Financial Analysis CHAPTER 4

Overview of Financial Analysis FIRST ORDER OF BUSINESS IS TO SPECIFY THE OBJECTIVES OF THE ANALYSIS REMEMBER -- THE IDENTITY OF THE USER HELPS DEFINE WHAT INFORMATION IS NEEDED

Potential Financial Statement Users: Creditors Investors Managers –What types of questions do each of these users seek answers to?

Creditors Why does the firm want/need to borrow funds? What is the firm’s capital structure? How leveraged are they? How will they pay it back? What kind of cash flows are being generated by operations?

Investors How has the firm performed/what are future expectations? How much RISK is inherent in the capital structure? What are the expected returns from the firm? What is firm’s competitive position?

Managers Need all info creditors and investors need PLUS: What operating areas have contributed to success and which have not? What are strengths/weaknesses of company’s financial position? What changes are indicated to improve future performance?

Caution!!! Keep in mind: management PREPARES financial statements Analyst should be alert to potential for management to influence reporting to make data more “appealing” May want to supplement analysis with information apart from Annual Report prepared by management

Where to look for data... Financial statements (and notes) Annual Report 10K and 10Q reports filed with SEC (EDGAR) Computerized data bases –Info on industry norms/ratios –Info on particular companies/industries/mutual funds Websites

Basic Tools Common size financial statements Financial ratios –Trend analysis –Industry comparisons

Common Sizing Firm A Firm B Sales COGS Gr. Profit

Common Sizing Firm A Firm B Sales2,531,4564,561,234 COGS784,5641,556,456 Gr. Profit1,746,8913,004,778

Common Sizing Firm A Firm B Sales2,531, % 4,561, % COGS784,564 31% 1,556,456 34% Gr. Profit1,746,891 69% 3,004,778 66%

Common Size Statements Common size income statement –expresses each income statement category as a percentage of sales Common size balance sheet –expresses each item on balance sheet as a percentage of total assets

Comparisons/ benchmarking

Explain how big the sun is relative to the Earth using data below. Diameter –Earth 12,756 KM –Sun 1,392,000 KM Mass –Earth 1 –Sun 330,000

How big is Antares (one of the largest stars in our galaxy)?

21 Ratio Analysis Profitability ratios Liquidity ratios Leverage (solvency) ratios Efficiency ratios Market-value ratios Five Categories of Ratios

22 Ratio Analysis Profitability Ratios Measure the overall effectiveness of the firm’s management.

23 Gross Profit Margin = Gross Profit Sales How effective is the firm at generating revenue in excess of its cost of goods sold? Ratio Analysis Profitability Ratios

Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Bonds$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Income Statement Excalibur Corporation Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Net Operating Income$330 Interest Expense 60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 $575 $1,450 Gross Profit Margin == 39.7% Gross Profit = Margin Gross Profit Sales

Balance Sheet Excalibur Corporation Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625 Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $330 $1,450 Oper. Profit Margin == 22.8% Operating Profit = Margin Operating Income Sales

26 Net Profit Margin or Profit Margin = Net Income Sales How much net profit is being generated from each dollar of sales? Ratio Analysis Profitability Ratios Note: Net Income equals Earnings Available to CS when there is no preferred stock.

27 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625 Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $162 $1,450 Net Profit Margin == 11.2% Net Profit = Margin Net Income Sales

28 Return on Assets = Net Income Total Assets How effectively is the firm generating net income from its assets ? Ratio Analysis Profitability Ratios

29 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40)108 Net Income%$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $162 $2,530 ROA = = 6.4% Return on Assets Net Income Total Assets =

30 Return on Equity = Net Income Equity How well is the firm generating return to its equity providers? Ratio Analysis Profitability Ratios

Balance Sheet Excalibur Corporation Assets Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $162 $1,700 ROE == 9.53% Return on Equity = Net Income Equity

32 Ratio Analysis Liquidity Ratios Current Ratio = Current Assets Current Liabilities Measure the ability of the firm to meet its short-term financial obligations. Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

33 Balance Sheet Excalibur Corporation Assets Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 $1,230 $230 Current Ratio = = 5.35x Current Ratio = Current Assets Current Liabilities

34 Ratio Analysis Liquidity Ratios Measure the ability of the firm to meet its short-term financial obligations. Quick Ratio = Current Assets - Inventory Current Liabilities What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

35 Balance Sheet Excalibur Corporation Assets Liabilities $1,230 -$625 $230 Acid-Test Ratio = = 2.63x Quick Ratio = Current Assets - Inventory Current Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530

36 Ratio Analysis Leverage Ratios Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt.

37 Debt Ratio = Total Debt Total Assets What proportion of the firm’s assets is financed with debt? Ratio Analysis Debt Ratios

Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Income Statement Excalibur Corporation Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 $230 + $600 $2,530 Debt Ratio = = 33% Debt Ratio = Total Debt Total Assets

39 Times Interest Earned Ratio = Operating Income Interest Expense What is the firm’s ability to repay interest payments from its operating income? Ratio Analysis Debt Ratios

40 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities $330 $330$60 TIE Ratio = = 5.50x Times Interest = Earned Ratio Operating Income Interest Expense Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

41 Equity Multiplier = Total Assets Total Equity What is the firm’s investment in assets relative to it’s equity? Ratio Analysis Debt Ratios

42 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities $2,530 $2,530$1,700 Eq Mult= = 1.49x Equity Multiplier = Total Assets Total Equity Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

43 Ratio Analysis Efficiency Ratios Help assess how effectively the firm is using assets to generate sales.

44 Ratio Analysis Efficiency Ratios How long does it take for the firm on average to collect its credit sales from customers? DSO – Days Sales Out. or Average Collection Period = Accounts Receivable Avg. Daily Sales

Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Bonds$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation Average Collection = Period Accounts Receivable Avg. Daily Sales $430 $1,450/365 DSO = = 108 days Days in a year

46 Inventory Turnover Ratio = COGS Inventory Is inventory efficiently translating into sales for the firm? Ratio Analysis Efficiency Ratios

Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $875 $625 Inventory Turnover = = 1.4x Inventory Turnover = Ratio COGS Inventory

48 Fixed Asset Turnover Ratio = Sales Net Fixed Assets How effective is the firm in using its fixed assets to help generate sales? Ratio Analysis Efficiency Ratios

Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $1,450 $1,300 Fixed Asset Turnover = = 1.12x Fixed Asset Turnover = Ratio Sales Net Fixed Assets

50 Total Asset Turnover Ratio = Sales Total Assets How effective is the firm in using its overall assets to generate sales? Ratio Analysis Efficiency Ratios

51 Assets Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation $1,450 $2,530 Total Asset Turnover = = 0.57x Total Asset Turnover = Sales Total Assets Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

52 Price to Earnings Ratio = (PE) Price per Share Earnings per Share How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.) Ratio Analysis Market Value Ratios

53 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Assets Liabilities Balance Sheet Excalibur Corporation Additional Info: 100 shares $20.00 per share $20 $162/100 P/E ratio = = 12.35x P/E Ratio Price/Share EPS = Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

54 Market (price) to Book Ratio = Market (price) to Book Ratio = Price per Share Book Value per Share How much are investors willing to pay per dollar of book value? Ratio Analysis Market Value Ratios

Assets Liabilities Balance Sheet Excalibur Corporation $20 $1,700/100 M/B = = 1.18x Market to = Book Price/Share Common Equity/ # shares Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Additional Info: 100 shares $20 per share Income Statement Excalibur Corporation Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62

56 Ratio Industry Excalibur Profitability Gross Profit Margin 38% 40% Operating Profit Margin20%23% Net Profit Margin12%11% Return on Assets9.0%6.4% Return on Equity13.4%9.5% Summary of Excalibur Corporation Ratios

57 Ratio Industry Excalibur Liquidity Current Ratio 5.00x 5.35x Quick Ratio 3.00x 2.63x

58 Ratio Industry Excalibur Debt Debt Ratio35%33% Times Interest Earned7.0x5.5x Equity Multiplier ?x 1.49x

59 Ratio Industry Excalibur Asset Activity Avg. Collection Period90 days108 days Inventory Turnover3.0x1.4x Fixed Asset Turnover1.0x1.1x Total Asset Turnover0.75x.57x

60 Ratio Industry Excalibur Market Value PE Ratio Market to Book

61 Relationships Among Ratios: The Du Pont Equation Ratio Analysis generally involves an examination of related ratios. Comparison of these relationships over time helps to identify the company’s strengths and weaknesses.

Net Profit Margin Total Asset Turnover Return on Assets = x Return on Assets (ROA)

63 Du Pont Equation Net Inc. Net Inc. Sales Assets Equity Sales Assets Equity = x x Net Profit Margin Total Asset Turnover Return on Equity Multiplier = x x

TGT vs. Wal-Mart Net Profit Margin Asset Turnover Target4.0%1.45 Wal-Mart3.6%2.40 Which would you prefer?

DuPont Equation: TGT vs. Wal-Mart Net Profit Margin Asset Turnover ROA Target4.0% % Wal-Mart3.6% %

DuPont Equation: TGT vs. Wal-Mart Net Profit Margin Asset Turnover Equity Multiplier ROE Target4.0% % Wal-Mart3.6% % What is Target’s debt ratio? What debt ratio would Target need for ROE = 21%?

–The DuPont approach is nice because it divides the firm into three tasks expense management –(measured by the profit margin) asset management –(measured by asset turnover) debt management –(measured by the equity multiplier)

DuPont Example Wal-Mart Sears Profit M.4% 6% Ass.Turn ROA ? ? Eq. Mult.2 1 ROE ? ?

DuPont Example Wal-Mart Sears Profit M.4% 6% Ass.Turn ROA 12% 9% Eq. Mult.1 2 ROE ? ?

DuPont Example Wal-Mart Sears Profit M.4% 6% Ass.Turn ROA 12% 9% Eq. Mult.1 2 ROE 12% 18%

What is the best overall ratio?

A ratio analysis becomes relevant only when compared against a benchmark. Financial managers can create a benchmark for comparison in three ways Selecting a Benchmark 1. Trend analysis 2. Industry Average 3. Peer group

Trend analysis Selecting a Benchmark  Based on firm’s historical performance  Allows management to examine each ratio over time, determine whether trend is good or bad for firm

Industry average analysis Selecting a Benchmark  Another way of developing benchmark  Firms in same industry grouped by size, sales, and product lines, to establish benchmark ratios  Can identify industry groups with North American Industry Classification System (NAICS)

Peer group analysis Selecting a Benchmark  Instead of selecting an entire industry, management may select firms similar in size or sales, or who compete in same market  Average ratios of this peer group would then be used as benchmark  Peer groups can be only 3 or 4 firms, depending on industry

 Ratio analysis depends on accounting data based on historical costs Limitations of Ratio Analysis  No theoretical backing in making judgments based on financial statement and ratio analysis  When doing industry or peer group analysis one often encounters large, diversified firms that do not fit into any one SIC code

 Trend analysis could be distorted by financial statements affected by inflation Limitations of Ratio Analysis  Multinational firms deal with many accounting standards  Difficult to compare financial reports

Ratio Exercise