Share Ratios

Learning Objectives

To appreciate that accounting data can be transformed into financial ratios. To understand that financial ratios can be useful for aiding investment decisions. To know how to calculate various financial ratios and understand how to interpret them. To be able to create a holistic analysis of a company from its financial ratios. To understand the problems associate with financial ratio analysis

To prepare you for this weeks individual share ratio assignment.

Outline

Ratio analysis
Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

Balance Sheet: Assets 1999E Cash 14,000 71,632 ST investments AR 878,000 Inventories 1,716,480 Total CA 2,680,112 Gross FA 1,197,160 Less: Deprec. 380,120 Net FA 817,040 Total assets 3,497,152 1998 7,282 0 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592

Liabilities and Equity

1999E 1998 Accounts payable 436,800 524,160 Notes payable 600,000 720,000 Accruals 408,000 489,600 Total CL 1,444,800 1,733,760 Long-term debt 500,000 1,000,000 Common stock 1,680,936 460,000 Retained earnings (128,584) (327,168) Total equity 1,552,352 132,832 Total L & E 3,497,152 2,866,592

Income Statement Sales COGS Other expenses Depreciation Tot. op. costs EBIT Interest exp. EBT Taxes (40%) Net income 1999E 7,035,600 5,728,000 680,000 116,960 6,524,960 510,640 88,000 422,640 169,056 253,584 1998 5,834,400 5,728,000 680,000 116,960 6,524,960 (690,560) 176,000 (866,560) (346,624) (519,936)

Other Data

1999E Shares out. EPS DPS Stock price Lease pmts 250,000 $1.014 $0.220 $12.17 $40,000

1998 100,000 ($5.199) $0.110 $2.25 $40,000

Why are ratios useful?

Standardize numbers; facilitate comparisons

Used to highlight weaknesses and strengths

What are the five major categories of ratios, and what questions do they answer?

Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales?
(More)

Debt management: Do we have the right mix of debt and equity?

Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Calculate the firms forecasted current and quick ratios for 1999. CA CR99 = CL $2,680 = $1,445 = 1.85x.

CA - Inv. QR99 = CL $2,680 - $1,716 = = 0.67x. $1,445

Comments on CR and QR
1999 CR QR 1.85x 0.67x 1998 1.1x 0.4x 1997 2.3x 0.8x Ind. 2.7x 1.0x

Expected to improve but still below the industry average.

Liquidity position is weak.

Financing Liquidity

Highly Liquid Assets/Total Liabilities

Highly liquid assets include
Vault Cash Precious metals (Gold) Deposits with the RBA and other financial institutions Readily marketable securities Net inter-bank lending and borrowing with a remaining maturity period of up to one month.

What is the inventory turnover ratio as compared to the industry average? Sales Inv. turnover = Inventories $7,036 = = 4.10x. $1,716

1999
Inv. T. 4.1x

1998
4.5x

1997
4.8x

Ind.
6.1x

Comments on Inventory Turnover

Inventory turnover is below industry average.

Firm might have old inventory, or its control might be poor. No improvement is currently forecasted.

DSO is the average number of days after making a sale before receiving cash.
DSO Receivables Average sales per day =

Receivables = Sales/360
= 44.9 days.

$878 = $7,036/360

Appraisal of DSO 1999 1998 1997 Ind. DSO 44.9 39.0 36.8 32.0 Firm collects too slowly, and situation is getting worse. Poor credit policy.

Fixed Assets and Total Assets Turnover Ratios Fixed assets Sales = turnover Net fixed assets = $7,036 = 8.61x. $817

Total assets = turnover

Sales Total assets $7,036 = 2.01x. = $3,497 (More)

1999
1997 Ind. FA TO 8.6x 6.2x TA TO 2.0x 2.0x

1998
10.0x 2.3x 7.0x 2.6x

FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

Calculate the forecasted operating capital requirement ratio (OCR).

Operating capital = Net operating + working capital Net fixed assets

Net operating = ($14,000 + $878,000 + working capital $1,716,480) - ($436,800 + $408,000) = $1,763,680.
Operating capital = $1,763,680 + $817,040 = $2,580,720.
(More)

OCR = Operating capital/Sales = $2,580,720/$7,035,600 = 36.7%. 1999 1998 1997 Ind. OCR 36.7% 31.8% 33.2% 29.5% The OCR is not improving. It is worse than the industry average.

Calculate the debt, TIE, and fixed charge coverage ratios.

Debt ratio

Total debt Total assets $1,445 + $500 = $3,497 =

=
= 55.6%.

EBIT TIE Int. expense $510.6 = 5.8x. $88

(More)

Fixed charge = FCC coverage EBIT + Lease payments = Interest Lease Sinking fund pmt. + pmt. + expense (1 - T) $510.6 + $40 = 4.3x. = $88 + $40 + $0 All three ratios reflect use of debt, but focus on different aspects.

How do the debt management ratios compare with industry averages? 1999 1998

1997 Ind. D/A 55.6% 95.4% 54.8% 50.0% TIE 5.8x -3.9x 3.3x 6.2x FCC 4.3x -3.0x 2.4x 5.1x Too much debt, but projected to improve.

Financing Asset/Debt Management

Asset/Debt Management Ratios

Debt Ratio (Total Liabilities/Total Assets)

Gearing (Total Liabilities/Total Equity) NTA per Share Dividend Payout Ratio (Dividends Paid/NPAT)

After-tax operating profit margin (ATOPM) ATOPM = EBIT(1 - T) = $510,640(1 - 0.4) Sales $7,035,600 = 4.4%. 1999 1998 1997 Ind. ATOPM 4.4% -7.1% 3.7% 4.3% Very bad in 1998, but projected to exceed industry average in 1999.

Profit Margin (PM)

NI $253.6 PM = Sales = $7,036 = 3.6%. 1999 1998 1997 Ind. PM 3.6%-8.9%2.6% 3.5% Very bad in 1998, but projected to exceed industry average in 1999. Looking good.

Basic Earning Power (BEP)

EBIT BEP = Total assets $510.6 = $3,497 = 14.6%.

(More)

BEP

1999 1998 1997 Ind. 14.6%-24.1%14.2%19.1%

BEP removes effect of taxes and financial leverage. Useful for comparison. Projected to be below average. Room for improvement.

Return on Assets (ROA) and Return on Equity (ROE) Net income ROA = Total assets $253.6 = $3,497 = 7.3%.

(More)

Net income ROE = Common equity = $253.6 = 16.3%. $1,552 1999 1998

1997 Ind. ROA 7.3% -18.1% 6.0% 9.1% ROE 16.3% -391.0% 13.3% 18.2% Both below average but improving.

Effects of Debt on ROA and ROE

ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Financing Profitability

Non Interest Income Ratio Non Interest Income/Total Income Interest Income Ratio

Interest Income/Total Income

Return on Equity

Return on Assets

Calculate and appraise the P/E and M/B ratios.

Price = $12.17.
NI $253.6 EPS = Shares out. = 250 = $1.01.

Price per share $12.17 P/E = = $1.01 = 12x. EPS

(More)

BVPS

Com. equity Shares out. $1,552 = 250 Mkt. price per share = Book value per share $12.17 = = 1.96x. $6.21

=
= $6.21.

M/B

(More)

1999

1998

1997 Ind. P/E 12.0x -0.4x 9.7x 14.2x M/B 1.96x 1.7x 1.3x 2.4x P/E: How much investors will pay for $1 of earnings. High is good.

M/B: How much paid for $1 of book value. Higher is good.

P/E and M/B are high if ROE is high, risk is low.

Explain the Du Pont System

Profit margin

)(

TA turnover

)(
x

Equity multiplier = ROE

TA CE x x x x 2.2 21.6 2.3 2.0

NI Sales Sales x TA

= ROE.
= 13.2% = -391.0% = 16.3% = 18.2%

1997 2.6% x 2.3 1998 -8.9% x 2.0 1999 3.6% x 2.0 Ind. 3.5% x 2.6

The Du Pont system focuses on:

Expense control (PM)

Asset utilization (TATO) Debt utilization (EM)

It shows how these factors combine to determine the ROE.

Simplified Firm Data

A/R $ 878 Debt Other CA 1,802 Equity Net FA 817 Total assets $3,497 L&E Sales day

$1,945 1,552
$3,497

$7,035,600 = = $19,543. 360

Q. How would reducing DSO to 32 days affect the company?

Effect of reducing DSO from 44.9 days to 32 days:

Old A/R = $19,543 x 44.9 $878,000

New A/R = 625,376

= $19,543 x 32.0

Cash freed up: $252,624 Initially shows up as additional cash.

New Balance Sheet Added cash A/R Other CA Net FA Total assets $ 253 Debt $1,945 625 Equity 1,552 1,802 817 $3,497 Total L&E $3,497

What could be done with the new cash? Effect on stock price and risk?

Potential use of freed up cash

Repurchase stock. Higher ROE, higher EPS.

Expand business. Higher profits.

Reduce debt. Better debt ratio; lower interest, hence higher NI.

(More)

Inventories are also too high. Could analyze the effect of an inventory reduction on freeing up cash and increasing the quick ratio and asset management ratios. Such an analysis would be similar to what was done with DSO in previous slides. All these actions would likely improve stock price.

Would you lend money to this company?

Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment.

However, company should not have relied so heavily on debt financing in the past.

What are some potential problems and limitations of financial ratio analysis?

Comparison with industry averages is difficult if the firm operates many different divisions.

Average performance is not necessarily good. Seasonal factors can distort ratios.
(More)

Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is good or bad. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

What are some qualitative factors analysts should consider when evaluating a companys likely future financial performance?

Are the companys revenues tied to a single customer? To what extent are the companys revenues tied to a single product? To what extent does the company rely on a single supplier? (More)

What percentage of the companys business is generated overseas? What is the competitive situation?

What does the future have in store?

What is the companys legal and regulatory environment? And so on.

Share Ratio Assignment

This week you are required to do a share analysis of the 6 shares that you will need to consider for your group assignment.
The idea is that you complete a bottom-up analysis of each of the 6 shares so that you may judge which is best and then to-gethor with your group invest.

Conclusions

We have completed a financial ratio analysis. Comparisons have been made between a company and the industry average over time. In this way, we have managed to obtain a picture of the overall health of the company.

We have discussed why this picture is somewhat limited due to intrinsic problems with the financial ratio approach.