Chapter 3

* How to standardize financial statements for comparison purposes * How to compute and interpret important financial ratios * The determinants of a firm’s profitability and growth * Understand the problems and pitfalls in financial statement analysis

3 * Almost Everyone in the Business World * Bankers – analyze loans and cash flow * Portfolio Managers – projections of stock prices * Marketing Managers – market penetration and impacts to profitability * Human Resources – compensation analysis * Senior Management – corporate strategy * Sales Managers – commission rates on sales * Internal Financial Analysts – profitability analysis * Customer Service Managers – efficiency ratios

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?

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?

* 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?

* 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

* Common size financial statements * Financial ratios * Trend analysis * Industry comparisons

Firm A Firm B Sales COGS Gr. Profit

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

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 Balance Sheets * All accounts = percent of total assets (%TA) * Common-Size Income Statements * All line items = percent of sales (%SLS) * Standardized statements are useful for: * Comparing financial information year-to-year * Comparing companies of different sizes, particularly within the same industry

* Diameter * Earth 12,756 KM * Sun 1,392,000 KM * Mass * Earth 1 * Sun 330,000

* Ratios need to be compared to something * Time-Trend Analysis * How the firm’s performance is changing through time * Internal and external uses * Peer Group Analysis * Compare to similar companies or within industries * SIC and NAICS codes

* Liquidity ratios or Short-term solvency * Financial leverage ratios or Long-term solvency ratios * Asset management or Turnover ratios * Profitability ratios * Market value ratios

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

23 Gross Profit Margin = Gross Profit Sales How effective is the firm at generating revenue in excess of its cost of goods sold? 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? 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 ? 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? 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 Measure the ability of the firm to meet its short-term financial obligations. Liquidity Ratios Current Ratio = Current Assets Current Liabilities 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 * Measure the ability of the firm to meet its short-term financial obligations. Liquidity Ratios 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 Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt. Leverage Ratios

37 Debt Ratio = Total Debt Total Assets What proportion of the firm’s assets is financed with debt? 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? 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? 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 * Help assess how effectively the firm is using assets to generate sales. Efficiency Ratios

44 Efficiency Ratios How long does it take for the firm on average to collect its credit sales from customers? Days Sales in Receivables or Average Collection Period = 365 days Rec. turnover

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 Days’ sales in receivables 365 days Rec turn 365 $1,450/430 DSR = = 108 days Days in a year

46 Inventory Turnover Ratio = COGS Inventory Is inventory efficiently translating into sales for the firm? 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? 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? 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.) 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? 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

* Enterprise value = Total market value of the stock + Book value of all liabilities – Cash * EBITDA ratio = Enterprise value / EBITDA * EBITDA = EBIT + Depreciation & Amortization Market Value Ratios

* Dividend payout ratio (“1 – b”) = DPS / EPS = Cash dividends / Net income * Retention ratio (“b”) = (EPS – DPS) / EPS = (Addition to Retained Earnings) / Net income

58 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

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

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

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

62 Ratio Industry Excalibur Market Value PE Ratio Market to Book

64 * Ratio Analysis generally involves an examination of related ratios. * Comparison of these relationships over time helps to identify the company’s strengths and weaknesses. * Walmart ROE = 21% * Target ROE = 15% * Why is Walmart outperforming?

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

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

67 Net Inc. Net Inc. Sales Assets Equity Sales Assets Equity = x x Net Profit Margin Total Asset Turnover Return on Equity Multiplier = x x

Net Profit Margin Asset Turnover ROA Target4.0% % Wal-Mart3.6% %

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)

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

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

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

* Conglomerates * No readily available comparables * Global competitors * Different accounting procedures * Different fiscal year ends * Differences in capital structure * Seasonal variations and one-time events