Managerial Finance

Financial Analysis/Class Practice The BA 620 Incorporated Balance Sheet

The balance sheet presents a summary of a firm’s financial position at a given point in time.

The statement balances the firm’s assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners).

Financial Analysis/Class Practice The BA 620 Incorporated Balance Sheet

Financial Analysis/Class Practice The BA 620 Incorporated Balance Sheet

Financial Analysis/Class Practice The BA 620 Incorporated Income Statements

The income statement provides a financial summary of a company’s operating results during a specified period.

Although they are prepared quarterly for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

Financial Analysis/Class Practice The BA 620 Incorporated Income Statements

Financial Analysis/Class Practice The BA 620 Incorporated Statement of Retained Earnings

The statement of retained earnings reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year.

Financial Analysis/Class Practice The BA 620 Incorporated Statement of Retained Earnings

Financial Analysis/Class Practice The BA 620 Incorporated

Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance.

Interested parties:

Current and prospective shareholders are interested in the firm’s current and future level of risk and return, which directly affect share price.

Creditors are interested in the short-term liquidity of the company and its ability to make interest and principal payments.

Management is concerned with all aspects of the firm’s financial situation, and it attempts to produce financial ratios that will be considered favorable by both owners and creditors.

Financial Analysis/Class Practice The BA 620 Incorporated

Types of Ratio Comparisons

Cross-sectional analysis is the comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios to those of other firms in its industry or to industry averages

Benchmarking is a type of cross-sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate.

Comparison to industry averages is also popular, as in the following example.

Financial Analysis/Class Practice The BA 620 Incorporated

Types of Ratio Comparisons

Time-series analysis is the evaluation of the firm’s financial performance over time using financial ratio analysis

Comparison of current to past performance, using ratios, enables analysts to assess the firm’s progress.

Developing trends can be seen by using multiyear comparisons.

The most informative approach to ratio analysis combines cross-sectional and time-series analyses.

Financial Analysis/Class Practice The BA 620 Incorporated

Based on the financial Statements, calculate the following ratios for the year 2015. Formula for each ratio is on the next slides

Current ratio

Quick ratio

Inventory turnover (times)

Average collection period (days)

Total asset turnover (times)

Debt ratio

Times interest earned

Gross profit margin

Net profit margin

Return on total assets

Return on equity

P/E ratio

Return on equity using DuPont Analysis

Financial Analysis/Class Practice The BA 620 Incorporated

The current ratio measures the ability of the firm to meet its short-term obligations.

Current ratio = Current assets ÷ Current liabilities

2015: $1,223,000 ÷ $620,000 = 1.97

The quick (acid-test) ratio excludes inventory, which is generally the least liquid current asset.

Financial Analysis/Class Practice The BA 620 Incorporated

Inventory turnover measures the activity, or liquidity, of a firm’s inventory.

Inventory turnover = Cost of goods sold ÷ Inventory

$2,088,000 ÷ $289,000 = 7.2

The average age of inventory is the average number of days’ sales in inventory.

Average Age of Inventory = 365 ÷ Inventory turnover

365 ÷ 7.2 = 50.7 days

Financial Analysis/Class Practice The BA 620 Incorporated

The average collection period is the average amount of time needed to collect accounts receivable.

Financial Analysis/Class Practice The BA 620 Incorporated

The average payment period is the average amount of time needed to pay accounts payable.

Financial Analysis/Class Practice The BA 620 Incorporated

Total asset turnover indicates the efficiency with which the firm uses its assets to generate sales.

Total asset turnover = Sales ÷ Total assets $3,074,000 ÷ $3,597,000 = 0.85

The debt ratio measures the proportion of total assets financed by the firm’s creditors.

Debt ratio = Total liabilities ÷ Total assets $1,643,000 ÷ $3,597,000 = 0.457 = 45.7%

Financial Analysis/Class Practice The BA 620 Incorporated

The debt-to-equity ratio measures the relative proportion of total liabilities and common stock equity used to finance the firm’s total assets.

Debt to equity = Total liabilities ÷ Common stock equity

$1,643,000 ÷ $1,754,000 = 0.937 = 93.7%

The times interest earned ratio measures the firm’s ability to make contractual interest payments; sometimes called the interest coverage ratio.

Times interest earned ratio = EBIT ÷ Interest $418,000 ÷ $93,000 = 4.49

The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits shown in the income statement.

Financial Analysis/Class Practice The BA 620 Incorporated

Gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods.

Financial Analysis/Class Practice The BA 620 Incorporated

Net profit margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted.

Net profit margin = Earnings available for common stockholders ÷ Sales

$221,000 ÷ $3,074,000 = 0.072 = 7.2%

Financial Analysis/Class Practice The BA 620 Incorporated

Earnings per share represents the number of dollars earned during the period on the behalf of each outstanding share of common stock.

Company’s earnings per share (EPS) in 2015 is:

$221,000 ÷ 76,262 = $2.90

Financial Analysis/Class Practice The BA 620 Incorporated

The return on total assets measures the overall effectiveness of management in generating profits with its available assets.

Return on total assets (ROA) = Earnings available for common stockholders ÷ Total assets

$221,000 ÷ $3,597,000 = 0.061 = 6.1%

The return on equity measures the return earned on common stockholders’ investment in the firm.

Return on Equity (ROE) = Earnings available for common stockholders ÷ Common stock equity

$221,000 ÷ $1,754,000 = 0.126 = 12.6%

Financial Analysis/Class Practice The BA 620 Incorporated

The price/earnings (P/E) ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings.

Price Earnings (P/E) Ratio = Market price per share of common stock ÷ Earnings per share

If the Company’s common stock at the end of 2015 was selling at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2015 is: $32.25 ÷ $2.90 = 11.12

Financial Analysis/Class Practice The BA 620 Incorporated

The DuPont system first brings together the net profit margin, which measures the firm’s profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales.

ROA = Net profit margin Total asset turnover

Financial Analysis/Class Practice The BA 620 Incorporated

The DuPont system first brings together the net profit margin, which measures the firm’s profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales.

ROA = Net profit margin Total asset turnover

Financial Analysis/Class Practice The BA 620 Incorporated

The DuPont system first brings together the net profit margin, which measures the firm’s profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales.

ROA = Net profit margin Total asset turnover

When the 2015 values of the net profit margin and total asset turnover for the Company, calculated earlier, are substituted into the DuPont formula, the result is:

ROA = 7.2% 0.85 = 6.1%

Financial Analysis/Class Practice The BA 620 Incorporated

The modified DuPont Formula relates the firm’s return on total assets to its return on common equity. The latter is calculated by multiplying the return on total assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

ROE = ROA FLM

Financial Analysis/Class Practice The BA 620 Incorporated

The modified DuPont Formula relates the firm’s return on total assets to its return on common equity. The latter is calculated by multiplying the return on total assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

ROE = ROA FLM

Substituting the values for the Company’s ROA of 6.1 percent, calculated earlier, and the FLM of 2.051 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the modified DuPont formula yields:

ROE = 6.1% 2.051 = 12.5%

DuPont System of Analysis

Financial Analysis/Class Practice The BA 620 Incorporated Common-Sized Income Statements

Financial Analysis/Class Practice The BA 620 Incorporated Statement of Cash Flows

The statement of cash flows provides a summary of the firm’s operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period.

This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

Financial Analysis/Class Practice The BA 620 Incorporated Statement of Cash Flows