1. CHAPTER 3 Analysis of Financial Statements
Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors

2. Balance Sheet: Assets
2002E
2001
Cash
14,000
7,282
ST investments
71,632 AR
878,000
632,160
Inventories
1,716,480
1,287,360
Total CA
2,680,112
1,926,802
Gross FA
1,197,160
1,202,950
Less: Deprec.
380,120
263,160
Net FA
817,040
939,790
Total assets
3,497,152
2,866,592

3. Liabilities and Equity
2001
Accounts payable
436,800
524,160
Notes payable
600,000
720,000
Accruals
408,000
489,600
Total CL
1,444,800
1,733,760
Long-term debt
500,000
1,000,000
Common stock
1,680,936
460,000
Retained earnings
(128,584)
(327,168)
Total equity
1,552,352
132,832
Total L&E
3,497,152
2,866,592

4. Income Statement
2002E
2001
Sales
7,035,600
5,834,400
COGS
6,100,000
5,728,000
Other expenses
312,960
680,000
Depreciation
120,000
116,960
Tot. op. costs
6,532,960
6,524,960
EBIT
502,640
(690,560)
Interest exp.
80,000
176,000
EBT
422,640
(866,560)
Taxes (40%)
169,056
(346,624)
Net income
253,584
(519,936)

5. Other Data
2002E
2001
Shares out.
250,000
100,000
EPS
$1.014
($5.199)
DPS
$0.220
$0.110
Stock price
$12.17
$2.25
Lease pmts
$40,000

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

7. Liquidity: Can we make required payments as they fall due?
What are the five major categories of ratios, and what questions do they answer?
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?
(More…)

8. Debt management: Do we have the right mix of debt and equity?
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?

9. Calculate the firm’s forecasted current and quick ratios for 2002.CL
$2,680
$1,445
CR02 = = = 1.85x.
CA - Inv. CL
QR02 =
$2,680 - $1,716
$1,445
= = 0.67x.

10. Comments on CR and QR
2002E
2001
2000
Ind. CR
1.85x
1.1x
2.3x
2.7x QR
0.67x
0.4x
0.8x
1.0x
Expected to improve but still below the industry average.
Liquidity position is weak.

11. What is the inventory turnover ratio as compared to the industry average?
Inv. turnover =
= = 4.10x.
Sales
Inventories
$7,036
$1,716
2002E
2001
2000
Ind.
Inv. T.
4.1x
4.5x
4.8x
6.1x

12. Comments on Inventory Turnover
Inventory turnover is below industry average.
Firm might have old inventory, or its control might be poor.
No improvement is currently forecasted.

13. DSO is the average number of days after making a sale before receiving cash.
Receivables
Average sales per day
DSO =
= =
= 44.9 days.
Receivables
Sales/360
$878
$7,036/360

14. Appraisal of DSO
2002E
2001
2000
Ind.
DSO
44.9
39.0
36.8
32.0
Firm collects too slowly, and situation is getting worse.
Poor credit policy.

15. Fixed Assets and Total Assets
Turnover Ratios
Fixed assets
turnover
Sales
Net fixed assets =
= = 8.61x.
$7,036
$817
Total assets
= = 2.01x.
$3,497
(More…)

16. 2002E
2001
2000
Ind.
FA TO
8.6x
6.2x
10.0x
7.0x
TA TO
2.0x
2.3x
2.5x
FA turnover is expected to exceed industry average. Good.
TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

17. Calculate the debt, TIE, and EBITDA coverage ratios.
Total debt
Total assets
Debt ratio =
= = 55.6%.
$1,445 + $500
$3,497
EBIT
Int. expense
TIE =
= = 6.3x.
$502.6
$80
(More…)

18. EBITDA
coverage
= EC
EBIT + Depr. & Amort. + Lease payments
Interest Lease Loan pmt.
expense pmt.
= = 5.5x.
$ $120 + $40
$80 + $40 + $0
All three ratios reflect use of debt, but focus on different aspects.

19. How do the debt management ratios compare with industry averages?
2001
2000
Ind.
D/A
55.6%
95.4%
54.8%
50.0%
TIE
6.3x
-3.9x
3.3x
6.2x EC
5.5x
-2.5x
2.6x
8.0x
Too much debt, but projected to improve.

20. Profit Margin (PM)
PM = = = 3.6%. NI
Sales
$253.6
$7,036
2002E
2001
2000
Ind. PM
3.6%
-8.9%
2.6%
Very bad in 2001, but projected to
meet industry average in Looking good.

21. Basic Earning Power (BEP)
EBIT
Total assets
BEP =
= = 14.4%.
$502.6
$3,497
(More…)

22. 2002E
2001
2000
Ind.
BEP
14.4%
-24.1%
14.2%
17.8%
BEP removes effect of taxes and financial leverage. Useful for comparison.
Projected to be below average.
Room for improvement.

23. and Return on Equity (ROE)
Return on Assets (ROA)
and Return on Equity (ROE)
Net income
Total assets
ROA =
= = 7.3%.
$253.6
$3,497
(More…)

24. ROE =
= = 16.3%.
Net income
Common equity
$253.6
$1,552
2002E
2001
2000
Ind.
ROA
7.3%
-18.1%
6.0%
9.0%
ROE
16.3%
-391.0%
13.3%
18.0%
Both below average but improving.

25. Effects of Debt on ROA and ROE
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.

26. Calculate and appraise the
P/E, P/CF, and M/B ratios.
Price = $12.17.
EPS = = = $1.01.
P/E = = = 12x. NI
Shares out.
$253.6
250
Price per share
EPS
$12.17
$1.01
(More…)

27. Typical industry average P/E ratios
Banking
17.15
Computer Software Services
33.01
Drug
41.81
Electric Utilities (Eastern U.S.)
19.40
Internet Services*
290.35
Semiconductors
78.41
Steel
12.71
Tobacco
11.59
Water Utilities
21.84
* Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies.

28. NI + Depr.
Shares out.
CF per share =
= = $1.49.
$ $120.0
250
Price per share
Cash flow per share
P/CF =
= = 8.2x.
$12.17
$1.49

29. Com. equity BVPS = Shares out. = = $6.21. $1,552 250
= = $6.21.
$1,552
250
Mkt. price per share
Book value per share
M/B =
= = 2.0x.
$12.17
$6.21
(More…)

30. 2002E
2001
2000
Ind.
P/E
12.0x
-0.4x
9.7x
14.2x
P/CF
8.2x
-0.6x
8.0x
7.6x
M/B
2.0x
1.7x
1.3x
2.9x
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.

31. Common Size Balance Sheets: Divide all items by Total Assets
2000
2001
2002E
Ind.
Cash
0.6%
0.3%
0.4%
ST Invest.
3.3%
0.0%
2.0% AR
23.9%
22.1%
25.1%
22.4%
Invent.
48.7%
44.9%
49.1%
41.2%
Total CA
76.5%
67.2%
76.6%
64.1%
Net FA
23.5%
32.8%
23.4%
35.9% TA
100.0%

32. Divide all items by Total Liabilities & Equity
2000
2001
2002E
Ind. AP
9.9%
18.3%
12.5%
11.9%
Notes pay.
13.6%
25.1%
17.2%
2.4%
Accruals
9.3%
17.1%
11.7%
9.5%
Total CL
32.8%
60.5%
41.3%
23.7%
LT Debt
22.0%
34.9%
14.3%
26.3%
Total equ.
45.2%
4.6%
44.4%
50.0%
Total L&E
100.0%

33. Analysis of Common Size Balance Sheets
Computron has higher proportion of current assets (49.1%) than Industry (41.2%).
Computron has slightly less equity (which means more debt) than Industry.
Computron has more short-term debt than industry, but less long-term debt than industry.

34. Common Size Income Statement: Divide all items by Sales
2000
2001
2002E
Ind.
Sales
100.0%
COGS
83.4%
98.2%
86.7%
84.5%
Other exp.
9.9%
11.7%
4.4%
Depr.
0.6%
2.0%
1.7%
4.0%
EBIT
6.1%
-11.8%
7.1%
Int. Exp.
1.8%
3.0%
1.1%
EBT
4.3%
-14.9%
6.0%
5.9%
Taxes
-5.9%
2.4% NI
2.6%
-8.9%
3.6%

35. Analysis of Common Size Income Statements
Computron has higher COGS (86.7) than industry (84.5), but lower depreciation. Result is that Computron has similar EBIT (7.1) as industry.

36. Percentage Change Analysis: Find Percentage Change from First Year (2000)
Income St.
2000
2001
2002E
Sales
0.0%
70.0%
105.0%
COGS
100.0%
113.0%
Other exp.
-8.0%
Depr.
518.8%
534.9%
EBIT
-430.3%
140.4%
Int. Exp.
181.6%
28.0%
EBT
-691.1%
188.3%
Taxes NI

37. Analysis of Percent Change Income Statement
We see that 2002 sales grow 105% from 2000, and that NI grows 188% from 2000.
So Computron has become more profitable.

38. Percentage Change Balance Sheets
Assets
2000
2001
2002E
Cash
0.0%
-19.1%
55.6%
ST Invest.
-100.0%
47.4% AR
80.0%
150.0%
Invent.
140.0%
Total CA
71.4%
138.4%
Net FA
172.6%
137.0% TA
95.2%
138.1%

39. Liab. & Eq.
2000
2001
2002E AP
0.0%
260.0%
200.0%
Notes pay.
Accruals
Total CL
LT Debt
209.2%
54.6%
Total equity
-80.0%
133.9%
Total L&E
95.2%
138.1%

40. Analysis of Percent Change Balance Sheets
We see that total assets grow at a rate of 138%, while sales grow at a rate of only 105%. So asset utilization remains a problem.

41. ( )( )( ) = ROE Explain the Du Pont System Profit margin TA turnover
Equity
multiplier NI
Sales
Sales TA TA CE
= ROE. x x
% x 2.3 x 2.2 = 13.2%
% x 2.0 x 21.6 = %
% x 2.0 x 2.3 = 16.3%
Ind. 3.6% x 2.5 x 2.0 = 18.0%

42. The Du Pont system focuses on:
Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)
It shows how these factors combine to determine the ROE.

43. Simplified Firm Data
A/R
$ 878
Debt
$1,945
Other CA
1,802
Equity
1,552
Net FA
817
Total assets
$3,497
L&E
$3,497
Sales $7,035,600
day
= = $19,543.
Q. How would reducing DSO to days affect the company?

44. Effect of reducing DSO from 44.9 days to 32 days:
Old A/R = $19,543 x 44.9 = $878,000
New A/R = $19,543 x 32.0 = 625,376
Cash freed up: $252,624
Initially shows up as additional cash.

45. New Balance Sheet
Added cash $
Debt
$1,945
A/R
625
Equity
1,552
Other CA
1,802
Net FA
817
Total assets
$3,497
Total L&E
$3,497
What could be done with the new
cash? Effect on stock price and risk?

46. Potential use of freed up cash
Repurchase stock. Higher ROE, higher EPS.
Expand business. Higher profits.
Reduce debt. Better debt ratio; lower interest, hence higher NI.
(More…)

47. Inventories are also too high
Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides.
All these actions would likely improve stock price.

48. Would you lend money to this company?
Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment.
However, company should not have relied so heavily on debt financing in the past.

49. “Average” performance is not necessarily good.
What are some potential problems and limitations of financial ratio analysis?
Comparison with industry averages is difficult if the firm operates many different divisions.
“Average” performance is not necessarily good.
Seasonal factors can distort ratios.
(More…)

50. Window dressing techniques can make statements and ratios look better.
Different accounting and operating practices can distort comparisons.
Sometimes it is difficult to tell if a ratio value is “good” or “bad.”
Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

51. Are the company’s revenues tied to a single customer?
What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?
Are the company’s revenues tied to a single customer?
To what extent are the company’s revenues tied to a single product?
To what extent does the company rely on a single supplier?
(More…)

52. What percentage of the company’s business is generated overseas?
What is the competitive situation?
What does the future have in store?
What is the company’s legal and regulatory environment?