Unformatted text preview: CHAPTER 4 Analysis of Financial Analysis Statements Statements 41 Learning Objectives Explain why ratio analysis is usually the first step in the Explain analysis of a company’s financial statements. analysis List the five groups of ratios, specify which ratios belong in List each group, and explain what information each group gives us about the firm’s financial position. about State what trend analysis is, and why it is important. Describe how the basic Du Pont equation is used, and how it Describe may be modified to form the extended Du Pont equation, which includes the effect of financial leverage. which List several limitations of ratio analysis. Identify some of the problems with ROE that can arise when Identify firms use it as a sole measure of performance. firms Identify some of the qualitative factors that must be Identify considered when evaluating a company’s financial performance. performance. 4 42 Financial Ratio Analysis (FRA)
What is Financial Ratio Analysis? FRA analysis isn't just comparing different numbers FRA from the balance sheet, income statement, and cash flow statement. It's comparing the number against previous years, other It's companies, the industry, or even the economy in general. Ratios look at the relationships between individual Ratios values and relate them to how a company has performed in the past, and might perform in the future.
4 43 Financial Ratio Analysis (FRA) What is the importance of FRA? From an investor's standpoint, FRA is used both to anticipate future conditions and, more important, as a starting point for planning actions that will improve future performance. FRA help the financial manager evaluate and interpret the financial statements. Enables the financial manager to spot trends in the firm and to compare its performance and condition with the average performance of similar companies in the same industry (benchmarking). FRA may provide early warning indications that allow you to solve the firm’s problems before the firm is affected by them. 4 44 Why are Financial ratios useful? Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths. Ratio comparisons should be made through time and with competitors
Trend analysis Peer (or Industry) analysis 4 45 What are the five major categories of ratios, and what questions do they answer? Liquidity: Can we make required payments? Asset management: right amount of assets vs. Asset sales? sales? Debt management: Right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and Profitability: are sales high enough as reflected in PM, ROE, and ROA? ROA? Market value: Do investors like what they see as Market reflected in P/E and M/B ratios? reflected 4 46 Liquidity Ratios A liquid asset is one that trades in a active market and can be quickly converted to cash. They question the firm’s ability to pay off its debt as they come due in the next 12 months. They measure the availability of cash to pay debt Shows the relationship of a firm’s cash and other current assets to its current liabilities Current Ratio and Quick Ratio are the most commonly used liquidity ratios. 4 47 Dell’s current and quick ratio for 2007. Current ratio = Current assets / Current liabilities = $1,012/ $540 = 1.87x Dell has $1.87 in CA for every $1 in CL, or Dell has its CL covered 1.87 times over. Quick ratio = (CA – Inventories) / CL = ($1,012– $515) / $540 = 0.92x Dell has $.92 in liquid assets for every $1 in CL, or Dell has its CL covered .92 times over. The unit of measure is either dollars or times.
4 48 Comments on Dell’s liquidity ratios
Current Ratio Quick Ratio 2006
2.51x 1.28x PC Industry
2.2x 1.3x 1.87x 0.92x Current ratio is below industry standards. Liquidity position is weak. Dell relies on the sale of its inventory to cover its debts within 1 yr. Solution: Increase CA or decrease CL 4 49 Asset Management Ratios (AMR) (aka Efficiency Ratios) Ratios that measure how effectively a firm is managing its assets Measure how efficiently or intensively a firm use its assets to generate sales AMR are : Inventory Turnover (ITO) Accounts Receivable Turnover (ARTO) Average Collection Period (ACP) Fixed Assets Turnover ratio (FATO) Total Assets Turnover ratio (TATO) 4 410 Inventory Turnover Ratio (ITO) A ratio showing how many times a firm's inventory is sold and replaced over a period. The higher the ratio is, the more efficiently we are managing inventory Formula Cost of Goods Sold/Average Inventory, also Inventory turnover ratio : Sales/Inventories 4 411 What is Dells’ inventory turnover vs. the industry average?
Inv. turnover = COGS / Avg Inventories = $2,030/ $515 = 3.94x Dell sold off or turned over the entire inventory 3.94 times. The unit of measure is times
4 412 Comments on Dell’s Inventory Turnover
Inventory Turnover 2006
4.8x 3.94x Inventory turnover is below industry average. Dell might have old inventory, or its control might be poor. Solution : Need to sell inventory by increasing sales
4 413 Accounts Receivable Turnover Ratio (ART) The ratio of the number of times that accounts receivable is collected throughout the year A ratio used to quantify a firm's effectiveness in extending credit as well as collecting debts. A high ratio implies either that a company operates mostly on a cash basis or that its extension of credit and collection of accounts receivable is efficient. A low declining ratio indicates a collection problem. It tells us how fast we can collect a credit sale
4 414 What is Dell’s accounts receivable turnover vs. the industry average?
A/R Turnover AR = Net Credit Sales/ Avg = $2,900/ $420 = 6.9x
Dell collected it outstanding credit accounts and reloaned 2007 2006 the money 6.9 times during the year. Industry
A/R Turnover 6.9x 6.32x 6.5x Dell has tight credit policies or Credit is limited. The unit of measure is times • 4 415 Average Collection Period (ACP)
Also called “ Days Sales Outstanding” is used to appraise AR. The ACP represents the average length of time the firm must wait after making a credit sale before receiving cash. Formula ACP= Receivables = Receivables Avg Sales per day Annual Sales/360 The unit of measure is days
4 416 ACP is the average number of days after making a sale before receiving cash. ACP = Receivables / Avg sales per day = Receivables / (Annual sales/360) = $420 / ($2900/360) = 52.14 days It takes Dell 52.14 days to collect on its credit sales.
4 417 Appraisal of ACP
56.99 days PC Industry
45 days 52.14 days Dell collects on sales too slowly Dell has a poor credit policy Solution: Dells needs to tighten its credit policy, expedite collections, or reduce credit sales
4 418 Fixed Assets Turnover Ratio (FATO) Measures how effectively the firm uses its plant and equipment. The higher the ratio the better Formula FAT= Sales/ NetFixed Assets 4 419 Dell’s FATO FA turnover = Sales / Net fixed assets = $2,900/ $2,133 = 1.36x For every dollar in FA, Dell generated $1.36 in sales, or Dell turned over its assets 1.36 times The unit measure is either times or dollars
4 420 Total Asset Turnover Ratio (TATO) Measures the turnover of all the firm’s assets. The higher the ratio the better It is calculated by dividing sales by total assets: Formula Total Asset Turnover = Sales/Total Assets 4 421 Dell’s Total Assets Turnover Ratio TA turnover = Sales / Total assets = $2,900/ $3,145 = .92x For every dollar in TA, Dell generated $.92 The unit measure is either times or dollars 4 422 Evaluating Dell’s FA turnover and TA turnover ratios
FA TO TA TO 2006
1.39x .93x Industry
1.0x 2.3x 1.36x .92x FA turnover exceeds the industry average. TA turnover below the industry average. This is caused by excessive currents assets (A/R and Inv). Solution: Sales need to be increased or assets should be disposed
4 423 DEBT MANAGEMENT RATIOS (DMR) (aka Leverage Ratios) Help analyze the degree and effect of a firm's use of borrowed funds (debt) to finance its operations. DMR are :
Total Debt Ratio (TD) Debt to Equity (DE) LongTerm Debt to Equity (LTDE) LongTerm Debt Ratio (LTD) 4 424 4 425 Calculate Dell’s Total Debt Ratio (TD)
Debt Ratio: The % of funds provided by creditors. Amount of debt that the firm uses to finance its assets. Debt ratio = Total debt / Total assets = $1,708 / $3,145 = .5431, 54.31% Total Debt financing makes up about 54.31% of the firm’s total assets. For every dollar in assets, the company uses $.5431 to finance the purchase of these assets. The unit of measure is either percentage or dollars
4 426 Calculate Dell’s LongTerm Debt Ratio (LTD)
LTD: Compares long term debt to total assets. LTD= LongTerm Debt/Total Assets LTD= $1,168/$3145 = .3714%, 37.14% LongTerm Deb financing makes up about 37.14% of the firm’s total assets. For every dollar owned in assets, the company uses $.3714 of Long Term Debt to finance the purchase of these assets. The unit of measure is either percentage or dollars
4 427 Calculate Dell’s Debt to Equity Ratio (DE)
Debt to Equity Ratio = It indicates what proportion of equity and debt the company is using to finance its assets. It compares total debit to shareholders. DE= Total Debt/Total Equity DE= $1,708/$1,436 = 1.1887, 118.87% Total Debt financing makes up about 118.87% of the firm’s capital structure/equity. For every dollar in equity, the company uses $1.18 to finance the company’s operations. The unit of measure is either percentage or dollars
4 428 Calculate the LongTerm Debt to Equity Ratio (LTDE)
LTDE: A ratio comparing longterm debt to shareholders` equity. LTDE= LongTerm Debt/ Equity LTDE= $1,168/$1,436 = .8134, or 81.34% Total LongTerm debt financing makes up about 81.34% of the firm’s capital structure/equity. For every dollar in equity, the company uses $.8134 of LTD to finance the company’s operations. The unit of measure is either percentage or dollars
4 429 How do the debt management /leverage ratios compare with the PC industry averages?
2007 2006 PC Industry 45% 41% 115% 83% TD LTD DE LTE 54.31% 37.14% 118.87% 81.29% 55.18% 41.79% 123.11% 93.23% 4 430 Profitability Ratios Ratios that show the combined effects of liquidity, asset management, and debt on operating results. Profitability ratios are used to assess a firm’s ability to generate earnings as compared to its expenses and incurred during a specific period of time. Profitability Ratios : Gross Profit Margin (GPM) Operating Profit Margin (OPM) Profit Margin (PM) Return on Total Assets (RA) Return on Equity (RE) 4 431 Dell’s Profitability ratios: Gross Profit Margin = Gross Profit/Sales = $870/$2900=30% Operating Profit Margin= Operating Profit/Sales $318/$2,900= 10.97% Profit margin = Net income / Sales = $133.9/ $2,900 = 4.6% 4 432 Appraising profitability with the profit margin
GPM OPM 2007 30% 10.97% 2006 30% 8.17% PC Industry 60% 40% PM 4.6% 3.43% 13% GPM and OPM are below industry levels. Dell is not very competitive and could easily be displaced in the PC market. Their production costs are twice as much as the competition. PM was very low in 2007 & 2007, below industry levels. Interest expenses are too high. Solution: Dell has to lower costs, especially its high debt costs, which lower NI. However, low PM due to Interest might NOT be a problem if there is a high ROE. 4 433 Profitability ratios: Return on Total Assets, Return on Equity, and Return on Common Equity ROA = Net income / Total assets = $133.9/ $3,145 =4.26% ROE = Net income / Total common equity = $133.9 / $1,436 = 9.32% 4 434 Appraising profitability with the return on assets and return on equity
ROA ROE 4.26% 9.32% 2006
3.17% 7.08% Industry 9% Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. Wide variations in ROE illustrate the effect that leverage can have on profitability. Solution: Dell needs to use more debt to increase ROE. 14% 4 435 Effects of debt on ROA and ROE ROA is lowered by debtinterest lowers NI, which also lowers ROA = NI/Assets. But use of debt also lowers equity, hence debt could raise ROE = NI/Equity. 4 436 Problems with ROE ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. ROE does not consider risk. ROE does not consider the amount of capital invested. Might encourage managers to make investment ROE focuses only on return and a better measure would consider risk and return.
4 437 decisions that do not benefit shareholders. Market Value Ratios Relate the firm’s stock price to its earnings, cash flow, and book value per share. Ratios give management an indication of what investors think of the company’s risk and future prospects. If liquidity, asset & debt management ratios, and profitability ratios look favorable, then the market value of the company will be high Market Value Rations
Price/Earning Ratio (P/E) Price/Cash Flow Ratio (P/CF) Market/Book Ratio (M/B) 4 438 Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.
P/E = Price / Earnings per share = $17 / ($133.90/38) = $17 / $3.52 = 4.83x Investors are willing to pay $4.83 for every dollar the company generates in net profits. P/CF = Price / Cash flow per share = $17 / [($133.9+62) ÷ 38] = $17/$5.16 = 3.29x Investors are willing to pay $3.29 for every dollar the company generates in net cash flows. The unit of measure is either dollars or times 4 439 Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.
M/B = Market price / Book value per share = $17 / ($1,436.9/ 38) = $17/ $37.85=.45x
Dell investors are willing to pay only $.44 for a dollar of accounting or book value. Is Dell Undervalued? 4 440 Appraising profitability with Price/Earnings, Price/Cash flow, and Market/Book ratios.
P/E P/CF M/B 4.83x 3.29x .45x 2006
4.62x 5.41x .65x Industry
5x 7x 1.3x P/E: Dell has less favorable growth prospects and more risk than average for the industry. P/CF: Dell is below average, less favorable growth prospects, and/ or above average risk. . M/B : Investors are willing to pay less for a dollar of Dell's book value than industry average. Dell is an undervalued stock. Solution: Dell has to be managed more efficiently, for its market 4 441 value ratios to increase. Analyzing the market value ratios P/E: How much investors are willing to pay for $1 of earnings. If the ratio is higher, investors are more optimistic about the company’s growth prospects and the company is below average risk P/CF: How much investors are willing to pay for $1 of cash flow. M/B: How much investors are willing to pay for $1 of book value equity. P/E and M/B are high if ROE is high and risk is low. 4 442 The Basic Du Pont Equation Shows that the rate of return on assets can be found as the product of the profit margin times the TATO. ROA= Profit Margin x Total Asset TO ROA= Net Income x Sales Sales Total Assets ROA =$133.9/ $2,900 x $2,900/$3,145 ROA = 4.62% x .92x = 4.26%
Dell made 4.62%, or 4.6 cents, on each dollar of sales, and assets were “turned over” .92 times during the year. Dell earned a returned of 4.26% on its assets
443 Total Assets 4 444 Extended Du Pont Equation
Profit Total assets Equity ROE = × × margin turnover multiplier
ROE= Net Income x Sales Sales It x Total Assets Equity Total Assets is a way to break down the ROE into its components. Focuses on expense control (PM), asset utilization (TATO), and debt utilization (Equity multiplier.)
445 Extended DuPont equation: Breaking down Return On Equity ROE = = = (NI / Sales) x (Sales/TA) x (TA/Equity) 4.62% 9.3% x .92x x 2.19x PM
2007 2006 Industry 4.62% 3.43% 13% TA TO
.92x .93x 2.3 EM
2.19x 2.23x 2.0 ROE
9.3% 7.08% 59.8%
446 Potential problems and limitations of financial ratio analysis Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. “Average” performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better (ie Rebates, Using LT loan funds to pay ST loans)
4 447 More issues regarding ratios Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is “good” or “bad”. Difficult to tell whether a company is, on balance, in strong or weak position. 4 448 Are the firm’s revenues tied to one key customer, product, or supplier? What percentage of the firm’s business is generated overseas? Competition Future prospects Legal and regulatory environment Qualitative factors to be considered when evaluating a company’s future financial performance 4 449 As a general rule…. Liquidity Ratios: The Higher the ratio the better Asset Management Ratios (aka Efficiency Ratios): The Higher the ratio the better Debt Management Ratios (aka Leverage Ratios): The Lower the ratio the better Profitability Ratios: The Higher the ratio the better Market Value Ratios: The Higher the ratio the better 4 450 Homework Due Next Week Read Chapter 5 Financial Markets & Institutions Excel Assignment Bentsen Boutique FS Analysis 4 451 ...
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