1. 3 - 1 Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors Lecture Three Evaluating the Firm for Planning and Forecasting Via Analysis of Financial Statements

2. 3 - 2 Balance Sheet: Assets 1998E1997 Cash85,6327,282 AR878,000632,160 Inventories1,716,4801,287,360 Total CA2,680,112 77% 1,926,802 67% Gross FA1,197,1601,202,950 Less: Deprec. 380,120 263,160 Net FA 817,040 939,790 Total assets3,497,1522,866,592 3 - 2

3. 3 - 3 Liabilities and Equity 1998E1997 Accounts payable436,800524,160 Notes payable600,000720,000 Accruals 408,000 489,600 Total CL1,444,800 41% 1,733,760 60% Long-term debt500,000 14% 1,000,000 35% Common stock1,680,936460,000 Retained earnings(128,584)(327,168) Total equity1,552,352 44% 132,832 5% Total L & E3,497,1522,866,592 3 - 3

4. 3 - 4 Income Statement 1998E1997 Sales7,035,6005,834,400 COGS5,728,000 Other expenses680,000 Depreciation 116,960 Tot. op. costs6,524,960 EBIT510,640(690,560) Interest exp. 88,000 176,000 EBT 422,640 (866,560) Taxes (40%) 169,056 (346,624) Net income 253,584 (519,936) 3 - 4

5. 3 - 5 Other Data 1998E1997 Shares out.250,000100,000 EPS$1.014($5.199) DPS$0.220$0.110 Stock price$12.17$2.25 Lease pmts$40,000

6. 3 - 6 Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Why are ratios useful?

7. 3 - 7 Liquidity: Can we make required payments? Asset management: Right amount of assets vs. sales? What are the five major categories of ratios, and what questions do they answer?

8. 3 - 8 Debt management: 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. 3 - 9 Calculate D’Leon’s forecasted current and quick ratios for 1998. CR 98 = = = 1.85x. QR 98 = = = 0.67x. CA CL $2,680 $1,445 $2,680 - $1,716 $1,445 CA - Inv. CL

10. 3 - 10 Expected to improve but still below the industry average. Liquidity position is weak. Comments on CR and QR 199819971996Ind. CR1.85x1.1x2.3x2.7x QR0.67x0.4x0.8x1.0x

11. 3 - 11 What is the inventory turnover ratio vs. the industry average? Inv. turnover= = = 4.10x. Sales Inventories $7,036 $1,716 199819971996Ind. Inv. T.4.1x4.5x4.8x6.1x

12. 3 - 12 Inventory turnover is below industry average. D’Leon might have old inventory, or its control might be poor. No improvement is currently forecasted. Comments on Inventory Turnover

13. 3 - 13 Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO= = = = 44.9. Receivables Sales/360 $878 $7,036/360

14. 3 - 14 Appraisal of DSO nD’Leon collects too slowly, and is getting worse. Poor credit policy. 199819971996Ind. DSO44.939.036.832.0

15. 3 - 15 F.A. and T.A. turnover vs. industry average Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets turnover Sales Total assets = = = 2.01x. $7,036 $3,497

16. 3 - 16 FA turnover project to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inv.) 1998 1997 1996 Ind. FA TO8.6x6.2x10.0x7.0x TA TO2.0x2.0x2.3x2.6x

17. 3 - 17 Calculate the debt, TIE, and fixed charge coverage ratios. Total debt Total assets Debt ratio= = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE= = = 5.8x. $510.6 $88

18. 3 - 18 All three ratios reflect use of debt, but focus on different aspects. Fixed charge coverage = FCC = = = 4.3x. EBIT + Lease payments Interest Lease Sinking fund pmt. expense pmt. (1 - T) + $510.6 +$40 $88 + $40 + $0

19. 3 - 19 Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 1998 1997 1996 Ind. D/A55.6%95.4%54.8%50.0% TIE5.8x-3.9x3.3x6.2x FCC4.3x-3.0x2.4x5.1x

20. 3 - 20 Another Debt Management Ratio used commonly is: D/E CAD FAE AL+NW TATL+NW=E To convert into something more familiar as D/TA we simply D/TA = D/E D/E + 1 or D TA = D E  1 + () D E Example: if D/E = 0.91 D TA = 0.91 1 + 0.91 = 0.91 1.91 = 47%

21. 3 - 21 Very bad in 1997, but projected to exceed industry average in 1998. Looking good. Profit margin vs. industry average? 199819971996Ind. P.M.3.6%-8.9%2.6%3.5% P.M. = = = 3.6%. NI Sales $253.6 $7,036 3 - 20

22. 3 - 22 BEP= = = 14.6%. BEP vs. Industry Average? EBIT Total assets $510.6 $3,497 3 - 21

23. 3 - 23 BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 199819971996Ind. BEP14.6%-24.1%14.2%19.1% 3 - 22

24. 3 - 24 Return on Assets ROA= = = 7.3%. Net income Total assets $253.6 $3,497 3 - 23

25. 3 - 25 ROE= = = 16.3%. Net income Common equity $253.6 $1,552 1998 1997 1996 Ind. ROA7.3%-18.1%6.0%9.1% ROE16.3%-391.0%13.3%18.2% Both below average but improving. 3 - 24

26. 3 - 26 ROA is lowered by debt--interest lowers NI, which also lowers ROA = NI/Assets. But use of debt lowers equity, hence could raise ROE = NI/Equity. Effects of Debt on ROA and ROE 3 - 25

27. 3 - 27 Calculate and appraise the P/E 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 3 - 26

28. 3 - 28 Com. equity Shares out. BVPS= = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B= = = 1.96x. $12.17 $6.21 3 - 27

29. 3 - 29 P/E: How much investors will pay for $1 of earnings. High is good. M/B: How much paid for $1 of BV. Higher is good. P/E and M/B are high if ROE is high, risk is low. 1998 1997 1996 Ind. P/E12.0x-0.4x9.7x14.2x M/B1.96x1.7x1.3x2.4x 3 - 28

30. 3 - 30 ( )( )( ) = ROE x x = ROE. Profit margin TA turnover Equity multiplier NI Sales TA CE 19962.6%x2.3x2.2=13.2% 1997-8.9%x2.0x21.9=-391.0% 19983.6%x2.0x2.3=16.3% Ind.3.5%x2.6x2.0=18.2% 3 - 29

31. 3 - 31 Converting Equity Multiplier into Debt/TA and vice versa TD TA = 1 - 1 EM () = 1 - TE TA () EM= 1 1 - TD TA () If firm has Preferred Stock, must adjust formula by using CE in place of TE and subtracting PS from TA.

32. 3 - 32 The Du Pont system focuses on: Expense control (P.M.) Asset utilization (TATO) Debt utilization (Eq. Mult.) It shows how these factors combine to determine the ROE. 3 - 30

33. 3 - 33 Ratio Analysis Spread Sheet Example De Leon Ratio Categories Liquidity Asset Management Leverage Profitability Market

34. 3 - 34 Altman’s “Z” Score Multiple Discriminant Analysis (MDA) statistical technique similar to regression analysis. Used to classify companies in two groups: High probability of bankruptcy Low probability of bankruptcy High probability of bankruptcy exists when: * 1. There is high leverage(Mkt. Value of Stk./Book value of Debt) X-4 * 2. Low liquidity(NWC/Assets) X-1 * 3. Low return on assets(EBIT/Assets) X-3 * 4. Poor asset utilization(Sales/Total Assets) X-5 * 5. Poor reinvestment opportunities (RE/TA) X-2 * all in extended Du Pont equation. MDA helps determine the actual probability of bankruptcy for a given level of any of above ratios plus it captures the effect of the interrelationship between the ratios. It is a technique used very much in banks & S&Ls in granting credit to customers; investment banks rating bonds (specially junk bonds). 84% success in predicting 2 years ahead. 70% success in predicting 5 years ahead.

35. 3 - 35 Simplified D’Leon Data A/R878 Debt1,945 Other CA1,802 Equity1,552 Net FA 817 Total assets$3,497 L&E$3,497 Q. How would reducing DSO to 32 days affect the company? Sales $7,035,600 day 360 = = $19,543. 3 - 31

36. 3 - 36 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. 3 - 32

37. 3 - 37 What could be done with the new cash? Effect on stock price and risk? New Balance Sheet Added cash$ 253Debt$1,945 A/R625Equity1,552 Other CA1,802 Net FA 817 Total assets$3,497Total L&E$3,497 3 - 33

38. 3 - 38 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. All these actions would improve stock price. 3 - 34

39. 3 - 39 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--similar to what was done with DSO in slides #31 - #33. 3 - 35

40. 3 - 40 Q.Would you lend money to the company? A.Maybe. Things could get better. In business, one has to take some chances! 3 - 36

41. 3 - 41 Company should not have relied exclusively on debt to finance its expansion. 3 - 37

42. 3 - 42 I. Examination or Analysis: A. Statement of Cash Flow B. Ratios II. Diagnosis or conclusions about the situation: An expansion began in 1996, which was financed with Long Term and Short Term debt. (Evident on the ratios and the balance sheets). The company apparently assumed that sales and profits would increase automatically with the expansion. Sales actually lagged and all ratios deteriorated in 1997. As sales in ‘97 increased consistently in subsequent months they provided support for a more optimistic sales forecast for 1998. All ratios improve dramatically in ‘98 except collection period or DSO. D’LEON Analysis/Diagnosis/Prescription

43. 3 - 43 III. Prescription or recommendations: In hindsight, before the company took on its expansion plans, it should have done an extensive ratio analysis to determine the effects of its proposed expansion on the firm’s operations. Had the ratio analysis been conducted, the company would have “gotten its house in order” before undergoing the expansion. For instance it would have used equity financing for part of the expansion. Without it they should not have expanded. The equity financing is indispensable for plant and capacity expansion because this source of funding does not require interest, principal, or dividend payments, giving the firm time to slowly increase its sales to utilize the added capacity and time to reach its eventual profitability target. That is a more conservative sales growth plan should have been assumed and the expansion at least partly financed by equity. Even losses could have been planned as is often the case after an expansion of plant capacity. The ratios in 1998 are pretty acceptable, except for two, and show the expected increase in sales. If the sales materialize they will be fine. If not, they may have to raise some equity financing and pay back some of the debt. The two ratios that are still deficient even in 1998 are DSO and Total Asset Turnover. Which show that the company credit policy is too lose and needs to be tightened. If they can improve their collections they can decrease the DSO and hence the invested funds into accounts receivable. Illustrated in blueprints 3-31 through 3-34. On the other hand, if the lenient credit is part of a predetermined strategy to increase sales to plant capacity by capturing a larger share of the market while the products become popular, then the higher level of receivables will have to be sustained but more equity financing might be required. All in all, the Co. seems to have very short run expansion or growing pains principally because all the expansion was financed with debt.

44. 3 - 44 What are some potential problems and limitations of financial ratio analysis? Comparison with industry averages is difficult if the firm operates many different divisions. 3 - 38

45. 3 - 45 “Average” performance not necessarily good. Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better. 3 - 39

46. 3 - 46 Different operating and accounting practices distort comparisons. Sometimes hard to tell if a ratio is “good” or “bad.” Difficult to tell whether company is, on balance, in strong or weak position. 3 - 40

47. 3 - 47 What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? Are the company’s revenues tied to 1 key customer? To what extent are the company’s revenues tied to 1 key product? To what extent does the company rely on a single supplier? (Cont…) 3 - 41

48. 3 - 48 What percentage of the company’s business is generated overseas? Competition Future prospects Legal and regulatory environment Management/Labor Relations and Productivity 3 - 42