Working With Financial Statements

1. Working With Financial Statements

2. Key Concepts and Skills • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Be able to compute and interpret the DuPont Identity • Understand the problems and pitfalls in financial statement analysis

3. Sample Income Statement Numbers in millions, except EPS & DPS

4. Sample common size Income Statement Numbers in millions, except EPS & DPS

5. Standardized Financial Statements • Common-Size Balance Sheets • Compute all accounts as a percent of total assets • Common-Size Income Statements • Compute all line items as a percent of sales • Standardized statements make it easier to compare financial information, particularly as the company grows • They are also useful for comparing companies of different sizes, particularly within the same industry

6. Common base year Income Statement

7. Combined common size and base year Balance Sheet

8. Ratio Analysis • Ratios also allow for better comparison through time or between companies • As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important • Ratios are used both internally and externally

9. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios

10. Sample Income Statement Numbers in millions, except EPS & DPS

11. Sample Balance Sheet Numbers in millions

12. Liquidity Ratios for 2007 • Current Ratio = CA / CL • 2,256 / 1,995 = 1.13 times • Quick Ratio = (CA – Inventory) / CL • (2,256 – 301) / 1,995 = .98 times • Cash Ratio = Cash / CL • 696 / 1,995 = .35 times • NWC to Total Assets = NWC / A • (2,256 – 1,995) / 5,394 = .05 • Interval Measure = CA / average daily operating costs • 2,256 / ((2,006 + 1,740)/365) = 219.8 days

13. Computing Long-term Solvency Ratios • Total Debt Ratio = (A –E) / A • (5,394 – 2,556) / 5,394 = 52.61% • Debt/Equity = D / E • (5,394 – 2,556) / 2,556 = 1.11 times • Equity Multiplier = A / E = 1 + D/E • 1 + 1.11 = 2.11 • Long-term debt ratio = LTD / (LTD + E) • 843 / (843 + 2,556) = 24.80%

14. Computing Coverage Ratios • Times Interest Earned = EBIT / Interest • 1,138 / 7 = 162.57 times • Cash Coverage = (EBIT + Depreciation) / Interest • (1,138 + 116) / 7 = 179.14 times

15. Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 2,006 / 301 = 6.66 times • Days’ Sales in Inventory = 365 / Inventory Turnover • 365 / 6.66 = 55 days

16. Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable • 5,000 / 956 = 5.23 times • Days’ Sales in Receivables = 365 / Receivables Turnover • 365 / 5.23 = 70 days

17. Computing Total Asset Turnover • Total Asset Turnover = Sales / Total Assets • 5,000 / 5,394 = .93 • It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets • NWC Turnover = Sales / NWC • 5,000 / (2,256 – 1,995) = 19.16 times • Fixed Asset Turnover = Sales / NFA • 5,000 / 3,138 = 1.59 times

18. Computing Profitability Measures • Profit Margin = Net Income / Sales • 689 / 5,000 = 13.78% • Return on Assets (ROA) = Net Income / Total Assets • 689 / 5,394 = 12.77% • Return on Equity (ROE) = Net Income / Total Equity • 689 / 2,556 = 26.96%

19. Computing Market Value Measures • Market Price = $87.65 per share • Shares outstanding = 190.9 million • PE Ratio = Price per share / Earnings per share • 87.65 / 3.61 = 24.28 times • Market-to-book ratio = market value per share / book value per share • 87.65 / (2,556 / 190.9) = 6.55 times

20. Deriving the DuPont Identity • ROE = NI / E • Multiply by 1 (A/A) and then rearrange • ROE = (NI / E) (A / A) • ROE = (NI / A) (A / E) = ROA * EM • Multiply by 1 (Sales/Sales) again and then rearrange • ROE = (NI / A) (A / E) (Sales / Sales) • ROE = (NI / Sales) (Sales / A) (A / E) • ROE = PM * TAT * EM

21. Using the DuPont Identity • ROE = PM * TAT * EM • Profit margin is a measure of the firm’s operating efficiency – how well it controls costs • Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets • Equity multiplier is a measure of the firm’s financial leverage

22. Expanded DuPont Analysis – Aeropostale Data • 2006 Inc. Statement Data (millions, $U.S.) • Sales = 1,204.35 • COGS = 841.87 • SG&A = 227.04 • Interest = (3.67) • Taxes = 55.15 • Computations • NI = 83.96 • PM = 6.97% • ROA = 16.66% • ROE = 29.49% • Bal. Sheet (1/28/06) Data (millions, $U.S.) • Cash = 225.27 • Inventory = 91.91 • Other CA = 22.16 • Fixed Assets = 164.62 • Computations • TA = 503.96 • TAT = 2.39 • EM = 1.77

23. Aeropostale Extended DuPont Chart x x   + +

24. Example : Du-Pont Identity A firm has an equity multiplier of 1.90, an asset turnover of 1.2 and a profit margin of 8%. What is the firm’s ROA, and ROE.

25. Real World Example – Home Depot • Liquidity ratios • Current ratio = 1.40x; Industry = 1.8x • Quick ratio = .45x; Industry = .5x • Long-term solvency ratio • Debt/Equity ratio (Debt / Worth) = .54x; Industry = 2.2x. • Coverage ratio • Times Interest Earned = 2282x; Industry = 3.2x

26. Real World Example – Home Depot • Asset management ratios: • Inventory turnover = 4.9x; Industry = 3.5x • Receivables turnover = 59.1x (6 days); Industry = 24.5x (15 days) • Total asset turnover = 1.9x; Industry = 2.3x • Profitability ratios • Profit margin before taxes = 10.6%; Industry = 2.7% • ROA (profit before taxes / total assets) = 19.9%; Industry = 4.9% • ROE = (profit before taxes / tangible net worth) = 34.6%; Industry = 23.7%

27. Why Evaluate Financial Statements? • Internal uses • External uses

28. Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis • Used to see how the firm’s performance is changing through time • Internal and external uses • Peer Group Analysis • Compare to similar companies or within industries • SIC and NAICS codes

29. Potential Problems • There is no underlying theory, so there is no way to know which ratios are most relevant • Benchmarking is difficult for diversified firms • Globalization and international competition makes comparison more difficult because of differences in accounting regulations • Varying accounting procedures, i.e. FIFO vs. LIFO • Different fiscal years • Extraordinary events

30. The Story of Enron Enron - a natural gas, natural gas liquids, electricity, exploration and production, operator of power plants and natural gas pipelines. Enron stock price fell from $75 to nothing due to bankruptcy. One aspect of their collapse was the way they managed to keep debt off their balance sheet and hid commitments to honor the debt. Without full disclosure, no one knew the true situation.

31. Off balance sheet practice is more common than you think • Make companies and managers look good because return on capital looks better. • Investors and regulators do not freak out when debt balloons. • Spreads confusion • These off balance sheet debt obligations are typically triggered (parent requited to pay debt) if stock falls bellow a certain level or its debt is downgraded. • That is why the SEC is taking care of these issues.

32. Quick Quiz • How do you standardize balance sheets and income statements and why is standardization useful? • What are the major categories of ratios and what are they good for? • What are some of the problems associated with financial statement analysis?

33. Comprehensive Problem • XYZ Corporation has the following financial information for the previous year: • Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M • Compute the ROE using the DuPont Analysis.

34. CASH CASH RECEIVABLES RECEIVABLES RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY Working Capital • A Simple Cycle of Operations:

36. Calculating the cash cycle Assume: AVG. Inventory – 352.5; AVG AR=285; AVG AP=235; COGS=480; Sales (all on credit) = 710 – calculate cash cycle: