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Working With Financial Statements

Working With Financial Statements. Chapter Three. Key Concepts and Skills. Understand sources and uses of cash and the Statement of Cash Flows Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios

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Working With Financial Statements

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  1. Working With Financial Statements Chapter Three

  2. Key Concepts and Skills • Understand sources and uses of cash and the Statement of Cash Flows • 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 Du Pont Identity • Understand the problems and pitfalls in financial statement analysis

  3. Chapter Outline • Cash Flow and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The Du Pont Identity • Using Financial Statement Information

  4. Analysis of Financial Statements • Financial Statement analysis - determine relative. strengths & weaknesses of company • Investors need to estimate future CF & riskiness of CF • Financial Managers need to evaluate past performance & map future plans. • Financial statement analysis - study relationship between IS & B/S, • how change over time (trend analysis) • & how compare with other firms in industry (comparative ratio analysis)

  5. Sample Balance Sheet Numbers in thousands

  6. Sample Income Statement Numbers in thousands, except EPS & DPS

  7. Sources and Uses • Sources • Cash inflow – occurs when we “sell” something • Decrease in asset account (Sample B/S) • Cash & equivalents is the only source • Increase in liability or equity account • Everything except accounts payable is a source • Uses • Cash outflow – occurs when we “buy” something • Increase in asset account • Everything except cash & equivalents is a use • Decrease in liability or equity account • Accounts payable is the only use

  8. Statement of Cash Flows • Statement that summarizes the sources and uses of cash • Changes divided into three major categories • Operating Activity – includes net income and changes in most current accounts • Investment Activity – includes changes in fixed assets • Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends

  9. Sample Statement of Cash Flows Numbers in thousands

  10. 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

  11. 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 is that information important • Ratios are used both internally and externally

  12. 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

  13. Liquidity Ratios • Current = Current Assets/Current Liabilities • Quick = (CA - Inventories - prepaid expenses)/CL • Quick also know as acid test • Current Cash Debt Coverage Ratio = Cash Provided by Operating Activities Average Current Liabilities • liquidity ratios are used to measure a firm’s ability to meet its current obligations (“CL”) as they come due.

  14. Computing Liquidity Ratios • Current Ratio = CA / CL • 1,801,690 / 1,780,785 = 1.01 times • Quick Ratio = (CA – Inventory) / CL • (1,801,690 – 314,454) / 1,780,785 = .835 times • Cash Ratio = Cash / CL • 3,171 / 1,780,785 = .002 times • Current Cash Debt Coverage Ratio = Cash Provided by Operating Activities Average Current Liabilities • = 726,387/ [(1,780,785 + 1,525,453)/2] = 726,837/1,653,119 = 0.4397 times

  15. Ratios - Debt Management (Long Term Solvency & Coverage) • Total Debt/TA = Total Liabilities/TA = TL/TA = debt ratio • Debt/Equity = Total Liabilities/shareholders Equity • TIE (Times Int. Earned) = EBIT/interest charges • Fixed charge coverage = • (EBIT + Lease payments)/ • [Interest charge +Lease pay. + (SF pay./(1 + T) ] • SF pay. = Sinking Fund payments • SF used for debt retirement-may be required for that debt issuance • Debt management ratios measure extent to which a firm is using debt financing (financial leverage) & degree of safety afforded to creditors.

  16. Computing Long-term Solvency Ratios • Total Debt Ratio = (TA – TE) / TA • (4,931,444 – 1,761,044) / 4,931,444 = .6429 times or 64.29% • The firm finances a little over 64% of its assets with debt. • Debt/Equity = TD / TE • (4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times • Equity Multiplier = TA / TE = 1 + D/E • 1 + 1.800 = 2.800

  17. Computing Coverage Ratios • Times Interest Earned = EBIT / Interest • 820,183 / 52,841 = 15.52 times • Cash Coverage = (EBIT + Depreciation) / Interest • (820,183 + 362,325) / 52,841 = 22.38 times

  18. Ratios - Asset Management • ITO (inventory turnover) = (Cost of Goods Sold)/Inventories • DSR (days sales in receivables) = AR/(annual Sales/365) = ACP = average collection period • F.A. turnover = Sales/Net F.A. • Net F.A. = (FA- accumulated depreciation) • TAT = T.A. turnover = Sales/TA • Asset management ratios measure how effectively a firm is managing its assets & whether or not the level of those assets is properly related to level of operations as measured by sales

  19. Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 1,762,721 / 388,947 = 4.53 times • Days’ Sales in Inventory = 365 / Inventory Turnover • 365 / 4.53 = 81 days

  20. Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable • 4,335,491 / 1,095,118 = 3.96 times • DSR = Days’ Sales in Receivables = 365 / Receivables Turnover = ACP (average collection period) • 365 / 3.96 = 92 days

  21. Computing Total Asset Turnover • Total Asset Turnover = Sales / Total Assets • 4,335,491 / 4,931,444 = .88 times • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

  22. Ratios - Profitability • Profit Margin on Sales = • NI (avail to common stockholders) /sales • BEP (Basic Earning power) = EBIT/TA • ROA (Return on Assets) = • NI (avail to common stockholders)/TA • ROE (return on common equity) = • NI (avail to common stock.)/Common Equity • Profitability ratios show comb. effects of liquidity, asset management & debt management on operating results

  23. Computing Profitability Measures • Profit Margin = Net Income / Sales • 471,916 / 4,335,491 = .1088 times or 10.88% • Return on Assets (ROA) = Net Income / Total Assets • 471,916 / 4,931,444 = . 0957 times or 9.57% • Return on Equity (ROE) = Net Income / Total Equity • 471,916 / 1,761,044 = .2680 times or 26.80% Basic Earning Power (BEP) = EBIT/TA = 820,183/ 4,931,444 = .1663 times or 16.63%

  24. Ratios - Market Value • P/E (Price/Earnings) = • Price per share (P)/ EPS (earnings per share) • M/B (Market/book) = • Market price per share (P)/ Book value per share • market cap = total market value of outstanding shares (market price x # shares) - not a ratio but a term you may hear. • market value ratios relate stock’s price to its earnings & book value per share; thus give management indication what investors think of company’s past performance & future prospects • EPS = earnings per share • DPS = dividends per share

  25. Computing Market Value Measures • Market Price = $60.98 per share • Shares outstanding = 205,838,910 • Market Cap = market capitalization = market price per share X # shares outstanding = $60.98 x 205,838,910 = $12,552,050 • PE Ratio = Price per share / Earnings per share • 60.98 / 2.41 = 25.3 times • Market-to-book ratio = market value per share / book value per share • 60.98 / (1,761,044,000 / 205,838,910) = 7.1 times

  26. Du Pont • modified Du Pont chart shows relationships between return on investment, assets turnover & profit margin. • profit margin x total asset turnover = Du Pont equation: ROA = profit margin x TAT • ROA x EM = extended Du Pont equation: • ROE = PM x TAT x EM • where EM (equity multiplier) = (TA/common equity) • it is important to analyze trends as well as their absolute level. Trend analysis provides clues as to whether firm’s financial situation is improving or deteriorating relative to past performance

  27. Deriving the Du Pont Identity • The Du Pont system focuses on: • Expense control (P.M.) • Asset utilization (TAT) • Debt utilization (EM =Equity Multiplier) • It shows how these factors combine to • determine the ROE. • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TE) (TA / TA) • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange • ROE = (NI / TA) (TA / TE) (Sales / Sales) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM

  28. Using the Du Pont Identity • ROE = PM * TAT * EM • Profit margin is a measure of the firm’s operating efficiency – how well does it control 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

  29. Why Evaluate Financial Statements? • Internal uses • Performance evaluation – compensation and comparison between divisions • Planning for the future – guide in estimating future cash flows • External uses • Creditors • Suppliers • Customers • Stockholders

  30. Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis • It is important to analyze trends as well as their absolute level. Trend analysis provides clues as to whether firm’s financial situation is improving or deteriorating relative to past performance • Used to see how the firm’s performance is changing through time • Internal and external uses • Peer Group Analysis • It is also important to compare ratios to the industry average ratios to see how compare to competitors. • Compare to similar companies or within industries • SIC and NAICS codes

  31. Real World Example - I • Ratios are figured using financial data from the 1999 Annual Report for Ethan Allen • Compare the ratios to the industry ratios in Table 3.11 in the book • Ethan Allen’s fiscal year end is June 30. • Be sure to note how the ratios are computed in the table so that you can compute comparable numbers. • Ethan Allan sales = $762 MM

  32. Real World Example - II • Liquidity ratios • Current ratio = 2.433x; Industry = 1.4x • Quick ratio = .763x; Industry = .6x • Long-term solvency ratio • Debt/Equity ratio (Debt / Worth) = .371x; Industry = 1.9x. • Coverage ratio • Times Interest Earned = 70.6x; Industry = 3.4x

  33. Real World Example - III • Asset management ratios: • Inventory turnover = 2.8x; Industry = 3.6x • Receivables turnover = 22.2x (16 days); Industry = 17.7x (21 days) • Total asset turnover = 1.6x; Industry = 2.2x • Profitability ratios • Profit margin before taxes = 17.4%; Industry = 3.1% • ROA (profit before taxes / total assets) = 27.6%; Industry = 5.8% • ROE = (profit before taxes / tangible net worth) = 37.9%; Industry = 17.6%

  34. Potential Problems with comparisons • 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 • “Average” performance not necessarily good. • Seasonal factors can distort ratios. • “Window dressing” techniques can make statements and ratios look better. • What is “window dressing”? - end of statement period when results are reported, take actions that will change ratios.

  35. What if could reduce DSR (ACP) to industry average? – initially shows up as additional cashPotential use of freed up cash: • Reduce debt. Better debt ratio; lower interest, hence higher NI. • Repurchase stock. Higher ROE, higher EPS. • Expand business. Higher profits. • All these actions would improve stock price.

  36. What if could increase ITO to industry average? – initially shows up as additional cash • Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. • The ITO (inventory turnover) ratio is low. It appears that the firm either has excessive inventory or some of the inventory is obsolete. If inventory were reduced, this would improve the liquidity ratios, the inventory & total assets turnover, and the debt ratio, which should improve the firm’s stock price & profitability. • All these actions might improve stock price.

  37. Suppose the company paid its suppliers much later than the due date & was not maintaining financial ratios at levels required in the bank loan agreements. Consequently, suppliers could cut off trade credit & bank could refuse to renew loan when it comes due in 90 days. On the basis of the data provided, would you as a credit manager, continue to sell to the company on credit (terms net 30)? Or would you demand COD (Cash on Delivery)? (demanding COD might cause the company to stop buying from your company.)If you were the bank officer, would you recommend renewing the loan or demand repayment? • Would your actions be influenced if, in early 2003, the company showed you the 2003 projections plus proof that it was going to raise more than $1 million of new equity capital?

  38. Would you lend money or extend trade credit to the company? • While the firm’s ratios based on the projected data appear to be improving, the firm’s liquidity ratios are low. As a credit manager, I would not continue to extend credit to the firm under its current arrangement. • Terms of COD might be hard and might push the firm into bankruptcy. • Similarly, if the bank demanded repayment, this action could also force the firm into bankruptcy. • Creditors’ actions would definitely be influenced by an infusion of equity capital into the firm. This would lower the firm’s debt ratio and creditor’s risk exposure. • Would you lend money to this company? Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. • However, company should not have relied so heavily on debt financing in the past.

  39. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? • Are the company’s revenues tied to 1 key customer, product, or supplier? • What percentage of the company’s business is generated overseas? • Competition • Future prospects • Legal and regulatory environment

  40. Ratios to know from chapter 3 • Current Ratio • Inventory Turnover ratio • DSR = Days Sales in Receivables = ACP = average collection period • Total Asset Turnover ratio • Debt ratio • Times-Interest-Earned ratio • Profit Margin on sales • Return on Assets • Return on Equity • Price/Earnings ratio • Extended du Pont equation • Equity multiplier • Earnings per share • Dividends per share • Current Cash Debt Coverage Ratio • BEP (Basic Earning Power) (need for capital structure chapter)

  41. Work the Web Example • The Internet makes ratio analysis much easier than it has been in the past • Click on the web surfer to go to Multex Investor • Choose a company and enter its ticker symbol • Click on comparison and see what information is available

  42. Quick Quiz • What is the Statement of Cash Flows and how do you determine sources and uses of cash? • How do you standardize balance sheets and income statements and why is standardization useful? • What are the major categories of ratios and how do you compute specific ratios within each category? • What are some of the problems associated with financial statement analysis?

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