Working With Financial Statements

1
Working With Financial Statements

• P.V. Viswanath
• For use with
• Fundamentals of Corporate Finance
• Brealey, Myers and Marcus, 4th ed.

2
Key Concepts and Skills

• Know how to standardize financial statements for
  comparison purposes
• Know how to compute and interpret important
  financial ratios
• Know the determinants of a firms profitability
  and growth
• Understand the problems and pitfalls in financial
  statement analysis

3
Chapter Outline

• Standardized Financial Statements
• Ratio Analysis
• The Du Pont Identity
• Internal and Sustainable Growth
• Using Financial Statement Information

4
Standardized Financial Statements

• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare
  financial information, particularly as the
  company grows
• They are also useful for comparing companies of
  different sizes, particularly within the same
  industry

5
Ratio Analysis

• Ratios also allow for better comparison through
  time or between companies
• As we look at each ratio, ask yourself what the
  ratio is trying to measure and why is that
  information important
• Ratios are used both internally and externally

6
Categories of Financial Ratios

• Liquidity ratios
• Short-term solvency or how easily the firm can
  lay its hands on cash.
• Financial leverage ratios
• Show long-term solvency how heavily the firm is
  in debt.
• Efficiency or turnover ratios
• Indicate how productively the firm is using its
  assets
• Profitability ratios
• Used to measure the firms return on its
  investments
• Market value ratios

7
Sample Balance Sheet
Numbers in thousands
Cash 6,489 Acc Payable 340,220
Acc Receiv 1,052,606 Notes Pay 86,631
Inventory 295,255 Other Curr Li 1,098,602
Other Curr A 199,375 Total CL 1,525,453
Total CA 1,553,725 LT Debt 871,851
Net Fixed A 2,535,072 Comm Stock 1,691,493
Total Assets 4,088,797 Tot Liab Eq 4,088,797
8
Sample Income Statement
Numbers in thousands, except EPS DPS
Revenues 3,991,997
Cost of Goods Sold 1,738,125
Expenses 1,269,479
Depreciation 308,355
EBIT 739,987
Interest Expense 42,013
Taxable Income 697,974
Taxes 272,210
Net Income 425,764
EPS 2.17
Dividends per share (DPS) 0.86
9
Computing Leverage Ratios

• Total Debt Ratio (Tot Assets Tot Eq) / TA
• (4,088,797 1,691,493) / 4,088,797 .5863 times
  or 58.63
• The firm finances almost 59 of their assets with
  debt.
• Debt/Equity Tot Debt / Tot Eq
• (4,088,797 1,691,493) / 1, 691,493 1.417
  times
• These numbers can also be computed for long-term
  debt
• Long Term Debt Ratio LT Debt/ (LT Debt Eq)
  871,851/(871851 1, 691,493) 0.34
• Long Term Debt/Equity 871851/ 1, 691,493 0.515

10
Data from last year

• Inventory 280,044
• Accounts Receivable 940,044
• Total Assets 3,998,256
• Total Equity 1,480,493

11
Computing Coverage Ratios

• Times Interest Earned EBIT / Interest
• 739,987 / 42,013 17.6 times
• Cash Coverage (EBIT Depreciation) / Interest
• (739,987 308,355) / 42,013 24.95 times
• Determinant of the riskiness of a firms debt

12
Computing Liquidity Ratios

• Current Ratio CA / CL
• 1,553,725 / 1,525,453 1.02 times
• Quick Ratio (CA Inventory) / CL
• (1,553,725 295,225) / 1,525,453 0.825 times
• Cash Ratio Cash / CL
• 6,489 / 1,525,453 .004 times
• Net Working Capital to TA Ratio NWC/TA
• (1,553,725 - 1,525,453)/ 4,088,797 0.007

13
Computing Inventory Ratios

• Inventory Turnover Cost of Goods Sold / Average
  Inventory
• 1,738,125 / (295,255 280,044)/2 6.04 times
• Days Sales in Inventory 365 / Inventory
  Turnover Av Inv/(COGS/365)
• 365 / 6.04 60.41 days
• When you have ratios with I/S numbers in the
  numerator and B/S numbers in the denominator, use
  average of year beginning and year end
  quantities.
• Last years Inventory 280,044.

14
Computing Receivables Ratios

• Receivables Turnover Sales / Av Accounts
  Receivable
• 3,991,997 / (1,052,606 940,044)/2 4.01
  times
• Average Collection Period Days Sales in
  Receivables 365 / Receivables Turnover Av
  Receiv/ (Av Sales)
• 365 / 4.01 91.1 days
• Ac Rec last year 940,044

15
Computing Total Asset Turnover

• Total Asset Turnover Sales / Av Total Assets
• 3,991,997 / (4,088,797 3,998,256)/2 0.99
  times
• Measure of asset use efficiency
• Not unusual for TAT lt 1, especially if a firm has
  a large amount of fixed assets
• Total Assets last year 3,998,256

16
Computing Profitability Measures

• Profit Margin Net Income / Sales
• 425,764 / 3,991,997 0.1067 times or 10.67
• Operating Profit Margin (NI Int) / Sales
• (425,764 42013) / 3,991,997 0.1172 times or
  11.72
• Return on Assets (ROA) (Net Income Interest)
  / Av TA
• (425,764 42013) / (4,088,797 3,998,256)/2
  0.11.57 times or 11.57
• Return on Equity (ROE) Net Income / Average
  Equity
• 425,764 / (1,691,493 1,480,493)/2 0.2685
  times or 26.85

17
Computing Market Value Measures

• Market Price 61.625 per share
• Shares outstanding 205,838,594
• P/E Ratio Price per share / Earnings per share
• 61.625 / 2.17 28.4 times
• Market-to-book ratio market value per share /
  book value per share
• 61.625 / (1,691,493,000 / 205,838,594) 7.5 times

18
Payout and Retention Ratios

• Dividend payout ratio Cash dividends / Net
  income
• 0.86 / 2.17 .3963 or 39.63
• Plowback ratio Retention ratio Additions to
  retained earnings / Net income 1 payout ratio
• 1.31 / 2.17 0.6037 60.37
• Or 1 - .3963 0.6037 60.37

19
Sustainable Growth

• The sustainable growth rate tells us how fast the
  firm can grow, without increasing financial
  leverage.
• Sustainable growth rate Growth in equity from
  plowback plowback ratio x ROE
• 0.6037 x 0.2685 0.1621 or 16.21
• If the firm can continue to earn 26.85 on its
  equity and can plow back 60 of earnings into
  operations, its earnings and equity should both
  grow at 16.21 p.a.
• Growth at this rate requires external financing
  to grow at the existing rate. Without any
  additional external financing, the firm can only
  grow at what is called the Internal Growth Rate.

20
Internal Growth

• 0.1621 x (1,691,493 1,480,493) /(4,088,797
  3,998,256) 0.1621 x 0.3922 0.0636 or 6.36

21
Determinants of Growth

• 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

22
Deriving the Du Pont Identity

• ROE NI / TE
• Multiply by 1 and then rearrange
• ROE (NI / TA) (TA / TE) ROA Equity
  Multiplier
• Multiply by 1 again and then rearrange
• ROE (NI / Sales) (Sales / TA) (TA / TE)
• ROE Profit Margin Total Asset Turnover
  Equity Multiplier

23
Deriving the Du Pont Identity

• ROA (NI Interest)/ TA
• Multiply by 1 and rearrange
• ROA (NI Int)/ TA(Sales / TA)
• ROA (Operating Profit Margin)(Asset Turnover)
• ROE NI / TE
• ROE (NI/Sales(Sales/TA)(TA/TE)
• Net Profit MarginAsset
  TurnoverEquity Multiplier
• ROE NI/(NIInt)(NI Int)/
  Sales(Sales/TA)(TA/TE)
• Debt Burden Op Profit Margin Asset
  TurnoverEq Multiplier
• Debt Burden ROAEquity Multiplier

24
Using the Du Pont Identity

• ROE Net Profit Margin Total Asset Turnover
  Equity Multiplier
• Net Profit margin is a measure of the firms
  operating efficiency how well does it control
  costs
• Total asset turnover is a measure of the firms
  asset use efficiency how well does it manage
  its assets
• Equity multiplier is a measure of the firms
  financial leverage

25
Table 3.6
26
Why Evaluate Financial Statements?

• Internal uses
• Performance evaluation compensation and
  comparison between divisions
• Planning for the future guide in estimating
  future cash flows
• External uses
• Creditors
• Suppliers
• Customers
• Stockholders

27
Benchmarking

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

28
Work the Web Example

• The Internet makes ratio analysis much easier
  than it has been in the past
• Go to Multex Investor (yahoo.multexinvestor.com)
• Choose a company and enter its ticker symbol
• Click on Ratios and see what comparative
  information is available

29
Quick Quiz

• How do you standardize balance sheets and income
  statements and why is standardization useful?
• What are the major categories of ratios and how
  do you compute specific ratios within each
  category?
• What are the major determinants of a firms
  growth potential?
• What are some of the problems associated with
  financial statement analysis?