Georgia Banking Schoolresources.gabankers.com/Event Agenda PDFs/2017/Georgia... · 2017-04-28 ·...
Transcript of Georgia Banking Schoolresources.gabankers.com/Event Agenda PDFs/2017/Georgia... · 2017-04-28 ·...
Georgia Banking School
Financial Statement Analysis
Dr. Christopher R Pope
Terry College of Business
University of Georgia
Financial Statement Analysis 2
Introduction
Objective
My objective is to introduce you to the analysis of financial statements. The
goal of the analysis is to obtain information about the timing, magnitude, and
riskiness of future cash flows. This information can then be combined with
other qualitative information to determine a firm’s creditworthiness.
Perspective
Last year, you learned to analyze the financial statements of a commercial
bank to determine the bank’s strengths and weaknesses and to provide
direction for future policy decisions. This year, we will use a similar set of
tools in the assessment of credit risks for commercial loan customers.
We will end our discussion with a loan analysis for Butler Lumber Company,
a small, growing firm that is looking for financing.
Financial Statement Analysis 3
Determining Credit Risk
Our objective is to use quantitative analysis to determine the credit
worthiness of the applicant firm. One of the most important questions
from the lender’s perspective is
“Will the customer be able to repay the loan from operating cash flows?”
This analysis provides several benefits:
It helps separate good credits from bad credits.
We do not want to extend credit to a customer who will default.
However, it is also costly to deny credit to a customer who can repay.
It identifies the borrower’s strengths and weaknesses and possible sources
of risk
It provides information to loan officers that helps them set up the terms of
the loan
Financial Statement Analysis 4
Analysis of Financial Statements Important Points
It is necessary to compare performance to various benchmarks
Trends: Generally 3 to 5 years worth of data is necessary to ascertain how
the firm’s financial performance is changing over time.
Industry: It is helpful to compare the firm’s performance to that of the
industry (or industries) in which it operates. Although industry averages may
not indicate where a firm wants to be, the comparison is helpful in analyzing
trends.
Competitors: It is also useful to compare the firm’s performance to that of
specific firms, such as the direct competition. These may be more
comparable than the overall industry.
It is extremely important to carefully read and analyze the annual report
- including the footnotes to the financial statements. Often these will
point to other factors, such as contractual obligations, past and future
financing policies, plans for further expansion or restructuring, or the
sale of part of the firm’s assets - that significantly affect the entire
financial analysis.
Off balance-sheet activity
Financial Statement Analysis 5
Analysis of Financial Statements Important Points (cont’d)
The analysis may raise further questions for which additional
information must be obtained (either from more in depth analysis or by
asking firm management). The important point is not to view the
financial analysis as an end in itself.
Also note: accounting conventions and window dressing.
Financial Statement Analysis 6
Tools of Financial Analysis Common-Size Financial Statements
Common-Size Financial Statements are a popular way to convert
dollar figures to relative (%) figures. They are routinely used with
income statements and balance sheets.
Income Statement
A common-size income statement is constructed by dividing the various
components of the income statement by net sales. Hence, net sales equals
100% and everything else is presented as a percentage of net sales.
Balance Sheet
A common-size balance sheet is calculated in the same manner, except that
all the statement components are divided by total assets to put them on a
common percentage basis.
Financial Statement Analysis 7
Common Size Financial Statements Selected Numbers: Barnes & Noble and Borders
Common-Size Balance Sheet
Barnes & Noble Borders Group
2003 2001 2003 2001
Inventory 1,395.9 46.6% 1,238.6 48.4% 1,183.3 52.2% 1,201.2 58.7%
Total Current Assets 1,887.0 48.6% 1,455.2 56.9% 1,543.4 68.0% 1,335.1 65.2%
Property & Equipment 622.3 20.8% 566.2 22.1% 553.8 24.4% 562.3 27.5%
Total Assets 2,995.4 100.0% 2,557.4 100.0% 2,268.2 100.0% 2,047.1 100.0%0.0%
Accounts Payable 711.0 23.7% 582.0 22.8% 565.4 24.9% 623.6 30.5%
Notes Payable 0.0 0.0% 0.0 0.0% 0.0 0.0% 0.0 0.0%
Total Current Liabilities 1,231.5 41.1% 935.0 36.6% 1,087.6 47.9% 1,117.9 54.6%
Long-Term Debt 300.0 10.0% 666.9 26.1% 69.0 3.0% 15.0 0.7%
Total Liabilities 1,967.6 65.7% 1,779.8 69.6% 1,237.6 54.6% 1,200.6 58.6%
Common-Size Income Statement
Barnes & Noble Borders Group
2003 2001 2003 2001
Sales 5,269.0 100.0% 4,375.8 100.0% 3,512.9 100.0% 3,271.2 100.0%
COGS 3,856.0 73.2% 3,169.7 72.4% 2,511.3 71.5% 2,354.5 72.0%
Gross Profit 1,413.0 26.8% 1,206.0 27.6% 1,001.6 28.5% 916.7 28.0%
Interest Expense 21.5 0.4% 53.5 1.2% 12.6 0.4% 13.1 0.4%
Pretax Income 199.0 3.8% -32.9 -0.8% 181.3 5.2% 115.8 3.5%
Taxes 80.2 1.5% 19.9 0.5% 69.6 2.0% 61.4 1.9%
Net Income 119.0 2.3% -51.9 -1.2% 111.7 3.2% 43.6 1.3%
Financial Statement Analysis 8
Tools of Financial Analysis Financial Ratio Analysis
Financial Ratio Analysis is the study of the relationships that exist
among and between various financial statement accounts at a given
point in time. It expands the information content of financial statements.
In essence, the financial statements are converted into more useable
information so that a better understanding can be obtained about the
company.
Some uses of financial ratios
Enable an analyst to understand a firm’s risk and future cash flow
generating ability
Enable a banker to asses a firm’s creditworthiness
The mechanics are simple
Selected information is gathered from the financial statements and used to
compute a set of ratios
Ratios are then compared to benchmarks.
Financial Statement Analysis 9
Financial Ratio Analysis Benchmarks Revisited
Financial ratios provide useful tools for analysis when compared
against a standard or norm. Two such norms are commonly used.
Trend Analysis
Compare the firm’s financial ratios to a similar set of ratios from previous
financial statements.
Industry Averages
Compare the firm’s financial ratios to a similar set of ratios computed for
a comparable group of firms. Sources of industry average ratios
include:
Dun and Bradstreet publishes annually a set of 14 key ratios for 125
lines of business.
Robert Morris Associates, the national association of bank loan and
credit officers, publishes a set of 16 key ratios for 350 lines of
business.
Many are also available on the internet
Financial Statement Analysis 10
Financial Ratios Categories
We will discuss five categories of financial ratios, each representing an
important aspect of the firm’s financial condition.
Internal liquidity
Operating performance
Risk profile
Growth potential
External liquidity
Note: Exact definitions of many ratios (and categories for that matter) vary
from publication to publication and user to user.
To illustrate the ratios, we will use the financial statements of Barnes &
Noble and Borders Group
Two major booksellers
Financial Statement Analysis 11
Financial Ratios Categories (cont’d)
Internal Liquidity
Indicates the ability of the firm to meet future short term financial
obligations. These compare near term financial obligations, such as
accounts payable or notes payable to current assets or cash flows that will
be available to meet these obligations.
Examples: current ratio, quick ratio, AR & Inventory turns
Operating performance
Operating efficiency ratios examine how management uses its assets and
capital, measured in terms of the dollars of sales generated by various asset
or capital categories
Examples: Total asset turnover, equity turnover
Operating profitability ratios analyze profits as a percentage of sales and as
a percentage of the assets and capital employed
Examples: gross margin, net profit margin
Financial Statement Analysis 12
Financial Ratios Categories (cont’d)
Risk profile
Relates to the uncertainty of income flows for both the entire firm and to
individual providers of capital (equity investors, debt holders, etc).
Comprised of business risk (variability of firm due to industry and economy)
and financial risk (variability brought on by introducing debt into capital
structure).
Growth potential
Indicates how fast a firm can/should grow without raising external capital.
Determined by the amount of resources retained and reinvested in the
business and the rate of return earned on these resources.
External liquidity
Market liquidity is ability to buy or sell an asset quickly with little price
change from the last transactions. Market liquidity is determined by the
number of shares (or dollar value) traded, and a smaller bid – ask spread.
Corporate variables that are proxies for market liquidity are total market
value and number of security holders, along with trading turnover as a % of
shares outstanding that trade in a given year.
Financial Statement Analysis 13
Internal Liquidity Ratios
Liquidity ratios help the financial analyst answer the following question:
Does the firm have sufficient cash and liquid assets to pay bills on
time?
Current Ratio
Current liabilities represent the firm’s maturing financial obligations.
The firm’s ability to repay these obligations when due depends largely
on whether it has sufficient cash together with assets that can be
converted into cash before the current liabilities mature. The firm’s
current assets are the primary sources of funds to repay current and
maturing financial obligations.
C u r r e n t A s s e tsC u r r e n t R a tio
C u r r e n t L ia b il i t ie s
Financial Statement Analysis 14
Internal Liquidity Ratios Current Ratio
2003 2002 2001
Barnes & Noble
Borders
Industry 2.4 2.7
Barnes & Noble, 2001:
1,335=1.19
1,11832.1
107,1
455,1
53.1231,1
887,1
42.1088,1
543,1
40.1140,1
591,1 56.1
935
455,1
56.1935
455,1
sLiabilitie Current
Assets CurrentRatio urrentC
Financial Statement Analysis 15
Internal Liquidity Ratios Quick Ratio
Quick Ratio
Since inventories are generally the least liquid of the firm’s current assets, it
may be desirable to remove them from the numerator in the current ratio,
thus obtaining a more refined liquidity measure.
sLiabilitieCurrent
sInventorieAssetsCurrentRatioQuick
C a s h M k tb le S e c s + A RQ u ic k R a tio
C u r r e n t L ia b il i t ie s
Financial Statement Analysis 16
Internal Liquidity Ratios Quick Ratio
2003 2002 2001
Barnes & Noble
Borders
Industry 0.7 0.8
Barnes & Noble, 2001:
33.0087,1
183,1543,1
25.0
107,1
179,1455,1
12.0
118,1
201,1335,1
40.0231,1
396,1887,1
27.0
140,1
285,1591,1
23.0
935
239,1455,1
23.0935
1239455,1
sLiabilitie Current
Inventory-Assets CurrentRatio uickQ
Financial Statement Analysis 17
Internal Liquidity Ratios Cash Ratio
Cash Ratio
The most conservative liquidity measure – only the most liquid assets
C a s h M k tb le S e c sC a s h R a tio
C u r r e n t L ia b il i t ie s
Financial Statement Analysis 18
Internal Liquidity Ratios Efficiency: A/R Turnover
How effectively is the firm using its assets to generate sales?
Accounts Receivable Turnover
This ratio allows us to assess whether the firm’s sales are being tied up in
receivables?
How quickly are receivables converted to cash
N e t S a le sA c c o u n ts R e c e iv a b le T u r n o v e r
A v g A c c o u n ts R e c e iv a b le
3 6 5A v g C o lle c tio n P e r io d =
A /R T u rn o v e r
Financial Statement Analysis 19
Internal Liquidity Ratios Efficiency: Average Collection Period
$ 4 ,3 7 5 .8 kA /R T u rn o v e r = = 6 1 .3
A v g ($ 8 4 .5 k , $ 5 8 .2 )
3 6 5 3 6 5A v e ra g e C o lle c tio n P e r io d = = 6 .0
A /R T u rn o v e r 6 1 .3
2003 2002 2001
Barnes & Noble
Borders
Industry 5.8 6.6
Barnes & Noble, 2001:
6.78.47
365 9.6
2.53
365 0.6
3.61
365
4.84.43
365 8.7
6.46
365 7.7
5.47
365
Financial Statement Analysis 20
Internal Liquidity Ratios Efficiency: Inventory Turnover
How effectively is the firm using its assets to generate sales?
For example, a firm that produces $8 million in sales using $2 million in
inventory is using its inventory more efficiently than a similar firm that had
$4 million invested in inventory.
Inventory Turnover
The efficiency with which a firm is managing its investment in inventories is
reflected in the number of times that its inventories are turned over during
the year.
C o s t o f G o o d s S o ldIn v e n to r y T u r n o v e r
A v g In v e n to r y
3 6 5D a y s in In v e n to r y =
In v e n to r y T u r n o v e r
Financial Statement Analysis 21
Efficiency Ratios (continued) Inventory Turnover
2003 2002 2001
Barnes & Noble
Borders
Industry
Barnes & Noble, 2001:
9.12688.2
365 4.129
82.2
365
8.17113.2
365 9.178
04.2
365 6.176
07.2
365
8.13471.2
365
71.2)m5.102,1,m6.238,1(Avg
m7.169,3
Inventory Avg
COGSTurnover Inventory
8.13471.2
365
Turnover Inventory
365Inventory in Days
Financial Statement Analysis 22
Internal Liquidity Ratios Efficiency: A/P Turnover
Accounts Payable Turnover
Note: Purchases = COGS + Ending Inventory – Beginning Inventory
How quickly does the firm pays its bills?
Turnover A/P
365 A/P in sDay
A/P Avg
COGS Turnover Payable Accounts
*
A/P Avg
urchasesP as estimated Sometimes*
Financial Statement Analysis 23
Efficiency Ratios (cont’d) Efficiency: A/P Turnover
2003 2002 2001
Barnes & Noble
Borders
Industry
Barnes & Noble, 2001:
37.5
365
Turnover A/P
365 A/P in sDay
37.57.590
7.169,3
A/P Avg
COGS Turnover Payable Accounts
6.6648.5
365 5.65
57.5
365 0.68
37.5
365
5.8717.4
365 8.94
85.3
365 3.93
91.3
365
Financial Statement Analysis 24
Internal Liquidity Ratios Efficiency: Cash Conversion Cycle
Cash Conversion Cycle
Measures how long and where cash is tied up (in days)
C a s h C o n v e r s io n C y c le A /R D a y s + In v e n to r y D a y s - A /P D a y s
Financial Statement Analysis 25
Operating Performance Ratios Efficiency: Total Asset Turnover
How effectively is the firm using its assets to generate sales?
Total Asset Turnover
This ratio measures the efficiency with which the firm uses all of its assets to
generate sales.
N e t S a le sT o ta l A s s e t T u r n o v e r
A v g T o ta l A s s e ts
Financial Statement Analysis 26
Operating Performance Ratios Efficiency: Total Asset Turnover
N e t S a le sT o ta l A s s e t T u r n o v e r =
A v g T o ta l A s s e ts
4 ,3 7 5 .8 k = = 1 .8
2 ,4 8 5 .6 k
2003 2002 2001
Barnes & Noble
Borders
Industry 2.1 2.2
Barnes & Noble, 2001:
87.13.2809
3.269,5 88.1
3.590,2
4.870,4 76.1
6.485,2
8.375,4
58.18.223,2
9.512,3 61.1
2.113,2
8.403,3 65.1
0.1981
2.271,3
Financial Statement Analysis 27
Operating Performance Ratios Efficiency: Net Fixed Asset Turnover
How effectively is the firm using its assets to generate sales?
Net Fixed Asset Turnover
This ratio measures the efficiency with which the firm uses its investment in
fixed assets to generate sales.
N e t S a le sF ix e d A s s e t T u r n o v e r
A v g N e t F ix e d A s s e ts
Financial Statement Analysis 28
Efficiency Ratios (continued) Net Fixed Asset Turnover
N e t S a le sF ix e d A s se t T u rn o v e r =
A v g N e t F ix e d A s se ts
4 ,3 7 5 .8 k = = 7 .7
5 6 7 .1 k
2003 2002 2001
Barnes & Noble
Borders
Industry 22.0 13.1 16.6
Barnes & Noble, 2001:
65.80.609
3.269,5 38.8
0.581
4.870,4 72.7
1.567
8.375,4
49.66.541
9.512,3 24.6
9.545
8.403,3 84.5
3.560
2.271,3
Financial Statement Analysis 29
Operating Performance Ratios Equity Turnover
Equity Turnover
Equity includes preferred and common stock
Could also compute common equity ratio
Measures the level of sales for each dollar of equity investment
Not particularly insightful
N e t S a le sE q u ity T u r n o v e r
A v g E q u ity
Financial Statement Analysis 30
Operating Performance Ratios Profitability
Profitability ratios help us answer some very important questions
regarding the effectiveness of the firm’s management in producing
profits from the resources entrusted to them.
Profitability ratios often fall under two categories
Profitability in relation to sales
These ratios can be used to asses the ability of the firm’s management
to control various expenses in generating sales. These ratios are
commonly referred to as Profit Margins.
Profitability in relation to investment
These ratios measure firm profits in relation to the funds invested to
generate those profits. They are useful in assessing the overall
effectiveness of the firm’s management.
Financial Statement Analysis 31
Operating Performance Ratios Profitability: Gross Profit Margin
Gross Profit Margin
This ratio reflects the firm’s markup on its cost of goods sold (its pricing
policy) as well as the ability of the management to minimize the firm’s cost
of goods sold in relation to sales.
G r o s s P r o fi tG r o s s P r o fi t M a r g in
N e t S a le s
Financial Statement Analysis 32
Operating Performance Ratios Profitability: Gross Profit Margin
G ro ss P ro fit 1 ,2 0 6 ,0 8 0G ro ss P ro fit M a rg in = = = 2 7 .6 %
N e t S a le s 4 ,3 7 5 ,8 0 4
2003 2002 2001
Barnes & Noble
Borders
Industry 41.4%
Barnes & Noble, 2001:
%8.263.269,5
5.413,1 %9.26
3.870,4
3.310,1 %6.27
8.375,4
1.206,1
%5.289.512,3
6.001,1 %7.28
8.403,3
8.975 %0.28
2.271,3
7.916
Financial Statement Analysis 33
Operating Performance Ratios Profitability: Operating Profit Margin
Operating Profit Margin
Operating Profit is gross profit less SG&A expenses
This margin reflects the firm’s operating expenses as well as its cost of
goods sold.
This ratio serves as an overall measure of operating effectiveness.
O p e r a tin g P r o fi tO p e r a tin g P r o fi t M a r g in
N e t S a le s
Financial Statement Analysis 34
Operating Performance Ratios Profitability: Operating Profit Margin
O p e ra tin g P ro fitO p e ra tin g P ro fit M a rg in =
N e t S a le s
1 3 3 ,8 2 6 = = 3 .1 %
4 ,3 7 5 ,8 0 4
2003 2002 2001
Barnes & Noble
Borders
Industry 11.3%
Barnes & Noble, 2001:
%5.59.512,3
9.193 %6.4
8.403,3
0.157 %9.3
2.271,3
9.128
%0.53.269,5
1.264 %0.5
3.870,4
7.245 %1.3
8.375,4
8.133
Financial Statement Analysis 35
Operating Performance Ratios Profitability: Net Profit Margin
Net Profit Margin
This margin tells us how much of each sales dollar is converted to profits
after taxes.
This margin reflects the firm’s cost of goods sold, operating expenses,
finance charges, and taxes.
How much of each sales dollar drops to the bottom line?
Should exclude one-time charges
N e t In c o m eN e t P r o fi t M a r g in =
N e t S a le s
Financial Statement Analysis 36
Operating Performance Ratios Profitability: Net Profit Margin
N e t In c o m e -5 1 ,9 6 6N e t P ro fit M a rg in = = = -1 .2 %
N e t S a le s 4 ,3 7 5 ,8 0 4
2003 2002 2001
Barnes & Noble
Borders
Industry 1.4% 1.1% 1.8%
Barnes & Noble, 2001:
%3.13.870,4
9.63 %2.1
8.375,4
0.52
%2.39.512,3
7.111 %6.2
8.403,3
4.87 %7.1
2.271,3
4.54
%3.23.269,5
119
Financial Statement Analysis 37
Operating Performance Ratios Profitability: Return on Total Capital
Profitability in Relation to Investment: How much profit did the firm earn
on each dollar of assets under its control?
Return on Tot Capital and/or Return on Tot Assets
This ratio provides an indication of the ability of the firm to earn a
satisfactory return on all of the capital it employs.
Capital is debt, preferred stock, common stock
Note: Typically want to use net income before extraordinary items
N e t In c o m e + In te r e s t E x p e n s eR e tu r n o n T o ta l C a p ita l =
A v g T o ta l C a p ita l
N e t In c o m e + In te r e s t E x p e n s e N e t In c o m eR e tu r n o n A s s e ts = o r
A v g T o ta l A s s e ts A v g T o ta l A s s e ts
Financial Statement Analysis 38
Operating Performance Ratios Profitability: Return on Assets
2003 2002 2001
Barnes & Noble
Borders
Industry 3.3% 2.1% 4.3%
Barnes & Noble, 2001: N e t In c o m e + In te r e s t E x p e n s e
R e tu r n o n A s s e ts = A v g T o ta l A s s e ts
N e t In c o m e -5 2 .0 m o r = = -2 .1 %
A v g T o ta l A s s e ts 2 ,4 8 5 .6 m
%2.43.809,2
1.119 %5.2
3.590,2
0.64 %1.2
6.485,2
0.52
%0.58.223,2
7.111 %1.4
2.113,2
4.87 %7.2
0.981,1
4.54
Financial Statement Analysis 39
Operating Performance Ratios Profitability: Return on Owner’s Equity
Return on Equity
This ratio provides an indication of how effective the management is from all
equity holders point of view.
It is directly affected by the return on total assets and the amount of
financial leverage employed.
This ratio, although helpful, does not focus on the returns that actually flow
to the investor in terms of cash dividends and/or market appreciation. For
this reason, return on equity is not a reliable measure of returns from the
investors’ viewpoint.
Note: Typically want to use net income before extraordinary items
N e t In c o m eR e tu r n o n O w n e r 's E q u ity =
A v g T o ta l E q u ity
Financial Statement Analysis 40
Operating Performance Ratios Profitability: Return on Owner’s Equity
N e t In c o m e -5 2 .0 kR e tu r n o n O w n e r 's E q u ity = = = -6 .4 %
A v g T o ta l E q u ity 8 1 2 .0 k
2003 2002 2001
Barnes & Noble
Borders
Industry
Barnes & Noble, 2001:
%3.113.990
7.111 %7.9
2.898
4.87 %6.6
6.824
4.54
%4.120.958
1.119 %7.7
9.832
0.64 %4.6
0.812
0.52
Financial Statement Analysis 41
Operating Performance Ratios Profitability: Return on Common Equity
Return on Common Equity
This ratio provides an indication of how effective the management is from
the common stockholders’ point of view.
It too is directly affected by the return on total assets and the amount of
financial leverage employed.
This ratio suffers from the same problems as other accounting measures of
return on equity.
Note: Typically want to use net income before extraordinary items
N e t In c o m e - P r e fe r r e d D iv sR e tu r n o n C o m m o n E q u ity =
A v g C o m m o n E q u ity
Financial Statement Analysis 42
Operating Performance Ratios Profitability: Return on Owner’s Equity
N e t In c o m e - P r e fe r r e d D iv s -5 2 .0 kR e tu r n o n C o m m o n E q u ity = = = -6 .4 %
A v g C o m m o n E q u ity 8 1 2 .0 k
2003 2002 2001
Barnes & Noble
Borders
Industry 7.2% 4.1% 8.7%
Barnes & Noble, 2001:
%9.167.659
7.111 %6.6
4.826
4.54
%3.126.970
1.119 %4.6
3.812
0.52
Financial Statement Analysis 43
Risk Analysis Business Risk: Operating Earnings Variability
Business Risk
Defined as the uncertainty of income caused by the firm’s industry.
In turn, this uncertainty is due to the firm’s variability of sales caused by its
products, customers and the way it produces its products.
Generally measured by the variability of the firm’s operating income
over time.
Sales Variability
Prime determinant of earnings variability
S td D e v O p e r E a r n in g sB u s in e s s R is k =
M e a n O p e r a tin g E a r n in g s
S td D e v o f S a le sS a le s V a r ia b il i ty =
M e a n S a le s
Financial Statement Analysis 44
Risk Analysis Business Risk: Operating Leverage
Operating leverage refers to the use of fixed production costs
Fixed production costs cause operating profits to vary more than sales
over the business cycle.
During slow periods, profits decline by a larger percentage than sales;
during an expansion, profits will increase by a larger percentage than sales.
C h a n g e in O p e r a tin g E a r n in g s
O p e r a tin g L e v e r a g e = C h a n g e in S a le s
Financial Statement Analysis 45
Risk Analysis Leverage Ratios
How has the firm financed its assets?
Can the firm afford the level of fixed charges associated with its use of
non-owner supplied funds such as bond interest and principal
repayment?
We define leverage as resulting from the firm’s use of debt, financial
leases, and preferred stock.
These sources all require a fixed cash payment or return for their use.
If the firm earns a return higher than that which is required by the suppliers,
then the excess goes to the owners.
However, should the return of the firm fall below the required return, then
the owners get nothing.
Financial Statement Analysis 46
Risk Analysis Leverage Ratios: Debt to Equity Ratio
Where did the firm obtain financing for its investments?
Here we are using information from the balance sheet only.
Debt to Equity Ratio
A measure of risk due to capital structure choices
Higher proportion of debt to equity makes earnings more volatile
If the firm cannot meet its interest payments, it leads to financial distress
T o ta l L o n g T e r m D e b tD e b t to E q u ity R a tio =
T o ta l E q u ity
Financial Statement Analysis 47
Risk Analysis Leverage Ratios: Debt to Long Term Capital
Debt to Long Term Capital
A different way to measure the debt to equity ratio
Long Term Capital is Debt + Equity
T o ta l L o n g T e r m D e b tL o n g T e r m D e b t to L o n g T e r m C a p ita l =
T o ta l L o n g T e r m C a p ita l
Financial Statement Analysis 48
Risk Analysis Leverage Ratios: Debt to Long Term Capital
T o ta l L o n g T e r m D e b tD e b t to L o n g T e r m C a p ita l =
T o ta l L o n g T e r m C a p ita l
6 6 6 .9 k = = 0 .4 6
s u m (6 6 6 .9 k , 7 7 7 .7 k )
2003 2002 2001
Barnes & Noble
Borders
Industry
Barnes & Noble, 2001:
06.06.030,169
69
05.0
9.9497.49
7.49
02.0
5.84615
0.15
23.8.027,1300
0.300
34.
1.888449
0.449
46.
7.7779.666
9.666
Financial Statement Analysis 49
Risk Analysis Leverage Ratios: Total Debt Ratios
Total Debt Ratio
Useful for a firm that derives substantial capital from short-term borrowing
T o ta l In te r e s t B e a r n in g D e b tT o ta l D e b t R a tio :
T o ta l C a p ita l - N o n In te r e s t B e a r in g L ia b il i t ie s
Financial Statement Analysis 50
Earnings Flow Ratios Leverage: Interest Coverage
Can the firm afford the level of fixed charges associated with its use of
non-owner supplied funds such as bond interest and principal
payments (or lease payments)?
Here we are using earnings information. These ratios are sometimes
referred to as Coverage Ratios.
Interest Coverage
This ratio indicates the firm’s ability to meet its interest payments out of its
annual operating earnings. It measures the number of times the firm is
covering its interest.
E a r n in g s B e fo r e In te r e s t a n d T a x e s (E B IT )In te r e s t C o v e r a g e =
In te r e s t C h a r g e s
Financial Statement Analysis 51
Earnings Flow Ratios Leverage: Total Fixed Charge Coverage
Total Fixed Charge Coverage
Measure of all fixed obligations by the firm
In c o m e B e fo re In te re s t , T a x e s a n d L e a se P a y m e n tsT o ta l F ix e d C h a rg e C o v e ra g e =
P re fe r re d D iv sIn te re s t + L e a se P a y m e n ts +
(1 -T a x R a te )
Financial Statement Analysis 52
Cash Flow Ratios Leverage: Cash Flow Leverage and Coverage
Cash Flow Ratios are used as alternative to earnings flow ratios
E.g., cash flow to outstanding debt has been used for predicting
bankruptcies and bond ratings.
C a sh F lo w + In t E xp + 1 /3 o f L e a se P a ym e n tsC a sh F lo w C o vera g e =
In t E x p + 1 /3 o f L ea se P a ym en ts
w h ere C a sh F lo w = N I + D e p r + C h a n g e in D e fe r red T a x es
N I + D e p r + C h a n g e in D e fe r r e d T a x e sC a s h F lo w / L T D e b t =
B V o f L o n g T e r m D e b t
N I + D e p r + C h a n g e in D e fe r r e d T a x e sC a s h F lo w / T o ta l D e b t =
B V o f L o n g T o ta l D e b t
Financial Statement Analysis 53
Growth Potential Sustainable Growth
Long-term Sustainable Growth
Maximum long-term growth rate that can be self-financed
Retention Ratio
Amount of earnings held for reinvestment in the business
L o n g -te r m S u s ta in a b le G r o w th = R e te n tio n R a tio x R O E
D iv id e n d s D e c la r e dR e te n tio n R a tio = 1 -
O p e r a tin g In c o m e A fte r T a x e s
Financial Statement Analysis 54
Du Pont Analysis Profitability, Efficiency
Du Pont Analysis
To improve its financial analysis, Du Pont introduced a system that ties
together relationships that might otherwise be missed. It ties:
Net Profit Margin, Total Asset Turnover, and Debt to Total Assets
This system focuses attention on the separate ideas of profitability and
asset utilization (efficiency).
Using Du Pont Analysis, we can also see how the firm’s use of leverage
affects the return on equity. Anything that changes net profit margin, total
asset turnover, or debt to total assets will affect return on equity.
Breaking down ROE (Net Income / Equity)
N e t In c o m e S a le s T o ta l A s se tsR O E = × ×
S a le s T o ta l A s se ts C o m m o n E q u ity
= P ro fi t M a rg in x T o ta l A s se t T u rn o v e r x F in a n c ia l L e v e ra g e
= R O A × L e v e ra g e
Financial Statement Analysis 55
DuPont Analysis Profitability, Efficiency
Barnes and NobleROE =
2003:
Profit Margin = Total Asset
Turnover =
Financial
Leverage =
12.4% 2.3% 1.9 2.9
2002:
7.3% 1.3% 1.9 3.0
BordersROE =
2003:
Profit Margin = Total Asset
Turnover =
Financial
Leverage =
11.1% 3.2% 1.6 2.2
2002:
9.5% 2.6% 1.6 2.3
Financial Statement Analysis 56
Barnes and Noble, Borders Summary Financial Ratios
Barnes and Noble Borders
2/3/01 02/03/02 02/03/03 1/28/01 1/27/02 1/26/03
Liquiditity Ratios
Current Ratio 1.56 1.40 1.53 1.19 1.32 1.42
Quick Ratio 0.23 0.27 0.40 0.12 0.25 0.33
Cash Ratio 0.03 0.09 0.22 0.05 0.17 0.25
Avg Coll Period 6.0 6.9 7.6 7.7 7.8 8.4
Days in Inventory 134.8 129.4 126.9 176.6 178.9 171.7
Days in A/P (COGS) 68.0 65.5 66.6 93.3 94.8 87.5
Cash Conversion (COGS) 128.1 117.1 108.1 130.8 130.6 127.6
Operating Performance Ratios
Asset Turnover 1.76 1.88 1.88 1.65 1.61 1.58
Net FA Turnover 7.72 8.38 8.65 5.84 6.24 6.49
Gross Profit Margin 27.6% 26.9% 26.8% 28.0% 28.7% 28.5%
Operating Profit Margin 3.1% 5.0% 5.0% 3.9% 4.6% 5.5%
Net Profit Margin -1.2% 1.3% 2.3% 1.7% 2.6% 3.2%
Return on Total Capital 0.1% 7.2% 10.6% 5.5% 8.4% 9.7%
ROA (NI + Int Exp) 0.1% 3.9% 5.0% 2.7% 4.1% 5.0%
ROA (NI) -2.1% 2.5% 4.2% 2.7% 4.1% 5.0%
Return on Owner's Equity -6.4% 7.7% 12.4% 6.6% 9.7% 11.3%
Return on Common Equity -6.4% 7.0% 12.3% 6.6% 9.7% 16.9%
Financial Statement Analysis 57
Barnes and Noble, Borders Summary Financial Ratios (cont’d)
Business and Financial Risk
Oper Income Variability 27.9% 26.6% 24.8% 19.2% 11.4% 14.4%
Sales Variability 23.2% 24.0% 22.5% 20.3% 16.3% 11.7%
LT Debt / LT Capital 0.46 0.34 0.23 0.02 0.05 0.06
Interest Coverage 2.5 6.8 12.3 nm nm nm
Growth Ratios
Sustainable growth rate -6.9% 7.3% 12.4% 6.6% 9.5% 11.1%
DuPont Analysis
Net Income / Sales (Profit Margin) -1.2% 1.3% 2.3% 1.7% 2.6% 3.2%
Sales / Total Assets 1.8 1.9 1.9 1.7 1.6 1.6
Total Assets / Equity 3.3 3.0 2.9 2.4 2.3 2.2
= ROE -6.9% 7.3% 12.4% 6.6% 9.5% 11.1%
Barnes and Noble Borders
2/3/01 02/03/02 02/03/03 1/28/01 1/27/02 1/26/03
Financial Statement Analysis 58
Barnes and Noble, Borders Summary Financial Ratios - Interpretation
Liquidity
Short-term liquidity is increasing for Borders, increased from 2002 for
Barnes and Noble
Both holding more cash in 2003
Efficiency
BKS appears better at inventory management, both improved in 2003
Possibly the nature of the products they are selling
Borders’ takes longer to pay their bills, although it is paying faster in 2003
than 2002
Also possibly the nature of the products they are selling
Financial Statement Analysis 59
Barnes and Noble, Borders Summary Financial Ratios - Interpretation
Efficiency (cont’d)
Overall takes borders longer to convert products into cash
BKS uses fewer assets per sales dollar
Profitability
From 2001 to 2003 net and operating margins increased for both BKS and
Borders, albeit more dramatically for BKS. Gross margins remained fairly
constant. Borders has slightly higher gross margin (more specialized
products?).
ROA and ROE increase for both firms in 2003 – both have similar ROA for
the year ended in 2003.
Note that BKS uses significantly more leverage than Borders, affecting the
variability of many of these performance measures.
Financial Statement Analysis 60
Barnes and Noble, Borders Summary Financial Ratios - Interpretation
Leverage
BKS uses much more long-term debt than Borders, although this amount
has been decreasing
Borders has very little long-term debt
Summary/DuPont
Borders has somewhat higher margins, uses slightly less leverage and
requires more asset investment as compared to BKS
Financial Statement Analysis 61
Limitations of Ratio Analysis
It is sometimes difficult to identify the industry category to which a firm
belongs when the firm engages in multiple lines of business.
Published industry averages are only approximations and provide the
user with general guidelines rather than scientifically determined
averages of the ratios of all or even a representative sample of the
firms within the industry.
Financial Statement Analysis 62
Limitations of Ratio Analysis (cont’d)
Accounting practices differ widely across firms and can lead to
differences in computed ratios.
Also note: Definitions of ratios vary slightly from publication to publication
and user to user.
Many firms experience seasonality in their operations.
Some ratios meaningless over short horizons
Window dressing and earnings management
Financial Statement Analysis 63
Other measures of cash flow for the firm?
The statement of cash flows for a firms tracks cash in three areas:
operations, financing, and investing.
The cash flow from operations is essentially net income with
adjustments for depreciation and working capital.
Investing cash flow tracks expenditures on plant, property, and
equipment.
Financing cash flow tracks cash from the purchase and sale of
liabilities and equity.