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Ratio analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

CHAPTER 5 Analysis of Financial Statements

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Cajun Made’s Balance Sheet: Assets

1999E 1998Cash 85,632 7,282AR 878,000 632,160Inventories 1,716,480 1,287,360 Total CA 2,680,112 1,926,802Gross FA 1,197,160 1,202,950Less: Deprec. 380,120 263,160 Net FA 817,040 939,790Total assets 3,497,152 2,866,592

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Liabilities and Equity

1999E 1998Accounts payable 436,800 524,160Notes payable 600,000 720,000Accruals 408,000 489,600 Total CL 1,444,800 1,733,760Long-term debt 500,000 1,000,000Common stock 1,680,936 460,000Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832Total L & E 3,497,152 2,866,592

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Cajun Made’s Income Statement

1999E 1998Sales 7,035,600 5,834,400COGS 5,728,000 5,728,000Other expenses 680,000 680,000Depreciation 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)

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Other Data

1999E 1998

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

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The Use of Financial Ratios

Financial ratio is a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm’s operations and status.

Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm’s performance and status.

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Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

There are two types of ratio comparisons that can be madeCross-Sectional Analysis

Time-Series Analysis

Why are ratios useful?

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Liquidity: Can we make required payments? A “liquid firm” is one that can meet its short-term obligations as they come due.

Asset management (Activity): Right amount of assets vs. sales? Activity is a more sophisticated analysis of a firm’ liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm’s efficiency.

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

answer?

5 - 9 Debt management: Right mix of debt and

equity? Debt is a “double-edged” sword as it allows for the generation of profits with the use of other people’s (creditors) money, but creates claims on earnings with a higher priority than those of the firm’s owners.

Financial Leverage is a term for the magnification of risk and return resulting from the use of fixed-cost financing such as debt & preferred stock.

There are two general types of Debt Measures.Degree of Indebtedness

Ability to Service Debts

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Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? These measure assess the firm’s ability to operate efficiently and are of concern to owners, creditors, and management.A common-size income statement, which

expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales.

Market value: Do investors like what they see as reflected in P/E and M/B ratios?

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Calculate Cajun Made’s Expected current and quick ratios for 1999.

CR99 = = = 1.85x.

QR99 =

= = 0.67x.

CACL

$2,680$1,445

$2,680 - $1,716$1,445

CA - Inv.CL

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Expected to improve but still below the industry average.

Liquidity position is weak.

Comments on CR and QR

1999 1998 1997 Ind.

CR 1.85x 1.1x 2.3x 2.7x

QR 0.67x 0.4x 0.8x 1.0x

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What is the inventory turnover ratio vs. the industry average?

Inv. turnover =

= = 3.34x.

COGSInventories

$5,728$1,716

1999 1998 1997 Ind.

Inv. T. 3.34X 4.45x 4.0x 6.1x

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Inventory turnover is below industry average.

Cajun Made might have old inventory, or its control might be poor.

No improvement is currently forecasted.

Comments on Inventory Turnover

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ReceivablesAverage sales per day

Average Collection Period (DSO) is the average number of days after making a

sale before receiving cash.

ACP =

= = = 44.9. ReceivablesSales/360

$878$7,036/360

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Appraisal of ACP (DSO)

Cajun Made collects too slowly, and is getting worse.

Poor credit policy.

1999 1998 1997 Ind.ACP 44.9 39.0 36.8 32.0

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F.A. and T.A. turnover vs. industry average

Fixed assetsturnover

Sales Net fixed assets=

= = 8.61x.$7,036$817

Total assetsturnover

Sales Total assets=

= = 2.01x.$7,036$3,497

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FA turnover project to exceed industry average. Good.

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

1999 1998 1997 Ind.FA TO 8.6x 6.2x 10.0x 7.0xTA TO 2.0x 2.0x 2.3x 2.6x

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Calculate the debt, TIE, and fixed charge coverage ratios.

Total debt Total assetsDebt ratio =

= = 55.6%.$1,445 + $500$3,497

EBIT Int. expense TIE =

= = 5.8x.$510.6$88

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All three ratios reflect use of debt, but focus on different aspects.

Fixed chargecoverage

= FCC

=

= = 4.3x.

EBIT + Lease payments Interest Lease Sinking fund pmt.expense pmt. (1 - T)+ +

$510.6 +$40 $88 + $40 + $0

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Too much debt, but projected to improve.

How do the debt management ratios compare with industry averages?

1999 1998 1997 Ind.D/A 55.6% 95.4% 54.8% 50.0%TIE 5.8x -3.9x 3.3x 6.2xFCC 4.3x -3.0x 2.4x 5.1x

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Very bad in 1998, but projected to exceed industry average in 1999. Looking good.

Profit margin vs. industry average?

1999 1998 1997 Ind.P.M. 3.6% -8.9% 2.6% 3.5%

P.M. = = = 3.6%. NI Sales

$253.6$7,036

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BEP =

= = 14.6%.

BEP vs. Industry Average?

EBIT Total assets

$510.6 $3,497

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BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be below average.

Room for improvement.

1999 1998 1997 Ind.BEP 14.6% -24.1% 14.2% 19.1%

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Return on Assets

ROA =

= = 7.3%.

Net income Total assets

$253.6 $3,497

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ROE =

= = 16.3%.

Net income Common equity

$253.6 $1,552

1999 1998 1997 Ind.ROA 7.3% -18.1% 6.0% 9.1%ROE 16.3% -391.0% 13.3% 18.2%

Both below average but improving.

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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.

Effects of Debt on ROA and ROE

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Calculate and appraise the P/E and M/B ratios.

Price = $12.17.

EPS = = = $1.01.

P/E = = = 12x.

NI Shares out.

$253.6250

Price per shareEPS

$12.17$1.01

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Com. equity Shares out.BVPS =

= = $6.21.$1,552250

Mkt. price per share Book value per share

M/B =

= = 1.96x.$12.17$6.21

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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 BV. Higher is good.

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

1999 1998 1997 Ind.P/E 12.0x -0.4x 9.7x 14.2xM/B 1.96x 1.7x 1.3x 2.4x

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( )( )( ) = ROE

x x = ROE.

Profitmargin

TAturnover

Equitymultiplier

NI Sales

SalesTA

TA CE

1997 2.6% x 2.3 x 2.2 = 13.2%1998 -8.9% x 2.0 x 21.9 = -391.0%1999 3.6% x 2.0 x 2.3 = 16.3%Ind. 3.5% x 2.6 x 2.0 = 18.2%

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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.

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Simplified Cajun Made Data

A/R 878 Debt 1,945Other CA 1,802 Equity 1,552Net FA 817Total assets $3,497 L&E $3,497

Q. How would reducing DSO to 32 days affect the company?

Sales $7,035,600 day 360

= = $19,543.

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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.

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What could be done with the newcash? Effect on stock price and risk?

New Balance Sheet

Added cash $ 253 Debt $1,945A/R 625 Equity 1,552Other CA 1,802Net FA 817Total assets $3,497 Total L&E $3,497

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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.

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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 #33 - #35.

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Q. Would you lend money to the company?

A. Maybe. Things could get better. In business, one has to take some chances!

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Cajun Made should not have relied exclusively on debt to finance its expansion.

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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.

A single ratio rarely tells enough to make a sound judgement

Audited Financial statements are more reliable than un-audited statements.

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“Average” performance not necessarily good.

Seasonal factors can distort ratios.

Inflation can distort comparisons.

“Window dressing” techniques can make statements and ratios look better.

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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.

Ratios should be computed in the same mannerFor example, Inventory Turnover can be computed

as Sales/Ending Inventory, COGS/Ending Inventory, or COGS/Average Inventory (I can show you three different texts with three different computations).

You must be consistent in your computations.

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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 1 key customer?

To what extent are the company’s revenues tied to 1 key product?

To what extent does the company rely on a single supplier? (Cont…)

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What percentage of the company’s business is generated overseas?

Competition

Future prospects

Legal and regulatory environment