Working With Financial Statements

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Working WithFinancial Statements

• Chapter 3

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Topics

1. How To Standardize Financial Statements For
   Comparison Purposes
2. How To Compute And Interpret Some Common Ratios
3. The Determinants Of A Firms Profitability And
   Growth
4. Some Problems And Pitfalls In Financial Statement
   Analysis

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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

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Financial Statements

1. Financial managers would like to have market
   value information, but often times this is not
   possible so financial managers rely on financial
   statements
2. Accounting numbers are just pale reflections of
   economic reality, but they frequently are the
   best available information
3. So, lets learn how to use and interpret
   financial statements
4. Common sized statements
5. Ratio analysis

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Standardized Financial StatementsCommon-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

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Balance Sheet
Common-Size Balance SheetCompute allaccounts as
apercent oftotal assets
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IncomeStatement
Common-Size Income StatementCompute all line
items as a percent of sales
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Standardized
Krispy Kream
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How To Compute And Interpret Some Common Ratios

• 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

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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!

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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

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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

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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

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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?

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Liquidity, Or Short-term Solvency Ratios

• Current ratio
• Quick ratio
• Cash ratio

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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

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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) ?

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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

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Cash Ratio

• Cash Ratio Cash/CL
• Do we even need to define this?

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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?

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Leverage, Or Long-term Solvency Ratios

• Total debt ratio
• Debt/equity ratio
• Equity multiplier
• Times interest earned ratio
• Cash coverage ratio

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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

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Variables

• Equity TE E
• Liability Debt TL D
• Assets TA A

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Leverage (Capital Structure)

• Total Debt Ratio
• Total Debt Ratio TL/TA (TATE)/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 (1D/E)
• For every 1 of equity how many dollars of assets
  are there
• Shows us the amount of leverage

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TL/TA, TL/TE, TA/TEFrom one, you can find the
others
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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?

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Cash Coverage Ratio

• Cash Coverage Ratio (EBITDepr.)/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

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Asset Turnover, Or Utilization Ratios

• Inventory Turnover
• Days sales in inventory
• Receivables turnover
• Days sales in receivables
• Total asset turnover
• Capital intensity

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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

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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

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Receivables Turnover

• Receivables Turnover Sales/AR
• Alternative (Credit_Sales)/((Beg.AREndAR)/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

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Payables Turnover

• Payables Turnover COGS/AP
• Example
• COGS/AP 5,600/800 7
• 365 days/7 ? 52 days to pay bill

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What does this tell us?

• Operating cycle days inventory sits days to
  collect after selling
• Cash cycle operating cycle payables period

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Asset Turnover

• Total Asset Turnover Sales/TA
• Alternative (Total_Operating_Revenue)/((Beg.TAE
  ndTA)/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 lt 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

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Profitability Ratio

• Profit margin
• Return on assets
• Return on equity
• Du Pont Identity

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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

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Return On Assets

• Return On Assets NI/TA ROA
• Profit per 1 of asset
• ROA NI/SalesSales/TA
• ROA Profit MarginAsset Turnover

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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 gt 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!

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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 (1D/E)
• ROE ROA x Equity Multiplier ?
• ROE ROA x (1D/E)
• ROE ROA (ROA Rd)D/E (chapter 13)

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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)

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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
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Analyze With The Du Pont Identity
ROA
ROE
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Du Pont AnalysisWhy did the firms ROE go down?
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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)
• gt1, stock market believes that firm is worth more
  than the book value of equity
• lt1, stock market believes that firm is worth less
  than the book value of equity

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The Determinants Of A Firms Profitability And
Growth

• Payout and Retention Ratios
• The Internal Growth Rate
• The Sustainable Growth Rate
• Determinants of Growth

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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

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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 wont go issue new equity or debt
• D/A will go down over time
• Firm gets funds to buy assets from retained
  earnings

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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

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Table 3.6
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Example
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Determinantsof Growth

• ROE NI/SalesSales/AssetsAssets/Equity
• Profit margin operating efficiency
• Total asset turnover asset use efficiency
• Financial leverage choice of optimal debt ratio
• Dividend policy choice of how much to pay to
  shareholders versus reinvesting in the firm
• You could also sell more shares
• Note, our formula is ok if we use Ending Equity,
  but, if you use Beginning Equity, then the
  formula is ROEb

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The Sustainable Growth Rate
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Increase The Sustainable Growth Rate The Firm
Must Increase Profit Margin, Increase Asset
Efficiency, Increase Leverage, Retain Earnings Or
Issue New Equity
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Using Financial Statement Information

• Why Evaluate Financial Statements?
• The primary reason that we look at accounting
  information is that we dont usually have market
  information
• Internal
• To make improvements
• To make projections for the future
• External
• Financial statements convey information from
  inside the firm to the outside
• Creditors, Investors, Competitors, Suppliers

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Choosing a Benchmark

• Time trend
• Over time, have things changed?
• Management by exception
• Directing attention to deviations
• Peer group
• Firms that compete in the same markets
• Have similar assets
• Operate in similar ways
• Standard Industrial Classification code SIC
  page 69

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Problems with Financial Statement Analysis

• Its accounting!
• Not market value
• Some conglomerates do not have parallel peers or
  industries
• International and National firms may use
  different standards and procedures than others
• Making financial statements difficult to compare
• Analysts often calculate ratios in different
  manners