3 3 Chapter Financial Information and Analysis Slides Developed by: Terry Fegarty Seneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 3 – Outline (1) Financial Information  Users of Financial Information  Sources of Financial Information  The Annual Report Ratio Analysis  Comparisons  Common Size Statements  Categories of Ratios  Liquidity Ratios  Asset Management Ratios

© 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 3 – Outline (2)  Debt Management Ratios  Profitability Ratios  Market Value Ratios  Dupont Equations  Sources of Comparative Information  Limitations and Weaknesses of Ratio Analysis  Words of Caution

© 2006 by Nelson, a division of Thomson Canada Limited 4 Financial Information Financial information—results of business operations in monetary terms  Responsibility of management  Created by company’s accountants  Creates a potential conflict of interest Management wants to portray firm in positive light  Published to a variety of audiences

© 2006 by Nelson, a division of Thomson Canada Limited 5 Users of Financial Information Investors and Financial Analysts  Financial analysts interpret information about companies and make recommendations to investors  Major part of analyst’s job is to study recent financial statements Vendors/Creditors  Use financial info to determine if firm is expected to make good on loans Management  Use financial info to pinpoint strengths and weaknesses in operations

© 2006 by Nelson, a division of Thomson Canada Limited 6 Sources of Financial Information Annual Report  Required from all publicly traded firms  Tends to portray firm in positive light Brokerage firms and investment advisory services  For example: Value Line Investment Survey

© 2006 by Nelson, a division of Thomson Canada Limited 7 The Annual Report Typically includes:  Letter to shareholders, reviewing the results and events of past year, and management’s strategies and plans for future  Management discussion and analysis, analyzing and explaining financial results for the year  Audited financial statements for past year and previous year, including income statement, balance sheet, statement of retained earnings, and statement of cash flows  Notes to the financial statements (audited)  Other recent and historic financial information.

© 2006 by Nelson, a division of Thomson Canada Limited 8 The Orientation of Financial Analysis Accounting—preparing financial statements Financial analysis—using financial statements to evaluate businesses  Financial analysis is critical and investigative

© 2006 by Nelson, a division of Thomson Canada Limited 9 Ratio Analysis Used to highlight different areas of performance Involves taking related numbers from the financial statements and forming ratios with them Each ratio is meaningful to operation of the business Can vary widely among industries

© 2006 by Nelson, a division of Thomson Canada Limited 10 Comparisons When examined separately, ratios don’t convey much information. Ratios are compared with:  History—examine trends (how ratio has changed over time)  Competition—compare with other firms in same industry  Budget—compare actual ratios with expected or desired ratios

© 2006 by Nelson, a division of Thomson Canada Limited 11 Common Size Statements First step in financial analysis is usually common size statement  Common size income statement Presents each line as percent of revenue  Common size balance sheet Presents each line as percent of total assets

© 2006 by Nelson, a division of Thomson Canada Limited 12 Common Size Statements Example

© 2006 by Nelson, a division of Thomson Canada Limited 13 Categories of Ratios  Liquidity—indicate firm’s ability to pay its bills in short run  Asset Management—show firm’s ability to generate revenue using minimum amount of assets  Debt Management—determine if the firm is using so much debt that it is assuming excessive financial risk  Profitability—allow assessment of the firm’s ability to make money  Market Value—give an indication of how investors feel about firm’s financial future

© 2006 by Nelson, a division of Thomson Canada Limited 14 Liquidity Ratios Current Ratio  To ensure solvency, current ratio is expected to exceed 1.0  Average is 1.3 for industrial corporations  May be too high if too much money is tied up in receivables and inventory

© 2006 by Nelson, a division of Thomson Canada Limited 15 Liquidity Ratios Quick Ratio (or Acid-Test Ratio)  Measures liquidity without considering inventory (least liquid current asset)  May be too high if too much money is tied up in receivables

© 2006 by Nelson, a division of Thomson Canada Limited 16 Asset Management Ratios Average Collection Period (ACP)  AKA: days sales outstanding (DSO)  Measures time to collect on credit sales. Compare to business credit terms (ex: 30 days) or

© 2006 by Nelson, a division of Thomson Canada Limited 17 Asset Management Ratios Average Collection Period (ACP) When ACP is too long, we can suspect:  poor credit management  inefficient collection procedures  risk of uncollectible accounts  risk of cash shortages  more reliance on bank financing, and  more interest expense.

© 2006 by Nelson, a division of Thomson Canada Limited 18 Asset Management Ratios Inventory Turnover  Measures how many times a year firm uses up an average stock of goods  Higher turnover implies doing business with less tied up in inventory  Indicates quality of inventory as well as how it is managed

© 2006 by Nelson, a division of Thomson Canada Limited 19 Asset Management Ratios Inventory Turnover A higher inventory turnover minimizes costs and risks of:  unsaleable stock  damage and shortages  insurance, storage, and financing costs, and  cash shortages A higher turnover is essential if inventory is  perishable (for example, food)  fashionable (for example, women’s fashions)  low margin goods (for example, consumer staples).

© 2006 by Nelson, a division of Thomson Canada Limited 20 Asset Management Ratios Capital Asset Turnover  Appropriate in industries where significant plant or equipment is required  High ratio may indicate full utilization of capacity  Low ratio may reflect new capital assets coming on stream

© 2006 by Nelson, a division of Thomson Canada Limited 21 Asset Management Ratios Total Asset Turnover  More widely used than Capital Asset Turnover  Long-term measure of performance

© 2006 by Nelson, a division of Thomson Canada Limited 22 Debt Management Ratios Debt management ratios measure financial risk from borrowing  High ratios viewed as risky by lenders and investors  Riskiness associated with debt and interest is called financial risk  High level of debt can burden income statement with excessive interest, a fixed financial charge  Firm may not be able to repay debt and interest if profits decline

© 2006 by Nelson, a division of Thomson Canada Limited 23 Debt Management Ratios Debt-to-equity ratio  Can be stated as a percentage, or as a x:y value  Measures mix of LT debt and equity within firm’s total capital

© 2006 by Nelson, a division of Thomson Canada Limited 24 Debt Management Ratios Debt Ratio  Need to determine if company is using so much debt that it is assuming excessive financial risk  High debt ratio is viewed as risky by investors

© 2006 by Nelson, a division of Thomson Canada Limited 25 Debt Management Ratios Times Interest Earned  TIE is a coverage ratio Reflects how much EBIT covers interest expense High level of interest coverage implies safety for lenders  High TIE ratio often means a low debt/equity ratio

© 2006 by Nelson, a division of Thomson Canada Limited 26 Debt Management Ratios Cash Coverage  TIE ratio has problems Interest is a cash payment but EBIT is not exactly a source of cash By adding amortization back into the numerator we have a more representative measure of cash income

© 2006 by Nelson, a division of Thomson Canada Limited 27 Debt Management Ratios Fixed Charge Coverage  Interest payments are not the only fixed charges  Lease payments are fixed financial charges similar to interest Must be paid regardless of business conditions

© 2006 by Nelson, a division of Thomson Canada Limited 28 Profitability Ratios Return on Sales (or: Profit Margin, Net Profit Margin)  Measures control of income statement: revenue, cost and expense  Indicates overall profitability of the business  Low ROS may be OK for large firm  Small firm needs higher ROS

© 2006 by Nelson, a division of Thomson Canada Limited 29 Profitability Ratios Gross Profit Margin  Indicates how efficiently firm buys or manufactures its products, and how well it marks up and maintains selling prices  Will vary, depending on industry and product lines involved. For instance, margin on jewellery typically is much higher than that on most food products

© 2006 by Nelson, a division of Thomson Canada Limited 30 Profitability Ratios Return on Assets  Adds effectiveness of asset management to Return on Sales  Measures ability of firm to utilize assets to earn profit  Often compared to firm’s cost of financing (after tax)

© 2006 by Nelson, a division of Thomson Canada Limited 31 Profitability Ratios Return on Equity  Adds effect of borrowing to Return on Assets  Measures ability to earn a return on owners’ investment  If firm has substantial debt, ROE tends to be higher than ROA in good times and lower in bad times  Compared to returns available from alternate investments

© 2006 by Nelson, a division of Thomson Canada Limited 32 Earnings and Book Value per Share Earnings per Share  Indicates how much income was earned for each common share outstanding

© 2006 by Nelson, a division of Thomson Canada Limited 33 Earnings and Book Value per Share Book Value per Share  Indicates how much equity was attributable to each common share outstanding

© 2006 by Nelson, a division of Thomson Canada Limited 34 Market Value Ratios Price/Earnings Ratio (PE Ratio)  Indicates value that stock market places on company  Tells how much investors are willing to pay for a dollar of firm’s earnings  Firm’s P/E is primarily function of investors’ expectations for its growth

© 2006 by Nelson, a division of Thomson Canada Limited 35 Market Value Ratios Market-to-Book Value Ratio  Healthy company is expected to have market value greater than its book value (Ratio > 1.0) Known as going concern value of firm Future earnings will be worth more than assets are worth today High ratio may indicate undervalued property on balance sheet  A ratio < 1.0 indicates poor outlook for firm

© 2006 by Nelson, a division of Thomson Canada Limited 36 Du Pont Equations Ratio measures are not entirely independent Performance on one is sometimes tied to performance on others Du Pont equations express relationships between ratios that give insights into successful operation

© 2006 by Nelson, a division of Thomson Canada Limited 37 Du Pont Equations Du Pont equation involves ROA, which can be written as: States that to run a business well, a firm must manage pricing, costs and expenses as well as generate lots of sales per dollar of assets. or

© 2006 by Nelson, a division of Thomson Canada Limited 38 Du Pont Equations Du Pont equation involves ROE, which can be written as: Equity Multiplier Related to the proportion to which the firm is financed by other people’s money as opposed to owner’s money. or

© 2006 by Nelson, a division of Thomson Canada Limited 39 Du Pont Equations Extended Du Pont equation states that operation of a business is reflected in its ROA  However, this result—good or bad—can be multiplied by borrowing, resulting in ROE  The way you finance a business can exaggerate the results from operations Du Pont equations can be used to isolate problems

© 2006 by Nelson, a division of Thomson Canada Limited 40 Table 3.2 : Sources of Comparative Information

© 2006 by Nelson, a division of Thomson Canada Limited 41 Limitations and Weaknesses of Ratio Analysis Ratio analysis requires judgment and experience  Examples of significant problems Diversified companies—comparing companies operating in several industries can be a problem Window dressing—companies make balance sheet items look better through temporary improvements Different accounting principles—similar companies may report same thing differently Inflation may distort numbers Illegal and/or misleading accounting practices may overstate assets, understate debt, or hide losses

© 2006 by Nelson, a division of Thomson Canada Limited 42 Words of Caution Ratios are only as good as information on which they are based Ratios become most valuable when:  Compared to past, competition, or budget When comparing ratios among different firms, ensure the ratios calculated using same method Ratios should cause one to ask questions; rarely do they provide answers themselves