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CHAPTER 13
Analysis of Financial Statements Ratio analysis

Du Pont system
Effects of improving ratios Limitations of ratio analysis

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Income Statement 2004 2005E Sales 5,834,400 7,035,600 COGS 4,980,000 5,800,000 Other expenses 720,000 612,960 Deprec. 116,960 120,000 Tot. op. costs 5,816,960 6,532,960 EBIT 17,440 502,640 Int. expense 176,000 80,000 EBT (158,560) 422,640 Taxes (40%) (63,424) 169,056 Net income (95,136) 253,584

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Balance Sheets: Assets Cash S-T invest. AR Inventories Total CA Net FA Total assets 2004 7,282 20,000 632,160 1,287,360 1,946,802 939,790 2,886,592 2005E 14,000 71,632 878,000 1,716,480 2,680,112 836,840 3,516,952

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Balance Sheets: Liabilities & Equity Accts. payable Notes payable Accruals Total CL Long-term debt Common stock Ret. earnings Total equity Total L&E 2004 324,000 720,000 284,960 1,328,960 1,000,000 460,000 97,632 557,632 2,886,592 2005E 359,800 300,000 380,000 1,039,800 500,000 1,680,936 296,216 1,977,152 3,516,952

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Other Data 2004 Stock price $6.00

2005E $12.17

# of shares
EPS

100,000
-$0.95

250,000
$1.01

DPS
Book val. per share Lease payments Tax rate

$0.11
$5.58 40,000 0.4

$0.22
$7.91 40,000 0.4

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Why are ratios useful?

Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

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What are the five major categories of ratios, and what questions do they answer? 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?
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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 firms forecasted current and quick ratios for 2005. CA CR05 = CL $2,680 = $1,040 = 2.58x.

CA - Inv. QR05 = CL $2,680 - $1,716 = = 0.93x. $1,040

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Comments on CR and QR
2005E CR QR 2.58x 0.93x 2004 1.46x 0.5x 2003 2.3x 0.8x Ind. 2.7x 1.0x

Expected to improve but still below the industry average.

Liquidity position is weak.

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What is the inventory turnover ratio as compared to the industry average? Sales Inv. turnover = Inventories $7,036 = = 4.10x. $1,716

2005E
Inv. T. 4.1x

2004
4.5x

2003
4.8x

Ind.
6.1x

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Comments on Inventory Turnover

Inventory turnover is below industry average.

Firm might have old inventory, or its control might be poor. No improvement is currently forecasted.

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DSO is the average number of days after making a sale before receiving cash.
Receivables DSO = Average sales per day

Receivables $878 = Sales/365 = $7,036/365

= 45.5 days.

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Appraisal of DSO 2005 45.5 2004 39.5 2003 37.4 Ind. 32.0

DSO

Firm collects too slowly, and situation is getting worse.

Poor credit policy.

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Fixed Assets and Total Assets Turnover Ratios Fixed assets Sales = turnover Net fixed assets = $7,036 = 8.41x. $837

Total assets = turnover

Sales Total assets $7,036 = 2.00x. = $3,517 (More)

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FA TO TA TO

2005E 2004 2003 8.4x 6.2x 10.0x 2.0x 2.0x 2.3x

Ind. 7.0x 2.5x

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).

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Calculate the debt, TIE, and EBITDA coverage ratios. Total liabilities Debt ratio = Total assets $1,040 + $500 = = 43.8%. $3,517

EBIT TIE = Int. expense $502.6 = 6.3x. = $80

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EBITDA = EC coverage EBIT + Depr. & Amort. + Lease payments Interest Lease expense + pmt. + Loan pmt. = $502.6 + $120 + $40 $80 + $40 + $0 = 5.5x.

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

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How do the debt management ratios compare with industry averages? 2005E 43.8% 6.3x 5.5x 2004 2003 Ind. 80.7% 54.8% 50.0% 0.1x 3.3x 6.2x 0.8x 2.6x 8.0x

D/A TIE EC

Recapitalization improved situation, but lease payments drag down EC.

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Profit Margin (PM)

NI $253.6 PM = Sales = $7,036 = 3.6%. 2005E 2004 2003 3.6% -1.6% 2.6% Ind. 3.6%

PM

Very bad in 2004, but projected to meet industry average in 2005. Looking good.

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Return on Assets (ROA) and Return on Equity (ROE) Net income ROA = Total assets $253.6 = $3,517 = 7.2%.

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Net income ROE = Common equity = $253.6 = 12.8%. $1,977 2005E 2004 2003 Ind. 7.2% -3.3% 6.0% 9.0% 12.8% -17.1% 13.3% 18.0%

ROA ROE

Both below average but improving.

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Effects of Debt on ROA and ROE 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.

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Calculate and appraise the P/E, P/CF, and M/B ratios.

Price = $12.17.
NI $253.6 EPS = Shares out. = 250 = $1.01.

Price per share $12.17 P/E = = $1.01 = 12x. EPS

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Explain the Du Pont System

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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The Du Pont System

Profit margin

)(

TA turnover

)(
x

Equity multiplier = ROE

TA CE x x x x 2.2 5.2 1.8 2.0 = = = =

NI Sales Sales x TA

= ROE.
13.2% -16.6% 13.0% 18.0%

2003 2.6% x 2.3 2004 -1.6% x 2.0 2005 3.6% x 2.0 Ind. 3.6% x 2.5

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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.
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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 companys likely future financial performance? Are the companys revenues tied to a single customer? To what extent are the companys 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 companys business is generated overseas? What is the competitive situation?

What does the future have in store?

What is the companys legal and regulatory environment?