AD 311 Business Finance Attila Odabasi Lec 3: Financial Analysis (Ch 3)

Main Points
o How to conduct financial analysis? o Techniques
 Ratio Analysis  Vertical Analysis (Percentage method)  Horizantal Analysis (Comparative method)  Be able to compute and interpret the DuPont Identity

o Understand the problems and pitfalls in financial statement analysis

Why Evaluate Financial Statements?

o Internal uses
 Performance evaluation against the target, comparison of divisions.  Planning for the future guide in estimating future cash flows,

o External uses
 Creditability checks by banks, suppliers,  Stockholders for investment purposes,

Ratio Analysis
o Time-Trend Analysis
 Used to see how the firms performance is changing through time

o Peer Group Analysis

 Compare to similar companies or within industries
SIC and NAICS codes SIC: Standard Industrial Classification Codes SIC: xxxx, first digit main industry, following digits narrow down ths industry NAICS: North American Industrial Classification Codes

Financial Ratio Analysis

o How to?
 Construct summary financial statements  Check out the numbers in the financial statements to have an idea about the total asset size, shortterm vs long-term asset (and liability) sizes, etc. So you can judge the firm size compared to other firms in the sector, etc.  Determine the financial ratios important for your analysis. Then, analyse these ratios. Verify their performance in the period, compared to previous periods, and compared to competitions ratios.  Apply DuPont analysis to find out whether there is place for improvement in firm profitability.

Ratio Analysis
Tips:
 One can calculate many ratios. Use only the ones relevant for the analysis.  As you look at each ratio, ask yourself what the ratio is trying to measure and why that information is important.  Pay attention to seasonality and crisis periods.  Use ratios and percentages together.  Use at least three years of data and compare with benchmarks (sector averages, competiton)  What are the bencmarks used for comparison?  What makes a ratio good or bad?

Categories of Financial Ratios

o Short-term solvency or liquidity ratios o Asset management or turnover ratios o Long-term solvency or financial leverage ratios o Coverage Ratios o Profitability ratios o Market value ratios

Sample Balance Sheet

Numbers in millions
2013 Cash A/R Inventory Other CA Total CA Net FA Total Assets 696 956 301 303 2,256 3,138 5,394 2014 58 A/P 992 N/P 361 Other CL 264 Total CL 1,675 LT Debt 3,358 C/S 5,033 Total Liab. & Equity 2013 307 26 1,662 1,995 843 2,556 5,394 2014 303 119 1,353 1,775 1,091 2,167 5,033

Sample Income Statement, 2014

Numbers in millions, except EPS & DPS
Revenues Cost of Goods Sold Expenses Depreciation EBIT Interest Expense Taxable Income Taxes Net Income EPS Dividends per share 3.61 1.08 5,000 (2,006) (1,740) (116) 1,138 (7) 1,131 (442) 689

Short-Term Solvency Ratios

o Current Ratio = CA / CL
 2,256 / 1,995 = 1.13 times

o Quick Ratio = (CA Inventory) / CL

 (2,256 301) / 1,995 = .98 times

o Cash Ratio = Cash / CL

 696 / 1,995 = .35 times

o NWC to Total Assets = NWC / TA

 (2,256 1,995) / 5,394 = .05

o Interval Measure = CA / average daily operating costs

 2,256 / ((2,006 + 1,740)/365) = 219.8 days

Computing Long-term Solvency Ratios

o Total Debt Ratio = (TA TE) / TA
 (5,394 2,556) / 5,394 = 52.61%

o Debt/Equity = TD / TE
 (5,394 2,556) / 2,556 = 1.11 times

o Equity Multiplier = TA / TE = 1 + D/E

 1 + 1.11 = 2.11

o Long-term debt ratio = LTD / (LTD + TE)

 843 / (843 + 2,556) = 24.80%

Computing Coverage Ratios

o Times Interest Earned = EBIT / Interest
 1,138 / 7 = 162.57 times

o Cash Coverage = (EBIT + Depreciation) / Interest

 (1,138 + 116) / 7 = 179.14 times

Computing Inventory Ratios

o Inventory Turnover = Cost of Goods Sold / Inventory
 2,006 / 301 = 6.66 times

o Days Sales in Inventory = 365 / Inventory Turnover

 365 / 6.66 = 55 days

Computing Receivables Ratios

o Receivables Turnover = Sales / Accounts Receivable
 5,000 / 956 = 5.23 times

o Days Sales in Receivables = 365 / Receivables Turnover

 365 / 5.23 = 70 days

Computing Total Asset Turnover

o Total Asset Turnover = Sales / Total Assets
 5,000 / 5,394 = .93  It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

o NWC Turnover = Sales / NWC

 5,000 / (2,256 1,995) = 19.16 times

o Fixed Asset Turnover = Sales / NFA

 5,000 / 3,138 = 1.59 times

Computing Profitability Measures

o Profit Margin = Net Income / Sales  689 / 5,000 = 13.78% o Return on Assets (ROA) = Net Income / Total Assets  689 / 5,394 = 12.77% o Return on Equity (ROE) = Net Income / Total Equity  689 / 2,556 = 26.96%

Computing Market Value Measures

o Market Price = $87.65 per share o Shares outstanding = 190.9 million o PE Ratio = Price per share / Earnings per share  87.65 / 3.61 = 24.28 times o Market-to-book ratio = market value per share / book value per share  87.65 / (2,556 / 190.9) = 6.55 times

o Tobins Q= MV / replacement cost

Deriving the DuPont Identity

o ROE = NI / TE o Multiply by 1 (TA/TA) and then rearrange
 ROE = (NI / TE) (TA / TA)  ROE = (NI / TA) (TA / TE) = ROA * EM

o Multiply by 1 (Sales/Sales) again and then rearrange

 ROE = (NI / TA) (TA / TE) (Sales / Sales)  ROE = (NI / Sales) (Sales / TA) (TA / TE)  ROE = PM * TAT * EM

Using the DuPont Identity

o ROE = PM * TAT * EM  PM - the firms operating efficiency how well it controls costs  TAT - the firms asset use efficiency how well does it manage its assets  EM - the firms financial leverage

o ROE13= o ROE14 =

Standardized Financial Statements

o Common-Size Statements (Vertical Analysis): o Useful in comparison of firms of unequal size or to compare a company through time as it grows. o Common-Size Balance Sheets
 Compute all accounts as a percent of total assets

o Common-Size Income Statements

 Compute all line items as a percent of sales

Vertical Analysis (B/S)

Accounts Current Assets Cash A/R Inventory Other CA Total CA Fixed Assets Net Fixed Asset Total 3138 5394 3358 696 956 301 303 2256 58 992 361 264 1675 L-T Debt L-T Debt Common Stock 843 2556 100 1091 2167 5033 100 2013 2014 Accounts S-T Debt A/P N/P Other CL Total CL 307 26 1662 1995 303 119 1353 1775 2013 2014

100 5033 100 Tot 5394 Liab&Equity

Vertical Analysis (Income Statement)

Accounts Revenues Cost of Goods Sold Expenses Depreciation EBIT Interest Expense Taxable Income Taxes Net Income 2014 5,000 (2,006) (1,740) (116) 1,138 (7) 1,131 (442) 689 % 100 40 34.8 2.3 22.8 0.0 22.6 8.8 13.8

Common-Base Year Financial Statement Horizantal Analysis

o Used for trend analysis o Select a base year and then express each item or account as a percent of the base-year value of that item. o An alternative is Combined Common-Size and Base-Year Analysis.

B/S Horizantal Analysis (in 000s)

Accounts Current Assets Cash A/R Inventory Other CA Total CA Fixed Assets Net Fixed Asset Total 3138 5394 3358 5033 220 (361) 7 (6.7) 696 956 301 303 2256 58 992 361 264 1675 (638) 36 60 (39) (581) (91.6) 3.8 19.9 (12.9) (25.8) 2013 2014 Diff %

B/S Horizantal Analysis (in 000s)

2013 S-T Debt A/P N/P Other CL Total CL 307 26 1662 1995 303 119 1353 1775 (4) 93 (309) (220) (1.3) 357 (18.6) (11) 2014 Diff %

L-T Debt L-T Debt Common Stock Tot Liab&Equity 843 2556 5394 1091 2167 5033 248 (389) (361) 29.4 (15.2) (6.7)

Potential Problems
o There is not a unique underlying theory. For example, there is no way to know which ratios are most relevant o Benchmarking is difficult for diversified firms o Globalization and international competition makes comparison more difficult because of differences in accounting regulations o Varying accounting procedures, i.e. FIFO vs. LIFO o Different fiscal years o Extraordinary events

Some qualitative factors that analysts should consider when judging the future financial performance of firms.
o Are the companys revenues tied to a single customer? o To what extent are the companys revenues tied to a single product? o To what extent does the company rely on a single supplier? o What percentage of the companys business is generated overseas? o etc

Potential Red Flags

o Unexplained transactions that boost profits (selling assets?) o Unusual increase in A/R in relation to sales increases (relaxing credit policies, artificially loading up its distributiun channels?) o Unusual increases in inventories in relation to sales increases
 If it is due to an increase in finished goods, the demand for the products may be slowing down,

Potential red flags

 If it is an increase in Work-in-progress inventory, it may signal that managers expect an increase in sales,  If it is a build up in raw materials, it could suggest manufacturing/procurement inefficiencies; consequently an increase in COGS, lower margins.

o An increasing gap between a firms reported income and its cash flow from operating activities! (Expectation is a steady relationship between the two if the firms accounting policies remain the same). o Large fourth-quarter adjustments.

Aeropostale Extended DuPont Chart

ROE = 29.49%

ROA = 16.66%

EM = 1.77

PM = 6.97%

x z
Sales = 1,204.35 Sales = 1,204.35

TAT = 2.39

NI = 83.96

TA = 503.96

Total Costs = - 1,120.39

Sales = 1,204.35

Fixed Assets = 164.62

Current Assets = 339.34

COGS = - 841.87

SG&A = - 227.04

Cash = 225.27

Inventory = 91.91

Interest = - (3.67)

Taxes = - 55.15

Other CA = 22.16