Analysis of FinancialStatements

Feb 10, 2010

Learning ObjectivesLearning Objectives

How financial ratio analysis helps How financial ratio analysis helps managers assess the firm’s health.managers assess the firm’s health.

Compute profitability, liquidity, debt, Compute profitability, liquidity, debt, asset activity, and market value ratios.asset activity, and market value ratios.

Compare financial information over time Compare financial information over time (trends) and among companies (trends) and among companies (benchmarking).(benchmarking).

Look at sources of financial informationLook at sources of financial information

Ratio AnalysisRatio Analysis

Managers use Managers use ratiosratios to interpret the raw to interpret the raw numbers on financial statements.numbers on financial statements.

Relative measures allow comparison over Relative measures allow comparison over time (time (trendstrends), to other firms, and to ), to other firms, and to benchmarks (Rule Of Thumb, ROT)benchmarks (Rule Of Thumb, ROT)

Ratios are used by financial managers, Ratios are used by financial managers, other business managers, creditors, other business managers, creditors, investors and college studentsinvestors and college students

Ratio AnalysisRatio Analysis

Profitability ratiosProfitability ratios

Liquidity ratios (cash)Liquidity ratios (cash)

Debt ratios (Solvency)Debt ratios (Solvency)

Asset activity ratiosAsset activity ratios

Market value ratiosMarket value ratios

Five Categories of Ratios:Five Categories of Ratios:

Ratio AnalysisRatio Analysis

Profitability RatiosMeasure the overall effectiveness of the firm’s Measure the overall effectiveness of the firm’s management in operating the business profitably.management in operating the business profitably.

Measures how the firm’s returns (earnings) compare Measures how the firm’s returns (earnings) compare with its sales, asset investments and equitywith its sales, asset investments and equity

Gross Profit Margin =Gross Profit Margin =Gross Profit

Sales

How effective is the firm at generating revenue in excess of its cost of goods sold? ROT says >40%

Ratio AnalysisRatio Analysis

Profitability Ratios

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Income StatementExcalibur Corporation

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Net Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162 $575

$1,450Gross Profit Margin = = 39.7%

GrossProfit =Margin

Gross ProfitSales

Operating Profit Margin =Operating Profit Margin =Operating Income

Sales

How effective is the firm in keeping costs of operating expenses as well as production low?

How much profit am I earning just from the basic operations of my business. EBIT.

ROT says 20% or better

Ratio AnalysisRatio Analysis

Profitability Ratios

Balance SheetExcalibur Corporation

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

$330 $1,450

Oper. Profit Margin = = 22.8%

OperatingProfit =Margin

Operating IncomeSales

Net Profit Margin =Net Profit Margin =Net Income

Sales

How much net profit is being generated from each dollar of sales? ROT says > 10%

Ratio AnalysisRatio Analysis

Profitability Ratios

Note: Net Income increases Retained Earnings. Dividends, either preferred or common, are paid out of retained earnings

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

$162 $1,450

Net Profit Margin = = 11.2%

NetProfit =Margin

Net IncomeSales

Return on Assets = Return on Assets = Net IncomeTotal Assets

How effectively is the firm generating net income from its investment in assets ?

How much income each dollar of assets produces. ROT says > 10%

Ratio AnalysisRatio Analysis

Profitability Ratios

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40) 108Net Income $162

Income StatementExcalibur Corporation

$162 $2,530ROA = = 6.4%

Return onAssets

Net IncomeTotal Assets=

Return on Equity =Return on Equity = Net Income Common Equity

How well is the firm generating return to its equity providers; the common stockholders? ROT says > 15%

How many dollars of income for each dollar invested in the company by owners

Ratio AnalysisRatio AnalysisProfitability Ratios

Balance SheetExcalibur Corporation

Assets Liabilities

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

$162 $1,700

ROE = = 9.53%

Return on Equity = Net Income Common Equity

Ratio AnalysisRatio AnalysisLiquidityLiquidity RatiosRatios

Current Ratio =Current Ratio = Current Assets Current Liabilities

Measure the ability of the firm to Measure the ability of the firm to meet its short-term financial obligations.meet its short-term financial obligations.Failure to pay can lead to bankruptcy.Failure to pay can lead to bankruptcy.

Are there sufficient current assets to pay off current liabilities? What is the cushion of safety? ROT says > 2 x

Balance SheetExcalibur Corporation

Assets Liabilities

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

$1,230$230

Current Ratio = = 5.35x

Current Ratio = Current Assets Current Liabilities

Is this good?

Ratio AnalysisRatio Analysis

Liquidity RatiosLiquidity RatiosMeasure the ability of the firm to meet Measure the ability of the firm to meet its short-term financial obligations.its short-term financial obligations.

Acid-Test Ratio =Acid-Test Ratio = Current Assets - InventoryCurrent Liabilities

What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets (inventory) is subtracted? ROT says > 1.5 x

Balance SheetExcalibur Corporation

Assets Liabilities

$1,230 -$625$230

Acid-Test Ratio = = 2.63x

Acid-Test Ratio = Current Assets - Inventory Current Liabilities

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Ratio AnalysisRatio AnalysisDebt Ratios - SolvencyDebt Ratios - Solvency

Measure the relative size of the firm’s debt load and the Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt.firm’s ability to pay off the debt.

What percent of the firm’s assets are financed by debt?What percent of the firm’s assets are financed by debt?

The reciprocal is the percent of assets financed by The reciprocal is the percent of assets financed by equity.equity.

Debt Ratio =Debt Ratio = Total Debt Total Assets

What proportion of the firm’s assets is financed with debt? ROT says between 40% and 50% ok. Higher than 50% becomes more risky.

Ratio AnalysisRatio Analysis

Debt RatiosDebt Ratios

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

$230 + $600 $2,530

Debt Ratio = = 33%

Debt Ratio = Total Debt Total Assets

What is the proportion of debt relative to equity financing for the firm? ROT says < 1.0

Ratio AnalysisRatio Analysis

Debt RatiosDebt Ratios

Debt to Debt to Equity Ratio Equity Ratio

Total Debt Common Equity

==

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

$230 + $600 $1,700

D/E = = .49

Debt to Equity Ratio

Total Debt Common Equity=

Times Interest Earned Ratio =Times Interest Earned Ratio = Operating IncomeInterest Expense

What is the firm’s ability to repay interest payments from its operating income?

ROT says > 7.0 x

Ratio AnalysisRatio Analysis

Debt RatiosDebt Ratios

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

$330 $330 $60$60TIE Ratio =TIE Ratio = = 5.50x= 5.50x

TimesInterest =Earned Ratio

Operating IncomeInterest Expense

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

Ratio AnalysisRatio Analysis

AssetAsset ActivityActivity RatiosRatios

Help assess how effectively the firm is using assets to generate sales.Help assess how effectively the firm is using assets to generate sales.Help assess how efficient the firm is in converting its current assets into cashHelp assess how efficient the firm is in converting its current assets into cash

Ratio AnalysisRatio Analysis

Asset Activity RatiosAsset Activity Ratios

How long does it take for the firm on average to collect its credit sales from customers? ROT says 45 to 60 days.

Average Collection Period =Average Collection Period = Accounts Receivable Avg. Daily Credit Sales

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

AverageCollection = Period

Accounts ReceivableAvg. Daily Credit Sales

$430 $1,450/365 ACP = = 108.3 days!

$3.97 sales per day

$3.97 sales per day

Additional Info:Additional Info:We assume all We assume all sales are creditsales are creditsales.sales.

Inventory Turnover Ratio =Inventory Turnover Ratio = COGS Inventory

Is inventory being efficiently converted into cost of goods sold for the firm?

How many times is the company turning its inventory over? ROT says 3 to 4 times

Note: Use COGS not sales for this ratio!

Ratio AnalysisRatio Analysis

Asset Activity RatiosAsset Activity Ratios

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

$875$625

Inventory Turnover = = 1.4x

InventoryTurnover =Ratio

COGS Inventory

Fixed Asset Turnover Ratio =Fixed Asset Turnover Ratio = Sales

Net Fixed Assets

How effective is the firm in using its fixed assets to help generate sales?

How many dollars of sales is generated for each dollar of investment in fixed assets? ROT says at least 1.50 x.

Ratio AnalysisRatio Analysis

Asset Activity RatiosAsset Activity Ratios

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

$1,450$1,300

Fixed Asset Turnover = = 1.12x

Fixed AssetTurnover = Ratio

Sales Net Fixed Assets

Total Asset Turnover Ratio =Total Asset Turnover Ratio = Sales Total Assets

How effective is the firm in using its overall assets to generate sales?

How many dollars of sales are generated by each dollar invested in total assets? ROT says 1.0 x.

Ratio AnalysisRatio Analysis

Asset Activity RatiosAsset Activity Ratios

Assets Liabilities

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

$1,450 $2,530

Total Asset Turnover = = 0.57x

Total AssetTurnover = Ratio

Sales Total Assets

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

Price to Earnings Ratio =Price to Earnings Ratio = Market Price per ShareEarnings per Share

How much are investors willing to pay per dollar of earnings of the firm? ROT says PE ratio about 20 to 30 x.

(Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.)

Ratio AnalysisRatio Analysis

Market Value RatiosMarket Value Ratios

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

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Assets Liabilities

Balance SheetExcalibur Corporation

Additional Info:100 shares Out - standingMarket Price $20.00 per share

$20.00 $162/100

P/E ratio = = 12.35x

P/E Ratio

Market Price/ShareEPS

=

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162

Income StatementExcalibur Corporation

(Earnings Per Share = $162/100 = $1.62)

Industry ComparisonsIndustry Comparisons

Comparing a ratio for one company Comparing a ratio for one company with the same ratio for other with the same ratio for other companies in the same industrycompanies in the same industry

Benchmarking – allows you to put Benchmarking – allows you to put the value of a firm’s ratio in the the value of a firm’s ratio in the context of its industry (vs. ROT)context of its industry (vs. ROT)

RatioRatio Industry Industry Excalibur ExcaliburProfitabilityProfitabilityGross Profit Margin 38% 39.7%Operating Profit Margin 20% 22.8%Net Profit Margin 12% 11.2%Return on Assets 9.0% 6.4%Return on Equity 13.4% 9.5%

Excalibur is good at keeping operating costs down, but not as good at total costs. ROA and ROE are low mainly due to productivity problems. They are not generating enough sales and have a large investment in accounts receivable and inventory.

RatioRatio Industry Excalibur Industry ExcaliburLiquidityLiquidityCurrent Ratio 3.00x 5.35xAcid-Test Ratio 2.00x 2.63x

Looking at the current ratio it appears that Excalibur is way more liquid than the industry.... when looking at Acid Test (a better measure) they are still more liquid indicating that inventory and receivable levels are both probably too high.

Summary of Excalibur Corporation RatiosSummary of Excalibur Corporation Ratios

RatioRatio Industry Industry Excalibur ExcaliburDebtDebtDebt Ratio 35% 33%Times Interest Earned 7.00x 5.50xDebt to Equity 49% 48%

While the debt ratio is close to the industry average, Excalibur is not able to cover interest payments as easily as the industry. This indicates Excalibur may have too much debt relative to what they can realistically afford, or paying very high interest rates.

RatioRatio Industry Industry Excalibur ExcaliburAsset ActivityAsset Activity Avg. Collection Period 60 days 108 daysInventory Turnover 3.00x 1.40xFixed Asset Turnover 1.50x 1.12xTotal Asset Turnover 0.75x .57x

Collection policies need examining, as Excalibur is slower than average at collecting receivables. Inventories are being sold more slowly than the industry average, again indicating inventories that are too high. Excalibur is not efficient at converting Fixed Assets to Sales (fixed assets are not as productive as they should be). However, overall assets are not productive indicating Current Assets (e.g. inventories and receivables) are not as productive as the rest of the industry.

RatioRatio Industry Industry Excalibur ExcaliburMarket ValueMarket Value Price Earnings 18.0 12.35

Excalibur’s Investors are not willing to pay as much per dollar of earningsas they are for shares in other firms in the industry. This signals that they consider the firm’s prospects for earnings and growth to be worse than the average.

Trend AnalysisTrend Analysis

Comparing a ratio for one year Comparing a ratio for one year with the same ratio for other with the same ratio for other yearsyears

Helps see whether a company’s Helps see whether a company’s financial situation is improving or financial situation is improving or worsening.worsening.

See table 5-3 on page 119 (116)See table 5-3 on page 119 (116)

Summary AnalysisSummary AnalysisA complete ratio analysis of a company A complete ratio analysis of a company combines both trend analysis and combines both trend analysis and industry comparisons. See Industry industry comparisons. See Industry comparisons (pages 118 to 120).comparisons (pages 118 to 120).

Ratio analysis includes examining a Ratio analysis includes examining a company’s profitability, liquidity, debt company’s profitability, liquidity, debt management, asset activity and market management, asset activity and market value ratiosvalue ratios

Sources of financial information appear Sources of financial information appear on table 5-4, p.121 (118)on table 5-4, p.121 (118)