Chapter 3 Working with Financial Statements This chapter is a continuation of Chapter 2. We use accounting numbers because of the unavailability of market numbers. We prefer to use market numbers. Common-Size Financial Statements We may want to compare financial statements of similar companies but of different sizes. For example; GM and Ford are different sizes and an analyst cannot compare the balance sheets. They are different. We may want to compare GM to Toyota. Now we have a difference in size and currency. We may want to compare GM through time. One solution is to work with percentages instead of dollars. Fin 311 Chapter 3 Handout Page 1
Common-Size Balance Sheets Divide by Total Assets (Total Liabilities and Owners Equity) Page 2 Fin 311 Chapter 3 Handout
Common-Size Income Statements Divide by Sales Fin 311 Chapter 3 Handout Page 3
Ratio Analysis Another way to compare firms of different sizes is using ratio analysis. We will cover most common ratios, but there are many others used by analysts. Ratios can be calculated differently by analysts; therefore, you need to know how ratios are calculated when used in a study. You need to document how you calculate ratios for use by others. Financial ratios are the relationships determined from a firm s financial information (statements) and used for comparison purposes. Financial ratios capture relevant differences between firms but a good analyst will look at all public information or reports. Things to consider when using financial ratios: How is it computed? Do we use historical (book) or market values? Will accounting conventions affect the ratio? What are the units of measurement? times, dollars, days Why are we interested in this measure? What does a high or low value mean? How might the measure be misleading? Can we improve this measure? What would a desirable ratio be? What is the benchmark? Do ratios capture all of the relevant differences between the firms? Page 4 Fin 311 Chapter 3 Handout
708 Current Ratio = 1. 30 540 98 Cash Ratio = 0. 18 540 708 422 Quick Ratio (QR) = 0. 53 540 These ratios provide information about liquidity. Can the firm pay in the short term? These ratios are important to short-term creditors. The book and market values should be close. What will affect the current ratio? Assume the CR > 1. Fixed assets are sold for cash LTD is issued to payoff CL A/R are collected Cash is used to payoff A/P Obtained bank loan and put the money in the checking account Fin 311 Chapter 3 Handout Page 5
Total Debt 540 457 Debt Ratio (DR) = 0. 28 Total Assets 3,588 3,588 Equity Multiplier = 1. 39 2,591 691 276 Cash Coverage Ratio = 6. 9 141 540 457 Debt-Equity = 0. 39 2,591 691 Times Interest Earned = 4. 9 141 Financial leverage is the amount of debt used in the capital structure. These ratios measure a firm s ability to meet long-term obligations. 1,344 Inventory Turnover = 422 3. 2 2,311 Receivables Turnover = 188 12. 3 2,311 Total Asset Turnover = 3,588 0. 64 365 Day s Sales in Inventory = 114 3.2 365 Day s Sales in Receivables = 30 12.3 These ratios measure how fast a firm sells its products. Seasonality can cause these ratios to vary. An increase in Inventory Turnover is better (up to a point). We do not stock outs. Receivables Turnover measures how fast we collect receivables. The best way to calculate Receivables Turnover is to use credit sales. In general, external analysts do not have access to this number. Page 6 Fin 311 Chapter 3 Handout
363 Profit Margin = 0.157 15.7% 2,311 363 ROE = 0.14 14% 2,591 363 ROA = 0.1012 10.12% 3,588 What would make the PM increase? Decrease in COGS Increase in corporate tax rate Changing Capital Structure 88 PE Ratio = 8 11 NI 363 EPS = 11 Shares Out 33 Price Sales Ratio = 88 88 2,311 70 1. 26 33 Market-to-Book = 88 88 2,591 78.5 1. 12 33 Fin 311 Chapter 3 Handout Page 7
Ratios are not very helpful by themselves; they need to be compared to something Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes Time Trend Analysis Used to see how the firm s performance is changing through time Internal and external uses Page 8 Fin 311 Chapter 3 Handout
Limitations of Ratio Analysis Multidivisional firms do not adapt to ratio analysis as well as narrowly focused firms. Most firms want to be better than average. Should focus on industry leaders or peer group. Developing and using comparative data (benchmarking) Inflation can distort balance sheets. Inflation also affects depreciation and inventory, also profits are affected. Time series must be interpreted using judgment. Seasonal factors Window dressing Different accounting practices can distort comparisons. GAAP versus IASB, FIFO vs. LIFO Financial statements notes It is difficult to interpret a particular ratio. It can be difficult to reach a conclusion about a firm as a whole. It may have ratios that are trending in a positive or negative direction. Foreign firms do not necessarily confirm to GAAP. This makes it challenging to compare to domestic firms. Market value versus Book value Accounting decisions End of fiscal year is slowest point of year Fin 311 Chapter 3 Handout Page 9
Uses of Ratio Analysis Internal uses Performance evaluation compensation and comparison between divisions Planning for the future guide in estimating future cash flows External uses Creditors Suppliers Customers Stockholders Page 10 Fin 311 Chapter 3 Handout
Growth rates Payout ratio = Dividends Net Income Retention or Plowback ratio = Add. to RE Net Income Internal growth rate = ROA b 1 ROA b Internal growth rate = Sustainable growth rate = ROE b 1 ROE b Sustainable growth rate = Both are often abbreviated: Internal growth rate = ROA b Sustainable growth rate = ROE b Fin 311 Chapter 3 Handout Page 11
The DuPont Identity ROE = Net income Sales Sales Total Assets Total Assets Equity ROE = (Profit margin)(total asset turnover)(equity multiplier) ROE = Factors that affect growth rates: Profit margin Total asset turnover Financial policy or leverage Dividend policy Page 12 Fin 311 Chapter 3 Handout