CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS

Financial Statement Analysis is used by: a) managers to evaluate and improve performance, b) lenders (banks and bondholders) and bond rating analysts (SP and Moody's) to evaluate the creditworthiness of a company, and c) stockholders (current or prospective) and stock analysts, to forecast earnings, DIV and stock price.

To assess firm's strengths and weaknesses, and improve future financial performance, financial ratio analysis is used to: a) compare firm to industry averages (benchmark analysis) and b) evaluate the firm's financial position over time, (trend analysis).

Ratios are calculated with data from either the balance sheet or the income statement.

LIQUIDITY RATIOS

Question: How liquid is the firm?  Will it be able to pay its debts as they come due?

1. Current Ratio:     CA (Cash + AR + INV) / CL (AP + NP)

\$1000  / \$310  =  3.2X   vs.   4.2X Industry

Conclusion:  MicroDrive is less liquid than industry, \$3.20 for every \$1 CL, compared to \$4.20 for industry.

Solution:  Increase CA or decrease CL?

Question: How liquid is the firm without relying on INV, the least liquid CA?

2. Quick Ratio:            (CA -  INV)  /  CL

where CA - INV = Cash + Short-Term Securities + AR

\$385 / \$310 =  1.2X   vs. 2.1X Industry

Conclusion: MicoDrive is less liquid than industry.  For every \$1 of CL, MicroDrive has \$1.20 of liquid assets vs. \$2.10 for industry.

ASSET MANAGEMENT RATIOS

Question: How effectively is the firm managing its assets?

1. Inventory Turnover Ratio:  SLS / INV

\$3000 /  \$615  =   4.9X    vs.   9.0X Industry

MicroDrive's INV is "turned over" about 5x per year, or about every 10 weeks, versus about every 6 weeks for industry (52 weeks / 9).

Conclusion: MicroDrive is holding too much inventory, or holding inventory too long.  Excess INV is unproductive.

Solution: Increase SLS or decrease INV, through more efficient INV management.

Question: How long does it take to convert a credit sale to cash?

2. Days Sales Outstanding (DSO):  AR / SLS per Day

\$375 / \$8.333 ≈  45 days  vs. 36 days Industry

Conclusion: If credit terms are "net 30 days," it means that MicroDrive's customers are not paying on time.

Solution: Try to expedite collection of AR.

Question: How effectively is firm managing/using its Property, Plant and Equipment?

3. Fixed Asset Turnover Ratio:    SLS /  FA (Plant and Equipment)

\$3000 /  \$1000  =   3.0X   vs. 3.0X Industry

Conclusion: OK

Question: How effectively is firm managing its TA?

4. TA Turnover Ratio:    SLS  /  TA

\$3000 /  \$2000  =  1.5X   vs.  1.8X Industry

Conclusion: MicroDrive is below industry.

Solution:  Increase SLS or decrease TA.  To meet industry avg., it should have \$3,600 of SLS for its TA of \$2000 (\$2,000 x 1.8X).  Or it should have \$1,666 of TA for its SLS of \$3000 (\$3000 / 1.8).

DEBT MANAGEMENT RATIOS

Financial Leverage is the use of debt financing, which creates risk, but which can increase ROE (Return on Equity).

Why does debt increase risk?

Example:  \$100,000 house, with 10% down payment (E = \$10,000) and 90% financing (D = \$90,000).  Suppose that house appreciates in value by 10%, to \$110,000.  What is your ROI (Return on Investment) or ROE?

ROI/ROE:  \$10,000 gain / \$10,000 investment  =  +100% ROI

Leverage Factor:  \$100,000 Asset / \$10,000 Investment (E) =  10X    or

Leverage Factor =  1 / (E / A)  =   1  /  .10   =   10X

ROE (ROI)  =  ROA  x Leverage Factor

ROI  =  10%  x 10X =  +100%

See Table 3-1 on p. 81.

RATIOS:

1. Debt Ratio =  D / TA

=  \$1064 / 2000  =  53.2%  vs.  40% Industry

Conclusion: MicroDrive has more leverage, higher debt level than industry.  Could make it costly to borrow additional funds.

Solution: Raise more equity capital to finance expansion, or increase RE.

2. Times-Interest-Earned (TIE)  =   EBIT   /   INT

\$283.8 / \$88 =  3.2X   vs.  6.0X Industry

TIE tells us: For every \$1 of INT expense, how many dollars of EBIT does the firm has?  How many times is each dollar of interest expense "covered" by EBIT?  For MicroDrive, only \$3.20, for Industry \$6.00.

Conclusion: MicroDrive has high interest expense relative to its operating income (EBIT).  At industry TIE, MicroDrive should have only INT = \$47.3 (\$283.8 / 6) or EBIT = \$528 (\$88 x 6).

Solution: Pay off debt to reduce INT, or increase EBIT.

3. EBITDA Coverage Ratio  =   EBITDA + LEASE PMTs  /   INT + PRINCIPAL + LEASE PMTs

TIE has two shortcomings: 1) Fixed PMTs for debt include principal payment (PMT = P + I), and firm may have fixed LEASE payments.  2) EBIT does not accurately reflect CF available to service debt, especially if there are large DEP or AMORT expenses.

Short-term commercial lenders (5 years or less) like banks prefer EBITDA Coverage Ratio, long-term lenders/bondholders focus on TIE.

Denominator of EBITDA Coverage Ratio = ALL fixed charges

Numerator = ALL CFs available to meet fixed financial charges. (Lease pmts are added back, because they were deducted (unlike interest expense, to calculate EBITDA).

EBITDA Coverage Ratio:      \$411.8 /  \$136  =  3.0X  vs.  4.3X Industry

For every \$1 of fixed financial charges, how many dollars of EBITDA does a firm have?

Conclusion: MicroDrive is in a weaker position than industry, for meeting fixed charges.

Solution: Increase EBITDA or lower fixed charges.

PROFITABILITY RATIOS

Show the combined effects of liquidity, asset management and debt on operating results.

1. Profit Margin (PM) on SLS:     NIAT / SLS

For \$100 SLS, how many dollars in profits (NIAT) are generated.

\$113.5  /  \$3000  =  3.8%   vs.  5% Industry

Conclusion: MicroDrive's profitability is below average.  At industry avg. of 5% PM, it should have NIAT = \$150 (\$3,000 x 5%).

Solution: MicroDrive has to lower costs, especially its high debt costs, which lower NIAT.  However, low PM due to INT might NOT be a problem if there is a high ROE.

2. Basic Earning Power (BEP):    EBIT /  TA

Shows the raw earning power of the firm's assets, before influence of taxes and leverage.

\$283.8 / \$2,000 =  14.2%  vs.  17.2% Industry

Conclusion: MicroDrive's BEP is below average.

Solution: Increase asset turnovers and increase profit margins.

3. Return on TA (ROA)  =   NIAT /   TA

\$113.5 / \$2000  =   5.7%  vs. 9% Industry

Conclusion: Low BEP and high debt relative to TA, causing NIAT to be low.

4. Return on Common Equity (ROE):    NIAT  / E

\$113.5 / \$896  =  12.7%  vs.  15% Industry

ROE measures the accounting return on investment for shareholders.

Conclusion: MicroDrive's ROE is below industry, but not as far below industry as its ROA, because of its use of D.

MARKET VALUE RATIOS

1. Price / Earnings (P / E)   =    P  / EPS

How much are investors willing to pay (P) per dollar of EPS?  The more (less) optimistic the growth prospects and the less (more) risky the firm, the higher (lower) the P/E.

\$23 / \$2.27  =  10.1X  vs.   12.5X Industry

Conclusion: MicroDrive has less favorable growth prospects and more risk than average for the industry.

Solution: MicroDrive has to be managed more efficiently, for its P to increase.

2. P / CF Ratio:  P / CFAT per share

How much are investors willing to pay per dollar of CFAT?

\$23 / \$4.27  =  5.4X  vs.  6.8X

Conclusion: P/CF for MicroDrive is below average, less favorable growth prospects, and/or above average risk.

3.  Book Value Per Share (BVPS):   E  / # Shares

\$896m / 50m  =  \$17.92  vs.

Market/Book (M/B) Ratio:  Price / BVPS

\$23.00 /  \$17.92  =  1.3X  vs.  1.7X Industry

Investors are willing to pay less for a dollar of MicroDrive's book value than industry avg.

Why is P > BVPS?

Average M/B was about 4X in 2002 for stocks in general, and 6X for Microsoft.

Summary of Financial Ratios, Table 3-2 on p. 88.

TREND ANALYSIS

Analyzing ratios over time to determine if there is improvement or decline in performance, i.e. positive or negative trend.  See Figure 3-1 on p. 90.

COMMON SIZE ANALYSIS

All balance sheet items are divided by TA, and all income statements items are divided by SLS, and all items are expressed as a percentage (instead of dollars), see Tables 3-3 and 3-4 on p. 90-91.

PERCENTAGE CHANGE (GROWTH RATE) ANALYSIS

See Table 3-5 on p. 91.  Note that SLS (5.3%) increased faster than operating costs (5%), leading to 7.9% growth in operating income (EBIT).  However, interest expense grew by 46.7%, so NIAT fell by 3.7%.  Percentage change analysis makes this result very clear. Also, INV grew by 48.2%, even though SLS grew by only 5.3%, indicating possible trouble with INV costs.

DUPONT CHART AND EQUATION

See Figure 3-2 on p. 93.

ROA  =  PM  x  TA Turnover

ROA  =  (NIAT / SLS)   x   (SLS / TA)

ROA   =  3.8%  x 1.5X  =  5.7%    MicroDrive

MicroDrive made 3.8% or \$3.80 per \$100 of SLS, and Assets were turned over 1.5X during the year, so MicroDrive made 5.7% on its TA.

ROA    =   5%   x   1.8X   =  9%    Industry

Note that if a firm has no D, and 100% E, then TA = E, and ROE and ROA will be the same.

NIAT / TA =  NIAT / E, when TA = E and D = 0.

MicroDrive uses some D, and E < TA, so ROE > ROA:

ROA =  \$113.5 /  \$2000  =  5.7%

ROE  =  \$113.5  / \$896  =  12.7%

ROA can be multiplied by the Equity Multiplier (EM) to calculate ROE:

ROE  =   ROA  x EM

12.7% =  5.7%  x 2.23

EM  =   TA  /  E

EM  =  \$2000 /  \$896  =  2.23X

The equity multiplier shows the effects of using leverage (D) on ROE.

EXTENDED DUPONT EQUATION

Shows how profit margin, TA turnover and use of debt interact to determine ROE.

ROE =  PM  x  TA Turnover x  EM

ROE =   NIAT   x    SLS   x    TA     =    NIAT

SLS           TA          E               E

MicroDrive:      ROE   =  3.8%  x  1.5X   x   2.23   =  12.7%

Industry:   ROE  =   5%  x   1.8X   x    1.67  =  15%

MicroDrive can use Extended Dupont Equation to analyze ways of improving performance.

1. Marketing.  Profitability can be improved by marketing efforts to increase SLS with price increases (if Demand is _________ ) or decrease prices (if Demand is __________ ), or trying new products or markets with higher margins.

2. Costs/Expenses.  Accountants, engineers and employees can work to reduce production and operational costs, become more cost-efficient.

3. Asset Management.  Finance, production and marketing can work to improve efficient use of assets (INV, AR, FA).

4. Debt.  Treasury can work to control interest expense.  Options?

BENCHMARKING

Ratio analysis by comparing firm to industry averages (banking industry), or its main competitors (large banks to other large banks).  MicroDrive is toward the bottom for its industry, see p. 95.  See Table 3-6, p. 96 for industry averages.

USES, LIMITATIONS OF RATIO ANALYSIS

1. Many MNCs operate in more than one industry, making benchmarking difficult.

2. Inflation affects balance sheet, book value might differ substantially from market value.  Comparison over time, or comparison of firms of different ages, might be distorted.

3.  Seasonal factors can affect financial ratios, e.g. INV will vary for many firms throughout the year.

4. "Window dressing" techniques can be used to make financial statement artificially appear more favorable or positive that they really are.

5. Different accounting methods can distort comparison, LIFO vs. FIFO, lease financing (assets don't appear on balance sheet, fixed lease payments don't appear as debt)

6. Are a firm's revenues tied to one customer or one product?

LOOKING BEYOND THE NUMBERS

1. Is a firm dependent one key customer (Wal-Mart), product or supplier?  Could be risky.

2. What % of SLS are overseas?  Could be risky: currency, political, business cycle.

3. How competitive is the market?

4. Future prospects for growth?

5. Legal and Regulatory Factors?  Could affect future growth prospects, pos or neg.  Examples: Deregulation of banking, airlines, transportation.  Antitrust policy and enforcement.  Lawsuits against tobacco or asbestos companies.