3 - 1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 3 Analysis of Financial Statements: Financial Statements and Reports Ratio Analysis Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida

3 - 2 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Financial Statements and Reports 4 The Income Statement 4 The Balance Sheet 4 Statement of Cash Flows 4 Statement of Retained Earnings

3 - 3 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Income Statement

3 - 4 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Balance Sheet: Assets

3 - 5 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Liabilities and Equity

3 - 6 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Statement of Cash Flows (2000)

3 - 7 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Statement of Cash Flows (continued)

3 - 8 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What Can You Conclude about Computron’s Financial Condition from its Statement of Cash Flows? n Net operating cash flow is ($73,780) –Operations are draining cash n Had to borrow $126,180 in long- and short- term debt to cover cash outlays, pay for fixed asset additions, and to pay dividends n Despite borrowing, cash account still fell $5,600 in 2000

3 - 9 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Statement of Retained Earnings Balance of retained earnings Dec. 31, 1999$203, Net Income44, dividends to stockholders (22,000) Balance of retained earnings Dec. 31, 2000$225,988

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Additional Data

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Ratio Analysis n An analysis of a firm’s ratios is generally the first step in financial analysis n The ratios are designed to show relationships between financial statement accounts within firms and between firms

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is the Purpose of Ratio Analysis? n Give idea of how well the company is doing n Standardize numbers; facilitate comparisons n Used to highlight weaknesses and strengths

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4 Liquidity: 4 Liquidity: Can we make required payments? 4 Asset mgt.: 4 Asset mgt.: Right amount of assets vs. sales? 4 Debt mgt.: 4 Debt mgt.: Right mix of debt and equity? 4 Profitability: 4 Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? 4 Market values: 4 Market values: Do investors like what they see as reflected in P/E and M/B ratios? What Are the Five Major Categories of Ratios? What Questions Do They Answer?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Industry Average Data (2000)

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What are Computron’s Current and Quick ratios?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comment on Computron’s Liquidity Position n Ratios held steady but slightly below ind. avg. n Inventories are the least liquid of Computron’s assets and they are the assets that suffer losses in the event of a forced sale. n The quick ratio shows that even if receivables are collected in full, Computron still needs to raise case from sale of inventories to meet obligations.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Note that the $1,290,000 in current assets is made up of... $ 52,000 in cash $402,000 in accts rec $836,000 in inventories $1,290,000 total Cur Lia - Cash - Acc Rec = Inventory needed to be liquidated to meet current liabilities Thus, cur. lia minus cash = $540,200 - $52,000 = $488,200 and $488,200 - accts rec = $488,200 - $402,000 = $86,200 in inventory… That would have to be liquidated in order to meet current liabilities

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Computron’s Inventory Turnover Ratio?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s Inventory Turnover n Compares poorly with industry. n Continuing on a downward trend. n May be holding excess inventories, or n May be holding old/obsolete inventory.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Computron’s Days Sales Outstanding Ratio?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s Days Sales Outstanding Ratio n Looks bad. n Higher than industry average. n Getting higher!!

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Computron’s Fixed Assets and Total Assets Turnover Ratios?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s Fixed Assets Turnover and Total Assets Turnover n Fixed assets turnover has improved. n However, total asset turnover remains the same and below industry average. n As we saw before, Computron may have excess inventories and receivables.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Calculate the Debt, TIE, and Fixed Charge Coverage Ratios. Debt Ratio = Total debt Total assets TIE = EBIT Int. expense

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. FCC = EBIT + Lease payments + S.F. Pmts. Interest + Lease + Sinking fund pmt. expense pmt. (1-T) All three ratios reflect use of debt, but focus on different aspects. Fixed Charge Coverage Ratio

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s Debt Management n Debt ratio is above industry and going higher. n Computron would find it difficult to borrow. n TIE and FCC below industry average and falling-- indicates Computron has high use of debt.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. If you are in the 30% tax bracket, you have to earn $1.43 before tax in order to put $1.00 into your pocket $1.43 – 30%($1.43) = $1.00 Or $1.00/(1-Tax Rate) = $1.00/(1-.30) = $1.43 “Amount/(1-T) “ is frequently used in Finance

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Calculate Computron’s Profitability Ratios-- Profit Margin, ROA, and ROE Low and Falling!

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron’s ROA, and ROE

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s ROA and ROE n Both ROA and ROE substantially below industry average. n Company stock probably not doing well.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Calculate Computron’s Market Value Ratios - - Price/Earnings Ratio and Market/Book Value Ratio EPS = Net Income / Shares Outstanding

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron’s Market/Book Value Ratio

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Book Value = Common Equity / shares outstanding

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s Market Value Ratios n P/E rose from 1999 to good? n NO! because earnings dropped! n M/B well below industry average. n Investors view Computron as riskier than other companies in the industry.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Summary of Ratio Analysis: The Du Pont Equation

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. DU PONT Equation Provides Overview of: profitability n Firm’s profitability (measured by ROA) expense control n Firm’s expense control (measured by profit margin) asset utilization n Firm’s asset utilization (measured by total asset turnover)

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n Expense control is poor and trending downward. n Asset utilization is below average but not getting worse. n Combination = ROA that is very low and falling. Computron’s DU PONT Equation

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Sales per day amount to: $3,850,000/ 360 = $10,694 Accounts Receivable are now $402,000, or 37.6 days sales $10,694 * 37.6 = $402, or $402, / $10,694 = 37.6 If DSO can be reduced to 27.6 days without affecting sales… Then accounts receivable would be: $10,694 * 27.6 = $295,154 Compared to the current accounts receivable this would mean a collection (cash inflow) of: $402,000 - $295,154 = $106,846

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What are Some Potential Problems and Limitations of Financial Ratio Analysis? n Comparison with industry averages is difficult if the firm operates many different divisions. n “Average” performance not necessarily good. n Inflation distorts balance sheets.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n Seasonal factors can distort ratios. n Window dressing” techniques can make statements and ratios look better. n Different operating and accounting practices distort comparisons. What are Some Potential Problems and Limitations of Financial Ratio Analysis?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n Sometimes hard to tell if a ratio is “good” or “bad.” n Difficult to tell whether company is, on balance, in strong or weak position. What are Some Potential Problems and Limitations of Financial Ratio Analysis?

Copyright (C) 2000 by Harcourt, Inc. All rights reserved. End of Chapter 3 Analysis of Financial Statements