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350-04a_note, 22F CHAPTER 4: ANALYSIS OF FINANCIAL STATEMENTS Section I: Outline Outline Study Guide I. Ratio Analysis A. Introduction (4-1, 4-9) B. Financial Statements C. Liquidity (4-2) D. Asset management (4-3) E. Debt management (4-4) F. Profitability (4-5, 4-8) G. Market value (4-6) H. Du Pont system (4-7) ● Why are ratios useful? ● What are the five major categories of ratios? What questions do they answer? ● What are liquidity ratios? ● What are asset management ratios? ● What are debt management ratios? ● What are profitability ratios? ● What are market value ratios? ● How to use the Du Pont system? II. Limitations of ratio analysis (4-10) ● What are the limitations of ratios? III. Exam Sample Section II: Homework Assignment Chapter 4 Question 1-3, 8 Problem 1-4, 8, 12, 18-19 ================================================================ Section III: Class Notes I. Ratio Analysis A. Introduction (4-1, 4-9) 1. Why are Ratios Useful? a) Ratios standardize numbers and facilitate comparisons. b) Ratios are used to highlight weaknesses and strengths. c) Ratio comparisons should be made through time and with competitors (1) Trend analysis: a comparison across time (2) Peer analysis: Examples such as Industry Average or Benchmarking 2. What are the five major categories of ratios, and what questions do they answer? a) Liquidity: Can we make the required payments? b) Current Assets / Current Liability c) Asset management: Productivity, the right amount of assets vs. sales? d) Debt management: Leverage, the right mix of debt and equity? e) Profitability: Do we make profits? What is the net result of our financing policies and operating decisions? f) Market value: Do investors like what they see? Page 1 of 19

350-04a_note, 22F B. Financial Statements: 1. Balance Sheet: 2016E 2015 2014 Assets Cash 86 7 58 AR 878 633 351 Inventories 1,717 1,287 715 Total CA 2,681 1,927 1,124 Gross FA 1,197 1,203 491 Less: Accumulated Dep 380 263 146 Net FA 817 940 345 Total Assets 3,498 2,867 1,469 Liabilities and Equity AP 437 524 146 Notes Payable 300 637 200 Accruals 408 490 136 Total CL 1,145 1,651 482 LT debt 400 723 323 Total Liability 1,545 2,374 805 Common Stock 1,721 460 460 Retained earnings RE 232 33 204 Total Equity 1,953 493 664 Total L+E 3,498 2,867 1,469 Page 2 of 19

350-04a_note, 22F 2. Income Statement 2016E 2015 2014 Sales 7,036 6,034 3,432 COGS 5,876 5,528 2,864 Other Expenses 550 520 359 EBITDA 610 (14) 209 Depreciation & Amortization 117 117 19 EBIT (Operating Income) 493 (131) 190 Interest Expense 70 136 44 EBT (Gross Income) 423 (267) 146 Taxes 169 (107) 59 Net Income 254 (160) 87 EPS 1.016 (1.600) 0.87 DPS 0.220 0.110 0.220 BV / Share 7.812 4.93 6.64 Stock Prices 12.17 2.25 8.5 Shares outstanding 250,000 100,000 100,000 Tax rate 40% 40% 40% Lease payments 40,000 40,000 40,000 Sinking fund payments 0 0 0 Page 3 of 19

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350-04a_note, 22F C. Liquidity Ratio (4-2) 1. Question: Can we make the required payment? 2. Calculation: Calculate D’Leon’s forecasted current ratio and quick ratio for 2016 Ratio Definition Discussion Calculation 2016E 2015 2014 Industry Current Ratio can they pay their current liabilities CR = CA CL Main complaint is that it's too optimistic that you can sell inventory quick enough -There are 2.34 times more current assets than there is current liability -For every one dollar of currently liability I have 2.34 dollars for current assets to pay for it $ 2681 $ 1145 2.34x 1.17x 2.33x 2.70x Quick Ratio QR = CA − Inventories CL It is more conservative -For every dollar of current liabilities we only have 84 cents to pay with current assets and less inventory. This means we do not have enough to pay off current liabilities $ 2681 − 1717 $ 1145 0.84x 0.39x 0.85x 1.00x 3. Comments: a) Expected to improve but still below the industry average. b) The liquidity position is weak Page 4 of 19

350-04a_note, 22F D. Asset Management (4-3) 1. Question: Do we manage our assets effectively? That is, do we have the right amount of assets vs. sales? 2. Calculation: Calculate D’Leon’s forecasted Inventory Turnover, FA Turnover, TA Turnover, and Days Sales Outstanding (DSO) Ratio Definition Discussion Calculation 2016E 2015 2014 Industry Inventory Turnover IT = Sales Inventory -How quick you can sell your inventory. The inventory can be sold 4.1 times in the period. Every dollar of inventory you receive you can sell 4.1 dollars worth -This can be done by decreasing your inventory or increasing your sales. Talk to marketing or sales management $ 7036 $ 1717 4.10x 4.69x 4.80x 6.10x Fixed Asset Turnover FAT = Sales Net Fixed Assets -Your NFA are making 8.61 dollars of sales for every dollar they’re worth $ 7036 $ 817 8.61x 6.42x 9.95x 7.00x Total Asset Turnover TAT = Sales Total Assets -Every dollar you have in total assets it makes 2.01 dollars in sales $ 7036 $ 3498 2.01x 2.10x 2.34x 2.60x Days Sales Outstanding DSO = AR Average SalesPer Day -How long it takes for you to receive your cash from sales. -Want a lower ratio because you receive cash faster -AR is responsible for ratio -They need a lot of liquidity (cash on hand) . $ 878 ( 7036 365 ) 45.6 days 38.3 37.3 32.0 Conflict of interest in DSO. Sometimes you don’t receive any cash because AR is not pushing enough, OR marketing is advertising that you can buy product without paying for X amount of days increasing sales but not cash right away 3. Comments: a) Comments on Inventory Turnover (1) Inventory turnover is below the industry average. No improvement is currently forecasted (2) D’Leon might have old inventory, or its control might be lacking. b) FA turnover is projected to exceed the industry average. c) TA turnover is below the industry average. It is caused by excessive current assets (A/R and Inv). Page 5 of 19

350-04a_note, 22F d) D’Leon collects on sales too slowly and is getting worse. D’Leon has a poor credit policy. Page 6 of 19

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350-04a_note, 22F 4. Example Q4-3 a) Q: Over the past year, MDR had an increase in its current ratio and a decline in its total assets turnover ratio. However, the company’s sales, cash and equivalents, DSO, and fixed assets turnover ratio remained constant. What balance sheet accounts must have changed to produce the indicated changes? b) A: ???? *** What do we know? Translate information *** What is the question? Q: What caused these changes? *** How to solve it? A: Ratio analysis 1. CR = CA/CL inc. 2. TAT = sales/TA dec 3. Sales = 2&3 = 7. TA inc 4. DSO = AR/Daily Sales = 3&4 = 8. AR inc 5. FAT = sales/NFA = 3&5 = 9. NFA 6. Cash 7&9 = 10. CA inc 6&8&10 = INV inc Page 7 of 19

350-04a_note, 22F 1. Effect on Improving Ratios a) Q: How would reducing the firm’s DSO from 45.6 days to 32 days affect its cash position (Assume no impact on sales)? Assets Liabilities and Equity Cash 87 AP 437 AR 878 Notes Payable 300 Inventories 1,715 Accruals 408 Total CA 2,680 Total CL 1,145 Gross FA 1,197 LT debt 400 Less: Acc. Dep 380 Common Stock 1,721 Retained earnings RE 231 Net FA 817 Total Equity 1,952 Total Assets 3,497 Total L+E 3,497 b) A: ???? *** What do we know? Translate information DSO = 45.6 = AR Daily sales DSO = 32 Sales = Sales BS ? AR = 878 AR = ? Cash = 87 Solve 45.6 = 878/X 878/45.6 = 19.25 Cash = ? *** What is the question? Q: What is the change in cash balance? X = Δ Cash *** How to solve it? A: Ratio analysis A1: 45.6 = 878 Daily sales -> Daily sales = 19.25 A2: 32 ¿ x 19.25 -> AR = 616 A3: Δ AR = (616-878) = -262 -> Δ Cash = + 262 Page 8 of 19

350-04a_note, 22F B. Debt Management (4-4) 1. Question: Do we manage our debt effectively? That is, do we have the right mix of debt and equity? 2. Calculation: Calculate D’Leon’s forecasted debt-to-capital ratio (debt ratio) and Times-Interest Earned (TIE) Ratio Definition Discussion Calculation 2016E 2015 2014 Industr y Liability-to- Asset Ratio Accounting ratio LA = TL TA Safer when ratio is lower TA = TL + TE Liabilities fund 44.2% of assets and equity fund 56% of assets Higher percent makes it more risky , however, it does not make it a bad company $ 1545 $ 3498 44.2% 82.8 % 54.8 % 50.0% Debt-to- Capital Ratio DC = TD TotalCapital TIC = TD + TE * * Total Capital = Total Invested Capital $ 300 + 400 $ 700 + 1953 26.4% 73.4 % 44.1 % 40.0% Equity Multiplier EM = TA TE = 1 1 − LA Use whichever ratio is possible/given Every dollar of stock we create 1.94 of assets $ 3798 $ 1953 1.94x 5.81x 2.21 x 2.00x Times Interest Earned Every one dollar of interest owed we have 7 dollars of operating income to pay for EBIT is operating income $ 493 $ 70 7.0x -1.0x 4.3x 6.2x 3. Comments: a) TIE is better than the industry average. Page 9 of 19

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350-04a_note, 22F C. Profitability: (4-5, 4-8) 1. Question: Do we make profits? What is the net result of our financing policies and operating decisions? 2. Calculation: Calculate D’Leon’s forecasted Operating Margin (OM), Profit Margin (PM), Basic Earning Power (BEP), Return on Assets (ROA), and Return on Equity (ROE) Ratio Definition Discussion Calculation 2016E 2015 2014 Industr y Profit Margin Every dollar of sales you keep 3.6% of that $ 254 $ 7036 3.6% -2.7% 2.5% 3.5% Operating Margin Every dollar of sales you make you keep 7.0% before interest and tax This is used to evaluate store managers as they are not responsible for interest or taxes ** EBIT = operating income $ 493 $ 7036 7.0% -2.2% 5.6% 7.3% Return on Assets Managers and lenders care about ROA as that’s more about the whole company Return means risk $ 254 $ 3498 7.3% -5.6% 5.9% 9.1% Return on Equity Stockholder care about ROE over ROA Return means risk $ 254 $ 1953 13.0% - 32.5 % 13.1 % 18.2% Basic Earning Power Similar to Profit margin vs operating margin. In this case BEP vs ROA $ 493 $ 3498 14.1% -4.6% 13.0 % 19.1% Return on Invested Capital $ 493 ∗ 0.6 $ 2653 11.1% -4.2% 9.6% 12.2% 3. Comments: Page 10 of 19

350-04a_note, 22F a) Appraising profitability with the PM and BEP (1) The profit margin was terrible in 2015 but is projected to exceed the industry average in 2016. Looking good. (2) BEP removes the effects of taxes and financial leverage. It is useful for comparison. (3) BEP is projected to improve, yet still below the industry average. There is definitely room for improvement. b) Appraising profitability with the ROA and ROE (1) Both ratios rebounded from the previous year but are still below the industry average. More improvement is needed. (2) Wide variations in ROE illustrate the effect that leverage can have on profitability. 4. Advanced question - Effects of Debt on profitability ratios: What is the impact on the following ratios when more debt is used? a) Assume Firm A decides to increase debt financing and keep the total asset constant. *** What do we know? Translate information *** What is the question? Q: What is the impact on PM, OM, ROA, and ROE? *** How to solve it? A: Ratio analysis TA = TL + TE TA = TL + TE 100 = 20 + 80 TL ↑, TE ↓ 100 = 60 + 40 A1: Interest expense ↑ -> NI ↓ BUT EBIT ≅ A2: Impact on PM = ¿ Sales ↓ BUT impact on OM = EBIT Sales ≅ A3: Impact on ROA = ¿ TA ↓ BUT impact on ROE = ¿ TE ????? 5. Is maximizing ROE the company’s financial goal? Why or why not? a) Risk: b) Amount of invested capital: Which project should you choose? (1) Project A: Investment of $50,000 with an ROE of 50% (2) Project B: Investment of $1,000,000 with an ROE of 45% c) Performance incentive: Your bonus is linked to ROE performance. Your division currently has an ROE of 45%. Will you accept a project with an estimated ROE of 35%? Page 11 of 19

350-04a_note, 22F This shows agency problem (chp 1) managers vs stockholders Page 12 of 19

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350-04a_note, 22F D. Market Value (4-6) 1. Question: Do investors like what they see? That is, do investors like us? 2. Calculation: Calculate D’Leon’s forecasted Price/Earnings and Market/Book Ratios Ratio Definition Discussion Cal. 2016E 2015 2014 Industr y P/E Higher or lower is not good or bad For every dollar we earn the market is willing to pay 12 dollars The market thinks that in the future it will be valued more $ 12.17 $ 1.016 12.0x -1.4x 9.7x 14.2x MV/BV For every dollar of value the market is willing to pay 12 dollars $ 12.17 $ 7.812 1.56x 0.5x 1.3x 2.4x Growth stock have a high potential to grow in the future Value stock aren’t expected to grow that much in the future 3. Comments: a) P/E: How much investors are willing to pay for $1 of earnings. b) M/B: How much investors are willing to pay for $1 of book value equity. c) For each ratio, the higher the number, the higher the perceived value of the firm from the market. d) P/E and M/B are high if ROE is high and risk is low. Page 13 of 19

350-04a_note, 22F E. The Du Pont System (4-7) 1. Calculation: ROA = Profit Margin * Total Asset Turnover (TAT) = * 2016E 7.3% = 3.6% * 2.0x 2015 -5.6% = -2.7% * 2.1x 2014 6.0% = 2.6% * 2.3x Industr y 9.1% = 3.5% * 2.6x 2. Calculation: ROE = Profit Margin * Total Asset Turnover (TAT) * Equity Multiplier (EM) = * * TA TE 2016E 13.0% = 3.6% * 2.0x * 1.8x 2015 -32.5% = -2.7% * 2.1x * 5.8x 2014 13.3% = 2.6% * 2.3x * 2.2x Industry 18.2% = 3.5% * 2.6x * 2.0x 3. Calculation: ROE = ROA * Equity Multiplier (EM) = * TA TE 2016E 13.0% = 7.3% * 1.8x 2015 -32.5% = -5.6% * 5.8x 2014 13.3% = 6.0% * 2.2x Industr y 18.2% = 9.1% * 2.0x Page 14 of 19

350-04a_note, 22F 4. II. Limitations and other methods (4-10) A. Limitations 1. Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. 2. “Average” performance is not necessarily good; perhaps the firm should aim higher. 3. “Inflation” distorts balance sheets. BV versus MV. 4. Seasonal factors can distort ratios. 5. “Window dressing” techniques can make statements and ratios look better. Managers move accounts around to make statements look better 6. Different operating and accounting practices can distort comparisons. i.e depreciation 7. Sometimes it is hard to tell if a ratio is “good” or “bad.” 8. Difficult to tell whether a company is, on balance, in a strong or weak position. Mixed signals from ratios. B. Look Beyond the numbers III. Exam Sample A. Answer All Questions. Read all the answers carefully and select the best answer for each question. 1. If a bank loan officer were considering a company’s loan request, which of the following statements would you consider to be CORRECT? a) Other things held constant, the lower the company’s inventory turnover ratio, the higher the interest rate the bank would charge the firm. Low inv. turnover ratio is bad because they aren’t selling as much b) Other things held constant, the higher the days sales outstanding ratio, the lower the interest rate the bank would charge the firm. High D.S.O is bad because you are taking longer time to receive cash therefore you have to finance more therefore the sentence is wrong c) Other things held constant, the higher the total debt to total capital ratio, the lower the interest rate the bank would charge the firm. High Debt to capital ratio is bad because you already have a higher amount of debt therefore the sentence is wrong d) Other things held constant, the lower the company’s TIE ratio, the lower the interest rate the bank would charge the firm. Low Total invested equity is bad because you have a larger amount of interest expense compared to operating income therefore the sentence is wrong e) Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm. A low current ratio is bad because you have a less assets to cover liabilities Page 15 of 19

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350-04a_note, 22F 2. Ace Industries has $2.0 million in current assets and $0.75 million in current liabilities. Ace decides to raise funds as additional notes payable and use them to increase inventory . How much can Ace’s notes payable increase without pushing its current ratio below 1.8? a) $0.1875 million b) $0.2578 million c) $0.8500 million. d) $0.2625 million. e) $0.8125 million. *** What do we know? Translate information *** What is the question? Q: What is the change in NP? X = Δ NP *** How to solve it? A: Ratio analysis This is at the beginning CA = 2 CL = 0.75 This is at the end Δ NP = Δ INV CR = CA CL 1.8 A1: CA = 2 + Δ INV A2: CL = 0.75 + Δ NP A3: CR = CA CL = CA + INV CL + NP 1.8 2 + INV 0.75 + NP = 2 + X 0.75 + X 1.8 (2+x)/(0.75+x) = 1.8 2+x = 1.8 (0.75 + x) 2 + x = 1.35 + 1.8x 0.65 = 0.8x 0.8125 = x technically the = is greater than or equal to Page 16 of 19

350-04a_note, 22F 3. A new firm is developing its business plan. It will require $600,000 of total capital , and it projects $435,000 of sales and $350,000 of operating costs for the first year. The firm is quite sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 5.0, and if the TIE falls below this level, the bank will call in the loan, and the firm will go bankrupt. What is the maximum debt-to-capital ratio the firm can use? a) 46.1% b) 37.8% c) 47.2% d) 48.6% e) 50.5% *** What do we know? Translate information *** What is the question? Q: What is the DC ratio? X = DC = X = DC = TD TIC = ? *** How to solve it? A: Ratio analysis TIC = 600 Sales = 435 Operating cost = 350 Interest rate = 7.5% = 0.075 TIE = EBIT ∫ ¿ > 5 ¿ A1: TIE = EBIT ∫ ¿ 5 ¿ -> ( 435 − 350 ) ∫ ¿ 5 ¿ 85/5 = -> 17 ≥ Interest expense Total debt is found by interest expense = total debt * interest rate A2: 17 ≥ TD*(0.075) -> 226.67 ≥ TD A3: DC = TD TIC = 226.67 600 0.3778 ∨ 37.78% Page 17 of 19

350-04a_note, 22F 4. Last year, Candle Corp had $250 of assets , $360 of sales , $15 of net income , and a liability -to- asset ratio of 60%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $22. Assets and sales would not be affected. Now suppose the new CFO convinces the president to decrease the liability -to-asset ratio to 50%. By how much would the cost reduction improve the ROE? *** What do we know? Translate information *** What is the question? Q: What is the change in ROE? X = Δ ROE ¿ ¿ TE = ? *** How to solve it? A: Ratio analysis What numbers change before and after? TA = 250 Same Sales = 360 Same NI = 15 NI = 22 LA = 60% = 0.6 = TL TA LA = 50% = 0.5 A1: LA = TL 250 = 0.6 -> TL = 150 LA = TL 250 = 0.5 -> TL = 125 A2: TA = TL + TE -> TE = 100 250 = 125 + TE -> TE = 125 A3: ROE = 15 100 = 0.15 ROE = 22 125 = 0.176 Δ ROE = (0.176-0.15) = 0.026 (OR 2.6%) 5. Last year, Candle Corp had $200 of assets, $300 of sales, $20 of net income, and a liability-to-asset ratio of 40%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $30.8. Assets, sales, and the liability-to-asset ratio would not be affected. By how much would the cost reduction improve the ROE? a) 8.33% b) 8.67% c) 9.00% d) 9.33% e) 9.67% 6. Last year, Candle Corp had $250 of assets, $300 of sales, $20 of net income, and a liability-to-asset ratio of 40%. Now suppose the new CFO convinces the president to increase the liability-to-asset ratio to 50%. Sales and total assets will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE? a) 3.33% b) 3.67% c) 4.33% d) 5.21% e) 2.67% Page 18 of 19

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350-04a_note, 22F Page 19 of 19

Chapter 4 notes

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