Working With Financial Statements Chapter Three 1Barton College Show Tools for Importing Financial Data Yahoo Finance Morningstar OLAP 2Barton College Forecast Warnings. 3Barton College Apple 4Barton College BB&T Summer Internships 5Barton College Key Concepts from Chapter 3 Sources and uses of cash and the Statement of Cash Flows Standardize financial statements for comparison purposes Common Size Statements (Vertical Analysis) Common Base Year Statements (Horizontal Analysis) Computation and interpretation of important financial ratios The Du Pont Identity Understand the problems and pitfalls in financial statement analysis 6Barton College Why Analyze Financial Statements? Objective valuations of many current and long term assets are almost impossible without some view of companys financial statements Historical reviews of financial statements are sometimes our only option for making forward based operational and or financial decisions. Financial metrics can be obtained from historical statements Allows for historical track records and monitoring Allows the analyst to create forward looking Pro-Forma statements, budgets and strategic plans Capital Budgeting. 7Barton College Financial Statements and Common Size Financial Statements 8Barton College Prufrock Corporation Balance Sheets - Table 3.1 9Barton College Prufrock Corporation Common-Size Balance Sheets Table 3.2 10Barton College Prufrock Corporation Income StatementTable 3.3 11Barton College Prufrock Corporation Common-Size Income Statement Table 3.4 Tells us what happened to each dollar of sales 12Barton College Apple from Morningstar Apple 13Barton College Cash Flow and Statement of Cash Flows Not in your book. 14Barton College Sources and Uses Activities that bring in cash are considered SOURCES. Firms raise cash by selling assets, borrowing money or selling securities. Activities that involve cash outflows are USES. Firms use cash to buy assets, pay off debt, repurchase stock or to pay dividends. Sources Cash inflow occurs when we sell something Good or service for example (cash received for service or product) Decrease in asset account (Sample B/S)Sample B/S Cash & equivalents is the only source Increase in liability or equity account Everything except accounts payable is a source Uses Cash outflow occurs when we buy something Increase in asset account Everything except cash & equivalents is a use Decrease in liability or equity account Accounts payable is the only use 15Barton College What is the change in cash from period to period? The change in cash using the direct approach is the delta between the accounts on the balance sheet from period to period. Simple Balance Sheet AssetsLiabilities & Equity CashLiabilities Other AssetsEquities Total AssetsTotal Liabilities & Equity Total Assets = Liabilities + Equities Cash + Other Assets = Liabilities + Equities Cash = Liabilities + Equities - Other Assets Cash = Cash2 - Cash1 = [liabilities2 + equities2 - other assets2] [liabilities1 + equities1 - other assets1] Change in Cash = (liabilities2 - liabilities1) + (equities2 - equities1) + (other assets1 - other assets2) 16Barton College Statement of Cash Flows Statement that summarizes the sources and uses of cash Changes divided into three major categories Operating Activity includes net income and changes in most current accounts Investment Activity includes changes in fixed assets Financing Activity includes changes in notes payable, long-term debt and equity accounts as well as dividends Assets (Firm) OCF change NWC NCS $ $ Cash flow of the Firm Creditors Stockholders (Owners) $ True Cash Flow From Operations (OCF- Change NWC NCS) OCF = EBIT + Depreciation - Taxes CFFA Free Cash Flow 17Barton College General Statement of Cash Flows Operating Activities + Net Income + Depreciation Increase (decrease) in current asset accounts (except cash) Increase (decrease) in current liability accounts Investment Activities + Ending net fixed assets - Beginning net fixed assets + Depreciation Financing Activities Notes Payable Change in long-term debt Change in common Stock - Dividends Putting it all together Net cash flow from operating activities Fixed asset acquisition Net cash flow from financing activities = Net increase (decrease) in cash over the period 18Barton College Sample Statement of Cash Flows Cash, beginning of year6,489Financing Activity Operating Activity Increase in Notes Payable141,217 Net Income471,916 Increase in LT Debt517,764 Plus: Depreciation362,325 Decrease in C/S-36,159 Increase in Other CL141,049 Dividends Paid-395,521 Less: Increase in A/R-46,127 Net Cash from Financing227,301 Increase in Inventory-93,692Net Decrease in Cash-3,319 Increase in Other CA-82,150Cash End of Year3,170* Decrease in A/P-26,934 Net Cash from Operations726,387 Investment Activity Fixed Asset Acquisition-957,007 Net Cash from Investments-957,007*Difference due to rounding of dividends Numbers in thousands 19Barton College Ratio Analysis 20Barton College Ratio Analysis Allow for better comparison through time or between companies Used both internally and externally For each ratio, ask yourself: What the ratio is trying to measure Why that information is important 21Barton College Standardized Financial Statements Standardized Financial Statements help us analyze firms of unequal size. Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry Dell vs. HP; Colgate vs. Proctor Gamble; GM vs. Ford 22Barton College Common Size Statements or (Vertical Analysis) 23Barton College Common Size Balance Sheet 24Barton College Common Size Balance Sheet 25Barton College Common Size Income Statement 26Barton College Common Size Income Statement 27Barton College Horizontal Analysis (28,244 28,671) / (28, 244) = -1.5% 28Barton College Common Size Statements Examples(with industry comparison) Lots of Examples Quick ExampleQuick Example Microsoft Common Size Income Statement and Forward % projections Common Size Income Statement And another.. Open outside of PowerPoint 29Barton College Ratio Analysis 30Barton College Ratio Analysis Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important Ratios are used both internally and externally Things to consider concerting financial ratios: What aspects of the firm are we trying to analyze What information do we need to compute the ratio, and how does it relate to the firm. What is the unit of measurement: Days, times, percent, etc. What benchmarks should we use for comparing the ratios. This lets us determine whether the ratio is good or badSIC codes for example Specific ratios will be important to certain firms and others will not: - Educational institution (Non-Profit) verses a for-profit mfg. for example. 31Barton College Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios The ability to meet long term obligations Asset management or turnover ratios Efficiency of asset usage Profitability ratios Efficiency of operations and it impacts the bottom line. Market value ratios How the market value of the firm relates to book value. Wikipedia on Financial Ratios . The front and back cover of most financial texts will have important ratios 32Barton College Ratio Analysis does not have to be $$$ Financial 33Barton College Other Ratio Examples Key Ratios for Airlines Available Seat Mile = (total # of seats available for transporting passengers) X (# of miles flown during period) Revenue Passenger Mile = (# of revenue-paying passengers) X (# of mile flown during the period) Revenue Per Available Seat Mile = (Revenue) (# of seats available) Available Seat Mile Revenue Passenger Mile Revenue Per Available Seat Mile Key Ratios for Higher Education Tuition Revenuer per FTE = Total Tuition Revenue / Total FTEs Cost per FTE = Total Costs / Total FTEs Assets per FTE = Total Assets / Total FTEs Real Estate Finance Debt Coverage Ratio Loan-to-value Ratio Debt to Equity Ratio Debt to Assets Ratio Cash-on-Cash Return or Owners Return on Equity 34Barton College Banking Ratios With all the saga now playing out with investment banks and the credit market, here are a few ratios bankers may be using at this moment. Reserves as a percentage of loans: ( Reserves / Total loans ) Charge-offs as percentage of loans: (Charge-offs / Total Loans ) Return on Assets (ROA) = Net Income / Total Assets Typically about 1% for banks Net Interest Margin = Net Interest Income / Average Earning Assets Margins above 4% are very impressive for most banks Fee Income per Average Assets = Fee Income / Average Assets Loan Loss Reserves to Total Loans = (gross loans reserve) = Net Loans / Total Loans Interest Coverage = EBIT / Interest Expense Non-Performing Assets/Total Loans Non-performing assets are non-performing loans plus other real estate owned. Provides an indication of how much of the loan portfolio might be impaired; should be as low as possible (greater than 4% to 5% isnt good, and above 8% to 10% can be life threatening). 35Barton College Vendors to help you create and analyze ratios.. Lots of Software Vendors to help with ratio analysis Cognos (IBM) SAS Microsoft FRx Acorn Systems Clarity All ERP Vendors: SAP & Oracle (MS = SQL & FRx, etc.) And the list goes on and on.. However. MS Excel is still the most widely used financial tool 36Barton College Ratios Discussed in your Text 37Barton College Table 3.5 38Barton College Liquidity Ratios Current Ratio = CA / CL 708 / 540 = 1.31 times Quick Ratio = (CA Inventory) / CL Acid Test ( ) / 540 = 0.53 times Cash Ratio = Cash / CL 98/ 540 =.18 times Although its usually good to have liquidity, carrying too much cash can be a sign of mismanagement of the firms cash. The extra cash could be invested in profitable investments or given back to shareholders as dividends. e.g., Microsoft for example ~ $62 billion in cash and short term investments 39Barton College Financial Leverage Ratios Total Debt Ratio = (TA TE) / TA (3,588 2,591) / 3,588 = 0.28 times Debt/Equity = TD / TE (0.28 / 0.72) = 0.38 times Equity Multiplier = TA/TE = 1 + D/E ($1 / 0.72) = ( ) = 1.38 This is a measure of financial leverage. The higher the ratio, the more the company is relying on debt to finance its asset base. 40Barton College Financial Leverage Ratios Times Interest Earned = EBIT / Interest 691 / 141 = 4.9 times Cash Coverage = (EBIT + Depreciation) / Interest ( ) / 141 = 6.9 times 41Barton College Asset Management: Inventory Ratios Inventory Turnover = COGS / Inventory 1,344 / 422 = 3.2 times Days Sales in Inventory = 365 / Inventory Turnover 365 / 3.2 = 114 days Typically we desire high inventory (Asset Utilization) ratios. We do not generally want cash invested in unused inventory. Note: Inventory can be computed using ending inventory or average inventory for the period. 42Barton College Asset Management: Asset Turnover Ratios Total Asset Turnover = Sales / Total Assets 2,311 / 3,588 = 0.64 times Capital Intensity Ratio = 1/TAT 1 / 0.64 = 1.56 Measure of asset use efficiency Not unusual for (total asset turnover) TAT < 1, especially if a firm has a large amount of fixed assets Power Company, Ship Builder, Airline, etc How do you think Deltas ratio is fairing..? 200 new $250 million per plane $50 Billion 43Barton College Profitability Measures Profit Margin = NI / Sales 363 / 2,311 = 15.70% Return on Assets (ROA) = NI / TA 363 / 3,588 = 10.12% Return on Equity (ROE) = NI / TE 363 / 2,591 = 14.01% Bottom Line 44Barton College Market Value Measures Market Price = $88 per share = PPS Shares outstanding = 33 million Earnings per Share = EPS = 363 / 33 = $11 PE ratio = PPS / EPS $88 / $11 = 8 times. or 8 times earnings (PE Multiple) Price/Sales ratio = PPS/Sales per share $88 / ($2,311 / 33) = 1.26 times Market-to-book ratio = PPS / Book value per share Book value per share = Total Equity/shares outstanding = $2,591 / 33 = $78.52 Market-to-Book = $88 / = 1.12 times 45Barton College EBITDA Ratio Similar to a P/E ratio but looks at operating-related assets. not non- operating assets EBITA Ratio = Enterprise Value / EBITDA where Enterprise Value = Total Value of Stock + Book Value of Libabilities 1 - Cash EBITDA = Revenue Operating Expenses (excluding..Interest Expense, Taxes and Depreciation Expense) Some companies may have no Net Earnings..!!! 1. Book Value of Liabilities can be assumed to be close to Market Value No need to pay for CASH 46Barton College Prufrock Ratios 47Barton College Ratios are Easily Obtainable for Public Companies Google Finance Yahoo Finance Morningstar MSN Money And a host of many others.. Edgar (10Q and 10K) Capital IQ 48Barton College Summary of Ratios You Can use this on a test. 49Barton College Quick Example of Ratio Analysis ARO: Aropostale PSUN: Pacific Sunwear (Pac Sun) ANF: Abocrombie 50Barton College The DuPont Identity ROE = NI / TE= Basic Formula ROE = PM * TAT * EM= Dupont Identity PM = Net Income / Sales TAT = Sales / Total Assets EM = Total Assets / Total Equity Profit Margin Asset Use Financial Leverage = ROE DuPont Analysis Model 51Barton College DuPont Model for Operations ROE = ROA x EM = ROA x (TD/TE) ROA = PM x Asset Turnover = (NI / Sales) x ( Sales / TA) 52Barton College Using the DuPont Identity ROE = PM * TAT * EM Profit margin Measures firms operating efficiency How well does it control costs Total asset turnover Measures the firms asset use efficiency How well does it manage its assets Equity multiplier Measures the firms financial leverage EM = TA / TE = 1 + D/E ratio 53Barton College Prufrocks DuPont Identity ROE = PM * TAT * EM PM = 15.7% TAT = 0.64 EM = 1.39 ROE = x 0.64 x 1.39 = 14% 54Barton College Efficiency to the Extreme. 55Barton College Payout and Retention Ratios Dividend payout ratio Cash dividends / Net income $121 / $363 =.3333 or 33.33% Retention ratio Addition to R/E / Net income = (EPS DPS) / EPS (Net Income - Dividends) / Net Income = $243/$363 = 66.66% Retention ratio = 1 Dividend Payout Ratio % = 66.66% Typically we would want to retain more earnings if we need cash for profitable projects in the future, and its expensive to issue stock or obtain credit. 56Barton College The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. Here b is the playback ratio or retention ratio. Note: ROA = Net Income / Total Assets 57Barton College The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. Note: ROE = Net Income / Total Equity 58Barton College Determinants of Growth Profit margin operating efficiency Total asset turnover asset use efficiency Financial leverage choice of optimal debt ratio Dividend policy choice of how much to pay to shareholders versus reinvesting in the firm 59Barton College Why Evaluate Financial Statements? Internal uses Performance evaluation compensation and comparison between divisions Planning for the future guide in estimating future cash flows External uses Creditors ---- Can you pay your debt payments (interest) Suppliers ---- (are you going to be able to pay me.) Customers ---- (are you going to be around next year) Stockholders ---- (what will be my return on investment) 60Barton College Benchmarking Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firms performance is changing through time (horizontal analysis) Internal and external uses Peer Group Analysis Compare to similar companies or within industries Standard Industrial Codes (SIC) and North American Industry Classification System (NAICS) codes http://www.census.gov/epcd/www/naics.htmlhttp://www.census.gov/epcd/www/naics.html Many Investment related sites create their own peer-group comparison. 61Barton College Potential Problems There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures i.e. (FIFO vs. LIFO) or (IFRS vs. GAAP) Different fiscal years Extraordinary events Big write-offs, Hurricanes, Terrorists attacks, etc. 62Barton College Work the Web Example The Internet makes ratio analysis much easier than it has been in the past Click on the Links below Choose a company and enter its ticker symbol Click on comparison and see what information is available Morningstar Reuters 63Barton College For Next Time Complete the problem set for chapter 3. These are located on the Assignments Page of the FIN 301 Web. For homework compare two publically traded companies Publicly available sites to find information include Morningstar Yahoo Finance, Reuters, Google Finance, MSN Money MorningstarYahoo FinanceReutersGoogle FinanceMSN Money Complete your analysis using MS Excel. Draw any conclusions about the condition of the companies (how they compare) based on their ratios? SIC Codes 64Barton College Appendix and Backup Material