1. Chapter 2,3 Financial Statement Analysis

2. Taxes Always changing Marginal vs. average tax rates –Marginal – the percentage paid on the next dollar earned –Average – the tax bill / taxable income Other taxes

3. Example: Marginal Vs. Average Rates Suppose your firm earns $4 million in taxable income. –What is the firm’s tax liability? –What is the average tax rate? –What is the marginal tax rate? If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

4. The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP). GAAP is authorized by the Financial Accounting Standards Board (FASB). The four key financial statements required by the SEC for reporting to shareholders are the income statement, balance sheet, statement of retained earnings, and statement of cash flows. The Stockholders’ Report

5. The income statement provides a financial summary of a company’s operating results during a specified period. Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes. The Four Key Financial Statements The Income Statement

6. The balance sheet presents a summary of a firm’s financial position at a given point in time. Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed. The Four Key Financial Statements The Balance Sheet

7. Market vs. Book Value The balance sheet provides the book value of the assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. Market value and book value are often very different. Why? Which is more important to the decision- making process?

8. The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings. The Four Key Financial Statements Statement of Retained Earnings

9. The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets. The Four Key Financial Statements Statement of Cash Flows

10. FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets into dollars for consolidation with the parent company’s financial statements. Consolidating International Financial Statements

11. 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 is that information important Ratios are used both internally and externally

12. Trend or time-series analysis cross-sectional analysis Combined Analysis Using Financial Ratios Types of Ratio Comparisons

13. 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

14. Sample Balance Sheet Cash6,489A/P340,220 A/R1,052,606N/P86,631 Inventory295,255Other CL1,098,602 Other CA199,375Total CL1,525,453 Total CA1,553,725LT Debt871,851 Net FA2,535,072C/S1,691,493 Total Assets 4,088,797Total Liab. & Equity 4,088,797 Numbers in thousands

15. Sample Income Statement Revenues3,991,997 Cost of Goods Sold1,738,125 Expenses1,269,479 Depreciation308,355 EBIT739,987 Interest Expense42,013 Taxable Income697,974 Taxes 272,210 Net Income425,764 EPS2.17 Dividends per share0.86 Numbers in thousands, except EPS & DPS

16. Computing Liquidity Ratios Current Ratio = CA / CL –1,553,725 / 1,525,453 = 1.02 times Quick Ratio = (CA – Inventory) / CL –(1,553,725 – 295,225) / 1,525,453 =.825 times Cash Ratio = Cash / CL –6,489 / 1,525,453 =.004 times

17. Computing Leverage Ratios Total Debt Ratio = (TA – TE) / TA –(4,088,797 – 1,691,493) / 4,088,797 =.5863 times or 58.63% –The firm finances almost 59% of their assets with debt. Debt/Equity = TD / TE –(4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times Equity Multiplier = TA / TE = 1 + D/E –1 + 1.417 = 2.417

18. Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory –1,738,125 / 295,255 = 5.89 times

19. Computing Total Asset Turnover Total Asset Turnover = Sales / Total Assets –3,991,997 / 4,088,797 =.98 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

20. Computing Profitability Measures Profit Margin = Net Income / Sales –425,764 / 3,991,997 =.1067 times or 10.67% Return on Assets (ROA) = Net Income / Total Assets –425,764 / 4,088,797 =.1041 times or 10.41% Return on Equity (ROE) = Net Income / Total Equity –425,764 / 1,691,493 =.2517 times or 25.17%

21. Computing Market Value Measures Market Price = $61.625 per share Shares outstanding = 205,838,594 PE Ratio = Price per share / Earnings per share –61.625 / 2.17 = 28.4 times Market-to-book ratio = market value per share / book value per share –61.625 / (1,691,493,000 / 205,838,594) = 7.5 times

22. See Table 3.5 for summary

23. 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

24. Payout and Retention Ratios Dividend payout ratio = Cash dividends / Net income –0.86 / 2.17 =.3963 or 39.63% Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio –1.31 / 2.17 =.6037 = 60.37% –Or 1 -.3963 =.6037 = 60.37%

25. The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

26. The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

27. 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