Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors CHAPTER 13 Analysis of Financial Statements

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

Ratio Analysis From an investor’s standpoint, predicting the future From management’s standpoint, financial statement analysis is useful both to help anticipate future conditions Starting point for planning actions that will improve the firm’s future performance. Financial ratios are designed to help evaluate financial statements

Ratio Analysis For example, Firm A have debt of $5,248,760 and interest charges of $419,900, Firm B have debt of $52,647,980 and interest charges of $3,948,600.  Which company is stronger?

Ratio Analysis The burden of these debts, and the companies’ ability to repay them, can best be evaluated by comparing (1) each firm’s debt to its assets and (2) the interest it must pay to the income it has available for payment of interest. Such comparisons are made by ratio analysis

Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Why are ratios useful?

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

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

Profitability Ratios Profitability is the net result of a number of policies and decisions. The ratios examined thus far provide useful clues as to the effectiveness of a firm’s operations, but the profitability ratios go on to show the combined effects of liquidity, asset management, and debt on operating results.

Profit Margin on Sales The profit margin on sales, calculated by dividing net income by sales, gives the profit per dollar of sales. Influence by Interest

Very bad in 2004, but projected to meet industry average in Looking good. Profit Margin (PM) 2005E Ind. PM3.6%-1.6%2.6%3.6% PM = = = 3.6%. NI Sales $253.6 $7,036

Basic Earning Power (BEP) The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes (EBIT) by total assets: This ratio shows the raw earning power of the firm’s assets, before the influence of taxes and leverage

BEP= = = 14.3%. Basic Earning Power (BEP) EBIT Total assets $502.6 $3,517 (More…)

BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 2005E Ind. BEP14.3%0.6%14.2%17.8%

Return on Assets (ROA) The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes:

Return on Equity (ROE) The most important, accounting ratio is the ratio of net income to common equity, which measures the return on common equity (ROE) Stockholders invest to get a return on their money, and this ratio tells how well they are doing in an accounting sense.

Return on Assets (ROA) and Return on Equity (ROE) ROA= = = 7.2%. Net income Total assets $253.6 $3,517 (More…)

ROE= = = 12.8%. Net income Common equity $253.6 $1, E Ind. ROA7.2%-3.3%6.0%9.0% ROE12.8%-17.1%13.3%18.0% Both below average but improving.

ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase. Effects of Debt on ROA and ROE

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.

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

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