Table 3-1 Allied Food Products

Table 3-1 Allied Food Products

Chapter 4: Analysis of Financial Statements

I.Ratio analysis

A.Analysis of financial statements can be used to predict future earnings and dividends

B.Analysis of financial statements is starting point for planning actions that will improve future performance

C.Ratio analysis: Calculates and interprets financial ratios to analyze firm’s performance

II.The different types of ratios

A.Two liquidity ratios

1.Liquid asset =asset that can be converted to cash quickly without having to reduce asset’s price very much

2.Liquidity ratios: ratios that show the relationship of a firm’s cash and other current assets to its current liabilities

3.Current ratio

a.Indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future

b.Formula:

4.Quick Ratio or Acid Test Ratio

a.Inventories least liquid of firm’s current assets and are assets on which assets most likely to occur in event of liquidation. Firm’s ability to pay-off short-term obligations without relying on sale of inventories is important

b.Formula:

B.Four asset management ratios

1.Asset management ratios = set of ratios that measure how effectively firm manages its assets

2.Inventory turnover ratio

3.Days sales outstanding (DSO) = average collection period = ACP

a.Indicates the average length of time the firm must wait after making a sale before it receives cash

b.Formula:

4.Fixed assets turnover ratio

a.Measures how effectively the firm uses its plant and equipment

b.Formula:

5.Total assets turnover ratio

C.Debt management ratios

1.Total debt to total assets

2.Times-interest-earned (TIE) ratio

a.Measures firm’s ability to meet its annual interest payments

b.Formula

3.EBITDA coverage ratio

a.Ratio whose numerator includes all cash flows available to meet fixed financial charges and whose denominator includes all fixed financial charges

b.Formula:

D.Four profitability ratios

1.Profitability ratios = group of ratios that show combined effects of liquidity, asset management, and debt on operating results

2.Profit margin on sales

3.Return on total assets (ROA)

4.Basic earning power (BEP) ratio

a.Ratio indicates the ability of firm’s assets to generate operating income

b.Formula

5.Return on common equity

a.Measures rate of return on common stockholders’ investment

b.Formula:

6.An important digression: The effect of leverage on ROE

a.The concept of leverage

i.Financial debt = use of debt financing

ii.Three important implications of using debt financing

●By raising funds through debt, stockholders can control a firm with limited amount of equity investment

●The higher the proportion of total capital provided by stockholders, the less risk faced by creditors.

●If firm earns more on its assets than the interest it pays on debt, then using debt “leverages” or magnifies the return on equity (ROE)

b.Example: A leveraged and unleveraged firm

Table 4-1: Effects of Financial Leverage on Stockholder Returns
FIRM U [UNLEVERAGED (NO DEBT)]
Current assets / $50 / Debt / $ 0
Fixed assets / 50 / Common Equity / 100
Total assets / $100 / Total Liabilities & Equity / $100
Business Conditions
Good / Expected / Bad
Sales Revenue / $150.0 / $100.0 / $75.0
Operating costs / Fixed / 45.0 / 45.0 / 45.0
Variable / 60.0 / 40.0 / 30.0
Total operating costs / 105.0 / 85.0 / 75.0
Operating Income (EBIT) / $45.0 / $15.0 / $0.0
Interest (Rate = 10%) / 0.0 / 0.0 / 0.0
Earnings before taxes (EBT) / $45.0 / $15.0 / $0.0
Taxes (rate = 40%) / 18.0 / 6.0 / 0.0
Net income / $27.0 / $9.0 / $0.0
ROE / 27.0% / 9.0% / 0.0%
FIRM L [LEVERAGED (SOME DEBT)]
Current assets / $50 / Debt / $50
Fixed assets / 50 / Common Equity / 50
Total assets / $100 / Total Liabilities & Equity / $100
Business Conditions
Good / Expected / Bad
Sales Revenue / $150.0 / $100.0 / $75.0
Operating costs / Fixed / 45.0 / 45.0 / 45.0
Variable / 60.0 / 40.0 / 30.0
Total operating costs / 105.0 / 85.0 / 75.0
Operating Income (EBIT) / $45.0 / $15.0 / $0.0
Interest (Rate = 10%) / 5.0 / 5.0 / 5.0
Earnings before taxes (EBT) / $40.0 / $10.0 / -$5.0
Taxes (rate = 40%) / 16.0 / 4.0 / 0.0
Net income / $24.0 / $6.0 / -$5.0
ROE / 48.0% / 12.0% / -10.0%

c.Results:

i.Because interest is deductible, use of debt lowers tax bill and leaves more of the firm’s operating income available to investors

ii.Use of debt require firms to balance higher expected returns against increased risk

E.Three market value ratios

1.Set of ratios that relate stock price to its earnings, cash flow and book value per share

2.Price/Earnings Ratio = P/E Ratio

a.Shows the dollar amount investors will pay for $1 of current earnings

b.Formula:

3.Price/cash flow ratio

a.Shows the dollar amount investors will pay for $1 of cash flow

b.Formula:

4.Market/Book Ratio

a.Book value per share:

b.market/book ratio:

III.Book’s example of Allied Food Products

A.Review financial statements developed in Chapter 3: Tables 3 – 1, 3 – 2, 3 – 3, 3 – 4

Chapter 4: Analysis of Financial StatementsPage 1

TABLE 4-2: Allied Food Products: Summary of Financial Ratios (Millions of Dollars)
Liquidity Ratios
Ratio / Formula / Calculation / 2004
Value / Industry
Average / Comment
Current Ratio / / / 3.7x / 4.2x / Poor
Quick / / / 1.8x / 2.2x / Poor
Asset Management
Ratio / Formula / Calculation / 2004
Value / Industry
Average / Comment
Inventory
Turnover / / / 6.9x / 10.9x / Poor
Days sales
outstanding / / / 40.3 days / 36 days / Poor
Fixed asset
turnover / / / 3.3x / 2.8x / OK
Total assets
turnover / / / 1.7x / 1.8x / Somewhat
Low
Debt Management
Ratio / Formula / Calculation / 2004
Value / Industry
Average / Comment
Total debt to
total assets / / / 47.6% / 40.0% / High
(risky)
Times-interest-earned
(TIE) / / / 4.4x / 6.0x / Low
(risky)
EBITDA
Coverage* / / / 3.5x / 4.3x / Low
(risky)
* Assumes lease payments = $28 million and principal payments = $20 million
TABLE 4-2 (Continued): Allied Food Products: Summary of Financial Ratios (Millions of Dollars)
Profitability
Ratio / Formula / Calculation / 2004
Value / Industry
Average / Comment
Profit margin on sale / / / 4.3% / 5.0% / Poor
Return on total asset
(ROA) / / / 7.3% / 9.0% / Poor
Basic earning power
(BEP) / / / 15.7% / 18.0% / Poor
Return on common equity
(ROE) / / / 13.8% / 15.0% / Poor
Market Value Ratios
Ratio / Formula / Calculation / 2004
Value / Industry
Average / Comment
Price/earnings (P/E) / / / 10.7x / 11.3x / Low
Price/cash flow / / / 6.13x / 5.4x / Low
Market/book (M/B) / / / 1.5x / 1.7x / Low

IV.Benchmarking: cross-sectional and trend comparisons

A.Trend analysis

1.= analysis of a firm’s financial ratios over time

2.Used to estimate the likelihood of improvement or deterioration in its financial condition

B.Cross-sectional analysis: compare company’s financial ratios with a group of “benchmark” companies

Chapter 4: Analysis of Financial StatementsPage 1

V.Tying ratios together: The Du Pont Equation

A.Basic Du Pont Equation

1.ROA is the product of the profit margin and the total asset turnover

2.Formula

3.Book’s 2005 Allied Food Example

B. ROA and ROE

1.If a company were financed only by common equity → no debt → no liabilities → assets = equity

2.Define the equity multiplier

a.Definition:

b.Firms with more leverage → ↑ debt and ↓ equity → ↑ equity multiplier

c.Book’s 2005 Allied Food example: equity multiplier = ($2,000)/($940) = 2.13

3.Extended Du Pont equation

a.

b.

c.Book’s 2005 Allied Food Example: ROE = (3.9%)(1.5)(2.13) = 12.5%

VI.Uses and limitations of ratio analysis

A.Comparison with industry averages more difficult for conglomerate firms that operate many divisions in different industries

B.“Average” performance is not necessarily good → Perhaps firm should have higher goal and focus on industry leader’s ratios → Benchmarking will help in this area

C.Inflation distorts balance sheets and income statements and comparisons of ratios across time must be done with care

D.Seasonal factors can distort ratios

E.Firms may employ “window dressing techniques” to make their financial statements look better than they really are

F.Different accounting and operating practices can distort comparisons of ratios

G.It is difficult to determine whether a given ratio value is good or bad

1.A high current ratio may imply excellent liquidity (which is good) or excessive cash (which is bad because it is a nonearning asset)

2.A high fixed asset turnover ratio may indicate a firm that uses its fixed assets efficiently or a firm that is short cash and doesn’t have capital for needed investments

H.Some of the firm’s ratios may look strong while some of its ratios look poor

1.Makes it difficult to determine overall position of firm

2.Statistical methods (discriminate analysis) have been used to determine the net effect of a set of ratios and determine which ones predict financial distress

VII.Problems with ROE

A.ROE and shareholder wealth are positively correlated but problems can anise when ROE is the sole measure of performance

B.Types of problems

1.ROE does not consider risk

2.ROE does not consider the amount of invested capital

3.Managers attempts to maximize ROE will ignore other profitable investments

Chapter 4: Analysis of Financial StatementsPage 1