978-1259709685 Chapter 3 Lecture Note Part 1

subject Type Homework Help
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subject Authors Jeffrey Jaffe, Randolph Westerfield, Stephen Ross

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Chapter 3
FINANCIAL STATEMENTS ANALYSIS AND FINANCIAL
MODELS
SLIDES
CHAPTER WEB SITES
Section Web Address
3.2 www.reuters.com/finance/stocks
www.sba.gov
3.4 www.planware.org
CHAPTER ORGANIZATION
3.1 Key Concepts and Skills
3.2 Chapter Outline
3.3 Financial Statements Analysis
3.4 Ratio Analysis
3.5 Categories of Financial Ratios
3.6 Computing Liquidity Ratios
3.7 Computing Leverage Ratios
3.8 Computing Coverage Ratios
3.9 Computing Inventory Ratios
3.10 Computing Receivables Ratios
3.11 Computing Total Asset Turnover
3.12 Computing Profitability Measures
3.13 Computing Market Value Measures
3.14 Using Financial Statements
3.15 The Du Pont Identity
3.16 Using the Du Pont Identity
3.17 Calculating the Du Pont Identity
3.18 Potential Problems
3.19 Financial Models
3.20 Financial Planning Ingredients
3.21 Percent of Sales Approach
3.22 Percent of Sales Approach
3.23 Percent of Sales and EFN
3.24 External Financing and Growth
3.25 The Internal Growth Rate
3.26 The Sustainable Growth Rate
3.27 Determinants of Growth
3.28 Some Caveats
3.29 Quick Quiz
3.30 Quick Quiz
3.1 Financial Statements Analysis
Standardizing Statements
Common-Size Balance Sheets
Common-Size Income Statements
3.2 Ratio Analysis
Short-Term Solvency or Liquidity Measures
Long-Term Solvency Measures
Asset Management or Turnover Measures
Profitability Measures
Market Value Measures
3.3 The DuPont Identity
A Closer Look at ROE
Problems with Financial Statement Analysis
3.4 Financial Models
A Simple Financial Planning Model
The Percentage of Sales Approach
3.5 External Financing and Growth
EFN and Growth
Financial Policy and Growth
A Note about Sustainable Growth Rate Calculations
3.6 Some Caveats Regarding Financial Planning Models
ANNOTATED CHAPTER OUTLINE
Slide 3.0 Chapter 3 Title Slide
Slide 3.1 Key Concepts and Skills
Slide 3.2 Chapter Outline
Lecture Tip: Students sometimes get the impression that
accounting data is useless because care must be used when some
of the results are interpreted. They sometimes ask why we bother
with financial statement analysis at all. Robert Higgins provides a
good answer to this question:
fiObjectively determinable current values of many assets
do not exist. Faced with a trade-off between relevant, but
subjective current values, and irrelevant, but objective
historical costs, accountants have opted for irrelevant, but
objective historical costs. This means that it is the users
responsibility to make adjustments”
Financial statement information is often our ONLY source of information.
Consequently, we use the information we have and make adjustments
where appropriate.
A possible extension to this discussion involves the movement to market
value accounting and its impact on the credit crisis (and associated write-
downs) and recession which begun in 2008.
1. Financial Statements Analysis
A. Standardizing Financial Statements
Standardized statements allow users to compare companies of different
sizes (particularly within the same industry) or to better compare an
individual company as it grows through time.
Slide 3.3 Financial Statements Analysis
B. Common-Size Balance Sheets
Express each account as a percent of total assets.
C. Common-Size Income Statement
Express each item as a percent of sales.
2. Ratio Analysis
Lecture Tip: Unfortunately, students often make it through an entire
business program without ever having to interpret the consolidated
financial statements in an annual report. Yet, they need to grasp the
differences between the simplified statements that are presented in
textbooks and the statements they will see in the business world. There are
several things you can do to increase their awareness of the differences.
One idea is to go to a company’s web site and pull up their annual report.
Go through the balance sheet and income statement and point out some of
the differences. For example, EBIT is often referred to as fioperating
income” or fiincome from operations,” and not all companies list ficost of
goods sold” on the income statement. An excellent homework assignment
is to have them download the financial statements for a company of your
(or their) choice, and then have them compute the ratios and discuss the
results in class.
Slide 3.4 Ratio Analysis
Questions to answer when interpreting financial ratios:
-How is the ratio computed?
-What aspects of the firm are we attempting to analyze?
-What is the unit of measurement (times, days, percent)?
-What does the value indicate? (What are the benchmarks used for
comparison? What makes a ratio figood” or fibad”?)
-What actions could the company take to improve the ratio? (How will this
affect other ratios?)
Slide 3.5 Categories of Financial Ratios
-Short-term solvency, or liquidity, ratios: The ability to pay bills in the
short-run
-Long-term solvency, or financial leverage, ratios: The ability to meet
long-term obligations
-Asset management, or turnover, ratios: Efficiency of asset use
-Profitability ratios: Efficiency of operations and how this translates to the
fibottom line”
-Market value ratios: How the market values the firm relative to the book
values
Lecture Tip: Students often fail to see the fiforest” for all the fitrees”
(equations) when they are first learning financial statement analysis. It is
important to remind them that we are not just computing ratios; we are
computing ratios to help us make better decisions. Teaching the ratios by
category and showing how each category can answer different questions
related to the financial strength of the firm may help students see the
overall picture painted by financial statement analysis, as well as how
ratios relate to each other.
A. Short-term Solvency or Liquidity Ratios
Slide 3.6 Computing Liquidity Ratios: Note that the ratios on Slides 3.6
through 3.13 are computed using financial data from Tables 3.1 and 3.4.
Lecture Tip: The notes in the PowerPoint slides provide detailed analysis
and interpretation of the computed ratios.
Current Ratio = current assets / current liabilities
Quick Ratio = (current assets – inventory) / current liabilities
Cash Ratio = cash / current liabilities
Lecture Tip: When asked to define liquidity, students invariably state that
it is the fiability to convert assets to cash quickly.” Wrong! You should
stress the inadequacy of this definition by pointing out that you can
convert anything to cash quickly if you lower the price enough. A good
example is to ask the students how long it would take to sell a house if the
seller only asked for $1. Then ask them if this means that the house is a
liquid asset. Most of them recognize that it is not, and then it is easier for
them to remember the second part of the definition – fiwithout a
significant loss in value.”
Lecture Tip: Students often think that a high current ratio is, in and of
itself, a good thing. This may be true if you are a short-term creditor and
you are evaluating whether or not to grant trade credit or make a short-
term loan, but liquid assets are generally less profitable for the company.
Consequently, too large an investment in current assets may reduce the
earnings power of the firm and actually reduce the stock price. Remind
the students that the goal of the firm is to maximize owner wealth.
Kirk Kerkorian’s takeover bid for Chrysler in April 1995 is a perfect
example of investor dissatisfaction with excess liquidity. At the time,
Chryslers management had accumulated $7.3 billion in cash and
marketable securities as a cushion against an economic down-turn. Mr.
Kerkorian instigated a takeover bid because Chryslers management
refused to pay this cash to stockholders. A Wall Street Journal article
noted that some analysts considered several other firms with large cash
holdings relative to firm value vulnerable to takeover bids as well.
Lecture Tip: You may want students to consider the interaction of ratios.
Suggest a scenario in which the current ratio exhibits no change over a
two- or three-year period, while the quick ratio experiences a steady
decline. How could this occur? Is it a desirable strategy? Have the
students consider the following:
1. The company is operating with lower levels of the most liquid assets,
and this situation should be monitored. A problem could arise should a
large amount of current liabilities come due for payment. However, this
may not be a major concern if the company has access to a line of credit
at a bank.
2. This situation also indicates that larger levels of inventory, relative
to current liabilities, have accumulated in the firm. Point out that an
examination of other ratios is required to explore this situation further.
For example, it would be useful to know how inventory relative to sales or
cost of goods sold has changed through time. This provides a nice lead-in
to the asset management section.
A. Long-Term Solvency Measures
These are also known as leverage ratios.
Slide 3.7 Computing Leverage Ratios
Total debt ratio = (total assets – total equity) / total assets
Variations:
debt/equity ratio = (total assets – total equity) / total equity
Using the balance sheet identity, the debt/equity ratio can also be
calculated as: debt ratio / (1 – debt ratio)
equity multiplier = total assets / total equity
= 1 + debt/equity ratio
The equity multiplier captures the leverage effect in the DuPont
identity.
Slide 3.8 Computing Coverage Ratios
Times interest earned ratio = EBIT / interest
Cash coverage ratio = (EBIT + depreciation + amortization) / interest
= EBITDA / interest
You can also calculate a type of inverse value as follows:
Interest Bearing Debt / EBITDA = (196 + 457) / 967 = .68
Values less than one are indicative of a stable position.
Lecture Tip: This group of ratios (i.e., long-term solvency) really
measures two different aspects of leverage – the level of indebtedness and
the ability to service debt. The former is indicative of the firm’s debt
capacity, while the latter more closely relates to the likelihood of default.
Further, it is sometimes helpful to alert students to some of the nuances
of the ratios within these subgroups. For example, the total debt ratio
measures what proportion of the firm’s assets are financed with borrowed
money, while the debt/equity ratio compares the amount of funds supplied
by creditors and owners. The long-term debt ratio looks at the percent of
long-term financing that is raised using debt.
Lecture Tip: The importance of coverage ratios is sometimes overlooked,
particularly when one considers their importance to all types of creditors.
There are several types of coverage ratios that may include interest
expense, sinking fund payments, and lease payments in the denominator.
The format of the ratios depends largely on the reason that the analyst is
looking at them, so it is always important to pay attention to exactly how
the ratio is being computed, not just what it is called.
B. Asset Management or Turnover Measures
Slide 3.9 Computing Inventory Ratios
Inventory turnover = cost of goods sold / inventory
Days’ sales in inventory = 365 days / inventory turnover
Lecture Tip: You may wish to mention that there may be significant
inconsistencies in the methods used to compute ratios by financial
advisory firms. When using ratios supplied by others, it is important to be
aware of the exact financial items used. A manufacturer would typically
consider inventory at cost, and thus, relate inventory to cost of goods sold.
However, a retailer might maintain its inventory level based on retail
price. In the latter case, inventory should be related to sales to compute
inventory turnover. The markup would cancel in the numerator and
denominator and give a more accurate indication of turnover based on
cost. You also have some analysts use average inventory over some period
instead of ending inventory. The same is true for the other assets used in
the various turnover ratios.
Slide 3.10 Computing Receivables Ratios
Receivables turnover = sales / accounts receivable
Days’ sales in receivables = 365 days / receivables turnover
(Also called fiaverage collection period” or fidays’ sales outstanding.”)
Lecture Tip: In discussing the nature of financial statement analysis, you
may wish to emphasize frequently that it is a means to an end, rather than
an end in itself. That is, financial ratios are fired flags” that a good
analyst will use to determine what needs to be investigated further. For
example, suppose a firm’s average collection period (days’ sales in
receivables) is significantly higher than the industry norm. What questions
might you ask?
-What are the firm’s credit terms? What are the industry’s terms on
average?
-Has the average collection period been trending upward, or is this an
aberration?
-Which consumers are contributing to the relatively high average
collection period?
-Is this an industry or economy wide phenomenon?
Clearly, these questions are not all easily answered. Nonetheless, it should
be emphasized that a thorough analyst will consider numerous questions
like these in making a final determination about the firm’s ability to
manage its assets.
Slide 3.11 Computing Total Asset Turnover
Total Asset Turnover (TAT) = sales / total assets
Lecture Tip: In addition to TAT, it may be helpful to calculate components
of TAT such as Fixed Asset Turnover or Net Working Capital Turnover.
This highlights that the firm may be doing better or worse in total, but it is
possible for segments to be doing the opposite.
Lecture Tip: Students should be warned that, just as one must take care in
making generalizations across industries, so intra-industry
generalizations should also be made with great caution. For example, a
fixed asset turnover ratio that is high relative to that of the industry can be
the result of efficient asset utilization, or it can indicate that the firm is
utilizing old (and perhaps inefficient) equipment, while others in the
industry have invested in modern equipment. This example also provides
you with the opportunity to illustrate the underlying linkages inherent in
financial statement analysis. In this case, the firm using inefficient
equipment would display a favorable fixed asset turnover ratio, but would
be likely to display a higher level of expenses, and unless offset by other
factors, lower profitability.
C. Profitability Measures
Slide 3.12 Computing Profitability Measures
These measures are based on book values, so they are not comparable with
returns that you see on publicly traded assets.
Profit margin = net income / sales
EBITDA Margin = EBITDA / Sales
Return on Assets (ROA) = net income / total assets
Return on Equity (ROE) = net income / total equity
For ROA, we could use EBIT rather than Net Income to get a measure that
is neutral with respect to capital structure.
Lecture Tip: Economic Value Added (EVA®) and Market Value Added
(MVA) are relatively recent additions to the analyst’s toolbox. EVA® was
developed by Stern Stewart & Company and is the difference between the
firm’s after-tax net operating profit and its cost of funds. The roots of
EVA® can be traced to Modigliani and Miller (1958). More recently, EVA®
has become a buzz-word among consultants and writers in the business
press. The degree to which EVA has entered the mainstream can be seen in
a November 1997 Fortune magazine article entitled fiAmerica’s Greatest
Wealth Creators” in which the authors ranked 200 firms on the basis of
their EVAs and MVAs. Interestingly, the article characterizes increasing
EVA® as fia good sign that a stock will soar.” Stern Stewart & Company’s
internal research shows that the stock of companies that have used EVA®
for at least five years have substantially outperformed comparable firms.
The stock performance is even more impressive if the companies also use
compensation plans based on EVA®. This, however, is ongoing research.
D. Market Value Measures
Slide 3.13 Computing Market Value Measures
Earnings Per Share (EPS) = net income / shares outstanding
Price-earnings ratio = price per share / earnings per share
Market-to-book ratio = market value per share / book value per share
Market capitalization = Price per share x Shares Outstanding
Enterprise Value (EV) = Market capitalization + Market value of interest
bearing debt – Cash
EV multiple = EV / EBITDA

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