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BCOR 2200 Chapter 3

BCOR 2200 Chapter 3. Working with Financial Statements. Chapter Outline. 3.1 Common-Size F inancial Statements 3.2 Ratio Analysis 3.3 The Du Pont Identity 3.4 Internal and Sustainable Growth 3.5 Using Financial Statement Information Extra: Personal Finance Applications.

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BCOR 2200 Chapter 3

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  1. BCOR 2200Chapter 3 Working with Financial Statements

  2. Chapter Outline 3.1 Common-Size Financial Statements 3.2 Ratio Analysis 3.3 The Du Pont Identity 3.4 Internal and Sustainable Growth 3.5 Using Financial Statement Information Extra: Personal Finance Applications

  3. Key Concepts and Skills • Know how to produce Common-Size 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

  4. 3.1 Common-Size Financial Statements The Basic idea: • Divide everything on the page… By the biggest number on the page • Balance Sheet The biggest number is Total Assets Same value as or Liabilities plus Equity • Income Statement The biggest number is Sales Sales is also called Revenue

  5. Common-Size Balance Sheet

  6. Common-Size Balance Sheet

  7. Common-Size Balance Sheet This is Table 3.1 laying over Table 3.2:

  8. Common-Size Income Statement This is Table 3.3 laying over Table 3.4: Some other stuff we will need later for the Ratio Analyses: • EBIT = NI + Int Exp + Tax Exp = 363 + 141 + 187 = $691 • EBITDA = NI + IntExp + Tax Exp + DepExp = 691 + 276 = $967

  9. 3.2 Ratio Analysis Instead of values, show Fractions of other Values (ratios) Ratio Categories: • Short-Term Solvency • Firm’s ability to pay current bills • Long-Term Solvency • Firm’s ability to meet LT debt obligations • Asset Management • aka Turnover Ratios (Efficiency measures) • Profitability Ratios • Market Value Ratios

  10. Some things to think about as we look at ratios: • Definition of the Ratio • How is it computed? Is it always the same? (It will be for us) • Sometime the Ending B-S value is used • Sometimes the Average value • What is the unit of Measure? • Dollars, years, Dollars of assets… • What are HIGH values? What are LOW values? • High or low for the company over time • for the industry • for the sector • for all companies…

  11. Category 1: Short-Term Solvency First Some Notation: • Current Assets = CA • Current Liabilities = CL • Total Assets = TA = A • Total Liabilities = TL = L = Total Debt = TD = Debt =D • Total Equity = TE = E [3.1] Current Ratio = CA/CL = 708/540 = 1.31 [3.2] Quick Ratio = (CA – Inv)/CL = (708 – 442)/540 = 0.53 • Inventory is the least liquid current asset [3.3] Cash Ratio = Cash/CL = 98/540 = 0.18 • Cash is the most liquid current asset

  12. Clicker Question Did the firm’s short-term solvency improve or deteriorate between the end of 2012 and then end of 2013? • Short-Term Solvency Improved • Short-Term Solvency deteriorated • The evidence is mixed

  13. Clicker Answer Each Short-Term Solvency ratio is higher at the end of 2013 The answer is A.

  14. Category 2: Long-Term Solvency Balance Sheet: [3.4] Total Debt Ratio = Debt to Assets = D/A = 997/3,588 = 0.28 Equity to Assets = E/A = 2,591/3,588 = 0.72 [3.5] Debt to Equity = D/E = 997/2,591 = 0.38 = 0.28/0.72 = 0.39 ≈ 0.38 [3.6] Equity Multiplier (EM) = A/E = 3,588/2,591 = 1.38 = 1/(E/A) = 1/0.72 = 1.38 = 1 + D/E = 1 + 0.38 = 1.38 Note: EM = A/E = (D + E)/E = E/E + D/E = 1 + D/E • All these are also called Financial Leverage Measures • In general, the more levered, the less likely a firm is to repay its debt

  15. Category 2: Long-Term Solvency (Continued) Income Statement: [3.7] Times Interest Earned (TIE) = EBIT/In Exp = 691/141 = 4.9 times [3.8] Cash Coverage Ratio = EBITDA/In Exp = 967/141 = 6.9 times

  16. Clicker Question Did the firm’s Long-term solvency improve or deteriorate between the end of 2012 and then end of 2013? • Long-Term Solvency Improved • Long-Term Solvency Deteriorated

  17. Clicker Answer • The firm borrowed $200 and bought new assets • LT solvency deteriorated since Leverage increased The Answer is B.

  18. Category 3: Asset Management or Efficiency [3.9] Inventory Turnover = COGS/Inventory = 1,344/422 = 3.2 times • This is the value of inventory sold during the year (COGS) divided by the amount of inventory on hand at the end of the year (2010) • So during the year, the firm sold 3.2 times amount of inventory on hand at year’s end [3.10] Days’ Sales in Inventory = 365/Inventory Turnover = 365/3.2 = 114 days • Since the firm sold the current amount of inventory 3.2 times over the last year, the current inventory will be sold in 1/3.2 years or 114 days [3.11] Receivables Turnover = Sales/(A/R) = 2,311/188 = 12.3 times • Really should be “Credit Sales” not total Sales. We don’t have that. • Would be number of times in the year credit was extended and then collected • Often Average A/R is used as opposed to Ending A/R

  19. Cat 3: Asset Management or Efficiency (Continued) [3.12] Days’ Sales in Receivables = 365/Receivables Turnover = 365/12.3 = 30 days • Credit was extended and collected 12.3 times over the last year or 1/12.3 years or 30 days [3.13] Asset Turnover = Sales/Assets = 2,311/3,588 = 0.64 • For each dollar of assets, the firm generated $0.64 in sales Capital Intensity = Assets/Sales = 3,588/2,311 = 1.56 • It takes $1.56 in Assets to generate $1 in Sales

  20. Clicker Question Calculate: (1) Inventory Turnover (IT) (2) Days’ Sales in Inventory (DSI) (3) Asset Turnover (AT) Hints: IT = Inv sold/Inv on hand DSI = Days per year/ # of times Inv turned in per year AT = Amount sold/Amount “employed” to generate sales

  21. Clicker Answer Calculate: (1) Inventory Turnover (IT) (2) Days’ Sales in Inventory (DSI) (3) Asset Turnover (AT) • IT = Inv sold/Inv on hand IT = COGS/Inv = $5,000/$1,000 = 5 • DSI = Days per year/ # of times Inv turned in per year DSI = 365/IT = 365/5 = 73 • AT = Amount sold/Amount “employed” to generate sales AT = Sales/Assets = $10,000/$25,000 = 0.4 The Answers is E

  22. Category 4: Profitability (Really Efficiency) [3.14] Profit Margin (PM) PM = NI/Sales = 363/2,311 = 15.7% • Income Statement “Bottom Line” divided “Top Line” • Accounting Profit per Dollar of Sales • Think of PM as a measure of Efficiency not Profitability • Measures the expenses needed to generate sales (Sales – Expenses = NI) [3.15] Return on Asset (ROA) ROA= NI/Assets = 363/3,588 = 10% • This is the (accounting) profit per unit of Assets • Compare with Asset Turnover Ratio (AT) = Sales/Assets = 2,311/3,588 = 0.64 • Sales are 64% of Assets and Profits are 10% of Assets • PM = ROA/AT = 0.10/0.64 = 15.7% • Think of ROA as a measure of Efficiency not Profitability • Think of assets as some number of trucks. How much profit is generated from these trucks? The more you generate, the more efficient the business. • It is a function of sales (more is better) and expenses (less is better)

  23. Category 4: Profitability [3.16] Return on Equity (ROE) ROE = NI/Equity = 363/2,591 = 14% • This measures the (accounting) profit per unit of Equity • ROE = ROA x EM = NI/Assets x Assets/Equity • So Profit (ROE) is a function of Efficiency (ROA) and Leverage (EM) • So increase profit by increasing efficiency or increasing leverage • Remember Efficiency has two components: Increasing Sales and Decreasing Expenses • Increase Efficiency by Increasing Sales or Decreasing expenses

  24. Important Relationship: ROE = NI/Equity (Profitability) ROA = NI/Assets (Efficiency) EM = Assets/Equity (Leverage) NI/Equity =NI/Assets xAssets/Equity ROE =ROA xEM Profitability =Efficiency xLeverage

  25. Category 5: Market Value Measures (But First: # of Shares Outstanding is 33 m and Price is $88 per share) [3.17] Earnings per Share (EPS) = NI/Shares = 363/33 = $11/Share • So each owners’ share earned $11 [3.18] Price-Earnings Ratio (PE or P/E) = Price/EPS = $88/$11 = 8 times • So pay $8 for $1 of earnings • PE (and EPS) can be compared across different stocks • Why pay more for a dollar of earnings? [3.19] Market-to-Book = Price per Share/Book Val of Equity per Share • Book Value of Equity per Share = 2,591/33 = $78.52 • Market-to-Book = 88/78.52 = 1.12 • aka Price-to-Book and is the inverse of Book-to-Market (BM)

  26. Clicker Question Given the market data and financial statement data above, which stock does the market expect to have higher growth? • YHOO • MSFT • There are Mixed Signals

  27. Clicker Answer • MSFT has a greater PE and Market-to-Book. • So “the market” is paying more for a dollar of MSFT’s earnings and more for a dollar of its equity. The Answer is B

  28. Recap: Table 3.5 page 64 Remember: Think of ROA and PM as Efficiency Ratios, not Profitability Ratios

  29. 3.3 DuPont Analysis • A method of calculating the contribution of different parts to overall profitability • Also called Profitability decomposition • Profitability is measured by ROE = NI/E • Decompose Profitability (ROE) into broad measures of Efficiency (ROA) and Leverage(EM) • Efficiency ROA = NI/A • Leverage  EM = A/E • ROE = ROA x EM NI/E = NI/A x A/E Profit = Efficiency X Leverage

  30. 3.3 DuPont Analysis • Decompose Efficiency into Sales generated from Assets (AT) and Expenses needed to generate the sales (PM) • Sales Generated from Assets (Asset Turnover) AT = Sales/A • Earnings kept from each dollar of sales PM = NI/Sales NI/A = Sales/A x NI/Sales ROA = AT x PM Efficiencyis a function of Sales andExpenses

  31. 3.3 DuPont Analysis (continued) • Decompose AT (Sales/A) into different Sales • Manufactured Products, Servicing, Consulting… • AT Product Sales/A, Servicing/A, Consulting/A, • What break-down categories are appropriate? Depends on the company and its business • Decompose PM (NI/Sales) into different expenses • COGS/Sales, SG&A/Sales, Int Exp/Sales, Tax Exp/Sales, Dep Exp/Sales • PM = NI/Sales = (Sales – Expenses)/Sales

  32. 3.3 DuPont Analysis (continued)

  33. 3.3 DuPont Analysis for the DuPont Corporation

  34. 3.3 DuPont Analysis for the DuPont Corporation

  35. 3.3 DuPont Analysis for Yahoo and Google • Which was more efficient at generating revenue in 2011? • Which was more efficient at controlling expenses in 2011? • Which was more levered in 2011? • Which was more profitable in 2011? WHY?

  36. Clicker Question For both firms calculate: (1) ROE = NI/E (2) ROA = NI/A (3) EM = A/E (4) AT = Sales/A (5) PM = NI/Sales Firm 2 is more profitable (greater ROE) than Firm 1 because: • It is more efficient in generating sales from its assets • It is more efficient in limiting its expenses • It is more efficient in limiting its tax liability • It is more levered

  37. Clicker Answer For both firms calculate: (1) ROE = NI/E (2) ROA = NI/A (3) EM = A/E (4) AT = Sales/A (5) PM = NI/Sales • ROE greater for Firm 2 because EM is bigger. • EM measures leverage The answer is D

  38. 3.4 Internal and Sustainable Growth • By definition, for a firm to Grow, Assets must grow • External Growth: Sell stocks or bonds (talk about this later) • Internal Growth: Retain Earnings (talk about this now) • Internally Financed Growth is a function of: • The Earnings (aka NI) as a percentage of Assets • The Earnings Retained by the business as a percentage of NI • So: How much did you make and how much did you keep? First some definitions: [3.21] Dividend Payout Ratio = Div/NI = 121/363 = 33% = 1/3 • Payout 1/3 of Accounting Profits [3.22] Retention Ratio (aka Plowback Ratio) = RE/NI = 242/363 = 2/3 • Also equal to 1 - Div/NI • Often denoted as “b”

  39. 3.4 Internal and Sustainable Growth • Let b = RE/NI (Plowback Ratio) • ROA = NI/A (Accounting profits per unit of assets) Internal Growth = (ROA x b)/(1 – ROA x b) For the example company (Prufrock): • ROA = 363/3,588 = 10.12% and b = 242/262 = 0.6667 • (How many digits after the decimal point? It depends.) • Internal Growth = (0.1012 x 0.6667)/(1 – 0.1012 x 0.6667) = 0.0724 = 7.24% • If the company plows back 2/3 of NI (which increases assets) and ROA is 10.12%, then the firm grows at 7.24% (without external financing). • Note that growth can be improved if ROA is improved • How can ROA be improved? Increase Sales or Decrease Expenses • Which parts of sales or expenses are best suited for improvement? How do you breakdown sales and expenses into different categories? 

  40. 3.4 Internal and Sustainable Growth (continued) • Note that retaining earnings increases… • Retained Earnings (the Equity account on the B-S) • But this does not increase Debt (liabilities) • So over time, the D/E ratio decreases • So to maintain the same D/E ratio, the firm must sell some debt This leads to the Sustainable Growth Rate: Sustainable Growth = (ROE x b)/(1 – ROE x b) • ROE = 14.01% • Sustainable Growth = (0.1401 x 0.6667)/(1 – 0.1401 x 0.6667) = 0.1030 = 10.30% • Internal Growth Rate = 7.24% • Sustainable Growth = 10.30% • Sustainable growth implies borrowing to maintain the same D/E ratio • Borrowing means increasing leverage

  41. 3.4 Internal and Sustainable Growth (continued) • So Growth is determined by four things: • Sales generated from Assets in place • Assets Use Efficiency: AT = Sales/Assets • NI (aka Earnings) kept from those sales • Operating Efficiency: PM = NI/Sales = (Sales – Expenses)/Sales • Portion of NI Retained • Plowback Ratio: b = RE/NI • Financing Policy • How much more is borrowed (relative to earnings retained) • Leverage: Equity Multiplier (EM) = A/E

  42. Clicker Question Calculate the Internal and Sustainable Growth rate for the firm. • Internal = 10% Sustainable = 20% • Internal = 8% Sustainable = 18% • Internal = 7% Sustainable = 14% • Internal = 5% Sustainable = 11% • Internal = 2% Sustainable = 6%

  43. Clicker Answer Internal Growth = (ROA x b)/(1 – ROA x b) = (0.1)(0.5)/[1 – (0.1)(0.5)] = 0.05 Sustainable Growth = (ROE x b)/(1 – ROE x b) = (0.2)(0.5)/[1 – (0.2)(0.5)] = 0.11 Answer is D

  44. 3.4 Recap: Table 3.9 Page 72

  45. 3.5 using Financial Statement Information • Compare to same firm over time • Compare to firms within industry • SIC codes • North American industry Classification System • NAICS or “Nakes” • See Table 3.10 page 75 • But use your own common sense and knowledge about the company or industry • See box on Page 81

  46. Personal Finance – Buying a House Long-Term Solvency(or Leverage) and Debt Service Business Long-Term Solvencyis Equity Multiplier • EM = A/E House Buyer Long-Term Solvency is Loan-to-Value Ratio • Loan to Value = D/A • Since D + E = A, given A/E, we can easily derive D/A • Business Debt Service is the Cash Coverage Ratio • Cash Coverage = EBITDA/In Exp • House Buyer Debt Service the PITI to Income Ratio • PITI = Principal, Interest, Taxes and Insurance • PITI is the “total monthly payment”

  47. Prime Mortgage Borrower Long-Term Solvency • Measured by the Loan-to-Value • Lower than 80% • So on a $250,000 home price, • Buyer can’t borrow more than 0.80($250,000) = $200,000 • So the Down Payment must be greater than $50,000

  48. Prime Mortgage Borrower Debt Service • Measured by the PITI to Income Ratio must be less than 28% • Assume a $200,000, 30yr Mortgage at 6.00% • Monthly Principal and Interest is $1,200 • Annual Principal and Interest is $14,400 • Assume Taxes are $2,000 per year and Insurance is $600 per year • PITI = $14,400 + $2,000 + $600 = $17,000 • Income must be greater than $17,000/0.28 = $60,714

  49. Prime Mortgage Borrower Additional Considerations • Total Debt Service to Income Ratio must be less than 36% • This includes car payments, credit card payments,… • Credit Score (FICO Score) at least 620 • Credit Score Components:

  50. Clicker Question • You want to use a Prime mortgage to buy a house. • Your annual income is $50,000 and you have $20,000 saved for a down payment. • Prime mortgage loans require: • 80% loan-to-value ratio (maximum) • 28% PITI to Income ratio (maximum) • What is the highest priced house on which you can make a down payment? • What is the greatest annual PITI you can pay? • Price = $80,000; PITI = $10,000 • Price = $90,000; PITI = $12,000 • Price = $100,000; PITI = $14,000 • Price = $110,000; PITI = $16,000 • Price = $120,000; PITI = $18,000

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