1. Analysis of Financial Statements
CHAPTER 3
Analysis of Financial Statements

2. Topics in Chapter Read the whole chapter except 3-1b & 3-1c:
Ratio analysis
DuPont equation
Benchmarking for ratio analysis
Limitations of ratio analysis
Qualitative factors

3. Determinants of Intrinsic Value:
Using Ratio Analysis
Net operating
profit after taxes
Required investments
in operating capital −
Free cash flow
(FCF) =
FCF1
FCF2
FCF∞
...
Value =
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Firm’s debt/equity mix
Cost of debt
Cost of equity
Market risk aversion
Firm’s business risk

4. Overview Ratios facilitate comparison of: Ratios are used by:
One company over time
One company versus other companies
Ratios are used by:
Lenders to determine creditworthiness
Stockholders to estimate future cash flows and risk
Managers to identify areas of weakness and strength

5. 3-1 Financial Analysis 3-1a Gather Data 3-1d Begin Ratio Analysis
Financial statements can be downloaded from many web sites. Zacks Investment Research provides financial statements in a standardized format.
3-1d Begin Ratio Analysis
We will calculate the 2016 financial ratios for MicroDrive Inc. using data from the balance sheet and income statement given in Figure 3-1 on P105 in the textbook. The 2016 industry averages are given for comparison purposes.

6. Income Statements (millions of dollars except for per share data): MicroDrive Inc.
2016
2015
Net Sales
$5,000
$4,760
COGS except depreciation
3,800
3,560
Depreciation
200
170
Other operating expenses
500
480
Total operating costs
4,500
4,210
EBIT
$500
$550
Interest expense
120
100
Pre-tax earnings (EBT)
$380
$450
Taxes (40%)
152
180
Net income
$228
$270
Preferred dividends 8
NI available to common shareholders
$220
$262

7. Balance Sheets: Assets (millions of dollars except for per share data): MicroDrive Inc.
2016
2015
Cash and equivalents $ $
S-T investments - 40
Accounts Receivable
500
380
Inventories
1,000
820
Total current assets
1,550
1,300
Net fixed assets
2,000
1,700
Total assets
$3,550
$3,000

8. Balance Sheets: Liabilities & Equity (millions of dollars except for per share data): MicroDrive Inc.
2016
2015
Accounts payable $ $
Notes payable
280
130
Accruals
300
Total current liabilities
780
600
Long-term debt
1,200
1,000
Preferred Stock
100
Common stock
500
Retained earnings
970
800
Total common equity
1470
1300
Total liabilities and equity
$3,550
$3,000

9. Other Data: (millions except for per share data)
2016
2015
Preferred dividends $8
# of preferred stock
0.4
Common stock price
$27
$40
# of common shares 50
Common dividends
$50
$48
Addition to retained earnings
$170
$214
Bond’s sinking fund payments
$20
Lease payments
$28
Tax rate
40%

10. 3-2 Liquidity Ratios
Can the company meet its short-term obligations using the resources it currently has on hand?

11. 3-2a & 3-2b: Current and Quick Ratios
CR16 = = = 2.0
QR16 =
= = 0.7 CA CL
$1,550
$780
$1,550-$1,000
CA - Inventories

12. 3-2a & 3-2b: Current and Quick Ratios (continued): Comments on CR and QR
2016
2015
Ind. 2016 CR
2.0
2.2 QR
0.7
0.8
Declined from 2015 and slightly below the industry average.
(How does MicroDrive compare to S&P 500 companies?)
There has been a steady decline in the average liquidity ratios of S&P 500 companies during the past decade. In 2015, the average current ratio is about 1.3 and the average quick ratio is about 0.4, so MicroDrive and its industry peers are more liquid than the typical S&P 500 company.

13. 3-3 Asset Management Ratios
How efficiently does the firm use its assets?
How much does the firm have tied up in assets for each dollar of sales?

14. 3-3a & 3-3b Fixed Assets and Total Assets Turnover Ratios
     Sales             
Net fixed assets =
= = 2.5
$5,000
$2,000
Total assets
turnover
     Sales       
Total assets =
= = 1.4
$5,000
3,550
(More…)

15. 3-3a & 3-3b Total Assets and Fixed Assets Turnover Ratios (continued)
Both FA turnover and TA turnover are not up to industry average, and the further declines from 2015 are not good signs.
2016
2015
Ind. 16
FA TO
2.5
2.8
3.0
TA TO
1.4
1.6
1.8

16. Receivables DSO = Average sales per day = = = 37 days $500 $5,000/365
3-3c Days Sales Outstanding (Average Collection Period): average number of days from sale until cash received
DSO =
= =
= 37 days
Receivables
Average sales per day
$500
$5,000/365
Sales/365

17. 3-3c Days Sales Outstanding (continued): Appraisal of DSO
Firm collects too slowly, and situation is getting worse.
Steps should be taken to review credit standards and to expedite the collection of accounts receivable.
Ind.16
DSO

18. 3-3d Inventory Turnover Ratio
= = 4.0
COGS
Inventories
$3,800+$200
$1,000
Ind.16
Inv. T

19. 3-3d Inventory Turnover Ratio (Continued): Comments on Inventory Turnover
Inventory turnover is below industry average and declined from 2015.
The firm is holding too much inventory. In addition, the firm may be holding obsolete goods not worth their stated value.
In summary, MicroDrive’s low fixed-assets-turnover ratio, high DSO, and low inventory turnover ratio each cause its total-asset-turnover ratio to be lower than the industry average.

20. 3-4 Debt Management Ratios
Does the company have too much debt? (leverage ratios)
Can the company’s earnings meet its debt servicing requirements? (coverage ratios)

21. 3-4a Leverage Ratios: Debt (-to-Assets) Ratio
Total debt (short +long)
Total assets
Debt ratio =
= = 41.7%
$280+$1,200
$3,550
(More…)

22. 3-4a Leverage Ratios: Debt-to-Equity Ratio
Total debt (short + long)
Total comm. equity
Debt-to-Equity Ratio =
= = 1.01
$280+$1,200
$1,470
(More…)

23. 3-4a Leverage Ratios: Liabilities-to-Assets Ratio
Total liabilities
Total assets
Liabilities/Assets ratio = =
= %
$1,980
$3,550
(More…)

24. 3-4b Times-Interest-Earned (TIE) Ratio /Interest Coverage Ratio
            EBIT        
Int. expense
TIE =
= =4.2
$500
$120
(More…)

25. 3-4c EBITDA Coverage Ratio
= = 4.3
(EBIT + Depr. & Amort.) + Lease payments
Interest Lease
expense pmt.
Loan pmt.
($500 + $200) + $28
$120 + $28 + $20

26. Debt Management Ratios vs. Industry Averages
D/A 41.7% 37.7% 25.0%
D/E
TL/TA 55.8% 53.3% 45.0%
TIE EC
MicroDrive has more leverage (higher level of debt) and lower coverage than its peers, and the situation is getting worse.
Consequently it might face difficulties if it attempts to borrow additional funds.

27. 3-5 Profitability Ratios
What is the company’s rate of return on:
Sales?
Assets?
Common equity?

28. Net profit margin (PM):
3-5a Profit Margins
PM = = = 4.4% NI
Sales
$220
$5,000
OM = = = 10%
EBIT
$500
Net profit margin (PM):
Operating profit margin (OM):
(More…)

29. 3-5a Profit Margins (Continued)
Gross profit margin (GPM):
Sales − COGS
Sales
$5,000-$4,000
$5,000
GPM = =
$1,000
$5,000
GPM = = 20%

30. Profit Margins vs. Industry Averages
PM 4.4% 5.5% 6.2%
OPM 10% 11.6% -
GPM 20% 21.6% -
Margins are declining, and the net profit margin are quite below the industry average.

31. 3-5b Basic Earning Power (BEP) Ratio
= = 14.1%
EBIT
Total assets
$500
$3,550
(More…)

32. 3-5b BEP vs. Industry Average (continued)
BEP removes effect of taxes and financial leverage. Useful for comparison with different tax situations and different degrees of financial leverage.
The firm’s BEP is declining and below industry average. A lot of room for improvement.
Ind.16
BEP 14.1% 18.3% 20.2%

33. 3-5c & 3-5d Return on Assets (ROA) and Return on Equity (ROE)
= = 6.2% NI
Total assets
$220
$3,550
(More…)

34. 3-5c & 3-5d Return on Assets (ROA) and Return on Equity (ROE)
= = 15.0% NI
Common Equity
$220
$1,470
(More…)

35. 3-5c & 3-5d Return on Assets (ROA) and Return on Equity (ROE)
Ind.16
ROA 6.2% 8.7% 11.0%
ROE 15.0% 20.2% 19.0%
ROA is declining and below average,
ROE has declined from slightly above
average in 2015 to below average in 2016.

36. 3-6 Market Value Ratios
Market value ratios incorporates expected growth and risk:
High expected growth in earnings and cash flow increases market value ratios
High risk of expected growth in earnings and cash flow decreases market value ratios

37. 3-6a Price/Earnings Ratio
EPS = = = $4.4
P/E = = = 6.1 NI
Shares out.
$220 50
Price per share
EPS
$27
$4.4

38. 3-6b Price/Cash Flow Ratio
NI + Depr.
Shares out.
CF per share =
= = $8.4
$220 + $200 50
Price per share
Cash flow per share
P/CF =
= = 3.2
$27
$8.4

39. Com. equity BVPS = Shares out. = = $29.4 $1,470 50
3-6c Market/Book Ratio
Com. equity
Shares out.
BVPS =
= = $29.4
$1,470 50
Mkt. price per share
Book value per share
M/B =
= = 0.9
$27
$29.4

40. Interpreting Market Value Based Ratios
P/E: How much investors will pay for $1 of earnings.
M/B: How much investors will pay for $1 of book value.
Ceteris Paribus, market value ratios are higher for firms with strong growth prospects, but lower for riskier firms.

41. Comparison with Industry Averages
P/E
P/CF
M/B
Compared to industry averages and based on the trend,
these market value ratios suggest that the firm is regarded by investors:
as having poorer growth prospects,
as being somewhat riskier than most,
or both.

42. 3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis
Trend Analysis examine a ratio over time.
Example: trend analysis of ROE for MicroDrive Inc. as shown in Figure 3-2 on P120.
All the other ratios can be analyzed similarly.

43. Common Size Balance Sheets (Figure 3-4 on P122): Divide all items by Total Assets
Ind.16
2016
2015
Cash
1.8%
1.4%
2.0%
ST Inv.
0.0%
1.3% AR
14.0%
14.1%
12.7%
Invent.
26.3%
28.2%
27.3%
Total CA
42.1%
43.7%
43.3%
Net FA
57.9%
56.3%
56.7% TA
100.0%

44. Common Size Balance Sheets (continued): Divide all items by Total Liabilities & Equity
Liab. & Eq.
Ind.16
2016
2015 AP
7.0%
5.6%
6.3%
Notes payable
0.0%
7.9%
4.3%
Accruals
12.3%
8.5%
9.3%
Total CL
19.3%
22.0%
20.0%
LT Debt
25.4%
33.8%
33.3%
Total Liab.
44.7%
55.8%
53.3%
Pre. Stock
2.8%
3.3%
Com. Equity
55.3%
41.4%
43.3%
Total L&E
100.0%

45. Analysis of Common Size Balance Sheets
MicroDrive’s inventories are higher than industry average.
MircoDrive uses much more debt than the average firm in the industry.

46. Common Size Income Statements (Figure 3-3 on P121): Divide all items by Sales
Ind.16
2016
2015
Sales
100.0%
COGS except depr.
75.5%
76%
74.8%
Depr.
3.0%
4.0%
3.6%
Other operating exp.
10.0%
10.1%
EBIT
11.5%
11.6%
Int. Exp.
1.2%
2.4%
2.1%
Pre-tax earnings
10.4%
7.6%
9.5%
Taxes
4.1%
3.8%
NI before Pref.
6.2%
4.6%
5.7%
Pref. dividends
0.0%
0.2%
NI avail. for Comm. shareholders
4.4%
5.5%

47. Analysis of Common Size Income Statements
MicroDrive’s EBIT is slightly below average, and its interest expenses are above average. The net effect is a relatively low net profit margin (4.4% vs. 6.2%).

48. Income Statement Percentage Change Analysis (Figure 3-5 on P122): Base Year 2015
Percentage change in 2016
Sales
5.0%
COGS except depr.
6.7%
Depr.
17.6%
Other operating exp.
4.2%
EBIT
(9.1%)
Int. Exp.
20%
EBT
(15.6%)
Taxes
NI before Pref.
Pref. dividends
0.0%
NI avail. to comm. shareholders
(16.0%)

49. Analysis of Percent Change Income Statement
Sales increased by 5% in 2016, but EBIT fell by 9.1% due to bigger increases in COGS and Depreciation. In addition, interest expenses grew by 20%. As a result the NI available to common shareholders fell by 16%.

50. Percentage Change Balance Sheet: Assets
Percentage change in 2016
Cash
(17%)
ST Invest.
(100%) AR
32%
Invent.
22%
Total CA
19%
Net FA
18% TA

51. Percentage Change Balance Sheet: Liabilities & Equity
Liab. & Eq.
Percentage change in 2016 AP 5%
Notes payable
115%
Accruals 7%
Total CL
30%
LT Debt
20%
Preferred stock 0%
Total comm. equity
13%
Total L&E
18%

52. Analysis of Percent Change Balance Sheet
Inventories grew at a whopping 22% and Accounts Receivable grew at 32%. With only 5% growth in sales, the extreme growth in receivables and inventories should be of great concerns to MicroDrive’s managers.
Both Short-term and long-term debt grew tremendously, suggesting possible financial troubles down the road if the firm doesn’t improve sales growth and profit margin.

53. 3-8 Tying the Ratios Together: the DuPont Equation
The DuPont equation focuses on:
Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)
It shows how these factors combine to determine the ROE.

54. ( )( )( ) = ROE The DuPont Equation Profit margin TA turnover Equity
multiplier NI
Sales
Sales TA TA CE
= ROE x x

55. Use DuPont Equation to Decompose ROENI
Sales TA CE x
= ROE
2015: 5.5% x 1.6 x 2.3 = 20%
2016: 4.4% x 1.4 x 2.4 = 15%

56. 3-9 Comparative Ratios and Benchmarking
Ratio Analysis involves comparisons. A company’s ratios are compared with those of other firms in the same industry.
However, firms also want to compare their ratios with those of a smaller set of leading companies in the industry. This is called benchmarking, and the companies used for the comparison are called benchmark companies.
Comparative ratios are available from a number of sources, including Value Line, Dun and Bradstreet (D&B), and the Annual Statement Analysis by Risk Management Associates.

57. 3-10 Potential Problems and Limitations of Ratio Analysis
Comparison with industry averages is difficult if the firm operates many different divisions.
It is best to benchmark on the industry leaders’ ratios rather than the industry average ratios.
Inflation can distort ratio analysis.
Seasonal factors can distort ratios.
Window dressing techniques can make statements and ratios look better.
Different accounting practices can distort comparisons.

58. 3-11 Qualitative Factors There is greater risk if:
revenues tied to a single customer
revenues tied to a single product
reliance on a single supplier?
High percentage of business is generated overseas?
What is the competitive situation?
What products are in the pipeline?
What are the legal and regulatory issues?