CHAPTER 4

Analysis of Financial Statements

2nd .
9 enter

Balance Sheet: Assets

Year 0 1 Year Ago

Cash 85,632 7,282

Accounts Receivable 878,000 632,160
Inventories 1,716,480 1,287,360
Total Current Assets 2,680,112 1,926,802

Gross Fixed Assets 1,197,160 1,202,950

Less: Depreciation 380,120 263,160
Net Fixed Assets 817,040 939,790

Total Assets 3,497,152 2,866,592

Liabilities & Equity

Year 0 1 Year Ago

Accts payable 436,800 524,160

Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568

Long-term debt 400,000 723,432

Common stock 1,657,780 460,000

Retained earnings 294,572 32,592
Total Equity 1,952,352 492,592

Total L & E 3,497,152 2,866,592

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 Income statement

Year 0 1 Year Ago

Sales 7,035,600 6,034,000

COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 105,660 ( 66,740)
Net income 316,980 (200,220)

Other data

No. of shares 250,000 100,000

EPS 1.268 -2.002
DPS 0.220 0.110
Stock price 12.17 2.25
Lease pmts 40,000 40,000

Why are ratios useful?

 Ratios standardize numbers and facilitate comparisons.

 Ratios are used to highlight weaknesses and strengths.

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

 Liquidity: Can we make required payments?

 Asset management: right amount of assets vs. sales?
 Debt management: 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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 Liquidity Ratios
Calculate D’Leon’s current ratio for Year 0
Year 0
Current ratio = Current assets / Current liabilities
= $2,680 / $1,145
= 2.34

Industry Current Ratio = 2.7 X

Asset Management Ratios

What is the inventory turnover vs. the industry average?
Year 0
INV. Turnover = Sales / Inventories
= $7,036 / $1,716 = 4.10 X

Industry Inv. Turnover = 6.1

 Inventory turnover is below industry average.

 D’Leon might have old inventory, or its control might be poor.
 No improvement is currently forecasted.

Year 0
DSO is the average number of days after making a sale before receiving cash.
DSO = Receivables / Average sales per day
= Receivables / Sales/365
= $878 / ($7,036/365)
= 45.6

INDUSTRY DSO = 32.0

Appraisal of DSO

D’Leon collects on sales too slowly, and getting worse.

D’Leon has a poor credit policy.

Year 0
Fixed asset and total asset turnover ratios vs. the industry average
FA turnover = Sales / Net fixed assets
= $7,036 / $817 = 8.61x Industry FA Turnover = 7.0X

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x Industry TA Turnover = 2.6X

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Evaluating the FA turnover and TA turnover ratios

FA turnover projected to exceed the industry average

TA turnover is below the industry average. Caused by excessive current
assets.

Debt Ratios
Calculate the debt ratio, TIE, and EBITDA coverage ratios.
Year 0
Debt ratio = Total debt / Total assets
= ($1,145 + $400) / $3,497 = 44.2% Industry Debt Ratios = 50%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x Industry TIE = 4.3X

1. The H.R. Pickett Corporation has $500,000 of debt outstanding, and it pays an
interest rate of
Times-interest- 10 percent annually. Pickett's annual sales are $2 million, its average tax rate is
30 percent, and
earned ratio its net profit margin on sales is 5 percent. If the company does not maintain a TIE
ratio of at least 5 times, its bank will refuse to renew the loan, and bankruptcy
will result. What is Pickett's TIE ratio?

Year 0
EBITDA = (EBITDA+Lease pmts)
coverage Int exp + Lease pmts + Principal pmts

= $609.6 + $40 / $70 + $40 + $0 Industry EBITDA Coverage = 8.0X

= 5.9x

2. Willis Publishing has $30 billion in total assets. The company's basic earning
power (BEP) ratio
EBITDA is 20 percent, and its times-interest-earned ratio is 8.0. Willis' depreciation and
amortization
coverage ratio expense totals $3.2 billion. It has $2 billion in lease payments and $1 billion must
go toward principal payments on outstanding loans and long-term debt. What is
Willis' EBITDA coverage ratio?

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How do the debt management ratios compare with industry averages?

D/A and TIE are better than the industry average, but EBITDA
coverage still trails the industry

Profitability ratios:

Profit margin and Basic earning power

Year 0
Profit margin = Net income / Sales
= $317.0 / $7,036 = 4.5% Industry Profit Margin = 3.5%

Year 0
BEP = EBIT / Total assets
= $492.6 / $3,497 = 14.1% Industry BEP = 19.1%

Appraising profitability with the profit margin and basic earning power

Profitability ratios:

Return on assets and Return on equity

Year 0
ROA = Net income / Total assets
= $317.0 / $3,497 = 9.1% Industry ROA = 9.1%

ROE = Net income / Total common equity

= $317.0 / $1,952 = 16.2% Industry ROE = 18.2%

Appraising profitability with the return on assets and return on equity

Both ratios are below industry average

3. Graser Trucking has $12 billion in assets, and its tax rate is 25 percent. The
company's

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 Ratio basic earning power (BEP) ratio is 15 percent, and its return on assets (ROA) is
6.25 percent. What
calculations is Graser's times-interest-earned (TIE) ratio?

Effects of debt on ROA and ROE

 ROA is lowered by debt--interest lowers NI, which also lowers ROA =

NI/Assets.
 But use of debt also lowers equity, hence debt could raise ROE =
NI/Equity.

Problems with ROE

 ROE and shareholder wealth are correlated, but problems can arise when
ROE is the sole measure of performance.
 ROE does not consider risk.

 ROE does not consider the amount of capital invested.

 Might encourage managers to make investment decisions that do not

benefit shareholders.

 ROE focuses only on return. A better measure is one that considers both
risk and return.

Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

Year 0
P/E = Price / Earnings per share
= $12.17 / $1.268 = 9.6x Industry P/E = 14.2 X

P/CF = Price / Cash flow per share

= $12.17 / [($317.0 + $117.0) ÷ 250]
= 7.01x Industry P/CF = 11.0 X

Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

Year 0
M/B = Mkt price per share / Book value per share
= $12.17 / ($1,952 / 250) = 1.56x Industry MB = 2.4 X

Analyzing the market value ratios

 P/E: How much investors are willing to pay for $1 of earnings.

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 P/CF: How much investors are willing to pay for $1 of cash flow.
 M/B: How much investors are willing to pay for $1 of book value equity.
 For each ratio, the higher the number, the better.
 P/E and M/B are high if ROE is high and risk is low.

Extended DuPont equation:

Breaking down Return on equity

Year 0
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
= 4.5% x 2 x 1.8
= 16.2%

The Du Pont system

Also can be expressed as:

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)

 Focuses on:
 Expense control (PM)
 Asset utilization (TATO)
 Debt utilization (Eq. Mult.)

 Shows how these factors combine to determine ROE.

Trend analysis

 Analyzes a firm’s financial ratios over time

 Can be used to estimate the likelihood of improvement or deterioration in
financial condition.

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4. Complete the balance sheet and sales information in the table that follows for
Balance sheet Hoffmeister Industries using the following financial data:
analysis
Debt ratio: 50%
Current ratio: 1.8x
Total assets turnover: 1.5x
Days sales outstanding: 36.5 daysa
Gross profit margin on sales: (Sales -Cost of goods sold)/Sales = 25%
Inventory turnover ratio: 5 X
a
Calculation is based on a 365-day year.

BALANCE SHEEET

Cash Accounts payable

Accounts receivable Long-term debt 60,000

Inventories Common stock

Fixed assets Retained earnings 97,500

Total assets $300,000 Total liabilities & equity

Sales Cost of goods sold

5. Assume you are given the following relationships for the Brauer Corporation:
Ratio
calculations Sales/total 1.5x
Return on assets (ROA) 3%
Return on equity (ROE) 5%

Calculate Brauer’s profit margin and debt ratio

 Comparison with industry averages is difficult for a conglomerate firm that

operates in many different divisions.
 “Average” performance is not necessarily good, perhaps the firm should
aim higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can make statements and ratios look
better.
More issues regarding ratios
 Different operating and accounting practices can distort comparisons.
 Sometimes it is hard to tell if a ratio is “good” or “bad”.
 Difficult to tell whether a company is, on balance, in strong or weak
position.

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Qualitative factors to be considered when evaluating a company’s future financial
performance
 Are the firm’s revenues tied to 1 key customer, product, or supplier?
 What percentage of the firm’s business is generated overseas?
 Competition
 Future prospects
 Legal and regulatory environment