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Chapter 4

Analysis of Financial Statements

 2005, Pearson Prentice


Hall
Ratio Analysis

 Are our decisions


maximizing
shareholder wealth?

 Identify some of the


financial strengths
and weaknesses of a
company.
We will want to answer
questions about the firm’s

 Liquidity
 Asset Management
 Debt Management
 Profitability
 Market Value
Financial Ratios
 Tools that help us determine the financial
health of a company.
 We can compare a company’s financial
ratios with its ratios in previous years
(trend analysis).
 We can compare a company’s financial
ratios with those of its industry (cross-
sectional analysis).
 We can compare a company’s financial
ratios with those ratios of benchmark
companies (benchmarking)
Example:
CyberDragon Corporation
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
Sales (all credit) CyberDragon’s $112,760
Cost of Goods Sold Income Statement (85,300)
Gross Profit 27,460
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Earnings before interest and taxes (EBIT) 11,520
Interest charges:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest charges (3,160)
Earnings before taxes (EBT) 8,360
Taxes (assume 40%) (3,344)
Net Income 5,016
CyberDragon
Other Information

Dividends paid on common stock $2,800


Earnings retained in the firm 2,216
Shares outstanding (000) 1,300
Market price per share 20
Book value per share 26.44
Earnings per share 3.86
Dividends per share 2.15
1. Liquidity Ratios

 Do we have enough liquid


(current) assets to meet
approaching obligations?
What is CyberDragon’s Current
Ratio?

current assets
current liabilities
Indicates a firm’s liquidity,
as measured by its liquid assets
(current assets) relative to its
liquid debt (short-term or
current liabilities).
What is CyberDragon’s Current
Ratio?

50,190
25,523 = 1.97

If the average current ratio for the


industry is 2.4, is this good or not?
What is the firm’s Acid Test
(Quick) Ratio?

current assets - inventories


current liabilities
Indicates a firm’s liquidity,
as measured by its liquid assets,
excluding inventories, relative
to its current liabilities.
What is the firm’s Acid Test Ratio?

50,190 - 27,530 = .89


25,523

Suppose the industry average is .92.


What does this tell us?
2. Asset Management Ratios

 Measure how effectively a firm is


managing its assets.
What is the firm’s Days Sales Outstanding
(Average Collection Period)?

accounts receivable
average sales per day
Indicates how rapidly a firm is
collecting its credit, as measured by
the average number of days it takes
to collect its accounts receivable.
What is the firm’s Days Sales Outstanding
(Average Collection Period)?

18,320 = 59.3 days


112,760/365

If the industry average is 47 days,


what does this tell us?
What is the firm’s Accounts
Receivable Turnover?

credit sales
accounts receivable
Indicates how rapidly the firm is
collecting its credit, as measured by
the number of times its accounts
receivable are collected or “rolled
over” during the year.
What is the firm’s Accounts
Receivable Turnover?

112,760 = 6.16 times


18,320

CyberDragon turns their A/R over 6.16


times per year. The industry average
is 8.2 times. Is this efficient?
What is the firm’s Inventory
Turnover?

cost of goods sold


inventory
Indicates the relative liquidity of
inventories, as measured by the
number of times a firm’s
inventories are replaced during the
year.
What is the firm’s Inventory
Turnover?

85,300
27,530 = 3.10 times

CyberDragon turns their inventory


over 3.1 times per year.
The industry average is 3.9 times.
Is this efficient?
Low inventory turnover:

The firm may have too much


inventory, which is expensive
because:
 Inventory takes up costly
warehouse space.
 Some items may become spoiled
or obsolete.
What is their Total Asset Turnover?

sales
total assets
Indicates management’s
effectiveness in managing the firm’s
balance sheet, its assets - as
indicated by the amount of sales
generated per one dollar of assets.
What is their Total Asset Turnover?

112,760 = 1.38 times


81,890

The industry average is 1.82 times.


The firm needs to figure out how to
squeeze more sales dollars out of its
assets.
What is the firm’s Fixed Asset
Turnover?

sales
net fixed assets
Indicates the efficiency with which
the firm use its fixed assets to
generate sales.
What is the firm’s Fixed Asset
Turnover?

112,760
31,700 = 3.56 times

If the industry average is 4.6 times, what


does this tell us about CyberDragon?
3. Debt Management Ratios
(financing decisions)
 Measure how effectively the a firm
manages its debt.
 Use of more debt will increase a firm’s
ROE if the firm earns more on its
assets than the interest rate it pays on
debt.
How does Leverage work?
 Suppose we have an all equity-financed
firm worth $100,000. Its earnings this
year total $15,000.

15,000
ROE = = 15%
100,000
How does Leverage work?
 Suppose the same $100,000 firm is
financed with half equity, and half 8%
debt (bonds). Earnings are still $15,000.

ROE = 15,000 - 4,000 = 22%


50,000
What is CyberDragon’s Debt Ratio?

total debt
total assets

Indicates how much debt is used to


finance a firm’s assets.
What is CyberDragon’s Debt Ratio?

47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?

Can leverage make the firm more


profitable?
Can leverage make the firm riskier?
What is the firm’s Times Interest
Earned Ratio?

operating income
interest expense

Indicates a firm’s ability to cover its


interest payments, as measured by its
earnings before interest and taxes
relative to its interest expense.
What is the firm’s Times Interest
Earned Ratio?

11,520
3,160 = 3.65 times

The industry average is 6.7 times. This


is further evidence that the firm uses
more debt financing than average.
4. Profitability Ratios

Show the combined effects of


liquidity, asset management, and
debt on operating results.
What is CyberDragon’s
Gross Profit Margin (GPM)?

gross profit
sales

Measures the percentage of


each sales dollar remaining after
the firm has paid for its goods.
What is CyberDragon’s
Gross Profit Margin (GPM)?

27,460
112,760 = 24.4%

•This is below the industry average of


26%.
What is their Operating Profit
Margin?

operating income
sales
Indicates management’s
effectiveness in managing the firm’s
income statement, as measured by
operating profits relative to sales.
What is their Operating Profit
Margin?

11,520 = 10.22%
112,760

•This is below the industry average of


12%.
What is CyberDragon’s
Net Profit Margin (NPM)?

net income
sales

Measures the net income of a


firm as a percent of sales.
What is CyberDragon’s
Net Profit Margin (NPM)?

5,016
112,760 = 4.4%

•This is below the industry average of


7%.
What is the firm’s Basic Earning
Power Ratio (BEP)?

operating income
total assets
Indicates the effectiveness of
management at generating operating
profits on the firm’s assets, as measured
by operating profits relative to the total
assets. Also called Operating Income
Return on Investment (OIROI).
What is the firm’s Basic Earning
Power Ratio (BEP)?

11,520 = 14.07%
81,890
•Slightly below the industry
average of 15%.
•The BEP reflects product pricing
and the firm’s ability to keep costs
down.
What is CyberDragon’s
Return on Assets (ROA)?

net income
total assets

Determines the amount of net


income produced on a firm’s assets
by relating net income to total
assets; also called the return on
investment (ROI).
What is CyberDragon’s
Return on Assets (ROA)?

5,016
81,890 = 6.1%

•This is below the industry average of


9%.
What is CyberDragon’s
Return on Equity (ROE)?

net income
common equity

Indicates the accounting rate of return


on the common stockholders’
investment, as measured by net income
relative to common equity.
What is CyberDragon’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%

The industry average is 17.54%.


Is this what we would expect,
given the firm’s leverage?
What is CyberDragon’s
Eanings per Share (EPS)?

earnings available for common stockholders


number of shares of common stock outstanding

Represents the dollar amount earned


on behalf of each outstanding share
of common stock.
What is CyberDragon’s
Earnings per Share (EPS)?

5,016
1,300 = $3.86

•This is below the industry average of


$5.90.
5. Market Value Ratios
Relate the firm’s stock price to its
earnings and book value per share.
What is CyberDragon’s
Price/Earnings (P/E) Ratio?

price per share


earnings per share

Measures the amount that investors are


willing to pay for each dollar of a firm’s
earnings; the higher the P/E ratio, the
greater the investor confidence.
What is CyberDragon’s
Price/Earnings (P/E) Ratio?

20
3.86 = 5.18x

•This is below the industry average of


7.63x.
What is CyberDragon’s
Market/Book (M/B) Ratio?

market price per share


book value per share

Provides an assessment of how investors


view the firm’s performance. To find the
book value per share of common stock is
the ratio of common equity to its shares
outstanding.
What is CyberDragon’s
Market/Book (M/B) Ratio?

20
26.44 = 0.76x

•This is below the industry average of


1.48x.
Conclusion:

 Even though CyberDragon has


higher leverage than the industry
average, they are much less
efficient, and therefore, less
profitable.
The DuPont Model

Brings together:

 Profitability
 Asset Management
 Debt Management
The DuPont Model

ROE = Net Profit x Total Asset x Equity


Margin Turnover Multiplier
ROE = NI /Sales x Sales/TA x TA/Equity
ROE = 5,016/112,760 x 112,760/81,890 x 81,890/34,367
ROE = 14.6%

ROA = Net Profit Margin x Total Asset Turnover