Chapter 3. Financial Statements Analysis and Financial Models. Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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1 Chapter 3 Financial Statements Analysis and Financial Models McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Key Concepts and Skills Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios Be able to develop a financial plan using the percentage of sales approach Understand how capital structure and dividend policies affect a firm s ability to grow 3-1

3 Chapter Outline 3.1 Financial Statements Analysis 3.2 Ratio Analysis 3.3 The DuPont Identity 3.4 Financial Models 3.5 External Financing and Growth 3.6 Some Caveats Regarding Financial Planning Models 3-2

4 3.1 Why Evaluate Financial Statements? Internal uses Performance evaluation compensation and comparison between divisions Management identify problem areas (e.g., too little or too much cash, too little or too much inventory) Planning for the future guide in estimating future cash flows External uses Creditors Suppliers Customers Stockholders / Investors 3-3

5 3.1 Financial Statements Analysis Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows. They are also useful for comparing companies of different sizes, particularly within the same industry. 3-4

6 3.2 Ratio Analysis Ratios also allow for better comparison through time or between companies. As we look at each ratio, ask yourself: How is the ratio computed? What is the ratio trying to measure and why? What is the unit of measurement? What does the value indicate? How can we improve the company s ratio? (This is hard! Typically no good answer Ratios may help highlight an issue, not much more) 3-5

7 Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios 3-6

8 Balance Sheet, Greene Co. 3-7

9 Income Statement, Greene Co. 3-8

10 1) Short Term Solvency/ Liquidity Measures Current Ratio: Current Ratio = Provides information about a firm s liquidity. For short-term creditors: higher current ratio is better. Higher ratio indicates more short-term liquidity. It should be at least 1. Current ratio of less than 1 implies negative net working capital. Current Ratio = CA / CL = 2,447,830 / 1,968,662 = 1.24 times Greene Co. has $1.24 in current assets for every $1 in current liabilities or Greene Co. has its current liabilities covered 1.24 times over. 3-9

11 1) Short Term Solvency or Liquidity Measures Quick or Acid - Test Ratio: Quick Ratio = Provides information about a firm s liquidity. Large inventories could be a sign of short-term trouble. Quick Ratio = (2,447, ,459) / 1,968,662 = 1.09 times 3-10

12 1) Short Term Solvency/ Liquidity Measures Cash Ratio: Cash Ratio = Cash Ratio = 680,623 / 1,968,662 =.346 times 3-11

13 Note on Liquidity Concerns a firm s ability to pay its bills over a short period of time. But is it ability to convert assets to cash quickly? No. You can convert anything to cash quickly if you lower the price enough! (e.g. price of a house). Hence, it is ability to convert assets to cash quickly without a significant loss in value. 3-12

14 Another Word of Caution about Liquidity Is a higher current ratio a good thing? Sufficiently high is good for short-term solvency. However, too high is not good. Liquid assets earn lower returns in general So too much in Current Assets/Liabilities compromises earning capacity of the firm, and reduces stock price. Investors would prefer that the firm invested in profitable projects. If the firm is sitting on too much cash, investors will wonder if the executives are incapable or unwilling to come up with such projects, or why no dividends are paid or why no stock is bought back. REMEMBER: objective of the firm is to maximize owner wealth! 3-13

15 Examples Kirk Kerkorian s takeover bid for Chrysler in April 1995 is a perfect example of investor dissatisfaction with excess liquidity. At the time, Chrysler s management had accumulated $7.3 billion in cash and marketable securities as a cushion against an economic down-turn. Mr. Kerkorian instigated a takeover bid because Chrysler s management refused to pay this cash to stockholders. More recently, Apple sitting on $137 billion! 3-14

16 Consider the Scenario: The current ratio exhibits no change over a two or three year period, while the quick ratio experiences a steady decline. How could this occur? Is it bad? Implies: -Co. is operating with lower levels of most liquid assets -Situation should be monitored -Problem could arise should a large amount of current liabilities come due for payment at the same time -But may not be major concern the company has sufficient line of credit at a bank -May indicate larger levels of inventory relative to current liabilities. Slowing sales? Need to look at more ratios! 3-15

17 2)Long-Term Solvency or Leverage Measures This group of ratios measures the level of indebtedness and the ability to service debt. Total Debt Ratio: Total Debt Ratio = Two Variations Total Assets - Total Equity Total Assets Debt-Equity Ratio = Total Debt Total Equity Equity Multiplier = Total Total Assets Equity (Total Equity Total Total Equity Debt) 3-16

18 2)Long-Term Solvency or Leverage Measures Total Debt Ratio = (TA TE) / TA - (5,862,989 2,984,513) / 5,862,989 =.491 times or 49.1% The firm finances slightly over 49% of their assets with debt. The firm has $0.49 in debt for every $1 in assets. Debt-Equity Ratio = TD / TE = = (1,968, ,814) / 2,984,513 =.964 times Equity Multiplier = TA / TE = 1 + TD/TE = = =

19 2)Long-Term Solvency or Leverage Measures Times Interest Earned (TIE) = EBIT / Interest = = 1,174,690 / 5,785 = 203 times - Informs us if the firm has its interest obligations covered. - EBIT is not a good measure of cash available to pay interest because it includes non-cash expenses (depreciation and amortization). Hence, Cash Coverage = EBITDA / Interest = =(EBIT + Depreciation+Amortization) / Interest = = (1,174, ,647) / 5,785 = 225 times 3-18

20 3) Asset Management or Turnover Measures How efficiently a firm uses its assets to generate sales. Inventory Turnover = Cost of Goods Sold / Inventory - 2,046,645 / 300,459 = 6.81 times - The entire inventory was sold off or turned over 6.8 times during the year. The higher the number the better. Days Sales in Inventory = 365 / Inventory Turnover / 6.81 = 54 days - It takes 54 days on average for the inventory to be sold. 3-19

21 3) Asset Management or Turnover Measures How fast the firm collects on its sales? Receivables Turnover = Sales / Accounts Receivable - 5,250,538 / 1,051,438 = 4.99 times - Collected the outstanding accounts and lent the money again 4.99 times during the year. - Easier to interpret in days. Days Sales in Receivables = 365 days / Receivables Turnover / 4.99 = 73 days - This ratio is also called average collection period. - This firm collects its credit sales in 73 days on average. 3-20

22 3) Asset Management or Turnover Measures Asset use efficiency ( big picture measure) Total Asset Turnover = Sales / Total Assets - 5,250,538 / 5,862,989 =.896 times - For every dollar in assets, the firm generated $0.89 in sales. Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets. Is high asset turnover always a good sign? Old assets imply high turnover (may need to buy new assets soon) New assets imply lower turnover; may be efficient in long run 3-21

23 4) Profitability Measures Profit Margin = Net Income / Sales 756,410 / 5,250,538 =.1441 times or 14.41% Greene co. generates about 14 cents in profit for each dollar in sales. Return on Assets (ROA) = Net Income / Total Assets 756,410 / 5,862,989 =.1290 times or 12.90% A measure of profit per dollar of assets Return on Equity (ROE) = Net Income / Total Equity A measure of how the stockholders fared during the year. 756,410 / 2,984,513 =.2534 times or 25.34% For every dollar in equity, the firm generated 25 cents in profit 3-22

24 5) Market Value Measures Market Price (12/31/09) = $91.54 per share Shares outstanding = 193,000 EPS = Net income/shares Outstanding = 756,410/193,000 = $3.92 Price-Earnings (PE) Ratio = Price per share / Earnings per share / 3.92 = times - High PE indicates that firm has prospects for future growth. Price-Sales Ratio = Price per share/sales per share - This ratio is used if a firm has negative earnings for extended period of time. 3-23

25 5) Market Value Measures Market-to-book ratio = market value per share / book value per share Book Value per share = Common equity/shares outstanding Book Value per share = (2,984,513 / 193,000) = $15.46 Market-to-Book ratio = / = 5.92 times - A value less than one indicates that the firm has not been very successful in creating value. Market Capitalization=PxShares outstanding=91.54x193,000=17,667,

26 3.3Tying Ratios Together: The Du Pont Identity Shows relationship between ROE and ROA Gives us a way to decompose ROE ROE = Net Income (NI) / Total Equity (TE) Multiply by Total Assets (TA)/Total Assets (TA) and then rearrange ROE = (NI / TE) x (TA / TA) ROE = (NI / TA) x (TA / TE) = ROA * Equity Multiplier Multiply by sales/sales and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = Profit Margin * Total Asset Turnover * Equity Multiplier 3-25

27 Using the Du Pont Identity ROE = Profit Margin * Total Asset Turnover * Equity Multiplier = * * = 0.25 = 25% Du Pont identity tells us that ROE is affected by three things: Profit margin is a measure of the firm s operating efficiency how well does it control costs Total asset turnover is a measure of the firm s asset use efficiency how well does it manage its assets Equity multiplier is a measure of the firm s financial leverage 3-26

28 Using Financial Statements Ratios are not very helpful by themselves: they need to be compared to something Time-Trend Analysis Used to see how the firm s performance is changing through time Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes 3-27

29 Limitations of Ratio Analysis Ratio analysis is more useful for small, narrowly focused firms as compared to large multidivisional firms (e.g. GE). Different accounting practices can distort comparisons. For instance, outside the US, financial statements may not conform to GAAP. A firm may have some ratios that make it look good and others bad. So it might be difficult to tell if a company is doing well or not. Different firms might use different accounting procedures. Different firms might end their fiscal years at different times. One time (extraordinary) events. 3-28

30 3.4 Financial Models Investment in new assets determined by capital budgeting decisions Degree of financial leverage determined by capital structure decisions Cash paid to shareholders determined by dividend policy decisions Liquidity requirements determined by net working capital decisions 3-29

31 Financial Planning Ingredients Sales Forecast many cash flows depend directly on the level of sales Pro Forma Statements setting up the plan as projected (pro forma) financial statements allows for consistency and ease of interpretation Asset Requirements the additional assets that will be required to meet sales projections Financial Requirements Plug Variable determined by management decisions about what type of financing will be used (makes the balance sheet balance) Economic Assumptions explicit assumptions about the coming economic environment 3-30

32 Percent of Sales Approach Some items vary directly with sales, others do not. Separate balance sheet and income statement accounts into two groups depending on whether they do vary with sales. Can then calculate financing needed to support predicted sales. Percentage of sales approach is a quick way to generate pro forma statements. Income Statement Costs may vary directly with sales Depreciation and interest expense may not vary directly with sales Dividends are a management decision and generally do not vary directly with sales (but dividend payout ratio = Cash dividends / Net income may reflect company policy, so reasonable to assume that is fixed) 3-31

33 Percent of Sales Approach Balance Sheet Initially assume all assets, including fixed, vary directly with sales. Accounts payable also normally vary directly with sales. Notes payable, long-term debt, and equity generally do not vary with sales because they depend on management decisions about capital structure. The changes in these sources of funds are what we are trying to determine. The change in the retained earnings portion of equity will come from the dividend decision. External Financing Needed (EFN) The difference between the forecasted increase in assets and the forecasted increase in liabilities and equity. 3-32

34 Percent of Sales and EFN Instead of creating pro forma statements, External Financing Needed (EFN) can also be calculated by the formula on the next page. Use Rosengarten e.g. from book Sales: this year $1000, next year $1250 Costs: this year $800 (80% of sales), next year $1000 (80% of sales) Accounts Payable: only liability that changes with Sales: this year $300 (30%), next year 375 (30%) Assets: this year $3000 (300%), needed next year $3750 (300%); therefore, new funding needed = $750 Profit Margin (PM)=13.2%; dividend payout ratio=33.3% 3-33

35 Percent of Sales and EFN Assets Sales Sales Spon Liab Sales ΔSales ( PM Projected Sales) (1 d ) (3 250) ( ) ( ) $

36 3.5 External Financing and Growth At low growth levels, internal financing (retained earnings) may exceed the required investment in assets. As the growth rate increases, the internal financing will not be enough, and the firm will have to go to the capital markets for financing, that is, the higher the rate of growth in sales or assets, the greater the need for external financing. Examining the relationship between growth and external financing required is a useful tool in financial planning. 3-35

37 The Internal Growth Rate The internal growth rate provides the maximum growth rate of assets that can be achieved by using retained earnings as the only source of financing. Using the information from the Greene Co. ROA =.1290 Retention or plowback ratio = b = [(EPS-Dividends per share)x193,000 shares]/ni = [2.72x193,000]/756,410=.694 b = 1-d or.694 = 1 (1.2x193,000/756,410) = 1.306, where d is the dividend payout ratio Internal Growth Rate = (ROA x b) / (1-ROA x b) =.098 = = 9.8% (This assumes no new debt, no new equity issues) 3-36

38 The Sustainable Growth Rate The sustainable growth rate provides the maximum growth that can be achieved without additional external equity financing while maintaining a constant debt-to-equity ratio, that is, the maximum growth rate without increasing financial leverage. Using the information from the Greene Co. ROE =.2534 b =.694 Sustainable Growth Rate = (ROE x b) / (1-ROE x b) =.213 = 21.3% 3-37

39 Determinants of Growth Profit margin operating efficiency Total asset turnover asset use efficiency Financial leverage choice of optimal debt ratio Dividend policy choice of how much to pay to shareholders versus reinvesting in the firm 3-38

40 3.6 Some Caveats Financial planning models do not indicate which financial polices are the best. Models are simplifications of reality, and the world can change in unexpected ways. Without some sort of plan, the firm may find itself adrift in a sea of change without a rudder for guidance. 3-39

41 Quick Quiz How do you standardize balance sheets and income statements? Why is standardization useful? What are the major categories of financial ratios? How do you compute the ratios within each category? What are some of the problems associated with financial statement analysis? 3-40

42 Quick Quiz What is the purpose of financial planning? What are the major decision areas involved in developing a plan? What is the percentage of sales approach? What is the internal growth rate? What is the sustainable growth rate? What are the major determinants of growth? 3-41