Working With Financial Statements

Key Concepts and Skills Chapter 3 Working With Financial Statements Chapter Outline • • • • • Standardized Financial Statements Ratio Analysis The Du Pont Identity Internal and Sustainable Growth Using Financial Statement Information 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 that information is important • Ratios are used both internally and externally • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Know the determinants of a firm’s profitability and growth • Understand the problems and pitfalls in financial statement analysis Standardized Financial Statements • 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 Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios 1-1 Sample Income Statement Sample Balance Sheet Numbers in thousands, except EPS & DPS Numbers in thousands Cash A/R Inventory Revenues 680,623 A/P 318,301 1,051,438 N/P 4,613 300,459 Other CL 1,645,748 Other CA 415,310 Total CL 1,968,662 Total CA 2,447,830 LT Debt 909,814 Net FA 3,415,159 C/S 2,984,513 Total Assets 5,862,989 Total Liab. & Equity 5,862,989 Computing Liquidity Ratios • Current Ratio = CA / CL – 2,447,830 / 1,968,662 = 1.24 times • Quick Ratio = (CA – Inventory) / CL – (2,447,830 – 300,459) / 1,968,662 = 1.09 times • Cash Ratio = Cash / CL – 680,623 / 1,968,662 = .346 times 5,250,538 - Cost of Goods Sold (2,046,645) - Expenses (1,904,556) - Depreciation & Amortization (124,647) EBIT 1,174,690 - Interest Expense (5,785) Taxable Income - Taxes 1,168,905 (412,495) Net Income 756,410 EPS (193,000 shares outstanding) 3.92 Dividends per share 1.20 Computing Leverage Ratios • Total Debt Ratio = (TA – TE) / TA – (5,862,989 – 2,984,513) / 5,862,989 = .491 times or 49.1% – The firm finances slightly over 49% of their assets with debt. • Debt/Equity = TD / TE – (5,862,989 – 2,984,513) / 2,984,513 = .964 times • Equity Multiplier = TA / TE = 1 + D/E – 1 + .964 = 1.964 Computing Coverage Ratios • Times Interest Earned = EBIT / Interest – 1,174,900 / 5,785 = 203 times • Cash Coverage = (EBIT + Depr. & Amort.) / Interest – (1,174,900 + 124,647) / 5,785 = 225 times Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory – 2,046,645 / 300,459 = 6.81 times • Days’ Sales in Inventory = 365 / Inventory Turnover – 365 / 6.81 = 54 days 1-2 Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable – 5,250,538 / 1,051,438 = 4.99 times • Days’ Sales in Receivables = 365 / Receivables Turnover – 365 / 4.99 = 73 days Computing Profitability Measures • Profit Margin = Net Income / Sales – 756,410 / 5,250,538 = .1441 times or 14.41% • Return on Assets (ROA) = Net Income / Total Assets – 756,410 / 5,862,989 = .1290 times or 12.90% • Return on Equity (ROE) = Net Income / Total Equity Computing Total Asset Turnover • Total Asset Turnover = Sales / Total Assets – 5,250,538 / 5,862,989 = .896 times • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets Computing Market Value Measures • Market Price (12/31/04) = $91.54 per share • Shares outstanding = 189,813,459 • PE Ratio = Price per share / Earnings per share – 91.54 / 3.92 = 23.35 times • Market-to-book ratio = market value per share / book value per share – 756,410 / 2,984,513 = .2534 times or 25.34% – 91.54 / (2,984,513,000 / 189,813,459) = 5.82 times Table 3.5 Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange – ROE = (NI / TE) (TA / TA) – ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange – ROE = (NI / TA) (TA / TE) (Sales / Sales) – ROE = (NI / Sales) (Sales / TA) (TA / TE) – ROE = PM * TAT * EM 1-3 Using the Du Pont Identity • ROE = PM * TAT * EM – Profit margin is a measure of the firm’s operating efficiency – how well does it control costs – Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets – Equity multiplier is a measure of the firm’s financial leverage Payout and Retention Ratios • Dividend payout ratio (“b”) = Cash dividends / Net income – 1.20 / 3.92 = .3061 or 30.61% • Retention ratio (“1 – b”) = Addn. to R/E / Net income = (EPS – DPS) / EPS – (3.92 – 1.20) / 3.92 = .6939 = 69.39% • Or: Retention ratio = 1 – Dividend Payout Ratio – 1 - .3061 = .6939 = 69.39% The Internal Growth Rate The Sustainable Growth Rate • The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. • 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. Internal Growth Rate = = ROA ´ b 1 - ROA ´ b .1290 ´ .3061 1 - .1290 ´ .3061 = 4.11% Sustainabl e Growth Rate = = .0411 Determinants of Growth = ROE ´ b 1 - ROE ´ b .2534 ´ .3061 1 - .2534 ´ .3061 = 8.41% = .0841 Table 3.7 • 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 1-4 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 Suppliers Customers Stockholders Real World Example - I • Ratios are figured using financial data from the 02/01/2004 Annual Report for Home Depot • Compare the ratios to the industry ratios in Table 3.10 in the book • Home Depot’s fiscal year ends Feb. 1 • Be sure to note how the ratios are computed in the table so you can compute comparable numbers. • Home Depot sales = $64,816 MM Real World Example - III • Asset management ratios: – Inventory turnover = 4.9x; Industry = 4.2x – Receivables turnover = 59.1x (every 6 days); Industry = 21.3x (every 17 days) – Total asset turnover = 1.9x; Industry = 2.8x • Profitability ratios – Profit margin before taxes = 10.6%; Industry = 3.0% – ROA (profit before taxes / total assets) = 19.9%; Industry = 7.3% – ROE = (profit before taxes / tangible net worth) = 34.6%; Industry = 16.8% Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis – Used to see how the firm’s performance is changing through time – Internal and external uses • Peer Group Analysis – Compare to similar companies or within industries – SIC and NAICS codes Real World Example - II • Liquidity ratios – Current ratio = 1.40x; Industry = 1.8x – Quick ratio = .45x; Industry = .6x • Long-term solvency ratio – Debt/Equity ratio (Debt / Worth) = .54x; Industry = 1.4x • Coverage ratio – Times Interest Earned = 2,282x; Industry = 4.8x Example: Work the Web • The Internet makes ratio analysis much easier than it has been in the past • Click on the Web surfer to go to Moneycentral.com – Choose a company and enter its ticker symbol – Click on “Financial Results” and “Key Ratios” to compare the firm to its industry and the S&P 500 for various ratio categories – Change the ratio category using the links to the left of the chart. 1-5 Quick Quiz Comprehensive Problem • How do you standardize balance sheets and income statements and why is standardization useful? • What are the major categories of ratios and how do you compute specific ratios within each category? • What are the major determinants of a firm’s growth potential? • What are some of the problems associated with financial statement analysis? • XYZ Corporation has the following financial information for the previous year: • Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M • Compute the ROE using the DuPont Analysis. 1-6