Financial Statement Analysis / Entrepreneurial Finance

Financial Analysis Overview An assessment of a company’s past, present and future financial condition Purpose is to diagnose company’s financial strengths and weaknesses Primary tools Financial Statements Ratios

Financial Statements

Main Financial Statements Balance Sheet Income Statement Statement of Cash Flows

The Balance Sheet The balance sheet shows a firm’s assets (what it owns) and liabilities (what it owes) The difference between a firm’s assets and liabilities is the firm’s net worth A snapshot in time

Liabilities and Equity Balance Sheet Items Assets Current assets: Cash & securities Accounts Receivable Inventories Fixed assets: Tangible assets like PPE Intangible assets Liabilities and Equity Current liabilities: Accounts payable Short-term debt Long-term liabilities Shareholders' equity

Anheuser-Busch Example December 30, 2006 (from annual report)

Income Statement The income statement summarizes revenues and expenses for the business Covers an interval of time (monthly, quarterly, annually) Major components: Revenues Expenses Taxes Extraordinary Items

Income Statement Format Sales revenue - Cost of goods sold = Gross profit margin - Operating expenses = EBITDA - Depreciation & Amortization = EBIT (Operating income) - Interest payments = Taxable income - Taxes = Net Income

Anheuser-Busch Example

Accounting vs. Economic Earnings Accounting definition of earnings ignores unrealized changes in market value of assets and liabilities Accounting profit does not recognize cost of equity capital Accounting profit may not contain all relevant costs e.g., opportunity cost of entrepreneur’s time

Cash Flow Statement Summarizes the levels of cash being generated or consumed by the business Covers an interval of time (monthly, quarterly, annually)

Cash Flow Statement Format Cash flow from operations Net income + Depreciation - Increase in accounts receivable - Increase in inventories + Increase in accounts payable Total cash flow from operations Cash flow from investing activities - Investment in plant and equipment Cash flow from financing activities - Dividends paid + Increase in short-term debt = Change in cash

Anheuser-Busch Example

Statement Connections Excel example

Ratio Analysis

Why do ratio analysis? A means of evaluating and diagnosing performance Ratios standardize numbers and facilitate comparisons Comparing performance to competitors or industry standards (horizontal comparison) Comparing performance to prior history (vertical comparison) Examine a variety of areas Liquidity Solvency Efficiency Profitability Remember that ratios are meaningless unless you have something to compare

Major Ratio Categories Liquidity ability to cover short-term obligations Solvency ability to cover long-term obligations; examines mix of debt and equity Efficiency amount of activity generated by resources deployed Profitability amount of profit generated by resources deployed Market value (if applicable) some of these ratios (e.g. price-earnings ratio, market-to-book ratio) are useful in valuation analysis, such as valuing private firms

Liquidity Ratios Current Ratio Quick Ratio The ratio between all current assets and all current liabilities. Formula:    Current Assets Current Liabilities Quick Ratio The ratio between all assets quickly convertible into cash (this excludes inventory) and all current liabilities. Cash + Accounts Receivable + Short-Term Investments        Current Liabilities Current Ratio Comments: One problem with the current ratio is that it ignores timing of cash received and paid out. For example, if payments are this week, and inventory is the only current asset (and it won't be sold until the end of the month), the current ratio tells very little about a company's ability to survive. If the ratio is less than one, the company has negative working capital. A high working capital ratio isn't always a good thing; it could indicate that the company has too much inventory or are not investing excess cash. Quick Ratio Indicates the extent to which current liabilities could be paid without relying on the sale of inventory Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments.

Anheuser-Busch Example Current Ratio: 1829.5 / 2246.1 = 0.81 December 30, 2006 (from annual report) Quick Ratio: (219.2 + 720.1 + 195.2) / 2246.1 = 0.51

Solvency Ratios Debt to Equity Interest coverage ratio Shows the ratio between capital invested by the owners and the funds provided by lenders. Formula: Total Liabilities   Total Equity Interest coverage ratio A measurement of the number of times a company could make its interest payments with its earnings before interest and taxes; the lower the ratio, the higher the company’s debt burden. Pretax Operating Income + Interest Expense Interest Expense Debt to Equity Comments: Comparison of how much of the business was financed through debt and how much was financed through equity. A ratio greater than one means assets are mainly financed with debt; less than one means equity provides a majority of the financing. If the ratio is high (financed more with debt) then the company is in a risky position - especially if interest rates are on the rise. Too much debt can put a business at risk... but too little debt may mean the business is not realizing its full potential. This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate). Interest Coverage Ratio Also called “Times Interest Earned” An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.

Anheuser-Busch Example Debt to Equity: (2246.1 + 1191.5 + 7653.5 + 1194.5 + 152.9) / 3938.7 = 3.16

Anheuser-Busch Example Interest Coverage Ratio: (2719.6) / 451.3 = 6.03

Profitability Gross Profit Margin Indicator of how much profit is earned on products without consideration of selling and administration costs. Formula: Sales - COGS Sales Net Profit Margin / Return on Sales (ROS) Shows how much profit comes from every dollar of sales. Net Income  Sales Gross Profit Comments: Compare to other businesses in the same industry to see if the business is operating as profitably as it should be. Look at the trend from month to month. Is it staying the same? Improving? Deteriorating? The results may be skewed if the company has a very large range of products. ROS Trend from month to month can show how well operating or overhead costs are being managed.

Anheuser-Busch Example Gross Profit Margin: 5552.1 / 15717.1 = 35.3% Net Profit Margin: 1965.2 / 15717.1 = 12.5%

Profitability Return on Equity (ROE) Return on Assets (ROA) Determines the rate of return on the investment in the business. Formula: Net Income Equity Return on Assets (ROA) Considered a measure of how effectively assets are used to generate a return.   Net Income     Total Assets Return on Invested Capital (ROIC)    Net Income      Total Liabilities + Stockholder’s Equity – Current Liabilities ROE Comments: Very common measure of profitability Has a number of drawbacks Timing – uses historical, not forward-looking, information Value – uses book values, which are often not representative of true value Risk – ignores risk as a consideration Compare the return on equity to other investment alternatives. Compare ratio to other businesses in the same or similar industry. ROA ROA shows the amount of income for every dollar tied up in assets (from owners and lenders). Year to year trends may be an indicator ... but watch out for changes in the total asset figure as you depreciate your assets (a decrease or increase in the denominator can affect the ratio and doesn't necessarily mean the business is improving or declining). ROIC Avoids the distortion of leverage contained in ROE.

Anheuser-Busch Example Return on Equity: 1965.2 / 3938.7 = 49.9% Info from income statement and balance sheet Return on Assets: 1965.2 / 16377.2 = 12.0% Info from income statement and balance sheet Return on Invested Capital: 1965.2 / (12438.5 + 3938.7 – 2246.1) = 13.9% Info from income statement and balance sheet

Efficiency Days in Receivables Accounts Receivable Turnover This calculation shows the average number of days it takes to collect accounts receivable (number of days of sales in receivables). Formula: Accounts Receivable       Sales  /  365 days Compare to industry standards. Accounts Receivable Turnover Number of times that trade receivables turnover during the year.   Net Sales            Accounts Receivable Days in Receivables Comments: Can use average AR for increased precision A high ratio indicates that the company is having problems getting paid for services or products. The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season. Look for trends that indicate a change in customers' payment habits. Compare the calculated days in receivables to stated terms. AR Turnover The higher the turnover, the shorter the time between sales and collecting cash. Compare to industry standards.

Efficiency Days in Inventory Inventory Turnover This calculation shows the average number of days it will take to sell inventory Formula: Average Inventory Cost of Goods Sold / 365 days Inventory Turnover Number of times that inventory is turned over (sold) during the year. Cost of Goods Sold Average Inventory Days in Inventory Comments: This is mathematically the same formula as in HBR article (just looks a bit different) Look for trends that indicate a change in inventory levels. Compare to industry standards. Inventory Turnover Generally, a high inventory turnover is an indicator of good inventory management. But a high ratio can also mean there is a shortage of inventory. A low turnover may indicate overstocking or obsolete inventory.

Efficiency Asset Turnover Days in Accounts Payable Indicates how efficiently business generates sales on each dollar of assets. Formula:      Sales         Total Assets Days in Accounts Payable This calculation shows the average length of time trade payables are outstanding before they are paid. Accounts Payable    COGS     /   365 days Accounts Payable Turnover The number of times trade payables turnover during the year.        COGS             Accounts Payable Asset Turnover Comments: Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover - it indicates pricing strategy. This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales. A volume indicator that can be used to measure efficiency of business from year to year. Days in Accounts Payable Compare the calculated days in payables to the terms offered by suppliers. Compare to industry standards. Accounts Payable Turnover The higher the turnover, the shorter the time between purchase and payment. A low turnover may indicate that there is a shortage of cash to pay bills or some other reason for a delay in payment.

Anheuser-Busch Example Assigned Efficiency Ratios Some Additional Efficiency Ratios Days in Receivables: 720.20 / (15,717.1/365) = 16.73 AR Turnover: 15,717.1 / 720.20 = 21.8 Days in Inventory: (694.9 + 654.5)/2 / (10,165.0/365) = 24.23 Days in Accounts Payable: 1,426.3 / (10165.0/365) = 51.21 Accounts Payable Turnover: 10165.0 / 1,426.3 = 7.13 Inventory Turnover: 10,165.0 / (694.9 + 654.5)/2 = 15.07 Asset Turnover: 15,717.1 / 16377.2 = 0.96

The DuPont Equation ROE = (Net Income/Sales) x (Sales/Total Assets) x (Total Assets/Equity = profit margin x asset turnover x leverage multiplier DuPont equation shows how three different areas combine to determine ROE expense management (measured by the profit margin) asset management (measured by asset turnover) debt management (represented by the debt ratio or leverage multiplier)

Using Ratio Analysis to Better Understand Profitability

Seemingly Similar Companies Brinker International, Inc. NYSE: EAT Darden Restaurants, Inc. NYSE: DRI Outback Steakhouses, Inc. NASDAQ: OSI

Seemingly Similar Performance Profitability Performance (Most Recent Year) Net Margin 4.63% 5.04% 6.50% Return on Equity 15.40% 16.70% 17.40% Source: Hoover’s Online

Potential Paths to Performance High Margins High Efficiency High Leverage

Beginning the Investigation Use company’s financial statements Income Statement and Balance Sheet Examine and compare common ratios Across time Across companies Use three year period (2000 – 2002)

Margin Performance

Cost Efficiency Higher = better Lower = better

Leverage Higher = more levered Lower = more levered

Summary Company A High margins Less efficient Low leverage Company B Moderate margins Moderate efficiency High leverage Company C Low margins High efficiency Moderate leverage They run very similar businesses and deliver similar results, but the paths are very different.

Questions to Consider Company A Company B Company C What value does it deliver to justify its higher margins? Are the margins sustainable? Company B Is a middle of the road strategy with higher leverage a good one? Company C What is the source of its operating efficiencies? Are the efficiencies sustainable?

Who is Who? A few additional clues 2002 sales ($millions) B: 4,369 C: 2,887 Sales growth (2002 – 2003) A: 14.4% B: 6.4% C: 13.5% A: Outback B: Darden C: Brinker

Using Financial in New Ventures

How to use financial ratios in new ventures? Remember, financial statements are pro-forma (expectations about what financial position will be) Could use average industry ratios as a starting point for generating pro-forma statements Pro-forma statements should reflect the underlying strategy of the firm

Adjusting ratios according to your strategy Key restaurant ratios Low Cost Strategy Differentiation strategy Inventory turnover (Wages & benefits) / sales Liquidity Gross profit margin Operating costs / sales

Limitations of Ratios They are outcome measures; if you have a problem with a ratio, you still have to figure out what’s causing the problem Choosing the right comparison data is sometimes difficult What’s the right industry? Published industry averages are just rough guidelines Who are the competitors? Accounting practices can differ across firms Seasonality may affect ratios We have only discussed ratios generated from financial statements These are based on historical data; we would like something that helps predict future performance Operational / marketing measures may be more critical Recall the Balanced Scorecard

Other Values to Consider SG&A to Sales Is company controlling overhead expenses? Direct labor utilization Often critical in professional services companies Customer acquisition cost Compare to lifetime value of a customer Others (company-specific) Create a Balanced Scorecard

The Balanced Scorecard Kaplan and Norton (1992)

What is it? A set of measures that gives top management a “fast but comprehensive view of the business” Brings together, in one management report, disparate elements of company’s competitive agenda (customer measures, internal measures, financial measures, etc.) Authors use analogy of dials and instruments in an airplane cockpit

Why do it? No single measure is adequate It’s important to examine the means used to achieve financial outcomes Many operational measures translate into future financial results Traditional measures might give misleading signals regarding continuous improvement and innovation (focus on short-term results)

The Four Perspectives Customer Perspective: How do customers see us? Internal Business Perspective: What must we excel at? Innovation and Learning Perspective: Can we continue to improve and create value? Financial Perspective: How do we look to shareholders?

The Balanced Scorecard Note that the objectives, measures, and targets will obviously vary from company to company.

Next Time Zipcar case on Monday This requires some financial thinking / analysis Think about what key measures / ratios should be for the business