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Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis

CHAPTER 3 Analysis of Financial Statements. Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors. Balance Sheet: Assets. 1999E. 1998. Cash. 14,000. 7,282. 71,632. ST investments. 0. AR. 878,000. 632,160. Inventories.

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Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis

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  1. CHAPTER 3 Analysis of Financial Statements • Ratio analysis • Du Pont system • Effects of improving ratios • Limitations of ratio analysis • Qualitative factors

  2. Balance Sheet: Assets 1999E 1998 Cash 14,000 7,282 71,632 ST investments 0 AR 878,000 632,160 Inventories 1,716,480 1,287,360 Total CA 2,680,112 1,926,802 Gross FA 1,197,160 1,202,950 Less: Deprec. 380,120 263,160 Net FA 817,040 939,790 Total assets 3,497,152 2,866,592

  3. Liabilities and Equity 1999E 1998 Accounts payable 436,800 524,160 Notes payable 600,000 720,000 Accruals 408,000 489,600 Total CL 1,444,800 1,733,760 Long-term debt 500,000 1,000,000 Common stock 1,680,936 460,000 Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832 Total L & E 3,497,152 2,866,592

  4. Income Statement 1999E 1998 Sales 7,035,600 5,834,400 COGS 5,728,000 5,728,000 Other expenses 680,000 680,000 Depreciation 116,960 116,960 Tot. op. costs 6,524,960 6,524,960 EBIT 510,640 (690,560) Interest exp. 88,000 176,000 EBT 422,640 (866,560) Taxes (40%) 169,056 (346,624) Net income 253,584 (519,936)

  5. Other Data 1999E 1998 Shares out. 250,000 100,000 EPS $1.014 ($5.199) DPS $0.220 $0.110 Stock price $12.17 $2.25 Lease pmts $40,000 $40,000

  6. Why are ratios useful? • Standardize numbers; facilitate comparisons • Used to highlight weaknesses and strengths

  7. 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? (More…)

  8. Debt management: Do we have the 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?

  9. Calculate the firm’s forecasted current and quick ratios for 1999. $2,680 $1,445 CA CL CR99 = = = 1.85x. CA - Inv. CL QR99 = $2,680 - $1,716 $1,445 = = 0.67x.

  10. Comments on CR and QR 1999 1998 1997 Ind. CR 1.85x 1.1x 2.3x2.7x QR 0.67x 0.4x 0.8x1.0x • Expected to improve but still below the industry average. • Liquidity position is weak.

  11. Sales Inventories Inv. turnover = = = 4.10x. $7,036 $1,716 1999 1998 1997 Ind. Inv. T. 4.1x 4.5x 4.8x6.1x What is the inventory turnover ratio as compared to the industry average?

  12. Comments on Inventory Turnover • Inventory turnover is below industry average. • Firm might have old inventory, or its control might be poor. • No improvement is currently forecasted.

  13. DSO is the average number of days after making a sale before receiving cash. Receivables Average sales per day DSO = = = = 44.9 days. Receivables Sales/360 $878 $7,036/360

  14. Appraisal of DSO 1999 1998 1997 Ind. DSO 44.9 39.0 36.832.0 • Firm collects too slowly, and situation is getting worse. • Poor credit policy.

  15. Fixed assets turnover Sales Net fixed assets = = = 8.61x. $7,036 $817 Total assets turnover Sales Total assets = = = 2.01x. $7,036 $3,497 Fixed Assets and Total Assets Turnover Ratios (More…)

  16. 1999 1998 1997 Ind. FA TO 8.6x 6.2x 10.0x7.0x TA TO 2.0x 2.0x 2.3x2.6x • 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).

  17. Calculate the forecasted operating capital requirement ratio (OCR). = + = ($14,000 + $878,000 + $1,716,480) - ($436,800 + $408,000) = $1,763,680. Operating capital = $1,763,680 + $817,040 = $2,580,720. Operatingcapital Net operatingworking capital Net fixedassets Net operatingworking capital (More…)

  18. 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.

  19. Total debt Total assets Debt ratio = = = 55.6%. $1,445 + $500 $3,497 EBIT Int. expense TIE = = = 5.8x. $510.6 $88 Calculate the debt, TIE, and fixed charge coverage ratios. (More…)

  20. Fixed charge coverage = FCC EBIT + Lease payments Interest Lease Sinking fund pmt. expense pmt. (1 - T) = = = 4.3x. + + $510.6 + $40 $88 + $40 + $0 All three ratios reflect use of debt, but focus on different aspects.

  21. 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 3.3x6.2x FCC 4.3x -3.0x 2.4x5.1x Too much debt, but projected to improve.

  22. After-tax operatingprofit 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.

  23. NI Sales $253.6 $7,036 PM = = = 3.6%. Profit Margin (PM) 1999 1998 1997 Ind. PM 3.6% -8.9% 2.6%3.5% Very bad in 1998, but projected to exceed industry average in 1999. Looking good.

  24. Basic Earning Power (BEP) EBIT Total assets BEP = = = 14.6%. $510.6 $3,497 (More…)

  25. 1999 1998 1997 Ind. BEP 14.6% -24.1% 14.2%19.1% • BEP removes effect of taxes and financial leverage. Useful for comparison. • Projected to be below average. • Room for improvement.

  26. Return on Assets (ROA) and Return on Equity (ROE) Net income Total assets ROA = = = 7.3%. $253.6 $3,497 (More…)

  27. Net income Common equity ROE = = = 16.3%. $253.6 $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.

  28. Effects of Debt on ROA and ROE • 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.

  29. Price = $12.17. EPS = = = $1.01. P/E = = = 12x. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 Calculate and appraise the P/E and M/B ratios. (More…)

  30. Com. equity Shares out. BVPS = = = $6.21. $1,552 250 Mkt. price per share Book value per share M/B = = = 1.96x. $12.17 $6.21 (More…)

  31. 1999 1998 1997 Ind. P/E 12.0x -0.4x 9.7x14.2x M/B 1.96x 1.7x 1.3x2.4x • P/E: How much investors will pay for $1 of earnings. High is good. • M/B: How much paid for $1 of book value. Higher is good. • P/E and M/B are high if ROE is high, risk is low.

  32. Explain the Du Pont System ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE. x x 1997 2.6% x 2.3 x 2.2 = 13.2% 1998 -8.9% x 2.0 x 21.6 = -391.0% 1999 3.6% x 2.0 x 2.3 = 16.3% Ind. 3.5% x 2.6 x 2.0 = 18.2%

  33. The Du Pont system focuses on: • Expense control (PM) • Asset utilization (TATO) • Debt utilization (EM) It shows how these factors combine to determine the ROE.

  34. Simplified Firm Data A/R $ 878 $1,945 Debt Other CA 1,802 Equity 1,552 Net FA 817 Total assets $3,497 $3,497 L&E Sales $7,035,600 day 360 = = $19,543. Q. How would reducing DSO to 32 days affect the company?

  35. Effect of reducing DSO from 44.9 days to 32 days: Old A/R = $19,543 x 44.9 = $878,000 New A/R = $19,543 x 32.0 = 625,376 Cash freed up: $252,624 Initially shows up as additional cash.

  36. New Balance Sheet Added cash $ 253 Debt $1,945 A/R 625 Equity 1,552 Other CA 1,802 Net FA 817 Total assets $3,497 Total L&E $3,497 What could be done with the new cash? Effect on stock price and risk?

  37. Potential use of freed up cash • Repurchase stock. Higher ROE, higher EPS. • Expand business. Higher profits. • Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…)

  38. 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.

  39. Would you lend moneyto this company? • 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.

  40. 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. (More…)

  41. 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.

  42. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? • Are the company’s revenues tied to a single customer? • To what extent are the company’s revenues tied to a single product? • To what extent does the company rely on a single supplier? (More…)

  43. What percentage of the company’s business is generated overseas? • What is the competitive situation? • What does the future have in store? • What is the company’s legal and regulatory environment? • And so on.

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