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CHAPTER 3 ANALYSIS OF FINANCIAL STATEMENTS

R ATIO ANALYSIS LIQUIDITY ASSET MANAGEMENT DEBT MANAGEMENT PROFITABILITY


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FINANCIAL RATIO ANALYSIS


DEFINITION
the calculation and comparison

of ratios which are derived from the information in a company's financial statements.

Why are ratios useful?


Ratios standardize numbers and facilitate

comparisons. Ratios are used to highlight weaknesses and strengths. Ratio comparisons should be made through time and with competitors
Trend analysis Peer (or Industry) analysis

Ratio Comparisons
Peer or Industry Analysis (Cross-sectional analysis) involves the comparison of different firms financial ratios at the same point in time; involves comparing the firms ratios to those other firms in its industry or to industry averages.
Trend Analysis (Time-series analysis) involves the

evaluation of the firms financial performance over time using financial ratios. Comparison of current to past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned.

Potential problems and limitations of financial ratio analysis


Comparison with industry averages is

difficult for a conglomerate firm that operates in many different divisions. Average performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better.

More issues regarding ratios


Sometimes it is hard to tell if a ratio is good

or bad. Difficult to tell whether a company is, on balance, in strong or weak position.

What are the major categories of ratios, and what questions do they answer?
Liquidity: Can we make required payments?
Asset management: right amount of assets

vs. sales?
equity?

Debt management: Right mix of debt and

Profitability: Do sales prices exceed unit

costs, and are sales high enough as reflected in PM, ROE, and ROA?

LIQUIDITY RATIOS
Ratios that show the relationship of a firms cash and other assets to its current liabilities
CA
CL It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future

Current Ratio

Quick (acid-test) Ratio

It measures a firm's ability CA inventories to pay off short-term obligations to more liquid CL type of assets.

ASSET MANAGEMENT RATIOS


A set of ratios that measure how effectively a firm is managing its assets. Inventory Turnover Ratio
Sales Inventories It indicates the salability of inventory the number of times a company sells its average inventory during the year.

Days Sales
Outstanding

(DSO)

Also called the average Receivables collection period (ACP), it indicates the average length Average sales of time the firm must wait per day after making a sale before it receives cash.

ASSET MANAGEMENT RATIOS


Fixed Assets It measures how effectively Sales Turnover the firm uses its plant and Ratio Net fixed assets equipment

Total Assets Turnover Ratio

Sales Total assets

It measures a firm's ability to generate sales given its total assets

DEBT MANAGEMENT RATIOS (FINANCIAL LEVERAGE)


Debt Management ratios help evaluate a company's long-term solvency, measuring the extent to which the company is using long-term debt.

Debt Ratio
Times Interest Earned (TIE) Ratio

Total debt Total assets EBIT Interest Charges

It indicates how much of

a company's assets are provided through debt.


A measure of the firms ability to meet its annual interest payments.

DEBT MANAGEMENT RATIOS (FINANCIAL LEVERAGE)

EBITDA Coverage

EBITDA + Lease payments


Interest + principal payments + lease payments

It shows if earnings are able to satisfy all financial obligations including leases and principal payments.

PROFITABILITY RATIOS
A group of ratios that show the combined effects of liquidity, asset management, and debt on operating results.

Profit margin on sales


Return on total assets (ROA)

Net income
Sales

This ratio measures net income per dollar of sales

It gives an idea as to how management Totals assets efficient is at using its assets to generate earnings.

Net income

PROFITABILITY RATIOS

Basic Earning Power (BEP)

EBIT

Total assets
Net income Common equity

It indicates the ability of the firms assets to generate operating income


It gives the amount of net income earned for each share of the companys common stock.

Return on common equity (ROE)

Balance Sheet: Assets


2011E 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152 2010 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592

Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

Balance sheet: Liabilities and Equity


Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E

2011E 436,800 300,000 408,000 1,144,800 400,000 1,721,176 231,176 1,952,352 3,497,152

2010 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592

Income statement
2011E 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584 2010 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)

Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income

Other data
No. of shares EPS DPS Stock price Lease pmts

2011E 250,000 $1.014 $0.220 $12.17 $40,000

2010 100,000 -$1.602 $0.110 $2.25 $40,000

Calculate DLeons forecasted current ratio and quick ratio for 2011.
Current ratio = CA/ CL = $2,680 / $1,145 = 2.34x Quick ratio = (CA Inventories) / CL = ($2,680 $1,716) / $1,145 = 0.84x

Comments on liquidity ratios


2011E
Current Ratio
Quick Ratio

2010
1.20x
0.39x

2009
2.30x
0.85x

Ind.
2.70x
1.00x

2.34x
0.84x

Expected to improve but still below the industry average. Liquidity position is weak.

What is the inventory turnover vs. the industry average?


Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10x
2011E
Inventory Turnover 4.1x

2010
4.70x

2009
4.8x

Ind.
6.1x

Comments on Inventory Turnover


Inventory turnover is below industry

average. DLeon might have old or too much inventory, which is expensive because

Inventory takes up costly warehouse space.

Some items may become spoiled or obsolete.

No improvement is currently forecasted.

DSO is the average number of days after making a sale before receiving cash.
DSO= Receivables / Avg sales per day = Receivables/(Annualsales/365)
= $878 / ($7,036/365) = 45.6 days

Appraisal of DSO
2011E
DSO

2010
38.2

2009
37.4

Ind.
32.0

45.6

DLeon collects on sales too slowly, and is getting worse. DLeon has a poor credit policy*.
*Clear, written guidelines that set (1) the term and conditions for supplying goods on credit, (2) customer qualification criteria, (3) procedure for making collections, and (3) steps to be taken in case of customer delinquency.

Fixed assets and total assets turnover ratios vs. the industry average
FA turnover = Sales / Net fixed assets = $7,036 / $817 = 8.61x
TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

Evaluating the FA turnover and TA turnover ratios


2011E
FA TO TA TO

2010
6.4x 2.1x

2009
10.0x 2.3x

Ind.
7.0x 2.6x

8.6x 2.0x

FA turnover projected to exceed the industry average. TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).

Calculate the debt ratio, times-interestearned, and EBITDA coverage ratios.


Debt ratio=Total debt / Total assets = ($1,145 + $400) / $3,497 = 44.2% TIE = EBIT / Interest expense = $492.6 / $70 = 7.0x

Calculate the debt ratio, TIE, and EBITDA coverage ratios.


EBITDA = coverage
(EBITDA + Lease pmts) Int exp + Lease pmts + Principal pmts

$609.6 + $40 = $70 + $40 + $0 = 5.9x

How do the debt management ratios compare with industry averages?


2011E
D/A TIE EBITDA coverage 44.2% 7.0x 5.9x

2010
82.8% -1.0x 0.1x

2009
54.8% 4.3x 3.0x

Ind.
50.0% 6.2x 8.0x

D/A and TIE are better than the industry average, but EBITDA coverage still trails the industry.

Profitability ratios: Profit margin and Basic earning power


Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6% BEP = EBIT / Total assets

= $492.6 / $3,497 = 14.1%

Appraising profitability with the profit margin and basic earning power
2011E
PM BEP

2010
-2.7% -4.6%

2009
2.6% 13.0%

Ind.
3.5% 19.1%

3.6% 14.1%

Profit margin was very bad in 2010, but is projected to exceed the industry average in 2011. Looking good.. BEP projected to improve, yet still below the industry average. There is definitely room for improvement.

Profitability ratios: Return on assets and Return on equity


ROA = Net income / Total assets = $253.6 / $3,497 = 7.3% ROE= Net income / Total common equity = $253.6 / $1,952 = 13.0%

Appraising profitability with the return on assets and return on equity


2011E
ROA ROE

2010
-5.6% -32.5%

2009
6.0% 13.3%

Ind.
9.1% 18.2%

7.3% 13.0%

Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.

INDUSTRY COMPARISON
The list of companies represents one industry. What can you say about Dolphins ROA compared to the industrys numbers?
Panther
Revenue Net Income Assets

Jaguar

Sharks

Dolphin

8,000,000 6,500,000 9,250,000 7,750,000 775,000


22,500,000

695,000
18,500,000

875,000
26,500,350

745,000
23,000,500

Daily Receivables

100,000

95,000

105,000

102,500

INDUSTRY COMPARISON
ROA (Panther) = Net income / Total assets =775,000 /22,500,000 =3.44%

INDUSTRY COMPARISON
ROA (Panther) = Net income / Total assets =775,000 /22,500,000 =3.44%

ROA (Jaguar)

= Net income / Total assets =695,000 /18,500,000 =3.76%

INDUSTRY COMPARISON
ROA (Shark) = Net income / Total assets =875,000 /26,500,350 =3.30%

INDUSTRY COMPARISON
ROA (Shark) = Net income / Total assets =875,000 /26,500,350 =3.30%

ROA (Dolphin) = Net income / Total assets =745,000 /23,000,500 =3.24%

INDUSTRY COMPARISON
Panther Jaguar Sharks Ind. Dolphin Average

ROA

3.44%

3.76%

3.30%

3.24%

3.44%

Industry Average = 3.44 +3.76+3.30+3.24


4

= 3.44%

TREND ANALYSIS for Dolphin


Given: Dolphins numbers for 4 years
2011 2010 2009 2008

Revenue
Net Income Assets Daily Receivables

8,000,000 6,500,000 9,250,000 7,750,000


775,000
22,500,000

695,000
18,500,000

875,000
26,500,350

745,000
23,000,500

100,000

95,000

105,000

102,500

TREND ANALYSIS for Dolphin


2011 2010 2009 2008

ROA

3.44%

3.76%

3.30%

3.24%

Dolphin's ROA
3.80 3.70 3.60 3.50 3.40 3.30 3.20 3.10 3.00 2.90
20081 2009 2 2010 3 2011 4

ROA

More Sample PROBLEMS


1. A firm has an annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable.

More Sample PROBLEMS


1. A firm has an annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable. a. What is its inventory ratio?

More Sample PROBLEMS


1. A firm has an annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable. a. What is its inventory ratio? Answer: 5X

More Sample PROBLEMS


1. A firm has an annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable. a. What is its inventory ratio? Answer: 5X b. What is its DSO based on a 365-day year?

More Sample PROBLEMS


1. A firm has an annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable. a. What is its inventory ratio? Answer: 5X
b. What is its DSO based on a 365-day year? Answer: 109.5 days

More Sample PROBLEMS


II. Lows Company, a home-improvement store chain, reported the following summarized figures:
LOW COMPANY Income Statement Year Ended December 31, 2011 (in billions) Net Sales $ 40.6 Cost of goods sold 22.5 Interest expense 0.4 All other expenses 6.9 Net income 10.8

More Sample PROBLEMS


LOWS COMPANY Balance Sheet December 31, 2011 and 2010 2011 2010 Liabilities and SE

Assets

2011 13.7

2010

Cash
Short-term investments Accounts receivable Inventory Other current assets

$ 2.2
24.0

$ 1.2
13.0

Total current liabilities $ 24.0


Long-term liabilities

$13.2
11.6

7.5
7.3 9.0

5.4
7.2 1.5

Common Stock
Retained Earnings

10.0
35.3

10.0
21.5

Intangible assets
Total assets

33.0
$ 83.0

28.0
$ 56.3 Total liabilities and $ 83.0 $ 56.3 Stockholders Equity

More Sample PROBLEMS


LOWS COMPANY Balance Sheet December 31, 2011 and 2010 2011 2010 Liabilities $ 2.2 24.0 7.5 7.3 9.0 50.0 $ 1.2 13.0 5.4 7.2 1.5 28.3 Long-term liabilities Total liabilities Stockholders Equity Common Stock Retained Earnings 10.0 35.3 10.0 21.5

Assets Cash Short-term investments Accounts receivable Inventory Other current assets Total current assets

2011 13.7 37.7

2010 $13.2 11.6 24.8

Total current liabilities $ 24.0

All other assets Total assets

33.0 $ 83.0

28.0 $ 56.3

Total SEquity Total liabilities and Stockholders Equity

45.3 $ 83.0

31.5 $ 56.3

More Sample PROBLEMS


Requirements: 1. Compute the companys current ratio at December 31, 2011 and 2010.

More Sample PROBLEMS


Requirements: 1. Compute the companys current ratio at December 31, 2011 and 2010.

Current ratio (2011)

= CA/ CL = $50/ $24 = 2.08x

More Sample PROBLEMS


Requirements: 1. Compute the companys current ratio at December 31, 2011 and 2010.

Current ratio (2011)

Current ratio (2010)

= = = = = =

CA/ CL $50/ $24 2.08x CA/ CL $28.3/ $13.2 2.14x

More Sample PROBLEMS


Requirements: 1. Compute the companys current ratio at December 31, 2011 and 2010.

= CA/ CL = $50/ $24 = 2.08x Current ratio (2010) = CA/ CL = $28.3/ $13.2 = 2.14x 2. Did Lows Companys current ratio, deteriorated, improved or hold steady during the 2011?

Current ratio (2011)

More Sample PROBLEMS


Requirements: 1. Compute the companys current ratio at December 31, 2011 and 2010.

Current ratio (2011)

Current ratio (2010)

= CA/ CL = $50/ $24 = 2.08x = CA/ CL = $28.3/ $13.2 = 2.14x

2. Did Lows Companys current ratio, deteriorated, improved or hold steady during the 2010? Deteriorated

More Sample PROBLEMS


3. Inventory Turnover?

More Sample PROBLEMS


3. Inventory Turnover for 2009? Answer: 5.56x

More Sample PROBLEMS


3. Inventory Turnover for 2009? Answer: 5.56x 4. Days Sales Outstanding for 2009?

More Sample PROBLEMS


3. Inventory Turnover for 2011? Answer: 5.56x 4. Days Sales Outstanding for 2011? Answer: 58 days

More Sample PROBLEMS


3. Inventory Turnover for 2011? Answer: 5.56x 4. Days Sales Outstanding for 2011? Answer: 58 days 5. Debt Ratio for December 31, 2011?

More Sample PROBLEMS


3. Inventory Turnover for 2011? Answer: 5.56x 4. Days Sales Outstanding for 2011? Answer: 58 days 5. Debt Ratio for December 31, 2011? Answer: 0.454

More Sample PROBLEMS


3. Inventory Turnover for 2011? Answer: 5.56x 4. Days Sales Outstanding for 2011? Answer: 58 days 5. Debt Ratio for December 31, 2011? Answer: 0.454

6. Is Lows ability to pay its liabilities strong or weak?

More Sample PROBLEMS


3. Inventory Turnover for 2011? Answer: 5.56x 4. Days Sales Outstanding for 2011? Answer: 58 days 5. Debt Ratio for December 31, 2011? Answer: 0.454

6. Is Lows ability to pay its liabilities strong or weak? Strong

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