AD 311 Business Finance Attila Odabasi Lec 3: Financial Analysis (Ch 3)

Key Concepts and Skills

o Understand sources and uses of cash and the Statement of Cash Flows
o Know how to standardize financial statements for comparison purposes

o Know how to compute and interpret important financial ratios

o Be able to compute and interpret the Du Pont Identity o Understand the problems and pitfalls in financial statement analysis

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Chapter Outline
o Cash Flow and Financial Statements: A Closer Look
o Standardized Financial Statements o Ratio Analysis o The Du Pont Identity o Using Financial Statement Information

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Sample Balance Sheet

Numbers in millions
2013 Cash A/R Inventory 696 956 301 2012 58 A/P 992 N/P 361 Other CL 2013 307 26 1,662 2012 303 119 1,353

Other CA Total CA
Net FA

303 2,256
3,138

264 Total CL 1,675 LT Debt

3,358 C/S

1,995 843
2,556

1,775 1,091
2,167

Total Assets

5,394

5,033 Total Liab. & Equity

5,394

5,033

Sample Income Statement, 2013

Numbers in millions, except EPS & DPS
Revenues Cost of Goods Sold 5,000 (2,006)

Expenses
Depreciation EBIT Interest Expense Taxable Income Taxes Net Income EPS Dividends per share 3.61 1.08

(1,740)
(116) 1,138 (7) 1,131 (442) 689

Sources and Uses

o Sources
Cash inflow occurs when we sell something Decrease in asset account (Sample B/S)
Accounts receivable, inventory, and net fixed assets

Increase in liability or equity account

Accounts payable, other current liabilities, and common stock

o Uses
Cash outflow occurs when we buy something

Increase in asset account

Cash and other current assets

Decrease in liability or equity account

Notes payable and long-term debt
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Statement of Cash Flows

o Statement that summarizes the sources and uses of cash
o Changes divided into three major categories
Operating Activity includes net income and changes in most current accounts Investment Activity includes changes in fixed assets

Financing Activity includes changes in notes payable, long-term debt, and equity accounts, as well as dividends
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Sample Statement of Cash Flows

Cash, beginning of year Operating Activity Net Income Plus: Depreciation Decrease in A/R Decrease in Inventory Increase in A/P Increase in Other CL Less: Increase in other CA Net Cash from Operations 689 116 36 60 4 309 -39 1,175 Cash End of Year 696 Net Increase in Cash 638 58 Financing Activity Decrease in Notes Payable Decrease in LT Debt Decrease in C/S (minus RE) Dividends Paid Net Cash from Financing -93 -248 -94 -206 -641

Investment Activity Sale of Fixed Assets Net Cash from Investments 104 104

Numbers in millions of dollars

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Standardized Financial Statements

o Common-Size Statements (Vertical Analysis):

o Useful in comparison of firms of unequal size or to compare a company through time as it grows.
o Common-Size Balance Sheets
Compute all accounts as a percent of total assets

o Common-Size Income Statements

Compute all line items as a percent of sales

Vertical Analysis (B/S)

Accounts
Current Assets Cash A/R Inventory Other CA Total CA 696 956 301 303 2256

2013
% 12.9 17.7 5.6 5.6 41.8

2012
% 58 992 361 264 1.2 19.7 7.17 5.24

Accounts
S-T Debt A/P N/P Other CL Total CL

2013
% 307 26 1662 1995 5.7 0.5 30.8 37

2012
% 303 119 1353 1775 6.0 2.4 26.9 35.3

1675 33.2 L-T Debt

Fixed Assets

L-T Debt

843

15.6

1091

21.7

Net Fixed
Asset Total

3138
5394

58.2
100

3358 66.7
5033 100

Common Stock
Tot Liab&Equity

2556
5394

47.6
100

2167
5033

43
100

Vertical Analysis (Income Statement)

Accounts Revenues Cost of Goods Sold Expenses Depreciation 2013 5,000 (2,006) (1,740) (116) % 100 40 34.8 2.3

EBIT
Interest Expense Taxable Income Taxes Net Income

1,138
(7) 1,131 (442) 689

22.8
0.0 22.6 8.8 13.8

Common-Base Year Financial Statement Horizantal Analysis

o Used for trend analysis
o Select a base year and then express each item or account as a percent of the base-year value of that item. o An alternative is Combined Common-Size and Base-Year Analysis.

B/S Horizantal Analysis (in 000s)

Accounts
Current Assets Cash A/R Inventory Other CA Total CA Fixed Assets Net Fixed Asset Total 3138 5394 3358 5033 (220) 361 -6.55 7.2 696 956 301 303 2256 58 992 361 264 1675 638 (36) (60) 39 581 1100 -3.6 -16.6 14.8 34.7

2013

2012

Diff

B/S Horizantal Analysis (in 000s)

2013 S-T Debt 2012 Diff %

A/P
N/P

307
26

303
119

4
-93

1.3
-78 22.8 12.4

Other CL
Total CL

1662
1995

1353
1775

309
220

L-T Debt L-T Debt Common Stock Tot Liab&Equity 843 2556 5394 1091 2167 5033 (248) 389 361 -22.7 18 7.2

Ratio Analysis
o Ratios allow for better comparison through time or between companies
o As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important o Ratios are used both internally and externally

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Categories of Financial Ratios

o Short-term solvency or liquidity ratios
o Asset management or turnover ratios o Long-term solvency or financial leverage ratios o Coverage Ratios o Profitability ratios o Market value ratios

Short-Term Solvency Ratios

o Current Ratio = CA / CL
2,256 / 1,995 = 1.13 times

o Quick Ratio = (CA Inventory) / CL

(2,256 301) / 1,995 = .98 times

o Cash Ratio = Cash / CL

696 / 1,995 = .35 times

o NWC to Total Assets = NWC / TA

(2,256 1,995) / 5,394 = .05

o Interval Measure = CA / average daily operating costs

2,256 / ((2,006 + 1,740)/365) = 219.8 days

Computing Long-term Solvency Ratios

o Total Debt Ratio = (TA TE) / TA
(5,394 2,556) / 5,394 = 52.61%

o Debt/Equity = TD / TE
(5,394 2,556) / 2,556 = 1.11 times

o Equity Multiplier = TA / TE = 1 + D/E

1 + 1.11 = 2.11

o Long-term debt ratio = LTD / (LTD + TE)

843 / (843 + 2,556) = 24.80%

Computing Coverage Ratios

o Times Interest Earned = EBIT / Interest
1,138 / 7 = 162.57 times

o Cash Coverage = (EBIT + Depreciation) / Interest

(1,138 + 116) / 7 = 179.14 times

Computing Inventory Ratios

o Inventory Turnover = Cost of Goods Sold / Inventory
2,006 / 301 = 6.66 times

o Days Sales in Inventory = 365 / Inventory Turnover

365 / 6.66 = 55 days

Computing Receivables Ratios

o Receivables Turnover = Sales / Accounts Receivable
5,000 / 956 = 5.23 times

o Days Sales in Receivables = 365 / Receivables Turnover

365 / 5.23 = 70 days

Computing Total Asset Turnover

o Total Asset Turnover = Sales / Total Assets
5,000 / 5,394 = .93 It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

o NWC Turnover = Sales / NWC

5,000 / (2,256 1,995) = 19.16 times

o Fixed Asset Turnover = Sales / NFA

5,000 / 3,138 = 1.59 times

Computing Profitability Measures

o Profit Margin = Net Income / Sales 689 / 5,000 = 13.78% o Return on Assets (ROA) = Net Income / Total Assets 689 / 5,394 = 12.8% o Return on Equity (ROE) = Net Income / Total Equity 689 / 2,556 = 27%

Computing Market Value Measures

o Market Price = $87.65 per share
o Shares outstanding = 190.9 million o PE Ratio = Price per share / Earnings per share 87.65 / 3.61 = 24.28 times o Market-to-book ratio = market value per share / book value per share 87.65 / (2,556 / 190.9) = 6.55 times

o Tobins Q= MV / replacement cost

Deriving the DuPont Identity

o ROE = NI / TE
o Multiply by 1 (TA/TA) and then rearrange
ROE = (NI / TE) (TA / TA)

ROE = (NI / TA) (TA / TE) = ROA * EM

o Multiply by 1 (Sales/Sales) again and then rearrange

ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM

Using the DuPont Identity

o ROE = PM * TAT * EM
PM - the firms operating efficiency how well it controls costs TAT - the firms asset use efficiency how well does it manage its assets EM - the firms financial leverage

o ROE13= 13.78% x 0.93 x 2.11= 27%

o

Extended DuPont Chart

ROE = 29.49%

ROA = 16.66%

EM = 1.77

PM = 6.97%

x
Sales = 1,204.35 Sales = 1,204.35

TAT = 2.39

NI = 83.96

TA = 503.96

Total Costs = - 1,120.39

Sales = 1,204.35

Fixed Assets = 164.62

Current Assets = 339.34

COGS = - 841.87

SG&A = - 227.04

Cash = 225.27

Inventory = 91.91

Interest = - (3.67)

Taxes = - 55.15

Other CA = 22.16

Why Evaluate Financial Statements?

o Internal uses
Performance evaluation compensation and comparison between divisions

Planning for the future guide in estimating future cash flows

o External uses
Creditors
Suppliers Customers

Stockholders
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Benchmarking
o Ratios are not very helpful by themselves; they need to be compared to something
o Time-Trend Analysis
Used to see how the firms performance is changing through time Internal and external uses

o Peer Group Analysis

Compare to similar companies or within industries
SIC: Standard Industrial Classification Codes NAICS: North American Industrial Classification Codes
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Potential Problems
o There is not a unique underlying theory. For example, there is no way to know which ratios are most relevant
o Benchmarking is difficult for diversified firms

o Globalization and international competition makes comparison more difficult because of differences in accounting regulations, but convergence observed
o Varying accounting procedures, i.e. FIFO vs. LIFO o Different fiscal years o Extraordinary events

Some qualitative factors that analysts should consider when judging the future financial performance of firms.
o Are the companys revenues tied to a single customer? o To what extent are the companys revenues tied to a single product? o To what extent does the company rely on a single supplier? o What percentage of the companys business is generated overseas? o etc

Potential Red Flags

o Some examples:
o Unexplained transactions that boost profits (selling assets?) o Unusual increase in A/R in relation to sales increases (relaxing credit policies, artificially loading up its distributiun channels?)

Potential Red Flags

o Unusual increases in inventories in relation to sales increases
If it is due to an increase in finished goods, the demand for the products may be slowing down,

If it is an increase in Work-in-progress inventory, it may signal that managers expect an increase in sales,
If it is a build up in raw materials, it could suggest manufacturing/procurement inefficiencies; consequently an increase in COGS, lower margins.

Potential red flags

o An increasing gap between a firms reported income and its cash flow from operating activities!
(Expectation is a steady relationship between the two if the firms accounting policies remain the same).

o Large fourth-quarter adjustments.