Financial Management 3301 Unit V Assignment

BBA 3301, Financial Management 1

Course Learning Outcomes for Unit V Upon completion of this unit, students should be able to:

5. Conduct preliminary financial statement and ratio analysis. 5.1 Analyze financial statements using a common-sized analysis. 5.2 Perform a financial analysis using ratio analysis.

Reading Assignment Chapter 4: Financial Analysis - Sizing Up Firm Performance, pp. 76-111

Unit Lesson Analysis of financial statements and ratio analysis are fundamental roles of financial managers. Financial statements reveal information about a company's performance and financial analysts compare them with other companies in the same industry. Financial analysts also perform ratio analysis to look at trends and compare with other companies. Take the case of Harvey Madden, who was tasked with the job of performing a financial analysis for his firm. Harvey Madden went to work for a large accounting firm, and his manager tasked him with analyzing financial statements for a new candy producer. Madden had a difficult time finding another company as small as ChocoThins. Madden found much larger producers of chocolates that made it difficult to compare against ChocoThins. For example, Harvey tried to compare another large producer’s (Hersey Company's) income statement alongside ChocoThins' financial statement. Madden questioned how he could draw a comparison of the two because of the size difference. Below is a side-by-side view of each company's income statement:

Hersey Co. ChocoThins

Net sales 7,421,768$ 3,421$

Cost of sales 4,085,602 2,185

Gross profit 3,336,166 1,236

Operating expenses 1,946,591 647

Income before interest and taxes 1,389,575 589

Interest expense 83,532 221

Income before taxes 1,306,043 368

Income taxes 459,131 134

Net income 846,912$ 234$

Comparative Income Statement

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Financial Analysis

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The balance sheet for both companies is as follows:

Madden prepared a common-sized statement to facilitate relative comparison of the two companies as follows:

Common-Sized Income Statement

Hersey Co. ChocoThins

Net sales $ 7,421,768 100.00% $ 3,421 100.00%

Cost of sales 4,085,602 55.05% 2,185 63.87%

Gross profit 3,336,166 44.95% 1,236 36.13%

Operating expenses 1,946,591 26.23% 647 18.91%

Income before interest and taxes 1,389,575 18.72% 589 17.22%

Interest expense 83,532 1.13% 221 6.46%

Income before taxes 1,306,043 17.60% 368 10.76%

Income taxes 459,131 6.19% 134 3.92%

Net income $ 846,912 11.41% $ 234 6.84%

By adding percentages for these financial statements, Madden can easily compare the performance of the two companies. For example, on the income statement, gross profit is 44.95% for Hersey Co. but only 36.13% for ChocoThins because Hersey has kept its costs of sales proportionately lower than ChocoThins.

Hersey Co. ChocoThins

Assets:

Current assets 2,247,047 689

Plant, property, and equipment, net 2,151,901 1,267

Goodwill 792,955 -

Other intangibles 294,841 63

Other assets 142,772 284

Total assets 5,629,516 2,303

Liabilities and Stockholders' Equity:

Current liabilities 1,935,647 63

Long-term debt 1,548,963 642

Other long-term liabilities 526,003 341

Deferred income taxes 99,373 11

Total liabilities 4,109,986 1,057

Stockholders' equity 1,519,130 1,246

Total liabilities and stockholders' equity 5,629,116 2,303

Comparative Balance Sheet

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Armed with comparable numbers, Madden could dig deeper by performing a ratio analysis. Ratio analysis involves five main categories, including: liquidity ratios, capital structure ratios, asset management efficiency ratios, profitability ratios, and market value ratios. Liquidity ratios address an organization's ability to pay its bills. Capital structure ratios look at how an organization finances it economic resources (assets). Asset management efficiency ratios explain how an organization uses its assets to generate sales. Profitability ratios measure returns an organization earns on its investments. Lastly, market value ratios provide a measure of value to investors and stockholders. Starting with liquidity ratios, Madden calculated current ratio for each company by dividing current assets by current liabilities. Hersey Co. ChocoThins

Another liquidity ratio is the quick ratio, which is the same calculation as the current ratio with inventory removed from current assets. Assuming inventory included in current assets is $957,987 for Hersey and $358 for ChocoThins, Madden could make the following calculation:

Removing inventory from the calculation helps because using only the most current assets is more realistic in determining the ability to pay current obligations. Madden could also calculate average collection period, which measures how long the organization takes to convert accounts receivable into cash. Madden can calculate average collection period by dividing accounts receivable by the annual credit sales divided by 365 days. Accounts receivable included in current assets for Hersey amounts to 243,075 and for ChocoThins amounts to 32. Assuming Hersey has credit sales of $7,421,768 and ChocoThins has credit sales of $3,421, Madden can calculate average collection period as follows:

Assets:

Current assets 2,247,047 39.92% 689 29.92%

Plant, property, and equipment, net 2,151,901 38.23% 1,267 55.02%

Goodwill 792,955 14.09% - 0.00%

Other intangibles 294,841 5.24% 63 2.74%

Other assets 142,772 2.54% 284 12.33%

Total assets 5,629,516 100.00% 2,303 100.00%

Liabilities and Stockholders' Equity:

Current liabilities 1,935,647 34.38% 63 2.74%

Long-term debt 1,548,963 27.52% 642 27.88%

Other long-term liabilities 526,003 9.34% 341 14.81%

Deferred income taxes 99,373 1.77% 11 0.48%

Total liabilities 4,109,986 73.01% 1,057 45.90%

Stockholders' equity 1,519,530 26.99% 1,246 54.10% Total liabilities and stockholders'

equity 5,629,516 100.00% 2,303 100.00%

Hersey Co. ChocoThins

Common-Sized Balance Sheet

Current assets 2,247,047 689

Current liabilities 1,935,647 63 1.16 10.94= =

Current assets - Inventory 2,247,047 - 957,857 689 - 358

Current liabilities 1,935,647 1,057 = 0.67 = 0.31

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Accounts receivable 243,075 =

11.95 days

32 =

3.37 days

Annual credit sales/365 7,421,768/36

5 3,461/3

65 This ratio told Madden how long it takes to collect accounts receivable, but he also wanted to know how often the company's accounts receivable turned over during the year. Madden calculated accounts receivable turnover as follows:

Based on the analysis, ChocoThins has a better turnover than Hersey because it turns over receivables just 30.53 times compared with 108.16 for Hersey. Next Madden calculated inventory turnover to see how often each company could turnover inventory. Madden calculated Inventory turnover as follows:

Madden calculated from inventory turns the number of days' sales sitting in inventory as follows:

Based on this analysis, Madden found it interesting that a big company like Hersey Co. took a longer time to sell inventory, but it keeps higher inventories than ChocoThins. Once Madden completed calculating efficiency ratios, he turned his attention to capital structure ratios. Madden calculated the debt ratio as follows for each company:

Madden determined Hersey Co. financed its operations more heavily with debt than did ChocoThins, which surprised him. Madden also calculated times interest earned as follows:

This calculation revealed that Hersey Co. did better than ChocoThins in covering its interest and having the ability to handle debt. Another category of ratios is asset management efficiency ratios. Madden turned his attention to these ratios after calculating capital structure ratios. Madden started with total asset turnover and calculated it as follows:

Besides total asset turnover another turnover ratio is fixed asset turnover. Madden calculated this ratio as follows:

Annual credit sales 7,421,768 3,461

Accounts receivable 243,075 32 30.53 = = 108.16

Cost of goods sold 4,085,602 2,185

Inventory 957,857 358 = =4.27 6.10

Number of days in year 365 365

Inventory turnover 4.27 6.1 = 85.48 days = 59.84 days

Total liabilities 4,109,986 1,057

Total assets 5,629,516 2,303 = 73.01% = 45.90%

Net operating income (EBIT) 1,389,575 589

Interest expense 83,532 221 = 16.64 = 2.67

Sales 7,421,768 3,421

Total assets 5,629,516 2,303 = 1.32 = 1.49

Sales 7,421,768 3,421

Net plant, property, and equipment 2,151,901 1,267 3.45= = 2.70

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This ratio also revealed interesting information showing Hersey used its fixed assets more effectively than ChocoThins despite ChocoThins using its total assets more effectively than Hersey. After calculating efficiency ratios, Madden moved on to calculate profitability ratios. Madden calculated the following profitability ratios: Gross profit margin:

Analyzing profitability ratios, Hersey did better than ChocoThins in all but the return on assets ratio. Madden has a good comparison between these companies about how they derived their profits. Madden now has an idea he needs to explore why ChocoThins could use its assets more effectively. Besides profitability ratios, another category of ratios to explore is market-value ratios. Madden found the price per share of common equity for Hersey is $110 and for Choco Thins $12. Hersey had 100,000 shares outstanding and ChocoThin had 70 shares outstanding. Madden calculated the price-earnings ratio for these companies as follows:

This analysis revealed to Madden that investors are willing to pay a higher multiple of earnings for Hersey than for ChocoThins. Hersey also has a higher market-to book value compared with ChocoThins. Calculation of these ratios concluded Madden's analysis of the two companies. It is always interesting to learn from the experiences of others. In 2004, we got an inside look at the administrative decision-making process of the Oakland Athletics baseball team and how they used statistical analysis to build a major league baseball team. The book was titled Moneyball: The Art of Winning an Unfair

Gross profit 3,336,166 1,236

Sales 7,421,768 3,421 = 44.95% = 36.13%

Operating profit margin:

Net operating income (EBIT) 1,389,575 589

Sales 7,421,768 3,421

Net profit margin:

Net income 846,912 234

Sales 7,421,768 3,421 = 11.41% = 6.84%

= 18.72% = 17.22%

Return (operating) on assets:

Net operating income (EBIT) 1,389,575 589

Total assets 5,629,516 2,303

Return on equity:

Net Income 846,912 234

Common Equity 1,519,530 1,246 55.74%= = 18.78%

= 24.68% = 25.58%

Price-Earnings ratio:

Market price per share 110.00$ 12.00$

Earnings per share 8.46$ 3.34$

Market-to-book ratio:

Market price per share 110.00$ 12.00$

Book value per share 15.20$ 17.80$

= 13.00 = 3.59

= 7.24 = 0.67

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Game. “The difference between the Yankees’ and the (Oakland Athletics) A’s opening day payrolls…ballooned from $62 million in 1999 to $90 million in 2002” (Lewis, 2004, p. 123). Lewis wrote in toward the end of his book “…superior management armed with science could be had so cheaply,” yet most professional baseball leaders did not access or make an attempt to interpret the raw data they had before them. (p. 277). Financial statement analysis relies on comparisons both within a company and with other companies in an industry. Harvey Madden's experience with his firm is an example of what it takes to analyze financial statements and perform ratio analysis. Both analysis revealed useful information to assess the performance of a company internally and provide information to investors outside the company.

Reference

Lewis, M. (2004). Moneyball: the art of winning in an unfair game. New York: W.W. Norton & Company, Inc.