# Discussion 3 and problem set 3

In this week’s discussion, prepare a synopsis of the material discussed in the chapter readings.   PFA for assignment

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1. 1.  Why are ratios useful? What three groups use ratio analysis and for what reasons?

2. 2.  What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?

3. 3.  What are some potential problems and limitations of financial ratio analysis?

Analysis of Financial Statements

CHAPTER 3

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Topics in Chapter
Ratio analysis
Ratios
Common size statements
Percent change statement
DuPont equation
Limitations of ratio analysis
Qualitative factors

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Determinants of Intrinsic Value: Using Ratio Analysis

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Overview
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

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Income Statement
2019 2020E
Sales \$6,000 \$6,600
COGS except depr. 4,800 5,210
Other expenses 320 370
Deprec. 420 400
EBIT \$ 460 \$ 620
Int. expense 108 100
EBT \$ 352 \$ 520
Taxes (40%) 88 130
Net income \$ 264 \$ 390

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Balance Sheets: Assets
2019 2020E
Cash \$ 50 \$ 60
S-T invest. 10 50
AR 520 530
Inventories 820 660
Total CA \$1,400 \$1,300
Net FA 3,500 3,700
Total assets \$4,900 \$5,000

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Balance Sheets: Liabilities & Equity
2019 2020E
Accts. payable \$ 400 \$ 330
Notes payable 250 100
Accruals 240 270
Total CL \$ 890 \$ 700
Long-term debt 1,100 1,100
Total liabilities \$1,990 \$1,800
Common stock 1,000 1,000
Ret. earnings 1,910 2,200
Total equity \$2,910 \$3,200
Total L&E \$4,900 \$5,000

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Other Data
2019 2020E
EPS \$2.64 \$3.90
DPS \$0.84 \$1.00
Book value per share \$29.10 \$32.00
Dividends \$84 \$100
Number of shares 100 100
Year-end stock price \$30.00 \$49.00
Lease payments \$20 \$20
Tax rate 25% 25%

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Profitability Ratios
What is the company’s rate of return on sales?
Profit margin
Operating profit margin
What is the company’s rate of return on assets?
Basic earning power
Return on assets
Return on equity

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Profit Margin
Net profit margin (PM):

2018 2019 2020E Ind.
Profit Margin 6.7% 4.4% 5.9% 7.2%

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Operating Profit Margin
Operating profit margin:

2018 2019 2020E Ind.
Profit Margin 10.2% 7.7% 9.4% 10.4%

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Basic Earning Power (BEP)

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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.
2018 2019 2020E Ind.
Basic Earning Power 13.7% 9.4% 12.4% 15.6%

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Return on Assets (ROA) and Return on Equity (ROE) (1 of 2)

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Return on Assets (ROA) and Return on Equity (ROE) (2 of 2)

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ROA and ROE vs. Industry Averages
2018 2019 2020 Industry
ROA 9.0% 5.4% 7.8% 10.8%
ROE 13.5% 9.1% 12.2% 15.4%

Both below industry average but improving.

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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.

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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?

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Inventory Turnover Ratio vs. Industry Average

2018 2019 2020E Ind.
Inventory turnover 7.4 6.2 8.5 9.0

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Inventory turnover:
Improved from previous year
Below industry average

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DSO: average number of days from sale until cash received.

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Appraisal of DSO
Higher than 2018, but a little lower than industry.
2018 2019 2020E Ind.
Days Sales Outstanding 26.5 31.6 29.3 28.0

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Fixed Assets and Total Assets Turnover Ratios
(1 of 2)

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Fixed Assets and Total Assets Turnover Ratios
(2 of 2)
Better than previous year.
Not up to industry average. Caused by high fixed assets relative to sales.
2018 2019 2020E Ind.
Fixed Asset Turnover 1.9 1.7 1.8 3.0
Total Asset
Turnover 1.348 1.224 1.320 1.5

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

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Forecasted Current and Quick Ratios

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Comments on Current and Quick Ratios
2018 2019 2020E Ind.
Current 2.1 1.6 1.9 2.5
Quick 1.0 0.7 0.9 1.9

Expected to improve but still below the industry average.
Liquidity position is weak.

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Debt Management Ratios
Does the company have too much debt?
Can the company’s earnings meet its debt servicing requirements?

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Leverage Ratios: Debt Ratio

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Leverage Ratios: Debt-to-Equity Ratio

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Leverage Ratios: Liabilities-to-Assets Ratio

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Leverage Ratios: Equity Multiplier
Equity multiplier = Total Assets
Common Equity
= \$5,000
\$3,200 = 1.5625

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Times Interest Earned Ratio

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EBITDA Coverage (EC)

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Debt Management Ratios vs. Industry Averages
2018 2019 2020E Industry
Debt Ratio 20.8% 27.6% 24.0% 15.0%
Debt-to-equity 0.31 0.46 0.38 0.22
Liabilities-to-assets 33.1% 40.6% 36.0% 32.0%
Earnings Multiplier 1.49 1.68 1.56 1.47
Times Interest Earned 8.2 4.3 6.2 13.0
EBITDA Coverage Ratio 9.9 6.3 8.4 17.2

Improved, but more debt than industry
More risk than industry

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Market Value Ratios
Market value ratios incorporate the:
High current levels of earnings and cash flow increase market value ratios
High expected growth in earnings and cash flow increases market value ratios
High risk of expected growth in earnings and cash flow decreases market value ratios

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Calculate and appraise the Price/Earnings (P/E) ratio.
Price per share (P) = \$49.00
Earnings per share (EPS) = \$3.90
P/E = P/E = \$49.00/\$3.90 = 16.8
P/E: How much investors will pay for \$1 of earnings. Higher is better.

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Calculate and appraise the M/B ratio.
BVPS = Equity/ # Shares
= \$3,200/100 = \$32.00.
M/B = P/BVPS
M/B = \$49.00/\$32.00 = 1.53
M/B: How much paid for \$1 of book value. Higher is better.

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Comparison with Industry Averages
2018 2019 2020E Ind.
Price-to Earnings 13.6 11.4 12.6 16.8
Market-to-Book 1.8 1.0 1.5 2.7

The P/E ratio and the M/B ratio indicate that the market doesn’t value the company as highly as it does the average firm in industry.

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Common Size Balance Sheets: Divide all items by Total Assets
Assets 2018 2019 2020E Ind.
Cash 1.5% 1.0% 1.2% 1.5%
ST Inv. 2.5% 0.2% 1.0% 7.6%
AR 9.8% 10.6% 10.6% 13.2%
Invent. 15.2% 16.7% 13.2% 17.8%
Total CA 28.9% 28.6% 26.0% 40.0%
Net FA 71.1% 71.4% 74.0% 60.0%
TA 100.0% 100.0% 100.0% 100.0%

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Divide all items by Total Liabilities & Equity
Liab. & Eq. 2018 2019 2020E Ind.
AP 7.4% 8.2% 6.6% 6.8%
Notes pay. 1.2% 5.1% 2.0% 3.0%
Accruals 4.9% 4.9% 5.4% 10.2%
Total CL 13.5% 18.2% 14.0% 20.0%
LT Debt 19.6% 22.4% 22.0% 12.0%
Total Liab. 33.1% 40.6% 36.0% 32.0%
Total eq. 66.9% 59.4% 64.0% 68.0%
Total L&E 100.0% 100.0% 100.0% 100.0%

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Analysis of Common Size Balance Sheets
Computron has higher proportion of net fixed assets than the industry.
Computron’s total debt is 24% (the combined percentages of notes payable and long-term bonds) of its assets, which is higher than the industry’s combined debt percentage of 20%.

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Common Size Income Statement: Divide all items by Sales
2018 2019 2020E Ind.
100.0% 100.0% 100.0% 100.0%
78.2% 80.0% 78.9% 69.0%
5.3% 5.3% 5.6% 3.3%
6.4% 7.0% 6.1% 17.3%
10.2% 7.7% 9.4% 10.4%
1.2% 1.8% 1.5% 0.8%
8.9% 5.9% 7.9% 9.6%
2.2% 1.5% 2.0% 2.4%
6.7% 4.4% 5.9% 7.2%

Sales
COGS
Depr.
Other exp.
EBIT
Int. Exp.
Pre-tax earn.
Taxes (25%)
NI

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Analysis of Common Size Income Statements
Computron’s profit margin is less than the industry ratio
Computron has lower Other Costs.
But… it has much higher costs of goods sold

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Percentage Change Analysis: Cumulative Change from First Year (2018)
Income St. 2018 2019 2020E
Sales 0.0% 9.1% 20.0%
COGS 0.0% 11.6% 21.2%
Depr. 0.0% 10.3% 27.6%
Other exp. 0.0% 20.0% 14.3%
EBIT 0.0% -17.9% 10.7%
Int. Exp. 0.0% 58.8% 47.1%
EBT 0.0% -28.5% 5.7%
Taxes 0.0% -28.5% 5.7%
NI 0.0% -28.5% 5.7%

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Analysis of Percent Change Income Statement
For 2019:
Sales grew by 9% in 2019.
Net income fell by 28.5%!
For 2020 projections:
Cumulative sales growth is 20%.
Cumulative net income growth is 5.7%
Improvement, but more work is needed

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Cumulative Percentage Change: Assets
Assets 2018 2019 2020E
Cash 0.0% -16.7% 0.0%
ST Invest. 0.0% -90.0% -50.0%
AR 0.0% 30.0% 32.5%
Invent. 0.0% 32.3% 6.5%
Total CA 0.0% 18.6% 10.2%
Net FA 0.0% 20.7% 27.6%
TA 0.0% 20.1% 22.5%

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Cumulative Percentage Change: Liabilities & Equity
Liab. & Eq. 2018 2019 2020E
AP 0.0% 33.3% 10.0%
Notes pay. 0.0% 400.0% 100.0%
Accruals 0.0% 20.0% 35.0%
Total CL 0.0% 61.8% 27.3%
LT Debt 0.0% 37.5% 37.5%
Total eq. 0.0% 6.6% 17.2%
Total L&E 0.0% 20.1% 22.5%

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Analysis of Percent Change Balance Sheets: 2019
Assets grew by 20.1% even though net income fell.
Much of the asset growth was in accounts receivable and inventories.
Not collecting on credit sales
Unsold product is piling up.
Growth was funded with big increase in debt.

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Analysis of Percent Change Balance Sheets: Projections Compared with 2019
Small cumulative increase in 2020E total assets (22.5%) compared with 2019 change in total assets (20.1%)
But big reduction in cumulative inventory growth (6.5% in 2020E vs. 32.3% in 2019)
Big drop in cumulative notes payable growth in 2020E relative to notes payable growth in 2019.

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Explain the Extended DuPont Equation
The DuPont equation focuses on:
Expense control (Profit margin, PM)
Asset utilization (Total asset turnover,TAT)
Debt utilization (Equity multiplier, EM)
It shows how these factors combine to determine the return on equity (ROE).

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The Simple Version of the DuPont Equation

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The Extended DuPont Equation

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ROE: (Profit margin)(TA turnover)(EM)
ROE2018 = (6.7%)(1.348)(1.495) = 13.5%
ROE2019 = (4.4%)(1.224)(1.684) = 9.1%
ROE2020E = (5.9%)(1.320)(1.563) = 12.2%
ROEInd = (7.2%)(1.5)(1.47) = 15.9%

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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.

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Qualitative Factors
There is greater risk if:
revenues tied to a single customer
revenues tied to a single product
reliance on a single supplier?
High percentage of business is generated overseas?
What is the competitive situation?
What products are in the pipeline?
What are the legal and regulatory issues?

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NI\$390
Sales\$6,600
PM5.9%.
===
.
EBIT\$6
P
20
Sales\$66
M9
,00
.4%
===
EBIT
BEP
Total assets
\$620
12.4%.
\$5,000
=
==
NI
ROA
Total assets
\$390
7.8%.
\$5,000
=
==
NI
ROE
Common Equity
\$390
12.2%.
\$3,200
=
==
COGS
Inv. Turnover
Inventories
\$5,210\$370
8.5
\$660
=
+
==
Receivables
DSO
Average sales per day
Receivables\$530
Sales365\$6,600365
29.3 days.
=
==
=
Sales
Fixed assets turnover
Net fixed assets
\$6,600
1.8
\$3,700
Sales
Total assets turnover
Total assets
\$6,600
1.320.
\$5,000
=
==
=
==
CA\$1,200
CR1.9.
CL\$700
CAInv.
QR
CL
\$1,200\$660
0.9.
\$700
===

=

==
Total debt
Debt ratio
Total assets
\$100\$1,100
24.0%.
\$5,000
=
+
==
Total debt
Debt-equity
Equity
\$100\$1,100
37.5%.
\$3,200
=
+
==
Total liabilities
LiabilitiesTA ratio
Total assets
\$1,800
\$5,000
36.0%.
=
=
=
EBIT
TIE
Int. expense
\$620
6.2
\$100
=
==
4
EBITDepr. &Amort.Lease payments
Interest expenseL
\$620\$370\$20
8
2
ease pmt.Loan
.
\$100\$0\$0
t pm.
++
++
==
++
++
Net income
Equity
Net incomeT
M
otal assets
Total assetsEqu
ROE
ROEROAE
ity
=

Net incomeTotal assets
Total assetsEquity
Net incomeSalesTotal assets
SalesTotal assetsEquity
Profit marginTotal asset turnoverEquity
multiplier
ROE
ROE
ROE

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