B&H Ch 3 Powerpoint

7/27/2019 B&H Ch 3 Powerpoint

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CHAPTER 3

Analysis of FinancialStatements

Ratio Analysis

Du Pont system

Effects of improving ratios Limitations of ratio analysis


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Why are ratios useful? Ratios standardize numbers and

facilitate comparisons.

Ratios are used to highlightweaknesses and strengths.


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What are the five major categories ofratios, and what questions do they

answer? Liquidity: Can we make required payments? Asset management: right amount of assets

vs. sales? Debt management: Right mix of debt and

equity? Profitability: Do sales prices exceed unit

costs, and are sales high enough as

reflected in PM, ROE, and ROA? Market value: Do investors like what they

see as reflected in P/E and M/B ratios?


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Liquidity Ratios: The Current

Ratio

Current ratio = Current assets / Current liabilities


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Asset Management Ratios:

Inventory TurnoverInv. turnover = Sales / Inventories

or

= COGS / Inventories


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Asset Management Ratios: Days

Sales Outstanding (DSO)

DSO = Receivables / Average sales per day

= Receivables / Sales/365


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Asset Management Ratios: Fixed

assets turnoverFA turnover = Sales / Net fixed assets


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Asset Management Ratios: Total

assets turnover TA turnover = Sales / Total assets


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Debt management ratios:

Debt ratioDebt ratio = Total debt / Total assets

Note: Total debt = CL + LTD


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Debt management ratios: Times-

interest-earned (TIE) ratio TIE = EBIT / Interest expense


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Debt management ratios:

EBITDA coverage ratio

paymentsLeasepaymentsPrincipalInterestpaymentsLeaseEBITDACoverageEBITDA


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Profitability ratios: Profit margin

on sales (or Net profit margin) Profit margin = Net income / Sales


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Profitability ratios: Basic

Earning Power (BEP) ratio BEP = EBIT / Total Assets


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Profitability ratios: Return on

Total Assets (ROA) ROA = Net income / Total assets


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Profitability ratios: Return on

common equity (ROE) ROE = Net income / Common equity


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Market value ratios: Price /

Earnings (P/E) ratio P/E = Price per share / EPS


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Market Value Ratios: Price / Cash

Flow Price-to-cash flow = Price per share /

cash flow per share

Note: Cash flow per share = (NI +Depr) / # shares outstanding


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Market Value Ratios: Market-to-

book ratio M/B = Market price per share / Book

value per share

Note: Book value per share = Commonequity / # shares outstanding


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The Du Pont System of Control The Du Pont equation

assetsTotal

incomeNet

assetsTotal

SalesX

Sales

incomeNetROA

overasset turnTotalXmarginProfitROA


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The Du Pont System of Control Extended Du Pont Equation:

equityCommon

incomeNetROE

equityCommon

assetsTotalX

assetsTotal

SalesX

Sales

incomeNetROE

multiplierEquityXoverasset turnTotalXmarginProfitROE


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Problems with ROE ROE and shareholder wealth are correlated,

but problems can arise when ROE is the sole

measure of performance. ROE does not consider risk. ROE does not consider the amount of capital

invested. Might encourage managers to make investment

decisions that do not benefit shareholders. ROE focuses only on return. A better

measure is one that considers both risk andreturn.


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Analyzing the market value ratios P/E: How much investors are willing to pay

for $1 of earnings.

P/CF: How much investors are willing topay for $1 of cash flow.

M/B: How much investors are willing topay for $1 of book value equity.

For each ratio, the higher the number, thebetter.

P/E and M/B are high if ROE is high andrisk is low.


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Trend analysis Analyzes a firms

financial ratios over

time Can be used to

estimate the likelihoodof improvement or

deterioration infinancial condition.


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An example:

The effects of improving ratiosA/R 878 Debt 1,545Other CA 1,802 Equity 1,952

Net FA 817 _____TA 3,497 Total L&E 3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firms DSO to 32days affect the company?


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Reducing accounts receivable and

the days sales outstanding Reducing A/R will have no effect on

sales

Old A/R = $19,275.62 x 45.6 = $878,000

New A/R = $19,275.62 x 32.0 = $616,820

Cash freed up: $261,180

Initially shows up as addition to cash.


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Effect of reducing receivables on

balance sheet and stock priceAdded cash $261 Debt 1,545

A/R 617 Equity 1,952

Other CA 1,802Net FA 817 _____

Total Assets 3,497 Total L&E 3,497

What could be done with the new cash?

How might stock price and risk be affected?


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Potential uses of freed up cash Repurchase stock

Expand business

Reduce debt

All these actions would likely improvethe stock price.


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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 aimhigher.

Seasonal factors can distort ratios.Window dressing techniques can make

statements and ratios look better.


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More issues regarding ratios Different operating and accounting

practices can distort comparisons.

Sometimes it is hard to tell if a ratio isgood or bad.

Difficult to tell whether a company is,

on balance, in strong or weak position.

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B&H Ch 3 Powerpoint