CHAPTER 3 Analysis of Financial Statements Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors

Balance Sheet: Assets 2002E 2001 Cash 14,000 7,282 ST investments 71,632 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 2001 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

Income Statement 2002E 2001 Sales 7,035,600 5,834,400 COGS 6,100,000 5,728,000 Other expenses 312,960 680,000 Depreciation 120,000 116,960 Tot. op. costs 6,532,960 6,524,960 EBIT 502,640 (690,560) Interest exp. 80,000 176,000 EBT 422,640 (866,560) Taxes (40%) 169,056 (346,624) Net income 253,584 (519,936)

Other Data 2002E 2001 Shares out. 250,000 100,000 EPS $1.014 ($5.199) DPS $0.220 $0.110 Stock price $12.17 $2.25 Lease pmts $40,000

Why are ratios useful? Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths

Liquidity: Can we make required payments as they fall due? What are the five major categories of ratios, and what questions do they answer? Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? (More…)

Debt management: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Calculate the firm’s forecasted current and quick ratios for 2002. CL $2,680 $1,445 CR02 = = = 1.85x. CA - Inv. CL QR02 = $2,680 - $1,716 $1,445 = = 0.67x.

Comments on CR and QR 2002E 2001 2000 Ind. CR 1.85x 1.1x 2.3x 2.7x QR 0.67x 0.4x 0.8x 1.0x Expected to improve but still below the industry average. Liquidity position is weak.

What is the inventory turnover ratio as compared to the industry average? Inv. turnover = = = 4.10x. Sales Inventories $7,036 $1,716 2002E 2001 2000 Ind. Inv. T. 4.1x 4.5x 4.8x 6.1x

Comments on Inventory Turnover Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted.

DSO is the average number of days after making a sale before receiving cash. Receivables Average sales per day DSO = = = = 44.9 days. Receivables Sales/360 $878 $7,036/360

Appraisal of DSO 2002E 2001 2000 Ind. DSO 44.9 39.0 36.8 32.0 Firm collects too slowly, and situation is getting worse. Poor credit policy.

Fixed Assets and Total Assets Turnover Ratios Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets = = 2.01x. $3,497 (More…)

2002E 2001 2000 Ind. FA TO 8.6x 6.2x 10.0x 7.0x TA TO 2.0x 2.3x 2.5x FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

Calculate the debt, TIE, and EBITDA coverage ratios. Total debt Total assets Debt ratio = = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE = = = 6.3x. $502.6 $80 (More…)

EBITDA coverage = EC EBIT + Depr. & Amort. + Lease payments Interest Lease Loan pmt. expense pmt. = = 5.5x. + + $502.6 + $120 + $40 $80 + $40 + $0 All three ratios reflect use of debt, but focus on different aspects.

How do the debt management ratios compare with industry averages? 2001 2000 Ind. D/A 55.6% 95.4% 54.8% 50.0% TIE 6.3x -3.9x 3.3x 6.2x EC 5.5x -2.5x 2.6x 8.0x Too much debt, but projected to improve.

Profit Margin (PM) PM = = = 3.6%. NI Sales $253.6 $7,036 2002E 2001 2000 Ind. PM 3.6% -8.9% 2.6% Very bad in 2001, but projected to meet industry average in 2002. Looking good.

Basic Earning Power (BEP) EBIT Total assets BEP = = = 14.4%. $502.6 $3,497 (More…)

2002E 2001 2000 Ind. BEP 14.4% -24.1% 14.2% 17.8% BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement.

and Return on Equity (ROE) Return on Assets (ROA) and Return on Equity (ROE) Net income Total assets ROA = = = 7.3%. $253.6 $3,497 (More…)

ROE = = = 16.3%. Net income Common equity $253.6 $1,552 2002E 2001 2000 Ind. ROA 7.3% -18.1% 6.0% 9.0% ROE 16.3% -391.0% 13.3% 18.0% Both below average but improving.

Effects of Debt on ROA and ROE ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Calculate and appraise the P/E, P/CF, 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 (More…)

Typical industry average P/E ratios Banking 17.15 Computer Software Services 33.01 Drug 41.81 Electric Utilities (Eastern U.S.) 19.40 Internet Services* 290.35 Semiconductors 78.41 Steel 12.71 Tobacco 11.59 Water Utilities 21.84 * Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies.

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 BVPS = Shares out. = = $6.21. $1,552 250 = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B = = = 2.0x. $12.17 $6.21 (More…)

2002E 2001 2000 Ind. P/E 12.0x -0.4x 9.7x 14.2x P/CF 8.2x -0.6x 8.0x 7.6x M/B 2.0x 1.7x 1.3x 2.9x P/E: How much investors will pay for $1 of earnings. High is good. M/B: How much paid for $1 of book value. Higher is good. P/E and M/B are high if ROE is high, risk is low.

Common Size Balance Sheets: Divide all items by Total Assets 2000 2001 2002E Ind. Cash 0.6% 0.3% 0.4% ST Invest. 3.3% 0.0% 2.0% AR 23.9% 22.1% 25.1% 22.4% Invent. 48.7% 44.9% 49.1% 41.2% Total CA 76.5% 67.2% 76.6% 64.1% Net FA 23.5% 32.8% 23.4% 35.9% TA 100.0%

Divide all items by Total Liabilities & Equity 2000 2001 2002E Ind. AP 9.9% 18.3% 12.5% 11.9% Notes pay. 13.6% 25.1% 17.2% 2.4% Accruals 9.3% 17.1% 11.7% 9.5% Total CL 32.8% 60.5% 41.3% 23.7% LT Debt 22.0% 34.9% 14.3% 26.3% Total equ. 45.2% 4.6% 44.4% 50.0% Total L&E 100.0%

Analysis of Common Size Balance Sheets Computron has higher proportion of current assets (49.1%) than Industry (41.2%). Computron has slightly less equity (which means more debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.

Common Size Income Statement: Divide all items by Sales 2000 2001 2002E Ind. Sales 100.0% COGS 83.4% 98.2% 86.7% 84.5% Other exp. 9.9% 11.7% 4.4% Depr. 0.6% 2.0% 1.7% 4.0% EBIT 6.1% -11.8% 7.1% Int. Exp. 1.8% 3.0% 1.1% EBT 4.3% -14.9% 6.0% 5.9% Taxes -5.9% 2.4% NI 2.6% -8.9% 3.6%

Analysis of Common Size Income Statements Computron has higher COGS (86.7) than industry (84.5), but lower depreciation. Result is that Computron has similar EBIT (7.1) as industry.

Percentage Change Analysis: Find Percentage Change from First Year (2000) Income St. 2000 2001 2002E Sales 0.0% 70.0% 105.0% COGS 100.0% 113.0% Other exp. -8.0% Depr. 518.8% 534.9% EBIT -430.3% 140.4% Int. Exp. 181.6% 28.0% EBT -691.1% 188.3% Taxes NI

Analysis of Percent Change Income Statement We see that 2002 sales grow 105% from 2000, and that NI grows 188% from 2000. So Computron has become more profitable.

Percentage Change Balance Sheets Assets 2000 2001 2002E Cash 0.0% -19.1% 55.6% ST Invest. -100.0% 47.4% AR 80.0% 150.0% Invent. 140.0% Total CA 71.4% 138.4% Net FA 172.6% 137.0% TA 95.2% 138.1%

Liab. & Eq. 2000 2001 2002E AP 0.0% 260.0% 200.0% Notes pay. Accruals Total CL LT Debt 209.2% 54.6% Total equity -80.0% 133.9% Total L&E 95.2% 138.1%

Analysis of Percent Change Balance Sheets 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.

( )( )( ) = ROE Explain the Du Pont System Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE. x x 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%

The Du Pont system focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) 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 Sales $7,035,600 day 360 = = $19,543. Q. How would reducing DSO to 32 days affect the company?

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 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 What could be done with the new cash? Effect on stock price and risk?

Potential use of freed up cash Repurchase stock. Higher ROE, higher EPS. Expand business. Higher profits. Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…)

Inventories are also too high 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. All these actions would likely improve stock price.

Would you lend money to this company? Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. However, company should not have relied so heavily on debt financing in the past.

“Average” performance is not necessarily good. What are some potential problems and limitations of financial ratio analysis? Comparison with industry averages is difficult if the firm operates many different divisions. “Average” performance is not necessarily good. Seasonal factors can distort ratios. (More…)

Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is “good” or “bad.” 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.

Are the company’s revenues tied to a single customer? What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? Are the company’s revenues tied to a single customer? To what extent are the company’s revenues tied to a single product? To what extent does the company rely on a single supplier? (More…)

What percentage of the company’s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company’s legal and regulatory environment?