3 - 1 Copyright © 2002 by James M. Johnson, Ph.D. All rights ...

3 - 1

Copyright © 2002 by James M. Johnson, Ph.D. All rights reserved.

Ratio analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

CHAPTER 3 Financial Statement Analysis

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Balance Sheet

Income Statement

Statement of Retained Earnings

Statement of Cash Flows

Financial Statement AnalysisFinancial Statements in 10Ks

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Compact Disclosure--student network

SEC.GOV for public companies

EDGAR library

Company websites

www.corporateinformation.com

Sources of Financial Statement Information

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Cash

Is cash cash?

Foreign currency translation & mark to market

Short-term investments

Effects of Accounting Choices on Financial Statement Analysis

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LIFO & FIFOAppreciating valueinventory units

New units cost more over time

Higher value units

Lower value units

LIFO

FIFO

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Inventory--appreciating value unitsFIFO LIFO

Balance sheet--inventory over orunderstated?Income statement--COGS over or understated? Profit margin over orunderstated?


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LIFO & FIFODepreciating valueinventory units

New units cost less over time

Lower value units

Higher value units

LIFO

FIFO

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Inventory--depreciating value unitsFIFO LIFO

Balance sheet--inventory over orunderstated?Income statement--COGS over or understated? Profit margin over orunderstated?


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Age Depreciation

Land

Buildings

Equipment


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Effects of Lease Financing

Capital Leases

Operating Leases


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Intangible Assets

Goodwill

M&A


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Mini Case Analysis

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Mini Case AnalysisStatement of Retained Earnings (1998)

Balance of retained

earnings, 12/31/97 $203,768

Add: Net income, 1998 (519,936)

Less: Dividends paid (11,000)

Balance of retained

earnings, 12/31/98 ($327,168)

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Mini Case AnalysisStatement of Cash Flows: 1998

OPERATING ACTIVITIESNet Income (519,936)Adjustments: Depreciation 116,960 Change in AR (280,960) Change in inventories (572,160) Change in AP 378,560 Change in accruals 353,600 Net cash provided by operations.

(523,936)

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Mini Case AnalysisStatement of Cash Flows: 1998

L-T INVESTING ACTIVITIESInvestments in fixed assets (711,950)

FINANCING ACTIVITIES Change in s-t investments 48,600 Change in notes payable 520,000 Change in long-term debt 676,568 Payment of cash dividends (11,000)

Net cash from financing 1,234,168

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Statement of Cash Flows: 1998

Summary:Beginning cash 9,000 Cash from operations (523,936)Investment in fixed assets (711,950)Net cash from financing 1,234,168 Equals: ending cash 7,282

Change in cash for year: (1,718)

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What effect did the company’s expansion have on its net cash flow

and net income for 1998?

NCF98 = NI + DEP==

NCF97 ==

NI98 - NI97= =

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The expansion was financed primarily with ______________

The company __________________ which reduced its financial strength and flexibility.

How was the expansion financed?

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What happens if fixed assets are depreciated over 7 years (as opposed

to the current 10 years)?

No effect on physical assets.Fixed assets on balance sheet

would _________.Net income would __________.Tax payments would _________.Cash position would __________.

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Other policies that can affectfinancial statements

Inventory valuation methods.

Capitalization of R&D expenses.

Policies for funding the company’s retirement plan.

Lease financing

Merger accounting

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Why are ratios useful?

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Liquidity:

What are the five major categoriesof ratios, and what questions do

they answer?

(More…)

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Asset management:


they answer?

(More…)

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Debt management:


they answer?

(More…)

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Profitability:


they answer?

(More…)

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Market value:


they answer?

(More…)

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Mini Case Analysis--Compute Statement of Cash Flows: 1999

OPERATING ACTIVITIESNet IncomeAdjustments: Depreciation Change in AR Change in inventories Change in AP Change in accrualsNet cash provided by operations.

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Mini Case Analysis--ComputeStatement of Cash Flows: 1999

L-T INVESTING ACTIVITIESInvestments in fixed assets

FINANCING ACTIVITIES Change in s-t investments Change in notes payable Change in long-term debt Payment of cash dividends

Net cash from financing

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Mini Case Analysis--ComputeStatement of Cash Flows: 1999

Summary:Beginning cash 9,000 Cash from operationsInvestment in fixed assetsNet cash from financingEquals: ending cash 7,282

Change in cash for year: (1,718)

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Calculate the firm’s forecasted current and quick ratios for 1999.

CR99 = = =

QR99 =

= =

CACL

CA - Inv.CL

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Comments on CR and QR

1999 1998 1997 Ind.

CR 1.1x 2.3x 2.7x

QR 0.4x 0.8x 1.0x

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What is the inventory turnover ratio as compared to the industry average?

Inv. turnover =

= =

SalesInventories

1999 1998 1997 Ind.

Inv. T. 4.5x 4.8x 6.1x

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Inventory turnover is _____ industry average.

Firm might have ___ inventory, or its control might be ____.

Is improvement forecasted?

Comments on Inventory Turnover

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ReceivablesAverage sales per day

DSO is the average number of days after making a sale before receiving

cash.

DSO =

= =

= 44.9 days.

ReceivablesSales/360

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Appraisal of DSO

Firm collects?

Credit policy?

1999 1998 1997 Ind. DSO 39.0 36.8 32.0

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Fixed Assets and Total AssetsTurnover Ratios

Fixed assetsturnover

Sales Net fixed assets=

= =

Total assetsturnover

Sales Total assets=

= = (More…)

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FA turnover is expected to ________________.

TA turnover?__________________

1999 1998 1997 Ind.FA TO 6.2x 10.0x 7.0xTA TO 2.0x 2.3x 2.6x

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Calculate the debt, TIE, and fixed charge coverage ratios.

Total debt Total assetsDebt ratio

=

EBIT Int. expense TIE =

= = (More…)

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All three ratios reflect use of debt, but focus on different aspects.

Fixed chargecoverage

= FCC

=

= =

EBIT + Lease payments Interest Lease Sinking fund pmt.expense pmt. (1 - T)+ +

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Debt situation?

How do the debt management ratios compare with industry averages?

1999 1998 1997 Ind.D/A 95.4% 54.8% 50.0%TIE -3.9x 3.3x 6.2xFCC -3.0x 2.4x 5.1x

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Profit margin story?

Profit Margin (PM)

1999 1998 1997 Ind. PM -8.9% 2.6% 3.5%

PM = = = NI Sales

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BEP =

= =

Basic Earning Power (BEP)

EBIT Total assets

(More…)

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BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be?

1999 1998 1997 Ind.BEP -24.1% 14.2% 19.1%

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

ROA =

= =

Net income Total assets

(More…)

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ROE =

= =

Net income Common equity

1999 1998 1997 Ind.ROA -18.1% 6.0% 9.1%ROE -391.4% 13.3% 18.2%

Story?

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ROA is ________by debt--interest expense ______ net income, which also ______ ROA.

However, the use of debt ______ equity, and if equity is ________ more than net income, ROE would

Effects of Debt on ROA and ROE

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Calculate and appraise theP/E and M/B ratios.

Price = $12.17.

EPS = = =

P/E = = =

NI Shares out.

Price per shareEPS

(More…)

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Com. equity Shares out.BVPS =

= =

Mkt. price per share Book value per share

M/B =

= =

(More…)

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P/E: How much investors will pay for $1 of earnings. High is good.

M/B: How much paid for $1 of book value. Higher is good.

P/E and M/B are high if ROE is high, risk is low.

1999 1998 1997 Ind.P/E -0.4x 9.7x 14.2xM/B 1.7x 1.3x 2.4x

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( )( )( ) = ROE

Profitmargin

TAturnover

Equitymultiplier

NI Sales

SalesTA

TA CE

1997 2.6% x 2.3 x 2.2 = 13.3%1998 -8.9% x 2.0 x 21.6 = -391.4%1999 x x =Ind. 3.5% x 2.6 x 2.0 = 18.2%

Explain the Du Pont System

x x = ROE.

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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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Simplified Firm Data

A/R $ 878 Debt $1,945Other CA 1,802 Equity 1,552Net FA 817Total assets $3,497 L&E $3,497

Q. How would reducing DSO to 32 days affect the company?

Sales $7,035,600 day 360

= = $19,543.

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Effect of reducing DSO from 44.9 days to 32 days:

Old A/R = = $878,000

New A/R = = 625,376

Cash freed up =

Initially shows up as additional cash.

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What could be done with the newcash? Effect on stock price and risk?

New Balance Sheet

Added cash $ 253 Debt $1,945A/R 625 Equity 1,552Other CA 1,802Net FA 817Total assets $3,497 Total L&E $3,497

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Potential use of freed up cash

Repurchase stock.

Expand business.

Reduce debt.

Pay a special cash dividend.

Buy another company

(More…)

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What are some potential problems and limitations of financial ratio analysis?

Comparison with industry averages is difficult if the firm operates many different divisions.

“Average” performance is not necessarily good.

Seasonal factors can distort ratios.

(More…)

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Window dressing techniques can make statements and ratios look better.

Different accounting and operating practices can distort comparisons.

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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What are some qualitative factors analysts should consider when

evaluating a company’s likely future financial performance?

Are the company’s revenues tied to a single customer?

To what extent are the company’s revenues tied to a single product?

To what extent does the company rely on a single supplier? (More…)

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What are some qualitative factors analysts should consider when

evaluating a company’s likely future financial performance?

What % of business is foreign?

What is the competitive situation?

What does the future have in store?

What is the company’s legal and regulatory environment?

3 - 1 Copyright © 2002 by James M. Johnson, Ph.D. All rights ...

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Transcript of 3 - 1 Copyright © 2002 by James M. Johnson, Ph.D. All rights ...