Lecture 4-350 4-1

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Lecture 4-350 4-1

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

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