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CHAPTER 3

CHAPTER 3. Analysis of Financial Statements. Topics in Chapter. Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors. Financial Analysis Procedure. Examine the statement of cash flows Return on invested capital (ROIC) vs. WACC

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CHAPTER 3

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  1. CHAPTER 3

    Analysis of Financial Statements
  2. Topics in Chapter Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors
  3. Financial Analysis Procedure Examine the statement of cash flows Return on invested capital (ROIC) vs. WACC Ratio Analysis
  4. Why ratio analysis (1)
  5. Why ratio analysis (2)
  6. Why ratio analysis (3) Ratios facilitate comparison of: One company over time One company versus other companies Ratios are used by: Lenders to determine creditworthiness Stockholders to estimate future cash flows and risk Managers to identify areas of weakness and strength
  7. Income Statement
  8. Balance Sheets: Assets
  9. Balance Sheets: Liabilities & Equity
  10. Other Data
  11. Liquidity Ratios Can the company meet its short-term obligations using the resources it currently has on hand?
  12. $2,680,112 $1,039,800 CA CL CR11= = = 2.58. CA - Inv. CL QR11= $2,680,112 - $1,716,480 $1,039,800 = = 0.93. Current and Quick Ratios
  13. Comments on CR and QR Expected to improve but still below the industry average. Liquidity position is weak.
  14. Asset Management Ratios How efficiently does the firm use its assets? How much does the firm have tied up in assets for each dollar of sales?
  15. Sales Inventories Inv. turnover = = = 4.10. $7,035,600 $1,716,480 Inventory Turnover Ratio vs. Industry Average
  16. Comments on Inventory Turnover Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted. 2011 2010 2009Ind. Inv. T. 4.1 4.5 4.8 6.1
  17. Receivables Average sales per day DSO = = = = 45.5 days. $878,000 $7,035,600/365 Receivables Sales/365 DSO: average number of days from sale until cash received. (or ACP)
  18. 2011 2010 2009 Ind. DSO 45.5 39.5 37.4 32.0 Appraisal of DSO Firm collects too slowly, and situation is getting worse. Poor credit policy.
  19. Fixed assets turnover Sales  Net fixed assets = = = 8.41. $7,035,600 $836,840 Fixed Assets and Total AssetsTurnover Ratios (1) Total assets turnover Sales Total assets = = = 2.00. $7,035,600 $3,516,952
  20. Fixed Assets and Total AssetsTurnover Ratios (2) FA turnover exceed industry average. Good. TA turnover not up to industry average. May be caused by excessive current assets (A/R and inventory).
  21. Debt Management Ratios Does the company have too much debt? Can the company’s earnings meet its debt servicing requirements?
  22. Total liabilities Total assets Debt ratio = = = 43.8%. $1,039,800 + $500,000 $3,516,952 Debt Ratio
  23. Debt to Equity Ratio Debt to equity ratio = Total liabilities/(Total assets – Total liabilities)
  24. EBIT Int. expense TIE = = = 6.3. $502.6 $80 Times-interest-earned (TIE)(all numbers are in thousand in following slides)
  25. 2011 2010 2009 Ind. D/A 43.8% 80.7% 54.8% 50.0% TIE 6.3 0.1 3.3 6.2 Debt Management Ratios vs. Industry Averages
  26. Profitability Ratios What is the company’s rate of return on: Sales? Assets?
  27. NI Sales EBIT Sales $503 $7,036 $253.6 $7,036 NPM = = = 3.6%. OPM = = = 7.1%. Net profit margin (NPM): Operating profit margin (OPM): (More…) Profit Margins
  28. Profit Margins (Continued) Gross profit margin (GPM): Sales − COGS Sales $7,036 − $5,800 $7,036 GPM = = $1,236 $7,036 = = 17.6%.
  29. 2011 2010 2009 Ind. NPM 3.6% -1.6% 2.6% 3.6% OPM 7.1 0.3 6.1 7.1 GPM 17.6 14.6 16.6 15.5 Profit Margins vs. Industry Averages Very bad in 2010, but meet or exceed industry average in 2011.
  30. EBIT Total assets BEP = = = 14.3%. $502.6 $3,517 (More…) Basic Earning Power (BEP)
  31. 2011 2010 2009 Ind. BEP 14.3% 0.6% 14.2% 17.8% Basic Earning Power vs. Industry Average BEP removes effect of taxes and financial leverage. Useful for comparing firms with different tax and leverage. Projected to be below average. Room for improvement.
  32. NI Total assets ROA = = = 7.2%. $253.6 $3,517 Return on Assets (ROA)
  33. NI Common Equity ROE = = = 12.8%. $253.6 $1,977 Return on Common Equity (ROE)
  34. 2011 2010 2009 Ind. ROA 7.2% -3.3% 6.0% 9.0% ROE 12.8% -17.1% 13.3% 18.0% ROA and ROE vs. Industry Averages Both below average but improving.
  35. Effect of debt on ROE, ROA
  36. Price = $12.17. EPS = = = $1.01. P/E = = = 12. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 P/E
  37. Interpreting Market Based Ratios P/E: How much investors will pay for $1 of earnings. Higher is better.
  38. Common Size Balance Sheets:Divide all items by Total Assets
  39. Divide all items by Total Liabilities & Equity
  40. Analysis of Common Size Balance Sheets Computron has higher proportion of inventory and current assets than Industry. Computron now has more equity (which means LESS debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.
  41. Common Size Income Statement:Divide all items by Sales
  42. Analysis of Common Size Income Statements Computron has lower COGS (82.4) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.
  43. Explain the Du Pont System The Du Pont system focuses on: Expense control Asset utilization Debt utilization It shows how these factors combine to determine the ROE.
  44. The Du Pont System (1) ( )( )( ) = ROE Net Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE x x
  45. The Du Pont System (1) ROE = ROA x Equity Multiplier =ROA x 1/(1-debt ratio)
  46. Example 1 You are given the following ratios for the XYZ Co.: Return on equity (ROE) 20% Return on assets (ROA) 17% What is the debt ratio?
  47. Example 2 If a firm increases its sales but keeps its debt ratio, net profit margin, and total assets constant, what would be the impact of this action on ROE? ROE would decrease. ROE would increase. ROE would remain unchanged. ROE may increase or decrease depending on the interaction between the equity multiplier and sales. None of the above answers are necessarily correct.
  48. Potential Problems and Limitations of Ratio Analysis Comparison with industry averages is difficult if the firm operates many different divisions. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons.
  49. Qualitative Factors There is greater risk if: revenues tied to a single customer revenues tied to a single product reliance on a single supplier? High percentage of business is generated overseas? What is the competitive situation? What products are in the pipeline? What are the legal and regulatory issues?
  50. In-class group project After chapter problem: (3-15) a,b,c,d,e.
  51. After Chapter Homework Problems: 3-1, 3-2, 3-5, 3-6, 3-7, 3-8, 3-10, 3-11, 3-13 (a,b,c).
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