Transcript MIM700 - Prof Dimond

Business Finance
BA303
Michael Dimond
Module G: Financial Statement Analysis
Michael Dimond
School of Business Administration
Understanding financial statements
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Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Meaningful Ratio Analysis
• Analysis means to break something down to understand it.
• Ratio analysis should be used to answer a specific question
or set of questions.
• If you were examining the financial statements for a
company, you might start with this basic question:
“Is this a good use of investors’ money?”
• What financial ratio would answer this question?
How about Return on Equity?
• How do you compute Return on Equity (ROE)?
Michael Dimond
School of Business Administration
Analyzing ROE
• ROE = NI ÷ Equity and answers the question, “is this a good
use of investors’ money?”
• If you were to break this down, there are three basic
questions to answer:
How profitable is this business?
How efficiently are assets being used?
How much does financial leverage help the investors?
• What financial ratios would answer these questions?
Profit Margin (PM)
Total Asset Turnover (TAT)
Equity Multiplier (EM)
Michael Dimond
School of Business Administration
Drivers of ROE
• Profit Margin (PM) = NI ÷ Sales and answers the question,
“How profitable is this business?”
• Total Asset Turnover (TAT) = Sales ÷ Total Assets and
answers the question, “How efficiently are assets being
used?”
• Equity Multiplier (EM) = Total Assets ÷ Equity and answers
the question, “How much does financial leverage help the
investors?”
Michael Dimond
School of Business Administration
The DuPont Identity
• ROE is directly driven by profitability, efficiency and leverage.
• ROE = PM x TAT x EM
How does that work?
ROE =
PM x
TAT
x
EM
NI
NI
Sales
Total Assets
=
x
x
Equity
Sales
Total Assets
Equity
NI
NI
Sales
Total Assets
=
x
x
Equity
Sales
Total Assets
Equity
• The numerators and denominators cancel to reduce the
equation to NI ÷ Equity
Michael Dimond
School of Business Administration
A note about the text’s version of ROE & DuPont
• The author uses Earnings Available to Common
Shareholders for ROE computations. While this is not terribly
incorrect, it isn’t really correct either.
• Net Income ÷ Equity = ROE
• Earnings Available to Common Shareholders ÷ (Equity – Preferred Equity) =
Return on Common Equity (ROCE, not ROE)
• The purpose of analysis is to answer important questions.
• If the question is how hard the investors’ money is working, compute ROE
• To find how hard common shareholders’ money is working, compute ROCE
• Never mix & match. ROCE uses Earnings Available to Common Shareholders
and Common Equity. ROE uses Net Income and Total Equity.
• Notice the author computes ROA as Earnings Available to Common
Shareholders ÷ Total Assets. What is wrong with this?
• ROE & ROA are sometimes very manipulated figures, used by managers to
prove a point. Always compute your own figures for analysis.
Michael Dimond
School of Business Administration
A word about ROA
• ROA = Return on Assets
• What’s the difference between Equity & Assets?
• Leverage
• What’s the difference between ROE & ROA?
• Leverage
• ROE = PM x TAT x EM
• EM represents leverage
• ROA = PM x TAT
• No leverage
Michael Dimond
School of Business Administration
Digging Deeper with Financial Ratios
• How would you analyze profitability, efficiency and leverage?
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How do profitability, efficiency and leverage relate?
What affects profitability?
What drives sales?
What is the composition of assets?
How were assets paid for?
How are liabilities managed?
• Where shall we begin?
Michael Dimond
School of Business Administration
Common-Size Financial Statements
• Shows each line item as a percent of an appropriate total.
• Common-size balance sheet
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% of Total Assets
Shows the composition of assets
Liabilities & equity items are also shown as % of total assets
Debt Ratio = Total Liabilities ÷ Total Assets
• Common-size income statement
• % of Sales
• PM = Net Income as % of Sales
Michael Dimond
School of Business Administration
Common-Size Income Statement
100%
7.19%
5.38%
Michael Dimond
School of Business Administration
Common-Size Balance Sheet
100%
45.68%
44.34%
Michael Dimond
School of Business Administration
We don’t make a common-size CF Statement
There are other
ways to examine
relevant information
which would be
more helpful
Michael Dimond
School of Business Administration
Vertical & Horizontal Analysis
• Vertical Analysis compares figures as a percent of a relevant
total (“common size” financial statements)
• Horizontal Analysis compares the same figure over a series
of periods (showing % change or % growth)
Michael Dimond
School of Business Administration
Measuring growth
• Financial figures change from year to year
• To find the % change (“% growth”) over a 1-year period,
divide the difference of the two figures by the first year’s
value:
• [ending – beginning] / [beginning]
OR
• [ending] / [beginning] - 1
• Measuring growth over more than one period means we
need to find the average growth during that time.
Michael Dimond
School of Business Administration
CAGR: Compound Annual Growth Rate
• The CAGR is the result of compounded increase over time at
a specific average rate
• (133.1/100)^(1/3)-1=0.10
• It can be tested by plugging the result into a compounding
formula using the same figures
• 100*(1+0.10)^3=133.10
• It can be figured using the TVM functions on your calculator
• PV = -100 FV = 133.10 n = 3 PMT = 0 solve for I = 10%
• What if you were given a series of % changes instead of
dollar figures?
• Year 1: 10% increase, Year 2: 12% increase, Year 3: 8% increase
• You need to find the Geometric Average Growth over the
three year period
Michael Dimond
School of Business Administration
Geometric Average vs Arithmetic Average
• Arithmetic Average only shows the “typical” result
• Geo Avg = [(1+20%)*(1+-16.67%)* (1+20%)*(1+16.67%)]^(1/4) -1 = 8.78%
• CAGR also shows the result of compounding
• (14/10)^(1/4) – 1 = 0.878 = 8.78%
• The price didn’t increase 8.78% each year, but we end up with
the same final value if we compound it by 8.78% every year.
• 5 years means 4 periods of compounding, so we find the 4th root ( ^1/4 power)
Michael Dimond
School of Business Administration
Categories of Financial Ratios
• Most finance texts group ratios into categories like these:
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Profitability ratios
Efficiency (or Activity) ratios
Liquidity ratios
Debt ratios
Market ratios
• It is usually more helpful to think of the questions to be
answered rather than just crunching a bunch of numbers.
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Uses critical thinking
Easier to read
Less time consuming
Uses fewer resources
Michael Dimond
School of Business Administration
Profitability Ratios
• PM = Net Income ÷ Sales (Sometimes called “Net Profit
Margin”).
• This also is the bottom line on a common-size income statement
• The author makes a distinction for Earnings Available to Common
Shareholders.
• Gross Margin = Gross Profit ÷ Sales
• Gross Profit = Sales – COGS
• Also called the “Gross Profit Margin”
• Operating Margin = Operating Profit ÷ Sales
• Also called the “Operating Profit Margin”
Michael Dimond
School of Business Administration
Efficiency Ratios
• TAT = Sales ÷ Total Assets
• How hard do specific assets work?
• Inventory Turnover
• Inventory Turnover = Sales ÷ Inventory
• The label “Inventory Turnover” is also used for COGS ÷ Avg. Inventory
• These two ratios answer different questions:
• How hard is inventory working? (Sales/Inventory)
• How many times/year is inventory replaced? (COGS/Average Inventory)
• How would you convert this into “Days in Inventory?”
• Average Collection Period or AR Conversion Period
• Days to Collect AR = Avg. Accts Receivable ÷ Avg. Daily Sales
• Average Daily Sales = Sales ÷ 365
• The sales figure should exclude sales paid for in cash, use only sales creating AR
Michael Dimond
School of Business Administration
Efficiency Ratios
• Average Payment Period
• Days to Pay AP = Avg. AP ÷ Avg Daily Purchases
• Avg Daily Purchases = Purchases ÷ 365
• Purchases = COGS + Ending Inventory – Beginning Inventory
• If you know how long it takes a company to sell inventory,
how long it takes to collect accounts receivable and how long
to pay its bills, you can compute how long their business
takes to function
• Operating Cycle: Days in Inventory + Days in Receivables
• Cash Cycle: Days in Inventory + Days in Receivables – Days in Payables
Michael Dimond
School of Business Administration
Efficiency Ratios
• There is an easy and consistent way to compute and
understand the components of the cash cycle.
• Each of the “Days in…” figures represents a year divided by the appropriate
turnover rate:
• Days in Inventory = 365 ÷ Inventory Turnover Rate
• Days in Receivables = 365 ÷ Receivables Turnover Rate
• Days in Payables = 365 ÷ Payables Turnover Rate
• This means the turnover rates can be simplified to these:
• Inventory Turnover Rate = COGS ÷ Avg. Inventory
• Receivables Turnover Rate = Sales ÷ Avg. Receivables
• Payables Turnover Rate = Purchases ÷ Avg. Payables
• …and the days in each can be computed as:
• Days in Inventory = 365 ÷ (COGS ÷ Avg. Inventory)
• Days in Receivables = 365 ÷ (Sales ÷ Avg. Receivables)
• Days in Payables = 365 ÷ (Purchases ÷ Avg. Payables)
Michael Dimond
School of Business Administration
Liquidity Ratios
• The Current Ratio
• Pretty much useless in my opinion, but memorize it anyway.
• Current Assets ÷ Current Liabilities
• Liquidity means something can be converted into cash
immediately without significant loss of value. Current Assets
includes inventory. Is inventory really liquid?
• Quick Ratio (also called the “Acid Test”)
• Answers the question, “how well can this firm meet its short-term
obligations?”
• [Current Assets – Inventory] ÷ Current Liabilities
Michael Dimond
School of Business Administration
Debt Management Ratios
• Debt ratio = Total Liabilities ÷ Total Assets
• Also called “Debt to Total Capital” ratio
• Debt-to-Equity ratio = Total Liabilities ÷ Total Equity
• EM (from DuPont) = 1 + D/E
• Times Interest Earned ratio = EBIT ÷ Interest
• NOTE: The book has a typo on page 78. It claims TIE = EBIT ÷ Tax, which is
not correct.
• TIE can be altered to cover any financial obligations.
• TIE = EBIT ÷ Interest
• :. TIE = (EBT + Interest) ÷ Interest
• (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts) = Fixed Payment
Coverage
(EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts +
Principal Repayments/(1-t)) = Fixed Payment Coverage
Michael Dimond
School of Business Administration
Market Value Ratios
• Price-to-Earnings ratio = Share Price ÷ Earnings per Share
• Earnings per Share (EPS) = Earnings Available to Common Shareholders ÷
Number of Shares of Common Stock
• If there is no preferred equity (or an insignificant amount), EPS can be NI ÷
Number of Shares
• Because the Numerator and Denominator are both “per share,” the PE ratio
can be computed as Market Capitalization ÷ Total Earnings Available
• Market-to-Book ratio = Price per Share ÷ Book Value per
Share
• Book Value per Share = Common Equity on Balance Sheet ÷ Number of
Shares
• Common Equity = All equity except preferred equity
• Again, because the Numerator and Denominator are both “per share,” the MB
ratio can be computed as Market Capitalization ÷ Total Common Equity
Michael Dimond
School of Business Administration
Other useful analysis
• Dividends & Retained Earnings
• d: Dividend Payout Ratio = Dividends ÷ Net Income
• b: Retention Ratio = 1 – d
Also called the “plowback ratio.” Why do you think that name is used?
• Growth Limitations
• SGR: Sustainable Growth Rate = b x ROE = b x PM x TAT x EM
• IGR: Internal Growth Rate = b x ROA = b x PM x TAT
• Breakeven
• BE = Total Fixed Costs ÷ Contribution Margin
• Contribution Margin = Price per unit – Variable Costs per unit
• Operating, Accounting, and Financial breakevens all exist. The definition of “Fixed
Costs” changes.
• Degree of Operating Leverage
• Looks a lot like an elasticity formula: %Δ Op. Income ÷ %Δ Sales
• As firm approaches breakeven, DOL gets larger
• A point estimate of DOL can be computed as Gross Profit ÷ Operating Income
Michael Dimond
School of Business Administration