Basic earning power ratio analysis

Chapter
Tool Kit Chapter 3 10/27/15
Analysis of Financial Statements
Financial statements are analyzed by calculating certain key ratios and then comparing them with the ratios of other firms and by examining the trends in ratios over time. We can also combine ratios to make the analysis more revealing, one below are exceptionally useful for this type of analysis.
3-1 Financial Analysis
Input Data:
2016 2015
Year-end common stock price $27.00 $40.00
Year-end shares outstanding (in millions) 50 50
Tax rate 40% 40%
After-tax cost of capital 11.0% 10.5%
Lease payments $28 $28
Required sinking fund payments $20 $20
Figure 3-1
MicroDrive Inc. Balance Sheets and Income Statements for Years Ending December 31
(Millions of Dollars, Except for Per Share Data)
Balance Sheets 2016 2015
Assets
Cash and equivalents $ 50 $ 60
Short-term investments - 40
Accounts receivable 500 380
Inventories 1,000 820
Total current assets $ 1,550 $ 1,300
Net plant and equipment 2,000 1,700
Total assets $ 3,550 $ 3,000
Liabilities and Equity
Accounts payable $ 200 $ 190
Notes payable 280 130
Accruals 300 280
Total current liabilities $ 780 $ 600
Long-term bonds 1,200 1,000
Total liabilities $ 1,980 $ 1,600
Preferred stock (400,000 shares) 100 100
Common stock (50,000,000 shares) 500 500
Retained earnings 970 800
Total common equity $ 1,470 $ 1,300
Total liabilities and equity $ 3,550 $ 3,000
Income Statements 2016 2015
Net sales $ 5,000 $ 4,760
Costs of goods sold except depreciation 3,800 3,560
Depreciation 200 170
Other operating expenses 500 480
Earnings before interest and taxes (EBIT) $ 500 $ 550
Less interest 120 100
Pre-tax earnings $ 380 $ 450
Taxes (40%) 152 180
Net income before preferred dividends $ 228 $ 270
Preferred dividends 8 8
Net income available to common stockholders $ 220 $ 262
Other Data
Common dividends $50 $48
Addition to retained earnings $170 $214
Lease payments $28 $28
Bonds' required sinking fund payments $20 $20
Common stock price per share $27 $40
Calculated Data: Operating Performance and Cash Flows
2016 2015
Net operating working capital (NOWC) = $1,050 $790
Total net operating capital = $3,050 $2,490
Net operating profit after taxes (NOPAT) = $300 $330
Operating profitability (OP) ratio = NOPAT/Sales = 6.00% 6.93%
Capital requirement(CR) ratio = (Total net operating capital/Sales) = 61.00% 52.31%
Return on invested capital (ROIC) = NOPAT/Total net operating capital = 9.8% 13.3%
Free cash flow (FCF) = NOPAT − Net investment in operating capital = -$260 N/A
Net cash flow = Net income + Depreciation = $ 420 $432
Earnings before interest, taxes, depreciation & amortization (EBITDA) = EBIT + Depreciation & amortization = $700 $720
Market capitalization (# shares x price per share) $1,350 $2,000
Calculated Data: Per-share Information
2016 2015
Earnings per share (EPS) $4.40 $5.24
Dividends per share (DPS) $1.00 $0.96
Book value per share (BVPS) $29.40 $26.00
Cash flow per share (CFPS) $8.40 $8.64
EDITDA per share $14.00 $14.40
Free cash flow per share (FCFPS) -$5.20 N/A
3-2 Liquidity Ratios Industry
2016 2015 Average
Liquidity ratios
Current Ratio = CA/CL 2.0 2.2 2.2
Quick Ratio = (CA - Inventories)/CL 0.7 0.8 0.8
3-3 Asset Management Ratios Industry
2016 2015 Average
Asset Management ratios
Total Asset Turnover = Sales/TA 1.4 1.6 1.8
Fixed Asset Turnover = Sales/Fixed assets 2.5 2.8 3.0
Days Sales Outstanding = Accounts receivable/Daily sales 36.5 29.1
Christopher Buzzard: To calculate the DSO ratio, a 365-day accounting year was used. 30.0
Inventory Turnover = COGS/Inventories 4.0 4.5 5.0
3-4 Debt Management Ratios Industry
2016 2015 Average
Debt Management ratios
Debt Ratio = Debt-to-Assets Ratio = Total debt/TA 41.7% 37.7% 25.0%
Debt-to-Equity Ratio = Total debt/Total common equity 1.01 0.87 0.46
Market Debt Ratio = Total debt/(Total debt + Market Cap) 52.3% 36.1% 20.0%
Liabilities-to-Assets Ratio = TL/TA 55.8% 53.3% 45.0%
Times Interest Earned = EBIT/Interest expense 4.2 5.5 10.0
EBITDA Coverage Ratio = (EBIT + Depreciation + Lease pmt) (Interest + Principal pmt + Lease pmt) 4.3 5.1 12.0
3-5 Profitability Ratios Industry
2016 2015 Average
Profitability ratios
Profit Margin = Net income/Sales 4.4% 5.5% 6.2%
Basic Earning Power = EBIT/TA 14.1% 18.3% 20.2%
Return on Assets = Net income/TA 6.2% 8.7% 11.0%
Return on Equity = Net income/Total common equity 15.0% 20.2% 19.0%
3-6 Market Value Ratios Industry
2016 2015 Average
Market Value ratios
Price-to Earnings Ratio = Price/(Net income/# shares) 6.1 7.6 10.5
Price-to-Cash Flow Ratio = Price (Net income + Depreciation)/# shares 3.2 4.6 6.3
Price-to-EBITDA Ratio = Price (EBIT + Depreciation)/# shares 1.9 2.8 4.0
Market-to-Book Ratio = Price/(Total common equity/#shares) 0.9 1.5 1.8
Market-to-Book Ratio = (Price x #shares)/(Total common equity) 0.9 1.5 1.8
3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis
TREND ANALYSIS
Trend analysis allows you to see how a firm's results are changing over time. For instance, a firm's ROE may be slightly below the benchmark, but if it has been steadily rising over the past four years, that should be seen as a good sign.
A trend analysis and graph have been constructed on this data regarding MicroDrive's ROE over the past 5 years. (MicroDrive and indusry average data for earlier years has been provided.)
ROE
MicroDrive Industry
2012 15.0% 14.0%
2013 18.0% 15.0%
2014 21.0% 18.0%
2015 20.2% 17.0%
2016 15.0% 19.0%
Figure 3-2
MicroDrive, Inc.: Return on Common Equity
COMMON SIZE ANALYSIS
In common size income statements, all items for a year are divided by the sales for that year.
Figure 3-3
MicroDrive Inc.: Common Size Income Statements
Industry Composite MicroDrive
2016 2016 2015
Net sales 100.0% 100.0% 100.0%
Costs of goods sold except depreciation 75.5% 76.0% 74.8%
Depreciation 3.0% 4.0% 3.6%
Other operating expenses 10.0% 10.0% 10.1%
Earnings before interest and taxes (EBIT) 11.5% 10.0% 11.6%
Less interest 1.2% 2.4% 2.1%
Pre-tax earnings 10.4% 7.6% 9.5%
Taxes (40%) 4.1% 3.0% 3.8%
Net income before preferred dividends 6.2% 4.6% 5.7%
Preferred dividends 0.0% 0.2% 0.2%
Net income available to common stockholders 6.2% 4.4% 5.5%
In common sheets, all items for a year are divided by the total assets for that year.
Figure 3-4
MicroDrive Inc.: Common Size Balance Sheets
Industry Composite MicroDrive
2016 2016 2015
Assets
Cash and equivalents 1.8% 1.4% 2.0%
Short-term investments 0.0% 0.0% 1.3%
Accounts receivable 14.0% 14.1% 12.7%
Inventories 26.3% 28.2% 27.3%
Total current assets 42.1% 43.7% 43.3%
Net plant and equipment 57.9% 56.3% 56.7%
Total assets 100.0% 100.0% 100.0%
Liabilities and Equity
Accounts payable 7.0% 5.6% 6.3%
Notes payable 0.0% 7.9% 4.3%
Accruals 12.3% 8.5% 9.3%
Total current liabilities 19.3% 22.0% 20.0%
Long-term bonds 25.4% 33.8% 33.3%
Total liabilities 44.7% 55.8% 53.3%
Preferred stock 0.0% 2.8% 3.3%
Total common equity 55.3% 41.4% 43.3%
Total liabilities and equity 100.0% 100.0% 100.0%
PERCENT CHANGE ANALYSIS
In percent change analysis, all items are divided by the that item's value in the beginning, or base, year.
Figure 3-5
MicroDrive Inc.: Income Statement Percent Change Analysis
Base year = 2015 Percent Change in
2016
Net sales 5.0%
Costs of goods sold except depreciation 6.7%
Depreciation 17.6%
Other operating expenses 4.2%
Earnings before interest and taxes (EBIT) (9.1%)
Less interest 20.0%
Pre-tax earnings (15.6%)
Taxes (40%) (15.6%)
Net income before preferred dividends (15.6%)
Preferred dividends 0.0%
Net income available to common stockholders (16.0%)
MicroDrive, Inc.: Balance Sheet Percent Change Analysis (not in textbook)
Base year = 2015 Percent Change in
2016
Assets
Cash and equivalents (16.7%)
Short-term investments (100.0%)
Accounts receivable 31.6%
Inventories 22.0%
Total current assets 19.2%
Net plant and equipment 17.6%
Total assets 18.3%
Liabilities and Equity
Accounts payable 5.3%
Notes payable 115.4%
Accruals 7.1%
Total current liabilities 30.0%
Long-term bonds 20.0%
Total liabilities 23.8%
Preferred stock (400,000 shares) 0.0%
Common stock (50,000,000 shares) 0.0%
Retained earnings 21.3%
Total common equity 13.1%
Total liabilities and equity 18.3%
3-8 DuPont Analysis
ROE = Profit margin x TA turnover x Equity multiplier
MicroDrive 2016 15.0% 4.40% 1.41 2.415
MicroDrive 2015 20.2% 5.50% 1.59 2.308
Industry Average 20.3% 6.20% 1.80 1.818
Suppose MicroDrive can improve its total asset turnover ratio.
Improved TA turover ratio = 1.8
ROE = Profit margin x TA turnover x Equity multiplier
19.1% 4.40% 1.80 2.415
MicroDrive
2012 2013 2014 2015 2016 0.15 0.18 0.21 0.20153846153846153 0.14965986394557823 Industry

2012 2013 2014 2015 2016 0.14000000000000001 0.15 0.18 0.17 0.19

ROE (%)

MicroDrive

2012 2013 2014 2015 2016 0.15 0.18 0.21 0.20153846153846153 0.14965986394557823 Industry

2012 2013 2014 2015 2016 0.14000000000000001 0.15 0.18 0.17 0.19

ROE (%)

3-2
SECTION 3-2
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. What is its current ratio? Its quick ratio?
Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670
Current assets $170
Current liabilities $55
Current ratio 3.1
Current assets − Inventories $70
Current liabilities $55
Quick ratio 1.3
A company has current liabilities of $800 million, and its current ratio is 2.5. What is its level of current assets? If this firm’s quick ratio is 2, how much inventory does it have?
Current liabilities ($M) $800
Current ratio 2.5
Current assets ($M) $2,000
Current liabilities ($M) $800
Current ratio 2.5
Quick ratio 2
Current assets - Inventories ($M) $1,600
Inventories ($M) $400
3-3
SECTION 3-2
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, interest expense = $20, and tax rate = 40%. Calculate the following ratios: total assets turnover, fixed assets turnover, days sales outstanding (based on a 365 day year), inventory turnover. Hint: This is the same company used in the previous Self-Test.
Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total assets $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670
Sales $820
COGS (excluding depreciation) $450
Depreciation $50
Other operating expenses $100
EBIT $220
Interest expense $20
Pre-tax earnings $200
Tax rate 40%
Tax expense $80
Net income $120
Days in year 365
Sales $820
Total assets $670
Total assets turnover 1.2
Sales $820
Fixed assets $500
Fixed assets turnover 1.6
Daily average sales $2.25
Accounts receivable $30
Days sales outstanding 13.4
COGS including depreciation $500
Inventories $100
Fixed assets turnover 5.0
A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory, and $60 million of accounts receivable. What is its inventory turnover ratio?
Annual Sales ($M) $200
Costs of good sold ($M) $180
Inventory ($M) $40
Accounts receivable ($M) $60
Inventory turnover 4.5
Annual Sales ($M) $200
Inventory ($M) $40
Accounts receivable ($M) $60
Days sales outstanding 109.5
3-4
SECTION 3-4
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, interest expense = $20, and tax rate = 40%. Calculate the following ratios: Debt-to-assets ratio, debt-to-equity ratio, liabilities-to-assets ratio, times-interest earned ratio, and EBITDA coverage ratio (the firm has no lease payments or required principal payments). Hint: This is the same company used in the previous Self-Test.
Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total assets $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670
Sales $820
COGS (excluding depreciation) $450
Depreciation $50
Other operating expenses $100
EBIT $220
Interest expense $20
Pre-tax earnings $200
Tax rate 40%
Tax expense $80
Net income $120
Days in year 365
Lease payments $0
Required principal payments $0
Total debt $225
Total assets $670
Debt-to-assets ratio 33.6%
Total debt $225
Total common equity $415
Debt-to-equity ratio 54.2%
Total liabilities $255
Total assets $670
Liabilities-to-assets ratio 38.1%
EBIT $220
Interest expense $20
Times-interest-earned ratio 11.0
Suppose the previous company has 100 shares of stock with a price of $15 per share. What is its market debt ratio (assume the market value of debt is close to the book value)? How does this compare with the previously calculated debt-to-assets ratio? Does the market debt ratio imply that the company is more or less risky than the debt-to-assets ratio indicated?
Number of shares 100
Price per share $15
Total debt $225
Market value of equity $1,500
Market debt ratio 13.0%
Notice that the market debt ratio is much less than the debt ratio based on book values, implying that the firm is less risky than indicated by the ratio based on book values.
A company has EBITDA of $600 million, interest payments of $60 million, lease payments of $40 million, and required principal payments (due this year) of $30 million. What is its EBITDA coverage ratio?
EBITDA ($M) $600
Interest payments $60
Lease payments $40
Principal payments $30
EBITDA coverage 4.9
3-5
SECTION 3-5
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, interest expense = $20, and tax rate = 40%. Net profit margin, operating profit margin, basic earning power ratio, return on total assets , and return on common equity. Hint: This is the same company used in the previous Self-Test.
Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total assets $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670
Sales $820
COGS (excluding depreciation) $450
Depreciation $50
Other operating expenses $100
EBIT $220
Interest expense $20
Pre-tax earnings $200
Tax rate 40%
Tax expense $80
Net income $120
Net income $120
Sales $820
Net profit margin 14.6%
EBIT $220
Sales $820
Operating profit margin 26.8%
EBIT $220
Total assets $670
Basic earnings power ratio 32.8%
Net income $120
Total assets $670
Return on total assets 17.9%
Net income $120
Total common equity $415
Return on common equity 28.9%
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. What is its profit margin? What is its ROA? What is its ROE?
Sales ($B) $200
Net income ($B) $10
Total assets ($B) $100
Debt ratio 50%
Profit margin 5.00%
Sales ($B) $200
Net income ($B) $10
Total assets ($B) $100
Debt ratio 50%
ROA 10.00%
Sales ($B) $200
Net income ($B) $10
Total assets ($B) $100
Debt ratio 50%
ROE 20.00%
3-6
SECTION 3-6
SOLUTIONS TO SELF-TEST
A company has $6 billion of net income, $2 billion of depreciation and amortization, $80 billion of common equity, and one billion shares of stock. If its stock price is $96 per share, what is its price/earnings ratio? Its price/cash flow ratio? Its market/book ratio?
Net income ($B) $6
Amortization and depreciation ($B) $2
Common equity $80
Number of shares ($B) 1
Stock price per share $96
Earnings per share $6
P/E ratio 16.00
Cash flow $8.00
Cash flow per share 8.00
Price/cash flow 12.00
Book value per share 80.00
Market/Book 1.20
3-8
SECTION 3-8
SOLUTIONS TO SELF-TEST
A company has a profit margin of 6%, a total asset turnover ratio of 2, and an equity multiplier of 1.5. What is its ROE?
Profit margin 6.0%
Total asset turnover 2.0
Equity multiplier 1.5
ROE 18.0%
Mini Case Data
10/27/15
Mini Case Data
Input Data:
2014 2015 2016
Bart Kreps: Projections
Year-end common stock price $8.50 $6.00 $12.17
Year-end shares outstanding 100,000 100,000 250,000
Tax rate 40% 40% 40%
Lease payments $40,000 $40,000 $40,000
Balance Sheets
Assets 2014 2015 2016
Cash and equivalents $9,000 $7,282 $14,000
Short-term investments $48,600 $20,000 $71,632
Accounts receivable $351,200 $632,160 $878,000
Inventories $715,200 $1,287,360 $1,716,480
Total current assets $1,124,000 $1,946,802 $2,680,112
Gross Fixed Assets $491,000 $1,202,950 $1,220,000
Less Accumulated Dep. $146,200 $263,160 $383,160
Net Fixed Assets $344,800 $939,790 $836,840
Total Assets $1,468,800 $2,886,592 $3,516,952
Liabilities and Equity
Accounts payable $145,600 $324,000 $359,800
Notes payable $200,000 $720,000 $300,000
Accruals $136,000 $284,960 $380,000
Total current liabilities $481,600 $1,328,960 $1,039,800
Long-term bonds $323,432 $1,000,000 $500,000
Total liabilities $805,032 $2,328,960 $1,539,800
Common stock (100,000 shares) $460,000 $460,000 $1,680,936
Retained earnings $203,768 $97,632 $296,216
Total common equity $663,768 $557,632 $1,977,152
Total liabilities and equity $1,468,800 $2,886,592 $3,516,952
Income Statements
2014 2015 2016
Net sales $3,432,000 $5,834,400 $7,035,600
Costs of Goods Sold Except Depr. $2,864,000 $4,980,000 $5,800,000
Depreciation and amortization $18,900 $116,960 $120,000
Other Expenses $340,000 $720,000 $612,960
Total Operating Cost $3,222,900 $5,816,960 $6,532,960
Earnings before interest and taxes (EBIT) $209,100 $17,440 $502,640
Less interest $62,500 $176,000 $80,000
Pre-tax earnings $146,600 ($158,560) $422,640
Taxes (40%) $58,640 ($63,424) $169,056
Net Income before preferred dividends $87,960 ($95,136) $253,584
EPS $0.880 ($0.951) $1.014
DPS $0.220 $0.110 $0.220
Book Value Per Share $6.638 $5.576 $7.909