Financial Analysis

1
Financial Analysis

• Chapter 3

2
After studying this chapter you should be able to

• Use financial ratios to measure a firms
  profitability, efficiency, leverage, liquidity
  and market value.
• Use the DuPont model to measure a firms
  performance and identify the drivers of firm
  performance.
• Understand the limitations of financial analysis.
• Calculate a firms internal and sustainable
  growth rate.

3
Integrated Case

• DLeon
• Part I of this case, presented in Section 3,
  discussed the situation that DLeon Inc., a
  regional snack foods producer, was in after a
  1994 expansion program. Like Borden, Inc.,
  DLeon had increased plant capacity and
  undertaken a major marketing campaign in an
  attempt to go national. Thus far, sales have
  not been up to the forecasted level, costs have
  been higher than were projected, and a large loss
  occurred in 1994 rather than the expected profit.
  Unlike Borden, DLeon does not have much
  underlying financial strength, so its managers,
  directors, and investors are concerned about the
  firms survival.
•  
• Donna Jamison was brought in as assistant to
  Fred Camp, DLeons chairman, who had the task of
  getting the company back into a sound financial
  position. DLeons 1993 and 1994 balance sheets
  and income statements, together with projections
  for 1995, are given in Tables C3-1 and C3-2. In
  addition, Table C3-3 gives the companys 1993 and
  1994  

4

• financial ratios, together with industry average
  data. The 1995 projected financial statement
  data represent Jamisons and Campos best guess
  for 1995 results, assuming that some new
  financing is arranged to get the company over
  the hump.
• Jamison examined monthly data for 1994 (not
  given in the case), and she detected an improving
  pattern during the year. Monthly sales were
  rising, costs were falling, and large losses in
  the early months had turned to a small profit by
  December. Thus, the annual data look somewhat
  worse than final monthly data. Also, it appears
  to be taking longer for the advertising program
  to get the message across, for the new sales
  offices to generate sales, and for the new
  manufacturing facilities to operate efficiently.
  In other words, the lags between spending money
  and deriving benefits were longer than DLeons
  managers had anticipated. For these reasons,
  Jamison and Campo see hope for the company -
  provided it can survive the short run.
•  
• Jamison must prepare an analysis of where the
  company is now, what it must do to regain its
  financial health and what
•  

5
Financial Statements

• Balance Sheet

6
(No Transcript)
7
Income Statement
8
Ratio Analysis
9
(No Transcript)
10
Why Evaluate Financial Statements?

• Internal uses
• Performance evaluation compensation and
  comparison between divisions
• Planning for the future guide in estimating
  future cash flows
• External uses
• Creditors
• Suppliers
• Customers
• Stockholders

11
Categories of Financial Ratios

• Liquidity Ratios
• Short-Term Solvency Ratios
• Debt Ratios
• Long Term Solvency
• Efficiency (Asset Management)
• Profitability
• Market Value

12
Liquidity Ratios

• Will the firm be able to repay debts due within
  the next year?
• Current Ratio

13

• Quick Ratio
• A more conservative estimate

• Since Inventories are usually the least liquid of
  current assets this provides a conservative
  estimate of liquidity.

14
Efficiency Ratios

• How Effectively is the firm managing its assets

• Measure how well we translate investments in
  assets into Sales and Profits

15
Efficiency Ratios

• Current Asset Management
• Inventory Turnover

3.34 times
16

• Days Sales in Receivables (Average Collection
  Period)

• Measures how long it takes, (on average), from
  day of sales to collection
• DLeon takes 45.55 days to collect credit sales
  in 1995
• DLeons collection period has steadily increased
  to 45.55 days
• High for the industry
• What are the companys credit terms?

17
-Fixed Asset Turnover

• Measures how effectively a firm generates sales
  from its fixed assets.
• Although it has varied DLeons turnover is above
  the industry average.

18
-Total Asset Turnover

• The ratio is below industry averages
• The result is a build up of accounts receivables
  and inventory
• Current Assets

19
Debt Management Ratios Measure the extent that a
firm uses debt financing

• Advantages

• Disadvantages

20
Example
(6)
1.5
27
18
21
- Debt to Assets Ratios
22

• Times Interest Earned

Improved but still lagging the industry
23

• Fixed Charge Coverage Ratio

24
Profitability

• Profit Margin and Sales

• Measures how well DLeon converts sales to
  profits
• Slightly better than industry average
• Expect to earn higher than average because of
  premium product

25

• Other Margins

26

• Return on Total Assets

• Measures how well DLeon converts assets to
  profits
• This is below industry averages
• Why?
• PM is high
• But ROA low

27

• Return on Equity (ROE)

• Measures how well DLeon converts equity to
  profits
• A measure of returns to shareholders (Our goal)
• Slightly below our peers

28
Market Value Ratios

• Price Earnings Ratio (P/E)

29

• Market-to-Book Ratio

30
Table 3.5
31
The DuPont Model
32
(No Transcript)
33
(No Transcript)
34

• Once strengths and weaknesses have been
  identified they can be further researched.
• Profit Margin Stronger than peers but is it
  strong enough for a premium product?
• Asset Utilization low
• High A/R
• High Inv.
• Low sales
• Equity Multiplier higher
• Is this good?
• Magnifies returns
• But also shows higher risk

35
There are Many Roads to Success
36
(No Transcript)
37
Further Analysis of DLeon

• Using financial analysis in planning
• What would happen if the company reduced its DSR
  to 32 days from the current 45.55 days.

• Sales Per Day 7,035,600/365 19,276
• New Accounts Rec. 19,276 32 616,832

38

• Freed Cash Old A/R New A/R
• 878,000 616,832
  261,168
• New Total Assets 3,497 261.2 3,235.8
• New Asset Turn 7,035.6/3,235.8 2.174
• ROE PM AT EM
• 3.604 2.174 2.25 17.63

39

• What would happen if we reduced inventory and
  increased inventory turnover.
• Reducing inventory would
• Increase asset turnover
• Reduce Debt
• Increase ROE
• Our inventory turn 4.1
• Peers inv. Turnover 6.1
• If we improve to 6.1
• Inventory falls to 1,153,377
• Total Assets fall by 563,103
• Asset turn increases to 2.62
• ROE 21.27

40
DLeon Conclusions

• In hindsight what could DLeon have done
  differently?
• More effectively planned for the impact of the
  new product on performance.

41
Steps to Financial Analysis

• 1st Start with a DuPont analysis of the firm
• Examine trends in the ratios
• Compare to peers
• Identify strengths and weaknesses
• Profitability, Asset Utilization, Leverage
• 2nd Examine more detailed ratios pertaining to
  weak or strong areas.
• Examine trends in the ratios
• Compare to peers

42
Benchmarking

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

43
Peer Group Analysis

• Standard Industry Codes (SIC)
• Four digit codes established by U.S. govt. for
  statistical reporting.
• Firms classified into industries of varying
  specificity
• Each SIC digit narrow the focus
• 6xxx Finance, Real Estate, and Insurance
  Companies
• 60xx Mostly Banks
• 602x Mostly Commercial Banks
• 6025 National Banks with Federal Reserve
  Membership

44

• Problems Assume you are examining the financial
  statements for Wal-Mart.
• 5310 Department Stores
• Includes
• Wal-Mart
• K-Mart
• Neiman Marcus
• What about size issues?
• Sources of Data
• Dun and Brad Street
• Robert Morris Associates

45
Limitations of Financial Anal.

• For some firms finding meaningful peer groups is
  difficult
• There are no universal ratio definitions.
• Average performance is not necessarily good.
• Examine industry leaders (Top 25 etc.)
• Inflation has badly distorted financial
  statements
• Effects depreciation which effects NI
• Effects asset values which effects turnover
  ratios
• Caution must be exercised when examining firms of
  different ages.
• Seasonal Factors

46

• Window Dressing
• Firms attempt to dress up there balance sheets
• Differences in accounting practices
• Depreciation
• Leasing
• Not always easy to determine if ratios are good
  or bad
• Inventory turnover
• Look at Net effects (DuPont)

47
Growth

• Payout and Retention Ratios
• Dividend payout ratio Cash dividends / Net
  income
• Retention ratio Additions to retained earnings
  / Net income 1 payout ratio

48
The Internal Growth Rate

• The internal growth rate tells us how much the
  firm can grow assets using retained earnings as
  the only source of financing.

49
The Sustainable Growth Rate

• 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.

50
Determinants of Growth

• Profit margin operating efficiency
• Total asset turnover asset use efficiency
• Financial leverage choice of optimal debt ratio
• Dividend policy choice of how much to pay to
  shareholders versus reinvesting in the firm

51
Table 3.6
52
Real World Example

• Ratios are figured using financial data from the
  2001 Annual Report for Ethan Allen
• Compare the ratios to the industry ratios in
  Table 3.9 in the book
• Ethan Allens fiscal year end is June 30.
• Be sure to note how the ratios are computed in
  the table so that you can compute comparable
  numbers.
• Ethan Allan sales 904.133 MM

53
Real World Example - II

• Liquidity ratios
• Current ratio 2.7x Industry 1.5x
• Quick ratio 1.1x Industry .5x
• Long-term solvency ratio
• Debt/Equity ratio (Debt / Worth) .3x Industry
  1.9x.
• Coverage ratio
• Times Interest Earned 170.0x Industry 5.8x

54
Real World Example - III

• Asset management ratios
• Inventory turnover 2.8x Industry 4.0x
• Receivables turnover 27.4x (13 days) Industry
  38.9x (9 days)
• Total asset turnover 1.5x Industry 2.8x
• Profitability ratios
• Profit margin before taxes 14.2 Industry
  3.7
• ROA (profit before taxes / total assets) 20.7
  Industry 8.8
• ROE (profit before taxes / tangible net worth)
  27.6 Industry 27.9

55
Work the Web Example

• The Internet makes ratio analysis much easier
  than it has been in the past
• Click on the web surfer to go to Multex Investor
• Choose a company and enter its ticker symbol
• Click on comparison and see what information is
  available

56
Chapter 2 11

• 2002
• LTD 1,900,000
• 2003
• LTD 2,300,000
• Interest 420,000
• What was the CF to Creditors in 2003?

57
Chapter 2 12

• 2002
• Common Stock 200,000
• Paid in Surplus 4,200,000
• 2003
• Common Stock 230,000
• Paid in Surplus 4,500,000
• Dividends 120,000
• What was the CF to Stockholders in 2003?

58
Chapter 2 13

• 2003
• Net Capital Spending 760,000
• Additions to Net Working Capital -135,000
• What was the OCF in 2003?

59
Chapter 2 15

• Sales 30,000
• COGS (19,000)
• Depr ?
• EBIT
• Interest 1,430
• EBT
• Tax (35) _____
• NI
• Dividends 900
• Addition to RE 2100

60
Chapter 3 42

• Sales 110,000
• NI 7,000
• Div 2,100
• Debt 51,000
• Equity 24,000
• What is the sustainable growth rate?
• If the company grows at this rate how much new
  debt must it raise assuming it wants to maintain
  the current debt ratio?
• If the company does not want to raise external
  capital how fast can it grow?

61
Chapter 3 32

• ROE .15
• Sales 1,700,000
• Debt ratio .40
• Debt 300,000
• ROA ?

62
Chapter 3 32