Analysis of Financial Statements

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CHAPTER 3

• Analysis of Financial Statements
• Dr. Omar Al Nasser
• FINC 6352

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Topics in Chapter 3

• Ratio analysis
• Du Pont system

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Why are ratios useful?

• Standardize numbers facilitate comparisons
• Used to highlight weaknesses and strengths
• From an investors standpoint
• The real value of financial statements lies in
  the fact that they can be used to predict future
  earnings, dividends, and free cash flow.
• From management standpoint
• Financial statements is useful to anticipate
  future conditions and as a starting point for
  planning actions that will improve the firms
  future performance.

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Income Statement
2007 2008E
Sales 5,834,400 7,035,600
COGS 4,980,000 5,800,000
Other expenses 720,000 612,960
Deprec. 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40) (63,424) 169,056
Net income (95,136) 253,584
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Balance Sheets Assets
2007 2008E
Cash 7,282 14,000
S-T invest. 20,000 71,632
AR 632,160 878,000
Inventories 1,287,360 1,716,480
Total CA 1,946,802 2,680,112
Net FA 939,790 836,840
Total assets 2,886,592 3,516,952
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Liabilities Equity
2007 2008E
Accts. payable 324,000 359,800
Notes payable 720,000 300,000
Accruals 284,960 380,000
Total CL 1,328,960 1,039,800
Long-term debt 1,000,000 500,000
Common stock 460,000 1,680,936
Ret. earnings 97,632 296,216
Total equity 557,632 1,977,152
Total LE 2,886,592 3,516,952
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Other Data
2007 2008E
Stock price 6.00 12.17
of shares 100,000 250,000
EPS -0.95 1.01
DPS 0.11 0.22
Book val. per share 5.58 7.91
Lease payments 40,000 40,000
Tax rate 0.4 0.4
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What are the five major categories of ratios?

• Liquidity Can the company makes the required
  payments for short-term creditors/suppliers and
  bankers?
• Asset management Do we have the right amount of
  assets for the level of sales?
• Debt management Do we have the right mix of debt
  and equity?

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What are the five major categories of ratios?

• Profitability Do sales prices exceed unit costs?
  Shed light upon the overall effectiveness of
  management regarding the returns generated on
  sales and investment.
• Market value What investors think about the
  companys past performance and future prospects?

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Liquidity Ratios

• Provides information on a companys ability to
  meet its short-term obligations.
• A liquid asset is one that be easily converted to
  cash without significant loss of its original
  value.

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Liquidity Ratios

• Current Ratio
• Is calculated by dividing current assets by
  current liabilities.
• Indicated the extent to which CL are covered by
  assets expected to be converted into cash in the
  near future
• Current ratio Current assets / Current
  liabilities
• 2680 / 1040 2.58 times

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Liquidity Ratios

• Quick Ratio
• Is calculated by deducting inventories from
  current assets and dividing the results by
  current liabilities.
• Quick ratio (CA Inventories) / CL
• (2,680 1,716) / 1,040
• 0.93x

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Asset Management Ratios

• A set of ratios that measures how well a firm is
  managing its asset.
• Inventory Turnover Ratio
• Is the ratio of total sales to inventory. This
  ratio indicates how many times inventory is
  created and sold during the period.

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DSO average number of days from sale until cash
received.

• This ratio is calculated by dividing AR by
  average sales per day.
• It indicates the average length of time the firm
  must wait after making a sale before it receives
  cash.
• DSO Receivables / Avg sales per day
• Receivables / (Annual sales/365)
• 878 / (7,036/365)
• 45.6 days

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Asset Management Ratios

• Fixed Assets Turnover Ratio
• Is the ratio of sales to fixed assets.
• This ratio indicates the ability of the companys
  management to put the fixed assets to work in
  order to generate sales.
• FA turnover Sales / Net fixed assets
• 7,036 / 837 8.41x
• If the ratio is close to the industry average,
  this indicates that the company is using its
  fixed assets as effectively as other companies in
  the industry.

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Asset Management Ratios

• Total Assets Turnover Ratio
• Is the ratio of sales to total assets. This ratio
  indicates the extent that the investment in total
  assets results in sales.
• TA turnover Sales / Total assets
• 7,036 / 3,517 2.00x
• If this ratio is below its industry average, it
  may indicate that the company is not generating
  enough sales given its total assets. Sales should
  be increased or assets should be sold.

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Debt Management Ratios

• Measure the extent to which a firm relies on debt
  financing (financial leverage).
• Debt Ratio
• The ratio of total debt to total assets. It
  measures the percentage of funds provided by
  creditors.

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Debt Management Ratios

• Times Interest Earned ratio.
• Is computed by dividing earnings before interest
  and taxes by interest charges.
• It measures the ability of the firm to meet its
  annual interest payments.
• We use earnings before interest and taxes, rather
  than net income, because interest is paid with
  pre-tax dollars, so the firms ability to pay its
  interest payments is not affected by taxes.
• TIE EBIT / Interest expense
• 502.6 / 80 6.3x
• The higher the ratio, the greater the company's
  ability to make its interest payments or take on
  more debt.

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Profitability Ratios

• Profitability Ratios show the combined effects of
  liquidity, asset management, and debt management
  on operating results.
• Profit margin on sales
• Net profit margin shows how much net profit is
  derived from every dollar of total sales.
• It indicates how well the business has managed
  its operating expenses.
• Profit margin Net income / Sales
• 253.6 / 7,036 3.6
• If the industry average is 5, this may indicates
  that the cost is too high which may be a results
  of inefficient operations.

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Profitability Ratios

• Basic Earning Power (BEP) Ratio
• It compares earnings apart from the influence of
  taxes or financial leverage, to the assets of the
  company.
• BEP EBIT / Total assets
• 502.6 / 3517 14.3
• If the industry average is 18.0, this indicates
  that the company is not earning as high return on
  assets as the average companies in its industry.

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Profitability Ratios

• Return on Equity
• Is computed by dividing net income available to
  common stockholders by common equity.
• It measure the rate of return on common
  stockholders investment. Higher return will
  results in happy common stockholders.
• ROE Net income / Total common equity
• 253.6 / 1977 12.8

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Profitability Ratios

• Return on Assets
• This evaluates how well the company employs its
  assets to generate a return.
• High return ratio indicates good use of assets
• ROA Net income / Total assets
• 253.6 / 3517 7.2
• If the industry average is 11.0, this indicate
  that the companys 7.2 return is well below the
  industry average for the following reasons
• The companys low basic earning power, and
• High interest costs resulting from its
  above-average use of debt. Both of which cause
  its NI to be relatively low.

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Market Value Ratios

• It relate the firms stock price to its earnings,
  cash flow, and book value per share.
• These ratios give management an indication of
  what investors think of the company risk and
  future performance.

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Price/Earning Ratio (P/E ratio)

• The ratio of the price per share to earnings per
  share.
• It is a useful indicator of what premium or
  discount investors are prepared to pay or receive
  for the investment.
• The higher the price in relation to earnings, the
  higher the P/E ratio which indicates the higher
  the premium an investor is prepared to pay for
  the share.
• P/E Price / Earnings per share
• 12.17 / 1.01 12.0x
• If the P/E ratio is below the industry average,
  this indicates that the company is riskier than
  other companies or have poor growth prospects.

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Price/Cash flow Ratio

• A measure of the market's expectations of a
  firm's future financial health. It is calculated
  by dividing the price per share by cash flow per
  share.
• Cash flow per share is equal to net income plus
  depreciation and amortization divided by common
  shares outstanding.
• P/CF Price / Cash flow per share
• 12.17 / (253.6120.0) 250
• 8.17x
• This indicate that the companys stock was
  trading at 8.17-times the company's cash flow of
  1.49 per share.

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Market/Book Ratio

• Is the ratio of the current share price to the
  book value per share. It measures how much a
  company worth at present.

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The Du Pont Equation

• In ratio analysis, managers often need a
  framework that ties together a firms
  profitability, its asset usage efficiency, and
  its use of debt.
• The basic Du Pont Equation shows that the ROA can
  be found as the product of the profit margin
  times the total assets turnover.
• ROA Profit Margin x Total assets turnover
• NI / sales x Sales / TA
• ROA Net income / Total asset
• 253.6 / 3517 7.2

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Extended DuPont Equation Breaking down Return
On Equity

• If the company were financed only with common
  equity, ROA and ROE would be the same because TA
  would equal common equity.
• The equality holds if and only if the company
  uses no debt.

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Extended DuPont Equation Breaking down Return
On Equity
3.6 x 2 x 1.8
13.0 However, the Dupont system, shows how
profit margin, total asset turnover, and the use
of debt interact to determine the return on
equity.