CASE ASSIGNMENT
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Ch4-Financialstatementanalysis.pptxCh. 4: Financial Statement Analysis
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Know how to standardize financial statements for comparison purposes
Know how to compute and interpret important financial ratios
Know the limitations of ratio analysis
Objectives
Financial Statement Analysis
Involves
Benchmark (peer)Analysis:
Comparing firm’s performance with others in the same industry
Trend Analysis:
Evaluating trends in the firm’s financial position over-time
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Financial Statement Analysis
Tools
1. Standardized statements
Common size balance sheet
Divide by total assets
Common size income statement
Divide by sales
2. Ratios
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- Differences in size create problems (time-series and cross-sectional)
- Currency
-We standardize by using percentages
- Ratios: problem--> people compute and use differently
– how computed, intended measure, unit, high/low values, improved?
- What can the company do to affect ratios and how might this affect other ratios?
Common Size Balance Sheet
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- Differences in size create problems (time-series and cross-sectional)
- Currency
-We standardize by using percentages
- Ratios: problem--> people compute and use differently
– how computed, intended measure, unit, high/low values, improved?
- What can the company do to affect ratios and how might this affect other ratios?
Common Size Income Statement
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Ratios also allow for better comparison through time or between companies
As we look at each ratio, ask yourself:
How is the ratio computed?
What is the ratio trying to measure and why?
What is the unit of measurement?
What does the value indicate?
How can we improve the company’s ratio?
Ratio Analysis
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Ratio Categories
Short-term solvency or liquidity ratios
Long-term solvency, or financial leverage ratios (capital structure ratios)
Asset management or turnover ratios
Profitability ratios
Market value ratios
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Liquidity ratios- firms ability to pay bills over the short run
Long-term solvency – financial leverage
Asset management (turnover) ratios – how efficient is firms use of assets to generate sales
Profit- how efficient does firm use assets to generate profits
Market value ratios – use market price of stock
Not just computing ratios… trying to make better decisions!
Liquidity Ratios
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First…liquidity (house selling for $1)
Current ratio: usually think higher the better (current assets and liabilities should be converted to cash within next year)
- could mean inefficient use of cash
- long term things have an effect (long term debt increases current cash)
- liquid assets generally less profitable
- think back to WSJ article
Quick ratio: inventory usually least liquid current asset and quality may not be known
Suppose CR stays the same and QR goes down
- Not increasing current assets…if liabilities come due could be an issue
– Large levels of inventory have accumulated (should look into inventory)
Inventory turnover ratio measures how many times the company turns over its inventory during the year.
Days’ Sales Outstanding
Asset Management Ratio
Fixed Asset Turnover Ratio measures how effectively the firm uses its plant and equipment.
Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in the firm’s assets.
Asset Management Ratio
Debt ratio measures the proportion of the firm’s assets that were financed using current plus long-term liabilities.
Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the interest on debt.
Capital Structure Ratios
Debt/Equity ratio is calculated by dividing Total Debt by Total Equity.
Equity Multiplier
Capital Structure Ratios
Profit Margin measures operating income, or EBIT, per dollar of sales
Basic Earning Power (BEP) Ratio indicates the ability of the firm’s assets to generate operating income.
Profitability Ratios
Return on Total Assets (ROA)
Return on Equity (ROE)
Profitability Ratios
Price/Earning Ratio(P/E) shows how much investors are willing to pay per dollar of earning
Market to Book Ratio (M/B)
Market Value Ratios
DuPont Equation
ROE = NI / TE
Multiply by 1 and then rearrange:
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrange:
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
= Profit Margin * Total Asset Turnover * Equity Multiplier
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Popularized by Du Pont Corporation
ROE is affected by 3 things:
1) operating efficiency (profit margin)
2) asset use efficiency (total asset turnover)
3) financial leverage (equity multiplier)
DuPont Identity
ROE = PM * TAT * EM
Profit margin
Operating efficiency
How well it controls costs
Total asset turnover
Asset use efficiency
How well it manages its assets.
Equity multiplier
Financial leverage
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Benchmark
Trend Analysis
Peer Group Comparisons
Standard Industrial Classification (SIC) Codes
North American Industry Classification System (NAICS)
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Sample ratios: Molson Coors
From Reuters
Management Effectiveness
Company Industry Sector S&P 500
Return on Assets (TTM) 3.89 1.13 1.19 6.89
Return on Assets - 5 Yr. Avg. 3.66 3.87 4.13 8.12
Return on Investment (TTM) 4.35 1.45 1.76 9.65
Return on Investment - 5 Yr. Avg. 4.40 5.74 6.06 11.00
Return on Equity (TTM) 6.61 2.16 3.65 20.90
Return on Equity - 5 Yr. Avg. 7.30 8.22 8.88 19.96
From Hoovers
Profitability Company Industry Market
Gross Profit Margin 40.50% 54.88% 28.77%
Pre-Tax Profit Margin 10.79% 18.51% 8.48%
Net Profit Margin 8.13% 12.51% 5.53%
Return on Equity 5.9% 16.7% 10.1%
Return on Assets 3.3% 6.5% 1.5%
Ret on Invested Capital 4.5% 9.1% 4.4%
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Potential Problems with Ratio Analysis
No underlying theory
No way to know which ratios are most relevant
Benchmarking is difficult
Especially for diversified firms
Globalization and international competition makes comparison more difficult
Differences in accounting regulations
Firms use varying accounting procedures
Firms have different fiscal years
Extraordinary, or one-time, events
Mixed signals
Relies on historical data
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Conglomerates
Trump case: Marvin Roffman sued when he questions Trump Taj Majal (1990)
New issues: Internet and information
s
liabilitie
Current
assets
Current
Ratio
Current
=
s
Liabilitie
Current
Inventory
-
Asset
Current
Ratio
(Quick)
Test
-
Acid
=
=
Cost of Goods Sold
Inventory Turnover
Inventories
Sales/365
Annual
s
Receivable
day
per
Sales
Average
s
Receivable
g
outstandin
sales
Days
=
=
Assets
Total
Sales
Ratio
Turnover
Assets
Total
=
Assets
Fixed
Net
Sales
Ratio
Turnover
Assets
Fixed
=
=
Total Liabilities
Debt Ratio
Total Assets
=
Times Interest
Net Operating Income or EBIT
EarnedInterest Expense
TE
TD
Ratio
Equity
Debt to
=
E
D
+
=
=
1
TE
TA
Multiplier
Equity
Sales
EBIT
Margin
Operating
=
Assets
Total
EBIT
BEP
=
Assets
Total
Income
Net
ROA
=
Equity
Total
Income
Net
ROE
=
share
per
Earning
share
per
Price
P/E
=
share
per
Book value
share
per
price
Market
M/B
=
