3 1 CHAPTER 3 Analysis of Financial Statements

3 -1 CHAPTER 3 Analysis of Financial Statements n Ratio analysis n Du Pont system n Effects of improving ratios n Limitations of ratio analysis n Qualitative factors Copyright © 2005 Harcourt, Inc. All rights reserved.

3 -2 Balance Sheet: Assets Cash ST investments AR Inventories Total CA Gross FA Less: Deprec. Net FA Total assets Copyright © 2005 Harcourt, Inc. 2002 E 14, 000 71, 632 878, 000 1, 716, 480 2, 680, 112 1, 197, 160 380, 120 817, 040 3, 497, 152 2001 7, 282 0 632, 160 1, 287, 360 1, 926, 802 1, 202, 950 263, 160 939, 790 2, 866, 592 All rights reserved.

3 -3 Liabilities and Equity 2002 E Accounts payable 436, 800 Notes payable 600, 000 Accruals 408, 000 Total CL 1, 444, 800 Long-term debt 500, 000 Common stock 1, 680, 936 Retained earnings (128, 584) Total equity 1, 552, 352 Total L&E 3, 497, 152 Copyright © 2005 Harcourt, Inc. 2001 524, 160 720, 000 489, 600 1, 733, 760 1, 000 460, 000 (327, 168) 132, 832 2, 866, 592 All rights reserved.

3 -4 Income Statement 2002 E 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) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 -5 Other Data Shares out. EPS DPS Stock price Lease pmts Copyright © 2005 Harcourt, Inc. 2002 E 250, 000 $1. 014 $0. 220 $12. 17 $40, 000 2001 100, 000 ($5. 199) $0. 110 $2. 25 $40, 000 All rights reserved.

3 -6 Why are ratios useful? n Standardize numbers; facilitate comparisons n Used to highlight weaknesses and strengths Copyright © 2005 Harcourt, Inc. All rights reserved.

3 -7 What are the five major categories of ratios, and what questions do they answer? n Liquidity: Can we make required payments as they fall due? n Asset management: Do we have the right amount of assets for the level of sales? (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 -8 n Debt management: Do we have the right mix of debt and equity? n Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? n Market value: Do investors like what they see as reflected in P/E and M/B ratios? Copyright © 2005 Harcourt, Inc. All rights reserved.

3 -9 Calculate the firm’s forecasted current and quick ratios for 2002. CA CR 02 = CL $2, 680 = $1, 445 = 1. 85 x. QR 02 = CA - Inv. CL $2, 680 - $1, 716 = = 0. 67 x. $1, 445 Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 10 Comments on CR and QR CR 2002 E 1. 85 x 2001 1. 1 x 2000 2. 3 x Ind. 2. 7 x QR 0. 67 x 0. 4 x 0. 8 x 1. 0 x n Expected to improve but still below the industry average. n Liquidity position is weak. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 11 What is the inventory turnover ratio as compared to the industry average? Sales Inv. turnover = Inventories $7, 036 = = 4. 10 x. $1, 716 2002 E Inv. T. 4. 1 x Copyright © 2005 Harcourt, Inc. 2001 4. 5 x 2000 4. 8 x Ind. 6. 1 x All rights reserved.

3 - 12 Comments on Inventory Turnover n Inventory turnover is below industry average. n Firm might have old inventory, or its control might be poor. n No improvement is currently forecasted. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 13 DSO is the average number of days after making a sale before receiving cash. Receivables DSO = Average sales per day Receivables $878 = = Sales/360 $7, 036/360 = 44. 9 days. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 14 Appraisal of DSO 2002 E 2001 2000 Ind. 44. 9 39. 0 36. 8 32. 0 n Firm collects too slowly, and situation is getting worse. n Poor credit policy. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 15 Fixed Assets and Total Assets Turnover Ratios Fixed assets Sales = turnover Net fixed assets = $7, 036 = 8. 61 x. $817 Total assets = turnover Sales Total assets $7, 036 = = 2. 01 x. $3, 497 (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 16 2002 E 2001 2000 Ind. FA TO 8. 6 x 6. 2 x 10. 0 x 7. 0 x TA TO 2. 0 x 2. 3 x 2. 5 x n FA turnover is expected to exceed industry average. Good. n TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory). Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 17 Calculate the debt, TIE, and EBITDA coverage ratios. Total debt Debt ratio = Total assets $1, 445 + $500 = = 55. 6%. $3, 497 EBIT TIE = Int. expense $502. 6 = = 6. 3 x. $80 Copyright © 2005 Harcourt, Inc. (More…) All rights reserved.

3 - 18 EBITDA coverage = EC EBIT + Depr. & Amort. + Lease payments Interest Lease Loan pmt. + + expense pmt. = $502. 6 + $120 + $40 $80 + $40 + $0 = 5. 5 x. All three ratios reflect use of debt, but focus on different aspects. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 19 How do the debt management ratios compare with industry averages? 2002 E D/A 2001 2000 Ind. 55. 6% 95. 4% 54. 8% 50. 0% TIE 6. 3 x -3. 9 x 3. 3 x 6. 2 x EC 5. 5 x -2. 5 x 2. 6 x 8. 0 x Too much debt, but projected to improve. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 20 Profit Margin (PM) NI $253. 6 PM = = = 3. 6%. Sales $7, 036 PM 2002 E 2001 2000 Ind. 3. 6% -8. 9% 2. 6% 3. 6% Very bad in 2001, but projected to meet industry average in 2002. Looking good. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 21 Basic Earning Power (BEP) EBIT BEP = Total assets $502. 6 = $3, 497 = 14. 4%. (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 22 2002 E BEP 2001 2000 Ind. 14. 4% -24. 1% 14. 2% 17. 8% n BEP removes effect of taxes and financial leverage. Useful for comparison. n Projected to be below average. n Room for improvement. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 23 Return on Assets (ROA) and Return on Equity (ROE) Net income ROA= Total assets $253. 6 = $3, 497 = 7. 3%. (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 24 Net income ROE = Common equity = $253. 6 = 16. 3%. $1, 552 2002 E 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. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 25 Effects of Debt on ROA and ROE n ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. n However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 26 Calculate and appraise the P/E, P/CF, and M/B ratios. Price = $12. 17. NI $253. 6 EPS = = = $1. 01. Shares out. 250 Price per share $12. 17 P/E = = = 12 x. EPS $1. 01 (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 27 Typical industry average P/E ratios Industry Banking Computer Software Services Drug Electric Utilities (Eastern U. S. ) Internet Services* Semiconductors Steel Tobacco Water Utilities P/E ratio 17. 15 33. 01 41. 81 19. 40 290. 35 78. 41 12. 71 11. 59 21. 84 * Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 28 NI + Depr. CF per share = Shares out. = $253. 6 + $120. 0 = $1. 49. 250 Price per share P/CF = Cash flow per share $12. 17 = = 8. 2 x. $1. 49 Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 29 Com. equity BVPS = Shares out. $1, 552 = = $6. 21. 250 Mkt. price per share M/B = Book value per share $12. 17 = = 2. 0 x. $6. 21 (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 30 P/E P/CF M/B 2002 E 2001 2000 Ind. 12. 0 x -0. 4 x 9. 7 x 14. 2 x 8. 2 x -0. 6 x 8. 0 x 7. 6 x 2. 0 x 1. 7 x 1. 3 x 2. 9 x n P/E: How much investors will pay for $1 of earnings. High is good. n M/B: How much paid for $1 of book value. Higher is good. n P/E and M/B are high if ROE is high, risk is low. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 31 Common Size Balance Sheets: Divide all items by Total Assets 2000 2001 2002 E Ind. Cash 0. 6% 0. 3% 0. 4% 0. 3% ST Invest. 3. 3% 0. 0% 2. 0% 0. 3% 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% Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 32 Divide all items by Total Liabilities & Equity 2000 AP 9. 9% Notes pay. 13. 6% Accruals 9. 3% Total CL 32. 8% LT Debt 22. 0% Total equ. 45. 2% Total L&E 100. 0% Copyright © 2005 Harcourt, Inc. 2001 18. 3% 25. 1% 17. 1% 60. 5% 34. 9% 4. 6% 100. 0% 2002 E 12. 5% 17. 2% 11. 7% 41. 3% 14. 3% 44. 4% 100. 0% Ind. 11. 9% 2. 4% 9. 5% 23. 7% 26. 3% 50. 0% 100. 0% All rights reserved.

3 - 33 Analysis of Common Size Balance Sheets n Computron has higher proportion of current assets (49. 1%) than Industry (41. 2%). n Computron has slightly less equity (which means more debt) than Industry. n Computron has more short-term debt than industry, but less long-term debt than industry. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 34 Common Size Income Statement: Divide all items by Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI 2000 100. 0% 83. 4% 9. 9% 0. 6% 6. 1% 1. 8% 4. 3% 1. 7% 2. 6% Copyright © 2005 Harcourt, Inc. 2001 2002 E Ind. 100. 0% 98. 2% 86. 7% 84. 5% 11. 7% 4. 4% 2. 0% 1. 7% 4. 0% -11. 8% 7. 1% 3. 0% 1. 1% -14. 9% 6. 0% 5. 9% -5. 9% 2. 4% -8. 9% 3. 6% All rights reserved.

3 - 35 Analysis of Common Size Income Statements n Computron has higher COGS (86. 7) than industry (84. 5), but lower depreciation. Result is that Computron has similar EBIT (7. 1) as industry. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 36 Percentage Change Analysis: Find Percentage Change from First Year (2000) Income St. Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI 2000 0. 0% 0. 0% Copyright © 2005 Harcourt, Inc. 2001 70. 0% 100. 0% 518. 8% -430. 3% 181. 6% -691. 1% 2002 E 105. 0% 113. 0% -8. 0% 534. 9% 140. 4% 28. 0% 188. 3% All rights reserved.

3 - 37 Analysis of Percent Change Income Statement n We see that 2002 sales grow 105% from 2000, and that NI grows 188% from 2000. n So Computron has become more profitable. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 38 Percentage Change Balance Sheets Assets Cash ST Invest. AR Invent. Total CA Net FA TA Copyright © 2005 Harcourt, Inc. 2000 0. 0% 0. 0% 2001 -19. 1% -100. 0% 80. 0% 71. 4% 172. 6% 95. 2% 2002 E 55. 6% 47. 4% 150. 0% 140. 0% 138. 4% 137. 0% 138. 1% All rights reserved.

3 - 39 Liab. & Eq. AP Notes pay. Accruals Total CL LT Debt Total equity Total L&E Copyright © 2005 Harcourt, Inc. 2000 0. 0% 0. 0% 2001 260. 0% 209. 2% -80. 0% 95. 2% 2002 E 200. 0% 54. 6% 133. 9% 138. 1% All rights reserved.

3 - 40 Analysis of Percent Change Balance Sheets n 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. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 41 Explain the Du Pont System ( Profit margin )( )( TA turnover NI Sales x Sales TA x 2000 2. 6% x 2. 3 2001 -8. 9% x 2. 0 2002 3. 6% x 2. 0 Ind. 3. 6% x 2. 5 Copyright © 2005 Harcourt, Inc. ) Equity = ROE multiplier x x TA CE = ROE. 2. 2 21. 6 2. 3 2. 0 = 13. 2% = -391. 0% = 16. 3% = 18. 0% All rights reserved.

3 - 42 The Du Pont system focuses on: n Expense control (PM) n Asset utilization (TATO) n Debt utilization (EM) It shows how these factors combine to determine the ROE. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 43 Simplified Firm Data A/R $ 878 Debt Other CA 1, 802 Equity Net FA 817 Total assets $3, 497 L&E Sales day $1, 945 1, 552 $3, 497 $7, 035, 600 = = $19, 543. 360 Q. How would reducing DSO to 32 days affect the company? Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 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. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 45 New Balance Sheet Added cash A/R Other CA Net FA Total assets $ 253 Debt $1, 945 625 Equity 1, 552 1, 802 817 $3, 497 Total L&E $3, 497 What could be done with the new cash? Effect on stock price and risk? Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 46 Potential use of freed up cash n Repurchase stock. Higher ROE, higher EPS. n Expand business. Higher profits. n Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 47 n 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. n All these actions would likely improve stock price. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 48 Would you lend money to this company? n Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. n However, company should not have relied so heavily on debt financing in the past. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 49 What are some potential problems and limitations of financial ratio analysis? n Comparison with industry averages is difficult if the firm operates many different divisions. n “Average” performance is not necessarily good. n Seasonal factors can distort ratios. (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 50 n Window dressing techniques can make statements and ratios look better. n Different accounting and operating practices can distort comparisons. n Sometimes it is difficult to tell if a ratio value is “good” or “bad. ” n 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. Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 51 What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? n Are the company’s revenues tied to a single customer? n To what extent are the company’s revenues tied to a single product? n To what extent does the company rely on a single supplier? (More…) Copyright © 2005 Harcourt, Inc. All rights reserved.

3 - 52 n What percentage of the company’s business is generated overseas? n What is the competitive situation? n What does the future have in store? n What is the company’s legal and regulatory environment? Copyright © 2005 Harcourt, Inc. All rights reserved.