Financial Analysis Principles & Tools

1. Chapter 4Financial Analysis— Sizing up Firm Performance

2. Slide Contents • Learning Objectives • Principles Applied in this Chapter • Why Do We Analyze Financial Statements • Common Size Statements – Standardizing Financial Information • Using Financial Ratios • Selecting a Performance Benchmark • Limitations of Ratio Analysis • Key Terms

3. Learning Objectives • Explain what we can learn by analyzing a firm’s financial statements. • Use common size financial statements as a tool of financial analysis. • Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.

4. Learning Objectives (cont.) • Select an appropriate benchmark for use in performing a financial ratio analysis. • Describe the limitations of financial ratio analysis.

5. Principles Used in this Chapter • Principle 3: Cash Flows Are the Source of Value. • Principle 4: Market Prices Reflect Information. • Principle 5: Individuals Respond to Incentives.

6. 4.1 Why Do We Analyze Financial Statements?

7. Why Do We Analyze Financial Statements? • An internal financial analysis might be done: • To evaluate the performance of employees • To compare the performance of different divisions • To prepare financial projections • To evaluate the firm’s financial performance in light of its competitors’ performance

8. Why Do We Analyze Financial Statements? (cont.) • External financial analysis is done by: • Banks and other lenders • Suppliers • Credit-rating agencies • Professional analysts • Individual investors

9. 4.2 COMMON SIZE STATEMENTS: STANDARDIZING FINANCIAL INFORMATION

10. Common Size Statements: Standardizing Financial Information • A common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages. • It helps to compare a firm’s financial statements with those of other firms, even if the other firms are not of equal size.

11. Common Size Statements: Standardizing Financial Information (cont.) • How to prepare a common size financial statement? • For a common size income statement, divide each entry in the income statement by sales. • For a common size balance sheet, divide each entry in the balance sheet by total assets.

12. Table 4.1 H. J. Boswell, Inc.

13. Table 4.1 Observations • Table 4-1 created by dividing each entry in the income statement of Table 3.1 by firm sales for 2013. • Cost of goods sold make up 75% of the firm’s sales resulting in a gross profit of 25%. • Selling expenses account for about 3% of sales. • Income taxes account for 4.1% of the firm’s sales. • After all expenses, the firm generates net income of 7.6% of firm’s sales.

14. Table 4.2 H. J. Boswell, Inc.

15. Table 4.2 Observations • Table 4.2 created by dividing each entry in the balance sheet of Table 3.2 by total assets. • Total current assets increased by 5.6% in 2013 while total current liabilities declined by 2%. • Long-term debt account for 39.2% of firm’s assets, showing a decline of 1.7%. • Retained earnings increased by 5.8% .

16. 4.3 Using Financial Ratios

17. Using Financial Ratios • Financial ratios provide a second method for standardizing the financial information on the income statement and balance sheet. • A ratio by itself may have no meaning. Hence, a given ratio is generally compared to: (a) ratios from previous years; or (b) ratios of other firms in the same industry.

18. Using Financial Ratios (cont.)

19. Liquidity Ratios

20. Liquidity Ratios • Liquidity ratios address a basic question: How liquid is the firm? • A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s liquidity from two perspectives (see next slide).

21. Liquidity Ratios (cont.) • Overall liquidity - analyzed by comparing the firm’s current assets to the firm’s current liabilities. • Liquidity of specific assets - analyzed by examining the timeliness in which the firm’s liquid assets (accounts receivable and inventories) are converted into cash.

22. Liquidity Ratios: Current Ratio • The overall liquidity of a firm is analyzed by computing the current ratio and acid-test ratio. Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-term) liabilities.

23. Liquidity Ratios: Current Ratio (cont.) • What is the current ratio for 2012 for Boswell? Current Ratio = $477 ÷ 292.5 = 1.63 times • The firm had $1.63 in current assets for every $1 it owed in current liability.

24. Liquidity Ratios: Quick Ratio • Acid-Test (Quick) Ratio excludes the inventory from current assets as inventory may not be very liquid.

25. Liquidity Ratios: Quick Ratio(cont.) • What is the quick ratio for Boswell for 2012? • Quick Ratio = ($477-$229.50) ÷ ($292.50) = 0.84 times • The firm has only $0.84 in current assets (less inventory) to cover $1 in current liabilities.

26. Liquidity Ratios: Individual Asset Categories We can also measure the liquidity of the firm by examining the liquidity of accounts receivable and inventories to see how long it takes the firm to convert its accounts receivables and inventories into cash.

27. Liquidity Ratios: Accounts Receivable Average Collection Period measures the number of days it takes the firm to collects its receivables.

28. Liquidity Ratios: Accounts Receivable (cont.) • What will be the average collection period for Boswell, Inc. for 2012 if we assume that the annual credit sales were $2,500 million? • Daily Credit Sales = $2,500 ÷ 365 days = $6.85 million • Average Collection Period = $139.5m ÷ $6.85m = 20.37 days

29. Liquidity Ratios: Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio measures how many times receivables are “rolled over” during a year.

30. Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.) • What will be the accounts receivable turnover ratio for Boswell, Inc. for 2012 if we assume that the annual credit sales were $2,500 million? • Accounts Receivable Turnover = $2,500 million ÷ $139.50 = 17.92 times • The firm’s accounts receivable were turning over at 17.92 times per year.

31. Liquidity Ratios: Inventory Turnover Ratio Inventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.

32. Liquidity Ratios: Inventory Turnover Ratio (cont.) • What will be the inventory turnover ratio for 2012 for Boswell, Inc. if we assume that the cost of goods sold were $1,980 million in 2012? • Inventory Turnover Ratio = $1,980 ÷ $229.50 = 8.63 times • The firm turned over its inventory 8.63 times per year.

33. Liquidity Ratios: Days’ Sales in Inventory • Days’ Sales in Inventory = 365÷ inventory turnover ratio = 365 ÷ 8.63 = 42.29 days • The firm, on average, holds it inventory for about 42 days.

34. Can a Firm Have Too Much Liquidity? • A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner. • However, an excessive investments in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.

35. Evaluating Dell’s Liquidity Why do you think HP’s inventory turnover ratio is so much lower than Dell’s inventory turnover ratio? CHECKPOINT 4.1: CHECK YOURSELF

36. Step 1: Picture the Problem • The inventory turnover ratio will measure how many days items remain in inventory before being sold. • Inventory turnover ratio is important as it has implications for cash flows and profitability of a firm.

37. Step 2: Decide on a Solution StrategyStep 3: Solve • We will use the following equation to compute the Inventory Turnover (IT) ratio IT ratio = Cost of Goods Sold ÷ Inventories • Inventory Turnover Ratio for HP = $97,529,000 ÷ 7,490,000 =13.02

38. Step 4: Analyze • HP’s inventory turnover ratio indicates that the inventory at HP remains on shelf for (365 ÷ 13.02) days or 28.03 days. This is much higher than Dell that has an inventory turnover ratio of 34.37 or shelf life of only 10.61 days. • The significant difference must be investigated further as the two firms are in the same industry.

39. Step 4: Analyze (cont.) There are two reasons why HP has a lower turnover of inventories relative to Dell: • HP sells computers out of inventory of computers while Dell builds computers only when orders are received. • HP carries more parts inventory on hand than does Dell.

40. Capital Structure Ratios

41. Capital Structure Ratios Capital structure refers to the way a firm finances its assets. Capital structure ratios address the important question: How has the firm financed the purchase of its assets?

42. Capital Structure Ratios (cont.) Debt ratio measures the proportion of the firm’s assets that are financed by borrowing or debt financing.

43. Capital Structure Ratios (cont.) • What is the debt ratio for H.J. Boswell, Inc. for 2012? • Debt Ratio = $1,012.50 million ÷ $1,764 million = 57.40% • The firm financed 57.39% of its assets with debt.

44. Capital Structure Ratios (cont.) • Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the interest on debt.

45. Capital Structure Ratios (cont.) • What will be the times interest earned ratio for Boswell for 2012 if we assume interest expense of $65 million and EBIT of $350 million? • Times Interest Earned = $350m ÷ $65m = 5.38 times • The firm can pay its interest expense 5.38 times or interest used 1/5.38th or 18.58% of its EBIT.

46. Capital Structure Ratios (cont.)

47. Comparing the Financing Decisions of HD and LOW What would be Home Depot’s times interest earned ratio if interest payments remained the same, but net operating income dropped by 80% to only $1.332 billion? Similarly if Lowes’ net operating income dropped by 80%, what would its times interest earned ratio be? CHECKPOINT 4.2:CHECK YOURSELF

48. Step 1: Picture the Problem • Times interest earned ratio is an important ratio for firms that use debt financing. It measures the firm’s ability to service its debt. • The ratio requires comparing net operating income or EBIT with Interest expense. Both items are found on the income statement.

49. Step 1: Picture the Problem (cont.) • Picture an Income Statement • Sales • Less: Cost of Good Sold • Equals: Gross Profit • Less: Operating Expenses • Equals: Net Operating Income (EBIT) • Less: Interest Expense • Equals: Earnings before Taxes • Less: Taxes • Equals Net Income EBIT Interest Expense

50. Step 2: Decide on a Solution Strategy • Here we are considering the impact of a drop in EBIT on the times interest earned ratio of Home Depot and Lowes. We will use the following ratio to measure the times interest earned (TIE) ratio. • TIE = EBIT ÷ Interest Expense