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CHAPTER 3
Analysis of Financial Statements
Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
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3-2
Balance Sheet: Assets
1999E
Cash
14,000
71,632
ST investments
AR
878,000
Inventories
1,716,480
Total CA
2,680,112
Gross FA
1,197,160
Less: Deprec.
380,120
Net FA
817,040
Total assets
3,497,152
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1998
7,282
0
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
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Liabilities and Equity
1999E
1998
Accounts payable
436,800
524,160
Notes payable
600,000
720,000
Accruals
408,000
489,600
Total CL
1,444,800 1,733,760
Long-term debt
500,000 1,000,000
Common stock
1,680,936
460,000
Retained earnings (128,584) (327,168)
Total equity
1,552,352
132,832
Total L & E
3,497,152 2,866,592
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3-4
Income Statement
Sales
COGS
Other expenses
Depreciation
Tot. op. costs
EBIT
Interest exp.
EBT
Taxes (40%)
Net income
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1999E
7,035,600
5,728,000
680,000
116,960
6,524,960
510,640
88,000
422,640
169,056
253,584
1998
5,834,400
5,728,000
680,000
116,960
6,524,960
(690,560)
176,000
(866,560)
(346,624)
(519,936)
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Other Data
1999E
1998
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
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3-6
Why are ratios useful?
Standardize numbers; facilitate
comparisons
Used to highlight weaknesses and
strengths
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3-7
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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3-8
Debt management: Do we have the
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?
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3-9
Calculate the firm’s forecasted current
and quick ratios for 1999.
CA
CR99 = CL
$2,680
= $1,445 = 1.85x.
CA - Inv.
QR99 =
CL
$2,680 - $1,716
=
=
0.67x.
$1,445
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3 - 10
Comments on CR and QR
1999
1998
1997
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.
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3 - 11
What is the inventory turnover ratio as
compared to the industry average?
Sales
Inv. turnover = Inventories
$7,036
=
= 4.10x.
$1,716
1999
1998
1997
Ind.
Inv. T. 4.1x
4.5x
4.8x
6.1x
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Comments on Inventory Turnover
Inventory turnover is below
industry average.
Firm might have old inventory, or
its control might be poor.
No improvement is currently
forecasted.
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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 days.
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3 - 14
Appraisal of DSO
DSO
1999
44.9
1998
39.0
1997
36.8
Ind.
32.0
 Firm collects too slowly, and
situation is getting worse.
 Poor credit policy.
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3 - 15
Fixed Assets and Total Assets
Turnover Ratios
Fixed assets
Sales
=
turnover
Net fixed assets
= $7,036 = 8.61x.
$817
Total assets
=
turnover
Sales
Total assets
$7,036
=
= 2.01x.
$3,497
(More…)
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FA TO
TA TO
1999
8.6x
2.0x
1998
6.2x
2.0x
1997
10.0x
2.3x
Ind.
7.0x
2.6x
FA turnover is expected to exceed
industry average. Good.
TA turnover not up to industry
average. Caused by excessive
current assets (A/R and inventory).
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3 - 17
Calculate the forecasted operating
capital requirement ratio (OCR).
Operating
Net operating
= working capital +
capital
Net fixed
assets
Net operating = ($14,000 + $878,000 +
working capital $1,716,480) - ($436,800 +
$408,000) = $1,763,680.
Operating capital = $1,763,680 + $817,040
= $2,580,720.
(More…)
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3 - 18
OCR = Operating capital/Sales
= $2,580,720/$7,035,600
= 36.7%.
1999 1998 1997 Ind.
OCR 36.7% 31.8% 33.2% 29.5%
The OCR is not improving.
It is worse than the industry average.
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3 - 19
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
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(More…)
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3 - 20
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.
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3 - 21
How do the debt management ratios
compare with industry averages?
D/A
TIE
FCC
1999
55.6%
5.8x
4.3x
1998
95.4%
-3.9x
-3.0x
1997
Ind.
54.8% 50.0%
3.3x
6.2x
2.4x
5.1x
Too much debt, but projected to
improve.
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3 - 22
After-tax operating
profit margin (ATOPM)
ATOPM = EBIT(1 - T) = $510,640(1 - 0.4)
Sales
$7,035,600
= 4.4%.
1999 1998 1997
Ind.
ATOPM
4.4% -7.1% 3.7% 4.3%
Very bad in 1998, but projected to
exceed industry average in 1999.
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3 - 23
Profit Margin (PM)
NI
$253.6
PM = Sales = $7,036 = 3.6%.
PM
1999
3.6%
1998
-8.9%
1997
2.6%
Ind.
3.5%
Very bad in 1998, but projected to
exceed industry average in 1999.
Looking good.
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3 - 24
Basic Earning Power (BEP)
EBIT
BEP =
Total assets
$510.6
= $3,497 = 14.6%.
(More…)
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3 - 25
BEP
1999
14.6%
1998
1997
Ind.
-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.
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3 - 26
Return on Assets (ROA)
and Return on Equity (ROE)
Net
income
ROA =
Total assets
$253.6
= $3,497 = 7.3%.
(More…)
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3 - 27
Net income
ROE = Common equity
= $253.6 = 16.3%.
$1,552
ROA
ROE
1999
7.3%
16.3%
1998
1997
Ind.
-18.1% 6.0% 9.1%
-391.0% 13.3% 18.2%
Both below average but improving.
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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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3 - 29
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
(More…)
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3 - 30
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.
(More…)
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3 - 31
P/E
M/B
1999
12.0x
1.96x
1998
-0.4x
1.7x
1997
9.7x
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 book
value. Higher is good.
P/E and M/B are high if ROE is high,
risk is low.
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3 - 32
Explain the Du Pont System
(
Profit
margin
)(
TA
turnover
NI
Sales
Sales x
TA
)(
x
1997 2.6% x 2.3
1998 -8.9% x 2.0
1999 3.6% x 2.0
Ind.
3.5% x 2.6
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)
Equity
multiplier = ROE
x
x
x
x
TA
CE
= ROE.
2.2
21.6
2.3
2.0
= 13.2%
= -391.0%
= 16.3%
= 18.2%
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3 - 33
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.
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3 - 34
Simplified Firm 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?
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3 - 35
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.
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3 - 36
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?
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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.
(More…)
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3 - 38
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. Such an
analysis would be similar to what was
done with DSO in previous slides.
All these actions would likely
improve stock price.
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3 - 39
Would you lend money
to this company?
Maybe. The situation could
improve, and the loan, with a high
interest rate to reflect the risk,
could be a good investment.
However, company should not have
relied so heavily on debt financing
in the past.
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3 - 40
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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3 - 42
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?
And so on.
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