CHAPTER 4 Analysis of Financial Statements

1. CHAPTER 4Analysis of Financial Statements Ratio Analysis Du Pont system Effects of improving ratios Limitations of ratio analysis

2. 2010E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152 2009 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

3. Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2010E 436,800 300,000 408,000 1,144,800 400,000 1,721,176 231,176 1,952,352 3,497,152 2009 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592

4. Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2010E 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584 2009 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)

5. 2010E 250,000 $1.014 $0.220 $12.17 $40,000 2009 100,000 -$1.602 $0.110 $2.25 $40,000 Other data No. of shares EPS DPS Stock price Lease pmts

6. Why are ratios useful? • Ratios standardize numbers and facilitate comparisons. • Ratios are used to highlight weaknesses and strengths. • Ratio comparisons should be made through time and with competitors • Peer (or Industry) analysis • Trend analysis

7. Ratios facilitate comparisons Firm A (RM)Firm B (RM) Sales 5,000,000 4,850,000 T. Assets 3,500,000 3,200,000

8. Turnover ratio Firm AFirm B 5,000,000 = 1.428x 4,850,000 = 1.52x 3,500,000 3,200,000 Industry analysis Firm BIndustry 1.52x 1.729x

9. Trend Analysis Turnover ratio firm’s BYear 1.256 2000 1.276 2001 1.325 2002 1.346 2003 1.426 2004 1.457 2005

11. What question do they answer? • Liquidity Ratio: Can we make required payments?

12. Calculate forecasted current ratio and quick ratio for 2010. Current ratio = Current assets / Current liabilities = $2,680 / $1,145 Industry = 2.34x 2.70x Quick ratio = (CA – Inventories) / CL = ($2,680 – $1,716) / $1,145 = 0.84x Industry 1.0x

13. Comments on liquidity ratios • Expected to improve but still below the industry average. • Liquidity position is weak.

14. What question do they answer? • Asset management ratios: right amount of assets vs. sales?

15. What is the inventory turnover vs. the industry average? Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10x

16. Comments on Inventory Turnover • Inventory turnover is below industry average. • Company might have overstocked of inventory or insufficient sales

17. DSO is the 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

18. Appraisal of DSO • Company collects on sales too slowly, and is getting worse. • Company has a poor credit policy.

19. Fixed assets and total assets turnover ratios vs. the industry average FA turnover = Sales / Net fixed assets = $7,036 / $817 = 8.61x TA turnover = Sales / Total assets = $7,036 / $3,497 = 2.01x

20. Evaluating the FA turnover and TA turnover ratios • FA turnover projected to exceed the industry average. • TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).

21. what question do they answer? • Debt management: Right mix of debt and equity?

22. Effects of Financial Leverage on Stockholder Returns

24. Leverage( debt) and the advantages ? Imagine that the company have RM 50 million to pay for the new building It is insufficient to buy the building for the company expansion plan, so the company use that money as a deposit on the loan and get a loan for the rest of the money due. If the building price is RM250 M, and the company put down RM50 M, the company can use the loan to leverage that cash so the company can afford the building.

25. Leverage( debt) and the advantages ? In this case the loan covers 80% of the purchase price. The company now can use any cash the company earn beyond the monthly loan repayment to pay other company’s expenditure. The real benefits of leverage is seen when the building price goes up over time.

26. Leverage( debt) and the advantages ? Suppose the building value increases by 20% to RM300 M at which point the company sell it and pay back the loan of RM 200 M. The company capital now has doubled from RM 50 M to RM 100M

27. Calculate the debt to equity ratio, debt ratio, times-interest-earned coverage ratios. Debt ratio = Total debt / Total equity = ($1,145 + $400) / 1,721 +231 Ind. = 0.79 0.83

28. Calculate the debt to equity ratio, debt ratio, times-interest-earned coverage ratios. Debt ratio = Total debt / Total assets = ($1,145 + $400) / $3,497 Ind. = 44.2% 50% TIE = EBIT / Interest expense Ind. = $492.6 / $70 = 7.0x 6.2%

29. How do the debt management ratios compare with industry averages? • D/E, D/A and TIE are compatible with the industry

30. What questions do they answer? • Profitability ratios: These ratios enable the investors to evaluate the firm’s profit with respect to a given level of sales, a certain level of assets, or the owners’ investments?

31. Profitability ratios: Profit margin and Basic earning power Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6% BEP = EBIT / Total assets = $492.6 / $3,497 = 14.1% Ind. 3.5% Ind. 19.1%

32. Appraising profitability with the profit margin and basic earning power • Profit margin was very bad in 2009, but is projected to exceed the industry average in 2010. Looking good. • BEP projected to improve, yet still below the industry average. There is definitely room for improvement.

33. Profitability ratios: Return on assets and Return on equity ROA = Net income / Total assets = $253.6 / $3,497 = 7.3% ROE = Net income / Total common equity = $253.6 / $1,952 = 13.0% Ind. 9.1% Ind. 18.2%

34. Appraising profitability with the return on assets and return on equity • Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.

35. Problems with ROE • ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. • ROE could not capture accounting manipulation risk.

36. Net income High ROE ROE= Net Income Common equity Capital structure policy Equity Liability High risk of financial distress

37. Market value ratios • A set of ratios that relate the firm’s stock price to its earnings, cash flow, and book value per share.

38. Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios. Share price= $12.17, Earnings= $253,584 # 0f shares= 250,000 P/E = Price / Earnings per share = $12.17 / $1.014 = 12.0x P/CF = Price / Cash flow per share = $12.17 / [($253.6+$117.0) ÷ 250] = 8.21x Ind. 14.2x Ind. 11.0x

39. Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios. M/B = Market price / Book value per share = $12.17 / ($1,952 / 250) = 1.56x Ind. 2.4x

40. Analyzing the market value ratios • P/E: How much investors are willing to pay for $1 of earnings. • P/CF: How much investors are willing to pay for $1 of cash flow. • M/B: How much investors are willing to pay for $1 of book value equity. • For each ratio, the higher the number, the better.

41. The Du Pont system • Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (Equity multiplier.)

42. Extended DuPont equation: Breaking down Return On Equity ROE = (NI / Sales) x (Sales/TA) x (TA/Equity) = 3.6% x 2 x 1.8 = 13.0% Ind. 18.2%

43. Potential problems and limitations of financial ratio analysis • Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. • “Average” performance is not necessarily good, perhaps the firm should aim higher. • “Window dressing” techniques can make statements and ratios look better. • Different operating and accounting practices can distort comparisons.

44. Electronic 1) Firm AFirm B Return on = 1m Return on = 5m Total asset 4m total asset 15m = 0.25 ≈ 25% = 0.33 ≈ 33% N. Income = RM1m T. Assets = RM4m N. Income = RM5m T. Assets = RM15m

45. 2) ROEROA Firm A 13% 5.9% Industry average 13.2% 5.9%

46. 3) Window Dressing ROE Firm A 12.6% Firm B 10.5% ROE = Net income ; A = L + E Equity

47. Different accounting practice Firm AFirm B Sales xxx xxx COGS (xx) (xx) Depreciation (x)(xx) Net income xx x straight line method Accelerated method

48. Potential problems and limitations of financial ratio analysis It is difficult to generalize about whether a particular ratio is good or bad. For example, a high current ratio may indicate a strong liquidity position (which is good) or excessive cash ( which is bad) because excess cash is non earning assets. Example 2, high fixed turnover ratio may indicate either the firm uses its assets efficiently, or that it is short of cash and cannot afford to make the needed investment in fixed assets.

49. Potential problems and limitations of financial ratio analysis Inflation can badly distort many firms’ balance sheet data. Thus the recorded values are often substantially different from “true” values Seasonal factors can distort ratio analysis. For example the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus just after the close of the canning season.