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Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis

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MAYES 2 & 4 Fin. Stmt. & Ratio Analysis

- Ratio analysis
- Du Pont system
- Effects of improving ratios
- Limitations of ratio analysis
- Qualitative factors

Common Size Financial Statements

Displays info as %, not $;

Provides 2 key benefits:

1. Allows for easy comparison between firms of different sizes.

2. Aids in spotting important trends which otherwise might not be obvious when looking at $ amounts.

Common Size Financial Statements

Common size Income Statement: all values a function of Sales $

Common size Balance Sheet: all values a function of Total Assets.

Analysis of Common Size Balance Sheets

- Elvis has ? proportion of inventory and current assets than Industry.
- Elvis now has ? Equity, which means (MORE? / LESS?) debt than Industry.
- Elvis has ? short-term debt than industry, but ? long-term debt than industry.

Analysis of Common Size Income Statements

- Elvis has ? COGS ( %) than industry’s ( %), but ? other expenses. Results?

Percentage Change Analysis:

Looks at Change rates from period to period between financial categories.

Indicator of +/- growth trends.

Analysis of Percent Change Income Statement

- i.e., Sales growth v. NI ?
- i.e., If NI grows faster than sales, then becoming more profitable.
- So becoming (more/less) profitable?

Analysis of Percent Change Balance Sheets

- i.e., Total assets growth v. sales. If assets grow at faster rate than sales, have asset utilization problem.

Why are ratios useful?

- Standardize numbers; facilitate comparisons
- Used to highlight weaknesses and strengths

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?

(More…)

Debt management:Do we have the right mix of debt and equity? (Leverage)

- Profitability:Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, andROA?
- Market value:Do investors like what they see as reflected in P/E and M/B ratios?

Things to ask? Better? Worse?

- Trends?
- Vs. Industry?
- Causes?
- Corrective actions?

Inventories

Inv. turnover =

What is the inventory turnover ratio as compared to the industry average?Days Sales in Inventory =

365

Inv To

Comments on Inventory Turnover

- Inventory turnover v. industry average?
- Due to?
- Improvement forecasted?

A/R

A/R turnover =

What is the Accts. Rec. turnover ratio & Average Collection Period?Ave Collection

Period =

365

A/R TO

Appraisal of Ave Collection Period

- Firm collects too slowly/quickly?
- Improving / worsening?
- Implication re: credit policy.

turnover

Sales

Net fixed assets

=

Total assets

turnover

Sales

Total assets

=

Fixed Assets and Total Assets

Turnover Ratios

Turnover Ratios

- FA turnover vs. industry?
- TA turnover vs. industry average?
- Causes? Corrective actions?

Total Equity

Debt/Eqty =

ratio

L/T Debt to Total

Capitalizationratio =

LEVERAGE

_____L/T Debt___________

LTD + Pref Eqty + Cmn Eqty

Total Equity

Eqty Multiplier

L/T Debt to Total

Equity =

LEVERAGE

_____L/T Debt___________

Pref Eqty + Cmn Eqty

How do the debt management ratios compare with industry averages?

2005E 2004 2003 Ind.

D/A

TIE

C/Cov

Effects? Reasons?

Gross Profit Margin = Gross Profit

Sales

Profitability Ratios (Profit Margins)OperatingPM = EBIT

Sales

Net PM = Net Income

Sales

Trends?

Prospects?

Total Equity

Profitability Ratios (Returns)ROA = Net Income

Total Assets

Return on = NI available to C.S-holders

Cmn Eqty Common Equity

Trends?

Prospects?

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.

( )( )( ) = ROE

Profit

margin

TA

turnover

Equity

multiplier

NI

Sales

Sales

TA

TA

CE

= ROE.

x

x

- PM= f(profitability)
- TA T/O = f(asset utilization)
- EM = f(debt & equity %s)
- Shows how these factors combine to

determine the ROE.

Economic Profit= NOPAT – A/Tax Cost of Op. Capital

Economic Profit Measures of PerformanceWhere:

NOPAT = EBIT (1-tax rate)

A/Tax Cost of Op. Capital =

WACC * (Net Op. Working Cap + Net Fixed Assets)

** NOWC = (Non-interest bearing C/A – Non-interest bearing C/L)

Trends?

Prospects?

Financial Distress & Z-score

- Technique to determine likelihood of financial distress.
- Altman shows model 80-90% accurate w/ Z-score cut-off of 2.675; that is Z-score < 2.675 = distress.
- Actually determined 3 levels
- Z<1.81 Bankruptcy predicted w/in 1 yr.
- 1.81<Z<2.675 Financial Distress, poss. Bankruptcy
- Z>2.675 No fin. Distress predicted

Financial Distress & Z-scoreZ = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5

- Where the variables are the following financial ratios:
- X1 = Net Working Capital / Total Assets
- X2 = Retained earnings / Total Assets
- X3 = EBIT / Total Assets
- X4 = Market Value of all equity / book value of Tot. Liabs
- X5 = Sales / Total Assets
- *For publicly traded companies

Market Price =From the stock exchanges

EPS =

P/E =

NI

C.S.Shares out.

Price per share

EPS

Calculate and appraise the

P/E, P/CF, and M/B ratios.

P/E

P/CF

M/B

- P/E: How much investors will pay for $1 of earnings. High is good.
- M/B: How much paid for $1 of book value. Higher is good.
- P/E and M/B are high if ROE is high, risk is low.

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.

(More…)

Window dressing techniques can make statements and ratios look better.

- 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.

What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?

- Are the company’s revenues tied to a single customer?
- To what extent are the company’s revenues tied to a single product?
- To what extent does the company rely on a single supplier?

(More…)

What percentage of the company’s business is generated overseas?

- What is the competitive situation?
- What does the future have in store?
- What is the company’s legal and regulatory environment?

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