1 © 2013 . Used by investors, creditors, management, and regulators to assess a firm’s financial...

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Financial Statement Analysis

© 2013 www.thefundamentalinvestor.com

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Ratio Analysis

Used by investors, creditors, management, and regulators to assess a firm’s financial condition and performance

Ratios can “standardize” F/S information and make it possible to compare companies of varying sizes

Anyone can crunch the numbers and generate the ratios…the real skill is putting life into the numbers


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The Analytical Process

(1) Determine the purpose of the analysis (2) Gather data (3) Process the data : calculate ratios, etc. (4) Analyze and interpret the data (5) Make conclusions (6) Follow-up, as necessary


Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.

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Getting Started: Key Questions The analyst should set the stage properly for the

analysis by understanding the landscape. Failure to do so could lead to wasted time, effort, and resources as the analyst keeps bumping into brick walls: What is the purpose of the analysis? What level of detail will be needed? What data are available? What are the factors and relationships that will influence

the analysis? What are the analytical limitations? Will these impair the

analysis?The analyst can then select the

appropriate tools to be used for the analysis



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Computation ≠ Analysis!!!

Analysis goes beyond merely gathering data, compiling data into a spreadsheet, and generating graphs or charts

Effective analysis of historical performance includes understanding WHAT happened, WHY it happened, and HOW it fits into the overall company strategy What aspects of performance are critical for the company

to successfully compete? How well did the company’s performance meet these

critical aspects? (Compare the company’s performance vs. benchmarks)

What were the key causes of this performance, and how does this performance reflect the company’s strategy?



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Forward-Looking Analysis

Additional guide questions for forward-looking analysis: What is the likely impact of the trends in the company,

industry, and economy on future cash flows? What is the likely response of management to trends? What are the recommendations of the analyst? What risks should be highlighted?



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The Numbers Tell A Story…

Motorola ($ Millions) 12/31/2005 12/31/2004 12/31/2003

Net sales 36,843 31,323 23,155

Operating earnings 4,696 3,132 1,273



Nokia Corporation (EUR Millions) 12/31/2005 12/31/2004 12/31/2003

Net sales 34,191 29,371 29,533

Operating earnings 4,639 4,326 4,960

Analysis notes:

The raw numbers are not directly comparable due to different currencies…thus, look at trends and percentages. Note: at that time, Nokia was the industry leader

Compare the following for the two companies: Trends in sales and operating earnings growth

Motorola shifted strategies: increase its presence in consumer marketing / consumer products to complement its historically strong technological position

From Motorola’s 10-K in 2005: The introduction of the RAZR in 2004, which sold more than 23 million units since being

launched. The handset segment reprsented 54% of 2004 sales, and 58% of 2005 sales.

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Keep in Mind…

Compare apples vs. apples: use F/S of companies that cover the same time period

Use audited F/S whenever possible Garbage in, garbage out Cost vs. benefit tradeoff:

A core set of 25 to 30 ratios will usually provide you with just about the same important information that 100 ratios will give you



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Select Benchmarks

The numbers, by themselves, are meaningless Benchmarks are needed to make meaningful

comparisons: Budgets, goals, and strategies Own historical performance General industry averages Similarly-situated peers Regulatory requirements



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Select Benchmarks

Care must be taken when using industry norms: Some ratios are industry-specific A single company might have several different lines of

businesses, thereby distorting the value of ratios calculated at the Parent (or aggregate) level

Difference in strategies for each division can affect the usefulness of some ratios

Different accounting methods



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Value of Ratio Analysis

Evaluation of past performance

Assessment of the current financial position

Gain insights useful for projecting future results: Microeconomic relationships

within a company Financial flexibility: ability to

obtain cash to grow the business, ability to pay obligations, etc.

Management’s capabilityRatios are not the end-game answers. Ratios are just the starting point and

indicate where to conduct further investigation.



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Value of Ratio Analysis

The goal is to understand the reasons for differences between a company’s performance vs. its peers…hence, the importance of selecting appropriate benchmarks

Even ratios that remain stable require understanding (and analysis) because there could be accounting policies selected to smooth out the trends



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Limitations of Ratio Analysis What is a good or bad ratio? Ratios tell you “what” happened, but not “why” it

happened. Analysts must understand WHY things happened.

ABC Inc. XYZ Inc.

Net Income Php 500,000 Php 12,000,000

Revenue Php 10,000,000 Php 400,000,000

Net Profit Margin (NPM)

5.0% 3.0%

Which company is more profitable?

What is the better measure of

profitability? Is it the 5.0% or the Php

1,200,000?

WHY does ABC Inc. have a higher NPM? Is it due to higher selling price or better cost control or

something else?Are there economies of scale that

would make the absolute Peso value more important than the

NPM percentage?


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Limitations of Ratio Analysis The use of alternative

accounting methods can distort the comparability of ratios…hence, analyst adjustments might be necessary.

Some ratios that would be affected:1. Inventory turnover2. Days to sell inventory3. Operating cycle4. Cash conversion cycle5. Gross profit margin6. Operating profit margin7. Net profit margin8. Return on assets9. Return on equity10. Current ratio


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Limitations of Ratio Analysis Some ratios are not relevant to

certain companies or industries. Conglomerates may have

divisions operating in many different industries, which can make it difficult to find comparable industry ratios at the parent company level.


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Limitations of Ratio Analysis The need to use human judgment in gathering

data, interviewing management, selecting the ratios, and analyzing results.

Some ratios might indicate conflicting signals. Inflationary conditions can distort ratios. The number of ratios that can be created is

practically limitless. When faced with a new ratio, simply analyze each component separately in order to understand it.

Financial ratios will eventually vary across time and across industries. The challenge is to interpret the

differences properly…in some cases, interpretation can be situation-

specific.



Using “Average” vs. “Yearend” Rule of thumb: if the numerator comes from the

Income Statement and the denominator comes from the Balance Sheet, then:

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The analyst can average using end-Quarter or end-Month figures to

account for seasonalities.


Using “Average” vs. “Yearend” Other possible types of “averages”:

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The analyst can average using end-Quarter or end-Month figures to

account for seasonalities.


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Using “Average” vs. “Yearend” Intuitively: it’s not practical to take the sum of

the denominator for 365 days, then divide it by 365 days, in order to match it with the 365 days of the numerator:


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Using “Average” vs. “Yearend” If the denominator (i.e. B/S item) is fairly stable

all throughout the year(s), then it would not matter if “beginning”, “ending”, or “average” amounts are used.

If the denominator (i.e. B/S item) either increased or decreased substantially during the year, then use the “average” amount: It is difficult to ascertain whether the numerator (i.e. I/S

item) was generated by February assets or November assets.

Intuitively:Revenues and Expenses are

generated by Assets, Liabilities, or Equity. Conceptually, more of the

denominator (B/S item) should lead to more of the numerator (I/S item).



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Getting Started

Two powerful tools to begin the number crunching: transform the Financial Statements from Peso amounts into percentages in order to perform: Vertical Analysis Horizontal Analysis or “trend analysis”

These can reveal possible red flags even before specific ratios are calculated.


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Vertical Analysis: B/S

Common-size Balance Sheet: All items as a % of Total Assets Total Assets = 100%

The analyst can dissect the composition of the B/S: What is the mix of assets?

▪ Current, non-current, tangible, intangible, etc.

How is the company financing itself?▪ Short-term debt, long-term debt, interest-bearing vs. non-interesting-

bearing debt, investor investments, accumulated profits, etc.

How does the company’s B/S compare to its peers, and what are the reasons for differences?


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Alaska MilkBalance SheetDecember 31

Actual Actual Vertical Vertical(in Php) Notes to FS 2010 2009 2010 2009ASSETSCurrent Assets

Cash and cash equivalents 5, 26, 27 1,110,623,996 857,054,066 12.15% 11.79%ST investments 6, 24, 26, 27 1,833,983,891 1,044,563,465 20.07% 14.37%Trade and other receivables 7, 26, 27, 30 827,839,418 893,566,768 9.06% 12.29%Inventories 8 2,117,670,472 1,153,181,393 23.17% 15.86%Prepaid expenses and other current assets26, 27 38,970,814 33,263,909 0.43% 0.46%

Total current assets 5,929,088,591 3,981,629,601 64.87% 54.76%

Noncurrent AssetsAvailable-for-sale investments 9, 26, 27 2,556,403 2,556,403 0.03% 0.04%Property, plant and equipment 10 1,562,810,605 1,515,257,935 17.10% 20.84%Intangible assets - net 11, 25 1,310,444,899 1,481,438,498 14.34% 20.37%Deferred tax assets 21 260,587,503 197,984,388 2.85% 2.72%Net pension assets 20 44,836,138 49,260,438 0.49% 0.68%Other noncurrent assets 26, 27 29,460,456 42,786,207 0.32% 0.59%

Total noncurrent assets 3,210,696,004 3,289,283,869 35.13% 45.24%

TOTAL ASSETS 9,139,784,595 7,270,913,470 100.00% 100.00%

What are your observations?


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Alaska MilkBalance SheetDecember 31

Actual Actual Vertical Vertical(in Php) Notes to FS 2010 2009 2010 2009LIABILITIES AND STOCKHOLERS' EQUITY

Current liabilitiesTrade and other payables 12, 25, 26, 27 2,096,022,469 1,839,819,125 22.93% 25.30%Acceptances payable 26, 27 704,782,480 560,124,762 7.71% 7.70%Income tax payable 131,913,063 109,980,839 1.44% 1.51%Dividends payable 14, 26, 27 125,099,266 52,097,499 1.37% 0.72%Current portion of obligation under finance leases25, 26, 27 7,227,315 4,019,227 0.08% 0.06%

Total current liabilities 3,065,044,593 2,566,041,452 33.54% 35.29%

Noncurrent liabilitiesObligation under finance leases - net of current portion25, 26, 27 28,638,522 27,465,248 0.31% 0.38%

Total liabilities 3,093,683,115 2,593,506,700 33.85% 35.67%

Stockholders' Equity 26Capital stock 13, 22 971,432,578 968,074,878 10.63% 13.31%APIC 22 152,393,329 118,361,998 1.67% 1.63%Retained earnings 14

Appropriated for various cpaital investment projectsand share buy-back program 2,075,000,000 1,625,000,000 22.70% 22.35%

Unappropriated 3,249,867,801 2,318,019,622 35.56% 31.88%Treasury stock 13, 14 (402,592,228) (352,049,728) -4.40% -4.84%

Total SHE 6,046,101,480 4,677,406,770 66.15% 64.33%

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY 9,139,784,595 7,270,913,470 100.00% 100.00%

What are your observations?

%


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Vertical Analysis: P&L

Common size Income Statement: All items as a % of Total Revenues Total Revenues = 100%

Several key profitability ratios will be revealed: The analyst should understand where the profits came

from, as well as which types of expenses are eating up the profits

Cost control is just as important as revenue growth [See Excel file “FS Analysis Examples” for further

illustration]


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Vertical Analysis: P&LCommon Size Income Statement Ratio

Sales or revenues 10,000.00Php 100.00%- Cost of sales (6,000.00) -60.00%= Gross profit 4,000.00Php 40.00% GP Margin- Operating expenses (1,250.00) -12.50% Operating Cost Ratio

Salaries (300.00) -3.00%Rent (600.00) -6.00%Insurance (150.00) -1.50%Office supplies (200.00) -2.00%

= EBITDA 2,750.00Php 27.50% EBITDA Margin- Depreciation (750.00) -7.50%- Depletion (225.00) -2.25%- Amortization (125.00) -1.25%= EBIT 1,650.00Php 16.50% EBIT Margin- Interest expense (575.00) -5.75%= EBT or Net Income Before Tax 1,075.00Php 10.75% EBT Margin- Tax: 30% (322.50) -3.23%= Net income after tax 752.50Php 7.53% Net Profit Margin


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Alaska MilkIncome StatementDecember 31

Actual Actual Actual Vertical Vertical Vertical(in Php) 2010 2009 2008 2010 2009 2008

Net sales 12,162,709,978 10,580,440,474 9,967,757,268 100.00% 100.00% 100.00%Cost of sales (7,558,650,096) (6,821,522,353) (7,903,815,821) -62.15% -64.47% -79.29%GROSS PROFIT 4,604,059,882 3,758,918,121 2,063,941,447 37.85% 35.53% 20.71%

Operating expenses (2,277,295,199) (1,869,510,056) (1,599,921,570) -18.72% -17.67% -16.05%Interest income 48,748,735 24,646,247 4,952,263 0.40% 0.23% 0.05%Foreign exchange gain (loss) (40,319,512) (26,700,674) 13,985,346 -0.33% -0.25% 0.14%Gain on disposals of PPE and investment properties3,216,898 766,164 9,431,114 0.03% 0.01% 0.09%Interest expense on obligation under finance leases(2,100,081) (1,867,856) - -0.02% -0.02% 0.00%Casualty loss - (156,536,291) - 0.00% -1.48% 0.00%Interest expense on bank loans - (2,453,962) (60,321,826) 0.00% -0.02% -0.61%Rent income - - 427,891 0.00% 0.00% 0.00%Dividend income and others (1,998) 13,892 1,174,323 0.00% 0.00% 0.01%

Total expenses (2,267,751,157) (2,031,642,536) (1,630,272,459) -18.65% -19.20% -16.36%

INCOME BEFORE INCOME TAX 2,336,308,725 1,727,275,585 433,668,988 19.21% 16.33% 4.35%

PROVISION FOR (BENEFIT FROM) INCOME TAXCurrent 583,312,875 361,555,720 80,034,252 4.80% 3.42% 0.80%Deferred (62,603,115) (43,668,855) 62,536,013 -0.51% -0.41% 0.63%

Subtotal 520,709,760 317,886,865 142,570,265 4.28% 3.00% 1.43%

TOTAL COMPREHENSIVE INCOME / NET INCOME1,815,598,965 1,409,388,720 291,098,723 14.93% 13.32% 2.92%


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Horizontal Analysis

The potential for growth of a business is important.

Trend analysis shows whether the company has experienced growth in the recent past: If there has been growth, can it be sustained? How will it

be sustained or increased? If there has been little growth, why? Is there any growth

in the future? Where will it come from? If the company expects growth in the coming

years, does it have the necessary resources to support it? Ex: cash, equipment, employees, funding sources, etc.

If the company does not foresee growth, what does it plan to do with its existing assets and liabilities?


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Horizontal Analysis

Growth in receivables and inventory vs. growth in revenues: It is generally more desirable for inventory and

receivables to grow at the same or slower pace than revenue growth

If receivables grow faster than revenues, this can indicate operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition

If inventory grows faster than revenue growth, this can indicate operational problems such as obsolescence or aggressive accounting policies (improper overstatement of inventory to increase profits)



30© 2013 www.thefundamentalinvestor.com

Trends!!!

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Major Categories of Ratios Operating Efficiency Ratios | Activity Ratios:

Measures how efficiently a company performs day-to-day tasks, such as collecting receivables

Liquidity Ratios: Measures the ability to meet short-term obligations

Solvency Ratios: Measures the ability to meet long-term obligations

Coverage Ratios: Measures the ability to meet regular debt (re)payments

Profitability Ratios Return on Sales Return on Investment

Cash Flow Ratios

Different ratios measure different aspects of the

business


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Operating Efficiency Ratios

RATIO CALCULATION WHAT IT MEASURES BETTER IF

Inventory Turnover (ITO)

Cost of Goods Sold ÷ Average Inventory

How long it takes to sell inventory

Higher

Days to Sell Inventory

365 days ÷ ITO How long it takes to sell inventory

Lower

Accounts Receivable Turnover (ARTO)

Net Credit Sales ÷ Average A/R

How long it takes to collect accounts receivable from

customers

Higher

Average A/R Collection Period

365 days ÷ ARTO How long it takes to collect accounts receivable from

customers

Lower

Allowance Adequacy ADA ÷ (A/R, net + ADA) The proportion of receivables covered by allowance for bad

debts

Higher

Accounts Payable Turnover (APTO)

Cost of Goods Sold ÷ Average A/P

How long it takes to pay suppliers

Lower

APTO variant Purchases ÷ Average A/P How long it takes to pay suppliers

Lower

Average A/P Payment Period

365 days ÷ APTO How long it takes to pay suppliers

Higher


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Intuition of “Turnover”

Inventory Turnover : Measures how many times per year the entire inventory was theoretically “turned over” or sold.

Inventory was theoretically sold out 24 times during the year.

Every 15 days, the warehouse would be emptied, then become full again…then become empty after 15 days…and so forth.

The same logic / intuition applies to Receivables Turnover and Payables

Turnover


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Intuition of “Turnover”Jan 1 Jan 16 Jan 31 Feb 15 March

2March

17April 1 April

16May 1 May 16

10,000Full

–- Empty

10,000Full

–- Empty

10,000Full

–- Empty

10,000Full

–- Empty

10,000Full

–- Empty

10,000Full

–- Empty

10,000Full

–- Empty

10,000Full

–- Empty

…

10,000Full

…

The cycle of “full” then “empty” happens 24x

during the year


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Analyzing Interim Periods If interim (i.e. less than full-year) data are used,

calculate the corresponding “annualized” figure: COGS for 1Q 2013 : Php 3,500,000 Average inventory for 1Q 2013 : Php250,000


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General analytical guidelines:

Low ITO (and high Days to Sell Inventory) means more resources tied up in inventory…i.e. potentially idle assets. Potential indicator of slow-moving inventory. Possible reasons: technological obsolescence, change in trends or fashion, etc.

Analytical questions: WHY is inventory slow moving? (or fast moving?) WHAT are the implications for future growth? Are the effects temporary or permanent? WHAT can be done to address the situation?

Useful benchmarks: (1) peers; and (2) industry norms. Analysis: compare the company’s ITO and revenue growth trend vs. the industry.

GOOD: Higher ITO (vs. industry) + Same or higher revenue growth (vs. industry) Effective inventory management.

BAD: Higher ITO (vs. industry) + Slower revenue growth (vs. industry) Inadequate inventory levels…which could result to inventory shortage and lost sales.

Operating Efficiency RatiosInventory Turnover=

Cost of Goods SoldAverage Inventory

Days ¿ Sell Inventory=365Days

ITO



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Average A /RCollectionPeriod=365daysARTO

A /RTurnover=Net Credit SalesAverage A /R




Ideally, use “Net Credit Sales”. If this is not available, then just use “Sales” as reported in the Income Statement.

Low ARTO (and high A/R Collection Period) means more resources tied up in receivables. Potential indicator of uncollectible receivables…i.e. problems in the credit and collection

system.

Analytical questions: WHY is A/R collection slow? (or fast?) WHAT are the implications for future growth? Are the effects temporary or permanent? WHAT can be done to address the situation?

Useful benchmarks: (1) peers; and (2) industry norms. Analysis: compare the company’s ARTO and revenue growth trend vs. the industry.

GOOD: Higher ARTO (vs. industry) + Same or higher revenue growth (vs. industry) Effective credit and collection system…receivables (and collection) are supporting sales

growth properly.

BAD: Higher ARTO (vs. industry) + Slower revenue growth (vs. industry) Possible indicator of very tight credit policy that could lead to lost sales (to competitors with

more lenient terms)

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Analyzing Receivables: #1


2011 2010

Sales Php 6,700,000 Php 7,500,000

A/R, net 202,000 320,000

Allowance for doubtful accounts 3,000 12,000

Analysis of accounts 2011 2010

ADA ÷ (A/R, net + ADA) 1.5% 3.6%

Growth rate: Sales − 10.7% ---

Growth rate: A/R, net − 36.9% ---

Growth rate: A/R, gross − 38.3% ---

Growth rate: ADA − 75.0% ---

- Sales have decreased so it is expected that the A/R and ADA would also decrease.

- A/R has decreased at a faster rate than sales while the ADA has decreased at a faster rate than accounts receivable.

- The percentage of estimated bad accounts has dropped by more than a percentage point relative to the prior year. Possible explanations for this inconsistency could be:

1. The company has tightened its credit policy;2. Prior bad debt estimates were too high and the company is correcting for this;

or3. Management has intentionally reduced bad debts to report a higher net

income.

Source: Fraser and Ormiston (2013). Understanding Financial Statements, 10th edition. Pearson.

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Analyzing Receivables: #2


Growth rate

Net sales 10.5%

Total accounts receivable 21.3%

Allowance for doubtful accounts 2.6%

` 2011 2010

ADA as a % of total A/R 3.8% 5.4%

- Sales, accounts receivable and the allowance for doubtful accounts have all grown, but not proportionately.

- The allowance account increased only slightly, and as a percentage of total accounts receivable, the allowance account has declined from 5.4% to 3.8%. This is not a normal pattern. Possible explanations are:

1. Management overestimated the account in prior years and is now correcting for that overestimation;

2. Customers are not defaulting as anticipated and management is adjusting the allowance account accordingly, or

3. Management is reducing the allowance account in order to decrease bad debt expense and increase net income in the current year.

- Other information that would be useful to the analyst would be the valuation schedule required by the SEC and any notes or information in the management's discussion and analysis related to accounts receivable and bad debts.

Source: Fraser and Ormiston (2013). Understanding Financial Statements, 10th edition. Pearson.

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To calculate “Purchases”

+ Cost of Goods Sold

+ Ending Inventory

− Beginning Inventory

= Purchases

A /PTurnover=Cost of Goods Sold

Average A /P

Average A /PPayment Period=365DaysAPTO


Implicit assumption: all purchases are made on credit (i.e. no outright cash payments). Use “Purchases” in the numerator Alternative: Use “Cost of Goods Sold” instead of “Purchases”

High APTO (and low A/P Payment Period) could mean that the company is either: [NOT GOOD] Not making full use of abilities to delay payment (and thus retain cash inside

the business); or [GOOD] Taking advantage of early payment discounts.

Low APTO (and high A/P Payment Period) could mean that the company is either: [NOT GOOD] Experiencing liquidity problems…i.e. unable to pay on time; or [GOOD] Exploiting lenient payment terms from the supplier.



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Operating Efficiency RatiosA /PTurnover=

Cost of Goods SoldAverage A /P

Average A /PPayment Period=365DaysAPTO


Compare APTO vs. Liquidity Ratios: If the Liquidity Ratios indicate sufficient amount of liquid assets, then a low APTO (and high

A/P Payment Period) could probably mean that the company is taking advantage of lenient payment terms…i.e. extending the payment period in order to retain the cash inside the business

Analytical questions: WHY is A/P payment slow? (or fast?) WHAT are the implications for future growth? Are the effects temporary or permanent? WHAT can be done to address the situation?



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Operating Efficiency RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Operating Cycle Days Inventory + Average A/R Collection

Period

How long it takes to complete one cycle of purchasing and selling

inventory

Lower

Cash Conversion Cycle

Days Inventory + Average A/R Collection Period − Average A/P

Payment Period

How long it takes to complete one cycle of purchasing and selling

inventory, and paying the suppliers (i.e. “cash to cash” cycle)

Lower

The operational efficiency of a business (i.e. Activity Ratios) has a direct impact on liquidity (i.e. Liquidity

Ratios)

How efficient are the resources used in generating revenues?

(Assets are acquired in order to generate revenue)

OPERATING CYCLE (in days)

+ Days Inventory

+Average A/R Collection Period

= Operating Cycle

CASH CONVERSION CYCLE (in days)

+ Days Inventory

+ Average A/R Collection Period

− Average A/P Payment Period

= Cash Conversion Cycle



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RATIO CALCULATION WHAT IT MEASURES BETTER IF

Fixed Asset Turnover(FATO)

Net Sales ÷ Average Fixed Assets

How much sales did the fixed assets generate

Higher

Total Asset Turnover(TATO)

Net Sales ÷ Average Total Assets

How much sales did the total assets generate

Higher

Equity Turnover (ETO)

Net Sales ÷ Average Stockholders’ Equity

How much sales did the owners’ investments generate

Higher

Working Capital (WC)

Current Assets − Current Liabilities

How much short-term assets in excess of short-term liabilities

are available

Higher

Working Capital Turnover(WCTO)

Net Sales ÷ Average Working Capital

How much sales did the working capital generate

Higher

Note: in the formulas, we use “Sales” and “Net Sales” interchangeably

The operational efficiency of a business (i.e. Activity Ratios) has a direct impact on liquidity (i.e. Liquidity

Ratios)


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Operating Efficiency Ratios¿ Asset Turnover=

SalesAverage ¿

Assets¿


FATO measures how efficiently the fixed assets generated revenues

FATO can be erratic: Even if the numerator is steady (or steadily increasing), the increases in the denominator

may not always follow a smooth pattern. Thus, the year-to-year changes in FATO may not necessarily indicate important changes in

efficiency.

High FATO could indicate: Efficient use of fixed assets in generating revenues.

Low FATO could indicate: Inefficient use of fixed assets in generating revenues; or The business is not yet operating at full capacity…hence, the “under utilization of fixed

assets” cannot be directly linked to the concept of efficiency; or The company has new fixed assets.



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Operating Efficiency RatiosTotal Asset Turnover=

SalesAverage Total Assets


TATO measures overall ability to generate revenues with a given level of assets:.

TATO includes both fixed assets and current assets: Inefficient working capital management can distort TATO. It’s best to analyze TATO, FATO, and WCTO separately

TATO can be erratic: Even if the numerator is steady (or steadily increasing), the increases in the denominator

may not always follow a smooth pattern. Thus, the year-to-year changes in TATO may not necessarily indicate important changes in

efficiency.

High TATO could indicate: Efficient use of assets in generating revenues; or The business is not capital-intensive…i.e. it could be labor-intensive.

Low TATO could indicate: Inefficient use of assets in generating revenues; or The business is capital-intensive; or The company has new fixed assets.



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Working Capital Turnover=SalesAverage Working Capital

Working Capital=Current Assets−Current Liabilities

Equity Turnover=Sales

Average Equity


Be careful when comparing ETO for different companies: Mature companies can have a capital structure comprised of lower equity and

higher debt.

A high ETO could mean a lower equity base…which could be a potential red flag.

A low ETO could mean there was a fresh equity infusion…which is not necessarily a bad thing in itself, but the analyst should find out the reason for the equity infusion.

For some companies, Working Capital can be close to zero or negative…this renders the WCTO meaningless.

A low WCTO could indicate higher Current Assets compared to Current Liabilities…which is not necessarily a bad thing.



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Liquidity RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Current Ratio Current Assets ÷ Current Liabilities Ability to pay short-term obligations

Higher

Quick Ratio (Cash + Short-term Marketable Securities + A/R) ÷ Current

Liabilities

Ability to pay short-term obligations

Higher

Cash Ratio (Cash + Short-term Marketable Securities) ÷ Current Liabilities


Higher

Defensive Interval Ratio

(Cash + Short-term Marketable Securities + A/R) ÷ Daily Cash

Expenditures


Higher


Liquidity: ability to settle short-term obligations.

Liquidity ratios measure how quickly assets are converted into cash.

Different industries require different levels of liquidity.

Assess a company’s current state of liquidity by comparing it to: Its own historical funding requirements. Anticipated future funding needs. Ability to obtain financing in the future and from what sources.

Consider the existence of contingent liabilities and the likelihood of being triggered.



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Liquidity Ratios

Cash Ratio=Cash+Short term Marketable SecuritiesCurrent Liabilities

Current Ratio=Current Assets

Current Liabilities

Quick Ratio=Cash+Short termMarketable Securities+A /R

Current Liabilities


Current Ratio implicitly assumes that Inventories and Accounts Receivable are truly liquid: Double-check Current Ratio against the Inventory Turnover and A/R Turnover ratios. If ITO and ARTO are poor, then it’s better to use the Quick Ratio or Cash Ratio.

Low Current Ratio indicates poor liquidity: Implication: greater reliance on Operating Cash Flow and external financing to meet short-

term obligations.

Quick Ratio implicitly assumes that inventories are not very liquid.

Cash Ratio is an indicator of liquidity in a crisis situation: This is useful if the company seems to have problems selling inventory and / or collecting

receivables.



49

Liquidity Ratios

Defensive Interval Ratio=Ca s h+Short term Marketable Securities+A / RDaily Cash Expenditures


Defensive Interval Ratio is similar to the “burn rate” metric: DIR measures how long (i.e. number of days) a company can pay its daily cash expenditures

using only the existing liquid assets, without any additional cash inflow. If DIR is low compared to benchmarks, then determine if there are other sources of cash flow.

To estimate cash expenditures: EXCLUDE TAXES

+ Cost of Goods Sold

+ Selling, General, and Administrative expense

+ R&D expense

−Non-cash expense: depreciation, amortization, etc.

= Estimated TOTAL cash expenditure

÷ Number of days in the period

= Estimated DAILY cash expenditure



50

Liquidity Ratios: Example



DELL, INC. for fiscal year ended:

January 28, 2005

January 30, 2004

January 31, 2003

+ Days to collect A/R 32 31 28

+ Days to sell inventory 4 3 3

− Days to pay A/P (73) (70) (68)

= Cash conversion cycle (37) (36) (37)

Comparative data for Cash Conversion Cycle, for fiscal

year ended: 2004 2003 2002

HP Compaq 27 37 61

Gateway (7) (9) (3)

Apple (40) (41) (40)


For Dell, Inc.: What does the minimal Days to Sell Inventory say about the company’s business model

and inventory system? Dell’s balance sheet indicates Cash and Short-term Investments of $10 billion. When

compared with the Days to Pay A/P, what can you say about the company’s REAL ability (and strategy) of paying suppliers?

What does a negative Cash Conversion Cycle imply?

How would you compare Dell’s liquidty vis-à-vis its peers?

51

Solvency RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Debt Asset Ratio Total Debt ÷ Total Assets The proportion of the assets that is funded by interest-bearing debt

Lower

Debt Capital Ratio

Total Debt ÷ (Total Debt + Total Equity)

The proportion of interest-bearing debt out of all the total long-term

capital sources

Lower

Debt Equity Ratio Total Debt ÷ Total Equity The proportion of interest-bearing debt vs. owners’ investments

Lower

Financial Leverage Ratio

Total Assets ÷ Total Equity

The proportion of liabilities vs. owners’ investments

Lower

Financial Leverage Ratio

Average Total Assets ÷ Average Total Equity

The proportion of liabilities vs. owners’ investments

Lower


Solvency ratios compare the capital structure components in order to measure ability to fulfill long-term obligations: Regular interest payments (see Coverage Ratios) Principal repayment

Understanding how the company uses short-term and long-term debt gives insights into the company’s risk and return profile…i.e. it affects the current and future cost of capital, as well as the ability to tap debt and equity financing sources when needed.



52

Solvency Ratios

Debt Asset Ratio=Total DebtTotal Assets

Debt Equity Ratio=Total DebtTotal Equity

Debt Capital Ratio=Total Debt

Total Debt+Total Equity


Debt acts like a “lever” in growing the company: the owners use lenders’ money to grow the business instead of investing more equity.

Total Debt = Interest-bearing Short-term Debt + Interest-bearing Long-term Debt For analytical purposes, do not include non-interest-bearing short-term debt such as

accounts payable, salary payable, etc…i.e. focus only on interest-bearing debt.

Other possible variants of “Total Debt”: Use interest-bearing and non-interest bearing for both short-term and log-term debt. Use “long-term interest-bearing debt” only.

Inconsistencies in the three ratios are worth analyzing further.



53

Solvency Ratios

Financial Leverage Ratio=Total AssetsTotal Equity


“Leverage” magnifies the effects of using fixed costs (i.e. interest expense). It’s a double-edged sword: Earnings become better. Losses become worse.

Zero debt: Php 1.00 of Equity will buy Php 1.00 of Assets. The use of debt will enable the company to buy more than Php 1.00 of Assets for every Php

1.00 of equity.

Mature companies can operate with a high degree of leverage.

The Financial Leverage Ratio will be used in the Du Pont ROE ratio.

See examples: Excel file Lehman Brothers 2007 Globe Telecom 2011

Financial Leverage Ratio=AverageTotal AssetsAverage Total Equity



54

Coverage RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Earnings Interest Coverage

EBIT ÷ Interest Expense Sufficiency of earnings to meet interest obligations

Higher

Cash Flow Interest Coverage

OCF BIT ÷ Interest Paid Sufficiency of cash flows to meet interest obligations

Higher

Debt Coverage Operating CF ÷ Total Liabilities Financial risk and financial leverage

Higher

Debt Payment Operating CF ÷ Cash paid for long-term debt repayment

Ability to pay debt using Operating CF

Higher

Fixed Charge Coverage

(EBIT + Lease Payments) ÷ (Interest Expense + Lease

Payments)

Sufficiency of earnings to cover fixed payment

obligations

Higher


Coverage ratios measure the sufficiency of earnings or cash flows to cover fixed payment obligations: Keep in mind: Earnings ≠ Cash Flow Coverage ratios can use Income Statement accrual earnings or Statement of Cash Flows

EBIT: Earnings Before Interest Expense and Income Tax

OCF BIT: Operating Cash Flow Before Interest Paid and Income Tax



55

Coverage Ratios

Earnings Interest Coverage=EBIT

Interest Expense

Cash Flow Interest Coverage=OCF BIT

Interest Paid



EBIT: Earnings Before Interest Expense and Income Tax

OCF BIT: Operating Cash Flow Before Interest Paid and Income Tax Operating CF + Interest Paid + Taxes Paid



56

Coverage Ratios

Debt Coverage=Operating CFTotal Liabilities

Debt Payment=Operating CFCash Paid for Long − term Debt Repayment

¿ChargeCoverage=EBIT +Lease Payments

Interest Payments+Lease PaymentsGeneral analytical guidelines:


The Fixed Charge Coverage Ratio can be used as an indication of the quality of Preferred Stock cash dividend: The higher the FCC, the more assurance that the P/S cash dividend will be paid.

See other examples: Lehman Brothers 2007 SMB SEC Form 17A 2012



57

Profitability RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Gross Profit Margin (GPM)

Gross Profit ÷ Sales Profitability before deducting any expenses

Higher

Operating Profit Margin (OPM)

Operating Income ÷ Sales Recurring profitability before interest expense and tax

Higher

Pre-tax Margin (PTM)

Earnings Before Tax ÷ Sales Recurring profitability before tax

Higher

Net Profit Margin (NPM)

Net Income ÷ Sales Profitability after deducting all expenses

Higher

Operating Cost Ratio

Marketing & Admin Expenses ÷ Sales

Ability to control costs Lower

RETURN ON SALES


58


GPM indicates the percentage of revenue available to cover all types of expenditures: Gross Profit is affected by a combination of product pricing and product costing. The ability to charge a higher selling price is affected by the degree of competition and

competitive advantage. Assess the extent to which product costing is affected by external factors beyond the

company’s control.

GOOD: If OPM increases faster than GPM, then it indicates improvements in controlling operating expenses. However, watch out for artificial increases in OPM brought about by deliberate cost-cutting

measures. Cutting costs in order to increase reported margins is not sustainable.

EBIT is the common proxy for Operating Income: Make sure that non-operating items (such as dividend income; gains or losses on investment

securities; etc.) are not included in EBIT.

Profitability Ratios

Operating Profit Margin=Operating Income

Sales

GrossProfit Margin=GrossProfit

Sales

OperatingCost Ratio=Marketing∧Administrative exp

Sales

RETURN ON SALES



59


Net Profit Margin=Net Income

Sales

Pretax Margin=Earnings BeforeTax

Sales


Assess whether Pre-tax Margin is due to operating or non-operating items: EBT: use Earnings Before Tax After Interest Expense EBT includes the effects of non-operating items, such as dividend income, gains or losses

from investment securities, etc.

NPM considers all types of recurring and non-recurring revenues and expenses: If there are significant non-recurring items, then it might be better to use “net income

adjusted for non-recurring items” in assessing the sustainability

RETURN ON SALES



60


Operating Return on Assets (OROA)

Operating Income ÷ Average Total Assets

Profitability of total assets Higher

Return on Assets (ROA)

Net Income ÷ Average Total Assets

Profitability of total assets Higher

Return on Total Capital (ROTC)

EBIT ÷ (Average Total Interest-bearing Debt + Average Total

Equity)

Profitability of capital deployed

Higher

Return on Equity (ROE)

Net Income ÷ Average Total Equity

Profitability of the owners’ investments

Higher

Return on Common Equity

(ROCE)

(Net Income − Preferred Stock Dividend) ÷ Average Common

Equity


Higher

RETURN ON INVESTMENT


61


Income Statement The Recipient Is:

EBIT

Earnings Before Interest Expense and Tax

Lender, Government, and Equity Owner

− Interest expense Lender

= EBT Earnings Before Tax Government and Equity Owner

− Income Tax Government

= EAT Net Income Residual Equity Owner

Operating Return on Assets=Operating IncomeAverage Total Assets

Return on Assets=Net Income

AverageTotal Assets

Accounting

Equation

The Recipient Is:

Liabilities

Lender & Government

+ Equity Residual Equity Owner

= Assets Everyone


The common proxy for Operating Income is EBIT.



62


Return on Common Equity=Net Income−P / S DividendsAve rage Common Equity

Return on Equity=Net Income

Average Total Equity

ROTC=EBIT

AverageTotal Interest Bearing Debt+Average Total Equity



ROTC measures the operating profit generated by all sources of capital: Short-term interest-bearing debt Long-term interest-bearing debt Equity: common stock, preferred stock, retained earnings, minority equity, etc.

ROE measures the profits generated by equity capital (common stock, preferred stock, retained earnings, minority equity, etc.)

ROCE focuses on Common Stock by removing the effects of Preferred Stock in the numerator and denominator: Numerator: Total net income less Preferred Stock cash dividends Denominator: Total SHE less Preferred Stock (par value and APIC)



63


Du Pont ROE: 3-level breakdown

Net Profit Margin x Total Asset Turnover x Financial Leverage Ratio


Higher

Du Pont ROE: 5-level breakdown

Tax Retention Rate x Interest Burden x Operating Profit Margin x Total

Asset Turnover x Financial Leverage Ratio


Higher



Decomposing the ROE can reveal the drivers of ROE.

The Du Pont ROE decomposition is actually a combination of several familiar ratios that measure efficiency, operating profitability, taxes, and financial leverage.

The decomposed ROE can be used by management to assess which areas of the business need improvement in order to improve overall ROE.

Ideal for Manufacturing or Retail Companies



64

Du Pont ROE

Net income Net income Sales AssetsROE

Equity Sales Assets Equity

Profitability

= =

x x

/ Efficiency Leverage

Cost Control

Net income Net income EBT EBIT Sales AssetsROE

Equity EBT EBIT Sales Assets Equity

x x x x= =

Tax Retention Interest Operating Efficiency Leverage

Rate Burden Profit Margin

3-Level

5-Level

If Leverage is zero, then ROE

= ROA

Alternatives:- Average Total

Assets- Average Total

Equity


65

Du Pont ROE

Net income Net income Sales AssetsROE

Equity Sales Assets Equity

Profitability

= =

x x

/ Efficiency Leverage

Cost Control

Net income Net income EBT EBIT Sales AssetsROE

Equity EBT EBIT Sales Assets Equity

x x x x= =

Tax Retention Interest Operating Efficiency Leverage

Rate Burden Profit Margin

3-Level

5-Level

If Leverage is zero, then ROE

= ROA

Alternatives:- Average Total

Assets- Average Total

Equity

See Excel for example


66

Du Pont ROE: Goldman Sachs

ROE=[ (OPM ∗TATO )−BorrowingCost ]∗ [ (Financial Leverage )∗ (1−tax rate ) ]

ROE=[( EBITSales )∗( SalesTotal Assets )−( Interest ExpenseTotal Assets )]∗[( Total AssetsBook Equity )∗ (1−tax rate )]


OPM: Operating Profit Margin using EBIT

TATO: Total Asset Turnover

Borrowing Cost: Interest Expense ÷ Total Assets This is a measure of financial stress (though not a commonly used version).

Financial Leverage: If the ratio is high, then liabilities are high.

Tax: This captures the effective tax rate.

ROE=[( EBIT − Interest ExpenseTotal Assets )]∗[( Total AssetsBook Equity )∗ (1−tax rate )]


67

Cash Flow RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Cash Flow to Revenue

Operating CF ÷ Revenue Quality of earnings: cash generated per Peso of

revenue

Higher

Cash ROA Operating CF ÷ Average Total Assets Cash generated from all assets

Higher

Cash ROE Operating CF ÷ Average Total Equity Cash generated from owners’ investments

Higher

Cash to Income

Operating CF ÷ Operating Income from Income Statement

Quality of earnings: cash generating ability of

operations

Higher

Cash Flow Per Share

(Operating CF − Preferred Stock Dividends) ÷ Weighted Average

Number of C/S Outstanding

Operating CF on a per share basis

Higher

PERFORMANCE RATIOS


68

Cash Flow Ratios

CF to Revenue=Operating CFNet Revenue

Cash ROA=Operating CFAverage Total Assets

Cash ROE=Operating CFAverage SHE

Cash to Income=Operating CFOperating Income in Income Statement

C ash Flow Per Share=OperatingCF−P/ S Dividends

Weighted AverageNumber of C / SOutstanding


69

Cash Flow RatiosRATIO CALCULATION WHAT IT MEASURES BETTER IF

Debt Coverage Operating CF ÷ Total Debt Financial risk and financial leverage

Higher

Cash Flow Interest

Coverage

OCF BIT ÷ Interest Paid Sufficiency of cash flows to meet interest obligations

Higher

Reinvestment Operating CF ÷ Cash paid for long-term assets

Ability to acquire assets using Operating CF

Higher

Debt Payment Operating CF ÷ Cash paid for long-term debt repayment

Ability to pay debt using Operating CF

Higher

Cash Dividend Payment

Operating CF ÷ Cash paid for dividends

Ability to pay cash dividends using Operating CF

Higher

Investing and Financing

Operating CF ÷ (Investing Cash Outflow + Financing Cash Outflow)

Ability to acquire assets, pay debts, and make

distributions to owners

Higher

COVERAGE RATIOS


OCF BIT: Operating Cash Flow Before Interest Paid and Income Tax Operating CF + Interest Paid + Taxes Paid



70

Cash Flow Ratios

Reinvestment=Operating CFCash Paid for Long − term Assets

Cash Flow Interest Coverage=OCF BIT

Interest Paid

Debt Coverage=Operating CFTotal Liabilities


71

Cash Flow Ratios

Cash Dividend Payment=Operating CFCash Dividends Paid

Investing and Financing=Operating CFInvesting Cash Out+Financing Cash Out

Debt Payment=Operating CFCash Paid for Long − term Debt Repayment


1 © 2013 . Used by investors, creditors, management, and regulators to assess a firm’s financial...

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Transcript of 1 © 2013 . Used by investors, creditors, management, and regulators to assess a firm’s financial...