1 Chapter 4 Analysis of Financial Statements

2 Learning Objectives  Measure and interpret financial ratios.  Analyze trends in financial ratios.  Manipulate financial ratios to find another ratio.

3 Ratio Analysis  Examines firm’s management of various facets of the company’s business through its financial statements.  Scales balance sheet and income statement information for easy comparison across time or to other companies.

4 Two common approaches  Trend Analysis - looks at changes in one company’s ratios over time.  Benchmarking: Comparison or Industry Analysis - compares company’s ratios against a similar company or against industry-wide ratios.  To illustrate trend analysis, we will compare Best Buy’s Feb and Feb ratios.  To illustrate benchmarking, we will calculate Best Buy’s Feb ratios and will compare to Circuit City’s Feb ratios.

5 Areas Examined by Ratio Analysis  Liquidity - measures the ability to meet short- term obligations  Asset Management - measures the ability to contain the growth of assets, and the ability to effectively utilize assets  Debt Management - measures the use of financial leverage (debt) and its impact  Profitability - measures the profitability of various segments of a company

6 Liquidity Ratios Feb. 2006Feb Best Buy Current Best Buy Quick Circuit City Current1.75 Circuit City Quick0.70

7 Asset Management Ratios Feb. 2006Feb Best Buy InvTurn Best Buy DSO Circuit City InvTurn6.83 Circuit City DSO8.06

8 Asset Management (Continued) Feb-06Feb-05 Best Buy Fixed asset turnover Best Buy Total asset turnover Circuit City FAT Circuit City TAT 2.85

9 Debt Management Ratios Feb-06Feb-05 BB Debt ratio 55.7%56.8% BB TIE CC Debt Ratio52.0% CC TIE77.07

10 Profitability Ratios Feb-06Feb-05 BB Profit margin 3.7%3.6% BB ROA 9.6% CC Profit Margin1.2% CC ROA3.4%

11 Profitability Ratios (Continued) Feb-06Feb-05 BB BEP 14.6%14.4% BB ROE 21.7%22.1% CC BEP6.0% CC ROE7.1%

12 Breaking Down ROE: DuPont Equation  ROE(NI/Eq) = Return on Assets (NI/TA) x Equity Multiplier (TA/Eq)  ROE = Profit Margin on Sales (NI/S) x Total Asset Turnover (S/TA) x TA/Eq 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

13 DuPont Equation: Best Buy vs. Circuit City  *Since Assets = Liabilities + Equity, 1 – debt ratio = equity/assets meaning for Circuit City: Feb. 2006Profit Margin Asset Turnover Assets to Equity* ROE Best Buy3.7% % Circuit City 1.2% %

14 Circuit City ROE Catch-up?  Circuit City would like to improve their ROE to 15%. They anticipate improvement in profit margin and total asset turnover to 2.0% and 3.0 respectively. What total debt to total asset ratio would be needed to achieve Circuit City’s ROE goal?

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16 Some DuPont ROE Comparisons Trailing 12 Months PMTATEq MultROE S&P % % Oil&Gas industry 11.5% % Electronics Store Ind. 3.2% % Microsoft28.5% % Nike8.8% % Yum! Brands 8.5% %

17 Market Ratios Feb Stock Price EPSFeb P/E Ratio Recent P/E Best Buy$54.04$ Circuit City $24.03$

18 Market Ratios Feb Stock Price # of shares (000) BV/shM/B ratio Best Buy$ ,300$ Circuit City $ ,400$