Discussion 3 and problem set 3

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Analysis of Financial Statements

CHAPTER 3

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Topics in Chapter

Ratio analysis

Ratios

Common size statements

Percent change statement

DuPont equation

Limitations of ratio analysis

Qualitative factors

Determinants of Intrinsic Value: Using Ratio Analysis

Overview

Ratios facilitate comparison of:

One company over time

One company versus other companies

Ratios are used by:

Lenders to determine creditworthiness

Stockholders to estimate future cash flows and risk

Managers to identify areas of weakness and strength

Income Statement

	2019	2020E
Sales	$6,000	$6,600
COGS except depr.	4,800	5,210
Other expenses	320	370
Deprec.	420	400
EBIT	$ 460	$ 620
Int. expense	108	100
EBT	$ 352	$ 520
Taxes (40%)	88	130
Net income	$ 264	$ 390

Balance Sheets: Assets

	2019	2020E
Cash	$ 50	$ 60
S-T invest.	10	50
AR	520	530
Inventories	820	660
Total CA	$1,400	$1,300
Net FA	3,500	3,700
Total assets	$4,900	$5,000

Balance Sheets: Liabilities & Equity

	2019	2020E
Accts. payable	$ 400	$ 330
Notes payable	250	100
Accruals	240	270
Total CL	$ 890	$ 700
Long-term debt	1,100	1,100
Total liabilities	$1,990	$1,800
Common stock	1,000	1,000
Ret. earnings	1,910	2,200
Total equity	$2,910	$3,200
Total L&E	$4,900	$5,000

Other Data

	2019	2020E
EPS	$2.64	$3.90
DPS	$0.84	$1.00
Book value per share	$29.10	$32.00
Dividends	$84	$100
Number of shares	100	100
Year-end stock price	$30.00	$49.00
Lease payments	$20	$20
Tax rate	25%	25%

Profitability Ratios

What is the company’s rate of return on sales?

Profit margin

Operating profit margin

What is the company’s rate of return on assets?

Basic earning power

Return on assets

Return on equity

Profit Margin

Net profit margin (PM):

	2018	2019	2020E	Ind.
Profit Margin	6.7%	4.4%	5.9%	7.2%

Operating Profit Margin

Operating profit margin:

	2018	2019	2020E	Ind.
Profit Margin	10.2%	7.7%	9.4%	10.4%

Basic Earning Power (BEP)

Basic Earning Power vs. Industry Average

BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be below average.

Room for improvement.

	2018	2019	2020E	Ind.
Basic Earning Power	13.7%	9.4%	12.4%	15.6%

Return on Assets (ROA) and Return on Equity (ROE) (1 of 2)

Return on Assets (ROA) and Return on Equity (ROE) (2 of 2)

ROA and ROE vs. Industry Averages

	2018	2019	2020	Industry
ROA	9.0%	5.4%	7.8%	10.8%
ROE	13.5%	9.1%	12.2%	15.4%

Both below industry average but improving.

Effects of Debt on ROA and ROE

ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.

However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Asset Management Ratios

How efficiently does the firm use its assets?

How much does the firm have tied up in assets for each dollar of sales?

Inventory Turnover Ratio vs. Industry Average

	2018	2019	2020E	Ind.
Inventory turnover	7.4	6.2	8.5	9.0

Comments on Inventory Turnover

Inventory turnover:

Improved from previous year

Below industry average

DSO: average number of days from sale until cash received.

Appraisal of DSO

Higher than 2018, but a little lower than industry.

	2018	2019	2020E	Ind.
Days Sales Outstanding	26.5	31.6	29.3	28.0

Fixed Assets and Total Assets Turnover Ratios (1 of 2)

Fixed Assets and Total Assets Turnover Ratios (2 of 2)

Better than previous year.

Not up to industry average. Caused by high fixed assets relative to sales.

	2018	2019	2020E	Ind.
Fixed Asset Turnover	1.9	1.7	1.8	3.0
Total Asset Turnover	1.348	1.224	1.320	1.5

Liquidity Ratios

Can the company meet its short-term obligations using the resources it currently has on hand?

Forecasted Current and Quick Ratios

Comments on Current and Quick Ratios

	2018	2019	2020E	Ind.
Current	2.1	1.6	1.9	2.5
Quick	1.0	0.7	0.9	1.9

Expected to improve but still below the industry average.

Liquidity position is weak.

Debt Management Ratios

Does the company have too much debt?

Can the company’s earnings meet its debt servicing requirements?

Leverage Ratios: Debt Ratio

Leverage Ratios: Debt-to-Equity Ratio

Leverage Ratios: Liabilities-to-Assets Ratio

Leverage Ratios: Equity Multiplier

Equity multiplier = Total Assets

Common Equity

= $5,000

$3,200 = 1.5625

Times Interest Earned Ratio

EBITDA Coverage (EC)

Debt Management Ratios vs. Industry Averages

	2018	2019	2020E	Industry
Debt Ratio	20.8%	27.6%	24.0%	15.0%
Debt-to-equity	0.31	0.46	0.38	0.22
Liabilities-to-assets	33.1%	40.6%	36.0%	32.0%
Earnings Multiplier	1.49	1.68	1.56	1.47
Times Interest Earned	8.2	4.3	6.2	13.0
EBITDA Coverage Ratio	9.9	6.3	8.4	17.2

Improved, but more debt than industry

More risk than industry

Market Value Ratios

Market value ratios incorporate the:

High current levels of earnings and cash flow increase market value ratios

High expected growth in earnings and cash flow increases market value ratios

High risk of expected growth in earnings and cash flow decreases market value ratios

Calculate and appraise the Price/Earnings (P/E) ratio.

Price per share (P) = $49.00

Earnings per share (EPS) = $3.90

P/E = P/E = $49.00/$3.90 = 16.8

P/E: How much investors will pay for $1 of earnings. Higher is better.

Calculate and appraise the M/B ratio.

BVPS = Equity/ # Shares

= $3,200/100 = $32.00.

M/B = P/BVPS

M/B = $49.00/$32.00 = 1.53

M/B: How much paid for $1 of book value. Higher is better.

Comparison with Industry Averages

	2018	2019	2020E	Ind.
Price-to Earnings	13.6	11.4	12.6	16.8
Market-to-Book	1.8	1.0	1.5	2.7

The P/E ratio and the M/B ratio indicate that the market doesn’t value the company as highly as it does the average firm in industry.

Common Size Balance Sheets: Divide all items by Total Assets

Assets	2018	2019	2020E	Ind.
Cash	1.5%	1.0%	1.2%	1.5%
ST Inv.	2.5%	0.2%	1.0%	7.6%
AR	9.8%	10.6%	10.6%	13.2%
Invent.	15.2%	16.7%	13.2%	17.8%
Total CA	28.9%	28.6%	26.0%	40.0%
Net FA	71.1%	71.4%	74.0%	60.0%
TA	100.0%	100.0%	100.0%	100.0%

Divide all items by Total Liabilities & Equity

Liab. & Eq.	2018	2019	2020E	Ind.
AP	7.4%	8.2%	6.6%	6.8%
Notes pay.	1.2%	5.1%	2.0%	3.0%
Accruals	4.9%	4.9%	5.4%	10.2%
Total CL	13.5%	18.2%	14.0%	20.0%
LT Debt	19.6%	22.4%	22.0%	12.0%
Total Liab.	33.1%	40.6%	36.0%	32.0%
Total eq.	66.9%	59.4%	64.0%	68.0%
Total L&E	100.0%	100.0%	100.0%	100.0%

Analysis of Common Size Balance Sheets

Computron has higher proportion of net fixed assets than the industry.

Computron’s total debt is 24% (the combined percentages of notes payable and long-term bonds) of its assets, which is higher than the industry’s combined debt percentage of 20%.

Common Size Income Statement: Divide all items by Sales

2018	2019	2020E	Ind.
100.0%	100.0%	100.0%	100.0%
78.2%	80.0%	78.9%	69.0%
5.3%	5.3%	5.6%	3.3%
6.4%	7.0%	6.1%	17.3%
10.2%	7.7%	9.4%	10.4%
1.2%	1.8%	1.5%	0.8%
8.9%	5.9%	7.9%	9.6%
2.2%	1.5%	2.0%	2.4%
6.7%	4.4%	5.9%	7.2%

Sales

COGS

Depr.

Other exp.

EBIT

Int. Exp.

Pre-tax earn.

Taxes (25%)

Analysis of Common Size Income Statements

Computron’s profit margin is less than the industry ratio

Computron has lower Other Costs.

But… it has much higher costs of goods sold

Percentage Change Analysis: Cumulative Change from First Year (2018)

Income St.	2018	2019	2020E
Sales	0.0%	9.1%	20.0%
COGS	0.0%	11.6%	21.2%
Depr.	0.0%	10.3%	27.6%
Other exp.	0.0%	20.0%	14.3%
EBIT	0.0%	-17.9%	10.7%
Int. Exp.	0.0%	58.8%	47.1%
EBT	0.0%	-28.5%	5.7%
Taxes	0.0%	-28.5%	5.7%
NI	0.0%	-28.5%	5.7%

Analysis of Percent Change Income Statement

For 2019:

Sales grew by 9% in 2019.

Net income fell by 28.5%!

For 2020 projections:

Cumulative sales growth is 20%.

Cumulative net income growth is 5.7%

Improvement, but more work is needed

Cumulative Percentage Change: Assets

Assets	2018	2019	2020E
Cash	0.0%	-16.7%	0.0%
ST Invest.	0.0%	-90.0%	-50.0%
AR	0.0%	30.0%	32.5%
Invent.	0.0%	32.3%	6.5%
Total CA	0.0%	18.6%	10.2%
Net FA	0.0%	20.7%	27.6%
TA	0.0%	20.1%	22.5%

Cumulative Percentage Change: Liabilities & Equity

Liab. & Eq.	2018	2019	2020E
AP	0.0%	33.3%	10.0%
Notes pay.	0.0%	400.0%	100.0%
Accruals	0.0%	20.0%	35.0%
Total CL	0.0%	61.8%	27.3%
LT Debt	0.0%	37.5%	37.5%
Total eq.	0.0%	6.6%	17.2%
Total L&E	0.0%	20.1%	22.5%

Analysis of Percent Change Balance Sheets: 2019

Assets grew by 20.1% even though net income fell.

Much of the asset growth was in accounts receivable and inventories.

Not collecting on credit sales

Unsold product is piling up.

Growth was funded with big increase in debt.

Analysis of Percent Change Balance Sheets: Projections Compared with 2019

Small cumulative increase in 2020E total assets (22.5%) compared with 2019 change in total assets (20.1%)

But big reduction in cumulative inventory growth (6.5% in 2020E vs. 32.3% in 2019)

Big drop in cumulative notes payable growth in 2020E relative to notes payable growth in 2019.

Explain the Extended DuPont Equation

The DuPont equation focuses on:

Expense control (Profit margin, PM)

Asset utilization (Total asset turnover,TAT)

Debt utilization (Equity multiplier, EM)

It shows how these factors combine to determine the return on equity (ROE).

The Simple Version of the DuPont Equation

The Extended DuPont Equation

ROE: (Profit margin)(TA turnover)(EM)

ROE2018 = (6.7%)(1.348)(1.495) = 13.5%

ROE2019 = (4.4%)(1.224)(1.684) = 9.1%

ROE2020E = (5.9%)(1.320)(1.563) = 12.2%

ROEInd = (7.2%)(1.5)(1.47) = 15.9%

Potential Problems and Limitations of Ratio Analysis

Comparison with industry averages is difficult if the firm operates many different divisions.

Seasonal factors can distort ratios.

Window dressing techniques can make statements and ratios look better.

Different accounting and operating practices can distort comparisons.

Qualitative Factors

There is greater risk if:

revenues tied to a single customer

revenues tied to a single product

reliance on a single supplier?

High percentage of business is generated overseas?

What is the competitive situation?

What products are in the pipeline?

What are the legal and regulatory issues?

NI$390

Sales$6,600

PM5.9%.

===

EBIT$6

Sales$66

,00

.4%

===

EBIT

BEP

Total assets

$620

12.4%.

$5,000

ROA

Total assets

$390

7.8%.

$5,000

ROE

Common Equity

$390

12.2%.

$3,200

COGS

Inv. Turnover

Inventories

$5,210$370

8.5

$660

Receivables

DSO

Average sales per day

Receivables$530

Sales365$6,600365

29.3 days.

Sales

Fixed assets turnover

Net fixed assets

$6,600

1.8

$3,700

Sales

Total assets turnover

Total assets

$6,600

1.320.

$5,000

CA$1,200

CR1.9.

CL$700

CAInv.

$1,200$660

0.9.

$700

===

Total debt

Debt ratio

Total assets

$100$1,100

24.0%.

$5,000

Total debt

Debt-equity

Equity

$100$1,100

37.5%.

$3,200

Total liabilities

LiabilitiesTA ratio

Total assets

$1,800

$5,000

36.0%.

EBIT

TIE

Int. expense

$620

6.2

$100

EBITDepr. &Amort.Lease payments

Interest expenseL

$620$370$20

ease pmt.Loan

$100$0$0

t pm.

Net income

Equity

Net incomeT

otal assets

Total assetsEqu

ROE

ROEROAE

ity

=´

Net incomeTotal assets

Total assetsEquity

Net incomeSalesTotal assets

SalesTotal assetsEquity

Profit marginTotal asset turnoverEquity

multiplier

ROE

=´

=´´