Business Finance

1. Business Finance BA303 Michael Dimond

2. Module G: Financial Statement Analysis

3. Understanding financial statements • Balance Sheet • Income Statement • Statement of Cash Flows • Statement of Shareholders’ Equity

7. Meaningful Ratio Analysis • Analysis means to break something down to understand it. • Ratio analysis should be used to answer a specific question or set of questions. • If you were examining the financial statements for a company, you might start with this basic question: “Is this a good use of investors’ money?” • What financial ratio would answer this question? How about Return on Equity? • How do you compute Return on Equity (ROE)?

8. Analyzing ROE • ROE = NI ÷ Equity and answers the question, “is this a good use of investors’ money?” • If you were to break this down, there are three basic questions to answer: How profitable is this business? How efficiently are assets being used? How much does financial leverage help the investors? • What financial ratios would answer these questions? Profit Margin (PM) Total Asset Turnover (TAT) Equity Multiplier (EM)

9. Drivers of ROE • Profit Margin (PM) = NI ÷ Sales and answers the question, “How profitable is this business?” • Total Asset Turnover (TAT) = Sales ÷ Total Assets and answers the question, “How efficiently are assets being used?” • Equity Multiplier (EM) = Total Assets ÷ Equity and answers the question, “How much does financial leverage help the investors?”

10. The DuPont Identity • ROE is directly driven by profitability, efficiency and leverage. • ROE = PM x TAT x EM How does that work? • The numerators and denominators cancel to reduce the equation to NI ÷ Equity

11. A note about the text’s version of ROE & DuPont • The author uses Earnings Available to Common Shareholders for ROE computations. While this is not terribly incorrect, it isn’t really correct either. • Net Income ÷ Equity = ROE • Earnings Available to Common Shareholders ÷ (Equity – Preferred Equity) = Return on Common Equity (ROCE, not ROE) • The purpose of analysis is to answer important questions. • If the question is how hard the investors’ money is working, compute ROE • To find how hard common shareholders’ money is working, compute ROCE • Never mix & match. ROCE uses Earnings Available to Common Shareholders and Common Equity. ROE uses Net Income and Total Equity. • Notice the author computes ROA as Earnings Available to Common Shareholders ÷ Total Assets. What is wrong with this? • ROE & ROA are sometimes very manipulated figures, used by managers to prove a point. Always compute your own figures for analysis.

12. A word about ROA • ROA = Return on Assets • What’s the difference between Equity & Assets? • Leverage • What’s the difference between ROE & ROA? • Leverage • ROE = PM x TAT x EM • EM represents leverage • ROA = PM x TAT • No leverage

13. Digging Deeper with Financial Ratios • How would you analyze profitability, efficiency and leverage? • How do profitability, efficiency and leverage relate? • What affects profitability? • What drives sales? • What is the composition of assets? • How were assets paid for? • How are liabilities managed? • Where shall we begin?

14. Common-Size Financial Statements • Shows each line item as a percent of an appropriate total. • Common-size balance sheet • % of Total Assets • Shows the composition of assets • Liabilities & equity items are also shown as % of total assets • Debt Ratio = Total Liabilities ÷ Total Assets • Common-size income statement • % of Sales • PM = Net Income as % of Sales

15. Common-Size Income Statement 100% 7.19% 5.38%

16. Common-Size Balance Sheet 100% 45.68% 44.34%

17. We don’t make a common-size CF Statement There are other ways to examine relevant information which would be more helpful

18. Vertical & Horizontal Analysis • Vertical Analysis compares figures as a percent of a relevant total (“common size” financial statements) • Horizontal Analysis compares the same figure over a series of periods (showing % change or % growth)

19. Measuring growth • Financial figures change from year to year • To find the % change (“% growth”) over a 1-year period, divide the difference of the two figures by the first year’s value: • [ending – beginning] / [beginning] OR • [ending] / [beginning] - 1 • Measuring growth over more than one period means we need to find the average growth during that time.

20. CAGR: Compound Annual Growth Rate • The CAGR is the result of compounded increase over time at a specific average rate • (133.1/100)^(1/3)-1=0.10 • It can be tested by plugging the result into a compounding formula using the same figures • 100*(1+0.10)^3=133.10 • It can be figured using the TVM functions on your calculator • PV = -100 FV = 133.10 n = 3 PMT = 0 solve for I = 10% • What if you were given a series of % changes instead of dollar figures? • Year 1: 10% increase, Year 2: 12% increase, Year 3: 8% increase • You need to find the Geometric Average Growth over the three year period

21. Geometric Average vs Arithmetic Average • Arithmetic Average only shows the “typical” result • Geo Avg = [(1+20%)*(1+-16.67%)* (1+20%)*(1+16.67%)]^(1/4) -1 = 8.78% • CAGR also shows the result of compounding • (14/10)^(1/4) – 1 = 0.878 = 8.78% • The price didn’t increase 8.78% each year, but we end up with the same final value if we compound it by 8.78% every year. • 5 years means 4 periods of compounding, so we find the 4th root ( ^1/4 power)

22. Categories of Financial Ratios • Most finance texts group ratios into categories like these: • Profitability ratios • Efficiency (or Activity) ratios • Liquidity ratios • Debt ratios • Market ratios • It is usually more helpful to think of the questions to be answered rather than just crunching a bunch of numbers. • Uses critical thinking • Easier to read • Less time consuming • Uses fewer resources

23. Profitability Ratios • PM = Net Income ÷ Sales (Sometimes called “Net Profit Margin”). • This also is the bottom line on a common-size income statement • The author makes a distinction for Earnings Available to Common Shareholders. • Gross Margin = Gross Profit ÷ Sales • Gross Profit = Sales – COGS • Also called the “Gross Profit Margin” • Operating Margin = Operating Profit ÷ Sales • Also called the “Operating Profit Margin”

24. Efficiency Ratios • TAT = Sales ÷ Total Assets • How hard do specific assets work? • Inventory Turnover • Inventory Turnover = Sales ÷ Inventory • The label “Inventory Turnover” is also used for COGS ÷ Avg. Inventory • These two ratios answer different questions: • How hard is inventory working? (Sales/Inventory) • How many times/year is inventory replaced? (COGS/Average Inventory) • How would you convert this into “Days in Inventory?” • Average Collection Period or AR Conversion Period • Days to Collect AR = Avg. Accts Receivable ÷ Avg. Daily Sales • Average Daily Sales = Sales ÷ 365 • The sales figure should exclude sales paid for in cash, use only sales creating AR

25. Efficiency Ratios • Average Payment Period • Days to Pay AP = Avg. AP ÷ Avg Daily Purchases • Avg Daily Purchases = Purchases ÷ 365 • Purchases = COGS + Ending Inventory – Beginning Inventory • If you know how long it takes a company to sell inventory, how long it takes to collect accounts receivable and how long to pay its bills, you can compute how long their business takes to function • Operating Cycle: Days in Inventory + Days in Receivables • Cash Cycle: Days in Inventory + Days in Receivables – Days in Payables

26. Efficiency Ratios • There is an easy and consistent way to compute and understand the components of the cash cycle. • Each of the “Days in…” figures represents a year divided by the appropriate turnover rate: • Days in Inventory = 365 ÷ Inventory Turnover Rate • Days in Receivables = 365 ÷ Receivables Turnover Rate • Days in Payables = 365 ÷ Payables Turnover Rate • This means the turnover rates can be simplified to these: • Inventory Turnover Rate = COGS ÷ Avg. Inventory • Receivables Turnover Rate = Sales ÷ Avg. Receivables • Payables Turnover Rate = Purchases ÷ Avg. Payables • …and the days in each can be computed as: • Days in Inventory = 365 ÷ (COGS ÷ Avg. Inventory) • Days in Receivables = 365 ÷ (Sales ÷ Avg. Receivables) • Days in Payables = 365 ÷ (Purchases ÷ Avg. Payables)

27. Liquidity Ratios • The Current Ratio • Pretty much useless in my opinion, but memorize it anyway. • Current Assets ÷ Current Liabilities • Liquidity means something can be converted into cash immediately without significant loss of value. Current Assets includes inventory. Is inventory really liquid? • Quick Ratio (also called the “Acid Test”) • Answers the question, “how well can this firm meet its short-term obligations?” • [Current Assets – Inventory] ÷ Current Liabilities

28. Debt Management Ratios • Debt ratio = Total Liabilities ÷ Total Assets • Also called “Debt to Total Capital” ratio • Debt-to-Equity ratio = Total Liabilities ÷ Total Equity • EM (from DuPont) = 1 + D/E • Times Interest Earned ratio = EBIT ÷ Interest • NOTE: The book has a typo on page 78. It claims TIE = EBIT ÷ Tax, which is not correct. • TIE can be altered to cover any financial obligations. • TIE = EBIT ÷ Interest • :. TIE = (EBT + Interest) ÷ Interest • (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts) = Fixed Payment Coverage • (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts + Principal Repayments/(1-t)) = Fixed Payment Coverage

29. Market Value Ratios • Price-to-Earnings ratio = Share Price ÷ Earnings per Share • Earnings per Share (EPS) = Earnings Available to Common Shareholders ÷ Number of Shares of Common Stock • If there is no preferred equity (or an insignificant amount), EPS can be NI ÷ Number of Shares • Because the Numerator and Denominator are both “per share,” the PE ratio can be computed as Market Capitalization ÷ Total Earnings Available • Market-to-Book ratio = Price per Share ÷ Book Value per Share • Book Value per Share = Common Equity on Balance Sheet ÷ Number of Shares • Common Equity = All equity except preferred equity • Again, because the Numerator and Denominator are both “per share,” the MB ratio can be computed as Market Capitalization ÷ Total Common Equity

30. Other useful analysis • Dividends & Retained Earnings • d: Dividend Payout Ratio = Dividends ÷ Net Income • b: Retention Ratio = 1 – d Also called the “plowback ratio.” Why do you think that name is used? • Growth Limitations • SGR: Sustainable Growth Rate = b x ROE = b x PM x TAT x EM • IGR: Internal Growth Rate = b x ROA = b x PM x TAT • Breakeven • BE = Total Fixed Costs ÷ Contribution Margin • Contribution Margin = Price per unit – Variable Costs per unit • Operating, Accounting, and Financial breakevens all exist. The definition of “Fixed Costs” changes. • Degree of Operating Leverage • Looks a lot like an elasticity formula: %Δ Op. Income ÷ %ΔSales • As firm approaches breakeven, DOL gets larger • A point estimate of DOL can be computed as Gross Profit ÷ Operating Income