Introduction & Financial Analysis

• Objectives for a firm?• Quick Review of Financial Statements• Financial Analysis

The firm's objectives?-To maximize profits?

- To act in an ethical manner?

- To increase market share?

- To maximize shareholder wealth?

-To maximize managers’ wealth?

What are agency problems?

Interests of managers & shareholders can be aligned by:

- compensation plans

- appointment & review by board of directors and auditors

- the threat of takeover

- scrutiny by banks & other specialists

Flow of cash between capital marketsand firm's operations

Financial

manager

Firm's

operations

Capital

markets

(1) Cash raised from investors

(2) Cash invested in firm

(3) Cash generated by operations

(4a) Cash reinvested

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)

3 Basic Financial Statements

• Income Statement (I/S)• Balance Sheet (B/S)• Statement of Cash Flows (CFs)

Income Statement

An Income Statement shows profitability

Sales - Cost of Goods Sold (COGS) = Gross Profit (GP)

GP - Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

EBIT - Interest = Earnings Before Taxes (EBT)

EBT - Taxes = Earnings After Taxes (EAT) or Net Income (NI)

Limitations of the Income Statement

• Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period.

• Inflation can impact reported profits (FIFO, LIFO)

• Backward looking…

Balance Sheet

• Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest– Delineates the firm’s holdings and obligations– Items are stated on an original cost basis rather

than at current market value

Limitations of the Balance Sheet

• Most of the values are based on historical/original cost price– Troublesome when it comes to plant and equipment

inventory

• FASB ruling on disclosure of inflation adjustments no longer in force – It is purely a voluntary act on the part of the

company

Limitations of the Balance Sheet (cont’d)

• Differences between per share values may be due to:– Asset valuation– Industry outlook– Growth prospects– Quality of management– Risk-return expectations

Comparison of Market Valueto Book Value per Share

Accrual Method of Accounting

• Is used most often by corporations

• Revenues and expenses are recognized when they occur, rather than when cash changes hands

• For example, a credit sale in December 2009 is shown as revenue in that year (2009), even though payment is not received until March 2010

Statement of Cash Flows

• Emphasizes critical nature of cash flow to the operations of the firm– It represents cash/cash equivalents items easily

convertible to cash within 90 days

• Cash flow analysis helps in combating discrepancies faced through accrual method of accounting

Illustration ofconceptsbehind thestatement ofcash flows

Steps in computing netcash flows fromoperating activitiesusing the indirectmethod

Free Cash Flow

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Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends

– Capital expenditures• Maintain productive capacity of firm

– Dividends• Maintain necessary payout on common stock and to

cover any preferred stock obligations• Free cash flow can be used for special financing activities

– Example leverage buyouts

– Excess Free cash flow can lead to agency costs.

Financial Analysis and Ratios

What is financial analysis?

• Evaluating a firm’s financial performance• Analyzing ratios or numerical calculations• Comparing a company to its industry

There are many potential ratios, with some variation in

applications. Below are some of the most common financial ratios: A. Profitability Ratios.

1. Profit margin.

2. Return on assets.

3. Return on equity.

B. Activity (Asset utilization) ratios.4. Receivable turnover.

5. Average collection period.

6. Inventory turnover.

7. Fixed asset turnover.

8. Total asset turnover.

C. Leverage (Debt utilization) ratios.9. Debt to total assets.

10. Times interest earned.

11. Fixed charge coverage.

D. Liquidity ratios.12. Current ratio.

13. Quick ratio.

Financial statementsfor sample ratio analysis

Profitability Ratios

Show how profitable a company is.

The ratios express:— Profit Margin or Return on Sales (%)— Return on Assets or Return on Investment

(%)— Return on Equity (%)

Profitability RatiosSaxton Company Industry Average

1. Profit margin = = 5% 6.7%

2. Return on assets =

a. = 12.5% 10%

b. 5% 2.5 = 12.5% 6.7% 1.5 = 10%3. Return on equity =

a. = 20% 15%

b. = 12.5% x 1.6 15% = 20%

Net incomesales

$200,000$4,000,000

Net incomeTotal assets

Net incomeSales

SalesTotal assets

$200,000$1,600,000

Net incomeStockholders’ equity

$200,000$1,000,000

Net incomeTotal Assets

Total Assetsequity

Return of Wal-Mart versus Macy’s using the Du Pont method of analysis, 2007

Activity (Asset Utilization) Ratios

Show how effectively a company uses its assets.

The ratios express:— Receivables Turnover (times)— Average Collection Period (days)— Inventory Turnover (times)— Fixed Asset Turnover (times)— Total Asset Turnover (times)

Saxton Company Industry Average

4. Receivables turnover =

= 11.410 times

5. Average collection period =

= 32 36 days

6. Inventory turnover =

= 10.8 7 times

Sales (credit)Receivables

$4,000,000$350,000

Accounts receivableAverage daily credit sales

$350,000$10,959

SalesInventory

$4,000,000$370,000

Activity (Asset Utilization) Ratios

Asset Utilization RatiosSaxton Company Industry

Average

7. Fixed asset turnover =

= 5 5.4 times

8. Total asset turnover =

= 2.5 1.5 times

SalesFixed assets

$4,000,000$800,000

SalesTotal assets

$4,000,000$1,600,000

Leverage (Debt Utilization) Ratios

Show how well a company is managing or using debt.

The ratios express:—Debt-to-Total Assets (%)—Times Interest Earned (times)—Fixed Charge Coverage (times)

(Fixed Charges = lease payments, i expense)

Leverage (Debt Utilization) RatiosSaxton Company Industry

Average

9. Debt to total asets =

= 37.5% 33%

10. Times interest earned =

= 11 7 times

11. Fixed charge coverage =

= 6 5.5 times

Total debtTotal assets

$600,000$1,600,000

Income before interest and taxes

Interest$550,000$50,000

Income before fixed charges and taxes

Fixed charges$600,000$100,000

Liquidity Ratios

Show how liquid a company is or how much $ it has to meet S/T needs.

The ratios express:—Current Ratio (times)—Quick Ratio or Acid-Test Ratio (times)

Liquidity Ratios Saxton Company Industry Average

12. Current ratio =

= 2.67 2.1

13. Quick ratio =

= 1.43 1.0

Current assetsCurrent liabilities

$800,000$300,000

Current assets − InventoryCurrent liabilities

$430,000$300,000

Ratio analysis

Trend analysis

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Trend Analysis in the Computer Industry

Cash Conversion Cycle

Is the length of time from the payment for the purchases of raw materials to the collection of accounts receivable that were generated by the sale of the finished product, (i.e., the time between paying out cash and receiving cash).

Cash Conversion Cycle = Inventory Conversion Period +Receivables Collection Period (DSO) -Payable Deferral Period

= Inventory/ Sales per Day +Receivables / Sales per day – Payables / Credit purchases per day

Leverage (Debt) Ratios

interest

ondepreciati+EBIT=Ratio EarnedInterest Times

equity

leases of value+debt termlong=ratioequity Debt

Efficiency (Utilization) Ratios - Show how effectively a company uses its assets.

assets totalAverage

Sales=ratioover Asset turn

sold/365 goods ofcost

inventory average=inventoryin salesDays'

salesdaily average

sreceivable average=period collection Average

Profitability Ratios - Show how profitable a company is.

assets totalaverage

tax-EBIT=assetson Return

sales

tax-EBIT=marginprofit Net

equity average

stockcommon for available earnings=equityon Return

Profitability Ratios

ratiopayout -1=

earnings

dividends-earnings=ratioPlowback

earnings

dividends=ratioPayout

earnings

dividends-earnings=plowback fromequity in Growth

P/E Ratio

• P/E Ratio = Price/Earnings Ratio

• P/E Ratio = Market Price of Stock / Earnings per share (EPS)

Market Value Ratios

g-r

1

aveEPS

P=ratio PE Forecasted

1

1

1

0 xEPS

Div

shareper earnings

pricestock =Ratio PE

pricestock

shareper dividend=yield Dividend

- PE ratio is one way of measuring desirability of a stock

- Indicates expectations about future of a company

Market Value Ratios

shareper book value

pricestock =ratiobook Market to

cost replcement estimated

assets of uemarket val=Q Tobins

Price-earnings Ratios for Selected US Companies

Which ratio is most important?

It depends on your perspective.• Suppliers and banks (lenders) are most interested

in liquidity ratios.• Stockholders are most interested in profitability

ratios.• A long-run trend analysis over a 5-10 year period

is usually performed by an analyst.

Growth and External Financing

Basic sources and uses relationships show us:

External capital required =

Investment in net working capital PLUS

Investment in Fixed Assets PLUS

Dividends LESS

Operating cash flow

Percent-of-Sales Method

A short-cut, less exact, easier method of determining financing needs (The “quick and dirty” approach)

Assumes that B/S accounts will maintain a constant percentage relationship to sales

Assets / Current Sales = % of Sales

Percent-of-Sales Method

RNF = A/S (change S) – L/S (change S) – PS2(1-D)

Where:A/S = % relationship of assets to saleschange S = Change in Sales (forecast – prior sales)P = Profit marginS2 = Forecasted SalesD = Dividend Payout Ratio. (1-D) is retention rate.

Internal & Sustainable Growth Rates

The growth rate that a company can achieve without external funds is known as the internal growth rate:

Internal growth rate = retained earnings/net assets = Retained earnings/net income x net income/equity x equity/net assets =plowback ratio x ROE x equity/net assets =.40 x .1822 x .5455 = 3.98%

The growth rate that a company can achieve without increasing its debt ratio is known as the sustainable growth rate:

Sustainable growth rate = plowback ratio x return on equity =.40 x .1822 = 7.29%

Importance of Ratios

Which ratio is most important?It depends on your perspective.• Suppliers and banks (lenders) are most

interested in liquidity ratios.• Stockholders are most interested in profitability

ratios.• A long-run trend analysis over a 5-10 year

period is usually performed by an analyst.

Developmentof pro formastatements

Percent-of-Sales Method

A short-cut, less exact, easier method of determining financing needs (The “quick and dirty” approach)

Assumes that B/S accounts will maintain a constant percentage relationship to sales

Assets / Current Sales = % of Sales

Percent-of-Sales Method

RNF = A/S (change S) – L/S (change S) – PS2(1-D)

Where:A/S = % relationship of assets to saleschange S = Change in Sales (forecast – prior sales)P = Profit marginS2 = Forecasted SalesD = Dividend Payout Ratio. (1-D) is retention rate.

Development of a pro formabalance sheet