CHAPTER 3 Financial Statement Analysis

1
Lecture Three Evaluating the Firm for Planning
and Forecasting Via Analysis of Financial
Statements

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

2
Balance Sheet Assets
3 - 2
1998E
1997
Cash
85,632
7,282
AR
878,000
632,160
Inventories
1,716,480
1,287,360
Total CA
2,680,112 77
1,926,802 67
Gross FA
1,197,160
1,202,950
Less Deprec.
380,120
263,160
Net FA
817,040
939,790
Total assets
3,497,152
2,866,592
3
Liabilities and Equity
3 - 3
1998E
1997
Accounts payable
436,800
524,160
Notes payable
600,000
720,000
Accruals
408,000
489,600
Total CL
1,444,800 41
1,733,760 60
Long-term debt
500,000 14
1,000,000 35
Common stock
1,680,936
460,000
Retained earnings
(128,584)
(327,168)
Total equity
1,552,352 44
132,832 5
Total L E
3,497,152
2,866,592
4
Income Statement
3 - 4
1998E
1997
Sales
7,035,600
5,834,400
COGS
5,728,000
5,728,000
Other expenses
680,000
680,000
Depreciation
116,960
116,960
Tot. op. costs
6,524,960
6,524,960
EBIT
510,640
(690,560)
Interest exp.
88,000
176,000
EBT
422,640
(866,560)
Taxes (40)
169,056
(346,624)
Net income
253,584
(519,936)
5
Other Data
1998E
1997
Shares out.
250,000
100,000
EPS
1.014
(5.199)
DPS
0.220
0.110
Stock price
12.17
2.25
Lease pmts
40,000
40,000
6
Why are ratios useful?

• Standardize numbers facilitate comparisons
• Used to highlight weaknesses and strengths

7
What are the five major categories of ratios, and
what questions do they answer?

• Liquidity Can we make required payments?
• Asset management Right amount of assets vs.
  sales?

8

• Debt management Right mix of debt and equity?
• Profitability Do sales prices exceed unit
  costs, and are sales high enough as reflected in
  PM, ROE, and ROA?
• Market value Do investors like what they see as
  reflected in P/E and M/B ratios?

9
Calculate DLeons forecasted current and quick
ratios for 1998.
2,680 1,445
CA CL
CR98 1.85x.
CA - Inv. CL
QR98
2,680 - 1,716 1,445
0.67x.
10
Comments on CR and QR
1998 1997 1996 Ind. CR 1.85x 1.1x 2.3x 2.7x QR 0.
67x 0.4x 0.8x 1.0x

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

11
What is the inventory turnover ratio vs. the
industry average?
12
Comments on Inventory Turnover

• Inventory turnover is below industry average.
• DLeon might have old inventory, or its control
  might be poor.
• No improvement is currently forecasted.

13
DSO is the average number of days after making a
sale before receiving cash.
Receivables Average sales per day
DSO
44.9.
Receivables Sales/360
878 7,036/360
14
Appraisal of DSO
1998 1997 1996 Ind. DSO 44.9 39.0 36.8 32.0

• DLeon collects too slowly, and is getting worse.
• Poor credit policy.

15
F.A. and T.A. turnover vs. industry average
16
1998 1997 1996
Ind. FA TO 8.6x 6.2x 10.0x 7.0x TA
TO 2.0x 2.0x 2.3x 2.6x

• FA turnover project to exceed industry average.
  Good.
• TA turnover not up to industry average. Caused
  by excessive current assets (A/R and inv.)

17
Calculate the debt, TIE, and fixed charge
coverage ratios.
18
Fixed charge coverage
FCC
EBIT Lease payments
Interest Lease Sinking fund pmt. expense
pmt. (1 - T)
4.3x.

510.6 40 88 40 0
All three ratios reflect use of debt, but focus
on different aspects.
19
How do the debt management ratios compare with
industry averages?
1998 1997 1996
Ind. D/A 55.6 95.4 54.8 50.0 TIE 5.8x -3.9x 3.
3x 6.2x FCC 4.3x -3.0x 2.4x 5.1x
Too much debt, but projected to improve.
20
Another Debt Management Ratio used commonly is
A
LNW
D/E
CA
D
FA
E
TA
TLNWE
To convert into something more familiar as D/TA
we simply
D/E
D
D
(
)
D
D/TA
or


1
D/E 1
TA
E
E
Example if D/E 0.91
D
0.91
0.91
47



TA
1 0.91
1.91
21
Profit margin vs. industry average?
3 - 20
1998 1997 1996 Ind. P.M. 3.6 -8.9 2.6 3.5
Very bad in 1997, but projected to exceed
industry average in 1998. Looking good.
22
3 - 21
BEP vs. Industry Average?
EBIT Total assets

• BEP
• 14.6.

510.6 3,497
23
3 - 22
1998 1997 1996 Ind. BEP 14.6 -24.1 14.2 19.1

• BEP removes effect of taxes and financial
  leverage. Useful for comparison.
• Projected to be below average.
• Room for improvement.

24
3 - 23
Return on Assets
Net income Total assets

• ROA
• 7.3.

253.6 3,497
25
3 - 24
1998 1997 1996
Ind. ROA 7.3 -18.1 6.0 9.1 ROE 16.3 -391.0 1
3.3 18.2
Both below average but improving.
26
3 - 25
Effects of Debt on ROA and ROE

• ROA is lowered by debt--interest lowers NI, which
  also lowers ROA NI/Assets.
• But use of debt lowers equity, hence could raise
  ROE NI/Equity.

27
3 - 26
Calculate and appraise the P/E and M/B ratios.
28
3 - 27
Com. equity Shares out.
BVPS 6.21.
1,552 250
Mkt. price per share Book value per share
M/B 1.96x.
12.17 6.21
29
3 - 28
1998 1997 1996
Ind. P/E 12.0x -0.4x 9.7x 14.2x M/B 1.96x 1.7x 1.3
x 2.4x

• P/E How much investors will pay for 1 of
  earnings. High is good.
• M/B How much paid for 1 of BV. Higher is good.
• P/E and M/B are high if ROE is high, risk is low.

30
3 - 29
( )( )( ) ROE
x x ROE.
Profit margin
TA turnover
Equity multiplier
NI Sales
Sales TA
TA CE
1996 2.6 x 2.3 x 2.2 13.2 1997 -8.9 x 2.0 x 2
1.9 -391.0 1998 3.6 x 2.0 x 2.3 16.3 Ind. 3
.5 x 2.6 x 2.0 18.2
31
Converting Equity Multiplier into Debt/TA and
vice versa
(
)
(
)
TD
1
TE
1 -
1 -


TA
EM
TA
1
EM

(
)
TD
1 -
TA
If firm has Preferred Stock, must adjust
formula by using CE in place of TE and
subtracting PS from TA.
32
The Du Pont system focuses on
3 - 30

• Expense control (P.M.)
• Asset utilization (TATO)
• Debt utilization (Eq. Mult.)

It shows how these factors combine to determine
the ROE.
33
Ratio Analysis Spread Sheet Example De Leon
Ratio Categories
Liquidity
Asset Management
Leverage
Profitability
Market
34
Altmans Z Score
Multiple Discriminant Analysis (MDA) statistical
technique similar to regression analysis. Used to
classify companies in two groups High
probability of bankruptcy Low probability of
bankruptcy High probability of bankruptcy exists
when 1. There is high leverage (Mkt. Value
of Stk./Book value of Debt) X-4 2. Low
liquidity (NWC/Assets) X-1 3. Low return on
assets (EBIT/Assets) X-3 4. Poor asset
utilization (Sales/Total Assets) X-5 5. Poor
reinvestment opportunities (RE/TA) X-2 all
in extended Du Pont equation. MDA helps determine
the actual probability of bankruptcy for a given
level of any of above ratios plus it captures the
effect of the interrelationship between the
ratios. It is a technique used very much in banks
SLs in granting credit to customers
investment banks rating bonds (specially junk
bonds). 84 success in predicting 2 years
ahead. 70 success in predicting 5 years ahead.
35
Simplified DLeon Data
3 - 31
A/R
878
Debt
1,945
Other CA
1,802
Equity
1,552
Net FA
817
Total assets
3,497
LE
3,497
Sales 7,035,600 day
360
19,543.
Q. How would reducing DSO to 32
days affect the company?
36
Effect of reducing DSO from 44.9 days to 32 days
3 - 32
Old A/R 19,543 x 44.9 878,000 New A/R
19,543 x 32.0 625,376 Cash
freed up 252,624 Initially shows up as
additional cash.
37
New Balance Sheet
3 - 33
What could be done with the new cash? Effect on
stock price and risk?
38
Potential use of freed up cash
3 - 34

• Repurchase stock. Higher ROE, higher EPS.
• Expand business. Higher profits.
• Reduce debt. Better debt ratio lower interest,
  hence higher NI.
• All these actions would improve stock price.

39
3 - 35
Inventories are also too high. Could analyze the
effect of an inventory reduction on freeing up
cash and increasing the quick ratio and asset
management ratios--similar to what was done with
DSO in slides 31 - 33.
40
3 - 36
Q. Would you lend money to the company? A. Maybe.
Things could get better. In business, one has
to take some chances!
41
Company should not have relied exclusively on
debt to finance its expansion.
3 - 37
42
DLEON Analysis/Diagnosis/Prescription

• I. Examination or Analysis
• A. Statement of Cash Flow
• B. Ratios
• II. Diagnosis or conclusions about the situation
• An expansion began in 1996, which was financed
  with Long Term and Short Term debt. (Evident on
  the ratios and the balance sheets). The company
  apparently assumed that sales and profits would
  increase automatically with the expansion. Sales
  actually lagged and all ratios deteriorated in
  1997.
• As sales in 97 increased consistently in
  subsequent months they provided support for a
  more optimistic sales forecast for 1998. All
  ratios improve dramatically in 98 except
  collection period or DSO.

43

• III. Prescription or recommendations
• In hindsight, before the company took on its
  expansion plans, it should have done an extensive
  ratio analysis to determine the effects of its
  proposed expansion on the firms operations. Had
  the ratio analysis been conducted, the company
  would have gotten its house in order before
  undergoing the expansion. For instance it would
  have used equity financing for part of the
  expansion. Without it they should not have
  expanded. The equity financing is indispensable
  for plant and capacity expansion because this
  source of funding does not require interest,
  principal, or dividend payments, giving the firm
  time to slowly increase its sales to utilize the
  added capacity and time to reach its eventual
  profitability target. That is a more conservative
  sales growth plan should have been assumed and
  the expansion at least partly financed by equity.
  Even losses could have been planned as is often
  the case after an expansion of plant capacity.
  The ratios in 1998 are pretty acceptable, except
  for two, and show the expected increase in sales.
  If the sales materialize they will be fine. If
  not, they may have to raise some equity financing
  and pay back some of the debt. The two ratios
  that are still deficient even in 1998 are DSO and
  Total Asset Turnover. Which show that the company
  credit policy is too lose and needs to be
  tightened. If they can improve their collections
  they can decrease the DSO and hence the invested
  funds into accounts receivable. Illustrated in
  blueprints 3-31 through 3-34.
• On the other hand, if the lenient credit is part
  of a predetermined strategy to increase sales to
  plant capacity by capturing a larger share of the
  market while the products become popular, then
  the higher level of receivables will have to be
  sustained but more equity financing might be
  required.
• All in all, the Co. seems to have very short run
  expansion or growing pains principally because
  all the expansion was financed with debt.

44
What are some potential problems and limitations
of financial ratio analysis?
3 - 38

• Comparison with industry averages is difficult if
  the firm operates many different divisions.

45
3 - 39

• Average performance not necessarily good.
• Seasonal factors can distort ratios.
• Window dressing techniques can make statements
  and ratios look better.

46
3 - 40

• Different operating and accounting practices
  distort comparisons.
• Sometimes hard to tell if a ratio is good or
  bad.
• Difficult to tell whether company is, on balance,
  in strong or weak position.

47
What are some qualitative factors analysts should
consider when evaluating a companys likely
future financial performance?
3 - 41

• Are the companys revenues tied to 1 key
  customer?
• To what extent are the companys revenues tied to
  1 key product?
• To what extent does the company rely on a single
  supplier?

(Cont)
48
3 - 42

• What percentage of the companys business is
  generated overseas?
• Competition
• Future prospects
• Legal and regulatory environment
• Management/Labor Relations and Productivity