Chapter 4 Analysis of Financial Statements Ratio Analysis

Chapter 4 Analysis of Financial Statements Ratio Analysis Du. Pont Equation Effects of Improving Ratios Limitations of Ratio Analysis Qualitative Factors 4 -1 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Why are ratios useful? • • • Ratios standardize numbers & facilitate comparisons Ratios are used to highlight weaknesses & strengths Comparisons through time & with competitors 1. 2. 3. Trend analysis Industry analysis Benchmark (peer) analysis 4 -2 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Five Major Categories of Ratios and the Questions They Answer 1. Liquidity: Can we make required payments? 2. Asset management: Right amount of assets vs. sales? 3. Debt management: Right mix of debt & equity? 4. Profitability: Do sales prices exceed unit costs & are sales high enough as reflected in PM, ROE, and ROA? 5. Market value: Do investors like what they see as reflected in P/E and M/B ratios? 4 -3 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Deprec. Net FA Total Assets 2013 E 85, 632 878, 000 1, 716, 480 2, 680, 112 1, 197, 160 380, 120 817, 040 3, 497, 152 2012 7, 282 632, 160 1, 287, 360 1, 926, 802 1, 202, 950 263, 160 939, 790 2, 866, 592 4 -4 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Balance Sheet: Liabilities & Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2013 E 436, 800 300, 000 408, 000 1, 144, 800 400, 000 1, 721, 176 231, 176 1, 952, 352 3, 497, 152 2012 524, 160 636, 808 489, 600 1, 650, 568 723, 432 460, 000 32, 592 492, 592 2, 866, 592 4 -5 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Income Statement Sales COGS Other expenses EBITDA Deprec. & amort. EBIT Interest exp. EBT Taxes Net income 2013 E 7, 035, 600 5, 875, 992 550, 000 609, 608 116, 960 492, 648 70, 008 422, 640 169, 056 253, 584 0 0 2012 6, 034, 00 5, 528, 00 519, 988 (13, 988) 116, 960 (130, 948 ) 136, 012 4 -6 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Other Data No. of shares EPS DPS Stock price Lease pmts 2013 E 250, 000 $1. 014 $0. 220 $12. 17 $40, 000 2012 100, 000 -$1. 602 $0. 110 $2. 25 $40, 000 4 -7 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Liquidity Ratios 4 -8 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Ratio & Quick Ratio Forecasted for 2013 4 -9 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comments on Liquidity Ratios • • • 2013 E 2012 2011 Ind. Current ratio 2. 34 x 1. 20 x 2. 30 x 2. 70 x Quick ratio 0. 84 x 0. 39 x 0. 85 x 1. 00 x Expected to improve but still below industry average Liquidity position is weak. Too high Current Ratio could indicate: 1. A strong liquid position & inefficient utilization • too much cash & other current assets relative to sales 2. The firm has lots of inventory that it can’t sell 4 -10 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Asset management Ratios 4 -11 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Inventory Turnover vs. the Industry Average Inv. turnover = Sales/Inventories = $7, 036/$1, 716 = 4. 10 x Measures how much inventory item is sold & restocked, or “turned over” Inventory turnover 2013 E 2012 2011 Ind. 4. 1 x 4. 70 x 4. 8 x 6. 1 x 4 -12 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comments on Inventory Turnover • • Inventory turnover is below industry average • No improvement is currently forecasted Might have old inventory, or its control might be poor – Inventory is not a good investment if there is no demand Ø Why would the inventory turnover ratio be more important for a company like Sultan Center than it is for Kuwait Insurance Company? 4 -13 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

DSO: Average Number of Days after Making a Sale before Receiving Cash DSO = Receivables/Avg. sales per day = Receivables/(Annual sales/365) = $878/($7, 036/365) = 45. 6 days 4 -14 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Appraisal of DSO • • 2013 E 2012 2011 Ind. 45. 6 38. 2 37. 4 32. 0 Collects on sales too slowly, and is getting worse Has a poor credit policy 4 -15 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 4 -16 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Fixed Assets & Total Assets Turnover Ratios FA turnover = Sales/Net fixed assets = $7, 036/$817 = 8. 61 x TA turnover = Sales/Total assets = $7, 036/$3, 497 = 2. 01 x 4 -17 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

FA & TA Turnover (S/TA) vs. the Industry Average • • 2013 E 2012 2011 Ind. FA TO 8. 6 x 6. 4 x 10. 0 x 7. 0 x TA TO 2. 0 x 2. 1 x 2. 3 x 2. 6 x FA turnover projected to exceed the industry average TA turnover below the industry average. • Caused by excessive currents assets (A/R & Inventory) 4 -18 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Debt management Ratios 4 -19 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Debt & Risk Why firm use debt? • If a firm earns more on its assets than its debt, it will be able to leverage up the ROE • However, debt is more risky than equity 4 -20 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

21

Debt Ratio & Times-Interest-Earned Ratio Debt ratio = Total debt/Total assets = ($1, 145 + $400)/$3, 497 = 44. 2% TIE = EBIT/Interest charges = $492. 6/$70 = 7. 0 x 4 -22 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Debt Management Ratios vs. Industry Averages • 2013 E 2012 2011 Ind. D/A 44. 2% 82. 8% 54. 8% 50. 0% TIE 7. 0 x -1. 0 x 4. 3 x 6. 2 x D/A & TIE are better than the industry average ü Allow a firm to borrow cheaply 4 -23 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Ratios 4 -24 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Ratios • BEP removes the effects of taxes & financial leverage o Shows earning power before the effect of debt & taxes o Useful for comparing firms with different debt structures 4 -25 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Appraising Profitability Operating margin Profit margin Basic earning power 2013 E 2012 7. 0% -2. 2% 3. 6% -2. 7% 14. 1% -4. 6% 2011 Ind. 5. 6% 7. 3% 2. 6% 3. 5% 13. 0% 19. 1% • Operating margin was very bad in 2012. • Profit margin was very bad in 2012 but is projected to exceed the industry average in 2013. Looking good • – Projected to improve in ‘ 13, but it is still remain below ind avg BEP projected to improve, yet below the industry average. – There is definitely room for improvement 4 -26 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

4 -27 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Ratios Return on Assets & Return on Equity ROA = Net income/Total assets = $253. 6/$3, 497 = 7. 25% Sometimes can be low because of the high use of debt – Need to look at the big picture not just one ratio ROE = Net income/Total common equity = $253. 6/$1, 952 =12. 99% 13. 00% ROIC = [EBIT(1 T)]/Total invested capital • = $295. 6/$2, 652. 4 = 11. 14% ROE is the most important ratio 4 -28 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Appraising Profitability ROA ROE ROIC • • 2013 E 2014 2013 7. 25% -5. 59% 5. 99% 12. 99% -32. 52% 13. 25% 11. 14% -4. 24% 9. 62% Ind. 9. 10% 18. 20% 14. 50% All ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. Ø More improvement is needed Wide variations in ROE illustrate the effect that leverage can have on profitability 4 -29 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Ratios § § Why does the use of debt lower the profit margin & ROA? Why doesn’t debt have the same effect on the ROE? Debt Lower net income, but its lower firm’s equity, and equity reduction can offset the lower net income 30 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Effects of Debt on ROA & ROE • Holding assets constant, if debt increases: • • ROA declines (due to the reduction in net income). – Equity declines – Interest expense increases – Which leads to a reduction in net income. ROE may increase or decrease – since both net income a& equity decline 4 -31 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Problems with ROE • • ROE & shareholder wealth are correlated Problems can arise when ROE is the sole measure of performance: 1. ROE does not consider risk 2. Does not consider the amount of capital invested 3. Managers turn down profitable projects • So, reliance on ROE may encourage managers to make investments that do not benefit shareholders. 4 -32 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 4 -33 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 4 -34 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Market value Ratios 4 -35 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Price/Earnings & Market/Book Ratios P/E = Price/Earnings per share = $12. 17/$1. 014 = 12. 0 x M/B = Market price/Book value per share = $12. 17/($1, 952/250) = 1. 56 x 2013 E 2012 2011 Ind. P/E 12. 0 x -1. 4 x 9. 7 x 14. 2 x M/B 1. 56 x 0. 5 x 1. 3 x 2. 4 x 4 -36 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Analyzing the Market Value Ratios • • P/E: How much investors are willing to pay for $1 of earnings. M/B: How much investors are willing to pay for $1 of book value equity. For each ratio, the higher the number, the better – Either high growth, low risk, or both P/E &M/B are high if ROE is high & risk is low. 4 -37 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 4 -38 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

4 -39 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

The Du. Pont Equation • Focuses on expense control (PM), asset utilization (TA TO) & debt utilization (equity multiplier) Why do we break it up? • To better understand the ROE comes from & find any areas for improvement 4 -40 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

4 -41 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Suppose you were comparing Gap with Louis Vuitton. Suppose further both firms had the same ROE. Using the Du. Pont equation, would you expect the three components to be the same for both firms? Profit Margins & turnover ratios vary from one industry to another. 42 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Du. Pont Equation: Breaking Down Return on Equity ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) = 3. 6% x 2 x 1. 8 = 13. 0% 2011 2012 2013 E Ind. PM 2. 6% -2. 7% 3. 6% 3. 5% TA TO 2. 3 2. 1 2. 0 2. 6 EM 2. 2 5. 8 1. 8 2. 0 ROE 13. 3% -32. 5% 13. 0% 18. 2% 4 -43 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 4 -44 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 4 -45 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

An Example: The Effects of Improving Ratios A/R Other CA Net FA TA $ 878 1, 802 817 $3, 497 Debt $1, 545 Equity Total L&E 1, 952 $3, 497 Sales/Day = $7, 035, 600/365 = $19, 275. 62 How would reducing the firm’s DSO to 32 days affect the company? 4 -46 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Reducing Accounts Receivable & Days Sales Outstanding • Reducing A/R will have no effect on sales • Initially shows up as addition to cash. 4 -47 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Effect of Reducing Receivables on Balance Sheet and Stock Price Added Cash A/R Other CA Net FA Total Assets $ 261 617 1, 802 817 $3, 497 Debt $1, 545 Equity Total L&E 1, 952 $3, 497 What could be done with the new cash? How might stock price and risk be affected? 4 -48 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Potential Uses of Freed Up Cash 1. Repurchase stock 2. Expand business 3. Reduce debt ü All these actions would likely improve the stock price 4 -49 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Benchmarking • • Ratios are not compared to industry average Instead to specific companies 1. Very comparable 2. Industry leaders 4 -50 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Potential Problems & Limitations of Financial Ratio Analysis • • Comparison with industry is difficult for a conglomerate firm – Operates in many different divisions Different operating & accounting practices can distort comparison “Average”is not always good, perhaps firm should aim higher Sometimes it is hard to tell if a ratio is “good” or “bad” – Difficult to tell whether it is in a strong or weak position Seasonal factors can distort ratios “Window dressing” can make ratios look better Inflation has distorted many firms’ balance sheets – So, Analyses must be interpreted with judgment 4 -51 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Consider Qualitative Factors When Evaluating a Company’s Future Financial Performance 1. Are the firm’s revenues tied to one key customer, product, or supplier? 2. What percentage of the firm’s business is generated overseas? 3. Firm’s competitive environment 4. Future prospects 5. Legal and regulatory environment 4 -52 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.