Chapter 4

Ch. 4 –Analysis of Financial Statements

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

Income Statement

Revenue

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

•Cost of Goods Sold Cost of Goods Sold

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

•Cost of Goods SoldCost of Goods Sold•Operating Expenses Operating Expenses

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

•Cost of Goods SoldCost of Goods Sold•Operating ExpensesOperating Expenses (marketing, administrative)(marketing, administrative)

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

•Cost of Goods SoldCost of Goods Sold•Operating ExpensesOperating Expenses (marketing, administrative)(marketing, administrative)•Financing CostsFinancing Costs

Income Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

•Cost of Goods SoldCost of Goods Sold•Operating ExpensesOperating Expenses (marketing, administrative)(marketing, administrative)•Financing CostsFinancing Costs•TaxesTaxes

SALESSALES

- - Cost of Goods SoldCost of Goods Sold

GROSS PROFITGROSS PROFIT

- - Operating ExpensesOperating Expenses

OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)

- - Interest ExpenseInterest Expense

EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)

- - Income TaxesIncome Taxes

NET INCOMENET INCOME

- - Preferred Stock DividendsPreferred Stock Dividends

- - NET INCOME AVAILABLENET INCOME AVAILABLE

TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS

Income Statement

SALESSALES

- - Cost of Goods SoldCost of Goods Sold

GROSS PROFITGROSS PROFIT

- - Operating ExpensesOperating Expenses

OPERATING INCOMEOPERATING INCOME (EBIT)(EBIT)

- - Interest ExpenseInterest Expense

EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)

- - Income TaxesIncome Taxes

NET INCOMENET INCOME

- - Preferred Stock DividendsPreferred Stock Dividends

- - NET INCOME AVAILABLENET INCOME AVAILABLE

TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS

Income Statement

SALESSALES

- - Cost of Goods SoldCost of Goods Sold

GROSS PROFITGROSS PROFIT

- - Operating ExpensesOperating Expenses

OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)

- - Interest ExpenseInterest Expense

EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)

- - Income TaxesIncome Taxes

NET INCOMENET INCOME

- - Preferred Stock DividendsPreferred Stock Dividends

- NET INCOME AVAILABLE- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS

Income Statement

Balance Sheet

Total Assets =Total Assets =

OutstandingOutstanding

DebtDebt

++

Shareholders’Shareholders’

EquityEquity

Balance Sheet

Balance SheetAssetsAssets

Balance SheetAssetsAssets Liabilities (Debt) & EquityLiabilities (Debt) & Equity

Balance SheetAssetsAssets Liabilities (Debt) & EquityLiabilities (Debt) & Equity

Current AssetsCurrent Assets CashCash

Marketable SecuritiesMarketable Securities

Accounts ReceivableAccounts Receivable

InventoriesInventories

Prepaid ExpensesPrepaid Expenses

Fixed AssetsFixed Assets Machinery & EquipmentMachinery & Equipment

Buildings and LandBuildings and Land

Other AssetsOther AssetsInvestments & patentsInvestments & patents

Current LiabilitiesCurrent Liabilities Accounts PayableAccounts Payable

Accrued ExpensesAccrued Expenses

Short-term notesShort-term notes

Long-Term LiabilitiesLong-Term LiabilitiesLong-term notes Long-term notes

MortgagesMortgages

EquityEquityPreferred Stock Preferred Stock

Common Stock (Par value)Common Stock (Par value)

Paid in CapitalPaid in Capital

Retained EarningsRetained Earnings

Financial Statement Analysis

Are our decisions maximizing Are our decisions maximizing shareholder wealth?shareholder wealth?

We will want to answer We will want to answer questions about the firm’squestions about the firm’s

LiquidityLiquidity Efficient use of AssetsEfficient use of Assets Leverage (financing)Leverage (financing) ProfitabilityProfitability

We will want to answer We will want to answer questions about the firm’squestions about the firm’s

LiquidityLiquidity Efficient use of AssetsEfficient use of Assets Leverage (financing)Leverage (financing) ProfitabilityProfitability

Financial Ratios

Tools that help us determine the Tools that help us determine the financial health of a company.financial health of a company.

We can compare a company’s We can compare a company’s financial ratios with its ratios in financial ratios with its ratios in previous years previous years (trend analysis)(trend analysis)..

We can compare a company’s We can compare a company’s financial ratios with those of its financial ratios with those of its industry.industry.

Example:CyberDragon Corporation

CyberDragon’s Balance Sheet ($000)

Assets:Assets: Liabilities & Equity:Liabilities & Equity: CashCash $2,540$2,540 Accounts payableAccounts payable 9,7219,721

Marketable securitiesMarketable securities 1,8001,800 Notes payable Notes payable 8,5008,500

Accounts receivableAccounts receivable 18,32018,320 Accrued taxes payableAccrued taxes payable 3,2003,200

InventoriesInventories 27,53027,530 Other current liabilitiesOther current liabilities 4,1024,102

Total current assetsTotal current assets 50,19050,190 Total current liabilitiesTotal current liabilities 25,52325,523

Plant and equipmentPlant and equipment 43,10043,100 Long-term debt (bonds)Long-term debt (bonds) 22,00022,000

less accum deprec.less accum deprec. 11,40011,400 Total liabilitiesTotal liabilities 47,52347,523

Net plant & equip.Net plant & equip. 31,70031,700 Common stock ($10 par)Common stock ($10 par) 13,00013,000

Total assetsTotal assets 81,89081,890 Paid in capital Paid in capital 10,00010,000

Retained earningsRetained earnings 11,36711,367

Total stockholders' equity Total stockholders' equity 34,36734,367

Total liabilities & equityTotal liabilities & equity 81,89081,890

Sales (all credit)Sales (all credit) $112,760$112,760

Cost of goods soldCost of goods sold (85,300)(85,300)

Gross profitGross profit 31,50031,500

Operating expenses:Operating expenses:

SellingSelling (6,540)(6,540)

General & administrativeGeneral & administrative (9,400)(9,400)

Total operating expensesTotal operating expenses (15,940)(15,940)

Earnings before interest and taxes (EBIT)Earnings before interest and taxes (EBIT) 11,52011,520

Interest charges:Interest charges:

Interest on bank notes:Interest on bank notes: (850)(850)

Interest on bonds:Interest on bonds: (2,310)(2,310)

Total interest chargesTotal interest charges ((3,160)3,160)

Earnings before taxes (EBT)Earnings before taxes (EBT) 8,6008,600

TaxesTaxes (3,344) (3,344)

Net IncomeNet Income 5,0165,016

CyberDragon’s Income Statement

CyberDragonOther Information

Dividends paid on common stockDividends paid on common stock$2,800$2,800

Earnings retained in the firmEarnings retained in the firm 2,2162,216

Shares outstanding (000)Shares outstanding (000) 1,3001,300

Market price per shareMarket price per share 2020

Book value per shareBook value per share 26.4426.44

Earnings per shareEarnings per share 3.863.86

Dividends per shareDividends per share 2.152.15

1. Liquidity Ratios

Do we have enough liquid assets Do we have enough liquid assets to meet approaching obligations?to meet approaching obligations?

What is CyberDragon’s Current Ratio?

What is CyberDragon’s Current Ratio?

50,19025,523 = 1.97

What is CyberDragon’s Current Ratio?

If the average current ratio for the If the average current ratio for the industry is industry is 2.42.4, is this good or not?, is this good or not?

50,19025,523 = 1.97

What is the firm’s Acid Test Ratio?

What is the firm’s Acid Test Ratio?

50,190 - 27,53025,523 = .89

What is the firm’s Acid Test Ratio?

Suppose the industry average is Suppose the industry average is .92.92..What does this tell us?What does this tell us?

50,190 - 27,53025,523 = .89

What is the firm’s Average Collection Period?

What is the firm’s Average Collection Period?

18,320112,760/365 = 59.3 days

What is the firm’s Average Collection Period?

If the industry average is If the industry average is 47 days47 days, , what does this tell us?what does this tell us?

18,320112,760/365 = 59.3 days

2. Operating Efficiency Ratios

Measure how efficiently the Measure how efficiently the firm’s assets generate operating firm’s assets generate operating profits.profits.

What is the firm’s Operating Income Return on Investment (OIROI)?

What is the firm’s Operating Income Return on Investment (OIROI)?

11,52081,890

= 14.07%

•Slightly below the industry Slightly below the industry average of average of 15%15%. .

What is the firm’s Operating Income Return on Investment (OIROI)?

11,52081,890

= 14.07%

•Slightly below the industry Slightly below the industry average of average of 15%15%. .

•The OIROI reflects product The OIROI reflects product pricing and the firm’s ability to pricing and the firm’s ability to

keep costs down.keep costs down.

What is the firm’s Operating Income Return on Investment (OIROI)?

11,52081,890

= 14.07%

What is their Operating Profit Margin?

What is their Operating Profit Margin?

11,520112,760 = 10.22%

What is their Operating Profit Margin?

•This is below the industry average of This is below the industry average of 12%12%..

11,520112,760 = 10.22%

What is their Total Asset Turnover?

What is their Total Asset Turnover?

112,76081,890 = 1.38 times

What is their Total Asset Turnover?

The industry average is The industry average is 1.82 times1.82 times. . The firm needs to figure out how to The firm needs to figure out how to squeeze more sales dollars out of its squeeze more sales dollars out of its

assets.assets.

112,76081,890 = 1.38 times

What is the firm’s Accounts Receivable Turnover?

What is the firm’s Accounts Receivable Turnover?

112,76018,320 = 6.16 times

What is the firm’s Accounts Receivable Turnover?

CyberDragon turns their A/R over CyberDragon turns their A/R over 6.166.16 times per year. The industry averagetimes per year. The industry average

is is 8.28.2 times. Is this efficient? times. Is this efficient?

112,76018,320 = 6.16 times

What is the firm’s Inventory Turnover?

What is the firm’s Inventory Turnover?

85,30027,530 = 3.10 times

What is the firm’s Inventory Turnover?

CyberDragon turns their inventory CyberDragon turns their inventory over 3.1 times per year. over 3.1 times per year.

The industry average is The industry average is 3.93.9 times. times. Is this efficient?Is this efficient?

85,30027,530 = 3.10 times

Low inventory turnover:

The firm may have too much The firm may have too much

inventory, which is expensive inventory, which is expensive

because:because:

Inventory takes up costly Inventory takes up costly

warehouse space.warehouse space.

Some items may become spoiled Some items may become spoiled

or obsolete.or obsolete.

What is the firm’s Fixed Asset Turnover?

What is the firm’s Fixed Asset Turnover?

112,76031,700 = 3.56 times

What is the firm’s Fixed Asset Turnover?

If the industry average is If the industry average is 4.64.6 times, what times, whatdoes this tell us about CyberDragon?does this tell us about CyberDragon?

112,76031,700 = 3.56 times

3. Leverage Ratios(financing decisions)

Measure the Measure the impact of using debt impact of using debt capitalcapital to finance assets. to finance assets.

Firms use debt to lever (increase) Firms use debt to lever (increase) returns on common equity.returns on common equity.

How does Leverage work?

Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.

ROE =ROE =

(ignore taxes for this example)(ignore taxes for this example)

How does Leverage work?

Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.

ROE = = 15%ROE = = 15%15,000100,000

How does Leverage work?

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.

ROE =ROE =

How does Leverage work?

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.

ROE =ROE = ==15,000 - 4,00050,000

How does Leverage work?

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.

ROE =ROE = = = 22%22%

15,000 - 4,00050,000

What is CyberDragon’s Debt Ratio?

What is CyberDragon’s Debt Ratio?

47,52381,890 = 58%

What is CyberDragon’s Debt Ratio?

If the industry average is If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?

47,52381,890 = 58%

What is CyberDragon’s Debt Ratio?

47,52381,890 = 58%

If the industry average is If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?

Can leverage make the firm Can leverage make the firm more more profitableprofitable??

Can leverage make the firm Can leverage make the firm riskierriskier??

What is the firm’s Times Interest Earned Ratio?

What is the firm’s Times Interest Earned Ratio?

11,5203,160 = 3.65 times

What is the firm’s Times Interest Earned Ratio?

The industry average is The industry average is 6.76.7 times. This times. This is further evidence that the firm usesis further evidence that the firm uses

more debt financing than average.more debt financing than average.

11,5203,160 = 3.65 times

4. Profitability

How well are the firm’s managers How well are the firm’s managers maximizing shareholder wealth?maximizing shareholder wealth?

What is CyberDragon’s Net Profit Margin?

5,016112760 = 4.45%

What is CyberDragon’sReturn on Equity (ROE)?

What is CyberDragon’sReturn on Equity (ROE)?

5,01534,367 = 14.6%

What is CyberDragon’sReturn on Equity (ROE)?

The industry average is The industry average is 17.54%17.54%..

5,01534,367 = 14.6%

What is CyberDragon’sReturn on Equity (ROE)?

5,01534,367 = 14.6%

The industry average is The industry average is 17.54%17.54%..Is this what we would expect, Is this what we would expect,

given the firm’s leverage?given the firm’s leverage?

Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.

P/EP/E = Price / Earnings per share= Price / Earnings per share= 20/3.86 = 5.18= 20/3.86 = 5.18

P/E: How much investors are willing to pay for $1 of earnings.P/E: How much investors are willing to pay for $1 of earnings.

M/B = Market price / Book value per shareM/B = Market price / Book value per share= 20/26.44 = 0.76= 20/26.44 = 0.76

M/B: How much investors are willing to pay for $1 of book value equity.M/B: How much investors are willing to pay for $1 of book value equity.

The Du Pont system

)(TA/Equity (Sales/TA) (NI/Sales) ROE

multiplierEquity

turnoverassets Total margin

Profit ROE

= 4.45*1.38* 81890/34367 = 14.63%= 4.45*1.38* 81890/34367 = 14.63% Focuses on expense control (PM), asset utilization Focuses on expense control (PM), asset utilization

(TA TO), and debt utilization (Equity multiplier.)(TA TO), and debt utilization (Equity multiplier.)

Conclusion:

Even though CyberDragon has Even though CyberDragon has higher leverage than the industry higher leverage than the industry

average, they are average, they are much less much less efficientefficient, and therefore, less , and therefore, less

profitable.profitable.

Potential problems and limitations of financial ratio analysis

Comparison with industry averages is Comparison with industry averages is difficult for a conglomerate firm that difficult for a conglomerate firm that operates in many different divisions.operates in many different divisions.

““Average” performance is not necessarily Average” performance is not necessarily good, perhaps the firm should aim higher.good, perhaps the firm should aim higher.

Seasonal factors can distort ratios.Seasonal factors can distort ratios. ““Window dressing” techniques can make Window dressing” techniques can make

statements and ratios look better.statements and ratios look better.

More issues regarding ratios

Different operating and accounting Different operating and accounting practices can distort comparisons.practices can distort comparisons.

Sometimes it is hard to tell if a ratio is Sometimes it is hard to tell if a ratio is “good” or “bad”.“good” or “bad”.

Difficult to tell whether a company is, on Difficult to tell whether a company is, on balance, in strong or weak position.balance, in strong or weak position.

Qualitative factors to be considered when evaluating a company’s future financial performance Are the firm’s revenues tied to one key Are the firm’s revenues tied to one key

customer, product, or supplier?customer, product, or supplier? What percentage of the firm’s business is What percentage of the firm’s business is

generated overseas?generated overseas? CompetitionCompetition Future prospectsFuture prospects Legal and regulatory environmentLegal and regulatory environment