Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis

1. CHAPTER 3 Analysis of Financial Statements • Ratio analysis • Du Pont system • Effects of improving ratios • Limitations of ratio analysis • Qualitative factors

2. Balance Sheet: Assets

3. Liabilities and Equity

4. Income Statement

5. Other Data

6. Why are ratios useful? • Standardize numbers; facilitate comparisons • Used to highlight weaknesses and strengths

7. What are the five major categories of ratios, and what questions do they answer? • Liquidity: Can we make required payments as they fall due? • Asset management: Do we have the right amount of assets for the level of sales? (More…)

8. Debt management: Do we have the right mix of debt and equity? • Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? • Market value: Do investors like what they see as reflected in P/E and M/B ratios?

9. Calculate the firm’s forecasted current and quick ratios for 2002. $2,680 $1,445 CA CL CR02 = = = 1.85x. CA - Inv. CL QR02 = $2,680 - $1,716 $1,445 = = 0.67x.

10. Comments on CR and QR • Expected to improve but still below the industry average. • Liquidity position is weak.

11. Sales Inventories Inv. turnover = = = 4.10x. $7,036 $1,716 What is the inventory turnover ratio as compared to the industry average?

12. 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.

13. DSO is the average number of days after making a sale before receiving cash. Receivables Average sales per day DSO = = = = 44.9 days. Receivables Sales/360 $878 $7,036/360

14. Appraisal of DSO • Firm collects too slowly, and situation is getting worse. • Poor credit policy.

15. Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets turnover Sales Total assets = = = 2.01x. $7,036 $3,497 Fixed Assets and Total Assets Turnover Ratios (More…)

16. FA turnover is expected to exceed industry average. Good. • TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

17. Total debt Total assets Debt ratio = = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE = = = 6.3x. $502.6 $80 Calculate the debt, TIE, and EBITDA coverage ratios. (More…)

18. EBITDA coverage = EC EBIT + Depr. & Amort. + Lease payments Interest Lease Loan pmt. expense pmt. = = 5.5x. + + $502.6 + $120 + $40 $80 + $40 + $0 All three ratios reflect use of debt, but focus on different aspects.

19. How do the debt management ratios compare with industry averages? Too much debt, but projected to improve.

20. NI Sales $253.6 $7,036 PM = = = 3.6%. Profit Margin (PM) Very bad in 2001, but projected to meet industry average in 2002. Looking good.

21. Basic Earning Power (BEP) EBIT Total assets BEP = = = 14.4%. $502.6 $3,497 (More…)

22. BEP removes effect of taxes and financial leverage. Useful for comparison. • Projected to be below average. • Room for improvement.

23. Return on Assets (ROA) and Return on Equity (ROE) Net income Total assets ROA = = = 7.3%. $253.6 $3,497 (More…)

24. Net income Common equity ROE = = = 16.3%. $253.6 $1,552 Both below average but improving.

25. Effects of Debt on ROA and ROE • ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. • However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

26. Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 Calculate and appraise the P/E, P/CF, and M/B ratios. (More…)

27. Typical industry average P/E ratios * Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies.

28. NI + Depr. Shares out. CF per share = = = $1.49. $253.6 + $120.0 250 Price per share Cash flow per share P/CF = = = 8.2x. $12.17 $1.49

29. Com. equity Shares out. BVPS = = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B = = = 2.0x. $12.17 $6.21 (More…)

30. P/E: How much investors will pay for $1 of earnings. High is good. • M/B: How much paid for $1 of book value. Higher is good. • P/E and M/B are high if ROE is high, risk is low.

31. Common Size Balance Sheets:Divide all items by Total Assets

32. Divide all items by Total Liabilities & Equity

33. Analysis of Common Size Balance Sheets • Computron has higher proportion of current assets (49.1%) than Industry (41.2%). • Computron has slightly less equity (which means more debt) than Industry. • Computron has more short-term debt than industry, but less long-term debt than industry.

34. Common Size Income Statement:Divide all items by Sales

35. Analysis of Common Size Income Statements • Computron has higher COGS (86.7) than industry (84.5), but lower depreciation. Result is that Computron has similar EBIT (7.1) as industry.

36. Percentage Change Analysis: Find Percentage Change from First Year (2000)

37. Analysis of Percent Change Income Statement • We see that 2002 sales grow 105% from 2000, and that NI grows 188% from 2000. • So Computron has become more profitable.

38. Percentage Change Balance Sheets

40. Analysis of Percent Change Balance Sheets • We see that total assets grow at a rate of 138%, while sales grow at a rate of only 105%. So asset utilization remains a problem.

41. Explain the Du Pont System ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE. x x 2000 2.6% x 2.3 x 2.2 = 13.2% 2001 -8.9% x 2.0 x 21.6 = -391.0% 2002 3.6% x 2.0 x 2.3 = 16.3% Ind. 3.6% x 2.5 x 2.0 = 18.0%

42. The Du Pont system focuses on: • Expense control (PM) • Asset utilization (TATO) • Debt utilization (EM) It shows how these factors combine to determine the ROE.

43. Simplified Firm Data A/R $ 878 $1,945 Debt Other CA 1,802 Equity 1,552 Net FA 817 Total assets $3,497 $3,497 L&E Sales $7,035,600 day 360 = = $19,543. Q. How would reducing DSO to 32 days affect the company?

44. Effect of reducing DSO from 44.9 days to 32 days: Old A/R = $19,543 x 44.9 = $878,000 New A/R = $19,543 x 32.0 = 625,376 Cash freed up: $252,624 Initially shows up as additional cash.

45. New Balance Sheet Added cash $ 253 Debt $1,945 A/R 625 Equity 1,552 Other CA 1,802 Net FA 817 Total assets $3,497 Total L&E $3,497 What could be done with the new cash? Effect on stock price and risk?

46. Potential use of freed up cash • Repurchase stock. Higher ROE, higher EPS. • Expand business. Higher profits. • Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…)

47. Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides. • All these actions would likely improve stock price.

48. Would you lend moneyto 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.

49. What are some potential problems and limitations of financial ratio analysis? • Comparison with industry averages is difficult if the firm operates many different divisions. • “Average” performance is not necessarily good. • Seasonal factors can distort ratios. (More…)

50. Window dressing techniques can make statements and ratios look better. • Different accounting and operating practices can distort comparisons. • Sometimes it is difficult to tell if a ratio value is “good” or “bad.” • Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.