Lecture 3 - Fs Analysis

9/21/2016
Chapter 4
Analysis of Financial Statements

Ratio Analysis
DuPont Equation
Effects of Improving Ratios
Limitations of Ratio Analysis
Qualitative Factors
4-1
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total Assets
2013E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
2012
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
4-2
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Balance Sheet: Liabilities and Equity
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2013E
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
2012
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-3
Income Statement
Sales
COGS
Other expenses
EBITDA
Deprec. & amort.
EBIT
Interest exp.
EBT
Taxes
Net income
2013E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2012
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-4
9/21/2016
Other Data
No. of shares
EPS
DPS
Stock price
Lease pmts
2013E
250,000
$1.014
$0.220
$12.17
$40,000
2012
100,000
-$1.602
$0.110
$2.25
$40,000
4-5
Why are ratios useful?
standardize numbers and facilitate comparisons.

used to highlight weaknesses and strengths.
Ratio comparisons should be made through time
and with competitors.
Trend analysis
Industry analysis
Benchmark (peer) analysis
4-6
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Common Size Statements Standardizing Financial

Information
A common size financial statement is a standardized

version of a financial statement in which all entries
are presented in percentages.
A common size financial statement helps to compare

entries in a firms financial statements, even if the
firms are not of equal size.
Common Size Balance

Sheet
(H. J. Boswell, Inc.)
9/21/2016
Common Size Income Statement

(H. J. Boswell, Inc.)
Five Major Categories of Ratios
Liquidity
Asset management
Debt management
Profitability
Market value
4-10
9/21/2016
LIQUIDITY
4-11
DLeons Forecasted Current Ratio and Quick

Ratio for 2013
Current assets
Current liabilitie s
$2,680
=
$1,145
= 2.34
Current ratio =
(Current assets Inventorie s)

Current liabilitie s
($2,680 $1,716)
=
$1,145
= 0.84
Quick ratio =
4-12
9/21/2016
Comments on Liquidity Ratios

2013E
2012
2011
Ind.
Current ratio
2.34x
1.20x
2.30x
2.70x
Quick ratio
0.84x
0.39x
0.85x
1.00x
4-13
Asset Management
4-14
9/21/2016
DLeons Inventory Turnover vs. the Industry

Average
Inv. turnover = Sales/Inventories
= $7,036/$1,716
= 4.10x
2013E 2012
2011
Inventory turnover
4.1x
4.70x
Ind.
4.8x
6.1x
DLeon might have old inventory, or its control

might be poor.
No improvement is currently forecasted.

4-15
DSO: Average Number of Days after Making a

Sale before Receiving Cash
DSO = Receivables/Avg. sales per day
= Receivables/(Annual sales/365)
= $878/($7,036/365)
= 45.6 days
DSO
2013E
2012
2011
Ind.
45.6
38.2
37.4
32.0
Collection -too slowly

DLeon has a poor credit policy.
4-16
9/21/2016
Fixed Assets and Total Assets Turnover Ratios vs.

the Industry Average
FA turnover = Sales/Net fixed assets
= $7,036/$817 = 8.61x
TA turnover = Sales/Total assets
= $7,036/$3,497 = 2.01x
2013E
2012
2011
Ind.
FA TO
8.6x
6.4x
10.0x
7.0x
TA TO
2.0x
2.1x
2.3x
2.6x
FA turnover projected to exceed the industry average.

TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv).
4-17
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total Assets
2013E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
2012
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
4-18
9/21/2016
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2013E
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
2012
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-19
Income Statement
Sales
COGS
Other expenses
EBITDA
Deprec. & amort.
EBIT
Interest exp.
EBT
Taxes
Net income
2013E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2012
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-20
10
9/21/2016
An Example:
The Effects of Improving Ratios
A/R
Other CA
Net FA
TA
$ 878
1,802
817
$3,497
Debt
$1,545
Equity
Total L&E
1,952
$3,497
Sales/Day = $7,035,600/365 = $19,275.62

How would reducing the firms DSO to 32 days affect
the company?
4-21
Reducing Accounts Receivable and the Days Sales

Outstanding
Reducing A/R will have no effect on sales

Old A/R = $19,275.62 45.6
= $878,000
New A/R = $19,275.62 32.0
= $616,820
Cash freed up:
$261,180
4-22
11
9/21/2016
Effect of Reducing Receivables on Balance Sheet

and Stock Price
Added Cash
A/R
Other CA
Net FA
Total Assets
$ 261
617
1,802
817
$3,497
Debt
$1,545
Equity
Total L&E
1,952
$3,497
What could be done with the new cash?
4-23
Debt Management
4-24
12
9/21/2016
Calculate the Debt Ratio and

Times-Interest-Earned Ratio
Debt ratio= Total debt/Total assets
TIE = EBIT/Interest charges
= ($1,145 + $400)/$3,497
= $492.6/$70
= 7.0x
= 44.2%
2013E
2012
2011
Ind.
D/A
44.2%
82.8%
54.8%
50.0%
TIE
7.0x
-1.0x
4.3x
6.2x
D/A and TIE are better than the industry average.

4-25
DLeons Debt Management Ratios vs. the

Industry Averages
2013E
2012
2011
Ind.
D/A
44.2%
82.8%
54.8%
50.0%
TIE
7.0x
-1.0x
4.3x
6.2x
D/A and TIE are better than the industry average.
4-26
13
9/21/2016
Appraising Profitability with Operating Margin, Profit

Margin, and Basic Earning Power
Operating margin
Profit margin
Basic earning power
2013E 2012
7.0% -2.2%
3.6% -2.7%
14.1% -4.6%
2011
Ind.
5.6% 7.3%
2.6% 3.5%
13.0% 19.1%
4-27
Profitability
4-28
14
9/21/2016
Profitability Ratios: Operating Margin, Profit Margin,

and Basic Earning Power
Operating margin = EBIT/Sales
= $492.6/$7,036 = 7.0%
Profit margin = Net income/Sales
= $253.6/$7,036 = 3.6%
Basic earning power = EBIT/Total assets
= $492.6/$3,497 = 14.1%
4-29
Profitability Ratios: Return on Assets and Return

on Equity
ROA = Net income/Total assets
= $253.6/$3,497 = 7.3%
ROE = Net income/Total common equity
= $253.6/$1,952 = 13.0%
4-30
15
9/21/2016
Appraising Profitability with ROA

and ROE
ROA
ROE
2013E
7.3%
13.0%
2012
-5.6%
-32.5%
2011
6.0%
13.3%
Ind.
9.1%
18.2%
Both ratios rebounded from the previous year, but

are still below the industry average. More
improvement is needed.
Wide variations in ROE illustrate the effect that

leverage can have on profitability.
4-31
Effects of Debt on ROA and ROE
Holding assets constant, if debt increases:
Equity declines.
Interest expense increases
ROA declines (due to the reduction in net income).

ROE may increase or decrease
4-32
16
9/21/2016
Problems with ROE
ROE and shareholder wealth are correlated, but

problems can arise when ROE is the sole measure
of performance.
ROE does not consider risk.

ROE does not consider the amount of capital
invested.
4-33
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2013E
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
2012
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-34
17
9/21/2016
Income Statement
Sales
COGS
Other expenses
EBITDA
Deprec. & amort.
EBIT
Interest exp.
EBT
Taxes
Net income
2013E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2012
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-35
Other Data
No. of shares
EPS
DPS
Stock price
Lease pmts
2013E
250,000
$1.014
$0.220
$12.17
$40,000
2012
100,000
-$1.602
$0.110
$2.25
$40,000
4-36
18
9/21/2016
Calculate the Price/Earnings and Market/Book

Ratios
P/E = Price/Earnings per share
= $12.17/$1.014 = 12.0x
M/B = Market price/Book value per share
= $12.17/($1,952/250) = 1.56x
2013E
2012
2011
Ind.
P/E
12.0x
-1.4x
9.7x
14.2x
M/B
1.56x
0.5x
1.3x
2.4x
4-37
Analyzing the Market Value Ratios
P/E: How much investors are willing to pay for $1 of

earnings.
M/B: How much investors are willing to pay for $1

of book value equity.
For each ratio, the higher the number, the better.

P/E and M/B are high if ROE is high and risk is low.
4-38
19
9/21/2016
Du Pont Equation
4-39
The DuPont Equation

Equity
Profit
Total assets
ROE = margin turnover
multiplier
ROE = (NI/Sales) (Sales/TA) (TA/Equity)
Focuses on expense control (PM), asset utilization

(TA TO), and debt utilization (equity multiplier).
4-40
20
9/21/2016
DuPont Equation:
Breaking Down Return on Equity
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
= 3.6%
1.8
= 13.0%
2011
2012
2013E
Ind.
PM
2.6%
-2.7%
3.6%
3.5%
TA TO
2.3
2.1
2.0
2.6
EM
2.2
5.8
1.8
2.0
ROE
13.3%
-32.5%
13.0%
18.2%
4-41
Reducing Accounts Receivable and the Days Sales

Outstanding
Reducing A/R will have no effect on sales

Old A/R = $19,275.62 45.6
= $878,000
New A/R = $19,275.62 32.0
= $616,820
Cash freed up:
$261,180
Initially shows up as addition to cash.
4-42
21
9/21/2016
Effect of Reducing Receivables on Balance Sheet

and Stock Price
Added Cash
A/R
Other CA
Net FA
Total Assets
$ 261
617
1,802
817
$3,497
Debt
$1,545
Equity
Total L&E
1,952
$3,497
What could be done with the new cash?

How might stock price and risk be affected?
4-43
Potential Problems and Limitations of Financial

Ratio Analysis
Comparison with industry averages is difficult for a

conglomerate firm that operates in many different
divisions.
Different operating and accounting practices can

distort comparisons.
Difficult to tell whether a company is, on balance, in

a strong or weak position.
4-44
22
9/21/2016
More Issues Regarding Ratios
Average performance is not necessarily good,

perhaps the firm should aim higher.
Seasonal factors can distort ratios.
Inflation has distorted many firms balance sheets,

so analyses must be interpreted with judgment.
Window dressing techniques can make

statements and ratios look better than they actually
are.
4-45
Consider Qualitative Factors When Evaluating a

Companys Future Financial Performance
Are the firms revenues tied to one key customer,

product, or supplier?
What percentage of the firms business is generated

overseas?
Firms competitive environment

Future prospects
Legal and regulatory environment
4-46
23

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9/21/2016

Analysis of Financial Statements

Balance Sheet: Assets

Balance Sheet: Liabilities and Equity

Why are ratios useful?

standardize numbers and facilitate comparisons.

Common Size Statements Standardizing Financial

A common size financial statement is a standardized

A common size financial statement helps to compare

Common Size Balance

Common Size Income Statement

Five Major Categories of Ratios

DLeons Forecasted Current Ratio and Quick

(Current assets Inventorie s)

Comments on Liquidity Ratios

DLeons Inventory Turnover vs. the Industry

DLeon might have old inventory, or its control

No improvement is currently forecasted.

DSO: Average Number of Days after Making a

Collection -too slowly

Fixed Assets and Total Assets Turnover Ratios vs.

FA turnover projected to exceed the industry average.

Balance Sheet: Assets

Balance Sheet: Liabilities and Equity

Sales/Day = $7,035,600/365 = $19,275.62

Reducing Accounts Receivable and the Days Sales

Reducing A/R will have no effect on sales

New A/R = $19,275.62 32.0

Cash freed up:

Effect of Reducing Receivables on Balance Sheet

What could be done with the new cash?

Calculate the Debt Ratio and

TIE = EBIT/Interest charges

D/A and TIE are better than the industry average.

DLeons Debt Management Ratios vs. the

D/A and TIE are better than the industry average.

Appraising Profitability with Operating Margin, Profit

Profitability Ratios: Operating Margin, Profit Margin,

Profitability Ratios: Return on Assets and Return

Appraising Profitability with ROA

Both ratios rebounded from the previous year, but

Wide variations in ROE illustrate the effect that

Effects of Debt on ROA and ROE

Holding assets constant, if debt increases:

ROA declines (due to the reduction in net income).

Problems with ROE

ROE and shareholder wealth are correlated, but

ROE does not consider risk.

Balance Sheet: Liabilities and Equity

Calculate the Price/Earnings and Market/Book

Analyzing the Market Value Ratios

P/E: How much investors are willing to pay for $1 of

M/B: How much investors are willing to pay for $1

For each ratio, the higher the number, the better.

The DuPont Equation

Focuses on expense control (PM), asset utilization

Reducing Accounts Receivable and the Days Sales

Reducing A/R will have no effect on sales

New A/R = $19,275.62 32.0

Cash freed up:

Initially shows up as addition to cash.

Effect of Reducing Receivables on Balance Sheet

What could be done with the new cash?