Financial Statement Analysis Traditional Ratios

Financial Statement Analysis Traditional Ratios Focus is on Financial Condition • liquidity • efficiency of asset use • expense control • debt use & default risk 8/13/2009 Robert C. Radcliffe 1 Balance Sheet Information Assets: Cash Accounts Rec. Inventory Current Assets Year 1 $52,000 402,000 836,000 1,290,000 Year 0 $57,600 351,000 715,200 1,124,000 Liab.& Equity: Year 1 Accounts Payable Notes Payable Accruals Current Liab. Long Term Debt Total Debt Equity Common Stock Retained Profits Total Equity Total Financing $175,200 225,000 140,000 540,200 424,612 964,812 Year 0 $145,600 200,000 136,000 481,600 323,432 805,032 Gross Fixed Assets 527,000 less Accum Deprec. 166,200 Net Fixed Assets 360,800 491,000 146,200 344,800 460,000 460,000 225,988 203,768 685,988 663,768 $1,650,800 $1,468,800 Total Assets $1,650,800 $1,468,800 8/13/2009 Robert C. Radcliffe 2 Operating Invested Capital Assets: Current Assets Minus non-interest bearing Debt Net OWC Net Fixed Assets Plus Other Operating Assets: OIC Traditional Ratio Analysis focuses on Total Assets, it does not consider non-operating assets as being different from Operating Invested Capital 8/13/2009 Robert C. Radcliffe Year 1 Year 0 1,290,000 1,124,000 -315,200 -281,600 974,800 842,400 360,800 344,800 NA NA $1,335,600 $1,187,200 This slide is intended to point out the difference in TA and OIC 3 Income Statement & Other Data Income Statement Year 1 Sales $3,850,000 CGS 3,250,000 Other Exp. 430,300 Deprec. 20,000 NOP-BT 149,700 Taxes 59,880 NOPAT 89,820 Year 0 $3,432,000 2,864,000 340,000 18,900 209,100 83,640 125,460 Other Info Year 1 Year 0 December 31 Stock Price $6.00 $8.50 Shares outstanding 100,000 100,000 Total Market Cap $600,000 $850,000 Book Equity 685,988 663,768 MVA -85,988 186,232 Earnings Per Share $0.44 Dividends Per Share $0.22 Annual Lease Sinking Fund (new info) $50,000 $20,000 $0.88 $0.22 $50,000 $20,000 Interest-BT 76,000 Int. Tax Shield 30,400 Interest-AT 45,600 Net Income 44,220 62,500 25,000 37,500 87,960 8/13/2009 Robert C. Radcliffe 4 DuPont Analysis of ROE ROE = ROA Net Income / Assets Asset * Net Profit Turn Margin 87,960 / 1,468,800 times Equity Multiplier * Assets / Equity Year 0 87,960 / 663,768= 0.1325 * * * 1,468,800 / 663,768 2.2128 2.2128 = 0.0599 = 3,432,000 * 87,960 1,468,800 3,432,000 = 0.0645 8/13/2009 2.3366 2.33 = * 0.0256 * Year 1 * 0.01149 * Robert C. Radcliffe 2.2128 2.41 5 The Problem with DuPont Model It measures the Return on Assets incorrectly DuPont ROA = Net Income / Assets This is an incorrect measure of ROA • “Net Income” includes a deduction for debt interest expense. • Debt interest expense is not an Operating Expense associated with the use of assets. • Debt interest expense arises solely due to a financing decision. • Asset returns should not be charged with a financing cost. • ROA should be calculated before any capital cost expense. 8/13/2009 Robert C. Radcliffe 6 The Correct Calculation of Return on Assets (ROA*) ROA* = Net Operating Profit After Tax / Assets = NOPAT / A Year 2 ROA* = 89,820 / 1,650,800 = 5.44% Year 1 = 125,460 / 1,468,800 = 8.54% Compare these with the DuPont measures of ROA. 8/13/2009 Robert C. Radcliffe 7 Return on Equity Using the Correct Measure of ROA ROE = ROE = ROA* + [D / E] [ ROA* - KdAT] Underlying return on assets + Gain from financial leverage Correct calculation of ROA (NOPAT / Assets) After-tax cost of debt capital Robert C. Radcliffe 8 ROA* = KdAT 8/13/2009 = Correct ROE Model Year 0 Year 1 Correct ROA* 125,460 1,468,800 = 0.0854 89,820 1,650,800 0.0544 After Tax Cost of Debt: 37,500 805,032 = 0.0466 45,600 964,812 0.0473 Determinants of ROE Year 0 Year 1 ROA* 0.0854 0.0544 plus + + D/E 1.2128 1.4065 times * * [ROA* - Kd(1-TR)] [0.0854-0.0466] equals = Debt to Equity Ratio = 1.2128 1.4065 [0.0544-0.0473] = ROE 0.1325 0.0645 8/13/2009 Robert C. Radcliffe 9 Liquidity Ratios Year 0 Year 1IND. 3 Current Ratio Quick Ratio 2.33 2.39 2.7 0.85 0.84 1.0 2.5 2 An estimate of Days Payables Outstanding: 175.2/[(3,250+430.3+29.48)/360] = 17 for Year 1 1.5 1 0.5 Current Quick 16.1 17.0 NA Liquidity appears ok, but it could be due solely to large inven & A/R 0 94 95 Ind 8/13/2009 Robert C. Radcliffe 10 Liquidity Ratios (Illustration of Scale Problem in Exhibit) Year 0 Year 1 IND Notice how the scale gets messed up due to scale of variables. Current Ratio Quick Ratio 2.33 2.39 2.7 0.85 0.84 1.0 Days Payables Outstanding: 175.2/[(3,250+430.3+29.48)/360] = 17 for 1995 16.1 17.0 NA Year 0 Year 1 8/13/2009 Robert C. Radcliffe Ind 18 16 14 12 10 8 6 4 2 0 Current Quick Days Pay 11 Inventory Utilization Year 0 Year 1 IND 8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 3 Year 0 Year 1 Inventory Turn On Sales 4.80 4.61 7.0 On CGS 4.00 3.89 NA Days Sales in Inventory: 360 / 3.89 = 92.60 for 1995 89.9 92.6 NA on CGS on Sales Company’s inventory use is considerably below average 8/13/2009 Robert C. Radcliffe 12 on CGS Conceptual Comparison of Company Inventory Balances Vs Industry Average $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 0 20 40 60 Company Inventory would be $286,000 lower if turnover equaled industry average Industry 80 100 120 140 160 180 200 220 240 260 280 300 320 340 360 8/13/2009 Robert C. Radcliffe 13 Accounts Receivable Utilization Accts. Receivable Turn Days Sales in Receivables: Year 0 Year 1 Industry 9.77 9.58 11.25 36.84 37.59 32.0 Yr 0 Yr 1 Ind AR Turn 13 12 11 10 9 8 7 If A/R turn had been equal to Industry average, the A/R balance would have been lower by $59,778 in Year 1. 402 - (3,850 / 11.25) 8/13/2009 Robert C. Radcliffe 14 Fixed Asset Utilization Calculated as Sales / Net Fixed Assets Very dependant on Depreciation Policy Generally useful only in long-run Thus, we will pass further discussion. 8/13/2009 Robert C. Radcliffe 15 Analysis of Debt Utilization Total Debt to Assets Long Term Debt to Equity Times Interest Earned Yr0 Yr1 55% 49% 58% 62% Industry = 50% 3.34x’s 1.97x’s Industry = 2.5x’s Fixed Charge Coverage (given Leases of $50,000) 2000000 1600000 1200000 800000 400000 0 2.30x’s 1.58x’s Industry = 2.1x’s STD LTD EQUITY 481,610 323,432 663,768 Yr 0 540,200 424,612 685,988 Yr 1 Robert C. Radcliffe +$ 58,600 (12.2% increase) +$ 101,180 (31.3% increase) +$ 22,222 (3.3% increase) 8/13/2009 16 Times Interest Earned Net Operating Profit Before Tax TIE = Total Interest Expense 1.97 = $149,700 $ 76,000 TIE equals the Net Operating Profit (income from assets available to pay interest) divided by interest. 8/13/2009 Robert C. Radcliffe 17 TIE Ratio versus Use of Debt Financing (No change in ROA*, Debt changes Assets NOI & interest expense) Based on current ROA* and increasing NOPAT as debt increases. Current Interest Rate on Notes and LTD. Accts. Payable & Accruals Assumed Free. 5 T I 4 E 3 R a 2 t i 1 o 0 0 1.97 1 2 Debt to Equity Ratio 3 4 8/13/2009 Robert C. Radcliffe 18 TIE Ratio versus Use of Debt Financing (No change in ROA*, Debt changes only assets & interest expense) Current debt O/S $ Percent No cost A/P & Acc. $315,200 32.67% Interest bearing 649,612 67.33% divided into $76,000 = 11.7% cost ROA* pre-tax $149,700 / $1,650,800 = 9.068% Debt to Total No Interest Total Equity Debt Interest Bearing Equity Assets NOPBT Interest TIE 0.20 137,198 44,822 92,376 685,988 823,186 74,649 10,807 6.91 0.8 548,790 179,288 369,503 685,988 1,234,778 111,974 43,229 2.59 1.406 964,812 315,200 649,612 685,988 1,650,800 149,700 76,000 1.97 The values above are exact from a spreadsheet, the Interest cost & ROA* are rounded 8/13/2009 Robert C. Radcliffe 19 TIE Ratio Should be Evaluated in “Worst of Times” 5 T I 4 E 3 R a 2 t i 1 o 0 0 Current ROA* Bad Times ROA of 2% (pre-tax) 1.97 0.2 0.4 0.6 0.8 1 Debt to Assets Ratio 8/13/2009 Robert C. Radcliffe 20 TIE Example • • • • • Assets ROA* Tax Rate Debt / Assets Kd = $100 = 8% =40% = 0.5 = 6% TIE = ($100)(0.08/[1-0.4]) 0.06($50) ROA* represent NOPAT / Assets It is an after-tax profitability number 8/13/2009 Robert C. Radcliffe AT = BT (1 - TR) BT = AT / (1 - TR) 21 Fixed Charge Coverage (Lease Expense = $50,000 Sinking Fund Payment = $20,000) For Last Year: Interest and Leases FCC = NOPBT + Lease Expense BT Interest + Lease Exp. 1.58 = $149,700 + $50,000 $76,000 + $50,000 Interest, Lease & Sinking Fund FCC = NOPBT + Lease Expense Interest + Lease + SF/(1-TR) 1.25 = $149,700 + $50,000 $76,000 + $50,000 + $20,000 / 0.6 4 3.5 3 2.5 2 1.5 1 0.5 0 YR0 YR1 TIE FCC(Lease) FCC(SF) 8/13/2009 Robert C. Radcliffe 22 Comments on Fixed Charge Coverage: Leases Lease Expense: In the numerator of the FCC calculation, lease expense must be added to NOI (pre-tax) in order to obtain the operating income available to cover both leases and interest. In the denominator of the FCC calculation, lease expense is already a pre-tax value. Thus no adjustment must be made to calculate its pre-tax value. 8/13/2009 Robert C. Radcliffe 23 Comments on Fixed Charge Coverage: Sinking Funds #1 Sinking Fund Definition: See the textbook. It is a payment of cash made in after-tax dollars (the payment is a payment of principal and thus not an expense of operations). Any legally required principal repayment can be treated in the equation in the same fashion that a “technical” sinking fund is treated. I.e., scheduled repayments of both short & long-term debt can be treated in the FIXED CHARGE COVERAGE RATIO. 8/13/2009 Robert C. Radcliffe 24 Comments on Fixed Charge Coverage: Sinking Funds #2 Treatment in FCC equation: Numerator: No adjustment is necessary since this is not a tax deductible expense. (Or even a non-tax deductible expense. It is not an expense, it is a principal payment.) Denominator: Since the payment is made in after-tax $, we must calculate the amount of money needed before taxes in order to have the require payment after-tax. This is done by dividing the payment by (1 minus Tax Rate) 8/13/2009 Robert C. Radcliffe 25 Financial Charges Covered by Cash Flow #1 The previous ratios use operating earnings in the numerator to capture the “earnings” available for paying various financial charges (interest, leases, principal repayments) These financial charges, of course, are actually paid with cash. Thus, a better measure of the “ability” of a firm to meet financial obligations would be cash flow generated from operations Measures of cash flows were discussed earlier. They can be used as shown on the next exhibit. 8/13/2009 Robert C. Radcliffe 26 Financial Charges Covered by Cash Flow Data used in calculations: Interest = $76,000 ; Lease expense = $50,000 ; Sink. Fund. = $20,000 Net Operating Income = $149,700 ; Depreciation = $20,000 ; TR = 40% Interest Covered by Cash Flow from Operating Income: 2.23 = ($149,700 + $20,000) / $76,000 Interest and Leases Covered by Cash Flow from Operating Income: 1.74 = ($149,700 + $20,000 + $50,000) / ($76,000 + $50,000) Int., Leases & Sinking Fund Covered by Cash Flow from Oper. Inc. 1.38 = ($149,700 + $20,000 + $50,000) / ($76,000 + $50,000 + [$20,000 / 0.6]) 8/13/2009 Robert C. Radcliffe 27 Market Value Ratios Price to Book (Market to Book): = Stock Price per Share / Book Value per Share Book Value per Share: = Total Equity in Balance Sheet / # of shares outstanding A measure of Market Value Added Price to Earnings: = Stock Price per Share / Earnings per Share 8/13/2009 Robert C. Radcliffe 28 Review Questions Find the worksheet entitled RatioReview in the file FinlMgtData.xls 1. Become familiar with the worksheet organization. 2. Examine how the ratios and Statement of Cash Flow were calculated. You will be expected to know how to calculate these on your test. 3. How much additional cash could the firm have created at the end of 2000 if the firm’s inventory turn (CGS) and accounts receivable turn had been equal to the industry average? 4. How much additional cash could the firm have created at the end of 2000 if the firm’s net profit margin had been equal to the industry average? 5. Be able to review this data and prepare a brief essay on the strengths and weaknesses of the firm. 8/13/2009 Robert C. Radcliffe 29 Review Questions Review the worksheet TIE&ROABT in the FinlMgtData.xls file. 6. Examine the calculations shown at the top of the worksheet. 7. Answer the review questions starting in row 30. 8. A firm has $1000 of assets supported by 40% debt and 60% equity. The tax rate is 40% and the cost of debt is 8% pre-tax. The firm’s ROA* is 12%. A. what will be the firm’s TIE ratio? B. what will be the firm’s ROE? C. repeat parts a & b assuming that debt is 60% and equity 40%. 9. What conclusions (2 basic ones) should be drawn from question 3? 8/13/2009 Robert C. Radcliffe 30 Find the worksheet entitled RatioReview in the file FinlMgtData.xls 1. Become familiar with the worksheet organization. 2. Examine how the ratios and Statement of Cash Flow were calculated. You will be expected to know how to calculate these on your test. 3. How much additional cash could the firm have created at the end of 2000 if the firm’s inventory turn (CGS) and accounts receivable turn had been equal to the industry average? 4. How much additional cash could the firm have created at the end of 2000 if the firm’s net profit margin had been equal to the industry average? 5. Be able to review this data and prepare a brief essay on the strengths and weaknesses of the firm. Other than question 5, you can find the answer by changing the input data at top of spreadsheet. 8/13/2009 Robert C. Radcliffe 31 Review the worksheet TIE&ROABT in the FinlMgtData.xls file. 6. Examine the calculations shown at the top of the worksheet. 7. Answer the review questions starting in row 30. The answer is shown below cell a60 in the spreadsheet. 8. A firm has $1000 of assets supported by 40% debt and 60% equity. The tax rate is 40% and the cost of debt is 8% pre-tax. The firm’s ROA* is 12%. A. what will be the firm’s TIE ratio? NOPBT / Interest Expense before tax [(0.12 * $1,000) / (1 - 0.4)] / (0.08 * $400) B. what will be the firm’s ROE? ROE = ROA* + D/E[ROA* - Kd,at) = 12% + 40/60[ 12% - 8% (1 - 0.4)] 8/13/2009 Robert C. Radcliffe 32 C. repeat parts a & b assuming that debt is 60% and equity 40%. NOPBT / Interest Expense before tax [(0.12 * $1,000) / (1 - 0.4)] / (0.08 * $600) ROE = ROA* + D/E[ROA* - Kd,at) = 12% + 60/40[ 12% - 8% (1 - 0.4)] 9. What conclusions (2 basic ones) should be drawn from question 3? 1. Increased debt will reduce the TIE Ratio and cause greater default risk 2. Increased debt will increase ROE as long as after tax debt cost is less than the ROA* 8/13/2009 Robert C. Radcliffe 33