Analyzing Financial Statements

1. Analyzing Financial Statements Chapter 3 Fin 325, Section 04 - Spring 2010 Washington State University

2. Introduction The real value of financial statements lies in the fact that managers, investors, and analysts can use the information in the statements to: • Assess firm performance • Plan changes to improve performance

3. Ratio Analysis • Ratios fall into five groups: • Liquidity ratios • Asset management ratios • Debt management ratios • Profitability ratios • Market value ratios • Using ratios to make two comparisons: • Time Series Analysis – comparison to the same firm over time (Trend) • Cross Sectional Analysis – comparison to other firms in the same industry (Competitors)

4. Liquidity Ratios • Liquidity ratios provide an indication of the ability of the firm to meet its obligations as they come due • current ratio Current Ratio = CA / CL • quick (or acid-test) ratio Quick Ratio = (CA – Inventory) / CL • cash ratio Cash Ratio = Cash / CL

5. Liquidity Ratios for DPH Current Ratio = CA / CL Current Ratio = 205 / 120 Current Ratio = 1.71 times • The industry average current ratio is 1.50 Quick Ratio = (CA – Inventory) / CL Quick Ratio = (205 – 111) / 120 Quick Ratio = 0.78 times • The industry average quick ratio is 0.50 Cash Ratio = Cash / CL Cash Ratio = 24 / 120 Cash Ratio = 0.20 times • The industry average cash ratio is 0.15

6. Based on all three measures, DPH has more liquidity on its balance sheet than the industry average • The more liquid assets a firm holds, the more likely the firm can pay its bills, so it has less liquidity risk. • However, liquid assets do not generate profits for the firm • Managers must consider the tradeoff of lower liquidity risk versus the disadvantages of reduced profits • Note that a firm with very predictable cash flows can safely maintain lower levels of liquidity

7. Asset Management Ratios Asset management ratios measure how efficiently assets are being utilized Many of these ratios are focused on a specific asset, such as inventory or accounts receivable

8. Inventory Management • Inventory Turnover = Sales or COGS / Inventory • Days’ Sales in Inventory = Inventory x 365 / Sales or COGS • Accounts Receivable Management • Average collection period (ACP) = Accounts receivable x 365 / Credit sales • Accounts receivables turnover = Credit Sales / Accounts Receivable

9. Accounts Payable Management • Average payment period (APP) = Accounts payable x 365 / COGS • Accounts payable turnover = COGS / Accounts payable • Fixed Asset and Working Capital Management • Fixed asset turnover ratio = Sales / Fixed assets • Sales to Working Capital ratio = Sales / Working capital • Total Asset Management • Total assets turnover ratio = Sales / Total assets • Capital intensity ratio = Total assets / Sales

10. Asset Management Ratios for DPH

12. In all cases DPH has better asset management than the industry average • Produces more sales per dollar of inventory • Collects its accounts receivables faster • Pays its accounts payables slower • Produces more sales per dollar of fixed assets, working capital, and total assets

13. Debt Management Ratios • Debt management ratios measure the extent to which the firm uses debt (financial leverage) versus equity to finance its assets • There are two major types of debt management ratios • Ratios that measure the amount of debt • Ratios that indicate the ability of the firm to service its debt

14. Debt vs. Equity Financing • Debt ratio = Total debt / Total assets • Debt-to-equity ratio = Total debt / Total equity • Equity multiplier ratio = Total assets / Total equity Equity multiplier = 1 / (1 – Debt ratio) = Debt-to-equity ratio +1

15. Coverage Ratios • Times interest earned = EBIT / Interest expense • Fixed charge coverage = Earnings available to meet fixed charges / Fixed charges • Cash coverage ratio = (EBIT + Depreciation) / Fixed charges • These coverage measures can indicate whether a firm has taken on a debt burden that is too large • A value less than 1 means that the firm has less than $1 of earnings or cash available to pay each dollar of interest or fixed charges

17. Profitability Ratios • These ratios show the combined effect of liquidity, asset management, and debt management on the overall operating results of the firm • These ratios are closely monitored by investors • Stock prices react very quickly to unexpected changes in these ratios

18. Profitability Ratios • Profit margin = Net income available to common stockholders / Sales • Basic earnings power ratio (BEP) = EBIT / Total assets • Return on Assets (ROA) = Net income available to common stockholders / Total Assets • Return on Equity (ROE) = Net income available to common stockholders / Common stockholders’ equity • Dividend payout ratio = Common stock dividends / Net income available to common stockholders

20. Market Value Ratios While ROE is a very important financial statement ratio, it doesn’t specifically incorporate risk. Market prices of publicly traded firms do incorporate risk, and so ratios that incorporate stock market values are important. Market values reflect what investors think of the company’s future performance and risk

21. The Market-to-Book ratio measures the amount that investors will pay for the firm’s stock per dollar of equity used to finance the firm’s assets Market-to-book ratio = Market price per share / Book value per share • Book value per share is an accounting-based number reflecting historical costs • This ratio compares the market (current) value of the firm's equity to their historical costs. • If liquidity, asset management, and accounting profitability are good for a firm, then the market-to-book ratio will be high

22. The Price-Earnings ratio (P/E) is the best known and most often quoted figure Price-earnings ratio = Market price per share / Earnings per share • Measures how much investors are willing to pay for each dollar of earnings • A high P/E ratio is often an indication of anticipated growth • Stocks are classified as growth stocks or value stocks based on the P/E ratio

24. DuPont Analysis The ROA depends on the firm’s profit margin (which is an indicator of expense control) and total asset turnover, an indicator of how efficiently the firm manages its assets • ROA and ROE can be broken down into components in an effort to explain why they may be low (or high). • The Basic DuPont equation ROA = Profit Margin x Total asset turnover

25. ROE = ROA x Equity Multiplier The full DuPont formula looks at the decomposition of ROE: ROE = Profit Margin x Total Asset Turnover x Equity Multiplier

27. Other Ratios • Spreading the Financial Statements • Managers, analysts, and investors often create “common size” financial statements • Balance sheet items are divided by total assets • Income statement items are divided by sales • Common size statements are conducive to: • Identifying trends for the firm • Comparisons across firms in the industry

28. Internal Growth Rate • The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) Internal growth rate = (ROA x RR) / [1-(ROA x RR)] • where RR = Retention Ratio • Retention ratio = 1 – Dividend Payout Ratio

29. Sustainable Growth Rate • The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio: Sustainable growth rate = (ROE x RR) / [1-(ROE x RR)] • Combining this with the DuPont equation, the sustainable growth rate depends on four factors: • Profit margin (operating efficiency) • Total asset turnover (efficiency in asset use) • Financial leverage (using debt vs. equity to finance assets) • Profit retention (reinvestment of NI rather paying dividends)

31. Cautions in Using Ratios • Financial statement data are historical • Firms use different accounting procedures • E.g. LIFO/FIFO, depreciation methods • Non-U.S. firms do not necessarily comply with GAAP • Sales and expenses may be seasonal Some items may be unusually high at the close of the fiscal year • Firms can use ‘window dressing’ to make financial statement look better