FIN 638 Vicentiu Covrig Financial Statements Analysis chapter

FIN 638 Vicentiu Covrig Financial Statements Analysis (chapter 10) 1

FIN 638 Vicentiu Covrig Investing versus Speculating n n n Stock investors own a small part of the companies they hold. - Business ownership - In the long run, the stock will perform as well (or as poorly) as the underlying business. Speculating - Expectation of short-term trading profits from share-price fluctuations. - Underlying business is irrelevant So investors need to know about the underlying business! 2

FIN 638 Vicentiu Covrig Ratio analysis: Why are ratios useful? n Ratios standardize numbers and facilitate comparisons n Ratios are used to highlight weaknesses and strengths. n Ratio comparisons should be made through time and with competitors. - Trend analysis. - Peer (or industry) analysis. 3

FIN 638 Vicentiu Covrig What are the five major categories of ratios, and what questions do they answer? n n n Liquidity: Can we make required payments? Asset management: right amount of assets vs. sales? Debt management: Right mix of debt and equity? 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

FIN 638 Vicentiu Covrig D’Leon’s Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets 2009 E 85, 632 878, 000 1, 716, 480 2, 680, 112 1, 197, 160 380, 120 817, 040 3, 497, 152 5 2008 7, 282 632, 160 1, 287, 360 1, 926, 802 1, 202, 950 263, 160 939, 790 2, 866, 592

FIN 638 Vicentiu Covrig D’Leon’s Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2009 E 436, 800 300, 000 408, 000 1, 144, 800 400, 000 1, 721, 176 231, 176 1, 952, 352 3, 497, 152 6 2008 524, 160 636, 808 489, 600 1, 650, 568 723, 432 460, 000 32, 592 492, 592 2, 866, 592

FIN 638 Vicentiu Covrig D’Leon’s Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2009 E 7, 035, 600 5, 875, 992 550, 000 609, 608 116, 960 492, 648 70, 008 422, 640 169, 056 253, 584 7 2008 6, 034, 000 5, 528, 000 519, 988 (13, 988) 116, 960 (130, 948) 136, 012 (266, 960) (106, 784) (160, 176)

FIN 638 Vicentiu Covrig Other data No. of shares EPS DPS Stock price 2009 E 250, 000 $1. 014 $0. 220 $12. 17 8 2008 100, 000 -$1. 602 $0. 110 $2. 25

FIN 638 Vicentiu Covrig Calculate D’Leon’s forecasted current ratio for 2009. Current ratio = Current assets / Current liabilities = 2009 2008 2007 Ind. 2. 34 x 1. 20 x 2. 30 x 2. 70 x Expected to improve but still below the industry average. n Liquidity position is weak. See also the Quick ratio in text n 9

FIN 638 What is the inventory turnover vs. the industry average? Vicentiu Covrig Inv. turnover = Cost of Sales / Inventories = Inventory Turnover 2009 2008 2007 Ind. 3. 42 x 4. 29 x 4. 8 x 6. 1 x Inventory turnover is below industry average. D’Leon might have old inventory, or its control might be poor. 10

FIN 638 Vicentiu Covrig Calculate the debt ratio and EBIT coverage ratios. Debt to equity = long-term debt/ equity = Debt to total capital = Interest coverage = Long term debt / (equity +long term debt) = EBIT / Debt Interest charge = 11

FIN 638 Vicentiu Covrig How do the debt management ratios compare with industry averages? 2009 2008 2007 Ind. D/TC 17% 60% 54. 8% 50. 0% Int. cov. D/E 7. 0 x 20% -1. 0 x 140% 4. 3 x 120% 6. 2 x 170% 12

FIN 638 Vicentiu Covrig Profitability ratios: Profit margin PM = Net income / Sales = 2009 3. 6% 2008 -2. 7% 2007 2. 6% Ind. 3. 5% Profit margin was very bad in 2008, but is projected to exceed the industry average in 2003. . 13

FIN 638 Vicentiu Covrig Profitability ratios: Return on assets and Return on equity ROA = Net income / Total assets = ROE = Net income / Total common equity = ROA ROE n n 2009 2008 2007 7. 3% -5. 6% 6. 0% 13. 0% -32. 5% 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. 14

FIN 638 Vicentiu Covrig Calculate the Price/Earnings and Market/Book ratios P/E = Price / Earnings per share = M/B = Mkt price per share / Book value per share =(Book value is Total Assets minus Total Liabilities) 2009 2008 2007 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 15

FIN 638 Vicentiu Covrig Analyzing the market value ratios n n 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. 16

FIN 638 Vicentiu Covrig Extended Du. Pont equation: Breaking down Return on equity ROE = (Profit margin) x (TA turnover) x (Equity multiplier) = = 3. 6% 13. 0% 2007 2008 2009 E Ind. x PM 2. 6% -2. 7% 3. 6% 3. 5% 2 x TA TO 2. 3 2. 1 2. 0 2. 6 17 1. 8 EM 2. 2 5. 8 1. 8 2. 0 ROE 13. 3% -32. 5% 13. 0% 18. 2%

FIN 638 Vicentiu Covrig The Du Pont system Also can be expressed as: ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) n Focuses on: - Expense control (PM) - Asset utilization (TATO) - Debt utilization (Eq. Mult. ) n Shows how these factors combine to determine ROE. 18

FIN 638 Vicentiu Covrig Potential problems and limitations of financial ratio analysis n n n n Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. “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. 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 strong or weak position. 19

FIN 638 Vicentiu Covrig Can Financial Statements Be Trusted? n Accounting scandals n Accounting restatements - Changing the numbers… 20

FIN 638 Vicentiu Covrig Learning objectives Discuss about the stock market investment versus stock market speculation Know to calculate all the financial ratios that are on the slides. Know to interpret the financial ratios, based on the textbook Know the calculations and interpretation of the Du. Pont formula Discuss the problems relying on the financial statements, based on p. 310 -311 text End of chapter questions 10. 1 to 10. 4, CFA problems 10. 1 to 10. 4 Midterm exam type questions 21