Chapter 4

Analysis of Financial Statements

1

Learning Objectives

Measure and interpret financial ratios.Analyze trends in financial ratios.Manipulate financial ratios to find another ratio.

2

Ratio Analysis

Examines firm’s management of various facets of the company’s business through its financial statements.

Scales balance sheet and income statement information for easy comparison across time or to other companies.

3

Two common approaches

Trend Analysis - looks at changes in one company’s ratios over time.

Benchmarking: Comparison or Industry Analysis - compares company’s ratios against a similar company or against industry-wide ratios.

To illustrate trend analysis, we will compare Best Buy’s Feb. 2006 and Feb. 2005 ratios.

To illustrate benchmarking, we will calculate Best Buy’s Feb. 2006 ratios and will compare to Circuit City’s Feb. 2006 ratios.

4

Areas Examined by Ratio Analysis

Liquidity - measures the ability to meet short-term obligations

Asset Management - measures the ability to contain the growth of assets, and the ability to effectively utilize assets

Debt Management - measures the use of financial leverage (debt) and its impact

Profitability - measures the profitability of various segments of a company

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Liquidity Ratios

Feb. 2006 Feb. 2005

Best Buy Current 1.32 1.39

Best Buy Quick 0.77 0.82

Circuit City Current 1.75

Circuit City Quick 0.706

seitilibailcurrent

assetscurrent = ratioCurrent

seitilibailcurrent

inventoryassets-current = ratioQuick

Asset Management Ratios

Feb. 2006 Feb. 2005

Best Buy InvTurn 9.24 9.62

Best Buy DSO 5.99 4.99

Circuit City InvTurn 6.83

Circuit City DSO 8.067

inventory

sales = turnoverInventory

Sales/365 Annual

sReceivalbe = g(DSO)Outstandin Sales Days

Asset Management (Continued)

Feb-06 Feb-05

Best Buy Fixed asset turnover 11.37 11.13

Best Buy Total asset turnover 2.60 2.66

Circuit City FAT 13.82

Circuit City TAT 2.858

assets fixedNet

Sales =Turnover Asset Fixed

assets total

sales = overasset turn Total

Debt Management Ratios

Feb-06 Feb-05

BB Debt ratio 55.7% 56.8%

BB TIE 108.56 42.23

CC Debt Ratio 52.0%

CC TIE 77.07

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chargesInterest

EBIT = earnedinterest-Times

assets total

seitilibail (debt) total = assets toDebt

Profitability Ratios

Feb-06 Feb-05

BB Profit margin 3.7% 3.6%

BB ROA 9.6% 9.6%

CC Profit Margin 1.2%

CC ROA 3.4%

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sales

incomeNet = saleson marginrofit P

assets Total

incomeNet = assets on total Return

Profitability Ratios (Continued)

Feb-06 Feb-05

BB BEP 14.6% 14.4%

BB ROE 21.7% 22.1%

CC BEP 6.0%

CC ROE 7.1%

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assets Total

EBIT = Power(BEP) Earning Basic

equity rs'Stockholde

incomeNet = equitycommon on Return

Breaking Down ROE: DuPont Equation

ROE(NI/Eq) = Return on Assets (NI/TA) x Equity Multiplier (TA/Eq)

ROE = Profit Margin on Sales (NI/S) x Total Asset Turnover (S/TA) x TA/EqProfit margin is a measure of the firm’s operating efficiency – how

well does it control costsTotal asset turnover is a measure of the firm’s asset use efficiency –

how well does it manage its assetsEquity multiplier is a measure of the firm’s financial leverage

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DuPont Equation: Best Buy vs. Circuit City

082.252.01

1

ratiodebt total1

1

equity

assets

*Since Assets = Liabilities + Equity, 1 – debt ratio = equity/assets meaning for Circuit City:

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Feb. 2006 Profit Margin

Asset Turnover

Assets to Equity*

ROE

Best Buy 3.7% 2.60 2.257 21.7%

Circuit City

1.2% 2.85 2.082 7.1%

Circuit City ROE Catch-up?

Circuit City would like to improve their ROE to 15%. They anticipate improvement in profit margin and total asset turnover to 2.0% and 3.0 respectively. What total debt to total asset ratio would be needed to achieve Circuit City’s ROE goal?

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15

Some DuPont ROE Comparisons

Trailing 12 Months

PM TAT Eq Mult ROE

S&P 500 13.5% 0.8 2.07 22.4%

Oil&Gas industry

11.5% 1.4 1.86 30.0%

Electronics Store Ind.

3.2% 2.8 2.27 20.3%

Microsoft 28.5% 0.6 1.67 28.6%

Nike 8.8% 1.6 1.55 21.9%

Yum! Brands

8.5% 1.6 3.99 54.3%16

Market Ratios

Feb. 2006 Stock Price

EPS Feb. 2006 P/E Ratio

Recent P/E

Best Buy $54.04 $2.33 23.2 21.7

Circuit City

$24.03 $0.80 30.0 28.317

shareper earnings

stockcommon of shareper pricemarket = ratio (P/E) ingsPrice/earn

Market Ratios

goutstandinstock common of shares ofnumber

equitystock common = shareper Book value

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Feb. 2006

StockPrice

# of shares (000)

BV/sh M/B ratio

Best Buy $54.04 490,300 $10.72 5.04

Circuit City

$24.03 174,400 $11.21 2.14

stockcommonofsharepervalueBook

stockcommonofsharepervalueMarketratio (M/B)k Market/boo