Financial Analysis

Financial AnalysisCHAPTER 4

Overview of Financial AnalysisFIRST ORDER OF BUSINESS IS TO SPECIFY THE OBJECTIVES OF THE ANALYSIS

REMEMBER -- THE IDENTITY OF THE USER HELPS DEFINE WHAT INFORMATION IS NEEDED

Potential Financial Statement Users:• Creditors• Investors• Managers

– What types of questions do each of these users seek answers to?

Creditors

• Why does the firm want/need to borrow funds?

• What is the firm’s capital structure? How leveraged are they?

• How will they pay it back? What kind of cash flows are being generated by operations?

Investors

• How has the firm performed/what are future expectations?

• How much RISK is inherent in the capital structure?

• What are the expected returns from the firm?

• What is firm’s competitive position?

Managers• Need all info creditors and investors need

PLUS:• What operating areas have contributed to

success and which have not?• What are strengths/weaknesses of

company’s financial position?• What changes are indicated to improve

future performance?

Caution!!!• Keep in mind: management

PREPARES financial statements• Analyst should be alert to potential for

management to influence reporting to make data more “appealing”

• May want to supplement analysis with information apart from Annual Report prepared by management

Where to look for data...• Financial statements (and notes)• Annual Report • 10K and 10Q reports filed with SEC

(EDGAR)• Computerized data bases

– Info on industry norms/ratios– Info on particular

companies/industries/mutual funds• Websites

Basic Tools

• Common size financial statements• Financial ratios

– Trend analysis– Industry comparisons

Common Sizing Firm A Firm B

Sales 2531456.24 4561234.87

COGS 784564.54 1556456.24

Gr. Profit 1746891.70 3004778.63


Sales 2,531,456 4,561,234

COGS 784,564 1,556,456

Gr. Profit 1,746,891 3,004,778


Sales 2,531,456 100% 4,561,234 100%

COGS 784,564 31% 1,556,456 34%

Gr. Profit 1,746,891 69% 3,004,778 66%

Common Size Statements

• Common size income statement– expresses each income statement

category as a percentage of sales• Common size balance sheet

– expresses each item on balance sheet as a percentage of total assets

Comparisons/benchmarking

Explain how big the sun is relative to the Earth using data below.• Diameter

– Earth 12,756 KM– Sun 1,392,000 KM

• Mass– Earth 1– Sun 330,000

How big is Antares (one of the largest stars in our galaxy)?

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Ratio Analysis

• Profitability ratios• Liquidity ratios • Leverage (solvency) ratios• Efficiency ratios• Market-value ratios

Five Categories of Ratios

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Ratio AnalysisProfitability Ratios

• Measure the overall effectiveness of the firm’s management.

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Gross Profit Margin = Gross ProfitSales

How effective is the firm at generating revenue in excess of its cost of goods sold?


Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity$1,700

Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Income StatementExcalibur Corporation

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Net Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62

$575 $1,450Gross Profit Margin = = 39.7%

GrossProfit =Margin

Gross ProfitSales


Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800



Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62


$330 $1,450Oper. Profit Margin = = 22.8%

OperatingProfit =Margin

Operating IncomeSales

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Net Profit Margin orProfit Margin =

Net IncomeSales

How much net profit is being generated from each dollar of sales?


Note: Net Income equals Earnings Available to CS

when there is no preferred stock.

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Cash $175 Accounts Payable $115Accounts Receivable430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800




Assets Liabilities



$162 $1,450Net Profit Margin = = 11.2%

NetProfit =Margin

Net IncomeSales

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Return on Assets = Net IncomeTotal Assets

How effectively is the firm generating net income from its assets ?


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Cash $175 Accounts Payable $115Accounts Receivable430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800




Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40) 108Net Income% $162Common Dividends Paid 100Addition to Retained Earnings$62


$162 $2,530ROA = =

6.4%

Return onAssets

Net IncomeTotal Assets=

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Return on Equity = Net Income Equity

How well is the firm generating return to its equity providers?



Assets Liabilities Cash $175 Accounts Payable $115Accounts Receivable430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800





$162 $1,700ROE = = 9.53%

Return on Equity = Net Income Equity

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Ratio AnalysisLiquidity Ratios

Current Ratio = Current Assets Current Liabilities

• Measure the ability of the firm to meet its short-term financial obligations.

Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

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Assets Liabilities Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800



$1,230$230 Current Ratio = = 5.35x

Current Ratio = Current Assets Current Liabilities

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Ratio AnalysisLiquidity Ratios

• Measure the ability of the firm to meet its short-term financial obligations.

Quick Ratio = Current Assets - InventoryCurrent Liabilities

What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

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Assets Liabilities

$1,230 -$625$230 Acid-Test Ratio = = 2.63x

Quick Ratio = Current Assets - Inventory Current Liabilities

Cash $175 Accounts Payable $115Accounts Receivable430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800



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Ratio AnalysisLeverage Ratios

• Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt.

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Debt Ratio = Total Debt Total Assets

What proportion of the firm’s assets is financed with debt?

Ratio AnalysisDebt Ratios





Assets Liabilities



$230 + $600 $2,530

Debt Ratio = = 33%

Debt Ratio = Total Debt Total Assets

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Times Interest Earned Ratio =Operating IncomeInterest Expense

What is the firm’s ability to repay interest payments from its operating income?


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Assets Liabilities

$330 $60TIE Ratio = = 5.50x

TimesInterest =Earned Ratio

Operating IncomeInterest Expense



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Equity Multiplier =Total AssetsTotal Equity

What is the firm’s investment in assets relative to it’s equity?


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Assets Liabilities

$2,530 $1,700Eq Mult= = 1.49x

EquityMultiplier =Total Assets

Total Equity



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Ratio AnalysisEfficiency Ratios

• Help assess how effectively the firm is using assets to generate sales.

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How long does it take for the firm on average to collect its credit sales from customers?

DSO – Days Sales Out. orAverage Collection Period =

Accounts Receivable Avg. Daily Sales

Cash $175 Accounts Payable $115Accounts Receivable430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800




Assets Liabilities



AverageCollection = Period

Accounts ReceivableAvg. Daily Sales

$430 $1,450/365DSO = = 108 days

Days in a year

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Inventory Turnover Ratio = COGS Inventory

Is inventory efficiently translating into sales for the firm?






Assets Liabilities



$875$625 Inventory Turnover = = 1.4x

InventoryTurnover =Ratio

COGS Inventory

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Fixed Asset Turnover Ratio = Sales Net Fixed Assets

How effective is the firm in using its fixed assets to help generate sales?






Assets Liabilities



$1,450$1,300Fixed Asset Turnover = = 1.12x

Fixed AssetTurnover = Ratio

Sales Net Fixed Assets

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Total Asset Turnover Ratio = Sales Total Assets

How effective is the firm in using its overall assets to generate sales?


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Assets Liabilities Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800




$1,450 $2,530Total Asset Turnover = = 0.57x

Total AssetTurnover =

Sales Total Assets



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Price to Earnings Ratio =(PE)

Price per ShareEarnings per Share

How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.)

Ratio AnalysisMarket Value Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800



Assets Liabilities

Balance SheetExcalibur CorporationAdditional

Info:100 shares$20.00 per share

$20 $162/100P/E ratio = = 12.35x

P/E Ratio

Price/ShareEPS

=

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62


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Market (price) to Book Ratio =Price per ShareBook Value per Share

How much are investors willing to pay per dollar of book value?

Ratio AnalysisMarket Value Ratios

Assets Liabilities


$20 $1,700/100M/B = = 1.18x

Market to = Book

Price/Share Common Equity/ # shares

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800



Additional Info:

100 shares$20 per share



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Ratio Industry ExcaliburProfitabilityGross Profit Margin 38% 40%Operating Profit Margin 20% 23%Net Profit Margin 12% 11%Return on Assets 9.0% 6.4%Return on Equity 13.4% 9.5%

Summary of Excalibur Corporation Ratios

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Ratio Industry ExcaliburLiquidityCurrent Ratio 5.00x 5.35x Quick Ratio 3.00x 2.63x

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Ratio Industry ExcaliburDebtDebt Ratio 35% 33%Times Interest Earned 7.0x 5.5xEquity Multiplier ?x 1.49x

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Ratio Industry ExcaliburAsset Activity Avg. Collection Period90 days 108 daysInventory Turnover 3.0x 1.4xFixed Asset Turnover 1.0x 1.1xTotal Asset Turnover 0.75x .57x

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Ratio Industry ExcaliburMarket Value PE Ratio 18.0 12.4Market to Book 2.5 1.2

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Relationships Among Ratios:The Du Pont Equation

• Ratio Analysis generally involves an examination of related ratios.

• Comparison of these relationships over time helps to identify the company’s strengths and weaknesses.

Net Inc. Net Inc. Sales Assets Sales Assets

= x

Net ProfitMargin

Total AssetTurnover

Return onAssets

= x

Return on Assets (ROA)

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Du Pont Equation

Net Inc. Net Inc. Sales AssetsEquity Sales Assets Equity

= x x

Net ProfitMargin

Total AssetTurnover

Return onEquity

EquityMultiplier= x x

TGT vs. Wal-Mart Net Profit Margin

Asset Turnover

Target 4.0% 1.45Wal-Mart

3.6% 2.40

Which would you prefer?

DuPont Equation: TGT vs. Wal-Mart

Net Profit Margin

Asset Turnover

ROA

Target 4.0% 1.45 5.8%Wal-Mart

3.6% 2.40 8.6%

DuPont Equation: TGT vs. Wal-Mart

Net Profit Margin

Asset Turnover

Equity Multiplier

ROE

Target 4.0% 1.45 2.5 15%Wal-Mart

3.6% 2.40 2.4 21%

What is Target’s debt ratio?What debt ratio would Target need for ROE = 21%?

–The DuPont approach is nice because it divides the firm into three tasks• expense management

– (measured by the profit margin)• asset management

– (measured by asset turnover)• debt management

– (measured by the equity multiplier)

DuPont Example Wal-Mart Sears

Profit M. 4% 6%Ass.Turn. 3 1.5ROA ? ?Eq. Mult. 2 1ROE ? ?


Profit M. 4% 6%Ass.Turn. 3 1.5ROA 12% 9%Eq. Mult. 1 2ROE ? ?


Profit M. 4% 6%Ass.Turn. 3 1.5ROA 12% 9%Eq. Mult. 1 2ROE 12% 18%

What is the best overall ratio?

•A ratio analysis becomes relevant only when compared against a benchmark.•Financial managers can create a benchmark for comparison in three ways

Selecting a Benchmark

1. Trend analysis2. Industry Average3. Peer group

Trend analysis


Based on firm’s historical performance Allows management to examine each ratio over time, determine whether trend is good or bad for firm

Industry average analysis


Another way of developing benchmark Firms in same industry grouped by size, sales, and product lines, to establish benchmark ratios

Can identify industry groups with North American Industry Classification System (NAICS)

Peer group analysis


Instead of selecting an entire industry, management may select firms similar in size or sales, or who compete in same market

Average ratios of this peer group would then be used as benchmark

Peer groups can be only 3 or 4 firms, depending on industry

Ratio analysis depends on accounting data based on historical costs

Limitations of Ratio Analysis

No theoretical backing in making judgments based on financial statement and ratio analysis When doing industry or peer group analysis one often encounters large, diversified firms that do not fit into any one SIC code

Trend analysis could be distorted by financial statements affected by inflation

Limitations of Ratio Analysis

Multinational firms deal with many accounting standards Difficult to compare financial reports

Ratio ExerciseInv turn. 5 Cash ______ Acc Pay _____

Debt to net worth

.50

Acc Rec. 14,795

Inv. ______ Stock 25,000

G. P. Margin

.30

Plant Eq. ______ Ret Earn. 35,000

Acid test

1.2

Total Assets

______

Tot. Liab & Eq.

_______

TA turnover

2

Sales ____ COGS ______

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Financial Analysis