1. 4-1 Lecture 4-350 CHAPTER 4 Analysis of Financial Statements Ratio Analysis Usefulness of ratios. Limitations of ratio analysis

2. 4-2 Lecture 4-350 Last week we learned how to calculate free cash flow (FCF), which will be useful when we come to stock valuation. This week we will talk about analyzing financial ratios. The ratios I focus are relatively more important.

3. 4-3 Lecture 4-350 Financial Ratios: Accounting data stated in relative terms Why are financial ratios useful? Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths. Ratios might be useful to predict future.

4. 4-4 Lecture 4-350 Ratios are not to be read in isolation. When Analyzing Financial Ratios, always examine: Trends across time Comparisons with other firms’ (industry average) ratios

5. 4-5 Lecture 4-350 Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets 2002 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 2003E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152

6. 4-6 Lecture 4-350 Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2002 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592 2003E 436,800 300,000 408,000 1,144,800 400,000 1,721,176 231,176 1,952,352 3,497,152 “E” means “estimates”.

7. 4-7 Lecture 4-350 Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2002 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2003E 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584

8. 4-8 Lecture 4-350 Other data No. of shares EPS DPS Stock price 2003E 250,000 $1.014 $0.220 $12.17 2002 100,000 -$1.602 $0.110 $2.25

9. 4-9 Lecture 4-350 What are some important ratios, and what questions do they answer? Liquidity: Can the firm meet short term obligations? Asset management: is the firm generating good revenue from assets? (Sales is important, at least from your marketing class:) Profitability: Is the firm sufficiently profitable as reflected in PM, ROE, and ROA? Debt management: is the firm using the right mix of debt and equity? Market value: Do investors like the form’s earnings and future growth prospect as reflected in P/E and M/B ratios?

10. 4-10 Lecture 4-350 How liquid is a firm? Liquidity is the ability to meet maturing debt obligations. Comparing cash and assets that can be converted into cash within the year with liabilities that are due within the year.

11. 4-11 Lecture 4-350 Calculate D’Leon’s forecasted current ratio for 2003. Current ratio = Current assets / Current liabilities = $2,680 / $1,145 = 2.34

12. 4-12 Lecture 4-350 Comments on current ratio 200320022001Ind. Current ratio 2.341.202.302.70 Expected to improve but still below the industry average. Liquidity position is weak.

13. 4-13 Lecture 4-350 Is Management Generating Adequate Sales on the Firm’s Assets? How efficiently a firm is using its assets in generating sales

14. 4-14 Lecture 4-350 Fixed asset and total asset turnover ratios vs. the industry average FA turnover= Sales / Net fixed assets = $7,036 / $817 = 8.61 TA turnover= Sales / Total assets = $7,036 / $3,497 = 2.01

15. 4-15 Lecture 4-350 Evaluating the FA turnover and TA turnover ratios 200320022001Ind. FA TO8.66.410.07.0 TA TO2.02.12.32.6 FA turnover projected to exceed the industry average. TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).

16. 4-16 Lecture 4-350 What is the inventory turnover vs. the industry average? 200320022001Ind. Inventory Turnover 4.14.704.86.1 Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10

17. 4-17 Lecture 4-350 Comments on Inventory Turnover Inventory turnover is below industry average. D’Leon might have old inventory, or its control might be poor. No improvement is currently forecasted.

18. 4-18 Lecture 4-350 DSO is the average number of days after making a sale before receiving cash. DSO= Receivables / Average sales per day = Receivables / Sales/365 = $878 / ($7,036/365) = 45.6

19. 4-19 Lecture 4-350 Appraisal of DSO 200320022001Ind. DSO45.638.237.432.0 D’Leon collects on sales too slowly, and is getting worse. D’Leon has a poor credit policy.

20. 4-20 Lecture 4-350 How is the Firm Financing Its Assets? Does the firm finance assets more by debt or equity? Debt Ratio

21. 4-21 Lecture 4-350 Calculate the debt ratio. Debt ratio (D/A)= Total debt / Total assets = ($1,145 + $400) / $3,497 = 44.2% It measures financial leverage. (1) If a firm is profitable, borrowing appropriate debt can leverage up return on shareholder equity. (2) Too much debt may increase risk of bankruptcy.

22. 4-22 Lecture 4-350 How does the debt ratio compare with industry averages? 200320022001Ind. D/A44.2%82.8%54.8%50.0% D/A is better than the industry average.

23. 4-23 Lecture 4-350 Is Management Generating Adequate Operating Profits on the Firm’s Assets? Operating Profit Margin Basic earning power (BEP) Return on Assets Return on equity

24. 4-24 Lecture 4-350 Profitability ratios: Profit margin and Basic earning power Profit margin (2003)= Net income / Sales = $253.6 / $7,036 = 3.6% BEP (2003)= EBIT / Total assets = $492.6 / $3,497 = 14.1%

25. 4-25 Lecture 4-350 Appraising profitability with the profit margin and basic earning power 200320022001Ind. PM3.6%-2.7%2.6%3.5% BEP14.1%-4.6%13.0%19.1% Profit margin was very bad in 2002, but is projected to exceed the industry average in 2003. Looking good. BEP removes the effects of taxes and financial leverage, and is useful for comparison of operating performance. BEP projected to improve, yet still below the industry average. There is definitely room for improvement.

26. 4-26 Lecture 4-350 Profitability ratios: Return on assets and Return on equity ROA= Net income / Total assets = $253.6 / $3,497 = 7.3% ROE= Net income / Total common equity = $253.6 / $1,952 = 13.0%

27. 4-27 Lecture 4-350 Appraising profitability with the return on assets and return on equity 200320022001Ind. ROA7.3%-5.6%6.0%9.1% ROE13.0%-32.5%13.3%18.2% Both ratios rebounded from the previous year, but are still below the industry average. Note ROE=ROA*(total asset/total equity)=ROA/(1-total debt/total asset)=ROA/(1-debt ratio). If ROA>0, the higher the debt ratio, the higher ROE. If ROA<0, the higher the debt ratio, the lower ROE. Wider variations in ROE illustrate the effect that leverage can have on profitability.

28. 4-28 Lecture 4-350 Calculate the Price/Earnings and Market/Book ratios. P/E= Price / Earnings per share = $12.17 / $1.014 = 12.0 M/B= Mkt price per share / Book value per share = $12.17 / ($1,952 / 250) = 1.56 200320022001Ind. P/E12.0-1.49.714.2 M/B1.560.51.32.4

29. 4-29 Lecture 4-350 Analyzing the market value ratios P/E: How much investors are willing to pay for $1 of earnings. When investors believe that the earnings are “real”, or earnings will grow, the P/E ratios is generally high. M/B: How much investors are willing to pay for $1 of book value equity. When investors believe that the growth prospect of the firm is good, M/B will be high. For each ratio, generally the higher the number, the better. However, higher ratios might also indicate that the stock is overvalued. (dot.com bubble.)

30. 4-30 Lecture 4-350 The Du Pont system Also can be expressed as: ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) ROA = (NI/Sales) x (Sales/TA) Focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization ( TA/Equity ) Shows how these factors combine to determine ROE.

31. 4-31 Lecture 4-350 Potential problems and limitations of financial ratio analysis Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. “Average” performance is not necessarily good, perhaps the firm should aim higher. Sometimes it is hard to tell if a ratio is “good” or “bad”. Seasonal factors. (Macy, Marriot) “Window dressing” and “big baths” techniques can make statements and ratios look better.

32. 4-32 Lecture 4-350 Window dressing To get a smaller debt ratio 12/31/200312/31/2004 1/6/200412/23/2003 Pay back debt Borrow new debt

33. 4-33 Lecture 4-350 Big bath Recognize more expense and charge in bad years to ensure a growing string of profits in the future, so investors might think the firm is making turnaround and growing.

34. 4-34 Lecture 4-350 More issues regarding ratios Different operating and accounting practices can distort comparisons. Off sheet liabilities.

35. 4-35 Lecture 4-350 To mitigate the limitation, 1. consider ratios together For example, if a firm has negative ROA in recent years and debt ratio is high, the high debt ratio may indicate risk of default. If a firm has been profitable in recent years, the high debt ratio may indicate that the firm is borrowing debt to expand business. Thus it pays to consider ROA and debt ratio together.

36. 4-36 Lecture 4-350 2. Consider qualitative factors Are the firm’s revenues tied to 1 key customer, product, or supplier? Competition (will high profit attract competitors?) Future prospects (does the firm spend any R&D?) Legal and regulatory environment (is it a regulated industry?)