CHAPTER 4 Analysis of Financial Statements

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CHAPTER 4Analysis of Financial Statements

• Ratio Analysis
• Du Pont system
• Effects of improving ratios
• Limitations of ratio analysis

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Balance Sheet Assets

• Cash
• A/R
• Inventories
• Total CA
• Gross FA
• Less Dep.
• Net FA
• Total Assets

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Balance sheet Liabilities and Equity

• Accts payable
• Notes payable
• Accruals
• Total CL
• Long-term debt
• Common stock
• Retained earnings
• Total Equity
• Total L E

2009 524,160 636,808
489,600 1,650,568 723,432 460,000 32,592
492,592 2,866,592
2010E 436,800 300,000
408,000 1,144,800 400,000 1,721,176
231,176 1,952,352 3,497,152
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Income statement

• Sales
• COGS
• Other expenses
• EBITDA
• Depr. Amort.
• EBIT
• Interest Exp.
• EBT
• Taxes
• Net income

2009 6,034,000 5,528,000 519,988
(13,988) 116,960 (130,948) 136,012
(266,960) (106,784) (160,176)
2010E 7,035,600 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 shares
• EPS
• DPS
• Stock price
• Lease pmts

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Why are ratios useful?

• Ratios standardize numbers and facilitate
  comparisons.
• Ratios are used to highlight weaknesses and
  strengths.
• Ratio comparisons should be made through time and
  with competitors
• Peer (or Industry) analysis
• Trend analysis

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Ratios facilitate comparisons

• Firm A (RM) Firm B (RM)
• Sales 5,000,000 4,850,000
• T. Assets 3,500,000 3,200,000

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• Turnover ratio
• Firm A Firm B
• 5,000,000 1.428x 4,850,000 1.52x
• 3,500,000 3,200,000
• Industry analysis
• Firm B Industry
• 1.52x 1.729x

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Trend Analysis

• Turnover ratio firms B Year
• 1.256 2000
• 1.276 2001
• 1.325 2002
• 1.346 2003
• 1.426 2004
• 1.457 2005

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What question do they answer?

• Liquidity Ratio Can we make required payments?

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Calculate forecasted current ratio and quick
ratio for 2010.

• Current ratio Current assets / Current
  liabilities
• 2,680 / 1,145 Industry
• 2.34x 2.70x
• Quick ratio (CA Inventories) / CL
• (2,680 1,716) / 1,145
• 0.84x Industry
• 1.0x

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Comments on liquidity ratios
2010E 2009 2008 Ind.
Current Ratio 2.34x 1.20x 2.30x 2.70x
Quick Ratio 0.84x 0.39x 0.85x 1.00x

• Expected to improve but still below the industry
  average.
• Liquidity position is weak.

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What question do they answer?

• Asset management ratios right amount of assets
  vs. sales?

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What is the inventory turnover vs. the industry
average?
Inv. turnover Sales / Inventories 7,036
/ 1,716 4.10x
2010E 2009 2008 Ind.
Inventory Turnover 4.1x 4.70x 4.8x 6.1x
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Comments on Inventory Turnover

• Inventory turnover is below industry average.
• Company might have overstocked of inventory or
  insufficient sales

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

• DSO Receivables / Avg sales per day
• Receivables / (Annual sales/365)
• 878 / (7,036/365)
• 45.6 days

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Appraisal of DSO
2010E 2009 2008 Ind.
DSO 45.6 38.2 37.4 32.0

• Company collects on sales too slowly, and is
  getting worse.
• Company has a poor credit policy.

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

• FA turnover Sales / Net fixed assets
• 7,036 / 817 8.61x
• TA turnover Sales / Total assets
• 7,036 / 3,497 2.01x

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Evaluating the FA turnover and TA turnover ratios
2010E 2009 2008 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

• 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 question do they answer?

• Debt management Right mix of debt and equity?

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Effects of Financial Leverage on Stockholder
Returns
  FIRM U UNLEVERAGED (NO DEBT) FIRM U UNLEVERAGED (NO DEBT) FIRM U UNLEVERAGED (NO DEBT)  
Current assets 50 Debt 0
Fixed assets 50 Common Equity 100
Total Assets 100 Total liabilities and equity 100
  BUSINESS CONDITIONS  
  Good Expected Bad
Sales revenues 150.0 100.0 75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total Operating costs 105.0 85.0 75.0
Operating income (EBIT) 45.0 15.0 0.0
Interest (Rate 10) 0.0 0.0 0.0
Earnings before taxes (EBT) 45.0 15.0 0.0
Taxes (Rate 40) 18.0 6.0 0.0
Net income (NI) 27.0 9.0 0.0
ROEu 27.0 9.0 0.0
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  FIRM L UNLEVERAGED (SOME DEBT) FIRM L UNLEVERAGED (SOME DEBT) FIRM L UNLEVERAGED (SOME DEBT)  
Current assets 50 Debt 50
Fixed assets 50 Common Equity 50
Total Assets 100 Total liabilities and equity 100
  BUSINESS CONDITIONS  
  Good Expected Bad
Sales revenues 150.0 100.0 75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total Operating costs 105.0 85.0 75.0
Operating income (EBIT) 45.0 15.0 0.0
Interest (Rate 10) 5.0 5.0 5.0
Earnings before taxes (EBT) 40.0 10.0 -5.0
Taxes (Rate 40) 16.0 4.0 0.0
Net income (NI) 24.0 6.0 -5.0
ROEL 48.0 12.0 -10.0
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Leverage( debt) and the advantages ?

• Imagine that the company have RM 50 million to
  pay for the new building
• It is insufficient to buy the building for the
  company expansion plan, so the company use that
  money as a deposit on the loan and get a loan for
  the rest of the money due.
• If the building price is RM250 M, and the company
  put down RM50 M, the company can use the loan to
  leverage that cash so the company can afford the
  building.

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Leverage( debt) and the advantages ?

• In this case the loan covers 80 of the purchase
  price.
• The company now can use any cash the company earn
  beyond the monthly loan repayment to pay other
  companys expenditure.
• The real benefits of leverage is seen when the
  building price goes up over time.

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Leverage( debt) and the advantages ?

• Suppose the building value increases by 20 to
  RM300 M at which point the company sell it and
  pay back the loan of RM 200 M.
• The company capital now has doubled from RM 50 M
  to RM 100M

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Calculate the debt to equity ratio, debt ratio,
times-interest-earned coverage ratios.

• Debt to Equity Total debt / Total equity
• (1,145 400) / 1,721 231 Ind.
• 0.79
  0.83

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Calculate the debt to equity ratio, debt ratio,
times-interest-earned coverage ratios.

• Debt ratio Total debt / Total assets
• (1,145 400) / 3,497 Ind.
• 44.2 50
• TIE EBIT / Interest expense Ind.
• 492.6 / 70 7.0x 6.2

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How do the debt management ratios compare with
industry averages?
2006E 2005 2004 Ind.
D/A 44.2 82.8 54.8 50.0
TIE 7.0x -1.0x 4.3x 6.2x
D/E 0.79 4.79 1.21 0.81

• D/E, D/A and TIE are compatible with the industry

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What questions do they answer?

• Profitability ratios These ratios enable the
  investors to evaluate the firms profit with
  respect to a given level of sales, a certain
  level of assets, or the owners investments?

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Profitability ratios Profit margin and Basic
earning power

• Profit margin Net income / Sales
• 253.6 / 7,036 3.6
• BEP EBIT / Total assets
• 492.6 / 3,497 14.1

Ind. 3.5
Ind. 19.1
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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

Ind. 9.1
Ind. 18.2
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Appraising profitability with the return on
assets and return on equity
2010E 2009 2008 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. More
  improvement is needed.

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Problems with ROE

• ROE and shareholder wealth are correlated, but
  problems can arise when ROE is the sole measure
  of performance.
• ROE could not capture accounting manipulation
  risk.

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Net income

• High ROE
• ROE Net Income
• Common equity

Capital structure policy
Equity Liability
High risk of financial distress
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Market value ratios

• A set of ratios that relate the firms stock
  price to its earnings, cash flow, and book value
  per share.

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Calculate the Price/Earnings, Price/Cash flow,
and Market/Book ratios.

• Share price 12.17, Earnings 253,584 0f
  shares 250,000
• P/E Price / Earnings per share
• 12.17 / 1.014 12.0x
• P/CF Price / Cash flow per share
• 12.17 / (253.6117.0) 250
• 8.21x

Ind. 14.2x
Ind. 11.0x
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Calculate the Price/Earnings, Price/Cash flow,
and Market/Book ratios.

• M/B Market price / Book value per share
• 12.17 / (1,952 / 250) 1.56x

Ind. 2.4x
2010E 2009 2008 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x
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Analyzing the market value ratios

• P/E How much investors are willing to pay for 1
  of earnings.
• P/CF How much investors are willing to pay for
  1 of cash flow.
• M/B How much investors are willing to pay for 1
  of book value equity.
• For each ratio, the higher the number, the better.

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The Du Pont system

• Focuses on expense control (PM), asset
  utilization (TA TO), and debt utilization (Equity
  multiplier.)

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Extended DuPont equation Breaking down Return
On Equity

• ROE (NI / Sales) x (Sales/TA) x (TA/Equity)
• 3.6 x 2 x 1.8
• 13.0

Ind. 18.2
PM TA TO EM ROE
2008 2.6 2.3 2.2 13.3
2009 -2.7 2.1 5.8 -32.5
2010E 3.6 2.0 1.8 13.0
Ind. 3.5 2.6 2.0 18.2
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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.
• Window dressing techniques can make statements
  and ratios look better.
• Different operating and accounting practices can
  distort comparisons.

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Electronic
Subs A

• 1) Firm A Firm B
• Return on 1m Return on 5m
• Total asset 4m total asset 15m
• 0.25 25 0.33 33

Subs B
N. Income RM1m T. Assets RM4m
N. Income RM5m T. Assets RM15m
Subs C
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• 2) ROE ROA
• Firm A 13 5.9
• Industry average 13.2 5.9

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• 3) Window Dressing
• ROE
• Firm A 12.6
• Firm B 10.5
• ROE Net income A L E
• Equity

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• Different accounting practice
• Firm A Firm B
• Sales xxx xxx
• COGS (xx) (xx)
• Depreciation (x) (xx)
• Net income xx x
• straight line method
  Accelerated method

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Potential problems and limitations of financial
ratio analysis

• It is difficult to generalize about whether a
  particular ratio is good or bad.
• For example, a high current ratio may indicate a
  strong liquidity position (which is good) or
  excessive cash ( which is bad) because excess
  cash is non earning assets.
• Example 2, high fixed turnover ratio may indicate
  either the firm uses its assets efficiently, or
  that it is short of cash and cannot afford to
  make the needed investment in fixed assets.

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Potential problems and limitations of financial
ratio analysis

• Inflation can badly distort many firms balance
  sheet data. Thus the recorded values are often
  substantially different from true values
• Seasonal factors can distort ratio analysis. For
  example the inventory turnover ratio for a food
  processor will be radically different if the
  balance sheet figure used for inventory is the
  one just before versus just after the close of
  the canning season.