Chapter 2 Analysis of Financial Statements

1
Chapter 2 Analysis of Financial Statements
2
Financial Ratio Analysis

• Are our decisions maximizing shareholder wealth?

3

• We will want to answer questions about the firms
• Liquidity
• Efficient use of Assets
• Leverage (financing)
• Profitability

4

• We will want to answer questions about the firms
• Liquidity
• Efficient use of Assets
• Leverage (financing)
• Profitability

5
Financial Ratios

• Tools that help us determine the financial health
  of a company.
• We can compare a companys financial ratios with
  its ratios in previous years (trend analysis).
• We can compare a companys financial ratios with
  those of its industry.

6
ExampleCyberDragon Corporation
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CyberDragons Balance Sheet (000)

• Assets Liabilities Equity
• Cash 2,540 Accounts payable 9,721
• Marketable securities 1,800 Notes payable
  8,500
• Accounts receivable 18,320 Accrued taxes
  payable 3,200
• Inventories 27,530 Other current
  liabilities 4,102
• Total current assets 50,190 Total
  current liabilities 25,523
• Plant and equipment 43,100 Long-term debt
  (bonds) 22,000
• less accum deprec. 11,400 Total liabilities
  47,523
• Net plant equip. 31,700 Common
  stock (10 par) 13,000
• Total assets 81,890 Paid in
  capital 10,000
• Retained earnings 11,367
• Total stockholders' equity
  34,367
• Total liabilities equity
  81,890

8
CyberDragons Income Statement

• Sales (all credit) 112,760
• Cost of Goods Sold (85,300)
• Gross Profit 27,460
• Operating Expenses
• Selling (6,540)
• General Administrative (9,400)
• Total Operating Expenses (15,940)
• Earnings before interest and taxes (EBIT)
  11,520
• Interest charges
• Interest on bank notes (850)
• Interest on bonds (2,310)
• Total Interest charges (3,160)
• Earnings before taxes (EBT) 8,360
• Taxes (assume 40) (3,344)
• Net Income 5,016

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CyberDragonOther Information

• Dividends paid on common stock 2,800
• Earnings retained in the firm 2,216
• Shares outstanding (000) 1,300
• Market price per share 20
• Book value per share 26.44
• Earnings per share 3.86
• Dividends per share 2.15

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1. Liquidity Ratios

• Do we have enough liquid assets to meet
  approaching obligations?

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What is CyberDragons Current Ratio?
12
What is CyberDragons Current Ratio?
current assets current liabilities
13
What is CyberDragons Current Ratio?
14
What is CyberDragons Current Ratio?
If the average current ratio for the industry is
2.4, is this good or not?
15
What is the firms Acid Test Ratio?
16
What is the firms Acid Test Ratio?
current assets - inventories current liabilities
17
What is the firms Acid Test Ratio?
18
What is the firms Acid Test Ratio?
Suppose the industry average is .92. What does
this tell us?
19
What is the firms Average Collection Period?
20
What is the firms Average Collection Period?
accounts receivable daily credit sales
21
What is the firms Average Collection Period?
22
What is the firms Average Collection Period?
If the industry average is 47 days, what does
this tell us?
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2. Operating Efficiency Ratios

• Measure how efficiently the firms assets
  generate operating profits.

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What is the firms Operating Income Return on
Investment (OIROI)?
25
What is the firms Operating Income Return on
Investment (OIROI)?
operating income total assets
26
What is the firms Operating Income Return on
Investment (OIROI)?
27
What is the firms Operating Income Return on
Investment (OIROI)?

• Slightly below the industry average of 15.

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What is the firms Operating Income Return on
Investment (OIROI)?

• Slightly below the industry average of 15.
• The OIROI reflects product pricing and the firms
  ability to keep costs down.

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What is their Operating Profit Margin?
30
What is their Operating Profit Margin?
operating income sales
31
What is their Operating Profit Margin?
32
What is their Operating Profit Margin?

• This is below the industry average of
• 12.

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What is their Total Asset Turnover?
34
What is their Total Asset Turnover?
sales total assets
35
What is their Total Asset Turnover?
36
What is their Total Asset Turnover?
The industry average is 1.82 times. The firm
needs to figure out how to squeeze more sales
dollars out of its assets.
37
What is the firms Accounts Receivable Turnover?
38
What is the firms Accounts Receivable Turnover?
credit sales accounts receivable
39
What is the firms Accounts Receivable Turnover?
40
What is the firms Accounts Receivable Turnover?
CyberDragon turns their A/R over 6.16 times per
year. The industry average is 8.2 times. Is
this efficient?
41
What is the firms Inventory Turnover?
42
What is the firms Inventory Turnover?
cost of goods sold inventory
43
What is the firms Inventory Turnover?
44
What is the firms Inventory Turnover?
CyberDragon turns their inventory over 3.1 times
per year. The industry average is 3.9 times.
Is this efficient?
45
Low inventory turnover

• The firm may have too much inventory, which is
  expensive because
• Inventory takes up costly warehouse space.
• Some items may become spoiled or obsolete.

46
What is the firms Fixed Asset Turnover?
47
What is the firms Fixed Asset Turnover?
sales fixed assets
48
What is the firms Fixed Asset Turnover?
49
What is the firms Fixed Asset Turnover?
If the industry average is 4.6 times, what does
this tell us about CyberDragon?
50
3. Leverage Ratios(financing decisions)

• Measure the impact of using debt capital to
  finance assets.
• Firms use debt to lever (increase) returns on
  common equity.

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How does Leverage work?

• Suppose we have an all equity-financed firm worth
  100,000. Its earnings this year total 15,000.
• ROE
• (ignore taxes for this example)

52
How does Leverage work?

• Suppose we have an all equity-financed firm worth
  100,000. Its earnings this year total 15,000.
• ROE 15

15,000 100,000
53
How does Leverage work?

• Suppose the same 100,000 firm is financed with
  half equity, and half 8 debt (bonds). Earnings
  are still 15,000.
• ROE

54
How does Leverage work?

• Suppose the same 100,000 firm is financed with
  half equity, and half 8 debt (bonds). Earnings
  are still 15,000.
• ROE

15,000 - 4,000 50,000
55
How does Leverage work?

• Suppose the same 100,000 firm is financed with
  half equity, and half 8 debt (bonds). Earnings
  are still 15,000.
• ROE 22

15,000 - 4,000 50,000
56
What is CyberDragons Debt Ratio?
57
What is CyberDragons Debt Ratio?
total debt total assets
58
What is CyberDragons Debt Ratio?
59
What is CyberDragons Debt Ratio?
If the industry average is 47, what does this
tell us?
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What is CyberDragons Debt Ratio?
If the industry average is 47, what does this
tell us? Can leverage make the firm more
profitable? Can leverage make the firm riskier?
61
What is the firms Times Interest Earned Ratio?
62
What is the firms Times Interest Earned Ratio?
operating income interest expense
63
What is the firms Times Interest Earned Ratio?
64
What is the firms Times Interest Earned Ratio?
The industry average is 6.7 times. This is
further evidence that the firm uses more debt
financing than average.
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4. Return on Equity

• How well are the firms managers maximizing
  shareholder wealth?

66
What is CyberDragonsReturn on Equity (ROE)?
67
What is CyberDragonsReturn on Equity (ROE)?
net income common equity
68
What is CyberDragonsReturn on Equity (ROE)?
69
What is CyberDragonsReturn on Equity (ROE)?
The industry average is 17.54.
70
What is CyberDragonsReturn on Equity (ROE)?
The industry average is 17.54. Is this what we
would expect, given the firms leverage?
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Conclusion

• Even though CyberDragon has higher leverage than
  the industry average, they are much less
  efficient, and therefore, less profitable.

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The DuPont Model

• Brings together
• Profitability
• Efficiency
• Leverage

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The DuPont Model
ROE x / (1-
)

• Net Profit Total Asset
  Debt
• Margin Turnover
  Ratio

74
The DuPont Model
ROE x / (1-
) x /(1-
)

• Net Profit Total Asset
  Debt
• Margin Turnover
  Ratio
• Net Income Sales
  Total Debt
• Sales Total Assets
  Total Assets

75
The DuPont Model
ROE x / (1-
) x /(1-
) x
/ (1 - )

• Net Profit Total Asset
  Debt
• Margin Turnover
  Ratio
• Net Income Sales
  Total Debt
• Sales Total Assets
  Total Assets
• 5,016 112,760
  47,523
• 112,760 81,890
  81,890

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The DuPont Model
ROE x / (1-
) x /(1-
) x
/ (1 - ) 14.6

• Net Profit Total Asset
  Debt
• Margin Turnover
  Ratio
• Net Income Sales
  Total Debt
• Sales Total Assets
  Total Assets
• 5,016 112,760
  47,523
• 112,760 81,890
  81,890