Analysis of Financial Statements

Chapter 3
Analysis of Financial
Statements
Ratio Analysis
DuPont System
Effects of Improving Ratios
Limitations of Ratio Analysis
Qualitative Factors
3-1
Balance Sheet: Assets

Cash
A/R
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total Assets
2009E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
2008
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
3-2
Balance Sheet: Assets

2009(E)
2008
$199,551
$208,323
Accounts receivable
876,897
690,294
Inventories
909,379
942,374
$1,985,827
$1,840,991
380,510
317,503
67,413
54,045
$313,097
$263,458
$2,298,924
$2,104,449
Cash
Total current assets

Gross fixed assets
Less accumulated depreciation
Net fixed assets

Total assets
4-3
Balance Sheet: Liabilities and Equity

2009(E)
$312,500
650,535
110,157
2008
$288,798
636,318
106,748
$1,073,192
$1,031,864
Long-term debt
656,600
410,769
Common stock (100,000 shares)
550,000
550,000
19,132
$569,132
111,816
$661,816
$2,298,924
$2,104,449
Short-term Borrow
Accounts payable
Accruals
Total current liabilities
Retained earnings
Total equity
Total liabilities and equity
3-4
Income Statement
Sales
Cost of goods sold
Other expenses
Total operating costs excluding
depreciation and amortization
Depreciation and amortization
EBIT
Interest expense
EBT
Taxes (40%)
Net income
2009(E)
$2,069,032
2008
$2,325,967
1,647,925
1,869,326
241,490
287,663
$1,889,415
$2,156,989
17,891
$161,726
25,363
$143,615
27,434
$134,292
53,717
$80,575
31,422
$112,193
44,877
$67,316
3-5
Other Data
2009(E)
2008
EPS
$0.81
$0.67
DPS
$1.00
$1.00
Book value per share
$5.69
$6.62
$19.20
$15.60
100,000
100,000
40%
40%
Stock price
Share outstanding
Tax rate
3-6
Why are ratios useful?
Ratios standardize numbers and facilitate

comparisons.
Ratios are used to highlight weaknesses and
strengths.
Ratio comparisons should be made through
time and with competitors.
Trend analysis.
Peer (or industry) analysis.
3-7
Five Major Categories of Ratios and the

Questions They Answer
Liquidity: Can we make required payments?

Asset management: right amount of assets
vs. sales?
Debt management: 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?
3-8
Everelites Forecasted Current Ratio and

Quick Ratio for 2009
Current assets
Current ratio =
Current liabilities
$1,986
=
$1,073
=1.85x
(Current assets - Inventories)
Current liabilities
($1,986 - $909)
=
$1,073
=1.00
Quick ratio =
3-9
Comments on Liquidity Ratios

2009E
2008
2007
Ind.
Current ratio
1.85x
1.78x
2.02x
2.05
Quick ratio
1.00x
0.87x
1.14x
Expected to improve but still below the

industry average.
Liquidity position is weak.
3-10
Everelites Inventory Turnover vs. the

Industry Average
Inventory turnover09
= Sales/Inventory
= $2,069/$909 = 2.28
2009E
Inventory turnover 2.28x
2008
2007
Ind.
2.47x 3.10x 6.1
3-11
Comments on Inventory Turnover
Inventory turnover is below industry average.

Everelite might have old inventory, or its
control might be poor.
No improvement is currently forecasted.
3-12
DSO: Average Number of Days after

Making a Sale before Receiving Cash
DSO = Receivables/Avg. sales per day
= Receivables/(Annual sales/365)
= $876/($2,069/365)
= 154.69 days
3-13
Appraisal of DSO
2009E
DSO
2008
154.69x 108.32x
2007
Ind.
135.60x
56
Everelite collects on sales too slowly, and

is getting worse.
Everelite has a poor credit policy.
3-14
Fixed Assets and Total Assets Turnover

Ratios vs. the Industry Average
FA turnover = Sales/Net fixed assets
= $2,069/$313 = 6.61
TA turnover = Sales/Total assets

= $2,069/$2,299 = 0.90
3-15
Evaluating the FA Turnover and TA

Turnover Ratios
FA TO
TA TO
2009E
2008
2007
Ind.
6.61x
0.90x
8.83x
1.11x
11.22x
1.21x
9.3
2.1
FA turnover projected to be still below the

industry average.
TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).
3-16
Calculate the Debt Ratio and

Times-Interest-Earned Ratio
Debt ratio = Total debt/Total assets
= ($1,073 + $657)/$2,299
= 75.25%
TIE = EBIT/Interest expense
= $161.7/$27.4 = 5.90
3-17
Everelites Debt Management Ratios vs.

the Industry Averages
2009E
D/A
TIE
2008
2007
Ind.
75.24% 68.55% 64.50% 50.00%

6.2
5.90x
4.57x
19.17x
D/A and TIE are worse than the industry

average.
3-18
Profitability Ratios: Operating Margin,

Profit Margin, and Basic Earning Power
Operating margin09= EBIT/Sales
= $161.7/$2,069
=7.82%.
Profit margin09= Net income/Sales
= $80.5/$2,069
= 3.89%.
Basic earning power09=EBIT/Total assets
= $161.7/$2,299
= 7.03%.
3-19
Appraising Profitability with Operating Margin,

Operating margin
Profit margin
Basic earning power
2009E 2008
2007
Ind.
7.82% 6.17% 11.91% 13%
3.89% 2.89% 6.78% 9.00%
7.03% 6.82% 14.38% 15.00%
3-20
Appraising Profitability with Operating Margin,

Operating margin was very bad in 2008. It is

projected to improve in 2009, but it is still
projected to remain below the industry average.
Profit margin was very bad in 2008. It is
projected to improve in 2009, but it is still
projected to remain below the industry average.
BEP removes the effects of taxes and financial
leverage, and is useful for comparison.
BEP projected to improve, yet still below the
industry average. There is definitely room for
improvement.
3-21
Profitability Ratios: Return on Assets and

Return on Equity
ROA = Net income/Total assets
= $80.5/$2,299 = 3.50%
ROE = Net income/Total common equity

= $80.5/$569 = 14.16%.
3-22
Appraising Profitability with ROA

and ROE
ROA
ROE
2009E
2008
2007
Ind.
3.50% 3.20% 8.18% 6.50%
14.16% 10.17% 23.03% 12.00%
Both ratios rebounded from the previous

year, but are still below the industry
average. More improvement is needed.
Wide variations in ROE illustrate the effect
that leverage can have on profitability.
3-23
Effects of Debt on ROA and ROE
ROA is lowered by debt interest lowers NI,

which also lowers ROA = NI/Assets.
But use of debt also lowers equity, hence
debt could raise ROE = NI/Equity.
3-24
Problems with ROE
ROE and shareholder wealth are correlated,

but problems can arise when ROE is the sole
measure of performance.
ROE does not consider risk.

ROE does not consider the amount of capital
invested.
Might encourage managers to make investment
decisions that do not benefit shareholders.
ROE focuses only on return and a better

measure would consider risk and return.
3-25
Calculate the Price/Earnings and

Market/Book Ratios
P/E = Price/Earnings per share
= $19.20/$0.81 = 23.70
M/B = Market price/Book value per share
= $19.20/$5.69 = 3.37
P/E
M/B
2009E
23.83x
3.37x
2008
23.17x
2.36x
2007
14.49x
3.34x
Ind.
10.00
3.00
3-26
Analyzing the Market Value Ratios
P/E: How much investors are willing to pay

for $1 of earnings.
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.
3-27
The DuPont System

ROE Profit
margin
Equity
Total
assets
turnover
multiplier
ROE (NI/Sales) (Sales/TA) (TA/Equity )
Focuses on expense control (PM), asset

utilization (TA TO), and debt utilization
(equity multiplier).
3-28
DuPont Equation:
Breaking Down Return on Equity
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
=3.89% 0.90 1/(1 0.7524)
= 14.16%.
2007
2008
2009E
PM
TA TO
6.78%
1.21
2.89%
1.11
3.89%
0.90
EM
2.82
3.18
4.04
ROE
23.03%
10.17%
14.16%
3-29
An Example:
The Effects of Improving Ratios
A/R
Other CA
Net FA
TA
$ 877
1,109
313
$2,299
Debt
Equity
$1,730
569
Total L&E
$2,299
Sales/Day = $2,069/365 = $5.67
How would reducing the firms DSO to 56 days

affect the company?
3-30
Reducing Accounts Receivable and

the Days Sales Outstanding
Reducing A/R will have no effect on sales.
Accounts receivable under new policy
= $5.67 56 days= $377.44.
Freed cash= old A/R new A/R
= $876.86 $377.44
= $559.42
Initially shows up as addition to cash.
3-31
Effect of Reducing Receivables on

Balance Sheet and Stock Price
What could be done with the new cash?
How might stock price and risk be affected?
3-32
Potential Uses of Freed up Cash
Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the
stock price.
3-33
Potential Problems and Limitations of

Financial Ratio Analysis
Comparison with industry averages is difficult

for a conglomerate firm that operates in
many different divisions.
Average performance is not necessarily
good, perhaps the firm should aim higher.
Seasonal factors can distort ratios.
Window dressing techniques can make
statements and ratios look better.
3-34
More Issues Regarding Ratios
Different operating and accounting practices

can distort comparisons.
Sometimes it is hard to tell if a ratio is good
or bad.
Difficult to tell whether a company is, on
balance, in strong or weak position.
3-35
Consider Qualitative Factors When Evaluating

a Companys Future Financial Performance
Are the firms revenues tied to one key

customer, product, or supplier?
What percentage of the firms business is
generated overseas?
The firms competitive environment
Future prospects
Legal and regulatory environment
3-36

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Chapter 3

Balance Sheet: Assets

Balance Sheet: Assets

Total current assets

Net fixed assets

Balance Sheet: Liabilities and Equity

Common stock (100,000 shares)

Book value per share

Why are ratios useful?

Ratios standardize numbers and facilitate

Five Major Categories of Ratios and the

Liquidity: Can we make required payments?

Everelites Forecasted Current Ratio and

Comments on Liquidity Ratios

Expected to improve but still below the

Everelites Inventory Turnover vs. the

2.47x 3.10x 6.1

Comments on Inventory Turnover

Inventory turnover is below industry average.

DSO: Average Number of Days after

Everelite collects on sales too slowly, and

Fixed Assets and Total Assets Turnover

TA turnover = Sales/Total assets

Evaluating the FA Turnover and TA

FA turnover projected to be still below the

Calculate the Debt Ratio and

Everelites Debt Management Ratios vs.

75.24% 68.55% 64.50% 50.00%

D/A and TIE are worse than the industry

Profitability Ratios: Operating Margin,

Appraising Profitability with Operating Margin,

Appraising Profitability with Operating Margin,

Operating margin was very bad in 2008. It is

Profitability Ratios: Return on Assets and

ROE = Net income/Total common equity

Appraising Profitability with ROA

Both ratios rebounded from the previous

Effects of Debt on ROA and ROE

ROA is lowered by debt interest lowers NI,

Problems with ROE

ROE and shareholder wealth are correlated,

ROE does not consider risk.

Might encourage managers to make investment

decisions that do not benefit shareholders.

ROE focuses only on return and a better

Calculate the Price/Earnings and

Analyzing the Market Value Ratios

P/E: How much investors are willing to pay

The DuPont System

ROE (NI/Sales) (Sales/TA) (TA/Equity )

Focuses on expense control (PM), asset

Sales/Day = $2,069/365 = $5.67

How would reducing the firms DSO to 56 days

Reducing Accounts Receivable and

Effect of Reducing Receivables on

Potential Uses of Freed up Cash

Potential Problems and Limitations of

Comparison with industry averages is difficult