03 04 analysis financial statement

Understanding Financial Statements and Cash Flows &

Evaluating a Firm’s Financial Performance

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Learning Objectives1. Describe the content of the four basic

financial statements and discuss the importance of financial statement analysis to the financial manager.

2. Evaluate firm profitability using the income statement.

3. Explain what we can learn by analyzing a firm’s financial statements.

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Learning Objectives4. Use common size financial statements as a

tool of financial analysis.5. Calculate and use a comprehensive set of

financial ratios to evaluate a company’s performance.

6. Select an appropriate benchmark for use in performing a financial ratio analysis.

7. Describe the limitations of financial ratio analysis.

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Principles Used in this Chapter• Principle 1: Money has a Time Value.

– Financial statements typically ignore time value of money. Thus financial managers and accountants may view financial statements very differently.

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Principles Used in this Chapter (cont.)• Principle 2: There Is a Risk-Return

Tradeoff.

– Financial statement analysis can yield important information about the strengths and weaknesses of a firm’s financial condition. The analysts can use such information to infer the risk-return tradeoff in a firm.

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Principles Used in This Chapter (cont.)• Principle 3: Cash Flows Are the Source of

Value.– Financial statements provide an important starting

point in determining the firm’s cash flow.– An important use of a firm’s financial statements

involves analyzing past performance as a tool for predicting future cash flows.

– We should distinguish between reported earnings and cash flow. It is possible for a firm to report positive earnings but have no cash!

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Principles Used in This Chapter (cont.) • Principle 4: Market Prices Reflect

Information.– Firm’s financial statements provide important

information that is used by investors in forming expectations about firm’s future prospects and subsequently, the market prices.

– Financial statement analysis requires gathering information about a firm’s financial condition, which is important to the valuation of the firm.

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Copyright © 2011 Pearson Prentice Hall. All rights reserved.

An Overview of the Firm’s Financial Statements

Basic Financial Statements• Following four types of financial

statements are mandated by the accounting and financial regulatory authorities:1. Income statement2. Balance sheet3. Cash flow statement4. Statement of shareholder’s equity

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Basic Financial Statements (cont.)• 1. Income Statement:

– An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months):

• Revenue, • Expenses, and• Profit.

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Basic Financial Statements (cont.)• 2. Balance sheet:

– Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010)

• Assets (value of what the firm owns),• Liabilities (value of firm’s debts), and• Shareholder’s equity (the money invested by the

company owners).

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Basic Financial Statements (cont.)• 3. Cash flow statement:

– It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).

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Basic Financial Statements (cont.)• 4. Statement of shareholder’s equity:

– It provides a detailed account of the firm’s activities in the following accounts over a period of time (for example, last six months):

• Common stock account,• Preferred stock account,• Retained earnings account, and• Changes to owner’s equity.

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Why Study Financial Statements?• Analyzing a firm’s financial statement can

help managers carry out three important tasks:1. Assess current performance through

financial statement analysis,2. Monitor and control operations, and3. Forecast future performance.

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Why Study Financial Statements? (cont.)1. Financial statement analysis:

– Financial statement analysis allows us to assess the present financial condition of a firm.

– Chapter 4 introduces the tools and techniques used to carry out financial statement analysis.

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Why Study Financial Statements? (cont.)2. Financial control:

– Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firm’s operations.

– For example, a creditor may analyze a firm’s financial statements to decide whether or not to renew company’s loan.

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Why Study Financial Statements? (cont.)3. Financial forecasting and planning:

– Financial planning models are typically built using the financial statements.

– Financial planning is covered in chapter 17.

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What are the Accounting Principles Used to Prepare Financial Statements?• The following three fundamental principles are

adhered to by accountants when preparing financial statements:1. The revenue recognition principle, 2. The matching principle, and 3. The historical cost principle.

• An understanding of these basic principles allows us to be a more informed user of financial statements.

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What are the Accounting Principles Used to Prepare Financial Statements? (cont.)

1. The revenue recognition principle:– It states that the revenue should be

included in the firm’s income statement for the period in which:

• Its goods and services were exchanged for cash or accounts receivable; or

• The firm has completed what it must do to be entitled to the cash.

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2. The matching principle:– This principle determines whether specific

costs or expenses can be attributed to this period’s revenues.

– The expenses are matched with the revenues they helped produce.

• For example, employees’ salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.

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3. The historical cost principle: – This principle provides the basis for

determining the dollar values the firm reports in its balance sheet.

– Most assets and liabilities are reported in the firm’s financial statements at historical cost i.e. the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities.

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An Income Statement• An income statement is also called a

profit and loss statement.

• An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).Revenues (or Sales) – Expenses = Profits

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An Income Statement (cont.)• An income statement will contain the following

basic elements:1. Revenues2. Expenses

• Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense

3. Profits• Gross profit, net operating income (also known as EBIT),

earnings before taxes (EBT), and net income

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An Income Statement (cont.)• Sales

– Minus Cost of Goods Sold • = Gross Profit• Minus Operating Expenses

– Selling expenses– General and Administrative expenses– Depreciation and Amortization Expense

• = Operating income (EBIT)• Minus Interest Expense• = Earnings before taxes (EBT) • Minus Income taxes• = Net income (EAT)

EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes

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Sample Income Statement

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Evaluating a Firm’s EPS and Dividends• We can use the income statement to

determine the earnings per share (EPS) and dividends.

• EPS = Net income÷ Number of shares outstanding

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Evaluating a Firm’s EPS and Dividends (cont.)• Example 1: A firm reports a net income

$90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)?

• EPS = Net income ÷ Number of shares= $90 million ÷ $35 million = $2.57

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Evaluating a Firm’s EPS and Dividends (cont.)• We can determine the dividends paid by

the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding.

• Dividends per share = Net income ÷ Number of shares

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Evaluating a Firm’s EPS and Dividends (cont.)• Example 2: A firm reports dividend payment

of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share?

Dividends per share = Net income ÷ Number of shares = $20 million ÷ $35 million = $0.57

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Connecting the Income Statement and the Balance Sheet• What can the firm do with the net

income?:1. Pay dividends to shareholders, and/or 2. Reinvest in the firm

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Connecting the Income Statement and the Balance Sheet (cont.)

• Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm?

• Amount retained = Net Income – Dividends= $90m - $20m = $70m

• The firm’s balance on retained earnings will increase by $70 million on the balance sheet.

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Interpreting Firm Profitability using the Income Statement• What can we learn from H.J. Boswell

Inc.’s income statement (Table 3-1)?

1. The firm has been profitable as its revenues exceeded its expenses.

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Interpreting Firm Profitability using the Income Statement (cont.)2. The gross profit margin (GPM)

= gross profits ÷ sales = $675 million ÷ $2,700 million = 25%

– GPM indicates the firm’s “mark-up” on its cost of goods sold per dollar of sales.

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Interpreting Firm Profitability using the Income Statement (cont.)

3. The operating profit margin= net operating income ÷ sales= $382.5 million ÷ $2,700 million= 14.17%

• The operating profit margin is equal to the ratio of net operating income or EBIT divided by firm’s sales.

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Interpreting Firm Profitability using the Income Statement (cont.)Net profit margin:

= net profits ÷ sales= $204.75 million ÷ $2,700 million= 7.58%

• Net profit margin indicates the percentage of revenues left after all expenses (including interest and taxes) have been considered.

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Interpreting Firm Profitability using the Income Statement (cont.)• These profit margins (gross profit margin,

operating profit margin, and net profit margin) should be closely monitored and compared to previous years and those of competing firms.

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GAAP and Earnings Management• While the firms must adhere to set of

accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firm’s reported earnings.

• Managers have an incentive to tamper with reported earnings as their pay depends upon it and investors care about it.

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The Balance Sheet• The balance sheet provides a snapshot of

the firm’s financial position on a specific date.

• The balance sheet is defined by the following equation:Total Assets = Total Liabilities + Total Shareholder’s Equity

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The Balance Sheet (cont.)• Total assets represents the resources

owned by the firm.• Total liabilities represent the total

amount of money the firm owes its creditors

• Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.

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The Balance Sheet (cont.)• In general, GAAP requires that the firm

report assets on its balance sheet using the historical costs.

• Cash and assets held for sale (such as marketable securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.

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The Balance Sheet (cont.)• Assets whose value is expected to

decline over time (such as equipment) is reported as “net equipment” which is equal to the historical cost minus accumulated depreciation.

• Note, the net value reported on balance sheet could be significantly different from the market value of the asset.

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The Balance Sheet (cont.)

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The Balance Sheet (cont.)

• The balance sheet includes the following main components:

1.Assets – Found on the left-hand side of the balance sheet. It includes current assets and fixed assets.

2.Sources of financing – Found on the right-hand side of the balance sheet. It includes current liabilities, long-term liabilities, and owner’s equity.

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The Balance Sheet (cont.)• Current assets consists of firm’s cash

plus other assets the firm expects to convert to cash within 12 months or less, such as receivables and inventory.

• Fixed assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.

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The Balance Sheet (cont.)• Current liabilities represent the amount

that the firm owes to creditors that must be repaid within a period of 12 months or less such as accounts payable, notes payable.

• Long-term liabilities refer to debt with maturities longer than a year such as bank loans, bonds.

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The Balance Sheet (cont.)• The stockholder’s equity is broken

down into two components:(1) The amount the company received from selling stock

to investors. It may be shown as common stock in the balance sheet or it may be divided into two components: par value and additional paid in capital above par. Par value is the stated or face value a firm puts on each share of stock. Paid in capital is the additional amount the firm raised when it sold the shares.

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The Balance Sheet (cont.)• For example, DLK corporation’s par value

per share is $2.00 and the firm has 30 million shares outstanding such that the par value of the firm’s common equity is $60 million. If the stocks were issued to investors for $240 million, $180 million represents paid in capital.

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The Balance Sheet (cont.)• (2) The amount of the firm’s retained

earnings. Retained earnings are the portion of net income that has been retained (i.e. not paid in dividends) from prior years operations.

• Thus stockholder’s equity = Par value of common stock + Paid in Capital + Retained Earnings

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The Balance Sheet (cont.)• We can also express stockholders’ equity

as follows:

Shareholders' equity = Total Assets – Total Liabilities

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Firm Liquidity and Net Working Capital• Liquidity refers to the speed with which an

the asset can be converted to cash without loss of value.

• For example, a firm’s bank account is perfectly liquid. Other types of assets are less liquid as they more difficult to sell and convert to cash such as PPE (property, plant and equipment).

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Firm Liquidity and Net Working Capital• For the overall firm, liquidity generally

refers to the firm’s ability to covert its current assts (accounts receivable and inventories) into cash so that it can pay its bills (current liabilities) on time.

• We can thus measure a firm’s liquidity by computing the net working capital = current assets – current liabilities

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Firm Liquidity and Net Working Capital (cont.)• If a firm’s net working capital is

significantly positive, it is in a good position to pay its debts on time and is consequently very liquid.

• Lenders consider the net working capital as an important indicator of firm’s ability to repay its loans.

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The Balance Sheet

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Debt and Equity Financing• The right-hand side of the balance sheet

reveals the sources of money used to finance the purchase of the firm’s assets listed on the left-hand side of the balance sheet.

• It shows how much was borrowed (debt financing) and how much was provided by firm’s owners (equity financing, through the sale of equity or retention of prior year’s earnings).

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Debt versus Equity• Payment: Payment for debt holders is

generally fixed (in the form of interest); Payment for equity holders (dividends) is not fixed nor guaranteed.

• Seniority: Debt holders are paid before equity holders in the event of bankruptcy.

• Maturity: Debt matures after a fixed period while equity securities do not mature.

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Book Values, Historical Costs, and Market Values• Book values (based on historical cost)

reported in the balance sheet can differ from market values.

• The gap between book value and market value is likely to be higher for fixed assets relative to current assets for two reasons:– Inflation affects the market price of asset; and – Depreciation adjustments in the balance sheet

do not reflect actual changes in market values.

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The Cash Flow Statement• The Cash Flow Statement is used by

firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash.

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Sources and Uses of Cash• Source of cash is any activity that brings

cash into the firm. For example, sale of equipment.

• Use of cash is any activity that causes cash to leave the firm. For example, payment of taxes.

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Balance Sheet for H.J. Boswell, Inc.

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Cash Flow Analysis• Why did the cash balance decline by $4.5

million from 2009 to 2010?1.Accounts receivable increased by $22.5

million representing an increase in uncollected cash from credit sales. Thus it represents $22.5m of use of cash to invest in accounts receivable.

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Cash Flow Analysis (cont.)2. Inventory increased by $148.50 million

indicating use of cash to procure inventory.3. Equipment increased by $175.50 million

indicating use of cash to invest in equipment.In general,

– an increase in an asset account = use of cash– a decrease in an asset account = source of cash

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Cash Flow Analysis (cont.)4. Accounts Payable, credit extended to the

firm, increased by $4.5million. Thus source of cash increased by $4.5million due to accounts payable.

5. Long-term debt increased by $51.75 million indicating a source of cash.

6. Short-term debt decreased by $9 million indicating use of cash to pay off the debt.

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Cash Flow Analysis (cont.)7. Retained earnings increased by $159.75

million representing a source of cash to the firm from the firm’s operations.

In general, – An increase in a liability account = source of

cash– A decrease in a liability account = use of cash

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Cash Flow Analysis (cont.)• Change in cash balance = Sources of cash

– Use of Cash = $216 - $220.50 = -$4.50Sources of Cash Uses of CashIncrease in Accounts Payable = $4.50

Increase in Accounts Receivable $22.50

Increase in long-term debt =$51.75

Increase in inventory = $148.50

Increase in retained earnings = $159.75

Increase in net plant and equipment = $40.50

Decrease in short-term notes = $9

Total Sources of cash = $216.00

Total Uses of cash = $220.50

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Cash Flow Analysis (cont.)• An analysis of H.J. Boswell’s operations reveals the

following for 2010:– The firm used more cash than it generated,

resulting in a deficit of $4.5 million– The primary source of cash flow was

retained earnings ($159.75 million) followed by long-term debt ($51.75 million)

– The largest use of cash was for acquiring inventory at $148.5 million.

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Cash Flow Analysis Summary

Sources of Cash Uses of CashDecrease in an asset account

Increase in an asset account

Increase in a liability account

Decrease in a liability account

Increase in an owner’s equity account

Decrease in an owners’ equity account

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Cash Flow Statement• The format for a traditional cash flow statement

is as follows:Beginning Cash Balance

Plus: Cash Flow from Operating ActivitiesPlus: Cash Flow from Investing ActivitiesPlus: Cash Flow from Financing ActivitiesEquals: Ending Cash Balance

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Cash Flow Statement (cont.)• Operating activities represent the

company’s core business including sales and expenses. Basically any activity that affects net income for the period.

• Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment.

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Cash Flow Statement (cont.)• Financing activities represent changes in

the firm’s use of debt and equity such as issue of new shares, payment of dividends.

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H.J. Boswell, Inc.Statement of Cash Flows

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Checkpoint 3.3Interpreting the Statement of Cash FlowYou are in your second rotation in the management training program at a regional brokerage firm and your supervisor calls you into her office on Monday morning to discuss your next training rotation. When you enter her office you are surprised to learn that you will be responsible for compiling a financial analysis of Chesapeake Energy Inc. (CHK). Chesapeake is the largest producer of natural gas in the United States and is headquartered in Oklahoma City. Your boss suggests that you begin your analysis by reviewing the firm’s cash flow statements for 2004 through 2007 (found below):

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Checkpoint 3.3

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Checkpoint 3.3

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Checkpoint 3.3

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Checkpoint 3.3

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Why Do We Analyze Financial Statements?• A firm’s financial statements can be

analyzed internally (by employees, managers) and externally (by bankers, investors, customers, and other interested parties).

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Why Do We Analyze Financial Statements? (cont.)• An internal financial analysis might be done:

– To evaluate the performance of employees and determine their pay raises and bonuses.

– To compare the financial performance of the firm’s different divisions.

– To prepare financial projections, such as those associated with the launch of a new product.

– To evaluate the firm’s financial performance in light of its competitors and determine how the firm might improve its operations.

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Why Do We Analyze Financial Statements? (cont.)• A variety of firms and individuals that have

an economic interest might also undertake an external financial analysis:– Banks and other lenders deciding whether to

loan money to the firm.– Suppliers who are considering whether to grant

credit to the firm.– Credit-rating agencies trying to determine the

firm’s creditworthiness.

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Why Do We Analyze Financial Statements? (cont.)• Professional analysts who work for

investment companies considering investing in the firm or advising others about investing.

• Individual investors deciding whether to invest in the firm.

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Common Size Statements – Standardizing Financial Information• A common size financial statement is a

standardized version of a financial statement in which all entries are presented in percentages.

• A common size financial statement helps to compare entries in a firm’s financial statements, even if the firms are not of equal size.

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Common Size Statements – Standardizing Financial Information (cont.)

• How to prepare a common size financial statement?– For a common size income statement, divide

each entry in the income statement by the company’s sales.

– For a common size balance sheet, divide each entry in the balance sheet by the firm’s total assets.

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Common Size Income Statement(H. J. Boswell, Inc.)

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Table 4-1 Observations• Table 4-1 is created by dividing each entry in the

income statement found in Table 3-1 by firm sales for 2010.– Cost of goods sold make up 75% of the firm’s

sales resulting in a gross profit of 25%.– Selling expenses account for about 3% of

sales. Income taxes account for 4.1% of the firm’s sales.

– After accounting for all expenses, the firm generates net income of 7.6% of firm’s sales.

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Common Size Balance Sheet(H. J. Boswell, Inc.)

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Table 4-2 Observations• Table 4-2 is created by dividing each entry

in the balance sheet found in Table 3-2 by total assets for the year.– Total current assets increased by 5.6% in 2010

while total current liabilities declined by 2%.– Long-term debt account for 39.2% of firm’s

assets, showing a decline of 1.7%.– Retained earnings increased by 5.8% in 2010.

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Using Financial Ratios• Financial ratios provide a second method for

standardizing the financial information on the income statement and balance sheet.

• A ratio by itself may have no meaning. Hence, a given ratio is compared to: (a) ratios from previous years; or (b) ratios of other firms in the same industry.

• If the differences in the ratios are significant, more in-depth analysis must be done.

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Using Financial Ratios (cont.)Question Category of Ratios Used

1. How liquid is the firm? Will it be able to pay its bills as they become due?

Liquidity ratios

2. How has the firm financed the purchase of its assets?

Capital structure ratios

3. How efficient has the firm’s management been in utilizing it assets to generate sales?

Asset management efficiency ratios

4. Has the firm earned adequate returns on its investments?

Profitability ratios

5. Are the firm’s managers creating value for shareholders?

Market value ratios

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Liquidity Ratios• Liquidity ratios address a basic question:

How liquid is the firm?• A firm is financially liquid if it is able to

pay its bills on time. We can analyze a firm’s liquidity from two perspectives:– Overall or general firm liquidity– Liquidity of specific current asset accounts

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Liquidity Ratios (cont.)• Overall liquidity is analyzed by comparing

the firm’s current assets to the firm’s current liabilities.

• Liquidity of specific assets is analyzed by examining the timeliness in which the firm’s primary liquid assets – accounts receivable and inventories – are converted into cash.

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Liquidity Ratios: Current Ratio• The overall liquidity of a firm is analyzed

by computing the current ratio and acid-test ratio.

• Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-term) liabilities.

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Liquidity Ratios: Current Ratio (cont.)• The text computes the current ratio for

H.J. Boswell, Inc. for 2010.

• What is the current ratio for 2009?

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Liquidity Ratios: Current Ratio (cont.)

• Current Ratio = $477 ÷ 292.5 = 1.63 times

• The firm had $1.63 in current assets for every $1 it owed in current liability. The current ratio improved in 2010 to 2.23 times as the current assets increased significantly in 2010.

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Liquidity Ratios: Quick Ratio• The overall liquidity of a firm is also

analyzed by computing the Acid-Test (Quick) Ratio. This ratio excludes the inventory from current assets as inventory may not always be very liquid.

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Liquidity Ratios: Quick Ratio (cont.)• The text computes the quick ratio for H.J.

Boswell, Inc. for 2010.

• What is the quick ratio for 2009?

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Liquidity Ratios: Quick Ratio (cont.)

• Quick Ratio = ($477-$299.50) ÷ ($292.50)= 0.63 times

• The firm is clearly less liquid using quick ratio as the firm has only $0.63 in current assets (less inventory) to cover $1 in current liabilities. The quick ratio improved in 2010 to 0.94 times largely due to an increase in current assets.

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Liquidity Ratios: Individual Asset Categories • We can also measure the liquidity of the

firm by examining the liquidity of individual current asset accounts, including accounts receivable and inventories.

• We can assess the liquidity of the firm by measuring how long it takes the firm to convert its accounts receivables and inventories into cash.

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Liquidity Ratios: Accounts Receivable

• Average Collection Period measures the number of days it takes the firm to collects its receivables.

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Liquidity Ratios: Accounts Receivable (cont.)

• The text computes the average collection period for H.J. Boswell, Inc. for 2010.

• What will be the average collection period for 2009 if we assume that the annual credit sales were $2,500 million in 2009?

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Liquidity Ratios: Accounts Receivable (cont.)

• Daily Credit Sales – = $2,500 million ÷ 365 days = $6.85 million

• Average Collection Period= Accounts Receivable ÷ Daily

Credit Sales= $139.5m ÷ $6.85m = 20.37 days

• The firm collects its accounts receivable in 20.37 days.

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Liquidity Ratios: Accounts Receivable Turnover Ratio• Accounts Receivable Turnover Ratio

measures how many times accounts receivable are “rolled over” during a year.

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Liquidity Ratios: Accounts Receivable Turnover Ratio• The text computes the accounts

receivable turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the accounts receivable turnover ratio for 2009 if we assume that the annual credit sales were $2,500 million in 2009?

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Liquidity Ratios: Accounts Receivable Turnover Ratio

• Accounts Receivable Turnover = $2,500 million ÷ $139.50= 17.92 times

• The firm’s accounts receivable were turning over at 17.92 times per year.

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Liquidity Ratios: Inventory Turnover Ratio

• Inventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.

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Liquidity Ratios: Inventory Turnover Ratio• The text computes the inventory turnover

ratio for H.J. Boswell, Inc. for 2010.

• What will be the inventory turnover ratio for 2009 if we assume that the cost of goods sold were $1,980 million in 2009?

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Liquidity Ratios: Inventory Turnover Ratio (cont.)

• Inventory Turnover Ratio= $1,980 ÷ $229.50= 8.63 times

• The firm turned over its inventory 8.63 times per year.

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Liquidity Ratios: Days’ Sales in Inventory• We can express the inventory turnover ratio in terms of

the number of days the inventory sits unsold on the firm’s shelves.

• Days’ Sales in Inventory = 365÷ inventory turnover ratio= 365 ÷ 8.63 = 42.29 days

• The firm, on average, holds it inventory for about 42 days.

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Can a Firm Have Too Much Liquidity?• A high investment in liquid assets will

enable the firm to repay its current liabilities in a timely manner.

• However, an excessive investments in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.

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Checkpoint 4.1Evaluating Dell Computer Corporation’s (DELL) LiquidityYou work for a small company that manufactures a new memory storage device. Computer giant Dell has offered to put the new device in their laptops if your firm will extend them credit terms that allow them 90 days to pay. Since your company does not have many cash resources, your boss has asked that you look into Dell’s liquidity and analyze its ability to pay their bills on time using the following accounting information for Dell and two other computer firms (figures in thousands of dollars):

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Checkpoint 4.1

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Checkpoint 4.1

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Checkpoint 4.1

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Checkpoint 4.1: Check Yourself

Calculate HP’s inventory turnover ratio. Why do you think this ratio is so much lower than Dell’s inventory turnover ratio?

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Step 1: Picture the Problem• One of the indicators of liquidity of the

firm is the inventory turnover ratio. This ratio will measure how many days items remain in inventory before being sold.

• Inventory turnover ratio is important as it has implications for cash flows and profitability of a firm.

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Step 2: Decide on a Solution Strategy• We will use the inventory turnover ratio to

determine HP’s inventory turnover ratio. This will give us clues about inventory practices at HP.

• We will use the following equation to compute the Inventory Turnover (IT) ratio– IT ratio = Cost of Goods Sold ÷ Inventories

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Step 3: Solve• Inventory Turnover Ratio for HP

– = Cost of Goods Sold ÷ Inventories– = $69,178,000 ÷ 7,750,000– = 8.93

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Step 4: Analyze• HP’s inventory turnover ratio indicates that the

inventory at HP remains on shelf for (365 ÷ 8.93) days or 40.87 days. This is much higher than Dell that has an inventory turnover ratio of 79.79 or shelf life of only 4.57 days.

• The significant difference must be investigated further as the two firms are in the same industry.

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Step 4: Analyze (cont.)• There are two reasons why HP has a

lower turnover of inventories relative to Dell:– HP sells computers out of inventory of

computers while Dell builds computers only when orders are received.

– HP carries more parts inventory on hand than does Dell

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Capital Structure Ratios• Capital structure refers to the way a firm

finances its assets.• Capital structure ratios address the

important question: How has the firm financed the purchase of its assets?

• We will use two ratios, debt ratio and times interest earned ratio, to answer the question.

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Capital Structure Ratios (cont.)• Debt ratio measures the proportion of the

firm’s assets that are financed by borrowing or debt financing.

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Capital Structure Ratios (cont.)• The text computes the debt ratio for H.J.


• What will be the debt ratio for 2009?

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Capital Structure Ratios (cont.)

• Debt Ratio – = $1,012.50 million ÷ $1,764 million– = 57.40%

• The firm financed 57.39% of its assets with debt.

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Capital Structure Ratios (cont.)• Times Interest Earned Ratio measures

the ability of the firm to service its debt or repay the interest on debt.

– We use EBIT or operating income as interest expense is paid before a firm pays its taxes.

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Capital Structure Ratios (cont.)• The text computes the times interest

earned ratio for H.J. Boswell, Inc. for 2010.

• What will be the times interest earned ratio for 2009 if we assume interest expense of $65 million and EBIT of $350 million?

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Capital Structure Ratios (cont.)

• Times Interest Earned = $350 million ÷ $65 million = 5.38

times• Thus the firm can pay its total interest expense 5.38

times or interest consumed 1/5.38th or 18.58% of its EBIT. Thus, even if the EBIT shrinks by 81.42% (100-18.58), the firm will be able to pay its interest expense.

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Checkpoint 4.2Comparing the Financing Decisions of Home Depot (HD) and Lowes Corporation (LOW)You inherited a small sum of money from your grandparents and currently have it in a savings account at your local bank. After enrolling in your first finance class in business school you have decided that you would like to begin investing your money in the common stock of a few companies. The first investment you are considering is stock in either Home Depot or Lowes. Both firms operate chains of home improvement stores throughout the United States and other parts of the world.

In your finance class you learned that an important determinant of the risk of investing in a firm’s stock is driven by the firm’s capital structure, or how it has financed its assets. In particular, the more money the firm borrows, the greater is the risk that the firm may become insolvent and bankrupt. Consequently, the first thing you want to do before investing in either company’s stock is to compare how they financed their investments. Just how much debt financing have the two firms used?

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Checkpoint 4.2

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Checkpoint 4.2

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Checkpoint 4.2

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What would be Home Depot’s times interest earned ratio if interest payments remained the same, but net operating income dropped by 80% to only $1.9346 billion? Similarly if Lowes’ net operating income dropped by 80%, what would its times interest earned ratio be?

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Step 1: Picture the Problem• Times interest earned ratio is an important

ratio for firms that use debt financing. It measures the firm’s ability to service its debt.

• The ratio requires comparing net operating income or EBIT with Interest expense. Both items are found on the income statement.

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Step 1: Picture the Problem (cont.)• Picture an Income Statement

– Sales

• Less: Cost of Good Sold• Equals: Gross Profit• Less: Operating Expenses• Equals: Net Operating Income (EBIT)• Less: Interest Expense• Equals: Earnings before Taxes• Less: Taxes• Equals Net Income

EBIT

InterestExpense

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Step 2: Decide on a Solution Strategy• Here we are considering the impact of a

drop in EBIT on the times interest earned ratio of Home Depot and Lowes. We will use the following ratio to measure the times interest earned (TIE) ratio.

• TIE = EBIT ÷ Interest Expense

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Step 3: Solve• Times Interest Earned (TIE)

– = EBIT ÷ Interest Expense

• TIE (Home Depot) – = $1.9346 billion ÷ $0.392 billion = 4.94

times• TIE (Lowes)

– = $1.03 billion ÷$0.154 billion = 6.69 times

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Step 4: Analyze• We observe that a drop in net operating income leads to

a significant drop in times interest earned ratio for both the firms.

• The times interest earned ratio drops from 24.68 to 4.94 for Home Depot and from 33.45 to 6.69 for Lowes.

• Should creditors be worried by this drop?

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Step 4: Analyze (cont.)• The ratio is still reasonably safe.

• For example, for Home Depot, it indicates that the firm can pay its interest expense 4.94 times out of its EBIT. Thus, even if the EBIT shrank further by 79.75% (1-1/4.94 = 1-.2025 or 79.75%), it can still pay its interest expense.

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How does Leverage work?

• Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.

ROE = = 15%15,000100,000

(ignore taxes for this example)(ignore taxes for this example)

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How does Leverage work?

• Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.

ROE = = 22%

15,000 - 4,00050,000

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Asset Management Efficiency Ratios• Asset management efficiency ratios

measure a firm’s effectiveness in utilizing its assets to generate sales.

• They are commonly referred to as turnover ratios as they reflect the number of times a particular asset account balance turns over during a year.

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Asset Management Efficiency Ratios (cont.)• Total Asset Turnover Ratio represents

the amount of sales generated per dollar invested in firm’s assets.

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Asset Management Efficiency Ratios (cont.)• The text computes the total asset

turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the total asset turnover ratio for 2009 if we assume the total sales in 2009 were $2,500 million?

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Asset Management Efficiency Ratios (cont.)

• Total Asset Turnover– = $2,500 million ÷ $1,764 million = 1.42 times

• Thus the firm generated $1.42 in sales per dollar of assets in 2009.

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Asset Management Efficiency Ratios (cont.)• Fixed asset turnover ratio measures

firm’s efficiency in utilizing its fixed assets (such as property, plant and equipment).

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Asset Management Efficiency Ratios (cont.)• The text computes the fixed asset

turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the fixed asset turnover ratio for 2009 if we assume sales of $2,500 million for 2009?

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• Fixed Asset Turnover– = $2,500 million ÷ $1,287 million = 1.94 times

• The firm generated $1.94 in sales per dollar invested in plant and equipment.

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Asset Management Efficiency Ratios (cont.)• We could similarly compute the turnover

ratio for other assets.

• We had earlier computed the receivables turnover and inventory turnover, which measured firm effectiveness in managing its investments in accounts receivables and inventories.

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For Boswell, 2010• Total Asset Turnover

= Sales ÷ Total Assets= $2,700m ÷ $1,971m = 1.37

• Fixed Asset Turnover = Sales ÷ Net Plant and Equipment= $2,700m ÷$1,327.5m = 2.03

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For Boswell, 2010• Receivables Turnover

= Credit Sales ÷ Accounts Receivable= $2,700m ÷ $162m = 16.67 times

• Inventory Turnover= Cost of Goods Sold ÷ Inventories= $2,025m ÷$378m = 3.36 times

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• The following grid summarizes the efficiency of Boswell’s management in utilizing its assets to generate sales in 2010.

Turnover Ratio

Boswell Peer Group

Assessment

Total Assets 1.37 1.15 Good

Fixed Assets 2.03 1.75 Good

Receivables 16.67 14.60 Good

Inventory 5.36 7.0 PoorAFS-152

Profitability Ratios• Profitability ratios address a very

fundamental question: Has the firm earned adequate returns on its investments?

• We answer this question by analyzing the firm’s profit margin, which predict the ability of the firm to control its expenses, and the firm’s rate of return on investments.

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Profitability Ratios (cont.)• Two fundamental determinants of firm’s

profitability and returns on investments are the following:– Cost Control

• Is the firm controlling costs and earning reasonable profit margin?

– Efficiency of asset utilization• Is the firm efficiently utilizing the assets to

generate sales?

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Profitability Ratios (cont.)• Gross profit margin shows how well the

firm’s management controls its expenses to generate profits.

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Profitability Ratios (cont.)• The text computes the gross profit margin


• What will be the gross profit margin ratio for 2009 if we assume sales of $2,500 million and gross profit of $650 million for 2009?

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Profitability Ratios (cont.)

• Gross Profit Margin – = $650 million ÷ $2,500 million = 26%

• The firm spent $0.74 for cost of goods sold for each dollar of sales. Thus, $0.26 out of each dollar of sales goes to gross profits.

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Profitability Ratios (cont.)• Operating Profit Margin measures how

much profit is generated from each dollar of sales after accounting for both costs of goods sold and operating expenses. It thus also indicates how well the firm is managing its income statement.

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Profitability Ratios (cont.)• The text computes the operating profit

margin ratio for H.J. Boswell, Inc. for 2010.

• What will be the operating profit margin ratio for 2009 if we assume sales of $2,500 million and net operating income of $350 million for 2009?

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• Operating Profit Margin= $350 million ÷ $2,500 million = 14%

• Thus the firm generates $0.14 in operating profit for each dollar of sales.

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Profitability Ratios (cont.)• Net Profit Margin measures how much

income is generated from each dollar of sales after adjusting for all expenses (including income taxes).

•

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Profitability Ratios (cont.)• The text computes the net profit margin


• What will be the net profit margin ratio for 2009 if we assume sales of $2,500 million and net income of $217.75 million for 2009?

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• Net Profit Margin – = $217.75 million ÷ $2,500 million = 8.71%

• The firm generated $0.087 for each dollar of sales after all expenses (including income taxes) were accounted for.

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Profitability Ratios (cont.)• Operating Return on Assets ratio is the

summary measure of operating profitability, which takes into account both the management’s success in controlling expenses, contributing to profit margins, and its efficient use of assets to generate sales.

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Profitability Ratios (cont.)• The text computes the operating return

on assets ratio for H.J. Boswell, Inc. for 2010.

• What will be the operating return on assets ratio for 2009 if we assume EBIT or net operating income of $350 million for 2009?

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• Operating Return on Assets– = $350 million ÷$1,764 million = 19.84%

• The firm generated $0.1984 of operating profits for every $1 of its invested assets.

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Profitability Ratios (cont.)• Decomposing the OROA ratio: We can use the

following equation to decompose the OROA ratio that allows us to analyze the firm’s ability to control costs and utilize its investments in assets efficiently.

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Figure 4-1 Observations • Firm’s OROA (operating return on assets) is better than

its peers. Thus the firm earned more net operating income per dollar invested in assets.

• Firm’s OPM (operating profit margin) is lower than its peers. Thus the firm retained a lower percentage of its sales in net operating income.

• Firm’s TATO (total asset turnover ratio) is higher than its peers. Thus the firm generated more sales from its assets.

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Figure 4-1 Recommendations• The firm has two opportunities to improve its

profitability:1.Reduce costs - The firm must investigate

the cost of goods sold and operating expenses to see if there are opportunities to reduce costs.

2.Reduce inventories – The firm must investigate if it can reduce the size of its inventories.

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Checkpoint 4.3Evaluating the Operating Return on Assets Ratio for Home Depot (HD) and Lowes (LOW)In Checkpoint 4.2 we evaluated how much debt financing Home Depot and Lowes used. We continue our analysis by evaluating the operating return on assets (OROA) earned by the two firms. Calculate the net operating income each firm earned during 2007 relative to the total assets of each firm using the information found below:

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Checkpoint 4.3

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Checkpoint 4.3

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Checkpoint 4.3

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If Home Depot were able to raise its total asset turnover ratio to 2.5 while maintaining its current operating profit margin, what would happen to its operating return on assets?

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Step 1: Picture the Problem• The operating return on assets ratio for a

firm is determined by two factors: cost control and efficiency of asset utilization. It is expressed by equation 4-13a. Here the focus is on asset utilization i.e. improvement in total asset turnover ratio.

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Step 2: Decide on a Solution Strategy• We will analyze the impact on operating

return on assets of improvement on the total asset turnover ratio by using the following equation:

• Operating Return on Assets (OROA)– = Total Asset Turnover × Operating Profit

Margin

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Step 3: Solve• Operating Return on Assets (OROA)

– = Total Asset Turnover × Operating Profit Margin

• Before = 1.74 × 10.65% = 18.53%

• Now = 2.5 × 10.65% = 26.63%

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Step 4: Analyze• An improvement in total asset turnover

ratio has a favorable impact on Home Depot’s operating return on assets (OROA).

• If Home Depot wants to increase its OROA more, it should focus on cost control that will help improve the net operating profit.

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Is the Firm Providing a Reasonable Return on the Owner’s Investment?

• A firm’s net income consists of earnings that is available for distribution to the firm’s shareholders. Return on Equity ratio measures the accounting return on the common stockholders’ investment.

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Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.)

• The text computes the return on equity ratio for H.J. Boswell, Inc. for 2010.

• What will be the return on equity ratio for 2009 if we assume net income of $217.75 million for 2009?

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Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.)

• Return on Equity – = $217.75 million ÷ $751.50 million = 28.98%

• Thus the shareholders earned 28.97% on their investments. • Note common equity includes both common stock plus the firm’s

retained earnings.

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Using the DuPont Method for Decomposing the ROE ratio• DuPont method analyzes the firm’s ROE by

decomposing it into three parts: profitability, efficiency and an equity multiplier.

– ROE = Profitability × Efficiency × Equity Multiplier

• Equity multiplier captures the effect of the firm’s use of debt financing on its return on equity. The equity multiplier increases in value as the firm uses more debt.

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Using the DuPont Method for Decomposing the ROE ratio (cont.)

• ROE = Profitability × Efficiency × Equity Multiplier

• ROE = Net Profit Margin × Total Asset Turnover Ratio × 1/(1-debt ratio)

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Using the DuPont Method for Decomposing the ROE ratio (cont.)• The following table shows why Boswell’s

return on equity was higher than its peers.

Return on

Equity

Net Profit

Margin

Total Asset

Turnover

EquityMultipli

er

H. J. Boswell, Inc.

22.5% 7.6% 1.37 2.16

Peer Group 18.0% 10.2% 1.15 1.54

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• The table suggests that Boswell had a higher ROE as it was able to generate more sales from its assets (1.37 versus 1.15 for peers) and used more leverage (2.16 versus 1.54).

• Note use of financial leverage may not always generate value for shareholders. Impact of financial leverage is discussed in detail in chapter 15.

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Market Value Ratios• Market value ratios address the

question, how are the firm’s shares valued in the stock market?

• Two market value ratios are:– Price-Earnings Ratio– Market-to-Book Ratio

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Market Value Ratios (cont.)• Price-Earnings (PE) Ratio indicates how

much investors are currently willing to pay for $1 of reported earnings.

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Market Value Ratios (cont.)• The text computes the PE ratio for H.J.


• What will be the PE ratio for 2009 if we assume the firm’s stock was selling for $22 per share at a time when the firm reported a net income of $217.75 million, and the total number of common shares outstanding are 90 million?

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Market Value Ratios (cont.)

• Earnings per share – = $217.75 million ÷ 90 million = $2.42

• PE ratio = $22 ÷ $2.42 = 9.09• The investors were willing to pay $9.09 for

every dollar of earnings per share that the firm generated.

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Market Value Ratios (cont.)• Market-to-Book Ratio measures the

relationship between the market value and the accumulated investment in the firm’s equity.

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Market Value Ratios (cont.)• The text computes the market-to-book


• What will be the market-to-book ratio for 2009 given that the current market price of the stock is $22 and the firm has 90 million shares outstanding?

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Market Value Ratios (cont.)• Book Value per Share

– = 751.50 million ÷ 90 million = $8.35 per share

• Market-to-Book Ratio= Market price per share ÷ Book value per share= $22 ÷ $8.35 = 2.63 times

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Checkpoint 4.4Comparing the Valuation of Dell (DELL) to Apple (APPL) Using Market Value RatiosThe following information on Dell and Apple was gathered on April 9, 2010:

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Checkpoint 4.4

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Checkpoint 4.4

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What price per share for Dell would it take to increase the firm’s price-to-earnings ratio to the level of Apple?

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Step 1: Picture the Problem• Price-to-earnings (PE) ratio depends on earnings per

share and price per share, pictured as follows:

Price per share standardized by

EPS = Net income ÷ number Of shares outstanding PE Ratio =

Price per share ÷ Earnings per share

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Step 2: Decide on a Solution Strategy• We need to determine the price per share

that will make PE ratio of Dell equal to the PE ratio of Apple. PE ratio of Dell has to increase from 11.04 to 18.20.

• PE ratio = Price per share ÷ Earnings per share

• ==> 18.20 = ? ÷ 1.14

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Step 3: Solve• PE ratio = Price per share ÷ Earnings per

share

• 18.20 = Price per share ÷ $1.14

• Price per share = 18.20 × 1.14 = $20.75

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Step 4: Analyze• PE ratio allows us to compare two stocks

with different prices by standardizing the stock prices by earnings.

• Apple has a much higher PE ratio. To reach the same PE valuation, the stock price of Dell will have to increase from $12.54 to $20.75.

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Summing up the Financial Analysis of H. J. Boswell, Inc. • Liquidity: With the exception of inventory

turnover ratio, liquidity ratios were adequate to good. The next step will be to see how inventory management can be improved.

• Financial Leverage: The firm uses more debt than its peers, which exposes the firm to a higher degree of financial risk or potential default on its debt in the future.

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Summing up the Financial Analysis of H. J. Boswell, Inc. • Profitability: H.J. Boswell had favorable net

operating income despite lower profit margins, largely due to its higher asset turnover ratio. The return on equity was also higher than the peer group due to use of more debt.

• Market Value Ratios: These ratios suggest that the market is pleased with the firm as indicated by higher stock valuations.

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Selecting a Performance Benchmark• There are two types of benchmarks that are

commonly used:– Trend Analysis – involves comparing a firm’s

financial statements over time.– Peer Group Comparisons – involves comparing

the subject firm’s financial statements with those of similar, or “peer” firms. The benchmark for peer groups typically consists of firms from the same industry or industry average financial ratios.

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Trend Analysis

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Financial Analysis of the Gap, Inc., June 2009

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The Limitations of Ratio Analysis1. Picking an industry benchmark can

sometimes be difficult.2. Published peer-group or industry

averages are not always representative of the firm being analyzed.

3. An industry average is not necessarily a desirable target or norm.

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The Limitations of Ratio Analysis (cont.)

4. Accounting practices differ widely among firms.5. Many firms experience seasonal changes in

their operations.6. Financial ratios offer only clues. We need to

analyze the numbers in order to fully understand the ratios.

7. The results of financial analysis are dependent on the quality of the financial statements.

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Practice Problems

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Example #1

• Assume you are given the following relationships for the Brauer Corporation:– Sales / Total Assets 1.5x– Return on Assets (ROA) 3%– Return on Equity (ROE)5%

Calculate Brauer’s profit margin and debt ratio.

AFS-211

Example #1

ROA = Profit margin Total assets turnover 3% = Profit margin x 1.5 Profit margin = 3% / 1.5 = 2%

ROE = ROA TA/E5% = 3% TA/ETA/E = 5% / 3%E/TA = 3/5 = 60% therefore, D/TA = 1 - 0.60 = 0.40 = 40%

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Complete the balance sheet and sales information in the table that follows for Hoffmeister Industries using the following financial data (all sales are on credit):

– Debt Ratio: 50%– Current Ratio: 1.8x– Total assets turnover: 1.5x– Accounts receivable turnover: 10x– Gross profit margin on sales: 25%– Inventory turnover ratio: 5x

Team Assignment

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Cash Accounts payable

Accounts receivable Long-term debt 60,000

Inventories Common stock

Fixed assets Retained earnings 97,500

Total assets $300,000 Total liabilities & equity

Sales Cost of goods sold

BALANCE SHEET

Team Assignment

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1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.

2. Accounts payable = Debt – Long-term debt = $150,000 - $60,000 = $90,000.

3. Common stock = Total liabilities & equity - Debt - Retained earnings

= $300,000 - $150,000 - $97,500 = $52,500.4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.5. Cost of goods sold = (Sales)(1 - 0.25)

= ($450,000)(0.75) = $337,500 6. Inventories = Cost of goods sold /5

= $337,500/5 = $67,500.

Team Assignment

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7. Accounts receivable = Credit Sales / Accounts receivable turnover = ($450,000/10) = $45,000.

8. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable)

Cash + $45,000 + $67,500 = (1.8)($90,000) Cash + $112,500 = $162,000 Cash = $49,500.9. Fixed assets = Total assets - (Cash + Accts rec.

+ Inventories)Fixed assets = $300,000 - ($49,500 + $45,000 + $67,500) = $138,000.

Team Assignment

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03 04 analysis financial statement

Documents

study financial

basic financial

prepare financial

net working

net profit

firms financial

operating

gross profit