3 - 1 copyright © 2002 harcourt, inc.all rights reserved. ratio analysis du pont system effects of...

3 - 1

Copyright © 2002 Harcourt, Inc. All rights reserved.

Ratio analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

CHAPTER 3 Analysis of Financial Statements

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Balance Sheet: Assets

2002E 2001

Cash 14,000 7,282

ST investments 71,632 0

AR 878,000 632,160

Inventories 1,716,480 1,287,360

Total CA 2,680,112 1,926,802

Gross FA 1,197,160 1,202,950

Less: Deprec. 380,120 263,160

Net FA 817,040 939,790

Total assets 3,497,152 2,866,592

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Liabilities and Equity

2002E 2001

Accounts payable 436,800 524,160

Notes payable 600,000 720,000

Accruals 408,000 489,600

Total CL 1,444,800 1,733,760

Long-term debt 500,000 1,000,000

Common stock 1,680,936 460,000Retained earnings (128,584) (327,168)

Total equity 1,552,352 132,832

Total L&E 3,497,152 2,866,592

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Income Statement

2002E 2001

Sales 7,035,600 5,834,400

COGS 6,100,000 5,728,000Other expenses 312,960 680,000

Depreciation 120,000 116,960

Tot. op. costs 6,532,960 6,524,960

EBIT 502,640 (690,560)

Interest exp. 80,000 176,000

EBT 422,640 (866,560)

Taxes (40%) 169,056 (346,624)

Net income 253,584 (519,936)

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Other Data

2002E 2001

Shares out. 250,000 100,000

EPS $1.014 ($5.199)

DPS $0.220 $0.110

Stock price $12.17 $2.25

Lease pmts $40,000 $40,000

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Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

Why are ratios useful?

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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?

What are the five major categories of ratios, and what questions do they

answer?

(More…)

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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?

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Calculate the firm’s forecasted current and quick ratios for 2002.

CR02 = = = 1.85x.

QR02 =

= = 0.67x.

CACL

$2,680$1,445

$2,680 - $1,716$1,445

CA - Inv.CL

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Expected to improve but still below the industry average.

Liquidity position is weak.

Comments on CR and QR

2002E 2001 2000 Ind.CR 1.85x 1.1x 2.3x 2.7x

QR 0.67x 0.4x 0.8x 1.0x

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What is the inventory turnover ratio as compared to the industry average?

Inv. turnover =

= = 4.10x.

SalesInventories

$7,036$1,716

2002E 2001 2000 Ind.Inv. T. 4.1x 4.5x 4.8x 6.1x

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Inventory turnover is below industry average.

Firm might have old inventory, or its control might be poor.

No improvement is currently forecasted.

Comments on Inventory Turnover

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ReceivablesAverage sales per day

DSO is the average number of days after making a sale before receiving

cash.

DSO =

= =

= 44.9 days.

ReceivablesSales/360

$878$7,036/360

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Appraisal of DSO

Firm collects too slowly, and situation is getting worse.

Poor credit policy.

2002E 2001 2000 Ind.

DSO 44.9 39.0 36.8 32.0

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Fixed Assets and Total AssetsTurnover Ratios

Fixed assetsturnover

Sales Net fixed assets=

= = 8.61x.$7,036$817

Total assetsturnover

Sales Total assets=

= = 2.01x.$7,036$3,497 (More…)

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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).

2002E 2001 2000 Ind.

FA TO 8.6x 6.2x 10.0x 7.0x

TA TO 2.0x 2.0x 2.3x 2.5x

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Calculate the debt, TIE, and EBITDA coverage ratios.

Total debt Total assetsDebt ratio =

= = 55.6%.$1,445 + $500$3,497

EBIT Int. expense TIE =

= = 6.3x.$502.6$80 (More…)

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All three ratios reflect use of debt, but focus on different aspects.

EBITDAcoverage

= EC

= = 5.5x.

EBIT + Depr. & Amort. + Lease payments Interest Lease Loan pmt.expense pmt. + +

$502.6 + $120 + $40 $80 + $40 + $0

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Too much debt, but projected to improve.

How do the debt management ratios compare with industry averages?

2002E 2001 2000 Ind.

D/A 55.6% 95.4% 54.8% 50.0%

TIE 6.3x -3.9x 3.3x 6.2x

EC 5.5x -2.5x 2.6x 8.0x

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Very bad in 2001, but projected to meet industry average in 2002. Looking good.

Profit Margin (PM)

PM = = = 3.6%. NI Sales

$253.6$7,036

2002E 2001 2000 Ind.

PM 3.6% -8.9% 2.6% 3.6%

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BEP =

= = 14.4%.

Basic Earning Power (BEP)

EBIT Total assets

$502.6 $3,497

(More…)

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BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be below average.

Room for improvement.

2002E 2001 2000 Ind.

BEP 14.4% -24.1% 14.2% 17.8%

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

ROA =

= = 7.3%.

Net income Total assets

$253.6 $3,497

(More…)

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ROE =

= = 16.3%.

Net income Common equity

$253.6 $1,552

Both below average but improving.

2002E 2001 2000 Ind.

ROA 7.3% -18.1% 6.0% 9.0%

ROE 16.3% -391.0% 13.3% 18.0%

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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.

Effects of Debt on ROA and ROE

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Calculate and appraise theP/E, P/CF, and M/B ratios.

Price = $12.17.

EPS = = = $1.01.

P/E = = = 12x.

NI Shares out.

$253.6250

Price per shareEPS

$12.17$1.01

(More…)

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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.

Industry P/E ratioBanking 17.15Computer Software Services 33.01Drug 41.81Electric Utilities (Eastern U.S.) 19.40Internet Services* 290.35Semiconductors 78.41Steel 12.71Tobacco 11.59Water Utilities 21.84

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NI + Depr. Shares out.CF per share =

= = $1.49.$253.6 + $120.0250

Price per share Cash flow per share

P/CF =

= = 8.2x.$12.17$1.49

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Com. equity Shares out.BVPS =

= = $6.21.$1,552250

Mkt. price per share Book value per share

M/B =

= = 2.0x.$12.17$6.21

(More…)

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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.

2002E 2001 2000 Ind.P/E 12.0x -0.4x 9.7x 14.2xP/CF 8.2x -0.6x 8.0x 7.6xM/B 2.0x 1.7x 1.3x 2.9x

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Common Size Balance Sheets:Divide all items by Total Assets

Assets 2000 2001 2002E Ind.Cash 0.6% 0.3% 0.4% 0.3%ST Invest. 3.3% 0.0% 2.0% 0.3%AR 23.9% 22.1% 25.1% 22.4%Invent. 48.7% 44.9% 49.1% 41.2%Total CA 76.5% 67.2% 76.6% 64.1%Net FA 23.5% 32.8% 23.4% 35.9%TA 100.0% 100.0% 100.0% 100.0%

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Divide all items by Total Liabilities & Equity

2000 2001 2002E Ind.

AP 9.9% 18.3% 12.5% 11.9%

Notes pay. 13.6% 25.1% 17.2% 2.4%

Accruals 9.3% 17.1% 11.7% 9.5%

Total CL 32.8% 60.5% 41.3% 23.7%

LT Debt 22.0% 34.9% 14.3% 26.3%

Total equ. 45.2% 4.6% 44.4% 50.0%

Total L&E 100.0% 100.0% 100.0% 100.0%

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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.

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Common Size Income Statement:Divide all items by Sales

2000 2001 2002E Ind.

Sales 100.0% 100.0% 100.0% 100.0%COGS 83.4% 98.2% 86.7% 84.5%Other exp. 9.9% 11.7% 4.4% 4.4%Depr. 0.6% 2.0% 1.7% 4.0% EBIT 6.1% -11.8% 7.1% 7.1%Int. Exp. 1.8% 3.0% 1.1% 1.1% EBT 4.3% -14.9% 6.0% 5.9%Taxes 1.7% -5.9% 2.4% 2.4%NI 2.6% -8.9% 3.6% 3.6%

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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.

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

Income St. 2000 2001 2002E

Sales 0.0% 70.0% 105.0%

COGS 0.0% 100.0% 113.0%

Other exp. 0.0% 100.0% -8.0%

Depr. 0.0% 518.8% 534.9%

EBIT 0.0% -430.3% 140.4%

Int. Exp. 0.0% 181.6% 28.0%

EBT 0.0% -691.1% 188.3%

Taxes 0.0% -691.1% 188.3%

NI 0.0% -691.1% 188.3%

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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.

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Percentage Change Balance Sheets

Assets 2000 2001 2002E

Cash 0.0% -19.1% 55.6%

ST Invest. 0.0% -100.0% 47.4%

AR 0.0% 80.0% 150.0%

Invent. 0.0% 80.0% 140.0%

Total CA 0.0% 71.4% 138.4%

Net FA 0.0% 172.6% 137.0%

TA 0.0% 95.2% 138.1%

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Liab. & Eq. 2000 2001 2002EAP 0.0% 260.0% 200.0%Notes pay. 0.0% 260.0% 200.0%Accruals 0.0% 260.0% 200.0%Total CL 0.0% 260.0% 200.0%LT Debt 0.0% 209.2% 54.6%Total equity 0.0% -80.0% 133.9%Total L&E 0.0% 95.2% 138.1%

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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.

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( )( )( ) = ROE

Profitmargin

TAturnover

Equitymultiplier

NI Sales

SalesTA

TA CE

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%

Explain the Du Pont System

x x = ROE.

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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.

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Simplified Firm Data

A/R $ 878 Debt $1,945Other CA 1,802 Equity 1,552Net FA 817Total assets $3,497 L&E $3,497

Q. How would reducing DSO to 32 days affect the company?

Sales $7,035,600 day 360

= = $19,543.

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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.

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What could be done with the newcash? Effect on stock price and risk?

New Balance Sheet

Added cash $ 253 Debt $1,945A/R 625 Equity 1,552Other CA 1,802Net FA 817Total assets $3,497 Total L&E $3,497

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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…)

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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.

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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.

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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…)

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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.

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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…)

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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?

3 - 1 copyright © 2002 harcourt, inc.all rights reserved. ratio analysis du pont system effects of...

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