Brigham & Ehrhardt

Financial Management:
Theory and Practice 14e

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1
CHAPTER 3

Analysis of Financial Statements

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Topics in Chapter
 Ratio analysis
 DuPont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors

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3
 Determinants of Intrinsic Value:
Using Ratio Analysis

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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4
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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5
Income Statement
2013 2014E
Sales $5,834,400 $7,035,600
COGS except depr. 4,980,000 5,800,000
Other expenses 720,000 612,960
Deprec. 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40%) (63,424) 169,056
Net income ($ 95,136) $ 253,584
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Balance Sheets: Assets
2013 2014E
Cash $ 7,282 $ 14,000
S-T invest. 20,000 71,632
AR 632,160 878,000
Inventories 1,287,360 1,716,480
Total CA 1,946,802 2,680,112
Net FA 939,790 836,840
Total assets $2,886,592 $3,516,952
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7
Balance Sheets: Liabilities &
Equity
2013 2014E
Accts. payable $ 324,000 $ 359,800
Notes payable 720,000 300,000
Accruals 284,960 380,000
Total CL 1,328,960 1,039,800
Long-term debt 1,000,000 500,000
Common stock 460,000 1,680,936
Ret. earnings 97,632 296,216
Total equity 557,632 1,977,152
Total L&E $2,886,592 $3,516,952
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Other Data
2013 2014E
Stock price $6.00 $12.17
# of shares 100,000 250,000
EPS -$0.95 $1.01
DPS $0.11 $0.22
Book val. per sh. $5.58 $7.91
Lease payments $40,000 $40,000
Tax rate 0.4 0.4
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9
Liquidity Ratios
 Can the company meet its short-term
obligations using the resources it
currently has on hand?

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 Forecasted Current and Quick
Ratios for 2014.

CA $2,680
CR14 = CL = $1,040 = 2.58.

CA - Inv.
QR14 = CL
$2,680 - $1,716
= $1,040 = 0.93.
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Comments on CR and QR
2014E 2013 2012 Ind.
CR 2.58 1.46 2.3 2.7
QR 0.93 0.5 0.8 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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13
 Inventory Turnover Ratio vs.
Industry Average

COGS
Inv. Turnover = Inventories
$5,800 + $120
= = 3.45.
$1,716

2014E 2013 2012 Ind.

Inv. T. 3.45 4.0 4.0 6.1
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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

= Receivables = $878
Sales/365 $7,036/365
= 45.5 days.

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

2014 2013 2012 Ind.

DSO 45.5 39.5 37.4 32.0

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17
Fixed Assets and Total Assets
Turnover Ratios

Fixed assets Sales

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

2014E 2013 2012 Ind.

FA TO 8.4 6.2 10.0 7.0
TA TO 2.0 2.0 2.3 2.5
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Debt Management Ratios
 Does the company have too much
debt?
 Can the company’s earnings meet its
debt servicing requirements?

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 Leverage Ratios: Debt Ratio

Total debt
Debt ratio = Total assets
$300 + $500
= $3,517 = 22.7%.

(More…)
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 Leverage Ratios:
Liabilities-to-Assets Ratio

Liabilities/TA ratio = Total liabilities

Total assets
= $1,039.8 + $500
$3,517
=43.8%.

(More…)
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22
Times Interest Earned Ratio

TIE = EBIT
Int. expense
= $502.6 = 6.3.
$80

(More…)
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 EBITDA Coverage (EC)

EBIT + Depr. & Amort. + Lease payments

Interest Lease
expense + pmt. + Loan pmt.

= $502.6 + $120 + $40 = 5.5.

$80 + $40 + $0
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 Debt Management Ratios vs.
Industry Averages

2014E 2013 2012 Ind.

D/TA 22.7% 59.6% 35.6% 32.0%
TL/TA 43.8% 80.7% 54.8% 50.0%
TIE 6.3 0.1 3.3 6.2
EC 5.5 0.8 2.6 8.0
Recapitalization improved situation, but
lease payments drag down EC.
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25
Profitability Ratios
 What is the company’s 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):

EBIT $503
OM = Sales = $7,036 = 7.1%.

(More…)
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27
 Profit Margins (Continued)

Gross profit margin (GPM):

Sales − COGS $7,036 − $5,800
GPM = Sales =
$7,036

$1,236
GPM = $7,036 = 17.6%.

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28
Profit Margins vs. Industry
Averages

2014E 2013 2012 Ind.

PM 3.6% -1.6% 2.6% 3.6%
OPM 7.1 0.3 6.1 7.1
GPM 17.6 14.6 16.6 15.5
Very bad in 2013, but projected to
meet or exceed industry average in
2014.
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Basic Earning Power (BEP)

EBIT
BEP =
Total assets

= $502.6 = 14.3%.
$3,517

(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.

2014E 2013 2012 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 = 7.2%.
$3,517

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

NI
ROE =
Common Equity

= $253.6 = 12.8%.
$1,977

(More…)
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33
ROA and ROE vs. Industry
Averages

2014E 2013 2012 Ind.

ROA 7.2% -3.3% 6.0% 9.0%
ROE 12.8% -17.1% 13.3% 18.0%

Both below average but improving.

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34
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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35
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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36
 Calculate and appraise the
P/E, P/CF, 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 = 12.

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37
 Market Based Ratios

NI + Depr.
CF per share = Shares out.
$253.6 + $120.0
= 250 = $1.49.

Price per share

P/CF = Cash flow per share

= $12.17 = 8.2.
$1.49
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38
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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39
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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40
Comparison with Industry
Averages

2014E 2013 2012 Ind.

P/E 12.0 -6.3 9.7 14.2
P/CF 8.2 27.5 8.0 7.6
M/B 1.5 1.1 1.3 2.9

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41
 Common Size Balance Sheets:
Divide all items by Total Assets
Assets 2012 2013 2014E Ind.
Cash 0.6% 0.3% 0.4% 0.3%
ST Inv. 3.3% 0.7% 2.0% 0.3%
AR 23.9% 21.9% 25.0% 22.4%
Invent. 48.7% 44.6% 48.8% 41.2%
Total CA 76.5% 67.4% 76.2% 64.1%
Net FA 23.5% 32.6% 23.8% 35.9%
TA 100.0% 100.0% 100.0% 100.0%
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42
 Divide all items by Total
Liabilities & Equity
Liab. & Eq. 2012 2013 2014E 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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43
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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44
 Common Size Income Statement:
Divide all items by Sales
2012 2013 2014E Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 85.4% 82.4% 84.5%
Depr. 0.6% 2.0% 1.7% 4.0%
Other exp. 9.9% 12.3% 8.7% 4.4%
EBIT 6.1% 0.3% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
Pre-tax earn. 4.3% -2.7% 6.0% 5.9%
Taxes 1.7% -1.1% 2.4% 2.4%
NI 2.6% -1.6% 3.6% 3.6%

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45
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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46
Percentage Change Analysis: %
Change from First Year (2012)
Income St. 2012 2013 2014E
Sales 0.0% 70.0% 105.0%
COGS 0.0% 73.9% 102.5%
Depr. 0.0% 518.8% 534.9%
Other exp. 0.0% 111.8% 80.3%
EBIT 0.0% -91.7% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes 0.0% -208.2% 188.3%
NI 0.0% -208.2% 188.3%
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47
Analysis of Percent Change
Income Statement
 We see that 2014 sales grew 105%
from 2012, and that NI grew 188%
from 2012.
 So Computron has become more
profitable.

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48
Percentage Change Balance
Sheets: Assets
Assets 2012 2013 2014E
Cash 0.0% -19.1% 55.6%
ST Invest. 0.0% -58.8% 47.4%
AR 0.0% 80.0% 150.0%
Invent. 0.0% 80.0% 140.0%
Total CA 0.0% 73.2% 138.4%
Net FA 0.0% 172.6% 142.7%
TA 0.0% 96.5% 139.4%
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49
Percentage Change Balance
Sheets: Liabilities & Equity
Liab. & Eq. 2012 2013 2014E

AP 0.0% 122.5% 147.1%

Notes pay. 0.0% 260.0% 50.0%
Accruals 0.0% 109.5% 179.4%
Total CL 0.0% 175.9% 115.9%
LT Debt 0.0% 209.2% 54.6%
Total eq. 0.0% -16.0% 197.9%
Total L&E 0.0% 96.5% 139.4%
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50
Analysis of Percent Change
Balance Sheets
 We see that total assets grew 139%,
while sales grew only 105%. So asset
utilization remains a problem.

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51
Explain the DuPont System
 The DuPont 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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52
 The DuPont System

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

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53
 The DuPont System

NI Sales TA = ROE
Sales x TA x CE

2012: 2.6% x 2.3 x 2.2 = 13.2%

2013: -1.6% x 2.0 x 5.2 = -16.6%
2014: 3.6% x 2.0 x 1.8 = 13.0%
Ind.: 3.6% x 2.5 x 2.0 = 18.0%
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54
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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55
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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