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Chapter 2: Financial Analysis Financial Analysis: Financial Analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account. Users of Financial Analysis: Financial Analysis can be undertaken by • Management of the firm • Parties outside the firm, viz. owners, creditors, investors and others. # Nature of analysis will differ depending on the purpose of the analyst. Ratio Analysis • Ratio analysis is a powerful tool of financial analysis. A Ratio is defined as “the indicated quotient of two mathematical expressions” and as “the relationship between the two things. • In financial analysis, a ratio is used as an index for evaluating the financial position and performance of a firm. • The relationship between two accounting figures, which is expressed mathematically, is known as financial ratio. Standards of Comparison A single ratio in itself does not indicate favorable or unfavorable condition. It should be compared with some standard. Standards of comparison may consist of • Ratios calculated from the past financial statements of the same firm; • Ratios developed using the projected, or pro forma, financial statements of the same firms; • Ratios of some selected firms, especially the most progressive and successful, at the same point in time, and • Ratios of the industry to which the firm belongs. Types of Ratios 1. Liquidity Ratios: Liquidity ratios measure the firm’s ability to meet current obligation. 2. Leverage Ratios: Leverage ratios show the proportions of debt and equity in financing the firm’s assets. 3. Activity Ratios: Activity ratios reflect the firm’s efficiency in utilizing its assets. 4. Profitability Ratios: Profitability ratios measure the overall performance and effectiveness of the firm. 5. Market Value Ratio: A set of ratios that relate the firm’s stocks price to its earnings and book value per share. These ratios give management an indication of what investors think of the company’s past performance and future prospects.

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1. Liquidity Ratios Current Assets (a) Current Ratio = ---------------------Current Liabilities • Current Assets include cash and those assets which can be converted into cash within a year, such as marketable securities, debtors(= accounts receivables) and inventories, prepaid expenses etc. • Current Liabilities include creditors(= accounts payables), bills payable, accrued expenses, short term bank loan, income tax liability and long term debt maturing in the current year. • Current ratio indicates the availability of current assets in taka for every one taka of current liability. A ratio of greater than one means that the firm has more current assets than current claims against them. • higher current ratio → greater ability to cover short-term debt obligations • current ratio “too high” → the firm may be "wasting" money by holding too much cash, etc. That money could conceivably be invested to earn a higher rate of return.

(b) Quick Ratio =

Current Assets -- Inventories ---------------------------------Current Liabilities – higher quick ratio → the greater is the ability to cover short-term debt obligations without selling off inventory. – As before, if the quick ratio is too high, the firm may be wasting money.

Cash + Marketable Securities -----------------------------------Current Liabilities • Actual capacity to payoff its most upcoming liabilities 2. Leverage Ratios Total Debt (a) Debt to Total Assets = -----------------Total Assets – example: $100 initial investment in a project that pays off $120, all equity firm • return to shareholders is 20% – example: same, but 50% debt (at 6% interest), 50% equity firm: • $50 × 1.06 = $53 goes to debtholders • $67 to shareholders ⇒ ($67-$50) / $50 = 34% return to shareholders – Other benefits of higher debt (c) Cash Ratio =

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–

• greater control (less shares outstanding) • interest tax deduction Drawbacks of higher debt • greater risk of bankruptcy • must appease debtholders

Income before Interest and Taxes (b) Time Interest Earned = -----------------------------------------Interest •

Time Interest Earned indicates the number of times that income before interest and taxes covers the interest obligation. • higher times-interest-earned ratio → the higher the profits beyond what is necessary to pay debtholders. o BUT… a firm with too little debt may have a high TIE → we must be cautious in interpreting the ratio.

Income before Fixed Charges and Taxes (c) Fixed Charge Coverage = --------------------------------------------------Fixed Charges •

Fixed Charge Coverage measures the firm’s ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.

3. Activity Ratios Cost of goods sold (a) Inventory Turnover = -----------------------Inventory •

This ratio indicates the efficiency of the firm in selling its product. • higher asset turnover → more effective use of inventory. • We often also specify the inventory turnover in days ≡ inventory / (COGS/n), where n is the number of days in the reporting period.

Credit Sales (b) Receivable Turnover = ----------------Receivables • The receivables turnover indicates the number of times on the average that receivables turnover each year.

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Accounts Receivable (c) Average Collection Period = ----------------------------------Average Daily Credit Sales 360 = ----------------------------Receivable Turnover – higher collection period → lower “quality” of sales – Note that we often do not have “credit sales,” so we proxy by using actual sales Sales (d) Fixed Assets Turnover = --------------------Fixed Assets • Fixed assets turnover shows the firm’s efficiency of utilizing fixed assets. • higher fixed asset turnover → more effective use of fixed assets. Sales (e) Total Assets Turnover = ----------------Total Assets – higher asset turnover → more effective use of assets. – BUT…may imply that the company has old assets. 4. Profitability Ratios Gross Profit (a) Gross Profit Margin = --------------------Sales Sales – Cost Of Goods Sold = ---------------------------------Sales • The gross profit margin reflects the efficiency with which management produces each unit of product. This ratio indicates the average spread between the cost of goods sold and the sales revenue. • higher gross margin → efficient control of costs or efficient generation of sales Net Income (b) Net Profit Margin = ---------------------Sales •

Net profit margin ratio establishes a relationship between net profit and sales and indicates management’s efficiency in manufacturing, administering and selling the products. • higher net profit margin → higher fraction of revenues kept as profits.

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Net Income (c) Return on Assets = ------------------Total Assets Net Income (d) Return on Equity = -----------------------Shareholder’s Equity – higher ROE → more profitable use of firm equity. – Of course a profitable firm with a lot of debt will tend to have a high ROE (since equity is low). So, we must be cautious in interpreting the ratio. 6. Market Value Ratios i. price to earnings ≡ market share price / earnings per share 1. higher P/E ratio → better market opinion of the future prospects of the firm. a. BUT…P/Es for firm’s with extremely low earnings can be misleading. b. One rule of thumb is to ignore P/E when the profit margin is less than some arbitrary value (4% perhaps?) c. Mathematically, it is more reasonable to look at E/P. ii. market to book ≡ market value of equity / book value of equity 1. higher market to book ratio → better market opinion of the current state of the firm. a. BUT…M/B may be high if assets are old. 2. M/B < 1 is a special case. Why? a. Two main explanations: b. 1. Book value of assets (and hence book value of equity) is misleading c. 2. The company has a high risk of bankruptcy The Du Pont Identity Net Income Sales Assets ROE = --------------- X ------------- X ------------Sales Assets Equity = Net Profit margin X Total Assets Turnover X Equity Multiplier The Du Pont Identity tells us that ROE is affected by three things • Operating Efficiency (as measured by profit margin) • Asset use efficiency (as measured by total assets turnover) • Financial Leverage (as measured by the equity multiplier)

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Utility of Ratio Analysis • Many diverse groups of people use ratios to determine the financial characteristics of the firm in which they are interested. With the help of ratios one can determine:  the ability of the firm to meet its current obligation;  the extend to which the firm has used its long-term solvency by borrowing funds;  the efficiency with which the firm is utilizing its various assets in generating sales revenue, and  the overall operating efficiency and performance of the firm. • In credit analysis, the analyst will usually select a few important ratios. He may use the current ratio or quick ratio to judge the firm’s liquidity or debt paying ability; debt ratio to determine the stake of the owners in the business and the firm’s capacity to survive in the long-run and any one of the profitability ratios, for example return on assets, to determine the firm’s earnings prospects. • The ratio analysis is also useful in security analysis. The major focus in security analysis is on the long-term profitability. Profitability is dependent on a number of factors and, therefore, the security analyst also analyses other ratios. Cautions In Using Ratio Analysis • It is difficult to decide on the proper basis of comparison. • The comparison is rendered difficult because of differences in situations of two companies or of one company over years. • The price level changes make the interpretations of ratios invalid. • The differences in the definitions of items in the balance sheet and the profit and loss statement make the interpretation of ratios difficult. • The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. • The ratios are generally calculated from past financial statements and, thus are no indicators of future. . QUESTION: BRIEFLY comment on the difficulties one faces in using financial statements to analysis the health of companies. Answer: Financial statement analysis is difficult because we never have current numbers, the numbers we do have are accounting ones and are backward looking, and financial managers have incentives to create statements that misrepresent the true status of the firm. Furthermore, companies may have different fiscal years, which make it difficult to determine appropriate industry averages. Most importantly, firms are not identical, so finding truly comparable companies may not be possible.

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Problem 1: Backer Oats had an asset turnover of 1.6 times per year. a) If the return on total assets (investment) was 11.2%, what was Backer’s profit margin? b) The following year, on the same level of assets, Baker’s asset turnover declined to 1.4 times and its profit margin was 8 percent. How did the return on total assets change from that of the previous year? (Problem 5 on text) Problem 2: The balance sheet for Stud Clothiers is given below. Sales for the year were $2,40,000, with 90 percent of sales sold on credit. STUD CLOTHIERS Balance Sheet 199X Assets Cash Accounts Receivable

60000 240000

Inventory Plant and Equipment

350000 410000

Total assets

106000 0

Liabilities and Equity Accounts Payable Accrued Taxes Bonds Payable (long term) Common stock Paid in capital Retained earnings Total liabilities and equity

Compute the following rations: a) Current Ratio b) Quick Ratio c) Debt-to-total assets ratio d) Asset turnover e) Average collection period (problem 12 on text) Problem 3 Complete the balance sheet by using following data Debt ratio 50% Quick ratio 0.80 times Total assets turnover 1.5 times Days sales outstanding 36 days Gross profit margin on sales: (Sales –Cost of goods sold)/sales 25% Inventory turnover ratio 5 times Balance Sheet Cash ? Accounts payables Accounts Receivables ? Long term debt Inventories ? Common stocks Fixed Assets ? Retained earnings Total Assets 300000 Total liabilities and equities Sales ? Cost of goods solds

? 60000 ? 97000 ? ?

220000 30000 150000 80000 200000 380000 106000 0

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SOLVED PROBLEM Problem 1: You have been investigating a certain company and have calculated the following ratios for the company and average ratios for that company’s industry. Ratio current ratio quick ratio inventory turnover fixed asset turnover total asset turnover collection period times interest earned debt ratio profit margin return on equity return on assets price to earnings market to book

Company 2.2 1.2 16.8 6.4 2.6 25.1 4.8 10% 6.4% 18.5% 16.7% 17.1 3.8

Industry Average 3.1 2.4 16.5 6.2 2.5 13.4 5.1 10% 6.2% 17.2% 15.5% 16.8 3.4

Analyze the firm from the perspective of both shareholders and debt holders. What problem area is evident (be as specific as possible). Should shareholders be concerned? Should debt holders be concerned? Answer: As always, we begin by examining the factors of the Dupont equation. Notice that the profit margin, total assets turnover, and debt ratio (and hence the equity multiplier) are close to the industry average. This suggests that the firm has no serious problems in terms of expense control, asset management, and debt management. We do notice, however, that the average collection period is unusually high and that the current and quick ratios are unusually low. Since all three ratios deal with current assets, this suggests that the firm may be having trouble managing its current assets. Both the current ratio and quick ratio are low, so it is unlikely that inventory is contributing to the problem. This leaves accounts receivable as the most likely problem. It appears that the firm may be granting too much credit and that this has somehow contributed to the low liquidity ratios. Notice, however, that the P/E ratio, the market-to-book ratio, ROA, and ROE all look fine. We conclude that although the firm may be having some trouble with receivables, the trouble does not appear to have affected the bottom line for the firm. Thus, the firm is not experiencing any major problems and debtholders and shareholders should not be overly concerned.

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Problem 2: You have examined a firm’s financial statements and have calculated the following ratios.

Ratio current ratio quick ratio inventory turnover collection period fixed assets turnover total assets turnover debt ratio times interest earned profit margin return on total assets return on equity price to earnings

Company 2.9 2.2 15 24 4.2 1.6 65% 3.8 5% 10% 23% 14

Industry Average 2.8 2.1 17 22 5.6 2.4 65% 3.4 3% 14% 21% 14

Analyze the ratios from the perspective of shareholders. What problem area is evident? Analyze the ratios from the perspective of debtholders. Will the firm be able to issue additional debt if necessary? Answer: As always, we begin by examining the factors of the DuPont equation. The profit margin and debt ratio look good, but the total assets turnover is low. This suggests that the firm is having trouble effectively managing its assets. The inventory turnover is above average, so the problem is probably not with inventory. The fixed asset turnover is below average, however. This suggests that the problem is with fixed assets. One possible explanation is that the firm is using outdated (inefficient) machinery. Another is that the firm has fixed assets that are not currently being used. The current ratio, the quick ratio, and times-interest-earned are above average. The debt ratio is average. So, there appear to be no problems as far as debtholders are concerned. If the firm needs to issue additional debt in the near future, it should have no problems doing so.