Financial Ratio Analysis

Transcription

1 Financial Ratio Analysis Engineering Economy Universidad Tecnológica de Bolívar Ignacio Pareja Professor Cartagena 1 Value Based Financial Management (1) Why is it so important to forecast the financial statements of the firm? This is imperative for management because it provides a vision of the future performance of the company. It is very important to develop strategies to overcome the difficulties that always arise. Firms not listed in the stock exchange: vast majority worldwide. More than 99.5%. They do not have the firm value every day from the stock market. Assessment tools: designed for unlisted companies. Estimate future cash flows and value They must maintain a model to measure the value and impact of future decisions on it. The most important is value and not profitability. If you create value, there is profitability. Greater profitability does not mean higher value. 21/06/2012 Financial Forecasting Ignacio Pareja Electronic copy available at: 1

2 Value Based Financial Management (2) It is proposed to construct three financial statements: Balance sheet, income statement and cash flow, without plugs and without circularity. That is, build a comprehensive and consistent financial planning model. It can be used to examine in advance the value creation effects of a decision. This can be done with sensitivity analysis, scenario analysis and Monte Carlo simulation. In addition, the financial model is useful for other purposes: When planning to raise funds for a new firm or a new project for an ongoing concern. When planning to sell or merge a business. When planning to issue bonds. The futility of plugs and circularity will be evident later. 21/06/2012 Financial Forecasting Ignacio Pareja Value Based Financial Management (3) With a financial model we make looking forward Financial Management. No autopsy is done. An example: usually they teach financial analysis to see "what happened" and answer some questions. Was the firm liquid last year? Was it profitable? How was financed? How were the funds spent? The question is why is it relevant to know that? What is more interested in the manager: to know what happened or to establish plans and policies into the future? In a financial model, these policies are designed to create value. That is, we can examine in terms creation or destruction of value the change in a policy and conclude if it is good or not. For example, the firm might consider whether to increase the portfolio turnover of 30 to 45 days and inventory turns from 20 to 10 days, creates or destroys value and how much. 21/06/2012 Financial Forecasting Ignacio Pareja Electronic copy available at: 2

3 Value Based Financial Management (4) As we shall see, the traditional analysis of historical financial statements can be used to identify explicit or implicit policies of the company when you require forecasted financial statements. It also serves to identify and correct errors to avoid them or to strengthen the successful decisions. Traditional financial ratios can be used to create predictive statistical models of bankruptcy or credit performance. They can be used to make some benchmarking with your competition. Where do you find information for that? In Colombia, visit the website of Superintendencia de Sociedades. In other countries there should be similar entities, governmental or private, where you find that. I.e. Compustat. Financial ratios are not the best procedure to measure the liquidity of the firm, for example. This can be done better with the Cash Budget. 21/06/2012 Financial Forecasting Ignacio Pareja The Financial Statement Income Statement Balance Sheet Cash Flow Statement or Cash Budget They are intertwined 6 3

4 A Commercial Firm: A Graphical Approach to Firm Activity End users AR Collection $ Cash Aportes de los socios $ Receipts of payment Product sold Invoicing Accounts Receivable AR Payment vouchers Payments to suppliers $ Cost of goods sold Inventory Suppliers Depreciation Fixed assets Invoices Selling expenses Accounts payable AP Payroll $ Administrative expenses Work Workers Taxes Taxes State Taxes Retained earnings Dividends $ Net Income Equity Capital Owners Income Statement Cash flow Balance Sheet External Environment Y Third parties Accounting operation Documents flow 7 Financial Analysis and Control The traditional financial analysis is based on "see what happened" and not emphasis in the future. It is like a necropsy. The analysis of the past will be useful if it serves to correct wrong actions or reinforce successful ones. We will study the following: Analysis of indicators, Financial Ratios and Sources and Uses of Funds Statement. Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis. 8 4

5 Financial Analyisis Beyond Ratio Analysis Financial analysis should squeeze information contained in the Financial Statements. This is to say, we must read what they are saying in a hidden form. Reading between the lines. 9 Example of reading the hidden We have information on Reserves. Retained earnings and Actual Net Income listed in the BS. Could we know how much the firm paid as dividends in year t? Could we know which percent of Net Income has been paid as dividends? The answer is YES! Item t-1 t Legal Reserve LR Other reserves OR Retained Earnings, RE Net Income NI Div t = NI t-1 (LR t LR t-1 + OR t OR t-1 + RE t - RE t-1 ) = 132 % of NI t distributed as dividends 132/320 = 41.3% 10 5

6 BS is like a reservoirs system Let us see in a graphical way how do we explain the equation: Div t = NI t-1 (LR t LR t-1 + OR t OR t-1 +RE t -RE t-1 ). Imagine that the BS is composed by tanks and what the BS does is to measure their levels. What reamains in each tank is what is left after some transactions. Level in t-1 The level of tank will increase with NI from t-1 that is partially added RE, LR and OR The level of tank will decrease with the payment of dividends in t Level in t +Part of NI t-1 LR t-1 that goes to LR +Part of NI t-1 OR t-1 that goes to OR +Part of NI t-1 RE that goes to RE t-1 - Dividends paid at t LR t Or t Re t NI t-1 NI t 11 Clean Surplus Relation We wish to know from data from two BS, one at t-1 and one at t, how much was paid in dividends in t. Let us note that the difference between the first three items between t-1 and t is precisely what is added to each of them. Part of NI t-1 that goes to LR + Part of NI t-1 that goes to OR + Part of NI t-1 that goes to RE = NI t-1 Then LR t + OR t + RE t = LR t-1 + OR t-1 + RE t-1 + NI t-1 Dividends t We solve for dividends Dividends t = LR t-1 + OR t-1 + RE t-1 + NI t-1 (LR t + OR t + OR t ) Dividends t = NI t-1 (LR t + OR t + RE t LR t-1 OR t-1 RE t-1 ) Organizing terms Dividends t = NI t-1 (LR t LR t-1 + OR t OR t-1 + RE t RE t-1 ) 12 6

7 Another way to read the hidden Now we have Retained earnings from the BS and includes NI plus reserves, and Net Income from the IS. Could we know how much the firm paid as dividends in year t? Could we know which percent of Net Income has been paid as dividends? The answer is YES! Observe that this is just a different way to show Retained Earnings in the BS. See that RE in this case includes NI, and legal and other reserves from previous example. Compare RE in this example with RE+LR+OR+NI in previous example. Item t-1 t Retained Earnings RE (BS) include NI and reserves 1,127 1, Net Income, NI (IS) Dividends t = NI t = (RE t RE t-1 ) 132 % distributed from 132/320 = UN t % 13 Indicators and ratios When managing a company there are certain key indicators to watch. These indicators act as traffic lights or flags, when they have certain critical values have a red signal and when the business is "going well" have a green signal. This analysis tool by ratios, is also known as financial ratio analysis and vertical and horizontal analysis. 14 7

8 What is a ratio? An indicator or index is a ratio between a value and another value called base. For example, the Net Income can be expressed as a ratio if divided by sales, and this result is called net profit margin on sales: Net profit margin Net Income t Sales revenues t t 15 Another example You can also calculate Gross margin: Gross Profit divided by Sales Gross margin Gross income Sales t t t 16 8

9 Vertical and Horizontal Analysis This type of financial analysis expresses the items of the Balance Sheet and Income Statement or Profit and Loss in percentage terms. In the first case (vertical analysis) in relation to total assets or total sales. In the second case (horizontal analysis), it finds the growth rates of each item, from one period to another. With this analysis, the analyst can interpret the information contained in the financial statements of a firm. 17 What is Vertical Analysis Vertical analysis redefines each amount of a financial statement as a percentage of another item. If we analyze the Income Statement in percentage terms in relation to sales, we call that vertical analysis for the IS and it can be useful to calculate indicators, which may serve as a reference point to establish policies or trends for forecasting financial statements. For vertical analysis you require the financial statement for a single year. 18 9

10 Horizontal Analysis The purpose of this analysis is to examine the behavior (growth or decline) of financial statement items. Then we calculate the change in percent for each item. The horizontal analysis indicators are calculated by dividing the most recent year data by the corresponding figure for the previous year, minus one. For conducting horizontal analysis you need at least two financial statements. 19 Example of Vertical Analysis for the BS For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets. The restated amounts from the vertical analysis of the balance sheet will be presented as a common-size balance sheet. A common-size balance sheet allows you to compare your company s balance sheet to another company s balance sheet or to the average for its industry. (Taken and adapted from visited on July 5, 2010) 20 10

11 Vertical analysis of Liabilities and equity Notes payable % 11.0% Accounts payable AP % 4.2% Other AP % 5.1% Unpaid taxes % 3.9% Total current liabilities % 24.2% Long term liabilities % 19.3% Total Liabilities % 43.6% Capital stock % 24.1% Current year net income % 4.3% Retained earnings % 28.0% Total equity % 56.4% Total liabilities and equity 1, , % 100.0% 21 Example of Vertical Analysis for the IS Vertical analysis of an income statement results in every income statement amount being presented as a percentage of sales. The restated amounts are known as a common-size income statement. A common-size income statement allows you to compare your firm s income statement to another company s or to the industry average. (Taken and adapted from visited on July 5, 2010) 22 11

12 Vertical analysis of Income Statement Income Statement Sales 1, , % 100.0% Cost of goods sold 1, , % 67.2% Gross Income % 32.8% Administrative expense % 16.3% Selling expenses % 3.2% Depreciation % 3.1% Earnings Before Interest and Taxes % 10.2% Interest expense % 1.9% Other expenses % 0.0% Other income % 0.0% Earnings Before taxes % 8.3% Less income taxes (52.1%) % 4.6% Net income % 3.7% 23 Example of Horizontal Analysis for the BS Horizontal analysis looks at amounts on the financial statements over the years. This analysis will be done for each item on the balance sheet. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis. (Taken and adapted from visited on July 5, 2010) 24 12

13 Horizontal analysis of Liabilities and equity Notes payable % Accounts payable AP % Other AP % Unpaid taxes % Total current liabilities % Long term liabilities % Total Liabilities % Capital stock % Current year net income % Retained earnings % Total equity % Total liabilities and equity 1, , % 25 Example of Horizontal Analysis for the IS Horizontal analysis looks at amounts on the financial statements over the years. This analysis will be done for each item on the income statement. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis. (Taken and adapted from visited on July 5, 2010) 26 13

14 Horizontal analysis of Income Statement Income Statement Sales 1, , % Cost of goods sold 1, , % Gross Income % Administrative expense % Selling expenses % Depreciation % Earnings Before Interest and Taxes EBIT % Interest expense % Other expenses - - Other income - - Earnings Before taxes % Less income taxes (52.1%) % Net income % 27 Ups and downs In financial ratio analysis it is not enough to say that "inventories increased by 12.5% in the first year and 2% in the second. This is not analysis, but the story of the figures in the tables, the analysis seeks to go further and investigate the causes for these changes: Was it a price increase or an increase in inventory quantities? If it is due to both causes, how much was due to the price increase and how much to the increase in the level of inventory? 28 14

15 Deflating data To deflated figures means to express them in monetary terms of the same period called a base period. Here it is assumed that this conversion can be done using the inflation rate (CPI, Consumer Price Index). Normally when it comes to deflate the figures are expressed in pesos of a base year, future or past. However, but I prefer to use deflated here to refer to figures in pesos a year earlier and inflated when referring to a future year figures. 29 Example for Deflating Sales Year Sales revenues 1,000 1,220 1,410 1,630 Inflation rate 18% 15% 12% Apparent or 22,0% 15.6% 15.6% Nominal growth In dollars of year 4 1, , , ,630.0 (inflated) Real growth 3.39% 0.5% 3.21% In dollars of year 1 1,000 1, , , (deflated) Real growth 3.39% 0.5% 3.21% Test now deflating the apparent growth that is (1 + Apparent Growth) / (1 + inflation) -1. What do you get? I say real growth because the actual real growth is given in units. This real growth consists of growth in units and real increase in prices

16 Non monetary figures Horizontal analysis is richer and fruitful if we analyze the items to reflect their true magnitudes and not necessarily in absolute monetary terms. For example, costs for labor can be measured in terms of minimum wages to analyze its growth, sales must be better measured in units sold or in tonnes -if any- sold, inventories in terms of raw material to be used in the process. 31 Financial Ratios In addition to the indexes to examine the relationship of each item with total values (total assets or sales), there are combinations of items that give a more detailed and analytical view of the firm. One of the tools most widely used in the business world, is the financial ratio analysis 32 16

17 Financial Ratios Liquidity ratios Turnover ratios Financial leverage ratios Return on investment and margin ratios 33 What can be done with financial ratios? Financial ratios if isolated, tell us very little. You have to compare them With company s history With the industry With the whole economy 34 17

18 The idea is to compare financial statements Assets Liabilities and Equity Income Statement Curent Assets Current Liabilities [4] Non Current Assets Non Current liabilities [1] Equity Total Liabilities [2] Total Assets [3] Total Liabilities and Equity 35 Liquidity ratios Liquidity ratios measure firm's ability to meet its short-term liabilities. Current ratio (or working capital ratio) Quick ratio

19 Current ratio The current ratio is the ratio of current assets to current liabilities: Current Assetst Current Liabilities t 37 Quick ratio This ratio is calculated subtracting the lesser current asset from total current assets. Usually, this is inventory. Cur. Assets t Less liquidcur. asset Current Liabilities t This ratio is also known as acid test. t 38 19

20 Working capital There is a relationship between current assets and current liabilities which is not a ratio. What is left to the firm after paying its current liabilities, is the Working Capital and is defined as the difference between current assets and current liabilities. Working Capital t = Current Assets t Current liabilities t Is there any relationship between Current ratio and working capital? Find it out. 39 Liquidity Liquidity is the ability of an asset to be converted into cash at the end of a period of time. It also refers to a firm s ability to pay its bills from cash or from other assets that can be turned into cash quickly. The money that a company gets, immediately becomes an asset and to convert these assets into cash again, they need some additional operations (unless they are held as cash) such as conversion into finished goods, selling, etc.. The liquidity must take into account three variables: The time after which the asset is available as cash. The quality of the assets to be converted into cash. The value to be recovered as cash

21 Recoverableness When evaluating a liability you should take into account when and how to pay. Therefore, when evaluating the creditworthiness or solvency (ability to pay debts) determine when the liability has to be reimbursed (the time in which debt is payable) and the inflexibility required for honoring that date. 41 Turnover or activity ratios They measure the effectiveness and efficiency of using firm s resources. Inventory turnover Measures how many times a firm s inventory is sold and replaced over a given period Receivables turnover ratio Quantifies a firm's efficiency in extending credit as well as collecting debts Accounts payable turnover ratio Quantifies the rate at which a company pays off its suppliers Total assets turnover ratio Measures how well assets are being used to produce revenue Fixed assets turnover ratio sales Measures a firm's ability to generate net sales from fixed-asset such as property, plant and equipment (PP&E) after of depreciation Equity turnover ratio Measures how well a firm uses its equity to generate revenue. Cash Conversion Cycle - CCC. Measures how long a firm has to finance its increase in investment of resources in order to expand sales

22 Inventory turnover ratio This ratio assesses inventory policy that the company has implemented in its operation. It measures the time it takes inventory to be sold and replaced in a given period. When calculating its inverse the number of times that this investment goes to market in a year, and how many times it is replaced. Inv entoryt 360 Cost of Goods Sold COGS t (in days) 43 Receivables turnover ratio This indicator allows in monitoring the credit policy and collection. The balance in accounts receivable should not exceed the sales, because it would then freeze the total funds in this asset, which reduces firm s ability to pay and will be subjected to a loss of purchasing power. Accounts receiv ablet 360 Salest (in day s) 44 22

23 Accounts payable turnover ratio With this indicator you can observe the behavior of working capital. Measures the number of days the firm takes to repay the credit the suppliers have granted. Accounts payable 360 Purchases t t (indays) How would you get purchases from the financial statements (BS and IS)? 45 Several formats for Turnover ratios We can express turnover ratios in three different ways: As a percent As days As times For instance to say AR turnover is Turnover of 6 times, 60 days and 16.67% of sales is to say exactly the same. You can derive one from the other. A turnover of 6 times a year means 360/6 = 60 days. It is 60/360 = 16.67% of one year (360 days) is 360*16.67% = 60. To have 60 in AR is 60/360 = 16.67%

24 How would you get purchases from the financial statements? Again the idea of tanks Level in t-1 Level of tank increases with purchases P in t Level of tank decreases with amount sold, this is COGS. Nivel en t +Purchases in t Inv t-1 - COGS in t Inv t Inv t = Inv t-1 + P t COGS t P t = Inv t Inv t-1 + COGS t 47 Total asset turnover ratio It measures the sales of the firm. This is, how many times you can put in the market a value equal to the investment made in the company. Use Total assets from previous period. Sales t TotalAssets t

25 Fixed assets turnover ratio Similar to above, but measures the ability of the company to generate sales from the capital "tied" in fixed assets specifically property, plant and equipment (PP&E) - net of depreciation. Is calculated by dividing total sales between net fixed assets from previous period. Sales t Net fixed assets t 1 49 Equity turnover ratio It measures the selling activity of the firm. This is, how many times you can put in the market a value equal to the investment that shareholders have in the company. Use equity from previous period. Sales Equity t t

26 Using averages in ratios Sometimes it is necessary to average the items in the ratio. For instance assets, equity, AR, AP, inventory, etc., depending if the values at t and at t-1 are too different. This average is calculated as the average between initial (t-1) and ending (t) values. Use this in case items are too different. In case you only have one period, use the item at the same period. 51 Cash Conversion Cycle - CCC Integration of indicators for inventory turnover, AR turnover and AP turnover ratios you can calculate a new index, more complete, which evaluate the time that the firm must finance the purchase of raw material. Cash Conversion Cycle CCC might be expressed as an equation as follows : CCC = Inventory Turnover + AR Turnover AP Turnover 52 26

27 In a graphical scheme (All turnover ratios in days) Raw Material Inflow Accounts recovery Payment to Suppliers Selling and Product delivery Inventory Turnover AR Turnover Cash Conversion Cycle AP turnover 53 Financial leverage ratios These ratios show the amount of resources that are obtained from third parties for the firm. Capital Structure Leverage Coverage of fixed costs Coverage of interest paid Coverage for principal and interest payments 54 27

28 Capital Structure This ratio gives a measure on how risky the firm is. The calculation is done dividing financial debt by equity. In fact what we try to compare is the proportion between the contribution of the two owners of capital: debt and equity holders CS t = Debt t Equity t 55 Total Leverage The percentage of total funds have been provided by the creditors, either in the short or long term, financial or not financial to invest in assets. Totalliabilities TotalAssets t t 56 28

29 Financial Leverage The percentage of total funds have been provided by financial creditors, either in the short or long term, to invest in the firm. The different with the previous ratio is that in this one we only considered financial liabilities. Remember that the owners of a firm are the financial creditors or debt holders and shareholders Total Debt t Total Assets t Nonfinanci al Liabilities t 57 Coverage of fixed costs The firm's ability to cover and pay fixed costs is crucial to understanding its survivability and leverage capacity. Is calculated by dividing the gross income by fixed costs. GrossIncome t Fixed expenses t 58 29

30 Coverage of interest paid Lenders will examine the firm s payment capacity when seeking financing. One way to measure this is comparing operating income with the interest to be paid and this gives an idea of the applicant's repayment capacity. It is also known as times interest earned ratio and it indicates the extent of which earnings are available to meet interest payments Income before interest Interestpayments t t 59 EBITDA a proxy to cash flow When a firm is indebted it has to pay not only interest but principal payments or amortization to capital. In this case you must recalculate the operating income for the purposes of correction for items not involving cash flow. That is, depreciation and accrued expenses, AE. When you add these items you get what is known as EBITDA (EBIT+ D + AE) by its acronym in English (Earning Before Interest Taxes Depreciation and Amortization). The value of EBITDA is close to the cash flow. EBITDA = EBIT+ D + AE 60 30

31 Coverage for principal and interest payments The coverage for debt payments is approximated by the ratio between EBITDA and total payment of debt: principal and interest. EBITDA t Interest & principal payments t 61 Return and margin ratios They measure the ability to generate income to the firm. Return on Equity ROE Operating Return on Assets ORA Return on assets ROA Margins on sales 62 31

32 What is the return in % Assume you invest $1,000 today and in one year you receive back $1,300. Your return is 23.1% 30.0% 26.1% Explain your answer 63 Discussion If you have chosen 23.1% you are wrong. Your return is calculated on the invested amount, in this case, $1,000. If you have chosen 26.1% you are wrong. You have calculated your return upon the average between your initial investment and your final funds. (1,150). The proper return is 30% as usually people will perceive

33 Return and Margin Return refers to the amount you earn compared to what was invested by you. It is very important to keep in mind that when calculating return you have to take into account the amount that was invested. This is, the amount invested in the previous period (t-1) to the earnings. When thinking on return keep in mind that it is the earnings someone receives compared with the amount invested by the same someone. You get the earnings out from the investment you have made. The owner of the earnings should be the same as the owner of the investment. I call this consistency. 65 Return and Margin (cont d) Margin refers to how much out of every dollar of sales the firm actually keeps as profits. This distinction is very relevant because in practice many people means margin when they say return on investment. Margins and return ratios allow to compare firms of different sizes

34 Difference and Consistency Between Margin and Return and Income and Investment Margin Income Balance sheet Statement at t at t-1 Sales Current assets COGS Fixed assets Gross income Total assets Operating expenses EBIT Current liabilities Financial Non Current expenses liabilities Earnings before taxes Total liabilities Taxes Net equity Liabilities and Net income equity Return 67 Check the following Return * Consistent? Owner of numerator Owner of denominator UN/Equity Yes Shareholder Shareholder UN/Debt No Shareholder Creditor UN/Total Assets No Shareholder Firm-creditor and shareholders Interest/Equity No Creditors Shareholders Interest/Debt Yes Creditors Creditors Interest/Total Assets No Creditors Firm-creditors and shareholders EBIT/Equity No Creditors and shareholders EBIT/Debt No Creditors and shareholders EBIT/Total Assets Yes Creditor and shareholders Shareholders Creditors Firm-Creditors and shareholders * Sub indexes for years have been dropped. They should be t in the numerator and t-1 in the denominator

35 Comparing return with an external benchmark Return ratios means nothing by themselves. I you do not have a reference to compare with, they are meaningless. Return on equity must be compared with the expectations shareholders have from their investment in the firm; return on debt (interest/debt) must be compared with the expectation debt holders have on their payments and finally operating return on assets (ORA) must be compared with an average of the expected cost of debt and expected return to shareholders (equity). This idea stresses the argument of considering some return ratios as consistent or inconsistent. 69 Return on Investment In general, return on investment (ROI) means to compare earnings with the cause (investment) of those earnings. There must be a causal link between the earnings and the resources invested. This correspondence can be seen as follows: Operating Profit Total Assets ORA Operating return on Assets Net Income Net Equity ROE Return on equity In the first case the firm has not paid to any of the owners of capital, in particular (or creditors, or shareholders). In the second, the owner of the debt has been paid out

36 Return on equity ROE Measures a shareholder's return on investment and tells the analyst how much profit a firm generates to shareholders compared with the funds they have invested This ratio is obtained by dividing the Net income by shareholder s equity at t-1. It is a measure of the return of the funds contributed by the investor. ROE Net income Net equity t t 1 71 Operating Return of Assets Given the situations described above, there must be a relationship between the income and the resources required to achieve it. In this case we use and compare operating income to total assets EBITt ORA Totalassets t

37 Return on assets (ROA) ratio Is obtained by dividing net income by total assets of the company, to determine the overall effectiveness of management and make a profit on total assets available. It measures the return of the business as an independent project of the shareholders. Although it does not meet the relationship and consistency mentioned above, it is used extensively. It makes little sense because we are comparing the net income (for shareholders) to total assets (from shareholders and debt holders). ROA Net income Totalassets t t 1 73 ROA is not return on investment where D% t-1 = (Total liabilities t-1 )/TotAssets t-1 = Total leverage t-1 In other words, ROA has no financial or economic meaning in itself. It is just a fraction (1-D%) of return on investment

38 Gross margin This ratio measures how much a firm earns after deducing the costs incurred in producing services and/or products. Gross margin is calculated as Gross income divided by Net sales and is expressed as a percentage. Gross income t Net sales t 75 Operating margin This is similar to the previous one, but it relates Operating profit (EBIT) with Net sales. It is what remains after operational expenses are deduced from Gross income. EBITt Net sales t 76 38

39 Net margin This ratio has different names: Net margin, profit margin, net profit ratio or net profit margin. Net income t Net sales t 77 DuPont analysis Often an analyst might ask about the low net margins on sales in some firms. There are cases where the net margin is very low. This can distort the analysis. We need to combine that with another ratio(s) to have a good overview of the financial situation of the firm. This is known as Dupont analysis. DuPont analysis (the DuPont Model or the DuPont method) is an expression which breaks ROE (Return On Equity) or ORA (Operating Return on Assets) into two or three ratios. It helps to understand how the return measure is obtained. It helps to define some future actions if the firm expects to pay a given return

40 Breaking down Return The idea is to combine different efficiency measures that contribute to the return. Some examples. Net Profit margin that measures net efficiency (NI/S) Equity turnover that measures Equity efficiency. (S/E) or Net Profit margin that measures net efficiency. (NI/S) Asset turnover that measures Asset efficiency. (S/A) An equity multiplier that measures Financial leverage. (A/E). Remember that E = A L. or Operating Profit margin that measures net efficiency (EBIT/S) Assets turnover that measures assets efficiency. (S/A) 79 Dupont Index (1/4) This is the most common version, but that does not comply with the correspondence and consistency between profits and assets. This ratio combines Net Profit margin that measures Operating efficiency (NI/S) Assets turnover that measures Assets efficiency. (S/A) And you obtain ROA Net income t Net sales t Net sales t Totalassets t 1 Net income t Totalassets t

41 Modified Dupont (2/4) This ratio combines Net margin that measures Operating efficiency (NI/Sales) Equity turnover that measures Equity efficiency. (Sales/E) This version is more reasonable and consistent, because the net income that belongs to shareholders, owners of equity, is compared with equity. It is measured as the turnover of beginning equity. Net income t Net sales Net income t t Net sales t Net equity t 1 Net equity t 1 81 Modified Dupont (3/4) Combines operating margin with total assets turnover and we obtain the operating return on assets, ORA. This is a reasonable and consistent version. ORA EBIT t Net sales t Net sales t Totalassets t 1 EBIT t Totalassets t 1 Análisis financiero. y Dávila 82 41

42 Modified Dupont (4/4) This version is very reasonable and consistent. Combines Net profit margin that measures net efficiency. (NI/S) Asset turnover that measures Asset efficiency. (S/A) An equity multiplier that measures Financial leverage. (A/E) This ratio obtains return on equity ROE. Net income t Net sales Totalassets Net income t t-1 t Net sales t Totalassets t-1 Net equity t-1 Net equity t 1 83 What does Dupont Analysis DA mean? The first reaction when studying Dupont Analysis DA would be to "why combine several ratios to get something that can be calculated directly? For example, return on equity. This is not the proper use of DA. A company with low net margins (a supermarket, for example) should compensate this situation with a very high turnover of assets or equity in order to achieve a reasonable return for equity holders. In other words, the DA allows a manager, faced with a firm that normally (depending on the type of business) has low margins make decisions to increase return. DA tells you what to do. Turnover equity as many times as necessary to obtain an acceptable return or combine total asset turnover and financial structure (Total Assets/Equity) to achieve the desired performance

43 Using financial ratios We have seen that ratios are a very simple calculation. The most important thing is interpretation. It requires "squeezing" the accounting information and financial ratios can help, but you always have to go beyond calculation. 85 Sources and Uses Statement One of the questions that any manager makes is where did the money is spent? How is funding the firm? These questions, which also are made by managers of banks that lend money to the company, can be answered with the Sources and Uses Statement. However, as management is a forward looking activity, what is of interest is designing how the firm will be financed in the future. Instead of looking backwards to see what happened, what is more relevant is to design the future financing for the firm. This can be done with the forecasted Cash Budget or Cash Flow Statement

44 How Cash has been or will be used The question is where the money will come from (sources) and how will be spent (uses). Looking backwards, It identifies which items of the Balance Sheet and Profit and Loss State increase or decrease the availability of cash. You calculate differences between these items from two consecutive years (the most distant figure is subtracted from the most recent one) and determine if the difference is a source or use of funds. Also, in the Profit and Loss Statement you determine the net income, depreciation and dividend payments (se calculation above and below). Now we identify what is a source and what is a use of funds. 87 Sources of Funds A net reduction of any asset different from Cash A net reduction of fixed assets before depreciation. A net increase of any liability. Increase in capital stock (issue of new shares). Internal funds generation including Net Income. Depreciation

45 Uses of funds An increase of any asset different from cash. An increase in fixed assets before depreciation. A decrease in liabilities. Repurchase of stock. Dividend payments. 89 Summary Item Source Use Asset - + Liabilities + - Equity

46 Calculating Investment in Fixed Assets To calculate the change in fixed assets before depreciation (investment in fixed assets) add depreciation charges to Net Fixed Assets at the end of period and subtract Net Fixed Assets at the beginning. NFA are called PP&E (Property, plant and equipment). Investment in FA t = NFA t + Dep t NFAF t-1 91 BS as a system of reservoirs that are named NFA or PP&E See the figure below to understand the previous equation Investment in FA t = NFA t + Dep t NFAF t-1 Imagine the BS as a system of tanks or reservoirs and you measure the level after some transactions. Level at t-1 Investment in fixed assets in t makes the level of NFA to increase from t-1 to t. Depreciation charges in t make the level to decrease. Level in t NFA t-1 +Investment in fixed assets in t - Depreciation charged in t NFA t 92 46

47 Investment in Fixed Assets in t From data found in two BS, one at t-1 and the other at t, how much was invested in Fixed Assets in t. Therefore, according to previous figure NFA t = NFA t-1 + Inv in FA t Depreciation t The ending balance of NFA are known from the two BS and the depreciation charge from the Income Statement or the financial annexes to the financial statements. Solve from above equation the value of Inv in FA t Investment in FA t = NFA t + Dep t NFA t-1 93 Calculating Dividends We use the well known Clean Surplus Relation. Dividends t = NI t-1 (LR t LR t-1 + OR t OR t-1 + RE t RE t-1 ) where NI = Net Income; LR = legal reserve or provision; OR = Other reserves

48 Examples of items for Sources and Uses Statement From BS Cash Account Receivable minus bad debts Inventories Prepaid expenses Taxes paid in advance Investment in fixed assets* From IS Dividends* Net Income Other assets Bank liabilities Accounts payable Accrued expenses Unpaid taxes Long term Liabilities Capital stock Depreciation * Special formula 95 Including cash? Yes. You can construct the Sources and Uses Statement in two ways: Excluding cash and in this case the difference between sources and uses should macth the cash balance in the Balance Sheet. Including cash and the sources and uses should be identical. They should match

49 Example: Sources and Uses Assets Current assets Change Sources Uses Cash $ 100 $ 30 $ 70 $ 0 $70 Inventories $ 120 $ 100 $20 $ 0 $20 AR $ 80 $ 110 -$30 $30 $ 0 TOTAL $ 300 $ 240 Fixed Assets Machinery $ 600 $ 550 Cumulated Depreciation -$ 100 -$ 70 Buildings $ 400 $ 400 Cumulated Depreciation Total NFA Total Assets Total S&U Assets -$ 200 -$ 180 $ 700 $ 700 $ 1000 $ 940 $ 30 $ Example: Sources and Uses Liabilities Change Sources Uses Accounts payable $ 90 $ 70 AP Other AP $ 10 $ 0 Short term financial liabilities $ 50 $ 30 TOTAL $ 150 $ 100 Long term liabilities Total liabilities Equity $ 200 $ 240 $ 350 $ 340 Capital stock $ 200 $ 200 Retained earnings $ 320 $ 300 Net income $ 130 $ 100 $ 20 $ 20 $ 0 $ 10 $ 10 $ 0 $ 20 $ 20 $ 0 -$ 40 $ 0 $ 40 $ 0 $ 0 $ 0 Total $ 650 $ 600 Total Liab+ Equity $ 1,000 $ 940 Total S&U Liab+Equity $ 50 $

50 Special calculations for S&U Originating Source Use Formula Depreciation $ 50 Investment in FA NFA t = Net Income Dividends $ 130 Total S&U special $180 $130 NFA t-1 $ 50 + Inv FA t Dep t Re t $ 80=RE t-1 +NI t-1 -Div t Deduced Formula Inv in FA t = NFA t + Dep t NFAF t = 50 Div t = NI t-1 (RE t RE t-1 ) Div t =100-( ) = Total Sources and Uses Source Use S&U Assets $ 30 $ 90 S&U Liabilities + Equity $ 50 $ 40 Special S&U $180$130 Total S&U $260$

51 Matching maturities Managers seek for matching maturities. This is, that there should be a coincidence between the maturities for deficits and loans to cover those deficits. Short term deficits should be covered with short term debt. It makes no sense to finance a transitory or temporary deficit with a loan at 20 years. On the other hand, the deficit for investing in capital assets should not be financed with an overdraft or a one year loan. Long term deficit could be financed with short term sources after the firm has financed short term deficits with short term sources. This is, LT deficit can be partially or totally financed with internally generated funds, IGF. 101 Internally Generated Funds This is the technical name for Cash reinvested or retained in the firm; IGF is depreciation plus earnings not paid out as dividends

52 Matching maturities (ST) Sources Uses Short term Short term Cash $ 70 Inventories $ 20 AR $ 30 AP $ 20 OAP $ 10 ST financial liabilities $ 20 Total $ 80 $ Matching maturities (LT) Sources Uses Long term Long term LT liabilities $ 40 Investment in Fixed assets $ 50 Total $

53 Internally Generated Funds IGF IGF Sources Uses Dividends $ 80 Depreciation $ 50 Net Income $ 100 Total $ 150 $ Matching maturities (summary) Sources Uses Matching maturities (ST) $ 80 $ 90 Matching maturities (LT) $ 90 Internally Generated Funds IGF $ 180 $ 80 Total $ 260 $

54 Equity S&U. Real case Diff. Clas. S U Capital Stock 182,5 172,5 10,0 S 10,0 0,0 New Capital stock 1,0 1,0 0,0 U 0,0 0,0 Issue Premium 58,0 58,0 0,0 U 0,0 0,0 Reserves 23,8 18,1 0,0 Restatement of stockholders equity 99,9 112,7-12,7 U 0,0 12,7 Currentyear Net income 35,2 51,8 0,0 Retained earnings (1) 28,7 21,4 0,0 Retained losses (2) 112,5 127,2 0,0 Retainedearningsnet (1) (2) -83,8-105,9 0,0 Superavit from commercial value of assets 1.683, ,6 149,1 S 149,1 0,0 Items in red are included in the Clean Surplus Relation for Dividends. This examplewas worked out by Luis Fernando Díaz Arroyo. 107 Construction of S&U statement If you do not include Cash in the S&U statement, the result of the sum of sources minus the sum of the uses must be identical to the cash and bank balance (cash). If you do include the Cash in the S&U Statement, as in this example, the total sources and total uses must be identical. The S&US is an indirect way to build cash flow

55 Summary We have studied different ways to extract information from financial statements using relationships between different financial statement items. This analysis should be carried out mainly to the future rather than the past