Topic 4 financial analysis b Read pages

What is an Accounting Equation? Assets = Liabilities + OE OR Something of Value = What’s Owed + What’s Owned

Characteristics of Balance Sheet A. Snap shot in time B.Assets arranged by liquidity C.Liability arranged by what needs to be paid most quickly D.Ownership accounts arranged by who has first to last claim of ownership

Characteristics of Income Statement A.Shows items for a length of time Day, Week, Month, Year B.The longer the period the greater the size CO MPANY REV -Cost- Exp. = Profit

Analyzing Financial Statements b Note $ size of statement b Note trends in $ amounts over time b Change summary statements into common-sized statements (%’s) b Compare common-sized statements -- good for trends b Use CPI to make $ adjustments b Use ratio analysis

CPI Index b Below is a simplified CPI index with 1997 as base year. This can be used for cases. b b b b b b b b

Inflation makes companies that are in zero growth look like they have 3-8% growth depending on changes in CPI

CHAPTER 4 Ratio Analysis Ratio’s mean nothing unless: b You know what items make up ratios, and what increases or decreases mean b Unless you compare to your company over time b Unless you compare to industry ratios

Financial Ratio Analysis — Liquidity 1. Liquidity Ratios Current ratio Quick (acid test) ratio Inventory to net working capital Cash ratio How FormulaExpressedMeaning Current assets ————————— Current liabilities Decimal A short-term indicator of the company’s ability to pay its short-term liabilities from short-term assets; how much of current assets are available to cover each dollar of current liabilities. Measures the company’s ability to pay off its short-term obligations from current assets, excluding inventories. A measure of inventory balance; measures the extent to which the cushion of excess current assets over current liabilities may be threatened by unfavorable changes in inventory. Measures the extent to which the company’s capital is in cash or cash equivalents; shows how much of the current obligations can be paid from cash or near-cash assets. Current assets – Inventory ———————————— Current liabilities Inventory ——————————————— Current assets – Current liabilities Cash + Cash equivalents ——————————— Current liabilities

Financial Ratio Analysis — Profitability 2. Profitability Ratios Net profit margin Gross profit margin Return on investment (ROI) Return on equity (ROE) Earnings per share (EPS) How FormulaExpressedMeaning Net profit after taxes ————————— Net sales Percentage Dollars per share Shows how much after-tax profits are generated by each dollar of sales. Indicates the total margin available to cover other expenses beyond cost of goods sold, and still yield a profit. Measures the rate of return on the total assets utilized in the company; a measure of management’s efficiency, it shows the return on all the assets under its control regardless of source of financing. Measures the rate of return on the book value of shareholders’ total investment in the company. Shows the after-tax earnings generated for each share of common stock. Sales – Cost of goods sold ————————————— Net sales Net profit after taxes ————————— Shareholders’ equity Net profit after taxes – perferred stock dividends ———————————— Average number of common shares Net profit after taxes ————————— Total assets

Financial Ratio Analysis — Activity 3. Activity Ratios Inventory turnover Days of inventory Net working capital turnover Asset turnover Fixed asset turnover Average collection period Accounts receivable turnover Accounts payable period Days of cash How FormulaExpressedMeaning Net sales ——————— Inventory Decimal Days Decimal Days Decimal Days Measures the number of times that average inventory of finished goods was turned over or sold during a period of time, usually a year. Measures the number of one day’s worth of inventory that a company has on hand at any given time. Measures how effectively the net working capital is used to generate sales. Measures the utilization of all the company’s assets; measures how many sales are generated by each dollar of assets. Measures the utilization of the company’s fixed assets (i.e., plant and equipment); measures how many sales are generated by each dollar of fixed assets. Indicates the average length of time in days that a company must wait to collect a sale after making it; may be compared to the credit terms offered by the company to its customers. Indicates the number of times that accounts receivable are cycled during the period (usually a year). Indicates the average length of time in days that the company takes to pay its credit purchases. Indicates the number of days of cash on hand, at present sales levels. Inventory ——————————— Cost of goods sold ÷ 365 Net sales ————————— Net working capital Sales ————————— Total assets Sales ——————— Fixed assets Accounts receivable ————————— Sales for year ÷ 365 Annual credit sales ————————— Accounts receivable Accounts payable ———————————— Purchases for year ÷ 365 Cash ——————————— Net sales for year ÷ 365

Financial Ratio Analysis — Leverage 4. Leverage Ratios Debt to asset ratio Debt to equity ratio Long-term debt to capital structure Times interest earned Coverage of fixed charges Current liabilities to equity How FormulaExpressedMeaning Total debt ——————— Total assets Percentage Decimal Percentage Measures the extent to which borrowed funds have been used to finance the company’s assets. Measures the funds provided by creditors versus the funds provided by owners. Measures the long-term component of capital structure. Indicates the ability of the company to meet its annual interest costs. A measure of the company’s ability to meet all of its fixed-charge obligations. Measures the short-term financing portion versus that provided by owners. Total debt ————————— Shareholders’ equity Long-term debt ————————— Shareholders’ equity Profit before taxes + Interest charges + Lease charges ———————————————— Interest charges + Lease obligations Profit before taxes + Interest charges ———————————————— Interest charges Current liabilities ————————— Shareholders’ equity

Financial Ratio Analysis — Other 5. Other Ratios Price/earning ratio Dividend payout ratio Divident yield on common stock How FormulaExpressedMeaning Market price per share ————————— Earnings per share Decimal Percentage Shows the current market’s evaluation of a stock, based on its earnings; shows how much the investor is willing to pay for each dollar of earnings. Indicates the percentage of profit that is paid out as dividends. Indicates the dividend rate of return to common shareholders at the current market price. Annual dividends per share ———————————— ANnual earnings per share Annual dividends per share ——————————————— Current market price per share Note: In using ratios for analysis, calculate ratios for the corporation and compare them to the average and quartile ratios for the particular industry. Refer to Standard and Poor’s and Robert Morris Associates for average industry data. Special thanks to Dr. Moustafa H. Abdelsamad, Dean, Business School, Texas A&M University–Corpus Christi, Corpus Christi, Texas, for his definitions of these ratios.

Altman’s Bankruptcy Formula Z =1.2 x x x x x 5 x 1 =Working capital divided by total assets. x 2 =Retained earnings divided by total assets. x 3 =Earnings before interest and taxes divided by total assets. x 4 =Market value of equity divided by total liabilities. x 5 =Sales divided by total assets. Z =Overall index of corporate fiscal health. (Z 3.00 a healthy co.)

Index of Sustainable Growth g*= [ p (1 – D) (1 + L)] / [T – P (1 – D) (1 = L)] where P = Net profit before taxes/net sales  100 D = Target dividends/profit after tax L = Total liabilities/net worth T = Total Assets/net sales  100 g*= the amount of growth that can be sustained by internal financing. Outside sources will have to be use for the rest of funding.

Strategic Audit Worksheet: Part 1 Continued

14.4bStategic Audit Worksheeet: Part 2 (Fig. 14.1)p. 331 Strategic Audit Worksheet: Part 2

Strategic Practice Exercise Convert the following two years of income statements from the Maytag Corporation into common-size statements. The dollar figures are in thousands. What does converting to a common-size reveal? 2004 % 2005 % 2006 % Net sales$3,041,223 $2,970,626 Cost of sales2,339,406 2,254,221 ———————————————————— Gross profits701, ,405 Selling, general, and admin. Expenses…528, ,898 Reorganization expenses95,000— ———————————————————— Operating income78, ,507 Interest expense(75,004) (75,159) Other—net3, ———————————————————— Income before taxes and accounting changes7, ,417 Income taxes(15,900) (44,400) Income before accounting changes(8,354) 79,017 Effects of accounting changes for post-retirement benefits(307,000)— ———————————————————— Net income (loss)$(315,354) $79,017 ————————————————————

b Income statement in 2006 for Strategic Practice Exercise b Assumptions: b Sales increased by 10% because of development of new market. b Cost of goods % will decrease by 2% from retrenchment strategy in production areas. b New marketing program and ads increase by $50,00,000 in addition to amount figured from last years selling, general and administrative expenses. b You borrowed $10,000,000 at 8% interest in addition to the same interest payments on old loans as in b Income taxes will be the average of the 2004 and 2005 taxes. b