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Ratio analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

MAYES 2 & 4 Fin. Stmt. & Ratio Analysis

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Common Size Financial Statements

Displays info as %, not $; Provides 2 key benefits: 1. Allows for easy comparison between firms of different sizes. 2. Aids in spotting important trends which otherwise might not be obvious when looking at $ amounts.

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Common Size Financial Statements

Common size Income Statement: all values a function of Sales $ Common size Balance Sheet: all values a function of Total Assets.

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Analysis of Common Size Balance Sheets

Elvis has ? proportion of inventory and current assets than Industry.

Elvis now has ? Equity, which means (MORE? / LESS?) debt than Industry.

Elvis has ? short-term debt than industry, but ? long-term debt than industry.

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Analysis of Common Size Income Statements

Elvis has ? COGS ( %) than industry’s ( %), but ? other expenses. Results?

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Percentage Change Analysis:

Looks at Change rates from period to period between financial categories. Indicator of +/- growth trends.

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Analysis of Percent Change Income Statement

i.e., Sales growth v. NI ?

i.e., If NI grows faster than sales, then becoming more profitable.

So becoming (more/less) profitable?

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Analysis of Percent Change Balance Sheets

i.e., Total assets growth v. sales. If assets grow at faster rate than sales, have asset utilization problem.

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Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

Why are ratios useful?

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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?

What are the five major categories of ratios, and what questions do they

answer?

(More…)

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Debt management: Do we have the right

mix of debt and equity? (Leverage)

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?

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Things to ask? Better? Worse?

Trends?

Vs. Industry?

Causes?

Corrective actions?

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Calculate the firm’s forecasted current and quick ratios

CR = =

QR =

CACL

CA - Inv.CL

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Expected to improve/ worsen?

Vs. industry average?

Liquidity position?

Comments on CR and QR

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What is the inventory turnover ratio as compared to the industry average?

Inv. turnover = CGSInventories

Days Sales in Inventory

=

365 Inv To

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Inventory turnover v. industry average?

Due to?

Improvement forecasted?

Comments on Inventory Turnover

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What is the Accts. Rec. turnover ratio & Average Collection Period?

A/R turnover = Credit salesA/R

Ave Collection

Period = 365A/R TO

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Appraisal of Ave Collection Period

Firm collects too slowly/quickly?

Improving / worsening?

Implication re: credit policy.

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Fixed Assets and Total AssetsTurnover Ratios

Fixed assetsturnover

Sales Net fixed assets=

Total assetsturnover

Sales Total assets=

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FA turnover vs. industry?

TA turnover vs. industry average?

Causes? Corrective actions?

Fixed Assets and Total AssetsTurnover Ratios

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Total liabilities Total assetsDebt ratio =

L/T Debt ratio =

LEVERAGE

L/T Debt Total assets

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Total liabilities Total EquityDebt/Eqty =

ratio

L/T Debt to TotalCapitalization ratio =

LEVERAGE

_____L/T Debt___________ LTD + Pref Eqty + Cmn Eqty

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Total Assets Total EquityEqty

Multiplier

L/T Debt to TotalEquity =

LEVERAGE

_____L/T Debt___________ Pref Eqty + Cmn Eqty

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EBIT + Deprec Exp Interest ExpCash =

Coverage

EBIT Int. expense TIE =

COVERAGE Ratios

(

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Effects? Reasons?

How do the debt management ratios compare with industry averages?

2005E 2004 2003 Ind.D/ATIEC/Cov

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Trends?Prospects?

Profitability Ratios (Profit Margins)

OperatingPM = EBIT Sales

Net PM = Net Income Sales

Gross Profit Margin = Gross Profit Sales

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Trends?Prospects?

Profitability Ratios (Returns)

ROA = Net Income Total Assets

Return on = NI available to C.S-holdersCmn Eqty Common Equity

ROE = Net Income Total Equity

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2005E 2004 2003 Ind.ROAROE

Trends? Vs. Industry? Prospects?.

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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.

Effects of Debt on ROA and ROE

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( )( )( ) = ROE

Profitmargin

TAturnover

Equitymultiplier

NI Sales

SalesTA

TA CE

PM= f(profitability)TA T/O = f(asset utilization)EM = f(debt & equity %s)

Shows how these factors combine to

determine the ROE.

The Du Pont System

x x = ROE.

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Trends?Prospects?

Economic Profit Measures of Performance

Where: NOPAT = EBIT (1-tax rate) A/Tax Cost of Op. Capital = WACC * (Net Op. Working Cap + Net Fixed Assets)

** NOWC = (Non-interest bearing C/A – Non-interest bearing C/L)

Economic Profit = NOPAT – A/Tax Cost of Op. Capital

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Financial Distress & Z-score

Technique to determine likelihood of financial distress.

Altman shows model 80-90% accurate w/ Z-score cut-off of 2.675; that is Z-score < 2.675 = distress.

Actually determined 3 levels

Z<1.81 Bankruptcy predicted w/in 1 yr.

1.81<Z<2.675 Financial Distress, poss. Bankruptcy

Z>2.675 No fin. Distress predicted

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Financial Distress & Z-scoreZ = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5

Where the variables are the following financial ratios:

X1 = Net Working Capital / Total Assets

X2 = Retained earnings / Total Assets

X3 = EBIT / Total Assets

X4 = Market Value of all equity / book value of Tot. Liabs

X5 = Sales / Total Assets

*For publicly traded companies

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Calculate and appraise theP/E, P/CF, and M/B ratios.

Market Price =From the stock exchanges

EPS =

P/E =

NIC.S.Shares out.

Price per shareEPS

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NI + Depr. C.S.Shares out.CF per share =

Price per share Cash flow per C.S. share

P/CF =

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Com. equity C.S.Shares out.BVPS =

Mkt. price per share Book value per share

M/B =

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P/E: How much investors will pay for $1 of earnings. High is good.

M/B: How much paid for $1 of book value. Higher is good.

P/E and M/B are high if ROE is high, risk is low.

2005E 2004 2003 Ind.P/EP/CFM/B

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What are some potential problems and limitations of financial 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.

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Window dressing techniques can make statements and ratios look better.

Different accounting and operating practices can distort comparisons.

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.

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What are some qualitative factors analysts should consider when

evaluating a company’s likely future financial performance?

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…)

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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?