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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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Financial Managers most interested in market values When market values aren’t available, need to use the information that is available –Accounting information

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Standardized Financial Statements Common-Size Balance Sheets –Compute all accounts as a percent of total assets Common-Size Income Statements –Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry

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Ratio Analysis Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important Ratios are used both internally and externally

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Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

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Liquidity Ratios show firm’s ability to pay bills in the short run Short term creditors are most interested in these

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Liquidity Ratios Current Ratio = CA / CL Shows how many $ of CA for every $ of CL In other words, how many times CA covers CL Short term creditor likes to see high Current ratio Firm doesn’t want to see the Current Ratio too high

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Liquidity Ratios Quick Ratio = (CA – Inventory) / CL Inventory is the least liquid CA Inventory book value will differ from market value when damaged or obsolete inventory Building inventory: sign of trouble

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Liquidity Ratios Cash Ratio = Cash / CL Looked at by a very short term creditor

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Long term solvency Ratios Financial Leverage Ratios Total Debt Ratio = (TA – TE) / TA Can be looked at either as How many $s of debt for every $ of assets OR What % of assets are financed with debt

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Long term solvency Ratios Financial Leverage Ratios Debt/Equity = TD / TE If ratio is above 1: more of the company is financed by debt If ratio is below 1: more of the company is financed by equity A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. If debt is used to increase earnings by a greater amount than the debt cost (interest), the increased earnings are being spread among the same amount of shareholders. If cost of debt is more than earnings generated by the debt: financial trouble The debt/equity ratio also depends on the industry Capital-intensive industries such as auto manufacturing: debt/equity ratio above 2 Personal computer companies: debt/equity under 0.5.

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Long term solvency Ratios Financial Leverage Ratios Equity Multiplier = TA / TE = 1 + D/E –shows a company's total assets per dollar of stockholders' equity –A higher equity multiplier indicates higher financial leverage, which means the company is relying more on debt to finance its assets

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Long Term Solvency Ratios Coverage Ratios Times Interest Earned = EBIT / Interest Shows how many times company can cover its interest obligations EBIT includes noncash items, such as depreciation and amortization

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Long Term Solvency Ratios Coverage Ratios Cash Coverage = (EBIT + Depr. & Amort.) / Interest Gives a better idea of cash available to cover interest Shows how many times cash flow can cover interest

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Asset Management or Turnover Ratios Inventory turnover Days’ sales in inventory Inventory turnover Days’ sales in inventory Total asset turnover

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Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / *Inventory Shows how many times you sold off the inventory during the year High ratio indicates efficient management Make sure you are not having stock-outs * Use ending inventory to show how long to sell off current inventory Use average inventory to show how long to sell off past inventory

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Computing Inventory Ratios Days’ Sales in Inventory = 365 / Inventory Turnover Shows how long you have inventory before it is sold

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Computing Receivables Ratios Receivables Turnover = Sales / Accounts Receivable Shows how many times credit was collected and extended to new customers during the period

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Computing Receivables Ratios Days’ Sales in Receivables = 365 / Receivables Turnover Shows how many days it takes to collect on credit sales This is called the ACP – average collection period

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Computing Total Asset Turnover Total Asset Turnover = Sales / Total Assets Measure of asset use efficiency Shows how much is generated in sales for every $ of assets Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

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Profitability measures Profit margin Return on Assets (ROA) Return on Equity (ROE)

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Computing Profitability Measures Profit Margin = Net Income / Sales Shows how many $s of net income for every $ of sales Usually: high profit margin is goal Sometimes, companies cut sales price, which decrease profit margin, but increases total profit if sales volume is increased Some companies have a low cost, high volume business strategy

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Computing Profitability Measures Return on Assets (ROA) = Net Income / Total Assets Shows profit % on the company’s investment in assets

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Computing Profitability Measures Return on Equity (ROE) = Net Income / Total Equity Shows profit % on the shareholder’s equity investment Remember: profit is a book #, can be manipulated; does not indicate market returns on investments

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Market value measures Computed for publicly traded companies Need to know market price and earnings per share

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Computing Market Value Measures PE Ratio = Price per share / Earnings per share Shows how much investors are willing to pay for every $ of earnings Need to look at other factors along with PE ratio a firm with low earnings will have a high PE ratio High PE ratio may indicate a more risky investment, since investors have high expectations

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Computing Market Value Measures Price-Sales Ratio = Price per share / Sales per share (Sales / # of shares outstanding) More useful for companies that have net loss ex.: start-up companies

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Computing Market Value Measures Market-to-book ratio = Market value per share / book value per share Book value per share = Total equity / # of shares outstanding Ratio compares market value to accounting value (historical costs) A ratio less than 1 indicates firm has not created value for shareholders

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DuPont Identity DuPont Corporation Shows where to look if ROE is unsatisfactory

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Deriving the Du Pont Identity ROE = NI / TE Can also be expressed as ROA X Equity Multiplier Net income Assets Assets Total Equity

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Deriving the Du Pont Identity Can also be expressed as ROA X Equity Multiplier Net income Assets Assets Total Equity (also: 1 + Debt to equity ratio) ROA can be expressed as: Profit X Total Asset Margin Turnover Net income Sales Sales Assets

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Deriving the Du Pont Identity So, ROE can be expressed as Profit X Total Asset X Equity Margin Turnover Multiplier Net income Sales Assets Sales Assets Total Equity

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Using the Du Pont Identity ROE = PM * TAT * EM –Profit margin is a measure of the firm’s operating efficiency – how well does it control costs –Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets –Equity multiplier is a measure of the firm’s financial leverage

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Payout and Retention Ratios Net income is either: Paid in dividends (Payout) Added to Retained Earnings (Retention)

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Payout and Retention Ratios Dividend payout ratio = Cash dividends / Net income Shows % of net income paid as dividends Retention ratio = Addn. to R/E / Net income (Net income – Dividends) OR (EPS – DPS) / EPS OR 1 – Dividend Payout Ratio Retention ratio is also called Plowback Ratio

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ROA, ROE & Growth Investors want sales to grow In the long run, assets have to grow in order for sales to grow Growth of assets have to be financed 2 sources of financing –Internal: firm earns money and “plows it back” into the business –External: firm borrows $ or sells stock

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The Internal Growth Rate Internal Growth Rate = ROA X Plowback ratio 1 – ROA X plowback ratio Shows % of growth per year if the addition to retained earnings is the only financing

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Debt to Equity Ratio Debt to equity ratio will decrease if only internal financing is used Some firms have a target debt to equity ratio that they maintain 37

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The Sustainable Growth Rate Sustainable Growth Rate = ROE X plowback ratio 1 – ROE X plowback ratio Shows how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt to equity ratio.

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Sustainable Growth Rate Since ROE is used to calculate, anything increasing ROE increases sustainable growth rate Also, increasing the plowback ratio increases sustainable growth 39

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Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

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Why Evaluate Financial Statements? Internal uses –Performance evaluation – compensation and comparison between divisions –Planning for the future – guide in estimating future cash flows External uses –Creditors –Suppliers –Customers –Stockholders

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Benchmarking Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis –Used to see how the firm’s performance is changing through time Peer Group Analysis –Compare to similar companies or within industries –SIC and NAICS codes

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Standard Industrial Classification Codes (SIC Codes) 4 digit code used by Government for statistical reporting 1 st digit in code indicates type of business Subsequent digits narrow down further Was supposed to be replaced by NAICS – North American Industry Classification 43

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Using SIC codes Identify competitors Identify aspirant group: the top firms in an industry Then, compare common size statements, ratios 44

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Problems with Financial Analysis Establishing benchmark is a judgment call Conglomerates don’t fit into an industry category Global economy –Hard to compare to foreign competitors3 45

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Example: Work the Web The Internet makes ratio analysis much easier than it has been in the past Click on the Web surfer to go to Moneycentral.com –Choose a company and enter its ticker symbol –Click on “Financial Results” and “Key Ratios” to compare the firm to its industry and the S&P 500 for various ratio categories –Change the ratio category using the links to the left of the chart.

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