FINA2303 Chapter+3

FINA 2303: Financial Management Fall 2015

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Ekkachai Saenyasiri 2/6/2015

Chapter 3–Working with Financial Statements (Financial Statements Analysis)


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Example: CyberDragon Corporation’s Balance Sheet

Cash 2,540 Accounts payable 9,721Marketable securities 1,800 Notes payable 8,500Accounts receivable 18,320 Accrued taxes payable 3,200Inventories 27,530 Other current liabilities 4,102Total current assets 50,190 Total current liabilities 25,523

Long‐term debt (bonds) 22,000Plant and equipment 43,100 Total liabilities 47,523less accum deprec. 11,400 Common stock ($10 par) 13,000Net plant & equip. 31,700 Paid in capital 10,000 Total assets 81,890 Retained earnings 11,367

Total stockholders' equity 34,367Total liabilities & equity 81,890

Assets Liabilities & Equity


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CyberDragon’s Income Statement

Sales $112,760 Cost of Goods Sold ‐85,300 Gross Profit 27,460 Selling, General & Admin Expenses ‐14,940 Depreciation ‐1,000 Earnings before interest and taxes (EBIT) 11,520 Interest charges: ‐3,160 Earnings before taxes (EBT) 8,360 Taxes (assume 40%) ‐3,344 Net Income 5,016


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Common‐Size Statements Express each item on the balance sheet as a percentage of total assets.

Express each item on the income statement as a percentage of sales

Make it possible to compare companies of different sizes


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Cash 3.1% Accounts payable 11.9%Marketable securities 2.2% Notes payable 10.4%Accounts receivable 22.4% Accrued taxes payable 3.9%Inventories 33.6% Other current liabilities 5.0%Total current assets 61.3% Total current liabilities 31.2%

Long‐term debt (bonds) 26.9%Plant and equipment 52.6% Total liabilities 58.0%less accum deprec. 13.9% Common stock ($10 par) 15.9%Net plant & equip. 38.7% Paid in capital 12.2% Total assets 100.0% Retained earnings 13.9%

Total stockholders' equity 42.0%Total liabilities & equity 100.0%

Assets Liabilities & Equity

CyberDragon’sCommon‐Size Balance Sheet


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CyberDragon’s Common‐Size Income Statement

Sales 100.0% Cost of Goods Sold ‐75.6% Gross Profit 24.4% Selling, General & Admin Expenses ‐13.2% Depreciation ‐0.9% Earnings before interest and taxes (EBIT) 10.2% Interest charges: ‐2.8% Earnings before taxes (EBT) 7.4% Taxes ‐3.0% Net Income 4.4%


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Financial Ratios

Financial ratios are the principal tools of financial analysis. Financial ratios help us identify some of the financial strengths and weakness of the company.

We can compare a company’s financial ratios with its ratios in previous years (trend analysis).

We can compare a company’s financial ratios with those of its industry or competitors.

All we are trying to do is standardize financial data so that we can make comparisons with industry norms or other standards.


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When we look at a firm, we want to answer questions about How liquid is the firm? Does the firm have enough cash to meet debt payments?

Is Management generating adequate operating profits from the firm's assets? How efficiently are the firm's assets being used?

How is the firm financing its assets? Does the firm raise capital more by debt or equity?

Are the owners (stockholders) receiving an adequate return on their investment?


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1. How liquid is the firm? The liquidity of a business is defined as its ability to meet maturing debt obligations. That is—does or will the firm have the resources to pay its creditors when its debts are due? There are two ways to approach the liquidity question. We can look at the firm’s assets that are relatively liquid in nature and compare them to the amount of the debts due in the near term. For example, current ratio and acid test ratio (quick ratio).

We can look at how quickly the firm’s liquid assets can be converted into cash. (Example, average collection period)


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What is CyberDragon’s Current Ratio? Current Ratio compares cash and assets that should be converted into cash within one year with the debts that are due and payable within one year.

Current Ratio = 97.1 523,25190,50

sLiabilitieCurrent AssetsCurrent

If the average current ratio for the industry is 2.4, CyberDragon has less ability to meet its maturing debt obligation compared to the industry average. CyberDragon has $1.97 in current assets for every $1 in current liabilities. Industry on average has $2.4 in current assets for every $1 in current liabilities.


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What is CyberDragon’s quick ratio (acid‐test ratio)? Quick ratio or acid‐test ratio is a more conservative measure of liquidity than the current ratio.

Quick Ratio = 89.0523,25

530,27190,50sLiabilitieCurrent

sInventorie - AssetsCurrent

Suppose the industry average is 0.92. This implies that CyberDragon has less ability to meet its maturing debt obligation than peer companies in the same industry


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What is CyberDragon’s Account Receivable Turnover Ratio? Account Receivable Turnover Ratio measures how many times account receivables are “rolled over” during a year, or how many times it collects payment from its credit sales within a year.

Account Receivable Turnover = 16.6320,18760,112

sReceivableAccount Sales Annual

times per year

Suppose that the industry average is 8.2 times per year, CyberDragon is slower at collecting its receivables than competing firms. (CyberDragon takes longer time to collect its receivables)


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What is CyberDragon’s Average Collection Period (Account Receivable Days)? Average collection period indicates how rapidly a firm can collect payment from credit sales, as measured by the average number of days it takes to collect its account receivable.

Average collection period = days 3.596.16365

turnoversReceivable365

Average collection period = account receivable / average daily sales

= days 3.5965)(112,760/3

18,320

If the industry average is 44.5 days, what does this tell us? CyberDragon takes longer time to collect it receivables than the average firm in the comparable group.


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What is CyberDragon’s Inventory Turnover Ratio? Inventory Turnover Ratio indicates the relative liquidity of inventory. It measures how many times we are turning over inventories into sales over the year (how fast the firm can sell its inventory)

Inventory turnover = yearper times1.3530,27300,85

Inventorysold goods ofCost

Suppose that the industry average is 3.9 times per year, CyberDragon is worse than its peer in inventory management.

In other words, CyberDragon sells its inventory in 7.1171.3

365 days on average.

Their competitors sell inventory in 9.3

365= 93.6 days on average.


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Note that because inventory is measured at cost, we use cost of goods sold, not sales, as numerator. Otherwise, the inventory turnover ratio would vary from one firm to the next solely due to differences in how each firm marks up its sales over cost. High inventory is not good because

1. Inventory takes up costly warehouse space. 2. Some items may become spoiled or obsolete.

To conclude, when it comes to CyberDragon’s liquidity, all financial ratios tell us that the firm has less liquidity than the industry average.


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Example: Our firm sells books at $25 per book. In a year our firm usually sells 4 books. Cost of Goods Sold of each book is $20. If our firm always carries only one book as inventory, how many times the firm sell the whole inventory in a year. Annual Revenue = 25 * 4 = 100 Annual Cost of Goods Sold =20 *4 = 80.

COGS = 20

Jan 2012 Dec 2012

Annual COGS = 80

COGS = 20 COGS = 20 COGS = 20

Inventory shown in Balance Sheet = 20

Inventory Turnover Ratio = 80/20 = 4. Our firm turnovers inventories 4 times in a year


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Example: Annual Revenue = 100 and Cost of Goods Sold = 80. If money from sales is collected twice a year, how does the time line look like?

Account receivable turnover = Sales/Account Receivable = 100/50 = 2

Average collection period = account receivable / average daily sales

= days5.182(100/365)

50

Collect 50

Jan 2012 Dec 2012

Revenue = 100

Collect 50

Account Receivable shown on Balance Sheet = 50


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2. How efficient is the management in managing our firm? Does the management generate adequate operating profits from the firm's assets?

We have several choices as to how we can measure profits Gross profit does not include important information such as marketing and distributing expense.

Operating profit (Earnings Before Interest and Tax) EBIT measures the firm’s pricing decision + ability to acquire or produce its product cheaply + ability to distribute the product to customers cheaply

Net income includes the effects of the firm’s financing policies.


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Profitability Ratios Gross Profit Margin = Gross Profit / Sales Operating Profit Margin = Operating Profit / Sales= EBIT / Sales Net Profit Margin = Net Income / Sales


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What is CyberDragon’s Operating Profit Margin? Operating profit margin indicates management’s effectiveness in managing the firm’s revenue and expenses.

Operating profit margin = SalesEBIT = %22.10

760,112520,11

This is below the industry average of 12%. Based on this finding, the management team is less competitive in managing the firm.


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Operating profit margin = SalesEBIT

Operating profit margin = SalesDepre-Expenses Marketing -A &SG - COGS Sales

The driving forces of the operating profit margin are the following: 1. The number of units of product sold

2. The average selling price

3. The cost of acquiring the product

4. The ability to control administrative expenses

5. The ability to control marketing and distributing the product.


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What is CyberDragon’s Total Asset Turnover? The total asset turnover measures the dollar sales per one dollar of assets. This ratio indicates how efficiently a firm is using its assets in generating sales.

Total Asset Turnover = 38.1890,81760,112

Assets TotalSales

times

The industry average is 1.82 times. CyberDragon can generate $1.38 in sales with $1 in assets. It utilizes its assets less efficiently than its peers. The firm needs to figure out how to squeeze more sales out of its assets.


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To determine the factors responsible for CyberDragon’s poor performance, measured by total asset turnover, we examine the turnover ratios for the primary assets held by the firms – account receivables, inventories, and fixed assets. CyberDragon Industry Average Account receivable turnover = 6.16 times/yr 8.2 times/yr Inventory turnover = 3.1 times/yr 3.9 times/yr

Fixed assets turnover = AssetsFixedNet

Sales56.3

700,31760,112

times 4.6 times

Given these turnover ratios, CyberDragon is bad in managing all kinds of its assets.


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Suppose we assume that the ratios of XYZ are the following: Firm XYZ Industry Average Total Asset Turnover = 1.38 times 1.82 times Account receivable Turnover = 3.2 times/yr 8.2 times/yr Inventory Turnover = 4.2 times/yr 3.9 times/yr Fixed assets turnover = 4.8 times 4.6 times The total asset turnover of XYZ is too low. To identify, which asset is underutilized, we calculate turnover ratios. From the data above, what should XYZ do? Answer: XYZ should improve its account receivable turnover; for example, it can give more incentives to customer to pay faster, or apply penalties for late payment.


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3. How is the firm financing its assets? What is CyberDragon’s Total Debt Ratio?

Total Debt ratio = %58890,81523,47

assets Totaldebt Total

assets Totalequity) Total - assets (Total

The industry average total debt ratio is 47%. Cyberdragon relies on debt more than its peers. It uses more leverage. Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable For this formula, sometimes only interest‐bearing debt is used


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Debt‐Equity Ratio Debt‐Equity Ratio = Total Debt / Total Equity Debt‐equity ratio is one of many measures for firm’s leverage CyberDragon’s Book D/E Ratio = 47,523/ 34,367 = 1.38 times


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What is CyberDragon’s Times Interest Earned (TIE) Ratio? Times interest earned compares operating income to interest expense. It measures firm’s capacity to service its debts.

Times interest earned ratio = ExpenseInterest EBIT

= 65.3160,3520,11

times

The industry average is 6.7 times. This confirms that the firm uses more debt financing than average. TIE ratio is based on EBIT, which in not really a measure of cash available to pay interest because depreciation, a noncash expense, has been deducted when computing for the EBIT.


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What is CyberDragon’s Cash Coverage Ratio?

Cash coverage ratio = ExpenseInterest onDepreciatiEBIT

= 96.3160,3

1000520,11


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4. Are the shareholders receiving an adequate return on their investments? We want to know if the earnings available to the firm’s shareholders are attractive when compared to those in the peer group. Return on common equity (ROE) indicates the accounting rate of return on the stockholders’ investment.

ROE = Earnings) Retained Capitalin Paid(ParIncomeNet

Equity of Book valueIncomeNet

Net income is for the full fiscal year (before dividends are paid to common stock holders but after dividends are paid to preferred stock holders) Shareholder's equity does not include preferred shares.


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What is CyberDragon’sReturn on equity?

For CyberDragon, its ROE = 367,34016,5

= 14.6%. The industry average is 17.54%.

We need further analysis to understand the reasons why CyberDragon’s shareholders receive lower returns than their peers.


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The Du Pont Analysis: An Integrative Approach to Ratio Analysis

The Du Pont Model shows that ROE is driven by Profitability

Efficiency

Leverage

ROE = Equity TotalIncomeNet

ROE = Equity TotalAssets Total

Assets TotalSales

SalesIncomeNet

ROE = ltiplier Equity MuTurnoverAsset Total MarginNet Profit

Higher Equity Multiplier indicate that the firm use more debt


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For CyberDragon, Net Profit Margin = SalesIncomeNet

= 760,112

016,5

Total Asset Turnover = AssetTotal

Sales=

890,81760,112

Equity Multiplier = EquityTotalAssets Total

= 34,36781,890

CyberDragon’s ROE = 34,36781,890

890,81760,112

112,7605,016

= 14.6%

ROE of CyberDragon is lower than industry average (17.54%).


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Because Return on Asset (ROA) = AssetsTotal

IncomeNet , we can also rewrite the

equation above as

ROE = EquityTotalAssets Total

Asset TotalIncomeNet

ROE = ltiplier Equity MuROA

ROE = 34,36781,890

81,8905,016

= 14.6%


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We also know that profitability and asset turnover of CyberDragon are lower than those of industry average

but its debt ratio is higher than debt ratio of industry average.

Therefore, CyberDragon can improve its ROE by

1. Reducing cost

2. Increasing sales

3. Increasing leverage (debt) but also take more risk, especially when CyberDragon’s debt ratio currently is higher than industry average. Note that increasing leverage can help improve ROE only when cost of debt is lower than EBIT/Total Asset (= 11,520/81,890 = 14.07%)

4. Selling assets that do not generate sufficient income.


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DuPont Analysis: Yahoo vs. Google


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DuPont Analysis: Wal‐Mart vs. Nordstrom

Determine how much WalMart would need to increase its net profit margin in order to match Nordstrom’s ROE.

Net Profit Margin Asset Turnover Equity Multiplier

WalMart 3.60% 2.4 2.6Nordstrom 7.70% 1.7 2.4

WalMart’s ROE = 3.6% * 2.4 *2.6 = 22.46% Nordstrom’s ROE = 7.7% * 1.7 * 2.4 = 31.42% New WalMart’s ROE = new net profit margin * 2.4 * 2.6 31.42% = new net profit margin * 2.4 * 2.6 New net profit margin = 5.0% WalMart have to increase its net profit margin from 3.6% to 5.0% in order to raise its ROE to 31.42%


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Limitations of Ratio Analysis:

- Difficult to identify peer firms especially when the firm engages in multiple lines of business. For example, which firm is similar to GE, which has six business lines?

- Accounting practices differ widely among firms (e.g. depreciation). This can lead to differences in computed ratios.

- Industry average may not provide a desirable target ratio, because it includes both good and bad firms. If the firm wants to be the best, it should use the best competitor as the target, or try to find self‐determined peer group.

- Seasonality in firm’s operation. Ratios are varied with the time of year when the statements are prepared (fiscal year end). To avoid this problem, an average account balance should be used. For example, an average of inventory balances might be used to compute inventory turnover.

user

Text Box

For example, firms may count inventory at time which benefit their ratio


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Valuation Ratio

• Buy or Sell? How could you know whether an asset is cheap or expensive?

• The price level alone does not give you enough information whether an asset is expensive or not. You will have to compare the price you pay with the value you receive.

• For example: If I want to sell you 3 things below. Which one is expensive?

1. A new 2,000 square feet condominium in Hong Kong, HKD 2,000,000 2. A new car (Honda, 2013) = HKD 80,000 3. A new iPhone5 = HKD 20,000


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Valuation Ratio: Price‐Earnings Ratio (P/E)

• The P/E ratio is used to assess whether a stock is over‐ or under‐valued based on the idea that the value of a stock should be proportional to the earnings it can generate.

For example, if a company is currently trading at $20 a share and earnings over the last 12 months is $1, the P/E ratio for the stock would be 20/1 = 20

• From this example, investors are willing to pay $20 for $1 of current earnings

• High‐P/E ratio suggests that investors expect high earnings growth.


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CyberDragon’s P/E

Assume that

CyberDragon has 2,000 shares outstanding

The stock sold for $30 per share

Recall that CyberDragon’s net income was $5,016 Earnings per share =

$2.508

P/E =

. 11.96


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Other Ratios

• Stock price / Sales per share P/S

• Stock price / Cash flow per share P/CF

• Stock price/ book value of equity per share P/B


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Which firm is more expensive? Firm A: Current Stock price $10 Firm B: Current Stock price $15


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Which firm is more expensive? Firm A: Current Stock price $10, EPS = 1 P/E =10 Firm B: Current Stock price $15, EPS = 1 P/E =15 Note that “expensive” refers to the situation where market price is higher than intrinsic value.


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Which firm is more expensive?

Suppose that

• Firm A’s expected EPS growth rate = 10% • Firm B’s expected EPS growth rate = 50%

Current stock price of firm A = $10 Firm A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Expected EPS $1.00 $1.10 $1.21 $1.33 $1.46 $1.61 Current stock price of firm B = $15 Firm B Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Expected EPS $1.00 $1.50 $2.25 $3.38 $5.06 $7.59


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PEG Ratio

• P/E ratios can vary widely across industries and tend to be higher for industries with higher growth rates.

• One way to capture the idea that a higher P/E ratio can be justified by higher expected earnings growth.

PEG /

Lower number is better

• If PEG ≤ 1, the stock may be worthy of investment attention and possible purchase

• PEG firm A = 10/10 = 1 Note that for PEG calculation, growth rate is not in % term

• PEG firm B = 15/50 = 0.3 Based on PEG, firm B seems to be more attractive to buy

• In real practice, we must also evaluate a stock from many other different criteria. P/E and PEG ignore a lot of important information.


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Market‐to‐Book Ratio

- Market‐to‐book ratio = Market Value of equity/Book value of equity

‐ Market‐to‐book ratio = Market value per share / Book value per share ‐ For CyberDragon, Book value per share = 34,367/2,000 = $17.18

Market‐to‐book ratio = 30/17.18 = 1.75 times - Note that book value is the total equity

- M/B sometimes called Price‐to‐book ratio (P/B) - Growth stock high market‐to‐book ratio, expecting high growth rate in the future. The company has been successful overall in creating value for its stockholders

- Value stock low market‐to‐book ratio, expecting growth rate to be low

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