (i.e., the oldest cost figure), Firm A will report the lower profit but have the higher cash flow (due to its lower taxes). </li></ul>
    42. 42. <ul><li>Although a high current ratio makes a company look more liquid , higher inventories held as safety stocks also leads to lower profit (due to the higher costs of insurance, storage, financing, etc.). </li></ul><ul><li>Often, what is safer is also less profitable . </li></ul>
    43. 43. <ul><li>Profitability ratios are book measures, and may not reflect the effect on shareholder wealth . </li></ul><ul><li>Could a firm’s profit margin be above average, and the stock price still fall? Yes, if the market was expecting an even higher profit margin and was disappointed . </li></ul>
    44. 44. <ul><li>Final note: Some sources may compute mixed ratios (ones involving both balance sheet and income statement values) by averaging the B/S item. </li></ul><ul><li>Consider Inv Turnover: </li></ul>

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