Lecture Essentials of corporate finance (2/e) – Chap 3: Working with financial statements

In this chapter, you will know how to standardise financial statements for comparison purposes, know how to compute and interpret important financial ratios, know the determinants of a firm’s profitability and growth, understand the problems and pitfalls in financial statement analysis.

Working with financial statements Chapter Key concepts and skills • Know how to standardise financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Know the determinants of a firm’s profitability and growth • Understand the problems and pitfalls in financial statement analysis Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-2 Chapter outline • • • • • Standardised financial statements Ratio analysis The Du Pont identity Internal and sustainable growth Using financial statement information Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-3 Standardised financial statements • Common-size balance sheets – Compute all accounts as a percentage of total assets • Common-size income statements – Compute all line items as a percentage of sales • Standardised statements make it easier to compare financial information, particularly as the company grows • They are also useful for comparing companies of different sizes, particularly within the same industry Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-4 Swagman Camping Ltd Balance sheet—Table 3.1 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-5 Swagman Camping Ltd (cont.) Common-size balance sheet— Table 3.2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-6 Swagman Camping Ltd (cont.) Income statement—Table 3.3 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-7 Swagman Camping Ltd (cont.) Common-size income statement— Table 3.4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-8 Ratio analysis • Allows for better comparison over time or between companies • Used both internally and externally • For each ratio, several questions arise: – How is it computed ? – What is the ratio trying to measure and why is that information important? – What is the unit of measurement? – What might a high or low value be telling us? How might such values be misleading? – How could this measure be improved? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-9 Categories of financial ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-10 SWAGMAN—Du Pont identity SWAGMAN CAMPING LT D RECAP Liquidity Ratios Financial Leverage Ratios Current Ratio 1.31 Total Debt Ratio 0.28 Quick Ratio 0.53 Debt to Equity 0.39 Cash Ratio 0.18 Equity Multiplier 1.39 Asset Management Ratios Times Interest Earned 4.9 Inventory Turnover 3.20 Cash Coverage 6.9 Days' Sales in Inventory 114 Profitability Measures Receivables Turnover 12.30 Profit Margin 16.70% Days' Sales in Receivables 30 ROA 10.73% Total Asset Turnover 0.64 ROE 14.90% Capital Intensity Ratio 1.56 Market Value Measures Market Price $ 88.00 Shares Outstanding 35 m EPS $ 11.00 PE Ratio 8.0 Book value per share $74.00 Market to Book 1.19 • ROE = PM * TAT * EM – PM = 16.7% – TAT = 64 – EM = 1.39 • ROE = 167 x 64 x 1.39 = 149= 14.9% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-23 An expanded Du Pont analysis Table 3.6 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-24 An expanded Du Pont analysis (cont.)—Figure 3.1 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-25 Internal and sustainable growth Dividend payout and earnings retention ratios • Dividend payout ratio (b) = Cash dividends/Net income • Retention ratio(1-b) = Additions to retained earnings/Net income = – Payout ratio (b) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-26 Internal and sustainable growth Dividend payout and earnings retention ratios (cont.) SWAGMAN CAMPING LTD Balance Sheet -2010 ASSETS Current Assets Cash $ 98 Accounts Receivable $ 188 Inventory $ 422 $ 708 Total SWAGMAN CAMPING LTD Income Statement - 2010 Liabilities & Owners Equity Sales $ 2,311 Current Liabilities COGS $ 1,344 Accounts Payable $ 344 Depreciation $ 276 Notes Payable $ 196 EBIT $ 691 Total $ 540 Interest $ 141 Long term debt $ 457 Taxable Income $ 550 Taxes $ 165 Net Income $ 385 Ow ners' Equity Fixed Assets Net Plant & Equipment Total Asets $ 2,880 $ 3,588 Common Stock and paid in surplus $ 550 Retained Earnings $ 2,041 $ 2,591 Dividends $ 143 $ 3,588 Addition to RE $ 242 Total Total Liabilties & Owners' Equity • Dividend payout ratio (‘b’) = – Cash dividends / Net income (DIV / NI) – 143/385 = 37% • Retention ratio (‘1 – b’) = (NI - DIV)/ NI – Addition to Retained earnings / Net income – $242/385 = 63% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-27 Internal growth rate • The internal growth rate tells us how much the firm can grow assets using retained earnings (internal financing) as the only source of financing Internal Growth Rate ROA b - ROA b 1012 667 1012 667 7.23% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-28 Sustainable growth rate • The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio ROE b Sustainable Growth Rate    ­ ROE b 149 63 1036 149 63 10.36% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-29 Determinants of growth • Profit margin—operating efficiency • Total asset turnover—asset use efficiency • Financial leverage—choice of optimal debt ratio • Dividend policy—choice of how much to pay to shareholders versus reinvesting in the firm Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-30 Summary of internal and sustainable growth rates Table 3.6 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-31 Using financial information— Why evaluate financial statements? • Internal uses – Performance evaluation—compensation and comparison between divisions – Planning for the future—guide in estimating future cash flows • External uses – Creditors – Suppliers – Customers – Shareholders Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-32 Using financial statement information— Benchmarking • Ratios are not very helpful by themselves; they need to be compared with something • Time-trend analysis – Used to see how the firm’s performance is changing over time – Internal and external uses • Peer-group analysis – Compare with similar companies or within industries – GICS codes • International codes used to classify a firm by its type of business operations Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-33 Problems with financial statement analysis • Conglomerates – No readily available comparables • • • • • Global competitors Different accounting procedures Different fiscal year ends Differences in capital structure Seasonal variations and one-time events Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-34 Example: Work the Web • The Internet makes ratio analysis much easier than it has been in the past • Click on the information icon to go to < www.asx.com.au > • Go to ‘Prices Research and Announcements’ • Click on ‘Company Research’ and enter DJS (company code for David Jones) • Look under ‘Company Announcements’ and find the latest annual report • Extract the relevant number from the balance sheet to calculate the financial ratios Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-35 Quick quiz • How you standardise balance sheets and income statements? – Why is standardisation useful? • What are the major categories of ratios and how you compute specific ratios within each category? • What are the major determinants of a firm’s growth potential? • What are some of the problems associated with financial statement analysis? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-36 Chapter END ... ROE = PM * TAT * EM – PM = 16.7% – TAT = 64 – EM = 1.39 • ROE = 167 x 64 x 1.39 = 149= 14.9% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross... PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 3-3 Standardised financial statements • Common-size balance sheets – Compute all accounts... accounts as a percentage of total assets • Common-size income statements – Compute all line items as a percentage of sales • Standardised statements make it easier to compare financial information,