Lecture 9 Analysis of Financial Statements

Transcription

1 Topic: Lecture 9 Analysis of Financial Statements * This lecture is to discuss techniques used by investors and managers to analyze financial statements. Financial statement analysis involves: 1) comparing the firm s performance with that of other firms in the same industry 2) evaluating trends in the firm s financial position over time. From an investor s standpoint, predicting the future is what financial statement analysis is all about; from management s standpoint, financial statement analysis is to help improve the firm s conditions. Agenda: I. Financial statement analysis: 1. liquidity ratios 2. asset management ratios 3. debt management ratios 4. profitability ratios 5. market value ratios II. III. Combination of Ratios Ratio Analysis Limitations:

2 I. Financial statement analysis: ~ The analysis begins with the calculation of a set of financial ratios designed to reveal the relative strengths and weaknesses of a company as compared with others in the same industry. We may roughly divide financial ratios into five groups liquidity ratios, asset management ratios, debt management ratios, profitability ratios, and market value ratios. At the same time, by using historical ratios, managers may plot trends (called trend analysis) to improve firms performance. Liquidity ratios show the relationship of a firm s current assets to its current liabilities, and thus its ability to meet maturing debts. Asset management ratios measure how effectively a firm is managing its assets. Debt management ratios reveal: 1) the extend to which the firm is financed with debt 2) its likelihood of defaulting on its debt obligations. Profitability ratios show the combined effects of liquidity, asset management, and debt management policies on operating results. Market value ratios relate the firm s stock price to its earnings and book value per share, and they give management an indication of what investors think of the company s past performance and future prospects. 1

3 ~ Liquidity ratios: Current ratio = Current Assets / Current Liabilities i.e. Based on Allied Food B/S, Current Ratio = 1000 / 310 = 3.2 * Current assets usually include cash, marketable securities, A/R, and inventories. * This ratio is the best single indicator of extend to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly. It is the most commonly used measure of short-term solvency. * The higher the current ratio, the better the ability to meet short term liabilities. Quick (Acid test) Ratio = Current assets - Inventories / Current Liabilities i.e. Based on Allied Food B/S, Current Ratio = ( ) / 310 = 1.2 * Inventories are typically the least liquid of a firm s current assets. * This ratio shows the firm s ability to pay off short-term obligations without relying on the sale of inventories. Cash Flow Ratio = Cash flow from operation / Current Liabilities 2

4 ~ Asset Management Ratios: If a firm has too many assets, its cost of capital will be too high. Hence its profits will be depressed. On the other hand, if assets are too low, profitable sales will be lost. Therefore, it is important to use assets efficiently. Evaluating Inventory Management efficiency: Inventory turnover ratio = Annual Sales / Inventories i.e. Based on Allied Food B/S and I/S, Inventory turnover ratio = 3,000/ 615 = 4.9 * Inventory turnover ratio shows how fast a firm can turn its inventory into profit. The higher the turnover is, the more efficient the management of inventory asset tends to be. * If this ratio is too low, it indicates that the firm is holding excessive sticks of inventory. Days in Inventory = Average Inventory / Cost of sales per day Evaluating Receivables and Payables: Days Sales Outstanding (DSO, Days in Accounts Receivable) = Account Receivables / Average sales per day = Receivables / (Annual sales/ 360) i.e. Based on Allied Food B/S and I/S, DSO = 375/ (30000/360)= 45 days. * This ratio is also called the average collection period (ACP). It indicates that the average length of time that the firm must wait after making a sale before receiving cash. * The lower the DSO (or ACP), the better the A/R management. Days in Accounts payable = Accounts Payable / Average Sales per day Operating Cycle = Days in Inventory + Days Sales Outstanding (DSO) Cash conversion cycle = Operation cycle Days in Accounts payable 3

5 Evaluating Fixed Assets: Fixed Assets Turnover ratio = Sales / Net Fixed Assets Evaluating Total Assets: i.e. Based on Allied Food B/S, FA turnover ratio = 3,000 / 1,000 = 3 times * This ratio measures how effectively the firm uses its plant and equipment. * The higher the turnover, the better the fixed asset management. * We need to interpret this ratio carefully. Because in accounting, the fixed assets reflect the historical costs. Inflation may cause the value of fixed assets to be seriously understated. Total assets turnover ratio = Sales / Total assets i.e. Based on Allied Food B/S and I/S, TA turnover ratio = 3,000 / 2,000 = 1.5 times * This ratio measures the turnover of all the firm s assets. It indicates that how good the firm is able to generate sufficient sales given its total asset investment. * The Higher the TA turnover, the better the management of TA. 4

6 ~ Debt Management Ratios: Financial leverage means the use of debt financing. There are four major advantages of financial leverage: 1) Cost of debt is tax deductible. Hence the after-tax cost is low. 2) Cost of debt (K d ) is usually lower than cost of common equity ( K s or K e ), because interest payment is certain, and return on stocks is uncertain. 3) In good time, the firms earns more on investments financed with borrowed funds than it pays in interest, the return on the owners capital is magnified, or leveraged. 4) By raising funds through debt, stockholders can maintain control of a firm while limiting their investment. On the other hand, the major disadvantage is that, in bad time, when a firm can not earn enough to pay interest expenses of debt, the cost of debt will increase dramatically and the chance of bankruptcy become extremely high. In a nutshell, in the boom, high leverage firms will have higher earnings for shareholders; in the recession, high leverage firms will have lower earnings for shareholders. It means that firms with lower financial leverage are less risky than those with high financial leverage. If firms choose to use low financial leverage, they will have lower chance of bankruptcy in the recession, but they give up higher earnings in the boom. If firms choose to use high financial leverage, they will have high chance of bankruptcy in the recession, but they have higher earnings in the boom. Therefore, the choice of degree of leverage is the trade-off between earnings and bankruptcy cost. 5

7 Debt ratio = Total Debt / Total Assets Based on Allied Food B/S, Debt ratio = ( ) / 2,000 = 53.2% * Debt ratio measures the percentage of funds provided by creditors. * Creditors prefer lower debt ratio, because lower leverage implies lower chance of bankruptcy and lower chance of default. Shareholders prefer higher debt ratio, because higher leverage implies higher earnings to them. Times-interest-earned (TIE) ratio = EBIT / interest charges Based on Allied Food I/S, TIE ratio = / 88 = 3.2 times * TIE ratio measures the ability of the firm to meet its annual interest payment. The higher the TIE ratio is, the lower the chance of bankruptcy is. Financial leverage ratio = Total Assets / Common equity 6

8 ~ Profitability Ratios: Profit margin on sales = Net Income available to common stockholders / Sales Based on Allied Food I/S, Profit margin on sales = 113.5/3,000= 3.8% * It measures how much profit shareholders can get for per dollar sales. * A low profit margin on sales may be caused by financial strategies, because a firm with higher leverage needs to pay higher interest expenses. Thus, high leverage reduces the net income available to common stockholders. Basic earning power ratio (BEP)= EBIT / Total assets Based on Allied Food B/S and I/S, BEP= / 2,000 = 14.2%. * BEP measures the ability of the firm s assets to generate operating income. Usually, investors prefer high BEP to low BEP. Return on Total Assets (ROA) = Net income available to common stockholders / Total Assets Based on Allied Food B/S and I/S, ROA= / 2,000 = 5.7% * ROA measures a firm s ability to generate return given total assets. * A low ROA may indicate1) lower earning power and 2) high interest costs. Return on Common Equity (ROE) = Net income available to common stockholders / Common Equity Based on Allied Food B/S and I/S, ROE=113.5/896 = 12.7% * ROE measures the rate of return on common stockholders investment. 7

9 ~ Market Value Ratios: These ratios provide management an indication of what investors think of the company s past performance and future prospects. Price Earning (P/E) ratio = Price per share / Earnings per share Based on Allied Food B/S and I/S, P/E = 23/ 2.27 = 10.1 times * P/E shows the dollar amount investors will pay for $1 of current earnings. Thus, the higher the P/E is, the stronger the growth prospect is. * The lower the P/E, the higher the risk of the firm. Market /Book ratio = M/B = Market price per share / Book value per share Based on Allied Food I/S, M/B = 23/17.92 = 1.3 times. * M/B measures the dollar amount investors will pay for $1 of book value. The higher the M/B, the stronger the growth prospect is. * Book value per share = Common Equity / Share outstanding Based on Allied Food I/S, BVPS = 896/50 = $

10 II. Combination of Ratios ROA = Profit margin Total assets turnover = [NI available to shareholders / Sales] [Sales / Total assets] = NI available to shareholders / Total assets. Based on Allied Food B/S and I/S, ROA = 3.8% * 1.5 = 5.7% ROE = ROA Equity Multiplier = Profit margin Total assets turnover Equity Multiplier = [ NI available to shareholders / Sales ] [Sales / Total assets] [Total assets / Common equity] = NI available to shareholders / Common equity. Based on Allied Food B/S and I/S, ROE = 3.8% * 1.5 * 2.23 = 12.7% * Total assets = Total Debt + Common Equity. Given Equity multiplier, we may figure out the Debt ratio ( D / TA). By the same token, Given Debt ratio, we can find equity multiplier. i.e. Equity Multiplier =TA / CE = It means that if CE is 1, then TA is So: D = TA - CE = = Debt ratio = D / TA = 1.23 / 2.23 = 55.16% * Comparative Ratios and Benchmarking: Benchmarking is the process of comparing a particular company with a group of Benchmark companies. Usually, benchmark companies are the leading companies in the particular industry. By this benchmark comparison, a firm can easily see exactly where it stands relative to its competition. 9

11 III. Ratio Analysis Limitations: ~ Ratio analysis is useful only when financial reports accurately and honestly reflect all correct information of firms. Therefore, if the information is not accurate or correct, ratio analysis may mislead our conclusions. The reasons of wrong information may come form several sources: a. invalid comparison: if a big company involves many different industries, we may have difficulty to find a specific industry to compare with the company. Therefore, ratio analysis is more useful for small firms. b. Inflation may distort firms balance sheets, i.e. fixed asset value, and inventory value. c. Window dressing techniques: firms can employ window dressing techniques to make their financial statements look better than they really are. d. Different accounting practices: they can distort ratio comparisons. e. Difficulty of ratio explanation: i.e. a high current ratio may indicate a strong ability to repaid short term debts, which is good, but it may also mean too much excess cash, which is bad. A good financial analysis shall not only consider financial ratios, but also some other qualitative factors. Example: Are a company s revenue tied to one key customer? Are the company s profit tied to key product? Does the company rely on single suppliers? What are the competition and legal environments? 10