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

1. MAYES 2 & 4 Fin. Stmt. & Ratio Analysis • Ratio analysis • Du Pont system • Effects of improving ratios • Limitations of ratio analysis • Qualitative factors

2. Common Size Financial Statements Displays info as %, not $; Provides 2 key benefits: 1. Allows for easy comparison between firms of different sizes. 2. Aids in spotting important trends which otherwise might not be obvious when looking at $ amounts.

3. Common Size Financial Statements Common size Income Statement: all values a function of Sales $ Common size Balance Sheet: all values a function of Total Assets.

4. Analysis of Common Size Balance Sheets • Elvis has ? proportion of inventory and current assets than Industry. • Elvis now has ? Equity, which means (MORE? / LESS?) debt than Industry. • Elvis has ? short-term debt than industry, but ? long-term debt than industry.

5. Analysis of Common Size Income Statements • Elvis has ? COGS ( %) than industry’s ( %), but ? other expenses. Results?

6. Percentage Change Analysis: Looks at Change rates from period to period between financial categories. Indicator of +/- growth trends.

7. Analysis of Percent Change Income Statement • i.e., Sales growth v. NI ? • i.e., If NI grows faster than sales, then becoming more profitable. • So becoming (more/less) profitable?

8. Analysis of Percent Change Balance Sheets • i.e., Total assets growth v. sales. If assets grow at faster rate than sales, have asset utilization problem.

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

10. 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…)

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

12. Things to ask? Better? Worse? • Trends? • Vs. Industry? • Causes? • Corrective actions?

13. Calculate the firm’s forecasted current and quick ratios CA CL CR = = CA - Inv. CL QR =

14. Comments on CR and QR • Expected to improve/ worsen? Vs. industry average? • Liquidity position?

15. CGS Inventories Inv. turnover = What is the inventory turnover ratio as compared to the industry average? Days Sales in Inventory = 365 Inv To

16. Comments on Inventory Turnover • Inventory turnover v. industry average? • Due to? • Improvement forecasted?

17. Credit sales A/R A/R turnover = What is the Accts. Rec. turnover ratio & Average Collection Period? Ave Collection Period = 365 A/R TO

18. Appraisal of Ave Collection Period • Firm collects too slowly/quickly? • Improving / worsening? • Implication re: credit policy.

19. Fixed assets turnover Sales Net fixed assets = Total assets turnover Sales Total assets = Fixed Assets and Total Assets Turnover Ratios

20. Fixed Assets and Total Assets Turnover Ratios • FA turnover vs. industry? • TA turnover vs. industry average? • Causes? Corrective actions?

21. Total liabilities Total assets Debt ratio = L/T Debt ratio = LEVERAGE L/T Debt Total assets

22. Total liabilities Total Equity Debt/Eqty = ratio L/T Debt to Total Capitalizationratio = LEVERAGE _____L/T Debt___________ LTD + Pref Eqty + Cmn Eqty

23. Total Assets Total Equity Eqty Multiplier L/T Debt to Total Equity = LEVERAGE _____L/T Debt___________ Pref Eqty + Cmn Eqty

24. EBIT + Deprec Exp Interest Exp Cash = Coverage EBIT Int. expense TIE = COVERAGE Ratios (

25. How do the debt management ratios compare with industry averages? 2005E 2004 2003 Ind. D/A TIE C/Cov Effects? Reasons?

26. Gross Profit Margin = Gross Profit Sales Profitability Ratios (Profit Margins) OperatingPM = EBIT Sales Net PM = Net Income Sales Trends? Prospects?

27. ROE = Net Income Total Equity Profitability Ratios (Returns) ROA = Net Income Total Assets Return on = NI available to C.S-holders Cmn Eqty Common Equity Trends? Prospects?

28. 2005E 2004 2003 Ind. ROA ROE Trends? Vs. Industry? Prospects?.

29. 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.

30. The Du Pont System ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE. x x • PM= f(profitability) • TA T/O = f(asset utilization) • EM = f(debt & equity %s) • Shows how these factors combine to determine the ROE.

31. Economic Profit= NOPAT – A/Tax Cost of Op. Capital Economic Profit Measures of Performance Where: NOPAT = EBIT (1-tax rate) A/Tax Cost of Op. Capital = WACC * (Net Op. Working Cap + Net Fixed Assets) ** NOWC = (Non-interest bearing C/A – Non-interest bearing C/L) Trends? Prospects?

32. Financial Distress & Z-score • Technique to determine likelihood of financial distress. • Altman shows model 80-90% accurate w/ Z-score cut-off of 2.675; that is Z-score < 2.675 = distress. • Actually determined 3 levels • Z<1.81 Bankruptcy predicted w/in 1 yr. • 1.81<Z<2.675 Financial Distress, poss. Bankruptcy • Z>2.675 No fin. Distress predicted

33. Financial Distress & Z-scoreZ = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5 • Where the variables are the following financial ratios: • X1 = Net Working Capital / Total Assets • X2 = Retained earnings / Total Assets • X3 = EBIT / Total Assets • X4 = Market Value of all equity / book value of Tot. Liabs • X5 = Sales / Total Assets • *For publicly traded companies

34. Market Price =From the stock exchanges EPS = P/E = NI C.S.Shares out. Price per share EPS Calculate and appraise the P/E, P/CF, and M/B ratios.

35. NI + Depr. C.S.Shares out. CF per share = Price per share Cash flow per C.S. share P/CF =

36. Com. equity C.S.Shares out. BVPS = Mkt. price per share Book value per share M/B =

37. 2005E 2004 2003 Ind. P/E P/CF M/B • 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.

38. 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…)

39. 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.

40. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? • Are the company’s revenues tied to a single customer? • To what extent are the company’s revenues tied to a single product? • To what extent does the company rely on a single supplier? (More…)

41. What percentage of the company’s business is generated overseas? • What is the competitive situation? • What does the future have in store? • What is the company’s legal and regulatory environment?