CHAPTER 10 Analysis of Financial Statements

Ratio Analysis Limitations of ratio analysis

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Balance Sheet: Assets

Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

2003E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152

2002 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592

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Balance sheet: Liabilities and Equity

Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E

2003E 436,800 300,000 408,000 1,144,800 400,000 1,721,176 231,176 1,952,352 3,497,152

2002 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592
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Income statement
Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income

2003E 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584

2002 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)
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Other data
No. of shares EPS DPS Stock price Lease pmts

2003E 250,000 $1.014 $0.220 $12.17 $40,000

2002 100,000 -$1.602 $0.110 $2.25 $40,000

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Why are ratios useful?

Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths.

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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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Acid-Test Ratio
Also referred to as the Quick ratio (Current assets inventory) = Current liabilities 1:1 seen as ideal The omission of stock gives an indication of the cash the firm has in relation to its liabilities (what it owes) A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes very healthy! A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm 3-8 under pressure at some point.

Calculate forecasted current ratio for 2003.

Current ratio = Current assets / Current liabilities = $2,680 / $1,145 = 2.34x Looks at the ratio between Current Assets and Current Liabilities Ideal level? 1.5 : 1 A ratio of 5 : 1 would imply the firm has 5 of assets to cover every 1 in liabilities A ratio of 0.75 : 1 would suggest the firm has only 75p in assets available to cover every 1 it owes Too high Might suggest that too much of its assets are tied up in unproductive activities too much stock, for example? Too low - risk of not being able to pay your future debts 3-9

Comments on current ratio

2003 Current ratio 2.34x 2002 1.20x 2001 2.30x Ind. 2.70x

Expected to improve but still below the industry average. Liquidity position is weak.
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Asset management Ratios- Inv turnover

The rate at which a companys stock is turned over A high stock turnover might mean increased efficiency?

But: dependent on the type of business supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio Low stock turnover could mean poor customer satisfaction if people are not buying the goods (depending upon the type of business) Compared with the industry avg

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What is the inventory turnover vs. the industry average?

Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10x Each item of inventory is sold out n restocked 4.1 times per year.
2003
Inventory Turnover 4.1x

2002
4.70x

2001
4.8x

Ind.
6.1x
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Comments on Inventory Turnover

Inventory turnover is below industry average. If low turnover, the co. is holding too much inventory Business might have obsolete inventory, or its control might be poor. No improvement is currently forecasted. High turnover is good

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Days Sales Outstanding/Avg Collection Period

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 Shorter the better Gives a measure of how long it takes the business to recover debts

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Appraisal of DSO
2003 DSO 45.6 2002 38.2 2001 37.4 Ind. 32.0

Business collects on sales too slowly, and is getting worse. Business has a poor credit policy. Can be skewed by the degree of credit facility a firm offers

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Fixed asset and total asset turnover ratios

FA turnover = Sales / Net fixed assets = $7,036 / $817 = 8.61x = Sales / Total assets = $7,036 / $3,497 = 2.01x Using assets to generate profit Measures how effectively the firm uses its plant and equipment. If it is below the industry average, the business is not generating enough sales compared to the volume of its assets. Sales should be increased, some assets should be disposed off or a combination of the two must be done.
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TA turnover

Evaluating the FA turnover and TA turnover ratios

2003 FA TO 8.6x 2002 6.4x 2001 10.0x Ind. 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).
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Debt Management Ratios

Debt ratio = Total debt / Total assets = ($1,145 + $400) / $3,497 = 44.2% Total debt includes all current and long-term liabilities. Creditors prefer low debt ratios. If debt ratio is high, it is costly to get loans in future and risky. Times Interest Earned Ratio = EBIT / Interest expense

= $492.6 / $70 = 7.0

Measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to pay interest leads to bankruptcy.
If this ratio is too low, the company would face difficulty in paying off its debts if it borrows more. 3-18

Calculate the debt ratio, TIE, and EBITDA coverage ratios.

EBITDA coverage pmts =

(EBITDA+Lease pmts) Int exp + Lease pmts + Principal

$609.6 + $40 $70 + $40 + $0= 5.9x Numerator= all cashflows available to meet fixed financial charges Denominator= all fixed financial charges This ratio assesses ability to pay fixed financial charges. Lease pmts are included in the numerator bc they are deducted when EBITDA is calculated. D & A are non cash expenses.
=

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How do the debt management ratios compare with industry averages?

2003 D/A TIE 7.0x 5.9x

2002 -1.0x 0.1x

2001 4.3x 3.0x

Ind. 6.2x 8.0x

44.2% 82.8% 54.8% 50.0%

EBITDA coverage

D/A and TIE are better than the industry average, but EBITDA coverage still trails the industry.
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Profitability Ratios- Gross Profit Margin

Gross Profit Margin = (Gross profit / sales turnover) x 100 The higher the better Enables the firm to assess the impact of its sales and how much it costs to generate (produce) those sales A gross profit margin of 45% means that for every 1 of sales, the firm makes 45p in gross profit
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Net Profit Margin

Net Profit Margin = (Net Profit / Sales Turnover) x 100 Net profit takes into account the fixed costs involved in production the overheads Keeping control over fixed costs is important could be easy to overlook for example the amount of waste - paper, stationery, lighting, heating, water, etc.

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Basic Earning Power ratio

BEP ratio= (EBIT/Total Assets) x 100 This ratio shows the raw earning power of the firms assets, before the influence of taxes and interest.

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Profitability ratios: Profit margin and Basic earning power

Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6%

BEP ratio = EBIT / Total assets = $492.6 / $3,497 =

14.1%

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Appraising profitability with the profit margin and basic earning power

PM BEP

2003 2002 3.6% -2.7% 14.1% -4.6%

2001 Ind. 2.6% 3.5% 13.0% 19.1%

Profit margin was very bad in 2002, but is projected to exceed the industry average in 2003. Looking good. BEP removes the effects of taxes and financial leverage, and is useful for comparison. BEP projected to improve, yet still below the industry average. There is definitely room for improvement.
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Return on Total Assets

Return on Total Assets= Net Income/Total assets Measures return on total assets after interest & taxes. If the company is relying too much on debt financing, its return on total assets would be low. WHY??

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Return on Common Equity (ROE)

ROE = Net Income / Common Equity The higher the better Shows how effective the firm is in using its capital to generate profit A ROE of 25% means that it uses every 1 of capital to generate 25p in profit Partly a measure of efficiency in organisation and use of capital

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Profitability ratios: Return on assets and Return on equity

ROA = Net income / Total assets = $253.6 / $3,497 = 7.3%

ROE = Net income / Total common equity = $253.6 / $1,952 = 13.0%

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Appraising profitability with the return on assets and return on equity

ROA ROE

2002 2001 Ind. -5.6% 6.0% 9.1% 13.0% 13.3% 18.2% 32.5%

2003 7.3%

Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.

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Market Value Ratios

P/E: How much investors are willing to pay for $1 of earnings. 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.
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Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

P/E = Price per share / Earnings per share = $12.17 / $1.014 = 12.0x
P/CF = Price per share/Cash flow per share = $12.17 / [($253.6 + $117.0) 250] = 8.21x
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Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

M/B = Mkt price per share / Book value per share = $12.17 / ($1,952 / 250) = 1.56x
2003 2002 2001 Ind.

P/E P/CF
M/B

12.0x 8.21x
1.56x

-1.4x -5.2x
0.5x

9.7x 8.0x
1.3x

14.2x 11.0x
2.4x
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Trend analysis
Analyzes a firms financial ratios over time Can be used to estimate the likelihood of improvement or deterioration in financial condition.
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Potential problems and limitations of financial ratio analysis 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.
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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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