Ch. 8

• 1. Analysis of Financial Statements Chapter 8

2. Financial Statement Analysis

• Involves

• • Comparing firms performance with others in same industry

• • Evaluating trends in the firms financial position over-time

• Managers want to estimate effect of actions

• Accounting

• • Keeps score

• • Does not address stock price impact

• • INTERPRET not make

3. Ratio Analysis

• Standardize numbers

• Facilitate comparison

• • different sizes

• Highlight (red flag)

• • strengths

• • weaknesses

• Anticipate future

• Planning starting point

4. Ratio Analysis

• Consider

• • What aspects are we analyzing?

• • What goes into a particular ratio?

• • What is unit of measure?

• • What is the benchmark?

5. Ratio Categories and Purposes

• Liquidity

• • Can we make required payments?

• Asset management

• • Right amount for sales

• Debt management

• • Right mix of debt and equity

• Profitability

• • How efficiently firms uses assets and manages operations

• Market value

• • Investor beliefs

6. Ratio Example: BUD

• Liquidity

• • Current Ratio Current Assets/Current Liabilities = ?

• • Quick Ratio (CA - Inv)/CL = ?

• • Consider together

• • Why inventory?

7. Ratio Example: BUD

• Asset Management

• • Inventory Turnover Sales/Inventories =?

• • Days Sales Outstanding Receivables/Avg. Sales Per Day= Receivables/(Sales/360)= ?

8. Ratio Example: BUD

• Others

• • Fixed Assets Turnover Ratio

• • • Sales/Net Fixed Assets

• • Total Assets Turnover Ratio

• • • Sales/Total Assets

• Which one is best?

9. Ratio Example: BUD

• Debt Management

• • Financial leverage

• • • If firms earns more on investments financed thru debt than it pays in interest, the return on capital is magnified or leveraged

• • • Balance higher expected returns and risk

• • Debt Ratio Total Debt/Total Assets = ?

10. Ratio Example: BUD

• • Times Interest Earned EBIT/Int. Exp. = ?

• Profitability

• • Profit Margin on Sales

• • • Net income available for common/Sales

• • Basic Earning Power

• • • EBIT/Total Assets

11. Ratio Example: BUD

• • Return on Assets Net Income/Total Assets = ?

• • Return on Equity Net Income/Common Equity= ?

• • Common -- but problems?

• • Debt?

• • • Int exp lowers NI, so ROA decreases

• • • Debt also lowers equity, but if equity lowered more than NI, ROE increases

12. More on profitability ratios

• Example: If firm improves ROE does EVA improve?

• • Correlated but

• • • ROE ignores risk

• • • ROE does not consider amount of invested capital

• • • ROE goals can lead managers to do the wrong thing

• Need to combine projects return with risk and size to determine effect on s/h wealth

• • ROE just return

13. Ratio Example: BUD

• Market Value Ratios

• • Price/Earnings Ratio (P/E) Price Per Share/Earnings Per Share

• • • High or low?

• • • How comparable?

• • Market-to-Book Ratio Market Price Per Share/Book Value Per Share where BVPS = Common Equity/Shares Outstanding

• • • Proxy for growth

14. Ratio Example: BUD

• What do we mean by book value?

• • Book Value = Money that has been paid in to the firm by stockholders or retained by the firm

• • Market Valueis the present value of all of the cash flows that are expected to accrue to the shareholders into the future

• Why does BV not equal MV?

• • BV is the amount of capital that has been paid in over time (historical figure--backward looking)

• • MV is the present value of all of the expected future cash flows (forward looking)

15. Effect of Changes

• What happens if DSO reduced to 18 days?

• • When 23.2 days

• • • Receivables = Averages Sales Per Day x DSO

• • • Average Sales Per Day = 30.739

• • • Receivables= 713.14

• • When 18 days

• • • Average Sales Per Day = 30.739

• • • Receivables =553.30

16. Effect of Changes

• • Cash!!!!

• • • What can we do with it?

• • • • Repurchase stock

• • • • • Higher ROE and EPS

• • • • Expand

• • • • • Higher profits

• • • • Reduce debt

• • • • • Better debt ratio, lower interest expense, higher net income

• • • Impact on stock price?

17. DuPont System

• Shows how ROE is affected by

• • ________ efficiency (profit margin)

• • ________ efficiency (turnover)

• • Financial _______ (equity multiplier)

• Decompose ROE

• • ROE = Net Income/Common Equity = Net Income/Common Equity x Total Assets/Total Assets = Net Income/Total Assets x Total Assets/Total Equity = ROA x Equity Multiplier

18. DuPont System

• Decompose ROA

• • ROA = Net Income/Total Assets = Net Income/Total Assets x Sales/Sales = Net Income/Sales x Sales/Total Assets = Profit Margin x Total Asset Turnover

• DuPont Identity

• • ROE = Profit Margin x Total Asset Turnover x Equity Multiplier

19. Ratio Analysis

• Who uses?

• • Internal

• • Creditors

• • Potential investors/analysts

• Must have benchmark

• • Time series

• • Peer group

20. Ratio Analysis

• Problems

• • Defining peers/benchmarks

• • Average performance is not necessarily good

• • Conglomerates

• • Accounting practices

• • Historical data

• • Seasonal variation/one-time events

• • Window dressing

• • Mixed signals

21. Times Series for Anheuser-Busch

• Ratio definitions from Compustat PC Plus

• Examine/compare/look for trends

• • Liquidity

• • Turnover

• • Profitability

• • Leverage

• • Market

22. Times Series for Anheuser-Busch Ratio Category: _____________ Strengths Weaknesses Interesting 23. Cross-Sectional Analysis

• Peer group

• • Strengths?

• • Weaknesses?

• Compare

• • Liquidity

• • Turnover

• • Profitability

• • Leverage

• • Market

24. Cross-Sectional Analysis Ratio Category: _____________ Strengths Weaknesses Interesting 25. Common Size Statements

• For balance sheet

• • LHS: divide all items by total assets

• • RHS: divide all items by total liabilities and equity

• For income statement

• • Divide all items by sales

• For percentage change analysis

• • Find percentage change from first year

26. Financial Statement Analysis

• Would you invest in one or more of them?

• Would you loan to them?

• What should Petes do differently?

27. Market Efficiency and Financial Statement Analysis

• What does Efficient Market Hypothesis imply regarding the validity of financial statement analysis?

• Does ratio analysis provide any value?

• • From beginning

• • • Standardize numbers?

• • • Facilitate comparison?

• • • Highlight strengths and weaknesses?

• • • Anticipate future?

• • • Planning starting point?