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Copyright © 2011 Pearson Prentice Hall. All rights reserved. Financial Analysis: Sizing up Firm Performance Chapter 4.

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1 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Financial Analysis: Sizing up Firm Performance Chapter 4

2 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-2 Slide Contents Learning Objectives Principles Used in this Chapter 1.Why Do We Analyze Financial Statements 2.Common Size Statements – Standardizing Financial Information 3.Using Financial Ratios 4.Selecting a Performance Benchmark

3 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-3 Slide Contents (cont.) 5.The Limitations of Ratio Analysis Key Terms

4 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-4 Learning Objectives 1.Explain what we can learn by analyzing a firm’s financial statements. 2.Use common size financial statements as a tool of financial analysis. 3.Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.

5 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-5 Learning Objectives (cont.) Select an appropriate benchmark for use in performing a financial ratio analysis. Describe the limitations of financial ratio analysis.

6 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-6 Principles Used in this Chapter Principle 1: Money has a Time Value. –Financial statements typically ignore time value of money. Thus financial managers and accountants may view financial statements very differently.

7 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-7 Principles Used in this Chapter (cont.) Principle 2: There Is a Risk-Return Tradeoff. –Financial statement analysis can yield important information about the strengths and weaknesses of a firm’s financial condition. The analysts can use such information to infer the risk-return tradeoff in a firm.

8 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-8 Principles Used in this Chapter (cont.) Principle 3: Cash Flows Are the Source of Value. –An important use of a firm’s financial statements involves analyzing past performance as a tool for predicting future cash flows.

9 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-9 Principles Used in this Chapter (cont.) Principle 4: Market Prices Reflect Information. –Financial statement analysis requires gathering information about a firm’s financial condition, which is important to the valuation of the firm.

10 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4.1 Why Do We Analyze Financial Statements?

11 Copyright © 2011 Pearson Prentice Hall. All rights reserved Why Do We Analyze Financial Statements? A firm’s financial statements can be analyzed internally (by employees, managers) and externally (by bankers, investors, customers, and other interested parties).

12 Copyright © 2011 Pearson Prentice Hall. All rights reserved Why Do We Analyze Financial Statements? (cont.) An internal financial analysis might be done: –To evaluate the performance of employees and determine their pay raises and bonuses. –To compare the financial performance of the firm’s different divisions. –To prepare financial projections, such as those associated with the launch of a new product. –To evaluate the firm’s financial performance in light of its competitors and determine how the firm might improve its operations.

13 Copyright © 2011 Pearson Prentice Hall. All rights reserved Why Do We Analyze Financial Statements? (cont.) A variety of firms and individuals that have an economic interest might also undertake an external financial analysis: –Banks and other lenders deciding whether to loan money to the firm. –Suppliers who are considering whether to grant credit to the firm. –Credit-rating agencies trying to determine the firm’s creditworthiness.

14 Copyright © 2011 Pearson Prentice Hall. All rights reserved Why Do We Analyze Financial Statements? (cont.) Professional analysts who work for investment companies considering investing in the firm or advising others about investing. Individual investors deciding whether to invest in the firm.

15 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4.2 Common Size Statements – Standardizing Financial Information

16 Copyright © 2011 Pearson Prentice Hall. All rights reserved Common Size Statements – Standardizing Financial Information A common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages. A common size financial statement helps to compare entries in a firm’s financial statements, even if the firms are not of equal size.

17 Copyright © 2011 Pearson Prentice Hall. All rights reserved Common Size Statements – Standardizing Financial Information (cont.) How to prepare a common size financial statement? –For a common size income statement, divide each entry in the income statement by the company’s sales. –For a common size balance sheet, divide each entry in the balance sheet by the firm’s total assets.

18 Copyright © 2011 Pearson Prentice Hall. All rights reserved Common Size Income Statement (H. J. Boswell, Inc.)

19 Copyright © 2011 Pearson Prentice Hall. All rights reserved Table 4-1 Observations Table 4-1 is created by dividing each entry in the income statement found in Table 3-1 by firm sales for –Cost of goods sold make up 75% of the firm’s sales resulting in a gross profit of 25%. –Selling expenses account for about 3% of sales. Income taxes account for 4.1% of the firm’s sales. –After accounting for all expenses, the firm generates net income of 7.6% of firm’s sales.

20 Copyright © 2011 Pearson Prentice Hall. All rights reserved Common Size Balance Sheet (H. J. Boswell, Inc.)

21 Copyright © 2011 Pearson Prentice Hall. All rights reserved Table 4-2 Observations Table 4-2 is created by dividing each entry in the balance sheet found in Table 3-2 by total assets for the year. –Total current assets increased by 5.6% in 2010 while total current liabilities declined by 2%. –Long-term debt account for 39.2% of firm’s assets, showing a decline of 1.7%. –Retained earnings increased by 5.8% in 2010.

22 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4.3 Using Financial Ratios

23 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using Financial Ratios Financial ratios provide a second method for standardizing the financial information on the income statement and balance sheet. A ratio by itself may have no meaning. Hence, a given ratio is compared to: (a) ratios from previous years; or (b) ratios of other firms in the same industry. If the differences in the ratios are significant, more in-depth analysis must be done.

24 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using Financial Ratios (cont.) QuestionCategory of Ratios Used 1. How liquid is the firm? Will it be able to pay its bills as they become due? Liquidity ratios 2. How has the firm financed the purchase of its assets? Capital structure ratios 3. How efficient has the firm’s management been in utilizing it assets to generate sales? Asset management efficiency ratios 4. Has the firm earned adequate returns on its investments? Profitability ratios 5. Are the firm’s managers creating value for shareholders? Market value ratios

25 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Liquidity Ratios

26 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios Liquidity ratios address a basic question: How liquid is the firm? A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s liquidity from two perspectives: –Overall or general firm liquidity –Liquidity of specific current asset accounts

27 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios (cont.) Overall liquidity is analyzed by comparing the firm’s current assets to the firm’s current liabilities. Liquidity of specific assets is analyzed by examining the timeliness in which the firm’s primary liquid assets – accounts receivable and inventories – are converted into cash.

28 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Current Ratio The overall liquidity of a firm is analyzed by computing the current ratio and acid- test ratio. Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-term) liabilities.

29 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Current Ratio (cont.) The text computes the current ratio for H.J. Boswell, Inc. for What is the current ratio for 2009?

30 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Current Ratio (cont.) Current Ratio = $477 ÷ = 1.63 times The firm had $1.63 in current assets for every $1 it owed in current liability. The current ratio improved in 2010 to 2.23 times as the current assets increased significantly in 2010.

31 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Quick Ratio The overall liquidity of a firm is also analyzed by computing the Acid-Test (Quick) Ratio. This ratio excludes the inventory from current assets as inventory may not always be very liquid.

32 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Quick Ratio (cont.) The text computes the quick ratio for H.J. Boswell, Inc. for What is the quick ratio for 2009?

33 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Quick Ratio (cont.) Quick Ratio = ($477-$299.50) ÷ ($292.50) = 0.63 times The firm is clearly less liquid using quick ratio as the firm has only $0.63 in current assets (less inventory) to cover $1 in current liabilities. The quick ratio improved in 2010 to 0.94 times largely due to an increase in current assets.

34 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Individual Asset Categories We can also measure the liquidity of the firm by examining the liquidity of individual current asset accounts, including accounts receivable and inventories. We can assess the liquidity of the firm by measuring how long it takes the firm to convert its accounts receivables and inventories into cash.

35 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Accounts Receivable Average Collection Period measures the number of days it takes the firm to collects its receivables.

36 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Accounts Receivable (cont.) The text computes the average collection period for H.J. Boswell, Inc. for What will be the average collection period for 2009 if we assume that the annual credit sales were $2,500 million in 2009?

37 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Accounts Receivable (cont.) Daily Credit Sales –= $2,500 million ÷ 365 days = $6.85 million Average Collection Period = Accounts Receivable ÷ Daily Credit Sales = $139.5m ÷ $6.85m = days The firm collects its accounts receivable in days.

38 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio measures how many times accounts receivable are “rolled over” during a year.

39 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.) The text computes the accounts receivable turnover ratio for H.J. Boswell, Inc. for What will be the accounts receivable turnover ratio for 2009 if we assume that the annual credit sales were $2,500 million in 2009?

40 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.) Accounts Receivable Turnover = $2,500 million ÷ $ = times The firm’s accounts receivable were turning over at times per year.

41 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Inventory Turnover Ratio Inventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.

42 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Inventory Turnover Ratio (cont.) The text computes the inventory turnover ratio for H.J. Boswell, Inc. for What will be the inventory turnover ratio for 2009 if we assume that the cost of goods sold were $1,980 million in 2009?

43 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Inventory Turnover Ratio (cont.) Inventory Turnover Ratio = $1,980 ÷ $ = 8.63 times The firm turned over its inventory 8.63 times per year.

44 Copyright © 2011 Pearson Prentice Hall. All rights reserved Liquidity Ratios: Days’ Sales in Inventory We can express the inventory turnover ratio in terms of the number of days the inventory sits unsold on the firm’s shelves. Days’ Sales in Inventory = 365÷ inventory turnover ratio = 365 ÷ 8.63 = days The firm, on average, holds it inventory for about 42 days.

45 Copyright © 2011 Pearson Prentice Hall. All rights reserved Can a Firm Have Too Much Liquidity? A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner. However, an excessive investments in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.

46 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.1 Evaluating Dell Computer Corporation’s (DELL) Liquidity You work for a small company that manufactures a new memory storage device. Computer giant Dell has offered to put the new device in their laptops if your firm will extend them credit terms that allow them 90 days to pay. Since your company does not have many cash resources, your boss has asked that you look into Dell’s liquidity and analyze its ability to pay their bills on time using the following accounting information for Dell and two other computer firms (figures in thousands of dollars):

47 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.1

48 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.1

49 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.1

50 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.1: Check Yourself Calculate HP’s inventory turnover ratio. Why do you think this ratio is so much lower than Dell’s inventory turnover ratio?

51 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 1: Picture the Problem One of the indicators of liquidity of the firm is the inventory turnover ratio. This ratio will measure how many days items remain in inventory before being sold. Inventory turnover ratio is important as it has implications for cash flows and profitability of a firm.

52 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 2: Decide on a Solution Strategy We will use the inventory turnover ratio to determine HP’s inventory turnover ratio. This will give us clues about inventory practices at HP. We will use the following equation to compute the Inventory Turnover (IT) ratio –IT ratio = Cost of Goods Sold ÷ Inventories

53 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 3: Solve Inventory Turnover Ratio for HP –= Cost of Goods Sold ÷ Inventories –= $69,178,000 ÷ 7,750,000 –= 8.93

54 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 4: Analyze HP’s inventory turnover ratio indicates that the inventory at HP remains on shelf for (365 ÷ 8.93) days or days. This is much higher than Dell that has an inventory turnover ratio of or shelf life of only 4.57 days. The significant difference must be investigated further as the two firms are in the same industry.

55 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 4: Analyze (cont.) There are two reasons why HP has a lower turnover of inventories relative to Dell: –HP sells computers out of inventory of computers while Dell builds computers only when orders are received. –HP carries more parts inventory on hand than does Dell

56 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Capital Structure Ratios

57 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios Capital structure refers to the way a firm finances its assets. Capital structure ratios address the important question: How has the firm financed the purchase of its assets? We will use two ratios, debt ratio and times interest earned ratio, to answer the question.

58 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios (cont.) Debt ratio measures the proportion of the firm’s assets that are financed by borrowing or debt financing.

59 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios (cont.) The text computes the debt ratio for H.J. Boswell, Inc. for What will be the debt ratio for 2009?

60 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios (cont.) Debt Ratio –= $1, million ÷ $1,764 million –= 57.40% The firm financed 57.39% of its assets with debt.

61 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios (cont.) Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the interest on debt. –We use EBIT or operating income as interest expense is paid before a firm pays its taxes.

62 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios (cont.) The text computes the times interest earned ratio for H.J. Boswell, Inc. for What will be the times interest earned ratio for 2009 if we assume interest expense of $65 million and EBIT of $350 million?

63 Copyright © 2011 Pearson Prentice Hall. All rights reserved Capital Structure Ratios (cont.) Times Interest Earned = $350 million ÷ $65 million = 5.38 times Thus the firm can pay its total interest expense 5.38 times or interest consumed 1/5.38 th or 18.58% of its EBIT. Thus, even if the EBIT shrinks by 81.42% ( ), the firm will be able to pay its interest expense.

64 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.2 Comparing the Financing Decisions of Home Depot (HD) and Lowes Corporation (LOW) You inherited a small sum of money from your grandparents and currently have it in a savings account at your local bank. After enrolling in your first finance class in business school you have decided that you would like to begin investing your money in the common stock of a few companies. The first investment you are considering is stock in either Home Depot or Lowes. Both firms operate chains of home improvement stores throughout the United States and other parts of the world. In your finance class you learned that an important determinant of the risk of investing in a firm’s stock is driven by the firm’s capital structure, or how it has financed its assets. In particular, the more money the firm borrows, the greater is the risk that the firm may become insolvent and bankrupt. Consequently, the first thing you want to do before investing in either company’s stock is to compare how they financed their investments. Just how much debt financing have the two firms used?

65 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.2

66 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.2

67 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.2

68 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.2: Check Yourself What would be Home Depot’s times interest earned ratio if interest payments remained the same, but net operating income dropped by 80% to only $ billion? Similarly if Lowes’ net operating income dropped by 80%, what would its times interest earned ratio be?

69 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 1: Picture the Problem Times interest earned ratio is an important ratio for firms that use debt financing. It measures the firm’s ability to service its debt. The ratio requires comparing net operating income or EBIT with Interest expense. Both items are found on the income statement.

70 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 1: Picture the Problem (cont.) Picture an Income Statement –Sales Less: Cost of Good Sold Equals: Gross Profit Less: Operating Expenses Equals: Net Operating Income (EBIT) Less: Interest Expense Equals: Earnings before Taxes Less: Taxes Equals Net Income EBIT Interest Expense

71 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 2: Decide on a Solution Strategy Here we are considering the impact of a drop in EBIT on the times interest earned ratio of Home Depot and Lowes. We will use the following ratio to measure the times interest earned (TIE) ratio. TIE = EBIT ÷ Interest Expense

72 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 3: Solve Times Interest Earned (TIE) –= EBIT ÷ Interest Expense TIE (Home Depot) –= $ billion ÷ $0.392 billion = 4.94 times TIE (Lowes) –= $1.03 billion ÷$0.154 billion = 6.69 times

73 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 4: Analyze We observe that a drop in net operating income leads to a significant drop in times interest earned ratio for both the firms. The times interest earned ratio drops from to 4.94 for Home Depot and from to 6.69 for Lowes. Should creditors be worried by this drop?

74 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 4: Analyze (cont.) The ratio is still reasonably safe. For example, for Home Depot, it indicates that the firm can pay its interest expense 4.94 times out of its EBIT. Thus, even if the EBIT shrank further by 79.75% (1- 1 /4.94 = or 79.75%), it can still pay its interest expense.

75 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Asset Management Efficiency Ratios

76 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios Asset management efficiency ratios measure a firm’s effectiveness in utilizing its assets to generate sales. They are commonly referred to as turnover ratios as they reflect the number of times a particular asset account balance turns over during a year.

77 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in firm’s assets.

78 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) The text computes the total asset turnover ratio for H.J. Boswell, Inc. for What will be the total asset turnover ratio for 2009 if we assume the total sales in 2009 were $2,500 million?

79 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) Total Asset Turnover –= $2,500 million ÷ $1,764 million = 1.42 times Thus the firm generated $1.42 in sales per dollar of assets in 2009.

80 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) Fixed asset turnover ratio measures firm’s efficiency in utilizing its fixed assets (such as property, plant and equipment).

81 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) The text computes the fixed asset turnover ratio for H.J. Boswell, Inc. for What will be the fixed asset turnover ratio for 2009 if we assume sales of $2,500 million for 2009?

82 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) Fixed Asset Turnover –= $2,500 million ÷ $1,287 million = 1.94 times The firm generated $1.94 in sales per dollar invested in plant and equipment.

83 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) We could similarly compute the turnover ratio for other assets. We had earlier computed the receivables turnover and inventory turnover, which measured firm effectiveness in managing its investments in accounts receivables and inventories.

84 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) For Boswell, 2010 Total Asset Turnover = Sales ÷ Total Assets = $2,700m ÷ $1,971m = 1.37 Fixed Asset Turnover = Sales ÷ Net Plant and Equipment = $2,700m ÷$1,327.5m = 2.03

85 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) For Boswell, 2010 Receivables Turnover = Credit Sales ÷ Accounts Receivable = $2,700m ÷ $162m = times Inventory Turnover = Cost of Goods Sold ÷ Inventories = $2,025m ÷$378m = 3.36 times

86 Copyright © 2011 Pearson Prentice Hall. All rights reserved Asset Management Efficiency Ratios (cont.) The following grid summarizes the efficiency of Boswell’s management in utilizing its assets to generate sales in Turnover Ratio BoswellPeer GroupAssessment Total Assets Good Fixed Assets Good Receivables Good Inventory Poor

87 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Profitability Ratios

88 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios Profitability ratios address a very fundamental question: Has the firm earned adequate returns on its investments? We answer this question by analyzing the firm’s profit margin, which predict the ability of the firm to control its expenses, and the firm’s rate of return on investments.

89 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Two fundamental determinants of firm’s profitability and returns on investments are the following: –Cost Control Is the firm controlling costs and earning reasonable profit margin? –Efficiency of asset utilization Is the firm efficiently utilizing the assets to generate sales?

90 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Gross profit margin shows how well the firm’s management controls its expenses to generate profits.

91 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) The text computes the gross profit margin ratio for H.J. Boswell, Inc. for What will be the gross profit margin ratio for 2009 if we assume sales of $2,500 million and gross profit of $650 million for 2009?

92 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Gross Profit Margin –= $650 million ÷ $2,500 million = 26% The firm spent $0.74 for cost of goods sold for each dollar of sales. Thus, $0.26 out of each dollar of sales goes to gross profits.

93 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Operating Profit Margin measures how much profit is generated from each dollar of sales after accounting for both costs of goods sold and operating expenses. It thus also indicates how well the firm is managing its income statement.

94 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) The text computes the operating profit margin ratio for H.J. Boswell, Inc. for What will be the operating profit margin ratio for 2009 if we assume sales of $2,500 million and net operating income of $350 million for 2009?

95 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Operating Profit Margin = $350 million ÷ $2,500 million = 14% Thus the firm generates $0.14 in operating profit for each dollar of sales.

96 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Net Profit Margin measures how much income is generated from each dollar of sales after adjusting for all expenses (including income taxes).

97 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) The text computes the net profit margin ratio for H.J. Boswell, Inc. for What will be the net profit margin ratio for 2009 if we assume sales of $2,500 million and net income of $ million for 2009?

98 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Net Profit Margin –= $ million ÷ $2,500 million = 8.71% The firm generated $0.087 for each dollar of sales after all expenses (including income taxes) were accounted for.

99 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Operating Return on Assets ratio is the summary measure of operating profitability, which takes into account both the management’s success in controlling expenses, contributing to profit margins, and its efficient use of assets to generate sales.

100 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) The text computes the operating return on assets ratio for H.J. Boswell, Inc. for What will be the operating return on assets ratio for 2009 if we assume EBIT or net operating income of $350 million for 2009?

101 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Operating Return on Assets –= $350 million ÷$1,764 million = 19.84% The firm generated $ of operating profits for every $1 of its invested assets.

102 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.) Decomposing the OROA ratio: We can use the following equation to decompose the OROA ratio that allows us to analyze the firm’s ability to control costs and utilize its investments in assets efficiently.

103 Copyright © 2011 Pearson Prentice Hall. All rights reserved Profitability Ratios (cont.)

104 Copyright © 2011 Pearson Prentice Hall. All rights reserved Figure 4-1 Observations Firm’s OROA (operating return on assets) is better than its peers. Thus the firm earned more net operating income per dollar invested in assets. Firm’s OPM (operating profit margin) is lower than its peers. Thus the firm retained a lower percentage of its sales in net operating income. Firm’s TATO (total asset turnover ratio) is higher than its peers. Thus the firm generated more sales from its assets.

105 Copyright © 2011 Pearson Prentice Hall. All rights reserved Figure 4-1 Recommendations The firm has two opportunities to improve its profitability: 1.Reduce costs - The firm must investigate the cost of goods sold and operating expenses to see if there are opportunities to reduce costs. 2.Reduce inventories – The firm must investigate if it can reduce the size of its inventories.

106 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.3 Evaluating the Operating Return on Assets Ratio for Home Depot (HD) and Lowes (LOW) In Checkpoint 4.2 we evaluated how much debt financing Home Depot and Lowes used. We continue our analysis by evaluating the operating return on assets (OROA) earned by the two firms. Calculate the net operating income each firm earned during 2007 relative to the total assets of each firm using the information found below:

107 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.3

108 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.3

109 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.3

110 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.3: Check Yourself If Home Depot were able to raise its total asset turnover ratio to 2.5 while maintaining its current operating profit margin, what would happen to its operating return on assets?

111 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 1: Picture the Problem The operating return on assets ratio for a firm is determined by two factors: cost control and efficiency of asset utilization. It is expressed by equation 4-13a. Here the focus is on asset utilization i.e. improvement in total asset turnover ratio.

112 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 2: Decide on a Solution Strategy We will analyze the impact on operating return on assets of improvement on the total asset turnover ratio by using the following equation: Operating Return on Assets (OROA) –= Total Asset Turnover × Operating Profit Margin

113 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 3: Solve Operating Return on Assets (OROA) –= Total Asset Turnover × Operating Profit Margin Before = 1.74 × 10.65% = 18.53% Now = 2.5 × 10.65% = 26.63%

114 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 4: Analyze An improvement in total asset turnover ratio has a favorable impact on Home Depot’s operating return on assets (OROA). If Home Depot wants to increase its OROA more, it should focus on cost control that will help improve the net operating profit.

115 Copyright © 2011 Pearson Prentice Hall. All rights reserved Is the Firm Providing a Reasonable Return on the Owner’s Investment? A firm’s net income consists of earnings that is available for distribution to the firm’s shareholders. Return on Equity ratio measures the accounting return on the common stockholders’ investment.

116 Copyright © 2011 Pearson Prentice Hall. All rights reserved Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.) The text computes the return on equity ratio for H.J. Boswell, Inc. for What will be the return on equity ratio for 2009 if we assume net income of $ million for 2009?

117 Copyright © 2011 Pearson Prentice Hall. All rights reserved Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.) Return on Equity –= $ million ÷ $ million = 28.98% Thus the shareholders earned 28.97% on their investments. Note common equity includes both common stock plus the firm’s retained earnings.

118 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using the DuPont Method for Decomposing the ROE ratio DuPont method analyzes the firm’s ROE by decomposing it into three parts: profitability, efficiency and an equity multiplier. –ROE = Profitability × Efficiency × Equity Multiplier Equity multiplier captures the effect of the firm’s use of debt financing on its return on equity. The equity multiplier increases in value as the firm uses more debt.

119 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using the DuPont Method for Decomposing the ROE ratio (cont.) ROE = Profitability × Efficiency × Equity Multiplier ROE = Net Profit Margin × Total Asset Turnover Ratio × 1/(1-debt ratio)

120 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using the DuPont Method for Decomposing the ROE ratio (cont.) The following table shows why Boswell’s return on equity was higher than its peers. Return on Equity Net Profit Margin Total Asset Turnover Equity Multiplier H. J. Boswell, Inc. 22.5%7.6% Peer Group 18.0%10.2%

121 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using the DuPont Method for Decomposing the ROE ratio (cont.) The table suggests that Boswell had a higher ROE as it was able to generate more sales from its assets (1.37 versus 1.15 for peers) and used more leverage (2.16 versus 1.54). Note use of financial leverage may not always generate value for shareholders. Impact of financial leverage is discussed in detail in chapter 15.

122 Copyright © 2011 Pearson Prentice Hall. All rights reserved Using the DuPont Method for Decomposing the ROE ratio (cont.)

123 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Market Value Ratios

124 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios Market value ratios address the question, how are the firm’s shares valued in the stock market? Two market value ratios are: –Price-Earnings Ratio –Market-to-Book Ratio

125 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios (cont.) Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1 of reported earnings.

126 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios (cont.) The text computes the PE ratio for H.J. Boswell, Inc. for What will be the PE ratio for 2009 if we assume the firm’s stock was selling for $22 per share at a time when the firm reported a net income of $ million, and the total number of common shares outstanding are 90 million?

127 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios (cont.) Earnings per share –= $ million ÷ 90 million = $2.42 PE ratio = $22 ÷ $2.42 = 9.09 The investors were willing to pay $9.09 for every dollar of earnings per share that the firm generated.

128 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios (cont.) Market-to-Book Ratio measures the relationship between the market value and the accumulated investment in the firm’s equity.

129 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios (cont.) The text computes the market-to-book ratio for H.J. Boswell, Inc. for What will be the market-to-book ratio for 2009 given that the current market price of the stock is $22 and the firm has 90 million shares outstanding?

130 Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Value Ratios (cont.) Book Value per Share –= million ÷ 90 million = $8.35 per share Market-to-Book Ratio = Market price per share ÷ Book value per share = $22 ÷ $8.35= 2.63 times

131 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.4 Comparing the Valuation of Dell (DELL) to Apple (APPL) Using Market Value Ratios The following information on Dell and Apple was gathered on April 9, 2010:

132 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.4

133 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.4

134 Copyright © 2011 Pearson Prentice Hall. All rights reserved Checkpoint 4.4: Check Yourself What price per share for Dell would it take to increase the firm’s price-to-earnings ratio to the level of Apple?

135 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 1: Picture the Problem Price-to-earnings (PE) ratio depends on earnings per share and price per share, pictured as follows: Price per share standardized by EPS = Net income ÷ number Of shares outstanding PE Ratio = Price per share ÷ Earnings per share

136 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 2: Decide on a Solution Strategy We need to determine the price per share that will make PE ratio of Dell equal to the PE ratio of Apple. PE ratio of Dell has to increase from to PE ratio = Price per share ÷ Earnings per share ==> = ? ÷ 1.14

137 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 3: Solve PE ratio = Price per share ÷ Earnings per share = Price per share ÷ $1.14 Price per share = × 1.14 = $20.75

138 Copyright © 2011 Pearson Prentice Hall. All rights reserved Step 4: Analyze PE ratio allows us to compare two stocks with different prices by standardizing the stock prices by earnings. Apple has a much higher PE ratio. To reach the same PE valuation, the stock price of Dell will have to increase from $12.54 to $20.75.

139 Copyright © 2011 Pearson Prentice Hall. All rights reserved Summing up the Financial Analysis of H. J. Boswell, Inc. Liquidity: With the exception of inventory turnover ratio, liquidity ratios were adequate to good. The next step will be to see how inventory management can be improved. Financial Leverage: The firm uses more debt than its peers, which exposes the firm to a higher degree of financial risk or potential default on its debt in the future.

140 Copyright © 2011 Pearson Prentice Hall. All rights reserved Summing up the Financial Analysis of H. J. Boswell, Inc. (cont.) Profitability: H.J. Boswell had favorable net operating income despite lower profit margins, largely due to its higher asset turnover ratio. The return on equity was also higher than the peer group due to use of more debt. Market Value Ratios: These ratios suggest that the market is pleased with the firm as indicated by higher stock valuations.

141 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4.4 Selecting a Performance Benchmark

142 Copyright © 2011 Pearson Prentice Hall. All rights reserved Selecting a Performance Benchmark There are two types of benchmarks that are commonly used: –Trend Analysis – involves comparing a firm’s financial statements over time. –Peer Group Comparisons – involves comparing the subject firm’s financial statements with those of similar, or “peer” firms. The benchmark for peer groups typically consists of firms from the same industry or industry average financial ratios.

143 Copyright © 2011 Pearson Prentice Hall. All rights reserved Trend Analysis

144 Copyright © 2011 Pearson Prentice Hall. All rights reserved Financial Analysis of the Gap, Inc., June 2009

145 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4.5 The Limitations of Ratio Analysis

146 Copyright © 2011 Pearson Prentice Hall. All rights reserved The Limitations of Ratio Analysis 1.Picking an industry benchmark can sometimes be difficult. 2.Published peer-group or industry averages are not always representative of the firm being analyzed. 3.An industry average is not necessarily a desirable target or norm.

147 Copyright © 2011 Pearson Prentice Hall. All rights reserved The Limitations of Ratio Analysis (cont.) 4.Accounting practices differ widely among firms. 5.Many firms experience seasonal changes in their operations. 6.Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios. 7.The results of financial analysis are dependent on the quality of the financial statements.

148 Copyright © 2011 Pearson Prentice Hall. All rights reserved Key Terms Accounts receivable turnover ratio Acid-test (quick) ratio Average collection period Book value per share Capital structure Current ratio Days’ sales in inventory

149 Copyright © 2011 Pearson Prentice Hall. All rights reserved Key Terms (cont.) Debt ratio DuPont method Equity Multiplier Earnings per share (EPS) Financial leverage Fixed asset turnover ratio Inventory turnover ratio

150 Copyright © 2011 Pearson Prentice Hall. All rights reserved Key terms (cont.) Liquidity ratios Market-to-book ratio Market value ratios Notes payable Operating return on assets Price-earnings ratio

151 Copyright © 2011 Pearson Prentice Hall. All rights reserved Key terms (cont.) Return on assets (ROA) Return on equity (ROE) Times interest earned Total asset turnover ratio Trend analysis


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