Wk2 DQ - Financial Management

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WORKING WITH FINANCIAL STATEMENTS

Chapter 3

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3.1

Standardize financial statements for comparison purposes

Compute, and more importantly, interpret some common ratios

Name the determinants of a firm’s profitability

Explain some of the problems and pitfalls in financial statement analysis

Key Concepts and Skills

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3.2

Digital Equipment’s CEO stated: “Make your numbers or I’m sure your successor will.”

Cash Flow and Financial Statements: A Closer Look

Standardized Financial Statements

Ratio Analysis

The DuPont Identity

Using Financial Statement Information

Chapter Outline

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	2018	2017		2018	2017
Cash	108	58	A/P	307	303
A/R	1,156	992	N/P	26	119
Inventory	501	361	Other CL	1,662	1,353
Other CA	403	264	Total CL	1,995	1,775
Total CA	2,168	1,675	LT Debt	843	1,091
Net FA	3,438	3,358	C/S	2,768	2,167
Total Assets	5,606	5,033	Total Liab. & Equity	5,606	5,033

Sample Balance Sheet

Numbers in millions of dollars

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3.4

Section 3.1

The following slides provide an additional example to help reinforce the concepts. For future calculations, it may be helpful to print copies of the sample balance sheet and income statement so that you do not need to keep referring back to these slides.

Sample Income Statement

Revenues	5,000
Cost of Goods Sold	(2,006)
Expenses	(1,740)
Depreciation	(116)
EBIT	1,138
Interest Expense	(7)
Taxable Income	1,131
Taxes	(238)
Net Income	893
EPS	4.68
Dividends per share	1.53

Numbers in millions of dollars, except EPS & DPS

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3.5

Section 3.1

The income statement is for 2018.

The net income figure and EPS are based on income from continuing operations. There are 190.9 million shares outstanding.

Sources

Cash inflow – occurs when we “sell” something

Decrease in asset account (Sample B/S)

Accounts receivable, inventory, and net fixed assets

Increase in liability or equity account

Accounts payable, other current liabilities, and common stock

Uses

Cash outflow – occurs when we “buy” something

Increase in asset account

Cash and other current assets

Decrease in liability or equity account

Notes payable and long-term debt

Sources and Uses of Cash

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3.6

Section 3.1 (A)

Click on Sample B/S to go to the Balance Sheet to illustrate the accounts that are sources and uses, On the B/S Click on the small green arrow to return to this slide.

Cash inflow – occurs when we sell assets, sell debt instruments (take on more debt), or sell stock shares

Cash outflow – occurs when we buy assets, buy back debt instruments (pay off some debt), or buy back stock shares

Statement that summarizes the sources and uses of cash

Changes divided into three major categories

Operating Activity – includes net income and changes in most current accounts

Investment Activity – includes changes in fixed assets

Financing Activity – includes changes in notes payable, long-term debt, and equity accounts, as well as dividends

Statement of Cash Flows

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Section 3.1 (B)

The new tax law will generally result in higher operating cash flow, as, all else equal, net income will be higher. This will result in a larger increase in equity as well.

3.7

Cash, beginning of year	58	Financing Activity
Operating Activity		Decrease in Notes Payable	-93
Net Income	893	Decrease in LT Debt	-248
Plus: Depreciation	116	Change in C/S (less RE)	0
Increase in A/P	4	Dividends Paid	-292
Increase in Other CL	309	Net Cash from Financing	-633
Less: Increase in other CA	-139
Increase in A/R	-164	Net Increase in Cash	50
Increase in Inventory	-140
Net Cash from Operations	879	Cash End of Year	108

Investment Activity
Purchase of Fixed Assets	-196
Net Cash from Investments	-196

Sample Statement of Cash Flows

Numbers in millions of dollars

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3.8

Section 3.1 (B)

Investment activity: change in net fixed assets + depreciation (have to add back depreciation because it was deducted from the fixed asset account to get the net fixed asset figure). If the number is positive, then we acquired fixed assets; if it’s negative, then we sold fixed assets.

3438 - 3358 + 116 = 196 so we bought 196 million worth of fixed assets

Remind students that part of the increase in the C/S account shown on the balance sheet is the increase in Retained Earnings. That is already incorporated in the net income under operating activity.

Dividends paid = 190.9*1.53 = 292 million

Additions to RE = 893 - 292 = 601

Change in C/S = 2768 - 2167 - 601 = 0

Common-Size Balance Sheets

Compute all accounts as a percent of total assets

Common-Size Income Statements

Compute all line items as a percent of sales

Standardized statements make it easier to compare financial information, particularly as the company grows.

They are also useful for comparing companies of different sizes, particularly within the same industry.

Standardized Financial Statements

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Section 3.2

The tax law change may result in a one-time (favorable) jump in ratios that are impacted by the reduced tax liability.

3.9

Ratios allow for better comparison through time or between companies.

As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important.

Ratios are used both internally and externally.

Ratio Analysis

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3.10

Section 3.3

Lecture Tip: Be sure that your students understand that “real-world” financial statements are not as straightforward as the simplified ones presented in the textbook. Actually reviewing some financial statements of companies with which they are familiar may help.

Short-term solvency, or liquidity, ratios

Long-term solvency, or financial leverage, ratios

Asset management, or turnover, ratios

Profitability ratios

Market value ratios

Categories of Financial Ratios

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3.11

Section 3.3

The ratios in the following slides will be computed using the 2018 information from the Sample Balance Sheet and Income Statement.

Lecture Tip: Remind students that the point of the analysis is not simply the ability to compute the ratios, but rather the ability to interpret them.

Current Ratio = CA / CL

2,168 / 1,995 = 1.09 times

Quick Ratio = (CA - Inventory) / CL

(2,168 - 501) / 1,995 = .84 times

Cash Ratio = Cash / CL

108 / 1,995 = .05 times

NWC to Total Assets = NWC / TA

(2,168 - 1,995) / 5,606 = .03

Interval Measure = CA / average daily operating costs

2,168 / ((2,006 + 1,740)/365) = 211.2 days

Computing Liquidity Ratios

B/S

I/S

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3.12

Section 3.3 (A)

The firm is just barely able to cover current liabilities with its current assets. A short-term creditor might find this a bit disconcerting and may reduce the likelihood that they would lend money to the company. The ratio should be compared to the industry – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books. Also, the CR for 2017 was .94, so the company has improved from the previous year.

The quick ratio is quite a bit lower than the current ratio, so inventory seems to be an important component of current assets.

This company carries a low cash balance, although the cash ratio has increased from the previous year (.03 in 2017). This may be an indication that they are aggressively investing in assets that will provide higher returns. We need to make sure that we have enough cash to meet our obligations, but too much cash reduces the return earned by the company.

The NWC to TA measure seems relatively low, but is consistent with the current ratio.

The Interval Measure indicates that the company can meet average daily expenses with current assets for about 211 days.

Lecture Tip: Remind students that a high current ratio may actually be a negative, as current assets generally produce a lower return than fixed assets. To build on this understanding, make students evaluate the interaction among ratios. For example, suggest a scenario in which the current ratio exhibits no change over a two- or three-year period, while the quick ratio experiences a steady decline. How could this occur?

Total Debt Ratio = (TA - TE) / TA

(5,606 - 2,768) / 5,606 = 50.62%

Debt/Equity = TD / TE

(5,606 - 2,768) / 2,768 = 1.03 times

Equity Multiplier = TA / TE = 1 + D/E

1 + 1.03 = 2.03

Long-term debt ratio = LTD / (LTD + TE)

843 / (843 + 2,768) = 23.35%

Computing Long-term Solvency Ratios

B/S

I/S

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3.13

Section 3.3 (B)

Note that these are often called leverage ratios and that this group of ratios measures two aspects of leverage: level of indebtedness and the ability to service this debt.

TE = total equity, and TA = total assets. The numerator in the total debt ratio could also be found by adding all of the current and long-term liabilities.

The firm finances about 50% of its assets with debt. This is down from about 57% from the previous year.

Another way to compute the D/E ratio if you already have the total debt ratio:

D/E = Total debt ratio / (1 - total debt ratio) = .5062 / (1 - .5062) = 1.03

The EM is one of the ratios that is used in the DuPont Identity as a measure of the firm’s financial leverage.

The Long-term debt ratio is down from 33.49% in 2011.

Times Interest Earned = EBIT / Interest

1,138 / 7 = 162.57 times

Cash Coverage = (EBIT + Depreciation) / Interest

(1,138 + 116) / 7 = 179.14 times

Computing Coverage Ratios

B/S

I/S

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3.14

Section 3.3 (B)

Even though the company is financed with over 52% debt, they have a substantial amount of operating income available to cover the required interest payments.

Remember that depreciation is a non-cash deduction. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation to get an estimate of cash flow before taxes.

Lecture Tip: The importance of coverage ratios is sometimes overlooked, particularly when one considers their importance to all types of creditors.

Inventory Turnover = Cost of Goods Sold / Inventory

2,006 / 501 = 4.00 times

Days’ Sales in Inventory = 365 / Inventory Turnover

365 / 4.00 = 91 days

Computing Inventory Ratios

B/S

I/S

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3.15

Section 3.3 (C)

Inventory turnover can be computed using either ending inventory or average inventory when you have both beginning and ending figures. It is important to be consistent with whatever benchmark you are using to analyze the company’s strengths or weaknesses.

It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be understated and you might believe that the company is not performing as well as it is. On the other hand, if the balance sheet is prepared when inventory has been drawn down due to seasonal sales, then the inventory turnover would be overstated and the company may appear to be doing better than it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you may want to look at quarterly averages to get a better indication of turnover.

Lecture Tip: You may wish to mention that there may be significant inconsistencies in the methods used to compute ratios by financial advisory firms. When using ratios supplied by others, it is important to be aware of the exact financial items used. A manufacturer would typically consider inventory at cost, and thus, relate inventory to cost of goods sold. However, a retailer might maintain its inventory level based on retail price. In the latter case, inventory should be related to sales to compute inventory turnover. The markup would cancel in the numerator and denominator and give an accurate indication of turnover based on cost. Furthermore, some analysts use average inventory over some period instead of ending inventory. The same is true for the other assets used in the various turnover ratios.

Receivables Turnover =

Sales / Accounts Receivable

5,000 / 1,156 = 4.33 times

Days’ Sales in Receivables =

365 / Receivables Turnover

365 / 4.33 = 84 days

Computing Receivables Ratios

B/S

I/S

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3.16

Section 3.3 (C)

Technically, the sales figure should be credit sales. This is often difficult to determine from the income statements provided in annual reports. If you use total sales instead of credit sales, you will overstate your turnover level. You need to recognize this bias when credit sales are unavailable, particularly if a large portion of the sales are cash sales.

As with inventory turnover, you can use either ending receivables or an average of beginning and ending.

You also run into the same seasonal issues as discussed with inventory.

Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If the company offers a discount (1/10 net 30), then you would like to see days’ sales in receivables less than 30. If the company does not offer a discount (net 30), then you would like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is substantially larger than the net terms, then you first need to look for biases, such as seasonality in sales. If this does not provide an explanation for the difference, then the company may need to take another look at its credit policy (who it grants credit to and its collection procedures).

Lecture Tip: Be sure to remind students that ratio analysis is a means to an end, not an end in itself. The results of the analysis provide us with red flags or items for additional investigation.

Lecture Tip: Students also need to realize that comparisons across industries can be problematic.

Total Asset Turnover =

Sales / Total Assets

5,000 / 5,606 = .89

It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

NWC Turnover = Sales / NWC

5,000 / (2,168 - 1,995) = 28.90 times

Fixed Asset Turnover = Sales / NFA

5,000 / 3,438 = 1.45 times

Computing Total Asset Turnover

B/S

I/S

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3.17

Section 3.3 (C)

Having a TAT of less than one is not a problem for most firms. Fixed assets are expensive and are meant to provide sales over a long period of time. This is why the matching principle indicates that they should be depreciated instead of immediately expensed.

This is one of the ratios that will be used in the DuPont identity.

Profit Margin = Net Income / Sales

893 / 5,000 = 17.86%

Return on Assets (ROA) = Net Income / Total Assets

893 / 5,606 = 15.93%

Return on Equity (ROE) = Net Income / Total Equity

893 / 2,768 = 32.26%

Computing Profitability Measures

B/S

I/S

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3.18

Section 3.3 (D)

You can also compute the gross profit margin and the operating profit margin.

GPM = (Sales - COGS) / Sales = (5,000 - 2,006) / 5,000 = 59.88%

OPM = EBIT / Sales = 1,138 / 5,000 = 22.76%

Profit margin is one of the components of the DuPont identity and is a measure of operating efficiency. It measures how well the firm controls the costs required to generate the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns almost $0.18 for each dollar in sales.

Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using.

ROE will always be higher (in absolute terms) than ROA as long as the firm has debt. The greater the leverage the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximization. The DuPont identity is used to identify factors that affect the ROE.

Market Price = $87.65 per share

Shares outstanding = 190.9 million

PE Ratio = Price per share / Earnings per share

87.65 / 4.68 = 18.73 times

Market-to-book ratio = Market value per share / Book value per share

87.65 / (2,768 / 190.9) = 6.04 times

Computing Market Value Measures – I

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3.19

Section 3.3 (D)

Lecture Tip: It is good for students to understand that average is not always best. Further, average levels may vary through time with the economy, and this is particularly relevant for market value measures. Further, comparisons across countries may be difficult due to differences in accounting and reporting standards.

A good discussion may be asking the question: “does a market-to-book ratio below one indicate a good investment?” It may be an indication of undervaluation; however, such a ratio may also indicate negative consensus regarding the future viability of the firm.

Enterprise value = market value of stock + book value of liabilities - cash

16,732 + 2,838 - 108 = $19,462

EBITDA ratio = Enterprise value / EBITDA

19,462 / (1,138 + 116) = 15.52 times

Computing Market Value Measures – II

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3.20

Section 3.3 (D)

We use the book value for liabilities because we typically can’t get market values, at least not for all of them. However, book value is usually a reasonable approximation for market value when it comes to liabilities, particularly short-term debts.

The EBITDA ratio is similar in spirit to the PE ratio, but it relates the value of all of the operating assets (the enterprise value) to a measure of the operating cash flow generated by those assets (EBITDA).

ROE = NI / TE

Multiply by 1 (TA/TA) and then rearrange

ROE = (NI / TE) (TA / TA)

ROE = (NI / TA) (TA / TE) = ROA × EM

Multiply by 1 (Sales/Sales) again and then rearrange

ROE = (NI / TA) (TA / TE) (Sales / Sales)

ROE = (NI / Sales) (Sales / TA) (TA / TE)

ROE = PM × TAT × EM

Deriving the DuPont Identity

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Section 3.4 (A)

3.21

ROE = PM × TAT × EM

Profit margin is a measure of the firm’s operating efficiency – how well it controls costs.

Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets.

Equity multiplier is a measure of the firm’s financial leverage.

Using the DuPont Identity

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3.22

Section 3.4 (A)

Improving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong, then we can look at fixed asset turnover and cash management.

We can also improve our ROE by increasing our leverage – up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilize our interest tax credit effectively, but we don’t want to overdo it. The choice of leverage is discussed in more detail in chapter 16.

Expanded DuPont Analysis – DuPont Data

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3.23

Section 3.4 (B)

Extended DuPont Chart

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3.24

Section 3.4 (B)

Internal uses

Performance evaluation – compensation and comparison between divisions

Planning for the future – guide in estimating future cash flows

External uses

Creditors

Suppliers

Customers

Stockholders

Why Evaluate Financial Statements?

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3.25

Section 3.5 (A)

Lecture Tip: Discuss with students that the ratios that are most important to a firm are those that best represent their business. So, whereas inventory turnover may be relevant for a retailer or manufacturer, it is less important for a service firm. The best ratios may be those that are uniquely developed for the business under review.

Ratios are not very helpful by themselves; they need to be compared to something.

Time-Trend Analysis

Used to see how the firm’s performance is changing through time

Internal and external uses

Peer Group Analysis

Compare to similar companies or within industries

SIC and NAICS codes

Benchmarking

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3.26

Section 3.5 (B)

SIC codes have been used many years to identify industries and allow for comparison with industry average ratios. The SIC codes are limited, however, and have not kept pace with a rapidly changing environment. Consequently, the North American Industry Classification System was introduced in 1997 to alleviate some of the problems with SIC codes.

Click on the link to go to the NAICS home page. It provides information on the change to the NAICS and conversion between SIC and NAICS codes.

There is no underlying theory, so there is no way to know which ratios are most relevant.

Benchmarking is difficult for diversified firms.

Globalization and international competition makes comparison more difficult because of differences in accounting regulations.

Varying accounting procedures, i.e. FIFO vs. LIFO

Different fiscal years

Extraordinary events

Potential Problems

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Section 3.5 (C)

3.27

The Internet makes ratio analysis much easier than it has been in the past.

Go to Reuters website.

Click on Markets, then Stocks, then choose a company and enter its ticker symbol.

Click on Financials to see what information is available.

Work the Web Example

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3.28

Section 3.5 (C)

Lecture Tip: An interesting discussion revolves around the benefits and disadvantages of the easy availability of information. The advantages are apparent, but the downside includes an ability for traders to take advantage of efficiency by quickly and widely disseminating false information.

What is the Statement of Cash Flows, and how do you determine sources and uses of cash?

How do you standardize balance sheets and income statements and why is standardization useful?

What are the major categories of ratios and how do you compute specific ratios within each category?

What are some of the problems associated with financial statement analysis?

Quick Quiz

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Section 3.6

3.29

Should financial analysts be held liable for their opinions regarding the financial health of firms?

How closely should ratings agencies work with the firms they are reviewing? I.e., what level of independence is appropriate?

Ethics Issues

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XYZ Corporation has the following financial information for the previous year:

Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M

Compute the ROE using the DuPont Analysis.

Comprehensive Problem

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3.31

Total assets = CA + FA = $2M + $6M = $8M

TAT = Sales / TA = $8M / $8M = 1

NWC = CA - CL; CL = CA - NWC = $2M - $1M = $1M

Total liabilities = CL + LTD = $1M + $3M = $4M

Total equity = total assets - total liabilities = $8M - $4M = $4M

EM = assets / equity = $8M / $4M = 2

ROE = PM × TAT × EM = 8% × 1 × 2 = 16%

Without using DuPont, ROE = NI / total equity = PM × sales / total equity = 8% × $8M / 4M = 16%

End of Chapter

Chapter 3

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