Chapter 11
Expanded
Analysis
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Perceptions of Financial Ratios
•
•
•
•
Commercial loan departments
Corporate controllers
CPAs
Chartered financial analysts
Chapter 11, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Commercial Loan Departments
Ratio
Debt/equity
Current ratio
Cash flow/current maturities
of long-term debt
Fixed charge coverage
Net profit margin after tax
Times interest earned
Net profit margin before tax
Degree of financial leverage
Inventory turnover in days
Accounts receivable turnover
in days
Significance
Rating
8.71
8.25
Primary
Measure
Debt
Liquidity
8.08
7.58
7.56
7.50
7.43
7.33
7.25
Debt
Debt
Profitability
Debt
Profitability
Debt
Liquidity
7.08
Liquidity
Chapter 11, Slide #3
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Corporate Controllers
Ratio
Earnings per share
Debt/equity ratio
Return on equity after tax
Current ratio
Net profit margin after tax
Dividend payout ratio
Return on total invested capital after tax
Net profit margin before tax
Accounts receivable turnover in days
Return on assets after tax
Percentage*
80.6
68.8
68.5
62.0
60.9
54.3
53.3
52.2
47.3
47.3
Primary
Measure
Profitability
Debt
Profitability
Liquidity
Profitability
Other
Profitability
Profitability
Liquidity
Profitability
*Percentage of firms indicating that the ratio was included in corporate objectives.
Chapter 11, Slide #4
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Certified Public Accountants
Significance
Ratio
Rating
Current ratio
7.10
Accounts receivable turnover in days
6.94
After-tax return on equity
6.79
Debt/equity ratio
6.78
Quick (acid test) ratio
6.77
Net profit margin after tax
6.67
Net profit margin before tax
6.63
Return on assets after tax
6.39
Return on total invested capital after tax
6.30
Inventory turnover in days
6.09
Chapter 11, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Primary
Measure
Liquidity
Liquidity
Profitability
Debt
Liquidity
Profitability
Profitability
Profitability
Profitability
Liquidity
Chartered Financial Analysts
Ratio
Return on equity after tax
Price/earnings ratio
Earnings per share
Net profit margin after tax
Return on equity before tax
Net profit margin before tax
Fixed charge coverage
Quick (acid test) ratio
Return on assets after tax
Times interest earned
Significance
Rating
8.21
7.65
7.58
7.52
7.41
7.32
7.22
7.10
7.06
7.06
Chapter 11, Slide #6
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Primary
Measure
Profitability
Other
Profitability
Profitability
Profitability
Profitability
Debt
Liquidity
Profitability
Debt
Comparison of Responses by
Loan Departments, Controllers, CPAs, and CFAs
Significance
Loan
Ranking
Departments
Corporate
Controllers
CPAs
CFAs
1
Debt/Equity
Earnings per
Share
Current Ratio
Return on
Equity After Tax
2
Current Ratio
Debt/Equity
Ratio
Accts Rec
Turnover
Price/Earnings
Ratio
3
Cash
Flow/Current
Maturities LT
Debt
Return on
Equity After
Tax
Return on
Equity After
Tax
Earnings per
Share
4
Fixed Charge
Coverage
Current ratio
Debt/Equity
Ratio
Net Profit
Margin
5
Net Profit
Margin After
Tax
Net Profit
Margin After
Tax
Quick Ratio
Return on
Equity Before
Tax
Debt
Liquidity
Key:
Profitability
Chapter 11, Slide #7
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Other
Financial Ratios in Annual Reports
Number President's Management Management Financial Financial
Included
Letter
Discussion
Highlights
Review Summary
Earnings per share
100
66
5
98
45
93
Dividends per share
98
53
10
85
49
88
Book value per share
84
10
3
53
18
63
Working capital
81
1
1
50
23
67
Return on equity
62
28
3
21
23
37
Profit margin
58
10
3
21
23
35
Effective tax rate
50
2
1
2
46
6
• Ratios related to profitability and investing most frequently
included
• Computation of ratios not consistent
• No regulatory agency currently accepts responsibility for
determining content or format for presentation of ratios in
annual reports
Chapter 11, Slide #8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Conservatism and Quality of Earnings
• Conservatism
– Achieved through the slowest reporting of net
income
– Yields higher quality of earnings
• Inventory (in periods of inflation)
– LIFO reports highest cost of goods sold and lowest
asset (inventory) value
• Fixed Assets
– Accelerated depreciation methods
– Shorter life estimates
Chapter 11, Slide #9
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Conservatism and Quality of Earnings
(cont’d)
• Intangible Assets
– Shorter life estimates
– Expensing of R&D as incurred
• Pensions
– Assumed discount rate
– Rate of compensation increase
Chapter 11, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Forecasting Financial Failure
• Financial failure defined as
– Liquidation
– Deferment of payments on debt
– Passing on preferred dividend
• Financial failure criteria
– No standard set of criteria
Chapter 11, Slide #11
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Forecasting Financial Failure (cont’d)
• Isolate ratios that may forecast failure;
construct model
–
–
–
–
Used by management as a preventative measure
Used by investors in portfolio management
Used by creditors in lending decisions
Used by auditor to assess ‘going concern’ status
• Recognized models
– Univariate [Beaver]
– Multivariate [Altman]
Chapter 11, Slide #12
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Univariate [Beaver] Model
• Single variable
• Identified ratios
– Cash flow/total debt
– Net income/total assets (return on assets)
– Total debt/total assets (debt ratio)
• Observed relationships
– Failed firms have less cash
– Failed firms have higher receivables
– Failed firms have less inventory
Chapter 11, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Multivariate [Altman] Model
• Multiple regression model with five ratios
Z = .012X1 + .014X2 + .033X3 + .006X4 + .010X5
X1 = Working Capital ÷ Total Assets
X2 = Retained Earnings ÷ Total Assets
X3 = Earnings Before Interest and Taxes ÷ Total Assets
X4 = Market Value of Equity ÷ Book Value of Total Debt
X5 = Sales ÷ Total Assets
• The lower the “Z” score, the more likely is
failure
Chapter 11, Slide #14
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Forecasting Financial Failure
•
•
•
•
Many academic studies exist
Weaker ratios indicate higher risk of failure
No conclusive model has been identified
Use an integrated approach
Chapter 11, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Analytical Review Procedures
• Auditors isolate
– Significant fluctuations
– Unusual items
• Performed in various stages of the audit
– Planning
– Fieldwork as substantive tests
– Review
Chapter 11, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Management’s Use of Analysis
• Relative liquidity, debt, and profitability
– Financial ratios
– Common-size analysis
• Indicative of investor’s perception of the firm
• As part of corporation planning
– General and specific objectives
– Budgeting
Chapter 11, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Use of LIFO Reserves
• Firms that use LIFO for financial reporting
• Disclosure:
– LIFO cost basis of inventory
– Approximate current cost of that inventory
– Difference is the LIFO reserve
Chapter 11, Slide #18
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Use of LIFO Reserves (cont’d)
• Determine adjusted financial statement
information based on LIFO reserve
–
–
–
–
–
Inventory
Deferred income tax
Cost of goods sold
Net income
Liquidity, debt, and profitability ratios
Chapter 11, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Graphing Financial Information
• Line graph
– A set of points connected by a line
– Shows change over time
Units (in millions)
25
20
15
10
5
0
2001
2002
2003
2004
Fiscal Year
Chapter 11, Slide #20
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
2005
2006
Graphing Financial Information (cont’d)
• Column graph
– Most appropriate for accounting data
$35
$30
Sales (000s)
$25
$20
$15
$10
$5
$0
Apr
May
Jun
Canoes
Jul
Tents
Aug
Sep
Bikes
Chapter 11, Slide #21
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Graphing Financial Information (cont’d)
• Pie graph
– Presented in segments
– Segments aggregate to 100%
Apr
22%
Jan
18%
Feb
26%
Mar
34%
Chapter 11, Slide #22
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Management of Earnings
• Cash basis of accounting
– Recognize revenue when cash is collected
– Recognize expenses when cash is paid
– Does not usually provide reasonable determination of income
over the short run
• Accrual basis of accounting
– Usually provides reasonable determination of income over the
short run
– Realization concept (revenue recognized when earned)
– Matching concept (expenses recognized when incurred)
– Requires use of estimates, assumptions, and judgment
Chapter 11, Slide #23
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Management of Earnings (cont’d)
• Manipulate earnings through
– Improper use of estimates
– Improper judgment
– Intentional errors
• Revenue recognition is often the focus of
financial manipulation
– Premature recognition of revenue
– Inventory cutoff
– Receivable timing and valuation
Chapter 11, Slide #24
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Enron
• 2001
– October: reduced after-tax income by $500 million
– November: restated 1997–2000 net income
– December: filed for bankruptcy
• Techniques
– Special-purpose entities
– Complex and opaque financial statements
Chapter 11, Slide #25
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
WorldCom
• 2002
– June: $3.8 billion of overstated profits over 5
quarters
– November: special bankruptcy court examiner
reported that the improper accounting would
exceed $7.2 billion
• Techniques
– Moved funds from reserve accounts to bolster
profits
– Capitalized operating costs
Chapter 11, Slide #26
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Valuation
• A process of estimating the value of a firm or
some component of a firm
• Approaches to valuation
– Fundamental analysis
– Discounted valuation models
Chapter 11, Slide #27
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Fundamental Valuation Analysis
• Acceptance
– Not well accepted by traditional financial literature
– Preferred by security analysts and fund managers
• Utilize basic accounting measures
– Reported earnings
– Cash flow
– Book value
• Use one or more multiples
–
–
–
–
Price-to-earnings
Price-to-book
Price-to-operating cash flow
Price-to-sales
Chapter 11, Slide #28
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Multiperiod Discounted Valuation Models
• Acceptance
– Strongly supported by financial literature
– Not widely used by analysts
• Discounted earnings models
– Discounted abnormal earnings
– Residual income
• Discounted cash flow models
– Free cash flow
– Dividend discount model
– Discounted cash flow
Chapter 11, Slide #29
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Discounted Earnings Models
• Discounted abnormal earnings (DAE)
– The value of the firm’s equity is the sum of its book
value and discounted forecasts of abnormal
earnings
• Residual income (RI)
– Discounted future expected earnings
– Earnings are a periodic measure of shareholder
wealth creation
Chapter 11, Slide #30
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Discounted Cash Flow Models
• Free cash flow (FCF)
– The projected future stream of free cash flows are
discounted to the present
–
–
–
–
=
Operating cash flows
Interest
Cash outlays for operating capacity
Debt repayments
Preferred dividends
Free cash flow
Chapter 11, Slide #31
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Discounted Cash Flow Models (cont’d)
• Dividend discount model (DDM)
– The projected future stream of common stock
dividends are discounted to the present
• Discounted cash flow (DCF)
– Projected future cash flows are discounted to the
present at the firm’s cost of capital
Chapter 11, Slide #32
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
What Analysts Use
• Barker European Accounting Review (1999,8:2)
– Price-earnings ratio was the preferred method of valuation
– Valuation models are important in the context of one another
rather than in isolation
• Demirakos, et al Accounting Horizons (2004,18:4)
– Price-earnings ratio is predominant
– Analysis tailor valuation methodologies to the industry
• Asquith, et al Journal of Financial Economics
(2005,75)
– Market-to-book value used as the asset multiple
Chapter 11, Slide #33
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Valuation and Management Consultants
• Discounted cash flows provide a more reliable picture
of a company’s value than an earnings-multiple
approach
• Discounted cash flows drive the value of a company
• Focus on long-term cash flows
– Short-term cash flows are subject to manipulation
• Mergers and acquisitions
– Shareholders of the acquired company experience greater
returns
– Acquiring companies may pay too much for the acquired
company
Chapter 11, Slide #34
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Dot.com Companies
• Apply classic methods to pricing of dot.coms
• High investments in customer acquisitions
• Factors for customer-value analysis
–
–
–
–
–
Average revenue per customer per year
Total number of customers
Contribution margin per customer
Average per-customer acquisition cost
Customer churn rate
Chapter 11, Slide #35
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.