1. 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.

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

3. 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.

4. 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)?

5. 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

6. 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

7. 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

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

9. 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?

10. 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?

11. 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

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

13. Note on WA Cost of CapitalRA
WACC
No debt
100% debt

14. ROA (ROIC) Decomposition

15. 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%

16. 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

17. 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
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?

18. 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?

19. 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.

20. 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

21. 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%)

22. Efficiency ratio summary

23. 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)

24. 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.

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

26. 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 ( ).

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

28. 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

29. Footnote (12) on taxes

30. 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).

31. 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.