Working WithFinancial Statements Chapter 3
Topics • How To Standardize Financial Statements For Comparison Purposes • How To Compute And Interpret Some Common Ratios • The Determinants Of A Firm’s Profitability And Growth • Some Problems And Pitfalls In Financial Statement Analysis
Financial Statements: • Financial statements convey information from within the firm controlled by managers to outside the firm (owners, investors, bankers, suppliers, customers, other constituents) • Internal managers also use the information internally to guide the firm to a profitable future
Financial Statements: • Financial managers would like to have market value information, but often times this is not possible so financial managers rely on financial statements • “Accounting numbers are just pale reflections of economic reality, but they frequently are the best available information” • So, let’s learn how to use and interpret financial statements: • Common sized statements • Ratio analysis
Standardized Financial Statements:Common-Size Balance SheetCommon-Size Income Statement Standardized statements make it easier to compare financial information: As the company grows, comparing one year to the next For comparing different companies of different sizes, particularly within the same industry For comparing companies when the statements are in different currencies Standardized statements use % instead of dollars
Balance Sheet Common-Size Balance SheetCompute allaccounts as apercent oftotal assets
IncomeStatement Common-Size Income StatementCompute all line items as a percent of sales
Standardized: Krispy Kream
Liquidity, or short-term solvency ratios Current ratio Quick ratio Cash ratio Leverage, or long-term solvency ratios Total debt ratio Debt/equity ratio Equity multiplier Times interest earned ratio Cash coverage ratio Asset turnover, or utilization ratios Inventory Turnover Days’ sales in inventory Receivables turnover Days’ sales in receivables Total asset turnover Capital intensity Profitability ratios Profit margin Return on assets Return on equity Du Pont Identity Market value ratios Price-earnings ratio Market-to-book ratio How To Compute And Interpret Some Common Ratios
Ratio Analysis • Ratios also allow for better comparison through time or between companies • Ratios are used both internally and externally • Ratios are computed differently by different people • The ones we see in this book are only one of many possible ways to compute them!
Hints About Financial Ratios • In calculating any ratio, we mean the ratio of one thing to something else • When we write the ratio as a fraction, we put the of part in the numerator and the to part in the denominator • Example: • Current ratio: find the ratio of current assets to current liabilities • (Current Assets)/(Current Liabilities) = $45,000/$30,000 = 1.5
Hints About Financial Ratios • If you keep the unit of measure (dollars) in both the numerator and denominator, the answer will hint at what the ratio means • (Current Assets)/(Current Liabilities) = $45,000/$30,000 = $1.50/$1.00 • In this case the ratio indicates that for every $1.00 of current liabilities, there is $1.50 worth of current assets to use to pay off the current liabilities • In general, this trick can be used with all ratios
Financial Ratios: • Who uses them? Why we might be interested? • Stock analysts • Should I buy/sell this stock? • Auditors • Are the financial statements free from material misstatement? • Internal Managers • How is the firm doing? • Investors • Should I sell/buy this stock? • Banks • Will the borrower be able to pay back the loan? • Basically: almost everyone
Questions To Ask When You Use Ratios: • How is it computed?! • Not everyone agrees about how to calculate a given ratio • What is it intended to measure and why might we be interested? • What is the unit of measure? • What might a high or low value be telling us? • How might such values be misleading? • Accounting behind the numbers…? • Does a low CA/CL mean trouble for a large firm? • How could the measure be improved?
Liquidity, Or Short-term Solvency Ratios • Current ratio • Quick ratio • Cash ratio
Current Ratio • Current Ratio = CA/CL • Measure of short term liquidity • $2/$1 = $2 CA for every $1 of CL • If you were to sell all CA and pay off all CL, you would have $2 for every $1 of CL • Above 1, in general is good • Less than 1, in general is not so good • High could mean firm saving up cash to make acquisition, or it could mean that they do not see profitable fixed assets to purchase • Low could mean that they may have a hard time paying short-term debt • CA/CL is used in debt contracts as indicator of short term liquidity
Current Ratio • If you incur long-term debt, CA/CL, (CA/CL) • If you pay off short-term creditors: 5/2 = 2.5 (5-1)/(2-1) = 4/1 = 4 • Firms may do these things before the report there numbers at the end of the period • An apparent low CA/CL may not be bad for a company with a large reserve of untapped borrowing power • Firm buys inventory with $, CA/CL stays same • Firm sells inventory for more than they have it on the books for, (CA/CL)
Quick Ratio (Acid Test) • Quick Ratio = (CA-INV)/CL = (Quick Assets)/CL • Measure of immediate short-term liquidity • Why take out inventory? • Inventory may not be at market value • May be hard to sell • May be obsolete • Using cash to buy inventory reduces the Quick Ratio • People who are interested in whether firm can pay bills or purchase assets in the short term may use this ratio: • Creditors, internal managers, investors
Cash Ratio • Cash Ratio = Cash/CL • Do we even need to define this?
Liquidity, Or Short-term Solvency Ratios • Current Ratio = CA/CL • Quick Ratio = (CA-INV)/CL • Cash Ratio = Cash/CL • What does it mean when these ratios are greater than 1? • What does it mean when these ratios are less than 1?
Leverage, Or Long-term Solvency Ratios • Total debt ratio • Debt/equity ratio • Equity multiplier • Times interest earned ratio • Cash coverage ratio
Leverage, Or Long-term Solvency Ratios • Capital Structure = Relationship Between Debt & Equity • A = L + E • 10 = 2 + 8 • Solvency = “the position of having enough money to cover expenses and debts” • Banks, Investors look at these ratios
Variables Equity = TE = E Liability = Debt = TL = D Assets = TA = A
Leverage (Capital Structure) • Total Debt Ratio • Total Debt Ratio = TL/TA = (TA–TE)/TA • Amount of debt for every $1 of assets • How much of every $1 of assets is financed with debt • Debt/Equity Ratio • Debt/Equity Ratio = TL/TE = D/E • Amount of debt for every $1 of equity • Equity Multiplier • Equity Multiplier = Leverage = TA/TE = (1+D/E) • For every $1 of equity how many dollars of assets are there • Shows us the amount of leverage
Times Interest Earned Ratio • Times Interest Earned Ratio =EBIT/Interest • How many times over interest can be paid • Who might be interested in this ratio?
Cash Coverage Ratio • Cash Coverage Ratio = (EBIT+Depr.)/Interest =EBDIT/Interest • One possible measure of cash flow to meet financial obligations • If the company has a great deal of non-cash deprecation expense, then it makes sense to use this one
Asset Turnover, Or Utilization Ratios • Inventory Turnover • Days’ sales in inventory • Receivables turnover • Days’ sales in receivables • Total asset turnover • Capital intensity
Inventory Turnover • Inventory Turnover =COGS/Inv. • Alternative = COGS/((Beg.Inv.+EndInv.)/2) • How many times we run inventory down to zero and then immediately restock • How many times did we buy and sell our inventory during the year • As long as we are not running out of stock and foregoing sales, the higher the ratio, the more efficient we are at managing inventory • Example: COGS/Inv.=5,000/1,000 = 5
Days’ Sales In Inventory • Days’ Sales In Inventory = 365/Inv. Turn • How long inventory sits before it is sold • Example: • If Inv. Turn = 5 • Days’ Sales In Inventory = 365days/5 = 73 days
Receivables Turnover • Receivables Turnover = Sales/AR • Alternative = (Credit_Sales)/((Beg.AR+EndAR)/2) • How fast we collect our receivable • # of times we collect and reloan the $ per year • Example: 10,000/1,000 = 10 • Days’ Sales In Receivables = 365/(Days’ Sales In Receivables) • Average time it takes to collect the AR • Example: 365days/10 = 36.5 days
Payables Turnover • Payables Turnover = COGS/AP • Example: • COGS/AP = 5,600/800 = 7 • 365 days/7 52 days to pay bill
What does this tell us? • Operating cycle = days inventory sits + days to collect after selling • Cash cycle = operating cycle – payables period
Asset Turnover • Total Asset Turnover = Sales/TA • Alternative = (Total_Operating_Revenue)/((Beg.TA+EndTA)/2) • How many sales do we generate from $1 of assets • The higher, the better, or the more efficient • Sales/TA, more efficient use of assets! • If a firm has newer assets that have not been depreciated, book value for assets may be high and may temporarily lower the ratio • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets • Capital Intensity = TA/Sales • For every $1 of sales how many $ of assets did it take to generate that $1
Profitability Ratio • Profit margin • Return on assets • Return on equity • Du Pont Identity
Profit Margin • Profit Margin = NI/Sales • For every $1 of sales, what is the profit? • Example: $60/$400 = .15 • High PM corresponds to low expense ratios relative to sales • High PM: • Internal managers could be managing cost efficiently • Product/service could be superior to others and could thus demand a high price
Return On Assets • Return On Assets = NI/TA = ROA • Profit per $1 of asset • ROA = NI/Sales*Sales/TA • ROA = Profit Margin*Asset Turnover
Return On Equity • Return On Equity = ROE = NI/Equity • Return to shareholders • What is the profit per $1 of equity? • The key: • When there is no debt, ROE = ROA • When there is debt this should happen: ROE > ROA • Why? Because the assets must earn a return for both the creditors and owners • The more debt there is, the higher (ROE – ROA) must be!
Return On Equity • ROE = NI/Equity • ROE = NI/Equity x TA/TA • ROE = NI/TA x TA/Equity • Since • ROA = NI/TA • Equity/TA = Equity Multiplier = (1+D/E) • ROE = ROA x Equity Multiplier • ROE = ROA x (1+D/E) • ROE = ROA + (ROA – Rd)*D/E (chapter 13)
ROE • If ROE goes up or down, what causes this? • The financial managers at DuPont Copr. Came up with a metric that helps analyze a few of the reasons that may cause ROE to change: • Profit margin • Efficient use of assets (Asset Turnover) • Leverage (Equity Multiplier)
Du Pont Identity Decomposing Into Component Parts ROE = NI/Equity = NI/Equity x Sales/Sales x TA/TA = (NI x Sales x TA)/(Equity x Sales x TA) = NI/Sales x Sales/TA x TA/Equity NI/Sales x Sales/TA x TA/Equity NI/Sales x Sales/TA x TA/Equity
Market Value Ratios (For publicly traded companies) • Price-Earnings Ratio = (Market Price per Share)/EPS) • Note: EPS = NI/(# Shares Outstanding) • $ paid for $1 of earnings • “Surrogate for growth” • Market-To-Book Ratio • Note: Book Value per Share = TE/(# Shares Outstanding) • (Market Value per Share)/(Book Value per Share) • >1, stock market believes that firm is worth more than the book value of equity • <1, stock market believes that firm is worth less than the book value of equity
The Determinants Of A Firm’s Profitability And Growth • Payout and Retention Ratios • The Internal Growth Rate • The Sustainable Growth Rate • Determinants of Growth
Firm Growth • In the long run if firm wants to increase Net Income, they must increase Sales, which in turn means they must buy more Assets • Assets cost $ • The $ come from E, D, or Retained Earnings • Remember: Net Income gets divided up: • Paid out as dividends • Dividends/NI = Dividend payout rate = DPR • Kept as retained earnings • (Retained earnings)/NI = plowback rate = b
The Internal Growth Rate • The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing • They won’t go issue new equity or debt • D/A will go down over time • Firm gets funds to buy assets from retained earnings
The Sustainable Growth Rate • The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio (issues no new equity) • Firm gets funds to buy assets from retained earnings and debt