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1 CHAPTER 4 Analysis of Financial Statements

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2 Topics in Chapter Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors

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3 Income Statement E Sales5,834,4007,035,600 COGS4,980,0005,800,000 Other expenses720,000612,960 Deprec.116,960120,000 Tot. op. costs5,816,9606,532,960 EBIT17,440502,640 Int. expense176,00080,000 EBT(158,560)422,640 Taxes (40%)(63,424)169,056 Net income(95,136)253,584

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4 Balance Sheets: Assets E Cash7,28214,000 S-T invest.20,00071,632 AR632,160878,000 Inventories1,287,3601,716,480 Total CA1,946,8022,680,112 Net FA939,790836,840 Total assets2,886,5923,516,952

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5 Balance Sheets: Liabilities & Equity E Accts. payable324,000359,800 Notes payable720,000300,000 Accruals284,960380,000 Total CL1,328,9601,039,800 Long-term debt1,000,000500,000 Common stock460,0001,680,936 Ret. earnings97,632296,216 Total equity557,6321,977,152 Total L&E2,886,5923,516,952

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6 Other Data E Stock price$6.00$12.17 # of shares100,000250,000 EPS-$0.95$1.01 DPS$0.11$0.22 Book val. per share$5.58$7.91 Lease payments$40,000 Tax rate0.4

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7 Why are ratios useful? Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths

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8 Five Major Categories of Ratios Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? (More…)

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9 Ratio Categories (Continued) Debt management: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

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10 Forecasted Current and Quick Ratios for CR 06 = = = 2.58x. QR 06 = = = 0.93x. CA CL $2,680 $1,040 $2,680 - $1,716 $1,040 CA - Inv. CL

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11 Comments on CR and QR 2006E Ind. CR2.58x1.46x2.3x2.7x QR0.93x0.5x0.8x1.0x Expected to improve but still below the industry average. Liquidity position is weak.

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12 Inventory Turnover Ratio vs. Industry Average Inv. turnover= = = 4.10x. Sales Inventories $7,036 $1, E Ind. Inv. T.4.1x4.5x4.8x6.1x

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13 Comments on Inventory Turnover Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted.

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14 Receivables Average sales per day DSO= = = 45.5 days. Receivables Sales/365 $878 $7,036/365 DSO: average number of days from sale until cash received.

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15 Appraisal of DSO Firm collects too slowly, and situation is getting worse. Poor credit policy Ind. DSO

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16 Fixed assets turnover Sales Net fixed assets = = = 8.41x. $7,036 $837 Total assets turnover Sales Total assets = = = 2.00x. $7,036 $3,517 (More…) Fixed Assets and Total Assets Turnover Ratios

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17 Fixed Assets and Total Assets Turnover Ratios FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory). 2006E Ind. FA TO8.4x6.2x10.0x7.0x TA TO2.0x 2.3x2.5x

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18 Total liabilities Total assets Debt ratio= = = 43.8%. $1,040 + $500 $3,517 EBIT Int. expense TIE= = = 6.3x. $502.6 $80 (More…) Calculate the debt, TIE, and EBITDA coverage ratios.

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19 = = 5.5x. EBIT + Depr. & Amort. + Lease payments Interest Lease expense pmt. + + Loan pmt. $ $120 + $40 $80 + $40 + $0 EBITDA Coverage (EC)

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20 Recapitalization improved situation, but lease payments drag down EC. 2006E Ind. D/A43.8%80.7%54.8%50.0% TIE6.3x0.1x3.3x6.2x EC5.5x0.8x2.6x8.0x Debt Management Ratios vs. Industry Averages

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21 Very bad in 2005, but projected to meet industry average in Looking good. Profit Margin (PM) 2006E Ind. PM3.6%-1.6%2.6%3.6% PM = = = 3.6%. NI Sales $253.6 $7,036

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22 BEP = = = 14.3%. EBIT Total assets $502.6 $3,517 (More…) Basic Earning Power (BEP)

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23 Basic Earning Power vs. Industry Average BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 2006E Ind. BEP14.3%0.6%14.2%17.8%

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24 ROA = = = 7.2%. NI Total assets $253.6 $3,517 (More…) Return on Assets (ROA) and Return on Equity (ROE)

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25 ROE = = = 12.8%. NI Common Equity $253.6 $1,977 (More…) Return on Assets (ROA) and Return on Equity (ROE)

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E Ind. ROA7.2%-3.3%6.0%9.0% ROE12.8%-17.1%13.3%18.0% Both below average but improving. ROA and ROE vs. Industry Averages

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27 Effects of Debt on ROA and ROE ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

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28 Price = $ EPS = = = $1.01. P/E = = = 12x. NI Shares out. $ Price per share EPS $12.17 $1.01 Calculate and appraise the P/E, P/CF, and M/B ratios.

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29 Industry P/E Ratios IndustryTicker*P/E BankingSTI17.17 SoftwareMSFT34.17 DrugPFE21.56 Electric UtilitiesDUK17.68 SemiconductorsINTC42.97 SteelNUE50.24 TobaccoMO12.34 S&P *Ticker is for typical firm in industry, but P/E ratio is for the industry, not the individual firm

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30 NI + Depr. Shares out. CF per share= = = $1.49. $ $ Price per share Cash flow per share P/CF = = = 8.2x. $12.17 $1.49 Market Based Ratios

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31 Com. equity Shares out. BVPS= = = $7.91. $1, Mkt. price per share Book value per share M/B= = = 1.54x. $12.17 $7.91 Market Based Ratios (Continued)

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32 Interpreting Market Based Ratios P/E: How much investors will pay for $1 of earnings. Higher is better. M/B: How much paid for $1 of book value. Higher is better. P/E and M/B are high if ROE is high, risk is low.

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E Ind. P/E12.0x-6.3x9.7x14.2x P/CF8.2x27.5x8.0x7.6x M/B1.5x1.1x1.3x2.9x Comparison with Industry Averages

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34 Common Size Balance Sheets: Divide all items by Total Assets Assets EInd. Cash0.6%0.3%0.4%0.3% ST Inv.3.3%0.7%2.0%0.3% AR23.9%21.9%25.0%22.4% Invent.48.7%44.6%48.8%41.2% Total CA76.5%67.4%76.2%64.1% Net FA23.5%32.6%23.8%35.9% TA100.0%

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35 Divide all items by Total Liabilities & Equity Assets EInd. AP9.9%11.2%10.2%11.9% Notes pay.13.6%24.9%8.5%2.4% Accruals9.3%9.9%10.8%9.5% Total CL32.8%46.0%29.6%23.7% LT Debt22.0%34.6%14.2%26.3% Total eq.45.2%19.3%56.2%50.0% Total L&E100.0%

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36 Analysis of Common Size Balance Sheets Computron has higher proportion of inventory and current assets than Industry. Computron now has more equity (which means LESS debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.

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37 Common Size Income Statement: Divide all items by Sales EInd. Sales100.0% COGS83.4%85.4%82.4%84.5% Other exp.9.9%12.3%8.7%4.4% Depr.0.6%2.0%1.7%4.0% EBIT6.1%0.3%7.1% Int. Exp.1.8%3.0%1.1% EBT4.3%-2.7%6.0%5.9% Taxes1.7%-1.1%2.4% NI2.6%-1.6%3.6%

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38 Analysis of Common Size Income Statements Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.

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39 Percentage Change Analysis: % Change from First Year (2004) Income St E Sales0.0%70.0%105.0% COGS0.0%73.9%102.5% Other exp.0.0%111.8%80.3% Depr.0.0%518.8%534.9% EBIT0.0%-91.7%140.4% Int. Exp.0.0%181.6%28.0% EBT0.0%-208.2%188.3% Taxes0.0%-208.2%188.3% NI0.0%-208.2%188.3%

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40 Analysis of Percent Change Income Statement We see that 2006 sales grew 105% from 2004, and that NI grew 188% from So Computron has become more profitable.

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41 Percentage Change Balance Sheets: Assets Assets E Cash0.0%-19.1%55.6% ST Invest.0.0%-58.8%47.4% AR0.0%80.0%150.0% Invent.0.0%80.0%140.0% Total CA0.0%73.2%138.4% Net FA0.0%172.6%142.7% TA0.0%96.5%139.4%

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42 Percentage Change Balance Sheets: Liabilities & Equity Liab. & Eq E AP0.0%122.5%147.1% Notes pay.0.0%260.0%50.0% Accruals0.0%109.5%179.4% Total CL0.0%175.9%115.9% LT Debt0.0%209.2%54.6% Total eq.0.0%-16.0%197.9% Total L&E0.0%96.5%139.4%

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43 Analysis of Percent Change Balance Sheets We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

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44 Explain the Du Pont System The Du Pont system focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

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45 ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE xx = ROE. The Du Pont System

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% x 2.3x2.2=13.2% %x2.0x5.2=-16.6% %x2.0x1.8=13.0% Ind.3.6%x2.5x2.0=18.0% NI Sales TA CE xx = ROE The Du Pont System

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47 Potential Problems and Limitations of Ratio Analysis? Comparison with industry averages is difficult if the firm operates many different divisions. “Average” performance is not necessarily good. Seasonal factors can distort ratios. (More…)

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48 Problems and Limitations (Continued) Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. (More…)

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49 Problems and Limitations (Continued) Sometimes it is difficult to tell if a ratio value is “good” or “bad.” Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

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50 Qualitative Factors Are the company’s revenues tied to a single customer? To what extent are the company’s revenues tied to a single product? To what extent does the company rely on a single supplier? (More…)

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51 Qualitative Factors (Continued) What percentage of the company’s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company’s legal and regulatory environment?

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