1. 1 CHAPTER 4 Analysis of Financial Statements

2. 2 Topics in Chapter Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors

3. 3 Income Statement 20052006E Sales5,834,4007,035,600 COGS4,980,0005,800,000 Other expenses720,000612,960 Deprec.116,960120,000 Tot. op. costs5,816,9606,532,960 EBIT17,440502,640 Int. expense176,00080,000 EBT(158,560)422,640 Taxes (40%)(63,424)169,056 Net income(95,136)253,584

4. 4 Balance Sheets: Assets 20052006E Cash7,28214,000 S-T invest.20,00071,632 AR632,160878,000 Inventories1,287,3601,716,480 Total CA1,946,8022,680,112 Net FA939,790836,840 Total assets2,886,5923,516,952

5. 5 Balance Sheets: Liabilities & Equity 20052006E Accts. payable324,000359,800 Notes payable720,000300,000 Accruals284,960380,000 Total CL1,328,9601,039,800 Long-term debt1,000,000500,000 Common stock460,0001,680,936 Ret. earnings97,632296,216 Total equity557,6321,977,152 Total L&E2,886,5923,516,952

6. 6 Other Data 20052006E Stock price$6.00$12.17 # of shares100,000250,000 EPS-$0.95$1.01 DPS$0.11$0.22 Book val. per share$5.58$7.91 Lease payments$40,000 Tax rate0.4

7. 7 Why are ratios useful? Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths

8. 8 Five Major Categories of Ratios Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? (More…)

9. 9 Ratio Categories (Continued) Debt management: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

10. 10 Forecasted Current and Quick Ratios for 2006. CR 06 = = = 2.58x. QR 06 = = = 0.93x. CA CL $2,680 $1,040 $2,680 - $1,716 $1,040 CA - Inv. CL

11. 11 Comments on CR and QR 2006E20052004Ind. CR2.58x1.46x2.3x2.7x QR0.93x0.5x0.8x1.0x Expected to improve but still below the industry average. Liquidity position is weak.

12. 12 Inventory Turnover Ratio vs. Industry Average Inv. turnover= = = 4.10x. Sales Inventories $7,036 $1,716 2006E20052004Ind. Inv. T.4.1x4.5x4.8x6.1x

13. 13 Comments on Inventory Turnover Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted.

14. 14 Receivables Average sales per day DSO= = = 45.5 days. Receivables Sales/365 $878 $7,036/365 DSO: average number of days from sale until cash received.

15. 15 Appraisal of DSO Firm collects too slowly, and situation is getting worse. Poor credit policy. 200620052004Ind. DSO45.539.537.432.0

16. 16 Fixed assets turnover Sales Net fixed assets = = = 8.41x. $7,036 $837 Total assets turnover Sales Total assets = = = 2.00x. $7,036 $3,517 (More…) Fixed Assets and Total Assets Turnover Ratios

17. 17 Fixed Assets and Total Assets Turnover Ratios FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory). 2006E20052004Ind. FA TO8.4x6.2x10.0x7.0x TA TO2.0x 2.3x2.5x

18. 18 Total liabilities Total assets Debt ratio= = = 43.8%. $1,040 + $500 $3,517 EBIT Int. expense TIE= = = 6.3x. $502.6 $80 (More…) Calculate the debt, TIE, and EBITDA coverage ratios.

19. 19 = = 5.5x. EBIT + Depr. & Amort. + Lease payments Interest Lease expense pmt. + + Loan pmt. $502.6 + $120 + $40 $80 + $40 + $0 EBITDA Coverage (EC)

20. 20 Recapitalization improved situation, but lease payments drag down EC. 2006E 2005 2004 Ind. D/A43.8%80.7%54.8%50.0% TIE6.3x0.1x3.3x6.2x EC5.5x0.8x2.6x8.0x Debt Management Ratios vs. Industry Averages

21. 21 Very bad in 2005, but projected to meet industry average in 2006. Looking good. Profit Margin (PM) 2006E20052004Ind. PM3.6%-1.6%2.6%3.6% PM = = = 3.6%. NI Sales $253.6 $7,036

22. 22 BEP = = = 14.3%. EBIT Total assets $502.6 $3,517 (More…) Basic Earning Power (BEP)

23. 23 Basic Earning Power vs. Industry Average BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 2006E20052004Ind. BEP14.3%0.6%14.2%17.8%

24. 24 ROA = = = 7.2%. NI Total assets $253.6 $3,517 (More…) Return on Assets (ROA) and Return on Equity (ROE)

25. 25 ROE = = = 12.8%. NI Common Equity $253.6 $1,977 (More…) Return on Assets (ROA) and Return on Equity (ROE)

26. 26 2006E 2005 2004 Ind. ROA7.2%-3.3%6.0%9.0% ROE12.8%-17.1%13.3%18.0% Both below average but improving. ROA and ROE vs. Industry Averages

27. 27 Effects of Debt on ROA and ROE ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

28. 28 Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 Calculate and appraise the P/E, P/CF, and M/B ratios.

29. 29 Industry P/E Ratios IndustryTicker*P/E BankingSTI17.17 SoftwareMSFT34.17 DrugPFE21.56 Electric UtilitiesDUK17.68 SemiconductorsINTC42.97 SteelNUE50.24 TobaccoMO12.34 S&P 500 24.84 *Ticker is for typical firm in industry, but P/E ratio is for the industry, not the individual firm

30. 30 NI + Depr. Shares out. CF per share= = = $1.49. $253.6 + $120.0 250 Price per share Cash flow per share P/CF = = = 8.2x. $12.17 $1.49 Market Based Ratios

31. 31 Com. equity Shares out. BVPS= = = $7.91. $1,977 250 Mkt. price per share Book value per share M/B= = = 1.54x. $12.17 $7.91 Market Based Ratios (Continued)

32. 32 Interpreting Market Based Ratios P/E: How much investors will pay for $1 of earnings. Higher is better. M/B: How much paid for $1 of book value. Higher is better. P/E and M/B are high if ROE is high, risk is low.

33. 33 2006E 2005 2004 Ind. P/E12.0x-6.3x9.7x14.2x P/CF8.2x27.5x8.0x7.6x M/B1.5x1.1x1.3x2.9x Comparison with Industry Averages

34. 34 Common Size Balance Sheets: Divide all items by Total Assets Assets200420052006EInd. Cash0.6%0.3%0.4%0.3% ST Inv.3.3%0.7%2.0%0.3% AR23.9%21.9%25.0%22.4% Invent.48.7%44.6%48.8%41.2% Total CA76.5%67.4%76.2%64.1% Net FA23.5%32.6%23.8%35.9% TA100.0%

35. 35 Divide all items by Total Liabilities & Equity Assets200420052006EInd. AP9.9%11.2%10.2%11.9% Notes pay.13.6%24.9%8.5%2.4% Accruals9.3%9.9%10.8%9.5% Total CL32.8%46.0%29.6%23.7% LT Debt22.0%34.6%14.2%26.3% Total eq.45.2%19.3%56.2%50.0% Total L&E100.0%

36. 36 Analysis of Common Size Balance Sheets Computron has higher proportion of inventory and current assets than Industry. Computron now has more equity (which means LESS debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.

37. 37 Common Size Income Statement: Divide all items by Sales 200420052006EInd. Sales100.0% COGS83.4%85.4%82.4%84.5% Other exp.9.9%12.3%8.7%4.4% Depr.0.6%2.0%1.7%4.0% EBIT6.1%0.3%7.1% Int. Exp.1.8%3.0%1.1% EBT4.3%-2.7%6.0%5.9% Taxes1.7%-1.1%2.4% NI2.6%-1.6%3.6%

38. 38 Analysis of Common Size Income Statements Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.

39. 39 Percentage Change Analysis: % Change from First Year (2004) Income St.200420052006E Sales0.0%70.0%105.0% COGS0.0%73.9%102.5% Other exp.0.0%111.8%80.3% Depr.0.0%518.8%534.9% EBIT0.0%-91.7%140.4% Int. Exp.0.0%181.6%28.0% EBT0.0%-208.2%188.3% Taxes0.0%-208.2%188.3% NI0.0%-208.2%188.3%

40. 40 Analysis of Percent Change Income Statement We see that 2006 sales grew 105% from 2004, and that NI grew 188% from 2004. So Computron has become more profitable.

41. 41 Percentage Change Balance Sheets: Assets Assets200420052006E Cash0.0%-19.1%55.6% ST Invest.0.0%-58.8%47.4% AR0.0%80.0%150.0% Invent.0.0%80.0%140.0% Total CA0.0%73.2%138.4% Net FA0.0%172.6%142.7% TA0.0%96.5%139.4%

42. 42 Percentage Change Balance Sheets: Liabilities & Equity Liab. & Eq.200420052006E AP0.0%122.5%147.1% Notes pay.0.0%260.0%50.0% Accruals0.0%109.5%179.4% Total CL0.0%175.9%115.9% LT Debt0.0%209.2%54.6% Total eq.0.0%-16.0%197.9% Total L&E0.0%96.5%139.4%

43. 43 Analysis of Percent Change Balance Sheets We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

44. 44 Explain the Du Pont System The Du Pont system focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

45. 45 ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE xx = ROE. The Du Pont System

46. 46 20042.6% x 2.3x2.2=13.2% 2005-1.6%x2.0x5.2=-16.6% 20063.6%x2.0x1.8=13.0% Ind.3.6%x2.5x2.0=18.0% NI Sales TA CE xx = ROE The Du Pont System

47. 47 Potential Problems and Limitations of Ratio Analysis? Comparison with industry averages is difficult if the firm operates many different divisions. “Average” performance is not necessarily good. Seasonal factors can distort ratios. (More…)

48. 48 Problems and Limitations (Continued) Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. (More…)

49. 49 Problems and Limitations (Continued) Sometimes it is difficult to tell if a ratio value is “good” or “bad.” Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

50. 50 Qualitative Factors Are the company’s revenues tied to a single customer? To what extent are the company’s revenues tied to a single product? To what extent does the company rely on a single supplier? (More…)

51. 51 Qualitative Factors (Continued) What percentage of the company’s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company’s legal and regulatory environment?