Chapter 4: Financial Statement Analysis FINC3131 Business Finance Chapter 4: Financial Statement Analysis

Learning Objectives Explain why creditors, stockholders and managers want to perform financial statement analysis. Calculate liquidity, asset utilization, debt utilization and profitability ratios. Identify 3 limitations of ratio analysis.

Objectives of financial statement analysis Creditors Firm’s ability to repay borrowed funds, i.e., creditworthiness Stockholders Firm’s future prospects (cash flows ) Managers Identify strengths & weaknesses so as to improve firm performance

Why Financial Statement Analysis? Financial Statements provide information of how well the company is doing currently and in the past. 2. Financial Statements provide information that helps to predict the future financial position and determine the expected cash flows. 4

Financial Ratios Examine relationships between Balance sheet accounts E.g., compare current assets to current liabilities Balance sheet accounts and values on the income statement E.g., compare net income to total assets

Why look at ratios? (1)

Financial ratio analysis involves… Comparison of financial ratios through time for a given firm This is trend analysis

Why look at ratios? (2) Please look at the second example.

Financial ratio analysis involves… Comparison of the firm’s financial ratios with those of the industry This is industry comparison

Types of financial ratios Liquidity ratios Asset management ratios Debt management ratios Profitability ratios Combination ratios

Liquidity ratios Measure how well company can meet short-term obligations Current ratio Quick (‘acid test’) ratio Same denominator as current ratio But numerator excludes inventory Higher ratios mean firm is better able to meet obligations on time

Quick review 1 1) The ABC company has a current ratio of 2 times. Its quick ratio is 1. If current assets are $4 million, what is inventory? 2) According to Crefeld Industries’s balance sheet, the company's assets total $50 million. The company has $8 million cash and is owed $15 million by its customers (i.e., A/R). It also has $13 million of goods on hand. Crefeld's net plant and equipment (i.e., net fixed assets) is worth $14 million. The company's current liabilities are $18 million. What is the current ratio?

Asset management ratios 1 Also called ‘asset utilization’ ratios or ‘efficiency’ ratios Unused or inactive assets are nonearning assets Either utilize assets more effectively or eliminate them

Asset management ratios 2 Inventory turnover ratio Measures how efficiently company is employing inventory. Larger ratio  more efficient. Industry specific. Day sales outstanding(DSO) Measures how fast company collects payments from credit sales. In number of days.

Asset management ratios 3 Total asset turnover Measures how productive a firm’s total assets are at producing final sales. Higher ratio means firm is more efficient in using total assets. Industry specific.

Debt management ratios 1 Measures the extent to which firm uses borrowed funds to finance operations. Leverage: using debt to finance assets/operations Debt utilization ratios also known as leverage ratios

Debt management ratios 2 Debt to capital ratio Measures proportion of capital financed with short-term and long-term interest-bearing debt, not including A/P or Accruals. Higher the ratio, higher the risk of default. Total capital = debt + equity

Debt management ratios 3 Times interest earned (TIE) Measures how many times the firm’s l operating earnings (EBIT) cover its debt-servicing charges (mainly interest). Larger ratio means firm is more likely to pay debt-servicing charges despite a drop in sales. .

Profitability ratios Compare a firm’s earnings to various factors that are needed to generate the earnings (assets, sales, equity) Return on assets Return on equity Operating profit margin on sales Net profit margin on sales

Market value ratios Price/Earnings ratio =(Price per share)/(Earnings per share)

Combination Ratios: Extended DuPont Equation Breaks down ROE into three components: Activity (total asset turnover) Profitability (net profit margin) Leverage (equity multiplier = total assets/equity) ROE = net income / equity = net profit margin x total asset turnover x Equity multiplier = ROA x equity multiplier If ROE changes, DuPont equation helps you to identify the reason for the change.

Quick review 5 The DuPont System allows us to decompose the return on equity into Return on assets and the Equity multiplier. Net profit margin, Tax retention ratio, and Inventory turnover. Gross profit margin, Total asset turnover, and the Debt-to-equity ratio. Net profit margin, Inventory turnover ratio, and the Equity multiplier None of the above. Answer?

ROE Questions 1 You are given the following ratios for Flotsam Inc whose assets are financed with debt and equity only. Return on Asset (ROA) = 22%, Debt to capital ratio is = 20% What is the ROE?

ROE Questions 2 If a firm's net profit margin is 7%, and its equity multiplier is 1.3 times, and return on equity is 16%, what is its total asset turnover (to two decimal places)?

General question Primecare Inc. recently issued long-term debt and deposited the proceeds in the company’s checking account. All else constant, this should be expected to: increase the firm’s return on assets. increase the firm’s current ratio. increase the firm’s earnings per share. decrease the firm’s debt to capital ratio. decrease the firm’s net profit margin. Answer?

Another general question If a firm that is financed with debt and equity only increases its sales but keeps its equity, net profit margin, and total assets constant, what would be the impact of this action on ROE? [Hint: Use the fact that ROE = net profit margin x total asset turnover x equity multiplier ] ROE would decrease. ROE would increase. ROE would remain unchanged. ROE may increase or decrease depending on the interaction between the equity multiplier and sales. None of the above answers are necessarily correct.

Limitations of ratios 1 1) Balance sheet values are stock measures Capture values of assets & liabilities on a specific date Ratios using balance sheet values may not reflect company’s situation during rest of the year Example: A company that reports $1 million in cash on last day of fiscal year may have only $100k two days later, after paying salaries and suppliers

Limitations of ratios 2 2) Financial ratios are calculated using accounting data not market values Accounting data is based on an asset’s historical costs. Example: if inventory market value declines below historical cost but management did not adjust for this – every ratio involving total assets will be inaccurate. Ratios not informative when asset market values deviate from historical costs. ( e.g., Land )

Limitations of ratios 3 3) Lack of a standard for each ratio. Example: current ratio. What is a good current ratio value? How about using industry average ratio as standard? Not necessarily useful. Deviations from industry average not always bad.

Summary Reasons for conducting financial statement analysis 5 types of ratios Limitations of financial ratios Assignment 4-2, 4-3,4-5,4-6,4-8,4-11.