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Analysis of Financial Statements

Chapter 4. Analysis of Financial Statements. Ratio Analysis DuPont Equation Effects of Improving Ratios Limitations of Ratio Analysis Qualitative Factors. Why are ratios useful?. Ratios standardize numbers & facilitate comparisons Ratios are used to highlight weaknesses & strengths

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Analysis of Financial Statements

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  1. Chapter 4 Analysis of Financial Statements Ratio Analysis DuPont Equation Effects of Improving Ratios Limitations of Ratio Analysis Qualitative Factors

  2. Why are ratios useful? • Ratios standardize numbers & facilitate comparisons • Ratios are used to highlightweaknesses & strengths • Comparisons through time & with competitors • Trend analysis • Industry analysis • Benchmark (peer) analysis

  3. 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 & equity? • Profitability: Do sales prices exceed unit costs & 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?

  4. 2013E 2012 Cash 85,632 7,282 878,000 632,160 A/R Inventories 1,716,480 1,287,360 2,680,112 1,926,802 Total CA 1,197,160 1,202,950 Gross FA Less: Deprec. 380,120 263,160 817,040 939,790 Net FA Total Assets 3,497,152 2,866,592 Balance Sheet: Assets

  5. 2013E 2012 Accts payable 436,800 524,160 Notes payable 300,000 636,808 Accruals 408,000 489,600 Total CL 1,144,800 1,650,568 Long - term debt 400,000 723,432 Common stock 1,721,176 460,000 Retained earnings 231,176 32,592 Total Equity 1,952,352 492,592 Total L & E 3,497,152 2,866,592 Balance Sheet: Liabilities & Equity

  6. 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)

  7. 2013E 2012 No. of shares 250,000 100,000 EPS $1.014 - $1.602 DPS $0.220 $0.110 Stock price $12.17 $2.25 Lease pmts $40,000 $40,000 Other Data

  8. Liquidity Ratios

  9. Current Ratio & Quick Ratio Forecasted for 2013

  10. Comments on Liquidity Ratios • Expected to improve but still below industry average • Liquidity position is weak. • Too high Current Ratio could indicate: • A strong liquid position & inefficient utilization • too much cash & other current assets relative to sales • The firm has lots of inventory that it can’t sell

  11. Asset management Ratios

  12. Inventory Turnover vs. the Industry Average Inv. turnover = Sales/Inventories = $7,036/$1,716 = 4.10x Measures how much inventory item is sold & restocked, or “turned over”

  13. Comments on Inventory Turnover • Inventory turnover is below industry average • Might have old inventory, or its control might be poor • Inventory is not a good investment if there is no demand • No improvement is currently forecasted • Why would the inventory turnover ratio be more important for a company like Sultan Center than it is for Kuwait Insurance Company?

  14. 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

  15. Appraisal of DSO • Collects on sales too slowly, and is getting worse • Has a poor credit policy

  16. Example

  17. Fixed Assets & Total Assets Turnover Ratios FA turnover = Sales/Net fixed assets = $7,036/$817 = 8.61x TA turnover = Sales/Total assets = $7,036/$3,497 = 2.01x

  18. FA & TA Turnover (S/TA) vs. the Industry Average • FA turnover projected to exceed the industry average • TA turnover below the industry average. • Caused by excessive currents assets (A/R & Inventory)

  19. Debt management Ratios

  20. Debt & Risk Why firm use debt? • If a firm earns more on its assets than its debt, it will be able to leverage up the ROE • However, debt is more risky than equity

  21. Debt Ratio & Times-Interest-Earned Ratio Debt ratio = Total debt/Total assets = ($1,145 + $400)/$3,497 = 44.2% TIE = EBIT/Interest charges = $492.6/$70 = 7.0x

  22. Debt Management Ratios vs. Industry Averages • D/A & TIE are better than the industry average • Allow a firm to borrow cheaply

  23. Profitability Ratios

  24. Profitability Ratios • BEP removes the effects of taxes & financial leverage • Shows earning power before the effect of debt & taxes • Useful for comparing firms with different debt structures

  25. Appraising Profitability • Operating margin was very bad in 2012. • Projected to improve in ‘13, but it is still remain below ind avg • Profit margin was very bad in 2012 but is projected to exceed the industry average in 2013. Looking good • BEP projected to improve, yet below the industry average. • There is definitely room for improvement

  26. Profitability RatiosReturn on Assets & Return on Equity ROA = Net income/Total assets = $253.6/$3,497 = 7.25% Sometimes can be low because of the high use of debt • Need to look at the big picture not just one ratio ROE = Net income/Total common equity = $253.6/$1,952 =12.99%  13.00% ROIC = [EBIT(1  T)]/Total invested capital = $295.6/$2,652.4 = 11.14% • ROE is the most important ratio

  27. Appraising Profitability • All ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. • More improvement is needed • Wide variations in ROE illustrate the effect that leverage can have on profitability

  28. Profitability Ratios • Why does the use of debt lower the profit margin & ROA? • Why doesn’t debt have the same effect on the ROE? Debt Lower net income, but its lower firm’s equity, and equity reduction can offset the lower net income

  29. Effects of Debt on ROA & ROE • Holding assets constant, if debt increases: • Equity declines • Interest expense increases • Which leads to a reduction in net income. • ROA declines (due to the reduction in net income). • ROE may increase or decrease • since both net income a& equity decline

  30. Problems with ROE • ROE & shareholder wealth are correlated • Problems can arise when ROE is the sole measure of performance: • ROE does not consider risk • Does not consider the amount of capital invested • Managers turn down profitable projects • So, reliance on ROE may encourage managers to make investments that do not benefit shareholders.

  31. Example

  32. Example

  33. Market value Ratios

  34. Price/Earnings & 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

  35. 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 • Either high growth, low risk, or both • P/E &M/B are high if ROE is high & risk is low.

  36. Example

  37. The DuPont Equation • Focuses on expense control (PM), asset utilization (TA TO) & debt utilization (equity multiplier) Why do we break it up? • To better understand the ROE comes from &find any areas for improvement

  38. Suppose you were comparing Gap with Louis Vuitton. Suppose further both firms had the same ROE. Using the DuPont equation, would you expect the three components to be the same for both firms? Profit Margins & turnover ratios vary from one industry to another.

  39. ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) = 3.6% x 2 x 1.8 = 13.0% DuPont Equation: Breaking Down Return on Equity

  40. Example

  41. Example

  42. An Example:The Effects of Improving Ratios A/R $ 878 Debt $1,545 Other CA 1,802 Net FA 817 Equity 1,952 TA $3,497 Total L&E $3,497 Sales/Day = $7,035,600/365 = $19,275.62 How would reducing the firm’s DSO to 32 days affect the company?

  43. Reducing Accounts Receivable & Days Sales Outstanding • Reducing A/R will have no effect on sales • Initially shows up as addition to cash.

  44. Effect of Reducing Receivables on Balance Sheet and Stock Price Added Cash $ 261 Debt $1,545 A/R 617 Other CA 1,802 Net FA 817 Equity 1,952 Total Assets $3,497 Total L&E $3,497 What could be done with the new cash? How might stock price and risk be affected?

  45. Potential Uses of Freed Up Cash • Repurchase stock • Expand business • Reduce debt • All these actions would likely improve the stock price

  46. Benchmarking • Ratios are not compared to industry average • Instead to specific companies • Very comparable • Industry leaders

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