1. 3 - 1 Copyright © 1999 by The Dryden PressAll rights reserved. Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors CHAPTER 3 Analysis of Financial Statements

2. 3 - 2 Copyright © 1999 by The Dryden PressAll rights reserved. Balance Sheet: Assets 1999E1998 Cash14,0007,282 AR878,000632,160 Inventories1,716,4801,287,360 Total CA2,680,1121,926,802 Gross FA1,197,1601,202,950 Less: Deprec. 380,120 263,160 Net FA 817,040 939,790 Total assets3,497,1522,866,592 ST investments 71,632 0

3. 3 - 3 Copyright © 1999 by The Dryden PressAll rights reserved. Liabilities and Equity 1999E1998 Accounts payable436,800524,160 Notes payable600,000720,000 Accruals 408,000 489,600 Total CL1,444,8001,733,760 Long-term debt500,0001,000,000 Common stock1,680,936460,000 Retained earnings(128,584)(327,168) Total equity1,552,352 132,832 Total L & E3,497,1522,866,592

4. 3 - 4 Copyright © 1999 by The Dryden PressAll rights reserved. (519,936) Income Statement 1999E1998 Sales7,035,6005,834,400 COGS5,728,000 Other expenses680,000 Depreciation 116,960 Tot. op. costs6,524,960 EBIT510,640(690,560) Interest exp. 88,000 176,000 EBT 422,640 (866,560) Taxes (40%) 169,056 (346,624) Net income 253,584

5. 3 - 5 Copyright © 1999 by The Dryden PressAll rights reserved. Other Data 1999E1998 Shares out.250,000100,000 EPS$1.014($5.199) DPS$0.220$0.110 Stock price$12.17$2.25 Lease pmts$40,000

6. 3 - 6 Copyright © 1999 by The Dryden PressAll rights reserved. Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Why are ratios useful?

7. 3 - 7 Copyright © 1999 by The Dryden PressAll rights reserved. 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? What are the five major categories of ratios, and what questions do they answer? (More…)

8. 3 - 8 Copyright © 1999 by The Dryden PressAll rights reserved. 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?

9. 3 - 9 Copyright © 1999 by The Dryden PressAll rights reserved. Calculate the firm’s forecasted current and quick ratios for 1999. CR 99 = = = 1.85x. QR 99 = = = 0.67x. CA CL $2,680 $1,445 $2,680 - $1,716 $1,445 CA - Inv. CL

10. 3 - 10 Copyright © 1999 by The Dryden PressAll rights reserved. Expected to improve but still below the industry average. Liquidity position is weak. Comments on CR and QR 199919981997Ind. CR1.85x1.1x2.3x2.7x QR0.67x0.4x0.8x1.0x

11. 3 - 11 Copyright © 1999 by The Dryden PressAll rights reserved. What is the inventory turnover ratio as compared to the industry average? Inv. turnover= = = 4.10x. Sales Inventories $7,036 $1,716 199919981997Ind. Inv. T.4.1x4.5x4.8x6.1x

12. 3 - 12 Copyright © 1999 by The Dryden PressAll rights reserved. Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted. Comments on Inventory Turnover

13. 3 - 13 Copyright © 1999 by The Dryden PressAll rights reserved. Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO= = = 44.9 days. Receivables Sales/360 $878 $7,036/360

14. 3 - 14 Copyright © 1999 by The Dryden PressAll rights reserved. Appraisal of DSO nFirm collects too slowly, and situation is getting worse. nPoor credit policy. 199919981997Ind. DSO44.939.036.832.0

15. 3 - 15 Copyright © 1999 by The Dryden PressAll rights reserved. Fixed Assets and Total Assets Turnover Ratios Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets turnover Sales Total assets = = = 2.01x. $7,036 $3,497 (More…)

16. 3 - 16 Copyright © 1999 by The Dryden PressAll rights reserved. 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). 19991998 1997Ind. FA TO8.6x6.2x10.0x7.0x TA TO2.0x2.0x2.3x2.6x

17. 3 - 17 Copyright © 1999 by The Dryden PressAll rights reserved. Calculate the forecasted operating capital requirement ratio (OCR). = + = ($14,000 + $878,000 + $1,716,480) - ($436,800 + $408,000) = $1,763,680. Operating capital = $1,763,680 + $817,040 = $2,580,720. (More…) Operating capital Net operating working capital Net fixed assets Net operating working capital

18. 3 - 18 Copyright © 1999 by The Dryden PressAll rights reserved. 1999 1998 1997 Ind. OCR 36.7%31.8%33.2%29.5% OCR = Operating capital/Sales = $2,580,720/$7,035,600 = 36.7%. The OCR is not improving. It is worse than the industry average.

19. 3 - 19 Copyright © 1999 by The Dryden PressAll rights reserved. Calculate the debt, TIE, and fixed charge coverage ratios. Total debt Total assets Debt ratio= = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE= = = 5.8x. $510.6 $88 (More…)

20. 3 - 20 Copyright © 1999 by The Dryden PressAll rights reserved. All three ratios reflect use of debt, but focus on different aspects. Fixed charge coverage = FCC = = = 4.3x. EBIT + Lease payments Interest Lease Sinking fund pmt. expense pmt. (1 - T) + $510.6 + $40 $88 + $40 + $0

21. 3 - 21 Copyright © 1999 by The Dryden PressAll rights reserved. Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 199919981997 Ind. D/A55.6%95.4%54.8%50.0% TIE5.8x-3.9x3.3x6.2x FCC4.3x-3.0x2.4x5.1x

22. 3 - 22 Copyright © 1999 by The Dryden PressAll rights reserved. Very bad in 1998, but projected to exceed industry average in 1999. After-tax operating profit margin (ATOPM) 199919981997Ind. ATOPM 4.4%-7.1% 3.7%4.3% ATOPM= EBIT(1 - T) = $510,640(1 - 0.4) Sales $7,035,600 = 4.4%.

23. 3 - 23 Copyright © 1999 by The Dryden PressAll rights reserved. Very bad in 1998, but projected to exceed industry average in 1999. Looking good. Profit Margin (PM) 199919981997Ind. PM3.6%-8.9%2.6%3.5% PM = = = 3.6%. NI Sales $253.6 $7,036

24. 3 - 24 Copyright © 1999 by The Dryden PressAll rights reserved. BEP= = = 14.6%. Basic Earning Power (BEP) EBIT Total assets $510.6 $3,497 (More…)

25. 3 - 25 Copyright © 1999 by The Dryden PressAll rights reserved. BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 199919981997Ind. BEP14.6%-24.1%14.2%19.1%

26. 3 - 26 Copyright © 1999 by The Dryden PressAll rights reserved. Return on Assets (ROA) and Return on Equity (ROE) ROA= = = 7.3%. Net income Total assets $253.6 $3,497 (More…)

27. 3 - 27 Copyright © 1999 by The Dryden PressAll rights reserved. ROE= = = 16.3%. Net income Common equity $253.6 $1,552 199919981997Ind. ROA7.3%-18.1%6.0%9.1% ROE16.3%-391.0%13.3%18.2% Both below average but improving.

28. 3 - 28 Copyright © 1999 by The Dryden PressAll rights reserved. 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. Effects of Debt on ROA and ROE

29. 3 - 29 Copyright © 1999 by The Dryden PressAll rights reserved. Calculate and appraise the P/E and M/B ratios. Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 (More…)

30. 3 - 30 Copyright © 1999 by The Dryden PressAll rights reserved. Com. equity Shares out. BVPS= = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B= = = 1.96x. $12.17 $6.21 (More…)

31. 3 - 31 Copyright © 1999 by The Dryden PressAll rights reserved. P/E: How much investors will pay for $1 of earnings. High is good. M/B: How much paid for $1 of book value. Higher is good. P/E and M/B are high if ROE is high, risk is low. 1999 1998 1997 Ind. P/E12.0x-0.4x9.7x14.2x M/B1.96x1.7x1.3x2.4x

32. 3 - 32 Copyright © 1999 by The Dryden PressAll rights reserved. ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE 19972.6% x 2.3x2.2=13.2% 1998-8.9%x2.0x21.6=-391.0% 19993.6%x2.0x2.3=16.3% Ind.3.5%x2.6x2.0=18.2% Explain the Du Pont System xx = ROE.

33. 3 - 33 Copyright © 1999 by The Dryden PressAll rights reserved. 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.

34. 3 - 34 Copyright © 1999 by The Dryden PressAll rights reserved. Simplified Firm Data A/R$ 878 Debt $1,945 Other CA1,802 Equity1,552 Net FA 817 Total assets$3,497 L&E $3,497 Q. How would reducing DSO to 32 days affect the company? Sales $7,035,600 day 360 = = $19,543.

35. 3 - 35 Copyright © 1999 by The Dryden PressAll rights reserved. Effect of reducing DSO from 44.9 days to 32 days: Old A/R= $19,543 x 44.9= $878,000 New A/R= $19,543 x 32.0= 625,376 Cash freed up: $252,624 Initially shows up as additional cash.

36. 3 - 36 Copyright © 1999 by The Dryden PressAll rights reserved. What could be done with the new cash? Effect on stock price and risk? New Balance Sheet Added cash$ 253Debt$1,945 A/R625Equity1,552 Other CA1,802 Net FA 817 Total assets$3,497Total L&E$3,497

37. 3 - 37 Copyright © 1999 by The Dryden PressAll rights reserved. Potential use of freed up cash Repurchase stock. Higher ROE, higher EPS. Expand business. Higher profits. Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…)

38. 3 - 38 Copyright © 1999 by The Dryden PressAll rights reserved. Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides. All these actions would likely improve stock price.

39. 3 - 39 Copyright © 1999 by The Dryden PressAll rights reserved. Would you lend money to this company? Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. However, company should not have relied so heavily on debt financing in the past.

40. 3 - 40 Copyright © 1999 by The Dryden PressAll rights reserved. What are some potential problems and limitations of financial 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…)

41. 3 - 41 Copyright © 1999 by The Dryden PressAll rights reserved. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. 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.

42. 3 - 42 Copyright © 1999 by The Dryden PressAll rights reserved. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? 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…)

43. 3 - 43 Copyright © 1999 by The Dryden PressAll rights reserved. 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? And so on.