Chapter 17Fundamentals of

Corporate

Finance

Fifth Edition

Slides by

Matthew Will

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Financial Statement Analysis

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Topics Covered

Financial RatiosDuPont SystemUsing Financial ratiosMeasuring Company PerformanceThe Role of Financial Ratios

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Type of Financial Ratios

Leverage ratios show how heavily the company is in debt.

Liquidity ratios measure how easily the firm can lay its hands on cash.

Efficiency or turnover ratios measure how productively the firm is using its assets.

Profitability ratios are used to measure the firm’s return on its investments.

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Financial Statements

Income Statement - Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.

Common-Size Income - Statement Income statement that presents items as a percentage of revenues.

Balance Sheet - Financial statement that shows the value of the firm’s assets and liabilities at a particular time.

Common-Size Balance Sheet - Balance sheet that presents items as a percentage of total assets.

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Leverage Ratios

equity+debt termlong

debt termlong=ratiodebt termLong

equity

debt termlong=ratioequity Debt

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Leverage Ratios

Total debt ratio =total liabilities

total assets

Times interest earned =EBIT

interest payments

Cash coverage ratio =EBIT + depreciation

interest payments

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Liquidity Ratios

Net working capital

to total assets ratio=

Net working capital

Total assets

Current ratio =current assets

current liabilities

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Liquidity Ratios

Cash ratio =cash + marketable securities

current liabilities

Quick ratio =cash + marketable securities + receivables

current liabilities

Interval measure =cash + marketable securities + receivables

average daily expenditures from operations

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Efficiency Ratios

Asset turnover ratio =Sales

Average total assets

NW Cturnover =sales

average net working capital

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Efficiency Ratios

Days' sales in inventory =average inventory

cost of goods sold / 365

Inventory turnover ratio =cost of goods sold

average inventory

Average collection period =average receivables

average daily sales

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Profitability Ratios

assets totalaverage

Interest IncomeNet =assetson Return

sales

incomenet =marginprofit Net

equity average

incomenet =equityon Return

sales

interest incomenet =marginprofit Operating

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Profitability Ratios

Plowback ratio =earnings - dividends

earnings

= 1 - payout ratio

Payout ratio =dividends

earnings

Growth in equity from plowback =earnings - dividends

earnings

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Market Value Ratios

g-r

1

EPS avg

P=ratio PE Forecasted

1

1

1

0 xEPS

Div

PE Ratio =stock price

earnings per share

Dividend yield =dividend per share

stock price

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Market Value Ratios

Market to book ratio =stock price

book value per share

Price per share = P =Div

r - g01

Tobins Q =market value of assets

estimated replcement cost

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The DuPont System

A breakdown of ROE and ROA into component ratios

equity

stock commonfor available earnings=ROE

assets

interest IncomeNet =ROA

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The DuPont System

sales

interestIncomeNet x

assets

sales=ROA

assetturnover

Operating profitmargin

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The DuPont System

interestIncomeNet

IncomeNet x

sales

interestIncomeNet x

assets

salesx

equity

assets=ROE

leverageratio

assetturnover

Operating profitmargin

debtburden

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Using Financial Ratios

Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, December 2004.

LT Debt, Interest NWC Quick Asset Oper Prof. Return on Return on PayoutIndustry Assets Coverage Assets Ratio Turnover Margin (%) Assets (%) Equity (%) Ratio

All manufacturing 0.19 4.13 0.07 0.91 0.93 6.88 6.37 15.76 0.31 Food products 0.28 3.65 0.09 0.81 1.37 6.20 8.50 17.80 0.36 Textiles 0.23 2.92 0.20 0.92 1.47 4.35 6.39 8.39 0.23 Petroleum/coal 0.15 3.64 0.04 1.00 1.34 3.31 4.45 18.14 0.25 Chemicals 0.19 4.27 - 0.72 0.59 10.37 6.13 7.31 0.33 Drugs 0.25 9.44 0.02 0.76 0.87 13.53 11.72 59.14 0.29 Machinery 0.19 4.64 0.13 1.02 0.89 8.04 7.19 14.82 0.17 Computers/electronic 0.11 4.52 0.14 1.31 0.66 5.30 3.52 10.06 0.20 Transportation equip. 0.17 2.22 0.01 0.72 0.94 3.94 3.69 13.12 0.30 Beverages/tobacco 0.28 5.25 –0.02 0.70 0.63 14.76 9.24 27.62 0.51

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MVA & Economic Profit

Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

Market Value Added = The difference between the market value of common stock and its book value

Invested Capital)(

Profit Economic

rROI

EP

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Residual Income & EVA

Residual Income or EVA = Net Dollar return after deducting the cost of capital

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

Investment Capital ofCost - Earned Income

required income-Earned Income

Income Residual

EVA

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Measuring PerformanceBenchmark Financial Ratios

Company Industry Sector S&P 500

Valuation Ratios

P/E ratio (TTM) 22.35 21.66 20.66 22.06Price to book (MRQ) 6.68 6.25 7.25 4.04Price to cash flow (TTM) 17.17 16.85 17.19 15.93Financial Strength

Quick ratio (MRQ) 0.95 0.87 0.65 1.21Current ratio (MRQ) 1.28 1.19 1.26 1.71LT debt to equity (MRQ) 0.18 0.31 0.77 0.6Total debt to equity (MRQ) 0.26 0.54 0.97 0.76Interest coverage (TTM) 31.49 29.74 17.14 12.59Profitability Ratios (%)

Operating margin (TTM) 17.97 20.91 17.02 21.97Net profit margin (TTM) 14.27 17.01 11.49 14.03Management Effectiveness (%)

Return on assets (TTM) 15.88 14.96 11.31 7.63Return on equity (TTM) 32.84 31.06 33.28 20Efficiency

Receivable turnover (TTM) 9.37 10.08 13.39 10.26Inventory turnover (TTM) 8.67 7.49 6.75 13.29Asset turnover (TTM) 1.11 0.92 1.09 0.96

Ratios PEPSICO INC (NYS)

Sector: Consumer/Noncyclical | Industry: Beverages (nonalcoholic)

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Measuring Performance

Market to Book Ratio

MVA($millions)

Return on Capital (%)

Cost of Capital (%)

Year avergae capital

($million)EVA

($million)

Microsoft 7.40 204,168.00 32.90 11.70 31,090.00 6,456.00

Wal-Mart 2.90 169,927.00 13.20 6.20 86,822.00 5,920.00

Johnson & Johnson 3.40 135,584.00 18.10 8.20 57,833.00 5,682.00

Intel 4.00 98,189.00 18.60 13.70 32,394.00 1,645.00

Coca-Cola 4.80 83,080.00 21.30 6.40 21,166.00 3,116.00

IBM 2.20 79,894.00 9.00 11.20 67,369.00 –1,506

Merck 2.10 37,921.00 17.90 8.00 36,887.00 3,705.00

Dow Chemical 1.00 25,403.00 5.90 6.50 44,639.00 –299

Delta Air Lines 1.00 4,090.00 –1.0 –6.7 27,888.00 –2,155

Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g., for Microsoft, EVA = (.329 –

.177) × $204,168 million

Source: Data provided by Stern Stewart & Co.

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Financial Ratios and Default Risk

AAA AA A BBB BB B CCC

Operating income/sales (%) 24.6 23.4 18.1 14.7 15.9 13.9 9.4Free cash flow/sales (%) 14.8 10.9 7.8 5.6 3.9 1.3 -0.9EBITDA int. + div. coverage 4 3.9 4.11 4.5 3 1.7 1Total liabilities/net worth (%) 70.3 123.6 138.8 152.6 198.7 206.9 -208.3EBITDA/total assets (%) 22.2 21.2 16.3 13.7 12.9 10.3 6.9Total debt/market capitalization (%) 0 8.1 17.2 27.5 43.5 55.8 79.7Historical default rate (%) 0.5 1.3 2.3 6.6 19.5 35.8 54.4

Three-Year (1998–2000) Medians

Note: EBITDA is earnings before interest, taxes, depreciation, and amortization.

Sources: Default rates from “Statement of Standard & Poor’s on Credit Rating Agencies to SEC,” Public Hearing, November

2002; all other data from Standard & Poor’s.

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Web Resources

www.reportgallery.com

www.prars.com

www.corporateinformation.com

www.jaxworks.com

http://finance.yahoo.com

http://edgarscan.pwcglobal.com

www.sternstewart.com

www.ibm.com/investor/financialguide

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