Chapter 3: Working With Financial Statements

FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsStandardized Financial StatementsTo start making comparisons, one obvious thing we might try to do is to somehowstandardize the financial statements.One very common and useful way of doing this is to work with percentages instead oftotal dollars.The resulting financial statements are called common-size statements.(used For comparing competitors, Firms OF different sizes, year-10-year FOR your Firm.)Common-Size Balance SheetsFor easy reference, Prufrock Corporation's 2021 and 2022 balance sheets; we constructcommon-size balance sheets by expressing each item as a percentage of total assets.used 10 track changes ina Firm's capital structure.Common-Size Income StatementsAuseful way of standardizing the income statement is to express each item as apercentage of total sales.Ratio AnalysisAnother way of avoiding the problems involved in comparing companies of differentsizes is to calculate and compare financial ratios.Such ratios are ways of comparing and investigating the relationships between differentpieces of financial information.We cover some of the more common ratios next, but there are many others that we don'ttouch on.One problem with ratios is that different people and different sources frequently don'tcompute them in exactly the same way, and this leads to much confusion.The specific definitions we use here may or may not be the same as ones you have seenor will see elsewhere.If you are using rations as a tool for analysis, you should be careful to document how youcalculate each one, and, if you are comparing your numbers to those of another source, besure you know how their numbers are computedCurrent RatioOne of the best-known and most widely used ratios is the current ratio. As you mightguess, the current ratio is defined as:Current ratio = Current assets/ Current liabilitiesTo a creditor, particularly a short-term creditor such as a supplier, the higher the currentratio, the better.To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficientuse of cash and other short term assets. (accounts payable)Absent some extraordinary circumstances, we would expect to see a current ratio of atleast 1 because a current ratio of less than 1 would mean that net working capital (currentassets less current liabilities) is negative.This would be unusual in a healthy firm, at least for most types of businesses.The current ratio, like any ratio, is affected by various types of transactions. FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsFor example, suppose the firm borrows over the long-term to raise money.The short-run effect would not be an increase in cash from the issue proceeds and anincrease in long-term debt.Current liabilities would not be affected, so the current ratio would rise.Finally, note that an apparently low current ratio may not be a bad sign for a companywith a large reserve of untapped borrowing power.Quick (or Acid-Test) RatioTo further evaluate liquidity, the quick, or acid-test, ratio is computed like the currentration, except inventory is omitted:Quick Ratio = Current assets - Inventory/ Current liabilitiesNote that using cash to buy inventory does not affect the current ratio, but it reduces thequick ratio.Cash RatioA very short-term creditor might be interested in the cash ratio.Cash ratio = Cash/ Current liabilitiesLong-Term Solvency MeasuresLong-term solvency ratios are intended to address the firm's long-run ability to meetitsobligations, or, more generally, its financial leverage.These ratios are sometimes called financial leverage ratios or leverage ratios.Total Debt RatioThe total debt ratio takes into account all debts of all maturities to all creditors.It can be defined in several ways, the easiest of which is:Total debt ratio = Total assets - Total equity/ Total assetsIn this case, an analyst might say that Prufrock uses 28 percent debt.Whether this is high or low or whether it even makes any difference depends on whetheror not capital structure matters, a subject we discuss in a later chapter.Times Interest EarnedAnother common measure of long-term solvency is the times interest earned (TIE) ratio.Once again, there are several possible (and common) definitions, but we'll stick with themost traditional:Times interested earned ratio = EBIT/ Interest FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsCash CoverageBecause interest is most definitely a cash outflow (to creditors), one way to define thecash coverage ratio is:Cash coverage ratio = EBIT + Depreciation/ InterestThe numerator here, EBIT plus depreciation, is often abbreviated EBITD (earningsbefore interest, taxes, and depreciation)It is a basic measure of the firm's ability to generate cash from operations, and it isfrequently used as a measure of cash flow available to meet financial obligations.Inventory Turnover and Days' Sales in InventoryWith these numbers, inventory turnover can be calculated as:Inventory turnover = Cost of goods sold/InventoryReceivables Turnover and Days' Sales in ReceivablesOur inventory measures give some indication of how fast we can sell products.We now look at how fast we collect on those sales.The receivables turnover is defined in the same way as inventory turnover:Receivables turnover = Sales/ Accounts receivablesLoosely speaking, we collected our outstanding credit accounts and reloaned the money12.56 times during the year.This ratio makes more if we convert it to days, so the days' sales in receivables is:Days sales in receivables = 365 days/ Receivables turnoverTherefore, on average, we collect on our credit sales in about 29 days. For obviousreasons, this ratio is very frequently called the average collection period (ACP).Total Asset TurnoverMoving away from specific accounts like inventory or receivables, we can consider animportant "big picture" ratio, the total asset turnover ratio.As the name suggests, total asset turnover is:Total asset turnover = Sales/ Total assetsProfit MarginCompanies pay a great deal of attention to their profit margin:Profit Margin = Net income/ SalesAll other things being equal, a relatively high profit margin is obviously desirable.This situation corresponds to low expense ratios relative to sales. FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsHowever, we hasten to add that other things are often not equal.For example, lowering our sales price usually will increase unit volume, but normallywill cause profit margins to shrink.Total profit (or, more importantly, operating cash flow) may go up or down, so the factthat margins are smaller isn't necessarily bad.After all, isn't it possible that, as the saying goes, "Our prices are so low that we losemoney on everything we sell, but we make it up in volume!"?Return on AssetsReturn on assets (ROA) is a measure of profit per dollar of assets.It can be defined several ways, but the most common is:Return on assets = Net income/Total assetsReturn on EquityReturn on equity (ROE) is a measure of how the stockholders fared during the year.Because benefiting shareholders is our goal, ROE is, in an accounting sense, the truebottom-line measure of performance. measures profibilityReturn on equity = Net income/ Total equityPrice-Earnings RatioThe first of our market value measures. the price earnings, or PE, ratio (or multiple), isdefined as:PE ratio = Price per share/ Earnings per sharesmarket value)Because the PE ratio measures how much investors are willing to pay per dollar ofcurrent earnings, higher PEs are often taken to mean that the firm has significantprospects for future growth.Of course, if a firm had no or almost no earnings, its PE would probably be quite large;so, as always, care is needed in interrupting this ratio.Price-Sales RatioIn some cases, companies will have negative earnings for extended periods, so their PEratios are not very meaningful.A good example is a recent start-up.Such companies usually do have some revenues, so analysts will often look at the price-sales ratio:Price-sales ratio = Price per share/Sales per share FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsMarket-to-Book RatioAnother commonly quoted measure is the market-to-book ratio:Market-to-book ration = Market value per share/Book value per shareNotice that book value per share is total equity (not just common stock) divided by thenumber of shares outstanding.Because book value per share is an accounting number, it reflects historical costs.Therefore, in a loose sense, the market-to-book ratio compares the market value of thefirm's investments to their costs.A value less than 1 could mean that the firm has not been successful overall in creatingvalue for its stockholders.The DuPont IdentityTo begin, let's recall the definition of ROE:Return on equity = Net Income/ Total equityIf we were so inclined, we could multiply this ratio by Assets/ Assets without changinganything:Return on equity = (Net Income/ Total equity) X (Assets/ Assets)(Net Income/ Assets) X (Assets/ Total equity)Notice that we have expressed the ROE as the product of two other ration - ROA and theequity multiplier:ROE = ROA X Equity multiplier = ROA X (1 + Debt-equity ratio)We can further decompose ROE by multiplying the top and bottom by total sales:ROE = (Sales/ Sales) X (Net Income/ Assets X (Assets/Total equity)If we rearrange things a bit, ROE is:What we have now done is to partition ROA into its two component parts, profit marginand total asset turnover.This last expression is called the DuPont identity, after the DuPont Corporation, which ispopularized its use.Dividend Payout and Earnings RetentionIf we express dividends paid as a percentage of net income, the result is the dividendpayout ratio:Dividend payout ratio = Cash dividends/ Net incomeThe Internal Growth RateSuppose a firm has a policy of financing growth using only internal financing.This means that the firm won't borrow any funds and won't sell any new stock. FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsHow rapidly can the firm grow?The answer is given by the internal growth rate:Internal growth rate = ROA x b/ 1 - ROA X bWhere ROA is, as usual, return on assets and b is the retention, or plowback, ratio we justdiscussed.The Sustainable Growth RateWith this in mind, we now consider hoe rapidly a firm can grow if (1) it wishes tomaintain a particular total debt ratio and (2) it is unwilling to sell new stock.There are various reasons a firm might wish to avoid selling stock, and equity sales byestablished firms area actually a relatively rare occurrence.Given these two assumptions, the maximum growth rate that can be achieved, called thesustainable growth rate, is:Sustainable growth rate =ROE x b/1 - ROE x bWhy Evaluate Financial Statements?It is important to emphasize that, whenever we have market information, we will use itinstead of accounting data.Also, if there is a conflict between accounting and market data, market data should begiven precedence.Financial statement analysis is essentially an application of "management by exception"In many cases, such analysis will boil down to comparing ratios for one business withsome kind of average or representative ratios.Those ratios that seem to differ the most from the averages are tagged for further study.Internal UsesFinancial statement information has a variety of uses within a firmAmong the most important of these is performance evaluation.For example, managers are frequently evaluated and compensated on the basis ofaccounting measures of performance such as profit margin and return on equity.Also, firms with multiple divisions frequently compare the performance of thosedivisions using financial statement informationAnother important internal use of financial statement information involves planning forthe future.Historical financial statement information is very useful for generating projections aboutthe future and for checking the realism of assumptions made in those projections.External UsesFinancial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors.For example, we could find such information quite useful in deciding whether or not togrant credit to a new customer. FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsWe also would use this information to evaluate suppliers, and suppliers would use ourstatements before deciding to extend credit to us.Large customers use this information to decide if we are likely to be around in the future.Credit-rating agencies rely on financial statements are a prime source of informationabout a firm's financial health.Time-Trend AnalysisOne standard we could use is history.Suppose we found that the current ratio for particular firm is 2.4 based on the most recentfinancial statement information.Looking back over the last 10 years, we might find that this ratio has declined fairlysteadily over that period.Based on this, we might wonder if the liquidity position of the firm has deteriorated.It could be, of course, that the firm has made changes that allow it to use its current assetsmore efficiently, that the nature of the firm's business has changed, or that businesspractices have changed.If we investigate, we might find any of these possible explanations.This is an example of what we mean by management by exception - a deteriorating timetrend may not be bad, but it does merit investigation.Problems with Financial Statements AnalysisIn one way or another, the basic problem with financial statement analysis is that there isnounderlying theory to help us identify which items or ratios to look at and to guide us inestablishing benchmarks.As we discuss in other chapters, there are many cases in which financial theory andeconomic logic provide guidance in making judgements about value and risk.Very little such help exists with financial statements.This is why we can't say which ratios matter the most and what a high or low value mightbe.One particularly severe problem is that many firms, such as General Electric (GE), areconglomerates owning more or less unrelated line of business.The consolidated financial statements for such firms don't really fit any neat industrycategory.More generally, the kind of peer group analysis we have been describing is going to workbest when the firms are strictly in the same line of business, the industry is competitive,and there is only one way of operating.Another problem that is becoming increasingly common is that major competitors andnatural peer group members in an industry may be scattered around the globe.The automobile industry is an obvious example.The problem here is that financial statements from outside the United States do notnecessarily conform at all to GAAP (more precisely, different countries can havedifferent countries can have different GAAPs).The existence of different standards and procedures makes it very difficult to comparefinancial statements across national borders.Even companies that are clearly in the same line of business may not be comparable. FIN3403: Corporate FinanceChapter 3: Working with Financial StatementsFor example, electric utilities engaged primarily in power generation are all classified inthe same group (SUC 4911).This group is often thought to be relatively homogeneousHowever, utilities generally operate as regulated monopolies, so they don't compete witheach other.Many have stockholders, and many are organized as cooperatives with no stockholdersThere are several different ways of generating power, ranging from hydroelectric tonuclear, so the operating activities can differ quite a bit.Finally, profitability is strongly affected by the regulatory environment, so utilities indifferent locations can be very similar but show very different profits.Several other general problems frequently crop up.First, different firms use different accounting procedures for inventory, for example.This makes it difficult to compare statements.Second, different firms end their fiscal years at different times.For firms in seasonal businesses (such as a retailor with a large Christmas season), thiscan lead to difficulties in comparing balance sheets because of fluctuations in accountsduring the year.Finally, for any particular firm, unusual or transient events, such as a one-time profitfrom an asset sale, may affect financial performance.In comparing firms, such events can give misleading signals.