CHAPTER 3

Analysis of Financial Statements

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

Determinants of Intrinsic Value: Using Ratio Analysis

Net operating profit after taxes Free cash flow (FCF) Required investments in operating capital =

Value =

FCF1 FCF2 FCF + + ... + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average cost of capital (WACC) Market interest rates Market risk aversion Cost of debt Cost of equity Firms debt/equity mix Firms business risk
3

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
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Income Statement
2010 Sales COGS Other expenses Deprec. Tot. op. costs EBIT Int. expense EBT Taxes (40%) Net income $5,834,400 4,980,000 720,000 116,960 5,816,960 17,440 176,000 (158,560) (63,424) ($ 95,136) 2011E $7,035,600 5,800,000 612,960 120,000 6,532,960 502,640 80,000 422,640 169,056 $ 253,584
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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
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Balance Sheets: Liabilities & Equity

Accts. payable Notes payable Accruals Total CL Long-term debt Common stock Ret. earnings Total equity Total L&E $ 2010 324,000 720,000 284,960 2011E $ 359,800 300,000 380,000 1,039,800 500,000 1,680,936 296,216 1,977,152 $3,516,952 7

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

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
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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.

CR10 CA = CL $2,680 = $1,040 = 2.58.

QR10

CA - Inv. = CL $2,680 - $1,716 = $1,040 = 0.93.

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Comments on CR and QR
2011E CR QR 2.58 0.93 2010 1.46 0.5 2009 2.3 0.8 Ind. 2.7 1.0

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

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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?

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Inventory Turnover Ratio vs. Industry Average

Inv. turnover Sales = Inventories $7,036 = = 4.10. $1,716 2010 4.5 2009 4.8 Ind. 6.1
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2011E Inv. T. 4.1

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.

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

DSO = Receivables Average sales per day = $878 $7,036/365

= Receivables Sales/365 = 45.5 days.

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Appraisal of DSO
Firm collects too slowly, and situation is getting worse. Poor credit policy.

DSO

2011 45.5

2010 39.5

2009 37.4

Ind. 32.0
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Fixed Assets and Total Assets Turnover Ratios

Fixed assets turnover Sales = Net fixed assets $7,036 = 8.41. = $837 Sales = Total assets $7,036 = 2.00. = $3,517 (More)

Total assets turnover

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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).

2011E FA TO TA TO 8.4 2.0

2010 6.2 2.0

2009 10.0 2.3

Ind. 7.0 2.5

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Debt Management Ratios

Does the company have too much debt? Can the companys earnings meet its debt servicing requirements?

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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)
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EBITDA Coverage (EC)

EBIT + Depr. & Amort. + Lease payments Interest Lease + Loan pmt. expense + pmt. $502.6 + $120 + $40 = $80 + $40 + $0 = 5.5.
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Debt Management Ratios vs. Industry Averages

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

D/A TIE EC

Recapitalization improved situation, but lease payments drag down EC.

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Profitability Ratios
What is the companys rate of return on:
Sales? Assets?

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

(Continued)

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

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Profit Margins vs. Industry Averages

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

PM OPM GPM

Very bad in 2010, but projected to meet or exceed industry average in 2011.
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Basic Earning Power (BEP)

EBIT BEP = Total assets $502.6 = $3,517 = 14.3%.

(More)
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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. 2011E 2010 2009 Ind. BEP 14.3% 0.6% 14.2% 17.8%
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Return on Assets (ROA) and Return on Equity (ROE)

NI ROA = Total assets $253.6 = $3,517 = 7.2%.

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

ROE = NI Common Equity = 12.8%.

$253.6 = $1,977

(More)
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ROA and ROE vs. Industry Averages

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

ROA ROE

Both below average but improving.

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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.

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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
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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 = = $1.01 EPS = $1.01.

= 12.
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Industry P/E Ratios:

Industry Banking Software Drug Electric Utilities Semiconductors Steel Tobacco S&P 500 Ticker* STI MSFT PFE DUK INTC NUE MO P/E 1.32 6.14 5.87 10.14 4.01 0.33 1.30 14.22

*Ticker is for typical firm in industry, but P/E ratio is for the industry, not 35 the individual firm; www.investor.reuters.com, January 2009.

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.
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= $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.
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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.

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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

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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%
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Divide all items by Total Liabilities & Equity

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%
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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.
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Common Size Income Statement: Divide all items by Sales

Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI 2009 100.0% 83.4% 9.9% 0.6% 6.1% 1.8% 4.3% 1.7% 2.6% 2010 100.0% 85.4% 12.3% 2.0% 0.3% 3.0% -2.7% -1.1% -1.6% 2011E 100.0% 82.4% 8.7% 1.7% 7.1% 1.1% 6.0% 2.4% 3.6% Ind. 100.0% 84.5% 4.4% 4.0% 7.1% 1.1% 5.9% 2.4% 3.6% 43

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.

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Percentage Change Analysis: % Change from First Year (2009)

Income St.
Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI 2009 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2010 70.0% 73.9% 111.8% 518.8% -91.7% 181.6% -208.2% -208.2% -208.2% 2011E 105.0% 102.5% 80.3% 534.9% 140.4% 28.0% 188.3% 188.3% 188.3% 45

Analysis of Percent Change Income Statement

We see that 2011 sales grew 105% from 2009, and that NI grew 188% from 2009. So Computron has become more profitable.

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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%
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Percentage Change Balance Sheets: Liabilities & Equity

Liab. & Eq.
AP Notes pay. Accruals Total CL LT Debt Total eq. Total L&E 2009 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2010 122.5% 260.0% 109.5% 175.9% 209.2% -16.0% 96.5% 2011E 147.1% 50.0% 179.4% 115.9% 54.6% 197.9% 139.4%
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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.

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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.

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The Du Pont System

Profit margin NI Sales

)(
x

TA turnover Sales TA

)(
x

Equity multiplier TA CE

) = ROE
= ROE

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The Du Pont System

NI Sales 2008: 2009: 2010: Ind.: x Sales TA x x x x x 2.3 2.0 2.0 2.5 x x x x TA CE 2.2 5.2 1.8 2.0 = ROE = 13.2% = -16.6% = 13.0% = 18.0%
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2.6% -1.6% 3.6% 3.6%

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 accounting and operating practices can distort comparisons.
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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?
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