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