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Financial Analysis

Financial Analysis. Chapter 3. How to standardize financial statements for comparison purposes How to compute and interpret important financial ratios The determinants of a firm’s profitability and growth Understand the problems and pitfalls in financial statement analysis.

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Financial Analysis

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  1. Financial Analysis Chapter 3

  2. How to standardize financial statements for comparison purposes • How to compute and interpret important financial ratios • The determinants of a firm’s profitability and growth • Understand the problems and pitfalls in financial statement analysis CH 3 Objectives

  3. Almost Everyone in the Business World Bankers – analyze loans and cash flow Portfolio Managers – projections of stock prices Marketing Managers – market penetration and impacts to profitability Human Resources – compensation analysis Senior Management – corporate strategy Sales Managers – commission rates on sales Internal Financial Analysts – profitability analysis Customer Service Managers – efficiency ratios Who uses Financial Statement Analysis?

  4. Why does the firm want/need to borrow funds? • What is the firm’s capital structure? How leveraged are they? • How will they pay it back? What kind of cash flows are being generated by operations? Creditors

  5. How has the firm performed/what are future expectations? • How much RISK is inherent in the capital structure? • What are the expected returns from the firm? • What is firm’s competitive position? Investors

  6. Need all info creditors and investors need PLUS: • What operating areas have contributed to success and which have not? • What are strengths/weaknesses of company’s financialposition? • What changes are indicated to improve future performance? Managers

  7. Financial statements (and notes) • Annual Report • 10K and 10Q reports filed with SEC (EDGAR) • Computerized data bases • Info on industry norms/ratios • Info on particular companies/industries/mutual funds • Websites Where to look for data...

  8. Common size financial statements • Financial ratios • Trend analysis • Industry comparisons Basic Tools

  9. Common Sizing

  10. Common Sizing

  11. Common Sizing

  12. Common-Size Balance Sheets All accounts = percent of total assets (%TA) Common-Size Income Statements All line items = percent of sales (%SLS) Standardized statements are useful for: Comparing financial information year-to-year Comparing companies of different sizes, particularly within the same industry Standardized Financial Statements

  13. Comparisons/benchmarking

  14. Diameter • Earth 12,756 KM • Sun 1,392,000 KM • Mass • Earth 1 • Sun 330,000 Explain how big the sun is relative to the Earth using data above.

  15. How big is Antares (one of the largest stars in our galaxy)?

  16. Ratios needto be compared to something Time-Trend Analysis 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 Benchmarking

  17. Liquidity ratios or Short-term solvency Financial leverage ratios or Long-term solvency ratios Asset management or Turnover ratios Profitability ratios Market value ratios Categories of Financial Ratios

  18. Measure the overall effectiveness of the firm’s management. Profitability Ratios Ratio Analysis

  19. Gross Profit Sales Gross Profit Margin = Profitability Ratios Ratio Analysis How effective is the firm at generating revenue in excess of its cost of goods sold?

  20. Gross Profit = Margin Gross Profit Sales $575 $1,450 Gross Profit Margin = = 39.7% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  21. Operating Profit = Margin Operating Income Sales $330 $1,450 Oper. Profit Margin = = 22.8% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  22. Profitability Ratios Note: Net Income equals Earnings Available to CS when there is no preferred stock. Net Income Sales Net Profit Margin or Profit Margin = Ratio Analysis How much net profit is being generated from each dollar of sales?

  23. Net Profit = Margin Net Income Sales $162 $1,450 Net Profit Margin = = 11.2% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  24. Net Income Total Assets Return on Assets = Profitability Ratios Ratio Analysis How effectively is the firm generating net income from its assets ?

  25. Net Income Total Assets Return on Assets = $162 $2,530 = 6.4% ROA = Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 Net Income% $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  26. Profitability Ratios Net Income Equity Return on Equity = Ratio Analysis How well is the firm generating return to its equity providers?

  27. Net Income Equity Return on Equity = $162 $1,700 ROE = = 9.53% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  28. Current Assets Current Liabilities Current Ratio = • Measure the ability of the firm to meet its short-term financial obligations. Liquidity Ratios Ratio Analysis Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

  29. Current Assets Current Liabilities Current Ratio = $1,230 $230 Current Ratio = = 5.35x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530

  30. Current Assets - Inventory Current Liabilities Quick Ratio = • Measure the ability of the firm to meet its short-term financial obligations. Liquidity Ratios Ratio Analysis What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

  31. Current Assets - Inventory Current Liabilities Quick Ratio = $1,230 -$625 $230 Acid-Test Ratio = = 2.63x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530

  32. Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt. Leverage Ratios Ratio Analysis

  33. Total Debt Total Assets Debt Ratio = Debt Ratios Ratio Analysis What proportion of the firm’s assets is financed with debt?

  34. Total Debt Total Assets Debt Ratio = $230 + $600 $2,530 Debt Ratio = = 33% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  35. Operating Income Interest Expense Times Interest Earned Ratio = Debt Ratios Ratio Analysis What is the firm’s ability to repay interest payments from its operating income?

  36. Times Interest = Earned Ratio Operating Income Interest Expense $330 $60 TIE Ratio = = 5.50x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  37. Total Assets Total Equity Equity Multiplier = Debt Ratios Ratio Analysis What is the firm’s investment in assets relative to it’s equity?

  38. Equity Multiplier = Total Assets Total Equity $2,530 $1,700 EqMult= = 1.49x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  39. Help assess how effectively the firm is using assets to generate sales. Efficiency Ratios Ratio Analysis

  40. Efficiency Ratios 365 days Rec. turnover Days Sales in Receivables or Average Collection Period = How long does it take for the firm on average to collect its credit sales from customers? Ratio Analysis

  41. Days’ sales in receivables 365 days Rec turn 365 $1,450/430 DSR = = 108 days Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62 Days in a year

  42. COGS Inventory Inventory Turnover Ratio = Efficiency Ratios Is inventory efficiently translating into sales for the firm? Ratio Analysis

  43. Inventory Turnover = Ratio COGS Inventory $875 $625 Inventory Turnover = = 1.4x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  44. Sales Net Fixed Assets Fixed Asset Turnover Ratio = Efficiency Ratios Ratio Analysis How effective is the firm in using its fixed assets to help generate sales?

  45. Fixed Asset Turnover = Ratio Sales Net Fixed Assets $1,450 $1,300 Fixed Asset Turnover = = 1.12x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  46. Sales Total Assets Total Asset Turnover Ratio = Efficiency Ratios Ratio Analysis How effective is the firm in using its overall assets to generate sales?

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