CHAPTER 3 Financial Statement Analysis

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Transcript CHAPTER 3 Financial Statement Analysis

CHAPTER 3

Analysis of Financial Statements

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Ratio analysis

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Du Pont system

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Effects of improving ratios

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Limitations of ratio analysis

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Balance Sheet: Assets 1999E Cash ST investments AR Inventories Total CA Gross FA Less: Deprec.

Net FA Total assets 14,000 71,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152 Copyright © 1999 by The Dryden Press 1998 7,282 0 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 All rights reserved.

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Liabilities and Equity Accounts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total equity Total L & E Copyright © 1999 by The Dryden Press 1999E 436,800 600,000 408,000 1,444,800 500,000 1,680,936 (128,584) 1,552,352 3,497,152 1998 524,160 720,000 489,600 1,733,760 1,000,000 460,000 (327,168) 132,832 2,866,592 All rights reserved.

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Income Statement Sales COGS Other expenses Depreciation Tot. op. costs EBIT Interest exp.

EBT Taxes (40%) Net income Copyright © 1999 by The Dryden Press 1999E 7,035,600 5,728,000 680,000 116,960 6,524,960 510,640 88,000 422,640 169,056 253,584 1998 5,834,400 5,728,000 680,000 116,960 6,524,960 (690,560) 176,000 (866,560) (346,624) (519,936) All rights reserved.

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Other Data Shares out.

$0.220

$12.17

$40,000 1998 100,000 ($5.199) $0.110

$2.25

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Why are ratios useful?

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Standardize numbers; facilitate comparisons

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

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Liquidity: Can we make required payments as they fall due?

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Asset management: Do we have the right amount of assets for the level of sales?

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Debt management: Do we have the right mix of debt and equity?

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Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

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Market value: Do investors like what they see as reflected in P/E and M/B ratios?

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Calculate the firm’s forecasted current and quick ratios for 1999.

CR 99 CA $2,680 $1,445 1.85x

QR 99 = CA - Inv.

CL $2,680 - $1,716 = = 0.67x

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Comments on CR and QR CR QR 1999 1.85x

0.67x

1998 1.1x

0.4x

1997 2.3x

0.8x

Ind.

2.7x

1.0x

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Expected to improve but still below the industry average.

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Liquidity position is weak.

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What is the inventory turnover ratio as compared to the industry average?

Inv. turnover = Sales Inventories = = 4.10x.

Inv. T.

1999 4.1x

1997 4.8x

Ind.

6.1x

Comments on Inventory Turnover

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Inventory turnover is below industry average.

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Firm might have old inventory, or its control might be poor.

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No improvement is currently forecasted.

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

DSO = Receivables Average sales per day Receivables $878 $7,036/360 = 44.9 days.

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Appraisal of DSO DSO 1999 44.9

1998 39.0

1997 36.8

Ind.

32.0

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Firm collects too slowly, and situation is getting worse.

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Poor credit policy.

Fixed Assets and Total Assets Turnover Ratios

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Fixed assets turnover = Sales Net fixed assets Total assets turnover = = $817 8.61x.

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FA TO TA TO 1999 8.6x

2.0x

1998 6.2x

2.0x

1997 10.0x

2.3x

Ind.

7.0x

2.6x

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FA turnover is expected to exceed industry average. Good.

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

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Calculate the forecasted operating capital requirement ratio (OCR).

Operating capital Net operating working capital Net fixed assets Net operating working capital = ($14,000 + $878,000 + $1,716,480) - ($436,800 + $408,000) = $1,763,680.

Operating capital = $1,763,680 + $817,040 = $2,580,720.

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OCR = Operating capital/Sales = $2,580,720/$7,035,600 = 36.7%.

1999 1998 1997 OCR 36.7% 31.8% 33.2% Ind.

29.5%

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The OCR is not improving.

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It is worse than the industry average.

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Calculate the debt, TIE, and fixed charge coverage ratios.

Debt ratio = Total debt Total assets = = $3,497 55.6%.

TIE = EBIT Int. expense = = $88 5.8x.

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Fixed charge coverage = FCC EBIT + Lease payments = Interest Lease Sinking fund pmt.

expense pmt. (1 - T) = = 4.3x.

All three ratios reflect use of debt, but focus on different aspects.

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How do the debt management ratios compare with industry averages?

D/A TIE FCC 1999 55.6% 5.8x

4.3x

1998 95.4% -3.9x

-3.0x

1997 54.8% 3.3x

2.4x

Ind.

50.0% 6.2x

5.1x

Too much debt, but projected to improve.

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After-tax operating profit margin (ATOPM) ATOPM = EBIT(1 - T) = $510,640(1 - 0.4) Sales = 4.4%.

$7,035,600 ATOPM 1999 1998 1997 4.4% -7.1% 3.7% Ind.

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Profit Margin (PM) NI $253.6

$7,036 3.6%.

1999 3.6% 1998 -8.9% 1997 2.6% Ind.

3.5% PM Very bad in 1998, but projected to exceed industry average in 1999. Looking good.

Basic Earning Power (BEP)

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BEP = EBIT Total assets $510.6 = = 14.6%.

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BEP 1999 14.6% 1998 1997 -24.1% 14.2% Ind.

19.1%

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BEP removes effect of taxes and financial leverage. Useful for comparison.

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Projected to be below average.

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Room for improvement.

Return on Assets (ROA) and Return on Equity (ROE)

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ROA = Net income Total assets $253.6 = = 7.3%.

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ROE = Net income Common equity = = $1,552 16.3%.

ROA ROE 1999 7.3% 16.3% 1998 1997 -18.1% 6.0% -391.0% 13.3% Ind.

9.1% 18.2% Both below average but improving.

Effects of Debt on ROA and ROE

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ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.

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

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

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Price = $12.17.

$253.6

250 $1.01.

Price per share $12.17

$1.01

12x.

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BVPS = Com. equity Shares out.

= = $6.21.

Mkt. price per share M/B = Book value per share $12.17

= = 1.96x.

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P/E M/B 1999 12.0x

1.96x

1998 -0.4x

1.7x

1997 9.7x

1.3x

Ind.

14.2x

2.4x

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P/E: How much investors will pay for $1 of earnings. High is good.

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

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

Explain the Du Pont System

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= ROE NI Sales x Sales TA x TA CE = ROE.

1997 1998 1999 Ind.

The Du Pont system focuses on:

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Expense control (PM)

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Asset utilization (TATO)

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Debt utilization (EM)

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It shows how these factors combine to determine the ROE.

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Simplified Firm Data A/R Other CA $ 878 Debt 1,802 Equity Net FA 817 Total assets $3,497 L&E $1,945 1,552 $3,497 day 360 Q. How would reducing DSO to 32 days affect the company?

Effect of reducing DSO from 44.9 days to 32 days:

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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.

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New Balance Sheet Added cash A/R Other CA Net FA Total assets $ 253 Debt 625 Equity 1,802 $1,945 1,552 817 $3,497 Total L&E $3,497 What could be done with the new cash? Effect on stock price and risk?

Potential use of freed up cash

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Repurchase stock . Higher ROE, higher EPS.

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Expand business . Higher profits.

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Reduce debt . Better debt ratio; lower interest, hence higher NI.

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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. Such an analysis would be similar to what was done with DSO in previous slides.

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All these actions would likely improve stock price .

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Would you lend money to this company?

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Maybe . The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment.

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However, company should not have relied so heavily on debt financing in the past.

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What are some potential problems and limitations of financial ratio analysis?

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

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“Average” performance is not necessarily good.

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Seasonal factors can distort ratios.

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Window dressing techniques can make statements and ratios look better.

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Different accounting and operating practices can distort comparisons.

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Sometimes it is difficult to tell if a ratio value is “good” or “bad.”

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Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

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What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?

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Are the company’s revenues tied to a single customer ?

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To what extent are the company’s revenues tied to a single product ?

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To what extent does the company rely on a single supplier ?

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What percentage of the company’s business is generated overseas ?

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What is the competitive situation ?

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What does the future have in store?

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What is the company’s legal and regulatory environment ?

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And so on.

CHAPTER 3 Financial Statement Analysis

Transcript CHAPTER 3 Financial Statement Analysis

CHAPTER 3

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