1. 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 32887- 6777

2. 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 - 3 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Income Statement

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

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

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

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

8. 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

9. 3 - 9 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Statement of Retained Earnings Balance of retained earnings Dec. 31, 1999$203,786 2000 Net Income44,220 2000 dividends to stockholders (22,000) Balance of retained earnings Dec. 31, 2000$225,988

10. 3 - 10 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron: Additional Data

11. 3 - 11 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

12. 3 - 12 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

13. 3 - 13 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?

14. 3 - 14 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Industry Average Data (2000)

15. 3 - 15 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What are Computron’s Current and Quick ratios?

16. 3 - 16 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.

17. 3 - 17 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

18. 3 - 18 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Computron’s Inventory Turnover Ratio?

19. 3 - 19 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.

20. 3 - 20 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Computron’s Days Sales Outstanding Ratio?

21. 3 - 21 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!!

22. 3 - 22 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Computron’s Fixed Assets and Total Assets Turnover Ratios?

23. 3 - 23 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.

24. 3 - 24 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

25. 3 - 25 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

26. 3 - 26 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.

27. 3 - 27 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

28. 3 - 28 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Calculate Computron’s Profitability Ratios-- Profit Margin, ROA, and ROE Low and Falling!

29. 3 - 29 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron’s ROA, and ROE

30. 3 - 30 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.

31. 3 - 31 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

32. 3 - 32 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Computron’s Market/Book Value Ratio

33. 3 - 33 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Book Value = Common Equity / shares outstanding

34. 3 - 34 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Comments on Computron’s Market Value Ratios n P/E rose from 1999 to 2000--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.

35. 3 - 35 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Summary of Ratio Analysis: The Du Pont Equation

36. 3 - 36 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)

37. 3 - 37 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

38. 3 - 38 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 = $402,094.40 or $402,094.40 / $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

39. 3 - 39 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.

40. 3 - 40 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?

41. 3 - 41 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?

42. 3 - 42 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. End of Chapter 3 Analysis of Financial Statements