Week 5 Assignment (2)
Learning Objectives
Upon completion of Chapter 11, you will be able to:
• Describe why financial statements are the foundation upon which financial analysis is built.
• Identify three shortcomings of financial statements.
• Describe a variety of sources of financial information that can be useful in financial analysis.
• Construct and interpret trend and common size financial statements.
• Calculate and interpret a set of the most commonly used financial ratios.
• Utilize bond ratings, economic value added, and DuPont analysis to assess the financial condi- tion and performance of a business.
Financial Analysis: Evaluation of Corporate Performance
11
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CHAPTER 11Section 11.1 Evaluating Corporate Performance
The evaluation of corporate performance is an important skill for managers, inves-tors, and even customers and employees. Such analysis is the topic of Chapter 11. This chapter covers financial statement analysis, particularly ratio analysis, as well as other methods of evaluating corporate performance. One of our objectives is to give you an appreciation for the complexities that confront a financial analyst and a sense of the role that judgment and logic play in evaluating a firm’s results. Good financial analy- sis is like good detective work on a complex case: Solutions are seldom obvious; rather, we solve the case by evaluating the evidence, logically interpreting clues, and eventually assembling a clear picture of what has transpired. Understanding what has happened at a business can help you understand what is likely to occur in the future. Good analysis provides a useful tool for evaluating past performance and planning for the future.
11.1 Evaluating Corporate Performance
Is the corporation doing well? This is a difficult question. What is meant by “doing well”? Who is asking the question? If stockholders pose the query, then “doing well” probably refers to the stock’s price performance. Bondholders, bankers, and other fixed claimants are more interested in the likelihood of bankruptcy. Managers are interested in keeping their jobs, improving their salaries, and enhancing their reputations. Thus, man- agers will judge what doing well means based on the incentive system upon which their performance will be rewarded.
Corporate performance is therefore defined differently depending on who is doing the evaluation. Fixed claimants, residual claimants, and employees all have different agen- das. Fixed claimants want to be paid as promised. Residual claimants want high returns in comparison to their risk exposure. Employees, such as managers, want job security and remuneration. Corporate performance is defined differently for each of these groups, and the analysis used by each group varies depending on its agenda.
In addition to financial claimants, other groups of interested parties have their own agen- das. Consumers, for example, may judge a manufacturer’s performance based on product reliability. A community in which a business is located may be concerned with the envi- ronmental impact of the factory’s waste emissions, as well as the prospects for employ- ment and tax revenues that the business brings to the area. Such groups are referred to as stakeholders because each has a stake or interest in some aspect of corporate performance. We largely confine our attention to the financial stakeholders (the financial claimants) and, therefore, focus on the analysis of corporate financial performance. Keep in mind that as residual claimants, the key financial stakeholders (stockholders) have a keen inter- est in the performance of the company from virtually all perspectives, including the risk of bonds, the satisfaction of customers, and even the performance of competitors.
The relationship among the key stakeholders—management, customers, and investors— is depicted in Figure 11.1.
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
Figure 11.1: Key stakeholder relationships
The evaluation of corporate performance is an important skill for managers, investors, and even customers and employees.
11.2 Information Sources and Their Characteristics
Like a detective, an analyst must know where to look for evidence. This section presents a sample of sources of information generally available to the analyst. Accounting Statements
All publicly traded firms and many privately held firms have an external accountant pre- pare financial statements on a regular basis. Detailed financial data are included in the company’s annual report, which includes the firm’s balance sheet as of the end of its fiscal year, its income statement, statement of cash flows, written statements by management, and notes to the statement, which are written by the firm’s accountant. Large publicly traded firms also complete 10-K reports, which are filed with the Securities and Exchange Commission (SEC). 10-Ks provide even more detailed financial data, often broken down by divisions or subsidiaries. These reports are freely available for all publicly traded firms on the EDGAR database maintained by the SEC (see the Web Resources at the end of the chapter for URLs).
Firms whose statements are externally audited and compiled according to Generally Accepted Accounting Principles (GAAP) are providing independently verified informa- tion to interested parties. GAAP ensures that, to the greatest degree possible, standard methods of accounting have been consistently applied, so that one firm’s numbers can
Source of Capital
Products
Management
Cash from Operations
InvestorsCustomers
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
be compared to another firm’s, and this year’s results can be compared to last year’s. Because of these reporting standards, accounting statements have traditionally been the foundation on which financial analysis is built. The auditors’ statement appearing at the end of an annual report is considered to be of paramount importance to the analyst. This statement, known as an unqualified opinion, confirms for the analyst that the information is representative of the firm’s activities for the period. A qualified opinion is a red flag for the analyst, signaling that something fishy may be going on. The following is an example of an unqualified auditor’s opinion.
We have examined the consolidated balance sheets of the Company and Subsidiaries as of December 31, 2010, and the related consolidated state- ments of income, stockholders’ equity, and changes in financial position for the period. Our examinations were made in accordance with Generally Accepted Auditing Standards and, accordingly, included such tests of the accounting records and such other auditing procedures, as we considered necessary in the circumstances.
In our opinion, these financial statements present fairly the consolidated financial position of the Company and Subsidiaries as of December 31, 2010, and the consolidated results of their operations and changes in their financial position for the period in conformity with Generally Accepted Accounting Principles applied on a consistent basis.
There are a variety of reasons why a firm’s auditor will render a qualified opinion. For example, inadequate disclosure of information leads to a qualified opinion in the follow- ing paragraph.
The Company declined to present a statement of cash flows for the years ended December 31, 2010 and 2011. Presentation of such a statement sum- marizing the Company’s operating, investing, and financing activities is required by Generally Accepted Accounting Principles.
An unjustified change in accounting procedures leads to the following qualified opinion.
As disclosed in Note X to the financial statements, in 2011 the Company adopted the first-in, first-out method of accounting for its inventories; it previously used the last-in, first-out method. Although use of the first- in, first-out method is in conformity with Generally Accepted Account- ing Principles, in our opinion the Company has not provided reasonable justification for making this change, as required by Generally Accepted Accounting Principles.
Any qualified opinion is a warning sign and should make the analyst search for the cause. Small businesses often have accounting statements prepared on an unaudited basis.
Unaudited financial statements are based on the numbers supplied to the accountant by management. Thus, if management says the firm holds a $100,000 receivable from a customer, that number is simply reported on the balance sheet without the accountant
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
ever actually confirming that the customer owes the amount reported. Data on unaudited statements have not been independently verified. Needless to say, analysts put less faith in unaudited statements than in audited statements.
Although reliability and comparability of audited financial statements are their strengths, they do have several weaknesses. First, there is some latitude allowed by GAAP as to what method may be used in compiling data. For example, firms may choose the type of depreciation method they use for certain assets, or they may choose different methods for valuing inventory, such a last-in, first-out (LIFO) and first-in, first-out (FIFO). Two firms, identical in all other respects, could report dramatically different results if they used dif- ferent accounting methods.
Consider the purchases and sales of widgets by Firms A and B, with Firm A using LIFO and Firm B using FIFO. Table 11.1 shows that the firms have radically different operating incomes, even though the cash flows for the two firms are identical.
Management also has some latitude in the timing of its expense and revenue recognition and in ordering inventory. For example, near the end of the fiscal year, management could choose to let inventory stocks run low. Doing so lowers the inventory account balance on the year-end balance sheet, inflating the inventory turnover ratio, which measures how fast inventory is typically sold by the firm. This strategy could cosmetically alter ratios, making them look more favorable than they actually are. The practice of manipulating accounts so they appear more favorable is known as window dressing by management, and although such practices might appear to be misleading, they are perfectly legal under current laws.
Table 11.1: LIFO versus FIFO
Date Activity Cash Flow
Oct.1 Purchase 100 widgets @ $2 each $200 outflow
Dec. 1 Purchase 100 widgets @ $3 each $300 outflow
Dec. 30 Sell 100 widgets @$6 each $600 inflow
Firm A LIFO Firm B FIFO
Sales $600 $600
Cost of goods sold 2$300 2$200
Operating income $300 $400
Cash inflow $600 $600
Cash outflow 2500 2500
Cash flow $100 $100
A third shortcoming of accounting data is their focus on profit (and not cash flow) and on book values (and not market values). These problems have been discussed earlier in the text. In Chapter 1 we highlighted the difference between the financial balance sheet and the accounting balance sheet, and in Chapter 5 we covered the importance of cash and
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
how accounting profits may be restated as cash flows. It is important to have a good grasp of that earlier material as you attempt to analyze financial data.
A fourth weakness is that accounting results are purely historical in nature. In many cases, good historical results do not necessarily translate into good future results. For example, large profits by a firm often invite entry into the firm’s market by competitors. For plan- ning purposes, it would be foolish to count on extraordinary profits continuing simply because they have been consistently achieved in the past. Likewise, dismal past perfor- mance does not always mean the future will also be bleak.
The last weakness of accounting data is that they report results in a single dimension: profitability. A firm that maximizes profits (or even cash flows) without regard to risk may be unwittingly lowering shareholders’ wealth. Unsustainable strategies for increas- ing profits may work in the short run, but the risks will eventually catch up and cause a collapse. This type of system was certainly at work in the subprime lending bubble that collapsed in 2007 and 2008. Thus, higher profits (better accounting-based results) do not necessarily translate into greater wealth creation, which should be management’s ulti- mate goal. A Closer Look: Strengths and Weaknesses of Accounting Statements summarizes the strengths and weaknesses of accounting statements.
A Closer Look: Strengths and Weaknesses of Accounting Statements
Strengths
• Independently audited GAAP statements provide some assurance of reliability and comparabil- ity. Information asymmetry is lowered.
• Statements are widely available.
Weaknesses
• Differences in accounting methods may lower the comparability of results.
• Window dressing may lower the reliability of the data reported.
• Accounting statements do not focus on cash flows, nor do they report market values.
• They are purely historical in nature.
• No consideration is given to risk when accounting performance is reported.
Market Data
The second important information source is market data. As the name implies, market data are the data generated in a marketplace. We discuss two types: stock market perfor- mance (measured by stock returns) and product market performance (measured by mar- ket share). Because it is generated by millions of market participants, market-based data are less subject to manipulation (window dressing) by management than are accounting data. Although it has been done, managers have a difficult time misleading millions of investors in the stock market or millions of consumers in product markets.
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
Stock Returns Early on, we identified shareholder wealth maximization as the corporation’s ultimate objective. This goal leads us directly to the necessity of evaluating share price changes or stock returns, as stock returns measure changes in shareholder wealth. Returns are avail- able in many formats. The Center for Research in Security Prices (CRSP) tapes, developed by the University of Chicago, offer users a data set of daily security returns decades long, covering thousands of publicly traded firms. Returns may also be calculated by gather- ing share price and dividend information from sources such as Yahoo! and Google. Recall that prices and dividends for any period may be converted into a periodic return using the following formula:
periodic return 5 priceend 2 pricebegin 1 dividends paid
pricebegin Stock prices and returns are also useful to the analyst because they are forward-looking, and they implicitly consider risk. Recall that two shortcomings of accounting statements are their historical nature and the fact that they don’t incorporate risk. To see that stock prices (and therefore returns) do not suffer from these faults, examine the formula for stock valuation first presented in Chapter 5:
pricet 5 0 5 a `
t 5 1
Dt 11 1 r2 t 5
Dt 5 1 r 2 gn
where D t is the dividend at period t, r is the investors’ required return, and g
n is the nor-
mal, constant growth rate.
Stock prices are forward-looking because they include the present value of future expected dividends. Investors’ required return, r, is dependent on the riskiness of the firm’s future cash flows, as discussed in Chapter 6. Therefore, when today’s price changes, it is responding to changes in expected return requirements (which can be caused by a perceived change in risk) and to changes in expected dividends.
Using stock returns has a shortcoming as well. We may observe a decline in share price, signaling poor performance, but it is impossible to know why the price declined without more information. Did price decline because the overall market declined? If so, this is out- side the firm’s ability to control. Or was the decline a signal of lower expected dividends and/or higher risk? Fortunately, there is a method for helping to separate the portion of a stock’s return caused by a market-wide movement from the part of a stock’s return with a firm-specific cause. The method is simply to subtract the market’s return from the stock’s return. What is left is known as the stock’s abnormal return (AR), or market- adjusted return, for the period. The AR is the firm-specific part of the period’s return, which has been isolated from that part of the return attributed to the general market trend. For example, let’s say XYZ Inc. had a good year last year, according to its CEO. Its stock increased in value by 15%. You probe a bit more and find that the overall stock market (measured by the S&P 500) had a 20% return last year. XYZ’s market-adjusted return last year was 25% (AR 5 15% 2 20% 5 25%). Thus, the firm underperformed the market, and its firm-specific return was negative. Now, let’s suppose the negative AR is caused by lower expected dividends. The analyst must still determine the reasons dividends are expected to decrease. Searching out these causes requires analysis of other information, including accounting-based data. Did sales decline? Did costs increase? Is the company reinvesting profits into new projects? Was there a lawsuit?
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
You can see, at this point, that in analysis no single source of information will provide you with all the pieces to the puzzle, yet each makes a contribution toward understanding the total picture.
Market Share The financial balance sheet model of the corporation identifies two markets critical to the success of a business. Financial markets are the source of the external capital the corpo- ration needs in order to fund its investment projects. Stock returns measure the success of the firm in financial markets. Product and service markets are the arenas in which the firm’s products compete, and these markets provide the cash that flows back to claim- ants. Ultimately, the risks and returns to which claimants are exposed are determined by the success or failure of the firm’s output in the product market. One method of gauging this success is through the calculation of a product’s market share. Here the demand for the product is reflected, and product pricing strategies, product differentiation, quality, reliability, service, delivery, brand-name recognition, and other attributes are collectively judged by consumers in comparison to competing products of other firms.
Market share is calculated by dividing the firm’s product sales by the total sales of prod- ucts perceived to be similar and competing for the same consumer purchases. A declining market share indicates that competitors are taking business away from the firm. Lower profits may result if sales decline, if prices are lowered in order to recapture market share, or if marketing expenses increase to promote greater demand.
Hand in hand with market share information is the size of the market. If, over time, total industry sales within a market are flat or trending downward, the company must imple- ment a strategy that addresses the problem. Similarly a growing market calls for a plan to meet potentially high growth. Firms in shrinking markets are challenged to gain a greater share in a smaller market. Such firms may attempt to develop new products that capital- ize on company strengths to replace current products that may be headed toward obsoles- cence. A good example is horse-drawn carriage manufacturers at the turn of the century, which, while seeing demand for carriages decline, entered automobile body manufactur- ing. IBM, once the most well known of all computer manufacturers, switched strategic direction from manufacturing computer hardware to information services because they saw computers becoming an almost commodity-like product with wafer-thin product margins.
Market size and share information are available from several sources. Government and industry publications are widely available, as well as information services such as Compustat and Standard & Poor ’s. The potential size of a market, for example, may be determined using the Census of Manufacturers, published by the U.S. Department of Commerce, or a private source such as the “Survey of Buying Power,” published in Sales and Marketing Management.
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
Opinions of Other Analysts
Many large firms are closely followed by securities analysts. In fact, an industry exists whose product is the publication of analysts’ opinions and forecasts of firm performance. The best known of these are Moody’s, Standard & Poor’s, Fitch, Morningstar, and Value Line. Almost any library carries one or more of these companies’ publications. Another source is brokerage firms, which often make their analysts’ reports available to investors.
Moody’s, Fitch, and Standard & Poor’s are best known as bond-rating agencies. Rat- ings are based on the agency’s opinion of the likelihood that a bond will default, and on the protection afforded the claimant by the bond contract in the event that default does occur. Table 11.2 shows the major rating categories used by these Moody’s and Standard & Poor’s, along with their meanings. Naturally, the higher the rating, the lower investors’ required return on the bonds will be and the lower the cost of debt for the company. AAA or Aaa bonds, for example, will have lower yields to maturity than BB or Ba bonds.
Table 11.2: Bond ratings
Very high quality High quality Speculative Very poor
Standard & Poor’s
AAA AA A BBB BB B CCC D
Moody’s Aaa Aa A Baa Ba B Caa C
Value Line Investment Survey analyzes about 1,700 stocks. Equities are rated for future price appreciation potential (timeliness) and relative riskiness (safety), and Value Line provides explicit estimates of future dividends, dividend growth, sales, and earnings, among other forecasts. Stocks are categorized by industry, and the publication includes some discussion of each firm’s prospects and challenges, as well as brief industry analysis. Value Line Invest- ment Survey also provides some historical data and calculates several ratios. You can find it in many libraries, and you can subscribe to Value Line’s publications online, as you can for Morningstar, which provides some of the same types of information as Value Line but also is well known for its analysis of mutual funds.
We must keep in mind that if markets are efficient, the information included in reports such as Moody’s or Value Line’s is already included in the market price of the firm’s bonds and stock. Additionally, these ratings and opinions represent those of only one or a small handful of analysts. However, when we analyze the financial performance of a firm, these sources provide useful data about the company in question and the industry of interest. Moreover, opinions of other analysts serve as a benchmark with which our own conclusions may be compared. To be sure, management of companies whose securities are followed by Moody’s, Standard & Poor’s, or Value Line pay attention to the widely read opinions of their companies. Finally, other rating agencies specialize in particular indus- tries. For example, A. M. Best ranks the financial safety of insurance companies. Major brokerage houses produce company and industry reports that include analysts’ forecasts and recommendations.
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CHAPTER 11Section 11.2 Information Sources and Their Characteristics
Comparative Data Suppose your employer’s sales increased 10% last year. Is this unexpectedly high or dis- appointing? To answer that question you must compare the result to (1) historical results, (2) your competitors’ results, and (3) your firm’s targeted sales. Historical results are read- ily available in prior years’ annual reports. In fact, annual reports include data from sev- eral years for just this purpose. If, in the last 5 years, sales had increased by a minimum of 15% per year, then a 10% increase for this year could be disappointing. On the other hand, if 10% were the largest increase in a decade, it might indicate outstanding performance. The historical record provides the analyst with a clue.
Look for comparable firms that are competitors in the same product market. Ideally, com- parables would be about the same size and have the same product mix as the firm you’re analyzing. If comparable firms had increases that averaged 20%, your firm’s 10% increase may look rather dismal. Of course, if comparables showed no sales growth, then your firm looks like a superstar.
You may have difficulty locating comparables. Diversified firms may not fit neatly into an industry classification. You may think, for example, that Coca-Cola and PepsiCo are natural comparables, but if you investigate, you will find that PepsiCo owns Frito Lay and other snack food companies. Surprisingly, it is snack foods that generate most of PepsiCo’s sales and profits. Thus, Coca-Cola and PepsiCo are not as comparable after all.
For firms that do fit into an industry classification, there are publications that produce industry average ratios for comparison purposes. Among the most widely available industry averages are those published by Dun & Bradstreet, Robert Morris Associates, and the annual surveys appearing in Forbes and Business Week. Value Line, as previously mentioned, classifies firms by industry and can be another useful source for data belonging to comparables.
The Media When you analyze quantitative data like ratios and growth rates, you may be tempted to evaluate performance using numbers alone. This level of analysis does not involve an understanding of the cause of performance. For instance, concluding that share price declined because earnings were lower is not very useful. If we take the quantitative analy- sis a step further and discover that earnings were lower because sales were down, then we’ve added to our knowledge but have not really reached the level of understanding that is useful for decision making. What a manager or a claimant needs to know is why sales were down. Did the company lose market share because a competitor introduced a superior product? Did competitors lower their prices? Were sales down because the overall market shrank? Was there was a recession last year that caused consumers to cut back their overall spending? Maybe adverse press caused the product’s sales to decline. Sales can also decline because of internal problems at the company. A strike may have hurt production, or a key salesperson may have retired. There is a myriad of possibilities, and it is the analyst’s job to find the correct one. Ratios are useful because they raise red flags, causing analysts to focus their attention in the correct places.
The point is that an analyst must look beyond the numbers. We have already mentioned two sources of information that are not quantitative in nature: annual reports and pub- lished analysts’ opinions such as those from Value Line. The press offers a wealth of similar
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CHAPTER 11Section 11.3 Financial Statement Analysis
information. The Wall Street Journal, Barron’s, Financial Times, Forbes, and Fortune are just a few of the publications devoted to business and economics.
The Internet is a source of information that is exploding in importance. Virtually all of the information sources listed here, from the Wall Street Journal to Robert Morris Asso- ciates, maintain their own websites (see the Web Resources at the end of the chapter). You can find a corporation’s website by using a search engine. You can access a corpora- tion’s financial statements by looking at their Securities and Exchange Commission fil- ings—annual reports, proxy statements, and 10-Ks. The SEC makes these available on its EDGAR database. General news about companies is provided online by television net- works such as ABC, CNN Money, and CBS, and by newspapers such as the New York Times. Business-specific news sources include Bloomberg, CNBC, PBS’s Nightly Business Report, and the British Financial Times, which is similar to the Wall Street Journal but with a more international perspective. Securities exchanges that have websites include the NYSE and NASDAQ. (See the Web Resources for links to all these sites.)
Whenever you gather information from the Internet, be careful. Anyone can create a web- site and say what they please, so stick with known, reliable site sponsors such as major newspapers, magazines, universities, exchanges, and the government. Beware of pundits, bloggers, and other self-proclaimed experts who hype a stock to increase price before “dumping” the stock (selling it for a quick profit). Some websites may require a subscrip- tion or fee to access their service. Often such sites allow limited access to the site or a free trial subscription before they require any payment.
11.3 Financial Statement Analysis
Shingard Inc. manufactures plastic shin guards used primarily by soccer players. Tables 11.3 and 11.4 show the firm’s income statements and balance sheets for the years 2009, 2010, and 2011. These two tables provide the information we will use to demonstrate techniques used to analyze financial statements.
Table 11.3: Shingard Inc. income statements, 2009–2011
2009 2010 2011
Revenue $52,846 $50,280 $57,394
Cost of goods sold (COGS) 223,781 223,632 229,271
Selling, general, and administrative expense (SG&A) 215,569 214,050 213,035
Depreciation 23,250 23,250 23,250
Earnings before interest and taxes (EBIT) $10,246 $9,348 $11,838
Interest expense 21,830 21,642 21,701
Earnings before taxes (EBT) $8,416 $7,706 $10,137
Taxes (34%) 22,861 22,620 23,447
Net income (NI) $5,555 $5,086 $6,690
Dividends $2,000 $2,000 $2,500
Retained earnings $3,555 $3,086 $4,190
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CHAPTER 11Section 11.3 Financial Statement Analysis
Table 11.4: Shingard Inc. balance sheets, 2009–2011 in 000s
Assets 2009 2010 2011
Cash $270 $148 $172
Marketable securities (Mkt. Sec.) 30 30 30
Accounts receivable (A/R) 2,490 2,723 2,909
Inventory (INV) 11,743 17,357 16,800
Total current assets (CA) $14,533 $20,258 $19,911
Equipment and buildings 27,400 27,400 27,400
Less accumulated depreciation 28,310 211,560 214,810
Net equipment and buildings $19,090 $15,840 $12,590
Land 259 259 259
Total fixed assets (FA) $19,349 $16,099 $12,849
Total assets (TA) $33,882 $36,357 $32,760
Liabilities and Owner’s Equity 2009 2010 2011
Accounts payable (A/P) $984 $1,112 $1,092
Wages payable (W/P) 229 250 273
Notes payable (N/P) 1,500 1,740 1,350
Total current liabilities (CL) $2,713 $3,102 $2,715
Long-term debt (LTD) $18,000 $17,000 $9,600
Common stock (par value $0.10) 20 20 20
Paid-in surplus of par 1,000 1,000 1,000
Retained earnings 12,149 15,235 19,425
Total equity (TE) $13,169 $16,255 $20,445
Total liabilities and owner’s equity $33,882 $36,357 $32,760
Trend Statements
Trend statements are used by analysts to uncover evidence of patterns in the data. They are constructed by taking a beginning year’s account balance as a benchmark year. Each account for subsequent years is then divided by the benchmark year’s balance. Thus, all accounts are re-expressed in a trend statement as a multiple of the beginning year’s bal- ance. Table 11.5 lists the balances of the revenue and cost of goods sold (COGS) accounts for Shingard and its trend statement values.
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CHAPTER 11Section 11.3 Financial Statement Analysis
Table 11.5: Trend analysis for Shingard’s revenues and COGS, 2009–2011
Dollar Values 2009 2010 2011
Revenue $52,846 $50,280 $57,394
Calculating the trend values 52,846 50,280 57,394
52,846 52,846 52,846
Trend values 1.000 0.951 1.086
Dollar Values 2009 2010 2011
COGS $23,781 $23,632 $29,271
Calculating the trend values 23,781 23,632 29,271
23,781 23,781 23,781
Trend values 1.000 0.994 1.231
Table 11.6 shows abbreviated trend income and balance sheets for Shingard. The most striking features of the trend statements for Shingard are that (1) net income was down in 2010 and made a dramatic recovery in 2011, (2) total assets were actually smaller at the end of 2011 than they were at the end of 2009, and (3) total equity was over 50% higher in 2011 than in 2009. Closer investigation of the trend statements and the underlying accounting statements reveals that net income was down in 2010 because of lower sales. The recov- ery in 2011 was driven by higher sales and control of selling, general, and administrative expenses. The latter factor was vital because it offset higher COGS in the same year. Total assets declined slightly as depreciation expense outstripped the increase in current asset accounts. And the total equity increase was fueled by 2011’s outstanding earnings, which led to a large increase in retained earnings. This internal capital replaced external long- term debt in the firm’s capital structure.
It is apparent from the trend statements that something unusual took place in 2011. Sales and profits were up dramatically. Remember that numbers do not explain things; they simply provide clues. If we were to investigate further by carefully reading 2011’s annual report or perhaps some industry literature for that year, we would discover that soccer’s World Cup was played during the summer of 2010, perhaps generating some interest in the sport and stimulating sales in 2011. This comes closer to explaining 2011’s outstanding results, but keep in mind it was the trend statement that highlighted that year’s dramatic turnaround, putting us on the correct investigative path.
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CHAPTER 11Section 11.3 Financial Statement Analysis
Table 11.6: Trend analysis for Shingard income statements and balance sheets, 2009–2011
Trend Income Statement 2009 2010 2011
Revenue 1.000 0.951 1.086
Cost of goods sold 1.000 0.994 1.231
Selling, general, and administrative 1.000 0.902 0.837
Net income 1.000 0.916 1.204
Trend Balance Sheet 2009 2010 2011
Inventory 1.000 1.478 1.431
Current assets 1.000 1.394 1.370
Net equipment and buildings 1.000 0.830 0.660
Total assets 1.000 1.073 0.967
Current liabilities 1.000 1.143 1.001
Long-term debt 1.000 0.944 0.533
Total equity 1.000 1.234 1.533
Common Size Statements
Common size statements allow analysts to compare the relative composition of the com- pany’s accounts over time. Each year’s common size income statement is found by divid- ing each account by that year’s revenue. Common size balance sheets are constructed by dividing each account by that year’s total assets. For example, the common size COGS for Shingard for 2010 is $23,632/$50,280 5 0.470, and the common size inventory account for 2010 equals 0.477. Table 11.7 shows abbreviated common size income and balance sheet statements.
Focusing our attention on the contrast between the 2009 and 2010 common size state- ments, we see two glaring changes. First, COGS sharply increased as a proportion of rev- enue, while selling, general, and administrative expense (SG&A) decreased.
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CHAPTER 11Section 11.3 Financial Statement Analysis
Table 11.7: Shingard Inc. common size income statement and balance sheet for selected accounts: 2009–2011
Common Size Income Statement 2009 2010 2011
Revenue 1.000 1.000 1.000
COGS 0.450 0.470 0.510
SG&A 0.295 0.279 0.227
EBIT 0.194 0.186 0.206
EBT 0.159 0.153 0.177
NI 0.105 0.101 0.117
Common Size Balance Sheet 2009 2010 2011
Total Assets 1.000 1.000 1.000
Inventory 0.347 0.477 0.513
Current Assets 0.429 0.557 0.608
Total Fixed Assets 0.571 0.443 0.392
Current Liabilities 0.080 0.085 0.083
Long-term Debt 0.531 0.468 0.293
Total Equity 0.389 0.447 0.624
To explain this we would need to decompose COGS: Was the increase due to labor costs or raw materials? If labor caused the increase, was the rise due to a renegotiated union contract? Or was management paying overtime to meet increased demand (rather than hiring more employees)? As analysts we need to look beyond the numbers. The decrease in selling, general, and administrative expense may be an intentional cost-cutting act on management’s part as a response to the increased COGS. Perhaps management canceled an advertising campaign, cut excess expenses in the central office, or began to pay sales- people on salary rather than by commission. We would need to look beyond the account- ing numbers to find how and why SG&A declined.
The second dramatic change takes place in the common size balance sheet long-term debt and total equity accounts. Clearly, retained earnings have been used to pay down debt balances. Thus, Shingard is using less financial leverage. However, there is a troubling aspect to this use of retained earnings: Recall that, from the trend balance sheet, total assets were shrinking over the period. Thus, management has apparently chosen to pay off debt rather than reinvest in new equipment or other assets. This could lead to trouble if the equipment begins to break down. A second concern is the signaling content of lower leverage (recall Chapter 9). Perhaps shareholders will believe that management is con- cerned that the firm’s future cash flows cannot support the previous level of debt. If you, for example, served on Shingard’s board of directors, you would require some explana- tion convincing you that paying off debt is wise policy.
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Ratio Analysis
A Closer Look: Financial Ratios for Shingard Inc. 2011 shows the most common financial ratios calculated from Shingard’s 2011 accounting statements. We will not burden you with in-depth coverage of the mechanics of calculating ratios. Like the skilled detective who leaves the DNA testing to the crime lab, we will leave the calculation of ratios to the calculator. You should, however, carefully review the information, paying particular attention to each ratio’s calculation and how the calculation relates to the ratio’s use.
What we’re most interested in is understanding which clues to look for, where to look for them, and how to interpret them once we have found them. For example, a school for detectives cannot cover all possible crimes, nor can it review all potential pieces of evi- dence. Rather, the detective school tries to cover some major types of crime in the hope that the ability to analyze one case will carry over to other new and different cases. In that spirit, we are going to present some events that commonly occur in business and analyze how these events are manifested in the firm’s ratios.
A Closer Look: Financial Ratios for Shinguard Inc. 2011
(a) Debt ratios measure the firm’s ability to meet principal and interest payments over the long term.
Ratio Formula Use
1. Debt ratio 5 long-term debt
total long-term capital 5
9,600 30,045
5 0.32 Measures the proportion of capital supplied by creditors.
2. Leverage ratio 1LEV2 5 total assets total equity
5 32,760 20,445
5 1.60 Measures how many dollars of assets the firm utilizes for each dol- lar of contributed equity.
3. Times interest earned ratio 5 EBIT
interest 1dollars2 5 11,838 1,701
5 6.96 Measures the ability to make inter- est payments.
(b) Liquidity ratios measure the firm’s ability to meet its maturing obligations and unexpected cash needs over the short term.
Ratio Formula Use
1. Current ratio 5 current assets
current liabilities 5
19,911 2,715
5 7.33 Measures short-term debt-paying capacity.
2. Quick ratio 1acid test2 5 current assets 2 inventory current liabilities
5 3,111 2,715
5 1.15 Measures immediate short-term liquidity.
(c) Profitability ratios measure the income or operating success of the enterprise.
Ratio Formula Use
1. Net profit margin 5 net income
revenue 5
6,690 57,394
5 0.117 Measures earnings generated per dollar of sales.
2. Return on assets 1ROA2 5 net income total assets
5 6,690
32,760 5 0.204
Measures the profitability of the use to which assets are being put.
(continued)
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A Closer Look: Financial Ratios for Shinguard Inc. 2011 (continued)
Ratio Formula Use
3. Return on equity 1ROE2 5 net income total equity
5 6,690
20,445 5 0.327
Measures the profits accruing to shareholders per dollar of contrib- uted equity.
4. Gross profit margin 5 revenue 2 COGS
revenue 5
28,123 57,394
5 0.490 Measures product pricing in com- parison with its basic cost.
5. Earning power 5 EBIT
total assets 5
11,838 32,760
5 0.361 Measures the profitability of the firm’s assets independent of lever- age and tax effects.
(d) Efficiency ratios measure the effectiveness and intensity of the firm’s management of its resources.
Ratio Formula Use
1. Inventory turnover 5 cost of goods sold
inventory 5
29,271 16,800
5 1.742 Measures the liquidity and control of inventory.
2. Days sales outstanding 5 receivables
annual revenue . 360 5
2.909 159.43
5 18.25 days Measures the liquidity and control of receivables.
3. Assets turnover 5 revenues
total assets 5
57,394 32,760
5 1.752 Measures sales generated per dollar of assets.
(e) Per-share measures express key financial variables on a per-share-of-stock basis.
Ratio Formula Use
1. Earnings per share 1EPS2 5 net income no. of shares1
5 $6,690,000
200,000 5 $33.45
Expresses profits on a per-share basis.
2. Book value per share 1BVPS2 5 total equity no. of shares
5 $12,849,000
200,000 5 $64.25
Expresses the capital contributed by shareholders on a per-share basis.2
3. Dividend per share 1DPS2 5 total dividends no. of shares
5 2,500,000 200,000
5 $12.50 Measures amount paid as dividends to each share of stock.
(f) Measures of relative value
Ratio Formula Use
1. Price-earnings ratio 1P/E2 5 price per share 3
EPS 5
$234.15 $33.45
5 7 Expresses stock value as multiple of last year’s earnings.
2. Price-to-book 1P/B2 5 price per share book value share
5 $234.15 $64.25
5 3.64 Expresses stock price as a multiple of equity holders’ historical contri- butions to capital.
1Number of shares is found by dividing the common stock account by the par value per share, less any repurchased treasury stock. Because Shingard has no treasury stock, its shares outstanding are $20,000/$0.10 5 200,000 shares.
2Keep in mind that retained earnings represents capital contributed by shareholders (rater than being paid out as dividends).
3Current market price is found in the stock quotes in the newspaper. For Shingard, we’ll assume the price per share was $234.15 on the date of these calculations.
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Case A: Increasing Leverage and Return on Equity Suppose a corporation decides to raise capital by borrowing. Whether its decision to “leverage-up” will have a positive or a negative impact on the firm’s ROE depends on the interest charged by the lender and the firm’s earning power (EP 5 EBIT/total assets). If the firm’s earning power is less than the interest rate (i), then ROE will fall, and vice versa.
If EP . i, ROE increases with leverage. If EP , i, ROE decreases with leverage.
Table 11.8 shows two firms of equal size, with equal debt ratios, being charged the same interest rate, but with drastically different earning power. Note what happens to their respective ROEs as their debt ratios change.
Table 11.8: Illustration of earning power, leverage, and ROE
Firm A
Favorable Financial leverage
Firm B
Unfavorable Financial leverage
Before After Before After
Debt 500 1,000 500 1,000
Equity 500 500 500 500
Total assets 1,000 1,500 1,000 1,500
Debt/total assets 0.50 0.67 0.50 0.67
EP% 20% 20% 9% 9%
EBIT 200 300 90 135
INT (10%) 250 2100 250 2100
EBT 150 200 40 35
Tax (40%) 260 280 216 214
NI 90 120 24 21
ROE% 18% 24% 4.8% 4.2%
Case B: Just-in-Time Inventory Just-in-time inventory systems deliver inventory directly to the assembly line as needed, rather than being stockpiled in a warehouse as is traditional. Thus, materials are delivered just in time for their use in the manufacturing process. This is a particularly common prac- tice in the consumer computer industry, where newer components are constantly becom- ing available and consumers demand the fastest processors and biggest disk drives. A just-in-time inventory system is very efficient. Less capital is invested in inventory, free- ing the cash for other projects or uses. Furthermore, less warehouse space is needed to stockpile inventory, and less labor is required to store the inventory and retrieve it when it is needed. Considering these characteristics of just-in-time systems, let’s see which effi- ciency ratios would be impacted if a manufacturer successfully initiated such an inventory
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system. Inventory turnover would certainly increase because less inventory would need to be kept on hand. Asset turnover would increase as total assets declined because of lower inventory and lower warehouse requirements.
If just-in-time inventory would improve these efficiency ratios, why don’t all manufactur- ers adopt the system? The answers in financial analysis don’t all come from the account- ing numbers. The downside of a just-in-time system is its risk. The manufacturing firm becomes extremely dependent on its suppliers and on its own ability to gauge and time demand for the finished product correctly. It may be that for some firms such risks out- weigh the benefits.
Now let’s consider a firm that has difficulties with its new just-in-time system. If the sup- plier cannot meet delivery schedules or if the manufacturer has difficulty gauging its own material requirements, production schedules may not be met. Chances are that sales will be lost and some raw materials would need to be rushed to the assembly line at a high cost in order to meet promised delivery dates. So, although the inventory turnover ratio may be improved, it is also likely that sales would decline and profit margins shrink.
At the extreme end of just-in-time inventory risk is disruption caused by a catastrophe. Such an event occurred on March 11, 2011, when a giant earthquake and tsunami hit Japan. The crisis caused widespread disruption in manufacturing with the effects being felt almost immediately by firms with just-in-time inventory systems in place. The risks of such disasters are great enough in some regions that planning groups are formed to develop contingency plans for addressing such events. For instance, the Cascadia Region Earthquake Workgroup has prepared a study titled, “Just-in-Time Inventory: Effects on Earthquake Recovery,” demonstrating the seriousness with which this risk is taken on the earthquake-prone Pacific Coast.
Cases A and B are brief illustrations of how the actions of a business may manifest them- selves in financial statements and ratios. As was pointed out earlier, the endless possibili- ties make an exhaustive study of ratio analysis impossible. However, it is a good habit when you read the business news to imagine some of the possible financial ramifications of each news item. Doing so will help you become an astute and sophisticated analyst.
Case C: Working Capital Analysis Here we present some information about a large U.S. technology company that will help hone your financial analysis skills. We won’t name the company yet, so you can focus on the financial data.
Here are facts from a recent Wall Street Journal article supplemented with data from the company’s annual report. Sales growth over the last fiscal year was less than 1%. The com- pany held 13 days of inventory (compared to just 7.5 days on average for its industry). Its accounts payable to suppliers was over 100 days (compared to 37 days on average for its industry), and its accounts receivable was 58 days (compared to 45 days on average for its industry).
This isn’t much information, but try to infer something about the financial health of this company. We might begin by simply comparing the company to its industry. It has about
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CHAPTER 11Section 11.3 Financial Statement Analysis
70% more inventory than other companies in its industry. It doesn’t pay its bills nearly as quickly, nor does it collect its credit sales as quickly. All of these indicators suggest poor working capital management.
But using industry averages as benchmarks assumes that the average firm in an indus- try is an outstanding performer that should be emulated. By definition the average firm is—well, average. Let us consider the working capital metrics for our mystery company in a different light. The company buys enough inventory for 13 days of sales (more on this later). It makes a sale and collects cash for the sale 58 days later. So from the time the inventory arrives at the company until it turns into cash is 71 days. On the other side of the ledger, it is able to postpone paying its suppliers for 100 days. Combining these numbers implies that the company has 29 days (100 2 71) of free use of cash before it pays its sup- pliers. Think about this. The company gets to use cash at no cost for 1 month. This is free financing! From this perspective the managers are incredibly clever.
The company is Dell. The Wall Street Journal article (see this chapter’s Web Resources) is somewhat cautionary, warning that this interest-free cash machine is slowing down as sales slow. But that doesn’t affect the lesson: that averages are average, and it is important to look at a company from several perspectives. The average data come from BizStats. The URL for the computer manufacturing industry is also listed in Web Resources at the end of the chapter.
Case D: Corporate Bond Ratings and Financial Ratios In the United States there are three companies that rate bonds: Standards & Poor’s (the S&P in the S&P 500), Moody’s, and Fitch. Bond ratings are important because investors depend on them when setting their required rate of return from investing in a bond. The rating is an indicator of risk. At any point in time more highly rated bonds, which would be less risky, will have a lower required rate of return than riskier bonds.
The rating process usually begins with a thorough financial ratio analysis. Rating ana- lysts then consider the prospects for the industry and the company being rated within that industry (e.g., how competition will affect the company? Are the company’s primary markets growing? and so on). In this case we will focus on the ratio analysis component of the bond rating process.
Moody’s published a paper several years that summarizes the financial ratios associated with different bond ratings for about 20 U.S. industrial sectors. The data are also aggre- gated for all the industries, so they provide a guide for how financial ratios determine bond ratings for all companies.
Table 11.9 shows the median ratios for eight different financial ratios and six different bond ratings. Some of the acronyms need defining. Aaa–Aa through Caa–C are Moody’s bond ratings categories from the highest (Aaa–Aa) to the very lowest (Caa–C). These Moody’s ratings correspond to S&P ratings of AAA–AA through CCC–C (see Table 11.2). The IG column is for investment grade, Aaa through Baa (or in S&P symbols: AAA through BB1). The SG acronym stands for speculative grade (the vertical line separates IG from SG) and is everything below investment grade (IG). This breakdown is important
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CHAPTER 11Section 11.3 Financial Statement Analysis
because some investors (for example, bank trust departments) can only invest in IG bonds, or have a strict limit on the amount invested in SG bonds.
Table 11.9: Moody’s aggregate metrics by rating category
Median Median
Aaa–Aa A Baa Ba B Caa–C IG SG
Interest Coverage 16.0 8.6 5.4 3.7 1.9 0.7 6.5 2.1
Asset Coverage 3.7 2.4 2.3 2.0 1.3 1.0 2.4 1.4
Leverage 31.6% 41.7% 44.8% 49.8% 68.7% 92.2% 43.6% 66.8%
Cash Flow-to-Debt 52.4% 32.6% 25.8% 21.6% 12.1% 6.4% 28.4% 12.7%
Return on Assets 11.6% 7.5% 5.3% 4.4% 1.7% 22.1% 6.3% 1.9%
Profit 11.8% 9.0% 6.7% 5.0% 2.0% 22.6% 7.8% 2.1%
Liquidity 7.8% 4.7% 4.0% 4.3% 3.9% 3.3% 4.6% 3.9%
Revenue Stability 7.2 7.3 6.1 5.2 6.1 7.3 6.6 5.9
Source: Moody’s. (2006). The distribution of common financial ratios by rating and industry for North American non-financial corporations: July 2006.
For all of the ratios except leverage, larger numbers are “better” because they lower credit risk (but they may not necessarily be “better” in other ways, such as in terms of their effect on a firm’s stock price). A company with higher interest coverage, higher cash-flow- to-debt, profit, etc., is superior to similar companies with lower ratios. We see this trend in Table 11.9 with highest numbers for those ratios (except leverage) associated with the highest rated bonds (Aaa–Aa) and declining steadily to the Caa–C rated bonds (with the exception of revenue stability for the lowest rated bonds). The numbers shown are median rather than means or averages. The median is not sensitive to extreme values, so it often provides a better measure of central tendency than the mean.
The definitions that Moody’s uses (shown in A Closer Look: Definition of Financial Metrics Used by Moody’s) are very similar to those introduced earlier in this chapter. You will notice a few slight variations, but overall the ratios are trying to measure the same characteristics.
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CHAPTER 11Section 11.3 Financial Statement Analysis
A Closer Look: Definition of Financial Metrics Used by Moody’s
• Interest Coverage:
� (EBIT) – Interest Capitalized 1 (1/3) 3 Rental Expense)/(Interest Expense 1 (1/3) 3 Rental Expense 1 Preferred Dividends/0.65)
• Asset Coverage:
� (Total Assets 2 Goodwill 2 Intangibles)/Total Debt
• Leverage:
� (Total Debt 1 8 3 Rental Expense)/(Total Debt 1 8 3 Rental Expense 1 Deferred Taxes 1 Minority Interest 1 Total Equity)
• Cash Flow/Debt:
� (Net After-Tax Income Before X-Items 1 Depreciations 2 Dividends)/(Total Debt 1 8 3 Rental Expense)
• Return on Assets:
� Net After-Tax Income Before X-Items/2 Year Average Assets
• Profit:
� Net After-Tax Income Before X-Items/Net Sales
• Liquidity:
� Cash & Market Securities/Total Assets
• Revenue Stability:
� 5 Year Average Net Sales/5 Year Standard Deviation Net Sales
From: Moody’s, “The Distribution of Common Financial Ratios by Rating and Industry for North American Non-Financial Corporations: July 2006.”
With the information about bond ratings and financial ratios complete, we can apply the Moody’s ratio analysis to an actual company. We will estimate the bond rating for Sears using data from 2010 and 2011.
Tables 11.10 and 11.11 show the last 4 years of income statements and balance sheets for Sears. Another piece of information you will need in order to construct the ratios for Sears bond rating estimation is that its revenue in 2008 was $49,867.
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CHAPTER 11Section 11.3 Financial Statement Analysis
Table 11.10: Sears Holding Corporation’s income statements, 2009–2012
Millions of USD (except for per share items)
52 weeks ending 2012–01–28
52 weeks ending 2011–01–29
52 weeks ending 2010–01–30
52 weeks ending 2009–01–31
Revenue 41,567 42,664 43,360 46,770
Total revenue 41,567 42,664 43,360 46,770
Cost of revenue, total 30,966 31,000 31,374 34,118
Gross profit 10,601 11,664 11,986 12,652
Selling/general/admin. expenses, total
10,664 10,425 10,499 11,060
Depreciation/amortization 853 869 894 981
Unusual expense (income) 585 267 274 309
Total operating expense 43,068 42,227 42,693 46,468
Operating income 21,501 437 667 302
Other, net 22 214 261 108
Income before tax 21,751 162 391 184
Income after tax 23,120 135 280 99
Minority interest 7 217 262 246
Net income before extraordinary items
23,113 118 218 53
Net income 23,140 129 235 53
Income available to common excluding extraordinary items
23,113 118 218 53
Income available to common including extraordinary items
23,140 129 235 53
Diluted weighted average shares
106.8 111.7 117.9 127
Diluted EPS excluding extraordinary items
229.15 1.06 1.85 0.42
Dividends per share — common stock primary issue
0 0 0 0
Diluted normalized EPS 219.88 0.74 2.55 3.69
From Sears 2011 Annual Report, http://www.searsholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page =1&zoom=100,0,0
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CHAPTER 11Section 11.3 Financial Statement Analysis
Table 11.11: Sears Holding Corporation’s balance sheets, 2009–2012
Millions of USD (except for per share items)
As of 2012–01–28
As of 2011–01–29
As of 2010–01–30
As of 2009–01–31
Cash and equivalents 747 1,359 1,689 1,173
Cash and short-term investments
747 1,359 1,689 1,173
Accounts receivable—trade, net
695 689 652 839
Total receivables, net 695 689 652 839
Total inventory 8,407 8,951 8,705 8,795
Prepaid expenses 388 334 351 458
Other current assets, total 7 227 41 151
Total current assets 10,244 11,560 11,438 11,416
Property/plant/equipment, total—gross
11,210 11,329 11,392 10,959
Accumulated depreciation, total
24,633 24,227 23,683 22,868
Goodwill, net 841 1,392 1,392 1,392
Intangibles, net 2,937 2,993 3,208 3,283
Other long-term assets, total 782 1,313 1,061 1,160
Total assets 21,381 24,360 24,808 25,342
Accounts payable 2,912 3,046 3,335 3,006
Accrued expenses 523 546 2 2,272
Notes payable/short-term debt
1,175 360 325 442
Current portion of LT debt/ capital leases
230 489 482 345
Other current liabilities, total 4,372 4,202 4,644 2,447
Total current liabilities 9,212 8,643 8,786 8,512
Long term-debt 2,088 2,344 1,698 2,132
Total long-term debt 2,088 2,344 1,698 2,132
Total debt 3,493 3,193 2,505 2,919
Deferred income tax 816 0 2 2
(continued)
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Millions of USD (except for per share items)
As of 2012–01–28
As of 2011–01–29
As of 2010–01–30
As of 2009–01–31
Minority interest 60 103 339 319
Other liabilities, total 4,924 4,759 4,889 4,999
Total liabilities 17,100 15,849 15,712 15,962
Common stock, total 1 1 1 1
Additional paid-in capital 10,005 10,185 10,465 10,441
Retained earnings (accumulated deficit)
1,865 4,930 4,797 4,562
Treasury stock—common 25,981 25,826 25,446 25,012
Other equity, total 21,604 2780 2730 2615
Total equity 4,281 8,511 9,096 9,380
Total liabilities & shareholders’ equity
21,381 24,360 24,808 25,342
Total common shares outstanding
106.3 108.9 114.8 122
From Sears 2011 Annual Report, http://www.searsholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page =1&zoom=100,0,0
Other relevant information will be introduced in tables to follow. All of this information comes from Sears Holding Corporation’s 2011 Annual Report (SEC Form 10-K). The com- pany did not report any capitalized interest and did not pay any dividends, either pre- ferred or common.
Interest expense is not broken out in the income statements. It is shown in Table 11.12.
Table 11.12: Sears Holding Corporation’s interest expense, 2009–2011
Interest expense (in millions) 2011 2010 2009
COMPONENTS OF INTEREST EXPENSE
Interest expense $248 $242 $243
Accretion of lease obligations at net present value 20 21 22
Amortization of debt issuance costs 21 30 23
Interest expense $289 $293 $248
From Sears 2011 Annual Report, http://www.searsholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page =1&zoom=100,0,0
Table 11.11: Sears Holding Corporation’s balance sheets, 2009–2012 (continued)
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Rental expense is shown in Table 11.13.
Table 11.13: Sears Holding Corporation’s rental expense for operating leases, 2009–2011
Rental expense (in millions) 2011 2010 2009
Minimum rentals $837 $844 $865
Percentage rentals 19 21 22
Less—Sublease rentals (30) (52) (51)
Total $826 $813 $836
From Sears 2011 Annual Report, http://www.searsholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page =1&zoom=100,0,0
Information about deferred taxes is presented in Table 11.14.
Table 11.14: Sears Holding Corporation’s taxes, 2009–2011
Taxes (in millions) 2011 2010 2009
U.S. $(1,809) $(157) $(67)
Foreign 58 323 458
Total $(1,751) $166 $391
Income tax expense (benefit)
Current:
Federal $19 $1 $(191)
State and local 0 (7) 14
Foreign 2 110 141
Total 21 104 (36)
Deferred:
Federal 1,357 (84) 127
State and local (35) 7 22
Foreign 26 — (2)
1,348 (77) 147
Total $1,369 $27 $111
From Sears 2011 Annual Report, http://www.searsholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page =1&zoom=100,0,0
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The Moody’s letter rating is a guess based on the medians shown in Table 11.15. The rev- enue stability metric is based on 4 years of data instead of the five Moody’s uses because that is what we had easily available. The pink shaded cells of the table indicate deteriora- tion in a ratio.
Table 11.15: Sears Holding Corporation’s bond rating financial ratios, 2009–2011
2011 2010 2009
Interest coverage: 22.118 1.289 1.746
Moody’s rating C Caa B
Asset coverage: 5.040 6.256 8.067
Moody’s rating Aaa Aaa Aaa
Leverage: 64.19% 53.53% 50.03%
Moody’s rating B B Ba
Cash flow/debt: 222.64% 10.29% 12.28%
Moody’s rating C B B
Return on assets: 23.41% 0.14% 0.28%
Moody’s rating C Caa B
Profit: 27.55% 0.30% 0.54%
Moody’s rating C Caa Caa
Liquidity: 3.49% 5.58% 6.81%
Moody’s rating C Ba Baa
Revenue stability: 13.134
Moody’s rating Aaa
It becomes a matter of judgment about what the bond rating should be for Sears Holding Corporation’s debt in 2009 through 2011. One approach is to use the same method used for computing grade point averages: Give each rating a numerical value, and then find the average of those values. There are nine ratings. If we assign Aaa a score of 9, Aa a score of 8, and so on, until C receives a score of 1, we have the results shown in Table 11.16.
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Table 11.16: Estimating Sears’s bond rating using financial ratios, 2009–2011
2011 2010 2009
Interest coverage 1 3 4
Asset coverage 9 9 9
Leverage 4 4 5
Cash flow/debt 1 4 4
Return on assets 1 3 4
Profit 1 3 3
Liquidity 1 5 6
Average 2.6 4.4 5.0
Caa–Ca Ba–B Ba
These results show that Sears’s rating has deteriorated over the 2 years from 2009 to 2011 from almost investment grade (Ba) to speculative. In fact, on January 4, 2012, the Wall Street Journal reported that Moody’s had downgraded Sears’s rating (see the Web Resources at the end of the chapter for more information).
Demonstration Problem 11.1: Ratio Analysis
For parts A, B, and C of this problem, refer to the following financial statements.
Evergreen Timber Inc. Income Statement
Sales $3,000,000
COGS 750,000
Gross profit $2,250,000
Selling, general, and administrative expense 1,000,000
Depreciation 250,000
EBIT $1,000,000
Interest 360,000
EBT $640,000
Tax (20%) 128,000
Net income $512,000
(continued)
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Demonstration Problem 11.1: Ratio Analysis (continued)
Balance Sheet 12/31/00
Cash $150,000
Accounts receivable 200,000
Inventory 100,000
Total current assets $450,000
Net fixed assets 13,200,000
Total assets $13,650,000
Current liabilities $600,000
Debt (12%) 3,000,000
Equity 10,050,000
Total liabilities & equity $13,650,000
Price per share: $21.50
Shares outstanding: 1,000,000
A. Calculate the following ratios for Evergreen Timber: Earning power Gross profit margin Inventory turnover Return on assets EPS P/E ratio Days sales outstanding Price-to-book Quick ratio Current ratio
Solution
Earning power 5 7.3% Gross profit margin 5 0.75% Inventory turnover 5 7.5 Return on assets 5 3.75% EPS 5 $0.51 P/E ratio 5 42 Days sales outstanding 5 24 Price-to-book 5 2.14 Quick ratio 5 0.583 Current ratio 5 0.75
B. Evergreen offers purchasers of its timber terms of net 30, meaning that buyers have 30 days in which to pay their bill. Does Evergreen seem to have a problem collecting its receivables?
Solution
The days sales outstanding ratio of 24 is less than the company policy of 30 days. Therefore, there appears to be no problem with collections.
C. Does the use of leverage appear to be enhancing Evergreen’s return to its stockholders?
Solution
Leverage will magnify return on equity if the interest rate is less than the firm’s earning power. Ever- green’s earning power is 7.3%, which is less than the interest rate on debt, 12%. It appears, therefore, that leverage is actually lowering the firm’s ROE.
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CHAPTER 11Section 11.4 Stock Prices and Ratio Analysis
11.4 Stock Prices and Ratio Analysis
If you are not careful, you could easily immerse yourself in analyzing ratios and lose track of financial management’s objective—the maximization of shareholders’ wealth. The manager and analyst must be concerned with how ratios can help to explain share price behavior. It’s important to know why the price is outperforming competing firms’ prices, or why the stock is underperforming its peers. In this section we establish a link between ratios and the value of common stock that will help us understand the perfor- mance of the shares.
Let’s begin by returning to the constant growth stock valuation formula. Although not every stock has constantly growing dividends, this formula is useful because it illustrates the interplay among dividends, risk, and growth that affects share price regardless of the stock being analyzed. Recall that the constant growth formula is
P0 D1
1r 2 gn2 where D
1 is the dividend, r is the required return, and g
n is the growth rate. Now we
decompose the terms in the formula. First, D 1 , the dividend, is equal to net income times
the firm’s payout ratio:
Dividend 5 (Net Income)(Payout)
Next, consider that net income is equal to sales times net profit margin:
Dividend 5 (Net Income) 3 (Payout) 5 (Sales) 3 (Net Profit Margin) 3 (Payout)
Because the dividend’s value appears in the numerator of the stock valuation formula, we know that, all else equal, a higher dividend will increase share price. Thus, increased sales will increase share price, if sales can be increased without affecting other factors. For example, if sales are increased by lowering prices, then the net profit margin may decline and share price may not increase. If, on the other hand, sales increase because of a new, outstanding product that can be sold without cutting the profit margin, then it is likely that share price will go up according to the formula’s prediction.
Now let’s consider the denominator (r 2 g n ) of the constant growth formula. Notice that
if the growth rate, g n , increases, the value of the denominator in the formula decreases. In
a fraction, such as this formula, a smaller denominator will increase the fraction’s value. Thus, increased growth leads to increased price (if everything else is held constant). So what increases growth? From a ratio-analysis perspective, growth is a function of return on equity (ROE) and the earnings retention rate (where the retention rate is found by dividing retained earnings by net income). In fact, the following identity is called the sus- tainable growth formula:
Growth 5 (ROE) 3 (Retention Rate)
Now, it is clear that ROE is a key driver of growth. What, then, affects ROE? Here a sys- tem of very important relationships between ratios called the DuPont system (Figure 11.2) becomes useful for analyzing ROE. Note that ROE is shown to be a function of return
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CHAPTER 11Summary
on assets (ROA) multiplied by the leverage ratio (LEV). ROA is then shown to equal net profit margin (NPM) times asset turnover.
The DuPont system can be particularly useful for analyzing price performance. Suppose, for example, the stock of a company you’re analyzing has lagged behind its competitors’ performance and you want to know why. One approach is to analyze sales growth com- pared to that of its competitors (remember that sales is a factor in the top of the valuation formula). If lagging sales is the problem, then you may want to analyze the reputation of the firm’s products, the pricing of its products, or the effectiveness of its marketing strategy.
Figure 11.2: The DuPont identity
If sales performance is not the root of the problem, perform a DuPont analysis. Is ROE fall- ing? Is it below competitors’ ROEs? If either is the case, the next step is to find out why by analyzing asset turnover, net profit margins, or leverage. Perhaps one of these ratios holds the key to the lagging stock price.
Summary
Financial analysis is one of the most important tools available to a firm’s managers, potential investors, bankers considering lending the corporation funds, suppliers who may offer the firm trade credit, new graduates interviewing with a corporation, sales personnel identifying their target market, and a number of others who have some interest in a firm’s financial performance. This chapter has introduced several sources of information useful to the financial analyst and has provided an overview of the mechanics of financial statement analysis. Most importantly, the chapter has illustrated how analysis can help lead the analyst toward the issues that may explain a company’s performance and how it is the key to the firm’s future success.
Thus far in the book, consideration has been given to how firms make decisions about what projects they should pursue in order to increase the wealth of owners. Similar con- sideration was given to the factors that should influence a firm’s choice of financing alter- natives. To aid in making these decisions, concepts such as market risk and the time value of money have been introduced, along with tools such as the mathematics of discounting. Some theories, such as the CAPM, were also discussed. Chapter 11 covers information sources and techniques that will be useful in evaluating how effectively the firm is utiliz- ing the tools, theories, and concepts discussed earlier in the book.
return on assets ×
leverage ratio
net profit margin ×
asset turnover ×
leverage ratio
= = return on
equity
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CHAPTER 11Web Resources
Key Terms
abnormal (market-adjusted) return The part of the securities return for the period obtained by subtracting the return of a market index, like the S&P 500, from the stock’s return.
annual report Detailed financial data, including the firm’s balance sheet as of the end of its fiscal year, its income statement, statement of cash flows, written state- ments by management, and notes to the statement (which are written by the firm’s accountant).
common size statements Reports used by a company’s analyst to compare the relative composition of the company’s accounts over time.
financial ratios Ratios of key financial statement accounts that are helpful in identifying financial performance that merits further analysis.
market share The calculation derived by dividing a company’s product sales by the total sale of products perceived to be simi- lar and competing for the same consumer purchases.
qualified opinion An auditor’s opinion that reveals some misgivings regarding the firm’s accounting policies.
Securities and Exchange Commission (SEC) A federal government agency founded in the aftermath of the 1929 stock market crash to regulate securities trading.
stakeholders Groups, such as stockhold- ers, financial claimants, employees, or community members, that have a stake or interest in some aspect of corporate performance.
sustainable growth formula ROE 5 (1 2 payout ratio).
trend statements Reports that give insights to a market sector’s future pros- pects of growth or decline.
unaudited financial statements Financial statements that have not had the account values independently verified by an out- side auditor.
window dressing The practice, by man- agement, of manipulating accounts so they appear more favorable on financial statements.
Web Resources
To find the distribution of common financial ratios by rating and industry, see http://www.moodys.com/sites/products/DefaultResearch/2005700000436062.pdf.
The complete Wall Street Journal article about the Sears rating downgrade is at http://online.wsj.com/article/BT-CO-20120104-710378.html.
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CHAPTER 11Web Resources
Dell’s inventory problem is described at http://online.wsj.com/article/SB10000872396390444082904577607842238443130. html?mod5djemheard_t.
Business statistics and financial ratios have been compiled by BizStats and are available at http://www.bizstats.com/corporation-industry-financials/manufacturing-31/computer -and-electronic-product-manufacturing-334/computers-and-peripheral-equipment -334110/show.
Sears’s Annual Reports can be downloaded from the investor relations segment of Sears’s website at http://www.searsholdings.com/invest/financial_info.htm.
Other useful websites to visit are the following:
ABC News: http://www.abcnews.go.com
Bloomberg: http://www.bloomberg.com
British Financial Times: http://www.ft.com
CBS News: http://www.cbsnews.com
CNBC: http://www.cnbc.com
CNN: http://www.cnn.com
EDGAR database: http://www.sec.gov/edgarhp.htm
Just-in-Time Inventory: Effects on Earthquake Recovery: http://www.crew.org/sites /default/files/JITfinal032405.pdf
MarketWatch: http://www.marketwatch.com/
NASDAQ: http://www.nasdaq.com
New York Times: http://www.nytimes.com
NYSE: http://www.nyse.com
MERGENT database: http://www.mergentonline.com/login.php
Robert Morris Associates: http://www.rmahq.org
Sales and Marketing Management: http://www.salesandmarketing.com/
The Wall Street Journal: http://www.wsj.com
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CHAPTER 11Practice Problems
Critical Thinking and Discussion Questions
1. We classified inventory turnover as an efficiency ratio. In what other classifica- tion category do you think it could belong? Why?
2. Under what condition will financial leverage increase ROE? 3. Under what circumstances do you think the current ratio and quick ratio would
give opposite signals of the liquidity of a firm? 4. Industry averages are often used as benchmarks in ratio analysis. Justify this
practice. 5. Artistic Designs Inc. has a current ratio of 3.0. What would be the impact on the
current ratio if the company a. used cash to pay off some current debt? b. used cash to repurchase some outstanding shares of stock? c. used cash to pay a dividend? d. borrowed cash from a local bank to purchase a company-owned automobile?
(The loan is short-term, due in 6 months.) e. borrowed short-term and used the funds to increase inventory?
6. Akira Abe, the treasurer at Acme Industries, notices that the firm keeps several million dollars in marketable securities invested in very short-term Treasury securities. Maturities are from 1 week to 3 weeks. Akira notices that by investing in longer-term government securities, the company can earn, on average, one full percentage point more income on the marketable securities account balance. Let’s assume that Akira implements his strategy and invests in government bonds with 10-year maturities. a. What would happen if market interest rates suddenly rose? b. What impact would Akira’s decision have on ROE if interest rates didn’t rise
immediately and the long-term bonds raised income? c. What impact would Akira’s decision have on the riskiness of the firm? d. If stockholders knew of Akira’s action, what impact do you think it would
have on their valuation of the firm?
Practice Problems
1. Consider the following income statement (in which all values are in hundreds of thousands of dollars):
2009 2010 2011 2012
Sales 393.9 431.2 458.1 556.0
COGS 336.7 365.6 390.1 483.3
Interest 4.1 4.3 3.0 2.7
NI 17.2 19.1 21.3 24.7
a. Compute common size and trend statements. b. What was the most important factor in the improvement in profit margins
from 2009 to 2012?
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CHAPTER 11Practice Problems
2. Let’s say that Xcel Energy stock was up 12% last year. The S&P 500 was up 15% last year. a. What was Xcel’s firm-specific return after adjustment for market-wide
movements? b. Another way to isolate firm-specific stock returns is to adjust for overall
industry performance. If, for example, an index of utility company stocks was up 10%, then did Xcel outperform, underperform, or just stay even with the industry?
c. The most sophisticated way to isolate firm-specific stock performance is via risk-adjusted returns. This method explicitly accounts for the firm’s risk by incorporating beta in the analysis. Recall that beta measures the stock’s sensi- tivity to market movements, thus measuring the firm’s systematic or market risk. If Xcel’s beta was 0.80, we would expect its stock to return 80% of the market return. Given the beta of 0.80 and the S&P 500 return of 15%, what return would you expect for Xcel? If the firm’s actual return was 12%, did the company have a positive risk-adjusted return, a negative risk-adjusted return, or a risk-adjusted return equal to zero?
3. A firm has sales of $3 million per year, all of which are credit sales. Its average collection period is 42 days. What is the average balance in accounts receivable?
4. Total interest expense at a business was $30,000 per year. Sales were $4 million, and the profit margin was 8%. If the business’s tax rate was 40%, what
was the firm’s times interest earned ratio? 5. A firm’s net profit margin is 12%, and its asset turnover is 1.1. What is the firm’s
ROA? 6. Half a firm’s capital, based on book values, comes from equity. This firm’s ROE is 15%. What is its ROA? 7. A firm’s inventory equals its total current liabilities. The company’s quick ratio
equals 1. What is its current ratio? 8. Suppose in 2012 Shingard’s current assets increased by $2 million from their 2011
level. Current liabilities also increased by $2 million. a. What is Shingard’s 2012 current ratio if all other accounts are unchanged? Did
the current ratio increase, decrease, or stay the same compared to the prior year?
b. Using the trend statement from Table 11.6 and your answer to part a, calcu- late the 2012 trend values for Shingard’s current asset and current liability accounts. Why was the change so much more dramatic for the current liability account’s trend than for the change in current assets?
9. A firm’s sales were $25 million. Its net profit margin was 7%, and there are 800,000 shares of common stock outstanding. The company’s leverage ratio is 2.0. Its assets total $20 million. The company’s price-to-book is 3. a. What is the price per share of the corporation’s stock? b. What is its P/E multiple?
10. Taking the data from Shingard’s accounts in Tables 11.3 and 11.4, perform a DuPont analysis of ROE for 2010 and 2011.
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