b&h ch 3 powerpoint
TRANSCRIPT
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CHAPTER 3
Analysis of FinancialStatements
Ratio Analysis
Du Pont system
Effects of improving ratios Limitations of ratio analysis
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Why are ratios useful? Ratios standardize numbers and
facilitate comparisons.
Ratios are used to highlightweaknesses and strengths.
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What are the five major categories ofratios, and what questions do they
answer? Liquidity: Can we make required payments? Asset management: right amount of assets
vs. sales? Debt management: Right mix of debt and
equity? Profitability: Do sales prices exceed unit
costs, and are sales high enough as
reflected in PM, ROE, and ROA? Market value: Do investors like what they
see as reflected in P/E and M/B ratios?
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Liquidity Ratios: The Current
Ratio
Current ratio = Current assets / Current liabilities
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Asset Management Ratios:
Inventory TurnoverInv. turnover = Sales / Inventories
or
= COGS / Inventories
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Asset Management Ratios: Days
Sales Outstanding (DSO)
DSO = Receivables / Average sales per day
= Receivables / Sales/365
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Asset Management Ratios: Fixed
assets turnoverFA turnover = Sales / Net fixed assets
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Asset Management Ratios: Total
assets turnover TA turnover = Sales / Total assets
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Debt management ratios:
Debt ratioDebt ratio = Total debt / Total assets
Note: Total debt = CL + LTD
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Debt management ratios: Times-
interest-earned (TIE) ratio TIE = EBIT / Interest expense
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Debt management ratios:
EBITDA coverage ratio
paymentsLeasepaymentsPrincipalInterestpaymentsLeaseEBITDACoverageEBITDA
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Profitability ratios: Profit margin
on sales (or Net profit margin) Profit margin = Net income / Sales
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Profitability ratios: Basic
Earning Power (BEP) ratio BEP = EBIT / Total Assets
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Profitability ratios: Return on
Total Assets (ROA) ROA = Net income / Total assets
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Profitability ratios: Return on
common equity (ROE) ROE = Net income / Common equity
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Market value ratios: Price /
Earnings (P/E) ratio P/E = Price per share / EPS
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Market Value Ratios: Price / Cash
Flow Price-to-cash flow = Price per share /
cash flow per share
Note: Cash flow per share = (NI +Depr) / # shares outstanding
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Market Value Ratios: Market-to-
book ratio M/B = Market price per share / Book
value per share
Note: Book value per share = Commonequity / # shares outstanding
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The Du Pont System of Control The Du Pont equation
assetsTotal
incomeNet
assetsTotal
SalesX
Sales
incomeNetROA
overasset turnTotalXmarginProfitROA
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The Du Pont System of Control Extended Du Pont Equation:
equityCommon
incomeNetROE
equityCommon
assetsTotalX
assetsTotal
SalesX
Sales
incomeNetROE
multiplierEquityXoverasset turnTotalXmarginProfitROE
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Problems with ROE ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance. ROE does not consider risk. ROE does not consider the amount of capital
invested. Might encourage managers to make investment
decisions that do not benefit shareholders. ROE focuses only on return. A better
measure is one that considers both risk andreturn.
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Analyzing the market value ratios P/E: How much investors are willing to pay
for $1 of earnings.
P/CF: How much investors are willing topay for $1 of cash flow.
M/B: How much investors are willing topay for $1 of book value equity.
For each ratio, the higher the number, thebetter.
P/E and M/B are high if ROE is high andrisk is low.
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Trend analysis Analyzes a firms
financial ratios over
time Can be used to
estimate the likelihoodof improvement or
deterioration infinancial condition.
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An example:
The effects of improving ratiosA/R 878 Debt 1,545Other CA 1,802 Equity 1,952
Net FA 817 _____TA 3,497 Total L&E 3,497
Sales / day = $7,035,600 / 365 = $19,275.62
How would reducing the firms DSO to 32days affect the company?
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Reducing accounts receivable and
the days sales outstanding Reducing A/R will have no effect on
sales
Old A/R = $19,275.62 x 45.6 = $878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up: $261,180
Initially shows up as addition to cash.
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Effect of reducing receivables on
balance sheet and stock priceAdded cash $261 Debt 1,545
A/R 617 Equity 1,952
Other CA 1,802Net FA 817 _____
Total Assets 3,497 Total L&E 3,497
What could be done with the new cash?
How might stock price and risk be affected?
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Potential uses of freed up cash Repurchase stock
Expand business
Reduce debt
All these actions would likely improvethe stock price.
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Potential problems and limitations
of financial ratio analysis Comparison with industry averages is
difficult for a conglomerate firm that
operates in many different divisions.Average performance is not necessarily
good, perhaps the firm should aimhigher.
Seasonal factors can distort ratios.Window dressing techniques can make
statements and ratios look better.
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More issues regarding ratios Different operating and accounting
practices can distort comparisons.
Sometimes it is hard to tell if a ratio isgood or bad.
Difficult to tell whether a company is,
on balance, in strong or weak position.