FINANCIAL STATEMENT ANALYSIS

1. CHAPTER 18 FINANCIAL STATEMENT ANALYSIS On Friday, June 6: Quiz or nothing depending on how hard people work Mon to Thursday.

2. Ratio Analysis • Ratio Analysis expresses the relationships between selected financial statement items. • There are 3 types of ratio analysis: • Liquidity Ratios : Measure short-term ability of the enterprise to pay its debts and to meet unexpected needs for cash. • Solvency ratios : Measure the ability of the enter prise to survive over a long period of time. • Profitability ratios: Measure the income or operating success of an enterprise for a given period of time.

3. Profit margin Gross profit margin Asset turnover Return on assets Return on common shareholders’ equity Earnings per share (EPS) Price-earnings (PE) ratio Payout ratio PROFITABILITY RATIOS

4. Who would be interested in finding out profitability ratios? CEO, other executives, Bankers, investors and owners Many CEO (CFO, CMO etc)’s bonuses are tied to EPS, PE ratio and profit margin. PROFITABILITY RATIOS

5. Gross profit margin = Gross profit Net sales GROSS PROFIT MARGIN • Measures margin between selling price and cost of goods sold generated by each dollar of sales • This ratio indicates a company’s ability to keep a selling price that is high enough above its cost of goods sold. • Gross profit = Net Sales - COGS (Discussed in Chapter 5)

6. Gross Profit Margin • Let’s say Hometown Tire’s numbers are: • 2004 GPM = 597000 / 1837000 = 32.5% • 2005 GPM = 616000 / 1997000 = 30.8% • Industry Average GPM = 23.5% • Canadian Tire GPM = 20% • How would you interpret GPM of Hometown? • GPM is decreasing from 2004, which is not a good sign. • In 2005, only 31% of its net sales was used to cover operating expenses and owner’s profit. • Hometown’s GPM is higher than industry average and Canadian Tire, so it is a positive sign. • Perhaps, Hometown Tire sells more quality tires.

7. Profit margin = Net income Net sales PROFIT MARGIN • Measures net income generated by each dollar of sales • This (Discussed in Chapter 5)

8. Profit Margin • 2004 PM = 75000 / 1837000 = 4.1% • 2005 PM = 82000 / 1997000 = 4.1% • Industry Average = 5.4% • Canadian Tire = 4.2% • Only 4.1% of their net sales ended up becoming their net income. • PM did not change from 2004 to 2005  neutral • PM of Hometown is lower than industry average and also Canadian Tire’s PM, although their Gross profit margin is higher than Canadian Tire’s number. • Perhaps Hometown’s operating expenses are too high compared to Canadian Tire or industry’s average operating expenses.

9. Earnings per share = Net income Number of common shares EARNINGS PER SHARE (EPS) • Measures net income earned on each common share (Discussed in Chapter 15)

10. EPS • There are two types of shares: • Prefered shares : They do not give voting rights to the shareholder. • In return, shareholders get fixed income. • Companies issue prefered shares to raise money and willing to pay fixed payments such as 6% of the investment. • Common shares : They give voting right to the shareholder. • Shareholders do not get fixed income. • Dividends can change depending on the net income for the quarter. • Companies issue common shares to raise money for the business without increasing their mandatory payments like interests.

11. EPS • Most companies are required to present this ratio directly on income statement. • Hometown Tires has 30,000 common shares issued. • There has been no change in this number over the past 3 years, so the weighted average number of shares is just 30,000 shares. • 2004: (75000-0) / 30,000 = 2.50 • 2005: (82000 -0) / 30,000 = 2.73 • Industry average = NA • Canadian Tire = $4.04 • EPS has grown year over year, which is a positive sign. (9% increase)

12. EPS • Comparison to Canadian Tire is not meaningful because Canadian Tire is a public company, which issued much more common shares. • EPS shows how much net income is made from one share, so it is extremely important number for investors.(people who want to buy or already purchased the common shares of this company) • Let’s say Samsung’s EPS is 5 whereas Apple’s EPS is 10, which one is a better stock to own? (assuming same price) • If the price for Samsung shares is $50 per share whereas Apple’s shares is $500, then which one is better one to buy?

13. Price-earnings ratio = Share price Earnings per share PRICE-EARNINGS (PE) RATIO • Measures relationship between market price per share and earnings per share • It shows how expensive the stock is considering its net income. • A valuation ratio of a company's current share price compared to its per-share earnings. (Discussed in Chapter 15)

14. PE Ratio • 2004: $5 / 2.50 = 2 • 2005: $5 / 2.75 = 1.8 • Industry Average = 15 • Canadian Tire = 17.2 • Hometown’s PE in 2005 is 1.8, meaning for every one dollar of earning per share, the investor has to pay $1.80. • Since the PE decreased year over year, this is a positive sign. (because EPS increased year over year) • Since Hometown’s PE is lower than Canadian Tire’s PE or industry average PE, it is worth to buy Hometown’s common shares.

15. PE Ratio • In general higher PE ratio means that this company is popular and more expensive than another company with low PE ratio. • Companies with high PE ratio: Although the company makes small net income, people are still buying this company? Why? • People feel that this company has good prospect for growth in the future. • People believe that there will be a breakout of this company’s revenue and net income in the future. For example, Bio Tech companies and High Tech companies typically have high PE ratio. • Many professional money managers (Mutual Fund manager and Hedge Fund manager) use EPS and PE ratio to make their buy or sell decisions everyday.

16. Classwork / Homework • P960 E18.9, E18.10 (only the ratios we learned so far) E18.11(C) • P964 P18.3 – only the ratios we learned so far

17. Asset turnover = Net sales Average total assets ASSET TURNOVER • Measures how efficiently assets are used to generate sales (Discussed in Chapter 10)

18. Return on assets = Net income Average total assets RETURN ON ASSETS • Measures overall profitability of assets (Discussed in Chapter 10)

19. Return on common shareholders’ equity = Net income Average common shareholders’ equity RETURN ON COMMON SHAREHOLDERS’ EQUITY • Measures profitability of common shareholders’ investment (Discussed in Chapter 14)

20. Payout ratio = Cash dividends Net income PAYOUT RATIO • Measures % of earnings distributed in the form of cash dividends (Discussed in Chapter 15)

21. SOLVENCY RATIOS • Debt to total assets • Interest coverage • Cash interest coverage • Cash total debt coverage

22. DEBT TO TOTAL ASSETS • Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets (Discussed in Chapter 16)

23. INTEREST COVERAGE • Measures ability to meet interest payments as they come due Interest coverage = Income before interest expense and income tax expense (EBIT) Interest expense (Discussed in Chapter 16)

24. CASH INTEREST COVERAGE • Measures cash available to meet interest payments as they come due (cash basis) Cash interest coverage = Income before interest expense, income tax expense, and amortization expense (EBITDA) Interest expense (Discussed in Chapter 16)

25. CASH TOTAL DEBT COVERAGE • Measures long-term debt-paying ability (cash basis) Cash total debt coverage ratio = Net cash provided by operating activities Average total liabilities (Discussed in Chapter 18)

26. LIMITATIONS OF FINANCIAL ANALYSIS • Estimates • Historical cost • Alternative accounting methods • Atypical data • Diversification