Chapter 4 Financial Analysis— Sizing up Firm Performance

Slide Contents Learning Objectives Principles Applied in this Chapter Why Do We Analyze Financial Statements Common Size Statements – Standardizing Financial Information Using Financial Ratios Selecting a Performance Benchmark Limitations of Ratio Analysis Key Terms

Learning Objectives Explain what we can learn by analyzing a firm’s financial statements. Use common size financial statements as a tool of financial analysis. Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.

Learning Objectives (cont.) Select an appropriate benchmark for use in performing a financial ratio analysis. Describe the limitations of financial ratio analysis.

Principles Used in this Chapter Principle 3: Cash Flows Are the Source of Value. Principle 4: Market Prices Reflect Information. Principle 5: Individuals Respond to Incentives.

4.1 Why Do We Analyze Financial Statements?

Why Do We Analyze Financial Statements? An internal financial analysis might be done: To evaluate the performance of employees To compare the performance of different divisions To prepare financial projections To evaluate the firm’s financial performance in light of its competitors’ performance

Why Do We Analyze Financial Statements? (cont.) External financial analysis is done by: Banks and other lenders Suppliers Credit-rating agencies Professional analysts Individual investors

4.2 COMMON SIZE STATEMENTS: STANDARDIZING FINANCIAL INFORMATION

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. It helps to compare a firm’s financial statements with those of other firms, even if the other firms are not of equal size.

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 sales. For a common size balance sheet, divide each entry in the balance sheet by total assets.

Table 4.1 H. J. Boswell, Inc.

Table 4.1 Observations Table 4-1 created by dividing each entry in the income statement of Table 3.1 by firm sales for 2013. 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 all expenses, the firm generates net income of 7.6% of firm’s sales.

Table 4.2 H. J. Boswell, Inc.

Table 4.2 Observations Table 4.2 created by dividing each entry in the balance sheet of Table 3.2 by total assets. Total current assets increased by 5.6% in 2013 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% .

4.3 Using Financial Ratios

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 generally compared to: (a) ratios from previous years; or (b) ratios of other firms in the same industry.

Using Financial Ratios (cont.)

Liquidity Ratios

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 (see next slide).

Liquidity Ratios (cont.) Overall liquidity - analyzed by comparing the firm’s current assets to the firm’s current liabilities. Liquidity of specific assets - analyzed by examining the timeliness in which the firm’s liquid assets (accounts receivable and inventories) are converted into cash.

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.

Liquidity Ratios: Current Ratio (cont.) What is the current ratio for 2012 for Boswell? Current Ratio = $477 ÷ 292.5 = 1.63 times The firm had $1.63 in current assets for every $1 it owed in current liability.

Liquidity Ratios: Quick Ratio Acid-Test (Quick) Ratio excludes the inventory from current assets as inventory may not be very liquid.

Liquidity Ratios: Quick Ratio (cont.) What is the quick ratio for Boswell for 2012? Quick Ratio = ($477-$229.50) ÷ ($292.50) = 0.84 times The firm has only $0.84 in current assets (less inventory) to cover $1 in current liabilities.

Liquidity Ratios: Individual Asset Categories We can also measure the liquidity of the firm by examining the liquidity of accounts receivable and inventories to see how long it takes the firm to convert its accounts receivables and inventories into cash.

Liquidity Ratios: Accounts Receivable Average Collection Period measures the number of days it takes the firm to collects its receivables.

Liquidity Ratios: Accounts Receivable (cont.) What will be the average collection period for Boswell, Inc. for 2012 if we assume that the annual credit sales were $2,500 million? Daily Credit Sales = $2,500 ÷ 365 days = $6.85 million Average Collection Period = $139.5m ÷ $6.85m = 20.37 days

Liquidity Ratios: Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio measures how many times receivables are “rolled over” during a year.

Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.) What will be the accounts receivable turnover ratio for Boswell, Inc. for 2012 if we assume that the annual credit sales were $2,500 million? 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.

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.

Liquidity Ratios: Inventory Turnover Ratio (cont.) What will be the inventory turnover ratio for 2012 for Boswell, Inc. if we assume that the cost of goods sold were $1,980 million in 2012? Inventory Turnover Ratio = $1,980 ÷ $229.50 = 8.63 times The firm turned over its inventory 8.63 times per year.

Liquidity Ratios: 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.

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.

CHECKPOINT 4.1: CHECK YOURSELF Evaluating Dell’s Liquidity Why do you think HP’s inventory turnover ratio is so much lower than Dell’s inventory turnover ratio?

Step 1: Picture the Problem The inventory turnover 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.

Step 2: Decide on a Solution Strategy Step 3: Solve We will use the following equation to compute the Inventory Turnover (IT) ratio IT ratio = Cost of Goods Sold ÷ Inventories Inventory Turnover Ratio for HP = $97,529,000 ÷ 7,490,000 = 13.02

Step 4: Analyze HP’s inventory turnover ratio indicates that the inventory at HP remains on shelf for (365 ÷ 13.02) days or 28.03 days. This is much higher than Dell that has an inventory turnover ratio of 34.37 or shelf life of only 10.61 days. The significant difference must be investigated further as the two firms are in the same industry.

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.

Capital Structure Ratios

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?

Capital Structure Ratios (cont.) Debt ratio measures the proportion of the firm’s assets that are financed by borrowing or debt financing.

Capital Structure Ratios (cont.) What is the debt ratio for H.J. Boswell, Inc. for 2012? Debt Ratio = $1,012.50 million ÷ $1,764 million = 57.40% The firm financed 57.39% of its assets with debt.

Capital Structure Ratios (cont.) Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the interest on debt.

Capital Structure Ratios (cont.) What will be the times interest earned ratio for Boswell for 2012 if we assume interest expense of $65 million and EBIT of $350 million? Times Interest Earned = $350m ÷ $65m = 5.38 times The firm can pay its interest expense 5.38 times or interest used 1/5.38th or 18.58% of its EBIT.

Capital Structure Ratios (cont.)

CHECKPOINT 4.2: CHECK YOURSELF Comparing the Financing Decisions of HD and LOW 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 $1.332 billion? Similarly if Lowes’ net operating income dropped by 80%, what would its times interest earned ratio be?

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.

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 Interest Expense

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

Step 3: Solve TIE (Home Depot) TIE (Lowes) = $1.332 billion ÷ $0.606 billion = 2.20 times TIE (Lowes) = $0.655 billion ÷$0.371 billion = 1.77 times

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. Should creditors be worried by this drop? The ratio is still reasonably safe. For example, for Home Depot, even if the EBIT shrank further by 55.55% (1-1/2.20 ), it can still pay its interest expense.

Asset Management Efficiency Ratios

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.

Asset Management Efficiency Ratios (cont.) Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in firm’s assets.

Asset Management Efficiency Ratios (cont.) What will be the total asset turnover ratio for Boswell, Inc. for 2012 if we assume total sales to be $2,500 million? Total Asset Turnover = $2,500 million ÷ $1,764 million = 1.42 times The firm generated $1.42 in sales per dollar of assets in 2012.

Asset Management Efficiency Ratios (cont.) Fixed asset turnover ratio measures firm’s efficiency in utilizing its fixed assets (such as property, plant and equipment).

Asset Management Efficiency Ratios (cont.) What will be the fixed asset turnover ratio for Boswell for 2012 if we assume sales of $2,500 million for 2012? 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.

Asset Management Efficiency Ratios (cont.) The following grid summarizes the efficiency of Boswell’s management in utilizing its assets to generate sales in 2013.

Profitability Ratios

Profitability Ratios Profitability ratios address a very fundamental question: Has the firm earned adequate returns on its investments?

Profitability Ratios (cont.) Two fundamental determinants of firm’s profitability and returns on investments: Cost Control – How well has the firm controlled its costs relative to each dollar of firm sales? Efficiency of asset utilization – How effective is the firm in using the assets to generate sales?

Cost Control: Is the Firm Earning Reasonable Profit Margins? Gross profit margin shows how well the firm’s management controls its expenses to generate profits.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.) What will be the gross profit margin ratio for 2012 for Boswell if we assume sales of $2,500 million and gross profit of $650 million? Gross Profit Margin = $650 million ÷ $2,500 million = 26% The firm spent $0.74 for cost of goods sold and thus $0.26 out of each dollar of sales went towards gross profits.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (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 also indicates how well the firm is managing its income statement.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.) What will be the operating profit margin ratio for Boswell for 2012 if we assume sales of $2,500 million and net operating income of $350 million? Operating Profit Margin = $350 million ÷ $2,500 million = 14% The firm generates $0.14 in operating profit for each dollar of sales.

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.) Net Profit Margin measures how much income is generated from each dollar of sales after adjusting for all expenses (including income taxes).

Cost Control: Is the Firm Earning Reasonable Profit Margins? (cont.) What will be the net profit margin ratio for 2012 if we assume sales of $2,500 million and net income of $217.75 million? Net Profit Margin = $217.75 million ÷ $2,500 million = 8.71% The firm generated $0.087 for each dollar of sales after all expenses were accounted for.

Return on Invested Capital Operating Return on Assets ratio is the summary measure of operating profitability. It takes into account the management’s success in controlling expenses and its efficient use of assets.

Profitability Ratios (cont.) What will be the operating return on assets ratio for Boswell for 2012 if we assume EBIT or net operating income of $350 million for 2012? 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.

Decomposing the Operating Return on Assets Ratio

Figure 4. 1 Analyzing H. J. Boswell, Inc Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating Return on Assets (OROA)

Figure 4-1 Observations Firm’s OROA (operating return on assets) is better than its peers. Firm’s OPM (operating profit margin) is lower than its peers. Firm’s TATO (total asset turnover ratio) is higher than that of its peers.

Figure 4-1 Recommendations Reduce costs - The firm must investigate the cost of goods sold and operating expenses to see if there are opportunities to reduce costs. Reduce inventories – The firm must investigate if it can reduce the size of its inventories.

CHECKPOINT 4.3: CHECK YOURSELF Evaluating the Operating Return on Assets (OROA) for HD and LOW 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?

Step 1: Picture the Problem The operating return on assets ratio for a firm is determined by two factors: cost control and asset utilization. Here the focus is on asset utilization.

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

Step 3: Solve Operating Return on Assets (OROA) = Total Asset Turnover × Operating Profit Margin Before = 1.74 × 9.46% = 16.46% Now = 2.5 × 9.46% = 23.65%

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.

Is the Firm Providing a Reasonable Return on the Owner’s Investment? Return on Equity (ROE) ratio measures the accounting return on the common stockholders’ investment.

Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.) What will be the ROE ratio for Boswell for 2012 if we assume net income of $217.75 million? ROE = $217.75m ÷ $751.50 mi = 28.98% Thus the shareholders earned 28.97% on their investments.

Using the DuPont Method for Decomposing the ROE ratio DuPont method analyzes the firm’s ROE by decomposing it into three parts. 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.

Using the DuPont Method for Decomposing the ROE ratio (cont.) ROE = Profitability × Efficiency × Equity Multiplier

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.

Using the DuPont Method for Decomposing the ROE ratio (cont.) Figure 4.2

Market Value Ratios

Market Value Ratios Market value ratios address the question, how are the firm’s shares valued in the stock market?

Price-Earnings Ratio Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1 of reported earnings.

Price-Earnings Ratio (cont.) What will be the PE ratio for 2012 for Boswell, Inc. 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?

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.

Market Value Ratios (cont.) Market-to-Book Ratio measures the relationship between the market value and the accumulated investment in the firm’s equity.

Market Value Ratios (cont.) What will be the market-to-book ratio for 2012 for Boswell if the market price of the stock is $22 and the firm has 90 million shares outstanding?

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

CHECKPOINT 4.4: CHECK YOURSELF Comparing the Valuation of DELL to APPL Using Market Value Ratios What price per share for Dell would it take to increase the firm’s price-to-earnings ratio to the level of Apple?

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

Step 2: Decide on a Solution Strategy We need to determine the price per share that will make PE ratio of Dell (4.83) equal to the PE ratio of Apple (13.22). PE ratio = Price per share ÷ Earnings per share ==> 13.22 = ? ÷ 2.01 Price per share = 13.22 × 2.01 = $26.57

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 $9.70 to $26.57.

4.4 Selecting a Performance Benchmark

Selecting a Performance Benchmark There are two types of benchmarks that are commonly used: Trend Analysis – compares a firm’s financial statements over time (time-series comparisons). Peer Group Comparisons – compares the subject firm’s financial statements with “peer” firms.

Trend Analysis Comparing a firm’s recent financial ratios with the past financial ratios provides insight into whether the firm is improving or deteriorating over time. This type of financial analysis is referred to as trend analysis.

Figure 4-3 A Time-Series (Trend) Analysis: Dell’s Inventory Turnover Ratio Versus Hewlett Packard’s: 1995–2011

Peer Firm Comparisons Peer groups often consist of firms from the same industry. Industry average financial ratios can be obtained from a number of financial databases and internet sources (such as yahoo finance and google finance).

Figure 4-4 Financial Analysis of the Gap, Inc., June 2009

4.5 LIMITATIONS OF RATIO ANALYSIS

The Limitations of Ratio Analysis Picking an industry benchmark can sometimes be difficult. Published peer-group or industry averages are not always representative of the firm being analyzed. An industry average is not necessarily a desirable target or norm.

The Limitations of Ratio Analysis (cont.) Accounting practices differ widely among firms. Many firms experience seasonal changes in their operations. Financial ratios offer only clues. The results of financial analysis are no better than the quality of the financial statements.

Key Terms Accounts receivable turnover ratio Acid-test (quick) ratio Average collection period Book value per share Capital structure Current ratio Days’ sales in inventory

Key Terms (cont.) Debt ratio DuPont method Equity Multiplier Earnings per share (EPS) Financial leverage Financial ratios Fixed asset turnover ratio Inventory turnover ratio

Key terms (cont.) Liquidity ratios Market-to-book ratio Market value ratios Notes payable Operating return on assets (OROA) Price-earnings (PE) ratio

Key terms (cont.) Return on assets (ROA) Return on equity (ROE) Times interest earned Total asset turnover ratio (TATO) Trend analysis