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Learning Objectives

After studying this chapter, you should be able to:

• Explain who a corporation’s stakeholders are and how they each evaluate performance.

• Describe various sources of financial information used in financial analysis, and the characteristics of these sources.

• Perform financial statement analysis, including analysis of trend and common size financial statements and ratios.

• Show how ratios are related to stock performance.

• Analyze methods used to evaluate the performance of management.

Associated Press11

Financial Analysis: Evaluation of Corporate Performance

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CHAPTER 11Pre-Test

Introduction

Figure 11.0: Chapter 11 in focus

Customers Products FundsInvestments

made by the firm

Sources of capital Investors

The Financial Balance Sheet

Management

Net cash generated from operations

The evaluation of corporate performance is an important skill for managers, investors, and even customers and employees. Such analysis is the topic of Chapter 11.

Evaluation of corporate performance is an important skill for managers, investors, and even customers and employees. This chapter covers financial statement analysis, particu- larly ratio analysis, as well as other methods of evaluating corporate performance. We aim to give you an appreciation for the complexities facing financial analysts and a sense of how judgment and logic play into 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 in a business’s financial past can help us understand what is likely to happen in its future. Good analysis provides a useful tool for evaluating past performance and planning for the future.

Pre-Test

1. Financial analysis may vary in its focus, depending on what stakeholder group is conducting the review of the firm’s performance.

a. True b. False

2. In a period of increasing costs, net income for a period is generally higher if the firm adopts LIFO inventory when accounting for cost of goods sold.

a. True b. False

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CHAPTER 11Section 11.1 Stakeholders and Evaluating Corporate Performance

3. Just-in-time inventory will tend to decrease inventory turnover. a. True b. False

4. The DuPont system can be used in performance analysis. a. True b. False

5. Similar to NPV, EVA examines potential future performance. a. True b. alse

11.1 Stakeholders and Evaluating Corporate Performance

How do we determine if a corporation is doing well, and what is meant by doing well? The answers depend on who is asking the questions. If stockholders pose the queries, then doing well probably refers to the stock’s price performance. As resid- ual claimants, stockholders want to see high returns in comparison to their risk exposure. On the other hand, bondholders, bankers, and other fixed claimants are more interested in the likelihood of bankruptcy. They are most concerned with being paid as promised. Employees (including managers) are interested in keeping their jobs and improving their salaries. Thus, this set of individuals will base doing well on the incentive systems that reward their performance. Because fixed claimants, resid- ual claimants, and employees all have different criteria for evaluating performance, the analysis used by each group varies. We largely confine our attention to the financial stake- holders (the financial claimants) and, therefore, focus on the analysis of corporate financial performance. As residual claim- ants, the key financial stake- holders (stockholders) have a keen interest in the performance of the company from virtually all perspectives, including the risk of bonds, the satisfaction of customers, and even the perfor- mance of competitors.

As company stakeholders, consumers play an important role in establishing the welfare of a corporation. For example, much of Apple’s success can be attributed to its loyal customers.

Imaginechina/Associated Press

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

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. Such groups are referred to as stake- holders because each has a stake or interest in some aspect of corporate performance.

Now that we have discussed who is concerned with a company’s performance, we can move on to the different sources used by financial claimants to conduct analysis.

11.2 Information Sources and Their Characteristics

Like a detective, an analyst must know where to look for evidence. This section pres-ents a sample of information sources generally available to the analyst. Accounting Statements All publicly traded firms and many privately held firms have an accountant prepare finan- cial 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. 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. A link to this site is provided in the Web Resources at the end of the chapter.

Firms whose statements are externally audited and compiled according to generally accepted accounting principles are providing independently verified information to inter- ested parties. GAAP ensures that, to the greatest degree possible, standard accounting methods are consistently applied, enabling one firm’s numbers to be compared to another firm’s, and this year’s results to be compared to last year’s. Because of these reporting standards, accounting statements have traditionally been the foundation on which finan- cial analysis is built.

Included at the end of the annual report is an auditors’ statement, which is highly important to the analyst. This statement, known as an unqualified opinion, confirms that the informa- tion provided is representative of the firm’s activities for the period. 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.

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

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. (AICPA, 1988)

On the other hand, a qualified opinion serves as a red flag for the analyst, signaling that something fishy may be going on. There are several reasons why a firm’s auditor will ren- der a qualified opinion. For example, inadequate disclosure of information would prompt the following qualified opinion:

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. (AICPA, 1988)

And an unjustified change in accounting procedures would result in the following quali- fied 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 accounting prin- ciples, in our opinion the Company has not provided reasonable justifica- tion for making this change, as required by generally accepted accounting principles. (AICPA, 1988)

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. Unau- dited financial statements are based on the numbers supplied to the accountant by manage- ment. 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 actually confirm- ing the claim’s accuracy. Data on unaudited statements has not been independently veri- fied, therefore, analysts put less faith in these than audited statements.

Despite their reliability and comparability, audited financial statements do have several weaknesses. First, GAAP allows some flexibility on the method used in compiling data. For example, firms may choose the type of depreciation method they use for certain assets. They may also 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 different accounting methods. We provide a moderate example of this difference in Table 11.1. Note that the firms have different oper- ating incomes, even though the cash flows for the two firms are identical.

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

Field Trip: Window Dressing

Window dressing manipulates accounting data and misleads stakeholders regarding a firm’s financial standing. In November of 2012, Hewlett Packard was forced to write off more than $8 billion, as a result of what they considered to be accounting misrepresentations on the part of a company they acquired in 2011 (Worthen, 2012).

Listen to this news broadcast discussing HP’s allegations and subsequent investigation: http://www.npr.org/2012/11/28/166054180/hp-mired-in-messy-allegations

Reflection Questions

1. Who do you think should be held responsible for HP’s multibillion dollar losses? 2. Should HP have investigated Autonomy’s accounting data more closely, or should Autonomy have

been more forthcoming with its financial situation?

Table 11.1: LIFO versus FIFO

Date Activity Cash flow

October 1 Purchase 100 widgets at $2 each $200 outflow

December 1 Purchase 100 widgets at $3 each $300 outflow

December 30 Sell 100 widgets at $6 each $600 inflow

Data Firm A (using LIFO) Firm B (using FIFO)

Sales $600 $600

Cost of goods sold –$300 –$200

Operating income $300 $400

Cash inflow $600 $600

Cash outflow –$500 –$500

Cash flow $100 $100

Additionally, management 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, man- agement may choose to let inventory stocks run low. This lowers the inventory account balance on the year-end balance sheet, inflating the inventory turnover ratio, which mea- sures how fast inventory is typically sold by the firm. This strategy could cosmetically alter ratios, making them look better than they actually are. The practice of manipulating accounts so they appear more favorable is known as window dressing.

A third shortcoming of accounting data is its focus on profit (as opposed to cash flow) and book values (as opposed to market values). The differences between these—and how they affect the appearance of firm value—were discussed earlier. Recall that in Chapter 1 we highlighted the difference between the financial balance sheet and the accounting balance

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npr.org/2012/11/28/166054180/hp

CHAPTER 11Section 11.2 Information Sources and Their Characteristics

sheet, and that in Chapter 5 we covered the importance of cash and how accounting prof- its may be restated as cash flows. It is important to have a firm grasp of that material as you attempt to analyze financial data.

A fourth weakness of audited financial statements is that accounting results are purely historical in nature. In many cases, good historical results do not necessarily translate into good future results. A firm that makes large profits often entices competitors to join the market. For example, Research in Motion, the maker of the BlackBerry, made over $380 million in profit in 2006. By 2012, this pioneer in the industry was struggling to survive, in part because a number of competing smart phones entered the market. For planning purposes, it would be foolish to count on extraordinary profits continuing simply because they have been consistently achieved in the past. Likewise, dismal past performance does not always mean the future will also be bleak. General Motors, for example, was saved from bankruptcy in 2008, but regained profitability by 2012.

The last weakness of accounting data is that it reports results in only one dimension: prof- itability. A firm that maximizes profits (or even cash flows) without regard to risk may be unwittingly lowering shareholder’s wealth. Unsustainable strategies for increasing prof- its 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 ultimate goal.

Table 11.2 summarizes the strengths and weaknesses of accounting statements.

Table 11.2: Strengths and weaknesses of accounting statements

Strengths Weaknesses

Independently audited GAAP statements provide some assurance of reliability and comparability, lowering information asymmetry.

Differences in accounting methods may lower comparability of results.

Statements are widely available. Window dressing may lower reliability of data.

Accounting statements do not focus on cash flows, nor do they report market values.

They are purely historical in nature.

Risk is not considered in report of performance.

Market Data The second important information source used by financial claimants to analyze per- formance is market data. As its name implies, market data are the data generated in a marketplace, such as the New York Stock Exchange or the Chicago Mercantile Exchange. Here, we will discuss two types of market data: stock market performance (measured by stock returns) and product market performance (measured by market share). Because it is generated by millions of market participants, market-based data are less subject to manip- ulation (window dressing) than accounting data are. Although it has been accomplished,

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

managers have a difficult time misleading millions of investors in the stock market or mil- lions of consumers in product markets.

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. Stock returns measure changes in shareholder wealth. Returns are available in many formats. For example, The Center for Research in Security Prices (CRSP), devel- oped by the University of Chicago, offers a data set of daily security returns decades long; it covers thousands of publicly traded firms. Returns may also be calculated by gathering share price and dividend information from sources like 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 implicitly consider risk. Recall that two shortcomings of accounting statements are (1) their historical nature and (2) the fact that they don’t incorporate risk. Stock prices (and therefore returns) do not suffer from these faults because they are forward-looking; that is, they include the present value of future expected dividends. Examine once again the stock valuation formula first presented in Chapter 5:

Pricet50 5 a`t 5 1 Dt

11 1 r2 t 5 Dividendt 5 1

r 2 gn

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.

However, using stock returns to evaluate corporate performance also has a shortcoming. 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 outside the firm’s ability to control. Or was the decline a signal of lower expected dividends and/or higher risk? Fortunately, there is a way to distinguish the portion of a stock’s return caused by a market-wide move- ment from the part with a firm-specific cause. This is achieved by subtracting 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 the part of the return attributed to the general mar- ket 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. By subtracting the market’s return from the firm’s return, we determine that XYZ’s market-adjusted return last year was 25% (AR 5 15% 2 20% 5 25%). Thus, the firm actually underperformed the market,

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

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? Was there a law- suit? The analyst must gather much more information before an accurate analysis can be drawn up.

The financial balance sheet model of the corporation identifies two markets critical to the success of a business: financial and product markets. Financial markets are the source of the external capital the corporation needs in order to fund its investment projects. As we have shown, stock returns measure the success of the firm in these markets. Next, we dis- cuss how to measure a firm’s performance in product and service markets: by analyzing market share.

Market Share A firm’s products compete within the product and service market arenas, which provide the cash that flows back to claimants. 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 mar-

ket share. Here, the demand for the product is reflected. Additionally, product pricing strategies, product differentiation, quality, reliability, ser- vice, 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 all products perceived to be similar and competing for the same consumer purchases. A declining market share indicates that competitors are taking busi- ness 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 down- ward, the company must implement a strategy that addresses the problem. Similarly, a growing market calls for a plan to meet potentially high growth. Firms in shrinking markets are chal- lenged to gain a greater share in a smaller market. Such firms may attempt to develop new products that capitalize on company strengths to replace current products that may be headed toward obsolescence. A good example is the horse-drawn

Understanding market share includes knowledge of market size. When the market for horse drawn carriages began to shrink due to the popularity of cars, manufactures followed the market.

Marka/SuperStock

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

carriage manufacturers at the turn of the century. Seeing demand for carriages decline, firms such as Fischer Body (now a division of General Motors) entered automobile body manufacturing. More recently, IBM switched strategic direction from manufacturing com- puter 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 online and through libraries, in addition to 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.

Opinions of Other Analysts In addition to performing their own research, analysts can supplement their analysis of a firm’s performance with the opinions of other analysts. Many large firms are closely followed by securities analysts, and an entire industry exists to publish analysts’ opin- ions and forecasts of firm performance. The best known of these publishers are Moody’s, Standard & Poor’s, Fitch, Morningstar, and Value Line, all of which are available online for a fee. Almost any library carries one or more of these company’s 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. These agencies base their ratings on the likelihood (in their opinion) that a bond will default and on the protection afforded to the claimant by the bond contract should default occur. Table 11.3 shows the major rating categories used by Moody’s and Standard & Poor’s. Naturally, the higher the rating is, 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 11.3: Standard & Poor’s and Moody’s bond rating categories

Agency 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 is another rating agency available to analysts. Their weekly publication, The Value Line Investment Survey, analyzes more than 1,700 stocks. They rate equities for future price appreciation potential (timeliness) and relative riskiness (safety), and provide explicit estimates of future dividends, dividend growth, sales, and earnings, among other fore- casts. Stocks are categorized by industry, and the publication includes some discussion of each firm’s prospects and challenges as well as brief industry analysis. Additionally, they also provide some historical data and calculate several ratios pertinent to analysis. See the Web Resources at the end of this chapter for links to Value Line’s main site and a sample Value Line investment survey.

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CHAPTER 11Section 11.2 Information Sources and Their Characteristics

Similar to Value Line, Morningstar also provides information on equities, dividends, and stocks. The agency is also well known for its analysis of mutual funds. See the Web Resources at the end of this chapter for more information on Morningstar.

We must keep in mind that, if markets are efficient, the information included in reports by Moody’s or Value Line is already included in the market price of a 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. To be sure, the opinions of major rating agencies certainly matter to the management of compa- nies whose securities they follow. Moreover, opinions of other analysts serve as a bench- mark with which our own conclusions may be compared.

Comparative Data Numbers, by themselves, don’t necessarily inform us of much. If I caught a fish weighing five pounds, that may be a big fish, if it is a trout, but it may be a little fish if it is a tuna. To have meaning, numbers need to be compared to some benchmark or target.

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 three pieces of data:

1. historical results, 2. your competitors’ results, 3. your firm’s targeted sales.

We will look specifically at historical results and your competitors’ results in this discus- sion of comparative data.

Let’s consider the first piece of data. Historical results are readily available in a firm’s annual reports. In fact, annual reports include data from several years for just this pur- pose. If, in the last five 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 larg- est increase in a decade, it might indicate outstanding performance. The historical record provides the analyst with a clue.

To examine the second piece of data, look for comparable firms that are competitors in the same product market. Ideally, comparables 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 natu- ral comparables, but if you investigate, you will find that PepsiCo owns Frito-Lay and the Quaker Oats Company, among other snack food companies (see http://www.pepsico. com/). Surprisingly, snack foods generate most of PepsiCo’s sales and profits, differenti- ating its product line from Coca-Cola’s. Thus, the two companies are not as comparable as one might assume.

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http://www.pepsico.com

CHAPTER 11Section 11.2 Information Sources and Their Characteristics

For firms that do fit into an industry classification, there are publications that produce industry average ratios for com- parison purposes. Among the most widely available industry averages are those published by Dun & Bradstreet, Risk Man- agement Association, 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 comparables data.

Print and Digital Media We have already mentioned two sources of information that are not quantitative in nature: annual reports and published analysts opinions. However, analysts must look beyond the numbers when evaluating a company’s performance. The press offers a wealth of valu- able information—both online and in print—that may be useful to the analyst.

Why should we consider information available through the media when performing financial analysis? 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 understand the cause of performance. For instance, concluding that share price declined because earnings were lower is not very useful; we don’t know why earnings were lower. If we take the quantitative analysis a step further and discover that earnings were lower because sales were down, then we’ve added to our knowledge, but we still have not reached a level of understanding that is useful to decision making. What a man- ager or a claimant needs to know is why sales were down. Did the company lose market share because a competitor introduced a superior product or lowered prices? Were sales down because the overall market shrank? Was there a recession last year that caused con- sumers to cut back their overall spending? Maybe bad press caused sales to decline, or maybe it was a result of internal problems at the company. A strike may have hurt produc- tion, 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, but numbers don’t always tell the complete story. Publications devoted to business and economics, such as The Wall Street Journal, Barron’s, Financial Times, Forbes, and Fortune are just a few resources that analysts can turn to for additional (non data-driven) information crucial to the analysis of a com- pany’s performance.

In addition to these print sources, numerous sources are available online. Virtually all of the information sources listed here, from The Wall Street Journal to the Risk Management Association, maintain their own sites. You can find a corporation’s website by using a

Coca-Cola and PepsiCo may seem like comparable companies, but a significant portion of Pepsi’s profits stem from Frito Lay. Can you think of better comparisons for the two companies?

Associated Press

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CHAPTER 11Section 11.3 Financial Statement Analysis

search engine, and you can access financial statements by looking at a corporation’s filings with the Securities and Exchange Commission—including their annual reports, proxy statements, and 10-Ks. The SEC makes these available on its EDGAR database. In addition to these sources, general news about companies is provided online by television networks such as ABC, CNN, and CBS, and by newspapers such as the New York Times. Business- specific news sources include Bloomberg, CNBC, and Britain’s Financial Times, which is similar to The Wall Street Journal but with a more international perspective. Another use- ful site is Financial Web, managed by Dr. James Graven. Finally, securities exchanges that manage their own sites include the NYSE and NASDAQ. See the Web Resources at the end of this chapter for more information on online resources.

As you can see, evaluating corporate performance requires a significant amount of research. No single source provides all the pieces of the puzzle, yet each makes a contri- bution toward understanding the full picture. Next, we examine how analysts take their gathered information and apply it to financial statement analysis.

11.3 Financial Statement Analysis

In the previous section we examined different sources analysts use to gather informa-tion when evaluating corporate performance. In this section, we will discuss how that information is applied to analyzing financial statements. Let’s start by looking at an example.

Shingard, Inc. manufactures plastic shin guards used primarily by soccer players. Figures 11.1 and 11.2 show the firm’s income statements and balance sheets for the years 2009, 2010, and 2011. These two figures provide the information we will use to demonstrate techniques used to analyze financial statements, including the calculation of trend and common size statements in the following section of the chapter.

Figure 11.1: Shingard, Inc. income statements, 2009–2011 (in 000s)

Revenue Cost of goods sold (COGS) Selling, general, and administrative expense (SG&A) Depreciation Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes (EBT) Taxes (34%) Net income (N.I.) Dividends Retained earnings

2011 57,394

229,271 213,035

23,250 11,838 21,701 10,137 23,447 6,690 2,500 4,190

$ $ $

50,280 223,632 214,050

23,250 9,348

21,642 7,706

22,620 5,086 2,000 3,086

$ $ $

2010 52,846

223,781 215,569

23,250 10,246 21,830

8,416 22,861 5,555 2,000 3,555

$ $ $

2009

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CHAPTER 11Section 11.3 Financial Statement Analysis

Figure 11.2: Shingard, Inc. balance sheets, 2009–2011 (in 000s)

Assets Cash Marketable securities (Mkt. Sec.) Accounts receivable (A/R) Inventory (INV) Total current assets (C.A.) Equipment and buildings Less accumulated depreciation Net equipment and buildings Land Total fixed assets (F.A.) Total assets (T.A.) Liabilities and owner’s equity Accounts (A/P) Wages payable (W/P) Notes payable (N/P) Total current liabilities (C.L.) Long-term debt (L.T.D.) Common stock (par value $0.10) Paid-in surplus of par Retained earnings Total equity (T.E.) Total liabilities and owner’s equity

2011 172 30

2,909 16,800 19,911 27,400

214,810 12,590

259 12,849 32,760

$ $

148 30

2,723 17,357 20,258 27,400

211,560 15,840

259 16,099 36,357

$ $

2010

2011 1,092

273 1,350 2,715 9,600

20 1,000

19,425 20,445 32,760

$ $

1,112 250

1,740 3,102

17,000 20

1,000 15,235 16,255 36,357

$ $

2010

270 30

2,490 11,743 14,533 27,400 28,310 19,090

259 19,349 33,882

$ $

2009

984 229

1,500 2,713

18,000 20

1,000 12,149 13,169 33,882

$ $

2009

These figures show the company’s income statements and balance sheets from 2009–2011.

Trend Statements Analysts use trend statements to uncover evidence of patterns in the data. They are con- structed 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 balance. Table 11.4 shows the balances of the revenue and cost of goods sold (COGS) accounts for Shingard and their trend statement values.

Table 11.4: Balances of revenue and COGS for Shingard, Inc.

Dollar Values 2009 2010 2011 Revenue $52,846 $50,280 $57,394 Calculating the trend values $52,846 $50,280 $57,394 Beginning year’s balance $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 Beginning year’s balance $23,781 $23,781 $23,781 Trend values 1.000 0.994 1.231

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CHAPTER 11Section 11.3 Financial Statement Analysis

Next, Figure 11.3 shows abbre- viated trend income and bal- ance 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 dra- matic 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 more than 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 recovery in 2011 was driven by higher sales and control of sell- ing, 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.

Figure 11.3: Trend analysis and trend balance sheet for Shingard, Inc., 2009–2011

Trend income statement Revenue Cost of goods sold Selling, general, and administrative Net income Trend Balance Sheet Inventory Current assets Net equipment and buildings Total assets Current liabilities Long-term debt Total equity

2011 1.086 1.231 .837

1.204

1.431 1.370 .660 .967

1.001 .533

1.553

.951

.994

.902

.916

1.478 1.394 .830

1.073 1.143 .944

1.234

2010

20112010

1.000 1.000 1.000 1.000

1.000 1.000 1.000 1.000 1.000 1.000 1.000

2009

What do trend statements help companies determine?

Trend statements provide the clues necessary to explain corporate performance. By investigating Shingard, Inc.’s trend statement, the analyst would discover that the World Cup may have impacted sales.

Comstock/Thinkstock

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CHAPTER 11Section 11.3 Financial Statement Analysis

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 the World Cup for soccer 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 outstand- ing results, but keep in mind that the trend statement highlighted that year’s dramatic turnaround, putting us on the correct investigative path.

Common Size Statements Common size statements are another tool used to analyze financial statements. These statements allow analysts to compare the relative composition of a company’s accounts over time. Each year’s common size income statement is found by dividing 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 would equal 0.477. Figure 11.4 shows abbreviated common size income and balance sheet statements.

Figure 11.4: Shingard, Inc. common size income statement and balance sheet, selected accounts: 2009–2011

Common size income statement Revenue COGS SG&A EBIT EBT NI Common size balance sheet Total assets Inventory Current assets Total fixed assets Current liabilities Long-term debt Total equity

2011 1.000 0.510 0.227 0.206 0.177 0.117

1.000 0.513 0.608 0.392 0.083 0.293 0.624

1.000 0.470 0.279 0.186 0.153 0.101

1.000 0.477 0.557 0.443 0.085 0.468 0.447

2010

20112010

1.000 0.450 0.295 0.194 0.159 0.105

1.000 0.347 0.429 0.571 0.080 0.531 0.389

2009

What does comparing these common size income statements and balance sheets offer to companies? What can they determine from this information?

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CHAPTER 11Section 11.3 Financial Statement Analysis

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 decreased.

To explain this, we would need to deconstruct 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 need to look beyond the accounting num- bers 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 bal- ances. 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 (Figure 11.3), 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, for example, you served on Shingard’s board of directors, you would require some explana- tion to convince you that paying off debt is a wise move on management’s part.

Ratio Analysis We will not burden you with in-depth coverage of ratios’ mechanics. Like the skilled detective who leaves the DNA testing to the crime lab, we will leave the calculation of ratios to the calculator. Figure 11.5 shows the most common financial ratios calculated from Shingard’s 2011 accounting statements. Carefully review each ratio, paying particu- lar attention the calculation and how it relates to the ratio’s use.

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CHAPTER 11Section 11.3 Financial Statement Analysis

Figure 11.5: Financial ratios for Shingard, Inc. for 2011

(a) Debt ratios measure the firm’s ability to meet principal and interest payments over the long term.

(b) Liquidity ratios measure the firm’s ability to meet its maturing obligations and unexpected cash needs over the short term.

(d) Efficiency ratios measure the effectiveness and intensity of the firm’s management of its resources.

1. Debt ratio

2. Leverage ratio (LEV)

3. Times interest earned ratio

1. Inventory turnover

2. Days sales outstanding

3. Asset turnover

1. Net profit margin 2. Return on

assets (ROA)

3. Return on equity (ROE)

4. Gross profit margin

5. Earning power

1. Current ratio

2. Quick ratio (acid test)

0.32

1.60

6.96

1.742

18.25 days

1.752

0.117

0.204

0.327

0.490

0.361

7.33

1.15

= = =

= = = = =

= =

= = =

= = = = =

= =

= = =

= = = = =

= =

Measures how many dollars of assets the firm utilizes for each dollar of contributed equity.

Measures the ability to make interest payments.

Measures the proportion of capital supplied by creditors.

Use

Measures the liquidity and control of receivables.

Measures the liquidity and control of inventory.

Use

Measures the profitability of the firm’s assets independent of leverage and tax effects.

Measures product pricing in comparison with it’s basic cost.

Measures the profits accruing to shareholders per dollar of contributed equity.

Measures the profitability of the use to which assets are being put.

Measure earnings generated per dollar of sales.

Use

Measures short-term debt-paying capacity.

Measures immediate short-term liquidity.

Use

Ratio

Formula

Long-term debt Total long-term capital

Total assets Total equity

EBIT Interest (dollars)

Cost of goods sold Inventory

Receivables Annual revenue>360

Revenues Total assets

Net income Revenue

Net income Total assets

Net income Total equity

Revenue − COGS Revenue

EBIT Total assets

Current assets Current liabilities

Current assets − inventory Current liabilities

9,600 30,045

32,760 20,445

11,838 1,701

29,271 16,800 2,909 159.43 57,394 32,760

6,690 57,394 6,690 32,760

6,690 20,445

28,123 57,394

11,838 32,760

19,911 2,715 3,111 2,715

Measures sales generated per dollar of assets.

(e) Per-share measures express key financial variables on a per-share-of-stock basis.

(f) Measures of relative value

1. Earnings per share (EPS)

1 Number 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 oustanding are $20,000/$0.10 = 200,000 shares.

2 Keep in mind that retained earnings represent capital contributed by shareholders (rahter than being paid out as dividends). 3 Current market price is found in the stock quotes in the newpaper. For Shingard, we’ll assume the price per share was $234.15 on the date of these calculations.

2. Book value per share (BVPS)

1. Price-earnings ratio (P/E)

2. Price-to-book (P/B)

$33.45

$64.25

3.64

= =

Expresses the capital contribued by shareholders on a per-share basis.2

Measures amount paid as dividends to each share of stock.

Expresses profits on a per-share basis.

Use

Expresses stock value as multiple of last year’s earnings.

Use

Total equity Number of shares

Ratio

Price per share Book value share

Ratio

Net income Number of shares1

Price per share3

EPS

$6,690,000 200,000

$12,849,000 200,000

Formula

$234.15 $33.45

$234.15 64.25

Formula

3. Dividend per share (DPS)

$12.50= = =Total dividendsNumber of shares 2,500,000 200,000

Expresses stock price as a multiple of equity holders’ historical contributions to capital.

This figure shows the most common financial rations from Shingard’s account statements from 2011.

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CHAPTER 11Section 11.3 Financial Statement Analysis

What we’re most interested in is understanding what clues to look for, where to look for them, and how to interpret them once they have been found. Just as a school for detectives cannot cover every crime or review all potential pieces of evidence, neither can we cover all scenarios an analyst may encounter. Rather, the detective school tries to cover 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 scenarios that commonly occur in business and analyze how these events are manifested in the firm’s ratios and financial statements.

Scenario 1: Increasing Leverage and Return on Equity (ROE) In the first scenario, we examine the relationship between borrowing and one of the most important ratios, return on equity (ROE 5 Net income/Total Equity). Suppose a corpora- tion decides to raise capital by borrowing. Whether this decision to “lever-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, then ROE will fall, and vice versa.

If EP . i, ROE increases with leverage. If EP , i, ROE decreases with leverage.

Figure 11.6 shows two firms of equal size, with equal debt ratios, being charged the same interest rate. The one difference between these two companies is a dramatic gap in earning power. Note what happens to their respective ROEs as their debt ratios change.

Figure 11.6: Illustration of earning power, leverage, and ROE

Debt Equity Total assets Debt/total assets EP% EBIT INT (10%) EBT Tax (40%) NI ROE%

Before 500 500

1,000 0.50 20% 200 250 150 260 90

18%

After 1,000

500 1,500 0.67 20% 300

2100 200 280 120

24%

Firm A Favorable Financial Leverage

500 500

1,000 0.50 9% 90

250 40

216 24

4.8%

AfterBefore 1,000

500 1,500 0.67 9% 135

2100 35

214 21

4.2%

Firm B Unfavorable Financial Leverage

What happens to their respective ROEs when the companies’ debt ratio changes?

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CHAPTER 11Section 11.3 Financial Statement Analysis

Scenario 2: Just-in-Time Inventory Let’s consider another scenario, concerning just-in-time inventory. Just-in-time inventory systems deliver inventory directly to the assembly line as needed, rather than the tra- ditional method of being stockpiled in a warehouse. Thus, materials are delivered just in time for their use in the manufacturing process, rather than being stored onsite. This is a very efficient system because less capital is invested in inventory, making it avail- able for other projects or uses. Furthermore, less warehouse space is needed to stockpile inventory, and less labor is required to store and retrieve it when needed. Considering these characteristics of just-in-time systems, let’s see what efficiency ratios from Figure 11.1 would be impacted if a manufacturer successfully implemented this inventory sys- tem. Inventory turnover would certainly increase because less inventory would be kept on hand, which lowers the denominator in the ratio. Asset turnover would also increase as total assets decline, due to lower inventory and warehouse requirements, lowering the ratio’s denominator.

If just-in-time inventory improves these effi- ciency ratios, why don’t all manufacturers adopt the system? The answer lies in the just-in-time inventory system’s potential for risk. The manu- facturer becomes extremely dependent on its suppliers, and on its ability to accurately gauge and time demand for the finished product. If the supplier cannot meet delivery schedules, or if the manufacturer inaccurately gauges its own mate- rial requirements, production schedules may be missed. Missed deadlines would likely result in loss of sales. If the company needs to meet higher than anticipated material needs, raw materials would have 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. For some com- panies, these risks may outweigh the benefits of implementing such a system.

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 earth- quake 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, like the Cascadia Region Earthquake Workgroup (CREW). CREW has even prepared a study titled, “Just-In-Time Inventory: Effects on Earthquake Recovery,” dem- onstrating the seriousness with which this risk is taken on the Pacific Coast. A link to this study can be found in the Web Resources at the end of this chapter.

The March 2011 tsunami in Japan affected businesses all over the world, as companies were relying on parts manufactured in Japan. Do you think just-in-time inventory plans need backups?

Associated Press

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CHAPTER 11Section 11.3 Financial Statement Analysis

Scenario 3: Working Capital Analysis This scenario will help you understand working capital. Here is some information about a large U.S. 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 Wall Street Journal article supplemented with data from the com- pany’s annual report. Sales growth during 2011 was less than 1%. The company held just 13 days of inventory (compared to 7.5 days on average for its industry). Its Accounts Pay- able 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) (Winkler, 2012).

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 70% more inventory than other companies in its industry and does not 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 industry 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 then makes a sale and collects cash for the sale 58 days later. This means that there is a 71-day gap between the time inventory arrives at the company and when it finally turns into cash. On the other side of the ledger, it is able to postpone paying its suppli- ers for 100 days. By combining these numbers (100 – 71) we see that the company has 29 days of free cash to use before it pays its suppliers. Think about this. The company gets to use cash at no cost for one month. This is free financing! From this perspective, the firm’s managers are incredibly clever.

The company we have been considering is Dell. The Wall Street Journal article is somewhat cautionary, warning that this interest-free cash machine is slowing down as sales slow. Despite this, the lesson remains clear: Averages are average, and it is important to look at a company from several perspectives.

Scenario 4: Corporate Bond Ratings and Financial Ratios The last scenario we cover relates to corporate bond ratings and financial ratios. Recall from earlier in this chapter that three companies rate bonds: Standard & Poor’s, Moody’s, and Fitch. As discussed, bond ratings serve as risk indicators, and investors depend on them when setting their required rate of return from investing in a bond.

The rating process usually begins with a thorough financial ratio analysis. Rating analysts then consider the prospects for the industry and the company being rated within that industry, (e.g., How will competition affect the company? Are the company’s primary markets growing?). In this scenario, we focus on the ratio analysis component of the bond- rating process.

Table 11.10 shows the medians for eight different financial ratios and six different bond ratings. Recall that Aaa-Aa through Caa-C are Moody’s bond rating categories from the

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CHAPTER 11Section 11.3 Financial Statement Analysis

highest to the very lowest (See Table 11.3), which correspond to S&P ratings of AAA-AA through CCC-C. The IG column is for Investment Grade, Aaa through Baa3 (or in S&P symbols: AAA through BB1). The IG column on the far right of Table 11.10 is for Invest- ment Grade, Aaa through Baa3 (or in S&P symbols: AAA through BB1). The SG acronym stands for Speculative Grade and is everything below Investment Grade. This breakdown is important because some investors, for example bank trust departments, can only invest in IG bonds, or have a strict limit on how much they will invest in SG bonds. The numbers shown are medians rather than means or averages. Because the median is not sensitive to extreme values, it often provides a better measure of central tendency than the mean. Table 11.11 lists Moody’s definition of these financial metrics.

Table 11.10: 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% –2.1% 6.3% 1.9% Profit 11.8% 9.0% 6.7% 5.0% 2.0% –2.6% 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 ratings and financial database as of July 1, 2006

For all of the listed metrics (except Leverage) larger numbers are better than smaller numbers. That is, a company with higher Interest Coverage, higher Cash Flow-to-Debt, Profit, and so on is superior to similar companies with lower ratios. This is apparent in Table 11.10, with the highest numbers for listed ratios (except Leverage) associated with the highest rated bonds (Aaa-Aa), declining steadily to the Caa-C rated bonds (with the exception of Revenue stability for the lowest rated bonds).

The definitions that Moody’s uses to compute its ratios (shown in Table 11.11) are very similar to those introduced earlier in this chapter. You will notice a few slight variations, but overall the ratios attempt to measure the same characteristics.

Table 11.11: Moody’s ratios defined

Ratio Definition Interest coverage (EBIT – Interest capitalized 1 (1/3) * Rental expense)/(Interest expense 1

(1/3) * Rental expense 1 Preferred dividends/0.65) Asset coverage (Total assets – Goodwill – Intangibles) / Total debt Leverage (Total debt 1 8 * Rental expense)/(Total debt 1 8 * Rental expense 1

Deferred taxes 1 Minority interest 1 Total equity) Cash flow/Debt Net after-tax income before X-items 1 Depreciations – Dividends)/(Total debt

1 8 * 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

Source: Mertz & Cantor (2006).

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CHAPTER 11Section 11.3 Financial Statement Analysis

Now that you have a better understanding of bond ratings and financial ratios, we can apply the Moody’s ratio analysis to an actual company, by estimating the bond rating for Sears (Ticker: SHLD) in the Applying Finance feature. We will be using data from 2010 and 2011.

Applying Finance: Moody’s Ratio Analysis

Tables 11.12 and 11.13 show four years of income statements and balance sheets for Sears. Other information you will need to construct the ratios for Sears bond rating estimation are: Revenue (2008) $49,867.

Table 11.12: Sears Holdings Corporation income statements, 2008–2011

In millions of USD (except for per share items)

52 weeks ending January 28, 2012

52 weeks ending January 29, 2011

52 weeks ending January 30, 2010

52 weeks ending January 31, 2009

Revenue 41,567.00 42,664.00 43,360.00 46,770.00

Total revenue 41,567.00 42,664.00 43,360.00 46,770.00

Cost of revenue, total 30,966.00 31,000.00 31,374.00 34,118.00

Gross Profit 10,601.00 11,664.00 11,986.00 12,652.00

Selling, general & administrative expenses, total 10,664.00 10,425.00 10,499.00 11,060.00

Depreciation/amortization 853.00 869.00 894.00 981.00

Unusual expense (income) 585.00 –67.00 –74.00 309.00

Total operating expense 43,068.00 42,227.00 42,693.00 46,468.00

Operating income –1,501.00 437.00 667.00 302.00

Other, net –2.00 –14.00 –61.00 108.00

Income before tax –1,751.00 162.00 391.00 184.00

Income after tax –3,120.00 135.00 280.00 99.00

Minority interest 7.00 –17.00 –62.00 –46.00

Net income before extra items –3,113.00 118.00 218.00 53.00

Net income –3,140.00 129.00 235.00 53.00

Income Available to Common Excl. Extra Items –3,113.00 118.00 218.00 53.00

Income Available to Common Incl. Extra Items –3,140.00 129.00 235.00 53.00

Diluted Weighted Average Shares 106.8 111.7 117.9 127.00

Diluted EPS Excluding Extraordinary Items –29.15 1.06 1.85 0.42

Dividends per Share—Common Stock Primary Issue 0.00 0.00 0.00 0.00

Diluted Normalized EPS –19.88 0.74 2.55 3.69

Source: Sears Holding Corporation (2011). (continued)

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CHAPTER 11Section 11.3 Financial Statement Analysis

Applying Finance: Moody’s Ratio Analysis (continued)

Table 11.13: Sears Holding Corporation’s balance sheets, 2008–2011

In millions of USD (except for per share items)

As of January 28, 2012

As of January 29, 2011

As of January 30, 2010

As of January 31, 2009

Cash & equivalents 747.00 1,359.00 1,689.00 1,173.00

Cash and short-term investments 747.00 1,359.00 1,689.00 1,173.00

Accounts receivable—trade, net 695.00 689.00 652.00 839.00

Total receivables, net 695.00 689.00 652.00 839.00

Total inventory 8,407.00 8,951.00 8,705.00 8,795.00

Prepaid expenses 388.00 334.00 351.00 458.00

Other current assets, total 7.00 227.00 41.00 151.00

Total current assets 10,244.00 11,560.00 11,438.00 11,416.00

Property, plant & equipment, total—gross 11,210.00 11,329.00 11,392.00 10,959.00

Accumulated depreciation, total –4,633.00 –4,227.00 –3,683.00 –2,868.00

Goodwill, net 841.00 1,392.00 1,392.00 1,392.00

Intangibles, net 2,937.00 2,993.00 3,208.00 3,283.00

Other long-term assets, total 782.00 1,313.00 1,061.00 1,160.00

Total assets 21,381.00 24,360.00 24,808.00 25,342.00

Accounts payable 2,912.00 3,046.00 3,335.00 3,006.00

Accrued expenses 523.00 546.00 — 2,272.00

Notes payable/short-term debt 1,175.00 360.00 325.00 442.00

Current port. of long term debt/ capital leases 230.00 489.00 482.00 345.00

Other current liabilities, total 4,372.00 4,202.00 4,644.00 2,447.00

(continued)

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CHAPTER 11Section 11.3 Financial Statement Analysis

Applying Finance: Moody’s Ratio Analysis (continued)

Table 11.13: Sears Holding Corporation’s balance sheets, 2008–2011 (continued)

In millions of USD (except for per share items)

As of January 28, 2012

As of January 29, 2011

As of January 30, 2010

As of January 31, 2009

Total current liabilities 9,212.00 8,643.00 8,786.00 8,512.00

Long-term debt 2,088.00 2,344.00 1,698.00 2,132.00

Total long-term debt 2,088.00 2,344.00 1,698.00 2,132.00

Total debt 3,493.00 3,193.00 2,505.00 2,919.00

Deferred income tax 816.00 0.00 — —

Minority interest 60.00 103.00 339.00 319.00

Other liabilities, total 4,924.00 4,759.00 4,889.00 4,999.00

Total liabilities 17,100.00 15,849.00 15,712.00 15,962.00

Common stock, total 1.00 1.00 1.00 1.00

Additional paid-in capital 10,005.00 10,185.00 10,465.00 10,441.00

Retained earnings (accumulated deficit) 1,865.00 4,930.00 4,797.00 4,562.00

Treasury stock—common –5,981.00 –5,826.00 –5,446.00 –5,012.00

Other equity, total –1,604.00 –780.00 -–730.00 –615.00

Total equity 4,281.00 8,511.00 9,096.00 9,380.00

Total liabilities & shareholders' equity 21,381.00 24,360.00 24,808.00 25,342.00

Total common shares outstanding 106.3 108.9 114.8 122.00

Source: Sears Holding Corporation (2011).

Additional relevant information is shown in Figure 11.7. The figure combines Sears’s interest expenses, rental expenses, and deferred taxes for 2009–2011. Interest expense is not broken out in the income statements. As shown, the company did not report any capitalized interest and did not pay any divi- dends, either preferred or common. (continued)

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CHAPTER 11Section 11.3 Financial Statement Analysis

Applying Finance: Moody’s Ratio Analysis (continued)

Figure 11.7: Sears Holding Corporation’s interest expense, rental expense, and deferred taxes, 2009–2011

$248

$289

2011

INTEREST

Interest expense for years 2011, 2010, and 2009 was as follows:

millions

COMPONENTS OF INTEREST EXPENSE

Interest expense

Accretion of lease obligations at net present value

Amortization of debt issuance costs

Interest expense

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2009

$203

$248

$242

$293

2010

NOTE 14—LEASES

We lease certain stores, office facilities, warehouses, computers and transportation equipment.

Operating and capital lease obligations are based upon contractual minimum rents and, for certain stores, amounts

in excess of these minimum rents are payable based upon specified percentages of sales. Contingent rent is accrued

over the lease term, provided that the achievement of the specified sales level that triggers the contingent rental is

probable. Certain leases include renewal or purchase options.

Rental expense for operating leases was as follows:

millions

Minimum rentals

Percentage rentals

Less—Sublease rentals

Total

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2011

$837

(30)

$826

2009

$865

(51)

$836

$844

(52)

$813

2010

NOTE 10—INCOME TAXES

millions

Income (loss) before income taxes

U.S.

Foreign

Total

Income tax expense (benefit)

Current:

Federal

State and local

Foreign

Total

Deferred:

Federal

State and local

Foreign

Total

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2011

(1,809)

(1,751)

1,357

(35)

1,348

1,369

2009

(67)

458

391

(191)

141

(36)

127

(2)

147

111

(157)

323

166

(7)

110

104

(84)

—

(77)

2010

Source: Sears Holding Corporation (2011). (continued)

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CHAPTER 11Section 11.3 Financial Statement Analysis

Applying Finance: Moody’s Ratio Analysis (continued)

Table 11.14 shows Sears’s bond rating financial ratios found using the definitions in Table 11.11. The pink shaded cells indicate deterioration in a ratio. The Moody’s letter rating is an estimate based on the medians shown in Table 11.10. The Revenue Stability metric is based on four years of data instead of the five Moody’s uses, because that is what was readily available.

Table 11.14: Sears Holding Corporation’s bond rating financial ratios, 2009–2011

2011 2010 2009

*Interest coverage: –2.118 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: –22.64% 10.29% 12.28%

Moody’s Rating C B B

• Return on assets: –3.41% 0.14% 0.28%

Moody’s Rating C Caa B

• Profit: –7.55% 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

Moody’s Rating Aaa

Based on the information from Table 11.14, estimating the bond rating for Sears’s debt from 2009 to 2011 becomes a matter of judgment. One approach is to use the same method used for computing grade point averages: give each rating a numerical value, then find the average of those values. There are nine ratings, so we assign Aaa a score of 9, Aa a score of 8, and so on, until C receives a score of 1. We show the results in Table 11.15. (continued)

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CHAPTER 11Section 11.4 Stock Prices and Ratio Analysis

Applying Finance: Moody’s Ratio Analysis (continued)

Table 11.15: 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

Moody’s Rating Caa-Ca Ba-B Ba

These results show that Sears’s rating has deteriorated from 2009 to 2011, dropping from almost investment grade (Ba) down to speculative grade. In fact, on January 4, 2012, The Wall Street Journal reported that Moody’s had downgraded Sears’s rating (Stynes, 2012).

The scenarios presented in this section illustrate how business’s actions may manifest themselves in financial statements and ratios. As 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.

11.4 Stock Prices and Ratio Analysis

An analyst could easily get lost in examining ratios and lose track of financial man-agement’s primary 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 all stocks have constantly growing dividends, this formula is useful because it illustrates the interplay between dividends, risk, and growth that affects share price regardless of the stock being analyzed. Recall that the constant growth formula is

P0 5 D1

1r 2 gn2

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CHAPTER 11Section 11.4 Stock Prices and Ratio Analysis

Now, let’s examine the terms in the formula, starting with the numerator.

First, D1, 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)(Payout) 5 (Sales)(Net profit margin)(Payout)

Because the dividend’s value appears in the numerator of the stock valuation formula, we can determine that, all else being 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. On the other hand, if 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 – gn) of the constant growth formula. Notice that if the growth rate, gn, increases, the value of the denominator in the formula decreases, which 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 per- spective, 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 sustainable growth formula:

Growth 5 (ROE)(Retention rate)

Now, it is clear that ROE is a key driver of growth. What, then, affects ROE? Here, a system of very important relationships between ratios called the DuPont system (see Figure 11.8) becomes useful for analyzing ROE. Note that ROE is shown to be a function of return on assets (ROA) multiplied by the leverage ratio (LEV). ROA is then shown to equal net profit margin (NPM) times asset turnover.

Figure 11.8: The DuPont System

REO

NPM ×

Asset turnover ×

LEV

ROA × LEV= =

The DuPont System can be used to calculate return on equity.

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CHAPTER 11Section 11.5 Evaluating Management’s Performance

The DuPont system can be particularly useful for analyzing price performance. Suppose, for example, you are analyzing a company’s stock that has lagged behind its competitors’ shares performance. You want to know why. One approach is to analyze your firm’s sales growth compared to the competitors’ (remember sales is a factor in the top of the valua- tion formula). If lagging sales is the problem, then you may want to analyze the reputa- tion of the firm’s products, the products’ pricing, or the effectiveness of the company’s marketing strategy. If sales performance is not the root of the problem, perform a DuPont analysis. Is ROE falling? 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.

11.5 Evaluating Management’s Performance

The central issue in determining how well a firm is doing is how much wealth has been created by the company’s projects. By investing on behalf of claimants, the firm strives to add value to the securities purchased by these suppliers of capital. As we have seen, the strategy for accomplishing this objective is to identify and pursue posi- tive net present value projects.

Economic value added (EVA), developed by Joel Stern and Bennett Stewart, is a method for evaluating how effective management is at adding value to the corporation. EVA can be thought of as a kind of historical NPV analysis. Whereas traditional NPV is done when evaluating a potential future project, EVA looks at past results to see whether the projects the company has pursued are actually producing wealth in excess of their cost. EVA sub- tracts the dollar amount of the firm’s cost of capital from its after-tax operating profits to arrive at the value added to the corporation. For example, suppose a firm’s cost of capital is 12% and the company employs $50,000,000 in assets. The dollar amount of the firm’s cost of capital is $6,000,000 annually (0.12 3 $50 million). If the company is able to pro- duce after-tax operating profits of $9 million, its EVA is $3 million.

Note that after-tax operating profit is essentially after-tax cash flow before depreciation expense and any distributions to debt or equity holders. The cost of capital includes in its calculation the cost of debt and the cost of equity. Therefore, when the cost of capital is subtracted from operating cash flow, the remaining cash (the EVA) is the cash flow that belongs to equity holders after their return requirements have been satisfied. Thus, EVA measures the additional wealth added to equity claims for the year; or the extra profit earned by the company beyond that necessary to finance the firm’s operations. A corpora- tion with positive EVA is doing a good job of investing on behalf of its stockholders, while a corporation with negative EVA is actually destroying wealth by investing in projects whose value is less than their cost.

One problem with EVA is that it measures only a single year’s operating results. These could be affected, for example, by a large financial commitment to research and develop- ment that would produce no operating income for several years. Such a project would initially lower EVA because the dollar cost of capital would reflect the new project and the operating cash flow realizes no project income during the product development period.

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CHAPTER 11Conclusion

Yet, such a project could have a positive net present value when the future cash flows are considered.

To correct for this shortcoming, some firms and analysts use a measure called market value added (MVA). MVA is found by taking the market value of the firm’s claims (the market price of the firm’s securities, both equity and debt, times the out- standing shares and bonds) and subtracting the book value of the liabilities and equity. If MVA is positive, the firm has taken the historical contributions of the claimants (reflected in book val- ues) and increased their worth (reflected in their higher market values). Because market values incorporate investors’ expectations about the firm’s future cash flows, MVA reflects the future benefits that a project is expected to produce. Thus, MVA answers one of the chief criticisms of EVA. Both MVA and EVA have been adopted by many large corporations, including Coca-Cola and Toys “R” Us, and show promise as tools for evaluating a firm’s—and management’s—performance.

New financial analysis metrics are being developed every year. For example, shareholder value added (SVA) is closely related to EVA and MVA. Other metrics may measure perfor- mance in new and much different ways. For example, the “Balanced Scorecard” attempts to measure performance for a wider perspective than the traditional financial metrics.

Conclusion

Financial analysis is one of the most important tools available to individuals with 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, which is crucial to the firm’s future success.

Throughout this text, we have considered how firms decide which projects to pursue in their aim to increase shareholder wealth. We have also examined the factors that firms should consider when selecting financing alternatives and dividend payment policy, as well as the concepts that aid in the development of such policy decisions. Additionally, we have covered the tools used in mathematics of discounting, and theories such as the CAPM. Using the financial balance sheet, these decisions have been placed in the context

Toys “R” Us is just one example of a corporation that has incorporated MBA and EVA into its financial strategy. What are the benefits of these techniques? What are the drawbacks?

age fotostock/SuperStock

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CHAPTER 11Post-Test

of the firm’s role as an investment vehicle in the hope of providing a vision of how these decisions fit into the process of wealth building.

Students sometimes compartmentalize their education; meaning, they use the material from finance class only in finance class, the material from marketing only in marketing, and so on. In this text, we have tried to show you how the concepts and tools typically associated with finance actually apply to many business areas. Just as the finance function relies on marketing, accounting, and other management areas, so too does finance con- tribute to those other fields. Good business decisions often require looking at a problem a little differently or applying a slightly different set of tools to the problem. We hope that this textbook has given you some ideas on how financial concepts and tools might be applied to a range of problems, both within and without the corporation.

Post-Test

1. Financial analysis may vary in its focus, depending on what stakeholder group is conducting the review of the firm’s performance.

a. True b. False

2. In a period of increasing costs, net income for a period is generally higher if the firm adopts LIFO inventory when accounting for cost of goods sold.

a. True b. False

3. Just-in-time inventory will tend to decrease inventory turnover. a. True b. False

4. The DuPont system can be used in performance analysis. a. True b. False

5. Similar to NPV, EVA examines potential future performance. a. True b. False

6. Which of the following was NOT discussed as a stakeholder who might be con- cerned with a company’s performance?

a. A fixed claimant b. The community c. The landlord d. An employee

7. Which of the following is NOT a weakness of accounting statements? a. They have limited comparability. b. They are subject to third-party auditing. c. They are historical in nature. d. They allow for window dressing.

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CHAPTER 11Key Ideas

8. Which firm has done the better job of investing shareholders’ money in the past? a. A firm with ROE 5 0.20, Price-to-book 5 2.00, Net profit margin 5 0 .18, Book

value per share 5 $50.00 b. A firm with ROE 5 0.25, Price-to-book 5 2.00, Net profit margin 5 0.18, Book

value per share 5 $40.00 c. A firm with ROE5 0.20, Price-to-book 5 1.90, Net profit margin 5 0.28, Book

value per share 5 $52.00 d. A firm with ROE5 0.20, Price-to-book 5 3.00, Net profit margin 5 0.18, Book

value per share 5 $30.00

9. A firm with net income of $1,250,000, total assets of $10 million, book value of equity of $7 million, and whose total dividend payments equal $400,000, has what sustainable growth rate?

a. 17.86% b. 12.14% c. 8.5% d. 5.7%

10. How does MVA differ from EVA? a. It has been adopted by large firms. b. It subtracts the book value of the firm’s liabilities and equities from the market

value of its claims. c. It measures a single year’s operating results. d. It subtracts the firm’s cost of capital from its after-tax operating profits.

Answers 1. a. True. The answer can be found in Section 11.1. 2. b. False. The answer can be found in Section 11.2. 3. b. False. The answer can be found in Section 11.3. 4. a. True. The answer can be found in Section 11.4. 5. b. False. The answer can be found in Section 11.5. 6. c. The landlord. The answer can be found in Section 11.1. 7. b. They are subject to third-party auditing. The answer can be found in Section 11.2. 8. d. A firm with ROE 5 0.20, Price-to-book 5 3.00, Net profit margin 5 0.18, Book value per share 5

$30.00. The answer can be found in Section 11.3. 9. b. 12.14%. The answer can be found in Section 11.4. 10. b. It subtracts the book value of the firm’s liabilities and equities from the market value of its claims.

The answer can be found in Section 11.5.

Key Ideas

• In addition to the auditor’s opinion, analysts should take a careful look at the footnotes to a firm’s financial statements. These footnotes may reveal important information like pending lawsuits that may not be reported elsewhere.

• The ultimate success or failure of a business is determined in product and in cap- ital markets. Therefore, it is imperative that the evaluation of firm performance include the analysis of market data.

• The corporation exists to benefit its owners, the shareholders. Stock returns directly measure the benefits of ownership of a for-profit corporation, while mar- ket share measures what proportion of sales a firm is capturing in the market for its products.

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CHAPTER 11Critical Thinking Questions

• The research of professional analysts can be a good source of information about a corporation or an industry. One should keep in mind, however, that these opin- ions are very subjective so care should be taken if you try to second-guess securi- ties markets based on an analyst’s recommendation.

• Raw data describing a company’s performance is not very useful without bench- marks with which it can be compared. Typically, comparisons are made with the firm’s historical performance as well as to similar firms.

• Useful evaluation of corporate performance uncovers the causes of the firm’s successes and shortcomings. This level of analysis requires looking beyond accounting statements so that qualitative information as well as quantitative information is considered.

• Trend statements compare current levels of performance with historical norms. • Common size statements compare the current composition of accounts with his-

torical benchmarks for account composition. • Financial ratios are very useful in that they can help isolate the performance of

the firm in a specific area like inventory management, and they are easily com- pared to the firm’s historical norms and to the industry.

• EVA and MVA are closely linked to classical economic principles and are gaining in popularity—two good reasons to be aware of these performance measures.

• The DuPont system deconstructs ROE in an insightful way, helping to trace the cause of return on equity’s performance.

Critical Thinking 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 circumstances do you think the current ratio and quick ratio would give opposite signals of the liquidity of a firm?

3. Industry averages are often used as benchmarks in ratio analysis. Justify this practice.

4. How do you think the average leverage ratio in the banking industry would compare to the average leverage ratio among computer manufacturers?

5. Suppose your father owns a stock that he feels has done very well. “In fact,” he says, “it went up 18% last year!” Do you think that 18% was good performance? How would you go about deciding whether 18% was good, bad, or mediocre for the past 12 months?

6. 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 six months. e. borrowed short term and used the funds to increase inventory?

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CHAPTER 11Key Formulas

Key Formulas

Debt ratio

Long-term debt

Total long-term capital

Leverage ratio (LEV)

Total assets Total equity

10-K reports Annual reports required by the U.S. Securities and Exchange Commis- sion, that give a comprehensive summary of a public company’s performance.

abnormal return (AR) or market-adjusted return The firm-specific part of the peri- od’s return, which has been isolated from the part of the return attributed to the general market trend.

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.

economic value added (EVA) A method, developed by Joel Stern and Bennett Stew- art, for evaluating how effective manage- ment is at adding value to the corporation.

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.

market value added (MVA) The market value of the firm’s claims (the market price of the firm’s securities, both equity and debt, times the outstanding shares and bonds) net of the book value of the liabili- ties and equity.

Securities and Exchange Commission (SEC) Federal agency that holds primary responsibility for enforcing the federal securities laws and regulating the secu- rities industry, the nation’s stock and options exchanges, and other electronic securities markets in the United States.

stakeholders Groups, such as stockhold- ers, financial claimants, employees, or community member, that have a stake or interest in some aspect of corporate performance.

trend statements Reports that give insights to a market sector’s future pros- pects of growth or decline.

window dressing The practice, by man- agement, of manipulating accounts so they appear more favorable on financial statements.

Key Terms

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CHAPTER 11Key Formulas

Times interest earned ratio

EBIT

Interest 1dollars2

Current ratio

Current assets

Current liabilities

Quick ratio (acid test)

Current assets 2 inventory

Current liabilities

Net profit margin

Net income

Revenue

Return on assets (ROA)

Net income Total assets

Return on equity

Net income Total equity

Gross profit margin

Revenue 2 COGS

Revenue

Earning power

EBIT

Total assets

Inventory turnover

Cost of goods sold

Inventory

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CHAPTER 11Key Formulas

Days sales outstanding

Receivables

Annual revenue / 360

Asset turnover

Revenues

Total assets

Earnings per share (EPS)

Net income

Number of shares

Book value per share (BVPS)

Total equity

Number of shares

Dividend per share (DPS)

Total dividends

Number of shares

Price-earnings ratio (P/E)

Price per share

EPS

Price-to-book (P/B)

Price per share

Book value share

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CHAPTER 11Web Resources

Web Resources

For free business statistics and financial rations, visit: http://www.bizstats.com

Moody’s paper titled “The Distribution of Common Financial Ratios by Rating and Industry for North American Non-Financial Corporations: July 2006” summarizes the financial ratios associated with different bond ratings for about 20 U.S. industrial sectors. It also aggregates data for all the industries, providing a guide for how financial ratios determine bond ratings for all companies: http://www.moodys.com/sites/products/DefaultResearch/2005700000436062.pdf

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

Visit the ValueLine website for a sample of a ratings and reports investment survey: http://www.valueline.com/Tools/Sample_Reports.aspx

The Risk Management Association website can be accessed at: http://www.rmahq.org

Britain’s Financial Times can be accessed at: http://www.ft.com/world/uk

Dr. James Graven’s Financial Web site can be accessed at: http://www.finweb.com/

The SEC’s EDGAR site can be accessed at: http://www.sec.gov/edgarhp.htm

For more information on Cascadia Region Earthquake Workgroup’s study, “Just- In- Time Inventory: Effects on Earthquake Recovery,” visit: http://www.crew.org/sites/default/files/JITfinal032405.pdf

byr80601_11_c11_311-348.indd 348 1/24/13 4:11 PM

http://www.bizstats.com

http://www.moodys.com/sites/products/DefaultResearch/2005700000436062.pdf

http://www.searsholdings.com/invest/financial_info.htm

http://www.valueline.com/Tools/Sample_Reports.aspx

http://www.rmahq.org

http://www.ft.com/world/uk

http://www.finweb.com

http://www.sec.gov/edgarhp.htm

http://www.crew.org/sites/default/files/JITfinal032405.pdf