Transcript IFM7 Chapter 7 - Raymond J. Harbert College of Business

7-1
CHAPTER 7
Analysis of Financial Statements
Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
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7-2
Balance Sheet: Assets
2002E
Cash
14,000
71,632
ST investments
AR
878,000
Inventories
1,716,480
Total CA
2,680,112
Gross FA
1,197,160
Less: Deprec.
380,120
Net FA
817,040
Total assets
3,497,152
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2001
7,282
0
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
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7-3
Liabilities and Equity
2002E
2001
Accounts payable
436,800
524,160
Notes payable
600,000
720,000
Accruals
408,000
489,600
Total CL
1,444,800 1,733,760
Long-term debt
500,000 1,000,000
Common stock
1,680,936
460,000
Retained earnings (128,584) (327,168)
Total equity
1,552,352
132,832
Total L & E
3,497,152 2,866,592
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7-4
Income Statement
Sales
COGS
Other expenses
Depreciation
Tot. op. costs
EBIT
Interest exp.
EBT
Taxes (40%)
Net income
2002E
7,035,600
6,100,000
312,960
120,000
6,532,960
502,640
80,000
422,640
169,056
253,584
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2001
5,834,400
5,728,000
680,000
116,960
6,524,960
(690,560)
176,000
(866,560)
(346,624)
(519,936)
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7-5
Other Data
2002E
2001
250,000
100,000
EPS
$1.014
($5.199)
DPS
$0.220
$0.110
Shares out.
Stock price
$12.17
$2.25
Lease pmts
$40,000
$40,000
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7-6
Why are ratios useful?
Standardize numbers; facilitate
comparisons
Used to highlight weaknesses and
strengths
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7-7
What are the five major categories of
ratios, and what questions do they
answer?
Liquidity: Can we make required
payments as they fall due?
Asset management: Do we have
the right amount of assets for the
level of sales?
(More…)
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7-8
Debt management: Do we have the
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?
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7-9
Calculate the firm’s forecasted current
and quick ratios for 2002.
CA
CR02 = CL
$2,680
= $1,445 = 1.85x.
CA - Inv.
QR02 =
CL
$2,680 - $1,716
=
=
0.67x.
$1,445
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7 - 10
Comments on CR and QR
2002E
2001
2000
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.
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7 - 11
What is the inventory turnover ratio as
compared to the industry average?
Sales
Inv. turnover = Inventories
$7,036
=
= 4.10x.
$1,716
2002E
Inv. T. 4.1x
2001
2000
Ind.
4.5x
4.8x
6.1x
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7 - 12
Comments on Inventory Turnover
Inventory turnover is below
industry average.
Firm might have old inventory, or
its control might be poor.
No improvement is currently
forecasted.
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7 - 13
DSO is the average number of days
after making a sale before receiving
cash.
Receivables
DSO = Average sales per day
Receivables
$878
= Sales/360 = $7,036/360
= 44.9 days.
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7 - 14
Appraisal of DSO
DSO
2002
44.9
2001
39.0
2000
36.8
Ind.
32.0
 Firm collects too slowly, and
situation is getting worse.
 Poor credit policy.
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7 - 15
Fixed Assets and Total Assets
Turnover Ratios
Fixed assets
Sales
=
turnover
Net fixed assets
= $7,036 = 8.61x.
$817
Total assets
=
turnover
Sales
Total assets
$7,036
=
= 2.01x.
$3,497
(More…)
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7 - 16
FA TO
TA TO
2002E 2001 2000
8.6x 6.2x 10.0x
2.0x 2.0x 2.3x
Ind.
7.0x
2.5x
FA turnover is expected to exceed
industry average. Good.
TA turnover not up to industry
average. Caused by excessive
current assets (A/R and inventory).
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7 - 17
Calculate the debt, TIE, and EBITDA
coverage ratios.
Total debt
Debt ratio =
Total assets
$1,445
+
$500
=
= 55.6%.
$3,497
EBIT
TIE =
Int. expense
$502.6
=
= 6.3x.
$80
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(More…)
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7 - 18
EBITDA
= EC
coverage
EBIT + Depr. & Amort. + Lease payments
Interest Lease Loan pmt.
expense + pmt. +
=
$502.6 + $120 + $40
$80 + $40 + $0
= 5.5x.
All three ratios reflect use of debt, but
focus on different aspects.
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7 - 19
How do the debt management ratios
compare with industry averages?
D/A
TIE
EC
2002E
55.6%
6.3x
5.5x
2001 2000
Ind.
95.4% 54.8% 50.0%
-3.9x 3.3x 6.2x
-2.5x 2.6x 8.0x
Too much debt, but projected to
improve.
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7 - 20
Profit Margin (PM)
NI
$253.6
PM = Sales = $7,036 = 3.6%.
PM
2002E 2001 2000
3.6% -8.9% 2.6%
Ind.
3.6%
Very bad in 2001, but projected to
meet industry average in 2002.
Looking good.
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7 - 21
Basic Earning Power (BEP)
EBIT
BEP =
Total assets
$502.6
= $3,497 = 14.4%.
(More…)
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7 - 22
BEP
2002E 2001 2000 Ind.
14.4% -24.1% 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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7 - 23
Return on Assets (ROA)
and Return on Equity (ROE)
Net
income
ROA =
Total assets
$253.6
= $3,497 = 7.3%.
(More…)
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7 - 24
Net income
ROE = Common equity
= $253.6 = 16.3%.
$1,552
ROA
ROE
2002E
2001 2000
Ind.
7.3% -18.1% 6.0% 9.0%
16.3% -391.0% 13.3% 18.0%
Both below average but improving.
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7 - 25
Effects of Debt on ROA and ROE
ROA is lowered by debt--interest
expense lowers net income, which
also lowers ROA.
However, the use of debt lowers
equity, and if equity is lowered
more than net income, ROE would
increase.
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7 - 26
Calculate and appraise the
P/E, P/CF, and M/B ratios.
Price = $12.17.
NI
$253.6
EPS = Shares out. = 250 = $1.01.
Price per share $12.17
P/E =
=
=
12x.
EPS
$1.01
(More…)
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7 - 27
Typical industry average P/E ratios
Industry
P/E ratio
Banking
17.15
Computer Software Services
33.01
Drug
41.81
Electric Utilities (Eastern U.S.) 19.40
Internet Services*
290.35
Semiconductors
78.41
Steel
12.71
Tobacco
11.59
Water Utilities
21.84
* Because many internet companies have negative earnings and no
P/E, there was only a small sample of internet companies.
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7 - 28
NI
+
Depr.
CF per share =
Shares out.
= $253.6 + $120.0 = $1.49.
250
Price per share
P/CF =
Cash flow per share
$12.17
= $1.49 = 8.2x.
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7 - 29
Com. equity
BVPS =
Shares out.
$1,552
=
= $6.21.
250
Mkt. price per share
M/B =
Book value per share
$12.17
= $6.21 = 2.0x.
(More…)
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7 - 30
2002E
2001 2000
Ind.
P/E
12.0x
-0.4x 9.7x 14.2x
P/CF
8.2x
-0.6x 8.0x
7.6x
M/B
2.0x
1.7x 1.3x
2.9x
P/E: How much investors will pay
for $1 of earnings. High is good.
M/B: How much paid for $1 of book
value. Higher is good.
P/E and M/B are high if ROE is high,
risk is low.
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7 - 31
Common Size Balance Sheets:
Divide all items by Total Assets
Assets
2000
2001 2002E
Cash
0.6%
0.3%
0.4%
ST Invest. 3.3%
0.0%
2.0%
AR
23.9% 22.1% 25.1%
Invent.
48.7% 44.9% 49.1%
Total CA 76.5% 67.2% 76.6%
Net FA
23.5% 32.8% 23.4%
TA
100.0% 100.0% 100.0%
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Ind.
0.3%
0.3%
22.4%
41.2%
64.1%
35.9%
100.0%
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7 - 32
Divide all items by
Total Liabilities & Equity
2000
2001 2002E
AP
9.9% 18.3% 12.5%
Notes pay. 13.6% 25.1% 17.2%
Accruals
9.3% 17.1% 11.7%
Total CL
32.8% 60.5% 41.3%
LT Debt
22.0% 34.9% 14.3%
Total equ. 45.2%
4.6% 44.4%
Total L&E 100.0% 100.0% 100.0%
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Ind.
11.9%
2.4%
9.5%
23.7%
26.3%
50.0%
100.0%
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7 - 33
Analysis of Common Size Balance
Sheets
Computron has higher proportion of
current assets (49.1%) than Industry
(41.2%).
Computron has slightly less equity
(which means more debt) than Industry.
Computron has more short-term debt
than industry, but less long-term debt
than industry.
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7 - 34
Common Size Income Statement:
Divide all items by Sales
2000
2001 2002E
Ind.
Sales
100.0% 100.0% 100.0% 100.0%
COGS
83.4% 98.2% 86.7% 84.5%
Other exp. 9.9% 11.7%
4.4%
4.4%
Depr.
0.6%
2.0%
1.7%
4.0%
EBIT
6.1% -11.8%
7.1%
7.1%
Int. Exp.
1.8%
3.0%
1.1%
1.1%
EBT
4.3% -14.9%
6.0%
5.9%
Taxes
1.7% -5.9%
2.4%
2.4%
NI
2.6% -8.9%
3.6%
3.6%
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7 - 35
Analysis of Common Size Income
Statements
Computron has higher COGS (86.7)
than industry (84.5), but lower
depreciation. Result is that
Computron has similar EBIT (7.1) as
industry.
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7 - 36
Percentage Change Analysis: Find
Percentage Change from First Year (2000)
Income St. 2000
2001 2002E
Sales
0.0%
70.0% 105.0%
COGS
0.0% 100.0% 113.0%
Other exp.
0.0% 100.0%
-8.0%
Depr.
0.0% 518.8% 534.9%
EBIT
0.0% -430.3% 140.4%
Int. Exp.
0.0% 181.6%
28.0%
EBT
0.0% -691.1% 188.3%
Taxes
0.0% -691.1% 188.3%
NI
0.0% -691.1% 188.3%
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7 - 37
Analysis of Percent Change Income
Statement
We see that 2002 sales grow 105%
from 2000, and that NI grows 188%
from 2000.
So Computron has become more
profitable.
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7 - 38
Percentage Change Balance Sheets
Assets
Cash
ST Invest.
AR
Invent.
Total CA
Net FA
TA
2000
2001 2002E
0.0% -19.1% 55.6%
0.0% -100.0% 47.4%
0.0% 80.0% 150.0%
0.0% 80.0% 140.0%
0.0% 71.4% 138.4%
0.0% 172.6% 137.0%
0.0% 95.2% 138.1%
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7 - 39
Liab. & Eq.
2000
2001
2002E
AP
0.0% 260.0% 200.0%
Notes pay.
0.0% 260.0% 200.0%
Accruals
0.0% 260.0% 200.0%
Total CL
0.0% 260.0% 200.0%
LT Debt
0.0% 209.2%
54.6%
Total equity 0.0% -80.0% 133.9%
Total L&E
0.0%
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95.2% 138.1%
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7 - 40
Analysis of Percent Change Balance
Sheets
We see that total assets grow at a
rate of 138%, while sales grow at a
rate of only 105%. So asset
utilization remains a problem.
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7 - 41
Explain the Du Pont System
(
Profit
margin
)(
TA
turnover
NI
Sales
Sales x
TA
)(
)
Equity
multiplier = ROE
x
2000 2.6% x 2.3
2001 -8.9% x 2.0
2002 3.6% x 2.0
Ind.
3.6% x 2.5
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x
x
x
x
TA
CE
= ROE.
2.2
21.6
2.3
2.0
= 13.2%
= -391.0%
= 16.3%
= 18.0%
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7 - 42
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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7 - 43
Simplified Firm Data
A/R
$ 878 Debt
Other CA
1,802 Equity
Net FA
817
Total assets $3,497 L&E
Sales
day
$1,945
1,552
$3,497
$7,035,600
=
= $19,543.
360
Q. How would reducing DSO to 32
days affect the company?
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7 - 44
Effect of reducing DSO from
44.9 days to 32 days:
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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7 - 45
New Balance Sheet
Added cash
A/R
Other CA
Net FA
Total assets
$
253 Debt
$1,945
625 Equity
1,552
1,802
817
$3,497 Total L&E $3,497
What could be done with the new
cash? Effect on stock price and risk?
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7 - 46
Potential use of freed up cash
Repurchase stock. Higher ROE,
higher EPS.
Expand business. Higher profits.
Reduce debt. Better debt ratio;
lower interest, hence higher NI.
(More…)
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7 - 47
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.
All these actions would likely
improve stock price.
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7 - 48
Would you lend money
to this company?
Maybe. The situation could
improve, and the loan, with a high
interest rate to reflect the risk,
could be a good investment.
However, company should not have
relied so heavily on debt financing
in the past.
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7 - 49
What are some potential problems and
limitations of financial ratio analysis?
Comparison with industry averages
is difficult if the firm operates many
different divisions.
“Average” performance is not
necessarily good.
Seasonal factors can distort ratios.
(More…)
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7 - 50
Window dressing techniques can make
statements and ratios look better.
Different accounting and operating
practices can distort comparisons.
Sometimes it is difficult to tell if a ratio
value is “good” or “bad.”
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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7 - 51
What are some qualitative factors
analysts should consider when
evaluating a company’s likely future
financial performance?
Are the company’s revenues tied to a
single customer?
To what extent are the company’s
revenues tied to a single product?
To what extent does the company
rely on a single supplier?
(More…)
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7 - 52
What percentage of the company’s
business is generated overseas?
What is the competitive situation?
What does the future have in store?
What is the company’s legal and
regulatory environment?
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