1 CHAPTER 3 Analysis of Financial Statements

2 Topics in Chapter Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors

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

4 Overview Ratios facilitate comparison of: 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

5 Income Statement E Sales$5,834,400$7,035,600 COGS4,980,0005,800,000 Other expenses720,000612,960 Deprec.116,960120,000 Tot. op. costs5,816,9606,532,960 EBIT17,440502,640 Int. expense176,00080,000 EBT(158,560)422,640 Taxes (40%)(63,424)169,056 Net income($ 95,136)$ 253,584

6 Balance Sheets: Assets E Cash$ 7,282$ 14,000 S-T invest.20,00071,632 AR632,160878,000 Inventories1,287,3601,716,480 Total CA1,946,8022,680,112 Net FA939,790836,840 Total assets$2,886,592$3,516,952

7 Balance Sheets: Liabilities & Equity E Accts. payable$ 324,000$ 359,800 Notes payable720,000300,000 Accruals284,960380,000 Total CL1,328,9601,039,800 Long-term debt1,000,000500,000 Common stock460,0001,680,936 Ret. earnings97,632296,216 Total equity557,6321,977,152 Total L&E$2,886,592$3,516,952

8 Other Data E Stock price$6.00$12.17 # of shares100,000250,000 EPS-$0.95$1.01 DPS$0.11$0.22 Book val. per sh.$5.58$7.91 Lease payments$40,000 Tax rate0.4

Five Categories of Fin. Ratios Liquidity Asset Mgmt Debt Mgmt Profitability Market Value 9

Five Categories of Fin. Ratios Liquidity: Ability to meet current obligations Asset Mgmt: Proper & effective use of assets Asset utilization (i.e., Total Asset Turnover Ratio: TAT = Sales / T. Assets Debt Mgmt: extent of debt & level of safety afforded creditors Debt utilization (i.e., Equity Multiplier: EM = T. Assets / T. Eqty 10

Five Categories of Fin. Ratios Profitability: reflects effects of liquidity, asset mgmt, & debt on operating results Expense Control: Profit Margin: PM = Net Income / Sales Market Value: indicators of what investors think of firm’s past results & future prospects 11

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

13 Forecasted Current and Quick Ratios for CR 10 = = = QR 10 = = = CA CL $2,680 $1,040 $2,680 - $1,716 $1,040 CA - Inv. CL

14 Comments on CR and QR 2011E Ind. CR QR Expected to improve but still below industry average. Liquidity position is weak.

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

16 Inventory Turnover Ratio vs. Industry Average Inv. turnover= = = Sales Inventories $7,036 $1, E Ind. Inv. T

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

18 DSO= = = 45.5 days. Receivables Average sales per day $878 $7,036/365 Receivables Sales/365 DSO: average number of days from sale until cash received.

19 Appraisal of DSO Firm collects too slowly, and situation is getting worse. Poor credit policy Ind. DSO

= = = Total assets turnover = = = Sales Total assets $7,036 $3,517 Fixed assets turnover Sales Net fixed assets $7,036 $837 Fixed Assets and Total Assets Turnover Ratios

21 Fixed Assets and Total Assets Turnover Ratios FA turnover: TA turnover not up to industry average. Implication? 2011E Ind. FA TO TA TO expected to exceed industry average. Good. Caused by excessive current assets (A/R and inventory).

22 Debt Management Ratios Does company have too much debt? Can company’s earnings meet its debt servicing requirements?

23 Total liabilities Total assets Debt ratio= = = 43.8%. $1,040 + $500 $3,517 EBIT Int. expense TIE= = = 6.3. $502.6 $80 (More…) Calculate the debt, TIE, and EBITDA coverage ratios.

24 = = 5.5. _________ + Lease Pmt. + Loan pmt. $ $120 + $40 $80 + $40 + $0 EBITDA Coverage (EC) EBIT + Depr. & Amort. + Lease payments Interest expense

25 Recapitalization improved situation, but lease pmts drag down EBITDA Cov. 2011E Ind. D/A43.8%80.7%54.8%50.0% TIE EC Debt Management Ratios vs. Industry Averages

Equity Multiplier = T. Assets/Cmn Eqty Firms with large amts of debt financing (high leverage) have high Eqty Multiplier Think: Assets = Debt + Eqty 26

Equity Multiplier = T. Assets/Cmn Eqty Firms with small amts of debt financing (low leverage) have smaller Eqty Multiplier 27

28 Profitability Ratios What is company’s rate of return on: Sales? Assets?

29 Profit Margins PM = = = 3.6%. NI Sales $253.6 $7,036 OM = = = 7.1%. EBIT Sales $503 $7,036 Net profit margin (PM): Operating profit margin (OM): (More…)

30 Sales − COGS Sales Profit Margins (Continued) GPM = = GPM = = 17.6%. $1,236 $7,036 Gross profit margin (GPM): $7,036 − $5,800 $7,036

31 Very bad in 2010, but projected to meet or exceed industry average in E Ind. PM3.6%-1.6%2.6%3.6% OPM GPM Profit Margins vs. Industry Averages

Basic Earning Power & Subway vs. Smelly Deli EBIT= T.Assets= BEP= EBIT/TA 32

33 BEP = = EBIT Total assets $502.6 $3,517 Basic Earning Power (BEP) =14.3%

34 Basic Earning Power vs. Industry Average BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 2011E Ind. BEP14.3%0.6%14.2%17.8%

35 ROA = = = 7.2%. NI Total assets $253.6 $3,517 (More…) Return on Assets (ROA) and Return on Equity (ROE)

36 ROE = = = 12.8%. NI Common Equity $253.6 $1,977 (More…) Return on Assets (ROA) and Return on Equity (ROE)

E Ind. ROA7.2%-3.3%6.0%9.0% ROE12.8%-17.1%13.3%18.0% Both below average but improving. ROA and ROE vs. Industry Averages

Effects of Debt on ROA & ROE No Debt (unlevered) vs. Debt (levered) 38

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

40 Important Implications of Debt Financing (Financial Leverage) By raising $ thru debt, stockholders can maintain control of firm w/o increasing their investment. Greater the equity stake, the less risk faced by lenders (creditors) If company earns greater return on investment financed with debt than it pays in interest on borrowed funds, then it the return on owners equity is magnified, or leveraged.

The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. Intrnl Grth rate = (ROA x Retention %) 1- (ROA x Retention %)

The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. Sustnbl Grth rate = (ROE x Retention %) 1- (ROE x Retention %)

43 Market Value Ratios Market value ratios: gives mgmt indication of what investors think of co.’s past performance & future prospects

44 Market Value Ratios Increase /decrease: High current levels of earnings and cash flow increase market value ratios 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

45 Market Value Ratios P/E = Mrkt price per share / Earning per share PEG ratio= (Price/Earnings) / Growth PEG <1.0 reflects fairly valued stock M/B= Mrkt price p.s. / Book Value p.s. P/CF=Price p.s. / CF p.s.

46 Price = $ EPS = = = $1.01. P/E = = = 12. NI Shares out. $ Price per share EPS $12.17 $1.01 Calculate and appraise the P/E, P/CF, and M/B ratios.

47 NI + Depr. Shares out. CF per share= = = $1.49. $ $ Price per share Cash flow per share P/CF = = = 8.2. $12.17 $1.49 Market Based Ratios

48 Com. equity Shares out. BVPS= = = $7.91. $1, Mkt. price per share Book value per share M/B= = = $12.17 $7.91 Market Based Ratios (Continued)

49 Interpreting Market Based Ratios P/E: How much investors will pay for $1 of earnings. Higher is better. M/B: How much paid for $1 of book value. Higher is better. P/E and M/B are high if ROE is high, risk is low.

Market Value Measures Value Stocks: Firms w/ low Mrkt to Book ratios Growth Stocks: Firms w/ high Mrkt to Book ratios Market Capitalization = Mrkt Value of Common Equity Enterprise Value= MV equity + MV debt – Cash – mrktbl securities. Measures value of firm’s underlying business

E Ind. P/E P/CF M/B Comparison with Industry Averages

52 Explain the Du Pont System 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.

53 ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE xx = ROE The Du Pont System

54 ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE x x = ROE Du Pont & Corp Operations

:2.6% x 2.3x2.2=13.2% 2009:-1.6%x2.0x5.2=-16.6% 2010:3.6%x2.0x1.8=13.0% Ind.:3.6%x2.5x2.0=18.0% NI Sales TA CE xx = ROE The Du Pont System

56 Common Size Balance Sheets: Divide all items by Total Assets Assets EInd. Cash0.6%0.3%0.4%0.3% ST Inv.3.3%0.7%2.0%0.3% AR23.9%21.9%25.0%22.4% Invent.48.7%44.6%48.8%41.2% Total CA76.5%67.4%76.2%64.1% Net FA23.5%32.6%23.8%35.9% TA100.0%

57 Divide all items by Total Liabilities & Equity Assets EInd. AP9.9%11.2%10.2%11.9% Notes pay. 13.6%24.9%8.5%2.4% Accruals9.3%9.9%10.8%9.5% Total CL32.8%46.0%29.6%23.7% LT Debt22.0%34.6%14.2%26.3% Total eq.45.2%19.3%56.2%50.0% Total L&E100.0 %

58 Analysis of Common Size Balance Sheets Computron has higher proportion of inventory and current assets than Industry. Computron now has more equity (which means LESS debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.

59 Common Size Income Statement: Divide all items by Sales EInd. Sales100.0% COGS83.4%85.4%82.4%84.5% Other exp.9.9%12.3%8.7%4.4% Depr.0.6%2.0%1.7%4.0% EBIT6.1%0.3%7.1% Int. Exp.1.8%3.0%1.1% EBT4.3%-2.7%6.0%5.9% Taxes1.7%-1.1%2.4% NI2.6%-1.6%3.6%

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

61 Percentage Change Analysis: % Change from First Year (2009) Income St E Sales0.0%70.0%105.0% COGS0.0%73.9%102.5% Other exp.0.0%111.8%80.3% Depr.0.0%518.8%534.9% EBIT0.0%-91.7%140.4% Int. Exp.0.0%181.6%28.0% EBT0.0%-208.2%188.3% Taxes0.0%-208.2%188.3% NI0.0%-208.2%188.3%

62 Analysis of Percent Change Income Statement We see that 2011 sales grew 105% from 2009, and that NI grew 188% from So Computron has become more profitable.

63 Percentage Change Balance Sheets: Assets Assets E Cash0.0%-19.1%55.6% ST Invest.0.0%-58.8%47.4% AR0.0%80.0%150.0% Invent.0.0%80.0%140.0% Total CA0.0%73.2%138.4% Net FA0.0%172.6%142.7% TA0.0%96.5%139.4%

64 Percentage Change Balance Sheets: Liabilities & Equity Liab. & Eq E AP0.0%122.5%147.1% Notes pay.0.0%260.0%50.0% Accruals0.0%109.5%179.4% Total CL0.0%175.9%115.9% LT Debt0.0%209.2%54.6% Total eq.0.0%-16.0%197.9% Total L&E0.0%96.5%139.4%

65 Analysis of Percent Change Balance Sheets Total assets grew at rate of 139%, while sales grew at rate of only 105%. So asset utilization remains a problem.

66 Potential Problems and Limitations of Ratio Analysis Comparison with industry averages is difficult if firm operates many different divisions. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons.

67 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 competitive situation? What products are in pipeline? What are legal and regulatory issues?