<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
The Story <ul><li>Computron Industries has completed an expansion program. </li></ul><ul><li>Up to now: </li></ul><ul><ul><li>Sales have not been up to the forecasted levels </li></ul></ul><ul><ul><li>Costs have been higher than were projected </li></ul></ul><ul><ul><li>A large loss occurred in 2001 rather than the expected profit </li></ul></ul><ul><li>Financial manager has detected an improving pattern in the monthly data: </li></ul><ul><ul><li>Advertising is taking longer to become effective </li></ul></ul><ul><ul><li>Lags between spending money and deriving benefits is taking longer than what managers had anticipated </li></ul></ul><ul><ul><li>If the company can survive in the short-run, there is hope for the future. </li></ul></ul>
Balance Sheet: Assets 1,468,800 344,800 146,200 491,000 1,124,000 715,200 351,200 48,600 9,000 2000 2,866,592 939,790 263,160 1,202,950 1,926,802 1,287,360 632,160 0 7,282 2001 3,497,152 Total assets 817,040 Net FA 380,120 Less: Deprec. 1,197,160 Gross FA 2,680,112 Total CA 1,716,480 Inventories 878,000 AR 71,632 ST investments 14,000 Cash 2002E
<ul><li>Standardize numbers; facilitate comparisons </li></ul><ul><li>Used to highlight weaknesses and strengths: </li></ul><ul><ul><li>Managers: improve firm’s performance </li></ul></ul><ul><ul><li>Lenders/Creditor: evaluate firm’s likelihood of repaying debts </li></ul></ul><ul><ul><li>Shareholders: forecast future earnings and dividends </li></ul></ul>Why are ratios useful?
<ul><li>Liquidity: Can we make required payments as they fall due? </li></ul><ul><li>Asset management: Do we have the right amount of assets for the level of sales? </li></ul>What are the five major categories of ratios, and what questions do they answer? (More…)
<ul><li>Debt management: Do we have the 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 the firm’s forecasted current and quick ratios for 2002. CR 02 = = = 1.85x . QR 02 = = = 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>1.0x 0.8x 0.4x 0.67x QR 2.7x 2.3x 1.1x 1.85x CR Ind. 2000 2001 2002E
What is the inventory turnover ratio as compared to the industry average? Inv. turnover = = = 4.10x. Sales Inventories $7,036 $1,716 6.1x 4.8x 4.5x 4.1x Inv. T. Ind. 2000 2001 2002E
<ul><li>Inventory turnover is below industry average. </li></ul><ul><li>Firm 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 (Days Sales Outstanding) is the average number of days a company waits after making a sale before receiving cash. DSO = = = = 44.9 days. Receivables Sales/360 $878 $7,036/360
Appraisal of DSO <ul><li>Firm collects too slowly, and situation is getting worse. </li></ul><ul><li>Poor credit policy. </li></ul>32.0 36.8 39.0 44.9 DSO Ind. 2000 2001 2002E
Fixed Assets and Total Assets Turnover Ratios (More…) 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 is expected to exceed industry average. Good. </li></ul><ul><li>TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory). </li></ul>2.5x 2.3x 2.0x 2.0x TA TO 7.0x 10.0x 6.2x 8.6x FA TO Ind. 2000 2001 2002E
Calculate the debt, TIE, and EBITDA coverage ratios. (More…) Total debt Total assets Debt ratio = = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE = = = 6.3x. $502.6 $80
All three ratios reflect use of debt, but focus on different aspects. EBITDA Coverage = EC = = 5.5x. EBIT + Depr. & Amort. + Lease payments Interest Lease Loan pmt . (sinking fund payments) expense pmt. + + $502.6 + $120 + $40 $80 + $40 + $0
Sinking Fund Payments <ul><li>A required annual payment designed to reduce the balance of a bond or preferred stock issue. </li></ul><ul><li>Sinking fund payments are made with after-tax cash flows. </li></ul>
Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 8.0x 2.6x -2.5x 5.5x EC 6.2x 3.3x -3.9x 6.3x TIE 50.0% 54.8% 95.4% 55.6% D/A Ind. 2000 2001 2002E
Profit Margin (PM) Very bad in 2001, but projected to meet industry average in 2002. Looking good. PM = = = 3.6%. NI Sales $253.6 $7,036 3.6% 2.6% -8.9% 3.6% PM Ind. 2000 2001 2002E
BEP = = = 14.4%. Basic Earning Power (BEP) EBIT Total assets $502.6 $3,497 (More…)
<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>17.8% 14.2% -24.1% 14.4% BEP Ind. 2000 2001 2002E
ROA = = = 7.3%. Return on Assets (ROA) and Return on Equity (ROE) Net income Total assets $253.6 $3,497 (More…)
Both below average but improving. ROE = = = 16.3%. Net income Common equity $253.6 $1,552 18.0% 13.3% -391.0% 16.3% ROE 9.0% 6.0% -18.1% 7.3% ROA Ind. 2000 2001 2002E
<ul><li>ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. </li></ul><ul><li>However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase. </li></ul>Effects of Debt on ROA and ROE
Calculate and appraise the P/E, P/CF, and M/B ratios. (More…) Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01
Typical industry average P/E ratios * Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies. 21.84 Water Utilities 11.59 Tobacco 12.71 Steel 78.41 Semiconductors 290.35 Internet Services* 19.40 Electric Utilities (Eastern U.S.) 41.81 Drug 33.01 Computer Software Services 17.15 Banking P/E ratio Industry
NI + Depr. Shares out. CF per share = = = $1.49. $253.6 + $120.0 250 Price per share Cash flow per share P/CF = = = 8.2x. $12.17 $1.49
Com. equity Shares out. BVPS = = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B = = = 2.0x. $12.17 $6.21 (More…)
<ul><li>P/E: How much investors will pay for $1 of earnings. Higher is good. </li></ul><ul><li>M/B: How much is paid for $1 of book value. Higher is good. </li></ul><ul><li>P/E and M/B are high if ROE is high and risk is low. </li></ul>2.9x 1.3x 1.7x 2.0x M/B 7.6x 8.0x -0.6x 8.2x P/CF 14.2x 9.7x -0.4x 12.0x P/E Ind. 2000 2001 2002E
Common Size Balance Sheets: Divide all items by Total Assets 100.0% 100.0% 100.0% 100.0% TA 35.9% 23.4% 32.8% 23.5% Net FA 64.1% 76.6% 67.2% 76.5% Total CA 41.2% 49.1% 44.9% 48.7% Invent. 22.4% 25.1% 22.1% 23.9% AR 0.3% 2.0% 0.0% 3.3% ST Invest. 0.3% 0.4% 0.3% 0.6% Cash Ind . 2002E 2001 2000 Assets
Divide all items by Total Liabilities & Equity 100.0% 100.0% 100.0% 100.0% Total L&E 50.0% 44.4% 4.6% 45.2% Total equ. 26.3% 14.3% 34.9% 22.0% LT Debt 23.7% 41.3% 60.5% 32.8% Total CL 9.5% 11.7% 17.1% 9.3% Accruals 2.4% 17.2% 25.1% 13.6% Notes pay. 11.9% 12.5% 18.3% 9.9% AP Ind. 2002E 2001 2000
Analysis of Common Size Balance Sheets <ul><li>Computron has higher proportion of current assets (76.6%) than Industry (64.1%). </li></ul><ul><li>Computron has slightly less equity (which means more debt) than Industry. </li></ul><ul><li>Computron has more short-term debt than industry, but less long-term debt than industry. </li></ul>
Analysis of Common Size Income Statements <ul><li>Computron has higher COGS (86.7) than industry (84.5), but lower depreciation. Result is that Computron has similar EBIT (7.1) as industry. </li></ul>
Percentage Change Analysis: Find Percentage Change from First Year (2000) 188.3% -691.1% 0.0% NI 188.3% -691.1% 0.0% Taxes 188.3% -691.1% 0.0% EBT 28.0% 181.6% 0.0% Int. Exp. 140.4% -430.3% 0.0% EBIT 534.9% 518.8% 0.0% Depr. -8.0% 100.0% 0.0% Other exp. 113.0% 100.0% 0.0% COGS 105.0% 70.0% 0.0% Sales 2002E 2001 2000 Income St.
Analysis of Percent Change Income Statement <ul><li>We see that in 2002 sales are expected to grow 105% from 2000, and that NI is expected to grow 188% from 2000. </li></ul><ul><li>So, Computron is expected to become more profitable. </li></ul>
Percentage Change Balance Sheets 138.1% 95.2% 0.0% TA 137.0% 172.6% 0.0% Net FA 138.4% 71.4% 0.0% Total CA 140.0% 80.0% 0.0% Invent. 150.0% 80.0% 0.0% AR 47.4% -100.0% 0.0% ST Invest. 55.6% -19.1% 0.0% Cash 2002E 2001 2000 Assets
138.1% 95.2% 0.0% Total L&E 133.9% -80.0% 0.0% Total equity 54.6% 209.2% 0.0% LT Debt 200.0% 260.0% 0.0% Total CL 200.0% 260.0% 0.0% Accruals 200.0% 260.0% 0.0% Notes pay. 200.0% 260.0% 0.0% AP 2002E 2001 2000 Liab. & Eq.
Analysis of Percent Change Balance Sheets <ul><li>We see that total assets grow at a rate of 138%, while sales grow at a rate of only 105%. So asset utilization remains a problem. </li></ul>
( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE 2000 2.6% x 2.3 x 2.2 = 13.2% 2001 -8.9% x 2.0 x 21.6 = -391.0% 2002 3.6% x 2.0 x 2.3 = 16.3% Ind. 3.6% x 2.5 x 2.0 = 18.0% Explain the Du Pont System x x = ROE.
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.
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.
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.
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
Potential use of freed up cash <ul><li>Repurchase stock . Higher ROE, higher EPS. </li></ul><ul><li>Expand business . Higher profits. </li></ul><ul><li>Reduce debt . Better debt ratio; lower interest, hence higher NI. </li></ul>(More…)
<ul><li>Inventories are also too high . Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides. </li></ul><ul><li>All these actions would likely improve stock price . </li></ul>
Would you lend money to this company? <ul><li>Maybe . The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. </li></ul><ul><li>However, company should not have relied so heavily on debt financing in the past. </li></ul>
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…)
<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>
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…)
<ul><li>What percentage of the company’s business is generated overseas ? </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>