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Financial Statement

Analysis
What is Financial Analysis

• Financial analysis is the selection, evaluation,


and interpretation of financial data and other
pertinent data.

• The financial analysts must determine which


information is needed and how to use it.
Financial Analysis-Information
• Aside from financial data, other information is
necessary in the prediction of future financial
condition or operating performance of a firm.

• Examples: gross domestic product, the


consumer price index, purchasing price index,
rate of inflation, and corporate specific events
(e.g., mergers, patents, industry of buss.)
Purpose of Analysis
Financial statement analysis helps users
make better decisions.

Internal Users External Users


Managers Shareholders
Officers Lenders
Internal Auditors Customers
Purpose of Analysis
Financial measures are often used
to rank corporate performance.
Example measures include:

Growth Return to Profit Return on


in sales stockholders margins equity

Determined by
analyzing the
financial
statements.
What do we need for the Financial
Statement Analysis?

– Financial statements
– Notes to Financial Statements.
– The definition of accounting methods
– Auditing reports
– 5-10 years financial information
Financial Statements Are Designed
for Analysis
Classified Comparative Consolidated
Financial Financial Financial
Statements Statements Statements

Items with certain Amounts from Information for the


characteristics are several years parent and subsidiary
grouped together. appear side by side. are presented.

Results Helps identify Presented as if


in standardized, significant the two companies
meaningful changes and are a single
subtotals. trends. business unit.
Tools of Analysis

Dollar &
Trend
Percentage
Percentages
Changes

Component
Ratios
Percentages
Horizontal Analysis

Increase/(Decrease)
2002 2001 Amount Percent
Sales 41,500 37,850 3,650 9.6%
Expense 40,000 36,900 3,100 8.4%
Net Income 1,500 950 550 57.9%
Horizontal Analysis

2002 2001 Difference


Sales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%


Dollar and Percentage Changes

Dollar Change:
Dollar Analysis Period Base Period
Change = Amount – Amount

Percentage Change:

% Percent
Change = Dollar Change
÷
Base Period
Amount
Dollar and Percentage Changes
Evaluating Percentage Changes
in Sales and Earnings

Sales and earnings In measuring quarterly


should increase at changes, compare to
more that the rate the same quarter in
of inflation. the previous year.

Percentages may be
misleading when the
base amount is small.
Dollar and Percentage Changes

Let’s look at the asset section of Clover,


Inc. comparative balance sheet and
income statement for 2005 and 2004.
Compute the dollar change and the percentage
change for cash.
Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2005 2004 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 ? ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2005 2004 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000–
$12,000 $23,500
$ 164,700 = $(11,500)
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2005 2004 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets ($11,500 ÷ $23,500)
$ 155,000 × 100% = 48.94%
$ 164,700
Property and equipment:
Land 40,000 40,000 Complete the
Buildings and equipment, net 120,000 85,000 analysis for
Total property and equipment $ 160,000 $ 125,000 the other
Total assets $ 315,000 $ 289,700
assets.
* Percent rounded to one decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2005 2004 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9%
Accounts receivable, net 60,000 40,000 20,000 50.0%
Inventory 80,000 100,000 (20,000) -20.0%
Prepaid expenses 3,000 1,200 1,800 150.0%
Total current assets $ 155,000 $ 164,700 (9,700) -5.9%
Property and equipment:
Land 40,000 40,000 - 0.0%
Buildings and equipment, net 120,000 85,000 35,000 41.2%
Total property and equipment $ 160,000 $ 125,000 35,000 28.0%
Total assets $ 315,000 $ 289,700 $ 25,300 8.7%
* Percent rounded to one decimal point.
Interpretation of Items
• Current assets-current liabilities
• Curent assets- plant assets
• Plant assets – L-T Debts
• Plant assets – Equity
• Total Debt – Equity
• Current Liab. – Total Sources
• L-T Debts – Total Sources
Intrepretation of Items
• Accounts recbl.- Accounts payable
• Accounts receivable – Sales
• Inventory – Sales
• Sales – COGS
• Sales – Gross Profit
• Sales – Operating Income
• Sales – Net Income
Trend Analysis
– are computed by selecting a base year
whose amounts are set equal to 100%.
• The amounts of each following year are
expressed as a percentage of the base
amount.

Trend % = Any year $ ÷ Base year $


Trend Percentages

Year 2000 1999 1998


Revenues $27,611 $24,215 $21,718
Cost of sales 15,318 14,709 13,049
Gross profit $12,293 $ 9,506 $ 8,669
1998 is the base year.

What are the trend percentages?


Trend Percentages

Year 2000 1999 1998


Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%

These percentages were calculated by


dividing each item by the base year.
Trend Analysis

Trend analysis is used to reveal patterns in data


covering successive periods.

Trend Analysis Period Amount


Percent
=
Base Period Amount ×100%
Trend Analysis
Berry Products
Income Information
For the Years Ended December 31,
Item 2005 2004 2003 2002 2001
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2004 2004 2003 2002 2001


Revenues 2001
145%is the129%
base period
116% so 105%
its 100%
Cost of sales amounts132%
150% will equal 100%.104%
118% 100%
Gross profit 135% 124% 112% 108% 100%

(290,000  275,000)  100% = 105%


(198,000  190,000)  100% = 104%
(92,000  85,000)  100% = 108%
Component Percentages
Examine the relative size of each item in the financial
statements by computing component
(or common-sized) percentages.

Component Analysis Amount


Percent
= Base Amount × 100%

Financial Statement Base Amount


Balance Sheet Total Assets
Income Statement Revenues
Clover, inc.
Comparative Balance Sheets
December 31,
Complete the common-size analysis for the other Common-size
assets. Percents*
2005 2004 2005 2004
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
($12,000 ÷ $315,000)
Total current assets $ 155,000×$100% = 3.8%
164,700
Property and equipment:
Land ÷ $289,700)
($23,500 40,000 × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2005 2004 2005 2004
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.6%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2005 2004 2005 2004
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities $ 70,000 $ 50,000 22.3% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities $ 145,000 $ 130,000 46.1% 44.9%
Shareholders' equity:
Preferred stock 20,000 20,000 6.3% 6.9%
Common stock 60,000 60,000 19.0% 20.6%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital $ 90,000 $ 90,000 28.5% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
Total shareholders' equity $ 170,000 $ 159,700 53.9% 55.1%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
Clover, Inc.
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2005 2004 2005 2004
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
Ratios
• Ratios are simply relationships between two
financial balances or financial calculations. These
relationships establish our references so we can
understand how well we are performing
financially. Ratios also extend our traditional way
of measuring financial performance; i.e. relying on
financial statements. By applying ratios to a set of
financial statements, we can better understand
financial performance.
Ratios
A ratio is a simple mathematical expression
of the relationship between one item and another.

Along with dollar and percentage changes,


trend percentages, and component percentages,
ratios can be used to compare:

Past performance to Other companies to


present performance. your company.
Why are ratios useful
• Ratios standardize numbers and facilitate
comparisons.
• Ratios are used to highlight weaknesses and
strengths.
How can we use ratios?
• Compare with previous ratios
• Compare with standards (average is found
by the academicans, analysts e.g.)
• Compare with industrial average.
What are the five major categories of
ratios, and what questions do they
answer?
• Liquidity ratios: Can we make required payments?
• Activity ratios Asset management: right amount of
assets vs. sales?
• Debt management ratios (leverage Ratios): Right
mix of debt and equity?
• 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?
Type of ratios
• Liquidity ratios provide information on
a firm's ability to meet its short-term
obligations.
• Activity ratios relate information on a
firm's ability to manage its resources
(that is, its assets) efficiently.
Type of ratios
• Financial leverage ratios provide
information on the degree of a firm's fixed
financing obligations and its ability to
satisfy these financing obligations.
• Profitability ratios provide information
on the amount of income from each
dollar of sales.
Type of ratios
• Return on investment ratios provide
information on the amount of profit,
relative to the assets employed to
produce that profit.
• Shareholder ratios describe the firm's
financial condition in terms of amounts per
share of stock.
Liquidity Ratios

Liquidity Ratios help us understand if we can meet our


obligations over the short-run. Higher liquidity levels indicate that
we can easily meet our current obligations. We can use several
types of ratios to monitor liquidity.

Let’s see if they can cover their short-


term obligations …
Liquidity ratios
• The current ratio is the ratio of current assets
to current liabilities; indicates a firm's ability
to satisfy its current liabilities with its current
assets.

• Quick ratio is the ratio of quick assets


(generally current assets less inventory) to
current liabilities; indicates a firm's ability to
satisfy current liabilities with its most liquid
assets.
Current ratio

current assets
Current ratio=
current liabilities
Example:
If current assets are $5 million and current
liabilities are $2 million,
Current ratio = $5 / $2 = 2.5
Comments on current ratio
2003 2002 2001 Ind.
Current
2.34x 1.20x 2.30x 2.70x
ratio

• Expected to improve but still below the


industry average.
• Liquidity position is weak.
Quick ratio

current assets  inventory


Quick ratio 
current liabilitie s
Also referred to as the acid test ratio
or liquidity ratio
Liquidity ratios: example
Suppose the firm has the following:
Cash $ 5
Accounts receivables 16
Inventory 20
Accounts payable 12

a. What is the firm’s current ratio?


b. What is the firm’s quick ratio?
Liquidity ratios: example, cont.

Cash $ 5
Accounts receivables 16
Inventory 20
Accounts payable 12

a. What is the firm’s current ratio?


Current ratio = ($5 + 16 + 20) / $12 = 3.42
b.What is the firm’s quick ratio?
Quick ratio = ($5 + 16) / $12 = 1.75
Nike
Working capital, 2002, in millions
Cash and cash equivalents $ 575.5
Receivables 1,621.1
Inventory 1,373.8
Other 275.8
Total current assets $4,157.7
Accounts payable $ 504.4
Debts due 480.5
Other 851.3
Total current liabilities $1,836.2
Source: Nike Annual Reports, various years
Problem
• Suppose a company has a current ratio of
1.5 and a quick ratio of 0.8. If its current
liabilities are $2 million, what is its
inventory?
Activity ratios

But are they any good at this stuff?


Activity ratios
• Accounts receivable turnover is the ratio
of net credit sales to accounts receivable.
• Indicates how many times in the period
credit sales have been created and collected.
A/R Turnover Ratio
• Accounts Receivable Turnover measures the number of
times we were able to convert our receivables over into
cash. Higher turnover ratios are desirable.

•Net Sales / Average Accounts Receivable


•Avrg. accounts receivable = (Beg.A/R + End. A/R) / 2

If there is only one year of information can be calculated as follows:

credit sales
A/R turnover =  ..times
accounts receivable s
A/R Turnover Ratio
• EXAMPLE — Sales are $ 480,000, the average
receivable balance during the year was $ 40,000 and
we have a $ 20,000 allowance for sales returns.
Accounts Receivable Turnover is ($ 480,000 - $
20,000) / $ 40,000 or 11.5. We were able to turn our
receivables over 11.5 times during the year.
• NOTE — We are assuming that all of our sales are
credit sales; i.e. we do not have any significant cash
sales.
Number of Days in Accounts
Receivable
• The Number of Days in Accounts Receivable is the average
length of time required to collect our receivables. A low
number of days is desirable. Days in Accounts Receivable is
calculated as follows:

365 or 360 / Accounts Receivable Turnover Ratio

• EXAMPLE — If we refer to our previous example and we


base our calculation on the full calendar year, we would
require 32 days on average to collect our receivables. 365 /
11.5 = 32 days.
Inventory Turnover Ratio
•Inventory Turnover is similar to accounts receivable turnover.
We are measuring how many times did we turn our inventory
over during the year. Higher turnover rates are desirable. A high
turnover rate implies that management does not hold onto excess
inventories and our inventories are highly marketable. Inventory
Turnover is calculated as follows:

Cost of Sales / Average Inventory


Avrg.Inventory = (Beg.Inventory + End.Inventory) / 2

EXAMPLE — Cost of Sales were $ 192,000 and the average inventory


balance during the year was $ 120,000. The Inventory Turnover Rate is 1.6 or
we were able to turn our inventory over 1.6 times during the year.
Inventory Turnover Ratio
• Days in Inventory is the average number of days we held our
inventory before a sale. A low number of inventory days is
desirable. A high number of days implies that management is
unable to sell existing inventory stocks. Days in Inventory is
calculated as follows:

• Inv.Turnover Ratio=365 or 360 / Inventory Turnover

EXAMPLE — If we refer back to the previous example and


we use the entire calendar year for measuring inventory, then
on average we are holding our inventories 228 days before a
sale. 365 / 1.6 = 228 days.
Activity ratios, continued.
• Total asset turnover is the ratio of sales to
total assets; indicates the extent that the
investment in total assets results in sales.

• Fixed asset turnover is the ratio of sales to


fixed assets; indicates the ability of the
firm's management to put the fixed assets to
work to generate sales.
Capital Turnover
Capital Turnover measures our ability to turn capital over into
sales. Remember, we have two sources of capital: Debt and
Equity. Capital Turnover is calculated as follows:

Net Sales / Interest Bearing Debt + Shareholders Equity

EXAMPLE — Net Sales are $ 460,000, we have $ 50,000 in Debt


and $ 200,000 of Equity. Capital Turnover is $ 460,000 / ($
50,000 + $ 200,000) = 1.84. For each $ 1.00 of capital invested
(both debt and equity), we are able to generate $ 1.84 in sales.
Turnover examples

Company Total asset turnover


for 2001
Nike (NKE) 1.5355 times

Skechers (SKX) 2.3569 times

Timberland (TBO) 2.3456 times

Source: Companies’ respective annual reports


The operating cycle
• The operating cycle is the length of time it
takes to turn the investment of cash in
inventory back into cash.
• The longer the operating cycle, the greater
the need for liquid assets.
• The operating cycle is the sum of:
 Number of days of inventory
 Number of days of receivables
The operating cycle
• Now that we have calculated the number of days for receivables
and the number of days for inventory, we can estimate our
operating cycle. Operating Cycle = Number of Days in
Receivables + Number of Days in Inventory. In our previous
examples, this would be 32 + 228 = 260 days. So on average, it
takes us 260 days to generate cash from our current assets.
• If we look back at our Current Ratio, we found that we had 2.5
times more current assets than current liabilities. We now want to
compare our Current Ratio to our Operating Cycle.
• Our turnover within the Operating Cycle is 365 / 260 or 1.40.
This is lower than our Current Ratio of 2.5. This indicates that we
have additional assets to cover the turnover of current assets into
cash. If our current ratio were below that of the Operating Cycle
Turnover Rate, this would imply that we do not have sufficient
current assets to cover current liabilities within the Operating
Cycle. We may have to borrow short-term to pay our expenses.
The number of days inventory
• The number of days inventory
= inventory / avg. day’s cost of goods
sold
• This the number of days a company could
go without adding inventory until they
deplete inventory.
The number of days receivable
• The number of days receivable
= accounts receivable / average day’s credit
• This is the number of days it takes to collect
on credit accounts.
Net operating cycle
• The net operating cycle is the number of
days it takes to turn the investment in
inventory into cash, considering that
purchases are acquired with credit.
• The number of days payables
= accounts payable / average day’s
purchases
Net operating cycle, continued

Number of days inventory


+ Number of days receivable
 Number of days payables
Net operating cycle
Example

Number of days General Electric


… 2002
Inventory 41.4 days

Receivables 148.9 days

Payables 93.7 days

Net operating 96.6 days


cycle
Financial leverage ratios

But can they handle their debt load?


Leverage Ratios measure the use of debt
and equity for financing of assets.
Financial leverage ratios
• The debt to assets ratio indicates the
proportion of assets that are financed with
debt (both short-term and long-term debt).

• The debt to equity ratio indicates the


relative uses of debt and equity as sources
of capital to finance the firm's assets,
evaluated using book values of the capital
sources.
Debt to Equity Ratios
• Debt to Equity is the ratio of Total Debt to Total Equity. It
compares the funds provided by creditors to the funds
provided by shareholders. As more debt is used, the Debt to
Equity Ratio will increase. Since we incur more fixed interest
obligations with debt, risk increases. On the other hand, the
use of debt can help improve earnings since we get to deduct
interest expense on the tax return. So we want to balance the
use of debt and equity such that we maximize our profits, but
at the same time manage our risk. The Debt to Equity Ratio is
calculated as follows:

• Total Liabilities / Shareholders Equity


Debt to Equity Ratios
• Total Liabilities / Shareholders Equity
• EXAMPLE — We have total liabilities of $ 75,000 and
total shareholders equity of $ 200,000. The Debt to Equity
Ratio is 37.5%, $ 75,000 / $ 200,000 = .375. When
compared to our equity resources, 37.5% of our resources
are in the form of debt.
• KEY POINT — As a general rule, it is advantageous to
increase our use of debt (trading on the equity) if earnings
from borrowed funds exceeds the costs of borrowing.
Times Interest Earned
• Times Interest Earned is the number of times our
earnings (before interest and taxes) covers our
interest expense. It represents our margin of safety
in making fixed interest payments. A high ratio is
desirable from both creditors and management.
Times Interest Earned is calculated as follows:
• Earnings Before Interest and Taxes /
Interest Expense
Times Interest Earned
• The interest coverage ratio indicates the
firm's ability to satisfy interest obligations
on its debt.

• Also known as the times-interest-earned


ratio.

EBIT
Interest coverage =
interest expense
Financial leverage examples
Debt-to-assets Debt-to-
equity
Nike (NKE) 40.41% 67.82%
July,2002
Skechers (SKX) 51.16% 104.75%
December, 2001
Timberland 40.47% 67.97%
(TBL)
December, 2001
Source: Data from Yahoo! Finance
Profitability ratios

But can they make any money doing


this stuff?
Gross profit margin
• Gross profit margin: the ratio of gross
profit to sales.
• Indicates how much of every dollar of sales
is left after costs of goods sold.

gross profit
Gross profit margin =
sales
Operating profit margin
• Operating profit margin: the ratio of
operating profit (EBIT) to sales.
• Indicates how much of each dollar of sales
is left over after operating expenses.

operating profit
Operating profit margin =
sales
Net profit margin
• Net profit margin: the ratio of net income
to sales.
• Indicates how much of each dollar of sales
is left over after all expenses are paid.

net profit
Net profit margin =
sales
IBM’s 2002 Income statement
in millions
Revenues $88,396
Less: Total costs 55,972
Gross profit $32,424
Less: Operating expenses 20,790
Operating income $11,634
Add: Other income 617
Less: Interest expense 717
Income before income taxes $11,534
Less: Provision for income taxes 3,441
Net income $8,093

Source: IBM 2002 Annual Report


Profitability ratios: IBM in
2002
Gross profit margin
= $32,424 / $88,396 = 36.68%
Operating profit margin
= $12,251 / $88,396 = 13.86%
Net profit margin
= $8,093 / $88,396 = 9.16%
K Mart
Income Statement, 1/31/2001 in millions
Net revenues $37,028
Less: Cost of revenues 29,658
Gross profit $7,370
Less: Operating expenses 7,461
Operating income -$91
Less: Interest expense 287
Add: Taxes (carryover) 134
Net income -$244

Source: Kmart 10-K Report


Return on investment

Hey, what’s the bottom line?


Return on investment ratios

• Basic earning power ratio is a measure of the


operating income resulting from the firm's
investment in total assets.
Basic earning power = EBIT / Total assets

• Return on assets indicates the firm's net profit


generated per dollar invested in total assets.
Return on assets = Net profit / Total assets
Return on investment
• Return on equity is the profit generated
per dollar of shareholders' investment (i.e.,
shareholders' equity).

net profit
Return on equity =
book value of equity
Coming attractions
• Return on investment ratios & the Du Pont
system
• Shareholder ratios
• Common size analysis
• Effective use of financial analysis
Market Value (Shareholder)
Ratios
The view of the firm from the
perspective of the owners, investor
and general public …
Market Value (Shareholder)
Ratios
These ratios attempt to measure the economic status
of the organization within the marketplace.
Investors use these ratios to evaluate and monitor
the progress of their investments.
Market Value Ratios
• Earnings per share (EPS) is the amount of
income earned during a period per share of
common stock.
• Basic EPS & Diluted EPS
• Book value equity per share is the amount of
the book value of common equity per share of
stock.
• The price-earnings ratio (P/E or PE ratio) is
the ratio of the price per share of stock to the
earnings per share of stock.
Market Value Ratios, continued
• Dividends per share (DPS) is the dollar
amount of cash dividends paid during a
period, per share of common stock.

• The dividend payout ratio is the ratio of


cash dividends paid to earnings for a period.

Dividend payout ratio = DPS / EPS


Earning Per Share
• Growth in earnings is often monitored with Earnings per
Share (EPS). The EPS expresses the earnings of a company
on a "per share" basis. A high EPS in comparison to other
competing firms is desirable. The EPS is calculated as:
• Earnings Available to Common Shareholders /
Number of Common Shares Outstanding
• EXAMPLE — Earnings are $ 100,000 and preferred stock
dividends of $ 20,000 need to be paid. There are a total of
80,000 common shares outstanding. Earnings per Share
(EPS) is ($ 100,000 - $ 20,000) / 80,000 shares outstanding
or $ 1.00 per share.
Price to Earnings (P/E)
• The relationship of the price of the stock in relation to EPS
is expressed as the Price to Earnings Ratio or P / E Ratio.
Investors often refer to the P / E Ratio as a rough indicator
of value for a company. A high P / E Ratio would imply
that investors are very optimistic (bullish) about the future
of the company since the price (which reflects market
value) is selling for well above current earnings. A low P /
E Ratio would imply that investors view the company's
future as poor and thus, the price the company sells for is
relatively low when compared to its earnings. The P / E
Ratio is calculated as follows:
Price to Earnings (P/E)
• Price of Stock / Earnings per Share *
• * Earnings per Share are fully diluted to
reflect the conversion of securities into
common stock.
• EXAMPLE — Earnings per share is $ 3.00
and the stock is selling for $ 36.00 per share.
The P / E Ratio is $ 36 / $ 3 or 12. The
company is selling for 12 times earnings.
Price to Book Value (P/B)
• Book Value per Share expresses the total net assets of a
business on a per share basis. This allows us to compare the
book values of a business to the stock price and gauge
differences in valuations. Net Assets available to
shareholders can be calculated as Total Equity less Preferred
Equity. Book Value per Share is calculated as follows:
• Net Assets Available to Common Shareholders * /
Outstanding Common Shares
• * Calculated as Total Equity less Preferred Equity.
• EXAMPLE — Total Equity is $ 5,000,000 including $
400,000 of preferred equity. The total number of common
shares outstanding is 80,000 shares. Book Value per Share is
($ 5,000,000 - $ 400,000) / 80,000 or $ 57.50
Dividend Yield
• The percentage of dividends paid to shareholders in
relation to the price of the stock is called the
Dividend Yield. For investors interested in a source
of income, the dividend yield is important since it
gives the investor an indication of how much
dividends are paid by the company. Dividend Yield
is calculated as follows:
• Dividends per Share / Price of Stock
• EXAMPLE — Dividends per share are $ 2.10 and
the price of the stock is $ 30.00 per share. The
Dividend Yield is $ 2.10 / $ 30.00 or 7%
The DuPont system

• The Du Pont system was developed by


E.I. du Pont Nemours.

• The system is a method of decomposing


the return ratios into their profit margin
and turnover components. e.g.,
 Return  =  total asset  x  net profit 
 on assets   turnover   margin 
     
A further breakdown
• Return on equity can be broken down into
the return on assets and the equity
multiplier.
• The greater the financial leverage, the
greater the equity multiplier.
return on = return on × equity
equity assets multiplier
net income net income assets
= ×
equity assets equity
Du Pont system: Return on assets

Return on assets
Net profit / Total assets

Net profit margin Total asset turnover


Net profit / Sales Total assets / Net profit

Operating profit margin


Operating profit / Sales
or EBIT / Sales

Earnings retention
(1 - tax rate)

Interest burden
Earnings before taxes / Operating profit
or EBT/EBIT
Du Pont system: Return on
equity
Return on equity
Net profit / Shareholders' equity

Net profit margin Total asset turnover Equity multiplier


Net profit / Sales Total assets / Net profit Total assets / Shareholders' equity

Operating profit margin


Operating profit / Sales
or EBIT / Sales

Earnings retention
(1 - tax rate)

Interest burden
Earnings before taxes / Operating profit
or EBT / EBIT
Kmart and the Du Pont system
8% 3.0

6%
2.5
4%
2.0
2%
Number of
Return 0% 1.5 times

-2%
1.0
-4%
Return on assets 0.5
-6% Net profit margin
-8% Total asset turnover 0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Source: Kmart Inc., Annual Reports


Wal-Mart: ROA & ROE
30%

25% ROA ROE

20%

15%

10%

5%

0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: Wal-Mart Stores, Inc., Annual Reports


Wal-Mart DuPont, 1991-2002

20% 3,5
3
15% 2,5
return
2
and 10% times
1,5
margin 1
5%
0,5
0% 0
1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002
Return on assets Net profit margin
Total asset turnover
Source: Wal-Mart Annual Reports, various years
Problems
• Suppose a company has a return on equity
of 10% and a return on assets of 5%. What
is its debt-to-equity ratio?
• If a company has a return on assets of 5%
and a total asset turnover of 5 times, what is
its net profit margin?
An example

Time to see if you can really do this


stuff.
For a selected company …
• Calculate the following ratios:
 Current ratio
 Debt-to-equity ratio
 Total asset turnover
 Net profit margin
 Equity multiplier
 Return on equity
• and turnover components.
Common size analysis
Common size analysis
• Common size analysis is the analysis of
financial statement items through comparisons
among financial statement or market data.
• Common size analysis compares each item in a
financial statement with a benchmark item.
• Common size analysis is useful in analyzing
trends in profitability and trends in investments
and financing activity.
Common size analysis, continued.
• For the income statement, the benchmark is
sales; each item in the income statement is
restated as a percentage of sales.

• For the balance sheet, the benchmark is


total assets; each item in the balance sheet is
restated as a percentage of total assets.
Common size example:
Toys R Us

100%
Assets
75%
Other
50% Intangibles
Plant and equipment
25% Current assets

0%
1997 1998 1999 2000 2001 2002
Source: Toys R Us Annual Reports
Common size example:
Toys R Us

100%
Liabilities
& equity
75% Shareholders' equity

Other long-term
50% liabilities
Long-term debt
25%
Deferred taxes

0% Current liabilities
1997 1998 1999 2000 2001 2002
Source: Toys R Us Annual Reports
Effective use of financial
analysis

Now what do we do with this stuff?


Uses of financial analysis

• Valuation
• Use financial relations to predict future cash
flows
• Determine creditworthiness
• Rating services (e.g., Moody’s)
• Bankruptcy prediction
• Develop a statistical model that predicts
bankruptcy on the basis of financial
characteristics
Case in point

IMC Global
IMC Global
• Industry: Agricultural chemicals
• Largest of the few companies in the
industry
• Chemical prices are cyclical and sensitive to
agricultural economy and world trade
IMC Global: Returns
10%
0%
-10%
-20%
-30%
ROE
-40%
ROA
-50%
-60%
-70%
-80%
1997 1998 1999 2000 2001 2002

Source: IMC Global 10-K Reports


IMC Global: Profit margins

15% Operating profit


10% margin
5% Net profit margin
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
1997 1998 1999 2000 2001 2002
Source: IMC Global 10-K Reports
IMC Global: Cash flows
600
400
200
0 CFO
-200 CFI
CFF
-400
-600
-800
1997 1998 1999 2000 2001 2002

Source: IMC Global 10-K Reports


IMC Global: Financial leverage
100% Debt as a %
of assets
80%

60%

40%

20%

0%
1993 1995 1997 1999 2001

Source: IMC Global 10-K Reports


IMC Global:
Additional considerations
• IMC Global is in a cyclical industry
• IMC Global has many environmental
liabilities that are not shown in the balance
sheet
• The reaction of competitors/industry to
slump in phosphate prices affects the firm
Problems and dilemmas

There had to be a catch …


Problems and dilemmas
• Using accounting information
• historical data [book v. market value]
• flexibility regarding methods of accounting
[i.e., the possibility of earnings management]
• “fuzzy” items [i.e., Enron, Enron, Enron]
• the possibility of earnings manipulation [Enron,
Sunbeam, Waste Management …]
Problems and Dilemmas, continued
• Selecting a benchmark
• Financial ratios are most useful when
compared with ratios of similar
companies (e.g., by industry).
• It is difficult to choose comparison firms
or to determine the industry.
Shoe companies

Net profit margin


9% 1997-2002
8%
7%
6%
5% Nike
4% Reebok
3% Skechers
2%
1%
0%
1997 1998 1999 2000 2001 2002

Source: Companies’ annual reports, various years


Problems and dilemmas, continued.
• Selecting and interpreting ratios
• A single ratio is not indicative of a
“good” or “bad” firm.
• Some ratios are not applicable to some
firms.
• Some ratios don’t make sense in certain
circumstance.
Forecasting with financial ratios
• Financial ratios are often used to determine
a trend over time, which may then be used
to develop expectations about the future.
• It is important to understand the accounting
numbers to adequately forecast based on
historical trends.
Wal-Mart Sales, 1971-2002

Sales $250,000
in
millions $200,000
$150,000

$100,000

$50,000

$0
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
Fiscal year

Source: Wal-Mart Annual Reports, various years


Enron Sales, 1991-2000

$120

$100

$80
Revenues
$60
(in billions)
$40

$20

$0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Fiscal year
Source: Enron 10-K Reports, various years
Matrix, Inc.
2005
Cash $ 30,000
Accounts receivable, net
Use this Beginning of year 17,000
informatio End of year 20,000
Inventory
n to Beginning of year 10,000
calculate End of year 15,000
Total current assets 65,000
the Total current liabilities 42,000
Total liabilities 103,917
liquidity Total assets
ratios for Beginning of year 300,000
End of year 346,390
Matrix, Revenues 494,000
Working Capital
Working capital is the excess of current
assets over current liabilities.

12/31/05
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
Current Ratio
This ratio measures the
short-term debt-paying
ability of the company.

Current Current Assets


=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000
Quick Ratio
Quick Quick Assets
=
Ratio Current Liabilities

Quick assets are cash, marketable


securities, and receivables.

This ratio is like the current


ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.
Quick Ratio
Quick Quick Assets
=
Ratio Current Liabilities

Quick $50,000
= = 1.19 : 1
Ratio $42,000

This ratio is like the current


ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.
Debt Ratio
A measure of creditor’s long-term risk.
The smaller the percentage of assets that
are financed by debt, the smaller the risk
for creditors.

Debt
Debt Total
Total
== ÷ ÷ Total
Total Assets
Assets
Ratio Liabilities
Ratio Liabilities
= $103,917 ÷ $346,390
= 30.00%
Uses and Limitations of Financial
Ratios
Uses Limitations

Ratios help users Management may enter


understand into transactions merely
financial relationships. to improve the ratios.

Ratios provide for Ratios do not help with


quick comparison analysis of the company's
of companies. progress toward
nonfinancial goals.
Measures of Profitability

An income statement can be prepared in either a


multiple-step or single-step format.

The single-step format is simpler.


The multiple-step format provides
more detailed information.
Income Statement (Multiple-Step)

Proper Heading { Martin Company


Income Statement
For the Year Ended 12/31/05

Gross
Margin { Sales, net
Cost of goods sold
Gross margin
Operating expenses:
$

$
785,250
351,800
433,450

Operating
Expenses { Selling expenses
General & Admin.
Depreciation
$ 197,350
78,500
17,500 293,350
Income from Operations $ 140,100

{
Non- Other revenues & gains:
Interest income $ 62,187
operating
Gain 24,600 86,787
Items Other expenses:
Interest $ 27,000
Remember to Loss 9,000 (36,000)
Income before taxes $ 190,887
compute EPS. Income taxes 62,500
Net income $ 128,387
Income Statement (Single-Step)

{
Martin Company
Proper Heading Income Statement
For the Year Ended 12/31/05
Revenues and gains:
Revenues
& Gains { Sales, net
Interest income
Gain on sale of plant assets
Total revenues and gains
$

$
785,250
62,187
24,600
872,037

Expenses and losses:

{
Cost of goods sold $ 351,800
Selling Expenses 197,350
Expenses General and Admin. Exp. 78,500
& Losses Depreciation 17,500
Interest 27,000
Income taxes 62,500
Loss: sale of investment 9,000
Remember to Total expenses & losses 743,650
compute EPS. Operating income $ 128,387
Matrix, Inc.
2005
Use this Number of common shares
information outstanding all of 2005 27,400
Net income $ 53,690
to calculate Shareholders' equity
the Beginning of year 180,000
profitability End of year 234,390
ratios for Revenues 494,000
Matrix, Inc. Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390
Return On Assets (ROA)
This ratio is generally considered
the best overall measure of a
company’s profitability.

Operating
ROA = ÷ Average total assets
income
= $ 53,690 ÷ ($300,000 + $346,390) ÷ 2
= 16.61%
Return On Equity (ROE)
This measure indicates how well the
company employed the owners’
investments to earn income.

Operating Average total stockholders'


ROE = ÷
income equity
= $ 53,690 ÷ ($180,000 + $234,390) ÷ 2
= 25.91%
More issues regarding ratios
• Different operating and accounting
practices can distort comparisons.
• Sometimes it is hard to tell if a ratio is
“good” or “bad”.
• Difficult to tell whether a company is, on
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 1 key
customer, product, or supplier?
• What percentage of the firm’s business is
generated overseas?
• Competition
• Future prospects
• Legal and regulatory environment
Objective 2

Perform a vertical analysis


of financial statements.
Vertical Analysis...
– compares each item in a financial statement
to a base number set to 100%.
• Every item on the financial statement is
then reported as a percentage of that base.
Vertical Analysis
1999 %
Revenues $38,303 100.0
Cost of sales 19,688 51.4
Gross profit $18,615 48.6
Total operating expenses 13,209 34.5
Operating income $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
Vertical Analysis
Assets 1999 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
Objective 3

Prepare common-size
financial statements.
Common-size Statements
• On the income statement, each item is
expressed as a percentage of net sales.
• On the balance sheet, the common size is
the total on each side of the accounting
equation.
• Common-size statements are used to
compare one company to other companies,
and to the industry average.
Benchmarking
Percent of Net Sales
Lucent Technologies MCI
12,4% 10,8%

7,4% 8,0%

43,0%
51,4%

28,8%
38,2%

Cost of goods sold Operating expenses


Income tax Net income
Objective 4

Compute the standard


financial ratios.
Ratio Classification
1 Measuring ability to pay current liabilities
2 Measuring ability to sell inventory and
collect receivables
3 Measuring ability to pay short-term and
long-term debt
4 Measuring profitability
5 Analyzing stock as an investment
Ratio Classification
Liquidity ratios: Mesuring ability to pay
current liabilities
Activity ratios: Measuring ability to sell
inventory and collect receivables
Financial leverage ratios: Measuring ability to
pay short-term and long-term debt
Profitability ratios: Measuring profitability of
the bussines.
Palisades Furniture Example
Net sales (Year 2002) $858,000
Cost of goods sold 513,000
Gross profit $345,000
Total operating expenses 244,000
Operating income $101,000
Interest revenue 4,000
Interest expense (24,000)
Income before taxes $ 81,000
Income taxes 33,000
Net income $ 48,000
Palisades Furniture Example
Assets 20x2 20x1
Current assets:
Cash $ 29,000 $ 32,000
Receivables net 114,000 85,000
Inventories 113,000 111,000
Prepaid expenses 6,000 8,000
Total current assets $262,000 $236,000
Long-term investments 18,000 9,000
Plant and equipment, net 507,000 399,000
Total assets $787,000 $644,000
Palisades Furniture Example

Liabilities 20x2 20x1


Current liabilities:
Notes payable $ 42,000 $ 27,000
Accounts payable 73,000 68,000
Accrued liabilities 27,000 31,000
Total current liabilities $142,000 $126,000
Long-term debt 289,000 198,000
Total liabilities $431,000 $324,000
Palisades Furniture Example

Stockholders’ Equity 20x2 20x1


Common stock, no par $186,000 $186,000
Retained earnings 170,000 134,000
Total stockholders’ equity $356,000 $320,000
Total liabilities and
stockholders’ equity $787,000 $644,000
Measuring Ability to
Pay Current Liabilities

The current ratio measures


the company’s ability to pay
current liabilities with current assets.

Current ratio =
Total current assets ÷ Total current liabilities
Measuring Ability to
Pay Current Liabilities
• Palisades’ current ratio:
• 20x1: $236,000 ÷ $126,000 = 1.87
• 20x2: $262,000 ÷ $142,000 = 1.85
• The industry average is 1.80.
• The current ratio decreased slightly
during 20x2.
Measuring Ability to
Pay Current Liabilities

The acid-test ratio shows the company’s


ability to pay all current liabilities
if they come due immediately.

Acid-test ratio =
(Cash + Short-term investments
+ Net current receivables)
÷ Total current liabilities
Measuring Ability to
Pay Current Liabilities
• Palisades’ acid-test ratio:
• 20x1: ($32,000 + $85,000) ÷ $126,000 = .93
• 20x2: ($29,000 + $114,000) ÷ $142,000 = 1.01
• The industry average is .60.
• The company’s acid-test ratio improved
considerably during 20x2.
Measuring Ability to
Sell Inventory

Inventory turnover is a measure


of the number of times the average
level of inventory is sold during a year.

Inventory turnover = Cost of goods sold


÷ Average inventory
Measuring Ability to
Sell Inventory
• Palisades’ inventory turnover:
• 20x2: $513,000 ÷ $112,000 = 4.58
• The industry average is 2.70.
• A high number indicates an ability to
quickly sell inventory.
Measuring Ability to
Collect Receivables

Accounts receivable turnover measures a company’s


ability to collect cash from credit customers.

Accounts receivable turnover =


Net credit sales ÷ Average accounts receivable
Measuring Ability to
Collect Receivables
• Palisades’ accounts receivable turnover:
• 20x2: $858,000 ÷ $99,500 = 8.62 times
• The industry average is 22.2 times.
• Palisades’ receivable turnover is much
lower than the industry average.
• The company is a home-town store that
sells to local people who tend to pay their
bills over a lengthy period of time.
Measuring Ability to
Collect Receivables

Days’ sales in receivable ratio measures how


many day’s sales remain in Accounts Receivable.

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =


Average net Accounts Receivable ÷ One day’s sales
Measuring Ability to
Collect Receivables
• Palisades’ days’ sales in Accounts
Receivable for 20x2:
• One day’s sales:
• $858,000 ÷ 365 = $2,351
• Days’ sales in Accounts Receivable:
• $99,500 ÷ $2,351 = 42 days
• The industry average is 16 days.
Measuring Ability to
Pay Debt

The debt ratio indicates the proportion


of assets financed with debt.

Total liabilities ÷ Total assets


Measuring Ability to
Pay Debt
• Palisades’ debt ratio:
• 20x1: $324,000 ÷ $644,000 = 0.50
• 20x2: $431,000 ÷ $787,000 = 0.55
• The industry average is 0.61.
• Palisades Furniture expanded operations
during 20x2 by financing through
borrowing.
Measuring Ability to
Pay Debt

Times-interest-earned ratio
measures the number of times
operating income can cover interest expense.

Times-interest-earned
= Income from operations
÷ Interest expense
Measuring Ability to
Pay Debt
• Palisades’ times-interest-earned ratio:
• 20x1: $ 57,000 ÷ $14,000 = 4.07
• 20x2: $101,000 ÷ $24,000 = 4.21
• The industry average is 2.00.
• The company’s times-interest-earned ratio
increased in 20x2.
• This is a favorable sign.
Measuring Profitability

Rate of return on net sales shows the percentage


of each sales dollar earned as net income.

Rate of return on net sales =


Net income ÷ Net sales
Measuring Profitability
• Palisades’ rate of return on sales:
• 20x1: $26,000 ÷ $803,000 = 0.032
• 20x2: $48,000 ÷ $858,000 = 0.056
• The industry average is 0.008.
• The increase is significant in itself and also
because it is much better than the industry
average.
Measuring Profitability

Rate of return on total assets measures


how profitably a company uses its assets.

Rate of return on total assets = (Net income


+ interest expense) ÷ Average total assets
Measuring Profitability
• Palisades’ rate of return on total assets
for 20x2:
• ($48,000 + $24,000) ÷ $715,500 = 0.101
• The industry average is 0.049.
• How does Palisades compare to the
industry?
• Very favorably.
Measuring Profitability

Common equity includes additional


paid-in capital on common
stock and retained earnings.

Rate of return on common stockholders’ equity


= (Net income – preferred dividends)
÷ Average common stockholders’ equity
Measuring Profitability
• Palisades’ rate of return on common
stockholders’ equity for 20x2:
• ($48,000 – $0) ÷ $338,000 = 0.142
• The industry average is 0.093.
• Why is this ratio larger than the return on
total assets (.101)?
• Because Palisades uses leverage.
Measuring Profitability

Earnings per share of common stock


= (Net income – Preferred dividends)
÷ Number of shares of common stock
outstanding
Measuring Profitability
• Palisades’ earnings per share:
• 20x1: ($26,000 – $0) ÷ 10,000 = $2.60
• 20x2: ($48,000 – $0) ÷ 10,000 = $4.80
• This large increase in EPS is considered
very unusual.
Analyzing Stock as an
Investment
• Price/earning ratio is the ratio of market
price per share to earnings per share.
• 20x1: $35 ÷ $2.60 = 13.5
• 20x2: $50 ÷ $4.80 = 10.4
• Given Palisades Furniture’s 20x2 P/E ratio
of 10.4, we would say that the company’s
stock is selling at 10.4 times earnings.
Analyzing Stock as an
Investment

Dividend yield shows the percentage


of a stock’s market value returned as
dividends to stockholders each period.

Dividend per share of common


(or preferred) stock ÷ Market price per share
of common (or preferred) stock
Analyzing Stock as an
Investment
• Dividend yield on Palisades’ common stock:
• 20x1: $1.00 ÷ $35.00 = .029 (2.9%)
• 20x2: $1.20 ÷ $50.00 = .024 (2.4%)
• An investor who buys Palisades Furniture
common stock for $50 can expect to receive
2.4% of the investment annually in the form
of cash dividends.
Analyzing Stock as an
Investment

Book value per share of common stock


= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock outstanding
Analyzing Stock as an
Investment
• Book value per share of palisades’ common
stock:
• 20x1: ($320,000 – $0) ÷ 10,000 = $32.00
• 20x2: ($356,000 – $0) ÷ 10,000 = $35.60
• Book value bears no relationship to market
value.
Objective 5

Use ratios in decision making.


Limitations of Financial
Analysis
• Business decisions are made in a world of
uncertainty.
• No single ratio or one-year figure should be
relied upon to provide an assessment of a
company’s performance.
Objective 6

Measure economic value added.


Economic Value Added (EVA®)

• Economic value added (EVA®) combines


accounting income and corporate finance to
measure whether the company’s operations
have increased stockholder wealth.
• EVA® = Net income + Interest expense –
Capital charge