1 Analysis of Financial Statements

Overview of Financial Analysis First order of business is to SPECIFY THE OBJECTIVES OF THE ANALYSIS Remember -- the identity of the user helps define what information is needed

Potential Financial Statement Users: Creditors Investors Managers Employees What types of questions do each of these users seek answers to?

Creditors Why does the firm want/need to borrow funds? What is the firm’s capital structure? How leveraged are they? How will they pay it back? What kind of cash flows are being generated by operations?

Investors How has the firm performed/what are future expectations? How much RISK is inherent in the capital structure? What are expected returns from the firm? What is firm’s competitive position?

Managers Need all info creditors and investors need PLUS: What operating areas have contributed to success and which have not? What are strengths/weaknesses of company’s financial position? What changes are indicated to improve future performance?

Caution!!! Keep in mind: management PREPARES financial statements Analyst should be alert to potential for management to influence reporting to make data more “appealing” May want to supplement analysis with information apart from Annual Report prepared by management

Where to look for data... Financial statements (and notes) Annual Report 10K and 10Q reports filed with SEC Computerized data bases Info on industry norms/ratios Info on particular companies/industries/mutual funds Websites

Basic Tools Common size financial statements Financial ratios Trend analysis Industry comparisons

Common Sizing Firm A Firm B Sales COGS Gr. Profit

Common Sizing Firm A Firm B Sales2,531,4564,561,234 COGS784,5641,556,456 Gr. Profit1,746,8913,004,778

Common Sizing Firm A Firm B Sales2,531, % 4,561, % COGS784,564 31% 1,556,456 34% Gr. Profit1,746,891 69% 3,004,778 66%

Common Size Statements Common size income statement expresses each income statement category as a percentage of sales Common size balance sheet expresses each item on balance sheet as a percentage of total assets or equities

14 Ratio Analysis Profitability Liquidity Debt Utilization Asset Utilization ratios Four Categories of Ratios

15 Ratio Analysis Profitability Ratios Measure the overall effectiveness of the firm’s management.

16 Gross Profit Margin = Gross Profit Sales How effective is the firm at generating revenue in excess of its cost of goods sold? Ratio Analysis Profitability Ratios

17 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Bonds$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Income Statement Excalibur Corporation Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Net Operating Income$330 Interest Expense 60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 $575 $1,450 Gross Profit Margin == 39.7% Gross Profit = Margin Gross Profit Sales

18 Operating Profit Margin = Operating Income Sales How effective is the firm in keeping costs of production low? Ratio Analysis Profitability Ratios

19 Balance Sheet Excalibur Corporation Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625 Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $330 $1,450 Oper. Profit Margin == 22.8% Operating Profit = Margin Operating Income Sales

20 Profit Margin or Return on Sales = Net Income Sales How much net profit is being generated from each dollar of sales? Ratio Analysis Profitability Ratios Note: Net Income equals Earnings Available to CS when there is no preferred stock.

21 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625 Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $162 $1,450 Profit Margin == 11.2% Net Profit = Margin Net Income Sales

22 Return on Assets = Net Income Total Assets How effectively is the firm generating net income from its assets ? Ratio Analysis Profitability Ratios

23 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40)108 Net Income%$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $162 $2,530 ROA = = 6.4% Return on Assets Net Income Total Assets =

24 Return on Common Equity = Net Income Equity How well is the firm generating return to its equity providers? Ratio Analysis Profitability Ratios

25 Balance Sheet Excalibur Corporation Assets Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $162 $1,700 ROE == 9.53% Return on Equity = Net Income Equity

26 Ratio Analysis Liquidity Ratios Current Ratio = Current Assets Current Liabilities Measure the ability of the firm to meet its short-term financial obligations. Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

27 Balance Sheet Excalibur Corporation Assets Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 $1,230 $230 Current Ratio = = 5.35x Current Ratio = Current Assets Current Liabilities

28 Ratio Analysis Liquidity Ratios Measure the ability of the firm to meet its short-term financial obligations. Quick Ratio = Current Assets - Inventory Current Liabilities What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

29 Balance Sheet Excalibur Corporation Assets Liabilities $1,230 -$625 $230 Acid-Test Ratio = = 2.63x Quick Ratio = Current Assets - Inventory Current Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530

30 Ratio Analysis Debt Utilization Ratios Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt.

31 Debt Ratio = Total Debt Total Assets What proportion of the firm’s assets is financed with debt? Ratio Analysis Debt Ratios

32 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Income Statement Excalibur Corporation Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 $230 + $600 $2,530 Debt Ratio = = 33% Debt Ratio = Total Debt Total Assets

33 Times Interest Earned Ratio = Operating Income Interest Expense What is the firm’s ability to repay interest payments from its operating income? Ratio Analysis Debt Ratios

34 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities $330 $330$60 TIE Ratio = = 5.50x Times Interest = Earned Ratio Operating Income Interest Expense Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

35 Ratio Analysis Asset Management Ratios Help assess how effectively the firm is using assets to generate sales.

36 Ratio Analysis Asset Utililzation Ratios How long does it take for the firm on average to collect its credit sales from customers? Average Collection Period = Accounts Receivable Avg. Daily Cr. Sales

37 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Bonds$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation Average Collection = Period Accounts Receivable Avg. Daily Sales $430 $1,450/365 ACP = = days Days in a year Additional Info: We assume all sales are credit sales.

38 Inventory Turnover Ratio = Sales Inventory Is inventory efficiently translating into sales for the firm? Ratio Analysis Asset Management Ratios

39 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $1450 $625 Inventory Turnover = = 2.3x Inventory Turnover = Ratio Sales Inventory

40 Fixed Asset Turnover Ratio = Sales Net Fixed Assets How effective is the firm in using its fixed assets to help generate sales? Ratio Analysis Asset Management Ratios

41 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation Assets Liabilities Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation $1,450 $1,300 Fixed Asset Turnover = = 1.12x Fixed Asset Turnover = Ratio Sales Net Fixed Assets

42 Total Asset Turnover Ratio = Sales Total Assets How effective is the firm in using its overall assets to generate sales? Ratio Analysis Asset Management Ratios

43 Assets Liabilities Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Balance Sheet Excalibur Corporation $1,450 $2,530 Total Asset Turnover = = 0.57x Total Asset Turnover = Ratio Sales Total Assets Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

44 Price to Earnings Ratio = Price per Share Earnings per Share How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.) Ratio Analysis Market Value Ratios

45 Cash$175Accounts Payable$115 Accounts Receivable430 S-T Notes Payable 115 Inventories625Current Liabilities$230 Current Assets$1,230Long-term Debt$600 Plant & Equipment$2,500Owner’s Equity Less:Acc. Depr.(1,200)Common Stock$300 Net Fixed Assets$1,300Capital in Excess of Par600 Total Assets$2,530Retained Earnings800 Total Owners’ Equity$1,700 Total Liabilities and Owners Equity$2,530 Assets Liabilities Balance Sheet Excalibur Corporation Additional Info: 100 shares $20.00 per share $20.00 $162/100 P/E ratio = = 12.35x P/E Ratio Price/Share EPS = Sales$1,450 Cost of Goods Sold875 Gross Profit$575 Operating Expenses45 Depreciation200 Operating Income$330 Interest Expense60 Income Before Taxes$270 Taxes (40%)108 Net Income$162 Common Dividends Paid100 Addition to Retained Earnings$62 Income Statement Excalibur Corporation

46 Ratio Industry Excalibur Profitability Gross Profit Margin 38% 39.7% Operating Profit Margin20%22.8% Net Profit Margin12%11.2% Return on Assets9.0%6.4% Return on Equity13.4%9.5%

47 Ratio Industry Excalibur Profitability Gross Profit Margin 38% 39.7% Operating Profit Margin20%22.8% Net Profit Margin12%11.2% Return on Assets9.0%6.4% Return on Equity13.4%9.5% Excalibur is good at keeping operating costs down, but not as good at total costs. ROA and ROE are low mainly due to productivity problems.

48 Ratio Industry Excalibur Liquidity Current Ratio 5.00x 5.35x Quick Ratio 3.00x 2.63x Summary of Excalibur Corporation Ratios

49 Ratio Industry Excalibur Liquidity Current Ratio 5.00x 5.35x Quick Ratio 3.00x 2.63x Looking at the current ratio it appears that Excalibur is more liquid than the industry.... however when looking at Acid Test (a better measure) they are not as liquid indicating that inventory levels are probably too high. Summary of Excalibur Corporation Ratios

50 Ratio Industry Excalibur Debt Debt Ratio35%33% Times Interest Earned7.00x5.50x

51 Ratio Industry Excalibur Debt Debt Ratio35%33% Times Interest Earned7.00x5.50x While the debt ratio is close to the industry average, Excalibur is not able to cover interest payments as easily as the industry. This indicates Excalibur may have too much debt relative to what they can realistically afford.

52 Ratio Industry Excalibur Asset Management Avg. Collection Period90 days108 days Inventory Turnover3.00x2.32x Fixed Asset Turnover1.00x1.12x Total Asset Turnover0.75x.57x

53 Ratio Industry Excalibur Asset Management Avg. Collection Period90 days108 days Inventory Turnover3.00x2.32x Fixed Asset Turnover1.00x1.12x Total Asset Turnover0.75x.57x Collection policies need examining, as Excalibur is slower than average at collecting receivables. Inventories are being sold more slowly than the industry average, again indicating inventories that are too high. Excalibur is very efficient at converting Fixed Assets to Sales (fixed assets are productive). However, overall assets are not productive indicating Current Assets (e.g. inventories) are not as productive as for the industry.

54 Ratio Industry Excalibur Market Value PE Ratio

55 Ratio Industry Excalibur Market Value PE Ratio Excalibur’s Investors are not willing to pay as much per dollar of earnings or per dollar of book value as they are for shares in other firms in the industry. This signals that they consider the firm’s prospects to be worse than the average. However, the firm is still selling for more than its accounting book value.

56 Relationships Among Ratios: The Du Pont System Ratio Analysis generally involves an examination of related ratios. Comparison of these relationships over time helps to identify the company’s strengths and weaknesses.

57 Net Inc. Net Inc. Sales Assets Sales Assets = x The Du Pont Equation Net Profit Margin Total Asset Turnover Return on Assets = x Relationships Among Ratios: The Du Pont System

58 Relationships Among Ratios: The Du Pont System Net Inc. Net Inc. Sales Assets Equity Sales Assets Equity = x x Net Profit Margin Total Asset Turnover Return on Equity Multiplier = x x

DuPont Equation: TGT vs. Walmart Net Profit Margin Asset Turnover Target4.0%1.45 Wal-Mart3.6%2.40 Which would you prefer?

DuPont Equation: TGT vs. Walmart Jan. 2005Net Profit Margin Asset Turnover ROA Target4.0% % Wal-Mart3.6% %

DuPont Equation: TGT vs. Walmart Jan. 2005Net Profit Margin Asset Turnover Equity Multiplier ROE Target4.0% % Wal-Mart3.6% % What is Target’s debt ratio? How much debt would Target need for ROE=21%

The DuPont approach is nice because it divides the firm into three tasks expense management (measured by the profit margin) asset management (measured by asset turnover) debt management (measured by the equity multiplier)

DuPont Example Wal-Mart Sears Profit M.4% 6% Ass.Turn ROA ? ? Eq. Mult.2 1 ROE ? ?

What is the top overall ratio?

Ratio Exercise