1. FINANCIAL STATEMENT ANALYSIS On Friday, June 6: Quiz or nothing depending on how hard people work Mon to Thursday. CHAPTER 18

2. Ratio Analysis expresses the relationships between selected financial statement items. There are 3 types of ratio analysis: 1.Liquidity Ratios : Measure short-term ability of the enterprise to pay its debts and to meet unexpected needs for cash. 2.Solvency ratios : Measure the ability of the enter prise to survive over a long period of time. 3.Profitability ratios : Measure the income or operating success of an enterprise for a given period of time. Ratio Analysis

3. PROFITABILITY RATIOS Profit margin Gross profit margin Asset turnover Return on assets Return on common shareholders’ equity Earnings per share (EPS) Price-earnings (PE) ratio Payout ratio

4. PROFITABILITY RATIOS Who would be interested in finding out profitability ratios? CEO, other executives, Bankers, investors and owners Many CEO (CFO, CMO etc)’s bonuses are tied to EPS, PE ratio and profit margin.

5. GROSS PROFIT MARGIN Measures margin between selling price and cost of goods sold generated by each dollar of sales This ratio indicates a company’s ability to keep a selling price that is high enough above its cost of goods sold. Gross profit = Net Sales - COGS (Discussed in Chapter 5) Gross profit margin = Gross profit Net sales

6. Gross Profit Margin Gross Profit Margin Let’s say Hometown Tire’s numbers are: 2004 GPM = 597000 / 1837000 = 32.5% 2005 GPM = 616000 / 1997000 = 30.8% Industry Average GPM = 23.5% Canadian Tire GPM = 20% How would you interpret GPM of Hometown?

7. Gross Profit Margin Gross Profit Margin How would you interpret GPM of Hometown? 1.GPM’s trend: GPM is decreasing from 2004, which is not a good sign. (Instead of 32.5% in 2004) In 2005, only 31% of its net sales was used to cover operating expenses and owner’s profit. 2.Hometown’s GPM is higher than industry average and Canadian Tire, so it is a positive sign. 3.Perhaps, Hometown Tire sells more quality tires whereas Canadian Tire sells cheap tires. This means it is critical that Hometown Tire maintains high GPM in order to cover operating expenses and to maintain decent net income.

8. PROFIT MARGIN Measures net income generated by each dollar of sales What is the percentage of net sales, which ended up making net income? (Discussed in Chapter 5) Profit margin = Net income Net sales

9. Profit Margin Profit Margin 2004 PM = 75000 / 1837000 = 4.1% 2005 PM = 82000 / 1997000 = 4.1% Industry Average = 5.4% Canadian Tire = 4.2% Only 4.1% of their net sales ended up becoming their net income.

10. Profit Margin Profit Margin PM did not change from 2004 to 2005  neutral PM of Hometown is lower than industry average and also Canadian Tire’s PM, although their Gross profit margin is higher than Canadian Tire’s number. Perhaps Hometown’s operating expenses are too high compared to Canadian Tire or industry’s average operating expenses.

11. EARNINGS PER SHARE (EPS) Measures net income earned on each common share (Discussed in Chapter 15) Earnings per share = Net income Number of common shares

12. EPS EPS There are two types of shares: Prefered shares : They do not give voting rights to the shareholder. –In return, shareholders get fixed income. –Companies issue prefered shares to raise money and willing to pay fixed payments such as 6% of the investment. Common shares : They give voting right to the shareholder. –Shareholders do not get fixed income. –Dividends can change depending on the net income for the quarter. –Companies issue common shares to raise money for the business without increasing their mandatory payments like interests.

13. EPS EPS Most companies are required to present this ratio directly on income statement. Hometown Tires has 30,000 common shares issued. There has been no change in this number over the past 3 years, so the weighted average number of shares is just 30,000 shares. 2004: (75000-0) / 30,000 = 2.50 2005: (82000 -0) / 30,000 = 2.73 Industry average = NA Canadian Tire = $4.04 EPS has grown year over year, which is a positive sign. (9% increase)

14. EPS EPS Comparison to Canadian Tire is not meaningful because Canadian Tire is a public company, which issued much more common shares. EPS shows how much net income is made from one share, so it is extremely important number for investors.(people who want to buy or already purchased the common shares of this company) Let’s say Samsung’s EPS is 5 whereas Apple’s EPS is 10, which one is a better stock to own? (assuming same price) If the price for Samsung shares is $50 per share whereas Apple’s shares is $500, then which one is better one to buy?

15. PRICE-EARNINGS (PE) RATIO Measures relationship between market price per share and earnings per share It shows how expensive the stock is considering its net income. A valuation ratio of a company's current share price compared to its per-share earnings. (Discussed in Chapter 15) Price-earnings ratio = Share price Earnings per share

16. PE Ratio PE Ratio 2004: $5 / 2.50 = 2 2005: $5 / 2.75 = 1.8 Industry Average = 15 Canadian Tire = 17.2 Hometown’s PE in 2005 is 1.8, meaning for every one dollar of earning per share, the investor has to pay $1.80. Since the PE decreased year over year, this is a positive sign. (because EPS increased year over year) Since Hometown’s PE is lower than Canadian Tire’s PE or industry average PE, it is worth to buy Hometown’s common shares.

17. PE Ratio PE Ratio In general higher PE ratio means that this company is popular and more expensive than another company with low PE ratio. Companies with high PE ratio: Although the company makes small net income, people are still buying this company? Why? –People feel that this company has good prospect for growth in the future. –People believe that there will be a breakout of this company’s revenue and net income in the future. For example, Bio Tech companies and High Tech companies typically have high PE ratio. Many professional money managers (Mutual Fund manager and Hedge Fund manager) use EPS and PE ratio to make their buy or sell decisions everyday.

18. Classwork / Homework Classwork / Homework P960 E18.9, E18.10 (only the ratios we learned so far) E18.11(C) P964 P18.3 – only the ratios we learned so far