2. Assessing the Business Environment
Meaningful interpretation of financial information requires an understanding of the broader business context
The business
Operations
Environment in which a business operates
Analysts must ask questions about
Customers
Outputs
Inputs
Labor
Technology
Capital
Life Cycle
Competition
Politics

3. common-size financial statements.
Learning Objective 1
Prepare and analyze
common-size financial statements.

4. Also called common-size financial statements
Vertical Analysis
Restates financial statement information in ratio form
Income statement items as a percentage of net sales
Balance sheet items as a percent of total assets
Facilitates comparison
Across companies of different sizes, and
Between accounts within a set of financial statements
Also called common-size financial statements

5. Vertical Analysis of Income Statements
Lowe’s Companies’ common-size income statements for years ending January 30, 2015, and January :
Jan 30,
2015
Jan 31,
2014
$56,223
$53,417
100.00%
36,665
34,941
65.21%
65.41%
19,558
18,476
34.79%
34.59%
Selling, General and Administrative
13,281
12,865
23.62%
24.08%
Depreciation
1,485
1,462
2.64%
2.74%
Total operating expenses
14,766
14,327
26.26%
26.82%
4,792
4,149
8.52%
7.77%
Interest - net
516
476
0.92%
0.89%
Income before tax
4,276
3,673
7.61%
6.88%
Income tax expense
1,578
1,387
2.81%
2.60%
$2,698
$2,286
4.80%
4.28%
Net income
Percentages
Year ending
Total revenue
Cost of sales
Gross profit
Earnings before interest and
$36,665 / $56,223 = 65.21%

6. Vertical Analysis of Balance Sheets
Lowe’s Companies’ common-size balance sheets at January 30, 2015 & January 31, 2014
Each account balance is expressed as a percentage of total assets.

7. [Second year amount – Base year amount]
Horizontal Analysis
Examines changes in data across time
Assists in analyzing company performance and in predicting future performance
Percent Change =
[Second year amount – Base year amount]
Base year amount

8. Horizontal Analysis of Income Statements
Lowe’s Companies’ income statements for years ending January 30, 2015 and January 31, 2014:
Jan 30,
2015
Jan 31,
2014
Percentage
$56,223
$53,417
5.3%
36,665
34,941
4.9%
19,558
18,476
5.9%
Selling General and
Administrative
13,281
12,865
3.2%
Depreciation
1,485
1,462
1.6%
Total Operating Expenses
14,766
14,327
3.1%
4,792
4,149
15.5%
Interest - net
516
476
8.4%
Income Before Tax
4,276
3,673
16.4%
Income Tax Expense
1,578
1,387
13.8%
$2,698
$2,286
18.0%
Year ending
Total Revenue
Cost of Sales
Gross Profit
Earnings Before Interest And Taxes
Net Income
($56,223 - $53,417)
$53,417
Net income is 18% higher in the year ending
January 30, 2015 compared to the prior year.

9. Compute and interpret measures of return on investment, including
Learning Objective 2
Compute and interpret measures of return on investment, including
return on equity (ROE),
return on assets (ROA), and
return on financial leverage (ROFL).

10. Return on Investment Metrics
Ratios that divide some measure of performance (typically income statement measures) by the average amount of investment as reported in the balance sheet
Three important return metrics
Return On
Equity
(ROE)
Return On
Assets
(ROA) =
Return On
Financial
Leverage
(ROFL) +

11. Average stockholders’ equity
Return on Equity (ROE)
Average investment by shareholders is measured by total stockholders’ equity from the balance sheet
Net income is measured by the performance of a firm for a specific period of time
Net income
Average stockholders’ equity
ROE =
ROE is the primary summary measure of company performance

12. Return on Equity (ROE) Example
Lowe’s Companies reported the following amounts in its fiscal 2014 annual report:
Net income for 2014
$ 2,698
million
Total equity, January 30, 2015
9,968
Total equity, January 31, 2014
11,853
Net income Average stockholders’ equity
ROE =
ROE =
$2,698 M [($11,853 M + $9,968 M) ÷ 2]
= 24.73%
Lowe’s generated a profit of about 25 cents for every dollar in its average equity throughout the year.

13. Earnings without interest expense (EWI) Average total assets
Return on Assets (ROA)
Measures the return earned on each dollar the firm invests in assets
Captures the returns generated by the firm’s operating and investing activities, ignoring how those assets are financed
Earnings without interest expense (EWI) Average total assets
ROA =
Net income + [Interest expense × (1 ‒ statutory tax rate)]
(Beginning total assets + Ending total assets) ÷ 2 =
EWI measures the income generated by the firm
before taking into account any of its financing costs.

14. Return on Assets (ROA) Example
Lowe’s Companies reported the following amounts in its 2014 annual report:
Net income
$2,698
million
Interest expense
516
Total assets, January 30, 2015
31,827
Total assets, January 31, 2014
32,732
ROA =
Earnings without interest expense (EWI) Average total assets
ROA =
$2,698 + [$516 x ( )]
[($31,827 + $32,732) ÷ 2
= 9.4%
Lowe’s generated about 9.4 cents of profit for every dollar in its average assets throughout the year.

15. Return on Financial Leverage (ROFL)
Gauges the effect of financial leverage on a firm
Captures the amount of ROE that can be attributed to financial leverage
Financial leverage
The effect that debt financing has on ROE
ROFL = ROE ‒ ROA
Contribution of Financial Leverage
to PepsiCo’s ROE

16. Return on Financial Leverage (ROFL) Example
Lowe’s Companies has the following ROE and ROA amounts for 2014:
ROE, 2014
24.73%
ROA, 2014
9.4%
ROFL = ROE ‒ ROA = 24.73% ‒ 9.4% = 15.33%
Over 60% of Lowe’s ROE is attributable to
financial leverage throughout the current year.
Managers can increase ROE
by using financial leverage effectively.

17. Learning Objective 3
Disaggregate ROA into
profitability (profit margin) and efficiency (asset turnover) components.

18. Components of ROA
Disaggregated into profit margin (PM) and asset turnover (AT)
Earnings without interest expense Average total assets
ROA = =
Earnings without interest Sales revenue
Sales revenue
Average total assets × AT PM
Captures both profitability and efficiency

19. Profit Margin (PM) Captures profitability
Measures profit before interest expense, that is generated from each dollar of sales revenue
Affected by
Level of gross profit
Level of operating expenses required to support sales of products and services
Level of competition and the company’s ability to manage pricing and control costs

20. Asset Turnover (AT)
Reveals insights into a company’s productivity and efficiency
Measures the level of sales generated by each dollar that a company invests in assets
Affected by
Level of sales
Level of assets
Can be improved by
Increasing sales revenue
Decreasing assets

21. PepsiCo’s Profit Margin and Asset Turnover Ratios

22. Profit Margin and Turnover Across Industries

23. Trade-Off Between Profit Margin and Asset Turnover
ROA can be increased by
Targeting higher profit margins
Increasing asset turnover
Results from strategic decisions made by management
Mix of margin and turnover is often dictated by a company’s industry
Managers often further disaggregate profit margin and asset turnover further to get insight into factors driving company performance

24. Disaggregation of Profit Margin (PM) Using Gross Profit Margin (GPM)
Sales revenue – Cost of goods sold Sales revenue
GPM =
Measures the percentage of each sales dollar that is left over after product costs are subtracted.
Lowe’s
2014 GPM
$56,223-$36,665 $56,223
= 34.8% =
Lowe’s has 34.8% of each sales dollar left over after product costs are subtracted.

25. Disaggregation of Profit Margin (PM) Using Expense-to-Sales (ETS)
Expense Sales revenue =
Expense-to-Sales (ETS)
Measures the percentage of each sales dollar that goes to cover a specific expense item
Can be applied to any category of expenses
2014 ETS for Lowe’s SG&A expense
$13,281 $56,223
= % =
Lowe’s spends just under 24% of each sales dollar for selling, general, and administrative costs.

26. Disaggregation of Asset Turnover (AT) Using Accounts Receivable Turnover
ART
Sales revenue Average accounts receivable =
Accounts Receivable Turnover (ART)
Measures how many times receivables have been collected during the period.
Since the majority of Lowes’ sales are credit card transactions, Lowe’s carries a very low balance for receivables.
An analysis of ART is not applicable for Lowe’s and similar companies.

27. Disaggregation of Asset Turnover (AT) Using Inventory Turnover
Inventory Turnover (INVT)
Cost of goods sold Average inventory
Inventory
Turnover (INVT) =
Measures the flow of goods out of inventory relative to the balance that is held in inventory.
2014 INVT
for Lowe’s
$36,665 ($8,911 + $9,127)/2
= 4.07 =
Lowe’s sold 4.07 times its inventory during 2014.

28. Sales revenue Average PP&E Net of accumulated depreciation
Disaggregation of Asset Turnover (AT) Using Property, Plant & Equipment (PP&E) Turnover
PP&E Turnover (PPET)
Sales revenue Average PP&E
PPET =
Net of accumulated depreciation
Provides insights into asset utilization and how efficiently a company operates given its productive technology
Lowe’s generated 2.75 times its average PP&E through sales revenue during 2014.
2014 PPET for Lowe’s
$56,223 ($20,834 + $20,034)/2
= times =

29. ROE Disaggregation
ROE Disaggregation

30. Compute and interpret measures of liquidity and solvency.
Learning Objective 4
Compute and interpret
measures of liquidity
and solvency.

31. Effect of Financing on ROE When ROA is Greater Than the Interest Rate
Company A is financed with 100% equity.
Company B is financed 50% with debt.
Company A
Company B
Assets (average)
$1,000
EWI
$100
ROA (EWI/Assets)
10%
Equity (average)
$500
Debt $0
Interest expense (4% of debt)
$20
Net income (EWI ‒ Interest)
$80
ROE (Net income/equity)
16%
ROFL (ROE- ROA) 0% 6%
Company B made effective use of its financing to improve its ROE.
In the best of times, financial leverage increases ROE.

32. Effect of Financing on ROE When ROA is Less Than the Interest Rate
Company A is financed with 100% equity.
Company B is financed 50% with debt.
Company A
Company B
Assets (average)
$1,000
EWI
$30
ROA (EWI/Assets) 3%
Equity
$500
Debt $0
Interest expense (4% of debt)
$20
Net income (EWI ‒ Interest)
$10
ROE (Net income/equity) 2%
ROFL (ROE- ROA) 0%
-1%
Debt financing caused Company B to decrease its ROE.
Too much debt is risky. It causes interest expense which decreases profit. When earnings are depressed,
financial leverage makes a bad year worse.

33. Other Issues of Using Debt Financing
Operating activities may be restricted by covenants
Covenants are restrictions on operating activities imposed by creditors
Help safeguard debt holders
Debt increases default risk
The risk that company’s may not be able to pay debt as it becomes due
Ability to service the debt may be impaired

34. Median Ratio of Liabilities to Equity for Selected Industries

35. Liquidity and Solvency Analysis
Liquidity Analysis
The analysis of available cash
Solvency Analysis
The ability to generate sufficient cash in the future
Ratios used to assess the degree of liquidity
Current ratio
Quick ratio
Operating cash flow to current liabilities
Ratios used to assess the degree of solvency
Debt-to-equity
Times interest earned

36. Current Ratio
The relative magnitude of current assets and current liabilities
Current Assets
Those assets that the company expects to convert into cash within the next accounting cycle
Current Liabilities
Those liabilities
that come due
within the next year
Current assets
Current liabilities
Current ratio =

37. Working Capital An excess of current assets over current liabilities
Positive working capital implies more expected cash inflows than outflows in the short run
Based on current balance sheet amounts
Ignores cash inflows from future sales
A company can efficiently manage its working capital by minimizing receivables and inventories and maximizing payables, and still be liquid.

38. Cash + Short-term securities + Accounts receivable
Quick Ratio
Similar to the current ratio
Reflects a company’s ability to meet its current liabilities without liquidating inventories that could include markdowns
Excludes inventories and prepaid assets
Cash + Short-term securities + Accounts receivable
Current liabilities
Quick ratio =
Quick assets

39. Operating Cash Flow to Current Liabilities (OCFCL)
Relates the net amount of cash from operating activities to the amount of current payment obligations
A key factor in the ultimate ability of a company to pay its debts
Operating Cash Flow to Current Liabilities =
Cash flow from operations Average current liabilities

40. Liquidity Analysis for Lowe’s
Current ratio =
$10,080M
$9,348M
= 1.78
Quick ratio =
$466M + $125M
$9,348M =
Working capital =
$10,080M – $9,348M = $732M
Operating Cash Flow to Current Liabilities =
= 0.54
$4,929M
($9,348M + $8,876M) ÷ 2
An analysis of Lowe’s at January 30, 2015 shows it will likely be able to pay its current obligations as they come due over the next year, however much of its current assets is tied up in inventory.

41. Solvency Analysis A company’s ability to meet its debt obligations
Including both periodic interest payments and repayment of the principal borrowed
Two measurement approaches
Use balance sheet data to assess the proportion of capital raised from creditors
Use income statement data to assess the profit generated relative to debt payment obligations

42. Debt-to-Equity
Conveys how reliant a company is on creditor financing compared with equity financing
Higher ratios imply less solvency, more risk
Total liabilities
Stockholders’ equity
Debt-to-equity ratio =
Debt-to-equity levels are affected by many factors including the mix of assets used and the stability of business operations, so comparisons to similar companies are very important.

43. Times Interest Earned (TIE)
How much operating profit is available to pay interest
Sometimes abbreviated as EBIT/I
Times interest earned =
Earnings before interest and taxes
Interest expense
Lenders prefer this ratio to be sufficiently high which implies a smaller risk of default.

44. Solvency Analysis Example
Lowe’s key solvency indicators for the year ending January 30, 2015:
Lowe’s debt-to-equity ratio =
$21,859$9,968
= 2.19
Lowe’s debt-to-equity ratio is higher than the retail industry average of 1.10, indicating a little less solvency.
$4,792
$516
= 9.29 times
Lowe’s times interest earned =
Lowe’s high times interest earned should make its creditors comfortable with the operations of the firm.

45. Measure and analyze the effect of operating activities on ROE.
Learning Objective 5
Appendix 5A
Measure and analyze the effect
of operating activities on ROE.

46. and cash flows of the company.
Operating Activities
Operating activities create the most long-lasting, persistent effects on future profitability
and cash flows of the company.
The core transactions and events of a company
Consist of research and development, establishment of supply chains, administrative support, production and marketing of products, follow ups with after-sale customer service
Reported in the income statement

47. Return on Net Operating Assets (RNOA)
Measures the effect of net operating assets on the return generated by the company
Average public company derives most of its ROE from RNOA
Net operating profit after taxes (NOPAT) Average net operating assets
RNOA =
RNOA can be disaggregated into
Net operating profit margin (NOPM), and
Net operating asset turnover (NOAT)

48. Net Operating Profit After Taxes (NOPAT)
Nonoperating activities must be separated from operating activities
Marginal tax rate is used
NOPAT =
Net
income ‒
Marginal
tax rate
1 ‒
Nonoperating revenues
Nonoperating expenses x
Lowe’s NOPAT for year ended January 30, 2015:
$2,698M + [$516M x (1 ‒ 35%)] = $3,033M
Focuses only on the operating performance
rather than the overall performance of the company

49. Net Operating Assets
Defined as operating assets less operating liabilities
Operating assets are those directly linked to operating activities
Includes:
Most current assets except short-term investments
Most long-term assets except long-term investments
Operating liabilities also arise from operations
Most current liabilities except for short-term notes payable, interest payable, and current maturities of long-term debt
Pension and other post-employment liabilities
Deferred income tax liabilities

50. Operating Return (RNOA) Example
The following amounts were determined from Lowe’s Companies 2014 annual report:
Net operating profit after taxes
$3,033
million
Net operating assets, January 30, 2015
20,856
Net operating assets, January 31, 2014
21,524
Net operating profit after taxes (NOPAT) Average net operating assets
RNOA =
$3,033 M
($20,856M+ $21,524M) ÷ 2 =
= 14.3%
Lowe’s generated 14.3% return on its net operating assets.

51. Disaggregation of RNOA: Net Operating Asset Turnover (NOAT)
Sales
Average NOA
NOAT =
NOAT for Lowe’s for year ending January 30, 2015:
$56,223
($21,856M+ $21,524M) ÷ 2
= 2.65
For every dollar of net operating assets, Lowe’s realizes $2.65 in sales. NOAT measures the productivity of the company’s net operating assets.

52. Disaggregation of RNOA: Net Operating Profit Margin (NOPM)
NOPAT
Sales
NOPM =
NOPM for Lowe’s for year ending January 30, 2015:
$3,033M
$56,223M
= %
For every dollar of sales at Lowe’s for its year ending January 30, 2015, the company earns 5.39 cents of profit after all operating expenses and taxes.

53. Disaggregation of RNOA Example
RNOA is the product of NOPM and NOAT.
Lowe’s RNOA for year ending January 30, 2015:
RNOA = NOPM × NOAT
= 5.39% × 2.65
= 14.3%

54. Prepare pro forma financial statements.
Learning Objective 6
Appendix 5B
Prepare pro forma financial statements.

55. Pro Forma Financial Statements
Pro forma statements are hypothetical statements prepared to reflect specific assumptions about the company and its transactions
Seven steps to prepare pro forma statements
Forecast sales revenue
Forecast operating expenses, such as cost of goods sold and SG&A expenses
Forecast operating assets and liabilities
Forecast nonoperating assets, liabilities, contributed capital, revenues, and expenses
Forecast net income, dividends, and retained earnings
Forecast the amount of cash required to balance the balance sheet
Prepare a pro forma cash flow statement based on the pro forma income statement and balance sheet

56. Step 1: Forecast Sales Revenue
Crucial first step
Depended upon by many amounts used in the pro forma income statement and balance sheet
Must assume a revenue growth rate
Starting point may be the historical rate of sales growth
Uses data from horizontal analysis
Forecasted revenues
= Current revenues × (1 + Revenue growth rate)

57. Step 2: Forecast Operating Expenses
Estimates rely on the common-size income statement as a starting point to identify relationship between operating expense items and sales revenue
Historical rates may have to be adjusted up or down based on observed trends or additional information
Forecasted operating expenses
= Forecasted revenues × ETS ratio

58. Step 3: Forecast Operating Assets and Liabilities
Sales forecast can be the basis to estimate operating assets and liabilities
Asset turnover analysis provides the relationship between operating assets and revenues
Forecasted accounts receivable
Reported accounts receivable
Reported sales revenue
= Forecasted sales revenue ×
The same approach can be applied to other operating assets and operating liabilities.

59. Step 4: Forecast Nonoperating Assets, Liabilities, Revenues, and Expenses
Nonoperating revenues such as interest and dividend revenue
Related to investments
Nonoperating expenses such as interest expense
Related to debt financing
Starting point is to assume no change from current amounts
Additional information may appear in notes or MD&A

60. Step 5: Forecast Net income, Dividends, and Retained Earnings
Income tax expense
Sales revenue (Step 1) less operating expenses (Step 2) plus or minus nonoperating revenues and expenses (step 4) equals income before taxes
Effective tax rate
Average tax rate applied to pretax earnings
Calculated as
Reported income tax expense ÷ Reported pretax earnings
Forecasted income tax expense
= Forecasted pretax income × Effective tax rate

61. Beginning retained earnings
Step 5: Forecast Net income, Dividends, and Retained Earnings continued
Forecasted dividends
Relies on the dividend payout ratio
Dividend payments ÷ Net income
Forecasted
dividends =
net income x
Dividend
Payout ratio
Forecasted retained earnings
Relies on forecasts of net income and dividends
Forecasted retained
earnings =
Beginning retained earnings +
Forecasted
net
income ‒
Forecasted dividends

62. Step 6: Forecast Cash
A ‘plug’ amount that makes the balance sheet balance
If negative or unreasonably small or large
Adjust forecast of short-term debt and interest expense to reflect increased borrowing OR
Assume that excess cash is invested in marketable securities and increase the amount of interest income
Any changes may require adjustments of income taxes, net income, dividends and retained earnings

63. Step 7: Prepare the Pro Forma Cash Flow Statement
Based upon the income statement and balance sheet
Must forecast depreciation expense if not part of the operating expenses
Same approach as forecasting other operating expenses

64. Additional Considerations
Pro forma statements are based on assumptions
Decisions made from pro forma statements will be based on assumptions
Sensitivity analysis is useful
Used to examine the effect of alternative assumptions on the pro forma statements
Forecast errors
Differences between the forecasted and the actual amounts
Goal of a good forecast is accuracy, not precision.

65. The End