Working with Financial Statements

Working with Financial Statements Lakehead University September 2004 Overview of the Lecture 3.1 Cash Flow and Financial Statements 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 A ratio is a numerator divided by a denominator. The units of a ratio can be of three types: 1. A percent (35% of sales, for example); 2. A times (1.5 times earnings, for example); 3. A number of days (67 days, for example). 14

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. 15 Ratio Analysis The ratios of a company should be compared to those of its nearest 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. 16

Ratio Analysis What is important to know about a ratio is 1. How it is computed. 2. What it is intended to measure. 3. What does a high or low value mean. 4. What are the drawbacks of this measure. 17 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 18

Ratio Analysis: Liquidity Ratios Computation: Most often used are item/current liabilities, but there are other types of liquidity ratios. Intention: These ratios measure the firm s ability to meet its short-term obligations. High/Low: A high value indicates that short-term liquidity is not a problem. A value too high may indicate that management is too conservative. Problems: These measures are not perfect, as we will see shortly. 19 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 20

Ratio Analysis: Liquidity Ratios Current Ratio A current ratio above 2 is often considered a good sign, but this depends on the industry the firm operates in. 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 is a solution to this problem. 21 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 22

Ratio Analysis: Liquidity Ratios Quick, or Acid-Test Ratio One must compare a firm s acid-test ratio with those of its competitors. Like the current ratio, the acid-test ratio also considers assets that are not 100% liquid. The cash ratio is a solution to this problem. 23 Ratio Analysis: Liquidity Ratios Cash Ratio Cash ratio = Unibroue s cash ratio was Cash (and Marketable Securities) Current liabilities 2,300 4,136 2,114 3,209 = 0.56 in 2002 = 0.66 in 2001 24

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. 25 Ratio Analysis: Leverage Ratios Computation: Depends on the ratio. Intention: These ratios measure the firm s ability to meet its long-term obligations, i.e. its financial leverage. High/Low: A high value for debt ratio increases the probability of financial distress. A too low value may indicate that management does not sufficiently take advantage of leverage. Problems: These measures are not perfect, as we will see shortly. 26

3.3 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 27 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 28

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 29 Ratio Analysis: Leverage Ratios Equity Multiplier Note that Equity multiplier = 1 + Debt/equity ratio. 30

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 31 Ratio Analysis: Leverage Ratios Times Interest Earned Cash Coverage Times interest earned ratio = EBIT Interest Cash coverage ratio = EBIT + Depreciation Interest 32

Ratio Analysis: Activity Ratios Computation: Usually related to total sales and/or total assets. Intention: These ratios measure how efficiently a firm utilizes its assets to generate sales. High/Low: A high turnover ratio is usually a sign of efficiency. Problems: Each measure looks at a specific item, need more than one measure to make a decision. 33 Ratio Analysis: Activity Ratios Inventory Turnover Inventory turnover = COGS Inventory Average Age of Inventory Average Age of Inventory = 365 Inventory Turnover 34

Ratio Analysis: Activity Ratios Inventory Turnover What value should we use for inventory? COGS comes from the income statement, which is a statement showing what happened during the year. Inventory is a figure on the balance sheet, i.e. the value of an asset at a certain point in time. This value, however, varies during the year. 35 Ratio Analysis: Activity Ratios Inventory Turnover It makes more sense to calculate the inventory turnover by dividing COGS on the income statement of year 2002, say, by the average value of inventories between December 2001 and December 2002. For Unibroue, the inventory turnover in 2002 was 11,824 4,128 = 2.86 using Dec. 31, 2002, inventories 11,824 (4,128+3,417)/2 = 3.13 using average inventories for 2002 36

Ratio Analysis: Activity Ratios Inventory Turnover Unibroue s average age of inventory was, in 2002, 365 2.86 365 3.13 = 127 days using Dec. 31, 2002, inventories = 116 days using average inventories for 2002 A high inventory turnover ratio (i.e. small average age of inventory) is a sign of efficiency. 37 Ratio Analysis: Activity Ratios Receivables Turnover Receivables turnover = Average Collection Period Sales Accounts receivable Days Sales in Receivables = 365 Receivables Turnover 38

Ratio Analysis: Activity Ratios Receivables Turnover As with inventories, we can use either the value for accounts receivable that appears on the balance sheet or the average value of accounts receivable during the year. Unibroue s receivables turnover in 2002 was 23,622 3,891 = 6.07 using Dec. 31, 2002, A/R 23,622 (3,891+4,435)/2 = 5.67 using average A/R for 2002 39 Ratio Analysis: Activity Ratios Receivables Turnover Unibroue s average collection period was, in 2002, 365 6.07 365 5.67 = 60 days using Dec. 31, 2002, A/R = 64 days using average A/R for 2002 A high receivables turnover ratio (i.e. small average collection period) is a sign that the firm has no difficulty collecting cash. 40

Ratio Analysis: Activity Ratios Payable Turnover Payables turnover = COGS Accounts payable Average Payment Period Average Payment period = 365 Payables Turnover 41 Ratio Analysis: Activity Ratios Payable Turnover Again, we can use either the value for accounts payable that appears on the balance sheet or the average value of accounts payable during the year. Unibroue s payables turnover in 2002 was 11,824 3,199 = 3.70 using Dec. 31, 2002 A/P 11,824 (3,199+2,257)/2 = 4.33 using average A/P for 2002 42

Ratio Analysis: Activity Ratios Payable Turnover Unibroue s average payment period was, in 2002, 365 3.70 365 4.33 = 99 days using Dec. 31, 2002, A/P = 85 days using average A/P for 2002 A low payables turnover ratio (i.e. large average payment period) is a sign that the firm gets favourable credit from its suppliers. 43 Ratio Analysis: Activity Ratios Note that a long average payment period is not necessarily a good sign since suppliers may be willing to tighten their credit policies in the future. 44

Ratio Analysis: Activity Ratios Other Activity Ratios NWC turnover = Sales/NWC Fixed asset turnover = Sales/Net fixed assets Total asset turnover = Sales/Total assets 45 Ratio Analysis: Profitability Ratios Computation: Usually Net income/item. Intention: These ratios measure how efficiently assets are used to generate bottom line, net income. High/Low: A high profitability ratio is usually a good sign. Problems: Each measure looks at a specific item, cannot rely on only one measure. 46

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 47 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 48

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 49 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 50

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 51 Ratio Analysis: Profitability Ratios Since computing ROE and ROA involves dividing an income statement item (profit) by a balance sheet item (total equity for ROE and total assets for ROA), it may make more sense to divide the income statement item by an average of the balance sheet items. That is, ROE 02 = NI 02 (TE 02 + TE 01 )/2 and ROA 02 = NI 02 (TA 02 + TA 01 )/2 52

Ratio Analysis: Market Value Ratios Computation: Usually stock price/item or earnings/item. Intention: These ratios measure how shareholders value different items pertaining to the firm. High/Low: A high ratio may or may not be a good sign. Problems: Again, need more than one measure. 53 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 54

Ratio Analysis: Market Value Ratios A stock may be considered cheap when its P/E ratio is below 15. Rule of 19: Over the past 40 years, the average P/E ratio in the U.S. has been 19 minus the inflation rate. Hence, if the inflation rate is 3%, the right P/E ratio is 19 3 = 16. 55 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. 56

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. 57 Ratio Analysis: Market Value Ratios Dividend Payout Ratio Dividend Payout Ratio = Common Share Dividend Earnings Available to Common Shareholders 58

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 59 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 60

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 61 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 62

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 63 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. 64

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 65 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% 66