Ch03 PPT Brighamfm1ce

PowerPoint Presentation
prepared by
Traven Reed Canadore College
chapter 3
Analysis of Financial Statements
Corporation Valuation and Analysis of Financial Statements

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Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Topics in Chapter
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Ratio analysis Trend, common-size and percentage change analysis Du Pont system Uses and limitations of ratio analysis
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Income Statement
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2009 Net sales Op. costs excluding depre. & amort. EBITDA Depre. & amort. EBIT Int. expense EBT Taxes (40%) Net income 3,000.0 2,616.2 $383.8 100.0 $283.8 88.0 $195.8 78.3 $117.5
2008 2,850.0 2,497.0 $353.0 90.0 $263.0 60.0 $203.0 81.2 $121.8
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Balance Sheets: Assets

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Cash S-T invest. AR Inventories Total CA Net FA Total assets
2009 10 0 375 615 $1,000 1,000 $2,000

2008 15 65 315 415 $810 870 $1,680

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Balance Sheets: Liabilities & Equity

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2009
Accts. payable Notes payable Accruals Total CL Long-term bonds Total liabilities Pref. stock (400,000 shares) Com. Stock (50,000,000 shares) Ret. earnings Total common equity Total L&E 60 110 140 $310 754 $1,064 40 130 766 $896 $2,000
2008
30 60 130 $220 580 $800 40 130 710 $840 $1,680
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Other Data
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Stock price # of shares EPS DPS CFPS BVPS Lease payments Tax rate
2009 2008 $23.00 $26.00 50,000,000 50,000,000 $2.27 $2.36 $1.15 $1.06 $4.27 $4.16 $17.92 $16.80 $28 $28 0.4 0.4
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Why are ratios useful?

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Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths
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Five Major Categories of Ratios

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Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? Debt management: Do we have the 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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Forecasted Current and Quick Ratios for 2009

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CA CR09 = CL
$1,000 = $310 = 3.2x
CA - Inv. QR09 = CL $1,000 - $615 = $310 = 1.2x

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Comments on CR and QR
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2009 CR QR 3.2x 1.2x
2008 Industry 3.7x 1.8x 4.2x 2.1x
Expected to worsen and still below the industry average. Liquidity position is weak. Shareholders may not want a high CR
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Inventory Turnover Ratio vs. Industry Average

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Sales Inv. turnover = Inventories $3,000 = = 4.90x $615 2009 Inv. T. 4.9 x 2008 6.9x Ind. 9.0x
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Comments on Inventory Turnover

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Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. True turnover will be overstated when sales are stated at market prices, but inventories are recorded at historical cost
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DSO: average number of days from sale until cash received

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DSO =
Receivables Average sales per day $375 = $3,000/365
= Receivables Sales/365
= 45.6 days 46 days
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Appraisal of DSO
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Firm collects too slowly, and situation is getting worse. Poor credit policy.
DSO
2009 46
2008 40
Ind. 36
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Average Payables Period

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Payables APP ! Avg.OperatingCostPerDay Payables ! AnnualOperatingCost / 365

APP ! $60 $60 ! ! 8.4days } 8days $2,616.2 365 $7.1677
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APP: Interpretation
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With an industry average of 9 days, the firm is doing fine with sufficient cash flow to pay bills on time. If APP is significantly longer than the credit term provided, firm will be at risk of losing those credit terms. If APP is lower than the credit terms offered, firm has not taken advantage of the free financing from suppliers.
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Fixed Assets and Total Assets Turnover Ratios

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Fixed assets Sales = turnover Net fixed assets $3,000 = 3.0x = $1,000 Total assets = turnover Sales Total assets $3,000 = 1.5x = $2,000
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Fixed Assets and Total Assets Turnover Ratios

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FA turnover is equal to the industry average suggesting that the firm has about the right amount of fixed assets in relation to other firms. TA turnover not up to industry average caused by excessive current assets (A/R and inventory).
2009 FA TO TA TO 3.0x 1.5x
2008 3.3x 1.7x
Ind. 3.0x 1.8x

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Calculate the debt and TIE ratios

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Total liabilities Debt ratio = Total assets $310 + $754 = = 53.2% $2,000 EBIT TIE = Int. expense $283.8 = 3.2x = $88
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EBITDA Coverage Ratio

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EBITDA + Lease payments Interest Lease + Loan pmt. expense + pmt.
($283.8 + $100) + $28 = $88 + $28 + $20
= 3.0x
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Debt Management Ratios vs. Industry Averages

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D/A TIE EC
2009 2008 Ind. 53.2% 47.6% 40.0% 3.2x 4.4x 6.0x 3.0x 0.8x 4.3x
Recapitalization improved situation, but lease payments drag down EC.

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Profit Margin (PM)

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$113.5 NI PM = Sales = $3,000 = 3.8% PM 2009 3.8% 2008 4.1% Ind. 5.0%
Very bad in 2009, because of high costs. It is resulted from inefficient operations or heavy use of debt.
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Basic Earning Power (BEP)

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EBIT BEP = Total assets $283.8 = $2,000 = 14.2%
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Basic Earning Power vs. Industry Average

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BEP removes effect of taxes and financial leverage. Useful for comparison. BEP is below average probably due to the low turnover ratios and low profit margin on sales. Room for improvement.
BEP
2009 2008 Ind. 14.2% 15.7% 17.2 %
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Return on Assets (ROA) and Return on Equity (ROE)

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NI ROA = Total assets $113.5 = $2,000 = 5.7%
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Return on Assets (ROA) and Return on Equity (ROE)

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NI ROE = Common Equity $113.5 = $896 = 12.7%
(More)
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ROA and ROE vs. Industry Averages

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ROA ROE
2009 5.7% 12.7%
2008 Ind. 7.0% 9.0% 14.0% 15.0%
Both below average but worsening.
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Effects of Debt on ROA and ROE

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ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.
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Calculate and appraise the P/E, P/CF, and M/B ratios

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Price = $23.00 NI $113.5m EPS = Shares out. = 50m = $2.27 Price per share $23.00 P/E = = $2.27 = 10.1X EPS
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Market Value Ratios

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NI + Depr. CF per share = Shares out. $113.5 + $100.0 = = $4.27 50 Price per share P/CF = Cash flow per share = $23.00 = 5.4x $4.27
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Market Based Ratios (contd)

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Com. equity BVPS = Shares out. $896m = 50m = $17.92 Mkt. price per share M/B = Book value per share $23.00 = $17.92 = 1.3x
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Interpreting Market Based Ratios

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P/E: How much investors will pay for $1 of earnings. Higher is better. M/B: How much paid for $1 of book value. Higher is better. P/E and M/B are high if ROE is high, risk is low.
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Comparison with Industry Averages

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P/E P/CF M/B
2009 10.1x 5.4x 1.3x
2008 Ind. 11.0x 12.5x 6.3x 6.8x 1.1x 1.7x
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Common Size Balance Sheets: Divide all items by Total Assets

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Assets Cash ST Inv. AR Invent. Total CA Net FA TA
2009 2008 0.5% 0.9% 0.0% 3.9% 18.8% 18.8% 30.8% 24.7% 50.0% 48.2% 50.0% 51.8% 100.0% 100.0%
Ind. 1.0% 2.2% 17.8% 19.8% 40.8% 59.2% 100.0%

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Divide all items by Total Liabilities & Equity

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Assets AP Notes pay. Accruals Total CL LT Bonds Total Liabilities Pref. stock Total com. eq. Total L&E
2009 2008 Ind. 3.0% 1.8% 1.8% 5.5% 3.6% 4.4% 7.7% 3.6% 7.0% 15.5% 13.1% 9.8% 37.7% 34.5% 30.2% 53.2% 47.6% 40.0% 2.0% 2.4% 0.0% 44.8% 50.0% 60.0% 100.0% 100.0% 100.0%
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Analysis of Common Size Balance Sheets

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The company has higher proportion of inventory and current assets than Industry. The company has less equity (which means more debt) than Industry. The company now has zero shortterm debt, but more long-term debt than industry.
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Common Size Income Statement: Divide all items by Sales

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2009 Net sales Op.costs EBITDA Depr. EBIT Int. Exp. EBT Taxes NI before pref. div. Pref. dividends NI (profit margin) 100.0% 87.2% 12.8% 3.3% 9.5% 2.9% 6.5% 2.6% 3.9% 0.1% 3.8%
2008 100.0% 87.6% 12.4% 3.2% 9.2% 2.1% 7.1% 2.8% 4.3% 0.1% 4.1%
Ind. 100.0% 87.6% 12.4% 2.8% 9.6% 1.3% 8.3% 3.3% 5.0% 0.0% 5.0%
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Analysis of Common Size Income Statements

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The company has similar operating cost (87.2) as industry (87.6), but slightly higher depreciation and amortization. Result is that the company has similar EBIT. However, the high interest expense lowers the EBT (6.5) compared to industry (8.3).
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Income Statement Percentage Change Analysis: % Change from Base Year

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Base year (2008) Net sales Operating costs EBITDA Depr. & Amortization EBIT Int. Exp. EBT Taxes @40% NI before pref. dividends Preferred dividends NI
% in 2009 5.3% 4.8% 8.7% 11.1% 7.9% 46.7% (3.5%) (3.5%) (3.5%) 0.0% (3.7%)
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Analysis of Percent Change Income Statement

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We see that 2009 sales grew 5.3% from 2008, and that NI fell 3.7% from 2008. So the company has become less profitable. The analysis reveals whether the firms condition has been improving or deteriorating over time. Similar analysis can be performed on the balance sheet.
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Explain the Du Pont System

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The Du Pont system focuses on:

Expense control (PM) Asset utilization (TATO) Debt utilization (EM)
It shows how these factors combine to determine the ROE.
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The Du Pont System

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Profit margin NI Sales
)(
TA turnover
)(
x
Equity multiplier = ROE
Sales x TA
TA CE
= ROE.
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The Du Pont System

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NI Sales x Sales TA
TA CE 2.23=
= ROE 12.7%
2009: 3.8% x 1.5 x
Alternatively, ROE = ROA equity multiplier = 5.7% x ($2,000/$896) = 12.7%

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Potential Problems and Limitations of Ratio Analysis?

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Comparison with industry averages is difficult if the firm operates many different divisions. Average performance is not necessarily good. Seasonal factors can distort ratios.
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Problems and Limitations (contd)

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Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons.
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Problems and Limitations (contd)

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Sometimes it is difficult to tell if a ratio value is good or bad. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.
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PowerPoint Presentation

Traven Reed Canadore College

Corporation Valuation and Analysis of Financial Statements

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Balance Sheets: Assets

Cash S-T invest. AR Inventories Total CA Net FA Total assets

2009 10 0 375 615 $1,000 1,000 $2,000

2008 15 65 315 415 $810 870 $1,680

Balance Sheets: Liabilities & Equity

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Why are ratios useful?

Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Five Major Categories of Ratios

Forecasted Current and Quick Ratios for 2009

$1,000 = $310 = 3.2x

CA - Inv. QR09 = CL $1,000 - $615 = $310 = 1.2x

Copyright 2011 by Nelson Education Ltd. All rights reserved.

2009 CR QR 3.2x 1.2x

2008 Industry 3.7x 1.8x 4.2x 2.1x

Inventory Turnover Ratio vs. Industry Average

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Comments on Inventory Turnover

DSO: average number of days from sale until cash received

Receivables Average sales per day $375 = $3,000/365

= 45.6 days 46 days

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Average Payables Period

Payables APP ! Avg.OperatingCostPerDay Payables ! AnnualOperatingCost / 365

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Fixed Assets and Total Assets Turnover Ratios

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Fixed Assets and Total Assets Turnover Ratios

2009 FA TO TA TO 3.0x 1.5x

2008 3.3x 1.7x

Ind. 3.0x 1.8x

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Calculate the debt and TIE ratios

EBITDA Coverage Ratio

EBITDA + Lease payments Interest Lease + Loan pmt. expense + pmt.

($283.8 + $100) + $28 = $88 + $28 + $20

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Debt Management Ratios vs. Industry Averages

Recapitalization improved situation, but lease payments drag down EC.

Profit Margin (PM)

Basic Earning Power (BEP)

EBIT BEP = Total assets $283.8 = $2,000 = 14.2%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Basic Earning Power vs. Industry Average

2009 2008 Ind. 14.2% 15.7% 17.2 %

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Return on Assets (ROA) and Return on Equity (ROE)

NI ROA = Total assets $113.5 = $2,000 = 5.7%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Return on Assets (ROA) and Return on Equity (ROE)

NI ROE = Common Equity $113.5 = $896 = 12.7%

ROA and ROE vs. Industry Averages

2009 5.7% 12.7%

2008 Ind. 7.0% 9.0% 14.0% 15.0%

Both below average but worsening.