Chapter 4- Financial Statement Analysis Tools

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					Chapter 4: Financial Statement Analysis Tools

Financial Ratios are some of the most valuable tools for financial analysts
           They are used internally to plan for the future, set goals, and evaluate workers
           They are used externally to grant companies credit, attract investors, and monitor performance.

Liquidity Ratios
          Liquidity is the speed with which an asset can be converted into cash
          Accounts Receivable is considered very liquid
          Others require large price discounts, such as buildings
          Creditors are concerned with liquidity

           Current Ratio
                    = Current Assets / Current Liabilities
                                       2.39 times
                    Assesses the ability of firms to pay their bills.
                    The higher, the more likely a company will be able to pay its bills and receive credit
                    Shareholders, however, want fewer current assets, because they make a lower return

           Quick Ratio
                     =(Current Assets - Inventories) / Current Liabilities
                                       0.840 times
                     Inventories are considered illiquid. Excluding it often paints a better picture of liquidity.
                     Always less than Current Ratio

Efficiency Ratios
           How well the company is using its assets to generate sales

           Inventory Turnover Ratio
                     Number of times a firm replaces inventories in a year
                     -- or -- stated differently, Number of dollars In sales generated per dollar of inventory.
                     =Cost of Goods Sold / Inventory
                                          3.89 times

           Accounts Receivable Turnover Ratio
                     Dollars in sales generated by one dollar invested in Accounts Receivable
                     Tells how well a firm is managing its Accounts Receivable
                     = Credit Sales / Accounts Receivable
                                        9.58 times
                                 (Assumes all sales are on credit)
                     Higher is generally better, but too high suggests credit is being denied to creditworthy customers

           Average Collection Period
                     a.k.a. Days Sales Outstanding
                     Indicates how many days, on average, it takes to collect on a credit sale
                     = Accounts Receivable / Annual Credit Sales * 360
                                       37.59 days
                     Provides us with the same information as A/R Turnover Ratio (it is simply the inverse)
                     (Preferred metric, since it is intuitively easier to understand).

          Fixed Asset Turnover Ratio
                    Describes dollar amount of sales generated by each dollar invested in fixed assets
                    = Sales / Net Fixed Assets
                                      10.67 times

          Total Asset Turnover Ratio
                    Describes how efficiently the firm is using all of its assets to generate sales
                    = Sales / Total Assets
                                       2.33 times
                    Generally, higher is better, but depends on the industry.

Leverage Ratios
          Leverage is a multiplication of force
          Leverage = Amount of debt a company uses to finance its operation
          Lots of debt means a company is "highly leveraged"
          Leverage ratios are important to creditors and shareholders

          Total Debt Ratio
                    = Total amount of Debt (both short- and long-term) / Total Assets
                    This says "Debt makes up about 58.5% of a firm's capital structure"

          Long-Term Debt Ratio
                   Often considered more useful to focus just on Long Term debt
                              … because Short Term Debt is easily modified but Long Term Debt is not
                   = Long Term Debt / Total Assets

          Long-Term Debt to Total Capitalization Ratio
                   Defined as the percentage of long-term sources of capital provided by long-term debt
                   = Long Term Debt / (Long Term Debt + Equity)

          Debt to Equity Ratio
                    Exactly the same information as Total Debt Ratio, but preferred by most analysts
                    =Total Debt / Total Equity
           Long-Term Debt to Equity Ratio
                    =Long Term Debt / Equity

Profitability Ratios
           Provide an easy way to compare profits across time periods or to different firms
           Without exception, higher is better
           Mature industries and those with lots of competition see lower profitability ratios
                      (Grocery stores will be lower than software companies)

           Gross Profit Margin
                     Indicates the amount of funds available to pay operating expenses
                     = Gross Profit / Sales
                                 Means COGS consumed 84.42% of Sales

           Operating Profit Margin
                     Profits remaining after paying usual (i.e. non-financial and interest) expenses
                     = Net Operating Income / Sales … also stated as EBIT / Sales

           Net Profit Margin
                      Profits to Sales-- tells the percentage of sales remaining for the shareholders
                      = Net Income / Sales

           Return on Total Assets
                     The total assets of a firm are the investment stakeholders have made to their company
                     ROA tells the return a firm is able to get for its stakeholders
                     = Net Income / Total Assets
                     A key measure of opportunity cost-- can help decide if investment is better made elsewhere

           Return on Equity
                     Some investment is debt; Equity is the shareholders' own invested funds, sans debt
                     = Net Income / Total Equity

           Return on Common Equity
                     Excludes preferred stock; indicates return generated for common shareholders
                     Does not include preferred dividends; same as ROE if there is no preferred stock
           Summary of EPI's Profitability Ratios
                   Profitability slipped dramatically from 2006 to 2007
                   Gross profit margin is a bit lower, but operating profit margin is much lower in 2007
                               This indicated potential problems in controlling operating expeses… particular SG&A
                   The other profitability ratios are lower because there's a lot of extra debt in 2007, resulting in higher int
                   Operating expenses have grown considerably, leading to a decline in profit margin.
                               Reducing these expenses should be a priority.

Financial Distress Prediction
          Much work has gone into developing models showing companies' danger of falling into bankruptcy

           Original Z-Score Model
                     Places a company into groups, depending on the score.
                     The lower the Z-score, the higher the risk of financial distress.

                      For public companies, Z-Score equals:

                                  1.2 * (Net working capital / total assets) plus
                                  1.4 * (Retained earnings / total assets) plus
                                  3.3 * (EBIT / total assets) plus
                                  0.6 * (Market value of equity / book value of liabilities) plus
                                  1.0 * (Sales / total assets)

                     Z < 1.81                Bankruptcy predicted within one year
                     1.81 < Z < 2.675        Financial distress; possible bankruptcy
                     Z > 2.675               No financial distress predicted
                                no financial distress
Using Financial Ratios
          Trend Analysis involves comparing ratios across time for a given firm
          Industry Comparables involves comparing a firm's ratios to those of its competitors
                     Sometimes Comps are difficult to identify; as such, a range of Comps is often necessary
          Company Goals can be a good measure of success-- how well ratios met earlier targets
          Using appropriate ratios when measuring performance can make a big difference

           Setting up an Expert System involves determining in advance how to categorize ratios as "good" vs. "bad"
                       For example, "IF [Ratio] > [predetermined healty level], "Good", "Bad"
                       Use AND if MORE THAN ONE ratio must meet a predetermined level
                       Use OR if ANY ONE OF SEVERAL ratios must meet a predetermined level for performance to be co

Economic Profit Measures of Performance
         Economic profit is profit earned in excess of a firms costs, INCLUDING OPPORTUNITY COSTS
                    Opportunity cost is often the cost of capital-- the amount a firm could earn by investing its asset money
         The basic idea: the firm cannot increase shareholder wealth unless its profit exceeds its cost of capital
Normal accounting measures are not enough.

Economic Profit = After-tax net operating profit (a.k.a. NOPAT) - After-tax cost of operating capital
                     NOPAT = EBIT * (1 - tax rate)
                     Operating Capital = (Non-interest-bearing Current Assets + Net Fixed Assets) - (Non-intere

Net Income can be positive but misleading… Economic Profit provides a clearer indication of contribution to shar
, and monitor performance.

y its bills and receive credit
se they make a lower return

aints a better picture of liquidity.

erated per dollar of inventory.

ounts Receivable

 being denied to creditworthy customers
on a credit sale

Ratio (it is simply the inverse)

ar invested in fixed assets

ts to generate sales

ed but Long Term Debt is not

l provided by long-term debt

 eferred by most analysts
tability ratios

nd interest) expenses

for the shareholders

s have made to their company

nvestment is better made elsewhere

n invested funds, sans debt

common shareholders
ere is no preferred stock
 argin is much lower in 2007
 ng operating expeses… particular SG&A
 lot of extra debt in 2007, resulting in higher interest expense
  a decline in profit margin.

 anger of falling into bankruptcy

                                        From Financials:
 liabilities) plus                       0.549993

                                        no distress

 of its competitors
nge of Comps is often necessary
 s met earlier targets
a big difference

o categorize ratios as "good" vs. "bad"
el], "Good", "Bad"
determined level
a predetermined level for performance to be considered "good"

  a firm could earn by investing its asset money risk-free
 ts profit exceeds its cost of capital
After-tax cost of operating capital

urrent Assets + Net Fixed Assets) - (Non-interest bearing Current Liabilities)

 des a clearer indication of contribution to shareholder wealth.
             Elvis Products International                                Elvis Products Internationa
                  Income Statement                                              Balance Sheet
          For the Year Ended Dec. 31, 2009                                    As of Dec. 31, 2009
                                   2007      2006    Assets
  Sales                        3,850,000 3,432,000        Cash and Equivalents
  Cost of Goods Sold           3,250,000 2,864,000        Accounts Receivable
Gross Profit                     600,000   568,000        Inventory
  SG&A Expenses                  330,300   240,000   Total Current Assets
  Fixed Expenses                 100,000   100,000        Plant & Equipment
  Depreciation Expense            20,000    18,900        Accumulated Depreciation
EBIT                             149,700   209,100   Net Fixed Assets
  Interest Expense                76,000    62,500   Total Assets
Earnings Before Taxes             73,700   146,600   Liabilities and Owner's Equity
  Taxes                           29,480    58,640        Accounts Payable
Net Income                        44,220    87,960        Short-term Notes Payable
                                                          Other Current Liabilities
Notes:                                               Total Current Liabilities
Tax Rate                         40%                      Long-term Debt
                                                     Total Liabilities
Market Value of Equity       884,400                      Common Stock
Cost of Capital                  13%                      Retained Earnings
Total Shareholder's Equity
Total Liabilities and Owner's Equity
ducts International                                 Elvis Products International
alance Sheet                                          Statement of Cash Flows
f Dec. 31, 2009                             For the Year Ended Dec. 31, 2009 ($ in 000's)
                   2007        2006   Cash Flows from Operations
                 52,000      57,600   Net Income                                44,220
                402,000     351,200   Depreciation Expense                      20,000
                836,000     715,200   Change in Accounts Receivable            (50,800)
              1,290,000   1,124,000   Change in Inventories                   (120,800)
                527,000     491,000   Change in Accounts Payable                29,600
                166,200     146,200   Change in Other Current Liabilities        4,000
                360,800     344,800   Total Cash Flows from Operations         (73,780)
              1,650,800   1,468,800   Cash Flows from Investing
                                      Change in Plant & Equipment              (36,000)
                175,200    145,600    Total Cash Flows from Investing          (36,000)
                225,000    200,000    Cash Flows from Financing
                140,000    136,000    Change in Short-term Notes Payable        25,000
                540,200    481,600    Change in Long-term Debt                 101,180
                424,612    323,432    Change in Common Stock                         0
                964,812    805,032    Cash Dividends Paid to Shareholders      (22,000)
                460,000    460,000    Total Cash Flows from Financing          104,180
                225,988    203,768    Net Change in Cash Balance                (5,600)
  685,988     663,768
1,650,800   1,468,800
                           Elvis Products International
                         Ratio Analysis for 2008 and 2009
Liquidity Ratios                                            2009        2008 Liquidity Min      2009
Current Ratio                                                2.39        2.33       2.3    liquid
Quick Ratio                                                  0.84        0.85       0.8    liquid
Efficiency Ratios
Inventory Turnover                                           3.89        4.00
Accounts Receivable Turnover                                 9.58        9.77
Average Collection Period                                   37.59       36.84
Fixed Asset Turnover                                        10.67        9.95
Total Asset Turnover                                         2.33        2.34
Leverage Ratios
Total Debt Ratio                                        58.4%          54.8%
Long-Term Debt Ratio                                    25.7%          22.0%
Long-Term Debt to Total Capitalization Ratio            38.2%          32.8%
Debt to Equity Ratio                                      1.41           1.21
Long-Term Debt to Equity Ratio                          61.9%          48.7%
Profitability Ratios
Gross Profit Margin                                     15.6%          16.6%
Operating Profit Margin                                  3.9%           6.1%
Net Profit Margin                                        1.1%           2.6%
Return on Total Assets                                   2.7%           6.0%
Return on Equity                                         6.4%          13.3%
Return on Common Equity                                  6.4%          13.3%

                                                      0.55                      1.2 * (Net working capital / total assets)
                                                      0.19                      1.4 * (Retained earnings / total assets) p
                            Z-Score                   0.30                      3.3 * (EBIT / total assets) plus
                                                      0.55                      0.6 * (Market value of equity / book value
                                                      2.33                      1.0 * (Sales / total assets)

Economic Profit                                          2009           2008
Tax Rate                                                  40%            40%              Given
NOPAT                                                  89,820        125,460              EBIT * (1 - Tax Rate)

Total Operating Capital                             1,335,600       1,187,200             Current Assets + Net Fixed Assets
After-tax Cost of Capital                                 13%             13%             Given

Dollar Cost of Capital                                173,628        154,336              Total Operating Capital * After-ta
Economic Profit                                       (83,808)       (28,876)             NOPAT - Dollar Cost of Capital
                  2008      Liquidity
             liquid         liquidity healthy
             liquid         liquidity healthy

orking capital / total assets) plus
 ed earnings / total assets) plus
 total assets) plus
t value of equity / book value of liabilities) plus
/ total assets)

BIT * (1 - Tax Rate)

urrent Assets + Net Fixed Assets - (Current Liabilities - S/T Notes Payable)

otal Operating Capital * After-tax Cost of Capital
OPAT - Dollar Cost of Capital

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