1. 3 - 1 Copyright © 2002 Harcourt, Inc.All rights reserved. Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors CHAPTER 3 Analysis of Financial Statements

2. 3 - 2 Copyright © 2002 Harcourt, Inc.All rights reserved. Balance Sheet: Assets 2002E2001 Cash14,0007,282 ST investments71,6320 AR878,000632,160 Inventories1,716,4801,287,360 Total CA2,680,1121,926,802 Gross FA1,197,1601,202,950 Less: Deprec.380,120263,160 Net FA817,040939,790 Total assets3,497,1522,866,592

3. 3 - 3 Copyright © 2002 Harcourt, Inc.All rights reserved. Liabilities and Equity 2002E2001 Accounts payable436,800524,160 Notes payable600,000720,000 Accruals408,000489,600 Total CL1,444,8001,733,760 Long-term debt500,0001,000,000 Common stock1,680,936460,000 Retained earnings(128,584)(327,168) Total equity1,552,352132,832 Total L&E3,497,1522,866,592

4. 3 - 4 Copyright © 2002 Harcourt, Inc.All rights reserved. Income Statement 2002E2001 Sales7,035,6005,834,400 COGS6,100,0005,728,000 Other expenses312,960680,000 Depreciation120,000116,960 Tot. op. costs6,532,9606,524,960 EBIT502,640(690,560) Interest exp.80,000176,000 EBT422,640(866,560) Taxes (40%)169,056(346,624) Net income253,584(519,936)

5. 3 - 5 Copyright © 2002 Harcourt, Inc.All rights reserved. Other Data 2002E2001 Shares out.250,000100,000 EPS$1.014($5.199) DPS$0.220$0.110 Stock price$12.17$2.25 Lease pmts$40,000

6. 3 - 6 Copyright © 2002 Harcourt, Inc.All rights reserved. Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Why are ratios useful?

7. 3 - 7 Copyright © 2002 Harcourt, Inc.All rights reserved. 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? What are the five major categories of ratios, and what questions do they answer? (More…)

8. 3 - 8 Copyright © 2002 Harcourt, Inc.All rights reserved. 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?

9. 3 - 9 Copyright © 2002 Harcourt, Inc.All rights reserved. Calculate the firms forecasted current and quick ratios for 2002. CR 02 = = = 1.85x. QR 02 = = = 0.67x. CA CL $2,680 $1,445 $2,680 - $1,716 $1,445 CA - Inv. CL

10. 3 - 10 Copyright © 2002 Harcourt, Inc.All rights reserved. Expected to improve but still below the industry average. Liquidity position is weak. Comments on CR and QR 2002E20012000Ind. CR1.85x1.1x2.3x2.7x QR0.67x0.4x0.8x1.0x

11. 3 - 11 Copyright © 2002 Harcourt, Inc.All rights reserved. What is the inventory turnover ratio as compared to the industry average? Inv. turnover= = = 4.10x. Sales Inventories $7,036 $1,716 2002E20012000Ind. Inv. T.4.1x4.5x4.8x6.1x

12. 3 - 12 Copyright © 2002 Harcourt, Inc.All rights reserved. Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted. Comments on Inventory Turnover

13. 3 - 13 Copyright © 2002 Harcourt, Inc.All rights reserved. Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO= = = 44.9 days. Receivables Sales/360 $878 $7,036/360

14. 3 - 14 Copyright © 2002 Harcourt, Inc.All rights reserved. Appraisal of DSO nFirm collects too slowly, and situation is getting worse. nPoor credit policy. 2002E20012000Ind. DSO44.939.036.832.0

15. 3 - 15 Copyright © 2002 Harcourt, Inc.All rights reserved. Fixed Assets and Total Assets Turnover Ratios Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets turnover Sales Total assets = = = 2.01x. $7,036 $3,497 (More…)

16. 3 - 16 Copyright © 2002 Harcourt, Inc.All rights reserved. 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). 2002E20012000Ind. FA TO8.6x6.2x10.0x7.0x TA TO2.0x 2.3x2.5x

17. 3 - 17 Copyright © 2002 Harcourt, Inc.All rights reserved. Calculate the debt, TIE, and EBITDA coverage ratios. Total debt Total assets Debt ratio= = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE= = = 6.3x. $502.6 $80 (More…)

18. 3 - 18 Copyright © 2002 Harcourt, Inc.All rights reserved. All three ratios reflect use of debt, but focus on different aspects. EBITDA coverage = EC = = 5.5x. EBIT + Depr. & Amort. + Lease payments Interest Lease Loan pmt. expense pmt. + $502.6 + $120 + $40 $80 + $40 + $0

19. 3 - 19 Copyright © 2002 Harcourt, Inc.All rights reserved. Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 2002E20012000Ind. D/A55.6%95.4%54.8%50.0% TIE6.3x-3.9x3.3x6.2x EC5.5x-2.5x2.6x8.0x

20. 3 - 20 Copyright © 2002 Harcourt, Inc.All rights reserved. Very bad in 2001, but projected to meet industry average in 2002. Looking good. Profit Margin (PM) PM = = = 3.6%. NI Sales $253.6 $7,036 2002E20012000Ind. PM3.6%-8.9%2.6%3.6%

21. 3 - 21 Copyright © 2002 Harcourt, Inc.All rights reserved. BEP= = = 14.4%. Basic Earning Power (BEP) EBIT Total assets $502.6 $3,497 (More…)

22. 3 - 22 Copyright © 2002 Harcourt, Inc.All rights reserved. BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 2002E20012000Ind. BEP14.4%-24.1%14.2%17.8%

23. 3 - 23 Copyright © 2002 Harcourt, Inc.All rights reserved. Return on Assets (ROA) and Return on Equity (ROE) ROA= = = 7.3%. Net income Total assets $253.6 $3,497 (More…)

24. 3 - 24 Copyright © 2002 Harcourt, Inc.All rights reserved. ROE= = = 16.3%. Net income Common equity $253.6 $1,552 Both below average but improving. 2002E20012000Ind. ROA7.3%-18.1%6.0%9.0% ROE16.3%-391.0%13.3%18.0%

25. 3 - 25 Copyright © 2002 Harcourt, Inc.All rights reserved. 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. Effects of Debt on ROA and ROE

26. 3 - 26 Copyright © 2002 Harcourt, Inc.All rights reserved. Calculate and appraise the P/E, P/CF, and M/B ratios. Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 (More…)

27. 3 - 27 Copyright © 2002 Harcourt, Inc.All rights reserved. Typical industry average P/E ratios * Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies. Industry P/E ratio Banking 17.15 Computer Software Services 33.01 Drug 41.81 Electric Utilities (Eastern U.S.) 19.40 Internet Services* 290.35 Semiconductors 78.41 Steel 12.71 Tobacco 11.59 Water Utilities 21.84

28. 3 - 28 Copyright © 2002 Harcourt, Inc.All rights reserved. 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

29. 3 - 29 Copyright © 2002 Harcourt, Inc.All rights reserved. Com. equity Shares out. BVPS= = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B= = = 2.0x. $12.17 $6.21 (More…)

30. 3 - 30 Copyright © 2002 Harcourt, Inc.All rights reserved. P/E: How much investors will pay for $1 of earnings. High is good. M/B: How much paid for $1 of book value. Higher is good. P/E and M/B are high if ROE is high, risk is low. 2002E20012000Ind. P/E12.0x-0.4x9.7x14.2x P/CF8.2x-0.6x8.0x7.6x M/B2.0x1.7x1.3x2.9x

31. 3 - 31 Copyright © 2002 Harcourt, Inc.All rights reserved. Common Size Balance Sheets: Divide all items by Total Assets Assets200020012002EInd. Cash0.6%0.3%0.4%0.3% ST Invest.3.3%0.0%2.0%0.3% AR23.9%22.1%25.1%22.4% Invent.48.7%44.9%49.1%41.2% Total CA76.5%67.2%76.6%64.1% Net FA23.5%32.8%23.4%35.9% TA100.0%

32. 3 - 32 Copyright © 2002 Harcourt, Inc.All rights reserved. Divide all items by Total Liabilities & Equity 200020012002EInd. AP9.9%18.3%12.5%11.9% Notes pay.13.6%25.1%17.2%2.4% Accruals9.3%17.1%11.7%9.5% Total CL32.8%60.5%41.3%23.7% LT Debt22.0%34.9%14.3%26.3% Total equ.45.2%4.6%44.4%50.0% Total L&E100.0%

33. 3 - 33 Copyright © 2002 Harcourt, Inc.All rights reserved. Analysis of Common Size Balance Sheets Computron has higher proportion of current assets (49.1%) than Industry (41.2%). Computron has slightly less equity (which means more debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.

34. 3 - 34 Copyright © 2002 Harcourt, Inc.All rights reserved. Common Size Income Statement: Divide all items by Sales 200020012002EInd. Sales 100.0% COGS 83.4%98.2%86.7%84.5% Other exp. 9.9%11.7%4.4% Depr. 0.6%2.0%1.7%4.0% EBIT 6.1%-11.8%7.1% Int. Exp. 1.8%3.0%1.1% EBT 4.3%-14.9%6.0%5.9% Taxes 1.7%-5.9%2.4% NI 2.6%-8.9%3.6%

35. 3 - 35 Copyright © 2002 Harcourt, Inc.All rights reserved. Analysis of Common Size Income Statements Computron has higher COGS (86.7) than industry (84.5), but lower depreciation. Result is that Computron has similar EBIT (7.1) as industry.

36. 3 - 36 Copyright © 2002 Harcourt, Inc.All rights reserved. Percentage Change Analysis: Find Percentage Change from First Year (2000) Income St.200020012002E Sales 0.0%70.0%105.0% COGS 0.0%100.0%113.0% Other exp. 0.0%100.0%-8.0% Depr. 0.0%518.8%534.9% EBIT 0.0%-430.3%140.4% Int. Exp. 0.0%181.6%28.0% EBT 0.0%-691.1%188.3% Taxes 0.0%-691.1%188.3% NI 0.0%-691.1%188.3%

37. 3 - 37 Copyright © 2002 Harcourt, Inc.All rights reserved. Analysis of Percent Change Income Statement We see that 2002 sales grow 105% from 2000, and that NI grows 188% from 2000. So Computron has become more profitable.

38. 3 - 38 Copyright © 2002 Harcourt, Inc.All rights reserved. Percentage Change Balance Sheets Assets200020012002E Cash 0.0%-19.1%55.6% ST Invest. 0.0%-100.0%47.4% AR 0.0%80.0%150.0% Invent. 0.0%80.0%140.0% Total CA 0.0%71.4%138.4% Net FA 0.0%172.6%137.0% TA 0.0%95.2%138.1%

39. 3 - 39 Copyright © 2002 Harcourt, Inc.All rights reserved. Liab. & Eq.200020012002E AP 0.0%260.0%200.0% Notes pay. 0.0%260.0%200.0% Accruals 0.0%260.0%200.0% Total CL 0.0%260.0%200.0% LT Debt 0.0%209.2%54.6% Total equity 0.0%-80.0%133.9% Total L&E 0.0%95.2%138.1%

40. 3 - 40 Copyright © 2002 Harcourt, Inc.All rights reserved. Analysis of Percent Change Balance Sheets We see that total assets grow at a rate of 138%, while sales grow at a rate of only 105%. So asset utilization remains a problem.

41. 3 - 41 Copyright © 2002 Harcourt, Inc.All rights reserved. ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE 20002.6% x 2.3x2.2=13.2% 2001-8.9%x2.0x21.6=-391.0% 20023.6%x2.0x2.3=16.3% Ind.3.6%x2.5x2.0=18.0% Explain the Du Pont System xx = ROE.

42. 3 - 42 Copyright © 2002 Harcourt, Inc.All rights reserved. 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.

43. 3 - 43 Copyright © 2002 Harcourt, Inc.All rights reserved. Simplified Firm Data A/R$ 878 Debt $1,945 Other CA1,802 Equity1,552 Net FA 817 Total assets$3,497 L&E $3,497 Q. How would reducing DSO to 32 days affect the company? Sales $7,035,600 day 360 = = $19,543.

44. 3 - 44 Copyright © 2002 Harcourt, Inc.All rights reserved. Effect of reducing DSO from 44.9 days to 32 days: Old A/R= $19,543 x 44.9= $878,000 New A/R= $19,543 x 32.0= 625,376 Cash freed up: $252,624 Initially shows up as additional cash.

45. 3 - 45 Copyright © 2002 Harcourt, Inc.All rights reserved. What could be done with the new cash? Effect on stock price and risk? New Balance Sheet Added cash$ 253Debt$1,945 A/R625Equity1,552 Other CA1,802 Net FA 817 Total assets$3,497Total L&E$3,497

46. 3 - 46 Copyright © 2002 Harcourt, Inc.All rights reserved. Potential use of freed up cash Repurchase stock. Higher ROE, higher EPS. Expand business. Higher profits. Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…)

47. 3 - 47 Copyright © 2002 Harcourt, Inc.All rights reserved. Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides. All these actions would likely improve stock price.

48. 3 - 48 Copyright © 2002 Harcourt, Inc.All rights reserved. Would you lend money to this company? Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. However, company should not have relied so heavily on debt financing in the past.

49. 3 - 49 Copyright © 2002 Harcourt, Inc.All rights reserved. What are some potential problems and limitations of financial 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…)

50. 3 - 50 Copyright © 2002 Harcourt, Inc.All rights reserved. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. 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.

51. 3 - 51 Copyright © 2002 Harcourt, Inc.All rights reserved. What are some qualitative factors analysts should consider when evaluating a companys likely future financial performance? Are the companys revenues tied to a single customer? To what extent are the companys revenues tied to a single product? To what extent does the company rely on a single supplier? (More…)

52. 3 - 52 Copyright © 2002 Harcourt, Inc.All rights reserved. What percentage of the companys business is generated overseas? What is the competitive situation? What does the future have in store? What is the companys legal and regulatory environment?