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Brigham_2020_Chapter_3_Edition_16th.pdf
Copyright Information (bibliographic)
Document Type: Book Chapter
Title of Book: Financial Management Theory and Practice (16th Edition)
Author(s) of Book: Eugene F. Brigham, Michael C. Ehrhardt
Chapter Title: Chapter 3 Analysis of Financial Statements
Author(s) of Chapter: Eugene F. Brigham, Michael C. Ehrhardt
Year: 2020
Publisher: Cengage Learning
Place of Publishing: the United States of America
The copyright law of the United States (Title 17, United States Code) governs the making of photocopies or other reproductions of copyrighted materials. Under certain conditions specifies in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these conditions is that the photocopy or reproduction is not to be used for any purpose other than private study, scholarship, or research. If a user makes a request for, or later uses, a photocopy or reproduction for purposes in excess of fair use, that user may be liable for copyright infringement.
Analysis of Financial Statements
Even though Twitter Inc. had not yet had a profitable quarter based on generally
accepted accounting principles (GAAP), its stock price jumped by 18% on September
26, 2017, when it reported minus $21 million in earnings before interest, taxes,
depreciation, and amortization (EBITDA). The reason for the positive stock reaction?
First, a loss of $21 million was better than the $103 million loss it reported in the
previous quarter. Second, Twitter stated that it might report positive EBITDA in its
next report.
Most companies guide analysts by providing estimates of future revenues.
According to a survey by the National Investors Relations Institute, 94% of respondents
in 2014 provided some form of guidance for analysts and investors. Despite the high
proportion of companies that provide guidance, a 2015 survey by Integrated Corporate
Relations reports that over half of the responding investment professionals don't think
guidance is vital for determining whether to recommend purchasing a company's
stock. It appears as though many investors rely on other types of information, including
ratio analysis.
Source: See the reports at www.cnbc.com/2017/10/26/twitter-earnings-q3-revenue-eps-and-maus.html,
http://files.shareholder.com/downloads/AMDA-2FS26X/5619402910x0x961127/658476E7-9D8B
-4 B 17-BES D-B 77034D21FC E/TWTR_ Q3 _17 _Earn in gs_Press_Release. pdf, www. ma rketwatch .com
/news/markets/earningswatch.asp, http://niri.org/Main-Menu-Category/resource/publications/Executive
-Alert/2014-Executive-Alert-Archive/NIRI-Guidance-Practices-Survey-2014-Report-102214.aspx, and
http://icrinc.com/en/pdfs/xchange/XChange_2015_ICR_Survey.pdf.
101
102 Part 1 The Company and Its Environment
Intrinsic Value,Free Cash Flow, and Financial Statements
The intrinsic value of a firm is determined by the present This chapter explains how to use financial statements to
value of the expected future free cash flows (FCFs) when evaluate a company's profitability, required capital invest-
discounted at the weighted average cost of capital (WACC). ments, business risk, and mix of debt and equity .
• Net operating profit after taxes
Required investments in operating capital
Free cash flow (FCF)
FCF1 FCF2 · FCF., Value=-----+-----+ ... +-----
(1 + WACC)l (1 + WACC)2 (1 + WACC) °'
Weighted average cost of capital (WACC)
•
Market interest rates Cost of debt
Cost of equity
Firm's debt/equity mix •
• Market risk aversion Firm's business risk
!JJ(Ce
The textbook's Web site
contains on Excel file that
will guide you through the
chapter's co/cu/otions.
The file for this chapter is
Ch03 Tool Kit.xlsx, and
we encourage you to open
the file and follow along
as you read the chapter.
WWW
See www.zacks.com for
o source of standardized
financial statements.
Financial statement analysis involves (1) comparing a firm's performance with that of other firms in the same industry and (2) evaluating trends in the firm's financial posi tion over time. Managers use financial analysis to identify situations needing attention, potential lenders use financial analysis to determine whether a company is creditworthy, and stockholders use financial analysis to help predict future earnings, dividends, and free cash flow. This chapter will explain the similarities and differences among these uses.
3-1 Financial Analysis When we perform a financial analysis, we conduct the following steps.
3-la Gather Data
The first step in financial analysis is to gather data. As discussed in Chapter 2, financial statements can be downloaded from many different Web sites. One of our favorites is Zacks Investment Research, which provides financial statements in a standardized for mat. If you cut and paste financial statements from Zacks into a spreadsheet and then perform a financial analysis, you can quickly repeat the analysis on a different company by pasting that company's financial statements into the same cells of the spreadsheet. In other words, you do not need to reinvent the wheel every time you analyze a company.
3-lb Examine the Statement of Cash Flows
Some financial analysis can be done with virtually no calculations. For example, we always look to the statement of cash flows first, particularly the net cash provided by
0
0
(
Chapter 3 Analysis of Financial Statements 103
operating activities. Downward trends or negative net cash flow from operations almost always indicates problems. The statement of cash flows section on investing activities shows whether the company has made a big acquisition, especially when compared with prior years' net cash flows from investing activities. A quick look at the section on financ ing activities also reveals whether a company is issuing debt or buying back stock; in other words, is the company raising capital from investors or returning it to them?
Recall from the previous chapter (Figure 2-4) that MicroDrive generated $163 million from its operating activities but invested $420 million in new fixed assets. To make these purchases, MicroDrive borrowed heavily.
3-1c Calculate and Examine the Return on Invested Capital and Free Cash Flow
After examining the statement of cash flows, we calculate the net operating profit after taxes (NOPAT) and the total net operating capital. We use these measures to calculate the operating profitability ratio (OP), the capital requirement ratio (CR), the return on in vested capital (ROIC), and the free cash flow (FCF), as described in Chapter 2.
The ROIC provides a vital measure of a firm's overall performance. If the ROIC is greater than the company's weighted average cost of capital (WACC), then the company usually is adding value. If the ROIC is less than the WACC, then the company usually has serious problems. No matter what the ROIC tells us about overall performance, it is important to examine specific activities with different financial ratios.
We calculated these measures for MicroDrive in the previous chapter (see Figure 2-6) and report them here for convenience:
MicroDrive (Millions of Dollars)
Net operating working capital (NOWC) =
Total net operating capital =
Net operating profit after taxes (NOPAT) =
Operating profitability ratio (OP) = NOPAT/Sales =
Capital requirement ratio (CR) = (Total net operating capital/Sales) =
Return on invested capital (ROIC) = NOPAT/Total net operating capital =
Free cash flow (FCF) = NOPAT - Net investment in operating capital =
2018
$710
$2,490
$330
6.88%
51.88%
13.3%
NIA
2019
$1,000
$3,000
$300
6.00%
60.00%
10.0%
-$210
MicroDrive's operating profitability fell from 6.88% to 6.00%, and its capital require ment ratio increased from 51.88% to 60%, indicating that MicroDrive is not generating enough in sales from its operating capital. The result is a decline in its ROIC from 13.3% to 10.0%, which is less than MicroDrive's 11.5% cost of capital. We will use ratio analysis in the following sections to identify the root causes of the ROI C's decline.
3-1d Begin Ratio Analysis
Financial ratios are designed to extract important information that might not be obvi ous simply from examining a firm's financial statements. For example, suppose Firm A owes $5 million in debt while Firm B owes $50 million. Which company is in a stronger financial position? It is impossible to answer this question without first standardizing each firm's debt relative to total assets and earnings. Such standardized comparisons are provided through ratio analysis.
104 Part l The Company and Its Environment
We will calculate the 2019 financial ratios for MicroDrive Inc. using data from the balance sheets and income statements given in Figure 3-1; dollar amounts are in millions. Recall from Chapter 2 that MicroDrive reports only net plant, property, and equipment (PP&E) on its balance sheets instead of separately reporting cumulative depreciation and cumulative PP&E. For the sake of clarity, we break down the income statement's costs of goods sold into two components: (1) costs of goods sold excluding depreciation and (2) depreciation (MicroDrive has no amortization charges).
SELF -TEST
What insights does the Statement of Cash Flows provide regarding financial analysis?
What insights are provided by the (1) net operating profit after taxes (NOPAT); (2) operating
profitability ratio (OP); (3) capital requirement ratio (CR); (4) return on invested capital (ROJC);
and (5) free cash flow (FCF)?
3-2 Profitability Ratios Profitability is the net result of a number of policies and decisions. The ratios examined thus far provide an overview of a firm's operations, but the profitability ratios go on to show the combined effects of liquidity, asset management, and debt on operating and financial results.
3-2a Net Profit Margin
The net profit margin, also called the profit margin on sales or just the profit margin, is calculated by dividing net income by sales. It gives the profit per dollar of sales:
Net income available to common stockholders
Net profit margin = Sales
MicroDrive's net profit margin is:
$248 Net profit margin = -
$ -- = 4.96 = 5.0% 5,000
Industry average = 6.2%
MicroDrive's net profit margin is below the industry average, but why is this so? Is it due to inefficient operations, high interest expenses, or both?
Instead of just comparing net income to sales, many analysts also break the income statement into smaller parts to identify the sources of a low net profit margin. For exam ple, the operating profit margin is defined as:
EBIT Operating profit margin = -
al S es
The operating profit margin identifies how a company is performing with respect to its operations before the impact of interest expenses is considered.
Chapter 3 Analysis of Financial Statements
FIGURE3-1
MicroDrive Inc.: Balance Sheets and Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per Share Data)
A B C D E
15 Balance Sheets 2019 2018
16 Assets 17 Cash and equivalents $100 $102
18 Short-term investments 10 40
19 Accounts receivable 500 384
20 Inventories 1,000 774 21 Total current assets $1,610 $1,300
22 Net property, plant & equipment (PP&E) 2,000 1,780 23 Total assets $3,610 $3,080
24 25 Liabilities and Equity
26 Accounts payable $200 $180
27 Notes payable 150 28
28 Accruals 400 370 29 Total current liabilities $750 $578
30 Long-term bonds 520 350 31 Total liabilities $1,270 $928
32 Preferred stock 100 100
33 Common stock 500 500
34 Retained earnings 1,740 1,552
35 Total common equity $2,240 $2,052 36 Total llablllties and equity $3,610 $3,080
37
38 Income Statements 2019 2018
39 Net sales $5,000 $4,800
40 Costs of goods sold except depreciation 3,900 3,710
41 Depreciation" 200 180
42 Other operating expenses 500 470
43 Earnings before interest and taxes (EBIT) $400 $440
44 Less Interest 60 40
45 Pre-tax earnings $340 $400
46 Taxes (25%) 85 100
47 Net income before preferred dividends $255 $300
48 Preferred dividends 7 7 49 Net income available to common stockholders $248 $293
so
51 Additional Information 52 Common dividends $60.0 $59.4
53 Addition to retained earnings $188.0 $233.6
54 Number of common shares 60 60
55 Common stock price per share $31.00 $45.00
56 Lease payments $28 $28
57 Bonds' required sinking fund payments $20 $20
58 Tax rate 25% 25%
Source: See the file Ch03 Tool Klt.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values will be inexact.
Note:
'MicroDrive has no amortization charges, so we omit them from the item name.
105
106
I
Part l The Company and Its Environment
MicroDrive's operating margin is:
$400 Operating profit margin = -
$ -- = 8.0% 5,000
Industry average = 9.0%
Some analysts drill even deeper by breaking operating costs into their components. For example, the gross profit margin is defined as:
. Sales - Cost of goods sold including depreciation Gross profit margm =
al IS es The gross profit margin identifies the gross profit per dollar of sales before any other expenses are deducted.
Rather than calculate each type of profit margin here, later in the chapter we will use common size analysis and percent change analysis to focus on different parts of the income statement. In addition, we will use the DuPont equation to show how the ratios interact with one another.
Sometimes it is confusing to have so many different types of profit margins. To sim plify the situation, we will focus primarily on the net profit margin throughout the book and call it the profit margin.
3-2b Basic Earning Power (BEP) Ratio
The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes (EBIT) by total assets:
EBIT Basic earning power (BEP) ratio =
al Tot assets I The World Might Be Flat, but Global Accounting Is Bumpy! The Case of IFRS versus FASB
In a flat world, distance is no barrier. Work flows to where it
can be done most efficiently, and capital flows to where it can
be invested most profitably. If a radiologist in India is more
efficient than one in the United States, then images will be
e-mailed to India for diagnosis; if rates of return are higher in
Brazil, then investors throughout the world will provide fund
ing for Brazilian projects. One key to "flattening" the world
is agreement on common standards. For example, there are
common Internet standards so that users throughout the
world are able to communicate.
A glaring exception to standardization is in accounting.
The Securities and Exchange Commission (SEC) in the United
States requires firms to comply with standards set by the Fi
nancial Accounting Standards Board (FASB). But the European
Union requires all EU-listed companies to comply with the
International Financial Reporting Standards (IFRS), as defined
by the International Accounting Standards Board (IASB).
IFRS tends to rely on general principles, whereas FASB
standards are rules-based. As we write this in 2018, some prog
ress toward standardizing accounting rules has been made,
but it does not seem likely that the United States and the EU
will be using the same accounting rules in the near future.
To keep abreast of developments in IFRS/GAAP convergence, visit the IASB
Web site at www.iasb.org and the FASB Web site at www.fasb.org.
Chapter 3 Analysis of Financial Statements
For MicroDrive, the ratio is:
$400 Basic earning power (BEP) ratio= --- = 11.1%
$3,610
Industry average = 13.8%
107
This ratio shows the earning power of the firm's assets before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage. MicroDrive has a lower BEP than its peers, partly because its profit margin is low and partly because it manages assets inefficiently, as we show in Section 3-3.
3-2c Return on Total Assets
The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes. This ratio is also called the return on assets and is defined as follows:
Net income available to common stockholders
Return on assets = ROA = -------- Total assets
For MicroDrive, the ROA is:
$248 Return on assets = -- = 6.87% = 6.9%
$3,610
Industry average = 9.6%
MicroDrive's 6.9% return is well below the 9.6% average for the industry. This low return is due to (1) the company's low basic earning power and (2) high interest costs resulting from its above-average use of debt. Both of these factors cause MicroDrive's net income to be relatively low.
3-2d Return on Common Equity
The ratio of net income to common equity measures the return on common equity (ROE), which is often called just the return on equity:
Net income available to Return on
. = ROE = common stockholders
common equity Common equity
MicroDrive's ROE is:
$248 Return on equity=-
$ --= 11.1% 2,240
Industry average = 13.6%
Stockholders invest to earn a return on their money, and this ratio tells how well they are doing in an accounting sense. MicroDrive's 11.1% return is below the 13.6% industry average but not as far below as its return on total assets. This somewhat better result is due to the company's greater use of debt, a point that we explain later in the chapter.
108 Part 1 The Company and Its Environment
SELF -TEST
Identify and write out the equations for four profitability ratios.
Why is the basic earning power ratio useful?
Why does the use of debt lower ROA?
What does ROE measure?
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt= $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest expense = $20, and tax rate = 25%. Calculate the following ratios: Net profit margin (18.3%), operating profit margin (26.8%), basic earning power ratio (32.8%), return on total assets (22.4%), and return on common equity (36.1%).
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. What is its profit margin? (5%) What is its ROA? (10%) What is its ROE? (20%) Would ROA increase if the firm used less leverage? (Yes) Would ROE increase? (No)
3-3 Asset Management Ratios Asset management ratios measure how effectively a firm is managing its assets. For this reason, they are also called efficiency ratios. If a company has excessive investments in assets, then its operating capital is unduly high, which reduces its free cash flow and ultimately its stock price. On the other hand, if a company does not have enough assets, then it may lose sales, which would hurt profitability, free cash flow, and the stock price. Therefore, it is important to have the right amount invested in assets. Ratios that analyze the different types of assets are described in this section.
3-3a Evaluating Total Assets: The Total Assets Turnover Ratio
The- total assets turnover ratio measures the dollars in sales that are generated for each dollar that is tied up in assets:
Sales Total assets turnover ratio =
al Tot assets
For MicroDrive, the ratio is:
$5,000 Total assets turnover ratio = --- = 1.39 = 1.4
$3,610
Industry average = 1.5
I
MicroDrive's ratio is somewhat below the industry average, indicating that the com pany is not generating as much business (relative to its peers), given its total asset invest ment. In other words, MicroDrive uses its assets relatively inefficiently. The following ratios can be used to identify the specific asset classes that are causing this problem.1
'Sales occur throughout the year, but assets are reported at end of the period. For a growing company or a company with seasonal variation, it would be better to use average assets held during the year when calculating turnover ratios. However, we use year-end values for all turnover ratios so that we are more comparable with most reported industry averages.
(
Chapter 3 Analysis of Financial Statements
3-3b Evaluating Fixed Assets: The Fixed Assets Turnover Ratio
109
The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It is the ratio of sales to net fixed assets:
Sales Fixed assets turnover ratio =
fix d Net e assets
MicroDrive's fixed assets turnover ratio is:
$5,000 Fixed assets turnover ratio = -- = 2.5
$2,000
Industry average = 2.7
I
MicroDrive's ratio of 2.5 is a little below the industry average, indicating that the firm is using its fixed assets less intensively than its peers.
Inflation can cause problems when interpreting the fixed assets turnover ratio because fixed assets are reported using the historical costs of the assets instead of current replace ment costs that may be higher due to inflation. Therefore, a mature firm with fixed assets acquired years ago might well have a higher fixed assets turnover ratio than a younger company with newer fixed assets that are reported at inflated prices relative to the histori cal prices of the older assets. However, this would reflect the difficulty accountants have in dealing with inflation rather than inefficiency on the part of the new firm. You should be alert to this potential problem when evaluating the fixed assets turnover ratio.
3-3c Evaluating Receivables: The Days Sales Outstanding
Days sales outstanding (DSO), also called the average collection period (ACP), is used to appraise accounts receivable, and it is calculated by dividing accounts receivable by aver age daily sales to find the number of days' sales that are tied up in receivables. Thus, the DSO represents the average length of time that the firm must wait after making a sale be fore receiving cash, which is the average collection period. MicroDrive's DSO is 37, above the 29-day industry average:
Days sales Receivables Receivables DSO = = -------- = ------- outstanding Average sales per day Annual sales/365
MicroDrive's DSO is about 37 days:
$500 $500 DSO =
$ / = -
$ - = 36.50 days = 37 days
5,000 365 13.7
Industry average = 29 days
I
MicroDrive's sales terms call for payment within 30 days. The fact that 37 days of sales are outstanding indicates that customers, on average, are not paying their bills on time. As with inventory, high levels of accounts receivable cause high levels of net operating work ing capital (NOWC), which hurts FCF and stock price.
110 Part 1 The Company and Its Environment
A customer who is paying late may be in financial trouble, which means MicroDrive may have a hard time collecting the receivable. Therefore, if the trend in DSO has been rising unexpectedly, steps should be taken to review credit standards and to expedite the collection of accounts receivable.
3-3d Evaluating Inventories: The Inventory Turnover Ratio
The inventory turnover ratio is defined as costs of goods sold (COGS) divided by inven tories. 2 The previous ratios use sales instead of COGS. However, sales revenues include costs and profits, whereas inventory usually is reported at cost. Therefore, the inventory turnover ratio compares inventory with costs rather than sales:
COGS Inventory turnover ratio = ----
Inventories I MicroDrive's income statement in Figure 3-1 separately reports depreciation and the
portion of costs of goods sold that is not comprised of depreciation, which is helpful when calculating cash flows. However, we need the total COGS for calculating the inventory turnover ratio. MicroDrive has no amortization charges, and virtually all depreciation is associated with producing its products. MicroDrive's COGS is:
COGS = Costs of goods sold except depreciation + Depreciation
= $3,900 + $200 = $4,100 million
We can now calculate MicroDrive's inventory turnover:
COGS $4,100 Inventory turnover ratio = = -
$ -- = 4.1
Inventory 1,000
Industry average = 5.3
As a rough approximation, each item of MicroDrive's inventory is sold out and restocked, or "turned over," 4.1 times per year.
MicroDrive's turnover of 4.1 is lower than the 5.3 industry average. This suggests that MicroDrive is holding too much inventory. High levels of inventory add to net operat ing working capital, which reduces FCF, which leads to lower stock prices. In addition, MicroDrive's low inventory turnover ratio makes us wonder whether the firm is holding obsolete goods not worth their stated value.
In summary, MicroDrive's low fixed assets turnover ratio, high DSO, and low inven tory turnover ratio each cause MicroDrive's total assets turnover ratio to be lower than the industry average.
SELF -TEST
Identify four ratios that measure how effectively a firm is managing its assets, and write out
their equations.
What problem might arise when comparing firms' fixed assets turnover ratios?
'We calculate the turnover ratio using the ratio of COGS to inventories because most sources report the turn
over ratio this way. However, you should be aware that a few sources, such as Dun & Bradstreet, define inven
tory turnover as the ratio of sales to inventories.
(
esource
See Ch03 Tool Kit.xlsx
for alt calculations.
Chapter 3 Analysis of Financial Statements
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20,
111
accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest expense = $20, and tax rate = 25%. Calculate the following ratios: total assets turnover (1.2), fixed assets turnover (1.6), days sales outstanding (based on a 365-day year) (13.4), inventory turnover (5.0). (Hint: This is the same company used in the previous Self-Test.)
A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory, and $60 million of accounts receivable. What is its inventory turnover ratio? (4.5) What is its DSO based on a 365-day year? (109.5 days)
3-4 Liquidity Ratios As shown in Figure 3-1, MicroDrive has current liabilities of$750 million that it must pay off within the coming year. Will it have trouble satisfying those obligations? Liquidity ratios attempt to answer this type of question. We discuss two commonly used liquidity ratios in this section.
3-4a The Current Ratio
Current assets normally include cash, marketable securities, accounts receivable, and in ventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses. The current ratio measures liquidity by comparing the current assets to the current liabilities:
Current assets Current ratio =
1 bil Current ia · ities
MicroDrive's current ratio is:
$1,610 Current ratio = -- = 2.147 = 2.1
$750
Industry average = 2.3
I
MicroDrive has a slightly lower current ratio than the average for its industry. 3 Is this good or bad? Sometimes the answer depends on who is asking the question. For example, suppose a supplier is trying to decide whether to extend credit to MicroDrive. In general, creditors like to see a high current ratio. If a company starts to experience financial dif ficulty, it will begin paying its bills (accounts payable) more slowly and borrowing more from its bank, so its current liabilities will be increasing. If current liabilities are rising faster than current assets, then the current ratio will fall, and this could spell trouble. Because the current ratio provides the best single indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly, it is the most commonly used measure of short-term solvency.
Now consider the current ratio from a shareholder's perspective. A high current ratio could mean that the company has a lot of money tied up in nonproductive assets, such as excess cash or marketable securities. Or perhaps the high current ratio is due to large
'A good source for industry ratios and for S&P 500 ratios is CS!Market.com: http://csimarket.com/Industry /industry_Financial_Strength_Ratios.php.
112 Part 1 The Company and Its Environment
inventory holdings, which might become obsolete before they can be sold. Thus, share holders might not want a high current ratio.
An industry average is not a magic number that all firms should strive to maintain in fact, some well-managed firms will be above the average, while other good firms will be below it. However, if a firm's ratios are far from the averages for its industry, this is a red flag, and analysts should be concerned about why the variance occurs. For example, suppose a low current ratio is traced to low inventories. Is this a competitive advan tage resulting from the firm's mastery of just-in-time inventory management, or is it an Achilles' heel that is causing the firm to miss shipments and lose sales? Ratio analysis doesn't answer such questions, but it does point to areas of potential concern.
3-4b The Quick Ratio
The quick ratio, also called the acid test ratio, is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities:
k Current assets - Inventories
Quic ratio=---------- Current liabilities
MicroDrive's quick ratio is:
$1,610 - $1,000 Quick ratio = ------ = 0.81 = 0.8
$750
Industry average = 1.0
I
A liquid asset is one that trades in an active market, so it can be converted quickly to cash at the going market price. Inventories are typically the least liquid of a firm's cur rent assets; hence, they are the current assets on which losses are most likely to occur in a bankruptcy. Therefore, a measure of the firm's ability to pay off short-term obligations without relying on the sale of inventories is important.
MicroDrive's quick ratio is just below the industry average and is below 1.0. This means that MicroDrive would have to liquidate inventory in order to pay off current lia bilities should the need arise.
How does MicroDrive compare to S&P 500 companies? There has been a steady decline in the average liquidity ratios of S&P 500 companies during the past decade. As we write this in 2018, the average current ratio is about 1.5, and the average quick ratio is about 0.6, so MicroDrive and its industry peers are a little more liquid than the typical S&P 500 company.
SELF -TEST
Identify two ratios to use to analyze a firm's liquidity position, and write out their equations.
What are the characteristics of a liquid asset? Give some examples.
Which current asset is typically the least liquid?
A company has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20, accruals = $10, short term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. What is its current ratio? (3.1) Its quick ratio? (1.3)
Morris Corporation has current liabilities of $800 million, and its current ratio is 2.5. What is its level of current assets? ($2,000 million) If this firm's quick ratio is 2, how much inventory does it have? ($400 million)
(
Chapter 3 Analysis of Financial Statements 113
3-5 Debt Management Ratios The extent to which a firm uses debt financing is called financial leverage. Here are three important implications: (1) Stockholders can control a firm with smaller invest ments of their own equity if they finance part of the firm with debt. (2) If the firm's assets generate a higher pre-tax return than the interest rate on debt, then the share holders' returns are magnified, or "leveraged." Conversely, shareholders' losses are also magnified if assets generate a pre-tax return less than the interest rate. (3) If a company has high leverage, even a small decline in performance might cause the firm's value to fall below the amount it owes to creditors. Therefore, a creditor's position becomes risk ier as leverage increases. Keep these three points in mind as you consider the impact of financial leverage.
Debt management ratios, which are also called leverage ratios, help identify (1) a firm's use of debt relative to equity and (2) its ability to pay interest and principle. These ratios aid in judging the likelihood of default, as explained next.
3-Sa How the Firm Is Financed: Leverage Ratios
MicroDrive's two primary types of debt are notes payable and long-term bonds, but more complicated companies also might report the portion of long-term debt due within a year, the value of capitalized leases, and other types of obligations that charge interest. For MicroDrive, total debt is:
Total debt = Notes payable + Long-term bonds = $150 + $520 = $670 million
ls this too much debt, not enough, or the right amount? To answer this question, we begin by calculating the percentage of MicroDrive's assets that are financed by debt. The ratio of total debt to total assets is called the debt-to-assets ratio. It is sometimes short ened to debt ratio. Total debt is the sum of all short-term debt and long-term debt; it does not include other liabilities. The debt ratio is:
Total debt Debt-to-assets ratio = Debt ratio =
al Tot assets I MicroDrive's debt ratio is 18.6%, which is substantially higher than the 11.7% industry
average:
$150 + $520 $670 Debt-to-assets ratio =
$ = -
$ -- = 18.6%
3,610 3,610
Industry average = 11.7%
The debt-to-equity ratio is defined as:
Total debt Debt-to-equity ratio =
al Tot common equity I
114 Part 1 The Company and Its Environment
MicroDrive's debt ratio is:
$150 + $520 $670 Debt-to-equity ratio =
$ = -
$ -- = 0.30
2,240 2,240 Industry average = 0.17
The debt-to-equity ratio shows that MicroDrive has $0.30 of debt for every dollar of equity, whereas the debt ratio shows that 18.6% of MicroDrive's assets are financed by debt. We find it more intuitive to think about the percentage of the firm that is financed with debt, so we usually use the debt ratio. However, the debt-to-equity ratio is also widely used, so you should know how to interpret it as well.
Be sure you know how a ratio is defined before you use it. Some sources define the debt ratio using only long-term debt instead of total debt; others use investor-supplied capital instead of total assets. Some sources make similar changes in the debt-to-equity ratio, so be sure to check your source's definition.
Sometimes it is useful to express debt ratios in terms of market values. It is easy to calculate the market value of equity, which is equal to the stock price multiplied by the number of shares. MicroDrive's market value of equity is $31(60 million) = $1,860 million. Often it is difficult to estimate the market value of debt, so many analysts use the debt reported in the financial statements. The market debt ratio is defined as:
Total debt Market debt ratio = ------------
Total debt + Market value of equity
MicroDrive's ratio is:
$150 + $520 Market debt ratio =
($ $ ) ($ ) = 26.5%
150 + 520 + 31 X 60
Industry average = 11.5%
I
MicroDrive's market debt ratio in the previous year was 12.3%. The big increase was due to two factors: debt increased and the stock price fell. The stock price reflects a com pany's prospects for generating future cash flows, so a decline in stock price indicates a likely decline in future cash flows. Thus, the market debt ratio reflects a source of risk that is not captured by the conventional debt ratio.
The ratio of total liabilities to total assets shows the extent to which a firm's assets are not supported by equity. The liabilities-to-assets ratio is defined as:
Total liabilities Liabilities-to-assets ratio =
al Tot assets
MicroDrive's ratio is:
L. b'l' . . $1,270
35 20, 1a 11t1es-to-assets ratio = - $
-- = . 70 3,610
Industry average = 29.6%
I
Chapter 3 Analysis of Financial Statements 115
The equity multiplier ratio is the factor by which the return on assets is multiplied to determine the return on equity. It is defined as the ratio of total assets to common equity:
Return on equity Equity multiplier = -----
Return on assets
(Net income)/(Common equity) =
(Net income)/(Total assets)
Total assets =------
Common equity
MicroDrive's equity multiplier is:
$3,610 Equity multiplier = -$--
= 1.6 2,240
Industry average = 1.4
With a little algebra, the equity multiplier can also be defined as:
1 Equity multiplier = -----------
1 - Liabilities-to-assets ratio I For all the ratios we examined, MicroDrive has more leverage than its industry peers.
The next section shows how close MicroDrive might be to serious financial distress.
3-Sb Ability to Pay Interest: Times-Interest Earned Ratio
The times-interest-earned (TIE) ratio, also called the interest coverage ratio, is deter mined by dividing earnings before interest and taxes (EBIT in Figure 3-1) by the interest expense:
EBIT Times-interest-earned (TIE) ratio = -----
Interest expense
MicroDrive's times-interest-earned ratio is:
$400 Times-interest-earned (TIE) ratio = - $-
= 6.7 60
Industry average = 13.3
I
The TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by the firm's creditors, possibly resulting in bankruptcy. Note that earnings before interest and taxes, rather than net income, is used in the numerator. Because interest is paid with pre-tax dollars, the firm's ability to pay current interest is not affected by taxes.
116 Part 1 The Company and Its Environment
MicroDrive's interest is covered 6.7 times, which is well above 1, the point at which EBIT isn't sufficient to pay interest. The industry average is 13.3, so even though MicroDrive has enough EBIT to pay interest expenses, it has a lower margin of safety compared to its peers.
3-Sc Ability to Service Debt: EBITDA Coverage Ratio
The TIE ratio is useful for assessing a company's ability to meet interest charges on its debt, but this ratio has two shortcomings: (1) Interest is not the only fixed financial charge companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments. Failure to repay debt or meet lease payments may force them into bankruptcy. (2) EBIT (earnings before interest and taxes) does not represent all the cash flow available to service debt, especially if a firm has high noncash expenses, like depre ciation and/or amortization charges. A better coverage ratio would take all of the "cash" earnings into account in the numerator and the other financial charges in the denomina tor. The EBITDA coverage ratio is:4
EBITDA + Lease payments
IEBITDA coverage ratio=------------------ •
Interest + Principal payments + Lease payments
MicroDrive had $400 million ofEBIT and $200 million in depreciation, for an EBITDA (earnings before interest, taxes, depreciation, and amortization) of $400 + $200 = $600 million. Also, lease payments of $28 million were deducted when calculating EBITDA. That $28 million was available to meet financial charges; hence, it must be added back, bringing the total available to cover fixed financial charges to $628 million. Fixed financial charges consisted of $60 million of interest, $20 million of sinking fund payments, and $28 million for lease payments, for a total of $108 million.5
MicroDrive's EBITDA coverage ratio is:
($400 + 200) + $28 $628 EBITDA coverage ratio =
$ $ $ = -- = 5.8
60 + 20 + 28 $108
Industry average = 12.0
MicroDrive covered its fixed financial charges by a factor of 5.8. MicroDrive's ratio is well below the industry average, so again the company seems to have a relatively high level of debt.
The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks, which rarely make loans (except real estate-backed loans) for longer than about 5 years. Over a relatively short period, depreciation-generated funds can be used to service debt. Over a longer time, those funds must be reinvested to maintain the plant and equip ment or else the company cannot remain in business. Therefore, banks and other rela tively short-term lenders focus on the EBITDA coverage ratio, whereas long-term bond holders focus on the TIE ratio.
'Different analysts define the EBITDA coverage ratio in different ways. For example, some omit the lease payment information; others "gross up" principal payments by dividing them by 1 - T because these payments are not tax deductions and so must be made with after-tax cash flows. We included lease payments because they are quite important for many firms, and failing to make them can lead to bankruptcy as surely as failing to make payments on "regular" debt. We did not gross up principal payments because a company's tax rate will probably be zero if it is financially distressed; hence, the gross-up is not necessary whenever the ratio is really important.
'A sinking fund is a required annual payment designed to reduce the balance of a bond or preferred stock issue.
Chapter 3 Analysis of Financial Statements 117
SELF -TEST
How does the use of financial leverage affect current stockholders' control position?
Name six ratios that are used to measure the extent to which a firm uses financial leverage, and write out their equations.
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt= $200, and total common equity= $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest expense = $20, and tax rate = 40%. Calculate the fol/awing ratios: debt-ta-assets ratio (33.6%), debt-to-equity ratio (54.2%), liabilities-to-assets ratio (38.1 %), and times-interest earned ratio (11.0). (Hint: This is the same company used in the previous Self-Test.)
Suppose Morris Corporation has 100 shares of stock with a price of $15 per share. What is its mar ket debt ratio (assume the market value of debt is close to the book value)? (13.0%) How does this compare with the previously calculated debt-to-assets ratio? Does the market debt ratio imply that the company is more or less risky than the debt-to-assets ratio indicated?
A company has EB/TOA of $600 million, interest payments of $60 million, lease payments of $40 million, and required principal payments (due this year) of $30 million. What is its EB/TOA coverage ratio? (4.9)
3-6 Market Value Ratios
Market value ratios relate a firm's stock price to its earnings, cash flow, and book value per share. Market value ratios are a way to measure the value of a company's stock relative to that of another company.
3-6a Price/Earnings Ratio
The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported profits.
Price per share Price/earnings (P/E) ratio = .
h Earmngs per s are I MicroDrive has $248 million in net income and 60 million shares, so its earnings per
share (EPS) is $4.13 = $248/60. MicroDrive's stock sells for $31, so its PIE ratio is:
$31.00 Price/earnings (P/E) ratio = -- = 7.5
$4.13
Industry average = 9.4
Price/earnings ratios are higher for firms with strong growth prospects, other things held constant, but they are lower for riskier firms. Because MicroDrive's PIE ratio is below the average, this suggests that the company is regarded as being somewhat riskier than most, as having poorer growth prospects, or both. In mid-2018, the average P/E ratio for firms in the S&P 500 was 26.10, indicating that investors were willing to pay $26.10 for every dollar of earnings. 6
'There are two reasons why the actual S&P 500 P/E ratio is so much higher than MicroDrive's ratio. As we show in Chapter 7, we assume that MicroDrive's growth slows down to about 5% a year during the next 5 years. We do this so that MicroDrive's forecasted financial statements will fit on one page. However, growth often remains high for many years for S&P 500 companies, which increases their prices relative to their current earnings.
118 Part I The Company and Its Environment
3-6b Price/Free Cash Flow (P/FCF) Ratio
Stock prices depend on a company's ability to generate free cash flow (FCF). Consequently, investors often look at the price/free cash flow (P/FCF) ratio:
Price per share Price/free cash flow ratio =
h fl h Free cas ow per s are
MicroDrive's price/free cash flow ratio is:
$31.00 Price/free cash flow ratio =
$ / = -8.9
- 210 60
Industry average = 11.1
I
Not only is MicroDrive's price/free cash flow ratio below the industry average, it is negative! The price/EBITDA ratio is defined as price divided by EBITDA. It is a better mea
sure of operating performance than the PIE ratio, which incorporates nonoperating items (i.e., interest expenses and taxes). MicroDrive's EBITDA per share is (EBIT + Depreciation) = ($400 + $200)/60 = $10, so its price/EBITDA is $31/$10 = 3.1. The industry average price/EBITDA ratio is 4.6, so we see again that MicroDrive is below the industry average.
Note that some analysts look at other multiples as well. For example, depending on the industry, some may look at measures such as price/visits (e.g., visits to a Web site) or price/ customers. You should view these measures with caution-unless these measures are cor related with cash flow, they are likely to be misleading.
3-6c Market/Book Ratio
The ratio of a s tock's market price to its book value gives another indication of how investors regard the company. Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns. First, we find MicroDrive's book value per share:
Total common equity Book value per share =
d Shares outs tan ing
MicroDrive's book value per share is:
$2,240 Book value per share = -- = $37.33
60
I
Now we divide the market price per share by the book value per share to get a market/ book (M/B) ratio:
Market price per share Market/book ratio = M/B =
k h Boo value per s are I
(
Chapter 3 Analysis of Financial Statements
For MicroDrive, the ratio market/book ratio is:
$31.00 Market/book ratio = --= 0.8
$37.33
Industry average = 1.3
119
It is also possible to define the market/book ratio as the market value of equity divided by the total common equity reported in the financial statements. The total market value of equity, which is called the market capitalization (or just market cap) is:
Market capitalization = (Price per share) (Total number of shares)
For MicroDrive, the market cap is:
Market cap = $31.00(60 million) = $1,860 million
Now we divide the market cap by the total common equity:
. Market cap Market/book ratio = M/B =
T al ot common eqwty
$1,860 =--=0.8
$2,240
■
I Both approaches give the same answer, 0.8, which is much lower than the industry
average of 1.3. This indicates that investors are willing to pay relatively little for a dollar of MicroDrive's book value.
The book value is a record of the past, showing the cumulative amount that stockhold ers have invested, either directly by purchasing newly issued shares or indirectly through retaining earnings. In contrast, the market price is forward looking, incorporating inves tors' expectations of future cash flows. For example, Volkswagon AG had a market/book ratio of 0.88 in late 2017, reflecting its recent scandals involving emission tests, whereas Apple's market/book ratio was 6.83, indicating that investors expected Apple's past suc cesses to continue.
Table 3-1 summarizes selected ratios for MicroDrive. As the table indicates, the com pany has many problems.
SELF-TEST
Describe three ratios that relate a firm's stock price to its earnings, cash flow, and book value per share, and write out their equations.
What does the price/earnings (P/E) ratio show? If one firm's P/E ratio is lower than that of another, what are some factors that might explain the difference?
How is book value per share calculated? Explain why book values often deviate from market values.
A company has $6 billion in net income, $8 billion of free cash flow, $80 billion of common equity, and one billion shares of stock. If its stock price is $96 per share, what is its price/earnings ratio? (16) Its price/free cash flow ratio? (12) Its market/book ratio? (1.2)
120
TABLE3-1
MicroDrive Inc.: Summary of Selected Financial Ratios (Millions of Dollars)
Ratio Formula
Profitability
Profit margin Net income available to common stockholders
on sales Sales
Operating profit Earnings before interest and taxes (EBIT)
margin Sales
Return on total Net income available to common stockholders
assets (ROA) Total assets
Return on common Net income available to common stockholders
equity (ROE) Common equity
Asset Management
Sales Total assets turnover Total assets
Sales Fixed assets turnover
Net fixed assets
Days sales Receivables
outstanding (DSO) Annual sales/365
COGS Inventory turnover Inventories
Liquidity
Current Current assets
Current liabilities
Quick Current assets - Inventories
Current liabilities
Debt Management
Debt-to-assets ratio Total debt
Total assets
Times-interest- Earnings before interest and taxes (EBIT)
earned (TIE) Interest charges
Price/earnings (P/E) Price per share
Earnings per share
Market/book (M/B) Market price per share
Book value per share
Part l
Calculation
$248 =
$5,000
$400 =
$5,000
$248 = $3,610
$248
$2,240 =
$5,000
$3,610 =
$5,000
$2,000 =
$500
$5,000/365
$4,100 --= $1,000
$1,610
$750 =
$1,610 - $1,000
$750
$670 =
$3,610
$400
$60 =
$31.00
$4.13 =
$31.00
$37.33 =
The Company and Its Environment
Industry
Ratio Average Comment
5.0% 6.2% Poor
8.0% 9.0% Poor
6.9% 9.6% Poor
11.1% 13.6% Poor
1.4 1.5 Poor
2.5 2.7 Poor
36.5 29.0 Poor
4.1 5.3 Poor
2.1 2.3 Riskier
0.8 1.0 Riskier
18.6% 11.7% Riskier
6.7 13.3 Riskier
7.5 9.4 Poor
0.8 1.3 Poor
(
Chapter 3 Analysis of Financial Statements 121
3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis
Trends give clues as to whether a firm's financial condition is likely to improve or deterio rate. To do a trend analysis, you examine a ratio over time, as shown in Figure 3-2. This graph shows that MicroDrive's rate of return on common equity has been declining since 2017, in contrast to the industry average. All the other ratios could be analyzed similarly.
In a common size analysis, all income statement items are divided by sales, and all balance sheet items are divided by total assets. Thus, a common size income statement shows each item as a percentage of sales, and a common size balance sheet shows each item as a percentage of total assets.7 The advantage of common size analysis is that it facilitates comparisons of balance sheets and income statements over time and across companies.
Common size statements are easy to generate if the financial statements are in a spreadsheet. In fact, if you obtain your data from a source that uses standardized finan cial statements, then it is easy to cut and paste the data for a new company over your original company's data, and all of your spreadsheet formulas will be valid for the new company. We generated Figure 3-3 in the Excel file Ch03 Tool Kit.xlsx. Figure 3-3 shows MicroDrive's 2018 and 2019 common size income statements, along with the composite statement for the industry. (Note: Rounding may cause addition/subtraction differences in Figures 3-3, 3-4, and 3-5.) MicroDrive's EBIT is slightly below average, and its interest expenses are slightly above average. The net effect is a relatively low profit margin.
Figure 3-4 shows MicroDrive's common size balance sheets along with the industry composite. Its accounts receivable are slightly higher than the industry average, its inven tories are significantly higher, and it uses much more debt than the average firm.
FIGURE3·2
MicroDrive Inc.: Trend Analysis of Rate of Return on Assets
ROE
(%)
10.0% Industry
8.0%
MicroDrive
6.0%
4.0%
2.0%
0.0% 2015 2016 2017 2018 2019
Source: See the file Ch03 Tool Kit.xlsx.
7Some sources of industry data, such as Risk Management Associates (formerly known as Robert Morris Associates), are presented exclusively in common size form.
122 Part l The Company and Its Environment
FIGURE3-3
MicroDrive Inc.: Common Size Income Statement
A I B I C I D I E I F 212 Industry - 213 Composite MlcroDrive - 214 2019 2019 2018 215 Net sales 100.0% 100.0% 100.0%
2l6 -
Costs of goods sold except depreciation 77.6% 78.0% 77.3%
217 Depreciation• 3.9% 4.0% 3.8% - 218 -
Other operating expenses 9.9% 10.0% 9.8% 219 -
Earnings before interest and taxes (EBIT) 8.7% 8.0% 9.2% 220 Less interest 0.6% 1.2% 0.8% -
221 Pre-tax earnings 8.1% 6.8% 8.3% - 222 -
Taxes (25%) 2.0% 1.7% 2.1% 223 Net income before preferred dividends 6.1% 5.1% 6.3% -
224 Preferred dividends 0.0% 0.1% 0.1% -
225 Net income available to common stockholders 6.1% 5.0% 6.1% - 226
Source: See the file Ch03 Tool Kft.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values will be inexact.
Note:
'MicroDrive has no amortization charges so we omit them from the item name.
FIGURE3-4
Micro Drive Inc.: Common Size Balance Sheet
A I B I C I D I E 234 Industry ---- 235 Composite MicroDrive
,__ 2019 236 2019 2018 237 Assets - 238 -
cash and equivalents 2.9% 2.8% 3.3% 239 Short-term investments 0.9% 0.3% 1.3% 240 Accounts receivable 13.2% 13.9% 12.5% - 241 Inventories 26.4% 27.7% 25.1% -
242 Total current assets 43.5% 44.6% 42.2% -
243 -
Net property, plant & equipment (PP&E) 56.5% 55.4% 57.8% 244 Total assets 100.0% 100.0% 100.0% 245 -
246 Liabilities and Equity -
247 Accounts payable 5.7% 5.5% 5.8% -
248 Notes payable 0.6% 4.2% 0.9% 249 Accruals 11.6% 11.1% 12.0% - 250 Total current liabilities 17.8% 20.8% 18.8% - 251 -
Long-term bonds 8.8% 14.4% 11.4% 252 Total liabilities 26.6% 35.2% 30.1% - 253 Preferred stock 0.0% 2.8% 3.2% 254 Total common equity 73.4% 62.0% 66.6% 255 Total liabilities and equity 100.0% 100.0% 100.0% - 256
Source: See the file Ch03 Tool Kft.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values will be inexact.
0
Chapter 3 Analysis of Financial Statements
FIGURE3-S
MicroDrive Inc.: Income Statement Percentage Change Analysis
264
265
266
267 Net sales
A B
Base year= 2018
268 Costs of goods sold except depreciation
269 Depreciationa 270 Other operating expenses
271 Earnings before interest and taxes (EBIT)
272 Less interest
273 Pre-tax earnings
274 Taxes (25%)
275 Net income before preferred dividends
276 Preferred dividends
C
277 Net income available to common stockholders
278
D
Percent
Changeln
2019
4.2%
5.1%
11.1%
6.4% -9.1%
50.0%
-15.0%
-15.0%
-15.0%
0.0% -15.4%
Source: See the file Ch03 Tool Klt.xlsx. Numbers are reported as rounded values for clarity but are calculated
using Excel's full precision. Thus, intermediate calculations using the figure's rounded values will be inexact.
123
In percentage change analysis, growth rates are calculated for all income statement items and balance sheet accounts relative to a base year. To illustrate, Figure 3-5 contains MicroDrive's income statement percentage change analysis for 2019 relative to 2018. Sales increased at a 4.2% rate during 2019, but EBIT fell by 9.1%. Part of this decline was due to an increase in depreciation, which is a noncash expense, but the cost of goods sold also increased by more than the growth in sales. In addition, interest expenses grew by SO! We apply the same type of analysis to the balance sheets (see the file Ch03 Tool Kit.xlsx), which shows that inventories grew at a whopping 30% rate and accounts receivable grew 29%. With only a 4.2% growth in sales, the extreme growth in receivables and inventories should be of great concern to MicroDrive's managers.
SELF-TEST
What is a trend analysis, and what information does it provide?
What is common size analysis?
What is percentage change analysis?
3-8 Tying the Ratios Together: The DuPont Equation
In ratio analysis, it is sometimes easy to miss the forest for all the trees. In particular, how do managerial actions affecting a firm's profitability, asset efficiency, and financial lever age interact to determine the return on equity, a performance measure that is important for investors? The extended DuPont equation provides just such a framework.
Net income ROE=----
Common equity
124 Part I The Company and Its Environment
The extended DuPont equation reconfigures the ROE into three components (profit margin, total asset turnover, and the equity multiplier):
Net income Sales Total assets ROE=---- X ---- X ------
Sales Total assets Common equity
= (Profit margin)(Total assets turnover)(Equity multiplier)
As calculated previously, MicroDrive's 2019 profit margin is 4.96%, its total assets turnover ratio is 1.39, and its equity multiplier is 1.61. Applying the DuPont equation to MicroDrive, its return on equity is:
ROE= (4.96%)(1.39)(1.61) = 11.1%
Note that this is the same value calculated previously, as shown in Table 3-1. Sometimes it is useful to focus just on asset profitability and financial leverage. Notice
that the first two terms in the second row of Equation 3-25 are the definition of return on assets. Substituting for these terms in Equation 3-25 provides an expression for ROE in terms of asset profitability and leverage:
Net income Total assets ROE=---- X ------
Total assets Common equity
= ROA X Equity multiplier
Using Equation 3-26, we see that MicroDrive's ROE is ll.1%, the same value given by the extended DuPont equation:
ROE= 6.87% X 1.61 = 11.1%
The insights provided by the DuPont model are valuable, and the model can be used for "quick and dirty" estimates of the impact that operating changes have on returns. For example, holding all else equal, if Micro Drive can implement lean production techniques and increase to 1.8 its ratio of sales to total assets, then its ROE will improve to 14.4%:
ROE = (4.96%)(1.8)(1.61) = 14.4%.
For a more complete what-if analysis, most companies use a forecasting model such as the one described in Chapter 12.
SELF-TEST
Explain how the extended, or modified, DuPont equation can be used to reveal the basic determi
nants of ROE.
What is the equity multiplier?
A company has a profit margin of 6%, a total assets turnover ratio of 2, and an equity multiplier
of 1.5. What is its ROE? (18%)
3-9 Comparative Ratios and Benchmarking Ratio analysis involves comparisons. A company's ratios are compared with those of other firms in the same industry-that is, with industry average figures. However, like most firms, MicroDrive's managers go one step further: They also compare their ratios with those of a smaller set of the leading computer companies. This technique is called
Chapter 3 Analysis of Financial Statements 125
benchmarking, and the companies used for the comparison are called benchmark companies. For example, MicroDrive benchmarks against five other firms that its man agement considers to be the best-managed companies with operations similar to its own.
Many companies also benchmark various parts of their overall operation against top companies, whether they are in the same industry or not. For example, MicroDrive has a division that sells hard drives directly to consumers through catalogs and the Internet. This division's shipping department benchmarks against Amazon, even though they are in different industries, because Amazon's shipping department is one of the best. MicroDrive wants its own shippers to strive to match Amazon's record for on-time shipments.
Comparative ratios are available from a number of sources, including Value Line, Dun and Bradstreet (D&B), and the Annual Statement Studies published by Risk Manage ment Associates, which is the national association of bank loan officers. Table 3-2 reports selected ratios from Reuters for Apple and its industry, revealing that Apple has a much higher net profit margin and return on assets than its peers.
Each data-supplying organization uses a somewhat different set of ratios designed for its own purposes. For example, D&B deals mainly with small firms, many of which are proprietorships, and it sells its services primarily to banks and other lenders. Therefore, D&B is concerned largely with the creditor's viewpoint, and its ratios emphasize cur rent assets and liabilities, not market value ratios. So, when you select a comparative data source, you should be sure that your own emphasis is similar to that of the agency whose ratios you plan to use. Additionally, there are often definitional differences in the ratios presented by different sources, so before using a source, be sure to verify the exact defini tions of the ratios to ensure consistency with your own work.
TABLE3-2 Comparative Ratios for Apple Inc., the Computer Hardware Industry, and the Technology Sector
Computer Hardware Technology Ratio Apple Industry• Sector•
P/E ratio 19.1 15.7 15.8
Market to book 6.7 3.4 2.3
Net profit margin 38.5% 27.1% 42.3%
Quick ratio 1.2 1.4 1.8
Current ratio 1.3 1.7 2.2
Total debt-to-equity< 86.3% 64.8% 16.0%
Interest coverage (TIE)d NA 12.4 6.3
Return on assets 13.9% 5.1% 12.4%
Return on equity 36.9% 11.1% 17.2%
Inventory turnover 40.4 16.3 14.8
Assets turnover 0.7 1.2 0.9
Source: Adapted from data at www.reuters.com/finance/stocks/financial-highlights/AAPL.OQ.com,
November 24, 2017.
Notes:
'The computer hardware industry includes such firms as IBM, Dell, Apple, and Silicon Graphics.
'The technology sector contains 11 industries, including communications equipment, computer hardware,
computer networks, semiconductors, and software and programming.
'This is based on book values. Apple's market equity is much bigger than its market debt, but its book equity
is small relative to its book debt.
'Apple had more interest income than interest expense.
126 Part 1 The Company and Its Environment
SELF -TEST
Compare and contrast trend analysis and comparative ratio analysis.
Explain benchmarking.
3-10 Uses and Limitations of Ratio Analysis Ratio analysis provides useful information concerning a company's operations and finan cial condition, but it has limitations that necessitate care and judgment. Some potential problems include the following.
1. Many large firms operate different divisions in different industries, and for such companies it is difficult to develop a meaningful set of industry averages. Therefore, industry averages are more meaningful for small, narrowly focused firms than for large, multidivisional ones.
2. To set goals for high-level performance, it is best to benchmark on the industry leaders' ratios rather than the industry average ratios.
3. Inflation may badly distort firms' balance sheets-reported values are often substan tially different from "true" values. Further, because inflation affects depreciation charges and inventory costs, reported profits are also affected. Thus, inflation can distort a ratio analysis for one firm over time or a comparative analysis of firms of different ages.
4. Seasonal effects can distort a ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus the one just after the close of the canning season. This problem can be minimized by using monthly averages for inventory (and receivables) when calculating turnover ratios.
5. Firms can employ window dressing techniques to make their financial statements look stronger. To illustrate, suppose a company takes out a 2-year loan in late Decem ber. Because the loan is for more than 1 year, it is not included in current liabilities even though the cash received through the loan is reported as a current asset. This improves the current and quick ratios and makes the year-end balance sheet look stronger. If the company pays the loan back in January, then the transaction was strictly window dressing.
6. Companies' choices of different accounting practices can distort comparisons. For example, choices of inventory valuation and depreciation methods affect financial statements differently, making comparisons among companies less meaningful. 8
Ratio Analysis Qn the Web
A great source for comparative ratios is www.reuters.com.
Hover over the Markets drop-down box and select U.S. Mar
kets. At the right in the Markets section, select the U.S. tab
and enter a company's ticker in the Search box. This brings
up a table with the stock quote, company information, and
additional links. Select Financials, which brings up a page
with a detailed ratio analysis for the company and includes
comparative ratios for other companies in the same sector
and the same industry. (Note: You may have to register to get
extra features, but registration is free.)
'Beginning in December 2018, almost all leases must be reported on the balance sheet as liabilities, and the leased assets must be reported as assets. This is in contrast to the prior rule in which operating leases were reported on the balance sheet, but financial leases were not reported. As we write this in mid-2018, the Finan cial Accounting Standards Board (FASB) is considering proposals to phase in the requirement over several accounting periods rather than apply it completely in December 2018. For more information, go to www.fasb .org, select Standards, Accounting Standards Updates Issued, and click on Update 2016-02.
Chapter 3 Analysis of Financial Statements 127
In summary, conducting ratio analysis in a mechanical, unthinking manner is dan gerous. But when ratio analysis is used intelligently and with good judgment, it can pro vide useful insights into a firm's operations and identify the right questions to ask.
SELF-TEST
List several potential problems with ratio analysis.
3-11 Looking Beyond the Numbers Sound financial analysis involves more than just calculating and comparing ratios qualitative factors must be considered. Here are some questions suggested by the American Association of Individual Investors (AAII):
1. To what extent are the company's revenues tied to one key customer or to one key product? To what extent does the company rely on a single supplier? Reliance on sin gle customers, products, or suppliers increases risk.
2. What percentage of the company's business is generated overseas? Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability.
3. What are the probable actions of current competitors and the likelihood of additional new competitors?
4. Do the company's future prospects depend critically on the success of products cur rently in the pipeline or on existing products?
5. How do the legal and regulatory environments affect the company?
SELF-TEST
What qualitative factors should analysts consider when evaluating a company's likely future
financial performance?
This chapter explained techniques investors and managers use to analyze financial state ments. The key concepts covered are listed here.
• Profitability ratios show the combined effects of liquidity, asset management, and debt management policies on operating and financial results. They include the net profit margin, operating profit margin, basic earning power (BEP) ratio, return on total assets (ROA), and return on common equity (ROE).
• Asset management ratios measure how effectively a firm is managing its assets. These ratios include inventory turnover, days sales outstanding, fixed assets turnover, and total assets turnover.
• Liquidity ratios show the relationship of a firm's current assets to its current liabilities and thus its ability to meet maturing debts. Two commonly used liquidity ratios are the current ratio and the quick ratio (also called the acid test ratio).
• Debt management ratios reveal (1) the extent to which the firm is financed with debt and (2) its likelihood of defaulting on its debt obligations. They include the debt-to-assets ratio (also called the debt ratio), debt-to-equity ratio, liabilities-to assets ratio, equity multiplier, times-interest-earned (TIE) ratio, and EBITDA coverage ratio.
128 Part 1 The Company and Its Environment
• Market value ratios relate the firm's stock price to its earnings, cash flow, and book value per share, thus giving management an indication of what investors think of the company's past performance and future prospects. These include the price/earnings (PIE) ratio, price/free cash flow (P/FCF) ratio, and market/book (M/B) ratio.
• Trend analysis, in which one plots a ratio over time, is important because it reveals whether the firm's condition has been improving or deteriorating.
• The DuPont equation shows how the profit margin on sales, the assets turnover ratio, and the use of debt all interact to determine the rate of return on equity.
• Benchmarking is the process of comparing a particular company with a group of similar successful companies.
Ratio analysis has limitations, but when used with care and judgment, it can be very helpful.
QUESTIONS
(3-1) Define each of the following terms:
(3-2)
(3-3)
(3-4)
(3-5)
(3-6)
a. Liquidity ratios: current ratio; quick, or acid test, ratio b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO);
fixed assets turnover ratio; total assets turnover ratio c. Financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; EBITDA
coverage ratio d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return
on total assets (ROA); return on common equity (ROE) e. Market value ratios: price/earnings (PIE) ratio; price/free cash flow ratio; market/
book (M/B) ratio; book value per share f. Trend analysis; comparative ratio analysis; benchmarking g. DuPont equation; window dressing; seasonal effects on ratios
Financial ratio analysis is conducted by managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios?
Over the past year, M. D. Ryngaert & Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company's sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes?
Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between a grocery chain and a steel company? Think particu larly about the turnover ratios, the profit margin, and the DuPont equation.
How might (a) seasonal factors and (b) different growth rates distort a comparative ratio analysis? Give some examples. How might these problems be alleviated?
Why is it sometimes misleading to compare a company's financial ratios with those of other firms that operate in the same industry?
SELF-TEST PROBLEMS SOLUTIONS SHOWN IN APPEI\JDIX A
(ST-1) Debt Ratio
Argent Corporation has $60 million in current liabilities, $150 million in total liabilities, and $210 million in total common equity; Argent has no preferred stock. Argent's total debt is $120 million. What is the debt-to-assets ratio? What is the debt-to-equity ratio?
(S T-2) Ratio Analysis
(3-1) DSO
(3-2) Debt Ratio
(3-3) Market/Book Ratio
(3-4) Price/Earnings Ratio
(3-5) ROE
(3-6) DuPont Analysis
(3-7) Current and Quick Ratios
(3-8) Profit Margin
and Debt Ratio
Chapter 3 Analysis of Financial Statements
The following data apply to Jacobus and Associates (millions of dollars):
Cash $ 400 Fixed assets $ 4,300 Sales $14,600 Net income $ 730 Quick ratio 2.0 Current ratio 3.0 DSO 40 days ROE 12.5%
129
Jacobus has no preferred stock-only common equity, current liabilities, and long-term debt. Find Jacobus's (1) accounts receivable, (2) current liabilities, (3) current assets, (4) total as sets, (5) ROA, (6) common equity, (7) long-term debt, (8) equity multiplier, (9) profit margin, and (10) total asset turnover. Substitute your calculated profit margin, total asset turnover, and equity multiplier into the DuPont equation and verify that resulting ROE is 12.5%.
EASY PROBLEMS 1-5
Greene Sisters has a DSO of 20 days. The company's average daily sales are $20,000. What is the level of its accounts receivable? Assume there are 365 days in a year.
Vigo Vacations has $200 million in total assets, $5 million in notes payable, and $25 mil lion in long-term debt. What is the debt ratio?
Winston Watch's stock price is $75 per share. Winston has $10 billion in total assets. Its balance sheet shows $1 billion in current liabilities, $3 billion in long-term debt, and $6 billion in common equity. It has 800 million shares of common stock outstanding. What is Winston's market/book ratio?
Reno Revolvers has an EPS of $1.50, a free cash flow per share of $3.00, and a price/free cash flow ratio of 8.0. What is its PIE ratio?
Needham Pharmaceuticals has a profit margin of 3% and an equity multiplier of 2.0. Its sales are $100 million, and it has total assets of $50 million. What is its ROE?
INTERMEDIATE PROBLEMS 6-10
Gardial & Son has an ROA of 12%, a 5% profit margin, and a return on equity equal to 20%. What is the company's total assets turnover? What is the firm's equity multiplier?
Ace Industries has current assets equal to $3 million. The company's current ratio is 1.5, and its quick ratio is 1.0. What is the firm's level of current liabilities? What is the firm's level of inventories?
Assume you are given the following relationships for the Haslam Corporation:
Sales/total assets 1.2 Return on assets (ROA) 4% Return on equity (ROE) 7%
Calculate Haslam's profit margin and liabilities-to-assets ratio. Suppose half its liabilities are in the form of debt. Calculate the debt-to-assets ratio.
130
(3-9) Current and Quick Ratios
(3-10) Times-Interest
Earned Ratio
(3-11) Balance Sheet
Analysis
(3-12) Comprehensive
Ratio Calculations
(3-13) Comprehensive
Ratio Analysis
Part 1 The Company and Its Environment
The Nelson Company has $1,312,500 in current assets and $525,000 in current liabilities. Its initial inventory level is $375,000, and it will raise funds as additional notes payable and use them to increase inventory. How much can Nelson's short-term debt (notes pay able) increase without pushing its current ratio below 2.0? What will be the firm's quick ratio after Nelson has raised the maximum amount of short-term funds?
The Morrit Corporation has $600,000 of debt outstanding, and it pays an interest rate of 8% annually. Morrit's annual sales are $3 million, its average tax rate is 25%, and its net profit margin on sales is 3%. If the company does not maintain a TIE ratio of at least 5 to l, then its bank will refuse to renew the loan, and bankruptcy will result. What is Morrit's TIE ratio?
CHALLENGING PROBLEMS 11-14
Complete the balance sheet and sales information in the table that follows for J. White Industries, using the following financial data:
Total assets turnover: 1.5 Gross profit margin on sales: (Sales - Cost of goods sold)/Sales = 25% Total liabilities-to-assets ratio: 40% Quick ratio: 0.80 Days sales outstanding (based on 365-day year): 36.5 days Inventory turnover ratio: 3.75
Partial Income Statement Information
Sales Cost of goods sold
Balance Sheet Information
Cash
Accounts receivable
Inventories
Fixed assets
Total assets $400,000
Accounts payable
Long-term debt
Common stock
Retained earnings
Total liabilities and equity
50,000
100,000
The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, a days sales outstanding of 36.5 days (based on a 365-day year), total current assets of $810,000, and cash and marketable securities of $120,000. What were Kretovich's annual sales?
Data for Lozano Chip Company and its industry averages follow.
a. Calculate the indicated ratios for Lozano. b. Construct the extended DuPont equation for both Lozano and the industry. c. Outline Lozano's strengths and weaknesses as revealed by your analysis.
Lozano Chip Company: Balance Sheet as of December 31, 2019 (Thousands of Dollars)
Cash $ 225,000 Accounts payable
Receivables 1,575,000 Notes payable
Inventories 1,125,000 Other current liabilities
Total current assets $2,925,000 Total current liabilities
Net fixed assets 1,350,000 Long-term debt
Common equity
Total assets $4,275,000 Total liabilities and equity
$ 600,000
100,000
525,000
$1,225,000
400,000
2,650,000
$4,275,000
(3-14) Comprehensive
Ratio Analysis
Chapter 3 Analysis of Financial Statements 131
Lozano Chip Company: Income Statement for Year Ended December 31, 2019 (Thousands of Dollars)
Sales
Cost of goods sold
Selling, general, and administrative expenses
Earnings before interest and taxes (EBIT)
Interest expense
Earnings before taxes (EBT)
Federal and state income taxes (25%)
Net income
Ratio
Current assets/Current liabilities
Days sales outstanding (365-day year)
COGS/Inventory
Sales/Fixed assets
Sales/Total assets
Net income/Sales
Net income/Total assets
Net income/Common equity
Total debt/Total assets
Total liabilities/Total assets
Lozano
$7,500,000
6,375,000
933,000
$ 192,000
40,000
$ 152,000
38,000
$ 114,000
Industry Average
2.0
35.0 days
6.7
12.1
3.0
1.2%
3.6%
9.0%
10.0%
35.0%
The Jimenez Corporation's forecasted 2020 financial statements follow, along with some industry average ratios. Calculate Jimenez's 2020 forecasted ratios, compare them with the industry average data, and comment briefly on Jimenez's projected strengths and weaknesses.
Jimenez Corporation: Forecasted Balance Sheet as of December 31, 2020
Assets
Cash $ 72,000
Accounts receivable 439,000
Inventories 894,000
Total current assets $1,405,000
Fixed assets 431,000
Total assets $1,836,000
Liabilities and Equity
Accounts payable $ 332,000
Notes payable 100,000
Accruals 170,000
Total current liabilities $ 602,000
Long-term debt 404,290
Common stock 575,000
Retained earnings 254,710
Total liabilities and equity $1,836,000
132
(3-15) Build a Model: Ratio Analysis
resource
Part 1 The Company and Its Environment
Jimenez Corporation: Forecasted Income Statement for 2020
Sales
Cost of goods sold
Selling, general, and administrative expenses
Earnings before taxes (EBT)
Interest expense
Earnings before taxes (EBT)
Taxes (25%)
Net income
Jimenez Corporation: Per Share Data for 2020
EPS
Cash dividends per share
PIE ratio
Market price (average)
Number of shares outstanding
$4,290,000
$
$
$
3,580,000
525,456
184,544
40,000
144,544
36,136
108,408
$ 4.71
$ 0.95
5.0
$23.57
23,000
Ratio Jimenez Industry Average•
Quick ratio
Current ratio
Inventory turnoverb
Days sales outstanding<
Fixed assets turnoverh
Total assets turnoverb
Return on assets
Return on equity
Profit margin on sales
Debt-to-assets ratio
Liabilities-to-assets ratio
PIE ratio
Market/Book ratio
Notes:
'Industry average ratios have been stable for the past 4 years.
•sased on year-end balance sheet figures.
'Calculation is based on a 365-day year.
1.0
2.7
7.0
32.0 days
13.0
2.6
9.1%
18.2%
3.5%
21.0%
50.0%
6.0
3.5
Start with the partial model in the file Ch03 PlS Build a Model.xlsx from the textbook's Web site. Joshua & White (J&W) Technology's financial statements are also shown here. Answer the following questions. (Note: Industry average ratios are provided in Ch03 PlS Build a Model.xlsx.)
a. Has J&W's liquidity position improved or worsened? Explain. b. Has J&W's ability to manage its assets improved or worsened? Explain. c. How has J&W's profitability changed during the last year?
Chapter 3 Analysis of Financial Statements
d. Perform an extended DuPont analysis for J&W for 2018 and 2019. What do these results tell you?
e. Perform a common size analysis. What has happened to the composition (that is, percentage in each category) of assets and liabilities?
133
f. Perform a percentage change analysis. What does this tell you about the change in profitability and asset utilization?
Joshua & White Technology: December 31 Balance Sheets (Thousands of Dollars)
Assets
Cash
Short-term investments
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
2019 2018 Liabilities & Equity 2019
$ 21,000 $ 20,000 Accounts payable $ 33,600
3,759 3,240 Accruals 12,600
52,500 48,000 Notes payable 19,929
84,000 56,000 Total current liabilities $ 66,129
$ 161,259 $127,240 Long-term debt 67,662
223,097 200,000 Total liabilities $ 133,791
$384,356 $327,240 Common stock 178,440
Retained earnings 72,125
Total common equity $250,565
Total liabilities & equity $384,356
Joshua & White Technology: Income Statements for Year Ending on December 31 (Thousands of Dollars)
2019
Sales $420,000
COGS excluding depr. & amort. 300,000
Depreciation and amortization 19,660
Other operating expenses 27,600
EBIT $ 72,740
Interest expense 5,740
EBT $ 67,000
Taxes (25%) 16,750
Net income $ 50,250
Common dividends $ 18,125
Additions to retained earnings $ 32,125
Other Data 2019
Year-end stock price $ 90.00
Number of shares (Thousands) 4,052
Lease payment (Thousands of Dollars) $20,000
Sinking fund payment (Thousands of Dollars) $ 5,000
2018
$ 32,000
12,000
6,480
$ 50,480
58,320
$108,800
178,440
40,000
$218,440
$327,240
2018
$400,000
298,000
18,000
22,000
$ 62,000
4,460
$ 57,540
14,385
$ 34,524
$ 17,262
$ 17,262
2018
$ 96.00
4,000
$20,000
$ 5,000
134 Part 1 The Company and Its Environment
The first part of the case, presented in the previous chapter, discussed the situation of Computron Industries after an expansion program. A large loss occurred rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm's survival.
Jenny Cochran was brought in as assistant to Computron's chairman, who had the task of getting the company back into a sound financial position. Cochran must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions to take. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers. Use the recent and projected financial information shown next.
Balance Sheets (Millions of Dollars)
2018 2019 2020E
Assets Cash and equivalents $ 60 $ 50 $ 60 Short-term investments 100 10 50 Accounts receivable 400 520 530 Inventories 620 820 660 Total current assets $ 1,180 $1, 400 $1,300 Net fixed assets 2,900 3,500 3,700 Total assets $4,080 $4,900 $5,000
Liabilities and equity 2019 2020 2021E Accounts payable $ 300 $ 400 $ 330 Notes payable 50 250 100 Accruals 200 2 40 270
Total current liabilities $ 550 $ 890 $ 700 Long-term bonds 800 1,100 1,100 Total liabilities $1,350 $1,990 $1,800 Common stock (100,000 shares) 1,000 1,000 1,000 Retained earnings 1,730 1,910 2,200 Total common equity $2,730 $2,910 $3,200 Total liabilities and equity $4,080 $4,900 $5,000
Note: "E" denotes the "estimated forecast."
Income Statements (Millions of Dollars)
2018 2019 2020E
Net sales $5,500 $6,000 $6,600 Cost of goods sold (excluding depr.) 4,300 4,800 5,210
Depreciation 290 320 370 Other operating expenses 350 420 400
-- --- ---
Earnings before interest and taxes (EBIT ) $ 560 $ 460 $ 620
Less interest 68 108 100 -- --
Pre-tax earnings $ 492 $ 352 $ 520
Taxes (25%) 123 88 130 -- --
Net income $ 369 $ 26 4 $ 390
Note: "E" denotes the "estimated forecast." Also, Computron has no amortization.
0
Chapter 3 Analysis of Financial Statements
Other Data
Per Share Information
EPS
DPS
Book value per share
Additional Information
Dividends (millions)
Additions to retained earnings (millions)
Year-end shares outstanding (millions)
Year-end common stock price
Lease payments (millions)
Tax rate
Note: "E" denotes the "estimated forecast."
Ratio Analysis
Ratio 2018
Profit margin 6.7%
Operating profit margin 10.2%
Basic earning power 13.7%
ROA 9.0%
ROE 13.5%
Inventory turnover 7.4
Days sales outstanding 26.5
Fixed assets turnover 1.9
Total assets turnover 1.348
Current 2.1
Quick 1.0
Debt ratio 20.8%
Debt-to-equity ratio 0.31
Liabilities-to-assets ratio 33.1%
Earnings multiplier 1.5
TIE 8.2
EBITDA coverage 9.9
Price/earnings (P/E) 13.6
Market/book 1.8
Note: "E" denotes the "estimated forecast."
135
2018 2019 2020E
$ 3.69 $ 2.64 $ 3.90
$ 0.90 $ 0.84 $ 1.00
$27.30 $29.10 $32.00
$ 90 $ 84 $ 100
$ 279 $ 180 $ 290
100 100 100
$50.00 $30.00 $49.00
$ 20 $ 20 $ 20
25% 25% 25%
Industry
2019 2020E Average
4.4% 7.2%
7.7% 10.4%
9.4% 15.6%
5.4% 10.8%
9.1% 15.4%
6.2 9.0
31.6 28.0
1.7 3.0
1.224 1.5
1.6 2.5
0.7 1.4
27.6% 15.0%
0.46 0.22
40.6% 30.0%
1.7 1.5
4.3 13.0
6.3 17.2
11.4 16.8
1.0 2.6
a. Why are ratios useful? What three groups use ratio analysis and for what reasons? b. Calculate the projected profit margin, operating profit margin, basic earning power
(BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?
c. Calculate the projected inventory turnover, days sales outstanding (DSO), fixed as sets turnover, and total assets turnover. How does Computron's utilization of assets stack up against that of other firms in its industry?
136 Part 1 The Company and Its Environment
d. Calculate the projected current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company's liquidity position and its trend?
e. Calculate the projected debt ratio, debt-to-equity ratio, liabilities-to-assets ratio, times-interest-earned ratio, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you con clude from these ratios?
f. Calculate the projected price/earnings ratio and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?
g. Perform a common size analysis and percentage change analysis. What do these analyses tell you about Computron?
h. Use the extended DuPont equation to provide a breakdown of Computron's projected return on equity. How does the projection compare with the previous years and with the industry's DuPont equation?
i. What are some potential problems and limitations of financial ratio analysis? j. What are some qualitative factors that analysts should consider when evaluating a
company's likely future financial performance?
The following cases from Cengage Compose cover many of the concepts discussed in this chapter and are available at http://compose.cengage.com.
Klein-Brigham Series:
Case 35, "Mark X Company (A)," illustrates the use of ratio analysis in the evaluation of a firm's existing and potential financial positions; Case 36, "Garden State Container Corporation," is similar in content to Case 35; Case 51, "Safe Packaging Corporation," updates Case 36; Case 68, "Sweet Dreams Inc.," also updates Case 36; and Case 71, "Swan-Davis, Inc.," illustrates how financial analysis-based on both historical statements and forecasted statements-is used for internal management and lending decisions.
C
