Ratio analysisDu Pont systemEffects of improving ratiosLimitations of ratio analysis

CHAPTER 7 Analysis of Financial Statements

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

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

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)

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

• Financial analysis focuses on cash flows• Accounting income may differ from cash

flow– Net cash flow = net income - non cash

revenues + non cash charges

• One major non cash charge is depreciation– Net cash flow = NI + depreciation

Accounting Income vs. Cash Flow

• Operating cash flow– Represents funds available to pay both debt

holders and share holders– Operating cash flow =

• EBIT * (1 - tax rate) + depreciation

• Net cash flow = operating cash flow - interest * (1 - tax rate)

Accounting Income vs. Cash Flow

(523,936)

Statement of Cash Flows (1998)

OPERATING ACTIVITIES Net income (519,936)Add (Sources of cash): Depreciation 116,960 Increase in A/P 378,560 Increase in accruals 353,600Subtract (Uses of cash): Increase in A/R (280,960) Increase in inventories (572,160)

Net cash provided by ops.

L-T INVESTING ACTIVITIES Investment in fixed assets (711,950)

FINANCING ACTIVITIES Increase in notes payable 520,000 Increase in long-term debt 676,568 Payment of cash dividends (11,000) Net cash from financing 1,185,568

NET CHANGE IN CASH (50,318)

Plus: Cash at beginning of year 57,600Cash at end of year 7,282

• Net cash from operations = -$523,936, mainly because of negative NI.

• The firm borrowed $1,185,568 to meet its cash requirements.

• Even after borrowing, the cash account fell by $50,318.

What can you conclude about D’Leon’s financial condition from its

statement of CFs?

What effect did the company’s expansion have on its net cash flow

and operating cash flow?

NCF98 = NI + DEP = ($519,936) + $116,960= ($402,976).

NCF97 = $87,960 + $18,900 = $106,860.OCF98 = EBIT(1 - T) + DEP

= (-$690,560)(0.6) + $116,960= ($297,376).

OCF97 = ($209,100)(0.6) + $18,900= $144,360.

Ratio Analysis• Why are financial ratios useful?

– Standardized numbers, facilitate comparisons– Used to highlight strengths and weaknesses

• Benchmarking– Comparing a company’s financial ratios with those

of a set of benchmark companies– Gives a way for the company to assess its

performance

Calculation of Ratios

• Issues to consider– When dealing with balance sheet numbers,

we may have a problem because those numbers represent the state of the company at a certain point in time• Often will use, when available, average numbers

over the year

Calculation of Ratios

• The Impact of Leverage– Risk sharing– Higher returns– Affect on ratios?

• Any ratio involving income (profitability ratios) will be impact by a company’s leverage choice

• Makes comparisons difficult• What is the difference between two identical companies that

use different leverage?

Limitations of Ratio Analysis

• Use data reported on financial statements– Seasonal factors can distort ratios.– “Window dressing” techniques can make

statements and ratios look better.– Different operating and accounting practices

distort comparisons.

Limitations of Ratio Analysis

• Making comparisons can be difficult– Comparison with industry averages is

difficult if the firm operates many different divisions.

– “Average” performance not necessarily good.

– Sometimes hard to tell if a ratio is “good” or “bad.”

• 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…)

• Debt management: Do we have the 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?

Calculate D’Leon’s forecasted 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

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

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

Inv. turnover =

= = 4.10x.

SalesInventories

$7,036$1,716

1999 1998 1997 Ind.

Inv. T. 4.1x 4.5x 4.8x 6.1x

• Inventory turnover is below industry average.

• D’Leon might have old inventory, or its control might be poor.

• No improvement is currently forecasted.

Comments on Inventory Turnover

ReceivablesAverage sales per day

DSO is the average number of days after making a sale before receiving

cash.

DSO =

= = = 44.9. ReceivablesSales/360

$878$7,036/360

Appraisal of DSO

D’Leon collects too slowly, and is getting worse.

Poor credit policy.

1999 1998 1997 Ind.DSO 44.9 39.0 36.8 32.0

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

FA turnover projected 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

Calculate the debt and TIE ratios.

Total debt Total assetsDebt ratio =

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

EBIT Int. expense TIE =

= = 5.8x.$510.6$88

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 6.2x

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

BEP =

= = 14.6%.

BEP vs. Industry Average?

EBIT Total assets

$510.6 $3,497

• 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%

Return on Assets

ROA =

= = 7.3%.

Net income Total assets

$253.6 $3,497

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% -391.4% 13.3% 18.2%

Both below average but improving.

• 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

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

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

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

M/B: How much paid for $1 of BV.

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

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.

The Du Pont Equations:

• ROA = PM * TATO =– (NI/Sales)*(Sales/TA)

• ROE = ROA * Equity Multiplier =– (NI/TA)*(TA/Common Equity)

• ROE = PM*TATO*EM– ROE = (NI/Sales)*(Sales/TA)*(TA/CE)

( )( )( ) = 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 21.6 = -391.4%1999 3.6% x 2.0 x 2.3 = 16.3%Ind. 3.5% x 2.6 x 2.0 = 18.2%

Simplified D’Leon 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.

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.

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