CHAPTER 3WORKING WITH FINANCIAL STATEMENTS

Students sometimes get the impression that accounting data is useless because care must be used when interpretingsome of the results. They sometimes ask why we bother with financial statement analysis at all. Robert Higginsprovides a good answer to this question:

“objectively determinable current values of many assets do not exist. Faced with a trade-off between relevant,but subjective current values, and irrelevant, but objective historical costs, accountants have opted for irrelevant,but objective historical costs. This means that it is the user’s responsibility to make adjustments.”

Financial statement information is often our ONLY source of information. Consequently, we use theinformation we have and make adjustments where appropriate.

CHAPTER ORGANIZATION

3.1 Standardized Financial Statements: Allows users to compare companies of different sizes or better compare a company as it grows through time.

Common-Size Balance Sheets – each item is converted to a percentage of Total Assets

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Common-Size Income Statements - each item is converted to a percentage of Sales

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3.2 Ratio Analysis

Things to consider concerning financial ratios:

-What aspects of the firm are we attempting to analyze?-What information goes into computing a particular ratio and how does that information relate to the aspect of the firm being analyzed?

-What is the unit of measurement (times, days, percent)?

-What are the benchmarks used for comparison? What makes a ratio “good” or “bad?”

In discussing the nature of financial statement analysis, realize that it is a means to an end, rather than an end in itself. That is, financial ratios uncover areas of interest that a good analyst will use to determine what needs to be investigated further.

♦ Short-Term Solvency or Liquidity Ratios – Measures the ability of the firm to meet its current (short-term, < 1 year) obligations.

Liquidity is defined as the ability to convert assets to cash quickly without a significant loss in value

Liquidity vs. Profitability trade-off

Current ratio = current assets / current liabilities

Quick ratio = (current assets – inventory) / current liabilities

Also referred to as the “acid-test” ratio.

Cash ratio = cash / current liabilities

♦ Long-Term Solvency Ratios - This group of ratios really measures two different aspects of leverage – the level of indebtedness and the ability to service debt. The former is indicative of the firm’s debt capacity, while the latter more closely relates to the likelihood of default. The total debt ratio measures what proportion of the firm’s assets are financed with borrowed money, while the debt/equity ratio compares the amount of funds supplied by creditors relative to owners.

Total debt ratio = (total assets – total equity) / total assets = total debt / total assets

Debt-equity ratio = (total assets – total equity) / total equity = total debt / total equity

Equity multiplier = total assets / total equity = (total equity + total debt) / total equity = 1 + debt-equity ratio

Times interest earned ratio = EBIT / Interest

Cash coverage ratio = (EBIT + depreciation) / interest

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♦ Asset Management or Turnover Ratios – Measures how effectively the firm is managing its assets; also called asset utilization ratios.

Inventory turnover = cost of goods sold / inventory

It is usually more accurate to use average inventory [Beg. + End. / 2] for this calculation.

Days’ sales in inventory = 365 days / inventory turnover

Days’ Sales in Inventory = Inventory / (Sales per day) = Inventory / (Sales / 365 Days)= 365 Days / (Sales / Inventory) = 365 Days / Inventory turnover

Receivables turnover = sales / accounts receivable

Days’ sales in receivables = 365 days / receivables turnover

Days’ Sales in Receivables = Accounts receivable / (Sales per day) = Accounts receivable / (Sales / 365 Days) = 365 Days / (Sales / Accounts receivable) = 365 Days / Receivables turnover

This ratio may also be called “average collection period” or “days’ sales outstanding.” We are implicitly assuming that all sales are on credit; if not, only credit sales should be used.

Payables turnover = cost of goods sold / accounts payable

Payables period = 365 / payables turnover

This is a measure of how long it takes the firm to pay its bills.

Total asset turnover = sales / total assets

Sales generated for every dollar of assets; affected by the age and book value of assets. A fixed asset turnover ratio (fixed asset turnover = sales / fixed assets) that is high relative to that of

the industry can be the result of efficient asset utilization, or it can indicate that the firm is utilizing old (and perhaps inefficient) equipment, while others in the industry have invested in modern equipment. In this case, the firm using inefficient equipment would display a favorable fixed asset turnover ratio, but would be likely to display a higher level of expenses, and unless offset by other factors, lower profitability – based on cash flow. The firm may have traded a noncash deduction (depreciation) for a higher true cash outflow (operating expense).

Capital intensity ratio = 1 / total asset turnover

The dollar investment in assets needed to generate $1 in sales.

♦ Profitability Measures – How efficiently the firm uses its assets and manages its operations. Based on book values, so they are not comparable with returns that you see on publicly traded assets.

Profit margin = net income / sales

Profit margin is an indicator of a company's pricing policies and its ability to control costs. Differences in competitive strategy and product mix cause profit margin to vary among different companies.

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Return on assets = net income / total assets

An indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the book value of the assets, some caution is required for companies whose book value may not correspond to the actual market value.

Return on equity = net income / total equity

Measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth.

♦ Market Value Measures – Relate the firm’s stock price to its earnings and book value per share.Earnings per share = net income available to common stockholders / common shares outstanding

Net income available to common stockholders is computed by subtracting preferred dividends from net income.

Price-earnings ratio = price per share / earnings per share

The amount investors are willing to pay per dollar of current earnings. Share prices in a publicly traded company are determined by market supply and demand, and thus

depend upon the expectations of buyers and sellers. The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is

the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a trailing P/E, because it involves taking earnings from the last four quarters; the 'forward P/E' (or current price compared to estimated earnings going forward twelve months) is also used.

The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings.

Price-sales ratio = price per share / sales per share

A stock's capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis. A low price to sales ratio (for example, below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales don't reveal the whole picture, since the company might be unprofitable. Because of the limitations, price to sales ratio are usually used only for unprofitable companies, since such companies don't have a price/earnings ratio (P/E ratio).

http://stocks.about.com/od/evaluatingstocks/a/ps.htm

http://www.fool.com/investing/high-growth/2006/04/10/foolish-fundamentals-the-pricetosales-ratio.aspx

Book value per share = total equity / number of common shares outstanding

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Example: A firm sells 12,000 shares for $10 each. The shares have a par value of $1. The retained earnings for this firm are $125,000. What is the book value per share?

Stockholder’s Equity

Common stock at par $ 12,000Paid-in-capital $108,000Retained earnings $125,000 Total equity $245,000

In this example, the book value per share = $245,000 / 12,000 = $20.42

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ("open market" including insiders' holdings). Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands, rather than pay dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a "bonus" to incentive compensation plans for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account. Another motive for stock repurchase is to protect the company against a takeover threat. These shares don't pay dividends, have no voting rights, and should not be included in shares outstanding calculations.

Market-to-book ratio = market value per share / book value per share

Also referred to as the Price-to-book ratio. http://stocks.about.com/od/evaluatingstocks/a/pb.htm Measures the value that has been added/subtracted to/from the owner’s (stockholder’s) investment.

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3.3 The Du Pont Identity - The Du Pont identity breaks down Return on Equity (that is, the return to equity that investors have contributed to the firm) into three distinct elements:

Operating efficiency (measured by profit margin) Asset use efficiency (measured by total asset turnover) Financial leverage (measured by the equity multiplier)

This analysis allows the analyst to understand where superior (or inferior) return is derived from by comparison with companies in similar industries (or between industries).

ROE = (NI / total equity)

multiply by one (assets / assets) and rearrangeROE = (NI / assets) (assets / total equity)

multiply by one (sales / sales) and rearrangeROE = (NI / sales) (sales / assets) (assets / total equity)

ROE = ROA x equity multiplier

ROE = profit margin x total asset turnover x equity multiplier

These three ratios indicate that a firm’s return on equity depends on its operating efficiency (profit margin), asset use efficiency (total asset turnover), and financial leverage (equity multiplier).

3.4 Internal and Sustainable Growth

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Internal growth - The internal growth rate is the growth rate that the firm can maintain without raising additional external capital.

Sustainable growth - The sustainable growth rate is the maximum growth rate that the firm can achieve without external equity financing while maintaining a constant debt/equity ratio.

Dividend Payout and Earnings Retention

Dividend payout ratio = cash dividends / net income

Retention ratio = addition to retained earnings / net income

Net income = dividends paid + additions to retained earnings

divide through by net income and you get:1 = dividend payout ratio + retention ratio

Retention (plowback) ratio = b = 1 – dividend payout ratio

ROA, ROE, and Growth

Internal growth rate = (ROA x b) / [1 – ROA x b]

Sustainable growth rate = (ROE x b) / [1 – ROE x b]

Based on the Du Pont identity, the following factors affect the growth rate:

-profit margin – an increase in profit margin increases the ability to generate funds internally, increasing both the internal and sustainable growth rate-total asset turnover – increasing the TAT increases sales per dollar of assets and thus decreases the need to purchase additional assets, increasing both the internal and sustainable growth rate-financial policy – increasing the debt/equity ratio makes additional debt financing available, increasing the sustainable growth rate-dividend policy – decreasing the dividend payout ratio allows the firm to retain more internally generated funds, increasing both the internal and sustainable growth rate

3.5 Using Financial Statement Information

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Why Evaluate Financial Statements?

Internal Uses – evaluate performance, look for trouble spots, generate projections. Managers use ratios to help analyze, control, and thus improve the firm’s operations.

External Uses – making credit decisions, evaluating competitors, assessing acquisitions. Credit analysts, including bank loan officers and bond rating analysts, use ratios to help determine a company’s ability to pay its debts. Security analysts (or investors) interested in the company’s efficiency and growth prospects, and bond analysts, who are concerned with a company’s ability to pay interest on its bonds as well as the liquidation value of the firm’s assets in the event of bankruptcy.

Choosing a Benchmark

Time-Trend Analysis – look for significant changes from one period to the next.

Peer Group Analysis – compare to other companies in the same industry, use SIC or NAICS (http://www.naics.com/search.htm) codes to determine the industry comparison figures. More specifically, compute and compare to the ratios of the company’s main competitors.

Problems with Financial Statement Analysis

-no underlying financial theory-finding comparable firms-what to do with conglomerates, multidivisional firms-differences in accounting practices-differences in capital structure-seasonal variations, one-time events

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RATIOS AND FINANCIAL PLANNING AT S&S AIR, INC.

Chris Guthrie was recently hired by S&S Air, Inc., to assist the company with its financial planning, and to evaluate the company's performance. Chris graduated from college five years ago with a finance degree. He has been employed in the finance department of a Fortune 500 company since then.

S&S Air was founded 10 years ago by friends Mark Sexton and Todd Story. The company has manufactured and sold light airplanes over this period, and the company's products have received high reviews for safety and reliability. The company has a niche market in that it sells primarily to individuals who own and fly their own airplanes. The company has two models, the Birdie, which sells for $53,000, and the Eagle, which sells for $78,000.

While the company manufactures aircraft, its operations are different from commercial aircraft companies. S&S Air builds aircraft to order. By using prefabricated parts, the company is able to complete the manufacture of an airplane in only five weeks. The company also receives a deposit on each order, as well as another partial payment before the order is complete. In contrast, a commercial airplane may take one and one-half to two years to manufacture once the order is placed.

Mark and Todd have provided the following financial statements. Chris has gathered the industry ratios for the light airplane manufacturing industry.

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QUESTIONS1. Calculate the ratios for S&S Air that are shown for the industry.

Ratios for S&S AirCurrent ratio = Quick ratio = Cash ratio =

Total asset turnover = Inventory turnover =

Receivables turnover = Total debt ratio =

Debt-equity ratio = Equity multiplier =

Times interest earned = Cash coverage = Profit margin =

Return on assets = Return on equity =

2. Mark and Todd agree that a ratio analysis can provide a measure of the company's performance. They have chosen Boeing as an aspirant company. Would you choose Boeing as an aspirant company? Why or why not?

3. Compare the performance of S&S Air to the industry. For each ratio, comment on why it might be viewed as positive or negative relative to the industry. Suppose you create an inventory ratio calculated by inventory divided by current liabilities. How do you think S&S Air's ratio would compare to the industry average?

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4. Calculate the internal growth rate and sustainable growth rate for S&S Air. What do these numbers mean?

ROA = NI / TA

b = Addition to RE / NI

Internal growth rate = (ROA x b) / [1 – (ROA x b)]

ROE = NI / TE

Sustainable growth rate = (ROE x b) / [1 – (ROE x b)]

The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure.

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