3 Financial Statement Analysis Are our decisions maximizing shareholder wealth?
4 We will want to answer questions about the firm’s LiquidityEfficient use of AssetsLeverage (financing)ProfitabilityPut on board. Four kinds of ratios.Liquidity – ability to meet maturing debt obligations. Will company have the resources to pay creditors when time comes.How Liquid? 1. Current ratio, 2. quick ratio, 3. AR receivable turnover, 4. Inventory Turnovera. How liquid are assets compared to debt b. How quickly can we convert to cashEfficient use of assets.Best way to measure profits relative to assets is operating income (rather than gross profit or net income)1. Operating income ROI 2. Operating profit margin 3. Gross profit margin 4. Asset turnover ratios Sales / total assets or AR or fixed assets or COGS/inventoryLeverageHow is firm financing its assets – debt or equity. Can they service their debt.Debt/Assets or Debt to Equity, Time Interest Earned EBIT/interesProfitabilityAre stockholders receiving adequate return on their investment. Can compare to retun of other companies,Return on Common Equity (exclude preferred stock)
5 Financial RatiosTools that help us determine the financial health of a company.We can compare a company’s financial ratios with its ratios in previous years (trend analysis).We can compare a company’s financial ratios with those of its industry.There are limits to ratio analysis.
7 CyberDragon’s Balance Sheet ($000) Assets: Liabilities & Equity:Cash $2,540 Accounts payable ,721Marketable securities 1,800 Notes payable ,500Accounts receivable 18,320 Accrued taxes payable ,200Inventories 27,530 Other current liabilities ,102Total current assets ,190 Total current liabilities ,523Plant and equipment 43,100 Long-term debt (bonds) ,000less accum deprec. 11,400 Total liabilities ,523Net plant & equip ,700 Common stock ($10 par) ,000Total assets ,890 Paid in capital ,000Retained earnings ,367Total stockholders' equity ,367Total liabilities & equity ,890
8 CyberDragon’s Income Statement Sales (all credit) $112,760Cost of Goods Sold (85,300)Gross Profit ,460Operating Expenses:Selling (6,540)General & Administrative (9,400)Total Operating Expenses (15,940)Earnings before interest and taxes (EBIT) 11,520Interest charges:Interest on bank notes: (850)Interest on bonds: (2,310)Total Interest charges (3,160)Earnings before taxes (EBT) ,360Taxes (3,344)Net Income ,016CyberDragon’s Income Statement
9 CyberDragon Other Information Dividends paid on common stock $2,800Earnings retained in the firm 2,216Shares outstanding (000) ,300Market price per shareBook value per shareEarnings per shareDividends per share
10 1. Liquidity RatiosDo we have enough liquid assets to meet approaching obligations?
12 What is CyberDragon’s Current Ratio? 50,19025,523= 1.97
13 What is CyberDragon’s Current Ratio? 50,19025,523= 1.97If the average current ratio for theindustry is 2.4, is this good or not?Want to have a high number to be able to pay off current liabilities with current assets (cash, receivables, securities, inventories) Cyber Dragon not as liquid as industry.
15 What is the firm’s Acid Test Ratio? 50, ,53025,523= .89
16 What is the firm’s Acid Test Ratio? 50, ,53025,523= .89Want this number to be large. Want to have enough current assets to meet current obligations. This firms ratio is lower than industry average. So not as liquid as average.Suppose the industry average is .92.What does this tell us?
18 What is the firm’s Average Collection Period? 18,320112,760/365= daysNumerator is accounts receivable. Denominator is average amount sold per day. Want denominator to be large because we want to collect a large amount per day. If denominator is large then the number of days to collect will be smaller.Easy example on board:Say AR is x2 $36,640Avg sales per day is $309 per day (112760/365)36,640/309 = days to collect
19 What is the firm’s Average Collection Period? 18,320112,760/365= daysIt takes us longer to collect the AR. That costs us money because we usually don’t get paid interest on AR. Also risk of not being paid.If the industry average is 47 days, what does this tell us?
20 2. Operating Efficiency Ratios Measure how efficiently the firm’s assets generate operating profits.
21 What is the firm’s Operating Income Return on Investment (OIROI)? OIROI is operating income/total assets.
22 What is the firm’s Operating Income Return on Investment (OIROI)? 11,52081,890= %
23 What is the firm’s Operating Income Return on Investment (OIROI)? 11,52081,890= %Slightly below the industry average of 15%.Not doing quite as well as industry.
24 What is the firm’s Operating Income Return on Investment (OIROI)? 11,52081,890= %Slightly below the industry average of 15%.The OIROI reflects product pricing and the firm’s ability to keep costs down.The operating income is the result of the sales revenues and operating costs.
25 What is their Operating Profit Margin? Operating income divided by sales
26 What is their Operating Profit Margin? 11,520112,760= %
27 What is their Operating Profit Margin? 11,520112,760= %This is below the industry average of12%.
28 What is their Total Asset Turnover? Sales divided by total assets
29 What is their Total Asset Turnover? 112,76081,890= timesDo we want to have high or low. Want high because we want to generate as much sales with the lowest amount of assets.
30 What is their Total Asset Turnover? 112,76081,890= timesThe industry average is 1.82 times.The firm needs to figure out how to squeeze more sales dollars out of its assets.
31 What is the firm’s Accounts Receivable Turnover? Also dividing sales by AR.
32 What is the firm’s Accounts Receivable Turnover? 112,76018,320= timesWant to have a high number. Want to generate sales with the lowest investment in AR
33 What is the firm’s Accounts Receivable Turnover? 112,76018,320= timesNo. Want to have a large ratio so Cyber Dragon not as efficient as industry.CyberDragon turns their A/R over 6.16times per year. The industry averageis 8.2 times. Is this efficient?
34 What is the firm’s Inventory Turnover? Cost of good sold divided by inventory. Inventory is valued at cost of goods sold so need to use that instead of sales. We want it to be low, we want turnover number to be high COGS divided by total inventory. We don’t want inventory sitting around. It cost $$ to borrow to pay for it.
35 What is the firm’s Inventory Turnover? 85,30027,530= times
36 What is the firm’s Inventory Turnover? 85,30027,530= timesCyberDragon turns their inventory over 3.1 times per year.The industry average is 3.9 times. Is this efficient?Cyber Dragon is again doing worse than the industry. Less efficient
37 Low inventory turnover: The firm may have too much inventory, which is expensive because:Inventory takes up costly warehouse space.Some items may become spoiled or obsolete.If you are carrying 100,000 of inventory and cost of borrowing is 8%, it costs you $8,000 per year to finance.
38 What is the firm’s Fixed Asset Turnover? Back to sales. Sales divided by fixed assets
39 What is the firm’s Fixed Asset Turnover? 112,76031,700= timesWant numerator to be high so want a high turnover.
40 What is the firm’s Fixed Asset Turnover? 112,76031,700= timesIf the industry average is 4.6 times, whatdoes this tell us about CyberDragon?Industry doing better than CyberDragon
41 3. Leverage Ratios (financing decisions) Measure the impact of using debt capital to finance assets.Firms use debt to lever (increase) returns on common equity.
42 ROE = How does Leverage work? Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.ROE =(ignore taxes for this example)If you make $15,000 on $100,000 what kind of percent return are you getting
43 ROE = = 15% 15,000 100,000 How does Leverage work? Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.ROE = = 15%15,000100,000Of course, want to have a high return.
44 ROE = How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.ROE =The numerator will be somewhat smaller because you need to pay interest on the bonds (8% X $50,000 = $4,000) But the Equity is much, much smaller. So what happens to ROE?
45 ROE = = 15,000 - 4,000 50,000 How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.ROE = =15, ,00050,000
46 ROE = = 22% 15,000 - 4,000 50,000 How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.ROE = = 22%15, ,00050,000It goes up dramatically. Give example of buying a house. If you buy a $200,000 house and pay cash and the next year sell it for $210,000 – what is your return (10%). But if you mortgage the house and only pay 10% down or $20,000 and then sell it for $210,000 you have a gain of $10,000 (less one year’s interest) you make about $10,000 on an investment of $20,000 or a 50% return.
47 What is CyberDragon’s Debt Ratio? This is a BS only ratio. Debt: total assets.
48 What is CyberDragon’s Debt Ratio? 47,52381,890= 58%
49 What is CyberDragon’s Debt Ratio? 47,52381,890= 58%If the industry average is 47%, whatdoes this tell us?Higher the debt the more risk because you have to be sure to be able to make interest payments. It is a trade off for a higher return.Cyber has high debt relative to its assets.
50 What is CyberDragon’s Debt Ratio? 47,52381,890= 58%If the industry average is 47%, whatdoes this tell us?Can leverage make the firm more profitable?Can leverage make the firm riskier?Not more profitable because you pay interest, but can get a high return for shareholders, Yes riskier.
51 What is the firm’s Times Interest Earned Ratio? How much income before interest and taxes (EBIT) that you have a available to pay your obligation of interest.
52 What is the firm’s Times Interest Earned Ratio? 11,5203,160= timesWant this to be high so that you have enough available to pay interest.
53 What is the firm’s Times Interest Earned Ratio? 11,5203,160= timesThe industry average is 6.7 times. Thisis further evidence that the firm usesmore debt financing than average.Much more leveraged. Numerator is same but denominator is higher because paying interest. EBIT/interest
54 4. Return on EquityRemember this is the Goal of the firm. Can tie managers compensation to this in order to minimize agency problem.How well are the firm’s managers maximizing shareholder wealth?
55 What is CyberDragon’s Return on Equity (ROE)? Net income/ stockholders equity
56 What is CyberDragon’s Return on Equity (ROE)? 5,01534,367= 14.6%
57 What is CyberDragon’s Return on Equity (ROE)? 5,01534,367= 14.6%The industry average is 17.54%.Not earning as much as industry. What will happen to stock price if all else is equal.
58 What is CyberDragon’s Return on Equit y (ROE)? 5,01534,367= 14.6%The industry average is 17.54%.Is this what we would expect, given the firm’s leverage?The company is more leveraged – has lower equity number and higher debt number. With a lower denominator we would expect a higher ROE. They are more highly leveraged. But the numerator (return) is lower because they are less efficent (not earning enough on its assets)
59 Conclusion:Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.