1. Analysis of Financial Statements
Chapter 4
Analysis of Financial Statements
Ratio Analysis DuPont Equation Effects of Improving Ratios Limitations of Ratio Analysis Qualitative Factors

2. Why are ratios useful?
Ratios standardize numbers & facilitate comparisons
Ratios are used to highlight weaknesses & strengths
Comparisons through time & with competitors
Trend analysis
Industry analysis
Benchmark (peer) analysis

3. Five Major Categories of Ratios and the Questions They Answer
Liquidity: Can we make required payments?
Asset management: Right amount of assets vs. sales?
Debt management: Right mix of debt & equity?
Profitability: Do sales prices exceed unit costs & 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?

4. Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA
Less: Deprec.
Net FA
Total Assets
2012
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2013E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152

5. Balance Sheet: Liabilities & Equity
Accts payable
Notes payable
Accruals
Total CL
Long -
term debt
Common stock
Retained earnings
Total Equity
Total L & E
2012
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2013E
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152

6. Income Statement
Sales COGS Other expenses EBITDA Deprec. & amort. EBIT Interest exp. EBT Taxes Net income
2013E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2012
6,034,000
5,528,000
519,988
(13,988) 116,960
(130,948)
136,012
(266,960) (106,784)
(160,176)

7. Other Data No. of shares EPS DPS Stock price Lease pmts 2013E 250,000
$1.014
$0.220
$12.17
$40,000
2012
100,000 -
$1.602
$0.110
$2.25

8. Liquidity Ratios

9. Current Ratio & Quick Ratio
Forecasted for 2013

10. Comments on Liquidity Ratios
2012
2011
Ind.
Current ratio
2.34x
1.20x
2.30x
2.70x
Quick ratio
0.84x
0.39x
0.85x
1.00x
Expected to improve but still below industry average
Liquidity position is weak.
Too high Current Ratio could indicate:
A strong liquid position & inefficient utilization
too much cash & other current assets relative to sales
The firm has lots of inventory that it can’t sell
When a company faces financial difficulty it beings paying its payables more slowly and uses debt to pay for it which increases its current liabilities.
If CL are increasing faster than CA, the liquidity ratios will drop, which reflect the firm’s weaker liquidity position
If you are above industry, you are good. Below, you might need to improve. Far deviations from Ind Avg need further analysis to understand why

11. Example
Quick Ratio?

12. Asset management Ratios

13. Inventory Turnover vs. the Industry Average
Inv. turnover = Sales/Inventories
= $7,036/$1,716
= 4.10x
Measures how much inventory item is sold & restocked, or “turned over”
2013E
2012
2011
Ind.
Inventory turnover
4.1x
4.70x
4.8x
6.1x
Lower than its industry indicates its holding, relatively, more inventory. Inventory is not a good investment if there is no demand. It could also be old inventory

14. Comments on Inventory Turnover
Inventory turnover is below industry average
Might have old inventory, or its control might be poor
Inventory is not a good investment if there is no demand
No improvement is currently forecasted
Why would the inventory turnover ratio be more important for a company like Sultan Center than it is for Kuwait Insurance Company?

15. DSO: Average Number of Days after Making a Sale before Receiving Cash
DSO = Receivables/Avg. sales per day = Receivables/(Annual sales/365) = $878/($7,036/365) = 45.6 days
Payment Terms?

16. Appraisal of DSO Collects on sales too slowly, and is getting worse
2012
2011
Ind.
DSO
45.6
38.2
37.4
32.0
Collects on sales too slowly, and is getting worse
Has a poor credit policy

17. Example

18. Example

19. Fixed Assets & Total Assets Turnover Ratios
FA turnover = Sales/Net fixed assets = $7,036/$817 = 8.61x TA turnover = Sales/Total assets = $7,036/$3,497 = 2.01x

20. FA & TA Turnover (S/TA) vs. the Industry Average
2012
2011
Ind.
FA TO
8.6x
6.4x
10.0x
7.0x
TA TO
2.0x
2.1x
2.3x
2.6x
FA turnover projected to exceed the industry average
TA turnover below the industry average.
Caused by excessive currents assets (A/R & Inventory)

21. Debt management Ratios

22. Debt & Risk Why firm use debt?
If a firm earns more on its assets than its debt, it will be able to leverage up the ROE
However, debt is more risky than equity

24. Debt Ratio & Times-Interest-Earned Ratio
Debt ratio = Total debt/Total assets = ($1,145 + $400)/$3,497 = 44.2% TIE = EBIT/Interest charges = $492.6/$70 = 7.0x
Total debt = Current Liabilities + Long-term Debt
Creditors want lower debt ratio to ensure their money returns, stock holders might want higher debt ratio to enhance their returns

25. Debt Management Ratios vs. Industry Averages
2012
2011
Ind.
D/A
44.2%
82.8%
54.8%
50.0%
TIE
7.0x
-1.0x
4.3x
6.2x
D/A & TIE are better than the industry average
Allow a firm to borrow cheaply

26. Profitability Ratios

27. Profitability Ratios
BEP removes the effects of taxes & financial leverage
Shows earning power before the effect of debt & taxes
Useful for comparing firms with different debt structures

29. Appraising Profitability
2013E
2012
2011
Ind.
Operating margin
7.0%
-2.2%
5.6%
7.3%
Profit margin
3.6%
-2.7%
2.6%
3.5%
Basic earning power
14.1%
-4.6%
13.0%
19.1%
Operating margin was very bad in 2012.
Projected to improve in ‘13, but it is still remain below ind avg
Profit margin was very bad in 2012 but is projected to exceed the industry average in Looking good
BEP projected to improve, yet below the industry average.
There is definitely room for improvement

30. Profitability Ratios Return on Assets & Return on Equity
ROA = Net income/Total assets
= $253.6/$3,497 = 7.3%
Sometimes can be low because of the high use of debt
Need to look at the big picture not just one ratio
ROE = Net income/Total common equity
= $253.6/$1,952 = 13.0%
ROE is the most important ratio
it is what shareholders are getting as a return from an accounting stand point of view

31. Appraising Profitability
2013E
2012
2011
Ind.
ROA
7.3%
-5.6%
6.0%
9.1%
ROE
13.0%
-32.5%
13.3%
18.2%
Both ratios rebounded from the previous year, but are still below the industry average
More improvement is needed
Wide variations in ROE illustrate the effect that leverage can have on profitability

32. Profitability Ratios
Why does the use of debt lower the profit margin & ROA?
Why doesn’t debt have the same effect on the ROE?
Debt Lower net income, but its lower firm’s equity, and equity reduction can offset the lower net income
Example: A company has $20 sales and $1 NI, its total assets are $10, financed half by common equity. What is its profit margin? ROA? ROE?
Would the ROA & ROE increase if it used less leverage?
Yes & NO

33. Effects of Debt on ROA & ROE
Holding assets constant, if debt increases:
Equity declines
Interest expense increases
Which leads to a reduction in net income.
ROA declines (due to the reduction in net income).
ROE may increase or decrease
since both net income a& equity decline

34. Problems with ROE ROE & shareholder wealth are correlated
Problems can arise when ROE is the sole measure of performance:
ROE does not consider risk
Does not consider the amount of capital invested
Managers turn down profitable projects
So, reliance on ROE may encourage managers to make investments that do not benefit shareholders.
3rd point: Managers might not invest in projects even though their ROE is higher than the firm’s cost of capital

35. Example

36. Example

37. Market value Ratios
Market Value Ratios relate the stock price to a firm’s earnings and book value
Do you know what Book Value/Share is? What is Book Value?

38. Price/Earnings & Market/Book Ratios
P/E = Price/Earnings per share = $12.17/$1.014 = 12.0x M/B = Market price/Book value per share = $12.17/($1,952/250) = 1.56x
2013E
2012
2011
Ind.
P/E
12.0x
-1.4x
9.7x
14.2x
M/B
1.56x
0.5x
1.3x
2.4x
P/E: how much investors are willing to pay for each dollar of earnings
High P/E is driven by either high growth, low risk, or both – same for M/B – If a dollar of earnings is stable you are willing to pay more for it
No correct P/E, the S&P 500 average is around 16, KSE is around 12-14
M/B are usually above 1 which means investors are willing to pay more than the book value of assets
This is because assets are recorded at historical costs => could be worth more
Assets do not reflect goodwill, management ability, patents

39. Analyzing the Market Value Ratios
P/E: How much investors are willing to pay for $1 of earnings.
M/B: How much investors are willing to pay for $1 of book value equity.
For each ratio, the higher the number, the better
Either high growth, low risk, or both
P/E &M/B are high if ROE is high & risk is low.

40. Example

42. The DuPont Equation
Focuses on expense control (PM), asset utilization (TA TO) & debt utilization (equity multiplier)
Why do we break it up?
To better understand the ROE comes from & find any areas for improvement

44. Suppose you were comparing Gap with Louis Vuitton
Suppose you were comparing Gap with Louis Vuitton. Suppose further both firms had the same ROE. Using the DuPont equation, would you expect the three components to be the same for both firms? Profit Margins & turnover ratios vary from one industry to another.

45. DuPont Equation: Breaking Down Return on Equity
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
= % x x
= % PM
TA TO EM
ROE
2011
2.6%
2.3
2.2
13.3%
2012
-2.7%
2.1
5.8
-32.5%
2013E
3.6%
2.0
1.8
13.0%
Ind.
3.5%
2.6
18.2%

46. Example

47. Example

48. An Example: The Effects of Improving Ratios
A/R $ 878 Debt $1,545 Other CA 1,802 Net FA 817 Equity 1,952 TA $3,497 Total L&E $3,497 Sales/Day = $7,035,600/365 = $19, How would reducing the firm’s DSO to 32 days affect the company?

49. Reducing Accounts Receivable & Days Sales Outstanding
Reducing A/R will have no effect on sales
Initially shows up as addition to cash.

50. Effect of Reducing Receivables on Balance Sheet and Stock Price
Added Cash $ 261 Debt $1,545 A/R 617 Other CA 1,802 Net FA 817 Equity 1,952 Total Assets $3,497 Total L&E $3,497 What could be done with the new cash? How might stock price and risk be affected?

51. Potential Uses of Freed Up Cash
Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the stock price

52. Benchmarking Ratios are not compared to industry average
Instead to specific companies
Very comparable
Industry leaders

53. Potential Problems & Limitations of Financial Ratio Analysis
Comparison with industry is difficult for a conglomerate firm
Operates in many different divisions
Different operating & accounting practices can distort comparison
“Average”is not always good, perhaps firm should aim higher
Sometimes it is hard to tell if a ratio is “good” or “bad”
Difficult to tell whether it is in a strong or weak position
Seasonal factors can distort ratios
“Window dressing” can make ratios look better
Inflation has distorted many firms’ balance sheets
So, Analyses must be interpreted with judgment

54. Consider Qualitative Factors When Evaluating a Company’s Future Financial Performance
Are the firm’s revenues tied to one key customer, product, or supplier?
What percentage of the firm’s business is generated overseas?
Firm’s competitive environment
Future prospects
Legal and regulatory environment