Analyzing Financial Statements

1. Analyzing Financial Statements Chapter 3 ACT3211 FINANCIAL MANAGEMENT

2. ACT3211 FINANCIAL MANAGEMENT

3. Introduction • The real value of financial statements lies in the fact that managers, investors, and analysts can use the information in the statements to: • Analyze firm performance • Plan changes to improve performance • Ratio Analysis • Calculating and analyzing financial ratios to assess a firm’s performance ACT3211 FINANCIAL MANAGEMENT

4. Ratios fall into five groups: • Liquidity ratios • Asset management ratios • Debt management ratios • Profitability ratios • Market value ratios • After managers, analysts, or investors calculate a firm’s ratios they make two comparisons: • Trend – comparison to the same firm over time • Competitors – comparison to other firms in the same industry • We will use the financial statements for DPH Tree Farm to illustrate the use of ratios ACT3211 FINANCIAL MANAGEMENT

5. Table 3-1 ACT3211 FINANCIAL MANAGEMENT

6. Liquidity Ratios Liquidity ratios provide an indication of the ability of the firm to meet its obligations as they come due The three most common liquidity ratios are the current ratio, the quick (or acid-test) ratio, and the cash ratio ACT3211 FINANCIAL MANAGEMENT

7. The broadest liquidity measure is the current ratio, which measures the dollars of current assets available to pay each dollar of current liabilities Current Ratio = CA / CL • Inventory is the least liquid of the current assets, and is the current asset for which book values are the least reliable measure of market value. The quick, or acid-test ratio excludes inventory in the numerator, and measures the firm’s ability to pay off short-term obligations without relying on inventory sales: Quick Ratio = (CA – Inventory) / CL ACT3211 FINANCIAL MANAGEMENT

8. The cash ratio measures a firm’s ability to pay short-term obligations with its available cash and marketable securities Cash Ratio = Cash / CL • The liquidity ratios for DPH Tree Farm are: Current Ratio = CA / CL Current Ratio = 205 / 120 Current Ratio = 1.71 times • The industry average current ratio is 1.50 ACT3211 FINANCIAL MANAGEMENT

9. Quick Ratio = (CA – Inventory) / CL Quick Ratio = (205 – 111) / 120 Quick Ratio = 0.78 times • The industry average quick ratio is 0.50 Cash Ratio = Cash / CL Cash Ratio = 24 / 120 Cash Ratio = 0.20 times • The industry average cash ratio is 0.15 ACT3211 FINANCIAL MANAGEMENT

10. Based on all three measures, DPH has more liquidity on its balance sheet than the industry average • The more liquid assets a firm holds, the more likely the firm can pay its bills, so it has less liquidity risk. • However, liquid assets do not generate profits for the firm • Managers must consider the tradeoff of lower liquidity risk versus the disadvantages of reduced profits • Note that a firm with very predictable cash flows can safely maintain lower levels of liquidity ACT3211 FINANCIAL MANAGEMENT

11. Asset Management Ratios Asset management ratios measure how efficiently a firm uses its assets Many of these ratios are focused on a specific asset, such as inventory or accounts receivable ACT3211 FINANCIAL MANAGEMENT

12. Inventory Management • The inventory turnover ratio measures the dollars of sales produced per dollar of inventory. Often this ratio uses cost of goods sold in the numerator rather than sales since inventory is listed on the balance sheet at cost Inventory Turnover = Sales / Inventory or Inventory Turnover = Cost of Goods Sold / Inventory ACT3211 FINANCIAL MANAGEMENT

13. The days’ sales in inventory ratio measures the average number of days that inventory is held Days’ Sales in Inventory = Inventory x 365 / Sales or COGS • Firms want to turn inventory over as quickly as possible to reduce costs associated with warehousing, monitoring, insurance • A high inventory turnover ratio and a low days’ sales in inventory ratio indicate good management • However, if inventory is too low then the firm risks losing sales or running out of raw materials, so there is a tradeoff between sufficient levels of inventory versus the costs of holding too much • Note that companies with good supply chain relations can maintain lower inventory levels ACT3211 FINANCIAL MANAGEMENT

14. Accounts Receivable Management • The Average Collection Period (ACP) measures the number of days that accounts receivable are held until they are collected Average collection period (ACP) = Accounts receivable x 365 / Credit sales • The Accounts Receivable Turnover ratio measures the dollars of sales produced per dollar of accounts receivable Accounts receivables turnover = Credit Sales / Accounts Receivable ACT3211 FINANCIAL MANAGEMENT

15. Firms want to produce a high level of sales per dollar of accounts receivable, and turn accounts receivable into cash as quickly as possible • A high accounts receivable turnover ratio and a low average collection period are indicators of good receivables management • If these ratios are too ‘good’, it may indicate that credit terms are so strict that the firm may be losing sales • Managers must consider the tradeoff between increasing sales through credit terms versus the cost of high accounts receivable ACT3211 FINANCIAL MANAGEMENT

16. Accounts Payable • The Average Payment Period (APP) measures the number of days that the firm holds accounts payable before it has to extend the cash to pay for raw materials Average payment period (APP) = Accounts payable x 365 / COGS • The Accounts Payable Turnover ratio measures the dollar COGS per dollar of accounts receivable Accounts payable turnover = COGS / Accounts payable ACT3211 FINANCIAL MANAGEMENT

17. Firms want to pay for purchases as slowly as possible • Accounts payable represent a form of financing from suppliers • The more the accounts payable, the less the firm will need other costly sources of financing such as notes payable or long-term debt. • A high APP and a low accounts payable turnover ratio is generally a sign of good management • If these indicators are too ‘good’ it may indicate that the firm is abusing their credit terms and jeopardizing their relationship with suppliers ACT3211 FINANCIAL MANAGEMENT

18. Fixed Asset and Working Capital Management • The Fixed Asset Turnover ratio measures the number of dollars of sales produced per dollar of fixed assets Fixed asset turnover ratio = Sales / Fixed assets • The Sales to Working Capital ratio measures the dollars of sales produced per dollar of net working capital (NWC = current assets – current liabilities) Sales to Working Capital ratio = Sales / Working capital ACT3211 FINANCIAL MANAGEMENT

19. The higher the level of sales produced per dollar of fixed assets or working capital, the more efficiently the firm is being run. • High fixed asset turnover ratios and sales to working capital ratios are signs of good management • If these ratios are too high the firm may be close to maximum capacity and may indicate that management has not made accommodations for growth • Caution: the age of a firm’s fixed assets will affect the fixed asset turnover ratio. A firm with newer (more expensive) fixed assets may appear to have a lower turnover ratio. ACT3211 FINANCIAL MANAGEMENT

20. Total Asset Management • The Total Asset Turnover ratio measures the dollars of sales produced per dollar of total assets Total assets turnover ratio = Sales / Total assets • The Capital Intensity ratio is simply the inverse of the total assets turnover ratio and measures the dollars of total assets needed to produce a dollar of sales Capital intensity ratio = Total assets / Sales ACT3211 FINANCIAL MANAGEMENT

21. These ratios provide an indication of how efficiently assets are being utilized If the ratios are too ‘good’ however it may indicate that the firm is in danger of inventory stockouts, capacity problems, or excessively tight credit terms which might indicate poor management ACT3211 FINANCIAL MANAGEMENT

22. Asset Management Ratios for DPH Tree Farm ACT3211 FINANCIAL MANAGEMENT

23. ACT3211 FINANCIAL MANAGEMENT

24. In all cases DPH has better asset management than the industry average • Produces more sales per dollar of inventory • Collects its accounts receivables faster • Pays its accounts payables slower • Produces more sales per dollar of fixed assets, working capital, and total assets ACT3211 FINANCIAL MANAGEMENT

25. Debt Management Ratios • Debt management ratios measure the extent to which the firm uses debt (financial leverage) versus equity to finance its assets • There are two major types of debt management ratios • Ratios that measure the amount of debt • Ratios that indicate the ability of the firm to service its debt ACT3211 FINANCIAL MANAGEMENT

26. Debt vs. Equity financing • The debt ratio measures the percentage of total assets financed with debt. Debt ratio = Total debt / Total assets • The debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity financing. Debt-to-equity ratio = Total debt / Total equity ACT3211 FINANCIAL MANAGEMENT

27. The Equity Multiplier ratio measures the dollars of assets on the balance sheet for every dollar of equity financing Equity multiplier ratio = Total assets / Total equity • All three of these measures are related: Equity multiplier = 1 / (1 – Debt ratio) = Debt-to-equity ratio +1 ACT3211 FINANCIAL MANAGEMENT

28. When a firm issues debt to finance its assets it gives the debtholders first claim to a fixed amount of its cash flows • Stockholders are entitled to any residual cash flows • When the firm does well, financial leverage increases the return to stockholders since the cash flows promised to debtholders is constant • Stockholders encourage the use of debt financing up to a point • Financial leverage also increases the risk of financial distress ACT3211 FINANCIAL MANAGEMENT

29. Investors view equity financing as a ‘safety cushion’ that can absorb fluctuations in the firm’s earnings and asset values The larger the fluctuations or variability of a firm’s cash flows the greater the need for an equity cushion In deciding the level of debt versus equity financing managers must consider the trade-off between maximizing cash flows to the firm’s stockholders versus the risk of being unable to make promised debt payments ACT3211 FINANCIAL MANAGEMENT

30. Coverage Ratios • The Times Interest Earned ratio measures the number of dollars of operating earnings available to meet each dollar of interest obligations Times interest earned = EBIT / Interest expense • The Fixed Charge Coverage ratio measures the number of dollars of operating earnings available to meet the firm’s interest and other fixed charges Fixed charge coverage = Earnings available to meet fixed charges / Fixed charges ACT3211 FINANCIAL MANAGEMENT

31. The Cash Coverage ratio measures the number of dollars of operating cash available to meet each dollar of interest and other fixed charges Cash coverage ratio = (EBIT + Depreciation) / Fixed charges • These coverage measures can indicate whether a firm has taken on a debt burden that is too large • A value less than 1 means that the firm has less than $1 of earnings or cash available to pay each dollar of interest or fixed charges ACT3211 FINANCIAL MANAGEMENT

32. Example 3-3 ACT3211 FINANCIAL MANAGEMENT

33. Profitability Ratios • These ratios show the combined effect of liquidity, asset management, and debt management on the overall operating results of the firm • These ratios are closely monitored by investors • Stock prices react very quickly to unexpected changes in these ratios ACT3211 FINANCIAL MANAGEMENT

34. The Profit Margin is the percent of sales left after all firm expenses are paid Profit margin = Net income available to common stockholders / Sales • The Basic Earnings Power ratio measures the EBIT earned per dollar of assets on the balance sheet and represents the operating return on the firm’s assets irrespective of financial leverage and taxes. Basic earnings power ratio (BEP) = EBIT / Total assets • BEP is a useful ratio for comparing firms that differ in financial leverage and taxes ACT3211 FINANCIAL MANAGEMENT

35. The Return on Assets (ROA) measures the overall return on the firm’s assets, inclusive of leverage and taxes Return on Assets (ROA) = Net income available to common stockholders / Total Assets • The Return on Equity (ROE) measures the return on common stockholders’ investment Return on Equity (ROE) = Net income available to common stockholders / Common stockholders’ equity ACT3211 FINANCIAL MANAGEMENT

36. ROE is affected by net income as well as the amount of financial leverage • A high ROE is generally considered to be a positive sign of firm performance • Unless it is driven by excessively high leverage • The Dividend Payout Ratio measures the fraction of earnings paid out to common stockholders as dividends Dividend payout ratio = Common stock dividends / Net income available to common stockholders ACT3211 FINANCIAL MANAGEMENT

37. Example 3-4 ACT3211 FINANCIAL MANAGEMENT

38. Market Value Ratios While ROE is a very important financial statement ratio, it doesn’t specifically incorporate risk. Market prices of publicly traded firms do incorporate risk, and so ratios that incorporate stock market values are important. Market values reflect what investors think of the company’s future performance and risk ACT3211 FINANCIAL MANAGEMENT

39. The Market-to-Book ratio measures the amount that investors will pay for the firm’s stock per dollar of equity used to finance the firm’s assets Market-to-book ratio = Market price per share / Book value per share • Book value per share is an accounting-based number reflecting historical costs • This ratio compares the market (current) value of the firm's equity to their historical costs. • If liquidity, asset management, and accounting profitability are good for a firm, then the market-to-book ratio will be high ACT3211 FINANCIAL MANAGEMENT

40. The Price-Earnings ratio is the best known and most often quoted figure Price-earnings ratio = Market price per share / Earnings per share • Measures how much investors are willing to pay for each dollar of earnings • A high PE ratio is often an indication of anticipated growth • Stocks are classified as growth stocks or value stocks based on the PE ratio ACT3211 FINANCIAL MANAGEMENT

41. Example 3-5 ACT3211 FINANCIAL MANAGEMENT

42. DuPont Analysis NI Sales Sales TA • DuPont analysis is a decomposition model • ROA and ROE can be broken down into components in an effort to explain why they may be low (or high). • The Basic DuPont equation ROA = Profit Margin x Total asset turnover = x ACT3211 FINANCIAL MANAGEMENT

43. The ROA depends on the firm’s profit margin (which is an indicator of expense control) and total asset turnover, an indicator of how efficiently the firm manages its assets ACT3211 FINANCIAL MANAGEMENT

44. NI Sales Sales TA TA CE • The full DuPont formula looks at the decomposition of ROE: ROE = profit margin x total asset turnover x equity multiplier ROE = X X ACT3211 FINANCIAL MANAGEMENT

45. The DuPont model focuses on • Expense control (PM) • Asset utilization (TATO) • Debt utilization (EM) • Notice that the first two terms in the ROE model are the same as ROA, so: ROE = ROA x equity multiplier ACT3211 FINANCIAL MANAGEMENT

46. Example 3-6 ACT3211 FINANCIAL MANAGEMENT

47. Other Ratios • Spreading the Financial Statements • Managers, analysts, and investors often create “common size” financial statements • Balance sheet items are divided by total assets • Income statement items are divided by sales • Common size statements are conducive to: • Identifying trends for the firm • Comparisons across firms in the industry ACT3211 FINANCIAL MANAGEMENT

48. Internal and Sustainable Growth Rates • The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) Internal growth rate = (ROA x RR) / [(1-ROA) x RR] • where RR = retention ratio ACT3211 FINANCIAL MANAGEMENT

49. If the firm uses retained earnings to support asset growth, the firm’s capital structure will change over time • More equity financing and decreasing debt ratio • To maintain the same capital structure managers must use both debt and equity financing to support asset growth ACT3211 FINANCIAL MANAGEMENT

50. The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio: Sustainable growth rate = (ROE x RR) / [(1-ROE) x RR] • Combining this with the DuPont equation, the sustainable growth rate depends on four factors: • Profit margin (operating efficiency) • Total asset turnover (efficiency in asset use) • Financial leverage (using debt vs. equity to finance assets) • Profit retention (reinvestment of NI rather paying dividends) ACT3211 FINANCIAL MANAGEMENT