Chapter 17: Financial Statement and Ratio Analysis

8/14/2019 Chapter 17: Financial Statement and Ratio Analysis

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CHAPTER 17: FINANCIAL STATEMENT AND RATIO ANALYSIS

A. OVERVIEW

Definition: A ratio is simply a numerator divided by a denominator Percentage (e.g. earnings as a % of sales revenue) Times (e.g. asset as xx times of debt) Number of days for certain activities to be completed (e.g. inventory to be sold)

Definition:Ratio analysis refers to methods of calculating and interpreting financial ratios to assess afirms performance

Question: Why is ratio analysis useful? Provide details for financial planning Put details into perspective Manage expectations (creditors and investors)

Types of ratio comparisons: Cross-sectional analysis Time-series analysis Combined (mixed)

Cross-sectional: Compares different firms financial ratios at the same time Benchmarking: relative to other firm(s) or the industrial average; check for deviations Caution: Large deviations as symptoms but inconclusive Example: Interested in average age of inventory

What might have caused the firm to have an AAI so much lower than the industrialaverage? Is it an indicator of good performance?

Avg. age of inventory,2003 (AAI)

Caldwell manufacturing 24.7 days

Industry average 43.3 days

Time-series: Evaluate a firms financial performance over time Establish trends to assess the firms performance over time

Combined / mixed: Use both cross-sectional and time-series

Types of financial ratios:

1. Liquidity2. Activity3. Leverage4. Profitability

Note: When commenting on the performance of a firm, be sure to organize your ideas by these four types of ratios compare these ratios of the firm over time compare with the industrial averages


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B. ANALYZING LIQUIDITY

Definition: Liquidity measures a firms ability to satisfy its short-term obligations as they come due Can the firm pay its bills?

Types of ratios used for analyzing liquidity (See Tables 3.3 and 3.4 for examples):1. Net working capital (not a ratio)2. Current ratio3. Quick ratio (acid test)

1. NET WORKING CAPITAL: Dollar amount of current assets exceeds / falls short of current liabilities

Example: Net working capital = $1,223,000-$620,000 = $603,000

Interpretation: Current assets exceed current liabilities by $603,000 at the end of 2002. Working capital: usually refers to current assets only Cash component: does not earn a return! So, too large a number does not necessarily imply a

good performance

Note: Not a useful measure for comparing among firms. Why? Nature of activities is different Size of operation is different

Net working capital = Current assets current liabilities


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2. CURRENT RATIO: Size of current assets relative to current liabilities

Example: Current ratio = $1,223,000/$620,000 = 1.97

Interpretation: For each dollar the firm owes (short-term liabilities), the firm has $1.97 in its asset.

Rule of thumb: current ratio=2, but if cash flow is predictable, a lower current ratio is acceptable

Twist: % of current assets that can be reduced such that the firm can still cover its short-termobligations as they come due

Example: (1-1/1.97) * 100% = 49.24

Interpretation: The firm can reduce its current asset by 49.24% and still be able to meet its short-termobligations

Question: What would be the net working capital when current ratio=1?

3. QUICK RATIO (ACID-TEST): Size of most liquid current assets relative to current liabilities

Note: Inventories excluded Inventories generally take longer to sell, often at discounted prices Inventories may be accounts receivable before they can be turned into cash

Example: Quick ratio = ($363,000 + $68,000 + $503,000) / $620,000 = 1.51

Rule of thumb: quick ratio=1

Note: Quick ratio vs. current ratio: depends on how liquid are the inventories

Final remarks Higher ratios firm is in a more liquid position Trade-off between liquidity (risk) and profitability

Higher ratio lower current liabilities, less costly than long-term financing (lower risk) Higher ratio larger current assets, less profitable than fixed assets (lower return

C. ANALYZING ACTIVITY

Definition: Activity ratios measure the firms effectiveness at managing accounts receivable, inventory,accounts payable, fixed assets, and total assets

Supplement to liquidity ratios: focus on the composition of current assets

Four ratios:1. Average age of inventory2. Average collection period3. Average payment period4. Fixed and total asset turnover

Current ratio = Current asset / Current liabilities

Quick ratio = Cash + marketable securities + accounts receivable / Current liabilities


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1. AVERAGE AGE OF INVENTORY Average time inventory is held by the firm (unsold)

Example: Average age of inventory = $289,000 / ($2,088,000 / 365 days) = 50.7 days

Interpretation: The firm takes, on average, 50.7 days to sell an average item of its inventory

Note: Importance of benchmarking against other firms in the same industry Too high: Risk of not being able to sell inventory Too low: Under-investment in inventory

2. AVERAGE COLLECTION PERIOD Average time taken to collect accounts receivable

Example: Avg. collection period = $503,000 / ($3,074,000 / 365 days) = 59.7 days

Interpretation: The firm takes, on average, 59.7 days to collect accounts receivable

Note: Important to compare with terms of credit

3. AVERAGE PAYMENT PERIOD Average time taken to pay its purchases

Example: Suppose the firm purchases 70% of its COGS. Avg. payment period = $382,000 /(0.7*$2,088,000 / 365 days) = 95.4 days

Interpretation: The firm takes, on average, 95.4 days to pay

Note: Important to compare with terms of credit given by creditors

Average age of inventory = Inventory / daily cost of goods sold (COGS)

= Inventory / (COGS/365)

Avg. collection period = Accts recble / avg. daily sales

= Accts recble / (Annual sales/365)

Avg. payment period = Accts payable / avg. daily purchase= Accts payable / (% COGS/365)


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4. FIXED AND TOTAL ASSET TURNOVER

Efficiency with which the firm uses its net fixed assets to generate sales

Example:Fixed asset turnover = $3,074,000 / $2,374,000 = 1.29Total asset turnover = $3,074,000 / $3,597,000 = 0.85

Interpretation: Every dollar of fixed asset generates $1.29 sales; every dollar of asset (total) generates$0.85 sales

Question: High fixed asset turnover and low total asset turnover low fixed-to-current assets. Why?

D. ANALYZING LEVERAGEDefinition: Amount of debt used in an attempt to maximize shareholders wealth

Two types: Capitalization ratios: How a firm has financed its investment

Debt ratio Debt/Equity ratio

Coverage ratios: Assess the firms ability to service the source of financing (payment debt,interest, leases, dividend payments i.e., fixed financial charges)

Times interest earned ratio Fixed-charge coverage ratio

Capitalization ratios1. DEBT RATIO

Proportion of total assets financed by creditors

Example: Debt ratio = $1,643,000 / $3,597,000 = 0.457 (45.7%)

Interpretation: 45.7% of assets have been financed by debt

Fixed asset turnover = Sales / Net fixed assets

Total asset turnover = Sales / Total assets

Debt ratio = Total liabilities / Total assets


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Related ratios: Preferred equity ratio Common equity ratio

1b. PREFERRED EQUITY RATIO Proportion of total assets financed by preferred shareholders

Example Preferred equity ratio = $200,000 / $3,597,000 = 0.056 (5.6%)

1c. COMMON EQUITY RATIO Proportion of total assets financed by common shareholders

Example Common equity ratio = $1,754,000 / $3,597,000 = 0.488 (48.8%)

Note: Common equity includes retained earningsNote: Debt ratio + preferred equity ratio + common equity ratio = 100%. Why?

2. DEBT / EQUITY RATIO Proportion of long-term debt to common equity

Example Debt/Equity ratio = $1,023,000 / $1,754,000 = 0.583 (58.3%)

Interpretation: For every dollar of common equity financing, the firm uses $0.583 of long-term debt

Suggested maximum: 100%

Coverage ratios1. TIMES INTEREST EARNED (INTEREST COVERAGE) RATIO

Firms ability to pay contractual interest The higher is the ratio, the more capable is the firm to pay

Example Interest coverage ratio = $418,000 / $93,000 = 4.49

Interpretation: For every dollar of interest, the firm has $4.49 of operating earnings available to pay

Rule of thumb: 3 to 5

Preferred equity ratio = Preferred shares / Total assets

Common equity ratio = Common shares / Total assets

Debt / Equity ratio = Long-term debt / Common equity

Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest


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Twist: (1 - 1/interest coverage ratio)*100%

Example: (1-1/4.49)*100% = 78%

Interpretation: The firm can shrink its earnings by 78% and still be able to pay its contractual interestpayment

Question: Suppose a firm has times interest earned ratio of 28.63 but the industrys average is 12.31.

Why might the companys ratio be so much higher than the industry average? Little debt Lower risk ( financial leverage and lower return)

2. FIXED-CHARGE COVERAGE RATIO Firms ability to pay fixed charges The higher is the ratio, the more capable is the firm to pay 4 types of fixed financial charges

Interest on debt Principal repayment on debt Lease payment Preferred-share dividend payments

Example A firm has EBIT: $418,000 with lease payments of $35,000 and interest payment of $93,000.Principal payments are $71,000. Preferred share dividends are $10,000. Find fixed-charge coverageratio.

Interpretation: For every dollar of fixed financial charges, the firm has $1.87 available to make thepayment

Note: The lower the ratio, the higher the risk to lenders and owners (harder for firm to pay fixedcharges)

E. ANALYZING PROFITABILITY Concerned with evaluating a firms earnings with respect to a given level of sales / assets / owners

investment or share value

1.

Common-size income statements2. Return on total assets (ROA)3. Return on equity (ROE)4. Earnings per share (EPS)5. Price/Earning (P/E) ratio

1. COMMON-SIZE INCOME STATEMENT Express every item on the income statement as a % of sales

Gross margin Operating margin Profit margin


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Gross margin: % of each sales dollar remaining after the firm has paid the direct COGS Operating margin: % of each sales dollar remaining after the firm has paid all expenses

(excluding financing expenses and taxes) Profit margin: % of each sales dollar remaining after the firm has paid all expenses (including

interest and taxes)

2. RETURN OF TOTAL ASSETS (ROA) Return on investment (ROI) Effectiveness in generating profits with its available assets The higher the better

Example ROI = $231,000 / $3,597,000 = 0.064 (6.4%)

Interpretation: For every $100 of assets, the firm has a return of $6.4.

3. RETURN ON EQUITY (ROE) Return on owners equity The higher the better

Example: ROE = $221,000 / $1,754,000 = 0.126 (12.6%)

Interpretation: For every $100 of common equity financing, the firm generates $12.6.

4. EARNINGS PER SHARE (EPS) Dollar amount earned on behalf of each common share The higher the better

Example: EPS = $221,000 / 76,262 = $2.90

Interpretation: Earnings are $2.90 per share

5. PRICE/EARNING (P/E) RATIO Amount investors are willing to pay for each dollar of earnings Indicates investors confidence

Example: Suppose market price is $32.25 per share. P/E = $32.25 / $2.90 = $11.12 per share

Interpretation: Investors are paying $11.2 for each $1 of earnings for each share

ROA = Net income after taxes / Total assets

ROE = Earnings available for common shareholders / Common equity

EPS = Earnings available for common shareholders / Number of common shares outstanding

P/E = Market price per share / Earnings per share


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F. COMPLETE RATIO ANALYSIS1. DuPont System : Diagnostic2. Summary analysis : Consider all aspects

1. DUPONT SYSTEM System used by management to dissect the firms financial statements and to assess the firms

financial conditions Merge income statement with balance sheet information Focus on

ROA ROE

2. SUMMARY ANALYSIS Tabulate all ratios discussed earlier

Liquidity Activity Leverage Profitability

Combining cross-sectional with time-series analyses

Chapter 17: Financial Statement and Ratio Analysis

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Transcript of Chapter 17: Financial Statement and Ratio Analysis