Course Title: Financial Statement Analysis Course Code: MGT-537 Course Instructor: Dr. Hafiz Muhammad Ishaq Total Lectures: 32

Previous Lecture Summary Analysis of Profitability DuPont Return on Assets, Interpretation through DuPont Analysis, Operating Income Margin, Operating Asset Turnover, Return on Operating Assets, Sales to Fixed Assets Practical Exercises

Analysis of Profitability Today's Lecture Topics Analysis of Profitability Return on Investment, Return on Total Equity, Return on Common Equity, The relationship between profitability ratios, Gross Profit Margin, Trends in Profitability, Segment Reporting, Gains and Losses that Bypass the Income Statement, Interim Reports Practical Exercises

Return on Investment (ROI) The return on investment applied to ratios measuring the income earned on the invested capital. These types of measures are widely used to evaluate enterprise performance. Measures the earnings on investment and indicates how well the firm utilizes its asset base. Evaluates enterprise performance

Return on Investment (ROI) (cont’d) Measures ability to reward investors and to attract providers of future funds Evaluates the earnings performance without regard to financing sources

Return on Total Equity The return on total equity measures the return to both common and preferred stockholders Adjustments for redeemable preferred stock Deduct dividends from net income (numerator) Deduct stock value from total equity (denominator)

Return on Common Equity This ratio measures the return to the common stockholder Common equity: Total stockholders’ equity less preferred capital less minority interest reported as equity

The Relationship Between Profitability Ratios Rate of return on Measures return to providers of Typical result Assets All funds Lowest (includes all assets) Investment Long-term funds Higher than ROA (relative small amount of short-term funds) Total equity Equity Higher than ROI (measures return only to shareholders) Common equity Highest Common shareholders absorb greatest degree of risk Requires that return to preferred shareholders exceed funds paid to preferred shareholders

Gross Profit Margin Sales – Cost of Goods Sold = Gross Profit Beginning Inventory + Purchases of Inventory – Ending Inventory

Why Gross Profit Margin Decline The cost of buying inventory has Increased more rapidly then have the selling price. Selling price decline due to competition The mix of goods has changed to include more products with lower margins. Theft is occurring. If sales are not recorded, the cost of good sold figure in relation to the sales figure is high. If inventory is being stolen, the ending inventory will be low and the cost of goods sold will be high.

Gross profit margin Uses….? Managers budget gross profit levels into their prediction of Profitability. Used to cost control Helpful to determine inventory levels for interim statement in merchandising industry. Used to estimated inventory involved in insured losses. Used by Auditors & Internal Revenue Services to judge the accuracy of accounting system

Segment Reporting Operating segments Firms frequently operate in more than one line of business. When a firm is diversified in this manner, the results of operations of the individual segments may vary among one another. Separate financial information is available Evaluated by the chief decision making officer Geographical information means statement also requires data on foreign operations by geographic area, export sales and major customers. Revenues earned Asset concentration Major customers Products and services

Gains and Losses from Prior Period Adjustments There are a few gains and losses that are not reported on the income statement under GAAP. Like, gains and losses from prior period adjustments, unrealized declines in the market value of investments, and foreign currency translations adjustments. Charged directly to retained earnings Changes in accounting principles Realization of net operating loss carry forward tax benefits from purchased subsidiaries Changes in accounting entity Correction of errors originating in prior periods

Comprehensive Income Items not included in net income Reported as a separate component of stockholders’ equity Foreign currency translation adjustments Unrealized holding gains and losses from available-for-sale marketable securities Changes to stockholders’ equity resulting from additional minimum pension liability adjustments Unrealized gains and losses from derivative instruments

Comprehensive Income (cont’d) Traditional profitability analysis utilizes net income Items of accumulated other comprehensive income are excluded from analysis Consider supplemental analysis including other comprehensive income items for Return on assets Return on investment Return on total equity Return on common equity

Pro Forma Financial Information Non-GAAP-based financial information Release timed to accord with release of GAAP financial results Sarbanes-Oxley Act of 2002 requires Reconciling of pro forma data to GAAP financial condition and results of operations Pro forma data is not misleading or untrue

Interim Reports Unaudited financial reports covering fiscal periods of less than one year Interim reports are an integral part of the annual report Quarterly information is disclosed in the annual report SEC requires quarterly information be filed on Form 10-Q Produced quickly; rely on more estimates

Research and development Other income (expense) Practical Exercise Fluctuation, Inc., recorded the following profit figures in 2008–2010. 2010 2009 2008 Net sales $30,500 $25,600  $22,900  Costs and expenses: Cost of products sold $12,600 $10,300  $8,350  Selling 7,875 5,025  4,580  General 2,950 2,325  2,150  Research and development  4,100  3,190  2,840  $27,525 $20,840  $17,920  Operating income $ 2,975 $ 4,760  $ 4,980  Other income (expense)     525 (300) (400) Earnings before tax $ 3,500 $ 4,460  $ 4,580  Income tax  1,480   1,990   2,100  Net income $ 2,020 $ 2,470  $ 2,480 

Practical Exercise (Cont’d) Required: a. Compute the net profit margin for 2008–2010. b. Compute the gross profit margin for 2008–2010. c. Describe the trend in profitability and pinpoint its causes.

Both net profit margin and gross profit margin have declined in the three years. A major factor has been the rising cost of goods which causes gross profit to fall. Selling expenses, general expenses, research and development expenses have all increased in relation to net sales.

Practical Exercise The Clothes Clutch, a retail clothier, has had average sales of $400,000 for the last five years, 2006–2010. The firm's total assets at the end of 2010 were $400,000, An internal staff cost analyst has prepared the following financial data from the annual reports. You have been hired as a consultant to help analyze the financial position. 2010 2009 2008 2007 2006 Current Ratio 2.80  2.43  2.36  2.10  2.00  Acid Test Ratio 2.03  1.93  1.82  1.61  1.47  Days' Sales in Receivables 61  58  54  42  35  Merchandise Inventory Turnover 4.20  4.10  3.90  3.70  Debt Ratio 0.48  0.50  0.49  0.47  Times Interest Earned 4.60  4.80  5.90  5.70  6.00  Sales as a Percent of 1996 Sales 1.46  1.23  1.12  1.06  1.00  Net Income as a Percent of 1996 Income 1.31  1.20  1.10  Gross Profit Margin 38.5% 38.8% 38.9% 40.0% 39.7% Operating Expenses to Net Sales 11.4% 11.3% 11.5% 11.7% Net Profit Margin 7.6% 8.6% 8.9% 9.4% 9.3% Return on Total Assets 9.6% 10.0% 10.7%

Practical Exercise (Cont’d) Required: Has the firm utilized its total assets effectively? Discuss the ability of the firm to generate sales based on total assets. (Use DuPont analysis.)

Practical Exercise Dexall Company recently had a fire in its store. Management must determine the inventory loss for the insurance company. Since the firm did not have perpetual inventory for the insurance company has suggested that it might accept an estimate using the gross profit test. The beginning inventory, as determined from the last financial statements, was $10,000. Purchase invoice indicate purchases of $100,000. Credit and cash sales during the period were $120,000. Last years, the gross profit for the firm was 40%, which was also the industry average. Required: Based on these data estimate the inventory loss If the industry average gross profit was 50%, why might the insurance company be leery of the estimated loss? If gross profit were higher, the loss would be higher.

Practical Exercise D.H. Muller Company presented the following income statement in its 2004 annual report: (Dollars in thousands expect For the Years Ended Per-share amounts) 2004 2003 2002 Net sales $297,580 $256,360 $242,150 Cost of sales 206,000 176,300 165,970 Gross profit $91,580 $80,060 $ 76,180 Selling, administrative and Other expenses 65,200 57,200 56,000 Operating earnings 26,380 22860 20,180 Interest expense (5,990) (5,100) (4,000) Other deductions, net (320) (1,100) (800) Earnings before income taxes, minority interests, and extraordinary items 20,070 16,660 15,380 Income taxes (8,028) (6,830) (6,229) Net earnings of subsidiaries Applicable to minority interests (700) (670) (668) Earnings before extraordinary items $11,342 $9,160 $8,483

Practical Exercise (Cont’d) Extraordinary Items: Gain on sale of Investment, Net of federal and state Income taxes of $520 Loss due to damages to south ---- 1050 ---- American facilities net of Minority interest of $430 ---- (1,600) ---- Net earnings $11,342 $ 8,610 $ 8,483 Earnings per common share Earnings before extra Ordinary items $2.20 $1.82 $1.65 Extra ordinary items -- (.06) -- Net earnings $2.20 $1.76 $1.65

Practical Exercise (Cont’d) The assets side of the balance sheet is summarized as follows: (Dollars in thousands) Current assets $89,800 $84,500 $83,100 Property, plant, and Equipment 45,850 40,300 39,800 Other assets (including investments Deposits, deferred Charges and intangibles) 10,110 12,200 13,100 Total assets $145,760 $137,000 $136,000

Practical Exercise (Cont’d) Required: Based on these data, compute the following for 2004, 2003 and 2002 Net profit margin 6. Return on operating assets (using Return on assets (using end of year operating assets) total assets) 7. Operating assets turnover (using 3. Total asset turnover (using end of year operating assets) total assets) 8. DuPont analysis wit 4. DuPont analysis operating ratios Operating income margin 9. Gross profit margin b. Discuss your findings.

Net profit margin and total asset turnover both improved Net profit margin and total asset turnover both improved. This resulted in a substantial improvement to return on assets. Operating income margin declined slightly in 2003 after a substantial improvement in 2002. Operating asset turnover improved each year. The result of the improvement in operating income margin and operating asset turnover was a substantial improvement in return on operating assets. Gross profit margin declined slightly each year. Overall profitability improved substantially over the three-year period.

Analysis of Profitability Lecture Summary Analysis of Profitability Return on Investment, Return on Total Equity, Return on Common Equity, The relationship between profitability rations, Gross Profit Margin, Trends in Profitability, Segment Reporting, Gains and Losses that Bypass the Income Statement, Interim Reports Practical Exercise