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Analysis of financial statements
(chapter 4)
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Ratio analysis: Why are 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
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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.
sales? Debt management: Right mix of debt and
equity? Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM, ROE, and ROA?
Market value: Do investors like what they see as reflected in P/E and M/B ratios?
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Balance Sheet: Assets
4-4
CashA/RInventories
Total CAGross FALess: Deprec.
Net FATotal Assets
20117,282
632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592
2012E85,632
878,0001,716,4802,680,1121,197,160 380,120 817,0403,497,152
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Balance Sheet: Liabilities and Equity
4-5
Accts payableNotes payableAccruals
Total CLLong-term debtCommon stockRetained earnings
Total EquityTotal L & E
2011524,160636,808
489,6001,650,568
723,432460,000
32,592 492,5922,866,592
2012E436,800300,000
408,0001,144,800
400,0001,721,176 231,1761,952,3523,497,152
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Income Statement
SalesCOGSOther expenses
EBITDADeprec. & amort.
EBITInterest exp.
EBTTaxesNet income
20116,034,0005,528,000
519,988 (13,988) 116,960 (130,948) 136,012 (266,960)
(106,784) (160,176)
2012E7,035,600
5,875,992 550,000
609,608 116,960
492,648 70,008
422,640 169,056 253,584
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Other Data
4-7
No. of sharesEPSDPSStock priceLease pmts
2012E250,000
$1.014$0.220$12.17
$40,000
2011100,000-$1.602$0.110
$2.25$40,000
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D’Leon’s Forecasted Current Ratio and Quick Ratio for 2012
4-8
2.34145,1$680,2$
sliabilitie Currentassets Current
ratio Current
48.0145,1$
)716,1$680,2($sliabilitie Current
)sInventorieassets (Current ratio Quick
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Comments on Liquidity Ratios2012E 2011 2010 Ind.
Current ratio 2.34x 1.20x 2.30x 2.70x
Quick ratio 0.84x 0.39x 0.85x 1.00x
4-9
• Expected to improve but still below the industry average.
• Liquidity position is weak.
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D’Leon’s Inventory Turnover vs. the Industry Average
2012E 2011 2010 Ind.
Inventory turnover 4.1x 4.70x 4.8x 6.1x
Inv. turnover = Sales/Inventories= $7,036/$1,716= 4.10x
Inventory turnover is below industry average. D’Leon might have old inventory, or its control
might be poor.
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DSO: Average Number of Days after Making a Sale before Receiving Cash
DSO = Receivables/Avg. sales per day= Receivables/(Annual sales/365)= $878/($7,036/365)= 45.6 days
2012E 2011 2010 Ind.
DSO 45.6 38.2 37.4 32.0
• D’Leon has a poor credit policy.
• D’Leon collects on sales too slowly, and is getting worse.
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Fixed Assets and Total Assets Turnover Ratios vs. the Industry Average
FA turnover = Sales/Net fixed assets
= $7,036/$817 = 8.61x
TA turnover = Sales/Total assets
= $7,036/$3,497 = 2.01x
4-12
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Evaluating the FA Turnover (S/Net FA) and TA Turnover (S/TA) Ratios
2012E 2011 2010 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x
4-13
• FA turnover projected to exceed the industry average.
• TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).
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Calculate the Debt Ratio and Times-Interest-Earned Ratio
Debt ratio = Total debt/Total assets
= ($1,145 + $400)/$3,497
= 44.2%
TIE = EBIT/Interest charges
= $492.6/$70 = 7.0x
4-14
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D’Leon’s Debt Management Ratios vs. the Industry Averages2012E 2011 2010 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
• D/A and TIE are better than the industry average.
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As a short-term creditor concerned with a company’s ability to meet its financial obligation to you, which one of the following combinations of ratios would you most likely prefer?
Current Debt ratio TIE ratio a. 0.5 0.5 0.33 b. 1.0 1.0 0.50 c. 1.5 1.5 0.50 * d. 2.0 1.0 0.67
Exam type question
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Profitability Ratios: Operating Margin, Profit Margin, and Basic Earning Power
4-17
Operating margin = EBIT/Sales = $492.6/$7,036 = 7.0% Profit margin = Net income/Sales = $253.6/$7,036 = 3.6%
Basic earning power = EBIT/Total assets = $492.6/$3,497 = 14.1%
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Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power
2012E 2011 2010 Ind.
Operating margin 7.0% -2.2% 5.6% 7.3%
Profit margin 3.6% -2.7% 2.6% 3.5%
Basic earning power 14.1% -4.6% 13.0% 19.1%
4-18
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Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power
Operating margin was very bad in 2011. It is projected to improve in 2012, but it is still projected to remain below the industry average.
Profit margin was very bad in 2011 but is projected to exceed the industry average in 2012. Looking good.
BEP removes the effects of taxes and financial leverage, and is useful for comparison.
BEP projected to improve, yet still below the industry average. There is definitely room for improvement.
4-19
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Profitability Ratios: Return on Assets and Return on Equity
ROA = Net income/Total assets= $253.6/$3,497 = 7.3%
ROE = Net income/Total common equity
= $253.6/$1,952 = 13.0%
4-20
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Appraising Profitability with ROA and ROE
2012E 2011 2010 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%
4-21
• 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.
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Effects of Debt on ROA and ROE Holding assets constant, if debt increases:
- Equity declines.- Interest expense increases – which leads to a
reduction in net income. ROA declines (due to the reduction in net
income). ROE may increase or decrease (since both
net income and equity decline).
4-22
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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. Given these problems, reliance on ROE may
encourage managers to make investments that do not benefit shareholders. As a result, analysts have looked to develop other performance measures, such as EVA.
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Calculate the Price/Earnings and Market/Book Ratios
P/E = Price/Earnings per share
= $12.17/$1.014 = 12.0x
M/B = Market price/Book value per share
= $12.17/($1,952/250) = 1.56x2012E 2011 2010 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x
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Analyzing the Market Value Ratios P/E: How much investors are willing to
pay for $1 of earnings. M/B: How much investors are willing to
pay for $1 of book value equity. For each ratio, the higher the number, the
better. P/E and M/B are high if ROE is high and
risk is low.
4-25
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The DuPont Equation
Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier).
4-26
)(TA/Equity (Sales/TA) (NI/Sales) ROE
multiplierEquity turnover
assets Total marginProfit ROE
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DuPont Equation: Breaking Down Return on Equity
PM TA TO EM ROE
2010 2.6% 2.3 2.2 13.3%
2011 -2.7% 2.1 5.8 -32.5%
2012E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
4-27
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
= 3.6% x 2 x 1.8
= 13.0%
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The Du Pont system
Also can be expressed as:ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) Focuses on:
- Expense control (PM)- Asset utilization (TATO)- Debt utilization (Eq. Mult.)
Shows how these factors combine to determine ROE.
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A firm that has an equity multiplier of 4.0 will have a debt ratio ofa. 4.00b. 3.00c. 1.00d. 0.75 *
Exam type questions
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Exam type questionThe Merriam Company has determined that its return on equity is 15 percent.
Management is interested in the various components that went into this calculation. You are given the following information: total debt/total assets = 0.35 and total assets turnover = 2.8. What is the profit margin?
a. 3.48% *b. 5.42%c. 6.96%d. 2.45%
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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. 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.
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Learning objectives Given all the information needed, know how to calculate and interpret all the
financial ratios that are discussed in the notes, including DuPont analysis. For the exam, there will be a page attached to the exam paper with all the formulas from this chapter.
Discuss potential problems and limitations of financial ratio analysis, including problems with ROE
end of chapter problems 4-1 to 4-14, 4-22