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Financial Statement Analysis

Income statement
Balance sheet
Statement of cash flows
Free cash flow
Performance measures
Financial ratio analysis

Financial Statements

Determinants of Intrinsic Value: Calculating FCF


Sales revenues

Operating costs and taxes

Required investments in operating capital

Free cash flow


(FCF)

Value =

FCF1
FCF2
FCF
+
+ ... +
(1 + WACC)1
(1 + WACC)2
(1 + WACC)
Weighted average
cost of capital
(WACC)

Market interest rates

Cost of debt

Firms debt/equity mix

Market risk aversion

Cost of equity

Firms business risk


3

Income Statement
2015

2016

Sales

$3,432,000

$5,834,400

COGS

2,864,000

4,980,000

340,000

720,000

18,900

116,960

3,222,900

5,816,960

209,100

17,440

62,500

176,000

146,600

(158,560)

58,640

(63,424)

87,960

($ 95,136)

Other expenses
Deprec.
Tot. op. costs
EBIT
Int. expense
Pre-tax earnings
Taxes (40%)
Net income

What happened to sales and net income


in 2016?
Sales increased by over $2.4 million.
Costs shot up by more than sales.
Net income was negative.
However, the firm received a tax refund since it
paid taxes of more than $63,424 during the past
two years.

Balance Sheet: Assets


Cash
S-T invest.
AR
Inventories
Total CA
Gross FA
Less: Depr.
Net FA
Total assets

2015
9,000
48,600
351,200
715,200
1,124,000
491,000
146,200
344,800
$1,468,800

2016
7,282
20,000

632,160
1,287,360
1,946,802
1,202,950
263,160
939,790
$2,886,592
6

Effect of Expansion on Assets


Net fixed assets almost tripled in size.
AR and inventory almost doubled.
Cash and short-term investments fell.

Balance Sheet: Liabilities & Equity


Accts. payable
Notes payable

2015
$ 145,600
200,000

2016
$ 324,000
720,000

Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E

136,000
481,600
323,432
460,000
203,768
663,768
$1,468,800

284,960
1,328,960
1,000,000
460,000
97,632
557,632
$2,886,592
8

What effect did the expansion have on


liabilities & equity?
CL increased as creditors and suppliers
financed part of the expansion.
Long-term debt increased to help finance the
expansion.
The company didnt issue any stock.
Retained earnings fell, due to the years
negative net income and dividend payment.

Past-year Exam Question:


Balance Sheet
On its 31 December 2015 balance sheet, Barnes & Co. showed
$510 million of retained earnings, and exactly that same amount
was shown the following year. Assuming that no earnings
restatements were issued, which of the following statements is
CORRECT?
a. If the company lost money in 2015, it must have paid dividends.
b. The company must have had zero net income in 2015.
c. The company must have paid out half of its 2015 earnings as
dividends.
d. The company must have paid no dividends in 2015.
e. Dividends could have been paid in 2015, but they would have
had to equal the earnings for the year.
10

Stock Price and Other Data


2015

2016

Stock price

$8.50

$6.00

# of shares

100,000

100,000

EPS

$0.88

-$0.95

DPS

$0.22

$0.11

11

Statement of Cash Flows: 2016


Operating Activities
Net Income

($ 95,136)

Adjustments:
Depreciation
Change in AR
Change in inventories
Change in AP
Change in accruals
Net cash provided (used) by ops.

116,960
(280,960)
(572,160)
178,400
148,960
($503,936)
12

Statement of Cash Flows: 2016

Investing Activities
Cash used to acquire FA
Change in S-T invest.
Net cash prov. (used) by inv. act.

($711,950)
28,600
($683,350)

13

Statement of Cash Flows: 2016


Financing Activities
Change in notes payable
$ 520,000
Change in long-term debt
676,568
Payment of cash dividends
(11,000)
Net cash provided (used) by fin. act. $1,185,568

14

Summary of Statement of CF
Net cash provided (used) by ops.

($ 503,936)

Net cash provided (used) by inv. act.

(683,350)

Net cash prov. (used) by fin. act.

1,185,568

Net change in cash

(1,718)

Cash at beginning of year


Cash at end of year

9,000
$

7,282

15

What can you conclude from the


statement of cash flows?
Net CF from operations = -$503,936,
because of negative net income and
increases in working capital.
The firm spent $711,950 on FA.
The firm borrowed heavily and sold some
short-term investments to meet its cash
requirements.
Even after borrowing, the cash account fell by
$1,718.

16

What is free cash flow (FCF)?


Why is it important?
FCF is the amount of cash available from
operations for distribution to all investors
(including stockholders and debtholders) after
making the necessary investments to support
operations.
A companys value depends on the amount of
FCF it can generate.

17

What are the uses of FCF?


1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies,
etc.)

18

Calculating Free Cash Flow in 5 Easy Steps


Step 1

Step 2

Earning before interest and taxes

Operating current assets

X (1 Tax rate)

Operating current liabilities

Net operating profit after taxes

Net operating working capital


Step 3

Net operating working capital

Operating long-term assets


Total net operating capital

Step 5

Net operating profit after taxes


Net investment in operating capital

Free cash flow

Step 4

Total net operating capital this year


Total net operating capital last year
Net investment in operating capital

19

Net Operating Profit after Taxes (NOPAT)

NOPAT = EBIT(1 - Tax rate)


NOPAT16

= $17,440(1 - 0.4)
= $10,464.

NOPAT15

= $125,460.

20

What are operating current assets?


Operating current assets are the CA needed to
support operations.
Op CA include: cash, inventory, receivables.
Op CA exclude: short-term investments, because
these are not a part of operations.

21

What are operating current liabilities?


Operating current liabilities are the CL resulting
as a normal part of operations.
Op CL include: accounts payable and accruals.
Op CL exclude: notes payable, because this is a
source of financing, not a part of operations.

22

Net Operating Working Capital (NOWC)

NOWC
NOWC16

NOWC15

Operating
CA

Operating
CL

= ($7,282 + $632,160 + $1,287,360)


- ($324,000 + $284,960)
= $1,317,842.
= $793,800.

23

Total net operating capital (also called


operating capital)
Operating Capital= NOWC + Net fixed assets.
Operating Capital in 2016
= $1,317,842 + $939,790
= $2,257,632.
Operating Capital in 2015 = $1,138,600.

24

Free Cash Flow (FCF) for 2016


FCF = NOPAT - Net investment in
operating capital
= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032
= -$1,108,568.
How do you suppose investors reacted?

25

Uses of FCF
After-tax interest payment =

$105,600

Reduction/increase in debt =

$1,196,568

Payment of dividends =

$11,000

Repurchase/Issue stock =

$0

Purchase/Sale of ST investments
=
Total uses of FCF =

$28,600
$1,108,568

26

Past-year Exam Question:


Free Cash Flow
Vasudevan Co. recently reported operating income of
$2.75 million, depreciation of $1.20 million, and had a tax
rate of 40%. The firm's expenditures on fixed assets and
net operating working capital totaled $0.6 million. How
much was its free cash flow, in millions?
a.
$1.93
b.
$2.03
EBIT(1-T) + Depreciation
c.
$2.14
[Cap Expense and Change in
NOWC]
d.
$2.25
2.75(1-0.4) +1.2 - (0.6)
e.
$2.36

27

Return on Invested Capital (ROIC)


ROIC = NOPAT / operating capital
ROIC16 = $10,464 / $2,257,632 = 0.5%.
ROIC15 = 11.0%.

28

If the firms cost of capital is 10%, did the


growth add value?
No. The ROIC of 0.5% is less than the WACC
of 10%. Investors did not get the return they
require.
Note: High growth usually causes negative FCF
(due to investment in capital), but thats ok if
ROIC > WACC. For example, in 2008
Qualcomm had high growth, negative FCF, but a
high ROIC.

29

Economic Value Added (EVA)


WACC is weighted average cost of capital
EVA = NOPAT- (WACC)(Capital)

30

Economic Value Added


(WACC = 10% for both years)
EVA

= NOPAT- (WACC)(Capital)

EVA16 = $10,464 - (0.1)($2,257,632)


= $10,464 - $225,763
= -$215,299.
EVA15 = $125,460 - (0.10)($1,138,600)
= $125,460 - $113,860
= $11,600.

31

Market Value Added (MVA)


MVA = Market Value of the Firm - Book Value of
the Firm
Market Value = (# shares of stock) x (price per
share) + Value of debt
Book Value = Total common equity + Value of
debt

32

MVA (Continued)
If the market value of debt is close to the book
value of debt, then MVA is:

MVA = Market value of equity book value of


equity

33

2016 MVA (Assume market value of debt


= book value of debt)
Market Value of Equity 2016:
(100,000)($6.00) = $600,000.

Book Value of Equity 2016:


$557,632.

MVA16 = $600,000 - $557,632 = $42,368.


MVA15 = $850,000 - $663,768 = $186,232.

34

Performance Measures and Financial


Ratio Analysis
Categories of financial ratios
DuPont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors

35

Why Financial Ratios?


Ratios facilitate comparison of:
One company over time
One company versus other companies

Ratios are used by:


Lenders to determine creditworthiness
Stockholders to estimate future cash flows and risk
Managers to identify areas of weakness and strength

36

Income Statement
2016

2017E

Sales

$5,834,400

$7,035,600

COGS

4,980,000

5,800,000

Other expenses

720,000

612,960

Deprec.

116,960

120,000

5,816,960

6,532,960

17,440

502,640

176,000

80,000

(158,560)

422,640

(63,424)

169,056

($ 95,136)

$ 253,584

Tot. op. costs

EBIT
Int. expense
EBT
Taxes (40%)

Net income

37

Balance Sheets: Assets


2016

Cash
S-T invest.

7,282

2017E

14,000

20,000

71,632

632,160

878,000

Inventories

1,287,360

1,716,480

Total CA

1,946,802

2,680,112

939,790

836,840

$2,886,592

$3,516,952

AR

Net FA

Total assets

38

Balance Sheets: Liabilities & Equity


Accts. payable
Notes payable
Accruals
Total CL

2016
$ 324,000
720,000
284,960
1,328,960

2017E
$ 359,800
300,000
380,000
1,039,800

Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E

1,000,000
460,000
97,632
557,632
$2,886,592

500,000
1,680,936
296,216
1,977,152
$3,516,952
39

Other Data
2016

2017E

Stock price

$6.00

$12.17

# of shares

100,000

250,000

-$0.95

$1.01

$0.11
$5.58

$0.22
$7.91

$40,000
0.4

$40,000
0.4

EPS
DPS
Book val. per share
Lease payments
Tax rate

40

Classes of Financial Ratios


1.
2.
3.

4.
5.

Liquidity
Asset Management
Debt Management
Profitability
Market Value

41

Liquidity Ratios
Can the company meet its short-term obligations
using the resources it currently has on hand?

42

Forecasted Current and Quick Ratios for


2017
CR17 =

QR17 =
=

CA
CL

$2,680
$1,040 = 2.58

CA - Inv
CL
$2,680 - $1,716
$1,040

= 0.93

43

Comments on CR and QR

2017E

2016

2015

Ind.

CR

2.58

1.46

2.3

2.7

QR

0.93

0.5

0.8

1.0

Expected to improve but still below the


industry average.
Liquidity position is weak.

44

Past-year Exam Question:


Current Ratio
Amram Companys current ratio is 2.0. Considered alone,
which of the following actions would lower the current ratio?
a. Borrow using short-term notes payable and use the
proceeds to reduce accruals. both are payables, substitution of payables
b. Borrow using short-term notes payable and use the
proceeds to reduce long-term debt. long-term debt is not in the equation
c. Use cash to reduce accruals.
d. Use cash to reduce short-term notes payable.
e. Use cash to reduce accounts payable.
all 3 will increase CA and decrease CL

45

Asset Management Ratios


How efficiently does the firm use its assets?
How much does the firm have tied up in assets
for each dollar of sales?

46

Inventory Turnover Ratio vs. Industry


Average
Inv. Turnover =
=

Inv. T.

COGS
Inventories
$5,800 = 3.38
$1,716

2017E

2016

2015

Ind.

3.38

4.0

4.0

6.1

47

Comments on Inventory Turnover


Inventory turnover is below industry average.
Firm might have old inventory, or its control
might be poor.
No improvement is currently forecasted.

48

DSO: Days Sales Outstanding

DSO =

Receivables
Average sales per day

= Receivables =
Sales/365
= 45.5 days

$878
$7,036/365

Measures average number of days from sale


until cash received.
Also known as Average Collection Period.
49

Appraisal of DSO
Firm collects too slowly, and situation is getting
worse.
Poor credit policy.

DSO

2017E
45.5

2016
39.5

2015
37.4

Ind.
32.0

50

Fixed Assets and Total Assets


Turnover Ratios
Fixed assets
turnover

=
=

Total assets
turnover

Sales
Net fixed assets

$7,036
$837

= 8.41

Sales
Total assets

= $7,036 = 2.00
$3,517
51

Fixed Assets and Total Assets


Turnover Ratios
FA turnover is expected to exceed industry average.
Good.
TA turnover not up to industry average. Caused by
excessive current assets (A/R and inventory).

2017E

2016

2015

Ind.

FA TO

8.4

6.2

10.0

7.0

TA TO

2.0

2.0

2.3

2.5
52

Debt Management Ratios


Does the company have too much debt?
Can the companys earnings meet its debt
servicing requirements?

53

Leverage Ratios: Debt Ratio

Debt ratio

=
=

Total debt
Total assets
$300 + $500 = 22.7%
$3,517

54

Leverage Ratios:
Liabilities-to-Assets Ratio

Liabilities/TA ratio =
=
=

Total liabilities
Total assets
$1,039.8 + $500
$3,517
43.8%.

55

Times Interest Earned (Coverage) Ratio

EBIT
Int. expense
= $502.6 = 6.3x
$80

TIE =

56

Debt Management Ratios vs. Industry


Averages

D/TA
TL/TA
TIE

2017E 2016
2015
Ind.
22.7% 59.6% 35.6% 32.0%
43.8% 80.7% 54.8% 50.0%
6.3
0.1
3.3
6.2

Debt situation is expected to improve.

57

Past-year Exam Question:


Financial Ratios
If a bank loan officer were considering a companys loan request, which
of the following statements would you consider to be CORRECT?
a. The lower the companys inventory turnover ratio, other things held
constant, the lower the interest rate the bank would charge the firm.
b. Other things held constant, the higher the days sales outstanding
ratio, the lower the interest rate the bank would charge.
c. Other things held constant, the lower the debt ratio, the lower the
interest rate the bank would charge.
d. The lower the companys TIE ratio, other things held constant, the
lower the interest rate the bank would charge.
e. Other things held constant, the lower the current ratio, the lower the
interest rate the bank would charge the firm.

58

Profitability Ratios
What is the companys rate of return on:
Sales?
Assets?

59

Profit Margins

Net profit margin (PM):


PM =

NI
Sales

$253.6
= $7,036 = 3.6%

Operating profit margin (OM):


OM =

EBIT
Sales

$503
= $7,036 = 7.1%

60

Profit Margins (Continued)

Gross profit margin (GPM):


GPM =

Sales COGS
Sales

$1,236
GPM = $7,036

$7,036 $5,800
$7,036

= 17.6%

61

Profit Margins vs. Industry Averages

PM
OPM
GPM

2017E 2016
2015
Ind.
3.6% -1.6% 2.6%
3.6%
7.1
0.3
6.1
7.1
17.6
14.6
16.6
15.5

Very bad in 2016, but projected to


meet or exceed industry average in 2017.

62

Basic Earning Power (BEP)

BEP =

EBIT
Total assets

= $502.6
$3,517

= 14.3%

63

Basic Earning Power vs. Industry


Average
BEP removes effect of taxes and financial
leverage. Useful for comparison.
Projected to be below average.
Room for improvement.

BEP

2017E
14.3%

2016
0.6%

2015
Ind.
14.2% 17.8%

64

Return on Assets (ROA)


and Return on Equity (ROE)

ROA =

NI
Total assets

= $253.6 = 7.2%
$3,517

65

Return on Assets (ROA)


and Return on Equity (ROE)

NI
ROE = Common Equity
= $253.6 = 12.8%
$1,977

66

ROA and ROE vs. Industry Averages

ROA
ROE

2017E
7.2%
12.8%

2016
2015
Ind.
-3.3% 6.0%
9.0%
-17.1% 13.3% 18.0%

Both below average but improving.

67

Effects of Debt on ROA and ROE


ROA is lowered by debt--interest expense
lowers net income, which also lowers ROA.
However, the use of debt lowers equity, and if
equity is lowered more than net income, ROE
would increase.

68

Market-Based Ratios
Calculate and appraise the P/E and M/B ratios
Price = $12.17

EPS =

NI
Shares out.

P/E =

Price per share


EPS

$253.6
250 = $1.01
= $12.17 = 12
$1.01

69

Market-Based Ratios
Common equity
BVPS = Shares outstanding
$1,977
= 250 = $7.91
Mkt price per share
M/B = Book value per share
$12.17
= $7.91 = 1.54

70

Interpreting Market Based Ratios


P/E: How much investors will pay for $1 of
earnings. Higher is better.
M/B: How much paid for $1 of book value.
Higher is better.
P/E and M/B are high if ROE is high, risk is low.

71

Comparison with Industry Averages

P/E
M/B

2017E
12.0
1.5

2016
-6.3
1.1

2015
9.7
1.3

Ind.
14.2
2.9

72

The DuPont System of Analysis


The DuPont system focuses on:
Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)

It shows how these factors combine to


determine the ROE.

73

The DuPont System

Profit
TA
Equity
( margin
)(turnover
)( multiplier
) = ROE
NI
Sales

Sales
TA

TA
CE

= ROE

74

The DuPont System


NI
Sales

Sales
TA

2015:
2016:
2017:
Ind.:

2.6%
-1.6%
3.6%
3.6%

x
x
x
x

x
2.3
2.0
2.0
2.5

x
x
x
x

TA
CE

= ROE

2.2
5.2
1.8
2.0

= 13.2%
= -16.6%
= 13.0%
= 18.0%

75

Past-year Exam Question:


Leverage Effects
Which of the following statements is CORRECT?
a. The use of debt financing will tend to lower the basic earning power
ratio, other things held constant.
b. A firm that employs financial leverage will have a higher equity
multiplier than an otherwise identical firm that has no debt in its capital
structure.
c. If two firms have identical sales, interest rates paid, operating costs,
and assets, but differ in the way they are financed, the firm with less
debt will generally have the higher expected ROE.
d. The numerator used in the TIE ratio is earnings before taxes (EBT).
EBT is used because interest is paid with post-tax dollars, so the firm's
ability to pay current interest is affected by taxes.
e. All else equal, increasing the debt ratio will increase the ROA.
76

Potential Problems and Limitations of


Ratio Analysis
Comparison with industry averages is difficult if
the firm operates many different divisions.
Seasonal factors can distort ratios.
Window dressing techniques can make
statements and ratios look better.
Different accounting and operating practices can
distort comparisons.

77

Questions and Answers

78

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