Investment Analysis

CHAPTER 14: Company Analysis

CSI Global Education Inc.

Chapter Highlights
The focus of this chapter is company analysis through the use of financial ratios. The objective: utilizing the tools of investment analysis for better security selection decisions.

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Ratio Analysis
A ratio shows the relationship between two numbers, in which a number is usually related to 1, e.g., 2.2 to 1 or 2.2:1. The four general categories of ratios are: Liquidity Ratios: used to judge a companys ability to meet its short-term commitments.

Risk Analysis Ratios: show how well a company can deal with its debt obligations.
Operating Performance Ratios: illustrates how well management has made use of the companys resources.

Value Ratios: shows the market worth of the companys shares or the return on owning them.

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Current Ratio (or Working Capital)

Purpose:

Assess liquidity (the ability to meet short-term financial obligations)

Formula:
Current Assets Current Liabilities

2:1 is a suggested or recommended level. But depends on type of business and industry.

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Quick Ratio or Acid Test

Purpose:

More stringent test of liquidity

Formula:
Current Assets Inventory Current Liabilities

1:1 is the suggested or industry recommended level. But depends on type of business and industry.

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Operating Cash Flow Ratio

Purpose:

Assess companys ability to generate cash from its day-to-day operations.

Cash Flow from Operations Current Liabilities Formula:

If the ratio falls below 1, the company is not generating enough cash from its operations to cover its current obligations.

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Liquidity Questions
Use the following information to answer the questions below.
Year 1 Year 2 Year 3 Year 4 Year 5

Current Ratio Quick Ratio

2.75x 1.13x

2.55x 1.06x

2.15x 1.00x

1.90x 1.02x

1.65x 1.05x

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Liquidity Questions
1. Evaluate the companys liquidity position.

2. A large debt payment becomes due next year. What impact will this have on its Current Ratio?
3. If the company wrote down its inventory value due to obsolescence, what impact will it have on the Current and Quick Ratios?

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Liquidity Questions
1. Evaluate the companys liquidity position. Deterioration in liquidity in all years. Current Ratio declined from an acceptable level of 2.75x in Year 2 to an unacceptable 1.65x in Year 5.

Quick Ratio, which is a more stringent measure, was always just above the ROT of 1x.
Quick Ratio declined from 1.13x to 1.00x in Year 3 and improved slightly to 1.05x by Year 5.

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Liquidity Questions
2. A large debt payment becomes due next year. What impact will this have on its Current Ratio? A large debt payment due would increase Current Liabilities. This would cause a decrease in the value of the Current Ratio if all other items were relatively unchanged.

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Liquidity Questions
3. If the company wrote down its inventory value due to obsolescence, what impact will it have on the Current and Quick Ratios? A writedown of the value of Inventory reduces the Current Ratio because the value of current assets declines. The Quick Ratio would not change because inventory is excluded from the calculation.

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Risk Analysis Ratios

Focus: analyze the riskiness of a company.

1. Is the debt level reasonable?

2. What is the companys ability to pay interest, as measured through the interest coverage ratio 3. What is the companys ability to repay its debt, as measured through asset coverage & cash flow to total debt ratios

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Asset Coverage Ratio

Purpose:

Assess debtholder protection provided by the companys tangible assets after removing all liabilities
Formula:
Total Assets Def. Charges Intangible Assets (Current Liabilities Less S hor t Term Debt) Total Debt (i.e. LTD + S TD)/1000

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Asset Coverage
Industry standards for this ratio vary due, in part, to the stability of income provided by the company. Utilities, for example, have a fairly stable source of income as they are characterized by heavy investment in permanent property, which accounts for a large part of their total assets.

They are also subject to regulation, which ensures the utility a fair return on its investment.

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Percentage of Total Capital Ratios

Purpose:

Asses the companys capitalization between debt and equity

Assess debtholder protection Formula: Invested Capital = ST Debt + LT Debt + All Equity = Total Debt + Total Shareholders Equity

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Percentage of Total Capital Ratios

% capital attributable to debtholders
S TD + LTD Inv. Capital

Although no general rule is used to determine what constitutes acceptable capitalization, the higher the proportion of debt the greater the financial riskiness of the company.

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Percentage of Total Capital Ratios

% capital attributable to preferred shareholders

Pref'd S hares Inv. Capital

% capital attributable to common common shareholders

S hareholders' Equity Preferred S hares Invested Capital

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Debt/Equity Ratio
Purpose:

Shows the proportion of borrowed funds used relative to the investments made by shareholders in the company.
Formula:
Total Debt (S TD + LTD) Book Value of Equity

If the debt burden is too large, it reduces the margin of safety protecting debtholders capital. Financial risk also increases.

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Cash Flow/Total Debt

Purpose:

Measure of ability to repay borrowed funds

Formula: Cash flow from operations Total debt outstanding Where cash flow = earnings before extraordinary items equity income + non-controlling interest in subsidiaries + deferred taxes + amortization + other noncash expenses + net change in working capital requirements Or, simply use cash flows from operating activities (CFO) from the cash flow statement.

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Interest Coverage
Purpose:

Measure of ability to pay interest on debt

Formula:

Net Earnings B4 Ext. Items Equity Income + Minority Int. in Earnings of Subsid. + All Inc. Taxes + Total Int. Charges Total Interest Charges

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Interest Coverage
The formula can be shortened to:

EBIT Interest Charges

Where EBIT = earnings before interest and taxes Standards vary from industry to industry. Key ratio for rating agencies.

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Preferred Dividend Coverage

Purpose:

Measure of ability to pay dividends (margin of safety)

Formula: Net Earnings B4 Ext. Items Equity Income + Minority Int. in Earnings of S ubsid. + All Inc. Taxes + Total Int. Charges Total Interest Charges + Preferred Dividend Payment B4 Tax or EBIT / Total interest charges + pref div payments

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Preferred Dividend Coverage (continued)

Look at the trend for the last five years - rising or stable trend is preferred. Analysts check that year-to-year coverage figures are above required minimums. If so, preferred dividend payments are likely to be continued without undue financial strain.

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Risk Analysis
Use the following information to answer the questions below.
Year 1 Year 2 Year 3 Year 4 Year 5

Debt/Equity Interest Cov Asset Cov

35% 3.22x $2,500

33% 3.31x $2,700

27% 3.52x $2,900

45% 3.30x $2,200

42% 3.45x $2,300

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Risk Analysis
1. Assess the debt protection offered by the company.

2. Determine the impact on a companys debt ratios in each of the following scenarios.
a) The economy is in recession and net income declines. Tolerance level increases. When Income drops lower, there are people may go bankrupt because they are not able to pay the interest. b) The company completes a large equity issue.

It decreases

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Risk Analysis
a) Assess the companys debt protection. This company offers acceptable debt protection in all three areas and for all years. All ratios improved from Year 1 to Year 3 but then worsened in Year 4. The company most likely issued additional debt in Year 4. However, the ratios show improvement between Years 4 and 5.

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Risk Analysis
b) If the companys net income position declines over the year, what impact will this have on each of the ratios? Interest coverage will deteriorate due to the decrease in net income. Cash flow to total debt will deteriorate due to the decrease in net income. The other ratios should not change substantially unless the lower cash flow necessitates additional financing. Debt/equity will likely deteriorate because the loss in net income will likely reduce retained earnings and therefore, total shareholders equity.

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Risk Analysis
c) The company completes a large equity issue. Debt/equity and Debt as % of invested capital will improve. Asset coverage will improve if the new equity is used to finance assets rather than repay debt.

Interest coverage and cash flow should improve if the new equity generates additional earnings.

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Operating Performance Ratios

Purpose:

Measure of the profit left after various expenses.

Shows how well management used the companys resources. Used to compare to others in industry and historic performance.

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Operating Performance Ratios (continued)

Gross Profit Margin:

Net S ales Cost of Goods S old Net S ales

Operating Profit Margin:

Net S ales COGS (S elling, Admin, General Expenses) Net S ales

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Operating Performance Ratios (continued)

Pre-Tax Profit Margin:
Net Income Before Tax Net S ales

Net Profit Margin:

Net Earnings B4 Ext. Items Equity Income + Min. Int. in S ubsid. Net S ales

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Pre-Tax Return on Invested Capital

Purpose:

Measure how well management has used invested capital.

Formula:
Net Earnings (B4 Ext. Items) + Income Tax + Total Interest Charges Invested Capital

Invested capital = ST debt + LT debt + shareholders equity

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Inventory Turnover
Purpose:

Measures amount of inventory in relation to sales.

Formula:
Cost of Goods S old Inventory OR Net S ales Inventory

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Inventory Turnover
Discussion: What is preferred - a high or low ratio?

What are reasons for a low inventory turnover?

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Value Ratios
Ratios used to assess the value of a stock in relation to its price.

Used to relate a stocks price to dividends and earnings.

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Percentage Dividend Payout Ratios

Purpose:

Measures extent that profits were paid to shareholders.

Formulas:
Total Dividends (Preferred + Common) Net Earnings Before Extraordinary Items

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Percentage Dividend Payout Ratios

Formula for Payout on Common:

Total Dividends on Common Net Earnings Before Extr. Items Pr eferred Dividend

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Earnings Per Common Share

Purpose:

Measures earnings available to each common share.

Formula:
Net Earnings (B4 Ext. Items) Pref'd Dividends Number of Common S hares Outstanding

What about on a diluted basis? What is the impact?

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Dividend Yield
Purpose:

Measures investors % return on investment from dividends.

Formula:

Annual Div. Per S hare Current Market Price

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Price-Earnings Ratio
Purpose:

Used to show how much an investor is paying for a companys earnings.

Allows a common comparison between others in the same industry. Formula: Current Market Price of Common Earnings Per S hare Over Last 12 Months

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Price-Earnings Ratio
Purpose:

Helps to evaluate stock value over market cycle.

P/Es in increasing stock market. P/Es in decreasing stock market.

High growth companies tend to have higher P/Es than low growth companies.

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Enterprise Multiple
Purpose:

Provides a measure of overall value; a reflection of what it would cost to purchase the company as a whole.
Formula:
MV common + MV preferred + MV debt + Minority Interest (Cash + Investments) Net Earnings + Int Exp + Taxes + Amortization

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Equity or Book Value Per Preferred & Common Shares

Purpose: Assess preferred shareholders protection Formula:
Pref'd + Common S hare Capital + Contributed S urplus + Retained Earnings + Foreign Exchange Adjustments Preferred S hares Outstanding

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Common
Purpose:

Assess common shareholders protection

Formula:

Common S hare Capital + Contributed S urplus + Retained Earnings + Foreign Exchange Adjustments Number of Common S hares Outstanding

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Investment Quality of Preferreds

There are four tests to consider:

1. Preferred Dividend Coverage

Is income sufficient to pay the dividend Is it stable and rising 2. Record of Continuous Dividend Payments 3. Equity Per Preferred Share

Is equity adequate to repay the par value of the preferred

4. Independent Credit Assessment
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Investment Quality Decision

Evaluate the investment quality of the preferred shares of the following industrial company:
Year 1 Year 2 Year 3 Year 4 Year 5

Dividend Coverage Equity Per Preferred

2.65x 12.5x

2.86x

2.99x

3.15x

3.42x

11.65x 11.35x 10.95x 10.75x

Has paid dividends in every quarter since issued except for two quarters in Year 5 that were paid in Q4. The S&P rating is Pfd-3.

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Investment Quality Decision

Preferred Dividend Coverage

Steady improvement over 5 years

Dividend Payment Continuous for last 5 years Equity per Preferred Share Significant, declining but still very high Credit Assessment Pfd-3 rating is a medium quality Overall: medium quality; coverage now acceptable; equity very high; dividend record OK
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