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Working With Financial Statements

Working With Financial Statements. P.V. Viswanath For use with Fundamentals of Corporate Finance Brealey, Myers and Marcus, 4 th ed. Key Concepts and Skills. 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 P.V. Viswanath For use with Fundamentals of Corporate Finance Brealey, Myers and Marcus, 4th ed.

  2. Key Concepts and Skills • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Know the determinants of a firm’s profitability and growth • Understand the problems and pitfalls in financial statement analysis P.V. Viswanath

  3. Chapter Outline • Standardized Financial Statements • Ratio Analysis • The Du Pont Identity • Internal and Sustainable Growth • Using Financial Statement Information P.V. Viswanath

  4. 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 P.V. Viswanath

  5. 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 P.V. Viswanath

  6. Categories of Financial Ratios • Liquidity ratios • Short-term solvency or how easily the firm can lay its hands on cash. • Financial leverage ratios • Show long-term solvency; how heavily the firm is in debt. • Efficiency or turnover ratios • Indicate how productively the firm is using its assets • Profitability ratios • Used to measure the firm’s return on its investments • Market value ratios P.V. Viswanath

  7. Sample Balance Sheet Numbers in thousands P.V. Viswanath

  8. Sample Income Statement Numbers in thousands, except EPS & DPS P.V. Viswanath

  9. Computing Leverage Ratios • Total Debt Ratio = (Tot Assets – Tot Eq) / TA • (4,088,797 – 1,691,493) / 4,088,797 = .5863 times or 58.63% • The firm finances almost 59% of their assets with debt. • Debt/Equity = Tot Debt / Tot Eq • (4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times • These numbers can also be computed for long-term debt: • Long Term Debt Ratio = LT Debt/ (LT Debt + Eq) = 871,851/(871851+ 1, 691,493) = 0.34 • Long Term Debt/Equity = 871851/ 1, 691,493 = 0.515 P.V. Viswanath

  10. Data from last year • Inventory = 280,044 • Accounts Receivable = 940,044 • Total Assets = 3,998,256 • Total Equity = 1,480,493 P.V. Viswanath

  11. Computing Coverage Ratios • Times Interest Earned = EBIT / Interest • 739,987 / 42,013 = 17.6 times • Cash Coverage = (EBIT + Depreciation) / Interest • (739,987 + 308,355) / 42,013 = 24.95 times • Determinant of the riskiness of a firm’s debt P.V. Viswanath

  12. Computing Liquidity Ratios • Current Ratio = CA / CL • 1,553,725 / 1,525,453 = 1.02 times • Quick Ratio = (CA – Inventory) / CL • (1,553,725 – 295,225) / 1,525,453 = 0.825 times • Cash Ratio = Cash / CL • 6,489 / 1,525,453 = .004 times • Net Working Capital to TA Ratio = NWC/TA • (1,553,725 - 1,525,453)/ 4,088,797 = 0.007 P.V. Viswanath

  13. Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Average Inventory • 1,738,125 / [(295,255 + 280,044)/2] = 6.04 times • Days’ Sales in Inventory = 365 / Inventory Turnover = Av Inv/(COGS/365) • 365 / 6.04 = 60.41 days • When you have ratios with I/S numbers in the numerator and B/S numbers in the denominator, use average of year beginning and year end quantities. • Last year’s Inventory = 280,044. P.V. Viswanath

  14. Computing Receivables Ratios • Receivables Turnover = Sales / Av Accounts Receivable • 3,991,997 / [(1,052,606 + 940,044)/2] = 4.01 times • Average Collection Period = Days’ Sales in Receivables = 365 / Receivables Turnover = Av Receiv/ (Av Sales) • 365 / 4.01 = 91.1 days • Ac Rec last year = 940,044 P.V. Viswanath

  15. Computing Total Asset Turnover • Total Asset Turnover = Sales / Av Total Assets • 3,991,997 / [(4,088,797 + 3,998,256)/2] = 0.99 times • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets • Total Assets last year = 3,998,256 P.V. Viswanath

  16. Computing Profitability Measures • Profit Margin = Net Income / Sales • 425,764 / 3,991,997 = 0.1067 times or 10.67% • Operating Profit Margin = (NI + Int) / Sales • (425,764 + 42013) / 3,991,997 = 0.1172 times or 11.72% • Return on Assets (ROA) = (Net Income + Interest) / Av TA • (425,764 + 42013) / [(4,088,797 + 3,998,256)/2] = 0.11.57 times or 11.57% • Return on Equity (ROE) = Net Income / Average Equity • 425,764 / [(1,691,493 +1,480,493)/2] = 0.2685 times or 26.85% P.V. Viswanath

  17. Computing Market Value Measures • Market Price = $61.625 per share • Shares outstanding = 205,838,594 • P/E Ratio = Price per share / Earnings per share • 61.625 / 2.17 = 28.4 times • Market-to-book ratio = market value per share / book value per share • 61.625 / (1,691,493,000 / 205,838,594) = 7.5 times P.V. Viswanath

  18. Payout and Retention Ratios • Dividend payout ratio = Cash dividends / Net income • 0.86 / 2.17 = .3963 or 39.63% • Plowback ratio = Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio • 1.31 / 2.17 = 0.6037 = 60.37% • Or 1 - .3963 = 0.6037 = 60.37% P.V. Viswanath

  19. Sustainable Growth • The sustainable growth rate tells us how fast the firm can grow, without increasing financial leverage. • Sustainable growth rate = Growth in equity from plowback = plowback ratio x ROE • 0.6037 x 0.2685 = 0.1621 or 16.21% • If the firm can continue to earn 26.85% on its equity and can plow back 60% of earnings into operations, its earnings and equity should both grow at 16.21% p.a. • Growth at this rate requires external financing to grow at the existing rate. Without any additional external financing, the firm can only grow at what is called the Internal Growth Rate. P.V. Viswanath

  20. Internal Growth • 0.1621 x (1,691,493 +1,480,493) /(4,088,797 + 3,998,256) = 0.1621 x 0.3922 = 0.0636 or 6.36% P.V. Viswanath

  21. Determinants of Growth • Profit margin – operating efficiency • Total asset turnover – asset use efficiency • Financial leverage – choice of optimal debt ratio • Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm P.V. Viswanath

  22. Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TA) * (TA / TE) = ROA * Equity Multiplier • Multiply by 1 again and then rearrange • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = Profit Margin * Total Asset Turnover * Equity Multiplier P.V. Viswanath

  23. Deriving the Du Pont Identity • ROA = (NI + Interest)/ TA • Multiply by 1 and rearrange • ROA = [(NI + Int)/ TA]*(Sales / TA) • ROA = (Operating Profit Margin)*(Asset Turnover) • ROE = NI / TE • ROE = (NI/Sales]*(Sales/TA)*(TA/TE) • = Net Profit Margin*Asset Turnover*Equity Multiplier • ROE = [NI/(NI+Int)]*[(NI +Int)/ Sales]*(Sales/TA)*(TA/TE) • = Debt Burden * Op Profit Margin * Asset Turnover*Eq Multiplier • = Debt Burden * ROA*Equity Multiplier P.V. Viswanath

  24. Using the Du Pont Identity ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier • Net 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 P.V. Viswanath

  25. Table 3.6 P.V. Viswanath

  26. 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 P.V. Viswanath

  27. 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 P.V. Viswanath

  28. Work the Web Example • The Internet makes ratio analysis much easier than it has been in the past • Go to Multex Investor (yahoo.multexinvestor.com) • Choose a company and enter its ticker symbol • Click on Ratios and see what comparative information is available P.V. Viswanath

  29. Quick Quiz • 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 the major determinants of a firm’s growth potential? • What are some of the problems associated with financial statement analysis? P.V. Viswanath

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