FIN638 Vicentiu Covrig 1 Financial Statements Analysis (chapter 10)

FIN638 Vicentiu Covrig 2 Investing versus Speculating Stock investors own a small part of the companies they hold. - Business ownership - In the long run, the stock will perform as well (or as poorly) as the underlying business. Speculating - Expectation of short-term trading profits from share-price fluctuations. - Underlying business is irrelevant So investors need to know about the underlying business!

FIN638 Vicentiu Covrig 3 Ratio analysis: Why are ratios useful? Ratios standardize numbers and facilitate comparisons Ratios are used to highlight weaknesses and strengths. Ratio comparisons should be made through time and with competitors. - Trend analysis. - Peer (or industry) analysis.

FIN638 Vicentiu Covrig 4 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: 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?

FIN638 Vicentiu Covrig 5 D’Leon’s Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets , ,160 1,287,360 1,926,802 1,202, , ,790 2,866, E 85, ,000 1,716,480 2,680,112 1,197, , ,040 3,497,152

FIN638 Vicentiu Covrig 6 D’Leon’s Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E , , ,600 1,650, , ,000 32, ,592 2,866, E 436, , ,000 1,144, ,000 1,721, ,176 1,952,352 3,497,152

FIN638 Vicentiu Covrig 7 D’Leon’s Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income ,034,000 5,528, ,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2009E 7,035,600 5,875, , , , ,648 70, , , ,584

FIN638 Vicentiu Covrig 8 Other data No. of shares EPS DPS Stock price 2009E 250,000 $1.014 $0.220 $ ,000 -$1.602 $0.110 $2.25

FIN638 Vicentiu Covrig 9 Calculate D’Leon’s forecasted current ratio for Current ratio = Current assets / Current liabilities = Ind. Current ratio 2.34x1.20x2.30x2.70x Expected to improve but still below the industry average. Liquidity position is weak. See also the Quick ratio in text

FIN638 Vicentiu Covrig 10 What is the inventory turnover vs. the industry average? Ind. Inventory Turnover 3.42x4.29x4.8x6.1x Inv. turnover = Cost of Sales / Inventories = Inventory turnover is below industry average. D’Leon might have old inventory, or its control might be poor.

FIN638 Vicentiu Covrig 11 Calculate the debt ratio and EBIT coverage ratios. Debt to equity = long-term debt/ equity = Debt to total capital= Long term debt debt / (equity +long term debt) = Interest coverage= EBIT / Debt Interest charge =

FIN638 Vicentiu Covrig 12 How do the debt management ratios compare with industry averages? Ind. D/TC17%60%54.8%50.0% Int. cov.7.0x-1.0x4.3x6.2x D/E20%140%120%170%

FIN638 Vicentiu Covrig 13 Profitability ratios: Profit margin Profit margin= Net income / Sales = Ind. PM3.6%-2.7%2.6%3.5% Profit margin was very bad in 2008, but is projected to exceed the industry average in

FIN638 Vicentiu Covrig 14 Profitability ratios: Return on assets and Return on equity ROA= Net income / Total assets = ROE= Net income / Total common equity = Ind. ROA7.3%-5.6%6.0%9.1% ROE13.0%-32.5%13.3%18.2% Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. Wide variations in ROE illustrate the effect that leverage can have on profitability.

FIN638 Vicentiu Covrig 15 Calculate the Price/Earnings and Market/Book ratios P/E= Price / Earnings per share = M/B= Mkt price per share / Book value per share =(Book value is Total Assets minus Total Liabilities) Ind. P/E12.0x-1.4x9.7x14.2x M/B1.56x0.5x1.3x2.4x

FIN638 Vicentiu Covrig 16 Analyzing the market value ratios P/E: How much investors are willing to pay for $1 of earnings. M/B: How much investors are willing to pay for $1 of book value equity. For each ratio, the higher the number, the better. P/E and M/B are high if ROE is high and risk is low.

FIN638 Vicentiu Covrig 17 Extended DuPont equation: Breaking down Return on equity ROE= (Profit margin) x (TA turnover) x (Equity multiplier) = 3.6% x 2 x 1.8 = 13.0% PMTA TOEMROE % % % % 2009E3.6% % Ind.3.5% %

FIN638 Vicentiu Covrig 18 The Du Pont system Also can be expressed as: ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) Focuses on: - Expense control (PM) - Asset utilization (TATO) - Debt utilization (Eq. Mult.) Shows how these factors combine to determine ROE.

FIN638 Vicentiu Covrig 19 Potential problems and limitations of financial ratio analysis Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. “Average” performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better. 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, on balance, in strong or weak position.

FIN638 Vicentiu Covrig 20 Can Financial Statements Be Trusted? Accounting scandals Accounting restatements - Changing the numbers…

FIN638 Vicentiu Covrig 21 Learning objectives Discuss about the stock market investment versus stock market speculation Know to calculate all the financial ratios that are on the slides. Know to interpret the financial ratios, based on the textbook Know the calculations and interpretation of the DuPont formula Discuss the problems relying on the financial statements, based on p text End of chapter questions 10.1 to 10.4, CFA problems 10.1 to 10.4 Midterm exam type questions