1. 1 Chapter 4 Analysis of Financial Statements

2. 2 Learning Objectives  Measure and interpret financial ratios.  Analyze trends in financial ratios.  Manipulate financial ratios to find another ratio.

3. 3 Ratio Analysis  Examines firm’s management of various facets of the company’s business through its financial statements.  Scales balance sheet and income statement information for easy comparison across time or to other companies.

4. 4 Two common approaches  Trend Analysis - looks at changes in one company’s ratios over time.  Benchmarking: Comparison or Industry Analysis - compares company’s ratios against a similar company or against industry-wide ratios.  To illustrate trend analysis, we will compare Best Buy’s Feb. 2006 and Feb. 2005 ratios.  To illustrate benchmarking, we will calculate Best Buy’s Feb. 2006 ratios and will compare to Circuit City’s Feb. 2006 ratios.

5. 5 Areas Examined by Ratio Analysis  Liquidity - measures the ability to meet short- term obligations  Asset Management - measures the ability to contain the growth of assets, and the ability to effectively utilize assets  Debt Management - measures the use of financial leverage (debt) and its impact  Profitability - measures the profitability of various segments of a company

6. 6 Liquidity Ratios Feb. 2006Feb. 2005 Best Buy Current1.321.39 Best Buy Quick0.770.82 Circuit City Current1.75 Circuit City Quick0.70

7. 7 Asset Management Ratios Feb. 2006Feb. 2005 Best Buy InvTurn9.249.62 Best Buy DSO5.994.99 Circuit City InvTurn6.83 Circuit City DSO8.06

8. 8 Asset Management (Continued) Feb-06Feb-05 Best Buy Fixed asset turnover 11.3711.13 Best Buy Total asset turnover 2.602.66 Circuit City FAT 13.82 Circuit City TAT 2.85

9. 9 Debt Management Ratios Feb-06Feb-05 BB Debt ratio 55.7%56.8% BB TIE 108.5642.23 CC Debt Ratio52.0% CC TIE77.07

10. 10 Profitability Ratios Feb-06Feb-05 BB Profit margin 3.7%3.6% BB ROA 9.6% CC Profit Margin1.2% CC ROA3.4%

11. 11 Profitability Ratios (Continued) Feb-06Feb-05 BB BEP 14.6%14.4% BB ROE 21.7%22.1% CC BEP6.0% CC ROE7.1%

12. 12 Breaking Down ROE: DuPont Equation  ROE(NI/Eq) = Return on Assets (NI/TA) x Equity Multiplier (TA/Eq)  ROE = Profit Margin on Sales (NI/S) x Total Asset Turnover (S/TA) x TA/Eq Profit margin is a measure of the firm’s operating efficiency – how well does it control costs Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets Equity multiplier is a measure of the firm’s financial leverage

13. 13 DuPont Equation: Best Buy vs. Circuit City  *Since Assets = Liabilities + Equity, 1 – debt ratio = equity/assets meaning for Circuit City: Feb. 2006Profit Margin Asset Turnover Assets to Equity* ROE Best Buy3.7%2.602.25721.7% Circuit City 1.2%2.852.0827.1%

14. 14 Circuit City ROE Catch-up?  Circuit City would like to improve their ROE to 15%. They anticipate improvement in profit margin and total asset turnover to 2.0% and 3.0 respectively. What total debt to total asset ratio would be needed to achieve Circuit City’s ROE goal?

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16. 16 Some DuPont ROE Comparisons Trailing 12 Months PMTATEq MultROE S&P 50013.5%0.82.0722.4% Oil&Gas industry 11.5%1.41.8630.0% Electronics Store Ind. 3.2%2.82.2720.3% Microsoft28.5%0.61.6728.6% Nike8.8%1.61.5521.9% Yum! Brands 8.5%1.63.9954.3%

17. 17 Market Ratios Feb. 2006 Stock Price EPSFeb. 2006 P/E Ratio Recent P/E Best Buy$54.04$2.3323.221.7 Circuit City $24.03$0.8030.028.3

18. 18 Market Ratios Feb. 2006 Stock Price # of shares (000) BV/shM/B ratio Best Buy$54.04490,300$10.725.04 Circuit City $24.03174,400$11.212.14