Chapter_3_financial_ratio_analysis - Lecture 3 Financial Ratio Analysis 1 Learning Goals 1 2 3 Understand who uses financial ratios and how Use ratios

Chapter_3_financial_ratio_analysis - Lecture 3 Financial...

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Unformatted text preview: Lecture 3 Financial Ratio Analysis 1 Learning Goals 1. 2. 3. Understand who uses financial ratios, and how. Use ratios to analyze a firm’s liquidity and activity. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt. 4. Use ratios to analyze a firm’s profitability and market value. 5. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis. 6. Understand limitations of financial ratio analysis 2 Learning Goals 7. Understand the financial planning process, including long-term (strategic) financial plans and short-term (operating) plans. 9. Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget. 3 Four Key Financial Statements Income Statement Balance Sheet Statement of Retained Earnings Statement of Cash Flows 4 Income Statement The income statement provides a financial summary of a company’s operating performance during a specified period . Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes. 5 Table 2.1 Bartlett Company Income Statements ($000) 6 SALES Income Statement - Cost of Goods Sold GROSS PROFIT - Operating Expenses (marketing,administrative,lease) OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends NET INCOME (Earnings distributable to common stockholders) 7 SALES - Cost of Goods Sold Income Statement GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends NET INCOME (Earnings distributable to common stockholders) 8 SALES - Cost of Goods Sold Income Statement GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends NET INCOME (Earnings distributable to common stockholders) 9 Preferred Shareholder Has a higher claim on the asset and average than C. stockholder Has a dividend that must be paid over before dividend to C.stockholders. Usually do not have voting rights Normally pay dividend with fixed interval Consider fixed income security Cons: give up voting right, cannot enjoy higher income when company make more profits. 10 Balance Sheet The balance sheet presents a summary of a firm’s financial position at a given point in time . Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed. 11 Table 2.2 Bartlett Company Balance Sheets ($000) 12 13 Balance Sheet Total Assets = Outstanding Debt + Shareholders’ Equity 14 Balance Sheet 15 Balance Sheet Assets Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Buildings and Land Other Assets Investments & patents Goodwill, Brand name Liabilities (Debt) & Equity Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term loans Bonds Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings 16 Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Net book value (NBV) = Cost – Accumulated Depreciation Other Assets: any asset that is not a current asset or fixed asset. Intangible assets, such as purchased goodwill, patents and copyrights. 17 Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. Long-term debt: loans from banks or other sources that lend money for longer than 12 months, corporate bonds issued. 18 Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid. 19 Statement of Retained Earnings The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings. 20 Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2009 21 Statement of Cash Flows The statement of cash flows is part of the financial statements issued by a business, and describes the cash flows into and out of the business. Its particular focus is on the types of activities that create and use cash. There can be significant differences between the results shown in the income statement and the cash flows in this statement, for the following reasons: 22 Statement of Cash Flows a)There are timing differences between the recordation of a transaction and when the related cash is actually expended or received. (exp: depreciation expenses) b)Management may be using aggressive revenue recognition to report revenue for which cash receipts are still some time in the future. (exp:accrual revenue revenue is recognized b4 cash is received) 23 Statement of Cash Flows Many investors feel that the statement of cash flows is the most transparent of the financial statements (i.e., most difficult to fudge), and so they tend to rely upon it more than the other financial statements to reflect the true performance of a business. Cash flows in the statement are divided into the following three areas: operating activities, investing activities and financing activities 24 Statement of Cash Flows Operating activities. These constitute the revenue-generating activities of a business. Examples of operating activities are cash received and disbursed for product sales, royalties, commissions, fines, lawsuits, supplier and lender invoices, and payroll. Investing activities. These constitute payments made to acquire long-term assets, as well as cash received from their sale. Examples of investing activities are the purchase of fixed assets and the purchase or sale of securities issued by other entities. Financing activities. These constitute activities that will alter the equity or borrowings of a business. Examples are the sale of company shares, the repurchase of shares, and dividend 25 payments. Statement of Cash Flows Cash flow statement require us to present the cash flow information that is directly associated with the items triggering cash flows, such as: Cash collected from customers Interest and dividends received Cash paid to employees Cash paid to suppliers Interest paid Income taxes paid 26 Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. Tools that help us determine the financial health of a company. It is of interest to shareholders, creditors, and the firm’s own management. 27 Using Financial Ratios: Types of Ratio Comparison We can compare a company’s financial ratios with its ratios in previous years (trend or time-series analysis). We can compare a company’s financial ratios with those of different firms (its competitors or industry average) at the same point in time (cross-sectional analysis). Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis. 28 Financial Ratio Analysis Are our decisions maximizing shareholder wealth? 29 Financial Ratio Analysis 1.Profitability Ratios Measure of financial performance of a company 2.Liquidity Ratios Enable user to measure of financial position of a company in the S/T It is including whether or not a company able to settle its S/T obligation when they become due Sometimes profitable business face financial crisis because of overtrading Means that a company has invested too much in fixed assets and inventory but too little liquid assets and thus short of cash 30 Financial Ratio Analysis 3.Leverage Ratios Enable user to measure of financial position of a company in the L/T Whether or not a company will be able to pay its L/T debts as and when they become due A business that is unable to do so is said to be insolvent, and will usually be forced into compulsory liquidation by its creditors 4.Efficiency Ratios Measure of how efficiently the firm utilizes its assets 5.Market Ratios Measure of business performance and use to screen potential investment. 31 We will want to answer questions about the firm’s Profitability ratios Liquidity ratios Leverage ratios Efficiency ratios Market ratios/ Market based performance Gross profit margin Current ratio Debt ratio Total assets turnover Price-to-earnings (P/E) Operating profit margin Acid test ratio Debt to equity ratio Account receivable collection period Market-to-book (M/B) Net profit margin Cash ratio Time interest earned Inventory holding period Earning per share Inventory turnover Return on assets Accounts Payable Turnover Return on equity Total Asset Turnover. 32 5 categories of Financial Ratios Liquidity, Activity (efficiency) and Leverage ratios primarily measure risks (both operating and financing risks) Profitability ratios measure return Market ratios measure of business performance and use to screen potential investment (exp:P/E Ratio compare the share’s price to the earnings, measure of how expensive a stock is) 33 Example: CyberDragon Corporation 34 CyberDragon’s Balance Sheet ($000) Assets: Liabilities & Equity: Cash $2,540 Accounts payable 9,721 Marketable securities 1,800 Notes payable 8,500 Accounts receivable 18,320 Accrued taxes payable 3,200 Inventories 27,530 Other current liabilities 4,102 Total current assets 50,190 Total current liabilities 25,523 Plant and equipment 43,100 Long-term debt (bonds) 22,000 less accum deprec. 11,400 Total liabilities 47,523 Net plant & equip. 31,700 Common stock ($10 par) 13,000 Total assets 81,890 Paid in capital 10,000 Retained earnings 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890 35 CyberDragon’s Income Statement ($000) Sales (all credit) Cost of Goods Sold Gross Profit Operating Expenses: Selling General & Administrative Total Operating Expenses Earnings before interest and taxes (EBIT) Interest charges: Interest on bank notes: Interest on bonds: Total Interest charges Earnings before taxes (EBT) Taxes (40%) Net Income $112,760 (85,300) 27,460 (6,540) (9,400) (15,940) 11,520 (850) (2,310) (3,160) 8,360 (3,344) 5,016 36 CyberDragon Other Information ($000) Dividends paid on common stock $2,800 Earnings retained in the firm $2,216 Number of shares of common stock issued and outstanding 1,300,000 Market price per share $20 Book value per share *** $26.44 Earnings per share *** $3.86 Dividends per share *** $2.15 37 CyberDragon Other Information ($000) Book Value per share = Common Stock Equity Number of Shares = $34,367,000 / 1,300,000 = $26.44 (Note: Total Stockholders’ Equity may include Preferred Stock Equity. Thus, Common Stock Equity = Total Stockholders’ Equity minus Preferred Stock Equity) (Note: Common Stock Equity = Total Assets minus Total Liabilities minus Preferred Stock Equity) To calculate per share value of a company based on its equity available One of the method for company to valuing another company 38 CyberDragon Other Information ($000) Earnings per share (EPS) = Earnings attributable to common stockholder Number of Shares = $5,016,000 / 1,300,000 = $3.86 **measure of the return on each ordinary share hold Dividends per share = Dividends paid on common stocks Number of Shares = $2,800,000 / 1,300,000 = $2.15 **Dividends are a form of profit distribution to the shareholder. Having a growing dividend per share can be a sign that the company's management believes that the growth can be sustained. 39 1. Liquidity Ratios Do we have enough liquid assets to meet approaching short-term obligations? 40 What is CyberDragon’s Current Ratio? current assets current liabilities 50,190 25,523 = 1.97 If the average current ratio for the industry is 2.4, is this good or not? Indicate as to whether a company has sufficient current assets to meet its short term obligation 41 What is the firm’s Acid Test Ratio? current assets - inventories current liabilities 50,190 - 27,530 25,523 = .89 Suppose the industry average is .92. What does this tell us? Indicate as to whether a company has sufficient current assets to meet its short term obligation 42 Consequences of too low liquidity ratios are: 1) late payments to trade creditors, resulting loss of cash discounts for prompt payment and creditors withhold further supplies 2) essential maintenance and replacement of fixed assets are frequently postponed, resulting in rising operating expenses (exp: selling expenses and depreciation expenses) 3) new investment projects are delayed, which may reduce future growth rate of the firm (exp: marketable securities) 43 If the current ratio and acid test ratio are too high, anxiety over cash flows are removed, but equally undesirable consequences are: 1) idle cash are tied up unproductively, without investing in potential profitable projects, which could affect future growth of the firm 2) unnecessarily large inventories (but sometimes might due to expecting price will increase in future), resulting in high storage and other carrying costs, and potential loss in market value of inventories that become obsolete (exp: electrical products, HP) 3) a valuable discipline on credit control will be lost, resulting in unwise amount and length of credit being advanced to customers (potential for bad debts increase) exp: a/c receivable turnover period too long might expose to the risk of bad debt) 44 ...
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