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Chapter 3

by: Hong Nguyen

Chapter 3 FINC318

Hong Nguyen
LA Tech
GPA 3.8

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Material for the first test
Business Finance
Dr. McCumber
Class Notes
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This 5 page Class Notes was uploaded by Hong Nguyen on Friday February 19, 2016. The Class Notes belongs to FINC318 at Louisiana Tech University taught by Dr. McCumber in Winter 2016. Since its upload, it has received 47 views. For similar materials see Business Finance in Finance at Louisiana Tech University.

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Date Created: 02/19/16
Working with financial statements Standardized financial statements ­ Problem with comparing financial statements o Size of the companies => problems with comparing even 1 companies but at different period of  time o Currency used => problems with comparing 2 companies operated in 2 different countries ­ Common­size statement: work with percentages instead of total dollars in financial statement =>  common and useful way to comparing financial statements o A standardized financial statement presenting all items in percentage terms. Balance sheet items  are shown as a percentage of assets and income statement items as a percentage of sales Ratio analysis ­ Financial ratios o Another way of avoiding problems involved in comparing companies of different sizes o Comparing and investigating the relationships between different pieces of financial information  o Problems  Different people and different sources frequently don’t compute them in exactly the same way  1. Short term solvency (liquidity measures) ­ Provide information about a firm’s liquidity ­ Primary concern is the firm’s ability to pay its bills over the short run without undue stress => interested  to short term lenders  ­ Focus on current assets and current liabilities  o Books values and market values are likely to be similar. Often, these assets and liabilities just  don’t live long enough for the 2 to get seriously out of step  o Can change fairly rapidly currentassets a. Current ratio =  currentliabilities ­ To a creditor, particularly a short term creditor, the higher the current ratio is, the better  ­ To the firm, a high current ratio indicates liquidity but also may indicate an inefficient use of cash and  other short term assets  ­ Normally, we would expect a current ratio of at least 1 o Current ratio <1 => net working capital is negative => unusual in a healthy firm  o An apparently low current ratio may not be a bad sign for a company with a large reserve of  untapped borrowing power  currentassets−inventory b. Quick (acid­test) ratio =  currentliabilities ­ Inventory is often the least liquid current assets, one for which book values are least reliable since the  quality of inventory isn’t considered o Relatively large inventories are often a sign of short term trouble  o Inventories are relatively illiquid to cash  cash c. Cash ratio =  currentliabilities ­ A very short term creditor might be interested in this 2. Long term solvency (financial leverage ratios) ­ Address firm’s long run ability to meet its obligations or more generally its financial leverage  Working with financial statements totalassets−totalequity a. Total debt ratio =  totalassets ­ Takes into account all debts of all maturities to all creditors  totaldebt ­ Debt equity ratio =  totalequity totalassets ­ Equity multiplier =  totalequity EBIT b. Times interest earned (TIE) =  interest ­ How well the company has its interest obligations covered ­ Problems: based on EBIT, which is not really a measure of cash available to pay interest because  depreciation, a noncash expense, has been deducted out  EBIT +depreciation c. Cash coverage =  interest ­ EBIT + depreciation = abbreviated EBITD = earnings before interest, taxes, depreciation, and  amortization (noncash deduction applied to intangible asset but not repayment of debt) =  basic measure  of firm’s ability to generate cash from operations and used as a measure of cash flow available to meet  financial obligations  3. Asset management (turnover ratios) a. Inventory turnover and days’ sales in inventory COGS ­ Inventory turnover =  inventory o As long as we aren’t running out of stock and thereby forging sales, the higher this ratio is, the  more efficiently we are managing inventory o Measure how fast we can sell the products  365days ­ Days’ sales in inventory =   = for how long the product stay in inventory before  inventoryturnover sales b. Receivables turnover and days’ sales in receivables sales ­ Receivables turnover =  accountreceivables 365days ­ Days’ sales in receivable =  receivableturnovers  = average collection period (ACP) sales c. Total asset turnover =  totalassets ­ Capital intensity ratio is the reciprocal of total asset turnover = dollar investment in assets needed to  generate $1 in sales  o High values = capital­intensive industry  4. Profitability ratios netincome a. Profit margin =  sales Working with financial statements ­ All other things being equal, a relatively high profit margin is obviously desirable. This situation  corresponds to low expense ratios relative to sales  netincome b. Return on (book) assets (ROA) = measure of profit per dollar of assets =  totalassets c. Return on (book) equity (ROE) = return on net worth =  measure of how the stockholders fared  netincome during the year =  totalequity 5. Market value ratios netincome ­ Earnings per share (EPS) =  sharesoutstanding price pershare a. Price­earnings ratio (PE) ratio =  earnings pershare price per share b. Price­sales ratio =  sales per share marketvalue pershare c. Market­to­book ratio =  bookvalue per share totalequity ­ Book value per share =  number of shareoutstanding ­ A value less than 1 means the firm hasn’t been successful overall in creating value for its stockholders d. Enterprise value –EBITDA ratio ­ Estimate of market value of company’s operating assets o Operating assets = assets of firm except cash ­ Enterprise value = total market value of the stock + book value of all liabilities – cash  o Total market value of stock + book value of all liabilities = value of the firm’s assets from  balance sheet identity  enterprisevalue ­ EBITDA ratio =  EBITDA o Relate the value of all operating asset to a measure of operating cash flow generated by those  assets  The dupont identity ­ ROE = ROA * equity multiplier = ROA * (1+ debt­equity ratio) = return on assets * assets/total equity = net income/sales * sales/assets * assets/total equity = profit margin * total asset turnover * equity  multiplier  ­ DuPont identity: ROE = profit margin * total asset turnover * equity multiplier  o Operating efficiency o Asset use efficiency  o Financial leverage  ­ Weakness in either operating or asset use efficiency will show up in a diminished return on asset, which  means lower ROE ­ Expanded DuPont analysis o Let us examine several ratios at once  Internal and sustainable growth Working with financial statements 1. Dividend payout and earnings retention ­ Dividend payout ratio = cash dividends/net income  ­ Retention ratio = addition to retained earnings/net income = plowback ratio (portion of net income that s plowed back  into the business) ­ Dividend payout ratio + retention ratio = 1 2. ROA, ROE, and growth ­ If sales are to growth, assets have to grow as well and vice versa to adequately finance the needed  acquisition  ­ A firm’s ability to grow depends on its financing policies ROA∗rententionratio a. The internal growth rate =  1−ROA∗rentationratio ­ Maximum possible growth rate for a firm that relies only on internal financing ­ Refers to what the firm earns and subsequently plows back into business  ROE∗rententionratio b. The sustainable growth rate =  1−ROE∗rentationratio ­ Illustrate  the explicit relationship between firm’s 4 major areas of concern: operating efficiency , assets  efficiency, finance policy, and dividend policy c. Determinants of growths ­ Profit margin: an increase in profit margin will increase the firm’s ability to generate funds internally  and thereby increase its sustainable growth ­ Total asset turnover: increase in firm’s total asset turnover increases the sales generated for each dollar  in assets. This decreases firm’s need for new assets as sales grow and increase the sustainable growth  rate o Increase total assets turnover = decrease capital intensity ­ Dividend policy: decrease in percentage of net income paid out as dividends increase retention ratio.  This increases internally generated equity  and increase internal and sustainable growth Using financial statement information 1. Why evaluate financial statements? a. Internal uses ­ Performance evaluation ­ Planning for future  b. External uses ­ Used to decide whether or not to grant credit to a new customer ­ Prime source of information about firm’s financial health ­ Evaluate main competitors ­ Identify potential target and decide what to offer 2. Choosing a benchmark a. Time trend analysis b. Peer group analysis ­ One common way of identifying potential peers is based on standard industrial classification (SIC)  codes o 4­digits codes established by US government for statistical reporting purposes  o First digit: general type of business  o Each additional digit narrows down the industry  ­ 1997, North America Classification System intended to replace the older SIC codes (but have not) ­ Aspirant group = top firm in the industry  Working with financial statements 3. Problem with financial statement analysis ­ There is no underlying theory and economic logic to help us identify which items or ratios to look at and to guide us in establishing benchmark ­ Many firms are conglomerates owning more or less unrelated lines of business  o Kind of peer group analysis is going to work best when firms are strictly in the same line of  business, industry is competitive and there is only one way of operating ­ Major competitors and natural peer group members in an industry may be scattered around the globe.  The existence of different standards and procedures makes it very difficult to compare financial  statements across national border  ­ Even companies that are clearly in the same line of business may not be comparable  ­ Others o Different firms use different account procedures o Different firms end their fiscal years at different times o For any particular firm, unusual or transient events may affect financial performance 


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