FIN 534 Financial Management
EVReid
LiquidityRatio.pptx
FIN 534 – FINANCIAL MANAGEMENT
with
Dr. charity ezenwa
WELCOME
1
Chapter 3:
ANALYSIS OF FINANCIAL STATEMENTS
WEEK 2
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Course Learning Outcome(s)
Analyze financial statements for key ratios, cash flow positions, and taxation effects.
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Topics
Ratio analysis
DuPont equation
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
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Why Financial Statement Analysis?
To facilitate comparison of:
One company over time
One company versus other companies
Uses: How can stakeholders benefit and why?
Lenders to determine creditworthiness
Stockholders to estimate future cash flows and risk
Managers to identify areas of weakness and strength
Financial statement analysis involves (1) comparing a firms; performance with that of the other firms in the same industry; and (2)Evaluating trends in the firm’s financial position over time.
Financial statement analysis is used by managers to identify situations needing attention. Potential lenders use financial statement analysis to determine whether a company is credit worthy, and stockholders use it to help them predict future earnings, dividends, and free cash flow.
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Ratio Analysis
Used to extract information not obvious from simply examining financial statements.
Provides standardized comparison of firms
Example: Giant owes $10 million in debt while Safeway owes $20 million in debt. Which firm has a stronger financial position?
It is very difficult to answer this question without first determining each company's debt relative to its assets, earnings, and interests. Ratio analysis allows us to standardize these debts so as to easily compare the two forms.
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The Income Statement Example
| 2016 | 2017E | |
| Sales | $5,834,400 | $7,035,600 |
| COGS except depr. | 4,980,000 | 5,800,000 |
| Other expenses | 720,000 | 612,960 |
| Deprec. | 116,960 | 120,000 |
| Tot. op. costs | 5,816,960 | 6,532,960 |
| EBIT | 17,440 | 502,640 |
| Int. expense | 176,000 | 80,000 |
| EBT | (158,560) | 422,640 |
| Taxes (40%) | (63,424) | 169,056 |
| Net income | ($ 95,136) | $ 253,584 |
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The Balance Sheet – Assets Example
| 2016 | 2017E | |
| Cash | $ 7,282 | $ 14,000 |
| S-T invest. | 20,000 | 71,632 |
| AR | 632,160 | 878,000 |
| Inventories | 1,287,360 | 1,716,480 |
| Total CA | 1,946,802 | 2,680,112 |
| Net FA | 939,790 | 836,840 |
| Total assets | $2,886,592 | $3,516,952 |
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The Balance Sheet – Liabilities & Equity
| 2016 | 2017E | |
| Accts. payable | $ 324,000 | $ 359,800 |
| Notes payable | 720,000 | 300,000 |
| Accruals | 284,960 | 380,000 |
| Total CL | 1,328,960 | 1,039,800 |
| Long-term debt | 1,000,000 | 500,000 |
| Common stock | 460,000 | 1,680,936 |
| Ret. earnings | 97,632 | 296,216 |
| Total equity | 557,632 | 1,977,152 |
| Total L&E | $2,886,592 | $3,516,952 |
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Other Data
| 2016 | 2017E | |
| Stock price | $6.00 | $12.17 |
| # of shares | 100,000 | 250,000 |
| EPS | -$0.95 | $1.01 |
| DPS | $0.11 | $0.22 |
| Book val. per sh. | $5.58 | $7.91 |
| Lease payments | $40,000 | $40,000 |
| Tax rate | 0.4 | 0.4 |
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What are Liquidity Ratios?
Measures a company’s ability to meet its short-term obligations.
Current Ratio
= Current assets / Current liabilities
The Quick Ratio or Acid test
= (Current assets – Inventory) / Current liabilities
Take a few minutes to calculate the CR and QR using the data given.
Take a few minutes to calculate the liquidity ratios with the data from Financial statement sample 2
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Liquidity Ratios
| 2015 | 2016 | 2017E | Ind. | |
| Current | 2.3 | 1.46 | 2.58 | 2.7 |
| Quick | 0.8 | 0.5 | 0.93 | 1.0 |
Is the company able to meet its short term obligations?
Given the information form the sample financial statements we have, can the company meet its short-term obligations using the resources it currently has on hand?
What other information will you need to make easy comparison with other firms?
Industry data!!!
Analysis: Given the following current and quick ratios for the years 2015 to 2017, as well as the the industry average, what can you say about the company’s liquidity position?
Expected to improve but still below the industry average.
Liquidity position is weak
So, can the company meet its short term obligations?
The company will struggle to meet its short term obligations. Since Quick ratio is less than 1, it means that inventories will have to be liquidated to meet obligations should need arise.
It also depends on who is asking the question.
Creditors like to see a high current ratio. Example: if a company is experiencing financial difficulty, it will be borrowing more and increasing its liability. When liabilities grow higher than the assets, CR will be low. So creditors like to see high CR to show a strong asset base than liability.
Stockholders: high CR may mean that the firm has a lot of money tied up in an unproductive assets such as excess cash or marketable securities. Or may be due to high inventory which may become obsolete before it can be sold. So shareholders might not want high CR.
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Asset Management/Efficiency Ratios
How effectively does the firm use its assets?
How much does the firm have tied up in assets for each dollar of sales?
A
B
The asset management ratio measures how effectively a firm is managing its assets. If a company has excessive investments in assets, its operating capital is unduly high, which reduces its Free cash Flow, and ultimately the stock price. On the other hand, if a firm does not have enough investments in assets, it may lose sales which will hurt profitability. This will in turn hurt FCF and the stock price.
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Asset Management Ratios
Inventory turnover ratio: How many times inventories are sold out and restocked in a year.
= COGS/Inventories
Days sales outstanding (DSO): The average collection period
= Receivables / Average sales per day
= Receivables / (Annual sales/365)
Total assets turnover ratio: Dollars in sales generated for each dollar tied up in assets:
= Sales / Total assets
Fixed assets turnover ratio: How effectively the firm uses its plants and equipment:
=Sales / Net fixed assets
So, take a few minutes and calculate the asset management ratios using data from the financial statement sample 2.
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Inventory Turnover Ratio
Inv. Turnover =
= = 3.45.
COGS
Inventories
$5,800 + $120
$1,716
| 2015 | 2016 | 2017E | Ind. | |
| Inventory turnover | 4.03 | 3.96 | 3.45 | 6.10 |
COGS = Cost of goods sold except depreciation + depreciation
Comments:
Inventory turnover is below industry average.
The firm is holding too much inventory
Firm might have old inventory, or its control might be poor.
No improvement is currently forecasted.
How does that affect shareholder Value?
High levels of inventory add to net operating working capital (NOWC), which reduces FCF, which in turn lowers stock prices.
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Days Sales Outstanding (DSO)
DSO, also called Average Collection Period, evaluates receivables.
DSO =
= =
= 45.5 days.
Receivables
Average sales per day
$878
$7,036/365
Receivables
Sales/365
DSO measures the average length of time the firm must wait after making sales before receiving cash.
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Appraisal of DSO
How can you appraise the company’s receivables?
| 2015 | 2016 | 2017E | Ind. | |
| Days Sales Outstanding | 37.4 | 39.5 | 45.5 | 32.00 |
The DSO is greater than the industry average. This means that their customers are not paying their bills on time.
Firm collects too slowly, and situation is getting worse.
Poor credit policy
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Fixed Assets & Total Assets Turnover Ratio
FA: Effective use of firm’s plants & equipment
TA: Dollar in sales generated for each dollar tied up in assets.
Fixed assets
turnover
Sales
Net fixed assets
=
= = 8.41.
$7,036
$837
Total assets
turnover
Sales
Total assets
$7,036
$3,517
= 2.00
=
=
Fixed assets turnover ratio measures how effectively the firm uses its plants and equipment.
The total assets turnover ratio measures the dollar in sales that are generated for each dollar tied up in assets.
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Debt Management Ratios
Leverage ratios: How the firm is financed
Debt-to-assets ratio
Debt-to-equity ratio
Market debt ratio
Times-interest-earned ratio: Ability to pay interest
EBITDA coverage ratio: Ability to service debt
Goal of the DM ratios: Provide answers to these qtns:
1. Does the company have too much debt?
2. Can the company’s earnings meet its debt servicing requirements?
The debt management ratios try to answer two questions:
1. Does the company have too much debt?
2. Can the company’s earnings meet its debt servicing requirements?
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Leverage Ratios: Debt Ratio
The % of assets financed by debts
Debt–to-assets ratio = Debt ratio
Debt ratio = Total debt / Total assets
= ($300 + $500) / $3,517 = 22.7%
Debt ratio shows if the firm has enough assets to pay its liabilities in case of bankruptcy.
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Leverage Ratios: Liabilities-to-Assets Ratio
The extent to which a firm’s assets are not supported by equity
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Times-Interest-Earned Ratio
Ability to pay interest.
TIE = EBIT / Interest Expense
TIE = $502.6 / $80 = 6.3
TIE answers the question:
Is the firm’s earnings large enough to satisfy interest payments?
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EBITDA Coverage Ratio (EC)
Ability to service debt
Note that depreciation and amortization were removed from EBITDA when calculating EBIT, so they must be added back. Also, lease payments were excluded from EBIT, so must be added back.
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Debt Management Ratios - Interpretation
| 2015 | 2016 | 2017 | Industry | |
| Debt Ratio | 35.6% | 59.6% | 22.7% | 32.0% |
| Liabilities-to-assets | 54.8% | 80.7% | 43.8% | 50.0% |
| Times Interest Earned | 3.35 | 0.10 | 6.28 | 6.20 |
| EBITDA Coverage Ratio | 2.61 | 0.81 | 5.52 | 8.00 |
Lower than the industry average except Times interest earned. Interest is covered 6.26 times (Well above 1) above industry average. Good.
The company seems to have relatively high level of debt. All other debt management ratios are below industry average. Short term lenders such as banks (loans for about 5 years) consider EBITDA most often.
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Profitability Ratios
The overall effects of liquidity, asset management, and debt on operating results (in %).
Profit Margin (PM)
= Net Income / Sales
Basic Earning Power (BEP)
= EBIT / Total Assets
Return on Total Assets (ROA)
= Net Income / Total Assets
Return on Common Equity (ROE)
= Net Income / Common Equity
Profitability ratios answers the question:
What is the company’s rate of return on:
Sales?
Assets?
ROE is the most important profitability ratio because it is considered the bottom line – has to the do with shareholders’ value.
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Profit Margin (PM)
PM shows profit per dollar of sales.
OPM shows result of operations before the impact of interests and taxes.
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Profit Margin (PM) Continued.
Gross Profit Margin (GPM) shows gross profit per dollar of sales before any other expenses are deducted.
GPM = (Sales – COGS) / Sales
GPM = ($7,036 - $5,800) / $7,036
GPM = $1,236 / $7,036
GPM = 17.6%
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Profit Margin - Interpretation
What can you say about the profit margin?
| 2015 | 2016 | 2017E | Industry | |
| Net Profit Margin | 2.6% | -1.6% | 3.6% | 3.6% |
| Operating Margin | 6.1% | 0.3% | 7.1% | 7.1% |
| Gross Profit Margin | 16.6% | 14.6% | 17.6% | 15.5% |
Very bad in 2016, but projected to
Meet or exceed industry average in 2017.
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Basic Earning Power (BEP)
Shows the raw earning power of the firm’s assets before tax and interest.
BEP = EBIT / Total Assets
BEP = $502.6 / $3,517= 14.3%.
Analysis of BEP
| 2015 | 2016 | 2017E | Ind. | |
| Basic Earning Power | 14.2% | 0.6% | 14.3% | 17.8% |
BEP removes effect of taxes and financial leverage. Useful for comparison.
Projected to be below average. It is not getting as high return on its assets as the average company in the industry.
Room for improvement.
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Return on Assets and Return on Equity
ROA = Net Income / Total Assets = $253.6 / $3,517
ROA = 7.2%
ROE = Net Income / Common Equity
ROE = $253.6 / $1,977 = 12.8%
Analysis of ROA & ROE
| 2015 | 2016 | 2017E | Industry | |
| Return on Assets | 6.0% | -3.3% | 7.2% | 9.0% |
| Return on Equity | 13.3% | -17.1% | 12.8% | 18.0% |
Both below industry average but improving.
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What is the Effect of Debt on ROA & 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
Debt increases interest, interest decreases net income which lowers ROA.
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Market Value Ratios
Measure the value of a company’s stock relative to that of another company.
Investor’s perception of past performance and future prospects.
Price / Earning Ratio (P/E)
Price / Cash Flow Ratio
Market / Book Ratio
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Market Value Ratios Continued
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
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Price Earning Ratio (P/E)
Shows how much investors are willing to pay per dollar of reported profit.
P/E ratio = Price per share / Earnings per share
Where EPS = NI / shares outstanding = $1.01
Price = $12.17
P/E = $12.17 / $1.01 = 12x
It means investors are willing to pay up to $12 for each dollar of earning.
A higher P/E ratio means that investors must see something good about the company to be willing to pay higher for a dollar of earning.
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Price / Cash Flow Ratio (P/CF)
Stock prices depend on the company’s ability to generate cash flows.
P/CF ratio = price per share/Cash flow per share
Cash flow per share = (NI + Depr.) / Shares Outstanding
= ($253.6 + $120.0) / 250 = $1.49
P/CF ratio = $12.17/$1.49 = 8.2
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Market / Book Ratio (M/B)
How much paid for $1 of book value. Higher is better
M/B ratio = Market price per share
Book value per share (BVPS)
BVPS = Total common equity
Shares outstanding
BVPS = = $1,977 / 250 = $7.91
M/B = $12.17 / 7.91
M/B = 1.54
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Market Value Ratios - Interpretation
| 2015 | 2016 | 2017E | Ind. | |
| Price-to Earnings | 9.66 | -6.31 | 12.00 | 14.20 |
| Price-to-Cash Flow | 7.95 | 27.49 | 8.14 | 7.60 |
| Market-to-Book | 1.28 | 1.08 | 1.54 | 2.90 |
Recall market value ratios:
Measure how the market values a company’s stock relative to that of another company.
Investor’s perception of past performance and future prospects.
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 (although P/CF indicates opposite.
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Trend Analysis, Common Size & Percentage Change Analysis
Trend Analysis:
Examine a ratio over time
Common Size Analysis: Divide all items in balance sheet by total assets.
Divide all items in income statement by total sales.
Compare in percentages with industry
Percentage Change analysis
Calculate growth rates for all I.S and B.S items relative to a base year.
See excel worksheet..
Trend analysis: Gives clue if financial condition is likely to improve or deteriorate
Common size analysis: Compares B.S & I.S over time and across companies.
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The DuPont Equation
Breaks down ROE into 3 parts:
Is Management successful in making profit through sales?
Profit Margin
How does the firm manage its assets?
TA Turnover
Is management able to manage borrowing or its equity with its assets to make profit
Equity Multiplier
It shows if management is successful in making profit through its sales (profit margin).
How it manages its assets (TA turnover)
If mgt is able to manage borrowing or its equity with its assets to make profit (Equity multiplier)
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The DuPont Equation
ROE =
2015: 2.6% x 2.3 x 2.2 = 13.2%
2016: -1.6% x 2.0 x 5.2 = -16.6%
2017E: 3.6% x 2.0 x 1.8 = 13.0%
Ind.: 3.6% x 2.5 x 2.0 = 18.0%
The equation ties these 3 parts together and provides a comprehensive understanding of how managerial actions relating to profitability, asset efficiency, and financial leverage interact to determine the return on equity.
To understand ROE, each part of the equation must be understood.
Managers can use the DuPont equation for different what-if scenarios. Example, if it should implement lean production and increase assets turnover, how would that affect ROE?
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Potential Problems / 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
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Looking Beyond the Numbers
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?
Sound financial analysis involves more than just calculating ratios and comparing them. Always dig deep and consider qualitative factors as above.
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Questions
???
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References
Brigham, E. & Ehrhardt, M. (2014). Financial Management: Theory and Practice (15th ed.). Boston, MA: Cengage Learning.
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Investment in Assets
Operating capital
FCF Stock Price
Investment
in Assets
Operating
capital
FCF
Stock
Price
Investment in Assets
Sales profitability FCF Stock Price
Investment
in Assets
Salesprofitability
FCFStock Price
( Profit Margin )( TA Turnover ) ( Equity Multiplier ) = ROE NI Sales TA
Sales TA CE X X = ROE
(
Profit
Margin
)(
TA
Turnover
)(
Equity
Multiplier
)=
ROE
NI Sales TA
Sales TA CE
X X
=
ROE
