CHAPTER 4 Analysis of Financial Statements Ratio Analysis Du Pont system <- learn this Effects of improving ratios Limitations of ratio analysis Qualitative factors

Why are ratios useful? Ratios Standardize numbers Facilitate comparisons Ratios highlight weaknesses and strengths. Ratio comparisons should be Made through time - Trend analysis Compare competitors - Peer or Industry analysis

What are the five major categories of ratios, and what questions do they answer? Liquidity: Can we make required payments? Asset Management: right amount of assets vs. sales? Debt Management: 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: How do investors value the business as reflected in P/E and Mkt/B ratios?

Balance Sheet: Assets Cash A/R Inventories Total Current Assets Fixed Assets Less: Accum Dep. Net FA Total Assets 2004 80 315 415 810 870 1,680 2005 10 375 615 1,000 2,000

Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Total Liabilities Common stock Retained earnings Total Equity Total L & E 2005 60 110 140 310 750 1,060 130 810 940 2,000 2004 30 60 130 220 580 800 750 880 1,680

Income statement Sales COGS EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2005 3,000 2,616 384 100 284 88 196 78 118 2004 2,850 2,497 353 90 263 60 203 81 122

Income statement Per Share Common Stk Price Earnings / share Dividends / share Book Value / Share Cash Flow /share 2005 23.00 2.35 1.15 18.80 4.35 2004 26.00 2.44 1.06 17.60 4.24

Liquidity Ratios  

Liquidity Ratios Measure company ability to pay bills Quick Ratio = Current Assets - Inventories Current Liabilities

Management Ratios Measure manager performance

Inventory Turnover Ratio  

Days Sales Outstanding  

Fixed Assets Turnover  

Total Assets Turnover  

DEBT MANAGEMENT RATIOS

Total Debt to Total Assets  

Time Interest Earned Ratio  

EBITDA Coverage Ratio EBITDA Coverage = EBITDA + Lease Payments _ Interest + Principal Pymt + Lease Pymt

PROFITABILITY RATIOS

Profit Margin Profit Margin on Sales = Net Income _ Sales

Return on Assts Return on Total Assets (ROA) = Net Income _

Basic Earning Power B E P = EBIT _ Total Assets

Return on Common Equity Return on Equity R O E = Net Income _ Common Equity

Market Value Ratios

Price / Earnings Ratio PE = Price per Share _ Earnings per Share

Price / Cash Flow Price/Cash Flow = Price per share _ Cash Flow per Share

Market / Book Book Value per share = Common Equity _ Shares Outstanding Market/Book = Market Price per Share _ Book Value per Share

TREND ANALYSIS Compare OVER TIME Are ratios improving Or deteriorating

DuPont Equation Return on Assets ROE = Net Income _ Measure of success ROE = Net Income _ Stock Holder Equity

The Du Pont system  

The Du Pont system  

Potential uses of freed up cash Repurchase stock Expand business Reduce debt All these actions would likely improve the stock price.

Potential problems and limitations of financial ratio analysis Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Example General Electric Businesses Elevators Air-conditioners Jet Engines Lends Money

Potential problems and limitations of financial ratio analysis “Average” performance is not necessarily good, perhaps the firm should aim higher.

Potential problems and limitations of financial ratio analysis Seasonal factors can distort ratios.

Potential problems and limitations of financial ratio analysis “Window dressing” techniques can make statements and ratios look better.

Potential problems and limitations of financial ratio analysis Comparison with industry averages difficult. “Average” is not necessarily good. Seasonal factors can distort ratios. “Window dressing”

More issues regarding ratios Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is “good” or “bad”. Difficult to tell whether a company is in strong or weak position.

Qualitative factors to be considered when evaluating a company’s future financial performance Are the firm’s revenues tied to one key customer, product, or supplier? What percentage of the firm’s business is generated overseas? Competition Future prospects Legal and regulatory environment