Financial Analysis and Ratios for Annual Reports

1. Chapter: 03 Financial Statements & Analysis

2. Financial Statements and Reports • Annual Report • a report issued annually by a corporation to its stockholders. • management’s opinion of the past year’s operations and the firm’s future prospects.

3. Financial Statements and Reports • Annual Report • basic financial statements • income statement • balance sheet • statement of retained earnings • statement of cash flows

6. What is Financial Analysis? • It is an evaluation of both firm’s past financial performance & its prospects for the future. A financial analyst use the ratios to make two types of comparison: • Industry Comparison or cross section. • Trend Analysis or time series.

7. Three Types of Analysis • Horizontal Analysis: To evaluate the trend in the accounts over the years. • Vertical Analysis: A significant item on a financial statement is used as a base value, & all the other items on the financial statement are compared to it. • Ratio Analysis: To compare figures from different categories.

8. Users of Financial Ratios • Present & prospective shareholders. • Creditors. • Firm’s own management. • Regulatory Bodies. • Others.

9. Why are ratios useful? • Ratios standardize numbers and facilitate comparisons. • Comparisons can be made intercompany, intra-company or with industry average • Or, Cross section or time series. • Ratios are used to highlight weaknesses and strengths.

10. Five Categories of Ratios • Liquidity Ratios, • Activity/Turnover/Asset Management Ratios, • Debt/Leverage/Solvency Ratios, • Profitability Ratios, & • Market Ratios.

11. Five major categories of Ratios • Liquidity ratios: It measures the company’s ability to meet its maturing short-term debt obligations. gives us an idea of the firm’s ability to pay off debts that are maturing within a year. • Asset management ratios: Measures the speed with which various accounts are converted into sales or cash – inflows or outflows. which gives us an idea of how efficiently the firm is using it’s assets • Debt management ratios: which gives us an idea of how the firm has financed it’s assets as well as the firm’s ability to repay it’s long-term debt as they become due. • Profitability ratios: which gives us an idea of how profitably the firm is operating and utilizing it’s assets. An indication of good financial health & how effectively the firm is being managed is the company’s ability to earn satisfactory profit & return on investment. • Market value: Relate a firm’s market value, as measured by its current share price, to certain accounting values. which brings in the stock price and gives us an idea of what investors think about the firm and it’s future prospects.

12. 2003 85,632 878,000 1,716,480 2,680,112 1,197,160 380,120 817,040 3,497,152 2002 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 Scenario:Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

13. Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2003 436,800 300,000 408,000 1,144,800 400,000 1,721,176 231,176 1,952,352 3,497,152 2002 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592

14. Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2003 7,035,600 5,875,992 550,000 609,608 116,960 492,648 70,008 422,640 169,056 253,584 2002 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)

15. 2003 250,000 $1.014 $0.220 $12.17 2002 100,000 -$1.602 $0.110 $2.25 Other data No. of shares EPS DPS Stock price

16. 1) Liquidity Ratios • Will the firm be able to pay off its debts as they come due and thus maintain a viable organization? • If there are more liquid assets then they can. • A liquid asset is the one that can be converted to cash quickly without having to reduce the asset’s price very much. • Ratio analysis provides a quick and easy-to-use measure of liquidity. • Two most commonly used liquidity ratios are: current ratio, acid-test ratio

17. 1) Liquidity Ratio:a) Current Ratio:Indicates the extent to which current liabilities are covered by liquid assets (current assets).Calculate the forecasted current ratio for 2003 & 2002. Current ratio = Current assets / Current liabilities = $2,680,112 / $1,144,800 = 2.34 times or, 2.34 : 1 2002 = ???

18. 1) Liquidity Ratio:b) Quick Ratio/Acid test Ratio: Not all current assets are very liquid. Quick ratio removes the least liquid assets like inventory, and prepaid expense from the current asset and then divides the remainder by current liabilities. Calculate the Quick ratio or, Acid Test for 2003 & 2002. Quick ratio = (Current assets – Inventory- prep.exp)/ Current liabilities = ($2,680,112 - 1,716,480)/ $1,144,800 = 0.84 times or, 0.84 : 1 2002 = ???

19. Comments on current & Quick ratio • Expected to improve but still below the industry average. • Liquidity position is weak.

20. 2) Activity Ratio/Asset Management Ratio: • To purchase assets capital is required and obtaining capital is expensive. • Too many assets will lead to high cost of capital and it can lower the profit • Too low asset will lead to losing out on profitable sales • Asset Management Ratios help us determine a reasonable asset cost in view of current and projected sales.

21. 2) Activity Ratio: a) Inventory Turnover Ratio • Any “turnover” ratio means Sales is divided by some asset. • How many times a particular asset is “turned over” to sales during the period. • Inventory turnover = Sales/ Inventory • Sales occur over entire period, whereas inventory figure is for one point in time • It is better to use an average inventory measure.

22. 2) Activity Ratio:a) Inventory turnover Ratio: What is the inventory turnover vs. the industry average? Inv. turnover = Sales / Inventories = $7,035600 / $1,716,480 = 4.10x

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

24. 2) Activity Ratio:b) Fixed asset turnover ratio: Measures the efficiency of Fixed Assets. FA turnover = Sales / Net fixed assets = $7,036 / $817 = 8.61x • When comparing with a newer company problem arises as the same asset costs differently. c) Total asset turnover ratio: TA turnover = Sales / Total assets = $7,036 / $3,497 = 2.01x

25. Evaluating the FA turnover and TA turnover ratios • FA turnover projected to exceed the industry average. • TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).

26. 2) Activity Ratio:d) the Average Collection period and DSO or ACP = Receivables / Annual sales/365 = $8,78,000 / 7,035,600/365 = 46 days e) Average payment period: Average payment period = Payables / Annual purchases/365 = $ 1,144,800/ $5,875,992/365 = 71 days

27. 3) Profitability Ratios • An indication of good financial health & how effectively the firm is being managed is the company’s ability to earn satisfactory profit & return on investment. The ratios are: • Gross Profit Margin= Gross profit/ Sales • Operating Profit Margin= Operating profit or EBIT/ Sales • Net Profit Margin = Net Income After Tax / Net Sales. • BEP = EBIT/Total Assets • Return on Assets (ROA) = Net Income After Tax / Total Assets. or, ROA = NetProfit Margin X Total Asset Turnover f) Return on Equity (ROE) = Net Income After Tax / Stockholders Equity. or, ROE = ROA X Equity Multiplier. ## equity multiplier = total assets / stockholders equity g) EPS= Earnings avl. For common stockholders or N.I/ number of share of common stock outstanding

28. Profitability ratios: Profit margin Net Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6%

29. Appraising profitability with the profit margin • Profit margin was very bad in 2002, but is projected to exceed the industry average in 2003.

30. Basic Earning Power (BEP) Ratio • The ability of the firm’s assets to generate operating income • BEP = EBIT/Total Assets • Shows the raw earning power of the firm’s assets before the influence of taxes and debt.

31. Profitability ratios: Return on assets: How much of the total assets contribute to the net income? ROA = Net income / Total assets = $253.6 / $3,497 = 7.3% Return on equity: • Measures the rate of return on common stockholder’s investment • Stockholders expect to earn a return on their money and this ratio tells how well they are doing. ROE = Net income / Total common equity = $253.6 / $1,952 = 13.0%

32. Appraising profitability with the return on assets and return on equity • Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. • Lower ROA ratio means either high operating cost or high interest expense. • Wide variations in ROE illustrate the effect that leverage can have on profitability. • Higher debt can lead to higher ROE

33. Problems with ROE • ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance. • ROE does not consider risk. • ROE does not consider the amount of capital invested. • Might encourage managers to make investment decisions that do not benefit shareholders. • ROE focuses only on return. A better measure is one that considers both risk and return.

34. 4) Debt Management Ratios • Use of debt increases a firm’s ROE if the firm earns more on it’s assets than the interest rate it pays on the debt. This is called “leverage”. • However, debt exposes the firm to more risk than if it financed only with equity. • Debt Management Ratios show how efficiently firm manages it’s debts.

35. 4) Debt Ratio: a) Debt ratio= Total debt / Total assets = ($1,145 + $400) / $3,497 = 44.2% Creditors are not willing to lend capital when debt ratio is too high. b) TIE = EBIT / Interest expense = $492.6 / $70 = 7.0x Firm’s ability to meet its annual interest payments. c) Fixed-payment Coverage: measures firms ability to meet fixed payment obligations.

36. How do the debt management ratios compare with industry averages? • What can we tell about D/A and TIE by comparing with the industry average?

37. 5) Market Ratios • Market Value depends on investor’s expectation and demand. • If liquidity, asset management, debt management, and profitability ratios all look good and if investors think these ratios will continue to look good in the future, then the market value will be high. • Market value ratios relate the firm’s stock price (market value) to it’s earnings and book value per share.

38. Market Ratios(cont.) • Market value ratios are used in three primary ways • By investors when they are deciding to buy or sell a stock. • By investment bankers when they are setting the share price for a new stock issue (IPO). • By firms when they are deciding how much to offer for another firm in a potential merger.

39. 5) Market Ratios:a) Calculate the Price/Earnings • P/E ratio shows how much investors are willing to pay per dollar of reported profit from each share. P/E = Mkt price per share/ Earnings per share = $12.17 / $1.014 = 12.0x

40. b) Market/Book ratios. M/B ratio is another indicator of how investors regard the company. M/B = Mkt price per share / Book value per share = $12.17 / ($1,952 / 250) = 1.56x

41. Analyzing the market value ratios • P/E: How much investors are willing to pay for $1 of earnings. • M/B: How much investors are willing to pay for $1 of book value equity. • For each ratio, the higher the number, the better. • Lower P/E ratio means perceived risk is high but it also means the market price correctly reflects the stock’s earning ability. • Higher M/B ratio means share is overvalued and investors expectations is very high.

42. **Also see formula table from book pg-72-73

43. The Du Pont system Also can be expressed as: ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) Or, ROE= ROA*FLM • Focuses on: • Expense control: (PM) • Asset utilization: (TATO) • Debt utilization: Eq. Mult. or FLM (financial leverage multiplier) • Shows how these factors combine to determine ROE.

44. DuPont Analysis • DuPont analysis is an expression which breaks ROE (Return On Equity) into three parts. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). • Dupont Formula • ROA= Profit margin)*(T.Asset turnover) ROE=(Profit margin)*(T.Asset turnover)*(Equity multiplier) #Profit Margin = Net Income After Tax / Net Sales. #Total Asset Turnover = Sales / Total Assets. #equity multiplier or FLM= total assets / stockholders equity • Modified Dupont formula: ROE= ROA*FLM

45. Extended DuPont equation: Breaking down Return on equity ROE = (Profit margin) x (TA turnover) x (Equity multiplier) = 3.6% x 2 x 1.8 = 13.0%

46. Trend analysis • Analyzes a firm’s financial ratios over time • Can be used to estimate the likelihood of improvement or deterioration in financial condition.

47. Potential problems and limitations of financial ratio analysis • Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. • “Average” performance is not necessarily good, perhaps the firm should aim higher. • Seasonal factors can distort ratios. • Different operating and accounting practices can distort comparisons. Example: LIFO, FIFO. • 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.

48. 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