3 - 1 copyright © 1999 by the dryden pressall rights reserved. ratio analysis du pont system...

3 - 1

Copyright © 1999 by The Dryden Press All rights reserved.

Ratio analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

CHAPTER 3 Analysis of Financial Statements

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Balance Sheet: Assets

1999E 1998

Cash 14,000 7,282

AR 878,000 632,160Inventories 1,716,480 1,287,360 Total CA 2,680,112 1,926,802Gross FA 1,197,160 1,202,950Less: Deprec. 380,120 263,160 Net FA 817,040 939,790Total assets 3,497,152 2,866,592

ST investments 71,632 0

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Liabilities and Equity

1999E 1998Accounts payable 436,800 524,160Notes payable 600,000 720,000Accruals 408,000 489,600 Total CL 1,444,800 1,733,760Long-term debt 500,000 1,000,000Common stock 1,680,936 460,000Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832Total L & E 3,497,152 2,866,592

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(519,936)

Income Statement

1999E 1998Sales 7,035,600 5,834,400COGS 5,728,000 5,728,000Other expenses 680,000 680,000Depreciation 116,960 116,960 Tot. op. costs 6,524,960 6,524,960 EBIT 510,640 (690,560)Interest exp. 88,000 176,000 EBT 422,640 (866,560)Taxes (40%) 169,056 (346,624)Net income 253,584

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Other Data

1999E 1998

Shares out. 250,000 100,000

EPS $1.014 ($5.199)

DPS $0.220 $0.110

Stock price $12.17 $2.25

Lease pmts $40,000 $40,000

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Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

Why are ratios useful?

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Liquidity: Can we make required payments as they fall due?

Asset management: Do we have the right amount of assets for the level of sales?

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

answer?

(More…)

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Debt management: Do we have the 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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Calculate the firm’s forecasted current and quick ratios for 1999.

CR99 = = = 1.85x.

QR99 =

= = 0.67x.

CACL

$2,680$1,445

$2,680 - $1,716$1,445

CA - Inv.CL

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Expected to improve but still below the industry average.

Liquidity position is weak.

Comments on CR and QR

1999 1998 1997 Ind.

CR 1.85x 1.1x 2.3x 2.7x

QR 0.67x 0.4x 0.8x 1.0x

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What is the inventory turnover ratio as compared to the industry average?

Inv. turnover =

= = 4.10x.

SalesInventories

$7,036$1,716

1999 1998 1997 Ind.

Inv. T. 4.1x 4.5x 4.8x 6.1x

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Inventory turnover is below industry average.

Firm might have old inventory, or its control might be poor.

No improvement is currently forecasted.

Comments on Inventory Turnover

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ReceivablesAverage sales per day

DSO is the average number of days after making a sale before receiving

cash.

DSO =

= =

= 44.9 days.

ReceivablesSales/360

$878$7,036/360

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Appraisal of DSO

Firm collects too slowly, and situation is getting worse.

Poor credit policy.

1999 1998 1997 Ind.DSO 44.9 39.0 36.8 32.0

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Fixed Assets and Total AssetsTurnover Ratios

Fixed assetsturnover

Sales Net fixed assets=

= = 8.61x.$7,036$817

Total assetsturnover

Sales Total assets=

= = 2.01x.$7,036$3,497 (More…)

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FA turnover is expected to exceed industry average. Good.

TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

1999 1998 1997 Ind.FA TO 8.6x 6.2x 10.0x 7.0xTA TO 2.0x 2.0x 2.3x 2.6x

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Calculate the forecasted operating capital requirement ratio (OCR).

= +

= ($14,000 + $878,000 + $1,716,480) - ($436,800 + $408,000) = $1,763,680.

Operating capital = $1,763,680 + $817,040 = $2,580,720.

(More…)

Operatingcapital

Net operatingworking capital

Net fixedassets

Net operatingworking capital

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1999 1998 1997 Ind. OCR 36.7% 31.8% 33.2% 29.5%

OCR = Operating capital/Sales = $2,580,720/$7,035,600 = 36.7%.

The OCR is not improving.It is worse than the industry average.

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Calculate the debt, TIE, and fixed charge coverage ratios.

Total debt Total assetsDebt ratio =

= = 55.6%.$1,445 + $500$3,497

EBIT Int. expense TIE =

= = 5.8x.$510.6$88 (More…)

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All three ratios reflect use of debt, but focus on different aspects.

Fixed chargecoverage

= FCC

=

= = 4.3x.

EBIT + Lease payments Interest Lease Sinking fund pmt.expense pmt. (1 - T)+ +

$510.6 + $40 $88 + $40 + $0

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Too much debt, but projected to improve.

How do the debt management ratios compare with industry averages?

1999 1998 1997 Ind.D/A 55.6% 95.4% 54.8% 50.0%TIE 5.8x -3.9x 3.3x 6.2xFCC 4.3x -3.0x 2.4x 5.1x

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Very bad in 1998, but projected to exceed industry average in 1999.

After-tax operatingprofit margin (ATOPM)

1999 1998 1997 Ind. ATOPM 4.4% -7.1% 3.7% 4.3%

ATOPM = EBIT(1 - T) = $510,640(1 - 0.4) Sales $7,035,600= 4.4%.

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Very bad in 1998, but projected to exceed industry average in 1999. Looking good.

Profit Margin (PM)

1999 1998 1997 Ind.PM 3.6% -8.9% 2.6% 3.5%

PM = = = 3.6%. NI Sales

$253.6$7,036

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BEP =

= = 14.6%.

Basic Earning Power (BEP)

EBIT Total assets

$510.6 $3,497

(More…)

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BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be below average.

Room for improvement.

1999 1998 1997 Ind.BEP 14.6% -24.1% 14.2% 19.1%

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Return on Assets (ROA)and Return on Equity (ROE)

ROA =

= = 7.3%.

Net income Total assets

$253.6 $3,497

(More…)

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ROE =

= = 16.3%.

Net income Common equity

$253.6 $1,552

1999 1998 1997 Ind.ROA 7.3% -18.1% 6.0% 9.1%ROE 16.3% -391.0% 13.3% 18.2%

Both below average but improving.

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ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.

However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Effects of Debt on ROA and ROE

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Calculate and appraise theP/E and M/B ratios.

Price = $12.17.

EPS = = = $1.01.

P/E = = = 12x.

NI Shares out.

$253.6250

Price per shareEPS

$12.17$1.01

(More…)

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Com. equity Shares out.BVPS =

= = $6.21.$1,552250

Mkt. price per share Book value per share

M/B =

= = 1.96x.$12.17$6.21

(More…)

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P/E: How much investors will pay for $1 of earnings. High is good.

M/B: How much paid for $1 of book value. Higher is good.

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

1999 1998 1997 Ind.P/E 12.0x -0.4x 9.7x 14.2xM/B 1.96x 1.7x 1.3x 2.4x

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( )( )( ) = ROE

Profitmargin

TAturnover

Equitymultiplier

NI Sales

SalesTA

TA CE

1997 2.6% x 2.3 x 2.2 = 13.2%1998 -8.9% x 2.0 x 21.6 = -391.0%1999 3.6% x 2.0 x 2.3 = 16.3%Ind. 3.5% x 2.6 x 2.0 = 18.2%

Explain the Du Pont System

x x = ROE.

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The Du Pont system focuses on:

Expense control (PM)

Asset utilization (TATO)

Debt utilization (EM)

It shows how these factors combine to determine the ROE.

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Simplified Firm Data

A/R $ 878 Debt $1,945Other CA 1,802 Equity 1,552Net FA 817Total assets $3,497 L&E $3,497

Q. How would reducing DSO to 32 days affect the company?

Sales $7,035,600 day 360

= = $19,543.

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Effect of reducing DSO from 44.9 days to 32 days:

Old A/R = $19,543 x 44.9 = $878,000

New A/R = $19,543 x 32.0 = 625,376

Cash freed up: $252,624

Initially shows up as additional cash.

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What could be done with the newcash? Effect on stock price and risk?

New Balance Sheet

Added cash $ 253 Debt $1,945A/R 625 Equity 1,552Other CA 1,802Net FA 817Total assets $3,497 Total L&E $3,497

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Potential use of freed up cash

Repurchase stock. Higher ROE, higher EPS.

Expand business. Higher profits.

Reduce debt. Better debt ratio; lower interest, hence higher NI.

(More…)

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Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides.

All these actions would likely improve stock price.

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Would you lend moneyto this company?

Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment.

However, company should not have relied so heavily on debt financing in the past.

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What are some potential problems and limitations of financial ratio analysis?

Comparison with industry averages is difficult if the firm operates many different divisions.

“Average” performance is not necessarily good.

Seasonal factors can distort ratios.

(More…)

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Window dressing techniques can make statements and ratios look better.

Different accounting and operating practices can distort comparisons.

Sometimes it is difficult to tell if a ratio value is “good” or “bad.”

Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

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What are some qualitative factors analysts should consider when

evaluating a company’s likely future financial performance?

Are the company’s revenues tied to a single customer?

To what extent are the company’s revenues tied to a single product?

To what extent does the company rely on a single supplier? (More…)

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What percentage of the company’s business is generated overseas?

What is the competitive situation?

What does the future have in store?

What is the company’s legal and regulatory environment?

And so on.

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