Analysis of Financial Statements

1

• Chapter 4
• Analysis of Financial Statements

2
Ratio Analysis Notes

• When analyzing companies, we compare ratios
  rather than dollar figures to adjust for
  differences in size.
• Industry averages are arithmetic medians (not
  arithmetic means) to avoid distortions caused by
  extreme outliers.

3
Liquidity Ratios (Refer to financial statements,
p.70,73)

• The liquidity group of ratios measures the
  ability of the company to pay short-term
  debts
• What is the current ratio for Allied Food
  Products for 2005?
• Current Ratio CA/CL
• 100/310 3.2

4

• The current ratio assumes that all current assets
  will be turned into cash within a year.
• If the industry norm is 4.2, then Allied Foods
  appears to have below-average level of liquidity,
  and a weaker-than-average ability to pay
  short-term debts.

5

• What is the quick ratio for AFP?
• Q.R. (CA Inv)/CL
• (1000 615)/310 1.2
• The quick ratio assumes that all current assets
  except for inventories will be turned into cash
  within a year.
• If the industry norm is 1.0, this ratio suggests
  above-average liquidity for Allied Foods.

6
Asset Management Ratios

• The asset management group of ratios measures how
  efficiently management is using the companys
  resources.
• Two other names for this group are efficiency or
  activity group.

7

• What is the inventory turnover ratio for AFP?
• Inv Turn Sales/Inv
• 3000/615 4.9
• If the industry norm is 9.0, then Allied Foods
  appears to be much less efficient than average.
  Note that this could be due to low sales or
  excessive inventories.

8

• The days sales outstanding (DSO) measures the
  average time between when a sale is made and when
  collection occurs.
• Another name for this measure is average
  collection period.

9

• What is the days sales outstanding (DSO) for AFP?
  
• DSP Rec x 365/sales
• 375 x 365/3,000 45.6 days
• If the industry norm is 36 days, Allied Foods is
  less efficient than average in making its
  collections.
• This might be an attempt to offer more attractive
  terms to their customers to sell off excess
  inventory.

10

• What is the fixed assets turnover ratio for AFP?
• FA Turn Sales/FAnet
• 3000/1000 3.0
• If the industry norm is 3.0, Allied Foods appears
  to have average efficiency in generating sales.

11

• Note If Allied Foods fixed assets are older than
  average, this would artificially inflate the FA
  Turnover measure, causing it to be distorted.

12

• What is the total assets turnover ratio for AFP?
• TA Turnover Sales/TA
• 3000/2000 1.5
• If the industry norm is 1.8, Allied Foods appears
  to be less efficient than average in generating
  sales.

13

• Note If inventories were high, this would cause
  TA Turnover to be low.
• TA Turn Sales/TA
• Sales / (CA FA)

14
Debt Management Ratios

• The debt management group of ratios measures the
  companys use of debt funding.
• Another name for this group is the leverage group.

15

• What is the debt ratio for AFP?
• Debt Ratio TD/TA
• (310 750)/2000 53
• If the industry norm is 40, this indicates that
  Allied Foods is riskier than average.

16

• Note If a company uses only short-term debt to
  fund increases in inventories, it will cause the
  debt ratio to rise.
• Example (not Allied Foods) of a company buying
  100 more in inventory, and funding it with an
  increase in short-term debt
• before C.R. 200/100 2.0
• after C.R. 300/200 1.5

17

• What is the times interest earned (TIE) ratio for
  AFP?
• TIE EBIT/I 283.8/88 3.2
• If the industry norm is 6.0, Allied Foods appears
  to have a weaker-than-average ability to carry
  its debt.

18

• Note If Allied Foods has a debt ratio that is
  above average, it not only carries a
  higher-than-average amount of debt, its higher
  risk also means that it likely pays a
  higher-than-average interest rate on each dollar
  of debt.
• Both of these effects will cause interest expense
  to be high, and the TIE ratio to be low.

19

• What is the EBITDA coverage ratio for AFP?
• EBITDA Coverage
• (EBIT Dep LeasePmts)
• I PrincipalPmts LeasePmts
• (283.8 100 28)/(88 20 28)
• 3.0

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• If the industry norm is 4.3, Allied Foods appears
  to have a less-than-average ability of Allied
  Foods to make its fixed financial payments.
• Note Like the TIE ratio, the EBITDA Coverage
  ratio assumes the company must make fixed
  financial payments. But since the EBITDA
  Coverage ratio assumes the firm must meet a
  broader array of fixed financial charges, it is
  considered to be more comprehensive.

21
Profitability Ratios

• The profitability group of ratios measures the
  overall performance of management (but this is
  only in an accounting sense).

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• What is the net profit margin for Allied Foods?
• PM NI/Sales
• 177.5/3000 3.9
• If the industry norm is 5.0, Allied Foods
  appears to be less profitable per dollar of sales.

23

• What is the basic earning power ratio for AFP?
• BEP EBIT/TA
• 283.8/2000 14.2
• If the industry norm is 17.2, Allied Foods
  appears to be less profitable.

24

• What is the return on total assets ratio (ROA)
  for AFP?
• ROA NIc/s/TA
• 117.5/2000 5.9
• If the industry norm is 9.0, Allied Foods
  appears to be less profitable than average.

25

• What is the return on equity ratio (ROE) for AFP?
• ROE NIc/s/Common Equity
• 117.5/940 12.5
• If the industry norm is 15.0, Allied Foods
  appears to be less profitable than average.

26
Market Value Ratios

• The market value group of ratios measures how the
  company is viewed by the market.

27

• What is the price earnings ratio (P/E) for AFP?
• P/E Price/EPS
• 23/2.35 9.8
• If the industry norm is 12.5, Allied Foods is
  viewed unfavorably by the market.

28

• What is the price to cash flow ratio (P/CF) for
  AFP?
• P/CF Price/CFPS
• 23/4.35 5.3
• If the industry norm is 6.8, Allied Foods is
  viewed unfavorably by the market.

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• Note If a companys profitability is low, it
  will artificially inflate (distort) the P/E
  ratio.
• Note If a firm is actively expanding, its CF
  will be high (due to the high depreciation
  charges on new equipment), which can cause the
  P/CF ratio to be low.

30

• What is the market to book ratio (M/B) for AFP?
• M/B Price/BVPS
• 23/18.801.2
• If the industry norm is 1.7, Allied Foods is
  viewed unfavorably by the market. (Note Unlike
  P/E and P/CF, the M/B ratio is not as easily
  distorted.)

31
Methods of Comparisons

• When we compare the firms ratios to industry
  averages, this is called cross-sectional
  analysis.
• When we examine how a firms ratios change over
  time, this is called time-series analysis.
• One other method of ratio analysis is to compare
  our firm to another comparable firm same size,
  same industry.

32
Du Pont Analysis

• The Du Pont analysis shows how ROE is the product
  of three other ratios.
• The Du Pont equation is
• ROE PM x TATurn x FLM
• where
• PM reflects cost control
• TATurn reflects volume
• FLM reflects debt leverage

33

• Note FLM 1 / (1 DR)
• Note that ROE can be increased through more a
  higher PM (more efficient cost control), greater
  TA Turnover (earn the PM on more sales dollars),
  or a higher financial leverage multiplier (higher
  debt ratio).

34

• What are the Du Pont values for AFP and the
  industry?
• ROE (NPM)(TATurn)(FLM)
• Firm (12.5) (3.9) (1.5) (2.13)
• Norm (15.0) (5.0) (1.8) (1.67)
• Company FLM 1 / (1 - .53) 2.13
• Norm FLM 1 / (1 - .40) 1.67

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• What does the analysis indicate are AFPs
  greatest weaknesses?
• Weaknesses
• 1st cost control (low PM)
• 2nd low volume (low TATurn)

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Sources of Industry Norms

• Value Line
• Dun Bradstreet
• Moodys Industrial Manual
• Robert Morris Associates
• Various trade publications
• Various internet sources

37
Limitations of Ratio Analysis

• The comparison to industry averages would be less
  valid if your firm operates in just one industry,
  and the industry average firm operates in
  multiple industries.
• Are matching the industry averages necessarily
  optimal goals? Who says being average should be
  our goal?

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• Fixed asset items may be worth more or less than
  indicated by the balance sheet. For example,
  land recorded at historical cost and bought many
  years ago should be worth much more than its book
  value.
• Do all of the industry firms close their books at
  the same time of the year? No. If you are
  comparing a firm that closed its books on Dec31
  to an industry-average firm that closed its books
  on Jun30, you would be comparing different time
  periods.

39

• Does management have the ability to manipulate
  reported profits in the short-run all within
  GAAP? Yes.
• Managers commonly manipulate reported expenses
  (such as pension contributions) to try to smooth
  earnings and make them look more stable.

40

• In seasonal industries, firms tend to close their
  books during the least active part of the season?
  
• During the slowest part of the season, balance
  sheet figures like inventories and receivables
  may be well below their values during the active
  portion of the year.

41

• Do all firms in an industry follow the same
  accounting procedures (e.g., FIFO vs LIFO)? No.
  
• If you have two identical firms during an
  inflationary period and Firm A uses LIFO (i.e.,
  the latest cost figure) while Firm B uses FIFO
  (i.e., the oldest cost figure), Firm A will
  report the lower profit but have the higher cash
  flow (due to its lower taxes).

42

• Although a high current ratio makes a company
  look more liquid, higher inventories held as
  safety stocks also leads to lower profit (due to
  the higher costs of insurance, storage,
  financing, etc.).
• Often, what is safer is also less profitable.

43

• Profitability ratios are book measures, and may
  not reflect the effect on shareholder wealth.
• Could a firms profit margin be above average,
  and the stock price still fall? Yes, if the
  market was expecting an even higher profit margin
  and was disappointed.

44

• Final note Some sources may compute mixed
  ratios (ones involving both balance sheet and
  income statement values) by averaging the B/S
  item.
• Consider Inv Turnover
• Author InvTurn07 Sales07/Inv07
• Others
• InvTurn07 Sales07/(Inv07 Inv06)/2