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CHAPTER 3

CHAPTER 3. Analysis of Financial Statements Dr. Omar Al Nasser FINC 6352. Topics in Chapter 3. Ratio analysis Du Pont system. Why are ratios useful?. Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths From an investor’s standpoint:

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CHAPTER 3

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  1. CHAPTER 3 Analysis of Financial Statements Dr. Omar Al Nasser FINC 6352

  2. Topics in Chapter 3 • Ratio analysis • Du Pont system

  3. Why are ratios useful? • Standardize numbers; facilitate comparisons • Used to highlight weaknesses and strengths • From an investor’s standpoint: The real value of financial statements lies in the fact that they can be used to predict future earnings, dividends, and free cash flow. • From management standpoint: Financial statements is useful to anticipate future conditions and as a starting point for planning actions that will improve the firm’s future performance.

  4. Income Statement

  5. Balance Sheets: Assets

  6. Liabilities & Equity

  7. Other Data

  8. What are the five major categories of ratios? • Liquidity: Can the company makes the required payments for short-term creditors/suppliers and bankers? • Asset management: Do we have the right amount of assets for the level of sales? • Debt management: Do we have the right mix of debt and equity?

  9. What are the five major categories of ratios? • Profitability: Do sales prices exceed unit costs? Shed light upon the overall effectiveness of management regarding the returns generated on sales and investment. • Market value: What investors think about the company’s past performance and future prospects?

  10. Liquidity Ratios • Provides information on a company’s ability to meet its short-term obligations. • A liquid asset is one that be easily converted to cash without significant loss of its original value.

  11. Liquidity Ratios • Current Ratio • Is calculated by dividing current assets by current liabilities. • Indicated the extent to which CL are covered by assets expected to be converted into cash in the near future Current ratio = Current assets / Current liabilities = $2680 / $1040 = 2.58 times

  12. Liquidity Ratios • Quick Ratio Is calculated by deducting inventories from current assets and dividing the results by current liabilities. Quick ratio = (CA – Inventories) / CL = ($2,680 – $1,716) / $1,040 = 0.93x

  13. Asset Management Ratios • A set of ratios that measures how well a firm is managing its asset. • Inventory Turnover Ratio: • Is the ratio of total sales to inventory. This ratio indicates how many times inventory is created and sold during the period.

  14. DSO: average number of days from sale until cash received. • This ratio is calculated by dividing AR by average sales per day. • It indicates the average length of time the firm must wait after making a sale before it receives cash. DSO = Receivables / Avg sales per day = Receivables / (Annual sales/365) = $878 / ($7,036/365) = 45.6 days

  15. Asset Management Ratios • Fixed Assets Turnover Ratio • Is the ratio of sales to fixed assets. • This ratio indicates the ability of the company’s management to put the fixed assets to work in order to generate sales. FA turnover = Sales / Net fixed assets = $7,036 / $837 = 8.41x • If the ratio is close to the industry average, this indicates that the company is using its fixed assets as effectively as other companies in the industry.

  16. Asset Management Ratios • Total Assets Turnover Ratio • Is the ratio of sales to total assets. This ratio indicates the extent that the investment in total assets results in sales. TA turnover = Sales / Total assets = $7,036 / $3,517 = 2.00x • If this ratio is below its industry average, it may indicate that the company is not generating enough sales given its total assets. Sales should be increased or assets should be sold.

  17. Debt Management Ratios • Measure the extent to which a firm relies on debt financing (financial leverage). • Debt Ratio: The ratio of total debt to total assets. It measures the percentage of funds provided by creditors.

  18. Debt Management Ratios • Times Interest Earned ratio. • Is computed by dividing earnings before interest and taxes by interest charges. • It measures the ability of the firm to meet its annual interest payments. • We use earnings before interest and taxes, rather than net income, because interest is paid with pre-tax dollars, so the firm’s ability to pay its interest payments is not affected by taxes. TIE = EBIT / Interest expense = $502.6 / $80 = 6.3x • The higher the ratio, the greater the company's ability to make its interest payments or take on more debt.

  19. Profitability Ratios • Profitability Ratios show the combined effects of liquidity, asset management, and debt management on operating results. Profit margin on sales: • Net profit margin shows how much net profit is derived from every dollar of total sales. • It indicates how well the business has managed its operating expenses. Profit margin= Net income / Sales = $253.6 / $7,036 = 3.6% • If the industry average is 5%, this may indicates that the cost is too high which may be a results of inefficient operations.

  20. Profitability Ratios Basic Earning Power (BEP) Ratio: • It compares earnings apart from the influence of taxes or financial leverage, to the assets of the company. BEP = EBIT / Total assets = $502.6 / $3517 = 14.3% • If the industry average is 18.0%, this indicates that the company is not earning as high return on assets as the average companies in its industry.

  21. Profitability Ratios Return on Equity: • Is computed by dividing net income available to common stockholders by common equity. • It measure the rate of return on common stockholders investment. Higher return will results in happy common stockholders. ROE = Net income / Total common equity = $253.6 / $1977 = 12.8%

  22. Profitability Ratios Return on Assets: • This evaluates how well the company employs its assets to generate a return. • High return ratio indicates good use of assets ROA = Net income / Total assets = $253.6 / $3517 = 7.2% • If the industry average is 11.0%, this indicate that the company’s 7.2% return is well below the industry average for the following reasons: • The company’s low basic earning power, and • High interest costs resulting from its above-average use of debt. Both of which cause its NI to be relatively low.

  23. Market Value Ratios • It relate the firm’s stock price to its earnings, cash flow, and book value per share. • These ratios give management an indication of what investors think of the company risk and future performance.

  24. Price/Earning Ratio (P/E ratio) • The ratio of the price per share to earnings per share. • It is a useful indicator of what premium or discount investors are prepared to pay or receive for the investment. • The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher the premium an investor is prepared to pay for the share. P/E = Price / Earnings per share = $12.17 / $1.01 = 12.0x • If the P/E ratio is below the industry average, this indicates that the company is riskier than other companies or have poor growth prospects.

  25. Price/Cash flow Ratio • A measure of the market's expectations of a firm's future financial health. It is calculated by dividing the price per share by cash flow per share. • Cash flow per share is equal to net income plus depreciation and amortization divided by common shares outstanding. P/CF = Price / Cash flow per share = $12.17 / [($253.6+$120.0) ÷ 250] = 8.17x • This indicate that the company’s stock was trading at 8.17-times the company's cash flow of $1.49 per share.

  26. Com. equity Shares out. BVPS = = = $7.91. $1,977 250 Mkt. price per share Book value per share M/B = = = 1.54x. $12.17 $7.91 Market/Book Ratio • Is the ratio of the current share price to the book value per share. It measures how much a company worth at present.

  27. The Du Pont Equation • In ratio analysis, managers often need a framework that ties together a firm’s profitability, its asset usage efficiency, and its use of debt. • The basic Du Pont Equation shows that the ROA can be found as the product of the profit margin times the total assets turnover. ROA = Profit Margin x Total assets turnover = NI / sales x Sales / TA ROA= Net income / Total asset = $253.6 / $3517 = 7.2%

  28. Extended DuPont Equation: Breaking down Return On Equity • If the company were financed only with common equity, ROA and ROE would be the same because TA would equal common equity. • The equality holds if and only if the company uses no debt.

  29. Extended DuPont Equation: Breaking down Return On Equity = 3.6% x 2 x 1.8 = 13.0% However, the Dupont system, shows how profit margin, total asset turnover, and the use of debt interact to determine the return on equity.

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