Lecture 2 Ratio Analysis PDF

LECTURE 2 RATIO ANALYSIS  Financial statements analysis Learning Objectives What are the major financial statements? Which are the major methods for analyzing financial information for decision making purposes? What is ratio analysis and why are the results important to bo...

LECTURE 2 RATIO ANALYSIS  Financial statements analysis Learning Objectives What are the major financial statements? Which are the major methods for analyzing financial information for decision making purposes? What is ratio analysis and why are the results important to both managers and investors?  The Annual Report Verbal Section – Usually a letter from the chairman …….. Financial Statements – The Income Statement – The Balance Sheet OR statement of financial position – Statement of Cash Flows 3  Financial statements Financial statements Income statement Balance sheet Statement of cash flows Shows profitability Shows the fin. performance Shows the change in cash (revenues - expenses) of the firm at a certain time why changed? (What it OWNS and it OWES). (operating, investing and financing changes)  Carrefour 1 [Income Stat for the year 201- (in millions of Euro] Revenues or sales 87,379* - Expenses 86,942 =Profit (or Loss) 437 Shows the profitability during a certain period (year) Does not show cash * For simplicity, we included only operating revenues. Any other non oper revenue or gain was net out with expenses. 5  Carrefour BALANCE SHEET or statement of 2 financial position As at Dec 31, 201- (in millions of Euro) ASSETS 51,553 LIABILITIES 40,438 SHAREHOLd. E. 11,115 ______ 51,553 51,553 OWNS OWES ALWAYS: Assets = Liabilities + Shareholders equity: Why? The balance sheet shows the financial position of the firm at a certain time only. It is like a ´snapshot´, a ´picture´.  BALANCE SHEET – MAJOR COMPONENTS 2 Balance Sheet LIABILITIES & ASSETS SHAREH. EQUITY SHAREHOLDERS EQ FIXED ASSETS -Capital -Retained Earnings LIABILITIES CURRENT ASSETS -Current -Long term Fixed assets: Whatever the firm owns and will be used for more than 1 year (property, plant, equipment, cars, long term investments etc) Current Assets: Assets that can be liquidated within 1 year (eg., cash, inventory, receivables) 7  Which are the major methods for analyzing financial information for decision making purposes Methods for analyzing fin. info Common size Trend analysis Ratio analysis Income stat Income stat Common size balance sheet balance sheet Trend analysis Benchmarking Trend analysis: comparison of financial information over time Common size or cross sectional: Balance sheet data are reported as a % of Total assets (100%) and elements of income statement are reported as a % of sales (100%); It is the comparison of firm´s performance with other firms. 8  Ratio Analysis Ratios are accounting numbers translated into relative values. Ratios are designed to show relationships between financial statement accounts within firms and between firms 9 The Purpose of Ratio Analysis Gives an idea of how well the company is doing Standardizes numbers; facilitates comparisons Used to highlight weaknesses and strengths 10  Five Major Categories of Ratios Liquidity: is the firm able to meet its current obligations Asset management: is the firm effectively managing its assets Debt management: does the firm have the right mix of debt and equity Profitability: the combined effects of liquidity, asset and debt management Market values: relates the firm’s stock price to its earnings and the book value per share 11 APPLY RATIO ANALYSIS USING THE UNILATE COMPANY  Liquidity Ratios Balance Sheet Ratios Current Ratio Current Assets Liquidity Ratios Current Liabilities Shows a firm’s ability Acid-Test (Quick) to cover its current Current Assets - Inv liabilities with its Current Liabilities current assets.  Unilate’s Current Ratio Current Ratio = Current Assets Current Liabilities = $465.0 = 3.6 times $130.0 Industry average = 4.1 times 14  Unilate’s Quick (Acid Test) Ratio Current Assets- Inventories Quick Ratio = Current Liabilities = $465.0 - $270.0 = $195.0 = 1.5 times $130.0 $130.0 Industry average = 2.1 times 15  2. Asset Management Ratios Inventory Turnover Ratio Days Sales Outstanding (DSO) Total Assets Turnover Ratio 16  Asset Management Ratios Inventory turnover ratio is a ratio showing how many times a company has sold and replaced inventory during a given period. It is calculated to see if a business has an excessive inventory in comparison to its sales level. A company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand.  Asset Management Ratios Days Sales Outstanding (DSO) A measure of the average number of days that a company takes to collect revenue after a sale has been made. A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money. Total Assets Turnover Ratio This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always more favorable. Higher turnover ratios mean the company is using its assets more efficiently. Lower ratios mean that the company isn't using its assets efficiently and most likely have management or production problems. 18  Unilate’s Inventory Turnover Ratio Cost of goods sold Inventory turnover = Inventory $1,230.0 = = 4.6.6 times $270.0 Industry average = 7.4 times is a ratio showing how many times a company has sold and replaced inventory during a given period. It is calculated to see if a business has an excessive inventory in comparison to its sales level. A company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. 19 Unilate’s Days Sales Outstanding Ratio Receivable s Receivable s DSO   Daily Sales  Annual Sales   365  $180.0 $180.0    43.8 days  $1,500.0  $4.109  365  Industry average = 32.1 days 20 Unilate’s Total Assets Turnover Ratio Sales Total assets turnover = Total assets $1,500.0 = = 1.8 times $845.0 Industry Average = 2.1 times 21  Debt Management Ratios Debt Ratio Times-Interest-Earned Ratio 22  Unilate’s Debt Ratio Debt Ratio = Total liabilities Total assets = $430.0 = 0.509 = 50.9% $845.0 Industry Average = 42.0% Shows the percentage of the firm’s assets that are supported by debt financing. 23  Unilate’s Times-Interest-Earned Ratio TIE = EBIT Interest charges $130.0 = = 3.3 times $40.0 Industry Average = 6.5 times Indicates a firm’s ability to cover interest charges. 24  Profitability Ratios Net Profit Margin Return on Total Assets Return on Common Equity 25  Unilate’s Profit Margin Ratio Net income Profit margin = Sales $54.0 = = 0.036 = 3.6% $1,500 Indicates the firm’s profitability after taking account of Industry Average = 4.9% all expenses and income taxes. 26 Unilate’s Return on Total Assets Net income ROA = Total assets $54.0 = 0.064 = 6.4% = $845.0 Industry Average = 10.3% An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. 27  Unilate’s Return on Common Equity Net income ROE = Common equity = $54.0 = 0.130 = 13.0% $415.0 Industry Average = 17.7% The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders' equity generates. 28  Market Value Ratios Price/Earnings Ratio it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. 29  Unilate’s Price/Earnings Ratio Price per share Price/Earnings Ratio = Earnings per share $23.00 = = 10.6 times $2.16 Industry Average = 15.0 times 30  MARKET VALUE RATIOS What does the PE ratio show? – Shows how many dollars/Euros investors are willing to pay for every 1 dollar/Euro the firm is having as profits. What do high/low P/E ratios show? – High (low) P/E ratios show that either the firm is overvalued (undervalued) or it has high (low) growth opportunities COMMON SIZE FINANCIAL ANALYSIS Common size or cross sectional: Balance sheet data are reported as a % of Total assets (100%) and elements of income statement are reported as a % of sales (100%) It is the comparison of firm´s performance with other firms.  COMMON SIZE FINANCIAL ANALYSIS BALANCE SHEET METRO AG BALANCE SHEET 2017 2018 2019 2020 100.0% 100.0% 100.0% 100.0% Total Liabilities 82.0% 81.6% 81.1% 82.5% Shareholders Equity 18.0% 18.4% 18.9% 17.5% CARREFOUR BALANCE SHEET 20017 2018 2019 2020 100.0% 100.0% 100.0% 100.0% Total Liabilities 78.9% 80.3% 84.1% 81.8% Shareholders Equity 21.1% 19.7% 15.9% 18.2% WALMART BALANCE SHEET 2017 2018 2019 2020 100.0% 100.0% 100.0% 100.0% Total Liabilities 57.4% 60.6% 60.8% 59.8% Shareholders Equity 42.6% 39.4% 39.2% 40.2% 33 Trend Analysis  Trend analysis Rate of Return on Common Equity (ROE) Industry Unilate 2017 2018 2019 2020 2021 35  Summary of Ratio Analysis: The DuPont Analysis DuPont equation is a formula that shows that the rate of return on equity (ROE) can be found as the product of profit margin, total asset turnover and equity multiplier.  DU PONT ANALYSIS How is ROE measured? ROE = Net income / common equity Since the major financial information is revenue (sales) and assets (TA), by multiplying ROE by these figures we get: Net profit sales TA This is ROE =-------------- * --------- * --------------- called sales TA common Eq Du Pont Profit Margin Asset Turnover Equity multiplier Analysis PROFITABILITY ASSET MGNT RISK ROA=Profit margin * asset turnover 37 END  Unilate Textiles: Income Statements for Years Ending Dec. 31 ($ millions, except per shares data) 2018 2019 Amount Amount Net sales $1,500.0 $1,435.0 Cost of goods sold(82% of sales) (1,230.0) (1,176.7) Gross profit $ 270.0 $ 258.3 Fixed operating costs except depreciation ( 90.0) ( 85.0) Earnings before interest, taxes, depreciation, and amortization (EBITDA $ 180.0 173.3 Depreciation ( 50.0) ( 40.0) Net Operating income (NOI) = Earnings before interest and taxes (EBIT) $ 130.0 133.3 Interest ( 40.0) ( 35.0) Earnings before taxes (EBT) $ 90.0 98.3 Taxes (40%) ( 36.0) ( 39.3) Net income $ 54.0 $ 59.0 Preferred dividends 0.0 0.0 Earnings available to common stockholders (EAC) $ 54.0 59.0 Common dividends ( 29.0) ( 27.0) Addition to retained earnings $ 25.0 32.0 Per share data (25,000,000 shares): Earnings per share = (Net income)/Shares $2.16 $2.36 Dividends per share = (Common dividends)/Shares $1.16 $1.08 40 Unilate Textiles: Dec. 31 Balance Sheets ($ millions, except per share data) 2018 2019 Amount Amount Assets Cash and equivalents $ 15.0 $ 40.0 Accounts receivables 180.0 160.0 Inventory 270.0 200.0 Total current assets $465.0 $400.0 Net plant and equipment 380.0 350.0 Total assets $845.0 $750.0 Liabilities and Equity Accounts payable $ 30.0 $ 15.0 Accruals 60.0 55.0 Notes payable 40.0 35.0 Total current liabilities $130.0 $105.0 Long–term bonds 300.0 255.0 Total liabilities (debt) $430.0 $360.0 Common stock (25,000,000 shares) 130.0 130.0 Retained earnings 285.0 260.0 Total common equity $415.0 390.0 Total liabilities and equity $845.0 $750.0 Book value per share = (Common equity)/Shares $16.60 $15.60 Market value per share (stock price) $23.00 $25.00 41