Chapter 3

Analysis of Financial Statements

Ratio Analysis DuPont System Effects of Improving Ratios Limitations of Ratio Analysis Qualitative Factors
3-1

Balance Sheet: Assets

Cash A/R Inventories Total CA Gross FA Less: Deprec. Net FA Total Assets 2009E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152 2008 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592
3-2

Balance Sheet: Assets

2009(E) Cash Accounts receivable Inventories $199,551 876,897 909,379 2008 $208,323 690,294 942,374

Total current assets

Gross fixed assets Less accumulated depreciation

$1,985,827
380,510 67,413

$1,840,991
317,503 54,045

Net fixed assets

Total assets

$313,097
$2,298,924

$263,458
$2,104,449
4-3

Balance Sheet: Liabilities and Equity

Short-term Borrow Accounts payable Accruals Total current liabilities 2009(E) $312,500 650,535 110,157 $1,073,192 2008 $288,798 636,318 106,748 $1,031,864

Long-term debt
Common stock (100,000 shares) Retained earnings Total equity Total liabilities and equity

656,600
550,000 19,132 $569,132 $2,298,924

410,769
550,000 111,816 $661,816 $2,104,449
3-4

Income Statement
Sales Cost of goods sold Other expenses Total operating costs excluding depreciation and amortization Depreciation and amortization EBIT Interest expense EBT Taxes (40%) Net income 2009(E) $2,069,032 1,647,925 241,490 $1,889,415 17,891 $161,726 27,434 $134,292 53,717 $80,575 2008 $2,325,967 1,869,326 287,663 $2,156,989 25,363 $143,615 31,422 $112,193 44,877 $67,316

3-5

Other Data
2009(E) EPS DPS Book value per share $0.81 $1.00 $5.69 2008 $0.67 $1.00 $6.62

Stock price
Share outstanding Tax rate

$19.20
100,000 40%

$15.60
100,000 40%
3-6

Why are ratios useful?

Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths. Ratio comparisons should be made through time and with competitors.

Trend analysis. Peer (or industry) analysis.

3-7

Five Major Categories of Ratios and the Questions They Answer

Liquidity: Can we make required payments? Asset management: right amount of assets vs. sales? 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?
3-8

Everelites Forecasted Current Ratio and Quick Ratio for 2009

Current assets Current ratio = Current liabilities $1,986 = $1,073 =1.85x
Quick ratio = (Current assets - Inventories) Current liabilities ($1,986 - $909) = $1,073 =1.00
3-9

Comments on Liquidity Ratios

2009E Current ratio Quick ratio 1.85x 1.00x 2008 1.78x 0.87x 2007 2.02x 1.14x Ind. 2.05 1

Expected to improve but still below the industry average. Liquidity position is weak.
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Everelites Inventory Turnover vs. the Industry Average Inventory turnover09 = Sales/Inventory = $2,069/$909 = 2.28
2009E Inventory turnover 2.28x 2008 2007 Ind.

2.47x 3.10x 6.1

3-11

Comments on Inventory Turnover

Inventory turnover is below industry average. Everelite might have old inventory, or its control might be poor. No improvement is currently forecasted.

3-12

DSO: Average Number of Days after Making a Sale before Receiving Cash
DSO = Receivables/Avg. sales per day = Receivables/(Annual sales/365) = $876/($2,069/365) = 154.69 days

3-13

Appraisal of DSO
2009E DSO 2008 2007 Ind.

154.69x 108.32x

135.60x

56

Everelite collects on sales too slowly, and is getting worse. Everelite has a poor credit policy.

3-14

Fixed Assets and Total Assets Turnover Ratios vs. the Industry Average
FA turnover = Sales/Net fixed assets = $2,069/$313 = 6.61

TA turnover = Sales/Total assets = $2,069/$2,299 = 0.90

3-15

Evaluating the FA Turnover and TA Turnover Ratios

2009E FA TO TA TO 6.61x 0.90x 2008 8.83x 1.11x 2007 11.22x 1.21x Ind. 9.3 2.1

FA turnover projected to be still below the industry average. TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).
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Calculate the Debt Ratio and Times-Interest-Earned Ratio

Debt ratio = Total debt/Total assets = ($1,073 + $657)/$2,299 = 75.25% TIE = EBIT/Interest expense = $161.7/$27.4 = 5.90

3-17

Everelites Debt Management Ratios vs. the Industry Averages

2009E 2008 2007 Ind.

D/A TIE

75.24% 68.55% 64.50% 50.00% 6.2 5.90x 4.57x 19.17x

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

3-18

Profitability Ratios: Operating Margin, Profit Margin, and Basic Earning Power
Operating margin09= EBIT/Sales = $161.7/$2,069 =7.82%. Profit margin09= Net income/Sales = $80.5/$2,069 = 3.89%. Basic earning power09=EBIT/Total assets = $161.7/$2,299 = 7.03%.
3-19

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power
2009E 2008 2007 Ind. 7.82% 6.17% 11.91% 13% 3.89% 2.89% 6.78% 9.00% 7.03% 6.82% 14.38% 15.00%

Operating margin Profit margin Basic earning power

3-20

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power

Operating margin was very bad in 2008. It is projected to improve in 2009, but it is still projected to remain below the industry average. Profit margin was very bad in 2008. It is projected to improve in 2009, but it is still projected to remain below the industry average. BEP removes the effects of taxes and financial leverage, and is useful for comparison. BEP projected to improve, yet still below the industry average. There is definitely room for improvement.
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Profitability Ratios: Return on Assets and Return on Equity

ROA = Net income/Total assets = $80.5/$2,299 = 3.50%

ROE = Net income/Total common equity = $80.5/$569 = 14.16%.

3-22

Appraising Profitability with ROA and ROE

ROA ROE 2009E 2008 2007 Ind. 3.50% 3.20% 8.18% 6.50% 14.16% 10.17% 23.03% 12.00%

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.
3-23

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 also lowers equity, hence debt could raise ROE = NI/Equity.

3-24

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. decisions that do not benefit shareholders.

Might encourage managers to make investment

ROE focuses only on return and a better measure would consider risk and return.
3-25

Calculate the Price/Earnings and Market/Book Ratios

P/E = Price/Earnings per share = $19.20/$0.81 = 23.70 M/B = Market price/Book value per share = $19.20/$5.69 = 3.37

P/E M/B

2009E 23.83x 3.37x

2008 23.17x 2.36x

2007 14.49x 3.34x

Ind. 10.00 3.00

3-26

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.

3-27

The DuPont System

ROE Profit margin Equity Total assets turnover multiplier

ROE (NI/Sales) (Sales/TA) (TA/Equity )

Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier).
3-28

DuPont Equation: Breaking Down Return on Equity

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) =3.89% 0.90 1/(1 0.7524) = 14.16%. PM TA TO 6.78% 1.21 2.89% 1.11 3.89% 0.90 EM 2.82 3.18 4.04 ROE 23.03% 10.17% 14.16%
3-29

2007 2008 2009E

An Example: The Effects of Improving Ratios

A/R Other CA Net FA TA $ 877 1,109 313 $2,299 Debt Equity Total L&E $1,730 569 $2,299

Sales/Day = $2,069/365 = $5.67

How would reducing the firms DSO to 56 days affect the company?
3-30

Reducing Accounts Receivable and the Days Sales Outstanding

Reducing A/R will have no effect on sales. Accounts receivable under new policy = $5.67 56 days= $377.44. Freed cash= old A/R new A/R = $876.86 $377.44 = $559.42 Initially shows up as addition to cash.
3-31

Effect of Reducing Receivables on Balance Sheet and Stock Price

What could be done with the new cash?
How might stock price and risk be affected?

3-32

Potential Uses of Freed up Cash

Repurchase stock Expand business Reduce debt All these actions would likely improve the stock price.

3-33

Potential Problems and Limitations of Financial Ratio Analysis

Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Average performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better.

3-34

More Issues Regarding Ratios

Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is good or bad. Difficult to tell whether a company is, on balance, in strong or weak position.

3-35

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? The firms competitive environment Future prospects Legal and regulatory environment

3-36