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Ratio analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
MAYES 2 & 4 Fin. Stmt. & Ratio Analysis
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Common Size Financial Statements
Displays info as %, not $; Provides 2 key benefits: 1. Allows for easy comparison between firms of different sizes. 2. Aids in spotting important trends which otherwise might not be obvious when looking at $ amounts.
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Common Size Financial Statements
Common size Income Statement: all values a function of Sales $ Common size Balance Sheet: all values a function of Total Assets.
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Analysis of Common Size Balance Sheets
Elvis has ? proportion of inventory and current assets than Industry.
Elvis now has ? Equity, which means (MORE? / LESS?) debt than Industry.
Elvis has ? short-term debt than industry, but ? long-term debt than industry.
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Analysis of Common Size Income Statements
Elvis has ? COGS ( %) than industry’s ( %), but ? other expenses. Results?
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Percentage Change Analysis:
Looks at Change rates from period to period between financial categories. Indicator of +/- growth trends.
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Analysis of Percent Change Income Statement
i.e., Sales growth v. NI ?
i.e., If NI grows faster than sales, then becoming more profitable.
So becoming (more/less) profitable?
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Analysis of Percent Change Balance Sheets
i.e., Total assets growth v. sales. If assets grow at faster rate than sales, have asset utilization problem.
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Standardize numbers; facilitate comparisons
Used to highlight weaknesses and strengths
Why are ratios useful?
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Liquidity: Can we make required payments as they fall due?
Asset management: Do we have the right amount of assets for the level of sales?
What are the five major categories of ratios, and what questions do they
answer?
(More…)
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Debt management: Do we have the right
mix of debt and equity? (Leverage)
Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
Market value: Do investors like what they see as reflected in P/E and M/B ratios?
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Things to ask? Better? Worse?
Trends?
Vs. Industry?
Causes?
Corrective actions?
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Calculate the firm’s forecasted current and quick ratios
CR = =
QR =
CACL
CA - Inv.CL
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Expected to improve/ worsen?
Vs. industry average?
Liquidity position?
Comments on CR and QR
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What is the inventory turnover ratio as compared to the industry average?
Inv. turnover = CGSInventories
Days Sales in Inventory
=
365 Inv To
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Inventory turnover v. industry average?
Due to?
Improvement forecasted?
Comments on Inventory Turnover
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What is the Accts. Rec. turnover ratio & Average Collection Period?
A/R turnover = Credit salesA/R
Ave Collection
Period = 365A/R TO
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Appraisal of Ave Collection Period
Firm collects too slowly/quickly?
Improving / worsening?
Implication re: credit policy.
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Fixed Assets and Total AssetsTurnover Ratios
Fixed assetsturnover
Sales Net fixed assets=
Total assetsturnover
Sales Total assets=
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FA turnover vs. industry?
TA turnover vs. industry average?
Causes? Corrective actions?
Fixed Assets and Total AssetsTurnover Ratios
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Total liabilities Total assetsDebt ratio =
L/T Debt ratio =
LEVERAGE
L/T Debt Total assets
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Total liabilities Total EquityDebt/Eqty =
ratio
L/T Debt to TotalCapitalization ratio =
LEVERAGE
_____L/T Debt___________ LTD + Pref Eqty + Cmn Eqty
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Total Assets Total EquityEqty
Multiplier
L/T Debt to TotalEquity =
LEVERAGE
_____L/T Debt___________ Pref Eqty + Cmn Eqty
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EBIT + Deprec Exp Interest ExpCash =
Coverage
EBIT Int. expense TIE =
COVERAGE Ratios
(
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Effects? Reasons?
How do the debt management ratios compare with industry averages?
2005E 2004 2003 Ind.D/ATIEC/Cov
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Trends?Prospects?
Profitability Ratios (Profit Margins)
OperatingPM = EBIT Sales
Net PM = Net Income Sales
Gross Profit Margin = Gross Profit Sales
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Trends?Prospects?
Profitability Ratios (Returns)
ROA = Net Income Total Assets
Return on = NI available to C.S-holdersCmn Eqty Common Equity
ROE = Net Income Total Equity
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2005E 2004 2003 Ind.ROAROE
Trends? Vs. Industry? Prospects?.
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ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.
However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.
Effects of Debt on ROA and ROE
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( )( )( ) = ROE
Profitmargin
TAturnover
Equitymultiplier
NI Sales
SalesTA
TA CE
PM= f(profitability)TA T/O = f(asset utilization)EM = f(debt & equity %s)
Shows how these factors combine to
determine the ROE.
The Du Pont System
x x = ROE.
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Trends?Prospects?
Economic Profit Measures of Performance
Where: NOPAT = EBIT (1-tax rate) A/Tax Cost of Op. Capital = WACC * (Net Op. Working Cap + Net Fixed Assets)
** NOWC = (Non-interest bearing C/A – Non-interest bearing C/L)
Economic Profit = NOPAT – A/Tax Cost of Op. Capital
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Financial Distress & Z-score
Technique to determine likelihood of financial distress.
Altman shows model 80-90% accurate w/ Z-score cut-off of 2.675; that is Z-score < 2.675 = distress.
Actually determined 3 levels
Z<1.81 Bankruptcy predicted w/in 1 yr.
1.81<Z<2.675 Financial Distress, poss. Bankruptcy
Z>2.675 No fin. Distress predicted
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Financial Distress & Z-scoreZ = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5
Where the variables are the following financial ratios:
X1 = Net Working Capital / Total Assets
X2 = Retained earnings / Total Assets
X3 = EBIT / Total Assets
X4 = Market Value of all equity / book value of Tot. Liabs
X5 = Sales / Total Assets
*For publicly traded companies
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Calculate and appraise theP/E, P/CF, and M/B ratios.
Market Price =From the stock exchanges
EPS =
P/E =
NIC.S.Shares out.
Price per shareEPS
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NI + Depr. C.S.Shares out.CF per share =
Price per share Cash flow per C.S. share
P/CF =
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Com. equity C.S.Shares out.BVPS =
Mkt. price per share Book value per share
M/B =
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P/E: How much investors will pay for $1 of earnings. High is good.
M/B: How much paid for $1 of book value. Higher is good.
P/E and M/B are high if ROE is high, risk is low.
2005E 2004 2003 Ind.P/EP/CFM/B
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What are some potential problems and limitations of financial ratio analysis?
Comparison with industry averages is difficult if the firm operates many different divisions.
“Average” performance is not necessarily good.
Seasonal factors can distort ratios.
(More…)
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Window dressing techniques can make statements and ratios look better.
Different accounting and operating practices can distort comparisons.
Sometimes it is difficult to tell if a ratio value is “good” or “bad.”
Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.
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What are some qualitative factors analysts should consider when
evaluating a company’s likely future financial performance?
Are the company’s revenues tied to a single customer?
To what extent are the company’s revenues tied to a single product?
To what extent does the company rely on a single supplier? (More…)
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What percentage of the company’s business is generated overseas?
What is the competitive situation?
What does the future have in store?
What is the company’s legal and regulatory environment?