FIN305 FTU FA24 Chapter 4 PDF

FIN305 FTU FA24...

FIN305 FTU FA24 12/11/2024 Overview Analysis of Financial Ratio Analysis Statements DuPont Equation Chapter 4 Effects of Improving Ratios Limitations of Ratio Analysis Qualitative Factors 2 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 2 What is Ratio Analysis? Why are ratios useful?  Analysis of a firm’s ratios is generally the first  Ratios standardize numbers and facilitate step in financial analysis. comparisons.  Ratios are designed to show relationships  Ratios are used to highlight weaknesses and between financial statement accounts within strengths. firms and between firms.  Ratio comparisons should be made through time and with competitors. Industry analysis Benchmark (peer) analysis Trend analysis 3 4 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 4 Five Major Categories of Ratios and the Questions List of ratios by category They Answer  Liquidity Liquidity: Can we make required payments? Current Ratio Quick, or Acid Test, Ratio Asset management: Right amount of assets vs. sales?  Asset Management Debt management: Right mix of debt and equity? Inventory Turnover Days Sales Outstanding (DSO) Profitability: Do sales prices exceed unit costs, and are sales Fixed Assets Turnover high enough as reflected in PM, ROE, and ROA? Total Assets Turnover Market value: Do investors like what they see as reflected in P/E and M/B ratios? 5 6 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 6 1 FIN305 FTU FA24 12/11/2024 List of ratios by category List of ratios by category  Debt Management  Market Value Total Debt to Total Capital Price/Earnings Ratio (P/E) Times-Interest-Earned (TIE) Ratio Market/Book Ratio (M/B) Enterprise Value/EBITDA Ratio (EV/EBITDA)  Profitability Operating Margin Profit Margin (i.e., Net Profit Margin) Return on Total Assets (ROA) Return on Common Equity (ROE) Return on Invested Capital (ROIC) Basic Earning Power (BEP) 7 8 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 8 Integrated Case: D’Leon Inc., Part II Balance Sheet: Assets (Refer to Integrated Case at the end of chapter 4 in the text) 2022E 2021 D’Leon Inc., is a small food producer in the Cash 85,632 7,282 snack-foods market. A/R 878,000 632,160 Company undertook a major expansion in Inventories 1,716,480 1,287,360 2020 and doubled plant capacity. Total CA 2,680,112 1,926,802 Gross FA 1,197,160 1,202,950 Analysis in previous chapter indicated Less: Deprec. 380,120 263,160 problems with slow sales, high costs and Net FA 817,040 939,790 negative earnings. Total Assets 3,497,152 2,866,592 The present chapter extends this analysis using ratio analysis. 9 10 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 10 Balance Sheet: Liabilities and Equity Income Statement 2022E 2021 2022E 2021 Accts payable 436,800 524,160 Sales 6,900,600 6,126,796 Accruals 408,000 489,600 COGS 5,875,992 5,528,000 Other expenses 550,000 519,988 Notes payable 300,000 636,808 EBITDA 474,608 78,808 Total CL 1,144,800 1,650,568 Deprec. & amort. 116,960 116,960 Long-term debt 400,000 723,432 EBIT 357,648 ( 38,152) Common stock 1,718,986 460,000 Interest exp. 70,008 122,024 Retained earnings 233,366 32,592 EBT 287,640 (160,176) Total Equity 1,952,352 492,592 Taxes 31,866 0 Total L & E 3,497,152 2,866,592 Net income 255,774 (160,176) 11 12 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 12 2 FIN305 FTU FA24 12/11/2024 D’Leon’s Forecasted Current Ratio and Quick Ratio Other Data for 2022  Current ratio = Current assets/Current liabilities 2022E 2021 = $2,680/$1,145 = 2.34x No. of shares 250,000 100,000 EPS $1.023 -$1.602  Quick ratio = (Current assets – Inventories) / Current liabilities DPS $0.220 $0.110 = ($2,680  $1,716)/$1,145 Stock price $12.17 $2.25 = 0.84x Lease pmts $40,000 $40,000 13 14 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 14 Comments on Liquidity Ratios D’Leon’s Inventory Turnover vs. the Industry Average 2022E 2021 2020 Ind.  Inv. turnover = COGS/Inventories Current ratio 2.34x 1.17x 2.33x 2.70x = $5,876/$1,716 = 3.42x Quick ratio 0.84x 0.39x 0.85x 1.00x 2022E 2021 2020 Ind. Expected to improve but still below the Inventory turnover 3.42x 4.29x 4.00x 5.50x industry average. Liquidity position is weak. 15 16 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 16 DSO: Average Number of Days After Making a Sale Comments on Inventory Turnover Before Receiving Cash  Inventory turnover is below industry average.  DSO = Receivables/Avg. sales per day  D’Leon might have old inventory, or its control = Receivables/(Annual sales/365) might be poor. = $878/($6,901/365)  No improvement is currently forecasted. = 46.44 days 17 18 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 18 3 FIN305 FTU FA24 12/11/2024 Calculate the Fixed Assets and Total Assets Appraisal of DSO Turnover Ratios 2022E 2021 2020 Ind.  FA turnover = Sales/Net fixed assets = $6,901/$817 = 8.45x DSO 46.44 37.66 37.35 32.00  TA turnover = Sales/Total assets D’Leon collects on sales too slowly, = $6,901/$3,497 = 1.97x and is getting worse. D’Leon has a poor credit policy. 19 20 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 20 Evaluating the FA Turnover (S/Net FA) Calculate the Debt-to-Capital Ratio and and TA Turnover (S/TA) Ratios Times-Interest-Earned Ratio 2022E 2021 2020 Ind.  Debt-to-capital ratio = Total debt / Total invested capital FA TO 8.45x 6.52x 9.95x 7.00x = ($300 + $400) / ($300 + $400 + $1,952.4) = 26.39% TA TO 1.97x 2.14x 2.34x 2.60x  TIE = EBIT/Interest  FA turnover projected to exceed the industry average. = $357.6/$70 = 5.11x  TA turnover below the industry average. Caused by excessive current assets (A/R and Inv). 21 22 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 22 D’Leon’s Debt Management Ratios vs. the Profitability Ratios: Operating Margin, Profit Margin, Industry Averages and Basic Earning Power  Operating margin = EBIT/Sales 2022E 2021 2020 Ind. = $357.6/$6,901 = 5.18% Debt/Total Inv. Capital 26.39% 73.41% 44.09% 40.00%  Profit margin = Net income/Sales Times-Interest-Earned 5.11x -0.31x 4.34x 6.20x = $255.8/$6,901 = 3.71%  Debt-to-capital ratio is better than the industry  Basic earning power = EBIT/Total assets average. = $357.6/$3,497 = 10.23%  TIE ratio greatly improved but still below the industry average. 23 24 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 24 4 FIN305 FTU FA24 12/11/2024 Appraising Profitability with Operating Margin, Profit Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power Margin, and Basic Earning Power Operating margin was very bad in 2021. It is 2022E 2021 2020 Ind. projected to improve in 2022, but it is still projected to remain below the industry average. Operating margin 5.18% -0.62% 5.55% 7.30% Profit margin was very bad in 2021. It is Profit margin 3.71% -2.61% 3.20% 4.30% projected to improve in 2022, but it is still Basic earning power 10.23% -1.33% 12.96% 19.10% projected to remain below the industry average. 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. 25 26 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 26 Profitability Ratios: Return on Assets, Return on Equity, and Return on Invested Capital Appraising Profitability with ROA and ROE  ROA = Net income/Total assets 2022E 2021 2020 Ind. = $255.8/$3,497 = 7.31% ROA 7.31% -5.59% 7.49% 11.2% ROE 13.10% -32.52% 16.56% 18.2%  ROE = Net income/Total common equity = $255.8/$1,952 = 13.10%  Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.  Wide variations in ROE illustrate the effect that leverage can have on profitability. 27 28 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 28 Effects of Debt on ROA and ROE Problems with ROE ROE and shareholder wealth Holding assets constant, if debt increases: are correlated, but problems Equity declines. can arise when ROE is the sole measure of performance. Given these problems, Interest expense increases – which leads to a reliance on ROE may reduction in net income. encourage managers to ROE does not consider make investments that risk. do not benefit shareholders. As a ROA declines (due to the reduction in net income). result, analysts have ROE does not consider looked to develop other the amount of capital performance measures, ROE may increase or decrease (since both net income and invested. such as EVA. equity decline). 29 30 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 30 5 FIN305 FTU FA24 12/11/2024 Calculate the Price/Earnings and Market/Book Ratios Analyzing the Market Value Ratios  P/E = Price/Earnings per share P/E: How much investors are willing to pay = $12.17/$1.0231 = 11.90x for $1 of earnings.  M/B = Market price/Book value per share M/B: How much investors are willing to pay for $1 of book value equity. = $12.17/($1,952/250) = 1.56x For each ratio, the higher the number, the 2022E 2021 2020 Ind. better. P/E 11.90x -1.40x 7.73x 14.20x P/E and M/B are high if expected growth is M/B 1.56x 0.46x 1.28x 2.40x high and risk is low. 31 32 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 32 EV/EBITDA Calculations for Chapter 4 Case The DuPont Equation  Enterprise Value = MVE + MVD + MVClaims – (Cash and Equivalents) The DuPont Equation  For D’Leon, EV/EBITDA calculations are as follows (assume bonds Total assets Equity are at par value): ROE = Profit Margin X X turnover multiplier  2022E: [($12.17 x 250,000) + ($300,000 + $400,000) - $85,632]/$474,608 = 7.7050, or approximately 7.7x ROE = (NI/Sales) X (Sales/TA) X (TA/Equity)  2021: [($2.25 x 100,000) + ($636,808 + $723,432) - $7,282]/$78,808 = 20.02, or approximately 20.0x  Focuses on expense control (PM), asset utilization  2020: [($8.50 x 100,000) + ($200,000 + $323,432) - (TATO), and debt utilization (equity multiplier). $57,600]/$209,328 = 6.2860, or approximately 6.3x 33 34 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 34 DuPont Equation: Breaking Down Return on Equity More Issues Regarding Ratios ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)  “Average” performance is not necessarily good, perhaps the firm should aim higher. = 3.71% x 1.97 x 1.7913  Seasonal factors can distort ratios. = 13.1%  “Window dressing” techniques can make statements and ratios look better than they PM TATO EM ROE actually are. 2020 3.2% 2.34 2.21 16.6%  Inflation has distorted many firms’ balance 2021 -2.6% 2.14 5.82 -32.5% sheets, so analyses must be interpreted with judgment. 2022E 3.7% 1.97 1.79 13.1% Ind. 4.3% 2.6 1.63 18.2% 35 36 © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 36 6 FIN305 FTU FA24 12/11/2024 End of Chapter 4 © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5 37 7