Finance - Chapter 3 PDF

9/25/19
CHAPTER 3 OUTLINE
CHAPTER 3 • 3-1. Financial Analysis
• 3-2. Liquidity Ratios
• 3-3. Asset Management Ratios
• 3-4. Debt Management Ratios
• 3-5. Profitability Ratios
3-6. Market Value Ratios
ANALYSIS OF FINANCIAL •
• 3-7. Trend Analysis, Common Size Analysis, and
STATEMENTS Percent Change Analysis
• 3-8. Tying the Ratios Together: The DuPont Equation
• 3-9. Comparative Ratios and Benchmarking
• 3-10. Uses and Limitations of Ratio Analysis
Copyright © 2017 by Nelson Education Ltd. 3-2
3-1. Financial Analysis 3-1. Income Statement

• Individual numbers in a firm’s financial 2016 2015
statements do not mean much if looked at Net sales $3,000.0 $2,850.0
independently. Costs of goods sold except depreciation 2,100.0 2,000.0
• Ratios are calculated to reveal relationships Depreciation and amortization 100.0 90.0
Other operating expenses 516.2 497.0
between different numbers and to extract
EBIT $283.8 $263.0
important information.
Int. expense 88.0 60.0
• Ratios also remove the size factor between EBT $195.8 $203.0
different firms and make comparison of Taxes (40%) 78.3 81.2
them meaningful ($5 million of net income Net income $117.5 $121.8
for $50 million vs. $100 million of sales). Preferred dividends 4.0 4.0
Net income available to shareholders (NI) $113.5 $117.8
Copyright © 2017 by Nelson Education Ltd. 3-3 Copyright © 2017 by Nelson Education Ltd. 3-4
3-1. Balance Sheets: Liabilities and

3-1. Balance Sheets: Assets
Equity
2016 2015
2016 2015 Accts. payable 60 30
Cash 10 15 Notes payable 110 60
Accruals 140 130
S-T invest. 0 65
Total CL $310 $220
AR 375 315 Long-term bonds 754 580
Inventories 615 415 Total liabilities $1,064 $800
Pref. stock (400,000 shares) 40 40
Total CA $1,000 $810
Com. stock (50,000,000 shares) 130 130
Net FA 1,000 870 Ret. earnings 766 710
Total assets $2,000 $1,680 Total common equity $896 $840
Total L&E $2,000 $1,680
Copyright © 2014 by Nelson Education

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3-1. Other Data 3-1. Why Are Ratios Useful?

2016 2015
• Standardize numbers and facilitate
Stock price $23.00 $26.00
comparisons both between firms and
# of shares 50,000,000 50,000,000 over time
EPS $2.27 $2.36
• Used to highlight weaknesses and strengths
DPS $1.15 $1.06
CFPS $4.27 $4.16
BVPS $17.92 $16.80
Lease payments $28 $28
Tax rate 0.4 0.4
3-1. Who Is Using Ratios? 3-1. Five Major Categories of Ratios

• Investors: Predicting the future • Liquidity: Can we make required payments as
they fall due?
• Management: Evaluating current situation and • Asset management: Do we have the right amount
planning to improve the firm’s future of assets for the level of sales?
performance • 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?
3-2. Liquidity Ratios 3-2. Current and Quick Ratios

• Provide a quick, easy-to-use measure of
liquidity CA $1,000
CR16 = CL = $310 = 3.2
• Two commonly used ratios:
– Current ratio (CR): Measures the ability to
meet short-term obligations CA – Inv.
QR16 = CL
– Quick, or acid test, ratio (QR): Measures the
ability to pay off short-term obligations $1,000 – $615
= $310 = 1.2
without relying on the sale of inventories

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3-2. Comments on CR and QR 3-3. Asset Management Ratios

2016 2015 Industry • Measure how effectively the firm is managing
CR 3.2× 3.7× 4.2× its assets
1.2× 1.8× 2.1×
• Answer the question: Does the firm have the
QR
right amount of each type of assets in view of
• It is expected to worsen and is still below the sales levels?
industry average. • Can be calculated for different types of assets:
• Liquidity position is weak. inventories, A/R, A/P, fixed assets, and total
• Shareholders may not want a high CR. assets
3-3. Evaluating Inventories: 3-3. Comments on Inventory

Inventory Turnover Ratio Turnover
COGS • Inventory turnover is below industry average.
Inv. turnover = Inventories • Firm might have old inventory, or its control
$2,200 might be poor.
= $615 = 3.60 • True turnover will be overstated when sales
are stated at market prices, but inventories
are recorded at historical cost.
2016 2015 Ind. • This ratio may be distorted by seasonal
Inv. t. 3.6 5.04 8.0 factors.
3-3. Evaluating Receivables: 3-3. Appraisal of DSO

The Days Sales Outstanding (DSO) • Also called the “average collection period”
(ACP), indicates the average length of time for
Receivables the firm to wait after making a sale before
DSO = Average sales per day
receiving cash
• Firm collects too slowly, and situation is
$375
= Receivables = $3,000/365 getting worse: poor credit policy
Sales/365
2016 2015 Ind.
= 45.6 days ≈ 46 days DSO 46 40 36

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3-3. Evaluating Payables: 3-3. APP: Interpretation

Average Payables Period (APP) • With an industry average of 9 days, the firm is
doing fine with sufficient cash flow to pay bills
Payables on time.
APP =
Avg.OperatingCostPerDay • If APP is significantly longer than the credit
term provided, the firm will be at risk of losing
Payables
= those credit terms.
AnnualOperatingCost / 365 • If APP is lower than the credit terms offered,
the firm has not taken advantage of the free
$60 $60 financing from suppliers.
APP = = = 8.4days » 8days
$2,616.2 365 $7.1677
3-3. Fixed Assets and Total Assets 3-3. Fixed Assets and Total Assets
Turnover Ratios Turnover Ratios
• FA turnover is equal to the industry average, suggesting that
Fixed assets Sales the firm has about the right amount of fixed assets in relation
turnover = Net fixed assets to other firms.
• Note the different accounting policies in recording fixed assets
= $3,000 = 3.0
when comparing two firms’ FA ratios.
$1,000 • TA turnover not up to industry average is caused by excessive
current assets (A/R and inventory).
Total assets Sales
turnover = Total assets 2016 2015 Ind.
FA TO 3.0× 3.3× 3.0×
= $3,000 = 1.5
$2,000 TA TO 1.5× 1.7× 1.8×
3-4. (Total) Debt and

3-4. Debt Management Ratios Times-Interest-Earned (Tie) Ratios
• Measure the extent to which a firm uses debt
financing or financial leverage Total debt
Debt (D/A) ratio = Total assets
• For shareholders, high debt ratios enable
$110 + $754
them to maintain control and earn more on = $2,000 = 43.2%
investments.
EBIT
• For creditors, low debt ratios provide a margin TIE = Int. expense
of safety.
= $283.8 = 3.2
$88

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3-4. Debt Management Ratios

3-4. EBITDA Coverage (EC) Ratio
vs. Industry Averages
2016 2015 Ind.
EBITDA + Lease payments D/A 43.2% 38.1% 30.0%
Interest Lease TIE 3.2 4.4 6.0
expense + pmt. + Loan pmt.
EC 3.0 0.8 4.3
• Creditors provide more funds, further increasing D/A ratio
= ($283.8 + $100) + $28 = 3.0 above industry average.
$88 + $28 + $20 • Higher debt worsens its ability to pay interest expenses.
• The firm seems to use the lease as an alternative to debt.
3-5. Profitability Ratios 3-5. Net Profit Margin (PM)

• Show the combined effects of liquidity, asset NI $113.5
management, and debt on operating results PM = Sales = $3,000 = 3.8%
• Profitability is the net result of a number of 2016 2015 Ind.
policies (including accounting) and decisions. PM 3.8% 4.1% 5.0%
PM was very bad in 2016 because of

high costs. It resulted from inefficient
operations or heavy use of debt.
3-5. Operating and Gross Profit Margin

3-5. Basic Earning Power (BEP)
Ratios
• Can be calculated to identify the source of a low EBIT
net profit margin BEP =
Total assets
Operating profit margin = EBIT/Sales
• This ratio identifies how a firm is performing
before the impact of interest expenses is
= $283.8 = 14.2%
$2,000
considered.
Gross profit margin = Gross profit/Sales
• Gross margin = Sales – Cost of goods sold
• This ratio identifies the gross profit per dollar of
sales before deducting any other expenses.

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3-5. Basic Earning Power vs. 3-5. Return on Assets (ROA) and
Industry Average Return on Equity (ROE)
• BEP removes the effect of taxes and financial
leverage; useful for comparison
NI
• BEP is below average probably due to the low ROA =
Total assets
turnover ratios and low profit margin on sales.
• Room for improvement = $113.5 = 5.7%
$2,000
2016 2015 Ind.

BEP 14.2% 15.7% 17.2%
3-5. Return on Assets (ROA) and 3-5. ROA and ROE vs. Industry
Return on Equity (ROE) Averages
NI 2016 2015 Ind.

ROE =
Common equity ROA 5.7% 7.0% 9.0%
ROE 12.7% 14.0% 15.0%
= $113.5 = 12.7%
$896
Both below average and worsening
3-5. Effects of Debt on ROA and

3-6. Market Value Ratios
ROE
• ROA is lowered by debt: Interest expense • Relate the firm’s stock price to its earnings,
lowers net income, which also lowers ROA. cash flow, and book value per share
• However, the use of debt lowers equity, and if • Measure the firm’s stock value in terms of its
equity is lowered more than net income, ROE competitors
would increase.

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3-6. Price/Earnings (P/E) Ratio 3-6. Price/Cash Flow (P/CF) Ratio
Price = $23.00 NI + Depr.

CF per share = Shares out.
NI $113.5m
EPS = Shares out = 50m = $2.27 $113.5 + $100.0
= 50 = $4.27
Price per share $23.00 Price per share

P/E = EPS = $2.27 = 10.1 P/CF = Cash flow per share
= $23.00 = 5.4
$4.27
3-6. Interpreting Market Value

3-6. Market/Book (M/B) Ratio
Ratios
• P/E: How much investors will pay for $1 of
Total Com. equity
BVPS = Shares out. earnings. Higher is better.
$896m • M/B: How much paid for $1 of book value.
= 50m = $17.92 Higher is better.
Mkt. price per share • P/E and M/B are high if ROE is high, risk is low.
M/B = Book value per share
• P/CF: How much paid for $1 of cash flow.
$23.00 Higher is better.
= $17.92 = 1.3
3-6. Comparison with Industry 3-7. Common Size Balance Sheets:

Averages Divide All Items by Total Assets
Assets 2016 2015 Ind.
2016 2015 Ind. Cash 0.5% 0.9% 1.0%
P/E 10.1 11.0 12.5 ST inv. 0.0% 3.9% 2.2%
P/CF 5.4 6.3 6.8 AR 18.8% 18.8% 17.8%
M/B 1.3 1.1 1.7 Invent. 30.8% 24.7% 19.8%
Total CA 50.0% 48.2% 40.8%
Net FA 50.0% 51.8% 59.2%
TA 100.0% 100.0% 100.0%

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3-7. Divide All Items by Total 3-7. Analysis of Common Size

Liabilities and Equity Balance Sheets
Assets 2016 2015 Ind.
AP 3.0% 1.8% 1.8%
• The company has a higher proportion of
Notes pay. 5.5% 3.6% 4.4%
inventory and current assets than industry.
Accruals 7.0% 7.7% 3.6% • The company has less equity (which means
Total CL 15.5% 13.1% 9.8% more debt) than industry.
LT bonds 37.7% 34.5% 30.2% • The company now has zero short-term debt
Total liabilities 53.2% 47.6% 40.0% but more long-term debt than industry.
Pref. stock 2.0% 2.4% 0.0%
Total com. eq. 44.8% 50.0% 60.0%
Total L&E 100.0% 100.0% 100.0%
3-7. Common Size Income Statement: 3-7. Analysis of Common Size

Divide All Items by Sales Income Statements
• The company has lower COGS (70.0) than
industry (77.6), but slightly higher
depreciation and amortization and other
operating expenses. The result is that the
company has similar EBIT. However, the high
interest expense lowers the EBT (6.5)
compared to industry (8.3).
3-7. Income Statement Percentage Change 3-7. Analysis of Percent Change Income
Analysis: Percent Change from Base Year Statement
• We see that 2016 sales grew 5.3% from 2015,
and that NI fell 3.7% from 2015. So the
company has become less profitable.
• The analysis reveals whether the firm’s
condition has been improving or deteriorating
over time.
• Similar analysis can be performed on the
balance sheet. The extreme growth in
inventories (48.2%) should be of great
concern.

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3-8. Tying the Ratios Together: 3-8. The DuPont Equation

The DuPont Equation
• The DuPont equation focuses on: ( margin
Profit
)( turnover
TA
)( multiplier
Equity
) = ROE
– expense control (PM)
– asset utilization (TATO) NI Sales TA
Sales TA CE = ROE
– debt utilization (EM)
• It shows how these factors combine to
determine the ROE.
• It also provides a “quick and dirty” estimate of
the impact of operating changes on returns
(see Chapter 5).
3-9. Comparative Ratios and

3-8. The DuPont Equation (cont’d)
Benchmarking
• Ratio analysis involves comparing a firm’s
NI Sales TA
CE = ROE ratios with industry average figures.
Sales TA
• Managers can also use a technique called
2016: 3.8% 1.5 2.23 =12.7% “benchmarking”—comparing the firm’s ratios
with those of a smaller set of leading
Alternatively, companies in its industry.
ROE = ROA Equity multiplier
• Comparative ratios are available from various
= 5.7% ($2,000/$896) = 12.7% sources including FPinfomart.
3-9. Comparative Ratios for 3-10. Uses and Limitations of Ratio

TransCanada Analysis
• Comparison with industry averages is difficult
if the firm operates many different divisions.
• “Average” performance is not necessarily
good.
• Seasonal factors and inflation can distort
ratios.
• “Window dressing” techniques can make
statements and ratios look better.

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3-10. Uses and Limitations (cont’d) Summary

• A discussion of techniques used by investors and
• Different accounting and operating practices managers to analyze financial statements
can distort comparisons.
• Various ratios calculated to evaluate a firm’s
• Sometimes it is difficult to tell if a ratio value is liquidity, asset and debt management,
“good” or “bad.” profitability, and market value
• To sum up, ratio analysis can provide useful • Ratios organized as trend analysis and
insights into a firm’s operations only when benchmarking
used intelligently and with good judgment.
• DuPont system used to show the relationship
between ratios and to analyze ways of improving
performance

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9/25/19

3-1. Financial Analysis 3-1. Income Statement

3-1. Balance Sheets: Liabilities and

Copyright © 2014 by Nelson Education

3-1. Other Data 3-1. Why Are Ratios Useful?

3-1. Who Is Using Ratios? 3-1. Five Major Categories of Ratios

3-2. Liquidity Ratios 3-2. Current and Quick Ratios

Copyright © 2014 by Nelson Education

3-2. Comments on CR and QR 3-3. Asset Management Ratios

3-3. Evaluating Inventories: 3-3. Comments on Inventory

3-3. Evaluating Receivables: 3-3. Appraisal of DSO

Copyright © 2014 by Nelson Education

3-3. Evaluating Payables: 3-3. APP: Interpretation

3-4. (Total) Debt and

Copyright © 2014 by Nelson Education

3-4. Debt Management Ratios

3-5. Profitability Ratios 3-5. Net Profit Margin (PM)

PM was very bad in 2016 because of

3-5. Operating and Gross Profit Margin

Copyright © 2014 by Nelson Education

2016 2015 Ind.

NI 2016 2015 Ind.

3-5. Effects of Debt on ROA and

Copyright © 2014 by Nelson Education

3-6. Price/Earnings (P/E) Ratio 3-6. Price/Cash Flow (P/CF) Ratio

Price = $23.00 NI + Depr.

Price per share $23.00 Price per share

3-6. Interpreting Market Value

3-6. Comparison with Industry 3-7. Common Size Balance Sheets:

Copyright © 2014 by Nelson Education

3-7. Divide All Items by Total 3-7. Analysis of Common Size

3-7. Common Size Income Statement: 3-7. Analysis of Common Size

Copyright © 2014 by Nelson Education

3-8. Tying the Ratios Together: 3-8. The DuPont Equation

3-9. Comparative Ratios and

3-9. Comparative Ratios for 3-10. Uses and Limitations of Ratio

Copyright © 2014 by Nelson Education

3-10. Uses and Limitations (cont’d) Summary

Copyright © 2014 by Nelson Education

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