Ch 03 - Analysis Of Financial Stmts (1) 59c4c

Analysis of Financial Statements Chapter 3

Topics in Chapter • • • • •

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

Overview • Ratios facilitate comparison of: – One company over time – One company versus other companies

• Ratios are used by: – Lenders to determine creditworthiness – Stockholders to estimate future cash flows and risk – Managers to identify areas of weakness and strength

Income Statement 2010

2011E

Sales

$5,834,400

$7,035,600

COGS

4,980,000

5,800,000

Other expenses

720,000

612,960

Deprec.

116,960

120,000

5,816,960

6,532,960

17,440

502,640

176,000

80,000

(158,560)

422,640

(63,424)

169,056

($ 95,136)

$ 253,584

Tot. op. costs EBIT Int. expense EBT

Taxes (40%) Net income

Balance Sheets: Assets Cash S-T invest. AR Inventories Total CA Net FA Total assets

2010 $ 7,282 20,000 632,160 1,287,360 1,946,802 939,790 $2,886,592

2011E $ 14,000 71,632 878,000 1,716,480 2,680,112 836,840 $3,516,952

Balance Sheets: Liabilities & Equity 2010

Accts. payable Notes payable Accruals Total CL Long-term debt Common stock Ret. earnings Total equity Total L&E

$

324,000 720,000 284,960 1,328,960 1,000,000 460,000 97,632 557,632 $2,886,592

2011E

$

359,800 300,000 380,000 1,039,800 500,000 1,680,936 296,216 1,977,152 $3,516,952

Other Data Stock price # of shares EPS DPS Book val. per sh. Lease payments Tax rate

2010 $6.00 100,000 -$0.95 $0.11 $5.58 $40,000 0.4

2011E $12.17 250,000 $1.01 $0.22 $7.91 $40,000 0.4

Liquidity Ratios • Can the company meet its short-term obligations using the resources it currently has on hand?

Forecasted Current and Quick Ratios for 2011. $2,680 = $1,040

CR10

CA = CL

QR10

CA - Inv. = CL

$2,680 - $1,716 = $1,040

= 2.58.

= 0.93.

Comments on CR and QR 2011E

2010

2009

Ind.

CR

2.58

1.46

2.3

2.7

QR

0.93

0.5

0.8

1.0

• Expected to improve but still below the industry average. • Liquidity position is weak.

Asset Management Ratios • How efficiently does the firm use its assets? • How much does the firm have tied up in assets for each dollar of sales?

Inventory Turnover Ratio vs. Industry Average Inv. turnover

2011E Inv. T. 4.1

Sales = Inventories $7,036 = = 4.10. $1,716 2010

2009

Ind.

4.5

4.8

6.1

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.

DSO: average number of days from sale until cash received. DSO =

Receivables Average sales per day

= Receivables Sales/365 = 45.5 days.

= $878 $7,036/365

Appraisal of DSO DSO

2011 45.5

2010 39.5

2009 37.4

Ind. 32.0

• Firm collects too slowly, and situation is getting worse. • Poor credit policy.

In-class Problem Baker Brothers has a DSO of 40 days, and its annual sales are $7,300,000. What is its s receivable balance? Assume that it uses a 365-day year.

Solution

Fixed Assets and Total Assets Turnover Ratios Fixed assets Sales = turnover Net fixed assets $7,036 = = 8.41. $837 Total assets turnover

Sales = Total assets $7,036 = = 2.00. $3,517 (More…)

Fixed Assets and Total Assets Turnover Ratios 2011E

2010

2009

Ind.

FA TO

8.4

6.2

10.0

7.0

TA TO

2.0

2.0

2.3

2.5

• 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).

Debt Management Ratios • Does the company have too much debt? • Can the company’s earnings meet its debt servicing requirements?

Calculate the debt, TIE, and EBITDA coverage ratios. Total liabilities Debt ratio = Total assets $1,040 + $500 = $3,517 EBIT TIE = Int. expense $502.6 = = 6.3. $80

= 43.8%.

(More…)

EBITDA Coverage (EC) EBIT + Depr. & Amort. + Lease payments Interest Lease + + Loan pmt. expense pmt. $502.6 + $120 + $40 = $80 + $40 + $0

= 5.5.

Debt Management Ratios vs. Industry Averages D/A TIE EC

2011E 43.8% 6.3 5.5

2010 80.7% 0.1 0.8

2009 Ind. 54.8% 50.0% 3.3 6.2 2.6 8.0

Recapitalization improved situation, but lease payments drag down EC.

Profitability Ratios • What is the company’s rate of return on: – Sales? – Assets?

Profit Margins Net profit margin (PM):

NI $253.6 PM = Sales = $7,036 = 3.6%. Operating profit margin (OM): EBIT $503 OM = Sales = $7,036 = 7.1%. (More…)

Profit Margins (Continued) Gross profit margin (GPM): Sales − COGS $7,036 − $5,800 GPM = = Sales $7,036 $1,236 GPM = $7,036 = 17.6%.

Profit Margins vs. Industry Averages PM OPM GPM

2011E 3.6% 7.1 17.6

2010 -1.6% 0.3 14.6

2009 Ind. 2.6% 3.6% 6.1 7.1 16.6 15.5

Very bad in 2010, but projected to meet or exceed industry average in 2011.

Basic Earning Power (BEP) EBIT BEP = Total assets = $502.6 $3,517

= 14.3%.

Basic Earning Power vs. Industry Average BEP

2011E 2010 2009 Ind. 14.3% 0.6% 14.2% 17.8%

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

Return on Assets (ROA) and Return on Equity (ROE) NI ROA = Total assets

= $253.6 $3,517

= 7.2%.

Return on Assets (ROA) and Return on Equity (ROE) ROE =

NI Common Equity

$253.6 = $1,977

= 12.8%.

ROA and ROE vs. Industry Averages ROA ROE

2011E 2010 2009 Ind. 7.2% -3.3% 6.0% 9.0% 12.8% -17.1% 13.3% 18.0%

Both below average but improving.

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.

In-class Problem Central City Construction (CCC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CCC will own no securities, so all of its income will be operating income. If it so chooses, CCC can finance up to 50% of its assets with debt, which will have an 8% interest rate. Assuming a 40% tax rate on all taxable income, what is the difference between CCC’s expected ROE if it finances with 50% debt versus its expected ROE if it finances entirely with common stock?

Solution

Market Value Ratios • Market value ratios incorporate the: – High current levels of earnings and cash flow increase market value ratios – High expected growth in earnings and cash flow increases market value ratios – High risk of expected growth in earnings and cash flow decreases market value ratios

Calculate and appraise the P/E, P/CF, and M/B ratios. Price = $12.17. NI $253.6 EPS = Shares out. = 250 Price per share $12.17 P/E = = EPS $1.01

= $1.01. = 12.

Market Based Ratios NI + Depr. CF per share = Shares out. $253.6 + $120.0 = 250

Price per share P/CF = Cash flow per share = $12.17 $1.49

= 8.2.

= $1.49.

Market Based Ratios (Continued) Com. equity BVPS = Shares out. $1,977 = 250 = $7.91. Mkt. price per share M/B = Book value per share $12.17 = $7.91 = 1.54.

Interpreting Market Based Ratios • P/E: How much investors are willing to pay for $1 of earnings. • P/CF: How much investors are willing to pay for $1 of cash flow. • M/B: How much investors are willing to pay for $1 of book value equity. • For each ratio, the higher the number, the better. • P/E and M/B are high if ROE is high and risk is low.

Comparison with Industry Averages P/E P/CF M/B

2011E 12.0 8.2 1.5

2010 -6.3 27.5 1.1

2009 9.7 8.0 1.3

Ind. 14.2 7.6 2.9

In-class Problem Fontaine Inc. recently reported net income of $2 million. It has 500,000 shares of common stock, which currently trades at $40 a share. Fontaine continues to expand and anticipates that 1 year from now, its net income will be $3.25 million. Over the next year, it also anticipates issuing an additional 150,000 shares of stock so that 1 year from now it will have 650,000 shares of common stock. Assuming Fontaine’s price/earnings ratio remains at its current level, what will be its stock price 1 year from now?

Solution The current EPS is $2,000,000/500,000 shares or $4.00. The current P/E ratio is then $40/$4 = 10.00. The new number of shares outstanding will be 650,000. Thus, the new EPS = $3,250,000/650,000 = $5.00. If the shares are selling for 10 times EPS, then they must be selling for $5.00(10) = $50.

Common Size Balance Sheets: Divide all items by Total Assets Assets Cash ST Inv. AR Invent. Total CA Net FA TA

2009 2010 2011E Ind. 0.6% 0.3% 0.4% 0.3% 3.3% 0.7% 2.0% 0.3% 23.9% 21.9% 25.0% 22.4% 48.7% 44.6% 48.8% 41.2% 76.5% 67.4% 76.2% 64.1% 23.5% 32.6% 23.8% 35.9% 100.0% 100.0% 100.0% 100.0%

Divide all items by Total Liabilities & Equity Assets

2009 2010 2011E Ind. AP 9.9% 11.2% 10.2% 11.9% Notes pay. 13.6% 24.9% 8.5% 2.4% Accruals 9.3% 9.9% 10.8% 9.5% Total CL 32.8% 46.0% 29.6% 23.7% LT Debt 22.0% 34.6% 14.2% 26.3% Total eq. 45.2% 19.3% 56.2% 50.0% Total L&E 100.0% 100.0% 100.0% 100.0%

Analysis of Common Size Balance Sheets • Company has higher proportion of inventory and current assets than Industry. • Company now has more equity (which means LESS debt) than Industry. • Company has more short-term debt than industry, but less long-term debt than industry.

Common Size Income Statement: Divide all items by Sales Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI

2009

2010

2011E

Ind.

100.0% 83.4% 9.9% 0.6% 6.1% 1.8% 4.3% 1.7% 2.6%

100.0% 85.4% 12.3% 2.0% 0.3% 3.0% -2.7% -1.1% -1.6%

100.0% 82.4% 8.7% 1.7% 7.1% 1.1% 6.0% 2.4% 3.6%

100.0% 84.5% 4.4% 4.0% 7.1% 1.1% 5.9% 2.4% 3.6%

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

Percentage Change Analysis: % Change from First Year (2009) Income St.

2009

2010

2011E

Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI

0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

70.0% 73.9% 111.8% 518.8% -91.7% 181.6% -208.2% -208.2% -208.2%

105.0% 102.5% 80.3% 534.9% 140.4% 28.0% 188.3% 188.3% 188.3%

Analysis of Percent Change Income Statement • We see that 2011 sales grew 105% from 2009, and that NI grew 188% from 2009. • So Company has become more profitable.

Percentage Change Balance Sheets: Assets Assets Cash ST Invest. AR Invent. Total CA Net FA TA

2009 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

2010 -19.1% -58.8% 80.0% 80.0% 73.2% 172.6% 96.5%

2011E 55.6% 47.4% 150.0% 140.0% 138.4% 142.7% 139.4%

Percentage Change Balance Sheets: Liabilities & Equity Liab. & Eq.

2009

2010

2011E

AP Notes pay. Accruals Total CL LT Debt Total eq. Total L&E

0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

122.5% 260.0% 109.5% 175.9% 209.2% -16.0% 96.5%

147.1% 50.0% 179.4% 115.9% 54.6% 197.9% 139.4%

Analysis of Percent Change Balance Sheets • We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

The Du Pont System • 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.

The Du Pont System

(

Profit margin

NI Sales

)(

TA turnover

x

Sales TA

)( x

Equity multiplier

TA CE

) = ROE = ROE

The Du Pont System NI Sales

Sales TA

x

2008: 2009: 2010: Ind.:

2.6% -1.6% 3.6% 3.6%

x x x x

x 2.3 2.0 2.0 2.5

x x x x

TA CE

= ROE

2.2 5.2 1.8 2.0

= 13.2% = -16.6% = 13.0% = 18.0%

In-class Problem Ebersoll Mining has $6 million in sales, its ROE is 12%, and its total assets turnover is 3.2×. The company is 50% equity financed. What is its net income?

Solution

Potential Problems and Limitations of Ratio Analysis • Comparison with industry averages is difficult if the firm operates many different divisions. • Seasonal factors can distort ratios. • Window dressing techniques can make statements and ratios look better. • Different ing and operating practices can distort comparisons.

Qualitative Factors • There is greater risk if: – revenues tied to a single customer – revenues tied to a single product – reliance on a single supplier? – High percentage of business is generated overseas?

• What is the competitive situation? • What products are in the pipeline? • What are the legal and regulatory issues?