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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:

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Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

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
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 statements1
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
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
Analysis of Common Size Income Statements

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


Percentage change analysis
Percentage Change Analysis:

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

Indicator of +/- growth trends.


Analysis of percent change income statement
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
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
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
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…)


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

  • Debt management: questions do they answer?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
Things to ask? Better? Worse? questions do they answer?

  • Trends?

  • Vs. Industry?

  • Causes?

  • Corrective actions?


Calculate the firm s forecasted current and quick ratios
Calculate the firm’s forecasted current and quick ratios questions do they answer?

CA

CL

CR = =

CA - Inv.

CL

QR =


Comments on cr and qr
Comments on CR and QR questions do they answer?

  • Expected to improve/ worsen?

    Vs. industry average?

  • Liquidity position?


What is the inventory turnover ratio as compared to the industry average

CGS questions do they answer?

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
Comments on Inventory Turnover questions do they answer?

  • Inventory turnover v. industry average?

  • Due to?

  • Improvement forecasted?


What is the accts rec turnover ratio average collection period

Credit sales questions do they answer?

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
Appraisal of Ave Collection Period questions do they answer?

  • Firm collects too slowly/quickly?

  • Improving / worsening?

  • Implication re: credit policy.


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Fixed assets questions do they answer?

turnover

Sales

Net fixed assets

=

Total assets

turnover

Sales

Total assets

=

Fixed Assets and Total Assets

Turnover Ratios


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Fixed Assets and Total Assets questions do they answer?

Turnover Ratios

  • FA turnover vs. industry?

  • TA turnover vs. industry average?

  • Causes? Corrective actions?


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Total liabilities questions do they answer?

Total assets

Debt ratio =

L/T Debt ratio =

LEVERAGE

L/T Debt

Total assets


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Total liabilities questions do they answer?

Total Equity

Debt/Eqty =

ratio

L/T Debt to Total

Capitalizationratio =

LEVERAGE

_____L/T Debt___________

LTD + Pref Eqty + Cmn Eqty


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Total Assets questions do they answer?

Total Equity

Eqty Multiplier

L/T Debt to Total

Equity =

LEVERAGE

_____L/T Debt___________

Pref Eqty + Cmn Eqty


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

EBIT + Deprec Exp questions do they answer?

Interest Exp

Cash =

Coverage

EBIT

Int. expense

TIE =

COVERAGE Ratios

(


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

How do the debt management ratios compare with industry averages?

2005E 2004 2003 Ind.

D/A

TIE

C/Cov

Effects? Reasons?


Profitability ratios profit margins

Gross Profit Margin averages? = Gross Profit

Sales

Profitability Ratios (Profit Margins)

OperatingPM = EBIT

Sales

Net PM = Net Income

Sales

Trends?

Prospects?


Profitability ratios returns

ROE = averages?Net Income

Total Equity

Profitability Ratios (Returns)

ROA = Net Income

Total Assets

Return on = NI available to C.S-holders

Cmn Eqty Common Equity

Trends?

Prospects?


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

2005E 2004 2003 Ind. averages?

ROA

ROE

Trends? Vs. Industry? Prospects?.


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Effects of Debt on ROA and ROE averages?

  • 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.


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

The Du Pont System averages?

( )( )( ) = 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 measures of performance

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

Economic Profit Measures of Performance

Where:

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
Financial Distress & Z-score averages?

  • 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 score z 1 2x 1 1 4x 2 3 3x 3 0 6x 4 x 5
Financial Distress & Z-score averages?Z = 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


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Market Price = averages?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.


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

NI + Depr. averages?

C.S.Shares out.

CF per share =

Price per share

Cash flow per C.S. share

P/CF =


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

Com. equity averages?

C.S.Shares out.

BVPS =

Mkt. price per share

Book value per share

M/B =


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

2005E 2004 2003 Ind. averages?

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
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…)


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis

  • Window dressing financial ratio analysis? 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.


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis
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…)


Ratio analysis du pont system effects of improving ratios limitations of ratio analysis