Example

Analysis of Financial Statements

Example
    

Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors

Income Statement
2008 Sales COGS Other expenses Deprec. Tot. op. costs EBIT Int. expense EBT Taxes (40%) Net income $5,834,400 4,980,000 720,000 116,960 5,816,960 17,440 176,000 (158,560) (63,424) ($ 95,136) 2009E $7,035,600 5,800,000 612,960 120,000 6,532,960 502,640 80,000 422,640 169,056 $ 253,584
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Balance Sheets: Assets

Cash S-T invest. AR Inventories Total CA Net FA Total assets 2008 $ 7,282 20,000 632,160 1,287,360 1,946,802 939,790 $2,886,592 2009E $ 14,000 71,632 878,000 1,716,480 2,680,112 836,840 $3,516,952
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Balance Sheets: Liabilities & Equity

Accts. payable Notes payable Accruals Total CL Long-term debt Common stock Ret. earnings Total equity Total L&E $ 2008 324,000 720,000 284,960 1,328,960 1,000,000 460,000 97,632 557,632 $2,886,592 $ 2009E 359,800 300,000 380,000 1,039,800 500,000 1,680,936 296,216 1,977,152 $3,516,952 5

Other Data
Stock price # of shares EPS DPS Book val. per sh. Lease payments Tax rate 2008 $6.00 100,000 -$0.95 $0.11 $5.58 $40,000 0.4 2009E $12.17 250,000 $1.01 $0.22 $7.91 $40,000 0.4
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Why are ratios useful?



Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths

Five Major Categories of Ratios



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?

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Ratio Categories (Continued)



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?
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Forecasted Current and Quick Ratios for 2009.

CR09 CA = CL $2,680 = $1,040 = 2.58.

QR09

CA - Inv. = CL $2,680 - $1,716 = $1,040 = 0.93.

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Comments on CR and QR
2009E CR QR


2008 1.46 0.5

2007 2.3 0.8

Ind. 2.7 1.0

2.58 0.93

Expected to improve but still below the industry average. Liquidity position is weak.

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Inventory Turnover Ratio vs. Industry Average

Sales Inv. turnover = Inventories $7,036 = = 4.10. $1,716 2009E Inv. T. 4.1 2008 4.5 2007 4.8 Ind. 6.1
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Comments on Inventory Turnover



Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted.

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DSO: average number of days from sale until cash received.

DSO = Receivables Average sales per day = $878 $7,036/365

= Receivables Sales/365 = 45.5 days.

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Appraisal of DSO


Firm collects too slowly, and situation is getting worse. Poor credit policy.

DSO

2009 45.5

2008 39.5

2007 37.4

Ind. 32.0
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Fixed Assets and Total Assets Turnover Ratios

Fixed assets Sales = turnover Net fixed assets $7,036 = 8.41. = $837 Total assets turnover Sales = Total assets $7,036 = 2.00. = $3,517 (More)

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Fixed Assets and Total Assets Turnover Ratios



FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

2009E FA TO TA TO 8.4 2.0

2008 6.2 2.0

2007 10.0 2.3

Ind. 7.0 2.5

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Calculate the debt, TIE, and EBITDA coverage ratios.

Total liabilities Debt ratio = Total assets $1,040 + $500 = $3,517 EBIT TIE = Int. expense $502.6 = 6.3. = $80

= 43.8%.

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EBITDA Coverage (EC)

EBIT + Depr. & Amort. + Lease payments Interest Lease + + Loan pmt. expense pmt. $502.6 + $120 + $40 = $80 + $40 + $0 = 5.5.
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Debt Management Ratios vs. Industry Averages

2009E 43.8% 6.3 5.5 2008 80.7% 0.1 0.8 2007 Ind. 54.8% 50.0% 3.3 6.2 2.6 8.0

D/A TIE EC

Recapitalization improved situation, but lease payments drag down EC.

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Profit Margin (PM)

NI PM = Sales PM $253.6 =$7,036 = 3.6%.

2009E 2008 2007 Ind. 3.6% -1.6% 2.6% 3.6%

Very bad in 2008, but projected to meet industry average in 2009. Looking good.
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Basic Earning Power (BEP)

EBIT BEP = Total assets $502.6 = $3,517 = 14.3%.

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Basic Earning Power vs. Industry Average

BEP removes effect of taxes and financial leverage. Useful for comparison.  Projected to be below average.  Room for improvement. 2009E 2008 2007 Ind. BEP 14.3% 0.6% 14.2% 17.8%

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Return on Assets (ROA) and Return on Equity (ROE)

NI ROA = Total assets $253.6 = $3,517 = 7.2%.

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Return on Assets (ROA) and Return on Equity (ROE)

ROE = NI Common Equity = 12.8%.

$253.6 = $1,977

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ROA and ROE vs. Industry Averages

2009E Ind. ROA ROE 2008 2007

7.2% -3.3% 6.0% 9.0% 12.8% -17.1% 13.3% 18.0%

Both below average but improving.

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Effects of Debt on ROA and ROE



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.

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

Price = $12.17. NI $253.6 EPS = Shares out. = 250 Price per share $12.17 P/E = = $1.01 EPS = $1.01.

= 12.
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Industry P/E Ratios

Industry Banking Software Drug Electric Utilities Semiconductors Steel Tobacco S&P 500 Ticker* STI MSFT PFE DUK INTC NUE MO P/E 15.35 30.26 27.30 20.55 25.63 14.72 17.49 20.45

*Ticker is for typical firm in industry, but P/E ratio is for the industry, not 29 the individual firm; www.investor.reuters.com, May 2007

Market Based Ratios

NI + Depr. CF per share = Shares out. $253.6 + $120.0 = 250 Price per share P/CF = Cash flow per share = $12.17 $1.49 = 8.2.
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= $1.49.

Market Based Ratios (Continued)

Com. equity BVPS = Shares out. $1,977 = 250 = $7.91. Mkt. price per share M/B = Book value per share $12.17 = $7.91 = 1.54.
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Interpreting Market Based Ratios



P/E: How much investors will pay for $1 of earnings. Higher is better. M/B: How much paid for $1 of book value. Higher is better. P/E and M/B are high if ROE is high, risk is low.

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Comparison with Industry Averages

P/E P/CF M/B

2009E 12.0 8.2 1.5

2008 -6.3 27.5 1.1

2007 9.7 8.0 1.3

Ind. 14.2 7.6 2.9

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Common Size Balance Sheets: Divide all items by Total Assets

Assets 2007 2008 2009E Ind. Cash 0.6% 0.3% 0.4% 0.3% ST Inv. 3.3% 0.7% 2.0% 0.3% AR 23.9% 21.9% 25.0% 22.4% Invent. 48.7% 44.6% 48.8% 41.2% Total CA 76.5% 67.4% 76.2% 64.1% Net FA 23.5% 32.6% 23.8% 35.9% TA 100.0% 100.0% 100.0% 100.0%
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Divide all items by Total Liabilities & Equity

Assets AP Notes pay. Accruals Total CL LT Debt Total eq. Total L&E 2007 9.9% 13.6% 2008 11.2% 24.9% 2009E 10.2% 8.5% Ind. 11.9% 2.4%

9.9% 10.8% 9.5% 9.3% 32.8% 46.0% 29.6% 23.7% 22.0% 34.6% 14.2% 26.3% 45.2% 19.3% 56.2% 50.0% 100.0% 100.0% 100.0% 100.0% 35

Analysis of Common Size Balance Sheets



Computron has higher proportion of inventory and current assets than Industry. Computron now has more equity (which means LESS debt) than Industry. Computron has more short-term debt than industry, but less long-term debt than industry.
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Common Size Income Statement: Divide all items by Sales

Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI 2007 100.0% 83.4% 9.9% 0.6% 6.1% 1.8% 4.3% 1.7% 2.6% 2008 100.0% 85.4% 12.3% 2.0% 0.3% 3.0% -2.7% -1.1% -1.6% 2009E 100.0% 82.4% 8.7% 1.7% 7.1% 1.1% 6.0% 2.4% 3.6% Ind. 100.0% 84.5% 4.4% 4.0% 7.1% 1.1% 5.9% 2.4% 3.6% 37

Analysis of Common Size Income Statements



Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.

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Percentage Change Analysis: % Change from First Year (2007)

Income St. Sales COGS Other exp. Depr. EBIT Int. Exp. EBT Taxes NI 2007 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2008 70.0% 73.9% 111.8% 518.8% -91.7% 181.6% -208.2% -208.2% -208.2% 2009E 105.0% 102.5% 80.3% 534.9% 140.4% 28.0% 188.3% 188.3% 188.3% 39

Analysis of Percent Change Income Statement



We see that 2009 sales grew 105% from 2007, and that NI grew 188% from 2007. So Computron has become more profitable.

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Percentage Change Balance Sheets: Assets

Assets Cash ST Invest. AR Invent. Total CA Net FA TA 2007 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2008 -19.1% -58.8% 80.0% 80.0% 73.2% 172.6% 96.5% 2009E 55.6% 47.4% 150.0% 140.0% 138.4% 142.7% 139.4%
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Percentage Change Balance Sheets: Liabilities & Equity

Liab. & Eq. AP Notes pay. Accruals Total CL LT Debt Total eq. Total L&E 2007 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2008 122.5% 260.0% 109.5% 175.9% 209.2% -16.0% 96.5% 2009E 147.1% 50.0% 179.4% 115.9% 54.6% 197.9% 139.4%
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Analysis of Percent Change Balance Sheets



We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

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Explain the Du Pont System



The Du Pont system focuses on:

  

Expense control (PM) Asset utilization (TATO) Debt utilization (EM)

It shows how these factors combine to determine the ROE.

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The Du Pont System

Profit margin NI Sales

)(
x

TA turnover Sales TA

)(
x

Equity multiplier TA CE

) = ROE
= ROE

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The Du Pont System

NI Sales 2007: 2008: 2009: Ind.: x Sales TA x x x x x 2.3 2.0 2.0 2.5 x x x x TA CE 2.2 5.2 1.8 2.0 = = = = = ROE 13.2% -16.6% 13.0% 18.0%
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2.6% -1.6% 3.6% 3.6%

Potential Problems and Limitations of 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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Problems and Limitations (Continued)



Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons.

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Problems and Limitations (Continued)



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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Qualitative Factors


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?

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Qualitative Factors (Continued)



  

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?

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