Financial Management I

Chap 03Analysis of Financial

Statements

Ratio Analysis Financial statements report Both on a firm’s

position at a point in time & on its operations over some past period.

Real Value of Financial Statements? Usefulness of Financial Statement Analysis? Ratio Analysis?

Ratio Analysis1. Liquidity Ratios2. Asset Management Ratios3. Debt Management Ratios4. Profitability Ratios5. Market Value Ratios6. DuPont Analysis

Liquidity Ratios A liquid Asset is one that can be converted to

cash quickly without having to reduce the Asset’s price very much.

Liquidity Ratios are ratios that show the relationship of a firm’s cash & other Current Assets to its liabilities.

Usefulness of Liquidity Ratios? Most Commonly Used liquidity Ratios?

Liquidity Ratios – Current Ratio

Current Ratio indicates the extent to which Current Liabilities are covered by those Assets expected to be converted to cash in near future.

Current Ratio = Current Assets/Current Liabilities

Too High Ratio? Too low Ratio?Increasing Trend? Decreasing Trend?

Current Ratio - Example

Cartwright Brothers has the following balance sheet (all numbers are expressed in millions of dollars):

Cash $ 250 Accounts payable $ 300Accounts receivable 250 Notes payable

300Inventories 250 Long-term debt 600Net fixed assets 1,250Common stock 800Total assets $2,000 Total claims

$2,000

Calculate Current Ratio:

Current Ratio - Example

Current Ratio = Cash + A/R +InventoryA/P + N/P

= 250 +250 + 250300 +300

= 1.25

Current Ratio - Example

Iken Berry Farms has $5 million in current assets, $3 million in current liabilities, and its initial inventory level is $1 million. The company plans to increase its inventory, and it will raise additional short-term debt (that will show up as notes payable on the balance sheet) to purchase the inventory. Assume that the value of the remaining current assets will not change. The company’s bond covenants require it to maintain a current ratio that is greater than or equal to 1.5. What is the maximum amount that the company can increase its inventory before it is restricted by these covenants?

Current Ratio - Example Iken Berry Farms has $5 million in current assets, $3 million in current

liabilities, and its initial inventory level is $1 million. The company plans to increase its inventory, and it will raise additional short-term debt (that will show up as notes payable on the balance sheet) to purchase the inventory. Assume that the value of the remaining current assets will not change. The company’s bond covenants require it to maintain a current ratio that is greater than or equal to 1.5. What is the maximum amount that the company can increase its inventory before it is restricted by these covenants?

Iken Berry Farms has a current ratio of 1.67If notes payable are going to be raised to buy inventories, both the numerator and the denominator of the ratio will increase causing Ratio to decrease.

Current Ratio - Example

.000,000,1$X

X000,000,1$

X5.0000,500$

X5.1000,500,4$X000,000,5$

5.1X000,000,3$

X000,000,5$

5.1XCL

XCA

Asset Management Ratios

Asset Management ratios is a set of ratios that measure how effectively a firm is managing its assets

Problem with having too many Assets? Or, too less Assets?

Most Commonly used Asset Management Ratios?

Asset Management Ratios

Asset Management ratios is a set of ratios that measure how effectively a firm is managing its assets

Problem with having too many Assets? Or, too less Assets?

Most Commonly used Asset Management Ratios:

1. Inventory Turnover ratio2. Days Sales Outstanding3. Fixed Asset Turnover Ratio4. Total Asset Turnover Ratio

Asset Management Ratios – Inventory Turnover Ratio

Inventory Turnover is an approximation indicating how many times in a year, a company’s inventory is sold out or converted to sales.

Inventory T.O = Sales / Inventory

Too high Ratio? Too Low ratio?Increasing Trend? Decreasing Trend?

Inventory Turnover Ratio - Example

XYZ’s balance sheet and income statement are given below:

Balance Sheet:Cash $ 50 Accounts payable $ 100A/R 150 Notes payable 0Inventories 300 Long-term debt (10%)

700Fixed assets 500 Common equity 200Total assets $1,000 Total liabilities & equity

$1,000Sales $1,000

Calculate Inventory Turnover Ratio? If Industry’s Inventory Turnover Ratio is 5, what would that imply for XYZ?

Inventory Turnover Ratio - Example

Inventory Turnover Ratio = 1000/ 300= 3.33

Asset management ratios – Days Sales outstanding

Days Sales outstanding (DSO), also called the collection period, indicates the average length of time the firm must wait after making a sale before it receives cash.

DSO = Receivables / Average Sales Per Day

= Receivables / (Annual Sales/ 365)

Should be compared with the terms on which the firm sells its goods!!

Days Sales outstanding - Example

Ruth Company currently has $1,000,000 in accounts receivable. Its days sales outstanding (DSO) is 50 days. The company wants to reduce its DSO to the industry average of 32 days by pressuring more of its customers to pay their bills on time. The company’s CFO estimates that if this policy is adopted the company’s average sales will fall by 10 percent. Assuming that the company adopts this change and succeeds in reducing its DSO to 32 days and does lose 10 percent of its sales, what will be the level of accounts receivable following the change? Assume a 365-day year.

Days Sales outstanding - Example

First, solve for current annual sales using the DSO equation as follows: 50 = $1,000,000/(Sales/365) annual sales = $7,300,000

If sales fall by 10%, The new sales level = $7,300,000(0.9) = $6,570,000.

Again, using the DSO equation, solve for the new accounts receivable figure as follows: 32 = AR/($6,570,000/365) AR = $576,000.

Asset management ratios – Fixed Asset Turnover Ratio

The Fixed Asset Turnover ratio measures how effectively the firm uses its Plant & Equipment.

Fixed Asset T.O = Sales / Net Fixed AssetsNet Fixed Assets = Gross Fixed Assets – Accumulated

Depreciation

Potential Problem with interpreting Fixed Asset T.O ratio?

Fixed Asset Turnover Ratio - Example

Your company had the following balance sheet and Sales of $10,000 for 2002:

Balance Sheet:Cash $ 20A/R 1,000

Inventories 5,000Total current assets $6,020 Debt

$4,000Net fixed assets 2,980 Equity 5,000Total assets $9,000 Total claims

$9,000

If Company wants to increase its sales by 10% & maintain a Fixed Asset Turnover Ratio of 4.45, what would should be the level of Net Fixed Assets. Also, calculate increase or Decrease in Net Fixed Assets.

Fixed Asset Turnover Ratio - Example

New Level of Sales = 10,000 (1.10) = 11,000Fixed Asset T.O = 4.45

Solve for New Level of Fixed assets:4.45 = 11,000 / XX = 11,000 / 4.45

= 2472

Decrease in Fixed Assets = 2980 – 2472= 508

Asset management ratios – Total Asset Turnover Ratio

The Total Asset Turnover Ratio measures the turnover of all the firm’s Assets.

Total Asset T.O = Sales / Total Assets

Asset Management Ratios - Example

Taft Technologies has the following relationships:Annual sales $1,200,000.00Current liabilities $ 375,000.00Days sales outstanding (DSO) 40.00Inventory turnover ratio 4.80Current ratio 1.20

The company’s current assets consist of cash, inventories, and accounts receivable. How much cash does Taft have on its balance sheet?

Asset Management Ratios - Example

First, find the amount of current assets: Current ratio = Current assets/Current liabilitiesCurrent assets = (Current liabilities)(Current ratio) = $375,000(1.2) = $450,000.Next, find the accounts receivables:DSO = AR/(Sales/365) AR = DSO(Sales)(1/365)= (40)($1,200,000)(1/365)

=$131,506.85.Next, find the inventories:Inventory turnover = Sales/InventoryInventory = $1,200,000/4.8 =$250,000.

Finally, find the amount of cash:Cash = Current assets - AR - Inventory = $450,000 - $131,506.85 - $250,000

= $68,493.15 $68,493.

Debt Management Ratios

The extent to which a firm has debt financing or Financial Leverage, has three important implications:

1. By raising funds through debt, stockholders can maintain the control of the firm while limiting their investments

2. Creditors look at the equity as owner supplied funds , to provide a margin of safety.

3. If the firm earns more on investments financed with borrowed funds than it pays in interest, the return on owner’s capital is magnified.

THE Effects of Financial Leverage - Example

We consider case of company X which has no debt & is considering restructuring to include debt in its capital structure.

We look at DEBT & NO DEBT situations

Taxes are ignored

THE Effects of Financial Leverage - Example

Current Proposed

Assets $8,000,000 $8,000,000

Debt 0 4,000,000

Equity 8,000,000 4,000,000

Debt-Equity Ratio 0 1

Share Price 20 20

# of Shares 400,000 200,000

Interest Rate 10% 10%

THE Effects of Financial Leverage - Example

Current Capital Structure: No DebtRecession Normal Expansion

EBIT $500,000 $1,000,000

$1,500,000

Interest 0 0 0

Net Income

500,000 1,000,000 1,500,000

ROE 6.25% 12.5% 18.75%

EPS 1.25 2.50 3.75

THE Effects of Financial Leverage - Example

Proposed Capital Structure: Debt - $4 Million

Recession Normal Expansion

EBIT $500,000 $1,000,000

$1,500,000

Interest 400,000 400,000 400,000

Net Income

100,000 600,000 1,100,000

ROE 2.50% 15.50% 27.50%

EPS 0.50 3.00 5.50

Debt Management Ratios – Debt Ratio

The Debt Ratio measures the percentage of funds provided by creditors. Total Debt includes both Current Liabilities & Long Term Debt.

Debt Ratio = Total Debt / Total Assets

Creditors prefer low Debt ratio because the lower the ratio, the greater the cushion against Creditor’s losses in the event of liquidation.

What about Stockholders?

Debt Ratio - Example

Kansas Office Supply had $24,000,000 in sales last year. The company’s net income was $400,000, its total assets turnover was 6.0, and the company’s ROE was 15 percent. The company is financed entirely with debt and common equity. What is the company’s debt ratio?

Debt Ratio - Example

Sales/Total assets = 6 Total assets = $24,000,000/6

= $4,000,000.

ROE = NI/EquityEquity = NI/ROE

= $400,000/0.15 = $2,666,667.

Debt = Total assets - Equity = $4,000,000 -

$2,666,667 = $1,333,333.

Debt ratio = $1,333,333/$4,000,000 = 0.3333.

Debt Management Ratios – Times Interest Earned Ratio

Times Interest Earned Ratio is a measure of the firm’s ability to meet its annual interest payments.

TIE = EBIT / Interest Charges

Point to Note:Earnings before interest & taxes, rather than Net income is used in the numerator because interest is paid with pre-tax dollars, the firm’s ability to pay current interest is not effected by taxes.

Times Interest Earned Ratio - Example

Culver Inc. has earnings after interest but before taxes of $300. The company’s times interest earned ratio is 7.00. Calculate the company’s interest charges.

Times Interest Earned Ratio - Example

Culver Inc. has earnings after interest but before taxes of $300. The company’s times interest earned ratio is 7.00. Calculate the company’s interest charges.

TIE = EBIT/INT

7 = ($300 + INT)/INT 7INT = $300 + INT 6INT = $300 INT = $50.

Times Interest Earned Ratio – Disadvantages

1. Interest is not the only financial charge- companies must also pay back principle & many firms lease assets & must make lease payments.

2. EBIT does not reflect all the cash flows available to service debt, especially if a firm has high depreciation and/or amortization charges.

Debt Management Ratios – EBITDA Coverage Ratio

The EBITDA coverage ratio is most useful for relatively short term lenders as over a relatively short period, depreciation generated funds can be used to service debt.

EBITDA Coverage Ratio:

EBITDA + lease Payments Interest +Principal Payment +Lease

Payments

Profitability Ratios

Profitability ratios include a group of ratios that show the combined effect of liquidity, asset management & debt on operating results.

Profitability ratios constitute of:

1. Profit Margin on Sales2. Basic Earning Power (BEP)3. Return on Total Assets (ROA)4. Return on Common Equity (ROE)

Profitability Ratios – Profit Margin on Sales

Profit Margin Ratio measures Net Income per dollar of Sales.

Profit Margin on Sales = Net Income / Sales

Special Case of Financial Leverage!!

Profitability Ratios - Basic Earning Power

The BEP ratio indicates the ability of the firm’s Assets to generate operating Income.

BEP = EBIT / Total Assets

This ratio shows the raw earning power of the firm’s Assets, before the influence of taxes & leverage, and it is useful for comparing firms with different tax situations & different degrees of financial leverage.

BEP - Example

Peterson Packaging Corp. has $9 billion in total assets. The company’s basic earning power (BEP) ratio is 9 percent, and its times interest earned ratio is 3.0. Peterson’s depreciation and amortization expense totals $1 billion. It has $0.6 billion in lease payments and $0.3 billion must go towards principal payments on outstanding loans and long-term debt. What is Peterson’s EBITDA coverage ratio?

BEP - Example

EBIT/$9,000,000,000 = 0.09 EBIT = $810,000,000.

3 = EBIT/INT 3 = $810,000,000/INT

INT = $270,000,000.

EBITDA = EBIT + DA = $810,000,000 +

$1,000,000,000 = $1,810,000,000.

EBITDA coverage ratio = (1.81+0.6)/(0.27+0.6+0.3)

= 2.0598 2.06.

Profitability Ratios – Return on Total Assets

The ratio of Net Income to total Assets measures the return on total Assets (ROA) after interest & taxes.

ROA = Net Income / Total Assets

ROA - Example

Aaron Aviation recently reported the following information:

Net income $500,000ROA 10%Interest expense $200,000

The company’s average tax rate is 40 percent. What is the company’s basic earning power (BEP)?

ROA - Example

Given ROA = 10% and net income of $500,000, total assets must be $5,000,000.

To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement:EBIT $1,033,333 ($200,000 + $833,333)Interest 200,000 (Given)EBT $ 833,333 ($500,000/0.6)Taxes (40%) 333,333 NI $ 500,000

BEP = EBIT /TA = 1033,333 / 5,000,000 = 0.2067 or 20.67%.

Profitability Ratios – Return on Common Equity

The Return on Common Equity Ratio measures the Return on Common Stockholders’ investments.

ROE = Net Income / Common Equity

Return on Common Equity - Example

Tapley Dental Supply Company has the following data:Net income $240Sales $10,000Total assets $6,000Debt ratio 75%TIE ratio 2.0Current ratio 1.2BEP ratio 13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to $300 without affecting sales or the balance sheet (the additional profits will be paid out as dividends), by how much would its ROE increase?

Return on Common Equity - Example

Equity = 0.25($6,000) = $1,500.

Current ROE = 240/1500= 16%.

New ROE =300/1500 = 0.20 or 20%.

ROE = 20% - 16% = 4%.

Financial Management I

Chap 03Analysis of Financial

Statements

Ratio Analysis1. Liquidity Ratios2. Asset Management Ratios3. Debt Management Ratios4. Profitability Ratios5. Market Value Ratios6. DuPont Analysis

Market Value Ratios

Market Value Ratios constitute set of ratios that relate the firm’s stock price to its earnings, cash flows & book value per share:

1. Price/ Earning Ratio2. Price/ Cash flow ratio3. Market/Book Value Ratio

Market Value Ratios – Price/Earnings Ratio

The ratio of Price per Share to earnings per share shows the dollar amount investors will pay for $1 of current earnings.

P/E Ratio = Price Per Share / Earnings Per Share

Purpose?

Price/Earnings Ratio - Example

Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is $750,000, and its P/E is 8. What is the company’s stock price?

Price/Earnings Ratio - Example

Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is $750,000, and its P/E is 8. What is the company’s stock price?

EPS = $750,000/100,000 = $7.50.P/E = Price/EPS = 8.

Thus, Price = 8 $7.50 = $60.00.

Market Value Ratios/ Price/Cash flow Ratio

The ratio of Price per Share to cash flow per share shows the dollar amount investors will pay for $1 of cash flows.

P/CF Ratio = Price Per Share / Cash Flow Per Share

Where:CF = (NI + Non Cash Charges)

Purpose?

Market Value Ratios - Market/Book Value Ratio

The ratio of stock’s Market price to its book value gives another indication of how investors regard the company.

Companies with relatively high rates of return on Equity generally sell at higher multiples of book Value than those with low Returns.

Market/Book Ratio = Market Price per share Book Value per

Share

Market/Book Value Ratio - Example

Strack Houseware Supplies Inc. has $2 billion in total assets. The other side of its balance sheet consists of $0.2 billion in current liabilities, $0.6 billion in long-term debt, and $1.2 billion in common equity. The company has 300 million shares of common stock outstanding, and its stock price is $20 per share. What is Strack’s market/book ratio?

Market/Book Value Ratio - Example

TA = $2,000,000,000; CL = $200,000,000; LT debt = $600,000,000; CE = $1,200,000,000; Shares outstanding = 300,000,000; P0 = $20; M/B = ?

Book value = 1200 Million / 300 Million = $4.00.

M/B = 20/4 = 5.0.

The DuPont Equation

The DuPont Equation is the formula which shows that the rate of return on Assets can be found as the product of the profit Margin times the total Asset Turnover.

Thus,ROA = Profit Margin * Total Asset Turnover

= (NI/Sales) * (Sales/Total Assets)

The Extended DuPont Equation

ROA = Net Income / Total AssetsROE = Net Income/Total EquityEquity Multiplier = Total Assets/Common Equity

The Extended DuPont Equation

ROA = Net Income / Total AssetsROE =Net Income/Total EquityEquity Multiplier = Total Assets/Common Equity

Thus,

ROE = Profit Margin * TATO * Equity Multiplier

= (NI/Sales) * (Sales/TA) * (TA/Equity)

The Extended DuPont Equation - Example

Company A has sales of $1,000, assets of $500, a debt ratio of 30 percent, and an ROE of 15 percent. Company B has the same sales, assets, and net income as Company A, but its ROE is 30 percent. What is B’s debt ratio? (Hint: Begin by looking at the Du Pont equation.)

The Extended DuPont Equation - Example

ROE = (NI/Sales) * (Sales/TA) * (TA/Equity)0.15 = (NI/1000) * (1000/500) * (500/0.7*500)

Thus,NI = 52.50

Therefore,

NPM (B) = 52.5/1000= 5.25%

The Extended DuPont Equation - Example

Data for Co. B:ROE = (NI/Sales) * (Sales/TA) * (TA/Equity)0.30 = 0.0525 * 2 * ( TA / Equity)0.30 = 0.1050 * (500 /Equity)

Hence,Equity= $175Debt = 500 – 175

= 325Therefore,

Debt Ratio = 325 /500= 65 %

Limitations of Ratio Analysis

Multiple Divisions in different Industries Average Not Enough for Most firms Inflation Seasonal Factors Window Dressing Techniques Different Accounting Practices Difficult to generalize

Thank you for your Time & Patience