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Financial Markets for Non-SBM Students

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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 111
  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

				
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posted:8/12/2011
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