# Short and Bankruptcy and Outline

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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
NOTE: WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

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
58.45%                 41.55%
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
25.72%

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)
38.23%

Debt to Equity Ratio
Exactly the same information as Total Debt Ratio, but preferred by most analysts
=Total Debt / Total Equity
1.41
Long-Term Debt to Equity Ratio
=Long Term Debt / Equity
0.62

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
15.58%
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
3.89%

Net Profit Margin
Profits to Sales-- tells the percentage of sales remaining for the shareholders
= Net Income / Sales
1.15%

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
2.68%
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
6.45%

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
6.45%
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)

Scoring:
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
Where…
NOPAT = EBIT * (1 - tax rate)
and
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
CURRENT LIABILITIES

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

140.6456089610900%

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

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:
0.545045
0.191654
0.299255
liabilities) plus                       0.549993
2.332203
3.91815

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"
determined level
a predetermined level for performance to be considered "good"

DING OPPORTUNITY COSTS
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, 2007                                    As of Dec. 31, 2007
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, 2007                             For the Year Ended Dec. 31, 2007 (\$ 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 2006 and 2007
Liquidity Ratios                                            2007        2006 Liquidity Min      2007
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)
3.92

Economic Profit                                          2007           2006
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                                  7%             13%             Given

Dollar Cost of Capital                                 93,492        154,336              Total Operating Capital * After-ta
Economic Profit                                        (3,672)       (28,876)             NOPAT - Dollar Cost of Capital
2006      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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