Financial Statements Analysis Tools

1. Chapter 4 Financial Statements Analysis Tools Ratio analysis The six major categories of ratios The du Pont Analysis Economic Value Added EVA

2. Why Analyze Financial Statements • Important to both internal & external purposes: • Internal: identify weakness and emphasize strength, set goals, evaluate performance of managers • External: • Credit analyst/lenders: help them assess the firms ability to repay its debts and monitor the financial performance. • Stock analyst: help assess the firms efficiency, risk, and growth prospective • Thus, the analysis of fin. statements should involves • Overtime analysis: Evaluate the trends in the firm’s financial position over time-overtime • Benchmark (peer) analysis: Comparing the firms performance to the industry or top firms in the same industry

3. Analyzing Financial Statement • Three common way to perform such analysis: • Ratio Analysis • Common Size Analysis • Percentage Change Analysis

4. Ratio Analysis Ratio is comparing two numbers by division (fraction) The great advantage of the ratio analysis is that it is a measure of a relative size. Thus, using it makes it easier to compare to pervious time periods or other firms than if we used changes in dollar amounts.

5. Six Major Categories of Ratios • Liquidity Ratios: • The speed to convert asset to cash without discounts to value • Asset management Ratio (Efficiency Ratio): • Right amount of assets vs. sales? • Debt management Ratio (Leverage Ratios): • Right mix of debt and equity? • Coverage ratios • Is there enough funds to cover certain expenses, such as interest? • Profitability Ratios: • How profitable is the firm after taking care of all its obligations. • Market Value Ratios: • Incorporates the market stock price

6. 1. Liquidity Ratios What do think will happen to both ratios if we sold inventory with cash or on-credit (holding every thing constant)?

7. 2. Asset Management Ratios (Efficiency) Inventory turnover = Sales/Inventories A/R turnover = Sales/ AR Average collection time (Days sales outstanding) = AR / (Sales/360) Fixed asset turnover = Sales/ FA Total assets turnover= Sales/ TA

8. 3. Leverage Ratios (Debt Ratios) • Debt is an important source of funds: • Too much debt  increase financial distress risk, bankruptcy risk, default risk (especially in bad economic condition). • Few debt • Could come at the expense of lower ROE. • Conservative managements • Also, one important issue why firms should consider debt financing is that • Interest payments are also considered as a tax shield where it reduces the taxable income.

9. Illustration

10. Cont’d Illustration

11. 3. Leverage Ratios (Debt Ratios) Debt ratio = Total debt (TA-TE)/Total assets Long -term debt (LTD) ratio= LTD/Total assets Debt- to-equity = Total Debt / (Total common Equity+ Preferred stocks) Debt-to-capital = Debt/(Debt + Common Equity + Preferred stock) = Debt / Investor Supplied Capital (ISC) Long -term debt-equity= LTD/ (Total common Equity+ Preferred stocks)

12. 4. Coverage Ratio Time Interest Earned (TIE) Ratio TIE = EBIT/Interest charges Cash coverage ratio = EBIT + noncash expenses/Interest charges Noncash expenses such as depreciation These ratio shows how many time can operating income decline before the firm default on its debt. Note use EBIT not NI coz interest payment is using a pretax dollars

13. 5. Profitability Ratios Gross profit margin = Gross profit / Sales Operating profit margin = EBIT/ Sales Net profit margin = NI / Sales Return on Total Assets (ROA)= NI/ TA Return on Equity (ROE) = NI / Total Equity (Common stock + RE) Return on common equity = NI-Preferred dividends / Total Equity Reflects the firms operating costs Reflects the heavy use of debt

14. Should managers strive to max ROE? ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. • ROE does not consider risk • Firm1: expected ROE 10% and CF are quite stable over time. • Firm2: expected ROE 18%, but CF are risky  there is possibility that ROE might not materialized. If ROE was achieved, manager1 could receive less compensation than manager2 even though manager1 adds more value to shareholders. • Thus, compensating managers based on ROE is not always right.

15. Should managers strive to max ROE? ROE does not consider the amount of capital invested. Project1: expected ROE 10%, but requires investment of $200,000 to earn that ROE Project2: expected ROE 10% but requires investment of $2,000,000 to earn that ROE So if we are looking at only ROE to assess projects, we will not be able to see how much money these projects requires us to put upfront.

16. Should managers strive to max ROE? • Reliance on ROE to evaluate managers may encourage managers to make decisions that do not benefit shareholders in the long run. • If mangers are compensated if they reach the targeted ROE for this year of 40%, • And managers have an opportunity to invest in a low risky project that produce 15% ROE and the cost of capital is only 10%. (project is very much profitable) • Managers will be reluctant to invest in such project because that will lower their average ROE and thus year-end bonus.

17. 6. Market Value Ratios • Shows what the investors think about the firm & it operations 1- P/E = Market Price/Earnings per share = Market Price/(NI/ number of share outstanding) 2- M/B= Market price of shares/Book value of total Equity per share = (Price of share X number shares outstanding)/ (Total Equity / number of shares outstanding)

18. The DuPont Equation • Focuses on expense control (PM), • asset utilization (TATO), and • debt utilization (equity multiplier). • If the firm is financed by only equity and debt, then DR = 1 – (1/EM) = 1 – (E/TA) = (TA – E) / TA = D/TA • High EM  high DR • EM is always>1 if the firm is financed with debt

19. Altman Z-score • It is a model to predict the possibility the firm is going to experience financial distress or possible bankruptcy next year. • The Idea behind that model is as follows: • If the firm scores above the threshold, it is safe • If the firm score below the threshold, the model predict that it will face bankruptcy within a year. • If the firm scores in between, it is in the “gray zone”

20. Altman Z-score • The models: one for public and the other for private firms. • Publicly Firms: • Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5 • If Z<1.81  Bankruptcy predicted within one year • If 1.81<Z<2.675  Financial distress, possible BR • If Z>2.675  No financial distress predicted • Private Firms: • Z’ = .717 X1 + .847 X2 + 3.107 X3 + .42 X4 + .998 X5 • If Z’<1.21  Bankruptcy predicted within one year • If 1.23<Z’<2.90  Financial distress, possible BR • If Z’>2.90  No financial distress predicted

21. Comparison and Analysis • Calculating the Ratio is meaningless task if do not know how to them. • Thus, to make meaningful decisions and conclusions using these ratio, we must not draw conclusions by looking at a single number. • We should: • Compare the ratio with previous periods for the firm to examine and identify trends overtime (Trend Analysis) • Note that we need to be extra cautious if we have seasonality. • Compare ratios to an industry average ratios or a peer firm ratio.

22. Economic Value Added (EVA) • This is also called Economic Profit. • It measures the profit in excess of the firm’s both explicit and implicit costs. • Explicit cost : depreciation, interest rates, taxes,…etc. • Implicit cost: cost of equity, cost of preferred stock • On the other hand, Accounting profit (NI) provides us with the profit in excess of only the explicit costs. • Thus, the benefit of the EVA : • If +, then shareholders wealth will increase • If -, shareholder wealth will decrease. • This is because, in order to increase S/H wealth (the ultimate goal for managers), the firm must cover all costs, including the implicit ones (cost of capital provided to the firm).

23. Economic Value Added (EVA) EVA or EP = NOPAT – (ISC x WACC) Where NOPAT = EBIT (1-T) ISC: investor supplied capital (interest-bearing debt + preferred equity + common equity)

24. 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. • Different depreciation and inventory methods. • Sometimes it is hard to tell if a ratio is “good” or “bad.” • High current ratio may indicate strong liquidity position (good), but it can also indicate excessive cash or inventory (bad). • Inflation and leasing my cause misinterpretation to financial ratios • If the firm has sales that are seasonal, thus, measuring ratios during out-of –season will be misleading.