Analysis of Financial StatementsChapter 3Ratio AnalysisDuPont SystemEffects of Improving RatiosLimitations of Ratio AnalysisQualitative Factors

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Balance Sheet: AssetsCashA/RInventoriesTotal CAGross FALess: Deprec.Net FATotal Assets3-*

Balance Sheet: Assets4-*

2009(E) 2008Cash $199,551$208,323Accounts receivable 876,897690,294Inventories 909,379942,374Total current assets $1,985,827$1,840,991Gross fixed assets 380,510317,503Less accumulated depreciation 67,41354,045Net fixed assets $313,097$263,458Total assets $2,298,924$2,104,449

Balance Sheet: Liabilities and Equity3-*

2009(E)2008Short-term Borrow$312,500$288,798Accounts payable 650,535636,318Accruals 110,157106,748Total current liabilities $1,073,192$1,031,864Long-term debt 656,600410,769Common stock (100,000 shares) 550,000550,000Retained earnings 19,132111,816Total equity $569,132$661,816Total liabilities and equity $2,298,924$2,104,449

Income Statement3-*

2009(E)2008Sales $2,069,032 $2,325,967 Cost of goods sold 1,647,925 1,869,326 Other expenses 241,490 287,663 Total operating costs excluding depreciation and amortization $1,889,415 $2,156,989 Depreciation and amortization 17,891 25,363 EBIT $161,726 $143,615 Interest expense 27,434 31,422 EBT $134,292 $112,193 Taxes (40%) 53,717 44,877 Net income$80,575 $67,316

Other Data3-*

2009(E)2008EPS $0.81 $0.67 DPS$1.00 $1.00 Book value per share$5.69$6.62Stock price$19.20$15.60Share outstanding100,000100,000Tax rate40%40%

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.3-*

Five Major Categories of Ratios and the Questions They AnswerLiquidity: 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?3-*

Everelites Forecasted Current Ratio and Quick Ratio for 20093-*

Comments on Liquidity Ratios3-*Expected to improve but still below the industry average.Liquidity position is weak.

2009E20082007Ind.Current ratio1.85x 1.78x 2.02x 2.05Quick ratio1.00x 0.87x 1.14x 1

Everelites Inventory Turnover vs. the Industry AverageInventory turnover09 = Sales/Inventory = $2,069/$909 = 2.283-*

2009E20082007Ind.Inventory turnover2.28x 2.47x 3.10x 6.1

Comments on Inventory TurnoverInventory turnover is below industry average.Everelite might have old inventory, or its control might be poor.No improvement is currently forecasted.3-*

DSO: Average Number of Days after Making a Sale before Receiving CashDSO= Receivables/Avg. sales per day= Receivables/(Annual sales/365)= $876/($2,069/365) = 154.69 days3-*

Appraisal of DSOEverelite collects on sales too slowly, and is getting worse.Everelite has a poor credit policy.3-*

2009E20082007Ind.DSO154.69x 108.32x 135.60x 56

Fixed Assets and Total Assets Turnover Ratios vs. the Industry AverageFA turnover= Sales/Net fixed assets= $2,069/$313 = 6.61

TA turnover= Sales/Total assets= $2,069/$2,299 = 0.90

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Evaluating the FA Turnover and TA Turnover RatiosFA turnover projected to be still below the industry average.TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).3-*

2009E20082007Ind.FA TO6.61x 8.83x 11.22x 9.3TA TO0.90x 1.11x 1.21x 2.1

Calculate the Debt Ratio and Times-Interest-Earned RatioDebt ratio= Total debt/Total assets= ($1,073 + $657)/$2,299 = 75.25%TIE= EBIT/Interest expense= $161.7/$27.4 = 5.90

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Everelites Debt Management Ratios vs. the Industry AveragesD/A and TIE are worse than the industry average.3-*

2009E20082007Ind.D/A75.24%68.55%64.50%50.00%TIE5.90x 4.57x 19.17x 6.2

Profitability Ratios: Operating Margin, Profit Margin, and Basic Earning Power3-*Operating margin09= EBIT/Sales = $161.7/$2,069 =7.82%.Profit margin09= Net income/Sales = $80.5/$2,069 = 3.89%.Basic earning power09=EBIT/Total assets = $161.7/$2,299 = 7.03%.

Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power3-*

2009E20082007Ind.Operating margin7.82%6.17%11.91%13%Profit margin3.89%2.89%6.78%9.00%Basic earning power7.03%6.82%14.38%15.00%

Operating margin was very bad in 2008. It is projected to improve in 2009, but it is still projected to remain below the industry average.Profit margin was very bad in 2008. It is projected to improve in 2009, but it is still projected to remain below the industry average.BEP removes the effects of taxes and financial leverage, and is useful for comparison.BEP projected to improve, yet still below the industry average. There is definitely room for improvement.3-*Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power

Profitability Ratios: Return on Assets and Return on EquityROA= Net income/Total assets= $80.5/$2,299 = 3.50%

ROE= Net income/Total common equity= $80.5/$569 = 14.16%.3-*

Appraising Profitability with ROA and ROE3-*Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.Wide variations in ROE illustrate the effect that leverage can have on profitability.

2009E20082007Ind.ROA3.50%3.20%8.18%6.50%ROE14.16%10.17%23.03%12.00%

Effects of Debt on ROA and ROEROA is lowered by debt interest lowers NI, which also lowers ROA = NI/Assets.But use of debt also lowers equity, hence debt could raise ROE = NI/Equity.3-*

Problems with ROEROE 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 and a better measure would consider risk and return.3-*

Calculate the Price/Earnings and Market/Book RatiosP/E= Price/Earnings per share= $19.20/$0.81 = 23.70

M/B= Market price/Book value per share= $19.20/$5.69 = 3.37

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2009E20082007Ind.P/E23.83x 23.17x14.49x10.00M/B3.37x 2.36x3.34x3.00

Analyzing the Market Value RatiosP/E: How much investors are willing to pay for $1 of earnings.M/B: How much investors are willing to pay for $1 of book value equity.For each ratio, the higher the number, the better.P/E and M/B are high if ROE is high and risk is low.3-*

The DuPont SystemFocuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier).3-*

DuPont Equation: Breaking Down Return on EquityROE= (NI/Sales) x (Sales/TA) x (TA/Equity)=3.89% 0.90 1/(1 0.7524)= 14.16%.3-*

An Example:The Effects of Improving RatiosA/R $ 877 Debt$1,730Other CA1,109Equity 569Net FA313TA$2,299Total L&E$2,299

Sales/Day = $2,069/365 = $5.67

How would reducing the firms DSO to 56 days affect the company?3-*

Reducing Accounts Receivable and the Days Sales OutstandingReducing A/R will have no effect on sales.Accounts receivable under new policy = $5.67 56 days= $377.44.Freed cash= old A/R new A/R = $876.86 $377.44 = $559.42

Initially shows up as addition to cash.3-*

Effect of Reducing Receivables on Balance Sheet and Stock Price

What could be done with the new cash?

How might stock price and risk be affected?3-*

Potential Uses of Freed up CashRepurchase stockExpand businessReduce debtAll these actions would likely improve the stock price.3-*

Potential Problems and Limitations of Financial Ratio AnalysisComparison 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.3-*

More Issues Regarding RatiosDifferent operating and accounting practices can distort comparisons.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.3-*

Consider Qualitative Factors When Evaluating a Companys Future Financial PerformanceAre the firms revenues tied to one key customer, product, or supplier?What percentage of the firms business is generated overseas?The firms competitive environmentFuture prospectsLegal and regulatory environment3-*

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