Working With Financial Statements P.V. Viswanath For use with Fundamentals of Corporate Finance Brealey, Myers and Marcus, 4 th ed.

P.V. Viswanath2 Key Concepts and Skills  Know how to standardize financial statements for comparison purposes  Know how to compute and interpret important financial ratios  Know the determinants of a firm’s profitability and growth  Understand the problems and pitfalls in financial statement analysis

P.V. Viswanath3 Chapter Outline  Standardized Financial Statements  Ratio Analysis  The Du Pont Identity  Internal and Sustainable Growth  Using Financial Statement Information

P.V. Viswanath4 Standardized Financial Statements  Common-Size Balance Sheets Compute all accounts as a percent of total assets  Common-Size Income Statements Compute all line items as a percent of sales  Standardized statements make it easier to compare financial information, particularly as the company grows  They are also useful for comparing companies of different sizes, particularly within the same industry

P.V. Viswanath5 Ratio Analysis  Ratios also allow for better comparison through time or between companies  As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important  Ratios are used both internally and externally

P.V. Viswanath6 Categories of Financial Ratios  Liquidity ratios Short-term solvency or how easily the firm can lay its hands on cash.  Financial leverage ratios Show long-term solvency; how heavily the firm is in debt.  Efficiency or turnover ratios Indicate how productively the firm is using its assets  Profitability ratios Used to measure the firm’s return on its investments  Market value ratios

P.V. Viswanath7 Sample Balance Sheet Cash6,489Acc Payable340,220 Acc Receiv1,052,606Notes Pay86,631 Inventory295,255Other Curr Li1,098,602 Other Curr A199,375Total CL1,525,453 Total CA1,553,725LT Debt871,851 Net Fixed A2,535,072Comm Stock1,691,493 Total Assets4,088,797Tot Liab & Eq4,088,797 Numbers in thousands

P.V. Viswanath8 Sample Income Statement Revenues3,991,997 Cost of Goods Sold1,738,125 Expenses1,269,479 Depreciation308,355 EBIT739,987 Interest Expense42,013 Taxable Income697,974 Taxes 272,210 Net Income425,764 EPS2.17 Dividends per share (DPS)0.86 Numbers in thousands, except EPS & DPS

P.V. Viswanath9 Computing Leverage Ratios  Total Debt Ratio = (Tot Assets – Tot Eq) / TA (4,088,797 – 1,691,493) / 4,088,797 =.5863 times or 58.63% The firm finances almost 59% of their assets with debt.  Debt/Equity = Tot Debt / Tot Eq (4,088,797 – 1,691,493) / 1, 691,493 = times  These numbers can also be computed for long-term debt:  Long Term Debt Ratio = LT Debt/ (LT Debt + Eq) = 871,851/( , 691,493) = 0.34  Long Term Debt/Equity = / 1, 691,493 = 0.515

P.V. Viswanath10 Data from last year  Inventory = 280,044  Accounts Receivable = 940,044  Total Assets = 3,998,256  Total Equity = 1,480,493

P.V. Viswanath11 Computing Coverage Ratios  Times Interest Earned = EBIT / Interest 739,987 / 42,013 = 17.6 times  Cash Coverage = (EBIT + Depreciation) / Interest (739, ,355) / 42,013 = times  Determinant of the riskiness of a firm’s debt

P.V. Viswanath12 Computing Liquidity Ratios  Current Ratio = CA / CL 1,553,725 / 1,525,453 = 1.02 times  Quick Ratio = (CA – Inventory) / CL (1,553,725 – 295,225) / 1,525,453 = times  Cash Ratio = Cash / CL 6,489 / 1,525,453 =.004 times  Net Working Capital to TA Ratio = NWC/TA (1,553, ,525,453)/ 4,088,797 = 0.007

P.V. Viswanath13 Computing Inventory Ratios  Inventory Turnover = Cost of Goods Sold / Average Inventory 1,738,125 / [(295, ,044)/2] = 6.04 times  Days’ Sales in Inventory = 365 / Inventory Turnover = Av Inv/(COGS/365) 365 / 6.04 = days  When you have ratios with I/S numbers in the numerator and B/S numbers in the denominator, use average of year beginning and year end quantities.  Last year’s Inventory = 280,044.

P.V. Viswanath14 Computing Receivables Ratios  Receivables Turnover = Sales / Av Accounts Receivable 3,991,997 / [(1,052, ,044)/2] = 4.01 times  Average Collection Period = Days’ Sales in Receivables = 365 / Receivables Turnover = Av Receiv/ (Av Sales) 365 / 4.01 = 91.1 days  Ac Rec last year = 940,044

P.V. Viswanath15 Computing Total Asset Turnover  Total Asset Turnover = Sales / Av Total Assets 3,991,997 / [(4,088, ,998,256)/2] = 0.99 times  Measure of asset use efficiency  Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets  Total Assets last year = 3,998,256

P.V. Viswanath16 Computing Profitability Measures  Profit Margin = Net Income / Sales 425,764 / 3,991,997 = times or 10.67%  Operating Profit Margin = (NI + Int) / Sales (425, ) / 3,991,997 = times or 11.72%  Return on Assets (ROA) = (Net Income + Interest) / Av TA (425, ) / [(4,088, ,998,256)/2] = times or 11.57%  Return on Equity (ROE) = Net Income / Average Equity 425,764 / [(1,691,493 +1,480,493)/2] = times or 26.85%

P.V. Viswanath17 Computing Market Value Measures  Market Price = $ per share  Shares outstanding = 205,838,594  P/E Ratio = Price per share / Earnings per share / 2.17 = 28.4 times  Market-to-book ratio = market value per share / book value per share / (1,691,493,000 / 205,838,594) = 7.5 times

P.V. Viswanath18 Payout and Retention Ratios  Dividend payout ratio = Cash dividends / Net income 0.86 / 2.17 =.3963 or 39.63%  Plowback ratio = Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio 1.31 / 2.17 = = 60.37% Or = = 60.37%

P.V. Viswanath19 Sustainable Growth  The sustainable growth rate tells us how fast the firm can grow, without increasing financial leverage.  Sustainable growth rate = Growth in equity from plowback = plowback ratio x ROE x = or 16.21% If the firm can continue to earn 26.85% on its equity and can plow back 60% of earnings into operations, its earnings and equity should both grow at 16.21% p.a.  Growth at this rate requires external financing to grow at the existing rate. Without any additional external financing, the firm can only grow at what is called the Internal Growth Rate.

P.V. Viswanath20 Internal Growth x (1,691,493 +1,480,493) /(4,088, ,998,256) = x = or 6.36%

P.V. Viswanath21 Determinants of Growth  Profit margin – operating efficiency  Total asset turnover – asset use efficiency  Financial leverage – choice of optimal debt ratio  Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

P.V. Viswanath22 Deriving the Du Pont Identity  ROE = NI / TE  Multiply by 1 and then rearrange ROE = (NI / TA) * (TA / TE) = ROA * Equity Multiplier  Multiply by 1 again and then rearrange ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = Profit Margin * Total Asset Turnover * Equity Multiplier

P.V. Viswanath23 Deriving the Du Pont Identity  ROA = (NI + Interest)/ TA Multiply by 1 and rearrange ROA = [(NI + Int)/ TA]*(Sales / TA) ROA = (Operating Profit Margin)*(Asset Turnover)  ROE = NI / TE ROE = (NI/Sales]*(Sales/TA)*(TA/TE) = Net Profit Margin*Asset Turnover*Equity Multiplier ROE = [NI/(NI+Int)]*[(NI +Int)/ Sales]*(Sales/TA)*(TA/TE) = Debt Burden * Op Profit Margin * Asset Turnover*Eq Multiplier = Debt Burden * ROA*Equity Multiplier

P.V. Viswanath24 Using the Du Pont Identity ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier Net Profit margin is a measure of the firm’s operating efficiency – how well does it control costs Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets Equity multiplier is a measure of the firm’s financial leverage

P.V. Viswanath25 Table 3.6

P.V. Viswanath26 Why Evaluate Financial Statements?  Internal uses Performance evaluation – compensation and comparison between divisions Planning for the future – guide in estimating future cash flows  External uses Creditors Suppliers Customers Stockholders

P.V. Viswanath27 Benchmarking  Ratios are not very helpful by themselves; they need to be compared to something  Time-Trend Analysis Used to see 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

P.V. Viswanath28 Work the Web Example  The Internet makes ratio analysis much easier than it has been in the past  Go to Multex Investor (yahoo.multexinvestor.com)  Choose a company and enter its ticker symbol Click on Ratios and see what comparative information is available

P.V. Viswanath29 Quick Quiz  How do you standardize balance sheets and income statements and why is standardization useful?  What are the major categories of ratios and how do you compute specific ratios within each category?  What are the major determinants of a firm’s growth potential?  What are some of the problems associated with financial statement analysis?