Analysis of Financial Statements

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Presentation transcript:

Analysis of Financial Statements CHAPTER 3 Analysis of Financial Statements

Topics in Chapter Read the whole chapter except 3-1b & 3-1c: Ratio analysis DuPont equation Benchmarking for ratio analysis Limitations of ratio analysis Qualitative factors

Determinants of Intrinsic Value: Using Ratio Analysis Net operating profit after taxes Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

Overview Ratios facilitate comparison of: Ratios are used by: One company over time One company versus other companies Ratios are used by: Lenders to determine creditworthiness Stockholders to estimate future cash flows and risk Managers to identify areas of weakness and strength

3-1 Financial Analysis 3-1a Gather Data 3-1d Begin Ratio Analysis Financial statements can be downloaded from many web sites. Zacks Investment Research provides financial statements in a standardized format. 3-1d Begin Ratio Analysis We will calculate the 2016 financial ratios for MicroDrive Inc. using data from the balance sheet and income statement given in Figure 3-1 on P105 in the textbook. The 2016 industry averages are given for comparison purposes.

Income Statements (millions of dollars except for per share data): MicroDrive Inc. 2016 2015 Net Sales $5,000 $4,760 COGS except depreciation 3,800 3,560 Depreciation 200 170 Other operating expenses 500 480 Total operating costs 4,500 4,210 EBIT $500 $550 Interest expense 120 100 Pre-tax earnings (EBT) $380 $450 Taxes (40%) 152 180 Net income $228 $270 Preferred dividends 8 NI available to common shareholders $220 $262

Balance Sheets: Assets (millions of dollars except for per share data): MicroDrive Inc. 2016 2015 Cash and equivalents $ 50 $ 60 S-T investments - 40 Accounts Receivable 500 380 Inventories 1,000 820 Total current assets 1,550 1,300 Net fixed assets 2,000 1,700 Total assets $3,550 $3,000

Balance Sheets: Liabilities & Equity (millions of dollars except for per share data): MicroDrive Inc. 2016 2015 Accounts payable $ 200 $ 190 Notes payable 280 130 Accruals 300 Total current liabilities 780 600 Long-term debt 1,200 1,000 Preferred Stock 100 Common stock 500 Retained earnings 970 800 Total common equity 1470 1300 Total liabilities and equity $3,550 $3,000

Other Data: (millions except for per share data) 2016 2015 Preferred dividends $8 # of preferred stock 0.4 Common stock price $27 $40 # of common shares 50 Common dividends $50 $48 Addition to retained earnings $170 $214 Bond’s sinking fund payments $20 Lease payments $28 Tax rate 40%

3-2 Liquidity Ratios Can the company meet its short-term obligations using the resources it currently has on hand?

3-2a & 3-2b: Current and Quick Ratios CR16 = = = 2.0 QR16 = = = 0.7 CA CL $1,550 $780 $1,550-$1,000 CA - Inventories

3-2a & 3-2b: Current and Quick Ratios (continued): Comments on CR and QR 2016 2015 Ind. 2016 CR 2.0 2.2 QR 0.7 0.8 Declined from 2015 and slightly below the industry average. (How does MicroDrive compare to S&P 500 companies?) There has been a steady decline in the average liquidity ratios of S&P 500 companies during the past decade. In 2015, the average current ratio is about 1.3 and the average quick ratio is about 0.4, so MicroDrive and its industry peers are more liquid than the typical S&P 500 company.

3-3 Asset Management Ratios How efficiently does the firm use its assets? How much does the firm have tied up in assets for each dollar of sales?

3-3a & 3-3b Fixed Assets and Total Assets Turnover Ratios      Sales              Net fixed assets = = = 2.5 $5,000 $2,000       Total assets turnover      Sales        Total assets = = = 1.4 $5,000 3,550 (More…)

3-3a & 3-3b Total Assets and Fixed Assets Turnover Ratios (continued) Both FA turnover and TA turnover are not up to industry average, and the further declines from 2015 are not good signs. 2016 2015 Ind. 16 FA TO 2.5 2.8 3.0 TA TO 1.4 1.6 1.8

Receivables DSO = Average sales per day = = = 37 days $500 $5,000/365 3-3c Days Sales Outstanding (Average Collection Period): average number of days from sale until cash received DSO = = = = 37 days Receivables Average sales per day $500 $5,000/365 Sales/365

3-3c Days Sales Outstanding (continued): Appraisal of DSO Firm collects too slowly, and situation is getting worse. Steps should be taken to review credit standards and to expedite the collection of accounts receivable. 2016 2015 Ind.16 DSO 37 29 30

3-3d Inventory Turnover Ratio = = 4.0 COGS Inventories $3,800+$200 $1,000 2016 2015 Ind.16 Inv. T. 4.0 4.6 5.0

3-3d Inventory Turnover Ratio (Continued): Comments on Inventory Turnover Inventory turnover is below industry average and declined from 2015. The firm is holding too much inventory. In addition, the firm may be holding obsolete goods not worth their stated value. In summary, MicroDrive’s low fixed-assets-turnover ratio, high DSO, and low inventory turnover ratio each cause its total-asset-turnover ratio to be lower than the industry average.

3-4 Debt Management Ratios Does the company have too much debt? (leverage ratios) Can the company’s earnings meet its debt servicing requirements? (coverage ratios)

3-4a Leverage Ratios: Debt (-to-Assets) Ratio Total debt (short +long) Total assets Debt ratio = = = 41.7% $280+$1,200 $3,550 (More…)

3-4a Leverage Ratios: Debt-to-Equity Ratio Total debt (short + long) Total comm. equity Debt-to-Equity Ratio = = = 1.01 $280+$1,200 $1,470 (More…)

3-4a Leverage Ratios: Liabilities-to-Assets Ratio Total liabilities Total assets Liabilities/Assets ratio = = = 55.8% $1,980 $3,550 (More…)

3-4b Times-Interest-Earned (TIE) Ratio /Interest Coverage Ratio             EBIT         Int. expense TIE = = =4.2 $500 $120 (More…)

3-4c EBITDA Coverage Ratio = = 4.3 (EBIT + Depr. & Amort.) + Lease payments Interest Lease expense pmt. + + Loan pmt. ($500 + $200) + $28 $120 + $28 + $20

Debt Management Ratios vs. Industry Averages D/A 41.7% 37.7% 25.0% D/E 1.01 0.87 0.46 TL/TA 55.8% 53.3% 45.0% TIE 4.2 5.5 10.0 EC 4.3 5.1 12.0 MicroDrive has more leverage (higher level of debt) and lower coverage than its peers, and the situation is getting worse. Consequently it might face difficulties if it attempts to borrow additional funds.

3-5 Profitability Ratios What is the company’s rate of return on: Sales? Assets? Common equity?

Net profit margin (PM): 3-5a Profit Margins PM = = = 4.4% NI Sales $220 $5,000 OM = = = 10% EBIT $500 Net profit margin (PM): Operating profit margin (OM): (More…)

3-5a Profit Margins (Continued) Gross profit margin (GPM): Sales − COGS Sales $5,000-$4,000 $5,000 GPM = = $1,000 $5,000 GPM = = 20%

Profit Margins vs. Industry Averages PM 4.4% 5.5% 6.2% OPM 10% 11.6% - GPM 20% 21.6% - Margins are declining, and the net profit margin are quite below the industry average.

3-5b Basic Earning Power (BEP) Ratio = = 14.1% EBIT Total assets $500 $3,550 (More…)

3-5b BEP vs. Industry Average (continued) BEP removes effect of taxes and financial leverage. Useful for comparison with different tax situations and different degrees of financial leverage. The firm’s BEP is declining and below industry average. A lot of room for improvement. 2016 2015 Ind.16 BEP 14.1% 18.3% 20.2%

3-5c & 3-5d Return on Assets (ROA) and Return on Equity (ROE) = = 6.2% NI Total assets $220 $3,550 (More…)

3-5c & 3-5d Return on Assets (ROA) and Return on Equity (ROE) = = 15.0% NI Common Equity $220 $1,470 (More…)

3-5c & 3-5d Return on Assets (ROA) and Return on Equity (ROE) 2016 2015 Ind.16 ROA 6.2% 8.7% 11.0% ROE 15.0% 20.2% 19.0% ROA is declining and below average, ROE has declined from slightly above average in 2015 to below average in 2016.

3-6 Market Value Ratios Market value ratios incorporates expected growth and risk: High expected growth in earnings and cash flow increases market value ratios High risk of expected growth in earnings and cash flow decreases market value ratios

3-6a Price/Earnings Ratio EPS = = = $4.4 P/E = = = 6.1 NI Shares out. $220 50 Price per share EPS $27 $4.4

3-6b Price/Cash Flow Ratio NI + Depr. Shares out. CF per share = = = $8.4 $220 + $200 50 Price per share Cash flow per share P/CF = = = 3.2 $27 $8.4

Com. equity BVPS = Shares out. = = $29.4 $1,470 50 3-6c Market/Book Ratio Com. equity Shares out. BVPS = = = $29.4 $1,470 50 Mkt. price per share Book value per share M/B = = = 0.9 $27 $29.4

Interpreting Market Value Based Ratios P/E: How much investors will pay for $1 of earnings. M/B: How much investors will pay for $1 of book value. Ceteris Paribus, market value ratios are higher for firms with strong growth prospects, but lower for riskier firms.

Comparison with Industry Averages P/E 6.1 7.6 10.5 P/CF 3.2 4.6 6.8 M/B 0.9 1.5 1.8 Compared to industry averages and based on the trend, these market value ratios suggest that the firm is regarded by investors: as having poorer growth prospects, as being somewhat riskier than most, or both.

3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis Trend Analysis examine a ratio over time. Example: trend analysis of ROE for MicroDrive Inc. as shown in Figure 3-2 on P120. All the other ratios can be analyzed similarly.

Common Size Balance Sheets (Figure 3-4 on P122): Divide all items by Total Assets Ind.16 2016 2015 Cash 1.8% 1.4% 2.0% ST Inv. 0.0% 1.3% AR 14.0% 14.1% 12.7% Invent. 26.3% 28.2% 27.3% Total CA 42.1% 43.7% 43.3% Net FA 57.9% 56.3% 56.7% TA 100.0%

Common Size Balance Sheets (continued): Divide all items by Total Liabilities & Equity Liab. & Eq. Ind.16 2016 2015 AP 7.0% 5.6% 6.3% Notes payable 0.0% 7.9% 4.3% Accruals 12.3% 8.5% 9.3% Total CL 19.3% 22.0% 20.0% LT Debt 25.4% 33.8% 33.3% Total Liab. 44.7% 55.8% 53.3% Pre. Stock 2.8% 3.3% Com. Equity 55.3% 41.4% 43.3% Total L&E 100.0%

Analysis of Common Size Balance Sheets MicroDrive’s inventories are higher than industry average. MircoDrive uses much more debt than the average firm in the industry.

Common Size Income Statements (Figure 3-3 on P121): Divide all items by Sales Ind.16 2016 2015 Sales 100.0% COGS except depr. 75.5% 76% 74.8% Depr. 3.0% 4.0% 3.6% Other operating exp. 10.0% 10.1% EBIT 11.5% 11.6% Int. Exp. 1.2% 2.4% 2.1% Pre-tax earnings 10.4% 7.6% 9.5% Taxes 4.1% 3.8% NI before Pref. 6.2% 4.6% 5.7% Pref. dividends 0.0% 0.2% NI avail. for Comm. shareholders 4.4% 5.5%

Analysis of Common Size Income Statements MicroDrive’s EBIT is slightly below average, and its interest expenses are above average. The net effect is a relatively low net profit margin (4.4% vs. 6.2%).

Income Statement Percentage Change Analysis (Figure 3-5 on P122): Base Year 2015 Percentage change in 2016 Sales 5.0% COGS except depr. 6.7% Depr. 17.6% Other operating exp. 4.2% EBIT (9.1%) Int. Exp. 20% EBT (15.6%) Taxes NI before Pref. Pref. dividends 0.0% NI avail. to comm. shareholders (16.0%)

Analysis of Percent Change Income Statement Sales increased by 5% in 2016, but EBIT fell by 9.1% due to bigger increases in COGS and Depreciation. In addition, interest expenses grew by 20%. As a result the NI available to common shareholders fell by 16%.

Percentage Change Balance Sheet: Assets Percentage change in 2016 Cash (17%) ST Invest. (100%) AR 32% Invent. 22% Total CA 19% Net FA 18% TA

Percentage Change Balance Sheet: Liabilities & Equity Liab. & Eq. Percentage change in 2016 AP 5% Notes payable 115% Accruals 7% Total CL 30% LT Debt 20% Preferred stock 0% Total comm. equity 13% Total L&E 18%

Analysis of Percent Change Balance Sheet Inventories grew at a whopping 22% and Accounts Receivable grew at 32%. With only 5% growth in sales, the extreme growth in receivables and inventories should be of great concerns to MicroDrive’s managers. Both Short-term and long-term debt grew tremendously, suggesting possible financial troubles down the road if the firm doesn’t improve sales growth and profit margin.

3-8 Tying the Ratios Together: the DuPont Equation The DuPont equation focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

( )( )( ) = ROE The DuPont Equation Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE x x

Use DuPont Equation to Decompose ROE NI Sales TA CE x = ROE 2015: 5.5% x 1.6 x 2.3 = 20% 2016: 4.4% x 1.4 x 2.4 = 15%

3-9 Comparative Ratios and Benchmarking Ratio Analysis involves comparisons. A company’s ratios are compared with those of other firms in the same industry. However, firms also want to compare their ratios with those of a smaller set of leading companies in the industry. This is called benchmarking, and the companies used for the comparison are called benchmark companies. Comparative ratios are available from a number of sources, including Value Line, Dun and Bradstreet (D&B), and the Annual Statement Analysis by Risk Management Associates.

3-10 Potential Problems and Limitations of Ratio Analysis Comparison with industry averages is difficult if the firm operates many different divisions. It is best to benchmark on the industry leaders’ ratios rather than the industry average ratios. Inflation can distort ratio analysis. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting practices can distort comparisons.

3-11 Qualitative Factors There is greater risk if: revenues tied to a single customer revenues tied to a single product reliance on a single supplier? High percentage of business is generated overseas? What is the competitive situation? What products are in the pipeline? What are the legal and regulatory issues?