1. 5 - 1 Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors CHAPTER 5 Analysis of Financial Statements

2. 5 - 2 Cajun Made’s Balance Sheet: Assets 1999E1998 Cash85,6327,282 AR878,000632,160 Inventories1,716,4801,287,360 Total CA2,680,1121,926,802 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. 5 - 3 Liabilities and Equity 1999E1998 Accounts payable436,800524,160 Notes payable600,000720,000 Accruals 408,000 489,600 Total CL1,444,8001,733,760 Long-term debt500,0001,000,000 Common stock1,680,936460,000 Retained earnings(128,584)(327,168) Total equity1,552,352 132,832 Total L & E3,497,1522,866,592

4. 5 - 4 Cajun Made’s Income Statement 1999E1998 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)

5. 5 - 5 Other Data 1999E1998 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. 5 - 6 The Use of Financial Ratios Financial ratio is a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm’s operations and status. Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm’s performance and status.

7. 5 - 7 Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths There are two types of ratio comparisons that can be made Cross-Sectional Analysis Time-Series Analysis Why are ratios useful?

8. 5 - 8 Liquidity: Can we make required payments? A “liquid firm” is one that can meet its short- term obligations as they come due. Asset management (Activity): Right amount of assets vs. sales? Activity is a more sophisticated analysis of a firm’ liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm’s efficiency. What are the five major categories of ratios, and what questions do they answer?

9. 5 - 9 Debt management: Right mix of debt and equity? Debt is a “double-edged” sword as it allows for the generation of profits with the use of other people’s (creditors) money, but creates claims on earnings with a higher priority than those of the firm’s owners. Financial Leverage is a term for the magnification of risk and return resulting from the use of fixed-cost financing such as debt & preferred stock. There are two general types of Debt Measures. Degree of Indebtedness Ability to Service Debts

10. 5 - 10 Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? These measure assess the firm’s ability to operate efficiently and are of concern to owners, creditors, and management. A common-size income statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales. Market value: Do investors like what they see as reflected in P/E and M/B ratios?

11. 5 - 11 Calculate Cajun Made’s Expected current and quick ratios for 1999. CR 99 = = = 1.85x. QR 99 = = = 0.67x. CA CL $2,680 $1,445 $2,680 - $1,716 $1,445 CA - Inv. CL

12. 5 - 12 Expected to improve but still below the industry average. Liquidity position is weak. Comments on CR and QR 199919981997Ind. CR1.85x1.1x2.3x2.7x QR0.67x0.4x0.8x1.0x

13. 5 - 13 What is the inventory turnover ratio vs. the industry average? Inv. turnover= = = 3.34x. COGS Inventories $5,728 $1,716 199919981997Ind. Inv. T.3.34X4.45x4.0x6.1x

14. 5 - 14 Inventory turnover is below industry average. Cajun Made might have old inventory, or its control might be poor. No improvement is currently forecasted. Comments on Inventory Turnover

15. 5 - 15 Receivables Average sales per day Average Collection Period (DSO) is the average number of days after making a sale before receiving cash. ACP= = = = 44.9. Receivables Sales/360 $878 $7,036/360

16. 5 - 16 Appraisal of ACP (DSO) nCajun Made collects too slowly, and is getting worse. Poor credit policy. 199919981997Ind. ACP44.939.036.832.0

17. 5 - 17 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

18. 5 - 18 FA turnover project to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inv.) 1999 1998 1997 Ind. FA TO8.6x6.2x10.0x7.0x TA TO2.0x2.0x2.3x2.6x

19. 5 - 19 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

20. 5 - 20 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

21. 5 - 21 Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 1999 1998 1997 Ind. D/A55.6%95.4%54.8%50.0% TIE5.8x-3.9x3.3x6.2x FCC4.3x-3.0x2.4x5.1x

22. 5 - 22 Very bad in 1998, but projected to exceed industry average in 1999. Looking good. Profit margin vs. industry average? 199919981997Ind. P.M.3.6%-8.9%2.6%3.5% P.M. = = = 3.6%. NI Sales $253.6 $7,036

23. 5 - 23 BEP= = = 14.6%. BEP vs. Industry Average? EBIT Total assets $510.6 $3,497

24. 5 - 24 BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 199919981997Ind. BEP14.6%-24.1%14.2%19.1%

25. 5 - 25 Return on Assets ROA= = = 7.3%. Net income Total assets $253.6 $3,497

26. 5 - 26 ROE= = = 16.3%. Net income Common equity $253.6 $1,552 1999 1998 1997 Ind. ROA7.3%-18.1%6.0%9.1% ROE16.3%-391.0%13.3%18.2% Both below average but improving.

27. 5 - 27 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

28. 5 - 28 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

29. 5 - 29 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

30. 5 - 30 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. 1999 1998 1997 Ind. P/E12.0x-0.4x9.7x14.2x M/B1.96x1.7x1.3x2.4x

31. 5 - 31 ( )( )( ) = ROE x x = ROE. Profit margin TA turnover Equity multiplier NI Sales TA CE 19972.6%x2.3x2.2=13.2% 1998-8.9%x2.0x21.9=-391.0% 19993.6%x2.0x2.3=16.3% Ind.3.5%x2.6x2.0=18.2%

32. 5 - 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.

33. 5 - 33 Simplified Cajun Made Data A/R878 Debt 1,945 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.

34. 5 - 34 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.

35. 5 - 35 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

36. 5 - 36 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.

37. 5 - 37 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 #33 - #35.

38. 5 - 38 Q.Would you lend money to the company? A.Maybe. Things could get better. In business, one has to take some chances!

39. 5 - 39 Cajun Made should not have relied exclusively on debt to finance its expansion.

40. 5 - 40 What are some potential problems and limitations of financial ratio analysis? Comparison with industry averages is difficult if the firm operates many different divisions. A single ratio rarely tells enough to make a sound judgement Audited Financial statements are more reliable than un-audited statements.

41. 5 - 41 “Average” performance not necessarily good. Seasonal factors can distort ratios. Inflation can distort comparisons. “Window dressing” techniques can make statements and ratios look better.

42. 5 - 42 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. Ratios should be computed in the same manner For example, Inventory Turnover can be computed as Sales/Ending Inventory, COGS/Ending Inventory, or COGS/Average Inventory (I can show you three different texts with three different computations). You must be consistent in your computations.

43. 5 - 43 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…)

44. 5 - 44 What percentage of the company’s business is generated overseas? Competition Future prospects Legal and regulatory environment