CHAPTER 8 Analysis of Financial Statements Topics in Chapter Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors Income Statement 253,584 (95,136) Net income 169,056 (63,424) Taxes (40%) 422,640 (158,560) EBT 80,000 176,000 Int. expense 502,640 17,440 EBIT 6,532,960 5,816,960 Tot. op. costs 120,000 116,960 Deprec. 612,960 720,000 Other expenses 5,800,000 4,980,000 COGS 7,035,600 5,834,400 Sales 2007E 2006 Balance Sheets: Assets 3,516,952 2,886,592 Total assets 836,840 939,790 Net FA 2,680,112 1,946,802 Total CA 1,716,480 1,287,360 Inventories 878,000 632,160 AR 71,632 20,000 S-T invest. 14,000 7,282 Cash 2007E 2006 Balance Sheets: Liabilities & Equity 3,516,952 2,886,592 Total L&E 1,977,152 557,632 Total equity 296,216 97,632 Ret. earnings 1,680,936 460,000 Common stock 500,000 1,000,000 Long-term debt 1,039,800 1,328,960 Total CL 380,000 284,960 Accruals 300,000 720,000 Notes payable 359,800 324,000 Accts. payable 2007E 2006 Other Data 0.4 0.4 Tax rate $40,000 $40,000 Lease payments $7.91 $5.58 Book val. per share $0.22 $0.11 DPS $1.01 -$0.95 EPS 250,000 100,000 # of shares $12.17 $6.00 Stock price 2007E 2006 Why are ratios useful? Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Five Major Categories of Ratios 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…) Ratio Categories (Continued) 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? Forecasted Current and Quick Ratios for 2007. CR07 = = = 2.58x. QR07 = = = 0.93x. CA CL $2,680 $1,040 $2,680 - $1,716 $1,040 CA - Inv. CL Comments on CR and QR Expected to improve but still below the industry average. Liquidity position is weak. 1.0x 0.8x 0.5x 0.93x QR 2.7x 2.3x 1.46x 2.58x CR Ind. 2005 2006 2007E Inventory Turnover Ratio vs. Industry Average Inv. turnover = = = 4.10x. Sales Inventories $7,036 $1,716 2007E 2006 2005 Ind. Inv. T. 4.1x 4.5x 4.8x 6.1x 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. Receivables Average sales per day DSO = = = = 45.5 days. Receivables Sales/365 $878 $7,036/365 Appraisal of DSO Firm collects too slowly, and situation is getting worse. Poor credit policy. 2007 2006 2005 Ind. DSO 45.5 39.5 37.4 32.0 Fixed Assets and Total Assets Turnover Ratios Fixed assets turnover Sales Net fixed assets = = = 8.41x. $7,036 $837 Total assets turnover Sales Total assets = = = 2.00x. $7,036 $3,517 (More…) Fixed Assets and Total Assets Turnover Ratios 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). 2.5x 2.3x 2.0x 2.0x TA TO 7.0x 10.0x 6.2x 8.4x FA TO Ind. 2005 2006 2007E Calculate the debt, TIE, and EBITDA coverage ratios. Total liabilities Total assets Debt ratio = = = 43.8%. $1,040 + $500 $3,517 EBIT Int. expense TIE = = = 6.3x. $502.6 $80 (More…) EBITDA Coverage (EC) = = 5.5x. EBIT + Depr. & Amort. + Lease payments Interest Lease expense pmt. + + Loan pmt. $502.6 + $120 + $40 $80 + $40 + $0 Debt Management Ratios vs. Industry Averages Recapitalization improved situation, but lease payments drag down EC. 2007E 2006 2005 Ind. D/A 43.8% 80.7% 54.8% 50.0% TIE 6.3x 0.1x 3.3x 6.2x EC 5.5x 0.8x 2.6x 8.0x Profit Margin (PM) Very bad in 2006, but projected to meet industry average in 2007. Looking good. 2007E 2006 2005 Ind. PM 3.6% -1.6% 2.6% 3.6% PM = = = 3.6%. NI Sales $253.6 $7,036 Basic Earning Power (BEP) BEP = = = 14.3%. EBIT Total assets $502.6 $3,517 (More…) Basic Earning Power vs. Industry Average BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement. 2007E 2006 2005 Ind. BEP 14.3% 0.6% 14.2% 17.8% Return on Assets (ROA) and Return on Equity (ROE) ROA = = = 7.2%. NI Total assets $253.6 $3,517 (More…) Return on Assets (ROA) and Return on Equity (ROE) ROE = = = 12.8%. NI Common Equity $253.6 $1,977 (More…) ROA and ROE vs. Industry Averages 2007E 2006 2005 Ind. ROA 7.2% -3.3% 6.0% 9.0% ROE 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. Calculate and appraise the P/E, P/CF, and M/B ratios. Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 Industry P/E Ratios 21.92 S&P 500 *Ticker is for typical firm in industry, but P/E ratio is for the industry, not the individual firm 14.14 MO Tobacco 11.91 NUE Steel 25.96 INTC Semiconductors 17.12 DUK Electric Utilities 21.12 PFE Drug 30.70 MSFT Software 15.75 STI Banking P/E Ticker* Industry Market Based Ratios NI + Depr. Shares out. CF per share = = = $1.49. $253.6 + $120.0 250 Price per share Cash flow per share P/CF = = = 8.2x. $12.17 $1.49 Market Based Ratios (Continued) Com. equity Shares out. BVPS = = = $7.91. $1,977 250 Mkt. price per share Book value per share M/B = = = 1.54x. $12.17 $7.91 Interpreting Market Based Ratios P/E: How much investors will pay for $1 of earnings. Higher is better. M/B: How much paid for $1 of book value. Higher is better. P/E and M/B are high if ROE is high, risk is low. Comparison with Industry Averages 2007E 2006 2005 Ind. P/E 12.0x -6.3x 9.7x 14.2x P/CF 8.2x 27.5x 8.0x 7.6x M/B 1.5x 1.1x 1.3x 2.9x Common Size Balance Sheets: Divide all items by Total Assets 100.0% 100.0% 100.0% 100.0% TA 35.9% 23.8% 32.6% 23.5% Net FA 64.1% 76.2% 67.4% 76.5% Total CA 41.2% 48.8% 44.6% 48.7% Invent. 22.4% 25.0% 21.9% 23.9% AR 0.3% 2.0% 0.7% 3.3% ST Inv. 0.3% 0.4% 0.3% 0.6% Cash Ind. 2007E 2005 2005 Assets Divide all items by Total Liabilities & Equity 100.0% 100.0% 100.0% 100.0% Total L&E 50.0% 56.2% 19.3% 45.2% Total eq. 26.3% 14.2% 34.6% 22.0% LT Debt 23.7% 29.6% 46.0% 32.8% Total CL 9.5% 10.8% 9.9% 9.3% Accruals 2.4% 8.5% 24.9% 13.6% Notes pay. 11.9% 10.2% 11.2% 9.9% AP Ind. 2007E 2006 2005 Assets Analysis of Common Size Balance Sheets Computron has higher proportion of inventory and current assets than Industry. Computron now has more equity (which means LESS debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry. Common Size Income Statement: Divide all items by Sales 3.6% 3.6% -1.6% 2.6% NI 2.4% 2.4% -1.1% 1.7% Taxes 5.9% 6.0% -2.7% 4.3% EBT 1.1% 1.1% 3.0% 1.8% Int. Exp. 7.1% 7.1% 0.3% 6.1% EBIT 4.0% 1.7% 2.0% 0.6% Depr. 4.4% 8.7% 12.3% 9.9% Other exp. 84.5% 82.4% 85.4% 83.4% COGS 100.0% 100.0% 100.0% 100.0% Sales Ind. 2007E 2006 2005 Analysis of Common Size Income Statements Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry. Percentage Change Analysis: % Change from First Year (2005) 188.3% -208.2% 0.0% NI 188.3% -208.2% 0.0% Taxes 188.3% -208.2% 0.0% EBT 28.0% 181.6% 0.0% Int. Exp. 140.4% -91.7% 0.0% EBIT 534.9% 518.8% 0.0% Depr. 80.3% 111.8% 0.0% Other exp. 102.5% 73.9% 0.0% COGS 105.0% 70.0% 0.0% Sales 2007E 2006 2005 Income St. Analysis of Percent Change Income Statement We see that 2007 sales grew 105% from 2005, and that NI grew 188% from 2005. So Computron has become more profitable. Percentage Change Balance Sheets: Assets 139.4% 96.5% 0.0% TA 142.7% 172.6% 0.0% Net FA 138.4% 73.2% 0.0% Total CA 140.0% 80.0% 0.0% Invent. 150.0% 80.0% 0.0% AR 47.4% -58.8% 0.0% ST Invest. 55.6% -19.1% 0.0% Cash 2007E 2006 2005 Assets Percentage Change Balance Sheets: Liabilities & Equity 139.4% 96.5% 0.0% Total L&E 197.9% -16.0% 0.0% Total eq. 54.6% 209.2% 0.0% LT Debt 115.9% 175.9% 0.0% Total CL 179.4% 109.5% 0.0% Accruals 50.0% 260.0% 0.0% Notes pay. 147.1% 122.5% 0.0% AP 2007E 2006 2005 Liab. & Eq. 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. Explain 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 ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE x x = ROE. The Du Pont System 2005 2.6% x 2.3 x 2.2 = 13.2% 2006 -1.6% x 2.0 x 5.2 = -16.6% 2007 3.6% x 2.0 x 1.8 = 13.0% Ind. 3.6% x 2.5 x 2.0 = 18.0% NI Sales Sales TA TA CE x x = ROE Potential Problems and Limitations of 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…) Problems and Limitations (Continued) Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. (More…) Problems and Limitations (Continued) 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. Qualitative Factors 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…) Qualitative Factors (Continued) 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?