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MAYES 2 & 4
Fin. Stmt. & Ratio Analysis
Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
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Common Size Financial Statements
Displays info as %, not $;
Provides 2 key benefits:
1. Allows for easy comparison
between firms of different sizes.
2. Aids in spotting important trends
which otherwise might not be obvious
when looking at $ amounts.
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Common Size Financial Statements
Common size Income Statement: all
values a function of Sales $
Common size Balance Sheet: all values a
function of Total Assets.
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Analysis of Common Size Balance
Sheets
Elvis has ?
proportion of inventory
and current assets than Industry.
Elvis now has
? Equity, which
means (MORE? / LESS?) debt than
Industry.
Elvis has ? short-term debt than
industry, but ? long-term debt than
industry.
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Analysis of Common Size Income
Statements
Elvis has ? COGS ( %) than
industry’s ( %), but ? other
expenses. Results?
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Percentage Change Analysis:
Looks at Change rates from period to
period between financial categories.
Indicator of +/- growth trends.
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Analysis of Percent Change Income
Statement
i.e., Sales growth v. NI ?
i.e., If NI grows faster than sales,
then becoming more profitable.
So becoming (more/less) profitable?
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Analysis of Percent Change Balance
Sheets
i.e., Total assets growth v. sales. If
assets grow at faster rate than sales,
have asset utilization problem.
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Why are ratios useful?
Standardize numbers; facilitate
comparisons
Used to highlight weaknesses and
strengths
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What are the five major categories of
ratios, and what questions do they
answer?
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…)
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Debt management: Do we have the right
mix of debt and equity? (Leverage)
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?
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Things to ask? Better? Worse?
Trends?
Vs. Industry?
Causes?
Corrective actions?
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Calculate the firm’s forecasted current
and quick ratios
CR =
CA
CL =
QR =
CA - Inv.
CL
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Comments on CR and QR
 Expected to improve/ worsen?
Vs. industry average?
 Liquidity position?
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What is the inventory turnover ratio as
compared to the industry average?
CGS
Inv. turnover = Inventories
Days Sales in
Inventory
365
= Inv To
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Comments on Inventory Turnover
Inventory turnover v. industry
average?
Due to?
Improvement forecasted?
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What is the Accts. Rec. turnover ratio
& Average Collection Period?
Credit sales
A/R turnover =
A/R
Ave Collection
Period
= 365
A/R TO
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Appraisal of Ave Collection Period
 Firm collects too slowly/quickly?
 Improving / worsening?
 Implication re: credit policy.
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Fixed Assets and Total Assets
Turnover Ratios
Fixed assets
Sales
=
turnover
Net fixed assets
Total assets
=
turnover
Sales
Total assets
Fixed Assets and Total Assets
Turnover Ratios
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FA turnover vs. industry?
TA turnover vs. industry average?
Causes? Corrective actions?
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LEVERAGE
Total
liabilities
Debt ratio =
Total assets
L/T Debt
L/T Debt ratio =
Total assets
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LEVERAGE
Total
liabilities
Debt/Eqty =
Total Equity
ratio
L/T Debt to Total
Capitalization ratio
= _____L/T Debt___________
LTD + Pref Eqty + Cmn Eqty
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LEVERAGE
Eqty
Multiplier
L/T Debt to Total
Equity
Total Assets
Total Equity
= _____L/T Debt___________
Pref Eqty + Cmn Eqty
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COVERAGE Ratios
Cash
Coverage
EBIT + Deprec Exp
=
Interest Exp
EBIT
TIE =
Int. expense
(
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How do the debt management ratios
compare with industry averages?
2005E 2004 2003
D/A
TIE
C/Cov
Effects? Reasons?
Ind.
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Profitability Ratios (Profit Margins)
Gross Profit Margin
=
Gross Profit
Sales
OperatingPM = EBIT
Sales
Net PM
=
Trends?
Prospects?
Net Income
Sales
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Profitability Ratios (Returns)
ROE = Net Income
Total Equity
ROA = Net Income
Total Assets
Return on = NI available to C.S-holders
Cmn Eqty
Common Equity
Trends?
Prospects?
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2005E
2004
2003
Ind.
ROA
ROE
Trends? Vs. Industry? Prospects?.
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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.
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The Du Pont System
(
Profit
margin
)(
TA
turnover
NI
Sales
Sales x
TA
)(
x
)
Equity
multiplier = ROE
TA
CE
PM= f(profitability)
TA T/O = f(asset utilization)
EM = f(debt & equity %s)
Shows how these factors combine to
determine the ROE.
= ROE.
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Economic Profit Measures of Performance
Economic Profit = NOPAT – A/Tax Cost of Op. Capital
Where:
NOPAT = EBIT (1-tax rate)
A/Tax Cost of Op. Capital =
WACC * (Net Op. Working Cap + Net Fixed Assets)
** NOWC = (Non-interest bearing C/A – Non-interest
bearing C/L)
Trends?
Prospects?
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Financial Distress & Z-score
 Technique to determine likelihood of financial
distress.
 Altman shows model 80-90% accurate w/ Z-score cutoff of 2.675; that is Z-score < 2.675 = distress.
 Actually determined 3 levels
 Z<1.81 Bankruptcy predicted w/in 1 yr.
 1.81<Z<2.675 Financial Distress, poss. Bankruptcy
 Z>2.675 No fin. Distress predicted
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Financial Distress & Z-score
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5
 Where the variables are the following financial ratios:
 X1 = Net Working Capital / Total Assets
 X2 = Retained earnings / Total Assets
 X3 = EBIT / Total Assets
 X4 = Market Value of all equity / book value of Tot. Liabs
 X5 = Sales / Total Assets
 *For publicly traded companies
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Calculate and appraise the
P/E, P/CF, and M/B ratios.
Market Price =From the stock exchanges
NI
EPS = C.S.Shares out.
Price per share
P/E =
EPS
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CF per share =
NI + Depr.
C.S.Shares out.
Price per share
P/CF =
Cash flow per C.S. share
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BVPS =
Com. equity
C.S.Shares out.
Mkt. price per share
M/B =
Book value per share
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2005E
2004
2003
Ind.
P/E
P/CF
M/B
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.
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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…)
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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.
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What are some qualitative factors
analysts should consider when
evaluating a company’s likely future
financial performance?
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…)
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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?