Working with financial statements Chapter 3

Key concepts and skills Know how to standardise 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 3-2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline Standardised financial statements Ratio analysis The Du Pont identity Internal and sustainable growth Using financial statement information 3-3 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Standardised financial statements Common-size balance sheets – Compute all accounts as a percentage of total assets Common-size income statements – Compute all line items as a percentage of sales Standardised 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. 3-4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Swagman Camping Ltd Balance sheet—Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Swagman Camping Ltd (cont.) Common-size balance sheet—Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Swagman Camping Ltd (cont.) Income statement—Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Swagman Camping Ltd (cont.) Common-size income statement— Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Ratio analysis Allows for better comparison over time or between companies Used both internally and externally For each ratio, several questions arise: – How is it computed ? – What is the ratio trying to measure and why is that information important? – What is the unit of measurement? – What might a high or low value be telling us? How might such values be misleading? – How could this measure be improved? 3-9 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Categories of financial ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios 3-10 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Common financial ratios Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Short-term solvency or liquidity ratios Current ratio = Current assets / Current liabilities 708 / 540 = 1.31 times Quick ratio (or acid-test ratio) = (Current assets – Inventory) / Current liabilities ( ) / 540 = 0.53 times Cash ratio= Cash / Current liabilities 98/ 540 = 0.18 times 3-12 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Long-term solvency measures Total debt ratio – (TA – TE) / TA ( ) / 3588 = 0.28 times Debt/Equity – TD / TE 0.28/0.72) = 0.39 times Equity multiplier – TA/TE = 1 + D/E ($1 /0.72) = Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Long-term solvency measures (cont.) Times interest earned – EBIT/Interest 691/ 141 = 4.9 times Cash coverage – (EBIT + Depreciation)/Interest ( ) / 141 = 6.9 times 3-14 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Asset management: Inventory ratios Inventory turnover = Cost of goods sold/Inventory 1344/422 = 3.2 times Days’ sales in inventory = 365/Inventory turnover 365 / 3.2 = 114 days 3-15 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Asset Management: Receivables Ratios Receivables Turnover = Sales/Accounts Receivable 2311 / 188= 12.3 times Days’ Sales in Receivables = 365/Receivables Turnover 365 / 12.3= 30 days 3-16 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh

Asset management: Asset turnover ratios Total asset turnover (TAT) = Sales/Total assets – 2311/3588 = 0.64 times Measure of asset use efficiency Not unusual for TAT <1, especially if a firm has a large amount of fixed assets Capital intensity ratio = 1/TAT – 1/0.64 = Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Profitability measures Profit margin = Net income/Sales 385/2311 = 16.7% Return on assets (ROA) = Net income/Total assets 385/3588 = 10.73% Return on equity (ROE) = Net income/Total equity 363 / 2591 = 14.9% 3-18 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Market value measures Market price = $88 per share = PPS Shares outstanding = 35 million Earnings per share = EPS = Net income/Shares outstanding – 385/35 = $11 PE ratio = Price per share (PPS )/ Earnings per share (EPS) – $88 / $11 = 8 times Market-to-book ratio = Market value per share/ Book value per share – Book value per share = Total equity/Shares outstanding = $2591/35 = $74 – Market-to-book = $88/74 = 1.19 times 3-19 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Swagman ratios 3-20 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The Du Pont identity Return on equity (ROE) = Net income (NI)/ Total equity (TE)= Basic formula Du Pont identity – ROE = Profit margin (PM) * Total asset turnover (TAT) * Equity multiplier (EM) PM = Net income / Sales TAT = Sales / Total assets EM = Total assets / Total equity 3-21 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Using the Du Pont identity ROE = PM*TAT*EM – Profit margin (PM) is a measure of a firm’s operating efficiency—how well it controls costs. – Total asset turnover (TAT) is a measure of the firm’s asset-use efficiency—how well it manages its assets. – Equity multiplier (EM) is a measure of the firm’s financial leverage Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

SWAGMAN—Du Pont identity ROE = PM * TAT * EM – PM = 16.7% – TAT =.64 – EM = 1.39 ROE =.167 x.64 x 1.39 =.149= 14.9% 3-23 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

An expanded Du Pont analysis Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

An expanded Du Pont analysis (cont.)—Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Internal and sustainable growth Dividend payout and earnings retention ratios Dividend payout ratio (b) = Cash dividends/Net income Retention ratio(1-b) = Additions to retained earnings/Net income = 1 – Payout ratio (b) 3-26 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Internal and sustainable growth Dividend payout and earnings retention ratios (cont.) Dividend payout ratio (‘b’) = – Cash dividends / Net income (DIV / NI) – 143/385 = 37% Retention ratio (‘1 – b’) = (NI - DIV)/ NI – Addition to Retained earnings / Net income – $242/385 = 63% 3-27 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Internal growth rate The internal growth rate tells us how much the firm can grow assets using retained earnings (internal financing) as the only source of financing Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 3-30 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Summary of internal and sustainable growth rates Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Using financial information— 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 – Shareholders 3-32 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Using financial statement information— Benchmarking Ratios are not very helpful by themselves; they need to be compared with something Time-trend analysis – Used to see how the firm’s performance is changing over time – Internal and external uses Peer-group analysis – Compare with similar companies or within industries – GICS codes International codes used to classify a firm by its type of business operations 3-33 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Problems with financial statement analysis Conglomerates – No readily available comparables Global competitors Different accounting procedures Different fiscal year ends Differences in capital structure Seasonal variations and one-time events 3-34 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Example: Work the Web The Internet makes ratio analysis much easier than it has been in the past. Click on the information icon to go to. Go to ‘Prices Research and Announcements’. Click on ‘Company Research’ and enter DJS (company code for David Jones). Look under ‘Company Announcements’ and find the latest annual report. Extract the relevant number from the balance sheet to calculate the financial ratios Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Quick quiz How do you standardise balance sheets and income statements? – Why is standardisation 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? 3-36 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter 3 END