A total asset turnover ratio of 3.5 indicates that

C H A P T E R 3 Analysis of Financial Statements

To guide or not to guide, that is the question. Or at least it’s the questionmany companies are wrestling with regarding earnings forecasts.Should a company provide earnings estimates to investors? In 2006, Best Buy answered this question by announcing that it would no longer provide quarterly earnings forecasts. It’s no coincidence that Best Buy’s decision came shortly after its actual earnings came in just 2 cents below the forecast, yet its stock price fell by 12%. Coca-Cola, Motorola, and Citigroup are among the growing number of companies that no longer provide quarterly earnings forecasts.

Virtually no one disputes that investors need as much information as possible to accurately evaluate a company, and academic studies show that companies with greater transparency have higher valuations. However, greater disclosure often brings the possibility of lawsuits if investors have reason to believe that the disclosure is fraudulent. Although the Private Securities Litigation Reform Act of 1995 helped prevent “frivolous” lawsuits, many companies still chose not to provide information directly to all investors. Instead, before 2000, many companies provided earnings information to brokerage firms’ analysts, and the analysts then forecast their own earnings expectations. In 2000 the SEC adopted Reg FD (Regulation Fair Disclosure), which prevented companies from disclosing information only to select groups, such as analysts. Reg FD led many companies to begin providing quarterly earnings forecasts directly to the public, and a survey by the National Investors Relations Institute showed that 95% of respondents in 2006 provided either annual or quarterly earnings forecasts, up from 45% in 1999.

Two trends are now in evidence. First, the number of companies reporting quarterly earnings forecasts is falling, but the number reporting annual forecasts is increasing. Second, many companies are providing other types of forward-looking information, including key operating ratios plus qualitative information about the company and its industry. Ratio analysis can help investors use such information, so keep that in mind as you read this chapter.

Sources: Adapted from Joseph McCafferty, “Guidance Lite,” CFO, June 2006, 16–17, and William F. Coffin

and Crocker Coulson, “Is Earnings Guidance Disappearing in 2006?” 2006, White Paper, available at http://www

.ccgir.com/ccgir/white_papers/pdf/Earnings%20Guidance%202006.pdf.

87 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial statement analysis involves (1) comparing a firm’s performance with that of other firms in the same industry and (2) evaluating trends in the firm’s financial posi- tion over time. Managers use financial analysis to identify situations needing atten- tion; potential lenders use financial analysis to determine whether a company is creditworthy; and stockholders use financial analysis to help predict future earnings, dividends, and free cash flow. As we explain in this chapter, there are similarities and differences among these uses.1

3.1 FINANCIAL ANALYSIS When we perform a financial analysis, we conduct the following steps.

Gather Data The first step in financial analysis is to gather data. As we discussed in Chapter 2, financial statements can be downloaded from many different Web sites. One of our favorites is Zacks Investment Research, which provides financial statements in

Intrinsic Value and Analysis of Financial Statements

The intrinsic value of a firm is determined by the present value of the expected future free cash flows (FCF) when discounted at the weighted average cost of capital

(WACC). This chapter explains how to use financial state- ments to evaluate a company’s profitability, required capi- tal investments, business risk, and mix of debt and equity.

Value = + … ++ FCF1 FCF∞

(1 + WACC)1

FCF2

(1 + WACC)2 (1 + WACC)∞

Free cash flow (FCF)

Market interest rates

Firm’s business riskMarket risk aversion

Firm’s debt/equity mixCost of debt Cost of equity

Weighted average cost of capital

(WACC)

Required investments in operating capital

Net operating profit after taxes −

=

1Widespread accounting fraud has cast doubt on whether all firms’ published financial statements can be trusted. New regulations by the SEC and the exchanges, as well as new laws enacted by Congress, have improved oversight of the accounting industry and increased the criminal penalties on management for fraudulent reporting.

resource

The textbook’s Web site contains an Excel file that will guide you through the chapter’s calculations. The file for this chapter is Ch03 Tool Kit.xls, and we encourage you to open the file and follow along as you read the chapter.

WWW See http://www.zacks.com for a source of standard- ized financial statements.

88 Part 1: Fundamental Concepts of Corporate Finance

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a standardized format. If you cut and paste financial statements from Zacks into a spreadsheet and then perform a financial analysis, you can quickly repeat the analysis on a different company by simply pasting that company’s financial statements into the same cells as the original company’s statements. In other words, there is no need to reinvent the wheel each time you analyze a company.

Examine the Statement of Cash Flows Some financial analysis can be done with virtually no calculations. For example, we always look to the statement of cash flows first, particularly the net cash provided by operating activities. Downward trends or negative net cash flow from operations almost always indicate problems. The statement of cash flows section on investing activities shows whether the company has made a big acquisition, especially when compared with the prior years’ net cash flows from investing activities. A quick look at the section on financing activities also reveals whether or not a company is issuing debt or buying back stock; in other words, is the company raising capital from inves- tors or returning it to them?

Calculate and Examine the Return on Invested Capital After examining the statement of cash flows, we calculate the return on invested cap- ital (ROIC) as described in Chapter 2. The ROIC provides a vital measure of a firm’s overall performance. If ROIC is greater than the company’s weighted average cost of capital (WACC), then the company usually is adding value. If ROIC is less than WACC, then the company usually has serious problems. No matter what ROIC tells us about the firm’s overall performance, it is important to examine specific areas within the firm, and for that we use ratios.

Begin Ratio Analysis Financial ratios are designed to extract important information that might not be ob- vious simply from examining a firm’s financial statements. For example, suppose Firm A owes $5 million of debt while Firm B owes $50 million of debt. Which com- pany is in a stronger financial position? It is impossible to answer this question with- out first standardizing each firm’s debt relative to total assets, earnings, and interest. Such standardized comparisons are provided through ratio analysis.

We will calculate the 2010 financial ratios for MicroDrive Inc., using data from the balance sheets and income statements given in Table 3-1. We will also evaluate the ratios in relation to the industry averages. Note that dollar amounts are in millions.

3.2 LIQUIDITY RATIOS As shown in Table 3-1, MicroDrive has current liabilities of $310 million that must be paid off within the coming year. Will it have trouble satisfying those obligations? Liquidity ratios attempt to answer this type of question: We discuss two commonly used liquidity ratios in this section.

The Current Ratio The current ratio is calculated by dividing current assets by current liabilities:

Current ratio ¼ Current assets Current liabilities

resource

See Ch03 Tool Kit.xls for all calculations.

Chapter 3: Analysis of Financial Statements 89

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

¼ $1; 000 $310

¼ 3:2 Industry average ¼ 4:2

Current assets normally include cash, marketable securities, accounts receivable, and inventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses.

MicroDr ive Inc.: Balance Sheets and Income Statements for Years Ending December 31 (Mi l l ions of Dol lars, Except for Per Share Data)

TABLE 3-1

ASSETS 2010 2009 LIABILITIES AND EQUITY 2010 2009

Cash and equivalents $ 10 $ 15 Accounts payable $ 60 $ 30 Short-term investments 0 65 Notes payable 110 60 Accounts receivable 375 315 Accruals 140 130 Inventories 615 415 Total current liabilities $ 310 $ 220 Total current assets $1,000 $ 810 Long-term bondsa 754 580

Net plant and equipment 1,000 870 Total liabilities $1,064 $ 800 Preferred stock (400,000 shares) 40 40 Common stock (50,000,000 shares) 130 130 Retained earnings 766 710 Total common equity $ 896 $ 840

Total assets $2,000 $1,680 Total liabilities and equity $2,000 $1,680

2010 2009

Net sales $3,000.0 $2,850.0 Operating costs excluding depreciation and amortizationb 2,616.2 2,497.0 Earnings before interest, taxes, depreciation, and amortization (EBITDA) $ 383.8 $ 353.0 Depreciation 100.0 90.0 Amortization 0.0 0.0 Depreciation and amortization $ 100.0 $ 90.0 Earnings before interest and taxes (EBIT, or operating income) $ 283.8 $ 263.0 Less interest 88.0 60.0

Earnings before taxes (EBT) $ 195.8 $ 203.0 Taxes (40%) 78.3 81.2

Net income before preferred dividends $ 117.5 $ 121.8 Preferred dividends 4.0 4.0

Net income $ 113.5 $ 117.8

Common dividends $ 57.5 $ 53.0 Addition to retained earnings $ 56.0 $ 64.8

Per-Share Data Common stock price $ 23.00 $ 26.00 Earnings per share (EPS) $ 2.27 $ 2.36 Book value per share (BVPS) $ 17.92 $ 16.80 Cash flow per share (CFPS) $ 4.27 $ 4.16

aThe bonds have a sinking fund requirement of $20 million a year. bThe costs include lease payments of $28 million a year.

90 Part 1: Fundamental Concepts of Corporate Finance

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MicroDrive has a lower current ratio than the average for its industry. Is this good or bad? Sometimes the answer depends on who is asking the question. For example, sup- pose a supplier is trying to decide whether to extend credit to MicroDrive. In general, creditors like to see a high current ratio. If a company is getting into financial difficulty, it will begin paying its bills (accounts payable) more slowly, borrowing from its bank, and so on, so its current liabilities will be increasing. If current liabilities are rising faster than current assets then the current ratio will fall, and this could spell trouble. Because the current ratio provides the best single indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly, it is the most commonly used measure of short-term solvency.

Now consider the current ratio from the perspective of a shareholder. A high cur- rent ratio could mean that the company has a lot of money tied up in nonproductive assets, such as excess cash or marketable securities. Or perhaps the high current ratio is due to large inventory holdings, which might well become obsolete before they can be sold. Thus, shareholders might not want a high current ratio.

An industry average is not a magic number that all firms should strive to maintain—in fact, some very well-managed firms will be above the average, while other good firms will be below it. However, if a firm’s ratios are far removed from the averages for its industry, this is a red flag, and analysts should be concerned about why the variance occurs. For example, suppose a low current ratio is traced to low inventories. Is this a competitive advantage resulting from the firm’s mastery of just-in-time inventory management, or is it an Achilles’ heel that is causing the firm to miss shipments and lose sales? Ratio analysis doesn’t answer such questions, but it does point to areas of potential concern.

The Quick, or Acid Test, Ratio The quick, or acid test, ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities:

Quick; or acid test; ratio ¼ Current assets − Inventories Current liabilities

¼ $385 $310

¼ 1:2 Industry average ¼ 2:1

A liquid asset is one that trades in an active market and hence can be converted quickly to cash at the going market price. Inventories are typically the least liquid of a firm’s current assets; hence they are the current assets on which losses are most likely to occur in a bankruptcy. Therefore, a measure of the firm’s ability to pay off short-term obligations without relying on the sale of inventories is important.

The industry average quick ratio is 2.1, so MicroDrive’s 1.2 ratio is low in compari- son with other firms in its industry. Still, if the accounts receivable can be collected, the company can pay off its current liabilities without having to liquidate its inventory.

Self-Test Identify two ratios that are used to analyze a firm’s liquidity position, and write out their equations. What are the characteristics of a liquid asset? Give some examples. Which current asset is typically the least liquid? A company has current liabilities of $800 million, and its current ratio is 2.5. What is its level of current assets? ($2,000 million) If this firm’s quick ratio is 2, how much inventory does it have? ($400 million)

Chapter 3: Analysis of Financial Statements 91

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3.3 ASSET MANAGEMENT RATIOS Asset management ratios measure how effectively a firm is managing its assets. If a company has excessive investments in assets, then its operating capital will be unduly high, which will reduce its free cash flow and ultimately its stock price. On the other hand, if a company does not have enough assets then it will lose sales, which will hurt profitability, free cash flow, and the stock price. Therefore, it is important to have the right amount invested in assets. Ratios that analyze the different types of assets are described in this section.

Evaluating Inventories: The Inventory Turnover Ratio The inventory turnover ratio is defined as sales divided by inventories:

Inventory turnover ratio ¼ Sales Inventories

¼ $3;000 $615

¼ 4:9 Industry average ¼ 9:0

As a rough approximation, each item of MicroDrive’s inventory is sold out and re- stocked, or “turned over,” 4.9 times per year.2

MicroDrive’s turnover of 4.9 is much lower than the industry average of 9.0. This suggests that MicroDrive is holding too much inventory. High levels of inventory add to net operating working capital (NOWC), which reduces FCF, which leads to lower stock prices. In addition, MicroDrive’s low inventory turnover ratio makes us wonder whether the firm is actually holding obsolete goods not worth their stated value.3

Note that sales occur over the entire year, whereas the inventory figure is mea- sured at a single point in time. For this reason, it is better to use an average inventory measure.4 If the firm’s business is highly seasonal, or if there has been a strong up- ward or downward sales trend during the year, then it is especially useful to make some such adjustment. To maintain comparability with industry averages, however, we did not use the average inventory figure.

2“Turnover” is a term that originated many years ago with the old Yankee peddler who would load up his wagon with goods and then go off to peddle his wares. If he made 10 trips per year, stocked 100 pans, and made a gross profit of $5 per pan, his annual gross profit would be (100)($5)(10) = $5,000. If he “turned over” (i.e., sold) his inventory faster and made 20 trips per year, then his gross profit would double, other things held constant. So, his turnover directly affected his profits. 3A problem arises when calculating and analyzing the inventory turnover ratio. Sales are stated at market prices, so if inventories are carried at cost, as they generally are, then the calculated turnover overstates the true turnover ratio. Therefore, it would be more appropriate to use cost of goods sold in place of sales in the formula’s numerator. However, established compilers of financial ratio statistics such as Dun & Bradstreet use the ratio of sales to inventories carried at cost. To develop a figure that can be compared with those published by Dun & Bradstreet and similar organizations, it is necessary to measure inventory turnover with sales in the numerator, as we do here. 4Preferably, the average inventory value should be calculated by summing the monthly figures during the year and dividing by 12. If monthly data are not available, one can add the beginning and ending annual figures and divide by 2. However, most industry ratios are calculated as shown here, using end-of-year values.

92 Part 1: Fundamental Concepts of Corporate Finance

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Receivables: The Days Sales Outstanding Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily sales to find the number of days’ sales that are tied up in receivables.5

Thus, the DSO represents the average length of time that the firm must wait after mak- ing a sale before receiving cash, which is the average collection period. MicroDrive has 46 DSO, well above the 36-day industry average:

DSO ¼ Days sales outstanding

¼ Receivables Average sales per day

¼ Receivables Annual sales=365

¼ $375 $3;000=365

¼ $375 $8:2192

¼ 45:6 days ≈ 46 days Industry average ¼ 36 days

MicroDrive’s sales terms call for payment within 30 days. The fact that 46 days of sales are outstanding indicates that customers, on average, are not paying their bills

THE GLOBAL ECONOMIC CRISIS

The Price is Right! (Or Wrong!) How much is an asset worth if no one is buying or sell- ing? The answer to that question matters because an accounting practice called “mark to market” requires that some assets be adjusted on the balance sheet to reflect their “fair market value.” The accounting rules are complicated, but the general idea is that if an asset is available for sale, then the balance sheet would be most accurate if it showed the asset’s market value. For example, suppose a company purchased $100 mil- lion of Treasury bonds and the value of those bonds later fell to $90 million. With mark to market, the com- pany would report the bonds’ value on the balance sheet as $90 million, not the original purchase price of $100 million. Notice that marking to market can have a significant impact on financial ratios and thus on inves- tors’ perception of a firm’s financial health.

But what if the assets are mortgage-backed securi- ties that were originally purchased for $100 million? As defaults increased during 2008, the value of such se- curities fell rapidly, and then investors virtually stopped trading them. How should the company report them? At the $100 million original price, at a $60 million price that

was observed before the market largely dried up, at $25 million when a hedge fund in desperate need for cash to avoid a costly default sold a few of these securities, or at $0, since there are no current quotes? Or should they be reported at a price generated by a computer model or in some other manner?

The answer to this question has vital implications for the global financial crisis. In early 2009, Congress, the SEC, FASB, and the U.S. Treasury all are working to find the right answers. If they come up with a price that is too low, it could cause investors mistakenly to believe that some companies are worth much less than their intrinsic values, and this could trigger runs on banks and bankruptcies for companies that might otherwise survive. But if the price is too high, some “walking dead” or “zombie” companies could linger on and later cause even larger losses for investors, in- cluding the U.S. government, which is now the largest investor in many financial institutions. Either way, an error in pricing could perhaps trigger a domino effect that might topple the entire financial system. So let’s hope the price is right!

5It would be better to use average receivables, but we have used year-end values for comparability with the industry average.

Chapter 3: Analysis of Financial Statements 93

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

on time. As with inventory, high levels of accounts receivable cause high levels of NOWC, which hurts FCF and stock price.

A customer who is paying late may well be in financial trouble, in which case MicroDrive may have a hard time ever collecting the receivable. Therefore, if the trend in DSO has been rising but the credit policy has not been changed, steps should be taken to review credit standards and to expedite the collection of accounts receivable.

Evaluating Fixed Assets: The Fixed Assets Turnover Ratio The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It is the ratio of sales to net fixed assets:

Fixed assets turnover ratio ¼ Sales Net fixed assets

¼ $3;000 $1;000

¼ 3:0 Industry average ¼ 3:0

MicroDrive’s ratio of 3.0 is equal to the industry average, indicating that the firm is using its fixed assets about as intensively as are other firms in its industry. Therefore, Micro- Drive seems to have about the right amount of fixed assets in relation to other firms.

A potential problem can exist when interpreting the fixed assets turnover ratio. Recall from accounting that fixed assets reflect the historical costs of the assets. Inflation has caused the current value of many assets that were purchased in the past to be seriously understated. Therefore, if we were comparing an old firm that had acquired many of its fixed assets years ago at low prices with a new company that had acquired its fixed assets only recently, we would probably find that the old firm had the higher fixed assets turnover ratio. However, this would be more reflective of the difficulty accountants have in dealing with inflation than of any inefficiency on the part of the new firm. You should be alert to this potential problem when evaluating the fixed assets turnover ratio.

Evaluating Total Assets: The Total Assets Turnover Ratio The total assets turnover ratio is calculated by dividing sales by total assets:

Total assets turnover ratio ¼ Sales Total assets

¼ $3;000 $2;000

¼ 1:5 Industry average ¼ 1:8

MicroDrive’s ratio is somewhat below the industry average, indicating that the com- pany is not generating a sufficient volume of business given its total asset investment. Sales should be increased, some assets should be sold, or a combination of these steps should be taken.

Self-Test Identify four ratios that are used to measure how effectively a firm is managing its assets, and write out their equations. What problem might arise when comparing different firms’ fixed assets turnover ratios? A firm has annual sales of $200 million, $40 million of inventory, and $60 million of accounts receivable. What is its inventory turnover ratio? (5) What is its DSO based on a 365-day year? (109.5 days)

94 Part 1: Fundamental Concepts of Corporate Finance

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3.4 DEBT MANAGEMENT RATIOS The extent to which a firm uses debt financing, or financial leverage, has three im- portant implications: (1) By raising funds through debt, stockholders can maintain control of a firm without increasing their investment. (2) If the firm earns more on investments financed with borrowed funds than it pays in interest, then its share- holders’ returns are magnified, or “leveraged,” but their risks are also magnified. (3) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so the higher the proportion of funding supplied by stockholders, the less risk cred- itors face. Chapter 15 explains the first two points in detail, while the following ratios examine leverage from a creditor’s point of view.

How the Firm is Financed: Total Liabilities to Total Assets The ratio of total liabilities to total assets is called the debt ratio, or sometimes the total debt ratio. It measures the percentage of funds provided by current liabilities and long-term debt:

Debt ratio ¼ Total liabilities Total assets

¼ $310þ $754 $2;000

¼ $1;064 $2;000

¼ 53:2% Industry average ¼ 40:0%

Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses in the event of liquidation. Stockholders, on the other hand, may want more leverage because it magnifies their return, as we explain in Section 3.8 when we discuss the Du Pont model.

MicroDrive’s debt ratio is 53.2% but its debt ratio in the previous year was 47.6%, which means that creditors are now supplying more than half the total financing. In addition to an upward trend, the level of the debt ratio is well above the industry av- erage. Creditors may be reluctant to lend the firm more money because a high debt ratio is associated with a greater risk of bankruptcy.

Some sources report the debt-to-equity ratio, defined as:

Debt-to-equity ratio ¼ Total liabilities Total assets − Total liabilities

¼ $310þ $754 $2;000 − ð$310þ $754Þ ¼

$1;064 $936

¼ 1:14 Industry average¼ 0:67

The debt-to-equity ratio and the debt ratio contain the same information but present that information slightly differently.6 The debt-to-equity ratio shows that Micro- Drive has $1.14 of debt for every dollar of equity, whereas the debt ratio shows that 53.2% of MicroDrive’s financing is in the form of liabilities. We find it more

6The debt ratio and debt-to-equity ratios are simply transformations of each other:

Debt-to-equity ¼ Debt ratio 1�Debt ratio and Debt ratio ¼

Debt-to-equity

1þDebt-to-equity

Chapter 3: Analysis of Financial Statements 95

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

intuitive to think about the percentage of the firm that is financed with debt, so we usually use the debt ratio. However, the debt-to-equity ratio is also widely used, so you should know how to interpret it.

Sometimes it is useful to express debt ratios in terms of market values. It is easy to calculate the market value of equity, which is equal to the stock price multiplied by the number of shares. MicroDrive’s market value of equity is $23(50) = $1,150. Often it is difficult to estimate the market value of liabilities, so many analysts define the market debt ratio as

Market debt ratio ¼ Total liabilities Total liabilitiesþMarket value of equity

¼ $1;064 $1;064þ ð$23 × 50Þ ¼

$1;064 $2;214

¼ 48:1%

MicroDrive’s market debt ratio in the previous year was 38.1%. The big increase was due to two major factors: Liabilities increased and the stock price fell. The stock price reflects a company’s prospects for generating future cash flows, so a de- cline in stock price indicates a likely decline in future cash flows. Thus, the market debt ratio reflects a source of risk that is not captured by the conventional book debt ratio.

If you use a debt ratio that you did not calculate yourself, be sure to find out how the ratio was defined. Some sources provide the ratio of long-term debt to total assets, and some provide the ratio of all debt to equity, so be sure to check your source’s definition.

Ability to Pay Interest: Times-Interest-Earned Ratio The times-interest-earned (TIE) ratio, also called the interest coverage ratio, is determined by dividing earnings before interest and taxes (EBIT in Table 3-1) by the interest expense:

Times-interest-earned ðTIEÞ ratio ¼ EBIT Interest expense

¼ $283:8 $88

¼ 3:2 Industry average ¼ 6:0

The TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by the firm’s creditors, possibly resulting in bankruptcy. Note that earnings before interest and taxes, rather than net income, is used in the numerator. Because interest is paid with pre-tax dollars, the firm’s ability to pay current interest is not affected by taxes.

MicroDrive’s interest is covered 3.2 times. The industry average is 6, so MicroDrive is covering its interest charges by a relatively low margin of safety. Thus, the TIE ratio reinforces the conclusion from our analysis of the debt ratio that MicroDrive would face difficulties if it attempted to borrow additional funds.

96 Part 1: Fundamental Concepts of Corporate Finance

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Ability to Service Debt: EBITDA Coverage Ratio The TIE ratio is useful for assessing a company’s ability to meet interest charges on its debt, but this ratio has two shortcomings: (1) Interest is not the only fixed financial charge—companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments. If they fail to repay debt or meet lease payments, they can be forced into bankruptcy. (2) EBIT does not represent all the cash flow avail- able to service debt, especially if a firm has high depreciation and/or amortization charges. The EBITDA coverage ratio accounts for these deficiencies:7

EBITDA coverage ratio ¼ EBITDAþ Lease payments Interestþ Principal paymentsþ Lease payments

¼ $383:8þ $28 $88þ $20þ $28¼

$411:8 $136

¼ 3:0

Industry average ¼ 4:3 MicroDrive had $383.8 million of earnings before interest, taxes, depreciation, and

amortization (EBITDA). Also, lease payments of $28 million were deducted while calculating EBITDA. That $28 million was available to meet financial charges; hence it must be added back, bringing the total available to cover fixed financial charges to $411.8 million. Fixed financial charges consisted of $88 million of interest, $20 mil- lion of sinking fund payments, and $28 million for lease payments, for a total of $136 million.8 Therefore, MicroDrive covered its fixed financial charges by 3.0 times. However, if EBITDA declines then the coverage will fall, and EBITDA certainly can decline. Moreover, MicroDrive’s ratio is well below the industry average, so again the company seems to have a relatively high level of debt.

The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks, which rarely make loans (except real estate-backed loans) for longer than about 5 years. Over a relatively short period, depreciation-generated funds can be used to service debt. Over a longer time, those funds must be reinvested to maintain the plant and equipment or else the company cannot remain in business. Therefore, banks and other relatively short-term lenders focus on the EBITDA coverage ratio, whereas long-term bondholders focus on the TIE ratio.

Self-Test How does the use of financial leverage affect current stockholders’ control position? Explain the following statement: “Analysts look at both balance sheet and income statement ratios when appraising a firm’s financial condition.” Name three ratios that are used to measure the extent to which a firm uses financial leverage, and write out their equations. A company has EBITDA of $600 million, interest payments of $60 million, lease pay- ments of $40 million, and required principal payments (due this year) of $30 million. What is its EBITDA coverage ratio? (4.9)

7Different analysts define the EBITDA coverage ratio in different ways. For example: some omit the lease payment information; others “gross up” principal payments by dividing them by 1 – T since these pay- ments are not tax deductions and hence must be made with after-tax cash flows. We included lease pay- ments because for many firms they are quite important, and failing to make them can lead to bankruptcy just as surely as can failure to make payments on “regular” debt. We did not gross up principal payments because, if a company is in financial difficulty, then its tax rate will probably be zero; hence the gross up is not necessary whenever the ratio is really important. 8A sinking fund is a required annual payment designed to reduce the balance of a bond or preferred stock issue.

Chapter 3: Analysis of Financial Statements 97

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3.5 PROFITABILITY RATIOS Profitability is the net result of a number of policies and decisions. The ratios exam- ined thus far provide useful clues as to the effectiveness of a firm’s operations, but the profitability ratios go on to show the combined effects of liquidity, asset manage- ment, and debt on operating results.

Net Profit Margin The net profit margin, which is also called the profit margin on sales, is calculated by dividing net income by sales. It gives the profit per dollar of sales:

Net profit margin ¼ Net income available to common stockholders

Sales

¼ $113:5 $3;000

¼ 3:8% Industry average ¼ 5:0%

MicroDrive’s net profit margin is below the industry average of 5%, but why is this so? Is it due to inefficient operations, high interest expenses, or both?

Instead of just comparing net income to sales, many analysts also break the income statement into smaller parts to identify the sources of a low net profit margin. For example, the operating profit margin is defined as

Operating profit margin ¼ EBIT Sales

The operating profit margin identifies how a company is performing with respect to its operations before the impact of interest expenses is considered. Some analysts drill even deeper by breaking operating costs into their components. For example, the gross profit margin is defined as