CFFM8 PPT ch04

Eugene F. Brigham & Joel F.
Houston
Fundamentals of Financial
Management Concise 8E
2-1
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Chapter 4
Analysis of Financial
Statements
Ratio Analysis
DuPont Equation
Effects of Improving Ratios
Limitations of Ratio Analysis
Qualitative Factors
4-2
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Balance Sheet: Assets

2015E
Cash
85,632
878,000
A/R
Inventories
1,716,480
2,680,112
Total CA
1,197,160
Gross FA
Less: Deprec.
380,120
817,040
Net FA
Total Assets 3,497,152
2014
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
4-3
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Balance Sheet: Liabilities and Equity
Accts payable
Accruals
Notes payable
Total CL
Longterm
debt
Common stock
Retained earnings
Total Equity
Total L & E
2015E
436,800
408,000
300,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
2014
524,160
489,600
636,808
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-4
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Income Statement
Sales
COGS
Other expenses
EBITDA
Deprec. & amort.
EBIT
Interest exp.
EBT
Taxes
Net income
2015E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2014
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-5
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Other Data
No. of shares
EPS
DPS
Stock price
Lease pmts
2015E
250,000
$1.014
$0.220
$12.17
$40,000
2014
100,000
$
- 1.602
$0.110
$2.25
$40,000
4-6
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Why are ratios useful?
Ratios standardize numbers and facilitate

comparisons.
Ratios are used to highlight weaknesses

and strengths.
Ratio comparisons should be made

through time and with competitors.
Industry analysis
Benchmark (peer) analysis
Trend analysis
4-7
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Five Major Categories of Ratios and the

Questions 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

4-8
see
as
reflected
in
P/E
and
M/B
ratios?
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
DLeons Forecasted Current Ratio and

Quick Ratio for 2015
Current assets
Current liabilities
$2,680
$1,145
2.34
Current ratio
(Current assets Inventories)

Current liabilities
($2,680 $1,716)
$1,145
0.84
Quick ratio
4-9
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Comments on Liquidity Ratios

2015E
2014
2013
Ind.
Current ratio 2.34x
1.20x
2.30x
2.70x
Quick ratio
0.39x
0.85x
1.00x
0.84x
Expected to improve but still below the

industry average.
Liquidity position is weak.
4-10
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
DLeons Inventory Turnover vs. the

Industry Average
Inv. turnover = Sales/Inventories
= $7,036/$1,716
= 4.10x
Inventory
turnover
2015
E
2014
2013 Ind.
4.1x
4.70x
4.8x 6.1x
4-11
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Comments on Inventory Turnover
Inventory turnover is below industry

average.
DLeon might have old inventory, or its

control might be poor.
No improvement is currently forecasted.
4-12
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
DSO: Average Number of Days After

Making a Sale Before Receiving Cash
DSO = Receivables/Avg. sales per day
= Receivables/(Annual sales/365)
= $878/($7,036/365)
= 45.6 days
4-13
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Appraisal of DSO
DSO
2015E
2014
2013
Ind.
45.6
38.2
37.4
32.0
DLeon collects on sales too slowly, and is

getting worse.
DLeon has a poor credit policy.
4-14
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Fixed Assets and Total Assets Turnover

Ratios vs. the Industry Average
FA turnover
= Sales/Net fixed assets
= $7,036/$817 = 8.61x
TA turnover
= Sales/Total assets
= $7,036/$3,497 = 2.01x
4-15
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Evaluating the FA Turnover (S/Net FA) and

TA Turnover (S/TA) Ratios
2015E
2014
2013
Ind.
FA TO
8.6x
6.4x
10.0x
7.0x
TA TO
2.0x
2.1x
2.3x
2.6x
FA turnover projected to exceed the

industry average.
TA turnover below the industry average.

Caused by excessive currents assets (A/R
and Inv).
4-16
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Calculate the Debt-to-Capital Ratio and

Times-Interest-Earned Ratio
Debt-to-capital ratio = Total debt/Total
invested capital
= ($300 + $400)/($300 + $400 + $1,952.4)
= 26.4%
TIE
= EBIT/Interest
= $492.6/$70 = 7.0x
4-17
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
DLeons Debt Management Ratios vs.

the Industry Averages
Debt/Total Inv.
Capital
TIE
2015E
2014
2013
Ind.
26.4%
73.4%
44.1%
40.0%
7.0x
-1.0x
4.3x
6.2x
Debt/Total invested capital and TIE are

better than the industry average.
4-18
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Profitability Ratios: Operating Margin,

Profit Margin, and Basic Earning Power
Operatingmargin= EBIT/Sales
= $492.6/$7,036 = 7.0%
Profit margin= Net income/Sales
= $253.6/$7,036 = 3.6%
Basic earning power
= EBIT/Total assets
= $492.6/$3,497 = 14.1%
4-19
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Appraising Profitability with Operating

Margin, Profit Margin, and Basic Earning
Power
Operating
margin
Profit margin
Basic earning
power
2015 2014 2013 Ind.

E
7.0%
5.5% 7.3%
2.2%
3.6%
2.6% 3.5%
2.7%
14.1
- 13.0 19.1
% 4.6%
%
%
4-20
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Appraising Profitability with Operating

Margin, Profit Margin, and Basic Earning
Power
Operating margin was very bad in 2014.

It is projected to improve in 2015, but it is
still projected to remain below the
industry average.
Profit margin was very bad in 2014 but is

projected to exceed the industry average
in 2015. Looking good.
BEP removes the effects of taxes and

financial leverage, and is useful for
comparison.
BEP projected to improve, yet still below 4-21

publicly accessible
in whole oraverage.
in part.
thewebsite,
industry
There is definitely
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
Profitability Ratios: Return on Assets,

Return on Equity, and Return on
Invested Capital
QUAL.
ROA = Net income/Total assets

= $253.6/$3,497 = 7.3%
ROE = Net income/Total common equity
= $253.6/$1,952 = 13.0%
ROIC = [EBIT(1 T)]/Total invested
capital
= $295.6/$2,652.4 = 11.1%
4-22
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Appraising Profitability with ROA, ROE,

and ROIC
ROA
ROE
ROIC
2015E 2014
7.3%
-5.6%
13.0% -32.5%
11.1%
-4.2%
2013
6.0%
13.3%
9.6%
Ind.
9.1%
18.2%
14.5%
All ratios rebounded from the previous

year, but are still below the industry
average. More improvement is needed.
Wide variations in ROE illustrate the

effect that leverage can have on
profitability.
4-23
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Effects of Debt on ROA and ROE
Holding assets constant, if debt

increases:
Equity declines.
Interest expense increases which leads
to a reduction in net income.
ROA declines (due to the reduction in net

income).
ROE may increase or decrease (since

both net income and equity decline).
4-24
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
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.
Given these problems, reliance on ROE may

encourage managers to make investments
that do not benefit shareholders. As a
result, analysts have looked to develop
other performance measures, such as EVA.
4-25
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Calculate the Price/Earnings and

Market/Book Ratios
P/E = Price/Earnings per share
= $12.17/$1.014 = 12.0x
M/B = Market price/Book value per
share
= $12.17/($1,952/250) = 1.56x
2015E
2014
2013
Ind.
P/E
12.0x
-1.4x
9.7x
14.2x
M/B
1.56x
0.5x
1.3x
2.4x
4-26
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Analyzing the Market Value Ratios
P/E: How much investors are willing to

pay for $1 of earnings.
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 expected growth

is high and risk is low.
4-27
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
The DuPont Equation

Profit Totalassets Equity
ROE margin turnover
multiplier
ROE (NI/Sales) (Sales/TA) (TA/Equity
)
Focuses on expense control (PM), asset

utilization (TA TO), and debt utilization
(equity multiplier).
4-28
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
DuPont Equation:
Breaking Down Return on Equity
ROE = (NI/Sales) x (Sales/TA) x
(TA/Equity)
=
1.7913
3.6%
= 13.0%
2013
2014
2015E
Ind.
x
PM
2.6%
-2.7%
3.6%
3.5%
2.01
TA TO
2.3
2.1
2.0
2.6
x
EM
2.2
5.8
1.79
2.0
ROE
13.3%
-32.5%
13.0%
18.2%
4-29
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
An Example:
The Effects of Improving Ratios
Sales/Day = $7,035,600/365 = $19,275.62

How would reducing the firms DSO to 32
days affect the company?
4-30
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Reducing Accounts Receivable and the

Days Sales Outstanding
Reducing A/R will have no effect on sales

Old A/R= $19,275.62 45.6 = $878,000
New A/R= $19,275.62 32.0 =$616,820
Cash freed up:
$261,180
Initially shows up as addition to cash.
4-31
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Effect of Reducing Receivables on

Balance Sheet and Stock Price
What could be done with the new cash?

How might stock price and risk be affected?
4-32
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Potential Uses of Freed Up Cash
Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the
stock price.
4-33
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
Potential Problems and Limitations of

Financial Ratio Analysis
Comparison with industry averages is

difficult for a conglomerate firm that
operates in many different divisions.
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 a strong or weak position.
4-34
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
QUAL.
More Issues Regarding Ratios
Average performance is not necessarily

good, perhaps the firm should aim higher.
Seasonal factors can distort ratios.
Inflation has distorted many firms

balance sheets, so analyses must be
interpreted with judgment.
Window dressing techniques can make

statements and ratios look better than
they actually are.
4-35
INTRO
RATIO ANALYSIS
DuPONT EQN
EFFECTS
ANALYSIS LIMITS
Consider Qualitative Factors When

Evaluating a Companys Future Financial
Performance
Are the firms revenues tied to one key

customer, product, or supplier?
What percentage of the firms business is

generated overseas?
Firms competitive environment
QUAL.
Future prospects
Legal and regulatory environment
4-36

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Eugene F. Brigham & Joel F.

Balance Sheet: Assets

Balance Sheet: Liabilities and Equity

Why are ratios useful?

Ratios standardize numbers and facilitate

Ratios are used to highlight weaknesses

Ratio comparisons should be made

Five Major Categories of Ratios and the

Liquidity: Can we make required

Asset management: Right amount of

Debt management: Right mix of debt and

Profitability: Do sales prices exceed unit

Market value: Do investors like what they

DLeons Forecasted Current Ratio and

(Current assets Inventories)

Comments on Liquidity Ratios

Current ratio 2.34x

Expected to improve but still below the

Liquidity position is weak.

DLeons Inventory Turnover vs. the

Comments on Inventory Turnover

Inventory turnover is below industry

DLeon might have old inventory, or its

No improvement is currently forecasted.

DSO: Average Number of Days After

DLeon collects on sales too slowly, and is

DLeon has a poor credit policy.

Fixed Assets and Total Assets Turnover

= Sales/Net fixed assets

Evaluating the FA Turnover (S/Net FA) and

FA turnover projected to exceed the

TA turnover below the industry average.

Calculate the Debt-to-Capital Ratio and

DLeons Debt Management Ratios vs.

Debt/Total invested capital and TIE are

Profitability Ratios: Operating Margin,

Appraising Profitability with Operating

2015 2014 2013 Ind.

Appraising Profitability with Operating

Operating margin was very bad in 2014.

Profit margin was very bad in 2014 but is

BEP removes the effects of taxes and

BEP projected to improve, yet still below 4-21

Profitability Ratios: Return on Assets,

ROA = Net income/Total assets

Appraising Profitability with ROA, ROE,

All ratios rebounded from the previous

Wide variations in ROE illustrate the

Effects of Debt on ROA and ROE

Holding assets constant, if debt

ROA declines (due to the reduction in net

ROE may increase or decrease (since

Problems with ROE

ROE and shareholder wealth are correlated,

ROE does not consider risk.

Given these problems, reliance on ROE may

Calculate the Price/Earnings and

Analyzing the Market Value Ratios

P/E: How much investors are willing to

M/B: How much investors are willing to

For each ratio, the higher the number,

P/E and M/B are high if expected growth

The DuPont Equation