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## Analysis of Financial Statements

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Title: Analysis of Financial Statements

1
• Chapter 4
• Analysis of Financial Statements

2
Ratio Analysis Notes
• When analyzing companies, we compare ratios
rather than dollar figures to adjust for
differences in size.
• Industry averages are arithmetic medians (not
arithmetic means) to avoid distortions caused by
extreme outliers.

3
Liquidity Ratios (Refer to financial statements,
p.70,73)
• The liquidity group of ratios measures the
ability of the company to pay short-term
debts
• What is the current ratio for Allied Food
Products for 2005?
• Current Ratio CA/CL
• 100/310 3.2

4
• The current ratio assumes that all current assets
will be turned into cash within a year.
• If the industry norm is 4.2, then Allied Foods
appears to have below-average level of liquidity,
and a weaker-than-average ability to pay
short-term debts.

5
• What is the quick ratio for AFP?
• Q.R. (CA Inv)/CL
• (1000 615)/310 1.2
• The quick ratio assumes that all current assets
except for inventories will be turned into cash
within a year.
• If the industry norm is 1.0, this ratio suggests
above-average liquidity for Allied Foods.

6
Asset Management Ratios
• The asset management group of ratios measures how
efficiently management is using the companys
resources.
• Two other names for this group are efficiency or
activity group.

7
• What is the inventory turnover ratio for AFP?
• Inv Turn Sales/Inv
• 3000/615 4.9
• If the industry norm is 9.0, then Allied Foods
appears to be much less efficient than average.
Note that this could be due to low sales or
excessive inventories.

8
• The days sales outstanding (DSO) measures the
average time between when a sale is made and when
collection occurs.
• Another name for this measure is average
collection period.

9
• What is the days sales outstanding (DSO) for AFP?
• DSP Rec x 365/sales
• 375 x 365/3,000 45.6 days
• If the industry norm is 36 days, Allied Foods is
less efficient than average in making its
collections.
• This might be an attempt to offer more attractive
terms to their customers to sell off excess
inventory.

10
• What is the fixed assets turnover ratio for AFP?
• FA Turn Sales/FAnet
• 3000/1000 3.0
• If the industry norm is 3.0, Allied Foods appears
to have average efficiency in generating sales.

11
• Note If Allied Foods fixed assets are older than
average, this would artificially inflate the FA
Turnover measure, causing it to be distorted.

12
• What is the total assets turnover ratio for AFP?
• TA Turnover Sales/TA
• 3000/2000 1.5
• If the industry norm is 1.8, Allied Foods appears
to be less efficient than average in generating
sales.

13
• Note If inventories were high, this would cause
TA Turnover to be low.
• TA Turn Sales/TA
• Sales / (CA FA)

14
Debt Management Ratios
• The debt management group of ratios measures the
companys use of debt funding.
• Another name for this group is the leverage group.

15
• What is the debt ratio for AFP?
• Debt Ratio TD/TA
• (310 750)/2000 53
• If the industry norm is 40, this indicates that
Allied Foods is riskier than average.

16
• Note If a company uses only short-term debt to
fund increases in inventories, it will cause the
debt ratio to rise.
• Example (not Allied Foods) of a company buying
100 more in inventory, and funding it with an
increase in short-term debt
• before C.R. 200/100 2.0
• after C.R. 300/200 1.5

17
• What is the times interest earned (TIE) ratio for
AFP?
• TIE EBIT/I 283.8/88 3.2
• If the industry norm is 6.0, Allied Foods appears
to have a weaker-than-average ability to carry
its debt.

18
• Note If Allied Foods has a debt ratio that is
above average, it not only carries a
higher-than-average amount of debt, its higher
risk also means that it likely pays a
higher-than-average interest rate on each dollar
of debt.
• Both of these effects will cause interest expense
to be high, and the TIE ratio to be low.

19
• What is the EBITDA coverage ratio for AFP?
• EBITDA Coverage
• (EBIT Dep LeasePmts)
• I PrincipalPmts LeasePmts
• (283.8 100 28)/(88 20 28)
• 3.0

20
• If the industry norm is 4.3, Allied Foods appears
to have a less-than-average ability of Allied
Foods to make its fixed financial payments.
• Note Like the TIE ratio, the EBITDA Coverage
ratio assumes the company must make fixed
financial payments. But since the EBITDA
Coverage ratio assumes the firm must meet a
broader array of fixed financial charges, it is
considered to be more comprehensive.

21
Profitability Ratios
• The profitability group of ratios measures the
overall performance of management (but this is
only in an accounting sense).

22
• What is the net profit margin for Allied Foods?
• PM NI/Sales
• 177.5/3000 3.9
• If the industry norm is 5.0, Allied Foods
appears to be less profitable per dollar of sales.

23
• What is the basic earning power ratio for AFP?
• BEP EBIT/TA
• 283.8/2000 14.2
• If the industry norm is 17.2, Allied Foods
appears to be less profitable.

24
• What is the return on total assets ratio (ROA)
for AFP?
• ROA NIc/s/TA
• 117.5/2000 5.9
• If the industry norm is 9.0, Allied Foods
appears to be less profitable than average.

25
• What is the return on equity ratio (ROE) for AFP?
• ROE NIc/s/Common Equity
• 117.5/940 12.5
• If the industry norm is 15.0, Allied Foods
appears to be less profitable than average.

26
Market Value Ratios
• The market value group of ratios measures how the
company is viewed by the market.

27
• What is the price earnings ratio (P/E) for AFP?
• P/E Price/EPS
• 23/2.35 9.8
• If the industry norm is 12.5, Allied Foods is
viewed unfavorably by the market.

28
• What is the price to cash flow ratio (P/CF) for
AFP?
• P/CF Price/CFPS
• 23/4.35 5.3
• If the industry norm is 6.8, Allied Foods is
viewed unfavorably by the market.

29
• Note If a companys profitability is low, it
will artificially inflate (distort) the P/E
ratio.
• Note If a firm is actively expanding, its CF
will be high (due to the high depreciation
charges on new equipment), which can cause the
P/CF ratio to be low.

30
• What is the market to book ratio (M/B) for AFP?
• M/B Price/BVPS
• 23/18.801.2
• If the industry norm is 1.7, Allied Foods is
viewed unfavorably by the market. (Note Unlike
P/E and P/CF, the M/B ratio is not as easily
distorted.)

31
Methods of Comparisons
• When we compare the firms ratios to industry
averages, this is called cross-sectional
analysis.
• When we examine how a firms ratios change over
time, this is called time-series analysis.
• One other method of ratio analysis is to compare
our firm to another comparable firm same size,
same industry.

32
Du Pont Analysis
• The Du Pont analysis shows how ROE is the product
of three other ratios.
• The Du Pont equation is
• ROE PM x TATurn x FLM
• where
• PM reflects cost control
• TATurn reflects volume
• FLM reflects debt leverage

33
• Note FLM 1 / (1 DR)
• Note that ROE can be increased through more a
higher PM (more efficient cost control), greater
TA Turnover (earn the PM on more sales dollars),
or a higher financial leverage multiplier (higher
debt ratio).

34
• What are the Du Pont values for AFP and the
industry?
• ROE (NPM)(TATurn)(FLM)
• Firm (12.5) (3.9) (1.5) (2.13)
• Norm (15.0) (5.0) (1.8) (1.67)
• Company FLM 1 / (1 - .53) 2.13
• Norm FLM 1 / (1 - .40) 1.67

35
• What does the analysis indicate are AFPs
greatest weaknesses?
• Weaknesses
• 1st cost control (low PM)
• 2nd low volume (low TATurn)

36
Sources of Industry Norms
• Value Line
• Moodys Industrial Manual
• Robert Morris Associates
• Various internet sources

37
Limitations of Ratio Analysis
• The comparison to industry averages would be less
valid if your firm operates in just one industry,
and the industry average firm operates in
multiple industries.
• Are matching the industry averages necessarily
optimal goals? Who says being average should be
our goal?

38
• Fixed asset items may be worth more or less than
indicated by the balance sheet. For example,
land recorded at historical cost and bought many
years ago should be worth much more than its book
value.
• Do all of the industry firms close their books at
the same time of the year? No. If you are
comparing a firm that closed its books on Dec31
to an industry-average firm that closed its books
on Jun30, you would be comparing different time
periods.

39
• Does management have the ability to manipulate
reported profits in the short-run all within
GAAP? Yes.
• Managers commonly manipulate reported expenses
(such as pension contributions) to try to smooth
earnings and make them look more stable.

40
• In seasonal industries, firms tend to close their
books during the least active part of the season?
• During the slowest part of the season, balance
sheet figures like inventories and receivables
may be well below their values during the active
portion of the year.

41
• Do all firms in an industry follow the same
accounting procedures (e.g., FIFO vs LIFO)? No.
• If you have two identical firms during an
inflationary period and Firm A uses LIFO (i.e.,
the latest cost figure) while Firm B uses FIFO
(i.e., the oldest cost figure), Firm A will
report the lower profit but have the higher cash
flow (due to its lower taxes).

42
• Although a high current ratio makes a company
look more liquid, higher inventories held as
safety stocks also leads to lower profit (due to
the higher costs of insurance, storage,
financing, etc.).
• Often, what is safer is also less profitable.

43
• Profitability ratios are book measures, and may
not reflect the effect on shareholder wealth.
• Could a firms profit margin be above average,
and the stock price still fall? Yes, if the
market was expecting an even higher profit margin
and was disappointed.

44
• Final note Some sources may compute mixed
ratios (ones involving both balance sheet and
income statement values) by averaging the B/S
item.
• Consider Inv Turnover
• Author InvTurn07 Sales07/Inv07
• Others
• InvTurn07 Sales07/(Inv07 Inv06)/2