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Analysis
What is Financial Analysis
Determined by
analyzing the
financial
statements.
What do we need for the Financial
Statement Analysis?
– Financial statements
– Notes to Financial Statements.
– The definition of accounting methods
– Auditing reports
– 5-10 years financial information
Financial Statements Are Designed
for Analysis
Classified Comparative Consolidated
Financial Financial Financial
Statements Statements Statements
Dollar &
Trend
Percentage
Percentages
Changes
Component
Ratios
Percentages
Horizontal Analysis
Increase/(Decrease)
2002 2001 Amount Percent
Sales 41,500 37,850 3,650 9.6%
Expense 40,000 36,900 3,100 8.4%
Net Income 1,500 950 550 57.9%
Horizontal Analysis
Dollar Change:
Dollar Analysis Period Base Period
Change = Amount – Amount
Percentage Change:
% Percent
Change = Dollar Change
÷
Base Period
Amount
Dollar and Percentage Changes
Evaluating Percentage Changes
in Sales and Earnings
Percentages may be
misleading when the
base amount is small.
Dollar and Percentage Changes
current assets
Current ratio=
current liabilities
Example:
If current assets are $5 million and current
liabilities are $2 million,
Current ratio = $5 / $2 = 2.5
Comments on current ratio
2003 2002 2001 Ind.
Current
2.34x 1.20x 2.30x 2.70x
ratio
Cash $ 5
Accounts receivables 16
Inventory 20
Accounts payable 12
credit sales
A/R turnover = ..times
accounts receivable s
A/R Turnover Ratio
• EXAMPLE — Sales are $ 480,000, the average
receivable balance during the year was $ 40,000 and
we have a $ 20,000 allowance for sales returns.
Accounts Receivable Turnover is ($ 480,000 - $
20,000) / $ 40,000 or 11.5. We were able to turn our
receivables over 11.5 times during the year.
• NOTE — We are assuming that all of our sales are
credit sales; i.e. we do not have any significant cash
sales.
Number of Days in Accounts
Receivable
• The Number of Days in Accounts Receivable is the average
length of time required to collect our receivables. A low
number of days is desirable. Days in Accounts Receivable is
calculated as follows:
EBIT
Interest coverage =
interest expense
Financial leverage examples
Debt-to-assets Debt-to-
equity
Nike (NKE) 40.41% 67.82%
July,2002
Skechers (SKX) 51.16% 104.75%
December, 2001
Timberland 40.47% 67.97%
(TBL)
December, 2001
Source: Data from Yahoo! Finance
Profitability ratios
gross profit
Gross profit margin =
sales
Operating profit margin
• Operating profit margin: the ratio of
operating profit (EBIT) to sales.
• Indicates how much of each dollar of sales
is left over after operating expenses.
operating profit
Operating profit margin =
sales
Net profit margin
• Net profit margin: the ratio of net income
to sales.
• Indicates how much of each dollar of sales
is left over after all expenses are paid.
net profit
Net profit margin =
sales
IBM’s 2002 Income statement
in millions
Revenues $88,396
Less: Total costs 55,972
Gross profit $32,424
Less: Operating expenses 20,790
Operating income $11,634
Add: Other income 617
Less: Interest expense 717
Income before income taxes $11,534
Less: Provision for income taxes 3,441
Net income $8,093
net profit
Return on equity =
book value of equity
Coming attractions
• Return on investment ratios & the Du Pont
system
• Shareholder ratios
• Common size analysis
• Effective use of financial analysis
Market Value (Shareholder)
Ratios
The view of the firm from the
perspective of the owners, investor
and general public …
Market Value (Shareholder)
Ratios
These ratios attempt to measure the economic status
of the organization within the marketplace.
Investors use these ratios to evaluate and monitor
the progress of their investments.
Market Value Ratios
• Earnings per share (EPS) is the amount of
income earned during a period per share of
common stock.
• Basic EPS & Diluted EPS
• Book value equity per share is the amount of
the book value of common equity per share of
stock.
• The price-earnings ratio (P/E or PE ratio) is
the ratio of the price per share of stock to the
earnings per share of stock.
Market Value Ratios, continued
• Dividends per share (DPS) is the dollar
amount of cash dividends paid during a
period, per share of common stock.
Return on assets
Net profit / Total assets
Earnings retention
(1 - tax rate)
Interest burden
Earnings before taxes / Operating profit
or EBT/EBIT
Du Pont system: Return on
equity
Return on equity
Net profit / Shareholders' equity
Earnings retention
(1 - tax rate)
Interest burden
Earnings before taxes / Operating profit
or EBT / EBIT
Kmart and the Du Pont system
8% 3.0
6%
2.5
4%
2.0
2%
Number of
Return 0% 1.5 times
-2%
1.0
-4%
Return on assets 0.5
-6% Net profit margin
-8% Total asset turnover 0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
20%
15%
10%
5%
0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
20% 3,5
3
15% 2,5
return
2
and 10% times
1,5
margin 1
5%
0,5
0% 0
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
Return on assets Net profit margin
Total asset turnover
Source: Wal-Mart Annual Reports, various years
Problems
• Suppose a company has a return on equity
of 10% and a return on assets of 5%. What
is its debt-to-equity ratio?
• If a company has a return on assets of 5%
and a total asset turnover of 5 times, what is
its net profit margin?
An example
100%
Assets
75%
Other
50% Intangibles
Plant and equipment
25% Current assets
0%
1997 1998 1999 2000 2001 2002
Source: Toys R Us Annual Reports
Common size example:
Toys R Us
100%
Liabilities
& equity
75% Shareholders' equity
Other long-term
50% liabilities
Long-term debt
25%
Deferred taxes
0% Current liabilities
1997 1998 1999 2000 2001 2002
Source: Toys R Us Annual Reports
Effective use of financial
analysis
• Valuation
• Use financial relations to predict future cash
flows
• Determine creditworthiness
• Rating services (e.g., Moody’s)
• Bankruptcy prediction
• Develop a statistical model that predicts
bankruptcy on the basis of financial
characteristics
Case in point
IMC Global
IMC Global
• Industry: Agricultural chemicals
• Largest of the few companies in the
industry
• Chemical prices are cyclical and sensitive to
agricultural economy and world trade
IMC Global: Returns
10%
0%
-10%
-20%
-30%
ROE
-40%
ROA
-50%
-60%
-70%
-80%
1997 1998 1999 2000 2001 2002
60%
40%
20%
0%
1993 1995 1997 1999 2001
Sales $250,000
in
millions $200,000
$150,000
$100,000
$50,000
$0
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
Fiscal year
$120
$100
$80
Revenues
$60
(in billions)
$40
$20
$0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Fiscal year
Source: Enron 10-K Reports, various years
Matrix, Inc.
2005
Cash $ 30,000
Accounts receivable, net
Use this Beginning of year 17,000
informatio End of year 20,000
Inventory
n to Beginning of year 10,000
calculate End of year 15,000
Total current assets 65,000
the Total current liabilities 42,000
Total liabilities 103,917
liquidity Total assets
ratios for Beginning of year 300,000
End of year 346,390
Matrix, Revenues 494,000
Working Capital
Working capital is the excess of current
assets over current liabilities.
12/31/05
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
Current Ratio
This ratio measures the
short-term debt-paying
ability of the company.
Current $65,000
= = 1.55 : 1
Ratio $42,000
Quick Ratio
Quick Quick Assets
=
Ratio Current Liabilities
Quick $50,000
= = 1.19 : 1
Ratio $42,000
Debt
Debt Total
Total
== ÷ ÷ Total
Total Assets
Assets
Ratio Liabilities
Ratio Liabilities
= $103,917 ÷ $346,390
= 30.00%
Uses and Limitations of Financial
Ratios
Uses Limitations
Gross
Margin { Sales, net
Cost of goods sold
Gross margin
Operating expenses:
$
$
785,250
351,800
433,450
Operating
Expenses { Selling expenses
General & Admin.
Depreciation
$ 197,350
78,500
17,500 293,350
Income from Operations $ 140,100
{
Non- Other revenues & gains:
Interest income $ 62,187
operating
Gain 24,600 86,787
Items Other expenses:
Interest $ 27,000
Remember to Loss 9,000 (36,000)
Income before taxes $ 190,887
compute EPS. Income taxes 62,500
Net income $ 128,387
Income Statement (Single-Step)
{
Martin Company
Proper Heading Income Statement
For the Year Ended 12/31/05
Revenues and gains:
Revenues
& Gains { Sales, net
Interest income
Gain on sale of plant assets
Total revenues and gains
$
$
785,250
62,187
24,600
872,037
{
Cost of goods sold $ 351,800
Selling Expenses 197,350
Expenses General and Admin. Exp. 78,500
& Losses Depreciation 17,500
Interest 27,000
Income taxes 62,500
Loss: sale of investment 9,000
Remember to Total expenses & losses 743,650
compute EPS. Operating income $ 128,387
Matrix, Inc.
2005
Use this Number of common shares
information outstanding all of 2005 27,400
Net income $ 53,690
to calculate Shareholders' equity
the Beginning of year 180,000
profitability End of year 234,390
ratios for Revenues 494,000
Matrix, Inc. Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390
Return On Assets (ROA)
This ratio is generally considered
the best overall measure of a
company’s profitability.
Operating
ROA = ÷ Average total assets
income
= $ 53,690 ÷ ($300,000 + $346,390) ÷ 2
= 16.61%
Return On Equity (ROE)
This measure indicates how well the
company employed the owners’
investments to earn income.
Prepare common-size
financial statements.
Common-size Statements
• On the income statement, each item is
expressed as a percentage of net sales.
• On the balance sheet, the common size is
the total on each side of the accounting
equation.
• Common-size statements are used to
compare one company to other companies,
and to the industry average.
Benchmarking
Percent of Net Sales
Lucent Technologies MCI
12,4% 10,8%
7,4% 8,0%
43,0%
51,4%
28,8%
38,2%
Current ratio =
Total current assets ÷ Total current liabilities
Measuring Ability to
Pay Current Liabilities
• Palisades’ current ratio:
• 20x1: $236,000 ÷ $126,000 = 1.87
• 20x2: $262,000 ÷ $142,000 = 1.85
• The industry average is 1.80.
• The current ratio decreased slightly
during 20x2.
Measuring Ability to
Pay Current Liabilities
Acid-test ratio =
(Cash + Short-term investments
+ Net current receivables)
÷ Total current liabilities
Measuring Ability to
Pay Current Liabilities
• Palisades’ acid-test ratio:
• 20x1: ($32,000 + $85,000) ÷ $126,000 = .93
• 20x2: ($29,000 + $114,000) ÷ $142,000 = 1.01
• The industry average is .60.
• The company’s acid-test ratio improved
considerably during 20x2.
Measuring Ability to
Sell Inventory
Times-interest-earned ratio
measures the number of times
operating income can cover interest expense.
Times-interest-earned
= Income from operations
÷ Interest expense
Measuring Ability to
Pay Debt
• Palisades’ times-interest-earned ratio:
• 20x1: $ 57,000 ÷ $14,000 = 4.07
• 20x2: $101,000 ÷ $24,000 = 4.21
• The industry average is 2.00.
• The company’s times-interest-earned ratio
increased in 20x2.
• This is a favorable sign.
Measuring Profitability