CHAPTER 3 Analysis of Financial Statements 1

Topics in Chapter      Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors 2

Determinants of Intrinsic Value: Using Ratio Analysis Net operating profit after taxes − Required investments in operating capital Free cash flow (FCF) = (1 + WACC) 2 ...

FCF ∞ (1 + WACC) ∞

Market interest rates Market risk aversion

Weighted average cost of capital (WACC)

Cost of debt Cost of equity

Firm’s debt/equity mix Firm’s business risk

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Overview   Ratios facilitate comparison of:   One company over time One company versus other companies Ratios are used by:  Lenders to determine creditworthiness   Stockholders to estimate future cash flows and risk Managers to identify areas of weakness and strength 4

Income Statement Sales COGS Other expenses Deprec.

Tot. op. costs EBIT Int. expense EBT Taxes (40%) Net income 2010 $5,834,400 4,980,000 720,000 116,960 5,816,960 17,440 176,000 (158,560) (63,424) ($ 95,136) 2011E $7,035,600 5,800,000 612,960 120,000 6,532,960 502,640 80,000 422,640 169,056 $ 253,584 5

Balance Sheets: Assets Cash S-T invest.

AR Inventories Total CA Net FA Total assets 2010 $ 7,282 20,000 632,160 1,287,360 1,946,802 939,790 $2,886,592 2011E $ 14,000 71,632 878,000 1,716,480 2,680,112 836,840 $3,516,952 6

Balance Sheets: Liabilities & Equity Accts. payable Notes payable Accruals Total CL Long-term debt Common stock Ret. earnings Total equity Total L&E 2010 $ 324,000 720,000 284,960 1,328,960 1,000,000 460,000 97,632 557,632 $2,886,592 2011E $ 359,800 300,000 380,000 1,039,800 500,000 1,680,936 296,216 1,977,152 $3,516,952 7

Other Data Stock price # of shares EPS DPS Book val. per sh.

Lease payments Tax rate 2010 $6.00

100,000 -$0.95

$0.11

$5.58

$40,000 0.4

2011E $12.17

250,000 $1.01

$0.22

$7.91

$40,000 0.4

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Five Categories of Fin. Ratios      Liquidity Asset Mgmt Debt Mgmt Profitability Market Value 9

Five Categories of Fin. Ratios    Liquidity: Ability to meet current obligations Asset Mgmt: Proper & effective use of assets  Asset utilization (i.e., Total Asset Turnover Ratio:  TAT = Sales / T. Assets Debt Mgmt: extent of debt & level of safety afforded creditors  Debt utilization (i.e., Equity Multiplier:  EM = T. Assets / T. Eqty 10

Five Categories of Fin. Ratios  Profitability: reflects effects of liquidity, asset mgmt, & debt on operating results  Expense Control: Profit Margin:  PM = Net Income / Sales  Market Value: indicators of what investors think of firm’s past results & future prospects 11

Liquidity Ratios  Can the company meet its short-term obligations using resources it currently has on hand?

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Forecasted Current and Quick Ratios for 2011.

CR 10 QR 10 = CA - Inv.

CL 13

Comments on CR and QR CR QR 2011E 2.58

0.93

2010 1.46

0.5

2009 2.3

0.8

Ind.

2.7

1.0

  Expected to improve but still below industry average.

Liquidity position is weak.

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Asset Management Ratios   How efficiently does firm use its assets?

How much does firm have tied up in assets for each dollar of sales?

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Inventory Turnover Ratio vs. Industry Average Inv. turnover = Sales Inventories 2011E 2010 Inv. T. 4.1

4.5

2009 4.8

Ind.

6.1

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Comments on Inventory Turnover    Inventory turnover: Below industry average Firm might have old inventory, or its control might be poor.

No improvement is currently forecasted.

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DSO: average number of days from sale until cash received.

DSO = Receivables Average sales per day = 45.5 days. 18

Appraisal of DSO   Firm collects too slowly, and situation is getting worse.

Poor credit policy.

DSO 2011 45.5

2010 39.5

2009 37.4

Ind.

32.0

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Fixed Assets and Total Assets Turnover Ratios Fixed assets turnover = Sales Net fixed assets Total assets turnover = Sales Total assets = = 2.00.

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Fixed Assets and Total Assets Turnover Ratios   FA turnover: expected to exceed industry average. Good.

TA turnover not up to industry average. Implication? FA TO TA TO Caused by excessive current assets (A/R and inventory).

2011E 8.4

2.0

2010 6.2

2.0

2009 10.0

2.3

Ind.

7.0

2.5

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Debt Management Ratios   Does company have too much debt?

Can company’s earnings meet its debt servicing requirements? 22

Calculate the debt, TIE, and EBITDA coverage ratios.

Debt ratio = Total liabilities Total assets TIE = EBIT Int. expense (More…) 23

EBITDA Coverage (EC) _________ Interest expense + Lease Pmt. + Loan pmt.

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Debt Management Ratios vs. Industry Averages D/A TIE EC 2011E 2010 2009 Ind.

43.8% 80.7% 54.8% 50.0% 6.3

0.1

3.3

6.2

5.5

0.8

2.6

8.0

Recapitalization improved situation, but lease pmts drag down EBITDA Cov.

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Equity Multiplier = T. Assets/Cmn Eqty  Firms with large amts of debt financing (high leverage) have high Eqty Multiplier  Think: Assets = Debt + Eqty 26

Equity Multiplier = T. Assets/Cmn Eqty  Firms with small amts of debt financing (low leverage) have smaller Eqty Multiplier 27

Profitability Ratios  What is company’s rate of return on:   Sales?

Assets?

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Profit Margins Net profit margin (PM): Operating profit margin (OM):

(More…)

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Profit Margins (Continued) Gross profit margin (GPM): Sales − COGS Sales $7,036 − $5,800 $7,036 30

Profit Margins vs. Industry Averages PM OPM GPM 2011E 2010 2009 3.6% -1.6% 2.6% 3.6% 7.1

17.6

0.3

14.6

6.1

16.6

Ind.

7.1

15.5

Very bad in 2010, but projected to meet or exceed industry average in 2011.

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Basic Earning Power & Subway vs. Smelly Deli  EBIT=  T.Assets=  BEP= EBIT/TA 32

Basic Earning Power (BEP) BEP = EBIT Total assets = = $3,517 =14.3% 33

Basic Earning Power vs. Industry Average BEP 2011E 2010 2009 Ind.

14.3% 0.6% 14.2% 17.8%    BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be below average.

Room for improvement.

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Return on Assets (ROA) and Return on Equity (ROE) ROA = NI Total assets

(More…)

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Return on Assets (ROA) and Return on Equity (ROE) ROE = NI Common Equity

(More…)

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ROA and ROE vs. Industry Averages ROA ROE 2011E 7.2% 2010 2009 Ind.

-3.3% 6.0% 9.0% 12.8% -17.1% 13.3% 18.0% Both below average but improving.

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Effects of Debt on ROA & ROE No Debt (unlevered) vs. Debt (levered) 38

Effects of Debt on ROA and ROE   ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.

However, use of debt lowers equity, and if equity is lowered more than net income, ROE increases.

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Important Implications of Debt Financing (Financial Leverage)    By raising $ thru debt, stockholders can maintain control of firm w/o increasing their investment.

Greater the equity stake, the less risk faced by lenders (creditors) If company earns greater return on investment financed with debt than it pays in interest on borrowed funds, then it the return on owners equity is magnified, or leveraged.

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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.

Intrnl Grth rate = (ROA x Retention %) 1- (ROA x Retention %)

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.

Sustnbl Grth rate = (ROE x Retention %) 1- (ROE x Retention %)

Market Value Ratios  Market value ratios: gives mgmt indication of what investors think of co.’s past performance & future prospects 43

Market Value Ratios  Increase /decrease:    High current levels of earnings and cash flow increase market value ratios High expected growth in earnings and cash flow increases market value ratios High risk of expected growth in earnings and cash flow ratios decreases market value 44

Market Value Ratios  P/E = Mrkt price per share / Earning per share   PEG ratio= (Price/Earnings) / Growth PEG <1.0 reflects fairly valued stock M/B= Mrkt price p.s. / Book Value p.s.

 P/CF=Price p.s. / CF p.s.

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Calculate and appraise the P/E, P/CF, and M/B ratios.

Price = $12.17.

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Market Based Ratios CF per share = NI + Depr. Shares out.

$253.6 + $120.0

250 P/CF = Price per share Cash flow per share 47

Market Based Ratios (Continued) BVPS = Com. equity Shares out.

M/B = Mkt. price per share Book value per share 48

Interpreting Market Based Ratios    P/E: How much investors will pay for $1 of earnings. Higher is better.

M/B: How much paid for $1 of book value. Higher is better.

P/E and M/B are high if ROE is high, risk is low.

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Market Value Measures     Value Stocks: Firms w/ low Mrkt to Book ratios Growth Stocks: Firms w/ high Mrkt to Book ratios Market Capitalization = Mrkt Value of Common Equity Enterprise Value= MV equity + MV debt – Cash – mrktbl securities. Measures value of firm’s underlying business

Comparison with Industry Averages P/E P/CF M/B 2011E 12.0

8.2

1.5

2010 2009 Ind.

-6.3

9.7

14.2

27.5

1.1

8.0

1.3

7.6

2.9

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Explain the Du Pont System   The Du Pont system focuses on:    Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

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The Du Pont System NI Sales x Sales TA x TA CE = ROE = ROE 53

Du Pont & Corp Operations margin TA turnover Equity multiplier NI Sales x Sales TA x TA CE = ROE = ROE 54

The Du Pont System NI Sales x Sales TA x TA CE = ROE 2008: 2.6% x 2.3 x 2.2 = 2009: -1.6% x 2.0 x 5.2 = -16.6% 2010: 3.6% x 2.0 x 1.8 = 13.2% 13.0% Ind.: 3.6% x 2.5 x 2.0 = 18.0% 55

Common Size Balance Sheets: Divide all items by Total Assets Assets Cash ST Inv.

AR Invent.

Total CA Net FA TA 2009 0.6% 3.3% 23.9% 48.7% 2010 0.3% 0.7% 21.9% 44.6% 2011E 0.4% 2.0% 25.0% 48.8% Ind.

0.3% 0.3% 22.4% 41.2% 76.5% 23.5% 67.4% 32.6% 76.2% 23.8% 64.1% 35.9% 100.0% 100.0% 100.0% 100.0% 56

Divide all items by Total Liabilities & Equity Assets AP Notes pay.

Accruals Total CL LT Debt Total eq.

Total L&E 2009 2010 2011E Ind.

9.9% 11.2% 10.2% 11.9% 13.6% 24.9% 8.5% 2.4% 9.3% 9.9% 10.8% 9.5% 32.8% 46.0% 29.6% 23.7% 22.0% 34.6% 14.2% 26.3% 45.2% 19.3% 56.2% 50.0% 57 100.0 100.0

100.0 100.0%

Analysis of Common Size Balance Sheets    Computron has higher proportion of inventory and current assets than Industry.

Computron now has more equity (which means LESS debt) than Industry.

Computron has more short-term debt than industry, but less long-term debt than industry.

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Common Size Income Statement: Divide all items by Sales Sales COGS Other exp.

Depr.

EBIT Int. Exp.

EBT Taxes NI 2009 100.0% 83.4% 9.9% 0.6% 6.1% 1.8% 4.3% 1.7% 2.6% 2010 100.0% 85.4% 12.3% 2.0% 0.3% 3.0% -2.7% -1.1% -1.6% 2011E 100.0% 82.4% 8.7% 1.7% 7.1% 1.1% 6.0% 2.4% 3.6% Ind.

100.0% 84.5% 4.4% 4.0% 7.1% 1.1% 5.9% 2.4% 3.6% 59

Analysis of Common Size Income Statements  Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.

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Percentage Change Analysis: % Change from First Year (2009) Income St.

Sales COGS Other exp.

Depr.

EBIT Int. Exp.

EBT Taxes NI 2009 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2010 70.0% 73.9% 111.8% 518.8% -91.7% 181.6% -208.2% -208.2% -208.2% 2011E 105.0% 102.5% 80.3% 534.9% 140.4% 28.0% 188.3% 188.3% 188.3% 61

Analysis of Percent Change Income Statement   We see that 2011 sales grew 105% from 2009, and that NI grew 188% from 2009.

So Computron has become more profitable.

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Percentage Change Balance Sheets: Assets Assets Cash ST Invest.

AR Invent.

Total CA Net FA TA 2009 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2010 -19.1% -58.8% 80.0% 80.0% 73.2% 172.6% 96.5% 2011E 55.6% 47.4% 150.0% 140.0% 138.4% 142.7% 139.4% 63

Percentage Change Balance Sheets: Liabilities & Equity Liab. & Eq.

2009 2010 2011E AP Notes pay.

Accruals Total CL LT Debt Total eq.

Total L&E 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 122.5% 260.0% 109.5% 175.9% 209.2% -16.0% 96.5% 147.1% 50.0% 179.4% 115.9% 54.6% 197.9% 139.4% 64

Analysis of Percent Change Balance Sheets  Total assets grew at rate of 139%, while sales grew at rate of only 105%. So asset utilization remains a problem.

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Potential Problems and Limitations of Ratio Analysis     Comparison with industry averages is difficult if firm operates many different divisions.

Seasonal factors can distort ratios.

Window dressing techniques can make statements and ratios look better.

Different accounting and operating practices can distort comparisons.

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Qualitative Factors     There is greater risk if:  revenues tied to a single customer    revenues tied to a single product reliance on a single supplier?

High percentage of business is generated overseas?

What is competitive situation?

What products are in pipeline?

What are legal and regulatory issues?

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