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.

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 -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.

Balance Sheet: Liabilities and 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 -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.

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 2012 6, 034, 000 5, 528, 000 519, 988 (13, 988) 116, 960 (130, 948) 136, 012 (266, 960) (106, 784) 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. (160, 176)

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 -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.

Why are ratios useful? • • • Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths. Ratio comparisons should be made through time and with competitors. – Trend analysis – Industry analysis – Benchmark (peer) analysis 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.

Five Major Categories of Ratios and the Questions They Answer • • Liquidity: Can we make required payments? • • Debt management: Right mix of debt and equity? • Asset management: Right amount of assets vs. sales? 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? 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.

D’Leon’s Forecasted Current Ratio and Quick Ratio for 2013 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.

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 the industry average. Liquidity position is weak. 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.

D’Leon’s Inventory Turnover vs. the Industry Average Inv. turnover = Sales/Inventories = $7, 036/$1, 716 = 4. 10 x Inventory turnover 2013 E 2012 2011 Ind. 4. 1 x 4. 70 x 4. 8 x 6. 1 x 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.

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

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 -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.

Appraisal of DSO • • 2013 E 2012 2011 Ind. 45. 6 38. 2 37. 4 32. 0 D’Leon collects on sales too slowly, and is getting worse. D’Leon has a poor credit policy. 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.

Fixed Assets and Total Assets Turnover Ratios vs. the Industry Average 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 -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.

Evaluating the FA Turnover (S/Net FA) and TA Turnover (S/TA) Ratios • • 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 and Inv). 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.

Calculate the Debt Ratio and 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 -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.

D’Leon’s Debt Management Ratios vs. the 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 and TIE are better than the industry average. 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.

Profitability Ratios: Operating Margin, Profit Margin, and Basic Earning Power 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.

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power 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% 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.

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power • • Operating margin was very bad in 2012. It is projected to improve in 2013, but it is still projected to remain below the industry average. Profit margin was very bad in 2012 but is projected to exceed the industry average in 2013. Looking good. BEP removes the effects of taxes and financial leverage, and is useful for comparison. BEP projected to improve, yet still below the industry average. There is definitely room for improvement. 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.

Profitability Ratios: Return on Assets and Return on Equity ROA = Net income/Total assets = $253. 6/$3, 497 = 7. 3% ROE = Net income/Total common equity = $253. 6/$1, 952 = 13. 0% 4 -21 © 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 with ROA and ROE ROA ROE • • 2013 E 7. 3% 13. 0% 2012 -5. 6% -32. 5% 2011 6. 0% 13. 3% Ind. 9. 1% 18. 2% Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. Wide variations in ROE illustrate the effect that leverage can have on profitability. 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.

Effects of Debt on ROA and ROE • • • Holding assets constant, if debt increases: – Equity declines. – Interest expense increases – which leads to a reduction in net income. ROA declines (due to the reduction in net income). ROE may increase or decrease (since both net income and equity decline). 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.

Problems with ROE • • ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. – ROE does not consider risk. – ROE does not consider the amount of capital invested. Given these problems, reliance on ROE may encourage managers to make investments that do not benefit shareholders. As a result, analysts have looked to develop other performance measures, such as EVA. 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.

Calculate the Price/Earnings and 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 -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.

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. P/E and M/B are high if ROE is high and risk is low. 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.

The Du. Pont Equation • Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier). 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.

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 -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.

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 -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.

Reducing Accounts Receivable and the Days Sales Outstanding • Reducing A/R will have no effect on sales • Initially shows up as addition to cash. 4 -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.

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 -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.

Potential Uses of Freed Up Cash • • Repurchase stock Expand business Reduce debt All these actions would likely improve the stock price. 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.

Potential Problems and Limitations of Financial Ratio Analysis • • Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is “good” or “bad. ” Difficult to tell whether a company is, on balance, in a strong or weak position. 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.

More Issues Regarding Ratios • • “Average” performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better than they actually are. Inflation has distorted many firms’ balance sheets, so analyses must be interpreted with judgment. 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.

Consider Qualitative Factors When Evaluating a Company’s Future Financial Performance • • • Are the firm’s revenues tied to one key customer, product, or supplier? What percentage of the firm’s business is generated overseas? Firm’s competitive environment Future prospects Legal and regulatory environment 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.