HOW HEALTHY IS C&C? C&C’s cash balance has fallen dramatically, and George Douglas wonders why. Cedric Renn, a potential employee, wonders if C&C will be around for the long term. Meredith Lincoln wonders if she should increase C&C’s credit limit. Each can use C&C’s financial statements to help answer their question.

WHAT IS FINANCIAL STATEMENT ANALYSIS? Analyzing a firm’s past financial performance Finding out how a firm measures up against other firms in the industry Forecasting future performance

WHY DO FINANCIAL STATEMENT ANALYSIS? Managers Stockholders (current AND potential) Creditors Customers Bankers Employees Analysts

HORIZONTAL ANALYSIS Shows the percentage increase or decrease in a particular line item on the financial statements; may also be expressed in dollars Requires two years’ of information to calculate The earliest year is considered the “base year”

HORIZONTAL ANALYSIS Current Year Amount – Base Year Amount Base Year Amount

HORIZONTAL ANALYSIS: SALES REVENUE 12/31/1012/31/09$ Change% Change Sales revenue$5,237,000$4,654,000$583, % Cost of goods sold 3,876,432 3,464, , % Gross margin1,360,5681,178,560171, % Selling and administrative expenses 1,160,566 1,067,721 92,8458.7% Operating income200,002121,83978, % Interest expense 41,715 43,210 (1,492)(3.5%) Income before taxes158,28778,62979, % Income tax expense 47,486 23,589 23, % Net income$ 110,801$ 55,040$ 55, %

C&C INCOME STATEMENT 12/31/1012/31/09$ Change% Change Sales revenue$5,237,000$4,654,000$583, % Cost of goods sold 3,876,432 3,464, , % Gross margin1,360,5681,178,560171, % Selling and administrative expenses 1,160,566 1,067,721 92,8458.7% Operating income200,002121,83978, % Interest expense 41,715 43,210 (1,492)(3.5%) Income before taxes158,28778,62979, % Income tax expense 47,486 23,589 23, % Net income$ 110,801$ 55,040$ 55, % Why don’t we add the % change column?

HORIZONTAL ANALYSIS ALLOWS US TO… Identify trends and changes in account balances over time Predict account balances based on the identified trend

TREND ANALYSIS Shows account balances as a percentage of the base year Can see how account balances are changing over time

TREND ANALYSIS CALCULATION FOR REVENUE 12/31/1012/31/09$ Change% Change Sales revenue$5,237,000$4,654,000$583, % Cost of goods sold 3,876,432 3,464, , % Gross margin1,360,5681,178,560171, % Selling and administrative expenses 1,160,566 1,067,721 92, % Operating income200,002121,83978, % Interest expense 41,715 43,210 (1,492)(13.5%) Income before taxes158,28778,62979, % Income tax expense 47,486 23,589 23, % Net income$ 110,801$ 55,040$ 55, %

COMMON-SIZE STATEMENTS Every line item on the financial statement is presented as a percentage of a major statement component Total assets for the balance sheet Net sales for the income statement Also known as vertical analysis

COMMON-SIZE BALANCE SHEET Account Balance Total Assets

COMMON SIZE BALANCE SHEET 12/31/1012/31/09 $%$% Cash$ 7, %$ 22, % Accounts receivable, net623, %583, % Total inventory640, %547, % Prepaid expenses 24, % 8, % Total current assets1,296, %1,160, % Property, plant & equipment532, %600, % Other assets 41, % 35, % Total assets$1,870, %$1,797, %

12/31/10 Cash0.42% Accounts receivable, net33.34% Total inventory34.23% Prepaid expenses1.30% Total current assets69.29% Property, plant & equipment28.48% Other assets2.23% Total assets100.00% COMMON-SIZE BALANCE SHEET 12/31/10 Accounts payable23.60% Other accrued expenses4.64% Short-term debt6.68% Current maturities of LTD1.07% Total current liabilities35.99% Long-term debt14.97% Total liabilities50.96% Common stock11.23% Retained earnings37.81% Total stockholders’ equity49.04% Total liabilities & equity100.00% Notice that the Total Assets and Total Liabilities & Stockholders’ Equity lines must total to 100%

12/31/10 Cash0.42% Accounts receivable, net33.34% Total inventory34.23% Prepaid expenses1.30% Total current assets69.29% Property, plant & equipment28.48% Other assets2.23% Total assets100.00% 12/31/10 Accounts payable23.60% Other accrued expenses4.64% Short-term debt6.68% Current maturities of LTD1.07% Total current liabilities35.99% Long-term debt14.97% Total liabilities50.96% Common stock11.23% Retained earnings37.81% Total stockholders’ equity49.04% Total liabilities & equity100.00% WHAT DOES THIS MEAN? 33.34% of C&C’s assets are in the form of accounts receivable % of C&C’s capitalization is provided by short-term creditors.

COMMON SIZE INCOME STATEMENT Account Balance Net Sales

COMMON SIZE INCOME STATEMENT 12/31/1012/31/09 Sales revenue$5,237, %$4,654, % Cost of goods sold 3,876, % 3,464, % Gross margin1,360, %1,178, % Selling and administrative expenses 1,160, % 1,067, % Operating income200, %121, % Interest expense 41, % 43, % Income before taxes158, %78, % Income tax expense 47, % 23, % Net income$ 110, %$ 55, %

COMMON SIZE INCOME STATEMENT 12/31/1012/31/09 Sales revenue100.00% Cost of goods sold 74.02% 74.44% Gross margin25.98%25.56% Selling and administrative expenses 22.16% 22.94% Operating income3.82%2.62% Interest expense 0.80% 0.93% Income before taxes3.02%1.69% Income tax expense 0.91% 0.51% Net income 2.11% 1.18% Notice that we start with Net Sales at 100%. If there had been Gross Sales and then Sales Returns, Gross Sales would be greater than 100.

WHAT DOES THIS MEAN? 12/31/1012/31/09 Sales revenue100.00% Cost of goods sold 74.02% 74.44% Gross margin25.98%25.56% Selling and administrative expenses 22.16% 22.94% Operating income3.82%2.62% Interest expense 0.80% 0.93% Income before taxes3.02%1.69% Income tax expense 0.91% 0.51% Net income 2.11% 1.18% This means that for every $1.00 collected in sales revenue, 74.44¢ goes to make C&C’s goods for sale.

COMMON SIZE STATEMENTS ALLOW US TO… Look at changes in the makeup of the base component Has COGS as a percentage of net sales increased this year? Compare companies of different absolute sizes Qualcomm vs. Ericsson Compare a firm to industry averages

RATIO ANALYSIS A comparison of the relationship between two or more financial statement items Reveals symptoms of underlying strengths and weaknesses Four major categories Liquidity ratios Leverage ratios Profitability ratios Market measure ratios

RATIO ANALYSIS ALLOWS US TO… Compare a company with industry averages or norms (cross-sectional analysis) Examine changes in a company’s ratios over time (longitudinal analysis) Focus further investigations into a company’s performance (reveals symptoms, not answers)

LIQUIDITY RATIOS What is liquidity? Ability to convert assets into cash within a year or the length of the business cycle Why is it important? Need to pay bills on time Need to take advantage of opportunities

WORKING CAPITAL CALCULATION Total Current Assets – Total Current Liabilities Current Assets12/31/10 Cash$ 7,752 Accounts receivable, net623,713 Total inventory640,372 Prepaid expenses24,388 Total current assets$1,296,225 Current Liabilities12/31/10 Accounts payable$441,602 Other accrued expenses86,749 Short-term debt125,000 Current maturities of LTD20,000 Total current liabilities$673,351 $1,296,225 – $673,351 = $622,874

CURRENT RATIO CALCULATION Total Current Assets Total Current Liabilities Current Assets12/31/10 Cash$ 7,752 Accounts receivable, net623,713 Total inventory640,372 Prepaid expenses24,388 Total current assets$1,296,225 Current Liabilities12/31/10 Accounts payable$441,602 Other accrued expenses86,749 Short-term debt125,000 Current maturities of LTD20,000 Total current liabilities$673,351 $1,296,225 $673,351 = 1.93

CURRENT RATIO – WHAT DOES IT MEAN? Literally, that C&C has 1.93 times more current assets than current liabilities Measures the buffer to cover shrinkage in asset value in the event of forced liquidation Measures ability to absorb random business shocks and uncertain cash flows Rule of thumb 2:1, but don’t let it get too high; very industry-sensitive

ACID-TEST RATIO CALCULATION Cash + Cash Equivalents + A/R Total Current Liabilities Current Assets12/31/10 Cash$ 7,752 Accounts receivable, net623,713 Total inventory640,372 Prepaid expenses24,388 Total current assets$1,296,225 Current Liabilities12/31/10 Accounts payable$441,602 Other accrued expenses86,749 Short-term debt125,000 Current maturities of LTD20,000 Total current liabilities$673,351 = 0.94 $7,752 + $623,713 $673,351

ACID-TEST RATIO – WHAT DOES IT MEAN? Literally, C&C has 0.94 times “highly liquid” current assets as current liabilities More stringent test than current ratio since it uses only the most liquid current assets Rule of thumb is 1:1

CURRENT AND ACID-TEST RATIO LIMITATIONS Static measures of liquidity Not useful for predictions of cash flows No insight into quality of the assets No insight into timing of cash conversion

ACTIVITY RATIOS What are they used for? To measure how well a company is managing (using) its assets Provides some insight into the quality of the assets underlying the liquidity ratios Two areas we’ll study Accounts Receivable Inventory

A/R TURNOVER CALCULATION Net Credit Sales Average A/R Current Assets12/31/1012/31/09 Cash$ 7,752$22,114 Accounts receivable, net623,713583,429 Total inventory640,372547,109 Prepaid expenses24,388 8,164 Total current assets$1,296,225$1,797,275 Income Statement12/31/10 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 $5,237,000 ($623,713 + $583,429) / 2 = 8.68 times

WHAT DOES IT MEAN? A/R Turnover Measures how many times receivables are generated and collected within a year Higher turnover means faster collection of cash

AVERAGE COLLECTION PERIOD 365 Days A/R Turnover 365 days 8.68 times = 42 days

INVENTORY TURNOVER CALCULATION Cost of Goods Sold Average Inventory Current Assets12/31/1012/31/09 Cash$ 7,752$22,114 Accounts receivable, net623,713583,429 Total inventory640,372547,109 Prepaid expenses24,388 8,164 Total current assets$1,296,225$1,160,816 Income Statement12/31/10 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 $3,876,432 ($640,372 + $547,109) / 2 = 6.53 times

WHAT DOES IT MEAN? Inventory Turnover Measures how many times inventory is sold within a year Higher turnover means faster sale of inventory and less likely to have obsolete items, but too high may indicate stock-out problems

AVERAGE DAYS TO SELL INVENTORY CALCULATION 365 Days Inventory Turnover 365 days 6.53 times = 55.9 days

DO YOU UNDERSTAND INVENTORY TURNOVER? Who would you expect to have the highest inventory turnover? Why? Ice cream manufacturer Airplane manufacturer ©Thomas Perkins/iStockphoto ©Andrew Johnson/iStockphoto

LEVERAGE RATIOS Longer time-frame of concern than short-term creditors Interested in short-term position for payment of interest Interested in long-term position for repayment of loan balance

DEBT RATIO CALCULATION Total Liabilities Total Assets Assets12/31/10 Total current assets$1,296,225 Property, plant & equipment, net532,858 Other assets 41,704 Total assets$1,870,787 Liabilities12/31/10 Total current liabilities$673,351 Long-term debt 280,000 Total liabilities$953,351 $1,870,787 = 50.9%

DEBT-TO-EQUITY RATIO CALCULATION Total Liabilities Total Stockholders’ Equity Liabilities12/31/10 Total current liabilities$673,351 Long-term debt 280,000 Total liabilities 953,351 Common stock210,000 Retained earnings 707,436 Total stockholders’ equity 917,436 Total liabilities & stockholders’ equity$1,807,787 $953,351 $917,436 = 1.04

WHAT DOES IT MEAN? Debt-to-Equity Ratio At C&C there is $1.04 in debt for every $1 of stockholder’s equity. Put another way, about 50% of the asset base is financed through debt, or borrowed money, while 50% is financed by stockholders’ capital The higher the ratio, the greater the risk assumed by the creditors

THE TIMES-INTEREST-EARNED CALCULATION Earnings before Interest and Taxes Interest Expense Income Statement12/31/10 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 Selling and administrative expenses 1,160,566 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 $200,002 $41,715 = 4.79 times

PROFITABILITY RATIOS Focuses on returns to the stockholder

GROSS MARGIN CALCULATION Gross Margin Net Sales Income Statement12/31/10 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 Selling and administrative expenses 1,160,566 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 $1,360,568 $5,237,000 = 25.98%

RETURN ON ASSETS CALCULATION NI + [ Interest Expense × (1 – tax rate) ] Average Total Assets Income Statement12/31/10 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 Balance Sheet12/31/1012/31/09 Total assets$1,870,787$1,797,275 $110,801 + [ 41,715× (1 – ) ] ($1,870,787 + $1,797,275) / 2 =7.63%

RETURN ON COMMON STOCKHOLDER’S EQUITY CALCULATION NI – Preferred Dividends Average Common Stockholders’ Equity Income Statement12/31/10 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 Balance Sheet12/31/1012/31/09 Common stock210,000 Retained earnings 707, ,635 Total common equity$917,436$806,635 $110,801 - $0 ($917,436 + $806,635) / 2 = 12.85%

MARKET MEASURE RATIOS Only calculated for publicly traded stocks

EARNINGS PER SHARE CALCULATION NI – Preferred Dividends Average Number of Shares Outstanding

PRICE/EARNINGS RATIO CALCULATION Market Price per Share Earnings per Share $66.07 $3.07 = times (Closing market price, 12/31/09)

DIVIDEND PAYOUT RATIO CALCULATION Dividends per Share Earnings per Share $0.98 $3.07 = 32%

SOME THINGS TO REMEMBER… Ratios are a snapshot The firm’s choice of accounting principles influences reported income Read the footnotes to find unusual items Contingent liabilities could influence future earnings Discontinued operations or extraordinary items may influence future performance

INDUSTRY CLASSIFICATION Standard Industrial Classification (SIC) code 2329 for C&C North American Industrial Classification System (NAICS) code for C&C

SOURCES OF INDUSTRY DATA Published Industry Analyses Government Statistics Industry trade groups

GOVERNMENT DATA EXAMPLE Value of U.S. Men’s and Boys’ Team Sports Uniform Shipments Sources: U.S. Census Bureau, Annual Survey of Manufactures Value of Product Shipments: 2001, 2004, 2006

TRADE ASSOCIATION DATA EXAMPLE Sources: SMGA, Sports Participation Topline Report: 2006 Edition; 2007 Sports and Fitness Participation Report; 2008 Sports and Fitness Participation Report; 2009 Sports and Fitness Participation Report U.S. Participants in Team Baseball, 6 Years of Age or Older, at Least Once per Year