Chapter 6: Analysis of Financial Statements
I.
Ratio Analysis
Liquidity or Solvency Ratios:
Measure the firm’s ability to meet its short-term financial obligations. Measures
the firm’s liquidity, or how easily and quickly assets can be converted into cash in
order to meet financial obligations. Liquidity also implies that the transformation
into cash can be accomplished at full market value of the asset. (No fire sales!)
Activity or Asset Management Ratios (aka Turnover ratios):
Measures how intensively a firm uses its assets to generate sales. These ratios
cover short-term assets (inventory turnover) and long-term assets (fixed-asset
turnover) and all involve sales.
Leverage (debt management) Ratios:
Measures the amount of long-term debt the firm uses to finance assets. It is a
closely followed measure of the total riskiness of the firm. A high debt ratio
indicates potential trouble if the firm is unable to generate enough sales revenue to
service that debt.
Profitability Ratios:
Measures how efficiently a firm manages its operations to produce profits or
returns. Different ratios focus on different areas of profit (e.g., return on equity vs.
return on assets).
Market Value Ratios:
Ratios that require data not contained in the financial statements (specifically, the
market price of a share of stock).
Fin 336: Chapter 6 - Analysis of Financial Statements, page 1
Basics of Ratio Analysis
Trend analysis
Looks at the change in ratios over time
Compare similar time periods (e.g., quarter-over-quarter, y-o-y)
Comparative analysis
Compares firms using industry averages, similar firms, or indexes as benchmarks
Problems with Financial Statement Analysis
Different accounting procedures can distort comparisons (e.g., depreciation methods such
as LIFO & FIFO will affect reported earnings.
“Window dressing” can make things look better than they are. There are ethical & legal
questions about practices such as earnings manipulation.
The problems involved in analyzing conglomerate operations. Such companies are more
complicated than “Pure plays”.
Ratio analysis tells only part of the story...MUST read footnotes, look at conditions in the
economy that exist. RED-GREEN-YELLOW flags!!
Common-Size Financial Statements
Purpose
To facilitate analysis of the changes in a company over time
To facilitate analysis and comparison across companies
Description
Common size balance sheet: each item as a percent of total assets
Common size income statement: each item as a percent of sales
Fin 336: Chapter 6 - Analysis of Financial Statements, page 2
II.
The Du Pont Identity
Decompose return on equity (ROE) into basic building blocks and evaluate those building
blocks in order to see how to improve ROE.
Net profit margin (NPM):
operating efficiency
Total asset turnover (TAT):
asset use efficiency
Equity multiplier (EM): use of financial leverage
A.
ROE =
NI
CE
=
Net Income
Common Equity
=
Net Income x
Total Assets
Total Assets
Common Equity
=
ROA
EM
=
Net Income x
Sales
Sales
x
Total Assets
Total Assets
Common Equity
=
NPM
TAT
EM
x
x
x
The Dupont Equation breaks down ROE into its constituent components and shows in
what area of the company problems may exist:
-
Looking at profit margin, marketing people might look at ways to adjust sales
(change prices to increase net income), or look at moving into higher margin
products.
-
Production people: can look at ways to reduce investment in low turnover assets
and increasing the efficiency of remaining ones.
-
Finance people might look for ways to increase the multiplier by reducing the
amount of equity needed to finance the company. They would consider substituting
debt for equity, being careful that interest costs don’t cut into NI.
Fin 336: Chapter 6 - Analysis of Financial Statements, page 3
Dupont example:
ROE =
NPM x
TAT x
EM
Noles, Inc
.13
x
.4
x
1.5
=
.078
Industry
.13
x
.35
x
2.0
=
.091
Benchmarks:
The industry average is our benchmark
Noles, Inc. shareholders are suffering....ROE is below industry.
However, profit margins are identical with the industry average.
And asset turnover is even better than the industry average.
So, what’s the problem? The equity multiplier (EM) for Noles, Inc is lower than
the industry average
Noles, Inc:
Total assets/Common equity
Industry Average: TA/CE
= 3,000/2,000 = 1.5
= 4,200/2,100 = 2.0
What can the firm do??
The firm might consider adding leverage (debt) to its capital structure
Maybe it could issue some bonds....buy back stock!
What are the tradeoffs (pros and cons) to doing this?
What other things can it do to improve ROE?
Fin 336: Chapter 6 - Analysis of Financial Statements, page 4
Problems with Using ROE as the Sole Performance Measure
1.
2.
3.
ROE fails to consider risk
ROE fails to consider the amount of capital invested
ROE might ignore a value maximizing project if it failed to achieve a desire
ROE.
Example: Seahawk Corporation
Given:
Starting Book Value (BV) = $1,000
ROE = 25% per year in perpetuity
Earnings = ROE x BV = .25 x $1,000 = $250
CASE 1:
All earnings (E) paid out in dividends (D)
Zero retained earnings (RE)
Time
Book Value
Earnings
Dividends
Retained
Earnings
0
1000
250
250
0
1
1000
250
250
0
2
1000
250
250
0
3 ……
1000
250
250
0
Consider: The shareholder’s required rate of return = .25
Market Value of Firm: D/r =
250/.25
=
$1000
Consider: The shareholder’s required rate of return = .20
Market Value of Firm: D/r =
250/.20
=
$1250
Consider: The shareholder’s required rate of return = .30
Market Value of Firm: D/r =
250/.30
=
$833
Conclusion: ROE alone can be misleading measure of performance!
Fin 336: Chapter 6 - Analysis of Financial Statements, page 5
Seahawk Corporation
Using ROE to Estimate the Dividend Growth Rate
Given:
Starting Book Value (BV) = $1,000
ROE = 25% per year in perpetuity
Earnings = ROE x BV = .25 x $1,000 = $250
CASE 1: All earnings (E) paid out in dividends (D);
Zero retained earnings (RE)
Time
BV
Earnings
Dividends
Retained
Earnings
0
1000
250
250
0
1
1000
250
250
0
2
1000
250
250
0
3 ……
1000
250
250
0
CASE 2: 30% earnings (E) paid out in dividends (D);
70% retained earnings (RE)
Time
BV
Earnings
Dividends
Retained
Earnings
0
1000
250
75
175
1
1175
293.75
88.12
205.63
What is growth rate of Book Value?
What is growth rate of Earnings?
What is growth rate of Dividends?
2
1380.63
345.16
103.55
241.61
3 ……
1622.24
405.56
121.67
283.89
1175/1000 – 1 = .175 = 17.5%
293.75/250 – 1 = .175
88.12/75 – 1 = .175
What is growth rate? ROE x Retention rate = .25 x .7 = .175
Or ROE x (1-payout rate)
Fin 336: Chapter 6 - Analysis of Financial Statements, page 6
Financial Ratios
CBS Equipment: 1987 Figures
Liquidity (Short-term Solvency)
Current Ratio: Current Assets/Current Liabilities _________________________
Quick Ratio: (CA – Inventory)/CL
____________________________________
Activity
Total Asset Turnover (TAT): Annual Sales/Total Assets ______________
Fixed Asset Turnover (FAT): Annual Sales/Fixed Assets ______________________
Receivables Turnover: Annual (Credit) Sales/Average Receivables _________________
Avg Collection Period: 365/RTO ________________________________________
Inventory Turnover: Annual COGS/Average Inventory __________________________
Days in Inventory: 365/ITO ____________________________________________
Leverage and Coverage
Debt Ratio: Total Debt/Total Assets _______________________________________
Debt-to-Equity Ratio: Total Debt/Total Equity _______________________________
Debt-to-Capital Ratio: Total Debt/(LT debt + Equity) __________________________
Equity Multiplier: Total Assets/Common Equity ______________________________
Times Interest Earned (Interest Coverage): EBIT/Interest Expense ________________
Fixed Charge Coverage: Similar to T.I.E., but considers all fixed charges
(EBIT + Lease Payments)/[(Interest +Lease Payments + Pref. Divs/(1-t)]
Fin 336: Chapter 6 - Analysis of Financial Statements, page 7
Profitability Ratios
Gross Profit Margin: (Annual Sales – COGS)/Annual Sales _____________________
Operating Profit Margin: EBIT (NOI)/Annual Sales ___________________________
Net Profit Margin: NI/Annual Sales ________________________________________
Return on Assets (ROA): NI/Total Assets ____________________________________
Return on Equity (ROE): NI/Common Equity _________________________________
Note: ROE = ROA x Equity Multiplier ______________________________________
Return on Capital: (NI + Interest)/(CE + LT Debt) ____________________________
Dupont Equation:
ROA = Net Profit Margin x TAT __________________________________________
ROE = ROA x Equity Multiplier __________________________________________
Market Value Ratios:
Price-Earnings (PE): Market price/Earnings-per-share ________________________
Price-to-Book (PB): Market price/Book value per share _______________________
Price-to-Sales (PS): Market price/Sales per share ___________________________
Dividend Yield: Dividend per share/Market price per share _____________________
Earnings per share (EPS): NI available to CS/Shares outstanding ________________
Dividends per share (DPS): Dividends to CS/Shares outstanding ________________
Dividend Payout Ratio (DPO): Dividends to CS/NI available to CS ______________
Retention Ratio (b): 1 – DPO ____________________________________________
Fin 336: Chapter 6 - Analysis of Financial Statements, page 8