2-1 financial statements, cash flow, ratio analysis, and projection

2-1

Financial Statements, Cash Flow, Ratio Analysis, and Projection

2-2

The Annual Report Balance sheet – provides a snapshot of a

firm’s financial position at one point in time. Income statement – summarizes a firm’s

revenues and expenses over a given period of time.

Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends.

Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

2-3

Balance Sheet: Assets

CashA/RInventories

Total CAGross FALess: Dep.

Net FATotal Assets

2005$ 15.0 180.0

270.0$ 465.0

680.0

(300.0) 380.0

$845.0

2004$40.0160.0

200.0400.0

600.0

(250.0) 350.0$750.0

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Balance sheet: Liabilities and Equity

Accts payableNotes payableAccruals

Total Current LiabilitiesLong-term debtTotal LiabilitiesCommon stockRetained earnings

Total EquityTotal Liabilities & Equity

2005$30.0 40.0 60.0$130.0

300.0$430.0

130.0 285.0$415.0$845.0

200415.035.0

55.0 $105.0

255.0$360.0 130.0

260.0$390.0

750.0

2-5

Income statement

SalesCOGSOther expenses

EBITDADepr. & Amort.

EBITInterest Exp.EBTTaxes (40%)Net incomeCommon Dividends

2005$1500.0

(1,230.0) (90.0)

180.0 (50.0)$130.0

(40.0)$90.0

(36.0)$ 54.0(29.0)

2004$1435.0

(1,176.7

)(85.5)173.3

(40.0)133.3

(35.0)$98.3

(39.3) $59.0(27.0)

2-6

Other data

Shares outstandingEPSDPSStock price

200525

$2.16$1.16

$25.00

200425

$2.36$1.08

$23.00

2-7

Statement of Retained Earnings (2005)

Balance of retainedearnings, 12/31/04

Add: Net income, 2005

Less: Dividends paid

Balance of retained earnings, 12/31/05

$26054

(29)

$285

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How to make cash-flow statement

There are 3 parts in the statement.

1. Cash flow from operating activities2. Cash flow from financing activities3. Cash flow from investment

activities

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Guidelines for cash flow from operating activities

1. Start with the net income after interest and taxes before distribution of dividends.

2. Add back depreciation.3. Among the items of current assets compare

between the figures of last year and the current year. if there is an increase, then deduct the amount as it refers to the use of cash. If there is a decrease, then add the amount as it is a source of cash.

4. Among the items of current liabilities, if there is an increase, then add as it refers to a source of cash. If there is a decrease, then deduct as it is a use of cash.

5. Ignore: (a) cash amount of current assets and (b) notes payable of current liabilities.

2-10

More tips for cash-flow statement

For investment activities, use the gross amount rather than net amount. Increase is assets is a use of cash, so deduct the amount. Decrease in assets is a source of cash, so add the amount.

For financing activities, increase in debt or stock means procurement in cash, so add the amount. Decrease in debt or stock means repayment, so deduct the amount. Distribution of dividends is a a use, so deduct the amount. Notes payable should be included and treated like any other long term debt.

2-11

Statement of Cash Flows (2005)

OPERATING ACTIVITIESNet income

Add back depreciationSubtract (Uses of cash):

Increase in A/RIncrease in inventories

Add (Sources of cash):Increase in A/PIncrease in accruals

Net cash provided by operations.

$54.0

50.0

(20.0)(70.0)

15.0

5.0

$34.0

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Statement of Cash Flows (2005) (Contd.)

a. Net cash provided by operation

b. Cash Flow from Investment c. FINANCING ACTIVITIES

Increase in notes payableIncrease in long-term debtPayment of cash dividend

Net cash from financing

NET CHANGE IN CASH

Plus: Cash at beginning of yearCash at end of year

$34.0(80.0)

5.045.0

(29.0)21.0

(25.0)

40.0$15.0

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Comment about the financial condition from the CF statement The net change in cash flow is negative.

This indicates that during the year the firm has more cash outflow than inflow. The cash position of the firm has deteriorated compared to the last year.

Huge inventories piled up that consumed cash as well as the accounting profit

Increase in fixed assets consumed cash as well

Long term debt issued to pay cash dividends

2-14

Methods of Ratio analysis Bench mark analysis Time series analysis Cross section analysis

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What are the five major categories of ratios, and what questions do they answer?

Liquidity: Can we make required payments?

Asset management: right amount of assets vs. sales?

Debt management: Right mix of debt and equity?

Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

Market value: Do investors like what they see as reflected in P/E and M/B ratios?

2-16

1. Liquidity Ratioa. Current Ratio for 2005.

Current ratio = Current assets / Current liabilities

= $465 / $130= 3.6

Industry average: 4.1Comment: poorer than the industry

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Comments on current ratio2005 2004 Ind.

Currentratio

3.6 3.8 4.1

The firm has a liquidity which is more than the benchmark of 2. However, compared to the industry average it is not enough. More importantly it is getting worse from the previous year.

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1. Liquidity Ratiob. Quick ratio for 2005.

Current assets - inventories Quick ratio2005=

Current liabilities =$195 / $130 =1.5x

Quick ratio2004=1.9Industry average=2.1Comment: Although the ratio is better than the norm of 1 but it is much lower than the industry standard. The firm needs to improve that.

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1. Overall comments on liquidity

Liquidity performances are poor. The firm needs to increase its cash balance which has drastically gone down in the current year. Another reason for low liquidity is that the sales has increased only around 4% in the current year which must be responsible for poor cash balance and poor accounts receivables. The cash flow finding of too much inventory piled up must have reduced cash balance as well as contributed to the poor liquidity.

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2. Asset Management Ratio:a. Inventory turnover

2005 2004 Ind.

InventoryTurnover

4.6x 5.9x 7.4x

Inv. turnover = Sales / Inventories= $1230 / $270= 4.6x

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Comments on Inventory Turnover

Unilate’s inventory is sold out and restocked, or “turned over”, 4.6 times per year, which is considerably lower than the industry average of 7.4 times. It might be holding excessive stock of inventory which indeed is unproductive. It might have old inventory piled up that suggests poor inventory management.

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2. Asset Management Ratio:b. Days Sales Outstanding: DSO is the average number of days required for collection of sales

DSO = Receivables / Average sales per day

= Receivables / (Sales/365)

= $180 / ($1,500/360)= 43.2 days

Unilete collects sales too slowly compared to the industry, and the collection performance is getting worse day-by-day. it has a poor credit policy.

2005 2004 Ind.

DSO 43.2 40.7 32.0

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2. Asset Management Ratio: c. Fixed asset turnover ratiod. Total asset turnover ratios

FA turnover = Sales / Net fixed assets= $1,500 / $380 = 3.9xIndustry average= 4.0x

TA turnover = Sales / Total assets

= $1,500 / $845 = 1.8x

Industry average= 2.1x

2005 2004 Ind.

FA TO 3.9x 4.1x 4.0x

TA TO 1.8x 1.9x 2.0x

2-24

Comment on Fixed Assets turnover and total asset turnover ratio

Compared to the industry, the fixed assets turnover ratio is alright but the total asset turnover ratio is weak. The reason might be the poor inventory management of the firm.

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2. Overall comments on asset management

Poor performances in all the asset management ratios are due to poor sales promotion. Considering the DSO, the firm can not relax the credit terms, so to reduce the sales price and/or aggressive market campaign may be a good option to promote sales. To improve the DSO, the firm should be more punctual in its collection of credit sales. Cash discount can be increased. The reason for poor asset management ratio is the inefficient inventory management. Abnormal increase in inventory in the current year [35%] does not match with sales promotion [4%].

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3. Debt Management Ratio

2005 2004 Ind.

Debt Ratio 50.9% 48% 45%

Times interest earned

3.3 x 3.8x 6.5x

a. Debt Ratio=Total Debt/Total Assetsb. Times interest earned=EBIT/Interest charges

2-27

Debt Management Ratio The debt ratio is significantly higher

than the industry. Compared to the previous year it is increasing as well. This is alarming as interest charges are compulsory obligation. In future this may result in a constraint to raise debt. It might be rationalized by an increased EPS by means of high debt financing.

2-28

Debt Management Ratio

Times interest earned ratio is worse than the industry, as well as, that of last year. Unilete is covering its interest charges by a low margin of safety. This affects the potentiality of raising further debt in future.

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3. Overall comments on Debt management

Poor debt ratio and TIE ratio indicate that the firm is highly a levered one. This may affect the cost of debt in future. The firm has raised debt capital to pay dividend, which is not a good sign. Whether the firm was capable of utilizing the advantage of debt financing depends on profitability.

2-30

4. Profitability Ratios (DuPont Method)

a. Profit Margin on Sales =Net income/salesx

b. Total Asset Turnover=Sales /Total Asset=

c. Return on Assets (ROA) = Net Income/Total Assets

x d. Financial Leverage=Total Assets/Common

Equity=

e. Return on Equity (ROE) =Net income (available to common stockholders)/Common Equity

2-31

Profitability Ratios2005 2004 Ind.

Profit Margin(54/1500)

3.6%(59/1435)

4.1%4.7%

Asset Turnover(1500/845)

1.77x(1435/750)

1.9x2

ROA(54/845)

6.4%(59/750)7.87%

9.5%

Financial Leverage

(845/415)2.04

(750/390)1.92

1.8

ROE(54/415)13.0%

15.1% 17.2%

2-32

Overall comments on Profit performances

Comment on Profitability Ratios: All the profitability ratios are poorer than those of industry. Deterioration is also noticeable compared to those of previous year. Both Asset Turnover and Return on Assets ratios are significantly lower for the firm in 2005 than the previous year, as well as, than the industry averages. On the other hand, Financial Leverage is higher than the industry. This confirms the earlier observation of excess of fixed assets and inventories, and debt. The firm should devote to inventory and asset management. The apparent benefit of leverage in terms of tax exemption is not evidential in profit promotion. Operating activities of the firm suffered from poor liquidity position, poor asset management, and above average debt.

2-33

DuPont analysis A major set back is that ROA has gone down from 7.9% of the last

year to 6.4% of the current year, when industry average is as high as 9.5%. The inefficiency is attributed to the decline in both profit margin and asset turnover ratios.

While enquiring into the reason behind the decline in profit margin we have seen the growth rate of the cost composition and sales (see the following slide). It can be seen that abnormal increase took place in depreciation and interest charges. Increase in depreciation is related to increase in fixed assets. Is the firm holding too much fixed assets? Fixed asset turnover increases from 3.9 to 4.1. This is partially responsible. Increase in interest charges may be due to off-balance sheet financing or higher debt. The growth rate of debt is 16.5% which rules out the role of off-balance sheet financing.

Asset turnover rate declined because of poor growth in sales (4.5%) and higher growth in assets (12.7%). The asset composition shows that the proportion of current assets to total assets has increased from 53% to 55%. This merits attention to the composition of current assets. The growth of current assets is 16% which by itself is high. Growth of cash is negative 63% and that of accounts receivable is 13%. What is noticeable is the growth of inventories which is as remarkable as 35%. This must have contributed to the inefficiency of asset management.

2-34

DuPont analysis (Contd.) Increase in financial leverage suggests that growth of total debt

is higher than that of equity. Total debt grew by 19.4% and equity grew by 6.4%. Increased financial leverage is also reflected in higher interest payments (from $35m to $40m). This should have contributed to a promotion of return on equity. However, the firm could not take advantage of non-taxable interest charges as because EBIT could not be promoted. In fact, EBIT has rather gone down from $133m to $130 million. As a result, although tax payment has gone down from $39.3m to $36m but return on equity has also gone down.

An enquiry into the debt composition shows that the proportion of long term debt into total debt was consistent around 70%. The growth rate short term liability (23%) is higher than that of long term liability (17.6%). Highest growth rate was that of accounts payable which doubled from that of the previous year. It has been noticed earlier that inventory grew by 35%. Now, we see that accounts payable has been doubled. This indicates that the firm is making use of facility of credit purchase and piling up inventory.

2-35

Enquiry into the growth of sales and cost composition

2005 2004 Growth

Sales 1500 1435 0.045

COGS 1230 1176 0.046

Selling & Admin Cost 90 85.5 0.053

Depreciation 50 40 0.250

interest expenses 40 35 0.143

Taxes 36 39.3 -0.084

2-36

Enquiry into the growth of current assets composition

   2005 2004 growth

Cash   $15.00 $40.00 ($0.63)

A/R   180 160 $0.13

Inventories   270 200 $0.35

 Total CA $465.00 400 $0.16

2-37

Enquiry into the growth of debt composition

   2005 2004 Growth

Accts payable $30.00 15 1

Accruals   60 55 0.09

Total Current Liabilities $130.00 $105.00 0.24

Long-term debt 300 255 0.176

Total Liabilities   $430.00 $360.00 0.19

2-38

Enquiry into the growth and composition of debt

  2005 2004Proportion

2005Proportion

2004 Growth

Accts payable $30 15 0.07 0.04 1

Notes payable 40 35 0.09 0.1 0.14

Accruals 60 55 0.14 0.15 0.09Total Current

Liabilities $130 $105 0.30 0.29 0.24

Long-term debt 300 255 0.70 0.71 0.176

Total Liabilities $430 $360 1.00 1.00 0.19

2-39

5. Market value ratio a. Price/ Earnings Ratio =Market price

per share/EPSEPS=Net income available to common

stockholders/No. of common shares outstanding. So, EPS=$54/25=$2.162005 2004 Industry

$25/$2.16=11.6x

$23/$2.36=9.7x 13.0x

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5. Market value ratio (Contd.) Comment: P/E is one of the most

popular ratios among investors. P/E ratio is higher for firms with high growth potentials. The ratio of the firm has increased from 9.7 to 11.6 in the current year. The increase is noticeable. Of course, compared to the industry the firm is still lagging behind.

2-41

5. Market value ratio (Contd.)

b. Market/Book value ratio Book value=Common equity/No. of shares

outstanding =$415/25=$16.60 M/B value ratio=Market price per share/Book value

per share=$25/$16.6 =1.5x Previous year: BV=$390/25=15.6 Previous year M/B=$23/$15.6=1.7x Industry average=2.0x

2005 2004 Industry

1.5 x 1.7x 2.0

2-42

5. Market value ratio (Contd.)

Comment: The market value per share is 1.5 times the book value per share of the firm in the current year. This is considerably lower than the industry average of 2 times. In the previous year the same ratio was 1.7 times for the firm. It demonstrates that not only the firm performs poorer than the industry but also the trust of investors in the firm goes down.

2-43

5. Overall comments on market performances

One of the most important ratios to evaluate the performances of the firm is the price-earnings ratio. The ratio is still less than the industry although it has increased in the current year compared to the previous year. The improvement may indicate that the firm is gaining more trust of investors. Our analysis fails to identify the good news the firm is having. Apparent deterioration is noticeable in both cash-flow and ratio analysis, still the share price of the firm is increased from $23 of the previous year to $25 in the current year.

2-44

Good news? The firm is apparently successful in wealth maximization as

share price increased from $23 to $25 (statistically significant?). Observations of ratio analysis might be reviewed as:

Liquidity: Weak ratios make more fund available for investment.

Poor inventory, fixed and total asset turnover might indicate that the firm slows down the sales process to avail higher sales prices in the next year. Weak DSO might indicate the strategy of promotion of new lines of product where the purpose is to introduce some new products to the market

Increase debt ratio can be explained as financing inventories in anticipation of increased prices in the next year.

Lack of profit can be explained by inadequate sales promotion in the current year and some hidden profits.

2-45

The Sustainable Growth Rate in Sales

)]1()1([

)1()1(

ED

dpT

ED

dpgs

065.0)

285130300130

1(*)5429

1(*150054

1500845

)285130300130

1(*)5429

1(*150054

sg

T =Ratio of total assets to salesp =Net profit margin on salesd =dividend payout ratio

2-46

Forecasting with different ‘g’Current Year 1 Year 2 Year 1 Year 1 Year 1

growth of sales N.A. 0.064 0.064 10% 20% 25%

Sales 1500 1596.2 1698.5 1650 1800 1875

Net Income 54 57.5 61.1 59.4 64.8 67.5

Dividend (Current 29/54) 29 30.9 32.8 31.9 34.8 36.25

Addition to retained earnings 25 26.6 28.3 27.5 30 31

Total assets 845 899.2 956.8 929.5 1014 1056

Total Debt 430 457.6 486.9 473 516 537.5

Common stock 130 130.0 130.0 130 130 130

Retained earnings 285 311.6 339.9 312.5 315 316.

Total Financing 845 899.2 956.8 915.5 961 983.8

Funds needed 0 0.0 0.0 14 53 72.5

Debt: Equity ratio 1.04 1.04 1.04 1.10 1.28 1.37

Sustainable Growth Rate 0.06 0.06 0.06 0.07 0.07 0.08

2-47

Notes:With a single growth rate of sales, as well as, of all the cost and current liability and long term liability there remains following constraints:

Higher growth of sales is not sustainable Floatation of new shares is not a variable Addition to retained earnings depends on net

income as well as payout ratio To finance the asset needed to support the sales,

External Funds Needed should be identified that often raises further debt and increases the Debt:Equity ratio. So leverage can not be constant.

If leverage is constant then dividend policy can not be fixed

2-48

Increasing the Sustainable Growth Rate

A firm can do several things to increase its sustainable growth rate: Sell new shares of stock Increase its reliance on debt Reduce its dividend-payout ratio Increase profit margins Decrease its asset-requirement ratio

2-49

Contextual Forecasting: Since the firm piled up inventories and fixed assets, we suppose, the firm is already prepared to finance higher sales in the next year. So, we keep these away from growth. Assume: gs=6.4%. Does this explain increase in share price?

Sales 1596

COGS (only 50% of direct cost follows growth) 1461

Taxable income 135

Net Income 81

Dividends 43

Addition to Retained earnings 38

Current assets 495

Fixed assets (Only half of Fixed assets has increased) 392

Total assets 887

Total debt 458

Equity (Common stock +Retained Earnings) 453

Total financing 910

Funds needed (This is negative debt or lending) -23

Debt:Equity 0.96

Growth 0.09

2-50

Prediction of Distress and Turnaround

Models for distress prediction Several models to predict distress have been developed

over the years. One of the more popular and robust models is the Altman’s Z-score model:

Bankruptcy prediction when Z is less than 1.2, Z within the range between 1.2 and 2.9 is gray area. Z above 3 is safe.

Z=.717(X1)+.847(X2)+3.11(X3)+.42(X4)+.998(X5)

2-51

Calculation of Z score2005 2004

X1 Net working capital/Total assets

(465-130)/845

=.75 400-105)/750

=0.39

X2 Cumulative retained earnings/Total assets

285/845 =.337 260/750 =0.3367

X3 EBIT/Total Assets 130/845 =.154 133/750 =.177

X4 Market value of equity/ Total liabilities

(25*25)/(845-415)

=1.45 (25*23)/(750-390

=1.6

X5 Sales/Total Assets 1500/845 =1.78 1435/750 =1.91

Z2005=(.717*0.75)+(.847*0.337)+(3.13*0.154)+(0.42*1.45)+(.998*1.78)=3.69

Z2004=(.717*0.39)+(.847*0.3367)+(3.13*0.177)+(0.42*1.6)+

(.998*1.91)=3.697 Comment on Financial Distress: The firm is safe in the current year although the Z-score slightly has gone down. All the odds of ratio and cash flow analysis are not significant enough to result in financial distress.

2-52

Capital Investment Decision: (SEC)

Solar Electronics Corporation (SEC) has recently developed the technology for solar powered jet engines. Cost of capital is 15%.The investment will cost $1500 million. Production will occur over the next 5 years. Annual sales would be 30% of the market of 10,000. Sales price is $2 million per unit and variable costs are $1 million per unit. Fixed costs estimated are $1,791 million. The following table represents other possibilities as well. Find out the NPVs under different situation.

The current market price per share is $645. Number of shares outstanding are 150 million. The firm holds a growth rate of 3% annually. What would be the your prediction of share price of the next year assuming the project is accepted and expected scenario prevails?

2-53

Pessimistic Expected Optimistic

Market size 5,000 10,000 20,000

Market share 20% 30% 50%

Price (in million dollar) 1.9 2 2.2

Variable cost in $m (per plane) 1.2 1 0.8

Fixed cost (per year) $m 1891 1791 1741

Investment $m 1900 1500 1000

Ke 12% 15% 17%

NPV

Market size -1802 1517 $8,154

Market share -695 1517 5942

Price (in million dollar) 853 1517 2844

Variable cost in $m(per plane) 189 1517 2844

Fixed cost (per year) $m 1,295 1517 1627

Investment $m 1208 1517 1903

Ke 1744 1517 1379

Problem 3: Scenario Analysis

2-54

Worksheet: Problem 3  Y0 Y1-5

Investment -1500  

Sales (No)   3000

Revenue   6000

TVC   -3000

FC   -1791

Depreciation   -300

Pretax Profit   909

Tax (.34)   309.06

Net profit   599.94

Annual Cash Inflow   899.94

PVIFA (i=.15,n=5)  3.352155

PV (Cash Inflow) 3017  

NPV 1517

2-55

Prediction of share priceCurrent market capitalization in million

dollar 645*150= $96,750

Market capitalization of the next year assuming 3% growth 96750*1.03= $99,653

Market capitalization including the project 99652.5+1517 $101,170

Share price of the next year in dollar 101169.5/150 $674.46

2-56

Problem 4: Off-balance sheet financing

Income Statements Figures in million taka

2009 2008

Sales 1870 1500

COGS -970 -900

Gross Profit 900 600

Fixed operating exp. -350 -300

Depreciation -120 -80

EBIT 430 220

Interest -100 -30

EBT 330 190

Tax (30%) -99 -57

Net income 231 133

2-57

Other informationNet income for common stockholders (Tk in million) 231 133

Common dividends (Tk in million) 100 80

Addition to retained earnings (Tk in million) 131 53

Book value per share (Tk) 1,368 1,106

EPS (Tk) 462 266

DPS (Tk) 200 160

Market price per share (Tk) 990 1,020

Question: Share price has gone down, although sales increased, net income (EPS) increased, DPS increased, retention and equity increased. Why?

2-58

Balance Sheet: AssetsAssets 2009 2008 Revised (2009)

Cash 65 45 65

Accounts receivable 170 100 170

Inventory 150 70 150

Total current assets 385 215 385

Gross plant and equipment 1000 705 1450

Accumulated depreciation -240 -120 -240

Net Plant & Equipment 760 585 1180

Total assets 1145 800 1595

• Increased gross plant and equipment is just equal to the amount of off-balance sheet financing (see next slide). Depreciation assumed same for simplification of calculation.

2-59

Balance Sheet: Liabilities & Equity

Liabilities 2009 2008 Revised (09)

Accounts payable 155 90 155

Accruals 43 27 43

Notes payable 33 30 33

Total current liability 231 147 231

Long term bond 230 100 650

Total liabilities 461 247 881

Common stock (500,000) 500 500 500

Retained earnings 184 53 184

Owners' equity 684 553 684

Total liability & equity 1145 800 1565

Revised long term debt: i=12%. Interest increased by 70 refers to new debt of 583. Out of that, B/S increase of debt is 133, i.e., (33+230)-(30+100). Rest of the increase in debt might be the off-balance sheet financing like 450= (583-133).

2-60

Calculation of Z- Score

2009 2008Revised

2009

X1 Net working capital/Total assets 0.13 0.09 0.10

X2Cumulative retained earnings/Total

assets 0.16 0.07 0.12

X3 EBIT/Total Assets 0.38 0.28 0.27

X4Market value of equity/ Total

liabilities 1.07 2.07 0.54

X5 Sales/Total Assets 1.63 1.88 1.17

Z Score 3.489 3.71 2.40

•Comment on Financial Distress: The firm is in financial distress as Z-score is below 3 if off-balance sheet financing is converted in to debt financing. Investors can not be fooled by that. Hence, price has gone down as the firm goes through distress although sales, income, EPS, DPS, equity increased.