Ratio analysis CHAPTER 3 Analysis of Financial Statements

Analysis of Financial Statements The primary goal of financial managers is to maximize the stock price, (a firm’s value),so it must take advantage of the firm’s strengths and correct its weaknesses. In this Chapter, we show how financial statements are used: By managers to improve performance,

Analysis of Financial Statements By lenders to evaluate the likelihood of collecting on loans, By stockholders to forecast earnings, dividends, free cash flow, and stock prices. Financial statement analysis involves 1.Comparing the firm’s performance with that of other firms in the same industry. 2.Evaluating trends in the firm’s financial position over time.

Ratio Analysis Financial statements report both on a firm’s financial position and on its operations (Performance). The real value of financial statements lies in the fact that they can be used to help predict future earnings, dividends, and free cash flow Financial ratios are designed to help evaluate financial statements

Five major categories of ratios, and The questions that they answer? (More…) Liquidity Asset management Debt management Profitability Market value

Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? Debt management: Do we have the right mix of debt and equity? what questions do they answer? (More…)

what questions do they answer? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Liquidity Can we make required payments as they fall due? A liquid asset is one that trades in an active market and hence can be quickly converted to cash at the going market price,

Asset Management Ratios Evaluating Inventories: The Inventory Turnover Ratio Evaluating Receivables: The Days Sales Outstanding Evaluating Fixed Assets: The Fixed Assets Turnover Ratio

Debt Management Ratios The extent to which a firm uses debt financing, or financial leverage, has three important implications: (1) By raising funds through debt, stockholders can maintain control of a firm without increasing their investment. (2) If the firm earns more on investments financed with borrowed funds than it pays in interest, then its shareholders’ returns are magnified, or “leveraged,” but their risks are also magnified. (3) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety,

Debt Management Ratios Ability to Service Debt: EBITDA Coverage Ratio Ability to Pay Interest: Times Interest Earned (TIE) debt ratio = total debt ratio

Profitability Ratios Profit Margin on Sales Basic Earning Power (BEP) Return on Assets (ROA)

Profitability Ratios Return on Equity (ROE)

Income Statement E Sales5,834,400 7,035,600 COGS4,980,000 5,800,000 Other expenses720, ,960 Deprec.116, ,000 Tot. op. costs5,816,960 6,532,960 EBIT17, ,640 Int. expense176,000 80,000 EBT(158,560)422,640 Taxes (40%)(63,424)169,056 Net income(95,136)253,584

Balance Sheets: Assets E Cash7,282 14,000 S-T invest.20,000 71,632 AR632, ,000 Inventories1,287,360 1,716,480 Total CA1,946,802 2,680,112 Net FA939, ,840 Total assets2,886,592 3,516,952

Balance Sheets: Liabilities & Equity E Accts. payable324, ,800 Notes payable720, ,000 Accruals284, ,000 Total CL1,328,960 1,039,800 Long-term debt1,000, ,000 Common stock460,000 1,680,936 Ret. earnings97, ,216 Total equity557,632 1,977,152 Total L&E2,886,592 3,516,952

Other Data E Stock price$6.00$12.17 # of shares100, ,000 EPS-$0.95$1.01 DPS$0.11$0.22 Book val. per share$5.58$7.91 Lease payments40,00040,000 Tax rate0.40.4

Market Value Ratios A final group of ratios, the market value ratios, relates the firm’s stock price to its earnings, cash flow, and book value per share. These ratios give management an indication of what investors think of the company’s past performance and future prospects. If the liquidity, asset management, debt management, and profitability ratios all look good, then the market value ratios will be high, and the stock price will probably be as high as can be expected.

The Financial Markets Businesses, individuals, and governments often need to raise capital. some individuals and firms have incomes that are greater than their current expenditures, so they have funds available to invest. People and organizations who want to borrow money are brought together with those with surplus funds in the financial markets.

What are some types of markets? A market is a method of exchanging one asset (usually cash) for another asset. Physical assets vs. financial assets Spot versus future markets Money versus capital markets Primary versus secondary markets

Earnings per share Earnings per share is calculated as net income divided by common shares outstanding.

Cash flow per share cash flow per share is calculated as net income plus depreciation and amortization divided by common shares outstanding.

Price/Earnings Ratio The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported profits. P/E ratios are higher for firms with strong growth prospects, other things held constant, but they are lower for riskier firms

Price/Cash Flow Ratio In some industries, stock price is tied more closely to cash flow rather than net income. Consequently, investors often look at the price/cash flow ratio:

Calculate and appraise the P/E, P/CF, and M/B ratios. Price = $ EPS = = = $1.01. P/E = = = 12x. NI Shares out. $ Price per share EPS $12.17 $1.01

NI + Depr. Shares out. CF per share= = = $1.49. $ $ Price per share Cash flow per share P/CF = = = 8.2x. $12.17 $1.49

Market/Book Ratio The ratio of a stock’s market price to its book value gives another indication of how investors regard the company. Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns. First, we find book value per share (BVPS): BVPS

Market/Book Ratio Then we divide the market price by the book value to get a market/book (M/B) ratio M/B

Com. equity Shares out. BVPS= = = $7.91. $1, Mkt. price per share Book value per share M/B= = = 1.54x. $12.17 $7.91

P/E: How much investors will pay for $1 of earnings. High is good. M/B: How much paid for $1 of book value. Higher is good. P/E and M/B are high if ROE is high, risk is low. 2005E Ind. P/E12.0x-6.3x9.7x14.2x P/CF8.2x27.5x8.0x7.6x M/B1.5x1.1x1.3x2.9x

Market/Book Ratio Since M/B ratios typically exceed 1.0, this means that investors are willing to pay more for stocks than their accounting book values. The book value is a record of the past, showing the cumulative amount that stockholders have invested, either directly by purchasing newly issued shares or indirectly through retaining earnings. In contrast, the market price is forward-looking, incorporating investors’ expectations of future cash flows. For example, in late 2001 American Airlines had a market/book ratio of only 0.45, reflecting the crisis in the airlines industry caused by the terrorist attacks earlier in the year, whereas Dell Computer’s market/book ratio was over 13, indicating that investors expect Dell’s past successes to continue.

Suppose you are the money manager of $4 million investment fund. The fund consist of 4 stocks with the following investments and betas Stock InvestmentBeta A$400, B 600, C1,000, D2,000, If the market required rate of return is 14% and the risk-free rate is 6%, What is the Funds required rate of return