Description
explains what information does a balance sheet provide, what are the limitations of balance sheet, what are various constituents of balance sheet. It also include income statement terminology. How financial ratio analysis helps managers assess the firm’s health. What information does ratio like profitability, liquidity, debt, asset activity, and market value ratios provide.
Analysis of Financial Statements
1
The Firm’s Financial Statements
? What are the Questions to be Answered in a
firm’s financial statements?
2
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm?
3
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm? ? How did the firm raise funds to finance these assets?
4
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm? ? How did the firm raise funds to finance these assets? ? How profitable are these assets?
5
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm? ? How did the firm raise funds to finance these assets? ? How profitable are these assets? ? How much uncertainty is embedded in these assets?
6
The Firm’s Financial Statements
? Accountants would answer these questions
differently than a MBA doing financial analysis ? Difference is in the objectives:
7
The Firm’s Financial Statements
? Accountants would answer these questions
differently than a MBA doing financial analysis ? Difference is in the objectives:
? Accountants try to measure the current standing &
immediate past performance ? MBA does financial analysis forward looking
8
Using Financial Statement Information
Why evaluate Financial Statements?
? Internal Uses
? Allocate capital by division
? Measure and reward performance ? External Uses ? Extend trade credit to customers
? Investor Community Ratio Analysis
? Banks requiring loan covenants ? Competitor Analysis ? Valuing a target in an acquisition ? Benchmarks ? Year on year ? Peer group
9
Using Financial Statement Information
Problems with Financial Statement Analysis
? The need for theory
? There is no compelling rationale for use of financial statement to
make judgements about value and risk. ? Which ratios matter most? ? What is the “right” value for the ratio
? Conglomerates ? Not identified in a single industry or sector ? Hard to find comparables ? Global reach ? Comparability of financial statements between countries
10
The Firm’s Financial Statements
?
Annual report includes:
? Balance sheet ? Income statement
? Statement of cash flows
? Statement of Retained Earnings
11
The Firm’s Financial Statements
? What information does a Balance Sheet provide?
12
The Firm’s Financial Statements
? Balance Sheet –
? summarizes assets & liabilities owned by a firm – value
of assets & ? mix of financing debt & equity to finance these assets up to a point of time.
13
What does the balance sheet tell us?
? In theory the balance sheet of a private limited company or a public limited
?
? ? ?
company should be able to tell us all about the company’s financial structure, and liquidity, the extent to which its assets and liabilities are held in cash or in a near cash form (for example, bank accounts and deposits). It should also tell us about the assets held by the company, the proportion of current assets and the extent to which they may be used to meet current obligations. An element of caution should be noted in analysing balance sheet information. The balance sheet is an historical document. It may have looked entirely different six months or a year ago, or even one week ago. There is not always consistency between the information included in one company’s balance sheet with that
14
Balance sheet limitations
? There are limitations to the conventional balance
sheet arising not only from the fact that it is an historical document, but from inconsistencies in its preparation between companies and industries, the employment of various asset valuation methods, offbalance sheet financing, and window dressing.
15
Balance Sheet
? Provides a firm’s financial position at a specific point
in time ? Assets are resources owned by the firm ? Liabilities and owner’s equity indicate how those resources are financed Total Assets =
Liabilities (debt) + Shareholder’s Equity
Or…A= L+OE
16
Balance Sheet Terminology
? Current assets or gross working capital comprise
assets that are relatively liquid, or expected to be converted into cash within 12 months. ? Current assets typically include:
? Cash
? Accounts Receivable
payments due from customers who buy on credit
? Inventory
raw materials, work in process, and finished goods held for eventual sale
? Other expenses
Prepaid expenses are those items paid for in advance
17
Balance Sheet Terminology
? Fixed Assets – Assets held for more than one year.
Typically Include:
? Machinery and equipment ? Buildings ? Land
? Other Assets – Assets that are not current assets
or fixed assets
? Patents
? Copyrights ? Goodwill
18
Balance Sheet Terminology
? Debt (Liabilities) ? Money that has been borrowed and must be repaid at some predetermined date ? Debt Capital
? financing provided by a creditor ? Current or short-term debt and long-term debt ? Current or short-term must be repaid within the next 12
months
19
Balance Sheet Terminology
? Current Liabilities: ? Accounts payable
? Credit extended by suppliers to a firm when it purchases
inventories
? Accrued expenses
? Short term liabilities incurred in the firm’s operations but not yet
paid for
? Short-term notes
? Borrowings from a bank or lending institution due and payable
within 12 months
? Long-Term Debt
? Loans from banks or other institutions for longer than 12 months
20
Balance Sheet Terminology
? Equity
? Includes the shareholder’s investment ? Preferred stock ? Common stock
? Treasury Stock ? stock that was once outstanding and has been re-purchased by the company
? Retained Earnings ? cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years
21
Balance Sheet
? ASSETS ? Current Assets ? Fixed Assets ? Total Assets ? LIABILITIES ? Current Liabilities ? Long-Term Liabilities ? Total Liabilities
? OWNER’S EQUITY ? Preferred Stock ? Common Stock ? Retained earnings ? Total Owner’s Equity
? Total liabilities + OE
22
The Firm’s Financial Statements
? Balance Sheet (as of a point in time)
Assets = Liabilities + Owners’ Equity
Current Assets Cash Inventory A/R Current Liabilities A/P Accruals S-T Debt
Owners’ Equity Common Stock Capital in Excess of Par Retained Earnings
Fixed Assets Long Term Liabilities Land Bonds Plant L-T Bank Debt Equipment Mortgages Less: Accum. Dep. 23
Executive Paper
Executive Paper Balacne Sheet Dec 1998 Assets Current Assets Cash & Sec urities Rec eivables Inventory Total Fixed Assets P, P, E ac c um Depr Net Fixed Assets
24
Dec 1999
diff
75.0 433.1 339.9 848.0
110.0 440.0 350.0 900.0
35.0 6.9 10.1 52.0
929.5 396.7 532.8 1,380.8
100.0 450.0 550.0 1,450.0
- 829.5 53.3 17.2 69.2
Total Assets
Executive Paper
Executive Paper Balacne Sheet Dec 1998 Liabilities and Equity Current Liabilities Debt due in 1 year 96.6 Payable 349.9 Total c urrent liabilities 446.5 Long term debt Shareholders equity 425.0 509.3 Dec 1999
diff
100.0 360.0 460.0 450.0 540.0 1,450.0
3.4 10.1 13.5 25.0 30.7 69.2
25
Total liabilities and equity 1,380.8
Executive Paper
Executive Paper - Other Data Market value of equity Average number of shares, millions Share price, dollars
1998 598 14.16 42.25
1999 708 14.16 50
26
?Balance Sheet
ACME CORPORATION
2005
2006 10,000,000 1,000,000 10,000,000 8,000,000 1,000,000 30,000,000 28,000,000 (8,000,000) 20,000,000 50,000,000 Change 1,000,000 300,000 -7,300,000 -1,000,000 0 -7,000,000 14,000,000 -2,000,000 12,000,000 5,000,000
For the Year Ended December 31:
Assets: Cash 9,000,000 Accounts receivable 700,000 Inventory 17,300,000 Marketable Securities 9,000,000 Prepaid Expenses 1,000,000 Total current assets 37,000,000 Fixed Assets, Gross 14,000,000 less Accumulated Depr. (6,000,000) Fixed Assets, Net 8,000,000
27
Total assets
45,000,000
?Balance Sheet
ACME CORPORATION
2005
2006 4,000,000 3,000,000 2,000,000 9,000,000 15,000,000 24,000,000 1,000,000 3,000,000 12,000,000 10,000,000 25,000,000 26,000,000 Change -3,000,000 -1,000,000 -1,000,000 -5,000,000 4,216,000 -784,000 -1,000,000 2,000,000 2,000,000 2,784,000 6,784,000 5,784,000
For the Year Ended December 31:
Liabilities & Equity: Accounts Payable Notes payable Accrued Expenses Total current liabilities Long-term debt Total liabilities Preferred Stock Common stock Capital in Excess of Par Retained earnings Total common equity 28 Total equity 7,000,000 4,000,000 3,000,000 14,000,000 10,784,000 24,784,000 2,000,000 1,000,000 10,000,000 7,216,000 18,216,000 20,216,000
Balance Sheet
ACME CORPORATION
Year Ended December 31
Assets = Liabilities + Owner’s Equity
2005 Assets: Cash Accounts receivable Inventory Marketable Securities Prepaid Expenses Total current assets Fixed Assets, Gross less Accumulated Depr. Fixed Assets, Net Total assets 9,000,000 700,000 17,300,000 9,000,000 1,000,000 37,000,000 14,000,000 -6,000,000 8,000,000 2006 Change
2005
Liabilities & Equity: 10,000,000 1,000,000 1,000,000 300,000 Accounts Payable 7,000,000 10,000,000 -7,300,000 Notes payable 4,000,000 8,000,000 -1,000,000 Accrued Expenses 3,000,000 1,000,000 0 Total current liabilities 14,000,000 30,000,000 -7,000,000 Long-term debt 10,784,000 28,000,000 14,000,000 Total liabilities 24,784,000 -8,000,000 -2,000,000 Preferred Stock 2,000,000 20,000,000 12,000,000 Common stock 1,000,000 45,000,000 Capital in Excess 5,000,000 10,000,000 50,000,000 of Par Retained earnings 7,216,000 Total common equity 18,216,000 Total equity 20,216,000 Total liabilities & equity 45,000,000
2006
Change
4,000,000 3,000,000 2,000,000 9,000,000 15,000,000 24,000,000 1,000,000 3,000,000 12,000,000 10,000,000 25,000,000 26,000,000 50,000,000
-3,000,000 -1,000,000 -1,000,000 -5,000,000 4,216,000 -784,000 -1,000,000 2,000,000 2,000,000 2,784,000 6,784,000 5,784,000 5,000,000
29
The Firm’s Financial Statements
? When analyzing a firm - what are the questions to which
we would like to know the answers to?
? Investments already made ? Assets in place ? Investments yet to be made ? Growth assets ? Firm can either borrow the fund its need to make these
investments using debt or raise it from the owners
? The Debt and Equity of the Firm
30
The Firm’s Financial Statements
? Balance sheet analysis similar to accounting
Balance Sheet – key difference – explicitly consider growth assets ? Accounting statements allow us to acquire information but fall short in terms –
? of both timeliness and ? the way we measure asset value, earnings & risk
31
The Firm’s Financial Statements
? Assets in place ? What are they? ? What is its value? ? How risky are they? ? Growth Assets ? What are growth assets? ? How valuable? ? Debt ? What is the value of debt? ? How risky is the debt? ? Equity ? What is the value of the equity? ? How risky are they?
32
Asset Measurement
? It depends on
? Type of asset ? Value of the asset ? Degree of uncertainty
? What is an asset?
33
Asset Measurement
? What is an asset? ? Any resource that has potential to either generate
future cash inflows or reduce future outflows ? Further it has to be acquired in a prior transaction and be able to quantify future benefits with reasonable precision
34
Asset Measurement
? Accountants value Assets at historical cost or book
value – adjusted upward (improvement) and downward (aging) – because of their
? Abiding belief in book value as best estimate ? Distrust Market Value or Estimated Value – because
market prices are volatile and easily manipulated or if dependent on future expected cash flows its even more suspicious ? General preference for underestimation (Conservative)
35
Fixed Assets
? Historical cost or market value ? Reduction in value due to depreciation or aging of
asset ? Why is depreciation in annual reports different from tax statements?
36
Current Assets
? Amenable to market valuation including marketable
securities ? Stocks – valuation?
37
Current Assets
? Amenable to market valuation including marketable
securities ? Stocks – valued on LIFO/ FIFO/ Weighted Average ? In case of high inflation which method would the companies adopt? Why?
38
Current Assets
? Short Term Investments – categorized into
? Held to maturity – historical value – dividend / interest
as income ? Available for sale – market value – difference adjusted against equity ? Trading investment – market value – unrealized gain or loss posted in income statement
39
Investment
? Up to 20% of equity – minority passive investment –
valued at historical cost ? Between 20% to 50% - minority active investment – valued at historical value – adjust to proportionate of net income or loss. Dividends to reduce acquisition value. Market value not considered till liquidated ? Greater than 50% - consolidation of balance sheet – substitute balance with balance sheet (asset – liability)
40
Historical Value
? Not a good measure of current market value of assets –
assets age & macro-economic conditions change ? Current value of non-traded asset can be better estimated looking at the future cash flows the asset will generate ? Publicly traded assets – market value ? Where market value of assets available use market values
41
Growth Assets
? Intangible Assets – a measure of growth assets – a good
measure for those companies having such patents/ trademarks/ etc. ? Value of patent does not show up if internally generated ? Moreover if patent acquired at BV it does not provide any measure of value of growth that can be generated by the patent ? A vast number of companies have neither ideas nor products that can be patented, often are able to generate high growth and have growth assets
42
Growth Assets
? Goodwill – Value – at the time of Mergers
? Difference between MV & BV of assets in place ? Value of growth asset ? Premium for synergy
43
Mergers
? Pooling or accounts & Purchase accounts – either
have real effect on cash flows
? Goodwill amortization is tax deductible ? MV > BV – higher cash flows – use pooling ? Constraint in Debt / Dividend policy – tighter in case of
purchase due to goodwill amortization that would reduce the amount available for distribution
44
Liabilities
? Liabilities must meet the following criteria:
45
Liabilities
? Liabilities must meet the following criteria:
? Must lead to future cash outflow or loss of future cash
flow at some specified or predetermined time ? Firm cannot avoid the obligation ? Transaction has to have happened In addition, for outside liability ? Has to be tax deductible ? Failure to meet can lead to loss of control of the firm
46
Current Liability
? Valuation – Book Value
? Can Change - Only if the default risk has
changed dramatically
47
Long Term Debt
? Bank/ Institution – Book Value
? Corporate Debt Issue – Market price
? At par – BV ? At Discount – amortize the difference over the life of the
corporate bond ? BV is unaffected by the interest rate fluctuations – however the bond prices do change ? If debt retired before maturity – difference between BV and amount paid – gain or loss in Income statement
48
Forex Debt
? Adjust Book Value for forex changes
49
Other Long term Liabilities
? Lessors/ Pension Fund obligations/ deferred tax
liability/ etc. ? Lease – operating lease – operating expense deducted from Income statement ? Capital Lease – PV of future lease rentals as Liability and written down to the extent of the rentals every year. Can claim depreciation
50
Capital Lease
? Conditions (any one has to be met)
51
Capital Lease
? Conditions (any one has to be met)
? Lease period should exceed 75% of the life of asset ? Transfer of ownership at the end of the lease term ? Option to purchase the asset at a “bargain price”
? PV of lease payments > 90% of the fair market value
of the asset
52
Pension Funds
? Check whether overfunded or underfunded ? If under-funded make provisions for the difference
53
Deferred Tax
? Calculations as per AS22 ? Doubt – whether a real liability –as the firm owes no
one that amount ? Thus resulting in the firm looking a lot riskier. ? Then why make these provisions?
54
Deferred Tax
? Calculations as per AS22 ? Doubt – whether a real liability –as the firm owes no
one that amount ? Thus resulting in the firm looking a lot riskier. ? Then why make these provisions? ? Conservative approach
55
Preferred Stock
? A hybrid instrument
? The failure to pay dividend does not lead to
bankruptcy
56
Some lacunae
? Most balance sheets do not report outstanding
Warrants and Equity Options issued but not exercised ? Also convertible bonds – the equity portion not considered in equity
57
The Firm’s Financial Statements
?
Annual report includes:
? Balance sheet ? Income statement ? Statement of cash flows
58
The Firm’s Financial Statements
? Income Statement?
59
The Firm’s Financial Statements
? Income Statement – provides
information regarding revenues and expenses of the firm and resulting profit during a particular period
60
Income Statement Terminology
? Revenue (Sales)
? Money derived from selling the company’s product or service
? Cost of Goods Sold (COGS)
? The cost of producing or acquiring the goods or services to be sold
? Operating Expenses
? Expenses related to marketing and distributing the product or service
and administering the business
? Financing Costs
? The interest paid to creditors and the dividends paid to preferred
stockholders
? Tax Expenses
? Amount of taxes owed, based upon taxable income
61
Income Statement
Sales
Less cost of goods sold
= Gross profit
Less operating expenses
= Operating income
Less interest expense
= Earnings before taxes
Less corporate taxes
= Earnings before preferred dividends
Less preferred stock dividends
= Net income available to common stockholders
62
Terms
? Net Working Capital Current assets – current liabilities ? Debt Ratio Percentage of debt a firm uses to finance its assets ? Accrual Basis Accounting Recording revenues when earned and expenses when incurred, rather than when cash is exchanged ? Free Cash Flows Cash flow that is free and available to be distributed to the firm’s investors.
63
Free Cash Flows
Free cash flows: (After-tax cashflows from operations) Less (Increase or decrease in net working capital) Less (Increase or decrease in gross fixed assets)
64
Traditional Statement of Cash Flows
? Three sections:
? Cash flows from Operating Activities ? Cash flows from Investing Activities
? Cash flows from Financing Activities
65
After-Tax Cash Flows From Operations
Operating Income (EBIT) + Depreciation - Income tax expense = After-tax cash flows from operations
66
Change in Operating Working Capital
Change in operating working capital = (change in current assets) (change in current liabilities)
67
Compute the Change in Fixed Assets
? The final step involves computing the change in
Gross Fixed Assets (not net Fixed Assets)
68
Financing Cash Flows
A firm can either receive money from or distribute money to its investors. The firm can: 1. Pay interest to lenders 2. Pay dividends to stockholders 3. Increase or decrease in long-term debt 4. Issue stock to new shareholders or repurchase stock from current shareholders
69
The Firm’s Financial Statements
?Income Statement (covers a period of time)
Revenues - Expenses = Net Income
Sales Investment Income Gains Interest Received Dividends Received COGS Salaries Depreciation Exp. Taxes Other Expenses Interest Paid
70
The Firm’s Financial Statements
? Income Statement Revenues - Expenses = Net Income
Retained Earnings
Dividends
71
Executive Paper
Executiv e Paper Income Statement (1999)
Revenues Costs Deprec iation EBIT Interest T ax Net income Dividend Retained earnings Earnings per share, dollars Dividend per share, dollars
$ millions 2,200.00 1,980.00 53.30 166.70 42.50 49.70 74.50 43.80 30.70 5.26 3.09
72
Income Statement
Net Sales Cost of goods sold Gross profit Depreciation S&A Expenses Operating Income (EBIT) Interest expense Income before taxes Income taxes (40%)
ACME CORPORATION
15,000,000 5,000,000 10,000,000 2,000,000 800,000 7,200,000 1,710,000 5,490,000 2,196,000 3,294,000
For the Year Ended December 31, 2006
Net income
73
Income Statement
? The questions it should answer are?
74
Income Statement
? The questions it should answer are?
? How profitable is the firm? ? What the firm earn on its assets in place?
75
Income Statement
? It is the measure of the earnings from assets in
place
? It follows 2 guiding principles
? Accrual Accounting ? Classification of expenses
76
Revenue Recognition & Matching Principle
? When is the revenue recognized?
77
Revenue Recognition & Matching Principle
? When is the revenue recognized? ? The services for which it is getting paid has been
performed in full or substantially for which it received cash or receivable that is observable and measureable.
78
Revenue Recognition & Matching Principle
? Complication/ exception?
79
Revenue Recognition & Matching Principle
? Complication/ exception? ? Long term contracts – where revenue is recognized
on a percentage completion basis ? In case there is uncertainty about the capacity of the buyer of the services, the firm may recognize the revenue only when it received payment
80
Operating Expenses
? They reflect those expenses that create revenue
in the given period ? 2 exceptions?
81
Operating Expenses
? They reflect those expenses that create revenue
in the given period ? 2 exceptions?
? Depreciation/ amortization ? R&D expenses which benefit over a number of
years
82
EBITDA
?
?
?
Earnings before interest, taxes, depreciation and amortization Represents revenues minus cash expenses from operations Used by financial analysts to approximate the amount of cash flow generated by the daily operations of a business
83
Depreciation
?
?
?
Accounting depreciation is the allocation of an asset’s initial cost over time. Book value is Asset Cost minus Depreciation Book Value does not equal Market Value
Allowable depreciation expense is determined by established accounting rules – Straight Line Method or Written Down Method
?
84
Calculation of Depreciation
? Depreciable basis ? Total amount to be depreciated over the accounting life of the asset. ? Equal to cost of the asset plus any setup and delivery costs incurred. ? Straight line depreciation –used per books ? Basis divided by accounting life with equal amounts of depreciation allocated to each time period.
85
R&D Expenses
? Adjust income to reflect the research expenses ? Adjusted operating income = Operating Income +
R&D Expenses – Amortization of R&D Asset ? However, amortization of R&D expenses are not tax deductible, as they are written off in the year of expenditure as per Income Tax
86
Non Recurring Items
? Unusual or infrequent items
? Extra-ordinary items
87
Non Recurring Items
? Unusual or infrequent items
? gain/ loss from asset sale; write-offs; restructuring
expenses
? Extra-ordinary items
? Marketable securities – loss or gain
88
The Firm’s Financial Statements
?
Annual report includes:
? Balance sheet ? Income statement ? Statement of cash flows
89
The Firm’s Financial Statements
? Cash flow Statement – specifies
sources of cash to the firm from both operations & new financing and uses of this cash during a period ? An attempt to explain how much the cash flows were during a period & why the cash balance changed during the period
90
The Firm’s Financial Statements
? Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash
From Operations:
Net Income +Incr/-Decr Accts Payable +Depreciation Exp. +Incr/-Decr Accrued Exp -Incr/+Decr of A/R -Incr/+Decr of Inventory -Incr/+Decr of Prepaids
91
The Firm’s Financial Statements
? Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash
From Investing:
+Sale of Fixed Assets -Purchase of fixed assets +Sale of Securities -Purchase of other firms -Purchase of Securities
92
The Firm’s Financial Statements
? Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash
From Financing:
+Sale of stock +Issue of LT debt or notes payable -Buy back stock -Repay LT debt -Pay dividends
93
Learning Objectives
?
?
?
?
How financial ratio analysis helps managers assess the firm’s health. Compute profitability, liquidity, debt, asset activity, and market value ratios. Compare financial information over time (trends) and among companies (benchmarking). Look at sources of financial information
94
Things to Consider When Using Financial Ratios
? What aspect of the firm or its operations are we attempting to
analyze? ? Firm performance can be measured along “dimensions”
? What goes into a particular ratio?
? Historical cost? Market values? Accounting conventions? ? What is the unit of measurement? ? Dollars? Days? Turns? ? What would a desirable ratio value be? What is the benchmark? ? Time-series analysis? Cross-sectional analysis?
95
Ratios – the connection between operating decisions and financial performance
? Operating decisions are levers by which
management controls financial performance ? Consider ratios in relationship to financial statements
? balance sheet = current and long term assets and liabilities
(asset management and financing decisions) ? Income statement = cost to generate sales (profitability)
? Ratio Analysis is relative – depends on the
perspective of the analyst
? Rule of thumb comparison ? Industry comparison ? Trend analysis – changes over time
96
Categories of Financial Ratios
? Short-Term Solvency, or Liquidity ? Ability to pay bills in the short-run ? Long-Term Solvency, or Financial Leverage
? Ability to meet long-term obligations
? Asset Management, or Turnover ? Intensity and efficiency of asset use ? Profitability
? The ability to control expenses
? Market Value ? Going beyond financial statements
97
Ratio Analysis
Five Categories of Ratios
? Profitability ratios ? Liquidity ratios ? Debt ratios ? Asset activity ratios ? Market value ratios
98
Ratio Analysis
Profitability Ratios
? Measure the overall effectiveness of the firm’s
management.
? Measures how the firm’s returns compare with its
sales, asset investments and equity
? Income statement gives how profitable the firm is
in absolute terms. For comparison we need to gauge it on % returns
99
Ratio Analysis
Profitability Ratios
Gross Profit Margin =
Gross Profit Sales
How effective is the firm at generating revenue in excess of its cost of goods sold?
100
Balance Sheet Excalibur Corporation Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $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
101
Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Bonds $600 Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530
Gross Profit Margin
=
Gross Profit Sales
$575 $1,450
Gross Profit Margin =
= 39.7%
Ratio Analysis
Profitability Ratios
Operating Profit Margin =
Operating Income Sales
How effective is the firm in keeping costs of production and operating expenses low?
102
How much profit am I earning just from the basic operations of my business. Excludes other income such as interest, dividends, etc.
Balance Sheet Excalibur Corporation Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $2,530 Income Statement Excalibur Corporation Sales Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income
103
$1,450 875 $575 45 200 $330 60 $270 108 $162
Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530
Operating Operating Income Profit = Sales Margin Oper. Profit Margin = $330 $1,450 = 22.8%
Ratio Analysis
Profitability Ratios
Note: Net Income increases Retained Earnings. Dividends, either preferred or common, are paid out of retained earnings Net Income Net Profit Margin = Sales How much net profit is being generated from each dollar of sales?
104
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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income
105
875 $575 45 200 $330 60 $270 108 $162
Net Profit Margin
=
Net Income Sales
$162 $1,450 = 11.2%
Net Profit Margin =
Ratio Analysis
Profitability Ratios
EBIT - tax Return on assets = average total assets
How effectively is the firm generating net income from its assets ? How much income each dollar of assets produces. ?Individual Assignment – July 1, 2007 Is ROA different from Return on Capital Employed (ROCE) or Return on Invested Capital (ROIC)?
106
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 Income Statement Owners Equity $2,530 Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Net Income Return on Depreciation 200 = Operating Income $330 Total Assets Assets Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 $162 = 6.4% Net Income% $162
107
ROA =
$2,530
Ratio Analysis
Profitability Ratios
Return on Equity = Net Income Common Equity
How well is the firm generating return to its equity providers; the common stockholders?
How many dollars of income for each dollar invested in the company.
108
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 Income Statement Total Owners’ Equity $1,700 Excalibur Corporation Total Liabilities and Owners Equity $2,530 Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Return on Equity = Net Income Common Equity Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 $162 Net Income $162
ROE =
109
$1,700
= 9.53%
ROCE and ROE
? ROE = PAT / BV of Equity
?
D ROE ? ROCE ? ?ROCE ? i ?1 ? t ?? ROCE = EBIT (1-t) / BV of Debt & Equity E
? D/E = BV Debt / BV Equity ? i = Interest rate ? t = Tax rate ? Individual Assignment – July 1, 2007
? Derive the above equation ROE = ROCE + ….
110
Three Determinants of Return on Equity (ROE)
Profitability ratios: Return on equity = Net income/Shareholders’ equity
? ROE measures “return per buck” ? Three operating levers for controlling ROE: ? Profit margin: earnings squeezed out of each dollar of
sales ? Asset turnover: sales generated for each dollar of assets ? Financial leverage: amount of equity used to finance the assets
? ROE = Profit Margin x Asset Turnover x Financial Leverage
111
Profit Margin and other indicators of profitability
Profitability ratios: Profit margin = Net income/Sales Gross margin = Gross profit/Sales Return on assets = Net income/Assets
?
Profit Margin: ? reflects pricing strategy and ability to control costs ? Tends to vary inversely with asset turnover ? Increases when company adds significant value to product (requires more assets so lower asset turn
? Gross Margin: ? Helps distinguish between fixed and variable costs (assuming most COGS are variable while other operating costs are fixed) ? Indicates susceptibility to decline in sales ? Return on Assets: ? Efficiency of management’s allocation of resources ? Measures profit as percentage of money provided by owners and creditors (where ROE only measures profit on money provided by owners
112
Asset Turnover indicate the relative importance and availability of assets in managing profitability
Turnover control ratios: Asset turnover = Sales/Assets Fixed-asset turnover = Sales/Net property, plant, and equipment
? Asset turnover ? Low AT indicates a capital intensive business and vice versa ? Performance improves as AT rises (other things constant)
? Can be critical indicator of success when products are similar
? Fixed AT indicates susceptibility to decline in sales or
payments (investment in CA or NWC can rise rapidly) ? Conversely, CA can be a source of cash if needed
113
“Balance Sheet Ratios” compare debt to assets and equity
Leverage ratios: Assets to equity Debt to assets Debt to equity = Assets/Shareholders’ equity = Total liabilities/Assets
(Interest-bearing debt is often substituted for of total liabilities.)
= Total liabilities/Shareholders’ equity
? A to E indicates how much of the assets are owned (vs.
borrowed) ? Unlike profitability and asset turnover, more is not necessarily better (costs associated with debt financing). ? Nature of business and types of assets influence appropriateness of financial leverage decisions
? ROA and financial leverage tend to be inversely related
? D to A is the % of asset book value that comes from creditors ? D to E is different way of saying the same thing: how much of
114
every dollar owned by the company is supplied by creditors vs. owners
Three Problems with Return on Equity (ROE)
Return on equity = Net income/Shareholders’ equity = Profit Margin x Asset Turnover x Financial Leverage
? Timing problem ? ROE is backward looking and focused on a single period ? Risk Problem ? ROE says nothing about how much risk a company has engaged in to generate the return ? Value Problem ? Most ratios use book value, but investors are more concerned about market value because that measure current realizable worth of their shares
115
Ratios that attempt to adjust for risk and value problems
Profitability ratios: Return on = Earnings before interest and taxes x (1 – Tax rate) invested capital Interest-bearing debt + Shareholders’ equity Price to earnings = Price per share/Earnings per share
? ROIC eliminates the distorting effect of leverage (debt)
? Also known as return on net assets ? “rate of return earned on the total capital invested in the business
without regard to whether its debt or equity ? Reflects the companies fundamental earning power without regard to different financing strategies
? PE Ratio
? Gives little insight on performance of company but is widely used ? Basically the price of $1 of current earnings, normalizes companies ? Dependent on 1) future earning prospect 2) risk associated with
those earnings
116
ROCE
? ROCE = EBIT (1-t) / BV of Debt & Equity
? ROCE = (EBIT (1-t) / Sales) x (Sales/ BV Debt +
Equity) ? ROCE = Operating margin x Capital Turnover ? To maximize ROCE, you either increase operating margins or increase Capital turnover ? There could be constraints of competition or technology
117
Accountant’s Measure profitability
? Do they provide us with good measures of earnings
of firm’s assets in place? ? Are ROE & ROCE reasonable estimates of returns made on the investments?
118
Accountant’s Measure profitability
? Do they provide us with good measures of earnings
of firm’s assets in place? ? Are ROE & ROCE reasonable estimates of returns made on the investments? ? Though invaluable, from analytical perspective however, components of it are misleading and incomplete.
119
Accountant’s Measure profitability
? Key Problems
? Accrual Accounting – different from cash earning.
Depreciation, inventory, accounts receivables and payables to be adjusted to arrive at cash earnings ? Cash Flow statement – does give us valuable information about capex, acquisition cost and other financing actions during the period. Its objective is not to estimate the cash earnings of the firm
120
Accountant’s Measure profitability
? Key Problems
? Operating, Financial and Capital Expenditure
classification – though reasonable rationale – 2 problems
? Rigidity with which capex is written off. Accounting depreciation
almost never equals economic depreciation ? Inconsistency in application – R&D expenses
121
Accountant’s Measure profitability
? Key Problems
? Measuring returns – to the extent the book value
estimates are outdated and do not reflect the true market value of the asset in place, the return estimates are likely to be misleading ? Inconsistency in accounting can have an impact – buyback of shares
122
Measuring Risk
? How risky are the investments the firm has made
over time? ? How much risk do equity investors in firm face? ? Accounting statements do not really claim to measure or quantify risk in a systematic way
123
Measuring Risk
? To a certain extent accounting statements and ratios do
attempt to measure risk ? 2 common themes
? Risk of default – risk that a fixed obligation will not be met.
The broader equity notion of risk – variance of actual return over expected – is ignored ? Static view of risk – looking at a firm’s capacity at point in time to meet its obligation – ratios – based on one period’s income statement & balance sheet
124
Accounting Measuring Risk
? Disclosures in the Notes to the Accounts ? Financial Ratios – Financial statements as a basis of
estimating financial ratios that measure profitability and risk and leverage
125
Ratio Analysis
Liquidity Ratios ? Measure the ability of the firm to meet its short-term financial obligations. ? Failure to pay can lead to bankruptcy.
Current Assets Current Liabilities
Current Ratio =
Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?
126
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
Current Ratio =
Current Assets Current Liabilities
Current Ratio = $1,230 = 5.35x $230
127
Ratio Analysis
Liquidity Ratios
? Measure the ability of the firm to meet
its short-term financial obligations. Current Assets - Inventory Current Liabilities
Acid-Test Ratio =
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?
128
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
Acid-Test Ratio =
Current Assets - Inventory Current Liabilities
Acid-Test Ratio =
129
$1,230 -$625 = 2.63x $230
Liquidity indicates the speed with which assets can be turned into cash
Liquidity ratios: Current ratio Acid test = Current assets/Current liabilities = Current assets – Inventory Current liabilities
•
• •
Maturity matching example: Fixed assets such as PPE are seldom financed with liquid assets (short term debt) because the loans could come due before cash is available to pay CR compares the assets that will become cash within a year to the liabilities that must be paid within a year – high ratio = high liquidity Acid Test also called the Quick Ratio is a conservative liquidity ratio – inventory is frequently illiquid (can’t be sold easily)
Ratio Analysis
Debt Ratios
? Measure the relative size of the firm’s debt
load and the firm’s ability to pay off the debt. financed by debt?
? What percent of the firm’s assets are ? The reciprocal is the percent of assets
financed by equity.
131
Ratio Analysis
Debt Ratios
Total Debt Total Assets
Debt Ratio =
What proportion of the firm’s assets is financed with debt?
132
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
Debt Ratio =
Total Debt Total Assets
Debt Ratio =
133
$230 + $600 $2,530
= 33%
Ratio Analysis
Debt Ratios
long term debt + value of leases Debt equity ratio = equity
What is the proportion of debt relative to equity financing for the firm?
134
Ratio Analysis
Debt Ratios
Times Interest Earned Ratio =
Operating Income Interest Expense
What is the firm’s ability to repay interest payments from its operating income?
135
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 Income Statement Total Liabilities and Excalibur Owners Equity $2,530 Sales Corporation $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Times Operating Income Operating Income $330 Interest = Interest Expense Interest Expense 60 Earned Ratio Income Before Taxes $270 Taxes (40%) 108 $330 Net Income $162
TIE Ratio =
$60
= 5.50x
136
Coverage ratios indicate financial burden on the company
Coverage ratios: Times interest earned Times burden covered = Earnings before interest and taxes/Interest expense = Earnings before interest and taxes Interest expense + Principal payments/(1 – Tax rate)
•
• • •
•
Ultimately it doesn’t matter how much debt is carried (relative to assets and equity) as long as the annual payments can be met (e.g. junk bonds) Consistency of cash flow indicates higher ability to carry debt Coverage should increase with business risk TIE is the ability to use earnings the company generates for interest payments (how many times more earnings are there than payment requirements?) TBC simply adds in the amount of debt that needs to be repaid in the current period (companies typically try to avoid repayment by establishing revolving credit lines or issuing new debt before old debt expires)
Market Value ratios indicate value tied up in the company because book values are historical
Leverage and liquidity ratios: Debt to assets (market value) Debt to equity (market value)
= Total liabilities/No. of shares of stock x Price per share = Total liabilities No. of shares of stock x Price per share + Total liabilities
• • • •
Market value ratios can be thought of as coverage ratios extended over many periods Today’s value of expected future income compared to today’s value of expected future financial burden Seldom used due in part to volatility of market values Ignore debt rollover risk (if company can’t renew debt)
Ratio Analysis
Asset Activity Ratios
? Help assess how effectively the firm is using
assets to generate sales. ? Help asses how efficient the firm is in converting its current assets into cash
139
Ratio Analysis
Asset Activity Ratios
Accounts Receivable Avg. Daily Credit Sales
Average Collection Period =
How long does it take for the firm on average to collect its credit sales from customers?
140
Additional Info: We assume all sales are credit sales.
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 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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income 875 $575 45 200 $330 60 $270 108 $162
Average Accounts Receivable Collection = Avg. Daily Credit Sales Period ACP = $430 $1,450/365 = 108.24 days
Days in a year
141
Ratio Analysis
Asset Activity Ratios
COGS Inventory
Inventory Turnover Ratio =
Is inventory efficiently translating into cost of goods sold for the firm?
How many times is the company turning its inventory over?
142
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 Income Statement Excalibur Corporation Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Sales $1,450 Owners Equity $2,530 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Inventory Operating Income $330 COGS Interest Expense 60 Turnover = Inventory Income Before Taxes $270 Ratio Taxes (40%) 108 Net Income $162
Inventory Turnover =
143
$875 $625
= 1.4x
Ratio Analysis
Asset Activity Ratios
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?
144
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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income
145
875 $575 45 200 $330 60 $270 108 $162
Fixed Asset Turnover Ratio
=
Sales Net Fixed Assets $1,450 = 1.12x $1,300
Fixed Asset Turnover =
Turnover control ratios eliminate sales induced changes as a confounding variable of performance
Turnover control ratios: Inventory turnover Collection period Days’ sales in cash Payables period
= Cost of goods sold/Ending inventory = Accounts receivable/Credit sales per day (If credit sales unavailable, use sales.) = Cash and securities/Sales per day = Accounts payable/Credit purchases per day (If purchases unavailable, use cost of goods sold.)
? I T indicates how many times each year inventory is entirely moved
146
out of the company ? C P indicates how many days it takes to collect on invoices (time lag between sale and receipt of cash OR how much money is tied up in accounts receivable) ? DSC indicates level of liquidity that the company has to facilitate day to day transactions ? P P is the opposite of C P – how many days before they pay their bills in accounts payable (note COGS differs from credit purchases with changes in inventory, depreciation charges, and other
Ratio Analysis
Asset Activity Ratios
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?
147
Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $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
148
Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530
Total Asset Turnover = Ratio Total Asset Turnover =
Sales Total Assets $1,450 $2,530
= 0.57x
Ratio Analysis
Market Value Ratios
Price to Earnings Ratio =
Market Price per Share Earnings per Share
How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.)
149
Additional Info: 100 shares $20.00 per share
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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income 875 $575 45 200 $330 60 $270 108 $162
P/E = Market Price/Share Ratio EPS
P/E ratio =
$20.00 = 12.35x $162/100
150
Leverage Ratios
long term debt Long term debt ratio = long term debt + equity
long term debt + value of leases Debt equity ratio = equity
151
Leverage Ratios
Total debt ratio = total liabilitie s total assets
Times interest earned =
EBIT interest payments
EBIT + depreciati on Cash coverage ratio = interest payments
152
Liquidity Ratios
Net workin g capital Net workin g capital = to total assets ratio Total assets
currentassets Current ratio = currentliabilitie s
153
Liquidity Ratios
Quick ratio = cash + marketable securities + receivables currentliabilitie s
cash + marketable securities Cash ratio = currentliabilitie s
cash + marketable securities + receivable s Interval measure = average daily expenditur es from operations
154
Efficiency Ratios
155
Efficiency Ratios
156
Profitability Ratios
157
Profitability Ratios
dividends Payout ratio = earnings
earnings - dividends Plowback ratio = earnings = 1 - payout ratio
earnings - dividends Growth in equity from plowback = earnings
158
Market Value Ratios
PE Ratio = stock price earnings per share
P0 Div 1 1 Forecasted PE ratio = = x aveEPS 1 EPS1 r - g
dividend per share Dividend yield = stock price
159
Market Value Ratios
Price per share = P0
Div 1 = r - g
stock price Market to book ratio = book value per share
m arket value of assets Tobins Q = estim ated replcem ent cost
160
The DuPont System
? A breakdown of ROE and ROA into component
ratios
EBIT - taxes ROA = assets EBIT - tax - interest ROE = equity
161
The DuPont System
sales EBIT - taxes ROA = x assets sales
asset turnover
profit margin
162
The DuPont System
assets sales EBIT - taxes EBIT - taxes - interest ROE = x x x equity assets sales EBIT - taxes
leverage asset profit ratio turnover margin
debt burden
163
T3.11 The Du Pont Identity (concluded)
164
Industry Comparisons
? Comparing a ratio for one company with the
same ratio for other companies in the same industry ? Benchmarking – allows you to put the value of a firm’s ratio in the context of its industry
165
Trend Analysis
? Comparing a ratio for one year with the same
ratio for other years ? Helps see whether a company’s financial situation is improving or worsening.
166
Operating Flows
Investment Flows
Labor
Accrued Wages
Fixed Assets
RM
A/cs Payable
Business Interests
WIP
Overhead Expenses
F.G.
Cash & Marketable Securities Financing Flows Debt (ST/ LT)
Other Op. Exp. & Interest Taxes
Sales
A/cs receivable
Equity
167
doc_749776944.pptx
explains what information does a balance sheet provide, what are the limitations of balance sheet, what are various constituents of balance sheet. It also include income statement terminology. How financial ratio analysis helps managers assess the firm’s health. What information does ratio like profitability, liquidity, debt, asset activity, and market value ratios provide.
Analysis of Financial Statements
1
The Firm’s Financial Statements
? What are the Questions to be Answered in a
firm’s financial statements?
2
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm?
3
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm? ? How did the firm raise funds to finance these assets?
4
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm? ? How did the firm raise funds to finance these assets? ? How profitable are these assets?
5
The Firm’s Financial Statements
? Questions to be Answered ? How Valuable are assets of a firm? ? How did the firm raise funds to finance these assets? ? How profitable are these assets? ? How much uncertainty is embedded in these assets?
6
The Firm’s Financial Statements
? Accountants would answer these questions
differently than a MBA doing financial analysis ? Difference is in the objectives:
7
The Firm’s Financial Statements
? Accountants would answer these questions
differently than a MBA doing financial analysis ? Difference is in the objectives:
? Accountants try to measure the current standing &
immediate past performance ? MBA does financial analysis forward looking
8
Using Financial Statement Information
Why evaluate Financial Statements?
? Internal Uses
? Allocate capital by division
? Measure and reward performance ? External Uses ? Extend trade credit to customers
? Investor Community Ratio Analysis
? Banks requiring loan covenants ? Competitor Analysis ? Valuing a target in an acquisition ? Benchmarks ? Year on year ? Peer group
9
Using Financial Statement Information
Problems with Financial Statement Analysis
? The need for theory
? There is no compelling rationale for use of financial statement to
make judgements about value and risk. ? Which ratios matter most? ? What is the “right” value for the ratio
? Conglomerates ? Not identified in a single industry or sector ? Hard to find comparables ? Global reach ? Comparability of financial statements between countries
10
The Firm’s Financial Statements
?
Annual report includes:
? Balance sheet ? Income statement
? Statement of cash flows
? Statement of Retained Earnings
11
The Firm’s Financial Statements
? What information does a Balance Sheet provide?
12
The Firm’s Financial Statements
? Balance Sheet –
? summarizes assets & liabilities owned by a firm – value
of assets & ? mix of financing debt & equity to finance these assets up to a point of time.
13
What does the balance sheet tell us?
? In theory the balance sheet of a private limited company or a public limited
?
? ? ?
company should be able to tell us all about the company’s financial structure, and liquidity, the extent to which its assets and liabilities are held in cash or in a near cash form (for example, bank accounts and deposits). It should also tell us about the assets held by the company, the proportion of current assets and the extent to which they may be used to meet current obligations. An element of caution should be noted in analysing balance sheet information. The balance sheet is an historical document. It may have looked entirely different six months or a year ago, or even one week ago. There is not always consistency between the information included in one company’s balance sheet with that
14
Balance sheet limitations
? There are limitations to the conventional balance
sheet arising not only from the fact that it is an historical document, but from inconsistencies in its preparation between companies and industries, the employment of various asset valuation methods, offbalance sheet financing, and window dressing.
15
Balance Sheet
? Provides a firm’s financial position at a specific point
in time ? Assets are resources owned by the firm ? Liabilities and owner’s equity indicate how those resources are financed Total Assets =
Liabilities (debt) + Shareholder’s Equity
Or…A= L+OE
16
Balance Sheet Terminology
? Current assets or gross working capital comprise
assets that are relatively liquid, or expected to be converted into cash within 12 months. ? Current assets typically include:
? Cash
? Accounts Receivable
payments due from customers who buy on credit
? Inventory
raw materials, work in process, and finished goods held for eventual sale
? Other expenses
Prepaid expenses are those items paid for in advance
17
Balance Sheet Terminology
? Fixed Assets – Assets held for more than one year.
Typically Include:
? Machinery and equipment ? Buildings ? Land
? Other Assets – Assets that are not current assets
or fixed assets
? Patents
? Copyrights ? Goodwill
18
Balance Sheet Terminology
? Debt (Liabilities) ? Money that has been borrowed and must be repaid at some predetermined date ? Debt Capital
? financing provided by a creditor ? Current or short-term debt and long-term debt ? Current or short-term must be repaid within the next 12
months
19
Balance Sheet Terminology
? Current Liabilities: ? Accounts payable
? Credit extended by suppliers to a firm when it purchases
inventories
? Accrued expenses
? Short term liabilities incurred in the firm’s operations but not yet
paid for
? Short-term notes
? Borrowings from a bank or lending institution due and payable
within 12 months
? Long-Term Debt
? Loans from banks or other institutions for longer than 12 months
20
Balance Sheet Terminology
? Equity
? Includes the shareholder’s investment ? Preferred stock ? Common stock
? Treasury Stock ? stock that was once outstanding and has been re-purchased by the company
? Retained Earnings ? cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years
21
Balance Sheet
? ASSETS ? Current Assets ? Fixed Assets ? Total Assets ? LIABILITIES ? Current Liabilities ? Long-Term Liabilities ? Total Liabilities
? OWNER’S EQUITY ? Preferred Stock ? Common Stock ? Retained earnings ? Total Owner’s Equity
? Total liabilities + OE
22
The Firm’s Financial Statements
? Balance Sheet (as of a point in time)
Assets = Liabilities + Owners’ Equity
Current Assets Cash Inventory A/R Current Liabilities A/P Accruals S-T Debt
Owners’ Equity Common Stock Capital in Excess of Par Retained Earnings
Fixed Assets Long Term Liabilities Land Bonds Plant L-T Bank Debt Equipment Mortgages Less: Accum. Dep. 23
Executive Paper
Executive Paper Balacne Sheet Dec 1998 Assets Current Assets Cash & Sec urities Rec eivables Inventory Total Fixed Assets P, P, E ac c um Depr Net Fixed Assets
24
Dec 1999
diff
75.0 433.1 339.9 848.0
110.0 440.0 350.0 900.0
35.0 6.9 10.1 52.0
929.5 396.7 532.8 1,380.8
100.0 450.0 550.0 1,450.0
- 829.5 53.3 17.2 69.2
Total Assets
Executive Paper
Executive Paper Balacne Sheet Dec 1998 Liabilities and Equity Current Liabilities Debt due in 1 year 96.6 Payable 349.9 Total c urrent liabilities 446.5 Long term debt Shareholders equity 425.0 509.3 Dec 1999
diff
100.0 360.0 460.0 450.0 540.0 1,450.0
3.4 10.1 13.5 25.0 30.7 69.2
25
Total liabilities and equity 1,380.8
Executive Paper
Executive Paper - Other Data Market value of equity Average number of shares, millions Share price, dollars
1998 598 14.16 42.25
1999 708 14.16 50
26
?Balance Sheet
ACME CORPORATION
2005
2006 10,000,000 1,000,000 10,000,000 8,000,000 1,000,000 30,000,000 28,000,000 (8,000,000) 20,000,000 50,000,000 Change 1,000,000 300,000 -7,300,000 -1,000,000 0 -7,000,000 14,000,000 -2,000,000 12,000,000 5,000,000
For the Year Ended December 31:
Assets: Cash 9,000,000 Accounts receivable 700,000 Inventory 17,300,000 Marketable Securities 9,000,000 Prepaid Expenses 1,000,000 Total current assets 37,000,000 Fixed Assets, Gross 14,000,000 less Accumulated Depr. (6,000,000) Fixed Assets, Net 8,000,000
27
Total assets
45,000,000
?Balance Sheet
ACME CORPORATION
2005
2006 4,000,000 3,000,000 2,000,000 9,000,000 15,000,000 24,000,000 1,000,000 3,000,000 12,000,000 10,000,000 25,000,000 26,000,000 Change -3,000,000 -1,000,000 -1,000,000 -5,000,000 4,216,000 -784,000 -1,000,000 2,000,000 2,000,000 2,784,000 6,784,000 5,784,000
For the Year Ended December 31:
Liabilities & Equity: Accounts Payable Notes payable Accrued Expenses Total current liabilities Long-term debt Total liabilities Preferred Stock Common stock Capital in Excess of Par Retained earnings Total common equity 28 Total equity 7,000,000 4,000,000 3,000,000 14,000,000 10,784,000 24,784,000 2,000,000 1,000,000 10,000,000 7,216,000 18,216,000 20,216,000
Balance Sheet
ACME CORPORATION
Year Ended December 31
Assets = Liabilities + Owner’s Equity
2005 Assets: Cash Accounts receivable Inventory Marketable Securities Prepaid Expenses Total current assets Fixed Assets, Gross less Accumulated Depr. Fixed Assets, Net Total assets 9,000,000 700,000 17,300,000 9,000,000 1,000,000 37,000,000 14,000,000 -6,000,000 8,000,000 2006 Change
2005
Liabilities & Equity: 10,000,000 1,000,000 1,000,000 300,000 Accounts Payable 7,000,000 10,000,000 -7,300,000 Notes payable 4,000,000 8,000,000 -1,000,000 Accrued Expenses 3,000,000 1,000,000 0 Total current liabilities 14,000,000 30,000,000 -7,000,000 Long-term debt 10,784,000 28,000,000 14,000,000 Total liabilities 24,784,000 -8,000,000 -2,000,000 Preferred Stock 2,000,000 20,000,000 12,000,000 Common stock 1,000,000 45,000,000 Capital in Excess 5,000,000 10,000,000 50,000,000 of Par Retained earnings 7,216,000 Total common equity 18,216,000 Total equity 20,216,000 Total liabilities & equity 45,000,000
2006
Change
4,000,000 3,000,000 2,000,000 9,000,000 15,000,000 24,000,000 1,000,000 3,000,000 12,000,000 10,000,000 25,000,000 26,000,000 50,000,000
-3,000,000 -1,000,000 -1,000,000 -5,000,000 4,216,000 -784,000 -1,000,000 2,000,000 2,000,000 2,784,000 6,784,000 5,784,000 5,000,000
29
The Firm’s Financial Statements
? When analyzing a firm - what are the questions to which
we would like to know the answers to?
? Investments already made ? Assets in place ? Investments yet to be made ? Growth assets ? Firm can either borrow the fund its need to make these
investments using debt or raise it from the owners
? The Debt and Equity of the Firm
30
The Firm’s Financial Statements
? Balance sheet analysis similar to accounting
Balance Sheet – key difference – explicitly consider growth assets ? Accounting statements allow us to acquire information but fall short in terms –
? of both timeliness and ? the way we measure asset value, earnings & risk
31
The Firm’s Financial Statements
? Assets in place ? What are they? ? What is its value? ? How risky are they? ? Growth Assets ? What are growth assets? ? How valuable? ? Debt ? What is the value of debt? ? How risky is the debt? ? Equity ? What is the value of the equity? ? How risky are they?
32
Asset Measurement
? It depends on
? Type of asset ? Value of the asset ? Degree of uncertainty
? What is an asset?
33
Asset Measurement
? What is an asset? ? Any resource that has potential to either generate
future cash inflows or reduce future outflows ? Further it has to be acquired in a prior transaction and be able to quantify future benefits with reasonable precision
34
Asset Measurement
? Accountants value Assets at historical cost or book
value – adjusted upward (improvement) and downward (aging) – because of their
? Abiding belief in book value as best estimate ? Distrust Market Value or Estimated Value – because
market prices are volatile and easily manipulated or if dependent on future expected cash flows its even more suspicious ? General preference for underestimation (Conservative)
35
Fixed Assets
? Historical cost or market value ? Reduction in value due to depreciation or aging of
asset ? Why is depreciation in annual reports different from tax statements?
36
Current Assets
? Amenable to market valuation including marketable
securities ? Stocks – valuation?
37
Current Assets
? Amenable to market valuation including marketable
securities ? Stocks – valued on LIFO/ FIFO/ Weighted Average ? In case of high inflation which method would the companies adopt? Why?
38
Current Assets
? Short Term Investments – categorized into
? Held to maturity – historical value – dividend / interest
as income ? Available for sale – market value – difference adjusted against equity ? Trading investment – market value – unrealized gain or loss posted in income statement
39
Investment
? Up to 20% of equity – minority passive investment –
valued at historical cost ? Between 20% to 50% - minority active investment – valued at historical value – adjust to proportionate of net income or loss. Dividends to reduce acquisition value. Market value not considered till liquidated ? Greater than 50% - consolidation of balance sheet – substitute balance with balance sheet (asset – liability)
40
Historical Value
? Not a good measure of current market value of assets –
assets age & macro-economic conditions change ? Current value of non-traded asset can be better estimated looking at the future cash flows the asset will generate ? Publicly traded assets – market value ? Where market value of assets available use market values
41
Growth Assets
? Intangible Assets – a measure of growth assets – a good
measure for those companies having such patents/ trademarks/ etc. ? Value of patent does not show up if internally generated ? Moreover if patent acquired at BV it does not provide any measure of value of growth that can be generated by the patent ? A vast number of companies have neither ideas nor products that can be patented, often are able to generate high growth and have growth assets
42
Growth Assets
? Goodwill – Value – at the time of Mergers
? Difference between MV & BV of assets in place ? Value of growth asset ? Premium for synergy
43
Mergers
? Pooling or accounts & Purchase accounts – either
have real effect on cash flows
? Goodwill amortization is tax deductible ? MV > BV – higher cash flows – use pooling ? Constraint in Debt / Dividend policy – tighter in case of
purchase due to goodwill amortization that would reduce the amount available for distribution
44
Liabilities
? Liabilities must meet the following criteria:
45
Liabilities
? Liabilities must meet the following criteria:
? Must lead to future cash outflow or loss of future cash
flow at some specified or predetermined time ? Firm cannot avoid the obligation ? Transaction has to have happened In addition, for outside liability ? Has to be tax deductible ? Failure to meet can lead to loss of control of the firm
46
Current Liability
? Valuation – Book Value
? Can Change - Only if the default risk has
changed dramatically
47
Long Term Debt
? Bank/ Institution – Book Value
? Corporate Debt Issue – Market price
? At par – BV ? At Discount – amortize the difference over the life of the
corporate bond ? BV is unaffected by the interest rate fluctuations – however the bond prices do change ? If debt retired before maturity – difference between BV and amount paid – gain or loss in Income statement
48
Forex Debt
? Adjust Book Value for forex changes
49
Other Long term Liabilities
? Lessors/ Pension Fund obligations/ deferred tax
liability/ etc. ? Lease – operating lease – operating expense deducted from Income statement ? Capital Lease – PV of future lease rentals as Liability and written down to the extent of the rentals every year. Can claim depreciation
50
Capital Lease
? Conditions (any one has to be met)
51
Capital Lease
? Conditions (any one has to be met)
? Lease period should exceed 75% of the life of asset ? Transfer of ownership at the end of the lease term ? Option to purchase the asset at a “bargain price”
? PV of lease payments > 90% of the fair market value
of the asset
52
Pension Funds
? Check whether overfunded or underfunded ? If under-funded make provisions for the difference
53
Deferred Tax
? Calculations as per AS22 ? Doubt – whether a real liability –as the firm owes no
one that amount ? Thus resulting in the firm looking a lot riskier. ? Then why make these provisions?
54
Deferred Tax
? Calculations as per AS22 ? Doubt – whether a real liability –as the firm owes no
one that amount ? Thus resulting in the firm looking a lot riskier. ? Then why make these provisions? ? Conservative approach
55
Preferred Stock
? A hybrid instrument
? The failure to pay dividend does not lead to
bankruptcy
56
Some lacunae
? Most balance sheets do not report outstanding
Warrants and Equity Options issued but not exercised ? Also convertible bonds – the equity portion not considered in equity
57
The Firm’s Financial Statements
?
Annual report includes:
? Balance sheet ? Income statement ? Statement of cash flows
58
The Firm’s Financial Statements
? Income Statement?
59
The Firm’s Financial Statements
? Income Statement – provides
information regarding revenues and expenses of the firm and resulting profit during a particular period
60
Income Statement Terminology
? Revenue (Sales)
? Money derived from selling the company’s product or service
? Cost of Goods Sold (COGS)
? The cost of producing or acquiring the goods or services to be sold
? Operating Expenses
? Expenses related to marketing and distributing the product or service
and administering the business
? Financing Costs
? The interest paid to creditors and the dividends paid to preferred
stockholders
? Tax Expenses
? Amount of taxes owed, based upon taxable income
61
Income Statement
Sales
Less cost of goods sold
= Gross profit
Less operating expenses
= Operating income
Less interest expense
= Earnings before taxes
Less corporate taxes
= Earnings before preferred dividends
Less preferred stock dividends
= Net income available to common stockholders
62
Terms
? Net Working Capital Current assets – current liabilities ? Debt Ratio Percentage of debt a firm uses to finance its assets ? Accrual Basis Accounting Recording revenues when earned and expenses when incurred, rather than when cash is exchanged ? Free Cash Flows Cash flow that is free and available to be distributed to the firm’s investors.
63
Free Cash Flows
Free cash flows: (After-tax cashflows from operations) Less (Increase or decrease in net working capital) Less (Increase or decrease in gross fixed assets)
64
Traditional Statement of Cash Flows
? Three sections:
? Cash flows from Operating Activities ? Cash flows from Investing Activities
? Cash flows from Financing Activities
65
After-Tax Cash Flows From Operations
Operating Income (EBIT) + Depreciation - Income tax expense = After-tax cash flows from operations
66
Change in Operating Working Capital
Change in operating working capital = (change in current assets) (change in current liabilities)
67
Compute the Change in Fixed Assets
? The final step involves computing the change in
Gross Fixed Assets (not net Fixed Assets)
68
Financing Cash Flows
A firm can either receive money from or distribute money to its investors. The firm can: 1. Pay interest to lenders 2. Pay dividends to stockholders 3. Increase or decrease in long-term debt 4. Issue stock to new shareholders or repurchase stock from current shareholders
69
The Firm’s Financial Statements
?Income Statement (covers a period of time)
Revenues - Expenses = Net Income
Sales Investment Income Gains Interest Received Dividends Received COGS Salaries Depreciation Exp. Taxes Other Expenses Interest Paid
70
The Firm’s Financial Statements
? Income Statement Revenues - Expenses = Net Income
Retained Earnings
Dividends
71
Executive Paper
Executiv e Paper Income Statement (1999)
Revenues Costs Deprec iation EBIT Interest T ax Net income Dividend Retained earnings Earnings per share, dollars Dividend per share, dollars
$ millions 2,200.00 1,980.00 53.30 166.70 42.50 49.70 74.50 43.80 30.70 5.26 3.09
72
Income Statement
Net Sales Cost of goods sold Gross profit Depreciation S&A Expenses Operating Income (EBIT) Interest expense Income before taxes Income taxes (40%)
ACME CORPORATION
15,000,000 5,000,000 10,000,000 2,000,000 800,000 7,200,000 1,710,000 5,490,000 2,196,000 3,294,000
For the Year Ended December 31, 2006
Net income
73
Income Statement
? The questions it should answer are?
74
Income Statement
? The questions it should answer are?
? How profitable is the firm? ? What the firm earn on its assets in place?
75
Income Statement
? It is the measure of the earnings from assets in
place
? It follows 2 guiding principles
? Accrual Accounting ? Classification of expenses
76
Revenue Recognition & Matching Principle
? When is the revenue recognized?
77
Revenue Recognition & Matching Principle
? When is the revenue recognized? ? The services for which it is getting paid has been
performed in full or substantially for which it received cash or receivable that is observable and measureable.
78
Revenue Recognition & Matching Principle
? Complication/ exception?
79
Revenue Recognition & Matching Principle
? Complication/ exception? ? Long term contracts – where revenue is recognized
on a percentage completion basis ? In case there is uncertainty about the capacity of the buyer of the services, the firm may recognize the revenue only when it received payment
80
Operating Expenses
? They reflect those expenses that create revenue
in the given period ? 2 exceptions?
81
Operating Expenses
? They reflect those expenses that create revenue
in the given period ? 2 exceptions?
? Depreciation/ amortization ? R&D expenses which benefit over a number of
years
82
EBITDA
?
?
?
Earnings before interest, taxes, depreciation and amortization Represents revenues minus cash expenses from operations Used by financial analysts to approximate the amount of cash flow generated by the daily operations of a business
83
Depreciation
?
?
?
Accounting depreciation is the allocation of an asset’s initial cost over time. Book value is Asset Cost minus Depreciation Book Value does not equal Market Value
Allowable depreciation expense is determined by established accounting rules – Straight Line Method or Written Down Method
?
84
Calculation of Depreciation
? Depreciable basis ? Total amount to be depreciated over the accounting life of the asset. ? Equal to cost of the asset plus any setup and delivery costs incurred. ? Straight line depreciation –used per books ? Basis divided by accounting life with equal amounts of depreciation allocated to each time period.
85
R&D Expenses
? Adjust income to reflect the research expenses ? Adjusted operating income = Operating Income +
R&D Expenses – Amortization of R&D Asset ? However, amortization of R&D expenses are not tax deductible, as they are written off in the year of expenditure as per Income Tax
86
Non Recurring Items
? Unusual or infrequent items
? Extra-ordinary items
87
Non Recurring Items
? Unusual or infrequent items
? gain/ loss from asset sale; write-offs; restructuring
expenses
? Extra-ordinary items
? Marketable securities – loss or gain
88
The Firm’s Financial Statements
?
Annual report includes:
? Balance sheet ? Income statement ? Statement of cash flows
89
The Firm’s Financial Statements
? Cash flow Statement – specifies
sources of cash to the firm from both operations & new financing and uses of this cash during a period ? An attempt to explain how much the cash flows were during a period & why the cash balance changed during the period
90
The Firm’s Financial Statements
? Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash
From Operations:
Net Income +Incr/-Decr Accts Payable +Depreciation Exp. +Incr/-Decr Accrued Exp -Incr/+Decr of A/R -Incr/+Decr of Inventory -Incr/+Decr of Prepaids
91
The Firm’s Financial Statements
? Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash
From Investing:
+Sale of Fixed Assets -Purchase of fixed assets +Sale of Securities -Purchase of other firms -Purchase of Securities
92
The Firm’s Financial Statements
? Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash
From Financing:
+Sale of stock +Issue of LT debt or notes payable -Buy back stock -Repay LT debt -Pay dividends
93
Learning Objectives
?
?
?
?
How financial ratio analysis helps managers assess the firm’s health. Compute profitability, liquidity, debt, asset activity, and market value ratios. Compare financial information over time (trends) and among companies (benchmarking). Look at sources of financial information
94
Things to Consider When Using Financial Ratios
? What aspect of the firm or its operations are we attempting to
analyze? ? Firm performance can be measured along “dimensions”
? What goes into a particular ratio?
? Historical cost? Market values? Accounting conventions? ? What is the unit of measurement? ? Dollars? Days? Turns? ? What would a desirable ratio value be? What is the benchmark? ? Time-series analysis? Cross-sectional analysis?
95
Ratios – the connection between operating decisions and financial performance
? Operating decisions are levers by which
management controls financial performance ? Consider ratios in relationship to financial statements
? balance sheet = current and long term assets and liabilities
(asset management and financing decisions) ? Income statement = cost to generate sales (profitability)
? Ratio Analysis is relative – depends on the
perspective of the analyst
? Rule of thumb comparison ? Industry comparison ? Trend analysis – changes over time
96
Categories of Financial Ratios
? Short-Term Solvency, or Liquidity ? Ability to pay bills in the short-run ? Long-Term Solvency, or Financial Leverage
? Ability to meet long-term obligations
? Asset Management, or Turnover ? Intensity and efficiency of asset use ? Profitability
? The ability to control expenses
? Market Value ? Going beyond financial statements
97
Ratio Analysis
Five Categories of Ratios
? Profitability ratios ? Liquidity ratios ? Debt ratios ? Asset activity ratios ? Market value ratios
98
Ratio Analysis
Profitability Ratios
? Measure the overall effectiveness of the firm’s
management.
? Measures how the firm’s returns compare with its
sales, asset investments and equity
? Income statement gives how profitable the firm is
in absolute terms. For comparison we need to gauge it on % returns
99
Ratio Analysis
Profitability Ratios
Gross Profit Margin =
Gross Profit Sales
How effective is the firm at generating revenue in excess of its cost of goods sold?
100
Balance Sheet Excalibur Corporation Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $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
101
Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Bonds $600 Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530
Gross Profit Margin
=
Gross Profit Sales
$575 $1,450
Gross Profit Margin =
= 39.7%
Ratio Analysis
Profitability Ratios
Operating Profit Margin =
Operating Income Sales
How effective is the firm in keeping costs of production and operating expenses low?
102
How much profit am I earning just from the basic operations of my business. Excludes other income such as interest, dividends, etc.
Balance Sheet Excalibur Corporation Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $2,530 Income Statement Excalibur Corporation Sales Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income
103
$1,450 875 $575 45 200 $330 60 $270 108 $162
Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530
Operating Operating Income Profit = Sales Margin Oper. Profit Margin = $330 $1,450 = 22.8%
Ratio Analysis
Profitability Ratios
Note: Net Income increases Retained Earnings. Dividends, either preferred or common, are paid out of retained earnings Net Income Net Profit Margin = Sales How much net profit is being generated from each dollar of sales?
104
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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income
105
875 $575 45 200 $330 60 $270 108 $162
Net Profit Margin
=
Net Income Sales
$162 $1,450 = 11.2%
Net Profit Margin =
Ratio Analysis
Profitability Ratios
EBIT - tax Return on assets = average total assets
How effectively is the firm generating net income from its assets ? How much income each dollar of assets produces. ?Individual Assignment – July 1, 2007 Is ROA different from Return on Capital Employed (ROCE) or Return on Invested Capital (ROIC)?
106
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 Income Statement Owners Equity $2,530 Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Net Income Return on Depreciation 200 = Operating Income $330 Total Assets Assets Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 $162 = 6.4% Net Income% $162
107
ROA =
$2,530
Ratio Analysis
Profitability Ratios
Return on Equity = Net Income Common Equity
How well is the firm generating return to its equity providers; the common stockholders?
How many dollars of income for each dollar invested in the company.
108
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 Income Statement Total Owners’ Equity $1,700 Excalibur Corporation Total Liabilities and Owners Equity $2,530 Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Return on Equity = Net Income Common Equity Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 $162 Net Income $162
ROE =
109
$1,700
= 9.53%
ROCE and ROE
? ROE = PAT / BV of Equity
?
D ROE ? ROCE ? ?ROCE ? i ?1 ? t ?? ROCE = EBIT (1-t) / BV of Debt & Equity E
? D/E = BV Debt / BV Equity ? i = Interest rate ? t = Tax rate ? Individual Assignment – July 1, 2007
? Derive the above equation ROE = ROCE + ….
110
Three Determinants of Return on Equity (ROE)
Profitability ratios: Return on equity = Net income/Shareholders’ equity
? ROE measures “return per buck” ? Three operating levers for controlling ROE: ? Profit margin: earnings squeezed out of each dollar of
sales ? Asset turnover: sales generated for each dollar of assets ? Financial leverage: amount of equity used to finance the assets
? ROE = Profit Margin x Asset Turnover x Financial Leverage
111
Profit Margin and other indicators of profitability
Profitability ratios: Profit margin = Net income/Sales Gross margin = Gross profit/Sales Return on assets = Net income/Assets
?
Profit Margin: ? reflects pricing strategy and ability to control costs ? Tends to vary inversely with asset turnover ? Increases when company adds significant value to product (requires more assets so lower asset turn
? Gross Margin: ? Helps distinguish between fixed and variable costs (assuming most COGS are variable while other operating costs are fixed) ? Indicates susceptibility to decline in sales ? Return on Assets: ? Efficiency of management’s allocation of resources ? Measures profit as percentage of money provided by owners and creditors (where ROE only measures profit on money provided by owners
112
Asset Turnover indicate the relative importance and availability of assets in managing profitability
Turnover control ratios: Asset turnover = Sales/Assets Fixed-asset turnover = Sales/Net property, plant, and equipment
? Asset turnover ? Low AT indicates a capital intensive business and vice versa ? Performance improves as AT rises (other things constant)
? Can be critical indicator of success when products are similar
? Fixed AT indicates susceptibility to decline in sales or
payments (investment in CA or NWC can rise rapidly) ? Conversely, CA can be a source of cash if needed
113
“Balance Sheet Ratios” compare debt to assets and equity
Leverage ratios: Assets to equity Debt to assets Debt to equity = Assets/Shareholders’ equity = Total liabilities/Assets
(Interest-bearing debt is often substituted for of total liabilities.)
= Total liabilities/Shareholders’ equity
? A to E indicates how much of the assets are owned (vs.
borrowed) ? Unlike profitability and asset turnover, more is not necessarily better (costs associated with debt financing). ? Nature of business and types of assets influence appropriateness of financial leverage decisions
? ROA and financial leverage tend to be inversely related
? D to A is the % of asset book value that comes from creditors ? D to E is different way of saying the same thing: how much of
114
every dollar owned by the company is supplied by creditors vs. owners
Three Problems with Return on Equity (ROE)
Return on equity = Net income/Shareholders’ equity = Profit Margin x Asset Turnover x Financial Leverage
? Timing problem ? ROE is backward looking and focused on a single period ? Risk Problem ? ROE says nothing about how much risk a company has engaged in to generate the return ? Value Problem ? Most ratios use book value, but investors are more concerned about market value because that measure current realizable worth of their shares
115
Ratios that attempt to adjust for risk and value problems
Profitability ratios: Return on = Earnings before interest and taxes x (1 – Tax rate) invested capital Interest-bearing debt + Shareholders’ equity Price to earnings = Price per share/Earnings per share
? ROIC eliminates the distorting effect of leverage (debt)
? Also known as return on net assets ? “rate of return earned on the total capital invested in the business
without regard to whether its debt or equity ? Reflects the companies fundamental earning power without regard to different financing strategies
? PE Ratio
? Gives little insight on performance of company but is widely used ? Basically the price of $1 of current earnings, normalizes companies ? Dependent on 1) future earning prospect 2) risk associated with
those earnings
116
ROCE
? ROCE = EBIT (1-t) / BV of Debt & Equity
? ROCE = (EBIT (1-t) / Sales) x (Sales/ BV Debt +
Equity) ? ROCE = Operating margin x Capital Turnover ? To maximize ROCE, you either increase operating margins or increase Capital turnover ? There could be constraints of competition or technology
117
Accountant’s Measure profitability
? Do they provide us with good measures of earnings
of firm’s assets in place? ? Are ROE & ROCE reasonable estimates of returns made on the investments?
118
Accountant’s Measure profitability
? Do they provide us with good measures of earnings
of firm’s assets in place? ? Are ROE & ROCE reasonable estimates of returns made on the investments? ? Though invaluable, from analytical perspective however, components of it are misleading and incomplete.
119
Accountant’s Measure profitability
? Key Problems
? Accrual Accounting – different from cash earning.
Depreciation, inventory, accounts receivables and payables to be adjusted to arrive at cash earnings ? Cash Flow statement – does give us valuable information about capex, acquisition cost and other financing actions during the period. Its objective is not to estimate the cash earnings of the firm
120
Accountant’s Measure profitability
? Key Problems
? Operating, Financial and Capital Expenditure
classification – though reasonable rationale – 2 problems
? Rigidity with which capex is written off. Accounting depreciation
almost never equals economic depreciation ? Inconsistency in application – R&D expenses
121
Accountant’s Measure profitability
? Key Problems
? Measuring returns – to the extent the book value
estimates are outdated and do not reflect the true market value of the asset in place, the return estimates are likely to be misleading ? Inconsistency in accounting can have an impact – buyback of shares
122
Measuring Risk
? How risky are the investments the firm has made
over time? ? How much risk do equity investors in firm face? ? Accounting statements do not really claim to measure or quantify risk in a systematic way
123
Measuring Risk
? To a certain extent accounting statements and ratios do
attempt to measure risk ? 2 common themes
? Risk of default – risk that a fixed obligation will not be met.
The broader equity notion of risk – variance of actual return over expected – is ignored ? Static view of risk – looking at a firm’s capacity at point in time to meet its obligation – ratios – based on one period’s income statement & balance sheet
124
Accounting Measuring Risk
? Disclosures in the Notes to the Accounts ? Financial Ratios – Financial statements as a basis of
estimating financial ratios that measure profitability and risk and leverage
125
Ratio Analysis
Liquidity Ratios ? Measure the ability of the firm to meet its short-term financial obligations. ? Failure to pay can lead to bankruptcy.
Current Assets Current Liabilities
Current Ratio =
Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?
126
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
Current Ratio =
Current Assets Current Liabilities
Current Ratio = $1,230 = 5.35x $230
127
Ratio Analysis
Liquidity Ratios
? Measure the ability of the firm to meet
its short-term financial obligations. Current Assets - Inventory Current Liabilities
Acid-Test Ratio =
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?
128
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
Acid-Test Ratio =
Current Assets - Inventory Current Liabilities
Acid-Test Ratio =
129
$1,230 -$625 = 2.63x $230
Liquidity indicates the speed with which assets can be turned into cash
Liquidity ratios: Current ratio Acid test = Current assets/Current liabilities = Current assets – Inventory Current liabilities
•
• •
Maturity matching example: Fixed assets such as PPE are seldom financed with liquid assets (short term debt) because the loans could come due before cash is available to pay CR compares the assets that will become cash within a year to the liabilities that must be paid within a year – high ratio = high liquidity Acid Test also called the Quick Ratio is a conservative liquidity ratio – inventory is frequently illiquid (can’t be sold easily)
Ratio Analysis
Debt Ratios
? Measure the relative size of the firm’s debt
load and the firm’s ability to pay off the debt. financed by debt?
? What percent of the firm’s assets are ? The reciprocal is the percent of assets
financed by equity.
131
Ratio Analysis
Debt Ratios
Total Debt Total Assets
Debt Ratio =
What proportion of the firm’s assets is financed with debt?
132
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
Debt Ratio =
Total Debt Total Assets
Debt Ratio =
133
$230 + $600 $2,530
= 33%
Ratio Analysis
Debt Ratios
long term debt + value of leases Debt equity ratio = equity
What is the proportion of debt relative to equity financing for the firm?
134
Ratio Analysis
Debt Ratios
Times Interest Earned Ratio =
Operating Income Interest Expense
What is the firm’s ability to repay interest payments from its operating income?
135
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 Income Statement Total Liabilities and Excalibur Owners Equity $2,530 Sales Corporation $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Times Operating Income Operating Income $330 Interest = Interest Expense Interest Expense 60 Earned Ratio Income Before Taxes $270 Taxes (40%) 108 $330 Net Income $162
TIE Ratio =
$60
= 5.50x
136
Coverage ratios indicate financial burden on the company
Coverage ratios: Times interest earned Times burden covered = Earnings before interest and taxes/Interest expense = Earnings before interest and taxes Interest expense + Principal payments/(1 – Tax rate)
•
• • •
•
Ultimately it doesn’t matter how much debt is carried (relative to assets and equity) as long as the annual payments can be met (e.g. junk bonds) Consistency of cash flow indicates higher ability to carry debt Coverage should increase with business risk TIE is the ability to use earnings the company generates for interest payments (how many times more earnings are there than payment requirements?) TBC simply adds in the amount of debt that needs to be repaid in the current period (companies typically try to avoid repayment by establishing revolving credit lines or issuing new debt before old debt expires)
Market Value ratios indicate value tied up in the company because book values are historical
Leverage and liquidity ratios: Debt to assets (market value) Debt to equity (market value)
= Total liabilities/No. of shares of stock x Price per share = Total liabilities No. of shares of stock x Price per share + Total liabilities
• • • •
Market value ratios can be thought of as coverage ratios extended over many periods Today’s value of expected future income compared to today’s value of expected future financial burden Seldom used due in part to volatility of market values Ignore debt rollover risk (if company can’t renew debt)
Ratio Analysis
Asset Activity Ratios
? Help assess how effectively the firm is using
assets to generate sales. ? Help asses how efficient the firm is in converting its current assets into cash
139
Ratio Analysis
Asset Activity Ratios
Accounts Receivable Avg. Daily Credit Sales
Average Collection Period =
How long does it take for the firm on average to collect its credit sales from customers?
140
Additional Info: We assume all sales are credit sales.
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 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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income 875 $575 45 200 $330 60 $270 108 $162
Average Accounts Receivable Collection = Avg. Daily Credit Sales Period ACP = $430 $1,450/365 = 108.24 days
Days in a year
141
Ratio Analysis
Asset Activity Ratios
COGS Inventory
Inventory Turnover Ratio =
Is inventory efficiently translating into cost of goods sold for the firm?
How many times is the company turning its inventory over?
142
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 Income Statement Excalibur Corporation Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Sales $1,450 Owners Equity $2,530 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Inventory Operating Income $330 COGS Interest Expense 60 Turnover = Inventory Income Before Taxes $270 Ratio Taxes (40%) 108 Net Income $162
Inventory Turnover =
143
$875 $625
= 1.4x
Ratio Analysis
Asset Activity Ratios
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?
144
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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income
145
875 $575 45 200 $330 60 $270 108 $162
Fixed Asset Turnover Ratio
=
Sales Net Fixed Assets $1,450 = 1.12x $1,300
Fixed Asset Turnover =
Turnover control ratios eliminate sales induced changes as a confounding variable of performance
Turnover control ratios: Inventory turnover Collection period Days’ sales in cash Payables period
= Cost of goods sold/Ending inventory = Accounts receivable/Credit sales per day (If credit sales unavailable, use sales.) = Cash and securities/Sales per day = Accounts payable/Credit purchases per day (If purchases unavailable, use cost of goods sold.)
? I T indicates how many times each year inventory is entirely moved
146
out of the company ? C P indicates how many days it takes to collect on invoices (time lag between sale and receipt of cash OR how much money is tied up in accounts receivable) ? DSC indicates level of liquidity that the company has to facilitate day to day transactions ? P P is the opposite of C P – how many days before they pay their bills in accounts payable (note COGS differs from credit purchases with changes in inventory, depreciation charges, and other
Ratio Analysis
Asset Activity Ratios
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?
147
Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $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
148
Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owner’s Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530
Total Asset Turnover = Ratio Total Asset Turnover =
Sales Total Assets $1,450 $2,530
= 0.57x
Ratio Analysis
Market Value Ratios
Price to Earnings Ratio =
Market Price per Share Earnings per Share
How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.)
149
Additional Info: 100 shares $20.00 per share
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 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Cost of Goods Sold Gross Profit Operating Expenses Depreciation Operating Income Interest Expense Income Before Taxes Taxes (40%) Net Income 875 $575 45 200 $330 60 $270 108 $162
P/E = Market Price/Share Ratio EPS
P/E ratio =
$20.00 = 12.35x $162/100
150
Leverage Ratios
long term debt Long term debt ratio = long term debt + equity
long term debt + value of leases Debt equity ratio = equity
151
Leverage Ratios
Total debt ratio = total liabilitie s total assets
Times interest earned =
EBIT interest payments
EBIT + depreciati on Cash coverage ratio = interest payments
152
Liquidity Ratios
Net workin g capital Net workin g capital = to total assets ratio Total assets
currentassets Current ratio = currentliabilitie s
153
Liquidity Ratios
Quick ratio = cash + marketable securities + receivables currentliabilitie s
cash + marketable securities Cash ratio = currentliabilitie s
cash + marketable securities + receivable s Interval measure = average daily expenditur es from operations
154
Efficiency Ratios
155
Efficiency Ratios
156
Profitability Ratios
157
Profitability Ratios
dividends Payout ratio = earnings
earnings - dividends Plowback ratio = earnings = 1 - payout ratio
earnings - dividends Growth in equity from plowback = earnings
158
Market Value Ratios
PE Ratio = stock price earnings per share
P0 Div 1 1 Forecasted PE ratio = = x aveEPS 1 EPS1 r - g
dividend per share Dividend yield = stock price
159
Market Value Ratios
Price per share = P0
Div 1 = r - g
stock price Market to book ratio = book value per share
m arket value of assets Tobins Q = estim ated replcem ent cost
160
The DuPont System
? A breakdown of ROE and ROA into component
ratios
EBIT - taxes ROA = assets EBIT - tax - interest ROE = equity
161
The DuPont System
sales EBIT - taxes ROA = x assets sales
asset turnover
profit margin
162
The DuPont System
assets sales EBIT - taxes EBIT - taxes - interest ROE = x x x equity assets sales EBIT - taxes
leverage asset profit ratio turnover margin
debt burden
163
T3.11 The Du Pont Identity (concluded)
164
Industry Comparisons
? Comparing a ratio for one company with the
same ratio for other companies in the same industry ? Benchmarking – allows you to put the value of a firm’s ratio in the context of its industry
165
Trend Analysis
? Comparing a ratio for one year with the same
ratio for other years ? Helps see whether a company’s financial situation is improving or worsening.
166
Operating Flows
Investment Flows
Labor
Accrued Wages
Fixed Assets
RM
A/cs Payable
Business Interests
WIP
Overhead Expenses
F.G.
Cash & Marketable Securities Financing Flows Debt (ST/ LT)
Other Op. Exp. & Interest Taxes
Sales
A/cs receivable
Equity
167
doc_749776944.pptx