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1 Corporate performance analysis Financial ratio analysis and rating Helena Sůvová Guest lecture for the Czech University of Agriculture Course: Corporate Finance October, 2007

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2 Content of the lecture b Sources of financial ratios (indicators), users of corporate performance analysis b Objectives and caveats b Basic groups of financial ratios b Comprehensive systems of financial ratios, default prediction models b Credit rating – external, internal b Summary of the lecture b Assignments for the tutorial

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3 Sources of financial ratios b Financial statements: balance sheet, income statement, statement of cash flows, statement of retained earnings b ! Important: accounting /reporting standards GAAPGAAP IFRS or IFRS European versionIFRS or IFRS European version CASCAS b Accounting units registered on a regulated securities market in a EU Member State must report in IFRS – EU adjusted b Accrual accounting – recognizes timing X cash inflow – otflow: differences caused by: accrual principle, depreciation, taxes

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4 Sources of financial ratios, users b Other sources: web pages of individual firms, internet databases, paid databases – Magnus, Ariadna b Users of corporate performance analysis: stockholders, managers, employees, business partners (customers, suppliers), journalists, students, public generally stockholders, managers, employees, business partners (customers, suppliers), journalists, students, public generally

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5 Objectives, caveats b Financial ratio = mathematical relationship among several variables (numbers), stated in %, times, days b Financial ratios are used to analyze firm´s financial performace, however do not provide all answers b Ratios are not standardized b Ratios should not be analyzed in isolation to judge overall performance of a firm (x just specific aspect) b Accounting standards affect the ratios b Financial statements: annual, quarterly, monthly

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6 Objectives, caveats b Comparisons: cross sectional - industry norms, key competitors,cross sectional - industry norms, key competitors, time series, trends – comparisons with previous periodstime series, trends – comparisons with previous periods b Comparability: use the same ratio formulasuse the same ratio formulas preferably use audited (annual) statements based on the same accounting standardspreferably use audited (annual) statements based on the same accounting standards be aware of valuation of assetsbe aware of valuation of assets

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7 Objectives, caveats Example of cross-sectional and time-series analysis

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8 Basic groups of financial ratios b 5 basic groups: liquidity ratiosliquidity ratios debt management ratios (leverage ratios)debt management ratios (leverage ratios) asset management ratios (activity ratios)asset management ratios (activity ratios) profitability ratiosprofitability ratios market value (valuation) ratiosmarket value (valuation) ratios b 1) Liquidity ratios firm´s ability to pay its obligations in the short term current ratio = current assets/current liabilities (1,5)current ratio = current assets/current liabilities (1,5) quick ratio = (current assets – inventory)/current liabilities (1)quick ratio = (current assets – inventory)/current liabilities (1) cash ratio = (cash + near-cash)/current liabilities (0,25)cash ratio = (cash + near-cash)/current liabilities (0,25) net working cap. to total assets = (curr.assets – curr. liab.)/total assetsnet working cap. to total assets = (curr.assets – curr. liab.)/total assets

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9 Basic groups of financial ratios b 2) Debt management ratios characterize relative mix of debt and equity financing and measures the long term debt paying ability of the firm debt ratio = total liabilities (total debt)/total assets (0,5)debt ratio = total liabilities (total debt)/total assets (0,5) financial leverage = total assets/equityfinancial leverage = total assets/equity long term debt ratio = long term debt/ total assetslong term debt ratio = long term debt/ total assets interest coverage ratio (times interest earned) = EBIT/interest expense (5)interest coverage ratio (times interest earned) = EBIT/interest expense (5) fixed payment coverage = (EBIT + lease payments)/(interest + lease payments + 1/(1-T) * (principal payments + preferred stock dividends))fixed payment coverage = (EBIT + lease payments)/(interest + lease payments + 1/(1-T) * (principal payments + preferred stock dividends))

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10 Basic groups of financial ratios b 3) Asset managemet ratios = asset utilization/efficiency turnover is measured in sales or costs accounts receivable turnover = net credit sales/avrg accounts receivable (60)accounts receivable turnover = net credit sales/avrg accounts receivable (60) receivable collection period = 365/accounts receivable turnover (60)receivable collection period = 365/accounts receivable turnover (60) inventory turnover = cost of goods sold/ avrg inventoryinventory turnover = cost of goods sold/ avrg inventory inventory collection period (avrg age of invetory) = 365/inventory turnover ratio (60)inventory collection period (avrg age of invetory) = 365/inventory turnover ratio (60) fixed assets turnover = sales/ (net) fixed assetsfixed assets turnover = sales/ (net) fixed assets avrg payment period = accounts payable/avrg purchases per dayavrg payment period = accounts payable/avrg purchases per day

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11 Basic groups of financial ratios 4) Profitability ratios final answer about the effectivness of business profit margin on sales (net profit margin) = net income/ sales ( or EACS/sales)profit margin on sales (net profit margin) = net income/ sales ( or EACS/sales) gross profit margin = (sales-costs of goods sold)/salesgross profit margin = (sales-costs of goods sold)/sales return on (total) assets ROA = EBIT/ total assetsreturn on (total) assets ROA = EBIT/ total assets …… but also ROA = EACS/total assets…… but also ROA = EACS/total assets return on equity ROE = net income/ equityreturn on equity ROE = net income/ equity …. or EACS/equity…. or EACS/equity EACS = earnings available for common stockholders

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12 Basic groups of financial ratios – ROE in different Czech industries 2004, 2005

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13 Basic groups of financial ratios b 5) Market value ratios most comprehensive measures of performance P/E ratio = price of share/earnings per shareP/E ratio = price of share/earnings per share market to book ratio (M/B ratio) = market value/book valuemarket to book ratio (M/B ratio) = market value/book value EPS = EACS/number of sharesEPS = EACS/number of shares

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14 Comprehensive systems of financial ratios, default prediction models b Financial analysis may become a part of other corporate performance analyses b Example = credit analysis, rating b Questions of credit manager: How much money can I lend? How much risk am I exposed? b Credit analysis – long time relied on financial analysis b 1968 – first statistical methods used in financial ratio analysis: Z – Score model by Altman, based on discriminant analysis

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15 Comprehensive systems of financial ratios, default prediction models b 1977 – updated Zeta model b 1980 – KMV Corporation using modern portfolio theory → model Credit Monitor – default risk for publicly traded companies in North America and Europe models like this are called „Merton“ models b 1997 - J.P. Morgan developed Credit Metrics b 1999 - Moody´s introduced Risk Calc b 2002 - Kamakura Corporation credit risk models appeared – Merton type of models, reduced form models (similar to Z-Score), hybrid combining both methodologies

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16 Comprehensive systems of financial ratios, default prediction models b Z – Score: discriminates between firms that default (fail) and those that do not Z = 1,2 X1 + 1,4 X2 + 3,3 X3 + 0,6 X4 + 0,999 X5 X1 = working capital/total assets X2 = retained earnings/total assets X3 = EBIT/total assets X4 = market value of equity/book value of total liabilities X5 = sales/total assets Decision-making criteria: Z < 1,81 …. fail Z Є (1,81; 2,99) …. grey zone Z > 2,99 ….. on going

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17 Comprehensive systems of financial ratios, default prediction models b Czech index for assessment of the financial situation – IN index (index of Czech enterprise creditworthiness) b Comprehensive financial analysis – using organized system of financial ratios, e.g. Du Pont system or pyramid analysis

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18 Example of more complex pyramid system :

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19 Credit rating – external, internal b Credit rating = opinion of the general creditworthiness of an obligor. It represents the relative level of default risk. b Rating scale – from AAA to D investment grades: AAA, AA, A, BBBinvestment grades: AAA, AA, A, BBB speculative grades: BB, B, CCC, CC, Cspeculative grades: BB, B, CCC, CC, C default: Ddefault: D b Global rating agencies: S&P, Moody´s, Fitch b Rating by rating agencies are external (are published) b Rating methodology – long –term, through-the-cyclelong –term, through-the-cycle stress on sustainability of cash flowsstress on sustainability of cash flows

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20 Credit rating – external, internal This is an ideal through-the-cycle rating:

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21 b Types of rating: issue-specific X issuer ratingissue-specific X issuer rating long-term X short-term ratinglong-term X short-term rating international (foreign currency) X local ratinginternational (foreign currency) X local rating b Rating methodology usually includes the assessment of: 1) Business risk1) Business risk – – Country risk – – Industry characteristics – – Company position – – Product portfolio/Marketing – – Technology – – Cost efficiency – – Strategic and operational management – –competence – – Profitability/Peer group comparisons Credit rating – external, internal

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22 Credit rating – external, internal 2) Financial risk2) Financial risk – – Accounting – – Corporate governance/Risk – –tolerance/Financial policies – – Cash-flow adequacy – – Capital Structure/Asset Protection – – Liquidity/Short-term factors b Ratings widely accepted by the financial markets. b Rating is an example of comprehensive assessment: financial factors (including ratio analysis) must be completed by non-financial factors + expert judgement

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23 Credit rating – external, internal b Basic ratios used in rating methodology: growth of EBITDAgrowth of EBITDA growth of profit margingrowth of profit margin debt ratiodebt ratio interest coverage ratiointerest coverage ratio liquidityliquidity b Interpretation of ratios is never straightforward b „Rating is as much art as it is a science.“

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24 Credit rating – external, internal b Internal rating systems – used for internal purposes of financial institutions b similar basis as external rating by rating agencies, but tailor-made for internal portfolio and needs b methodology based on model, completed by expert judgement b usage: credit approvals, limit setting, pricing, internal reporting, setting strategy b for homogenous portfolios (e.g. retail loans) – scoring systems (automatic assessment)

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25 Summary of the lecture b Financial statements are basic source of financial analysis which is based on financial ratios. b Interpretation of ratios is not straigtforward, for comprehensive view must be be completed by non- financial information and expert judgement. b Financial analysis makes part of other analyses – credit analysis, credit rating, default prediction – used by certain users for pre-determined purposes.

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26 Assignments for the tutorial 1. What are some important caveats to remember when analyzing financial ratios? 2. For which business is inventory turnover important? manufacturing (production) companymanufacturing (production) company wholesalerwholesaler retailerretailer service sectorservice sector 3. How can a firm have a high current ratio and still be unable to pay its bills? (Q 8.6.) 4. „The higher the rates of return on assets, the better the firm´s managament“. Is this true? (Q 8.7.) 5. What factors would you examine if a firm´s ROA was too low? (Q8.8)

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27 Assignments for the tutorial 6. What does a credit rating mean? 7. Web case: –GO TO www. hoovers. com In the search box at the top of the page, enter UAL, select "by ticker" from the dropdown list, then click GO. –Who are the top competitors to United Airlines? –Who is the CEO of United Airlines? 6. Springfield Medical Devices, Inc., has a current assets valued at $15 million, inventory at $12 million, and current liabilities valued at $6 million. The cost of goods sold was $60 million. Based on this information, its current ratio is: 6. Springfield Medical Devices, Inc., has a current assets valued at $15 million, inventory at $12 million, and current liabilities valued at $6 million. The cost of goods sold was $60 million. Based on this information, its current ratio is: b a) 2.5 b) 0.25 c)0.5 d) 3.0. 9. Look at the data on Wisconsin Furniture Company (see Problem 8.3, page 197 of the textbook) and indicate the possible error in the management by calculating financial indicators. How could the company improve its performance? How could the company improve its performance? 10. Look at the financial statemets of ČEZ and make simple Du Pont analysis by using ROA, ROE and financial leverage in 2004/5.

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