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CHAPTER 3
Analysis of Financial Statements

 Ratio analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors
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3-2

Balance Sheet: Assets


2002E 2001
Cash 14,000 7,282
ST investments 71,632 0
AR 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Deprec. 380,120 263,160
Net FA 817,040 939,790
Total assets 3,497,152 2,866,592
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Liabilities and Equity


2002E 2001
Accounts payable 436,800 524,160
Notes payable 600,000 720,000
Accruals 408,000 489,600
Total CL 1,444,800 1,733,760
Long-term debt 500,000 1,000,000
Common stock 1,680,936 460,000
Retained earnings (128,584) (327,168)
Total equity 1,552,352 132,832
Total L&E 3,497,152 2,866,592
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3-4

Income Statement
2002E 2001
Sales 7,035,600 5,834,400
COGS 6,100,000 5,728,000
Other expenses 312,960 680,000
Depreciation 120,000 116,960
Tot. op. costs 6,532,960 6,524,960
EBIT 502,640 (690,560)
Interest exp. 80,000 176,000
EBT 422,640 (866,560)
Taxes (40%) 169,056 (346,624)
Net income 253,584 (519,936)
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3-5

Other Data

2002E 2001
Shares out. 250,000 100,000
EPS $1.014 ($5.199)
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000

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3-6

Why are ratios useful?

 Standardize numbers; facilitate


comparisons
 Used to highlight weaknesses and
strengths

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3-7

What are the five major categories of


ratios, and what questions do they
answer?

 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?
(More…)
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3-8

 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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3-9

Calculate the firm’s forecasted current


and quick ratios for 2002.

CA $2,680
CR02 = CL = $1,445 = 1.85x.

CA - Inv.
QR02 = CL
$2,680 - $1,716
= $1,445 = 0.67x.
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Comments on CR and QR

2002E 2001 2000 Ind.


CR 1.85x 1.1x 2.3x 2.7x
QR 0.67x 0.4x 0.8x 1.0x

 Expected to improve but still below


the industry average.
 Liquidity position is weak.
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What is the inventory turnover ratio as


compared to the industry average?

Sales
Inv. turnover = Inventories
$7,036
= = 4.10x.
$1,716

2002E 2001 2000 Ind.


Inv. T. 4.1x 4.5x 4.8x 6.1x

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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 is the average number of days


after making a sale before receiving
cash.

Receivables
DSO = Average sales per day

Receivables $878
= Sales/360 = $7,036/360

= 44.9 days.
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Appraisal of DSO

2002E 2001 2000 Ind.


DSO 44.9 39.0 36.8 32.0

■ Firm collects too slowly, and


situation is getting worse.
■ Poor credit policy.

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Fixed Assets and Total Assets


Turnover Ratios

Fixed assets Sales


=
turnover Net fixed assets
= $7,036 = 8.61x.
$817
Total assets Sales
=
turnover Total assets
= $7,036 = 2.01x.
$3,497 (More…)
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2002E 2001 2000 Ind.


FA TO 8.6x 6.2x 10.0x 7.0x
TA TO 2.0x 2.0x 2.3x 2.5x

 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).
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Calculate the debt, TIE, and EBITDA


coverage ratios.

Total debt
Debt ratio =
Total assets
= $1,445 + $500 = 55.6%.
$3,497
EBIT
TIE =
Int. expense
= $502.6 = 6.3x.
$80 (More…)
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EBITDA
= EC
coverage
EBIT + Depr. & Amort. + Lease payments
Interest Lease Loan pmt.
expense + pmt. +

= $502.6 + $120 + $40 =


$80 + $40 + $0
5.5x.
All three ratios reflect use of debt, but
focus on different aspects.
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How do the debt management ratios


compare with industry averages?

2002E 2001 2000 Ind.


D/A 55.6% 95.4% 54.8% 50.0%
TIE 6.3x -3.9x 3.3x 6.2x
EC 5.5x -2.5x 2.6x 8.0x

Too much debt, but projected to


improve.
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Profit Margin (PM)

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

2002E 2001 2000 Ind.


PM 3.6% -8.9% 2.6% 3.6%

Very bad in 2001, but projected to


meet industry average in 2002.
Looking good.
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Basic Earning Power (BEP)

BEP = EBIT
Total assets
$502.6
= $3,497 = 14.4%.

(More…)
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2002E 2001 2000 Ind.


BEP 14.4% -24.1% 14.2% 17.8%

 BEP removes effect of taxes and


financial leverage. Useful for
comparison.
 Projected to be below average.
 Room for improvement.
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Return on Assets (ROA)


and Return on Equity (ROE)

ROA = Net income


Total assets
$253.6
= $3,497 = 7.3%.

(More…)
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Net income
ROE = Common equity

= $253.6 = 16.3%.
$1,552
2002E 2001 2000 Ind.
ROA 7.3% -18.1% 6.0% 9.0%
ROE 16.3% -391.0% 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 = $1.01.

Price per share $12.17


P/E = EPS = $1.01 = 12x.
(More…)
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Typical industry average P/E ratios


Industry P/E ratio
Banking 17.15
Computer Software Services 33.01
Drug 41.81
Electric Utilities (Eastern U.S.) 19.40
Internet Services* 290.35
Semiconductors 78.41
Steel 12.71
Tobacco 11.59
Water Utilities 21.84
* Because many internet companies have negative earnings and no
P/E, there was only a small sample of internet companies.

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CF per share = NI + Depr.


Shares out.
= $253.6 + $120.0 = $1.49.
250

Price per share


P/CF =
Cash flow per share
$12.17
= $1.49 = 8.2x.

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Com. equity
BVPS =
Shares out.
= $1,552 = $6.21.
250

Mkt. price per share


M/B =
Book value per share
$12.17
= $6.21 = 2.0x.

(More…)
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2002E 2001 2000 Ind.


P/E 12.0x -0.4x 9.7x 14.2x
P/CF 8.2x -0.6x 8.0x 7.6x
M/B 2.0x 1.7x 1.3x 2.9x
 P/E: How much investors will pay
for $1 of earnings. High is good.
 M/B: How much paid for $1 of book
value. Higher is good.
 P/E and M/B are high if ROE is high,
risk is low.
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3 - 31
Common Size Balance Sheets:
Divide all items by Total Assets

Assets 2000 2001 2002E Ind.


Cash 0.6% 0.3% 0.4% 0.3%
ST Invest. 3.3% 0.0% 2.0% 0.3%
AR 23.9% 22.1% 25.1% 22.4%
Invent. 48.7% 44.9% 49.1% 41.2%
Total CA 76.5% 67.2% 76.6% 64.1%
Net FA 23.5% 32.8% 23.4% 35.9%
TA 100.0% 100.0% 100.0% 100.0%
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3 - 32
Divide all items by
Total Liabilities & Equity
2000 2001 2002E Ind.
AP 9.9% 18.3% 12.5% 11.9%
Notes pay. 13.6% 25.1% 17.2% 2.4%
Accruals 9.3% 17.1% 11.7% 9.5%
Total CL 32.8% 60.5% 41.3% 23.7%
LT Debt 22.0% 34.9% 14.3% 26.3%
Total equ. 45.2% 4.6% 44.4% 50.0%
Total L&E 100.0% 100.0% 100.0% 100.0%
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Analysis of Common Size Balance
Sheets
 Computron has higher proportion of
current assets (49.1%) than Industry
(41.2%).
 Computron has slightly less equity
(which means more debt) than
Industry.
 Computron has more short-term debt
than industry, but less long-term debt
than industry.
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3 - 34
Common Size Income Statement:
Divide all items by Sales
2000 2001 2002E Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 98.2% 86.7% 84.5%
Other exp. 9.9% 11.7% 4.4% 4.4%
Depr. 0.6% 2.0% 1.7% 4.0%
EBIT 6.1% -11.8% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -14.9% 6.0% 5.9%
Taxes 1.7% -5.9% 2.4% 2.4%
NI 2.6% -8.9% 3.6% 3.6%
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Analysis of Common Size Income
Statements
 Computron has higher COGS (86.7)
than industry (84.5), but lower
depreciation. Result is that
Computron has similar EBIT (7.1) as
industry.

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3 - 36
Percentage Change Analysis: Find
Percentage Change from First Year (2000)
Income St. 2000 2001 2002E
Sales 0.0% 70.0% 105.0%
COGS 0.0% 100.0% 113.0%
Other exp. 0.0% 100.0% -8.0%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -430.3% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -691.1% 188.3%
Taxes 0.0% -691.1% 188.3%
NI 0.0% -691.1% 188.3%
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3 - 37
Analysis of Percent Change Income
Statement
 We see that 2002 sales grow 105%
from 2000, and that NI grows 188%
from 2000.
 So Computron has become more
profitable.

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3 - 38

Percentage Change Balance Sheets


Assets 2000 2001 2002E
Cash 0.0% -19.1% 55.6%
ST Invest. 0.0% -100.0% 47.4%
AR 0.0% 80.0% 150.0%
Invent. 0.0% 80.0% 140.0%
Total CA 0.0% 71.4% 138.4%
Net FA 0.0% 172.6% 137.0%
TA 0.0% 95.2% 138.1%

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3 - 39

Liab. & Eq. 2000 2001 2002E


AP 0.0% 260.0% 200.0%
Notes pay. 0.0% 260.0% 200.0%
Accruals 0.0% 260.0% 200.0%
Total CL 0.0% 260.0% 200.0%
LT Debt 0.0% 209.2% 54.6%
Total equity 0.0% -80.0% 133.9%
Total L&E 0.0% 95.2% 138.1%

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3 - 40
Analysis of Percent Change Balance
Sheets
 We see that total assets grow at a
rate of 138%, while sales grow at a
rate of only 105%. So asset
utilization remains a problem.

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3 - 41

Explain the Du Pont System

( Profit
margin )( TA
turnover )( Equity
)
multiplier = ROE
NI Sales TA = ROE.
Sales x TA x CE

2000 2.6% x 2.3 x 2.2 = 13.2%


2001 -8.9% x 2.0 x 21.6 = -391.0%
2002 3.6% x 2.0 x 2.3 = 16.3%
Ind. 3.6% x 2.5 x 2.0 = 18.0%
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3 - 42

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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3 - 43

Simplified Firm Data

A/R $ 878 Debt $1,945


Other CA 1,802 Equity 1,552
Net FA 817
Total assets $3,497 L&E $3,497

Sales $7,035,600
= = $19,543.
day 360
Q. How would reducing DSO to 32
days affect the company?
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3 - 44

Effect of reducing DSO from


44.9 days to 32 days:

Old A/R = $19,543 x 44.9= $878,000


New A/R = $19,543 x 32.0= 625,376
Cash freed up: $252,624

Initially shows up as additional cash.


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3 - 45

New Balance Sheet

Added cash $ 253 Debt $1,945


A/R 625 Equity 1,552
Other CA 1,802
Net FA 817
Total assets $3,497 Total L&E $3,497

What could be done with the new


cash? Effect on stock price and risk?
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3 - 46

Potential use of freed up cash

 Repurchase stock. Higher ROE,


higher EPS.
 Expand business. Higher profits.
 Reduce debt. Better debt ratio;
lower interest, hence higher NI.

(More…)
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3 - 47

 Inventories are also too high. Could


analyze the effect of an inventory
reduction on freeing up cash and
increasing the quick ratio and asset
management ratios. Such an
analysis would be similar to what
was done with DSO in previous
slides.
 All these actions would likely
improve stock price.
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3 - 48

Would you lend money


to this company?

 Maybe. The situation could


improve, and the loan, with a high
interest rate to reflect the risk,
could be a good investment.
 However, company should not
have relied so heavily on debt
financing in the past.

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3 - 49

What are some potential problems and


limitations of financial 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.
(More…)
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3 - 50

 Window dressing techniques can make


statements and ratios look better.
 Different accounting and operating
practices can distort comparisons.
 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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3 - 51

What are some qualitative factors


analysts should consider when
evaluating a company’s likely future
financial performance?

 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? (More…)
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3 - 52

 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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