Week 5 Assignment (2)

Let me open up my discussion with a question – are you healthy? Regardless of your answer (although I hope it is affirmative), you can state with a relative degree of confidence how healthy you are. You know this by data you have received from your physician. And how does he or she know the state of your health? Your doctor utilizes his or her years of education and experience, and then combines this with the collection and analysis of data. We as financial managers must act in the same way for our organizations. We are educated, and with this Managerial Finance class, you will have some of the requisite training and the knowledge to know how to collect and analyze data necessary for the health of your organization (or even your portfolio).

During the first week of this class, we discussed the income statement and balance sheet. And as we can recall from Chapter 2, income statements and balance sheets report raw financial data. But how can we compare statements from year to year, or firm to firm? We do this through commonization of statements. Commonization takes the supplied financial data, and transforms those values to percentages. Commonization for both the income statement and balance sheet quickly allows us to assess the health and behavior of the organization.

Another way to assess health of the organization is to calculate financial ratios (Links to an external site.)Links to an external site.. Last week, we extensively looked at the ratio of debt to equity – or the debt-to-equity ratio (Links to an external site.)Links to an external site.. Using this ratio, we could readily assess the Leverage (Links to an external site.)Links to an external site. of the firm. For much of Chapter 3, we will be looking at the most common ratios used by financial managers. I came up with the following to summarize why I use financial ratios:

· I can spot areas of weakness or strengths in my financial activities

· I can more effectively allocate funds and resources.

· I see how my firm produces profits

· I can assess how effectively I use the cash I generate

· I can control future direction of the firms operations and help maximize wealth for my shareholders.

The first set of ratios we will consider are the liquidity ratios (Links to an external site.)Links to an external site.. Liquidity ratios are a firms ability to satisfy its short term obligations as they come due. How easy is it to pay the bills? They can provide early signs of cash flow problems and impending business failure. These ratios typically include the Current ratio, quick (acid test) ratio and the cash ratio.

Our next set of ratios include the Debt ratios (Links to an external site.)Links to an external site. (the book refers to them as the Long-Term Solvency Measures). The debt ratios measure the proportion of total assets financed by the firms creditors. These ratios include the Total Debt ratio, Times Interest earned, and cash coverage. We learned last week how important it is to pay our debt holders on time.

We now consider the Activity Ratios (Links to an external site.)Links to an external site. (the book calls them asset management or turnover measures). These ratios measure the speed in which various accounts are converted into sales or cash – inflows or outflows. Our goal here is to get cash payments to us as quickly as possible, and slow down disbursements to where we will not be penalized for late payments (I want my money working for me for as many days as I can). These ratios include our inventory turnover ratios and receivables turnover.

How profitable are we? Are my assets working hard for me? In this next set of ratios, we are going to look at how hard our assets are working – our Profitability (Links to an external site.)Links to an external site.. The most critical ratios as a financial manager are these. As you well know, we are utilizing our investments to provide a return for our shareholders. Although the book does a good job in explaining the ratios, I would like to discuss some of the more critical ones not covered by the text. The first one, Gross Profit Margin, measures the percentage of each sales dollar remaining after the firm has paid off it is goods. It shows how effectively a firms management uses material and labor in the production process. Next, the Operating Profit Margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. In other words, the pure profits earned on each sales dollar. It shows how successful a firms management has been in generating income from the operation of the business. Finally, Net Profit Margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest and taxes, and preferred stock dividends, have been deducted.

The Market ratios (Links to an external site.)Links to an external site. relate a firms market value, as measured by its current share price, to certain accounting values. How do my earning compare to the market as a whole? Included in these ratios are Price-Earnings (P/E) ratio and Market-To-Book (M/B) ratios.

To bring all of the above into perspective, we have the DuPont System of Analysis (Links to an external site.)Links to an external site. which is a system used to dissect the firms financial statements and to assess financial condition. The DuPont system uses the DuPont Formula (Links to an external site.)Links to an external site. which multiplies the firms net profit margin by it is total asset turnover to calculate the firms return on total assets. It is here where we get down to some basic numbers so we can quickly compare to other companies or industries.

The text does a great job of explaining the use of all these ratios and subsequent analysis. I would like to conclude the discussion on ratio analysis by sharing my list of cautions regarding ratio analysis.

Cautions about Using Ratio Analysis:

· Only use the ratio that applies to the situation – e.g. liquidity ratios should not be used for profitability.

· A single ratio does not generally provide sufficient information from which to judge overall performance of the organization. Use a group of ratios.

· Ratios being compared should be used at consistent points in time. Seasonality may play a role in conclusions.

· None of these measures has a correct value.

· Look out for window dressing (what if I took out a large loan before I prepared my financial statement).

· Results can be distorted by inflation.

· Also be aware of accounting practices (e.g. depreciation {accelerated vs. straight-line} valuation of inventories (FICO vs. LIFO)

So that does it for Principles of Finance. We have covered a lot in the past 5 weeks, and I sincerely hope that not only will you use the information that we have learned in your professional lives, but also in your personal lives as well. I am sure you will find that there are many applications of Managerial Finance that apply well to personal finance. I have found many, and in working with you guys over the past several weeks, have learned more. I hope the class sparks further interest in this subject, and you will continue to learn about this fascinating subject (at least to me). 

I would like to discuss your final assignment for this class, your Evaluation of Corporate Performance Document. OK, here are the specifications:

Name of Assignment: Evaluation of Corporate Performance

Assignment Instructions: The Final Project will involve applying the concepts learned in class to an analysis of a company using data from its annual report. Using the concepts from this course, you will analyze the strengths and weaknesses of the company and write a report either recommending or not recommending purchase of the company stock.

The completed report should include:

· An introduction to the company, including background information.

· A complete and thorough financial statement review.

· Pro Forma financial statements (Balance Sheet and Income Statement) for the next fiscal year, assuming a 10% growth rate in sales and Cost of Goods Sold (COGS) for the next year.

· Complete ratio analysis for the last fiscal year using at least two ratios from each of the following categories:

· Liquidity

· Financial leverage

· Asset management

· Profitability

· Market value

· Calculate Return on Equity (ROE) using the DuPont system.

· Calculate Economic Value Added.

· A synopsis of your findings, including your recommendations and rationale for whether or not to purchase stock from this company.

This report should be 8 – 10 pages long excluding title page and reference page(s) using APA 6th edition formatting guidelines. Support your findings and recommendations with evidence from at least five scholarly resources; such as the textbook, industry reports, and articles from the Ashford library.

OK, so key advice based on having read several hundred of these over the years:

The financial statement review should be based on what you have read in the text What we are looking for here are trends in the financial statements. It is nice to note that sales are up or down, but what is important is WHY. Tell me what has caused sales to go up or down. Tel me why COGS is up or down. Try to identify trends and tell me why these things are happening.

I am looking for Pro Forma financial statements based on the current financial statements. Some student just do not provide them. You will lose points if you ignore this part of the assignment.

The biggest problem I have with these papers is the Ratio Analysis section. First, some students only provide 2 ratios. The instructions clearly state two ratios in each category. You should have at least 10 ratios. Second, calculate the ratios – do not just give me the numbers. Third, tell me if the ratios are good or bad.

Calculate the DuPont ROE and the EVA. You will lose substantial points if you do not provide these calculations.

You need to conclude this paper with a clear recommendation based on the above. Summarize your finings using the data you collected and tell me why I should buy this stock or pass.