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Principles of Business FinanceFin 510

Dr. Lawrence P. Shao

Marshall University

Spring 2002

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Ratio analysisDu Pont systemEffects of improving ratiosLimitations of ratio analysisQualitative factors

CHAPTER 3 Analysis of Financial Statements

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Balance Sheet: Assets

1999E 1998Cash 85,632 7,282AR 878,000 632,160Inventories 1,716,480 1,287,360 Total CA 2,680,112 1,926,802Gross FA 1,197,160 1,202,950Less: Deprec. 380,120 263,160 Net FA 817,040 939,790Total assets 3,497,152 2,866,592

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Liabilities and Equity

1999E 1998Accounts payable 436,800 524,160Notes payable 600,000 720,000Accruals 408,000 489,600 Total CL 1,444,800 1,733,760Long-term debt 500,000 1,000,000Common stock 1,680,936 460,000Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832Total L & E 3,497,152 2,866,592

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Income Statement

1999E 1998Sales 7,035,600 5,834,400COGS 5,728,000 5,728,000Other expenses 680,000 680,000Depreciation 116,960 116,960 Tot. op. costs 6,524,960 6,524,960 EBIT 510,640 (690,560)Interest exp. 88,000 176,000 EBT 422,640 (866,560)Taxes (40%) 169,056 (346,624)Net income 253,584 (519,936)

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Other Data

1999E 1998

Shares out. 250,000 100,000

EPS $1.014 ($5.199)

DPS $0.220 $0.110

Stock price $12.17 $2.25

Lease pmts $40,000 $40,000

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Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

Why are ratios useful?

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Liquidity: Can we make required payments?

Asset management: Right amount of assets vs. sales?

What are the five major categories of ratios, and what questions do they

answer?

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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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Calculate D’Leon’s forecasted current and quick ratios for 1999.

CR99 = = = 1.85x.

QR99 =

= = 0.67x.

CACL

$2,680$1,445

$2,680 - $1,716$1,445

CA - Inv.CL

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Expected to improve but still below the industry average.

Liquidity position is weak.

Comments on CR and QR

1999 1998 1997 Ind.

CR 1.85x 1.1x 2.3x 2.7x

QR 0.67x 0.4x 0.8x 1.0x

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What is the inventory turnover ratio vs. the industry average?

Inv. turnover =

= = 4.10x.

SalesInventories

$7,036$1,716

1999 1998 1997 Ind.

Inv. T. 4.1x 4.5x 4.8x 6.1x

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Inventory turnover is below industry average.

D’Leon might have old inventory, or its control might be poor.

No improvement is currently forecasted.

Comments on Inventory Turnover

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ReceivablesAverage sales per day

DSO is the average number of days after making a sale before receiving

cash.

DSO =

= = = 44.9. ReceivablesSales/360

$878$7,036/360

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Appraisal of DSO

D’Leon collects too slowly, and is getting worse.

Poor credit policy.

1999 1998 1997 Ind.DSO 44.9 39.0 36.8 32.0

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F.A. and T.A. turnover vs. industry average

Fixed assetsturnover

Sales Net fixed assets=

= = 8.61x.$7,036$817

Total assetsturnover

Sales Total assets=

= = 2.01x.$7,036$3,497

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FA turnover projected to exceed industry average. Good.

TA turnover not up to industry average. Caused by excessive current assets (A/R and Inv.)

1999 1998 1997 Ind.FA TO 8.6x 6.2x 10.0x 7.0xTA TO 2.0x 2.0x 2.3x 2.6x

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Calculate the debt, TIE, and fixed charge coverage ratios.

Total debt Total assetsDebt ratio =

= = 55.6%.$1,445 + $500$3,497

EBIT Int. expense TIE =

= = 5.8x.$510.6$88

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Too much debt, but projected to improve.

How do the debt management ratios compare with industry averages?

1999 1998 1997 Ind.D/A 55.6% 95.4% 54.8% 50.0%TIE 5.8x -3.9x 3.3x 6.2x

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Very bad in 1998, but projected to exceed industry average in 1999. Looking good.

Profit margin vs. industry average?

1999 1998 1997 Ind.P.M. 3.6% -8.9% 2.6% 3.5%

P.M. = = = 3.6%. NI Sales

$253.6$7,036

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BEP =

= = 14.6%.

BEP vs. Industry Average?

EBIT Total assets

$510.6 $3,497

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BEP removes effect of taxes and financial leverage. Useful for comparison.

Projected to be below average.

Room for improvement.

1999 1998 1997 Ind.BEP 14.6% -24.1% 14.2% 19.1%

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Return on Assets

ROA =

= = 7.3%.

Net income Total assets

$253.6 $3,497

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ROE =

= = 16.3%.

Net income Common equity

$253.6 $1,552

1999 1998 1997 Ind.ROA 7.3% -18.1% 6.0% 9.1%ROE 16.3% -391.4% 13.3% 18.2%

Both below average but improving.

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ROA is lowered by debt--interest lowers NI, which also lowers ROA = NI/Assets.

But use of debt lowers equity, hence could raise ROE = NI/Equity.

Effects of Debt on ROA and ROE

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Calculate and appraise the P/E and M/B ratios.

Price = $12.17.

EPS = = = $1.01.

P/E = = = 12x.

NI Shares out.

$253.6250

Price per shareEPS

$12.17$1.01

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Com. equity Shares out.BVPS =

= = $6.21.$1,552250

Mkt. price per share Book value per share

M/B =

= = 1.96x.$12.17$6.21

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P/E: How much investors will pay for $1 of earnings. High is good.

M/B: How much paid for $1 of BV. Higher is good.

P/E and M/B are high if ROE is high, risk is low.

1999 1998 1997 Ind.P/E 12.0x -0.4x 9.7x 14.2xM/B 1.96x 1.7x 1.3x 2.4x

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( )( )( ) = ROE

x x = ROE.

Profitmargin

TAturnover

Equitymultiplier

NI Sales

SalesTA

TA CE

1997 2.6% x 2.3 x 2.2 = 13.2%1998 -8.9% x 2.0 x 21.6 = -391.4%1999 3.6% x 2.0 x 2.3 = 16.3%Ind. 3.5% x 2.6 x 2.0 = 18.2%

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The Du Pont system focuses on:

Expense control (P.M.)

Asset utilization (TATO)

Debt utilization (Eq. Mult.)

It shows how these factors combine to determine the ROE.

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Effect of reducing DSO from 44.9 days to 32 days:

Old A/R = 19,543 x 44.9 = 878,000

New A/R = 19,543 x 32.0 = 625,376

Cash freed up: 252,624

Initially shows up as additional cash.

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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 not necessarily good.

Seasonal factors can distort ratios.

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EVA takes into account the total cost of capital, which includes the cost of equity.

EVA is not a cash flow measure. It attempts to measure the true economic benefits and costs of a firm, division, or project.

EVA Concepts

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Economic Value Added (EVA)

EVA = -

= -

= EBIT(1 - T) - After-Tax Cost of Capital

Operating IncomeAfter Tax

After-TaxCapital Costs

Funds Availableto Investors

Cost ofCapital Used

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EVA99 = ($510,640)(1 - 0.4) - $300,000 = $6,384.

EVA98 = (-$690,560)(1 - 0.4) - $275,000 = -$689,336.

EVA97 = ($209,100)(1 - 0.4) - $125,000 = $460.

Jamison also has asked you to estimate D’Leon’s EVA. The after-tax total cost of

capital = $125,000 in 1997, $275,000 in 1998, and will be $300,000 in 1999.

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What are some qualitative factors analysts should consider when

evaluating a company’s likely future financial performance?

Are the company’s revenues tied to 1 key customer?

To what extent are the company’s revenues tied to 1 key product?

To what extent does the company rely on a single supplier?