1st exercise Hints Among the 3 most R&D intensive industries are (alphabetically) Computer communications equipment Computer peripherals Games and Toys (includes specialty games) Wholesalers typically have high inventory, high volume, and low margin.

(conventional ratios) ACCY 291 Financial Statement Analysis Financial Analysis (conventional ratios)

Recap Financial analysis framework i-free debt i-bearing debt & ---------- OE Assets Capital structure Primary goal of the firmMaximize the Value of the IC providers (aka Enterprise value).  Maximize Free Cash Flow in each period. Or, (almost equivalently): Maximize NOPAT, while Minimizing the size of IC. (Operating activities) Further, managing capital structure may bring additional benefits to shareholders.

Value maximization (increase in value) ≠ Size increase (expansion) i-free debt Assets OE $ 1 bil 100 mil shares 1. Value of the OE increased to $2 bil  value $___ per share. 2. Additional equity capital infusion of $1 bil Book value of OE  $_______. Market value of OE  $_______. If you were a shareholder of this firm, did this action increase your net worth (wealth)?

Which of the following should be maximized? Sales Accounts receivable Cost of goods sold Inventory Selling and administrative expense Tax expense Prepaid expenses Accounts payable Deferred revenue Accrued expense payable Bonds payable Owners’ equity

Interest-bearing, interest free debts and Capital structure LIABILITIES CVS WAG Accounts Payable 6,077.3 3,733.3 Notes Payable 2,085.0 878.5 Accrued Expenses 2,556.8 2,104.4 Taxes Payable 0.0 28.1 Debt (Long-Term) Due In One Year 47.2 Other Current Liabilities Total Current Liabilities 10,766.3 6,744.3 Long Term Debt 8,349.7 Deferred Taxes (Balance Sheet) 3,426.1 158.2 Investment Tax Credit Minority Interest Liabilities - Other 857.9 1,306.8 TOTAL LIABILITIES 23,400.0 8,209.3 SHAREHOLDERS' EQUITY Preferred Stock 203.0 Common Stock 15.9 80.1 Capital Surplus 26,831.9 558.5 Retained Earnings (Net Other) 9,891.5 11,971.3 Less: Treasury Stock 5,620.4 1,505.9 TOTAL SHAREHOLDERS' EQUITY 31,321.9 11,104.0 TOTAL LIABILITIES & EQUITY 54,721.9 19,313.3 Book Market

Perspective on conventional ratio analysis Conventional ratio analysis can be considered as an elaboration of NOPAT/ICap. To maximize NOPAT/ICap, you need to Maximize NOPAT (or EBIT) The components Maximize sales (typically measured by ??) Minimize cost of goods/sales Minimize S&A/Sales… etc. Minimize ICap (the components of it) Minimize Cash, AR, INV, PPE, etc. Maximize AP etc.  Typical “efficiency” ratios

Measurement of ROA and ROIC (=RONA) B/S D Assets NOPAT OE  A poor, but widely used, measure of ROA

RONA (ROIC) is a better measure of enterprise profitability than ROA, although ROA is more popular Max i- free debt Min. Assets i-debt OE Sales-Oper. Expenses-tax=NOPAT If $1 bil of i-bearing debt is replaced by $1 bil of i-free debt (is this a good outcome?) what happens to ROA? what happens to ROIC, RONA?

Theoretically, what would you compare ROA, RONA against? Consider buying a rental property for $1 million Annual rental income Year 1 50,000 earned 5% Year 2 70,000 earned 7% Year 3 40,000 earned 4% ….. The benchmark? The theoretical benchmark for ROIC?

i-D $2 bil Assets OE $4 bil Cost of Capital “Cost of Capital” or “Weighted Average Cost of Capital (WACC)?”? Suppose you need to raise $6 billion of capital, of which $2 billion in debt and 4 billion in equity. Cost of debt =6%, Cost of equity=12%, Tax =40% Assets i-D $2 bil OE $4 bil

i-D $2 bil Assets OE $4 bil WA Cost of Capital Without Tax With Tax. OE, i-D, V: Measured in market values

Note on WA Cost of Capital RA WACC No debt 100% debt

ROA (ROIC) Decomposition

Decomposition of ROA, ROIC Why decompose? 2002 NOPAT margin Groceries 2.5% Variety Stores 2.6% Metal Products 3.6% Petroleum Refining 5.3% Electric Utilities 8.7% Pharmaceuticals 16.0% 2002 Turnover Groceries 2.66 Metal Products 1.13 Petroleum Refining 1.16 Electric Utilities 0.39 Pharmaceuticals 0.74 ROA=NOPAT margin x Turnover Groceries 6.6% Metal products 4.2% Petroleum Refining 6.5% Electric Utilities 3.3% Pharmaceuticals 11.9%

Roadmap of conventional ratio discussions Leverage Session 3, 4 ROE E.P.S. Mkt Price of stock ROA ROIC Session 4, 5, 6 Asset Turnover NOPAT Margin AR Days INV Days Gross Margin S&A/ Sales Session 2 AP Days Session 3 PPE Turns

Efficiency/Turnover Ratios Asset side FY2007 CVS WAG Cash & Equivalents 1,084.1 254.8 Receivables - Total (Net) 4,579.6 2,236.5 Inventories - Total 8,008.2 6,790.5 Prepaid Expenses 0.0 Current Assets - Other 477.5 228.7 Current Assets - Total 14,149.4 9,510.5 Plant, Property & Equip (Net) 5,852.8 8,199.9 Investments Intangibles 30314.0 1,060.2 Deferred Charges 4037.9 Assets - Other 367.8 543.0 TOTAL ASSETS 54,721.9 19,313.6 Too big or too small? Relative to what?

Efficiency Ratios Days in AR (receivable) AR/Sales, or AR/daily sales Days in inventory INV/CGS, or INV/daily product sold Days in payable AP/expenses, or AP/daily operating expenses PPE turnover Sales/PPE Ratios are well defined when there is a cause-effect relation, so that denominator drives numerator, or vice versa. Days in… can be converted to Turnovers Strong efficiency ratios typically imply higher/lower Current ratio?

CVS days in AR Days in AR= 4,579/(76,329/365)  22 $209 mil/day sales Sales made Cash collected AR/Sales and Sales/AR are similar ratios.

Be able to assess the significance of efficiency ratio If CVS’s INV days Inventory balance = $ 8,008 Daily products sold (in cost) = CGS= $60,221 mil = $______mil/day

Be able to assess the significance of efficiency ratio If CVS’s INV days, now at 48.5 days, improves to 44.5 days, what is the benefit? CVS CGS= $165 mil/day What happens if it takes $1.0 billion to make it happen? What happens if the firm grows at 6%/year? (Cost of capital=10%)

Efficiency ratio summary

Efficiency/Turnover Ratios Right hand side LIABILITIES CVS WAG Accounts Payable 6,077.3 3,733.3 Notes Payable 2,085.0 878.5 Accrued Expenses 2,556.8 2,104.4 Taxes Payable 0.0 28.1 Debt (Long-Term) Due In One Year 47.2 Other Current Liabilities Total Current Liabilities 10,766.3 6,744.3 Long Term Debt 8,349.7 Deferred Taxes (Balance Sheet) 3,426.1 158.2 Investment Tax Credit Minority Interest Liabilities - Other 857.9 1,306.8 TOTAL LIABILITIES 23,400.0 8,209.3 SHAREHOLDERS' EQUITY Preferred Stock 203.0 Common Stock 15.9 80.1 Capital Surplus 26,831.9 558.5 Retained Earnings (Net Other) 9,891.5 11,971.3 Less: Treasury Stock 5,620.4 1,505.9 TOTAL SHAREHOLDERS' EQUITY 31,321.9 11,104.0 Payables/ (Expenses causing these payables/365)

Working capital (AR, INV, AP) turnover ratios are useful Why useful? Current, not outdated, values. Can be fixed over the short run. Have information values (supply & demand conditions). Have direct implications for financing needs. Operating Cycle, Cash Cycle 2006 US firms average: AR Days = 60 INV Days =50 AP Days = 53 These are merely crude measures that help provide an intuition for the operation.

Examples -- INV turnovers (represented by INV/CGS or INV days)

Turnover (efficiency) characteristics With economies of scale, we expect to see (generally but not always) improvement on Operating margins (e.g., S&A/Sales heading lower) Inventory days improving. Best Buy Example during growth (1996-2000).

Factors/Events affecting the ratios. Efficiency Ratios Factors/Events affecting the ratios. AR days INV days AP Days

Income statements of CVS & Walgreens, FY2007 Fiscal Year Ending CVS WAG Sales (Net) 76,329.5 53,762.0 Cost of Goods Sold 60,221.8 38,518.1 Gross Profit 16,107.7 15,243.9 Selling, General, & Admin Expenses 10,219.8 11,417.3 Operating Income Before Depreciation 5,887.9 3,826.6 Depreciation, Depletion, & Amortization 1,094.6 675.9 Operating Income After Depreciation 4,793.3 3,150.7 Interest Expense 468.3 0.0 Non-Operating Income/Expense 33.7 38.4 Special Items Pretax Income 4,358.7 3,189.1 Income Taxes - Total 1,721.7 1,147.8 Minority Interest Income Before Extraordinary Items & Discontinued Op. 2,637.0 2,041.3 Extraordinary Items Discontinued Operations Net Income (Loss) NOPAT? ______________ using reported tax rate NOPAT? ______________ using “normal” tax rate

Footnote (12) on taxes

Note on taxes Statutory (a.k.a. basic) tax rate Marginal tax rate Effective tax rate Reported tax rate For multiperiod comparisons of financial performance, use one fixed tax rate representative of the “normal” average tax rate, or analyze profit rates on pre-tax basis (e.g., EBIT rather than NOPAT). All else fails, use average reported tax rate (sometimes called effective tax rate).

EBIT and NOPAT Definition for our discussions Financial assets ______ Income i-free debt ?_____ i-bearing debt Operating assets OE ______ Income Assets Some authors define NOPAT as one excluding interest income.