Working With Financial Statements Chapter 3 Mc GrawHillIrwin

Working With Financial Statements Chapter 3 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Prepare for Capital Budgeting Part 2: Understand financial statement and cash flow C 2 -Identify cash flow from financial statement C 3 -Financial statement and comparison Part 3: Valuation of future cash flow C 4 -Basic concepts C 5 -More exercise Part 4: Valuing stocks and bonds C 6 -Bond C 7 -Stock Part 5: Capital budgeting 1 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Chapter Outline 1. 2. 3. 4. 5. Why Evaluate Financial Statements? Categories of Financial Ratios Du Pont Identity Payout, Retention Ratios, and Growth Rate Problems with Financial Statement 2 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

1. Evaluate Financial Statements n Performance evaluation – identifying problematic operation and adjusting forecasting target Internal uses n External uses n n n Creditors, Stockholders Suppliers, Customers n Planning for the future – estimating future cash flows 3 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Benchmarking n Time-Trend n Analysis Used to see how the firm’s performance is changing through time n Peer Group Analysis Compare to similar companies or within industries n SIC (Standard Industrial Classification) and NAICS (North American Industry Classification System) codes n 4 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Standardized Financial Statements n Common-Size Balance Sheets n n Compute all accounts as a percent of total assets Common-Size Income Statements n Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows n They are also useful for comparing companies of different sizes, particularly within the same industry n 5 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Balance Sheets 6 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Common-Size Balance Sheets 7 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Income Statements 8 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Common-Size Income Statements 9 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. Ratio Analysis n Ratios also allow for better comparison through time or between companies n As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important 10 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Categories of Financial Ratios n Short-term solvency or liquidity ratios n Long-term solvency or financial leverage ratios n Asset management or turnover ratios n Profitability ratios n Market value ratios 11 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Sample Balance Sheet Numbers in thousands Cash A/R 680, 623 A/P 318, 301 1, 051, 438 N/P 4, 613 Inventory 300, 459 Other CL 1, 645, 748 Other CA 415, 310 Total CL 1, 968, 662 Total CA 2, 447, 830 LT Debt 909, 814 Net FA 3, 415, 159 C/S 2, 984, 513 Total Assets 5, 862, 989 Total Liab. & Equity 5, 862, 989 12 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Sample Income Statement Numbers in thousands, except EPS & DPS Revenues 5, 250, 538 Cost of Goods Sold 2, 046, 645 Expenses 1, 904, 556 Depreciation & Amortization 124, 647 EBIT 1, 174, 690 Interest Expense 5, 785 Taxable Income Taxes 1, 168, 905 412, 495 Net Income 756, 410 EPS 3. 92 Dividends per share 1. 20 13 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 1 Short-term Solvency Measures: Liquidity Ratios Evaluate the firm’s ability to pay its bills over the short run without undue stress. n Current Ratio = CA / CL n 2, 447, 830 / 1, 968, 662 = 1. 24 times n Quick n (2, 447, 830 – 300, 459) / 1, 968, 662 = 1. 09 times n Cash n Ratio = (CA – Inventory) / CL Ratio = Cash / CL 680, 623 / 1, 968, 662 =. 346 times 14 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 2 Long-term Solvency Measures Evaluate the firm’s ability to meet Long-term obligations. n Leverage ratios n Coverage ratios 15 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Long-term Solvency Measures-1: Leverage Ratios n Total Debt Ratio = TD/TA= (TA – TE) / TA n n n Debt/Equity = TD / TE n n (5, 862, 989 – 2, 984, 513) / 5, 862, 989 =. 491 times or 49. 1% The firm finances slightly over 49% of their assets with debt. (5, 862, 989 – 2, 984, 513) / 2, 984, 513 =. 964 times Equity Multiplier (EM) = TA / TE = 1 + D/E n 1 +. 964 = 1. 964 16 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Long-term Solvency Measures-2: Coverage Ratios n Times n Interest Earned = EBIT / Interest 1, 174, 900 / 5, 785 = 203 times n Cash Coverage = (EBIT + Depr. & Amort. ) / Interest n (1, 174, 900 + 124, 647) / 5, 785 = 225 times 17 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 3 Asset Management Measures Evaluate how efficiently the firm uses its asset to generate sales. n Inventory ratios n Receivable ratios n Total asset turnover 18 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Asset Management Measures-1: Inventory Ratios n Inventory Turnover = Cost of Goods Sold / Inventory n 2, 046, 645 / 300, 459 = 6. 81 times n Days’ Sales in Inventory = 365 / Inventory Turnover n 365 / 6. 81 = 54 days 19 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Asset Management Measures-2: Receivables Ratios n Receivables Turnover = Sales / Accounts Receivable n 5, 250, 538 / 1, 051, 438 = 4. 99 times n Days’ Sales in Receivables = 365 / Receivables Turnover n 365 / 4. 99 = 73 days 20 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Asset Management Measures-3: Total Asset Turnover n Total n Asset Turnover = Sales / Total Assets 5, 250, 538 / 5, 862, 989 =. 896 times n Measure of asset use efficiency n Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets 21 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 4 Profitability Measures: Profitability Ratios Evaluate the operation efficiency (the ability to control cost) of the firm. n Profit Margin = Net Income / Sales n n Return on Assets (ROA) = Net Income / Total Assets n n 756, 410 / 5, 250, 538 =. 1441 times or 14. 41% 756, 410 / 5, 862, 989 =. 1290 times or 12. 90% Return on Equity (ROE) = Net Income / Total Equity n 756, 410 / 2, 984, 513 =. 2534 times or 25. 34% 22 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 5 Market Value Measures: Market Value Ratios Illustrate the difference between market and book value of the firm. n Market Price (12/31/04) = $91. 54 per share n Shares outstanding = 189, 813, 459 n PE Ratio = Price per share / Earnings per share n 91. 54 / 3. 92 = 23. 35 times n Market-to-book ratio = market value per share / book value per share n 91. 54 / (2, 984, 513, 000 / 189, 813, 459) = 5. 82 times 23 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Table 3. 5 50% Mc. Graw-Hill/Irwin 24 © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Question Profit Margin n Short-term Solvency n Long-term Solvency n Asset Management n Profitability n Market Value Total Asset Turnover Equity Multiplier 25 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

3. Du Pont Identity 26 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Deriving the Du Pont Identity n ROE = NI / TE n Multiply by 1 and then rearrange ROE = (NI / TE) (TA / TA) n ROE = (NI / TA) (TA / TE) = ROA * EM n n Multiply by 1 again and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) n ROE = (NI / Sales) (Sales / TA) (TA / TE) n ROE = PM * TAT * EM n 27 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Using the Du Pont Identity n ROE = PM * TAT * EM Profit margin is a measure of the firm’s operating efficiency – how well does it control costs n Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets n Equity multiplier is a measure of the firm’s financial leverage n 75% 28 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

4. Payout and Retention Ratios n Dividend payout ratio = Cash dividends / Net income n 1. 20 / 3. 92 =. 3061 or 30. 61% n Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio = b (3. 92 – 1. 20) / 3. 92 =. 6939 = 69. 39% n Or 1 -. 3061 =. 6939 = 69. 39% n 29 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

The Internal Growth Rate n The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. 30 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

The Sustainable Growth Rate n The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. 31 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Determinants of Growth n Profit margin – operating efficiency n Total asset turnover – asset use efficiency n Financial leverage – choice of optimal debt ratio n Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm 32 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Table 3. 6 33 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

5. Problems with Financial Statement n Little financial theory and economic logic exists with financial statements n Limits in comparability 1. Diversified business in conglomerates 2. Different accounting standards across nation 3. Different corporate structure 100% 34 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Review Questions 1. How do you standardize balance sheets and income statements and why is standardization useful? 2. What are the major categories of ratios and what does each category of ratios measure? How to interpret each ratio? What are the relationships among three leverage ratios? 3. What is Du Pont Identity and what are the components of Du Pont Identity? 4. What is retention ratio, internal/sustainable growth rate? What are the major determinants of a firm’s internal and sustainable growth potential? 5. What are some of the problems associated with financial statement analysis? 35 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved