CHAPTER 3 Analysis of Financial StatementsBalance Sheet: AssetsBalance sheet: Liabilities and EquityIncome statementOther dataWhy are ratios useful?What are the five major categories of ratios, and what questions do they answer?Calculate D’Leon’s forecasted current ratio for 2003.Comments on current ratioWhat is the inventory turnover vs. the industry average?Comments on Inventory TurnoverDSO is the average number of days after making a sale before receiving cash.Appraisal of DSOFixed asset and total asset turnover ratios vs. the industry averageEvaluating the FA turnover and TA turnover ratiosCalculate the debt ratio, TIE, and EBITDA coverage ratios.Slide 17How do the debt management ratios compare with industry averages?Profitability ratios: Profit margin and Basic earning powerAppraising profitability with the profit margin and basic earning powerProfitability ratios: Return on assets and Return on equityAppraising profitability with the return on assets and return on equityEffects of debt on ROA and ROEProblems with ROECalculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.Slide 26Analyzing the market value ratiosExtended DuPont equation: Breaking down Return on equityThe Du Pont systemTrend analysisAn example: The effects of improving ratiosReducing accounts receivable and the days sales outstandingEffect of reducing receivables on balance sheet and stock pricePotential uses of freed up cashPotential problems and limitations of financial ratio analysisMore issues regarding ratiosQualitative factors to be considered when evaluating a company’s future financial performance3-1CHAPTER 3Analysis of Financial StatementsRatio AnalysisDu Pont systemEffects of improving ratiosLimitations of ratio analysisQualitative factors3-2Balance Sheet: Assets CashA/RInventoriesTotal CAGross FALess: Dep.Net FATotal Assets 20027,282 632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592 2003E85,632 878,0001,716,4802,680,1121,197,160 380,120 817,0403,497,1523-3Balance sheet: Liabilities and EquityAccts payableNotes payableAccrualsTotal CLLong-term debtCommon stockRetained earningsTotal EquityTotal L & E 2002524,160 636,808 489,6001,650,568723,432460,000 32,592 492,5922,866,592 2003E436,800 300,000 408,0001,144,800400,0001,721,176 231,1761,952,3523,497,1523-4Income statementSalesCOGSOther expensesEBITDADepr. & Amort.EBITInterest Exp.EBTTaxesNet income 20026,034,000 5,528,000 519,988(13,988) 116,960(130,948) 136,012(266,960) (106,784)(160,176) 2003E7,035,600 5,875,992 550,000609,608 116,960492,648 70,008422,640 169,056 253,5843-5Other dataNo. of sharesEPSDPSStock priceLease pmts2003E250,000$1.014$0.220$12.17$40,0002002100,000-$1.602$0.110$2.25$40,0003-6Why are ratios useful?Ratios standardize numbers and facilitate comparisons.Ratios are used to highlight weaknesses and strengths.3-7What are the five major categories of ratios, and what questions do they answer?Liquidity: Can we make required payments?Asset management: right amount of assets vs. sales?Debt management: Right mix of debt and equity?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?3-8Calculate D’Leon’s forecasted current ratio for 2003.Current ratio = Current assets / Current liabilities= $2,680 / $1,145= 2.34x3-9Comments on current ratio2003 2002 2001 Ind.Currentratio2.34x 1.20x 2.30x 2.70xExpected to improve but still below the industry average.Liquidity position is weak.3-10What is the inventory turnover vs. the industry average?2003 2002 2001 Ind.InventoryTurnover4.1x 4.70x 4.8x 6.1xInv. turnover = Sales / Inventories= $7,036 / $1,716= 4.10x3-11Comments on Inventory TurnoverInventory turnover is below industry average.D’Leon might have old inventory, or its control might be poor.No improvement is currently forecasted.3-12DSO is the average number of days after making a sale before receiving cash.DSO= Receivables / Average sales per day= Receivables / Sales/365= $878 / ($7,036/365)= 45.63-13Appraisal of DSO2003 2002 2001 Ind.DSO 45.6 38.2 37.4 32.0D’Leon collects on sales too slowly, and is getting worse.D’Leon has a poor credit policy.3-14Fixed asset and total asset turnover ratios vs. the industry averageFA turnover = Sales / Net fixed assets= $7,036 / $817 = 8.61xTA turnover = Sales / Total assets= $7,036 / $3,497 = 2.01x3-15Evaluating the FA turnover and TA turnover ratios2003 2002 2001 Ind.FA TO 8.6x 6.4x 10.0x 7.0xTA TO 2.0x 2.1x 2.3x 2.6xFA turnover projected to exceed the industry average.TA turnover below the industry average. Caused by excessive currents assets (A/R and Inv).3-16Calculate the debt ratio, TIE, and EBITDA coverage ratios.Debt ratio = Total debt / Total assets= ($1,145 + $400) / $3,497 = 44.2%TIE = EBIT / Interest expense= $492.6 / $70 = 7.0x3-17Calculate the debt ratio, TIE, and EBITDA coverage ratios. EBITDA= (EBITDA+Lease pmts)coverage Int exp + Lease pmts + Principal pmts= $609.6 + $40 $70 + $40 + $0= 5.9x3-18How do the debt management ratios compare with industry averages?2003 2002 2001 Ind.D/A 44.2% 82.8% 54.8% 50.0%TIE 7.0x -1.0x 4.3x 6.2xEBITDA coverage5.9x 0.1x 3.0x 8.0xD/A and TIE are better than the industry average, but EBITDA coverage still trails the industry.3-19Profitability ratios: Profit margin and Basic earning powerProfit margin = Net income / Sales= $253.6 / $7,036 = 3.6%BEP = EBIT / Total assets= $492.6 / $3,497 = 14.1%3-20Appraising profitability with the profit margin and basic earning power2003 2002 2001 Ind.PM 3.6% -2.7% 2.6% 3.5%BEP 14.1% -4.6% 13.0% 19.1%Profit margin was very bad in 2002, but is projected to exceed the industry average in 2003. Looking good.BEP removes the effects of taxes and financial leverage, and is useful for comparison.BEP projected to improve, yet still below the industry average. There is definitely room for improvement.3-21Profitability ratios: Return on assets and Return on equityROA= Net income / Total assets= $253.6 / $3,497 = 7.3%ROE = Net income / Total common equity= $253.6 / $1,952 = 13.0%3-22Appraising profitability with the return on assets and return on equity2003 2002 2001 Ind.ROA 7.3% -5.6% 6.0% 9.1%ROE 13.0%-32.5%13.3% 18.2%Both ratios rebounded from the previous year, but are still below the industry average.