3-1
Lecture Three
Evaluating the Firm for Planning
and Forecasting Via
Analysis of Financial Statements
Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
3-2
Balance Sheet: Assets
Cash
AR
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total assets
1998E
85,632
878,000
1,716,480
2,680,112 77%
1,197,160
380,120
817,040
3,497,152
1997
7,282
632,160
1,287,360
1,926,802 67%
1,202,950
263,160
939,790
2,866,592
3-3
Liabilities and Equity
1998E
1997
Accounts payable
436,800
524,160
Notes payable
600,000
720,000
Accruals
408,000
489,600
Total CL
1,444,800 41%1,733,760 60%
Long-term debt
500,000 14%1,000,000 35%
Common stock
1,680,936
460,000
Retained earnings (128,584) (327,168)
Total equity
1,552,352 44% 132,832 5%
Total L & E
3,497,152 2,866,592
3-4
Income Statement
Sales
COGS
Other expenses
Depreciation
Tot. op. costs
EBIT
Interest exp.
EBT
Taxes (40%)
Net income
1998E
7,035,600
5,728,000
680,000
116,960
6,524,960
510,640
88,000
422,640
169,056
253,584
1997
5,834,400
5,728,000
680,000
116,960
6,524,960
(690,560)
176,000
(866,560)
(346,624)
(519,936)
3-5
Other Data
1998E
1997
250,000
100,000
EPS
$1.014
($5.199)
DPS
$0.220
$0.110
Shares out.
Stock price
$12.17
$2.25
Lease pmts
$40,000
$40,000
3-6
Why are ratios useful?
Standardize numbers; facilitate
comparisons
Used to highlight weaknesses and
strengths
3-7
What are the five major categories of
ratios, and what questions do they
answer?
Liquidity: Can we make required
payments?
Asset management: Right amount
of assets vs. sales?
3-8
Debt management: 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?
3-9
Calculate D’Leon’s forecasted current
and quick ratios for 1998.
CA
CR98 = CL
$2,680
= $1,445 = 1.85x.
CA - Inv.
QR98 =
CL
$2,680 - $1,716
=
=
0.67x.
$1,445
3 - 10
Comments on CR and QR
1998
1997
1996
Ind.
CR
1.85x
1.1x
2.3x
2.7x
QR
0.67x
0.4x
0.8x
1.0x
 Expected to improve but still below
the industry average.
 Liquidity position is weak.
3 - 11
What is the inventory turnover ratio vs.
the industry average?
Sales
Inv. turnover = Inventories
$7,036
=
= 4.10x.
$1,716
1998
1997
1996
Ind.
Inv. T. 4.1x
4.5x
4.8x
6.1x
3 - 12
Comments on Inventory Turnover
Inventory turnover is below
industry average.
D’Leon might have old inventory,
or its control might be poor.
No improvement is currently
forecasted.
3 - 13
DSO is the average number of days
after making a sale before receiving
cash.
Receivables
DSO = Average sales per day
Receivables
$878
= Sales/360 = $7,036/360 = 44.9.
3 - 14
Appraisal of DSO
DSO
1998
44.9
1997
39.0
1996
36.8
Ind.
32.0
 D’Leon collects too slowly, and is
getting worse.
Poor credit policy.
3 - 15
F.A. and T.A. turnover vs.
industry average
Fixed assets
Sales
=
turnover
Net fixed assets
$7,036
=
= 8.61x.
$817
Total assets
=
turnover
Sales
Total assets
$7,036
=
= 2.01x.
$3,497
3 - 16
FA TO
TA TO
1998 1997 1996
8.6x 6.2x 10.0x
2.0x 2.0x 2.3x
Ind.
7.0x
2.6x
FA turnover project to exceed
industry average. Good.
TA turnover not up to industry
average. Caused by excessive
current assets (A/R and inv.)
3 - 17
Calculate the debt, TIE, and fixed
charge coverage ratios.
Total debt
Debt ratio =
Total assets
$1,445
+
$500
=
= 55.6%.
$3,497
EBIT
TIE =
Int. expense
$510.6
=
= 5.8x.
$88
3 - 18
Fixed charge
= FCC
coverage
EBIT + Lease payments
=
Interest Lease Sinking fund pmt.
+
+
expense
pmt.
(1 - T)
$510.6
+$40
=
= 4.3x.
$88 + $40 + $0
All three ratios reflect use of debt, but
focus on different aspects.
3 - 19
How do the debt management ratios
compare with industry averages?
D/A
TIE
FCC
1998
55.6%
5.8x
4.3x
1997 1996
Ind.
95.4% 54.8% 50.0%
-3.9x 3.3x 6.2x
-3.0x 2.4x 5.1x
Too much debt, but projected to
improve.
3 - 20
Another Debt Management Ratio used commonly is:
D/E
A
L+NW
CA
D
FA
E
TA
TL+NW=E
To convert into something more familiar as D/TA we simply
D/TA =
D/E
D/E + 1
D
or
TA
=
D
E
Example: if D/E = 0.91
D
TA
=
0.91
1 + 0.91
=
0.91
1.91
= 47%
 (1 +
D
E
)
3 - 21
20
Profit margin vs. industry average?
NI
$253.6
P.M. = Sales = $7,036 = 3.6%.
P.M.
1998 1997 1996
3.6% -8.9% 2.6%
Ind.
3.5%
Very bad in 1997, but projected to
exceed industry average in 1998.
Looking good.
3 - 22
21
BEP vs. Industry Average?
EBIT
BEP =
Total assets
$510.6
= $3,497 = 14.6%.
3 - 23
22
BEP
1998 1997 1996 Ind.
14.6% -24.1% 14.2% 19.1%
BEP removes effect of taxes and
financial leverage. Useful for
comparison.
Projected to be below average.
Room for improvement.
3 - 24
23
Return on Assets
Net
income
ROA =
Total assets
$253.6
= $3,497 = 7.3%.
3 - 25
24
Net income
ROE = Common equity
= $253.6 = 16.3%.
$1,552
ROA
ROE
1998
1997 1996
Ind.
7.3% -18.1% 6.0% 9.1%
16.3% -391.0% 13.3% 18.2%
Both below average but improving.
3 - 26
25
Effects of Debt on ROA and ROE
ROA is lowered by debt--interest
lowers NI, which also lowers ROA =
NI/Assets.
But use of debt lowers equity,
hence could raise ROE = NI/Equity.
3 - 27
26
Calculate and appraise the P/E and
M/B ratios.
Price = $12.17.
NI
$253.6
EPS = Shares out. = 250 = $1.01.
Price per share $12.17
P/E =
=
=
12x.
EPS
$1.01
3 - 28
27
Com. equity
BVPS =
Shares out.
$1,552
=
= $6.21.
250
Mkt. price per share
M/B =
Book value per share
$12.17
= $6.21 = 1.96x.
3 - 29
28
P/E
M/B
1998
12.0x
1.96x
1997 1996
-0.4x 9.7x
1.7x 1.3x
Ind.
14.2x
2.4x
P/E: How much investors will pay
for $1 of earnings. High is good.
M/B: How much paid for $1 of BV.
Higher is good.
P/E and M/B are high if ROE is high,
risk is low.
3 - 30
29
(
Profit
margin
)(
TA
turnover
)(
Equity
multiplier
) = ROE
NI
Sales
TA
Sales x TA x CE = ROE.
1996 2.6% x 2.3
1997 -8.9% x 2.0
1998 3.6% x 2.0
Ind.
3.5% x 2.6
x
x
x
x
2.2
21.9
2.3
2.0
= 13.2%
= -391.0%
= 16.3%
= 18.2%
3 - 31
Converting Equity Multiplier into
Debt/TA and vice versa
TD
= 1TA
(
1
EM
) = 1 -(
TE
TA
)
1
EM =
1-
(
TD
TA
)
If firm has Preferred Stock, must adjust formula
by using CE in place of TE and subtracting PS from TA.
3 - 32
30
The Du Pont system focuses on:
Expense control (P.M.)
Asset utilization (TATO)
Debt utilization (Eq. Mult.)
It shows how these factors combine
to determine the ROE.
Ratio Analysis Spread Sheet Example
De Leon
Ratio
Categories
CURRENT
QUICK
INVENTORY TURNOVER
DAYS SALES OUTSTANDING (DSO)
Asset
FIXED ASSETS TURNOVER
Management
TOTAL ASSETS TURNOVER
DEBT RATIO
Leverage
TIE
FIXED CHARGE COVERAGE
PROFIT MARGIN
BASIC EARNING POWER
Profitability
ROA
ROE
PRICE/EARNINGS
Market
MARKET/BOOK
BOOK VALUE PER SHARE
“Z” SCORE
BANKRUPCY
Liquidity
1998E
1.9
0.7
4.1
44.9
8.6
2.0
55.6
5.8
4.3
3.6
14.6
7.2
16.3
12.0
2.0
$6.21
3.803
1997
1.1x
0.4x
4.5x
39.0
6.2x
2.0x
95.4%
-3.9x
-3.0x
-8.9%
-24.1%
-18.1%
-391.4%
-0.4x
1.7x
$1.33
1.209
3 - 33
1996
2.3x
0.8x
4.8x
36.8
10.0x
2.3x
54.8%
3.3x
2.4x
2.6%
14.2%
6.0%
13.3%
9.7x
1.3x
$6.64
4.156
Industry
Average
2.7x
1.0x
6.1x
32.0
7.0x
2.6x
50.0%
6.2x
5.1x
3.5%
19.1%
9.1%
18.2%
14.2x
2.4x
N.A.
3 - 34
Altman’s “Z” Score
Multiple Discriminant Analysis (MDA) statistical technique similar to regression analysis.
Used to classify companies in two groups:
High probability of bankruptcy
Low probability of bankruptcy
High probability of bankruptcy exists when:
* 1. There is high leverage
(Mkt. Value of Stk./Book value of Debt) X-4
* 2. Low liquidity
(NWC/Assets) X-1
* 3. Low return on assets
(EBIT/Assets) X-3
* 4. Poor asset utilization
(Sales/Total Assets) X-5
* 5. Poor reinvestment opportunities
(RE/TA) X-2
* all in extended Du Pont equation.
MDA helps determine the actual probability of bankruptcy for a given level of any of above ratios
plus it captures the effect of the interrelationship between the ratios.
It is a technique used very much in banks & S&Ls in granting credit to customers; investment
banks rating bonds (specially junk bonds).
84% success in predicting 2 years ahead.
70% success in predicting 5 years ahead.
3 - 35
31
Simplified D’Leon Data
A/R
878 Debt
Other CA
1,802 Equity
Net FA
817
Total assets $3,497 L&E
Sales
day
1,945
1,552
$3,497
$7,035,600
=
= $19,543.
360
Q. How would reducing DSO to 32
days affect the company?
3 - 36
32
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.
3 - 37
33
New Balance Sheet
Added cash
A/R
Other CA
Net FA
Total assets
$
253 Debt
$1,945
625 Equity
1,552
1,802
817
$3,497 Total L&E $3,497
What could be done with the new
cash? Effect on stock price and risk?
3 - 38
34
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.
All these actions would improve
stock price.
3 - 39
35
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--similar
to what was done with DSO in slides
#31 - #33.
3 - 40
36
Q.
Would you lend money to the
company?
A.
Maybe. Things could get better.
In business, one has to take
some chances!
3 - 41
37
Company should not have relied
exclusively on debt to finance its
expansion.
3 - 42
D’LEON Analysis/Diagnosis/Prescription
I. Examination or Analysis:
A. Statement of Cash Flow
B. Ratios
II. Diagnosis or conclusions about the situation:
•An expansion began in 1996, which was financed with Long Term and Short Term debt.
(Evident on the ratios and the balance sheets). The company apparently assumed that sales and
profits would increase automatically with the expansion. Sales actually lagged and all ratios
deteriorated in 1997.
•As sales in ‘97 increased consistently in subsequent months they provided support for a more
optimistic sales forecast for 1998. All ratios improve dramatically in ‘98 except collection period
or DSO.
III. Prescription or recommendations:
3 - 43
•In hindsight, before the company took on its expansion plans, it should have done an extensive
ratio analysis to determine the effects of its proposed expansion on the firm’s operations. Had the
ratio analysis been conducted, the company would have “gotten its house in order” before
undergoing the expansion. For instance it would have used equity financing for part of the
expansion. Without it they should not have expanded. The equity financing is indispensable for
plant and capacity expansion because this source of funding does not require interest, principal,
or dividend payments, giving the firm time to slowly increase its sales to utilize the added
capacity and time to reach its eventual profitability target. That is a more conservative sales
growth plan should have been assumed and the expansion at least partly financed by equity. Even
losses could have been planned as is often the case after an expansion of plant capacity. The
ratios in 1998 are pretty acceptable, except for two, and show the expected increase in sales. If
the sales materialize they will be fine. If not, they may have to raise some equity financing and
pay back some of the debt. The two ratios that are still deficient even in 1998 are DSO and Total
Asset Turnover. Which show that the company credit policy is too lose and needs to be tightened.
If they can improve their collections they can decrease the DSO and hence the invested funds into
accounts receivable. Illustrated in blueprints 3-31 through 3-34.
•On the other hand, if the lenient credit is part of a predetermined strategy to increase sales to
plant capacity by capturing a larger share of the market while the products become popular, then
the higher level of receivables will have to be sustained but more equity financing might be
required.
•All in all, the Co. seems to have very short run expansion or growing pains principally because
all the expansion was financed with debt.
3 - 44
38
What are some potential problems and
limitations of financial ratio analysis?
Comparison with industry averages
is difficult if the firm operates many
different divisions.
3 - 45
39
“Average” performance not
necessarily good.
Seasonal factors can distort ratios.
“Window dressing” techniques can
make statements and ratios look
better.
3 - 46
40
Different operating and accounting
practices distort comparisons.
Sometimes hard to tell if a ratio is
“good” or “bad.”
Difficult to tell whether company is,
on balance, in strong or weak
position.
3 - 47
41
What are some qualitative factors
analysts should consider when
evaluating a company’s likely future
financial performance?
Are the company’s revenues tied to 1
key customer?
To what extent are the company’s
revenues tied to 1 key product?
To what extent does the company
rely on a single supplier?
(Cont…)
3 - 48
42
What percentage of the company’s
business is generated overseas?
Competition
Future prospects
Legal and regulatory environment
Management/Labor Relations and
Productivity