Chp03+Fin+Sttement+CFlow+02

8/13/2019 Chp03+Fin+Sttement+CFlow+02

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ACT3211 FINANCIAL MANAGEMENT

Analyzing Financial Statements

Chapter 3


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Chapter 3 Learning Goals

LG1: Calculate and interpret major liquidity ratios

LG2: Calculate and interpret major asset management ratios

LG3: Calculate and interpret major debt ratios

LG4: Calculate and interpret major profitability ratios

LG5: Calculate and interpret major market value ratios

LG6: Appreciate how various ratios relate to one another

LG7: Discuss the differences between time series and cross-sectional ratio

analysis and decide which is most appropriate given an analytical

situation

LG8: Explain cautions that should be taken when examining financial ratios

and financial information in general


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Table

3-1


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Liquidity Ratios

Liquidity ratios provide an indication of the

ability of the firm to meet its obligations as

they come due

The three most common liquidity ratios are

the current ratio, the quick (or acid-test) ratio,

and the cash ratio


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The broadest liquidity measure is the current ratio,which measures the dollars of current assets availableto pay each dollar of current liabilities

Current Ratio = CA / CL

Inventory is the least liquid of the current assets, and isthe current asset for which book values are the leastreliable measure of market value. The quick, or acid-test ratio excludes inventory in the numerator, and

measures the firms ability to pay off short-termobligations without relying on inventory sales:

Quick Ratio = (CA Inventory) / CL


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The cash ratio measures a firms ability to payshort-term obligations with its available cash andmarketable securitiesCash Ratio = Cash / CL

The liquidity ratios for DPH Tree Farm are:Current Ratio = CA / CL

Current Ratio = 205 / 120

Current Ratio = 1.71 times

The industry average current ratio is 1.50


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Quick Ratio = (CAInventory) / CL

Quick Ratio = (205111) / 120

Quick Ratio = 0.78 times

The industry average quick ratio is 0.50

Cash Ratio = Cash / CL

Cash Ratio = 24 / 120

Cash Ratio = 0.20 times

The industry average cash ratio is 0.15


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Based on all three measures, DPH has moreliquidity on its balance sheet than the industry

average

The more liquid assets a firm holds, the more likelythe firm can pay its bills, so it has less liquidity risk.

However, liquid assets do not generate profits forthe firm

Managers must consider the tradeoff of lowerliquidity risk versus the disadvantages of reducedprofits

Note that a firm with very predictable cash flows cansafely maintain lower levels of liquidity


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Asset Management Ratios

Asset management ratios measure how

efficiently a firm uses its assets

Many of these ratios are focused on a specific

asset, such as inventory or accounts receivable


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The days sales in inventory ratio measures the average number of

days that inventory is held

Days Sales in Inventory = Inventory x 365 / Sales or COGS

Firms want to turn inventory over as quickly as possible to reduce

costs associated with warehousing, monitoring, insurance A high inventory turnover ratio and a low days sales in inventory

ratio indicate good management

However, if inventory is too low then the firm risks losing sales orrunning out of raw materials, so there is a tradeoff betweensufficient levels of inventory versus the costs of holding too much

Note that companies with good supply chain relations canmaintain lower inventory levels


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Accounts Receivable Management

The Average Collection Period (ACP) measuresthe number of days that accounts receivableare held until they are collected

Average collection period (ACP) = Accounts receivable x 365 / Credit sales

The Accounts Receivable Turnover ratiomeasures the dollars of sales produced per

dollar of accounts receivableAccounts receivables turnover = Credit Sales / Accounts Receivable


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Firms want to produce a high level of sales

per dollar of accounts receivable, and turnaccounts receivable into cash as quickly aspossible A high accounts receivable turnover ratio and a

low average collection period are indicators ofgood receivables management

If these ratios are too good, it may indicate thatcredit terms are so strict that the firm may belosing sales

Managers must consider the tradeoff betweenincreasing sales through credit terms versus thecost of high accounts receivable


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Accounts Payable The Average Payment Period (APP) measures the

number of days that the firm holds accounts payablebefore it has to extend the cash to pay for rawmaterials

Average payment period (APP) = Accounts payable x 365 / COGS

The Accounts Payable Turnover ratio measures thedollar COGS per dollar of accounts receivable

Accounts payable turnover = COGS / Accounts payable


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Firms want to pay for purchases as slowly aspossible Accounts payable represent a form of financing

from suppliers

The more the accounts payable, the less the firm

will need other costly sources of financing such asnotes payable or long-term debt.

A high APP and a low accounts payable turnoverratio is generally a sign of good management

If these indicators are too good it may indicate thatthe firm is abusing their credit terms and jeopardizingtheir relationship with suppliers


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Fixed Asset and Working Capital Management

The Fixed Asset Turnover ratio measures the numberof dollars of sales produced per dollar of fixed assets

Fixed asset turnover ratio = Sales / Fixed assets

The Sales to Working Capital ratio measures thedollars of sales produced per dollar of net workingcapital (NWC = current assetscurrent liabilities)

Sales to Working Capital ratio = Sales / Working capital


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The higher the level of sales produced per dollar offixed assets or working capital, the more efficientlythe firm is being run.

High fixed asset turnover ratios and sales toworking capital ratios are signs of good

management If these ratios are too high the firm may be close to

maximum capacity and may indicate thatmanagement has not made accommodations forgrowth

Caution: the age of a firms fixed assets will affectthe fixed asset turnover ratio. A firm with newer(more expensive) fixed assets may appear to havea lower turnover ratio.


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Total Asset Management

The Total Asset Turnover ratio measures thedollars of sales produced per dollar of total assets

Total assets turnover ratio = Sales / Total assets

The Capital Intensity ratio is simply the inverse ofthe total assets turnover ratio and measures thedollars of total assets needed to produce a dollarof sales

Capital intensity ratio = Total assets / Sales


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These ratios provide an indication of how

efficiently assets are being utilized

If the ratios are too good however it may

indicate that the firm is in danger of inventory

stockouts, capacity problems, or excessively

tight credit terms which might indicate poor

management


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Asset Management Ratios for

DPH Tree FarmAsset Management Ratio Industry Average

Inventory Turnover = Sales / Inventory

Inventory Turnover = 315/ 111

Inventory Turnover = 2.84 times

2.15 times

Days Sales in Inventory = Inventory x 365 / Sales

Days Sales in Inventory = 111 x 365 / 315Days Sales in Inventory = 129 days

1.70 days

Average collection period (ACP) = Accounts receivable x 365 /

Credit sales

ACP = 70 x 365 / 315

ACP = 81 days

95 days

Accounts receivables turnover = Credit Sales / AccountsReceivable

Accounts receivables turnover = 315 / 70

Accounts receivables turnover = 4.50 times

3.84 times


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Average payment period (APP) = Accounts payable x 365 / COGS

APP = 55 x 365 / 150

APP = 134 days

102 days

Accounts payable turnover = COGS / Accounts payable

Accounts payable turnover = 150 / 55

Accounts payable turnover = 2.73 times

3.55 times

Fixed asset turnover ratio = Sales / Fixed assetsFixed asset turnover ratio = 315 / 315

Fixed asset turnover ratio = 1.0

0.85 times

Sales to Working Capital ratio = Sales / Working capital

Sales to Working Capital ratio = 315 / 205-120

Sales to Working Capital ratio = 3.71 times

3.20 times

Total assets turnover ratio = Sales / Total assetsTotal assets turnover ratio = 315 / 570

Total assets turnover ratio = 0.55 times

0.40 times

Capital intensity ratio = Total assets / Sales

Capital intensity ratio = 570 / 315

Capital intensity ratio = 1.81 times

2.50 times


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In all cases DPH has better asset management

than the industry average

Produces more sales per dollar of inventory

Collects its accounts receivables faster

Pays its accounts payables slower

Produces more sales per dollar of fixed assets,

working capital, and total assets


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Debt Management Ratios

Debt management ratios measure the extent

to which the firm uses debt (financial

leverage) versus equity to finance its assets

There are two major types of debt

management ratios

Ratios that measure the amountof debt

Ratios that indicate the ability of the firm to

service its debt


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Debt vs. Equity financing The debt ratio measures the percentage of total

assets financed with debt.

Debt ratio = Total debt / Total assets

The debt-to-equity ratio measures the dollars of

debt financing used for every dollar of equity

financing.

Debt-to-equity ratio = Total debt / Total equity


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The Equity Multiplier ratio measures thedollars of assets on the balance sheet for

every dollar of equity financing

Equity multiplier ratio = Total assets / Total equity

All three of these measures are related:

Equity multiplier = 1 / (1Debt ratio) = Debt-to-equity ratio +1


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When a firm issues debt to finance its assets it gives

the debtholders first claim to a fixed amount of its cashflows

Stockholders are entitled to any residual cash flows

When the firm does well, financial leverage increases

the return to stockholders since the cash flowspromised to debtholders is constant

Stockholders encourage the use of debt financing up to apoint

Financial leverage also increases the risk of financialdistress


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Investors view equity financing as a safetycushion that can absorb fluctuations in the firmsearnings and asset values

The larger the fluctuations or variability of afirms cash flows the greater the need for anequity cushion

In deciding the level of debt versus equityfinancing managers must consider the trade-off

between maximizing cash flows to the firmsstockholders versus the risk of being unable tomake promised debt payments


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Coverage Ratios The Times Interest Earned ratio measures the number

of dollars of operating earnings available to meet eachdollar of interest obligations

Times interest earned = EBIT / Interest expense

The Fixed Charge Coverage ratio measures thenumber of dollars of operating earnings available tomeet the firms interest and other fixed charges

Fixed charge coverage = Earnings available to meet fixed charges / Fixedcharges


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The Cash Coverage ratio measures the number ofdollars of operating cash available to meet eachdollar of interest and other fixed charges

Cash coverage ratio = (EBIT + Depreciation) / Fixedcharges

These coverage measures can indicatewhether a firm has taken on a debt burdenthat is too large

A value less than 1 means that the firm has

less than $1 of earnings or cash available topay each dollar of interest or fixed charges

Example 3 3


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Example 3-3


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The Profit Margin is the percent of sales left after all firm expensesare paid

Profit margin = Net income available to common stockholders / Sales

The Basic Earnings Power ratio measures the EBIT earned per dollarof assets on the balance sheet and represents the operating returnon the firms assets irrespective of financial leverage and taxes.

Basic earnings power ratio (BEP) = EBIT / Total assets

BEP is a useful ratio for comparing firms that differ in financialleverage and taxes


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The Return on Assets (ROA) measures the overall return onthe firms assets, inclusive of leverage and taxes

Return on Assets (ROA) = Net income available to commonstockholders / Total Assets

The Return on Equity (ROE) measures the return oncommon stockholders investment

Return on Equity (ROE) = Net income available to commonstockholders / Common stockholders equity


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ROE is affected by net income as well as the amount offinancial leverage

A high ROE is generally considered to be a positive signof firm performance

Unless it is driven by excessively high leverage

The Dividend Payout Ratio measures the fraction ofearnings paid out to common stockholders asdividends

Dividend payout ratio = Common stock dividends / Netincome available to common stockholders

Example 3-4


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Example 3-4


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Market Value Ratios

While ROE is a very important financial statement ratio,

it doesnt specifically incorporate risk.

Market prices of publicly traded firms do incorporate

risk, and so ratios that incorporate stock market valuesare important.

Market values reflect what investors think of the

companys future performance and risk


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The Price-Earnings ratio is the best known andmost often quoted figure

Price-earnings ratio = Market price per share / Earnings per share

Measures how much investors are willing to pay foreach dollar of earnings

A high PE ratio is often an indication of anticipated

growth Stocks are classified as growth stocks or value stocks based

on the PE ratio


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Example 3-5


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DuPont Analysis

DuPont analysis is a decomposition model ROA and ROE can be broken down into

components in an effort to explain why

they may be low (or high). The Basic DuPont equation

ROA = Profit Margin x Total asset

turnover

= xNI

SalesSales

TA


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The ROA depends on the firms profit margin

(which is an indicator of expense control) and

total asset turnover, an indicator of how

efficiently the firm manages its assets


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The full DuPont formula looks at thedecomposition of ROE:

ROE = profit margin x total asset turnover x equitymultiplier

ROE = X XNI

Sales

Sales

TA

TA

CE


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The DuPont model focuses on

Expense control (PM)

Asset utilization (TATO)

Debt utilization (EM)

Notice that the first two terms in the ROE model

are the same as ROA, so:ROE = ROA x equity multiplier

E l 3 6


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Example 3-6


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Other Ratios

Spreading the Financial Statements

Managers, analysts, and investors often create

common size financial statements

Balance sheet items are divided by total assets Income statement items are divided by sales

Common size statements are conducive to:

Identifying trends for the firm

Comparisons across firms in the industry


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Internal and Sustainable Growth Rates

The internal growth rate measures the amount of

growth a firm can sustain if it uses only internal

financing (retained earnings)

Internal growth rate = (ROA x RR) / [(1-ROA) x RR] where RR = retention ratio


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If the firm uses retained earnings to support

asset growth, the firms capital structure will

change over time

More equity financing and decreasing debt ratio

To maintain the same capital structure

managers must use both debt and equity

financing to support asset growth


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The sustainable growth rate measures theamount of growth a firm can achieve using

internal equity and maintaining a constantdebt ratio:Sustainable growth rate = (ROE x RR) / [(1-ROE) x RR]

Combining this with the DuPont equation, thesustainable growth rate depends on four factors: Profit margin (operating efficiency)

Total asset turnover (efficiency in asset use)

Financial leverage (using debt vs. equity to finance

assets) Profit retention (reinvestment of NI rather paying

dividends)


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Time Series and Cross Sectional


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Time Series and Cross-Sectional

Analysis

To analyze ratios in a meaningful way theymust be compared to some benchmark

There are two types of benchmarks:

Performance of the firm over time (time

series analysis) Performance of the firm against other

companies in the same industry (cross-sectional analysis)

Comparative ratios for industries are availablefrom Value Line, Robert Morris Associates, Dun &Bradstreet, Hoovers Online, and MSN Money


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Cautions in Using Ratios

1. Financial statement data are historical2. Firms use different accounting procedures E.g. LIFO/FIFO, depreciation methods

3. Sales and expenses may be seasonal

1. Some items may be unusually high or low at the closeof the fiscal year

4. Large firms have multiple lines of business

5. Firms can use window dressing to make

financial statement look better

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