Transcript MIM700 - Prof Dimond | helping light bulbs go on

Business Finance
BA303
Michael Dimond
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
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
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 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 cash flow
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)
• Profit margin = net income / sales = 7.19%
• Debt Ratio (to Total Capital) = Total Liabilities / Total Assets = 45.68%
• Horizontal Analysis compares the same figure over a series
of periods (showing % change or % growth)
• By what percent did sales change?
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
• Sales Growth = 3074 / 2567 -1 = 19.8%
• Can we compute growth over more than one year?
• Measuring growth over more than one period means we need to find the
compound average growth rate 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:
•
•
•
•
•
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.
•
•
•
•
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
• Some authors make 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
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Debt-to-Equity ratio = Total Liabilities ÷ Total Equity
EM (from DuPont) = 1 + D/E
TIE = Times Interest Earned ratio = EBIT ÷ Interest
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
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 minus Variable Costs per unit
• Definition of “Fixed Costs” can be changed to find BE for OpInc, Net Inc, or NPV.
• Degree of Operating Leverage
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Looks a lot like an elasticity formula: %Δ Op. Income ÷ %Δ Sales
Based on cost relationships, not change over time.
As firm approaches breakeven (from above), DOL gets larger
A point estimate of DOL can be computed as Gross Profit ÷ Operating Income
Michael Dimond
School of Business Administration