Docstoc

Profit Earning Ratio Calculation

Document Sample
Profit Earning Ratio Calculation Powered By Docstoc
					Chapter 4: Analysis of Financial Statements

I. Ratio analysis

    A. Analysis of financial statements can be used to predict future earnings and dividends

    B. Analysis of financial statements is starting point for planning actions that will improve
       future performance

    C. Ratio analysis: Calculates and interprets financial ratios to analyze firm’s performance

II. The different types of ratios

    A. Two liquidity ratios
       1. Liquid asset =asset that can be converted to cash quickly without having to reduce
          asset’s price very much
       2. Liquidity ratios: ratios that show the relationship of a firm’s cash and othe r current
          assets to its current liabilities
       3. Curre nt ratio
          a. Indicates the extent to which current liabilities are covered by those assets expected
              to be conve rted to cash in the near future
          b. Formula:
                                                           current assets
                                         current ratio =
                                                         cuurent liabilities
       4. Quick Ratio or Acid Test Ratio
          a. Inventories least liquid of firm’s current assets and are assets on which assets most
              likely to occur in event of liquidation. Firm’s ability to pay-off short-term
              obligations without relying on sale of inventories is important
          b. Formula:
                                                         current assets - inventory
                               quick (acid-test) ratio =
                                                             current liabilities

    B. Four asset management ratios
       1. Asset management ratios = set of ratios that measure how effectively firm manages its
          assets
       2. Inventory turnover ratio
                                                                Sales
                                 Inventory turnover ratio =
                                                              Inventory
       3. Days sales outstanding (DSO) = ave rage collection period = ACP
          a. Indicates the average length of time the firm must wait after making a sale before it
             receives cash
          b. Formula:
                                                       Receivables           Receivables
                 DSO = days sales outstanding =                         =
                                                 Average sales per day     Annual sales 365
       4. Fixed assets turnover ratio
          a. Measures how effectively the firm uses its plant and equipme nt
          b. Formula:
Chapter 4: Analysis of Financial Statements                                                   Page 1
                                                                            sales
                                      fixed assets turnover ratio =
                                                                      net fixed assets
        5. Total assets turnover ratio
                                                                         sales
                                      total assets turnover ratio =
                                                                      total assets

    C. Debt manage ment ratios
       1. Total debt to total assets
                                                              total debt
                                              debt ratio =
                                                             total assets
        2. Times-interest-earned (TIE) ratio
           a. Measures firm’s ability to meet its annual interest payments
           b. Formula
                                                                       EBIT
                            times-interest-earned (TIE) ratio =
                                                                  interest charges
        3. EBITDA cove rage ratio
           a. Ratio whose nume rator includes all cash flows available to meet fixed financial
              charges and whose denominator includes all fixed financial charges
           b. Formula:
                                                        EBITDA + lease payments
                 EBITDA coverage ratio =
                                             interest + principal payments + lease payments

    D. Four profitability ratios
       1. Profitability ratios = group of ratios that show combined effects of liquidity, asset
          manage ment, and debt on operating results
       2. Profit margin on sales
                                                              net income
                                    profit margin on sales =
                                                                 sales
       3. Return on total assets (ROA)
                                                                 net income
                                 return on total assets = ROA =
                                                                  total assets
       4. Basic earning powe r (BEP) ratio
          a. Ratio indicates the ability of firm’s assets to generate operating income
          b. Formula
                                                                         EBIT
                                 basic earning power (BEP) ratio =
                                                                      total assets
       5. Return on common equity
          a. Measures rate of return on common stockholders’ investment
          b. Formula:
                                                                       net income
                              return on common equity = ROE =
                                                                    common equity
       6. An important digression: The effect of leverage on ROE
          a. The concept of leverage
             i. Financial debt = use of debt financing
             ii. Three important implications of using debt financing

Chapter 4: Analysis of Financial Statements                                                   Page 2
                  ● By raising funds through debt, stockholde rs can control a firm with limited
                    amount of equity investment
                  ● The higher the proportion of total capital provided by stockholders, the less
                    risk faced by creditors.
                  ● If firm earns more on its assets than the interest it pays on debt, then using
                    debt “leverages” or magnifies the return on equity (ROE)
            b. Example: A leveraged and unleveraged firm

                   Table 4-1: Effects of Financial Leverage on Stockholder Returns
                              FIRM U [UNLEVERAGED (NO DEBT)]
Curre nt assets                           $50                  Debt                              $0
Fixed assets                                50                 Common Equity                    100
Total assets                             $100                  Total Liabilities & Equity      $100

                                                                 Business Conditions
                                                  Good         Expected                  Bad
Sales Revenue                                        $150.0                      $100.0      $75.0
   Ope rating costs                   Fixed            45.0                        45.0       45.0
                                      Variable         60.0                        40.0       30.0
   Total ope rating costs                             105.0                        85.0       75.0
Ope rating Income (EBIT)                              $45.0                       $15.0       $0.0
   Inte rest (Rate = 10%)                                0.0                         0.0        0.0
Earnings before taxes (EBT)                           $45.0                       $15.0       $0.0
   Taxes (rate = 40%)                                  18.0                          6.0        0.0
Net income                                            $27.0                        $9.0       $0.0
ROE                                                  27.0%                        9.0%       0.0%

                                 FIRM L [LEVERAGED (SOME DEBT)]
Curre nt assets                           $50           Debt                                    $50
Fixed assets                               50           Common Equity                            50
Total assets                             $100           Total Liabilities & Equity             $100

                                                              Business Conditions
                                                  Good      Expected                  Bad
Sales Revenue                                        $150.0                   $100.0      $75.0
   Ope rating costs                   Fixed            45.0                     45.0       45.0
                                      Variable         60.0                     40.0       30.0
   Total ope rating costs                             105.0                     85.0       75.0
Ope rating Income (EBIT)                              $45.0                    $15.0       $0.0
   Inte rest (Rate = 10%)                               5.0                       5.0       5.0
Earnings before taxes (EBT)                           $40.0                    $10.0      -$5.0
   Taxes (rate = 40%)                                  16.0                       4.0       0.0
Net income                                            $24.0                     $6.0      -$5.0
ROE                                                   48.0%                       12.0%     -10.0%


Chapter 4: Analysis of Financial Statements                                                 Page 3
            c. Results:
               i. Because interest is deductible, use of debt lowe rs tax bill and leaves more of the
                   firm’s operating income available to investors
               ii. Use of debt require firms to balance higher expected returns against increased
                   risk

    E. Three market value ratios
       1. Set of ratios that relate stock price to its earnings, cash flow and book value pe r share
       2. Price/Earnings Ratio = P/E Ratio
          a. Shows the dollar amount investors will pay for $1 of curre nt earnings
          b. Formula:
                                                                 price per share
                                price/earnings (P/E) ratio =
                                                               earnings per share
       3. Price/cash flow ratio
          a. Shows the dollar amount investors will pay for $1 of cas h flow
          b. Formula:
                                                            price per share
                                     price/cash flow =
                                                          cash flow per share
       4. Market/Book Ratio
          a. Book value per share:
                                                              common equity
                                  book value per share =
                                                             shares outstanding
          b. market/book ratio:
                                                             market price per share
                              market/book ratio = M/B =
                                                              book value per share

III. Book’s example of Allied Food Products

    A. Review financial state ments developed in Chapter 3: Tables 3 – 1, 3 – 2, 3 – 3, 3 – 4




Chapter 4: Analysis of Financial Statements                                                     Page 4
                                    TABLE 4 -2: Allied Food Products: Summary of Financial Rati os (Millions of Dollars)

                                                                        Li qui di ty Rati os
                                                                                                                             2004       Industry
               Ratio                              Formul a                                        Calcul ati on                                    Comment
                                                                                                                             Value      Average
                                                current assets                                    $1,000
           Current Ratio                                                                                 = 3.2x               3.7x        4.2x       Poor
                                              cuurent liabilities                                  $310
                                          current assets - inventory                             $385
               Quick                                                                                  = 1.2x                  1.8x        2.2x       Poor
                                              current liabilities                                $310

                                                                       Asset Management
                                                                                                                             2004       Industry
               Ratio                              Formul a                                        Calcul ati on                                    Comment
                                                                                                                             Value      Average
             Inventory                              Sales                                        $3,000
                                                                                                        = 4.9x                6.9x       10.9x       Poor
             Turnover                             Inventory                                       $615
             Days sales                         Receivables                                     $375
                                                                                                       = 46 days            40.3 days   36 days      Poor
            outstandi ng                      Annual sales 365                                 $8.2192
            Fi xed asset                             sales                                       $3,000
                                                                                                        = 3.0x                3.3x        2.8x       OK
             turnover                          net fixed assets                                  $1,000
            Total assets                             sales                                       $3,000                                            Somewhat
                                                                                                        = 1.5x                1.7x        1.8x
             turnover                             total assets                                   $2,000                                              Low

                                                                       Debt Management
                                                                                                                             2004       Industry
               Ratio                              Formul a                                        Calcul ati on                                    Comment
                                                                                                                             Value      Average
           Total debt to                           total debt                                   $1,060                                               High
                                                                                                       = 53.0%               47.6%      40.0%
            total assets                          total assets                                  $2,000                                              (risky)
       Ti mes-interest-earned                        EBIT                                        $283.8                                              Low
                                                                                                        = 3.2x                4.4x        6.0x
                (TIE)                          interest charges                                  $88.0                                              (risky)
             EB ITDA                      EBITDA + lease payments                    $383.8 + $28    $411.8                                          Low
                      *                                                                            =        = 3.0x            3.5x        4.3x
             Coverage          interest + principal payments + lease payments      $88 + $20 + $28    $136                                          (risky)
       *
         Assumes lease payments = $28 million and pri nci pal payments = $20 million




Chapter 4: Analysis of Financial Statements                                                                        Page 5
                              TABLE 4 -2 (Continued): Allied Food Products: Summary of Financi al Ratios (Millions of Dollars)

                                                                            Profitability
                                                                                                        2004     Industry
                                     Ratio                    Formul a                  Calcul ati on                       Comment
                                                                                                        Value    Average
                                                             net income                $117.5
                             Profit margin on sale                                            = 3.9%    4.3%       5.0%      Poor
                                                                sales                  $3,000
                             Return on total asset           net income                $117.5
                                                                                              = 5.9%    7.3%       9.0%      Poor
                                   (ROA)                     total assets              $2,000
                             Basic earning power                EBIT                  $283.8
                                                                                             = 14.2%    15.7%     18.0%      Poor
                                    (B EP)                   total assets             $2,000
                           Return on common equity           net income               $117.5
                                                                                             = 12.5%    13.8%     15.0%      Poor
                                    (ROE)                  common equity               $940

                                                                    Market Value Ratios
                                                                                                        2004     Industry
                                     Ratio                    Formul a                  Calcul ati on                       Comment
                                                                                                        Value    Average
                                                           price per share             $23.00
                             Price/earnings (P/ E)                                            = 9.8x    10.7x      11.3x     Low
                                                         earnings per share            $2.35
                                                           price per share             $23.00
                                Price/cash flow                                               = 5.3x    6.13x      5.4x      Low
                                                         cash flow per share           $4.35
                                                       market price per share          $23.00
                              Market/ book (M/B)                                              = 1.2x    1.5x       1.7x      Low
                                                        book value per share           $18.80




IV. Benchmarking: cross-sectional and tre nd comparisons

    A. Trend analysis
       1. = analysis of a firm’s financial ratios over time
       2. Used to estimate the likelihood of improve ment or deterioration in its financial condition

    B. Cross-sectional analysis: compare company’s financial ratios with a group of “benchmark” companies

Chapter 4: Analysis of Financial Statements                                                                     Page 6
V. Tying ratios together: The Du Pont Equation

    A. Basic Du Pont Equation
       1. ROA is the product of the profit margin and the total asset turnover
       2. Formula
                                   Net Income      Net Income        Sales
                           ROA =                              
                                   Total Assets       Sales      Total Assets
       3. Book’s 2005 Allied Food Example
                                      ROA = 3.9%  1.5 = 5.9%

    B. ROA and ROE
       1. If a company we re financed only by common equity → no debt → no liabilities → assets
          = equity
                                     Net Inocme        Net Income
                            ROA =                 =                  = ROE
                                     Total Assets   Common Equity
       2. Define the equity multiplier
          a. Definition:
                                                          Total Assets
                                    Equity Multiplier =
                                                        Common Equity
          b. Firms with more leverage → ↑ debt and ↓ equity → ↑ equity multiplie r
          c. Book’s 2005 Allied Food example: equity multiplier = ($2,000)/($940) = 2.13
       3. Extended Du Pont equation

                          Net Income      Sales       Total Assets
            a. ROE =                              
                             Sales     Total Assets Common Equity

            b. ROE = (profit margin)  (total assets turnover)  (equity multipler)

            c. Book’s 2005 Allied Food Example: ROE = (3.9%)(1.5)(2.13) = 12.5%

VI. Uses and limitations of ratio analysis

    A. Comparison with industry averages more difficult for conglomerate firms that operate
       many divisions in different industries

    B. “Average” performance is not necessarily good → Perhaps firm should have highe r goal
       and focus on industry leader’s ratios → Benchmarking will help in this area

    C. Inflation distorts balance sheets and income statements and comparisons of ratios across
       time must be done with care

    D. Seasonal factors can distort ratios

    E. Firms may e mploy “window dressing techniques” to make their financial state ments look
       better than they really are

    F. Different accounting and operating practices can distort comparis ons of ratios
Chapter 4: Analysis of Financial Statements                                                Page 7
    G. It is difficult to determine whether a given ratio value is good or bad
       1. A high current ratio may imply excellent liquidity (which is good) or excessive cash
            (which is bad because it is a nonearning asset)
       2. A high fixed asset turnover ratio may indicate a firm that uses its fixed assets efficiently
            or a firm that is short cash and doesn’t have capital for needed investments

    H. Some of the firm’s ratios may look strong while some of its ratios look poor
       1. Makes it difficult to determine overall position of firm
       2. Statistical methods (discriminate analysis) have been used to determine the net effect of
          a set of ratios and determine which ones predict financial distress

VII.    Proble ms with ROE

    A. ROE and shareholder wealth are positively correlated but problems can anise when ROE
       is the sole measure of performance

    B. Types of problems
       1. ROE does not consider risk
       2. ROE does not consider the amount of invested capital
       3. Managers attempts to maximize ROE will ignore other profitable investments




Chapter 4: Analysis of Financial Statements                                                    Page 8

				
DOCUMENT INFO
Description: Profit Earning Ratio Calculation document sample