finance notes
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finance notes

Course: FINA 365, Spring 2012

School: South Carolina

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Outline Lecture 6 Lecture Organization Standardized Financial Statements Ratio Analysis Things to Consider When Using Financial Ratios Firm performance can be measured along a number of dimensions expressed through ratios what aspect of the firm or its operations are we attempting to analyze? Time-series analysis? analysis? Cross-sectional Categories of Financial Ratios Short-Term Solvency, or...

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6 Lecture Outline Lecture Organization Standardized Financial Statements Ratio Analysis Things to Consider When Using Financial Ratios Firm performance can be measured along a number of dimensions expressed through ratios what aspect of the firm or its operations are we attempting to analyze? Time-series analysis? analysis? Cross-sectional Categories of Financial Ratios Short-Term Solvency, or Liquidity Ability to pay bills in the short-run Long-Term Solvency, or Financial Leverage Ability to meet long-term obligations (Ability to pay long-term debt) Asset Management, or Turnover Intensity and efficiency of asset use Ex) sales / total assets Profitability The ability to control expenses Ex) Net income / total assets Difference between asset management and profitability is that that profitability takes in the ability to control costs and expenses. Hermetic, Inc. Balance Sheet as of December 31 ($ in thousands) Assets 2005 2006 Current assets Cash $ 45 $ 50 Accounts receivable 260 310 Inventory 320 385 Total Fixed assets Net plant and equipment Total assets $ 625 985 1100 $1610 $1845 $ 745 Hermetic, Inc. Balance Sheet (concluded) Liabilities and equity 2005 2006 $ 210 110 $ 260 175 $ 320 Current liabilities Accounts payable Notes payable Total Long-term debt 205 225 Stockholders equity Common stock and paid-in surplus Retained earnings Total 290 795 $1085 290 895 $1185 Total liabilities and equity $1610 $1845 $ 435 Income Statement ($ in thousands) Net sales $710.00 Cost of goods sold 480.00 Depreciation 30.00 Earnings before interest and taxes (EBIT) $200.00 Interest 20.00 Taxable income 180.00 Taxes 53.45 Net income $126.55 Dividends 26.55 Addition to retained earnings $100.00 Common Financial Ratios A. Short-Term Solvency, or Liquidity, Ratios 1. Current ratio Current Assets/Current liabilities Hermetic(05 06): $625/320= 1.95 $745/$435=1.71 The liquidity of this company is worsening because current liabilities is growing a lot faster then the current assets. (least conservative) 2. Quick ratio (Current Assets - inventory)/Current liabilities Hermetic (05 06): .95 .83 The liquidity situation has worsened 3. Cash ratio Cash/Current liabilities Common Financial Ratios A. Short-Term Solvency, or Liquidity, Ratios (continue) 4. NWC (CA-CL)/Total assets Hermetic (05 06): $ (625-320)/ 1610= 19% $(745-435)/ $1845= 17% 5. Interval measure Current assets/ (Average daily operating costs) Hermetic: $ 7($480/365)= 566.5 days Common Financial Ratios B. Long-Term Solvency Measures 1.Total Debt Ratio Debt/(Total assets) Hermetic (05 06): 33% $660/$1845=36% 2. Debt/Equity = (Total Debt)/Total equity -Total assets is always higher then total equity! 3. Equity multiplier = Total assets/Total equity = 1+ debt/ total equity Common Financial Ratios B. Long-Term Solvency Measures 4. Times Interest Earned (TIE) EBIT/Interest Hermetic: $200/ $20= 10 times 5. Cash Coverage (EBIT + Depreciation)/Interest Hermetic: $ (200 + 30)/$20=11.5 times Common Financial Ratios C. Asset Management, Turnover, or Ratios 1. Total Asset Turnover Total asset turnover = Sales/Total assets q Hermetic: $710/ $1845= .385 times Common Financial Ratios D. Profitability Measures (based upon book values, not market values) 1. Profit margin Net income/Sales: Hermetic:$ 126.55/$710=17.8% 2. Return on Assets Net income/Total assets Hermetic: $126.55/$1845=6.8% 3. Return on Equity Net income/Total equity Hermetic:$126.55/$1185= 10.7% Common Financial Ratios (concluded) E. Market Value Ratios Price-earnings ratio = price per share earnings per share Market-to-book ratio =market value per share book value per share The Du Pont Identity 1. Return on equity (ROE) can be decomposed as follows: ROE = Net income/Total equity = net income/ total equity x total assets/ total assets = net income/ total assets x total assets/ total equity = ROA x Equity multiplier 2. Return on assets (ROA) can be decomposed as follows: ROA = Net income/Total assets x Sales/ Sales = net income/ sales x sales/ total assets = profit margin x total asset turnover The Du Pont Identity (concluded) 3. Putting it all together gives the Du Pont identity: ROE = ROA x Equity multiplier = profit margin x total asset turnover x equity multiplier 4. Profitability (or the lack thereof!) thus has three parts: operating efficiency asset use efficiency financial leverage Total asset turnover told you how efficient your use of assets were Financial leverage tells you how much you are able to borrow Categories of Financial Ratios Too many categories? These categories can be thought of as the financial dimensions of the firm, which are analogous to the physical dimensions of an object (shape, weight, color, smell) Common Financial Ratios A: Why Evaluate Financial Statements? Financial ratios are red flags, and a good analyst will use them to determine what to investigate further Common Financial Ratios B: Who Uses Financial Ratios? qinvestors, stockholders, financial analysts, credits, the company itself q internal uses- evaluating performance, spotting trouble, generating projections qExternal uses- making credit decisions, evaluating competitors, assessing acquisitions C. Why to Choose a Benchmark? q understanding the trend: changing business q identifying a peer groups: basis for Common Financial Ratios D. Problems with Financial Statement Analysis no underlying financial theory q problem in finding comparable firms q what to do with conglomerates, multidivisional firms q differences in accounting practices q differences in capital structure qSeasonal variations, one time events q Common Financial Ratios Example: Suppose a firms Current Ratio (CR) is significantly lower than the industry norm. What questions might one ask? 1. What are the firms S-T borrowing policy? The industrys average? 2. Has the CR been trending downward? 3. Is this aberration? 4. What contributes most to the low CR? 5. Is this an industry wide phenomenon? Economy wide? q Thorough analyst will consider numerous questions like these in making a final determination about the firms ability to manage its short-term borrowing.

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