Managerial Finance Chapter 4

"Window dressing" techniques can make statements and ratios look better.

"window dressing " techniques are employed by firms to make their financial statements look better than they really are. The book talks about how a Chicago builder dramatically increased their current ratio and made themselves appear more liquid just before the annual fiscal year closes on December 31st. Basically the company took a two-year loan on December 27. So both cash and long-term debt increased on the company's balance sheet. Since CL was unchanged but CA increased, the current ratio increased and the firm thus appeared more liquid. However, after the reporting period, the company paid off the loan ahead of time on Jan 2nd, and the current ratio was back at the old level.

The five major categories of ratios

1. Liquidity ratio 2. Asset management ratio 3. Debt management ratio 4. Profitability ratio 5. Market value ratio

Quick Ratio

= (CA - Inventories) / CL Note that inventories are the least liquid among all the current assets. They are the assets on which losses are most likely to occur in the event of liquidation. As a more conservative measure, the quick ratio measures the firm's ability to pay off short-term obligations without relying on the sale of inventories. Just like in the case of current ratios, the higher the quick ratio, the better is the firm's short-term solvency. Quick ratio=(CA-inventories)/CL=(cash+A/R) / (N/P+A/P+accruals)

Inv. turnover

= Sales / Inventories "Turnover" is a term that originated many years ago with the old Yankee peddlers, who would load his wagon up with goods, and then go off his route to peddle his wares. His turnover is the number of trips he took each year. If he stocked 100 pans each time (each pan made him $5 gross profit) and made 10 trips a year, his annual profit would be 100*5*10=5,000. If he went faster and made 20 trips a year, he will double his profit to 100*5*20=10,000. So his turnover directly affected his profits. The higher the turnover, the higher the profits.

Profit margin on sales

= net income/ sales It tells us the profit per dollar of sales, i.e., for every dollar of sales, how much profits can the company make for shareholers? Recall the pizza example, we calculated a net profit margin of 4.59% for Papa John's. It means that for every $1 of sales, Papa John's get to pocket 4.59 cents after excluding all kinds of costs (materials, administration, interests, taxes...) A low profit margin may result from high costs, which, in turn, generally occur because of inefficient operations. Sometimes, heavy use of debt may also lead to higher costs (higher interest costs). If two firms have identical operations in the sense that their sales, operating costs, and EBIT are the same, but if one firm uses more debt than the other, it will have higher interest charges, which will pull net income down. So lower profit margin may indicate a difference in financing strategies, not necessarily an operating problem.

Current Ratio

=CA/CL If a company has just enough CA to meet CL (i.e., CA=CL), its current ratio will be 1. if company has more CA than CL, its current ratio will be higher than 1. On the other hand, if company has less CA than CL, its current ratio will be lower than 1 and the company is in trouble The higher the current ratio, the better is the firm's short-term solvency Current ratio=CA/CL=(cash+A/R+inventories) / (N/P+A/P+accruals)

Return on common equity (ROE)

=net income/equity ROE indicates profit per dollar of equity, i.e., investors' investment; That is, for every $1 of shareholder investment, how much profit does the company make it is the "Bottom-line" accounting ratio there is another way to calculate ROE: on a "per share basis" we can use EPS (which is "earnings per share"=Net income/# of shares outstanding) divided by book equity per share. Book equity per share is defined as total book value of equity divided by the # of shares of outstanding

Return on total assets (ROA)

=net income/total assets It tells us profit per dollar of total assets. That is, for every $1 of assets the company has, how much profit does the company make.

Current Ratio Example

A company with $1 million in current assets, and $1.5 million in current liabilities. The current ratio=CA/CL=1/1.5=0.67<1 So the company will have trouble meeting their short-term obligations. Their debtors will have to be worried. They may exert pressure on the company. For example, their suppliers may refuse to provide them with more credit and insist that they pay cash instead. Their banks may pressure them to ease the situation also.

Difficult to tell whether a company is, on balance, in strong or weak position.

A firm may have some ratios that look good, but other that look bad. It is difficult to say whether the company is, on balance, in strong or weak position. To summarize, while ratio analysis is useful, we need to be aware of its problems and limitations. It's dangerous to conduct ratio analysis in a mechanical and unthinking manner. Instead, good thinking and judgment are always needed in ratio analysis

Companies J and K each reported the same earnings per share (EPS), but Company J's stock trades at a higher price. Which of the following statements is correct? a.Company J must have a higher P/E ratio. b.Company J must have a higher market-to-book ratio. c.Company J must be riskier. d.Company J must have fewer growth opportunities. e.Company J must pay a lower dividend.

A. Price/Earnings per share is higher

"Average" performance is not necessarily good, perhaps the firm should aim higher.

Average is not necessarily good. It is best to focus on the industry leader's ratios.

Peer (or Industry) analysis

Basically, we try to compare apples with apples and oranges with oranges. We compare the company with its peers. We see Dominos has a net profit margin of 7.93%, and so Papa John's 4.83% stands worse than its competitor. Industry average. People also use industry average instead of a single company.

Name the two common liquidity ratios

Current ratio and Quick ratio

A firm's new president wants to strengthen the company's financial position. Which of the following actions would make it financially stronger? a.Increase accounts payable while holding sales constant. b.Increase accounts receivable while holding sales constant. c.Increase inventories while holding sales constant. d.Increase EBIT while holding sales constant. e.Increase notes payable while holding sales constant.

D. because company is earning more per dollar on sales if the earnings increases, but the sales stay constant.

Daily Sales Outstanding (DSO) : Which is better? A 67 days B 33 days Generally speaking, the ________, the better.

DSO represents the average length of time that the firm must wait after making a sale before receiving cash. Generally speaking, the shorter, the better. If customers are paying too late, it may deprive the company of funds that could have been used to reduce bank loans or some other types of costly capital. Also, those late customers may well be in financial trouble, in which case the company may never be able to collect the receivables. If DSO is too long, the company may need to tighten their credit (at the same time, try not to lose sales due to the tight credit policy) So B is generally better (as long as their credit policy is not so tight and their collection is not so aggressive that customers will be pissed off and sales are therefore negatively affected).

During the latest year, ABC Corp. had the following ratios: profit margin=4%, total asset turnover=2, total debt to total assets ratio=40%. Based on the Du Pont equation, what was the firm's ROE?

EM = 1/(1-debt ratio) = 1/(1-40%) = 1.67 ROE = PM*TA TO*EM = 4%*2*1.67 = .1336 = 13%

Fixed Assets turnover

FA turnover=sales/FA; it measures how effectively a firm uses its plant and equipment.

True or false: If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.

FALSE If two firms have the same ROA, the firm with the most debt can be expected to have the higher ROE

Seasonal factors can distort ratios (e.g., inventories).

For example, a booth in the mall usually stock up inventories before the holiday shopping season, but gradually reduce them after that. The Inventory turnover ratio (defined as Sales/Inventories) for the business will be very low before the shopping season when inventories are at the their highest point. The same ratio will be much higher after the shopping season. The problem can be minimized by, for example, using annual averages for inventories.

Different operating and accounting practices can distort comparisons.

For example, different inventory valuation policy (e.g., first in first out or first in last out?) and deprecation methods (e.g., accelerated or straight line?) can affect financial statements and thus distort comparison among firms.

Sometimes it is hard to tell if a ratio is "good" or "bad".

For example, is a high current ratio good or bad? While it indicates high solvency, it may also indicate that the company has excessive unproductive current assets yielding lower returns. Remember when Microsoft shareholders were angry because of the huge cash holding? While the company's liquidity position must have been fantastic, cash does not yield high returns, as we all know. Also as we all know, Microsoft finally decided to initiate dividends to get rid of some of the extra cash they are holding.

receivable turnover

Rec. turnover = Sales / receivable More intuitively, people calculate "Daily sales outstanding" or "average collection period", which equals the average number of days after making a sale before receiving cash , i.e., Daily sales outstanding= average collection period = Receivables / daily sales= Receivables/(sales/365)

Inventory Turnover Ratio: Which is better? A 5.8 times per year B 9.2 times per year Generally speaking, the ________, the better.

Turnover ratios are ratios where sales are divided by some assets. As the name implies, they show how many times the item is "turned over" during the year. Higher turnover ratio (more sales, less assets) usually leads to higher profits. So B is better (as long as they are not carrying so few inventories that sales are negatively affected).

True or False: Companies HD and LD are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company HD has the higher debt ratio. a.Company HD has a lower total assets turnover than Company LD. b.Company HD has a higher ROE than Company LD. c.Company HD has a lower equity multiplier than Company LD.

a. False - total asset turnover = S/TA; should be the same b. True - ROE = ROA*EM; ROA is the same for both companies, but HD has a higher EM, and so higher ROE) c. False - HD has a higher equity multiplier because it has more debt and less equity EM = TA/Equity

Liquidity ratios

are about a firm's "liquidity position", i.e., whether the firm will be able to pay off its debts coming due.

Turnover ratios

are ratios with sales divided by assets. As the name implies, they show how many times the item is "turned over" during the year.

managers use financial statements to

evaluate and improve the firm's performance

stockholders use financial statements to

evaluate the firm's performance and by security analysts to forecast earnings, dividends, and stock prices

lenders use financial statements to

evaluate the likelihood that borrowers will be able to pay off loans

According to the Du Pont equation, ROE is a result of three aspects:

expense control asset utilization debt utilization A company with better expense control (higher profit margin) has higher ROE, other things being equal. A company with better asset utilization (higher total asset turnover ratio) has higher ROE, other things being equal. A company with more debt (higher equity multiplier) has higher ROE, other things being equal. (Note that equity multiplier is defined as TA/equity. Thus, the greater the debt, the less equity, and thus the higher the equity multiplier.)

Stockholders may want a _______ debt ratio.

high; Stockholders may want more leverage, that is a high debt ratio, because it can magnify expected earnings (we will see it more clearly when we talk about the DuPont system).

The higher the equity multipler, the _______ the debt ratio)

higher the debt ratio, the more leveraged a company is

What do asset management ratios measure?

how effectively a firm manages its assets "assets" = the left side of the balance sheet gives us the assets: cash, inventories, A/R, fixed assets... "effectively" = Does the amount of each type of asset seem reasonable in view of current and projected sales. 1. Assets too high? Remember all assets need to be financed, and it is NOT free to finance the assets. The more assets the company has, the higher financing costs the company will need to pay, and the lower the profits. 2. Assets too low? While keeping financing costs down, the firm risks losing profitable sales. So reasonable means "just right"---not too high, and not too low either (Yeah..kind of like the Goldilocks story).

which statement would you look at to see profitability

income statement

Benchmarking

it means "compare with top performer in the industry." Realizing that industry average is not necessarily good, many firms also compare themselves with the top firms in their industry (Section 4-9b on your book)

Creditors prefer a _________ debt ratio.

low, since it is safer

You observe that a firm's ROE is above the industry average. What could be the possible reasons?

might be because either of the three (EM, PM, TA TO) higher than industry average

net profit margin

net income / sales allows two companies to be compared in regard to profitability on equal footing

Trend analysis

we compare the company with itself over time. For example, we can get the net profit margin of Papa Johns for 2013 (4.83%), 2012 (4.59%), 2011 (4.57%), 2010 (4.61%), 2009(5.19%), 2008 (3.25%), 2007 (3.08%), 2006 (6.33%) , and so we learn 4.83% is better than the past three years, and better than 2007-2008, but it is not as good as in 2009 or 2006. We can even plot the ratios over time and see an overall upward trend since 2007.

What's the firm's major strength and weakness? PM TA TO EM ROE 2004 2.60% 2.3 2.2 13.30% 2005 -2.70% 2.1 5.8 -32.50% 2006E 3.60% 2 1.8 13.00% Ind. 3.50% 2.6 2 18.20%

1. the company's profit margin is a little higher than the industry average (3.6% versus 3.5% for the industry). So PM is not a reason why the company has lower ROE. 2. the company's TA TO is below industry average (2.0 versus 2.6), leading to lower ROE. The company's total assets are "turned over" more slowly than the industry average. To improve TA TO (Sales/Total assets), the company need to investigate how to reduce total assets (inventories, fixed assets...), while keeping sales constant. 3. the company is expected to be less leveraged than the industry average, leading to lower ROE. Remember that debt can magnify ROE.

P/E Ratios Co. A = 10 to 1 Co. B = 7 to 1 Both companies have earnings of $2 per share. So why the different P/E ratios?

P/E ratios reflect how much investors are willing to pay per dollar of reported profits. Both companies have earnings of $2 per share. So investors are willing to pay more for every $1 of current earnings of company A. Why the different P/E ratios? Two things are possible: Riskiness: company A might be less risky. Growth prospects: company A might have better growth prospects

Match the ratios to what they tell us: PM Asset utilization TA TO Debt utilization Equity multiplier (TA/equity) Expense control

PM (profit margin) = expense control TA TO ( total asset turnover) = Asset Utilization Equity Multiplier (TA/Equity) = Debt Utilization

P/E Ratios

Price to Earnings ratio Price per share/earnings per share, where earnings per share=Net income/total # of shares outstanding Reflects how much investors are willing to pay per dollar of reported profits. Notice that there is no "correct" P/E ratio. The S&P 500's historical average is 15.9X, and it has ranged from 7.1X to 48.1X over the last 30 years. In the spring of 2010, The S&P's P/E ratio is 21.1X versus 27.2X for google, which has above-average growth prospect. P/E ratio will be more meaningful if we look at similar companies in the same industry. For example, Papa John's has a P/E ratio of 31.43, and Domino's has a P/E ratio of 30.28.

Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.

Ratio analysis is more useful for small, narrowly focused firms than for large multidivision ones. For conglomerate companies with various business lines, it would be really difficult to find a peer company to compare the ratios with.

Debt Ratio

Total debt to total assets : debt/assets

Answer: Higher debt ratio: more/less risky.

Higher debt ratio: more risky. Highly leveraged firms, that is, firms relying more on debts, are more risky. Although they may realize higher returns when they economy is good, they are exposed to a higher probability of loss when the economy enters a recession. FYI: I posted an article on the week 4-5 checklist about 15 companies that might not survive 2009. You will see that a lot of them carried huge debts, which make the companies worrisome during an economic downturn. Why? For the two sources of financing: debts and equity, one major difference is that companies can skip dividend payment to shareholders, but they cannot skip interest costs for debt. If they skip interest payments, the debtors can force bankruptcy. Say, a company has annual interest cost of $1 million, which might not be a problem during normal years for they to come up with the money. However, when the economy slows down, like it did in 2008, they might not have enough to cover the $1 million.

Example: suppose you have a little booth selling bottled water in the mall. The bottles of water are your inventories, or assets. You borrow from the bank to buy inventories. Are you carrying reasonable amount of inventory in view of current and projected sales (say, you usually sell 100 bottles per day)?

If you carry 1 million bottles, you need to borrow a lot from the bank, and have to pay a lot of interest to the bank, potentially lowering your profits. However, if you only carry 10 bottles, you may have to say a lot of "sorry, we are out" and lose potential profitable sales. Profits will suffer too!

M/B ratios:

Market to Book ratio price per share/book value per share, where book value per share=common equity/number of shares outstanding. Reflects how much investors are willing to pay per dollar of book value of equity. M/B ratios typically exceed 1. This means that investors are willing to pay more for stocks than their accounting book value. Why? First, assets in place are recorded at historical value on the balance sheets, and therefore do not reflect either inflation or "goodwill". Second, the book value of equity does not incorporate the company's future prospects or growth options. In the spring of 2010, Google had a M/B ratio of 4.9X, while Bank of America was only at 0.78X. Does it make sense given that Google is a high-tech company with higher growth potential.

Equity Multipler

On equity multiplier Equity multiplier is calculated as TA/Equity. It is related to the debt ratio (Debt/TA). Sometimes, in a question, you might be given the debt ratio. In that case, you can calculate the EM as 1/(1-debt ratio).

Considered alone, which of the following would increase a company's current ratio? A. An increase in accounts receivable. B. An increase in accounts payable. C. An increase in net fixed assets. D. An increase in notes payable. E. An increase in accrued liabilities. F. Price reductions along with generous credit terms that (1) enabled the firm to sell some of its excess inventory and (2) led to an increase in accounts receivable. G. Issue new common stock and use the proceeds to acquire additional fixed assets. H. Issue new common stock and use the proceeds to increase inventories.

Statement a and h are true, because the current ratio is increased either by an increase in current assets or a decrease in current liabilities. For the other choices: B, D, and E will increase current liabilities, and so decrease the current ratio C and G do not affect current ratio since they do not involve current assets or current liabilities F does not affect current ratio because total current assets are not changes (increase in A/R, and decrease in Inventories by the same amount, but the sum is still the same)

Last year ABC Inc had a total assets turnover of 1.60 and an equity multiplier of 2. Its sales were $200,000 and its net income was $10,000. The CFO believes that the company could have operated more efficiently, lowered its costs, and increased its net income by $5,000 without changing its sales, assets, or equity multiplier. Had it cut costs and increased its net income in this amount, by how much would the ROE have changed?

TA TO = 1.60 EM = 2 sales $200,000 NI = $10,000 PM = NI/sales = 5% current ROE = PM*TA TO*EM 5%*1.60*2 = 16% PM new = (10,000 + 5000)/200000 = 7.5% new ROE = 7.5%*1.60*2 = 24% Increase of 8%

Total assets turnover

TA turnover=sales/TA; it measures how effectively a firm uses all its assets.

For example, let's say we have a company with $1 million in current assets (CA), and $1.5 million in current liabilities (CL). Will this company be in trouble? Does this company have enough CA to meet CL obligations?

The answer is no. $1 million is not enough to cover $1.5 million debts that are coming due within a year. So the company might have liquidity problem, that is trouble paying its bills as they come due.

Inflation has badly distorted many firms' balance sheets

The book value of assets are often substantially different from the "true" value. The impact of inflation is larger for older firms. So we have to take caution when we compare companies of different ages, or examine a firm over time.