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Working with Financial Statements FINA 111, Spring 2008, Weeks 6-7 RWJ, Chapter 3 1 Chapter 3 learning objectives • Be able to construct standardized financial statements for comparison purposes • Be able to compute and interpret important financial ratios including the Du Pont identity • Describe the determinants of a firm’s profitability and growth • Explain the problems and pitfalls in financial statement analysis 2 Chapter 3 outline • Standardized financial statements • Ratio analysis • The Du Pont identity • Internal and sustainable growth rates • Using financial statement information 3 Financial Statements Topics Financial statements Standard- Firm ized Financial growth financial ratios rates statements Asset Short-term Long-term Market DuPont manage- Profitability Internal Sustainable solvency solvency value identity ment 4 Standardized financial statements 1. Common-size balance sheets • compute all accounts as a percent of assets 2. Common-size income statements • compute all line items as a percent of sales 3. Standardized statements make it easier to compare financial information for a company over time, particularly, as the company grows 4. Useful for comparing companies of different sizes, particularly within the same industry 5. Also useful for forecasting and identifying fixed versus variable costs 5 Sample common balance sheet Numbers in Numbers in % % thousands ($) thousands ($) Accounts Cash 6,489 0.16% payable 340,220 8.32% Accounts receivable 1,052,606 25.74% Notes payable 86,631 2.12% Other current Inventory 295,255 7.22% liabilities 1,098,602 26.87% Other current Total current assets 199,375 4.88% liabilities 1,525,453 37.31% Total current Long-term assets 1,553,725 38.00% debt 871,851 21.32% Net fixed assets 2,535,072 62.00% Equity 1,691,493 41.37% Total liabilities Total assets 4,088,797 100.00% and equity 4,088,797 100.00% 6 Sample common income statement Number in thousands ($) % Revenues 3,991,997 100.00% Cost of goods sold -1,738,125 43.54% Expenses -1,205,530 30.20% Depreciation -308,355 7.72% EBIT 739,987 18.54% Interest expense -42,013 1.05% Taxable income 697,974 17.49% Taxes (39%) -272,210 6.82% Net income 425,764 10.67% Shares outstanding: 196,204,610 $2.17 Earning per share (EPS) (425,764 ÷ 196,204,610) $0.86 Dividends per share (DPS) (168,735,965 ÷ 196,204,610) 7 Financial Statements Topics Financial statements Standard- Firm ized Financial growth financial ratios rates statements Asset Short-term Long-term Market DuPont manage- Profitability Internal Sustainable solvency solvency value identity ment 8 Financial ratio analysis • Ratios allow for comparisons – of a company over time (time series) – between companies at a given point in time (cross- section) • Ratios are used – internally by managers – externally by suppliers, banks, customers, managers, regulators, stock analysts, portfolio managers and other investors, and researchers • As you look at each ratio, ask yourself what the ratio is trying to measure and why is that information important • Click on moneycentral.msn.com/investor/finder/customstocks.asp for an illustration of how ratios can be used 9 Categories of financial ratios Short-term solvency ratios (liquidity ratios) Long-term solvency ratios (financial leverage ratios) Asset management ratios (turnover ratios) Profitability ratios Market value ratios 10 Solvency ratios Short-term solvency Long-term solvency ratios (liquidity ratios) ratios (financial measure leverage ratios) measure the firm’s ability to pay off current liabilities (e.g. how much debt the firm short term debt) has relative to equity by liquidating current the firm’s ability to repay assets (e.g. marketable its debt securities and accounts receivable) 11 Turnover, profitability and MV ratios Asset management ratios (turnover ratios) measure how efficiently assets are used Market value in generating sales revenue ratios measure how debt and Profitability ratios measure equity investors view the how much profit the company company is making in terms of Sales Assets Equity 12 Sample balance sheet As at year-end, numbers in thousands Cash 6,489 A/P 340,220 A/R 1,052,606 N/P 86,631 Inventory 295,255 Other C/L 1,098,602 Other C/A 199,375 Total C/L 1,525,453 Total C/A 1,553,725 LT debt 871,851 Net F/A 2,535,072 Equity 1,691,493 Total assets 4,088,797 Total liab. 4,088,797 & equity 13 Sample income statement Numbers in thousands, except EPS & DPS Sales revenue 3,991,997 Cost of goods sold 1,738,125 Expenses 1,205,530 Depreciation 308,355 EBIT 739,987 Interest expense 42,013 Taxable income 697,974 Taxes 272,210 Net income 425,764 Earnings per share 2.17 Dividends per share 0.86 14 Computing liquidity ratios • Current ratio = CA / CL – 1,553,725 / 1,525,453 = 1.02 times – a measure of short-term liquidity The firm is just barely able to cover current liabilities with it’s current assets. A short-term creditor might find this too risky and reduce the likelihood that they would lend money to the company. The ratio should be compared to the industry average – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books. 15 Liquidity ratios, cont • Quick ratio = (CA – Inventory) / CL – (1,553,725 – 295,225) / 1,525,453 = 0.825 times – inventory is excluded since it is presumed to be more difficult to convert to cash than other current liabilities • Cash ratio = Cash / CL – 6,489 / 1,525,453 = 0.0043 times – this company carries a very low cash balance. • however, this could be an indication that the firm is aggressively investing in assets that will provide higher returns – a firm needs to make sure that it has enough cash to meet its obligations, while recognizing that holding more cash reduces the return earned by the company 16 Calculating financial ratios • Average balance sheet values are often used rather than values for a single date – e.g. average beginning-of-year and end-of-year values • Whether to use an average or not depends on the reason for calculating the ratio – e.g. if you’re interested in how much liquidity a firm had in the past year, use average balance sheet values – if you want to know how much liquidity the firm has at present, use the most recent balance sheet values 17 Long-term solvency measures (financial leverage) • Total debt ratio = (A – E) / A = D / A – (4,088,797 – 1,691,493) / 4,088,797 = 0.5863 times or 58.63% – the firm finances almost 59% of its assets with debt • Debt / Equity = D / E – (4,088,797 – 1,691,493) / 1,691,493 = 1.42 times • Equity multiplier = A / E = 1 + D/E – 1 + 1.417 = 2.417 Given any two variables, solve for the third 18 Computing coverage ratios • Times interest earned = EBIT / Interest – 739,987 / 42,013 = 17.6 times – the firm has EBIT equal to 17.6 times the amount it needs to make interest payments • Cash coverage = (EBIT + Depreciation) / Interest – (739,987 + 308,355) / 42,013 = 24.95 times Note: Even though the company is financed with over 58% debt, there is a substantial amount of operating income available to cover the required interest payments. 19 Computing inventory ratios • Inventory turnover = Cost of goods sold / Inventory – also defined as Sales / Inventory – 1,738,125 / 295,255 = 5.89 times – the firm sold off or turned over its entire inventory 5.89 times during the year – the higher the ratio, the more efficient is the firm’s inventory management • Days’ sales in inventory = 365 / Inventory turnover – 365 / 5.89 = 62 days – inventory sits 62 days on average before it is sold Note: in FINA 111 we will compute turnover ratios using ending balance sheet values, unless otherwise stated 20 Computing receivables ratios • Receivables turnover = Sales / Accounts receivable • 3,991,997 / 1,052,606 = 3.79 times • if all sales are credit sales, the firm collects on its outstanding credit accounts and re-loans the money 3.79 times per year • Days’ sales in receivables = 365 / Receivables turnover • 365 / 3.79 = 96 days • on average, the firm collects on its credit sales in 96 days 21 Computing total asset turnover • Total asset turnover (TAT) = Sales / Assets – 3,991,997 / 4,088,797 = 0.98 times – for every dollar in assets, the firm generates $0.98 in sales • TAT measures asset use efficiency • Some industries are capital intensive, meaning TAT < 1; while others are labor intensive, meaning TAT > 1 – it’s not unusual for TAT to be < 1, especially if a firm has a large amount of fixed assets 22 Computing profitability measures • Profit margin = Net income / Sales (return on sales) – 425,764 / 3,991,997 = 0.1067 times or 10.67% – $0.1067 in profit results from each dollar of sales • Return on assets (ROA) = Net income / Assets – 425,764 / 4,088,797 = 0.1041 times or 10.41 – $0.1041 in profit results from each dollar of assets – but this is misleading? Why? More later.. • Return on equity (ROE) = Net income / Equity – 425,764 / 1,691,493 = 0.2517 times or 25.17% – $0.2517 in profit results from each dollar of equity 23 Computing market value measures • Market Price = $61.625 per share • Shares outstanding = 196,204,610 • Earnings per share = $2.17 • Price-earnings (PE) 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 – Market price / (Book value of equity / Number of shares outstanding) – 61.625 / (1,691,493,000 / 196,204,610) = 7.15 times 24 Problems with financial statement analysis • Financial advisory firms my differ in the way ratios are computed • Difficulty in finding comparable firms • How do we handle conglomerates and multi- divisional firms? • Differences in accounting practices • Differences in capital structures • Seasonal variations • One-time events • Different fiscal years 25 Financial Statements Topics Financial statements Standard- Firm ized Financial growth financial ratios rates statements Asset Short-term Long-term Market DuPont manage- Profitability Internal Sustainable solvency solvency value identity ment 26 Basic Du Pont identity NI NI S A ROE E S A E Profit Turn- Equity margin over multiplier Where NI = Net income ROE = return on equity E = Equity NI/S = net profit margin (PM) A = Assets S/A = total asset turnover (TAT) S = Sales A/E = equity multiplier (EM) 27 Deriving the Du Pont identity • ROE = Net income (NI) / Equity (E) • Multiply by A/A and then rearrange ROE = (NI / E) × (A / A) ROE = (NI / A) × (A / E) = ROA × EM • Multiply by Sales/Sales and rearrange ROE = (NI / A) × (A / E) (Sales / Sales) ROE = (NI / Sales) × (Sales / A) × (A / E) ROE = PM × TAT × EM 28 Components of the basic Du Pont identity • ROE = PM × TAT × EM – Profit margin (PM) is a measure of the firm’s operating efficiency – how well does it control costs? – Total asset turnover (TAT) is a measure of the firm’s asset use efficiency – how well does it manage its assets? – Equity multiplier (EM) is a measure of the firm’s financial leverage 29 Using the Du Pont identity • The Du Pont identity provides insight into a firm’s financial performance • What does this information say about how the firm is managed and why it performs the way it does? • To answer this question, we look at how the identity’s components – vary over time for a given firm – compare with the identity components of other firms at a given point in time 30 Extended Du Pont identity NI NI EBIT Sales EBT Assets ROE Equity E EBT Sales Assets EBIT Tax Turn- Equity factor over multiplier Profit Interest margin factor Note: the material in this slide and the next seven slides will not be covered in the examinations. It is presented as a logical and insightful extension such that all the information in the income statement is taken into account in analyzing ROE and financial performance. 31 Components of extended Du Pont identity • Basic components – Profit margin (PM) – Total asset turnover (TAT) – Equity multiplier (EM) • Extended components – Interest factor (EBT / EBIT) is the proportion of operating earnings remaining after interest is paid on debt – Tax factor (NI / EBT) is the proportion of earnings before taxes remaining after income taxes are paid 32 Restatement of Du Pont identity D ROE ROA ( ROA i) 1 t * * E Note: this ROA definition is Where: different from the one in the ROA* = EBIT / A text whereby ROA = NI / A i = interest rate = Interest / D ROA* i = spread between ROA* and interest rate on debt D = Debt E = Equity t = Tax rate 33 Proof of restated version of Du Pont NI ROE E NI EBT EBIT S A EBT EBIT S A E NI EBIT INT EBIT S A EBT EBIT S A E ROA* A iD 1 t ROA A A ROA* E * ROA* E D i D 1 t E E D D 1 t ROA* ROA* i E E E D ROA* ROA* i 1 t E Where: ROA* = EBIT / A; D = debt; E = equity; i = interest rate; INT = i D; t = tax rate; NI = net income; EBT = earnings before tax; EBT = EBIT – INT; EBIT = ROA* A; A = D + E 34 Interpretation of restated identity D ROE ROA* ( ROA* i ) 1 t E • The restated Du Pont identity tells us what happens to ROE when financial leverage (D/E) is increased • Recall that – ROA* = EBIT/A, a measure of how much operating profit a firm’s assets generate – i = Interest expense / Debt (D) = interest rate on debt • If ROA* > i, ROE increases as leverage is increased – shareholders benefit from greater leverage • If ROA* < i, ROE decreases as leverage is increased – Shareholders are hurt by greater leverage 35 More detailed example of Du Pont Note: both companies have the same total assets (A) and EBIT Company A Company B Assets (A) 100 Equity (E) 100 Assets (A) 100 Debt (D) 50 Equity (E) 50 EBIT 20 EBIT 20 Int @10% 0 Int @10% 5 Tax @ 40% 8 Tax @ 40% 6 Net income (NI) 12 Net Income (NI) 9 Company A Company B (Textbook) ROE = NI / E 12/100 = 12% 9/50 = 18% (Textbook) ROA = NI / A 12/100 = 12% 9/100 = 9% Define ROA* = EBIT/A 20/100 = 20% 20/100 = 20% 36 Now let’s apply our restated Du Pont identity ROE = [ROA* + (ROA* i) (D/E)] (1 t) ROEA= [0.20 + ( 0.20 0.10) 0] (1 0.4) = 0.20 (0.6) = 12 % ROEB= [0.20 + (0.20 0.10) 1] (1 0.4) = 0.20 0.6 + 0.10 0.6 = 0.12 + 0.06 = 12% (same as ROEA) + 6% = 18% due to financial leverage Note: both firms have the same operating performance (ROAA* = ROAB* = 20%) 37 Assume sales for Company A and B = $100 NI NI EBIT SALES EBT Asset ROEA Equity E EBT SALES Assets EBIT 12 12 20 100 20 100 100 20 100 100 20 100 0.6 0.20 111 12% 0.12 1 NI NI EBIT SALES EBT Asset ROEB Equity E EBT SALES Assets EBIT 9 9 20 100 15 100 50 15 100 100 20 50 0.6 0.20 1 0.75 2 18% 0.12 1.5 Interpretation: Company B employs financial leverage profitably and its equity investors benefit from a higher ROE than Company B which has no debt. 38 Financial Statements Topics Financial statements Standard- Firm ized Financial growth financial ratios rates statements Asset Short-term Long-term Market DuPont manage- Profitability Internal Sustainable solvency solvency value identity ment 39 How fast can a firm grow? • Investors and managers often want to know how fast a firm’s sales can grow • Given that – growth in sales requires growth in assets, at least over the long run, and in turn – growth in assets requires additional cash to pay for them • We see that a firm’s financing policies ultimately determine its ability to grow its sales 40 Financing policies • A firm can use two types of funds to finance sales growth and asset growth – internally-generated funds (mostly retained earnings) – externally generated funds (mainly short- and long-term debt but new equity can also be issued) • Not surprisingly, a firm’s maximum growth rate will be higher when external funds are used along with internal funds 41 Payout and retention ratios • Dividend payout ratio = Cash dividends / Net income – 0.86 / 2.17 = 0.3963 or 39.63% • Earnings retention ratio (b) = Additions to retained earnings / Net income – where 0 b 1 • Alternatively, b = 1 – dividend payout ratio – Dividend payout ratio = 0.86 / 2.17 = 0.3963 or 39.63% – b = 1 0.3963 = 0.6037 or 60.37% Note: these ratios may be computed either on a per share basis or on an aggregate basis 42 Maximum internal growth rate • The internal growth ROA = 10.41% (slide 23) rate tells us how fast b = 0.6037 (slide 42) the firm can grow its assets using retained Internal growth rate earnings as the only ROA b source of financing – remember, we use 1 - ROA b textbook definition of 0.1041 0.6037 ROA in which ROA 1 .1041 0.6037 = Net income / Assets 0.0671 or 6.71% 43 AFN Graphically + 0 g Internal growth rate AFN = additional funds needed, g = growth rate 44 The sustainable growth rate • The maximum sustainable growth rate tells us how fast the firm can grow by using internally generated funds and issuing new debt to maintain a constant debt ratio ROE = 25.17% (slide 23), b = 0.6037 (slide 42) ROE b Sustainabl e growth rate 1 ROE b 0.2517 0.6037 0.1792 1 0.2517 0.6037 17.92% Note that no new equity is issued 45 Sustainable growth calculations • The formula for the sustainable growth rate presented in the prior slide requires that ROE be calculated using end-of-year equity values – if beginning-of-year equity values are used, the sustainable growth rate is defined by the product of ROE × b • In our prior example, assuming equity grew by 17.92%, its beginning of year value would be 1,691,493 ÷ 1.1792 = 1,434,441 – ROE would then be 425,764 / 1,434,441 = 0.2968 – recalling that b = 0.6037, the sustainable growth rate will be ROE × b = 0.2968 × 0.6037 = 0.1792 or 17.92% – the is the same sustainable growth rate we got using end-of-year equity 46 Algebraic formulation • Sustainable growth rate (SGR) • SGR = b x ROE • SGR = b x NI/E • =b x NI/A x A/E • =b x NI/S x S/A x (D+E)/E • =b x NI/S x S/A x (1+D/E) – Dividend Profit Assets Financial – Policy Margin Turnover leverage 47 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 48