Working with Financial Statements

Working with Financial Statements Lakehead University September 2005 Overview of the Lecture 3.2 Standardizes Financial Statements 3.3 Ratio Analysis 3.4 Dupont Identity 3.5 Using Financial Statement Information 2

Standardized Financial Statements Rewriting financial statements in their common-size format means: Dividing all items on the income statement by sales; Dividing all items on the balance sheet by total assets. 3 Standardized Financial Statements Common-size analysis expresses each item on financial statements as a ratio and thus allows comparisons across years for the same firm. It allows to see how the firm s use of debt relatively to its size (total assets) is evolving over time. It allows to see how the firm s profits, relatively to the level of sales, are evolving over time. 4

Unibroue, Inc. Dec. 31, 2002 and Dec. 31, 2001, Income Statements ($000) 2002 2001 Sales 23,622 21,580 Cost of goods sold 11,824 11,540 Gross profit 11,798 10,040 Selling, gen. and admin. expenses (SGA) 7,669 6,543 Amortization 2,073 1,833 Earnings before interest and taxes (EBIT) 2,056 1,664 Interest expense 675 731 Foreign exchange gain (14) (14) Pretax income (EBT) 1,395 947 Taxes 434 338 Net income 961 609 Number of shares outstanding (weighted average) 6,111,875 6,235,451 Earnings per share $0.16 $0.10 Stock price (December) $2.43 $2.00 5 Unibroue, Inc. Dec. 31, 2002, and Dec. 31, 2001, Balance Sheets ($000) Assets 2002 2001 Cash 2,300 1,714 Short-term investments 0 400 Accounts receivable 3,891 4,435 Income taxes receivable 237 327 Inventories 4,128 3,417 Prepaid expenses 346 306 Total current assets 10,903 10,600 Net fixed assets 23,085 22,426 Total assets 33,988 33,086 Liabilities and Stockholders Equity Accounts payables and accrued liabilities 3,199 2,257 Instalments on long-term debt 937 952 Total current liabilities 4,136 3,209 Long-term debt 5,125 5,992 Future income taxes 2,573 2,248 Total liabilities 11,835 11,449 Capital stock 8,670 9,414 Contributed surplus 978 678 Retained earnings 12,506 11,545 Total equity 22,154 21,637 Total liabilities and equity 33,988 33,086 6

Unibroue, Inc. Dec. 31, 2002 and Dec. 31, 2001, Common-Size Income Statements (%) 2002 2001 Sales 100.00 100.00 Cost of goods sold 50.06 53.48 Gross profit 49.94 46.52 Selling, gen. and admin. expenses (SGA) 32.47 30.32 Amortization 8.78 8.49 Earnings before interest and taxes (EBIT) 8.70 7.71 Interest expense 2.86 3.39 Foreign exchange gain (0.06) (0.06) Pretax income (EBT) 5.91 4.39 Taxes 1.84 1.57 Net income 4.07 2.82 7 Unibroue, Inc. Dec. 31, 2002, and Dec. 31, 2001, Common-Size Balance Sheets (%) Assets 2002 2001 Cash 6.77 5.18 Short-term investments 0.00 1.21 Accounts receivable 11.45 13.40 Income taxes receivable 0.70 0.99 Inventories 12.15 10.33 Prepaid expenses 1.02 0.92 Total current assets 32.08 32.04 Net fixed assets 67.92 67.96 Total assets 100.00 100.00 Liabilities and Stockholders Equity Accounts payables and accrued liabilities 9.41 6.82 Instalments on long-term debt 2.76 2.88 Total current liabilities 12.17 9.70 Long-term debt 15.08 18.11 Future income taxes 7.57 6.79 Total liabilities 34.82 34.60 Capital stock 25.51 28.45 Contributed surplus 2.88 2.05 Retained earnings 36.80 34.89 Total equity 65.18 65.40 Total liabilities and equity 100.00 100.00 8

Standardized Financial Statements Common-base-year financial statements are such that all items on each statement is divided by the corresponding item on the base year financial statements. Common-base-year financial allows to look at the trends in financial statement items. 9 Unibroue, Inc. 2002 and 2001 CBY Income Statements (%, Base Year = 2001) 2002 2001 Sales 109.46 100.00 Cost of goods sold 102.46 100.00 Gross profit 117.51 100.00 Selling, gen. and admin. expenses (SGA) 117.21 100.00 Amortization 113.09 100.00 Earnings before interest and taxes (EBIT) 123.56 100.00 Interest expense 92.34 100.00 Foreign exchange gain (100.00) (100.00) Pretax income (EBT) 147.31 100.00 Taxes 128.40 100.00 Net income 157.80 100.00 10

Unibroue, Inc. 2002 and 2001 CBY Balance Sheets (%, Base Year = 2001) Assets 2002 2001 Cash 134.19 100.00 Short-term investments 0.00 100.00 Accounts receivable 87.73 100.00 Income taxes receivable 72.48 100.00 Inventories 120.81 100.00 Prepaid expenses 113.07 100.00 Total current assets 102.86 100.00 Net fixed assets 102.66 100.00 Total assets 102.73 100.00 Liabilities and Stockholders Equity Accounts payables and accrued liabilities 141.74 100.00 Instalments on long-term debt 98.42 100.00 Total current liabilities 128.89 100.00 Long-term debt 85.53 100.00 Future income taxes 114.46 100.00 Total liabilities 103.36 100.00 Capital stock 92.10 100.00 Contributed surplus 144.25 100.00 Retained earnings 108.32 100.00 Total equity 102.39 100.00 Total liabilities and equity 102.73 100.00 11 Standardized Financial Statements It is also possible to construct common-size, common-base-year, financial statements. Combining common-size and common-base-year analyses means looking at the trend in the common-size financial statements. 12

Ratio Analysis How to compare financial statements from different companies? Computing ratios is a good way to do so. A ratio standardizes an item on a statement, i.e. it makes it comparable to the same item on a different statement. Ratios put absolute numbers in perspective. 13 Ratio Analysis What can we do with ratios? Cross-Sectional Analysis: Analyze different companies in a given year. Times-Series Analysis: Analyze the same company over different years. Combined Analysis: Do both. 14

Ratio Analysis The ratios of a company should be compared to those of its competitors or to the average ratios of firms in the same industry. There are different categories of ratios, some ratios are more important than others depending on the industry a firm operates in. 15 Ratio Analysis Financial ratios are grouped in many categories: 1. Short-term solvency, or liquidity, ratios 2. Long-term solvency, or financial leverage, ratios 3. Asset management, or turnover, ratios (activity) 4. Profitability ratios 5. Market value ratios 16

Ratio Analysis: Liquidity Ratios Current Ratio Current ratio = Unibroue s current ratio was Current assets Current liabilities 10,903 4,136 = 2.64 in 2002 10,600 3,209 = 3.30 in 2001 17 Ratio Analysis: Liquidity Ratios Current Ratio One problem with the current ratio is that it considers assets that may never convert to cash, such as inventories. The quick, or acid-test ratio provides a solution to this problem. 18

Ratio Analysis: Liquidity Ratios Quick, or Acid-Test Ratio Quick Ratio = Unibroue s quick ratio was Current Assets Inventories Current liabilities 10,903 4,128 4,136 = 1.64 in 2002 10,600 3,417 3,209 = 2.24 in 2001 19 Ratio Analysis: Liquidity Ratios Quick, or Acid-Test Ratio Like the current ratio, the acid-test ratio also considers assets that are not 100% liquid. The cash ratio provides a solution to this problem. 20

Ratio Analysis: Liquidity Ratios Cash Ratio Cash ratio = Cash (and Marketable Securities) Current liabilities Unibroue s cash ratio was 2,300 4,136 2,114 3,209 = 0.56 in 2002 = 0.66 in 2001 21 Ratio Analysis: Liquidity Ratios Cash Ratio One must compare a firm s cash ratio with those of its competitors. The cash ratio is a very conservative measure of liquidity. Other liquidity ratios: NWC to total assets = Interval measure = NWC Total assets Current assets Average daily operating costs, where Average daily operating costs = (COGS + SGA)/365. 22

Ratio Analysis: Leverage Ratios Debt-Equity Ratio The debt-equity ratio is computed as follows: Debt/equity ratio = Total Debt Total Equity For Unibroue, we have Debt/equity ratio = 11,834 22,154 11,449 21,636 = 0.53 in 2002 = 0.53 in 2001 23 Ratio Analysis: Leverage Ratios Total Debt Ratio Total debt ratio = Unibroue s total debt ratio was Total assets Total equity Total assets 33,988 22,154 33,988 = 0.35 in 2002 33,086 21,637 33,086 = 0.35 in 2001 24

Ratio Analysis: Leverage Ratios Equity Multiplier Equity Multiplier = Total assets Total equity The equity multiplier for Unibroue was 33,988 22,154 33,086 21,636 = 1.53 in 2002 = 1.53 in 2001 25 Ratio Analysis: Leverage Ratios Equity Multiplier Note that Equity multiplier = 1 + Debt/equity ratio. 26

Ratio Analysis: Leverage Ratios Long-Term Debt Ratio Investors might be more interested in long-term debt, since short-term liabilities (accounts payable and bank borrowings, for instance) are constantly changing. The long-term debt ratio ignores short-term liabilities: Long-term debt ratio = Long-term debt Long-term debt + Total equity 27 Ratio Analysis: Leverage Ratios Times Interest Earned Cash Coverage Times interest earned ratio = EBIT Interest Cash coverage ratio = EBIT + Depreciation Interest 28

Ratio Analysis: Activity Ratios Inventory Turnover Inventory turnover = COGS Inventory Average Age of Inventory Average Age of Inventory = 365 Inventory Turnover 29 Ratio Analysis: Activity Ratios Inventory Turnover For Unibroue, the inventory turnover in 2002 was 11, 824 4,128 = 2.86 and the average age of inventory was 365 2.86 = 127 days. 30

Ratio Analysis: Activity Ratios Receivables Turnover Receivables turnover = Average Collection Period Sales Accounts receivable Days Sales in Receivables = 365 Receivables Turnover 31 Ratio Analysis: Activity Ratios Receivables Turnover Unibroue s receivables turnover in 2002 was 23, 622 3,891 = 6.07 and its average collection period was 365 6.07 = 60 days. 32

Ratio Analysis: Activity Ratios Payable Turnover Payables turnover = COGS Accounts payable Average Payment Period Average Payment period = 365 Payables Turnover 33 Ratio Analysis: Activity Ratios Payable Turnover Unibroue s payables turnover in 2002 was 11, 824 3,199 = 3.70 and its average payment period was 365 3.70 = 99 days. 34

Ratio Analysis: Activity Ratios Other Activity Ratios NWC turnover = Sales/NWC Fixed asset turnover = Sales/Net fixed assets Total asset turnover = Sales/Total assets 35 Ratio Analysis: Profitability Ratios Profit Margin Profit Margin = Net Income/Sales Unibroue s profit margin was 961 23,622 609 21,580 = 4.07% in 2002 = 2.82% in 2001 36

Ratio Analysis: Profitability Ratios Gross Profit Margin Gross Profit Margin = Gross Income/Sales Unibroue s gross profit margin was 11,798 23,622 11,540 21,580 = 49.9% in 2002 = 46.5% in 2001 37 Ratio Analysis: Profitability Ratios Operating Profit Margin Operating Profit Margin = EBIT/Sales Unibroue s operating profit margin was 2,056 23,622 1,664 21,580 = 8.7% in 2002 = 7.7% in 2001 38

Ratio Analysis: Profitability Ratios Return on Assets (ROA) ROA = Net Income/Total Assets Unibroue s return on assets was 961 33,988 609 33,086 = 2.83% in 2002 = 1.84% in 2001 39 Ratio Analysis: Profitability Ratios Return on Equity (ROE) ROE = Net Income/Total Equity Unibroue s return on equity was 961 22,154 609 21,637 = 4.34% in 2002 = 2.81% in 2001 40

Ratio Analysis: Market Value Ratios Price/Earnings (P/E) Ratio P/E ratio = Stock price/earnings per share This ratio usuall involves expected future earnings. Nevertheless, we could say that Unibroue s P/E ratio was 2.43 0.16 2.00 0.10 = 15.45 in 2002 = 20.48 in 2001 41 Ratio Analysis: Market Value Ratios Market-to-Book Ratio (ME/BE) ME/BE ratio = Stock price/book equity per share, where book equity per share means total equity, as it appears on the balance sheet, divided by the number of shares outstanding. For Unibroue, this ratio was 2.43 22,154/6,112 2.00 21,637/6,235 = 0.67 on Dec. 31, 2002, = 0.58 on Dec. 31, 2001. 42

Ratio Analysis: Market Value Ratios Market-to-Book Ratio (ME/BE) Since the book value of assets is usually below its market value, a stock with a market-to-book ratio below one may be considered a good buy. On the other hand, a market-to-book ratio below one is the sign that management has not been very successful at creating value and thus might not be able to create value in the future either. 43 Ratio Analysis: Market Value Ratios Dividend Payout Ratio Dividend Payout Ratio = Common Share Dividend Earnings Available to Common Shareholders 44

Ratio Analysis: The Dupont System ROE = = = Net income Total equity Net income Total equity Sales Total assets Sales Total assets Net income Sales Sales Total assets Total assets Total equity = Profit margin Total asset turnover }{{} ROA Equity Multiplier 45 Ratio Analysis: The Dupont System For Unibroue in 2002, we have ROE = 4.34% = NI Sales Sales TA TA TE = 961 23,622 23,622 33,988 33,988 22, 154 = 4.07% 0.70 1.53 46

Ratio Sleeman Unibroue 2002 2001 2002 2001 Profitability ratios (%) Gross Profit margin 49.66 50.94 49.94 46.52 Operating Profit margin 15.62 15.09 8.70 7.71 Net Profit margin 7.85 6.90 4.07 2.82 Return on assets 5.60 4.94 2.83 1.84 Return on equity 13.66 13.36 4.34 2.81 Financial leverage ratios Total debt ratio 0.59 0.63 0.35 0.35 Debt/equity ratio 1.44 1.70 0.53 0.53 Long-term debt ratio 0.45 0.50 0.21 0.24 Times interest earned 4.08 3.26 3.05 2.28 47 Unibroue, Inc. 2002 and 2001 Income Statements (in thousands of $) Sales 23,622 21,580 Cost of goods sold 11,824 11,540 Selling and administrative expenses (SGA) 7,669 6,543 Amortization 2,073 1,833 Earnings before interest and taxes 2,056 1,664 Interest expense 675 731 Foreign exchange gain (14) (14) Pretax income 1,395 947 Taxes 434 338 Net income 961 609 Number of shares outstanding 6,111,875 6,235,451 Earnings per share $0.16 $0.10 Stock price (December) $2.43 $2.00 48

Ratio Sleeman Unibroue 2002 2001 2002 2001 Liquidity ratios Current ratio 1.11 0.96 2.64 3.30 Acid-test ratio 0.59 0.52 1.50 2.04 Market value ratios P/E ratio 13.58 15.20 15.45 20.48 Market-to-book ratio 1.85 2.03 0.67 0.58 Asset management ratios Average age of inventory (days) 105 101 127 108 Average collection period (days) 65 62 60 75 Average payment period (days) 127 101 99 72 Total asset turnover 0.71 0.72 0.70 0.65 49 The Case of Unibroue Unibroue s long-term debt level is low compared to Sleeman and brewers in general. Long-term debt ratios in this industry are usually around 40-50%. Unibroue s profits margin is also low compared to other brewers: Anheuser-Busch: 13.2% in 2001 Coors: 5.1% in 2001. Return on equity: Anheuser-Busch: 41.6% in 2001 Coors: 13.1% in 2001. 50

U.S. Number for Brewers in 2002 Ratio Industry Average ROE 53.3% ROA 11.2% Oper Profit Margin 18.9% Net Profit Margin 12.1% Interest Coverage 7.9 times 51 Some U.S. Distillers and Wine Makers in 2001 Ratio Brown-Forman Constellation Brands ROE 18.3% 17.6% ROA 11.5% 4.9% Net Profit Margin 11.6% 4.9% 52