CHAPTER 3
Analysis of Financial Statements
1
Topics in Chapter





Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
2
Determinants of Intrinsic Value:
Using Ratio Analysis
Net operating
profit after taxes
Free cash flow
(FCF)
Value =
Required investments
in operating capital
−
=
FCF1
FCF2
FCF∞
... +
+
+
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Cost of debt
Firm’s debt/equity mix
Market risk aversion
Cost of equity
Firm’s business risk
3
Overview

Ratios facilitate comparison of:



One company over time
One company versus other companies
Ratios are used by:



Lenders to determine creditworthiness
Stockholders to estimate future cash flows and
risk
Managers to identify areas of weakness and
strength
4
Income Statement
2010
2011E
Sales
$5,834,400
$7,035,600
COGS
4,980,000
5,800,000
Other expenses
720,000
612,960
Deprec.
116,960
120,000
5,816,960
6,532,960
17,440
502,640
176,000
80,000
(158,560)
422,640
(63,424)
169,056
($ 95,136)
$ 253,584
Tot. op. costs
EBIT
Int. expense
EBT
Taxes (40%)
Net income
5
Balance Sheets: Assets
Cash
S-T invest.
AR
Inventories
Total CA
Net FA
Total assets
2010
$
7,282
20,000
632,160
1,287,360
1,946,802
939,790
$2,886,592
2011E
$
14,000
71,632
878,000
1,716,480
2,680,112
836,840
$3,516,952
6
Balance Sheets: Liabilities &
Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E
$
2010
324,000
720,000
$
2011E
359,800
300,000
284,960
1,328,960
1,000,000
380,000
1,039,800
500,000
460,000
97,632
557,632
1,680,936
296,216
1,977,152
$2,886,592
$3,516,9527
Other Data
Stock price
# of shares
EPS
DPS
Book val. per sh.
Lease payments
Tax rate
2010
$6.00
100,000
-$0.95
$0.11
$5.58
$40,000
0.4
2011E
$12.17
250,000
$1.01
$0.22
$7.91
$40,000
0.4
8
Five Categories of Fin. Ratios





Liquidity
Asset Mgmt
Debt Mgmt
Profitability
Market Value
9
Five Categories of Fin. Ratios


Liquidity: Ability to meet current obligations
Asset Mgmt: Proper & effective use of assets

Asset utilization (i.e., Total Asset Turnover Ratio:


TAT = Sales / T. Assets
Debt Mgmt: extent of debt & level of safety
afforded creditors

Debt utilization (i.e., Equity Multiplier:

EM = T. Assets / T. Eqty
10
Five Categories of Fin. Ratios

Profitability: reflects effects of liquidity, asset
mgmt, & debt on operating results

Expense Control: Profit Margin:


PM = Net Income / Sales
Market Value: indicators of what investors
think of firm’s past results & future prospects
11
Liquidity Ratios

Can the company meet its short-term
obligations using resources it currently
has on hand?
12
Forecasted Current and Quick
Ratios for 2011.
$2,680
= $1,040
CR10
CA
= CL
QR10
CA - Inv.
=
CL
$2,680 - $1,716
=
$1,040
= 2.58.
= 0.93.
13
Comments on CR and QR
2011E
2010
2009
Ind.
CR
2.58
1.46
2.3
2.7
QR
0.93
0.5
0.8
1.0


Expected to improve but still below industry
average.
Liquidity position is weak.
14
Asset Management Ratios


How efficiently does firm use its assets?
How much does firm have tied up in
assets for each dollar of sales?
15
Inventory Turnover Ratio vs.
Industry Average
Inv. turnover
2011E
Inv. T. 4.1
Sales
= Inventories
$7,036
=
= 4.10.
$1,716
2010
2009
Ind.
4.5
4.8
6.1
16
Comments on Inventory
Turnover



Inventory turnover: Below industry average
Firm might have old inventory, or its
control might be poor.
No improvement is currently forecasted.
17
DSO: average number of days
from sale until cash received.
DSO =
Receivables
Average sales per day
= Receivables
Sales/365
= $878
$7,036/365
= 45.5 days.
18
Appraisal of DSO


Firm collects too slowly, and situation is
getting worse.
Poor credit policy.
DSO
2011
45.5
2010
39.5
2009
37.4
Ind.
32.0
19
Fixed Assets and Total Assets
Turnover Ratios
Fixed assets
turnover
Sales
=
Net fixed assets
$7,036
=
= 8.41.
$837
Total assets
turnover
Sales
=
Total assets
$7,036
=
= 2.00.
$3,517
20
Fixed Assets and Total Assets
Turnover Ratios


FA turnover: expected to exceed industry average.
Good.
TA turnover not up to industry average. Implication?
Caused by excessive current assets (A/R and inventory).
2011E
2010
2009
Ind.
FA TO
8.4
6.2
10.0
7.0
TA TO
2.0
2.0
2.3
2.5
21
Debt Management Ratios


Does company have too much debt?
Can company’s earnings meet its debt
servicing requirements?
22
Calculate the debt, TIE, and
EBITDA coverage ratios.
Total liabilities
Debt ratio =
Total assets
$1,040 + $500
=
$3,517
EBIT
TIE =
Int. expense
= $502.6 = 6.3.
$80
= 43.8%.
(More…)
23
EBITDA Coverage (EC)
+
Lease
payments
+
Depr.
&
Amort.
EBIT
_________
Interest
expense + Lease Pmt. + Loan pmt.
$502.6
+
$120
+
$40
=
$80 + $40 + $0
= 5.5.
24
Debt Management Ratios vs.
Industry Averages
D/A
TIE
EC
2011E
43.8%
6.3
5.5
2010
80.7%
0.1
0.8
2009
Ind.
54.8% 50.0%
3.3
6.2
2.6
8.0
Recapitalization improved situation, but
lease pmts drag down EBITDA Cov.
25
Equity Multiplier =
T. Assets/Cmn Eqty


Firms with large amts of debt financing
(high leverage) have high Eqty Multiplier
Think: Assets = Debt
+
Eqty
26
Equity Multiplier =
T. Assets/Cmn Eqty

Firms with small amts of debt financing
(low leverage) have smaller Eqty Multiplier
27
Profitability Ratios

What is company’s rate of return on:


Sales?
Assets?
28
Profit Margins
Net profit margin (PM):
NI
$253.6
PM = Sales = $7,036 = 3.6%.
Operating profit margin (OM):
EBIT
$503
OM = Sales = $7,036 = 7.1%.
(More…)
29
Profit Margins
(Continued)
Gross profit margin (GPM):
Sales − COGS
$7,036 − $5,800
GPM =
=
Sales
$7,036
$1,236
GPM = $7,036 = 17.6%.
30
Profit Margins vs. Industry
Averages
PM
OPM
GPM
2011E
3.6%
7.1
17.6
2010
-1.6%
0.3
14.6
2009
Ind.
2.6% 3.6%
6.1
7.1
16.6 15.5
Very bad in 2010, but projected to
meet or exceed industry average in
2011.
31
Basic Earning Power &
Subway vs. Smelly Deli

EBIT=

T.Assets=

BEP= EBIT/TA
32
Basic Earning Power (BEP)
BEP =
=
EBIT
Total assets
$502.6 = =14.3%
$3,517
33
Basic Earning Power vs.
Industry Average
BEP



2011E 2010 2009 Ind.
14.3% 0.6% 14.2% 17.8%
BEP removes effect of taxes and
financial leverage. Useful for
comparison.
Projected to be below average.
Room for improvement.
34
Return on Assets (ROA)
and Return on Equity (ROE)
NI
ROA =
Total assets
$253.6
=
$3,517
= 7.2%.
(More…)
35
Return on Assets (ROA)
and Return on Equity (ROE)
ROE =
NI
Common Equity
$253.6
=
$1,977
= 12.8%.
(More…)
36
ROA and ROE vs. Industry
Averages
ROA
ROE
2011E 2010 2009 Ind.
7.2% -3.3% 6.0% 9.0%
12.8% -17.1% 13.3% 18.0%
Both below average but improving.
37
Effects of Debt on ROA & ROE
No Debt (unlevered) vs. Debt (levered)
38
Effects of Debt on ROA and
ROE


ROA is lowered by debt--interest
expense lowers net income, which also
lowers ROA.
However, use of debt lowers equity,
and if equity is lowered more than net
income, ROE increases.
39
Important Implications of Debt
Financing (Financial Leverage)



By raising $ thru debt, stockholders can
maintain control of firm w/o increasing their
investment.
Greater the equity stake, the less risk faced
by lenders (creditors)
If company earns greater return on
investment financed with debt than it pays in
interest on borrowed funds, then it the
return on owners equity is magnified, or
40
leveraged.
The Internal Growth Rate


The internal growth rate tells us how
much the firm can grow assets using
retained earnings as the only source of
financing.
Intrnl Grth rate = (ROA x Retention %)
1- (ROA x Retention %)
The Sustainable Growth Rate


The sustainable growth rate tells us
how much the firm can grow by using
internally generated funds and issuing
debt to maintain a constant debt ratio.
Sustnbl Grth rate = (ROE x Retention %)
1- (ROE x Retention %)
Market Value Ratios

Market value ratios: gives mgmt
indication of what investors think of
co.’s past performance & future
prospects
43
Market Value Ratios

Increase /decrease:



High current levels of earnings and cash
flow increase market value ratios
High expected growth in earnings and cash
flow increases market value ratios
High risk of expected growth in earnings
and cash flow decreases market value
ratios
44
Market Value Ratios

P/E = Mrkt price per share / Earning per share

PEG ratio= (Price/Earnings) / Growth
PEG <1.0 reflects fairly valued stock
M/B= Mrkt price p.s. / Book Value p.s.

P/CF=Price p.s. / CF p.s.

45
Calculate and appraise the
P/E, P/CF, and M/B ratios.
Price = $12.17.
NI
$253.6
EPS = Shares out. = 250
Price per share
$12.17
P/E =
=
EPS
$1.01
= $1.01.
= 12.
46
Market Based Ratios
CF per share =
NI + Depr.
Shares out.
= $253.6 + $120.0
250
= $1.49.
Price per share
P/CF = Cash flow per share
= $12.17
$1.49
= 8.2.
47
Market Based Ratios
(Continued)
Com. equity
BVPS = Shares out.
$1,977
= 250
= $7.91.
Mkt. price per share
M/B = Book value per share
$12.17
= $7.91
= 1.54.
48
Interpreting Market Based
Ratios



P/E: How much investors will pay for $1
of earnings. Higher is better.
M/B: How much paid for $1 of book
value. Higher is better.
P/E and M/B are high if ROE is high,
risk is low.
49
Market Value Measures




Value Stocks: Firms w/ low Mrkt to
Book ratios
Growth Stocks: Firms w/ high Mrkt to
Book ratios
Market Capitalization = Mrkt Value of
Common Equity
Enterprise Value= MV equity + MV debt
– Cash – mrktbl securities. Measures
value of firm’s underlying business
Comparison with Industry
Averages
P/E
P/CF
M/B
2011E
12.0
8.2
1.5
2010
-6.3
27.5
1.1
2009
9.7
8.0
1.3
Ind.
14.2
7.6
2.9
51
Explain the Du Pont System

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.
52
The Du Pont System
(
Profit
margin
NI
Sales
)(
TA
turnover
x
Sales
TA
)(
x
) = ROE
Equity
multiplier
TA
CE
= ROE
53
Du Pont & Corp Operations
(
)(
)(
TA
Equity
Profit
turnover
multiplier
margin
NI
Sales
TA
x
x
Sales
TA
CE
) = ROE
= ROE
54
The Du Pont System
NI
Sales
Sales
TA
x
2008:
2009:
2010:
Ind.:
2.6%
-1.6%
3.6%
3.6%
x
x
x
x
x
2.3
2.0
2.0
2.5
x
x
x
x
TA
CE
= ROE
2.2
5.2
1.8
2.0
= 13.2%
= -16.6%
= 13.0%
= 18.0%
55
Common Size Balance Sheets:
Divide all items by Total Assets
Assets
Cash
ST Inv.
AR
Invent.
Total CA
Net FA
TA
2009
2010
2011E
Ind.
0.6%
0.3%
0.4%
0.3%
3.3%
0.7%
2.0%
0.3%
23.9%
21.9% 25.0% 22.4%
48.7%
44.6% 48.8% 41.2%
76.5%
67.4% 76.2% 64.1%
23.5%
32.6% 23.8% 35.9%
100.0% 100.0% 100.0% 100.0%
56
Divide all items by Total
Liabilities & Equity
Assets
AP
Notes
pay.
Accruals
Total CL
LT Debt
Total eq.
2009 2010 2011E
9.9% 11.2% 10.2%
13.6% 24.9% 8.5%
Ind.
11.9%
2.4%
9.3% 9.9% 10.8%
32.8% 46.0% 29.6%
22.0% 34.6% 14.2%
45.2% 19.3% 56.2%
9.5%
23.7%
26.3%
50.0%
57
Analysis of Common Size
Balance Sheets



Computron has higher proportion of
inventory and current assets than
Industry.
Computron now has more equity (which
means LESS debt) than Industry.
Computron has more short-term debt
than industry, but less long-term debt
than industry.
58
Common Size Income Statement:
Divide all items by Sales
2009
100.0%
83.4%
2010
100.0%
85.4%
2011E
100.0%
82.4%
Ind.
100.0%
84.5%
Other exp.
Depr.
EBIT
9.9%
0.6%
6.1%
12.3%
2.0%
0.3%
8.7%
1.7%
7.1%
4.4%
4.0%
7.1%
Int. Exp.
EBT
Taxes
1.8%
4.3%
1.7%
3.0%
-2.7%
-1.1%
1.1%
6.0%
2.4%
1.1%
5.9%
2.4%
NI
2.6%
-1.6%
3.6%
3.6%
59
Sales
COGS
Analysis of Common Size
Income Statements

Computron has lower COGS (86.7) than
industry (84.5), but higher other
expenses. Result is that Computron
has similar EBIT (7.1) as industry.
60
Percentage Change Analysis: %
Change from First Year (2009)
Income St.
Sales
COGS
2009
0.0%
0.0%
2010
70.0%
73.9%
2011E
105.0%
102.5%
Other exp.
Depr.
EBIT
0.0%
0.0%
0.0%
111.8%
518.8%
-91.7%
80.3%
534.9%
140.4%
Int. Exp.
EBT
Taxes
0.0%
0.0%
0.0%
181.6%
-208.2%
-208.2%
28.0%
188.3%
188.3%
NI
0.0%
-208.2%
188.3%
61
Analysis of Percent Change
Income Statement


We see that 2011 sales grew 105%
from 2009, and that NI grew 188%
from 2009.
So Computron has become more
profitable.
62
Percentage Change Balance
Sheets: Assets
Assets
Cash
ST Invest.
AR
Invent.
Total CA
Net FA
TA
2009
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
2010
-19.1%
-58.8%
80.0%
80.0%
73.2%
172.6%
96.5%
2011E
55.6%
47.4%
150.0%
140.0%
138.4%
142.7%
139.4%
63
Percentage Change Balance
Sheets: Liabilities & Equity
Liab. & Eq.
2009
2010
2011E
AP
Notes pay.
Accruals
Total CL
LT Debt
Total eq.
Total L&E
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
122.5%
260.0%
109.5%
175.9%
209.2%
-16.0%
96.5%
147.1%
50.0%
179.4%
115.9%
54.6%
197.9%
139.4%
64
Analysis of Percent Change
Balance Sheets

Total assets grew at rate of 139%,
while sales grew at rate of only 105%.
So asset utilization remains a problem.
65
Potential Problems and
Limitations of Ratio Analysis




Comparison with industry averages is
difficult if firm operates many different
divisions.
Seasonal factors can distort ratios.
Window dressing techniques can make
statements and ratios look better.
Different accounting and operating
practices can distort comparisons.
66
Qualitative Factors

There is greater risk if:







revenues tied to a single customer
revenues tied to a single product
reliance on a single supplier?
High percentage of business is generated
overseas?
What is competitive situation?
What products are in pipeline?
What are legal and regulatory issues?
67