3-1

Lecture Three
Evaluating the Firm for Planning
and Forecasting Via
Analysis of Financial Statements

Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
 3-2

Balance Sheet: Assets

1998E 1997
Cash 85,632 7,282
AR 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 77% 1,926,802 67%
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
 3-3

Liabilities and Equity

1998E 1997
Accounts payable 436,800 524,160
Notes payable 600,000 720,000
Accruals 408,000 489,600
Total CL 1,444,800 41%1,733,760 60%
Long-term debt 500,000 14%1,000,000 35%
Common stock 1,680,936 460,000
Retained earnings (128,584) (327,168)
Total equity 1,552,352 44% 132,832 5%
Total L & E 3,497,152 2,866,592
 3-4

Income Statement

1998E 1997
Sales 7,035,600 5,834,400
COGS 5,728,000 5,728,000
Other expenses 680,000 680,000
Depreciation 116,960 116,960
Tot. op. costs 6,524,960 6,524,960
EBIT 510,640 (690,560)
Interest exp. 88,000 176,000
EBT 422,640 (866,560)
Taxes (40%) 169,056 (346,624)
Net income 253,584 (519,936)
 3-5

Other Data

1998E 1997
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
 3-6

Why are ratios useful?

Standardize numbers; facilitate

comparisons
Used to highlight weaknesses and
strengths
 3-7

What are the five major categories of

ratios, and what questions do they
answer?

Liquidity: Can we make required

payments?
Asset management: Right amount of
assets vs. sales?
 3-8

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?
 3-9

Calculate DLeons forecasted current

and quick ratios for 1998.

CR98 = CA = $2,680 = 1.85x.

CL $1,445

QR98 = CA - Inv.
CL

= $2,680 - $1,716 = 0.67x.

$1,445
 3 - 10

Comments on CR and QR

1998 1997 1996 Ind.

CR 1.85x 1.1x 2.3x 2.7x
QR 0.67x 0.4x 0.8x 1.0x

Expected to improve but still below

the industry average.
Liquidity position is weak.
 3 - 11

What is the inventory turnover ratio vs.

the industry average?

Inv. turnover = Sales

Inventories
= $7,036 = 4.10x.
$1,716

1998 1997 1996 Ind.

Inv. T. 4.1x 4.5x 4.8x 6.1x
 3 - 12

Comments on Inventory Turnover

Inventory turnover is below

industry average.
DLeon might have old inventory, or
its control might be poor.
No improvement is currently
forecasted.
 3 - 13

DSO is the average number of days

after making a sale before receiving
cash.

DSO = Receivables
Average sales per day

= Receivables = $878 = 44.9.

Sales/360 $7,036/360
 3 - 14

Appraisal of DSO

1998 1997 1996 Ind.

DSO 44.9 39.0 36.8 32.0

DLeon collects too slowly, and is

getting worse.
Poor credit policy.
 3 - 15

F.A. and T.A. turnover vs.

industry average

Fixed assets Sales

=
turnover Net fixed assets
= $7,036 = 8.61x.
$817
Total assets Sales
=
turnover Total assets
= $7,036 = 2.01x.
$3,497
 3 - 16

1998 1997 1996 Ind.

FA TO 8.6x 6.2x 10.0x 7.0x
TA TO 2.0x 2.0x 2.3x 2.6x

FA turnover project to exceed

industry average. Good.
TA turnover not up to industry
average. Caused by excessive
current assets (A/R and inv.)
 3 - 17

Calculate the debt, TIE, and fixed

charge coverage ratios.

Total debt
Debt ratio =
Total assets
= $1,445 + $500 = 55.6%.
$3,497
EBIT
TIE =
Int. expense
= $510.6 = 5.8x.
$88
 3 - 18

Fixed charge
= FCC
coverage
EBIT + Lease payments
=
Interest Lease Sinking fund pmt.
expense + pmt. + (1 - T)

= $510.6 +$40 = 4.3x.

$88 + $40 + $0

All three ratios reflect use of debt, but

focus on different aspects.
 3 - 19

How do the debt management ratios

compare with industry averages?

1998 1997 1996 Ind.

D/A 55.6% 95.4% 54.8% 50.0%
TIE 5.8x -3.9x 3.3x 6.2x
FCC 4.3x -3.0x 2.4x 5.1x

Too much debt, but projected to

improve.
 3 - 20

Another Debt Management Ratio used commonly is:

A L+NW
D/E CA D

FA E
TA TL+NW=E
To convert into something more familiar as D/TA we simply

D/E D D D
D/TA =
D/E + 1
or = (1 + )
TA E E

Example: if D/E = 0.91

D 0.91 0.91
= = = 47%
TA 1 + 0.91 1.91
 21
3 - 20

Profit margin vs. industry average?

NI $253.6
P.M. = Sales = $7,036 = 3.6%.

1998 1997 1996 Ind.

P.M. 3.6% -8.9% 2.6% 3.5%

Very bad in 1997, but projected to

exceed industry average in 1998.
Looking good.
 22
3 - 21

BEP vs. Industry Average?

EBIT
BEP = Total assets

$510.6
= $3,497 = 14.6%.
 23
3 - 22

1998 1997 1996 Ind.

BEP 14.6% -24.1% 14.2% 19.1%

BEP removes effect of taxes and

financial leverage. Useful for
comparison.
Projected to be below average.
Room for improvement.
 24
3 - 23

Return on Assets

Net income
ROA = Total assets

$253.6
= $3,497 = 7.3%.
 25
3 - 24

Net income
ROE = Common equity

= $253.6 = 16.3%.
$1,552

1998 1997 1996 Ind.

ROA 7.3% -18.1% 6.0% 9.1%
ROE 16.3% -391.0% 13.3% 18.2%

Both below average but improving.

 26
3 - 25

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 lowers equity,
hence could raise ROE = NI/Equity.
 27
3 - 26

Calculate and appraise the P/E and

M/B ratios.

Price = $12.17.
NI $253.6
EPS = Shares out. = 250 = $1.01.

Price per share $12.17

P/E = EPS = $1.01 = 12x.
 28
3 - 27

Com. equity
BVPS =
Shares out.
= $1,552 = $6.21.
250

Mkt. price per share

M/B =
Book value per share
$12.17
= $6.21 = 1.96x.
 29
3 - 28

1998 1997 1996 Ind.

P/E 12.0x -0.4x 9.7x 14.2x
M/B 1.96x 1.7x 1.3x 2.4x

P/E: How much investors will pay

for $1 of earnings. High is good.
M/B: How much paid for $1 of BV.
Higher is good.
P/E and M/B are high if ROE is high,
risk is low.
 30
3 - 29

( Profit
margin )( TA
)(
turnover
Equity
multiplier ) = ROE
NI Sales TA
Sales x TA x CE = ROE.

1996 2.6% x 2.3 x 2.2 = 13.2%

1997 -8.9% x 2.0 x 21.9 = -391.0%
1998 3.6% x 2.0 x 2.3 = 16.3%
Ind. 3.5% x 2.6 x 2.0 = 18.2%
 3 - 31

Converting Equity Multiplier into

Debt/TA and vice versa

TD
TA
= 1- ( 1
EM
) = 1 -( TE
TA
)
1
EM =
1- ( TD
TA )
If firm has Preferred Stock, must adjust formula
by using CE in place of TE and subtracting PS from TA.
 32
3 - 30

The Du Pont system focuses on:

Expense control (P.M.)

Asset utilization (TATO)
Debt utilization (Eq. Mult.)

It shows how these factors combine

to determine the ROE.
 Ratio Analysis Spread Sheet Example 3 - 33
De Leon
Ratio Industry
Categories 1998E 1997 1996 Average
CURRENT 1.9 1.1x 2.3x 2.7x
Liquidity QUICK 0.7 0.4x 0.8x 1.0x
INVENTORY TURNOVER 4.1 4.5x 4.8x 6.1x
DAYS SALES OUTSTANDING (DSO) 44.9 39.0 36.8 32.0
Asset
FIXED ASSETS TURNOVER 8.6 6.2x 10.0x 7.0x
Management TOTAL ASSETS TURNOVER 2.0 2.0x 2.3x 2.6x
DEBT RATIO 55.6 95.4% 54.8% 50.0%
Leverage TIE 5.8 -3.9x 3.3x 6.2x
FIXED CHARGE COVERAGE 4.3 -3.0x 2.4x 5.1x
PROFIT MARGIN 3.6 -8.9% 2.6% 3.5%
BASIC EARNING POWER 14.6 -24.1% 14.2% 19.1%
Profitability ROA 7.2 -18.1% 6.0% 9.1%
ROE 16.3 -391.4% 13.3% 18.2%
PRICE/EARNINGS 12.0 -0.4x 9.7x 14.2x
Market MARKET/BOOK 2.0 1.7x 1.3x 2.4x
BOOK VALUE PER SHARE $6.21 $1.33 $6.64 N.A.
Z SCORE 3.803 1.209 4.156
BANKRUPCY
 3 - 34
Altmans Z Score
Multiple Discriminant Analysis (MDA) statistical technique similar to regression analysis.
Used to classify companies in two groups: High probability of bankruptcy
Low probability of bankruptcy
High probability of bankruptcy exists when:
* 1. There is high leverage (Mkt. Value of Stk./Book value of Debt) X-4
* 2. Low liquidity (NWC/Assets) X-1
* 3. Low return on assets (EBIT/Assets) X-3
* 4. Poor asset utilization (Sales/Total Assets) X-5
* 5. Poor reinvestment opportunities (RE/TA) X-2
* all in extended Du Pont equation.
MDA helps determine the actual probability of bankruptcy for a given level of any of above ratios
plus it captures the effect of the interrelationship between the ratios.
It is a technique used very much in banks & S&Ls in granting credit to customers; investment
banks rating bonds (specially junk bonds).
84% success in predicting 2 years ahead.
70% success in predicting 5 years ahead.
 35
3 - 31

Simplified DLeon Data

A/R 878 Debt 1,945

Other CA 1,802 Equity 1,552
Net FA 817
Total assets $3,497 L&E $3,497

Sales $7,035,600
= = $19,543.
day 360
Q. How would reducing DSO to 32
days affect the company?
 36
3 - 32

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.

 37
3 - 33

New Balance Sheet

Added cash $ 253 Debt $1,945

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

What could be done with the new

cash? Effect on stock price and risk?
 38
3 - 34

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.
All these actions would improve stock
price.
 39
3 - 35

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--similar
to what was done with DSO in slides
#31 - #33.
 40
3 - 36

Q. Would you lend money to the

company?

A. Maybe. Things could get better.

In business, one has to take
some chances!
 41
3 - 37

Company should not have relied

exclusively on debt to finance its
expansion.
 3 - 42
DLEON Analysis/Diagnosis/Prescription

I. Examination or Analysis:
A. Statement of Cash Flow
B. Ratios
II. Diagnosis or conclusions about the situation:
An expansion began in 1996, which was financed with Long Term and Short Term debt.
(Evident on the ratios and the balance sheets). The company apparently assumed that sales and
profits would increase automatically with the expansion. Sales actually lagged and all ratios
deteriorated in 1997.
As sales in 97 increased consistently in subsequent months they provided support for a more
optimistic sales forecast for 1998. All ratios improve dramatically in 98 except collection period
or DSO.
III. Prescription or recommendations:
3 - 43
In hindsight, before the company took on its expansion plans, it should have done an extensive
ratio analysis to determine the effects of its proposed expansion on the firms operations. Had the
ratio analysis been conducted, the company would have gotten its house in order before
undergoing the expansion. For instance it would have used equity financing for part of the
expansion. Without it they should not have expanded. The equity financing is indispensable for
plant and capacity expansion because this source of funding does not require interest, principal,
or dividend payments, giving the firm time to slowly increase its sales to utilize the added
capacity and time to reach its eventual profitability target. That is a more conservative sales
growth plan should have been assumed and the expansion at least partly financed by equity. Even
losses could have been planned as is often the case after an expansion of plant capacity. The
ratios in 1998 are pretty acceptable, except for two, and show the expected increase in sales. If
the sales materialize they will be fine. If not, they may have to raise some equity financing and
pay back some of the debt. The two ratios that are still deficient even in 1998 are DSO and Total
Asset Turnover. Which show that the company credit policy is too lose and needs to be tightened.
If they can improve their collections they can decrease the DSO and hence the invested funds
into accounts receivable. Illustrated in blueprints 3-31 through 3-34.
On the other hand, if the lenient credit is part of a predetermined strategy to increase sales to
plant capacity by capturing a larger share of the market while the products become popular, then
the higher level of receivables will have to be sustained but more equity financing might be
required.
All in all, the Co. seems to have very short run expansion or growing pains principally because
all the expansion was financed with debt.
 44
3 - 38

What are some potential problems and

limitations of financial ratio analysis?

Comparison with industry averages

is difficult if the firm operates many
different divisions.
 45
3 - 39

Average performance not

necessarily good.
Seasonal factors can distort ratios.
Window dressing techniques can
make statements and ratios look
better.
 46
3 - 40

Different operating and accounting

practices distort comparisons.
Sometimes hard to tell if a ratio is
good or bad.
Difficult to tell whether company is,
on balance, in strong or weak
position.
 47
3 - 41

What are some qualitative factors

analysts should consider when
evaluating a companys likely future
financial performance?

Are the companys revenues tied to 1 key

customer?
To what extent are the companys
revenues tied to 1 key product?
To what extent does the company rely on
a single supplier?
(Cont)
 48
3 - 42

What percentage of the companys

business is generated overseas?
Competition
Future prospects
Legal and regulatory environment
Management/Labor Relations and
Productivity