FM 2016 Week 4 - Chapter 4

Chapter 4

Financial Analysis—

Sizing up Firm Performance

Slide ContentsPRINCIPLES APPLIED IN THIS CHAPTER1.Why Do We Analyze Financial Statements2.Common Size Statements – Standardizing Financial Information3.Using Financial Ratios4.Selecting a Performance Benchmark5.Limitations of Ratio Analysis

4.1 WHY DO WE ANALYZE FINANCIAL STATEMENTS?

Why Do We Analyze Financial Statements? • An internal financial analysis might be done:

– To evaluate the performance of employees – To compare the performance of different

divisions– To prepare financial projections– To evaluate the firm’s financial performance in

light of its competitors’ performance

Why Do We Analyze Financial Statements? (cont.)• External financial analysis is done by:

– Banks and other lenders– Suppliers – Credit-rating agencies– Professional analysts– Individual investors

4.2 COMMON SIZE STATEMENTS:

STANDARDIZING FINANCIAL INFORMATION

Common Size Statements: Standardizing Financial Information• A common size financial statement is a

standardized version of a financial statement in which all entries are presented in percentages.

• It helps to compare a firm’s financial statements with those of other firms, even if the other firms are not of equal size.

Common Size Statements: Standardizing Financial Information (cont.)

• How to prepare a common size financial statement?– For a common size income statement, divide

each entry in the income statement by sales.– For a common size balance sheet, divide each

entry in the balance sheet by total assets.

Table 4.1 H. J. Boswell, Inc.

Table 4.2 H. J. Boswell, Inc.

4.3 USING FINANCIAL RATIOS

Using Financial Ratios

• Financial ratios provide a second method for standardizing the financial information on the income statement and balance sheet.

• A ratio by itself may have no meaning. Hence, a given ratio is generally compared to: (a) ratios from previous years; or (b) ratios of other firms in the same industry.

Using Financial Ratios (cont.)

LIQUIDITY RATIOS

Liquidity Ratios

• Liquidity ratios address a basic question: How liquid is the firm?

• A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s liquidity from two perspectives (see next slide).

Liquidity Ratios (cont.)

1. Overall liquidity - analyzed by comparing the firm’s current assets to the firm’s current liabilities.

2. Liquidity of specific assets - analyzed by examining the timeliness in which the firm’s liquid assets (accounts receivable and inventories) are converted into cash.

Liquidity Ratios: Current Ratio

• The overall liquidity of a firm is analyzed by computing the current ratio and acid-test ratio. Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-term) liabilities.

Liquidity Ratios: Current Ratio (cont.)• What is the current ratio for 2012 for

Boswell?

Current Ratio = $477 ÷ 292.5 = 1.63 times

• The firm had $1.63 in current assets for every $1 it owed in current liability.

Liquidity Ratios: Quick Ratio

• Acid-Test (Quick) Ratio excludes the inventory from current assets as inventory may not be very liquid.

Liquidity Ratios: Quick Ratio(cont.)• What is the quick ratio for Boswell for 2012?

• Quick Ratio = ($477-$229.50) ÷ ($292.50) = 0.84 times

• The firm has only $0.84 in current assets (less inventory) to cover $1 in current liabilities.

Liquidity Ratios: Individual Asset Categories

We can also measure the liquidity of the firm by examining the liquidity of accounts receivable and inventories to see how long it takes the firm to convert its accounts receivables and inventories into cash.

Liquidity Ratios: Accounts Receivable

Average Collection Period measures the number of days it takes the firm to collects its receivables.

Liquidity Ratios: Accounts Receivable (cont.)• What will be the average collection period

for Boswell, Inc. for 2012 if we assume that the annual credit sales were $2,500 million?

• Daily Credit Sales = $2,500 ÷ 365 days = $6.85 million

• Average Collection Period= $139.5m ÷ $6.85m = 20.37 days

Liquidity Ratios: Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio measures how many times receivables are “rolled over” during a year.

Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.)• What will be the accounts receivable

turnover ratio for Boswell, Inc. for 2012 if we assume that the annual credit sales were $2,500 million?

• Accounts Receivable Turnover = $2,500 million ÷ $139.50 = 17.92 times– The firm’s accounts receivable were turning over

at 17.92 times per year.

Liquidity Ratios: Inventory Turnover RatioInventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.

Liquidity Ratios: Inventory Turnover Ratio (cont.)• What will be the inventory turnover ratio for

2012 for Boswell, Inc. if we assume that the cost of goods sold were $1,980 million in 2012?

• Inventory Turnover Ratio= $1,980 ÷ $229.50 = 8.63 times

– The firm turned over its inventory 8.63 times per year.

Liquidity Ratios: Days’ Sales in Inventory• Days’ Sales in Inventory

= 365÷ inventory turnover ratio= 365 ÷ 8.63 = 42.29 days

• The firm, on average, holds it inventory for about 42 days.

Can a Firm Have Too Much Liquidity?• A high investment in liquid assets will enable

the firm to repay its current liabilities in a timely manner.

• However, an excessive investments in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.

CAPITAL STRUCTURE RATIOS

Capital Structure Ratios

Capital structure refers to the way a firm finances its assets. Capital structure ratios address the important question: How has the firm financed the purchase of its assets?

Capital Structure Ratios (cont.)

Debt ratio measures the proportion of the firm’s assets that are financed by borrowing or debt financing.

Capital Structure Ratios (cont.)• What is the debt ratio for H.J. Boswell, Inc.

for 2012?

• Debt Ratio = $1,012.50 million ÷ $1,764 million = 57.40%

– The firm financed 57.39% of its assets with debt.

Capital Structure Ratios (cont.)• Times Interest Earned Ratio measures

the ability of the firm to service its debt or repay the interest on debt.

Capital Structure Ratios (cont.)• What will be the times interest earned ratio

for Boswell for 2012 if we assume interest expense of $65 million and EBIT of $350 million?

• Times Interest Earned = $350m ÷ $65m = 5.38 times

– The firm can pay its interest expense 5.38 times or interest used 1/5.38th or 18.58% of its EBIT.

ASSET MANAGEMENT EFFICIENCY RATIOS

Asset Management Efficiency Ratios• Asset management efficiency ratios

measure a firm’s effectiveness in utilizing its assets to generate sales.

• They are commonly referred to as turnover ratios as they reflect the number of times a particular asset account balance turns over during a year.

Asset Management Efficiency Ratios (cont.)• Total Asset Turnover Ratio represents

the amount of sales generated per dollar invested in firm’s assets.

Asset Management Efficiency Ratios (cont.)

What will be the total asset turnover ratio for Boswell, Inc. for 2012 if we assume total sales to be $2,500 million?

•Total Asset Turnover= $2,500 million ÷ $1,764 million = 1.42 times– The firm generated $1.42 in sales per dollar of

assets in 2012.

Asset Management Efficiency Ratios (cont.)• Fixed asset turnover ratio measures

firm’s efficiency in utilizing its fixed assets (such as property, plant and equipment).

What will be the fixed asset turnover ratio for Boswell for 2012 if we assume sales of $2,500 million for 2012?

•Fixed Asset Turnover= $2,500 million ÷ $1,287 million = 1.94 times– The firm generated $1.94 in sales per dollar

invested in plant and equipment.

The following grid summarizes the efficiency of Boswell’s management in utilizing its assets to generate sales in 2013.

PROFITABILITY RATIOS

Profitability Ratios

Profitability ratios address a very fundamental question: Has the firm earned adequate returns on its investments?

Profitability Ratios (cont.)

Two fundamental determinants of firm’s profitability and returns on investments:

•Cost Control – How well has the firm controlled its costs relative to each dollar of firm sales?

•Efficiency of asset utilization – How effective is the firm in using the assets to generate sales?

Cost Control: Is the Firm Earning Reasonable Profit Margins?Gross profit margin shows how well the firm’s management controls its expenses to generate profits.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.)What will be the gross profit margin ratio for 2012 for Boswell if we assume sales of $2,500 million and gross profit of $650 million?•Gross Profit Margin

= $650 million ÷ $2,500 million = 26%– The firm spent $0.74 for cost of goods sold and

thus $0.26 out of each dollar of sales went towards gross profits.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.)Operating Profit Margin measures how much profit is generated from each dollar of sales after accounting for both costs of goods sold and operating expenses. It also indicates how well the firm is managing its income statement.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.)What will be the operating profit margin ratio for Boswell for 2012 if we assume sales of $2,500 million and net operating income of $350 million?

•Operating Profit Margin= $350 million ÷ $2,500 million = 14%

– The firm generates $0.14 in operating profit for each dollar of sales.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.)

Net Profit Margin measures how much income is generated from each dollar of sales after adjusting for all expenses (including income taxes).

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.)What will be the net profit margin ratio for 2012 if we assume sales of $2,500 million and net income of $217.75 million?

•Net Profit Margin = $217.75 million ÷ $2,500 million = 8.71%– The firm generated $0.087 for each dollar of

sales after all expenses were accounted for.

Return on Invested Capital

Operating Return on Assets ratio is the summary measure of operating profitability. It takes into account the management’s success in controlling expenses and its efficient use of assets.

Profitability Ratios (cont.)

What will be the operating return on assets ratio for Boswell for 2012 if we assume EBIT or net operating income of $350 million for 2012?

•Operating Return on Assets= $350 million ÷$1,764 million = 19.84%

– The firm generated $0.1984 of operating profits for every $1 of its invested assets.

Decomposing the Operating Return on Assets Ratio

Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating Return on Assets (OROA)

Figure 4-1 Observations

• Firm’s OROA (operating return on assets) is better than its peers.

• Firm’s OPM (operating profit margin) is lower than its peers.

• Firm’s TATO (total asset turnover ratio) is higher than that of its peers.

Figure 4-1 Recommendations

1. Reduce costs - The firm must investigate the cost of goods sold and operating expenses to see if there are opportunities to reduce costs.

2. Reduce inventories – The firm must investigate if it can reduce the size of its inventories.

Is the Firm Providing a Reasonable Return on the Owner’s Investment?Return on Equity (ROE) ratio measures the accounting return on the common stockholders’ investment.

Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.)What will be the ROE ratio for Boswell for 2012 if we assume net income of $217.75 million?

•ROE = $217.75m ÷ $751.50 mi = 28.98%

– Thus the shareholders earned 28.97% on their investments.

Using the DuPont Method for Decomposing the ROE ratio• DuPont method analyzes the firm’s ROE

by decomposing it into three parts.

ROE = Profitability × Efficiency × Equity Multiplier

• Equity multiplier captures the effect of the firm’s use of debt financing on its return on equity. The equity multiplier increases in value as the firm uses more debt.

Using the DuPont Method for Decomposing the ROE ratio (cont.)

ROE = Profitability × Efficiency × Equity Multiplier

Using the DuPont Method for Decomposing the ROE ratio (cont.)The following table shows why Boswell’s return on equity was higher than its peers.

Figure 4.2Using the DuPont Method for Decomposing the ROE ratio (cont.)

MARKET VALUE RATIOS

Market Value Ratios

Market value ratios address the question, how are the firm’s shares valued in the stock market?

Price-Earnings Ratio

Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1 of reported earnings.

Price-Earnings Ratio (cont.)

What will be the PE ratio for 2012 for Boswell, Inc. if we assume the firm’s stock was selling for $22 per share at a time when the firm reported a net income of $217.75 million, and the total number of common shares outstanding are 90 million?

Market Value Ratios (cont.)

• Earnings per share = $217.75 million ÷ 90 million = $2.42

• PE ratio = $22 ÷ $2.42 = 9.09

• The investors were willing to pay $9.09 for every dollar of earnings per share that the firm generated.

Market-to-Book Ratio measures the relationship between the market value and the accumulated investment in the firm’s equity.

What will be the market-to-book ratio for 2012 for Boswell if the market price of the stock is $22 and the firm has 90 million shares outstanding?

• Book Value per Share – = 751.50 million ÷ 90 million = $8.35 per share

• Market-to-Book Ratio= Market price per share ÷ Book value per share= $22 ÷ $8.35= 2.63 times

4.4 SELECTING A PERFORMANCE BENCHMARK

Selecting a Performance Benchmark• There are two types of benchmarks that are

commonly used:– Trend Analysis – compares a firm’s financial

statements over time (time-series comparisons).– Peer Group Comparisons – compares the subject

firm’s financial statements with “peer” firms.

Trend Analysis

• Comparing a firm’s recent financial ratios with the past financial ratios provides insight into whether the firm is improving or deteriorating over time. This type of financial analysis is referred to as trend analysis.

Peer Firm Comparisons

Peer groups often consist of firms from the same industry. Industry average financial ratios can be obtained from a number of financial databases and internet sources (such as yahoo finance and google finance).

4.5 LIMITATIONS OF RATIO ANALYSIS

The Limitations of Ratio Analysis1. Picking an industry benchmark can

sometimes be difficult.2. Published peer-group or industry averages

are not always representative of the firm being analyzed.

3. An industry average is not necessarily a desirable target or norm.

The Limitations of Ratio Analysis (cont.)

4. Accounting practices differ widely among firms.

5. Many firms experience seasonal changes in their operations.

6. Financial ratios offer only clues. 7. The results of financial analysis are no

better than the quality of the financial statements.

FM 2016 Week 4 - Chapter 4

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