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Learning Objectives
To appreciate that accounting data can be transformed into financial ratios. To understand that financial ratios can be useful for aiding investment decisions. To know how to calculate various financial ratios and understand how to interpret them. To be able to create a holistic analysis of a company from its financial ratios. To understand the problems associate with financial ratio analysis
Outline
Ratio analysis
Du Pont system
Qualitative factors
Balance Sheet: Assets 1999E Cash 14,000 71,632 ST investments AR 878,000 Inventories 1,716,480 Total CA 2,680,112 Gross FA 1,197,160 Less: Deprec. 380,120 Net FA 817,040 Total assets 3,497,152 1998 7,282 0 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592
Income Statement Sales COGS Other expenses Depreciation Tot. op. costs EBIT Interest exp. EBT Taxes (40%) Net income 1999E 7,035,600 5,728,000 680,000 116,960 6,524,960 510,640 88,000 422,640 169,056 253,584 1998 5,834,400 5,728,000 680,000 116,960 6,524,960 (690,560) 176,000 (866,560) (346,624) (519,936)
Other Data
1999E Shares out. EPS DPS Stock price Lease pmts 250,000 $1.014 $0.220 $12.17 $40,000
What are the five major categories of ratios, and what questions do they answer?
Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales?
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Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?
Calculate the firms forecasted current and quick ratios for 1999. CA CR99 = CL $2,680 = $1,445 = 1.85x.
Comments on CR and QR
1999 CR QR 1.85x 0.67x 1998 1.1x 0.4x 1997 2.3x 0.8x Ind. 2.7x 1.0x
Financing Liquidity
What is the inventory turnover ratio as compared to the industry average? Sales Inv. turnover = Inventories $7,036 = = 4.10x. $1,716
1999
Inv. T. 4.1x
1998
4.5x
1997
4.8x
Ind.
6.1x
DSO is the average number of days after making a sale before receiving cash.
DSO Receivables Average sales per day =
Receivables = Sales/360
= 44.9 days.
$878 = $7,036/360
Appraisal of DSO 1999 1998 1997 Ind. DSO 44.9 39.0 36.8 32.0 Firm collects too slowly, and situation is getting worse. Poor credit policy.
Fixed Assets and Total Assets Turnover Ratios Fixed assets Sales = turnover Net fixed assets = $7,036 = 8.61x. $817
1999
1997 Ind. FA TO 8.6x 6.2x TA TO 2.0x 2.0x
1998
10.0x 2.3x 7.0x 2.6x
FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).
Net operating = ($14,000 + $878,000 + working capital $1,716,480) - ($436,800 + $408,000) = $1,763,680.
Operating capital = $1,763,680 + $817,040 = $2,580,720.
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OCR = Operating capital/Sales = $2,580,720/$7,035,600 = 36.7%. 1999 1998 1997 Ind. OCR 36.7% 31.8% 33.2% 29.5% The OCR is not improving. It is worse than the industry average.
Debt ratio
=
= 55.6%.
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Fixed charge = FCC coverage EBIT + Lease payments = Interest Lease Sinking fund pmt. + pmt. + expense (1 - T) $510.6 + $40 = 4.3x. = $88 + $40 + $0 All three ratios reflect use of debt, but focus on different aspects.
How do the debt management ratios compare with industry averages? 1999 1998
1997 Ind. D/A 55.6% 95.4% 54.8% 50.0% TIE 5.8x -3.9x 3.3x 6.2x FCC 4.3x -3.0x 2.4x 5.1x Too much debt, but projected to improve.
After-tax operating profit margin (ATOPM) ATOPM = EBIT(1 - T) = $510,640(1 - 0.4) Sales $7,035,600 = 4.4%. 1999 1998 1997 Ind. ATOPM 4.4% -7.1% 3.7% 4.3% Very bad in 1998, but projected to exceed industry average in 1999.
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BEP
BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement.
Return on Assets (ROA) and Return on Equity (ROE) Net income ROA = Total assets $253.6 = $3,497 = 7.3%.
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Net income ROE = Common equity = $253.6 = 16.3%. $1,552 1999 1998
1997 Ind. ROA 7.3% -18.1% 6.0% 9.1% ROE 16.3% -391.0% 13.3% 18.2% Both below average but improving.
ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.
Financing Profitability
Non Interest Income Ratio Non Interest Income/Total Income Interest Income Ratio
Return on Equity
Return on Assets
Price = $12.17.
NI $253.6 EPS = Shares out. = 250 = $1.01.
BVPS
Com. equity Shares out. $1,552 = 250 Mkt. price per share = Book value per share $12.17 = = 1.96x. $6.21
=
= $6.21.
M/B
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1999
1998
1997 Ind. P/E 12.0x -0.4x 9.7x 14.2x M/B 1.96x 1.7x 1.3x 2.4x P/E: How much investors will pay for $1 of earnings. High is good.
Profit margin
)(
TA turnover
)(
x
NI Sales Sales x TA
= ROE.
= 13.2% = -391.0% = 16.3% = 18.2%
1997 2.6% x 2.3 1998 -8.9% x 2.0 1999 3.6% x 2.0 Ind. 3.5% x 2.6
A/R $ 878 Debt Other CA 1,802 Equity Net FA 817 Total assets $3,497 L&E Sales day
$1,945 1,552
$3,497
= $19,543 x 32.0
New Balance Sheet Added cash A/R Other CA Net FA Total assets $ 253 Debt $1,945 625 Equity 1,552 1,802 817 $3,497 Total L&E $3,497
What could be done with the new cash? Effect on stock price and risk?
Reduce debt. Better debt ratio; lower interest, hence higher NI.
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Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides. All these actions would likely improve stock price.
Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment.
However, company should not have relied so heavily on debt financing in the past.
What are some potential problems and limitations of financial ratio analysis?
Comparison with industry averages is difficult if the firm operates many different divisions.
Average performance is not necessarily good. Seasonal factors can distort ratios.
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Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is good or bad. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.
What are some qualitative factors analysts should consider when evaluating a companys likely future financial performance?
Are the companys revenues tied to a single customer? To what extent are the companys revenues tied to a single product? To what extent does the company rely on a single supplier? (More)
What percentage of the companys business is generated overseas? What is the competitive situation?
This week you are required to do a share analysis of the 6 shares that you will need to consider for your group assignment.
The idea is that you complete a bottom-up analysis of each of the 6 shares so that you may judge which is best and then to-gethor with your group invest.
Conclusions
We have completed a financial ratio analysis. Comparisons have been made between a company and the industry average over time. In this way, we have managed to obtain a picture of the overall health of the company.
We have discussed why this picture is somewhat limited due to intrinsic problems with the financial ratio approach.