Fundamentals of Corporate Finance Chapter 17 Financial Statement Analysis Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Topics Covered Financial Ratios DuPont System Using Financial ratios Measuring Company Performance The Role of Financial Ratios McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Type of Financial Ratios Leverage ratios show how heavily the company is in debt Liquidity ratios measure how easily the firm can lay its hands on cash Efficiency or turnover ratios measure how productively the firm is using its assets Profitability ratios are used to measure the firm’s return on its investments McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Financial Statements Income Statement - Financial statement that shows the revenues, expenses, and net income of a firm over a period of time Common-Size Income - Statement Income statement that presents items as a percentage of revenues Balance Sheet - Financial statement that shows the value of the firm’s assets and liabilities at a particular time Common-Size Balance Sheet - Balance sheet that presents items as a percentage of total assets McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Leverage Ratios long term debt Long term debt ratio = long term debt + equity long term debt Debt equity ratio = equity McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Leverage Ratios total liabilities Total debt ratio = total assets EBIT Times interest earned = interest payments Cash coverage ratio = McGraw-Hill/Irwin EBIT + depreciation interest payments Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Liquidity Ratios Net working capital Net working capital = to total assets ratio Total assets current assets Current ratio = current liabilities McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Liquidity Ratios cash + marketable securities + receivables Quick ratio = current liabilities cash + marketable securities Cash ratio = current liabilities Interval measure = McGraw-Hill/Irwin cash + marketable securities + receivables average daily expenditures from operations Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- Efficiency Ratios Sales Asset turnover ratio = Average total assets sales NWCturnover = average net working capital McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 10 Efficiency Ratios Average collection period = average receivables average daily sales cost of goods sold Inventory turnover ratio = average inventory average inventory Days' sales in inventory = cost of goods sold / 365 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 11 Profitability Ratios net income Net profit margin = sales net income + interest Operating profit margin = sales Net Income + Interest Return on assets = average total assets net income Return on equity = average equity McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 12 Profitability Ratios dividends Payout ratio = earnings earnings - dividends Plowback ratio = earnings = - payout ratio earnings - dividends Growth in equity from plowback = earnings McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 13 Market Value Ratios stock price PE Ratio = earnings per share P0 Div1 Forecasted PE ratio = = x avg EPS1 EPS1 r - g dividend per share Dividend yield = stock price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 14 Market Value Ratios Price per share = P0 Div = r - g stock price Market to book ratio = book value per share market value of assets Tobins Q = estimated replcement cost McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 15 The DuPont System A breakdown of ROE and ROA into component ratios Net Income + interest ROA = assets earnings available for common stock ROE = equity McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 16 The DuPont System sales Net Income + interest ROA = x assets sales asset turnover McGraw-Hill/Irwin Operating profit margin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 17 The DuPont System ROE = assets sales Net Income + interest Net Income x x x equity assets sales Net Income + interest leverage asset ratio turnover McGraw-Hill/Irwin Operating profit margin debt burden Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 18 Using Financial Ratios Source: U.S Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, December 2004 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 19 MVA & Economic Profit Market Value Added = The difference between the market value of common stock and its book value Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital EP = Economic Profit = ( ROI − r ) × Capital Invested McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 20 Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital EVA = Residual Income = Income Earned - income required = Income Earned - [ Cost of Capital × Investment] © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 21 Measuring Performance McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 22 Measuring Performance Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g., for Microsoft, EVA = (.329 – 177) × $204,168 million Source: Data provided by Stern Stewart & Co McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 17- 23 Financial Ratios and Default Risk Note: EBITDA is earnings before interest, taxes, depreciation, and amortization Sources: Default rates from “Statement of Standard & Poor’s on Credit Rating Agencies to SEC,” Public Hearing, November 2002; all other data from Standard & Poor’s McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... with permission McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 21 Measuring Performance McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 22 Measuring Performance Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g., for Microsoft, EVA = (.329... book value per share market value of assets Tobins Q = estimated replcement cost McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 15 The DuPont System A breakdown of ROE and ROA into component ratios Net Income + interest ROA = assets earnings available for common stock ROE = equity McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights... assets sales asset turnover McGraw- Hill/Irwin Operating profit margin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 17 The DuPont System ROE = assets sales Net Income + interest Net Income x x x equity assets sales Net Income + interest leverage asset ratio turnover McGraw- Hill/Irwin Operating profit margin debt burden Copyright © 2007 by The McGraw- Hill Companies, Inc All... Financial Ratios Source: U.S Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, December 2004 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 19 MVA & Economic Profit Market Value Added = The difference between the market value of common stock and its book value Economic Profit = capital invested multiplied by... return on investment and the cost of capital EP = Economic Profit = ( ROI − r ) × Capital Invested McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 20 Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital EVA = Residual Income = Income Earned - income required = Income Earned - [ Cost of Capital × Investment] © EVA...17- 11 Profitability Ratios net income Net profit margin = sales net income + interest Operating profit margin = sales Net Income + Interest Return on assets = average total assets net income Return on equity = average equity McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 12 Profitability Ratios dividends Payout ratio =... dividends Growth in equity from plowback = earnings McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 13 Market Value Ratios stock price PE Ratio = earnings per share P0 Div1 1 Forecasted PE ratio = = x avg EPS1 EPS1 r - g dividend per share Dividend yield = stock price McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17-... Stewart & Co McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 17- 23 Financial Ratios and Default Risk Note: EBITDA is earnings before interest, taxes, depreciation, and amortization Sources: Default rates from “Statement of Standard & Poor’s on Credit Rating Agencies to SEC,” Public Hearing, November 2002; all other data from Standard & Poor’s McGraw- Hill/Irwin... Sources: Default rates from “Statement of Standard & Poor’s on Credit Rating Agencies to SEC,” Public Hearing, November 2002; all other data from Standard & Poor’s McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved