Lecture 4-350 4-1

CHAPTER 4Analysis of Financial Statements

Ratio Analysis Usefulness of ratios. Limitations of ratio analysis

Lecture 4-350 4-2

Last week we learned how to calculate free cash flow (FCF), which will be useful when we come to stock valuation.

This week we will talk about analyzing financial ratios.

The ratios I focus are relatively more important.

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Financial Ratios: Accounting data stated in relative terms

Why are financial ratios useful? Ratios standardize numbers and

facilitate comparisons. Ratios are used to highlight

weaknesses and strengths. Ratios might be useful to predict

future.

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Ratios are not to be read in isolation.

When Analyzing Financial Ratios, always examine: Trends across time Comparisons with other firms’

(industry average) ratios

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Balance Sheet: Assets

CashA/RInventories

Total CAGross FALess: Dep.

Net FATotal Assets

20027,282

632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592

2003E85,632

878,0001,716,4802,680,1121,197,160 380,120 817,0403,497,152

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Balance sheet: Liabilities and Equity

Accts payableNotes payableAccruals

Total CLLong-term debtCommon stockRetained earnings

Total EquityTotal L & E

2002524,160

636,808 489,6001,650,568

723,432460,000

32,592 492,5922,866,592

2003E436,800

300,000 408,0001,144,800

400,0001,721,176 231,1761,952,3523,497,152

“E” means “estimates”.

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Income statement

SalesCOGSOther expenses

EBITDADepr. & Amort.

EBITInterest Exp.EBTTaxesNet income

20026,034,000

5,528,000 519,988

(13,988) 116,960(130,948) 136,012(266,960) (106,784)(160,176)

2003E7,035,600

5,875,992 550,000

609,608 116,960

492,648 70,008

422,640 169,056 253,584

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Other data

No. of sharesEPSDPSStock price

2003E250,000

$1.014$0.220$12.17

2002100,000-$1.602$0.110

$2.25

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What are some important ratios, and what questions do they answer? Liquidity: Can the firm meet short term

obligations? Asset management: is the firm generating

good revenue from assets? (Sales is important, at least from your marketing class:)

Profitability: Is the firm sufficiently profitable as reflected in PM, ROE, and ROA?

Debt management: is the firm using the right mix of debt and equity?

Market value: Do investors like the form’s earnings and future growth prospect as reflected in P/E and M/B ratios?

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How liquid is a firm? Liquidity is the ability to meet

maturing debt obligations. Comparing cash and assets that can

be converted into cash within the year with liabilities that are due within the year.

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Calculate D’Leon’s forecasted current ratio for 2003.

Current ratio = Current assets / Current liabilities

= $2,680 / $1,145= 2.34

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Comments on current ratio

2003 2002 2001 Ind.

Currentratio

2.34 1.20 2.30 2.70

Expected to improve but still below the industry average.

Liquidity position is weak.

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Is Management Generating Adequate Sales on the Firm’s Assets?

How efficiently a firm is using its assets in generating sales

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Fixed asset and total asset turnover ratios vs. the industry average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01

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Evaluating the FA turnover and TA turnover ratios

2003 2002 2001 Ind.

FA TO 8.6 6.4 10.0 7.0

TA TO 2.0 2.1 2.3 2.6

FA turnover projected to exceed the industry average.

TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).

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What is the inventory turnover vs. the industry average?

2003 2002 2001 Ind.

InventoryTurnover

4.1 4.70 4.8 6.1

Inv. turnover = Sales / Inventories= $7,036 / $1,716= 4.10

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Comments on Inventory Turnover

Inventory turnover is below industry average.

D’Leon might have old inventory, or its control might be poor.

No improvement is currently forecasted.

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DSO is the average number of days after making a sale before receiving cash.

DSO = Receivables / Average sales per day

= Receivables / Sales/365

= $878 / ($7,036/365)

= 45.6

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Appraisal of DSO

2003 2002 2001 Ind.

DSO 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.

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How is the Firm Financing Its Assets?

Does the firm finance assets more by debt or equity?

Debt Ratio

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Calculate the debt ratio.

Debt ratio (D/A)= Total debt / Total assets= ($1,145 + $400) / $3,497

= 44.2%It measures financial leverage.(1) If a firm is profitable, borrowing

appropriate debt can leverage up return on shareholder equity.

(2) Too much debt may increase risk of bankruptcy.

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How does the debt ratio compare with industry averages?

2003 2002 2001 Ind.

D/A 44.2% 82.8% 54.8% 50.0%

D/A is better than the industry average.

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Is Management Generating Adequate Operating Profits on the Firm’s Assets?

Operating Profit Margin Basic earning power (BEP) Return on Assets Return on equity

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Profitability ratios: Profit margin and Basic earning power

Profit margin (2003) = Net income / Sales

= $253.6 / $7,036 = 3.6%

BEP (2003) = EBIT / Total assets

= $492.6 / $3,497 = 14.1%

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Appraising profitability with the profit margin and basic earning power

2003 2002 2001 Ind.

PM 3.6% -2.7% 2.6% 3.5%

BEP 14.1% -4.6% 13.0% 19.1% Profit margin was very bad in 2002, but is projected to

exceed the industry average in 2003. Looking good. BEP removes the effects of taxes and financial leverage, and

is useful for comparison of operating performance. BEP projected to improve, yet still below the industry

average. There is definitely room for improvement.

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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%

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Appraising profitability with the return on assets and return on equity

2003 2002 2001 Ind.

ROA 7.3% -5.6% 6.0% 9.1%

ROE 13.0% -32.5% 13.3% 18.2%

Both ratios rebounded from the previous year, but are still below the industry average.

Note ROE=ROA*(total asset/total equity)=ROA/(1-total debt/total asset)=ROA/(1-debt ratio).

If ROA>0, the higher the debt ratio, the higher ROE. If ROA<0, the higher the debt ratio, the lower ROE. Wider variations in ROE illustrate the effect that leverage can have on

profitability.

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Calculate the Price/Earnings and Market/Book ratios.

P/E = Price / Earnings per share= $12.17 / $1.014 = 12.0

M/B = Mkt price per share / Book value per share= $12.17 / ($1,952 / 250) = 1.56

2003 2002 2001 Ind.

P/E 12.0 -1.4 9.7 14.2

M/B 1.56 0.5 1.3 2.4

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Analyzing the market value ratios

P/E: How much investors are willing to pay for $1 of earnings. When investors believe that the earnings are “real”, or earnings will grow, the P/E ratios is generally high.

M/B: How much investors are willing to pay for $1 of book value equity. When investors believe that the growth prospect of the firm is good, M/B will be high.

For each ratio, generally the higher the number, the better.

However, higher ratios might also indicate that the stock is overvalued. (dot.com bubble.)

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The Du Pont systemAlso can be expressed as:ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)ROA = (NI/Sales) x (Sales/TA) Focuses on:

Expense control (PM) Asset utilization (TATO) Debt utilization (TA/Equity)

Shows how these factors combine to determine ROE.

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Potential problems and limitations of financial ratio analysis 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. Sometimes it is hard to tell if a ratio is “good” or “bad”.

Seasonal factors. (Macy, Marriot) “Window dressing” and “big baths”

techniques can make statements and ratios look better.

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Window dressing To get a smaller debt ratio

12/31/2003 12/31/2004

1/6/200412/23/2003

Pay back debt Borrow new debt

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Big bath Recognize more expense and

charge in bad years to ensure a growing string of profits in the future, so investors might think the firm is making turnaround and growing.

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More issues regarding ratios Different operating and accounting

practices can distort comparisons. Off sheet liabilities.

Lecture 4-350 4-35

To mitigate the limitation, 1. consider ratios together For example, if a firm has negative ROA in

recent years and debt ratio is high, the high debt ratio may indicate risk of default.

If a firm has been profitable in recent years, the high debt ratio may indicate that the firm is borrowing debt to expand business.

Thus it pays to consider ROA and debt ratio together.

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2. Consider qualitative factors Are the firm’s revenues tied to 1 key

customer, product, or supplier? Competition (will high profit attract

competitors?) Future prospects (does the firm

spend any R&D?) Legal and regulatory environment

(is it a regulated industry?)