Why Do We
Analyze Financial Statements?
A
firm’s financial statements can be analyzed internally (by employees, managers)
and externally (by bankers, investors, customers, and other interested
parties).
An
internal financial analysis might be done:
–
To
evaluate the performance of employees and determine their pay raises and
bonuses.
–
To
compare the financial performance of the firm’s different divisions.
–
To
prepare financial projections, such as those associated with the launch of a
new product.
–
To
evaluate the firm’s financial performance in light of its competitors and
determine how the firm might improve its operations.
A
variety of firms and individuals that have an economic interest might also
undertake an external financial analysis:
–
Banks and other lenders deciding whether to loan money to the firm.
–
Suppliers
who are considering whether to grant credit to the firm.
–
Credit-rating agencies trying to determine the firm’s creditworthiness.
Professional analysts who work for investment companies considering investing in the firm or
advising others about investing.
Individual investors deciding whether to invest in the firm.Common Size Statements – Standardizing Financial Information
A common size financial statement is a standardized version of a financial
statement in which all entries are presented in percentages.
A
common size financial statement helps to compare entries in a firm’s financial
statements, even if the firms are not of equal size.
How
to prepare a common size financial statement?
–
For
a common size income statement, divide each entry in the income statement by
the company’s sales.
–
For
a common size balance sheet, divide each entry in the balance sheet by the
firm’s total assets.
Using Financial Ratios
Financial ratios provide another method for standardizing the financial information on
the income statement and balance sheet.
A
ratio by itself may have no meaning.
Hence, a given ratio is compared to: (a) ratios from previous years; or
(b) ratios of other firms in the same industry.
If
the differences in the ratios are significant, more in-depth analysis must be
done.
Liquidity Ratios
Liquidity
ratios address a basic question: How liquid is the firm?
A
firm is financially liquid if it is able to pay its bills on time. We can
analyze a firm’s liquidity from two perspectives:
–
Overall
or general firm liquidity
–
Liquidity
of specific current asset accounts
Overall liquidity is analyzed by comparing the firm’s current assets to the firm’s current
liabilities.
Liquidity of specific assets is analyzed by examining the timeliness in
which the firm’s primary liquid assets – accounts receivable and inventories –
are converted into cash.
The
overall liquidity of a firm is analyzed by computing the current ratio and
acid-test ratio.Liquidity Ratios: Current Ratio
Current Ratio:
Current Ratio compares a firm’s current (liquid) assets to its current
(short-term) liabilities.
Example:
Current ratio for H.J. Boswell,
Inc. for 2009 = $477 ÷ 292.5
= 1.63 times
Current ratio for H.J. Boswell,
Inc. for 2010 = 2.23 times
The
firm had $1.63 in current assets for every $1 it owed in current liability. The
current ratio improved in 2010 to 2.23 times as the current assets
increased significantly in 2010. Liquidity Ratios: Quick Ratio
The
overall liquidity of a firm is also analyzed by computing the Acid-Test
(Quick) Ratio. This ratio excludes the inventory from current assets as
inventory may not always be very liquid.
Example:
Quick ratio for H.J. Boswell,
Inc. for 2009
= ($477-$229.50) ÷ ($292.50) =
0.85 times
Quick ratio for H.J. Boswell,
Inc. for 2010 = 0.92 times
The
firm is clearly less liquid using quick ratio as the firm has only $0.85 in
current assets (less inventory) to cover $1 in current liabilities. The quick
ratio improved in 2010 to 0.92 times largely due to an increase in
current assets. Liquidity Ratios: Accounts Receivable
Average Collection Period measures the number of days it takes the firm to collect its
receivables.
Example:
What will be the average
collection period for H.J. Boswell, Inc. for 2009 if we assume that the annual
credit sales were $2,500 million in 2009?
Daily Credit Sales = $2,500
million ÷ 365 days = $6.85 million
Average Collection Period =
Accounts Receivable ÷ Daily Credit Sales
= $139.5m ÷ $6.85m = 20.37 days
The firm collects its accounts
receivable in 20.37 days.
Liquidity
Ratios: Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio measures how many times accounts receivable are
“rolled over” during a year.
Example:
What will be the accounts
receivable turnover ratio for H.J. Boswell, Inc. for 2009 if we assume that the
annual credit sales were $2,500 million in 2009?
Accounts Receivable Turnover =
$2,500 million ÷ $139.50
= 17.92 times
The firm’s accounts receivable
were turning over at 17.92 times per year.
Liquidity Ratios: Inventory Turnover Ratio and Days’ Sales in Inventory
Inventory turnover ratio measures how many times the company turns over its inventory during the
year. Shorter inventory cycles lead to greater liquidity since the items in
inventory are converted to cash more quickly.
Example:
What will be the inventory
turnover ratio for H.J. Boswell, Inc. for 2009 if we assume that the cost of
goods sold were $1,980 million in 2009?
Inventory Turnover Ratio =
$1,980 ÷ $229.50 = 8.63 times
The firm turned over its
inventory 8.63 times per year.
We
can express the inventory turnover ratio in terms of the number of days the
inventory sits unsold on the firm’s shelves.
Days’ Sales in Inventory = 365 ÷
inventory turnover ratio
= 365 ÷ 8.63 = 42.29 days
The firm, on average, holds it
inventory for about 42 days.
Can a Firm Have Too Much Liquidity?
A
high investment in liquid assets will enable the firm to repay its current
liabilities in a timely manner.
However,
an excessive investments in liquid assets can prove to be costly as liquid
assets (such as cash) generate minimal return.Capital Structure Ratios
Capital structure refers to the way a firm finances its assets.
Capital
structure ratios address the important question: How has the firm financed the
purchase of its assets?
We
will use two ratios, debt ratio and times interest earned ratio,
to answer the question.
Debt ratio measures
the proportion of the firm’s assets that are financed by borrowing or debt
financing.
Example:
What will be the debt ratio for
H.J. Boswell, Inc. for 2009?
Debt Ratio = $1,012.50
million ÷ $1,764 million = 57.40%
The firm financed 57.39% of its
assets with debt.
Times Interest Earned Ratio measures the ability of the firm to service its
debt or repay the interest on debt.
We use EBIT or operating income
as interest expense is paid before a firm pays its taxes.
Example:
What will be the times interest
earned ratio for 2009 if we assume interest expense of $65 million and EBIT of
$350 million?
Times Interest Earned = $350
million ÷ $65 million = 5.38 times
Thus the firm can pay its total
interest expense 5.38 times or interest consumed 1/5.38th or 18.58%
of its EBIT. Thus, even if the EBIT shrinks by 81.42% (100-18.58), the firm
will be able to pay its interest expense.
Asset Management Efficiency Ratios
Asset management efficiency ratios measure a firm’s effectiveness in utilizing its
assets to generate sales.
They
are commonly referred to as turnover ratios as they reflect the number
of times a particular asset account balance turns over during a year.
Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in firm’s
assets.
Example:
What will be the total asset
turnover ratio for 2009 if we assume the total sales in 2009 were $2,500
million?
Total Asset Turnover = $2,500
million ÷ $1,764 million = 1.42 times
Thus the firm generated $1.42 in
sales per dollar of assets in 2009.
Fixed asset turnover ratio measures firm’s efficiency in utilizing its fixed assets (such as
property, plant and equipment).
Example:
Fixed asset turnover ratio for
H.J. Boswell, Inc. 2009 if we assume sales of $2,500 million for 2009?
Fixed Asset
Turnover = $2,500 million ÷ $1,287 million
= 1.94 times
The firm generated $1.94 in
sales per dollar invested in plant and equipment.
For
Boswell, 2010
Total
Asset Turnover = Sales ÷ Total Assets
=
$2,700m ÷ $1,971m = 1.37
Fixed
Asset Turnover = Sales ÷ Net Plant and Equipment
=
$2,700m ÷$1,327.5m = 2.03
Receivables
Turnover
=
Credit Sales ÷ Accounts Receivable
=
$2,700m ÷ $162m = 16.67 times
Inventory
Turnover
=
Cost of Goods Sold ÷ Inventories
=
$2,025m ÷$378m = 3.36 times
The
following grid summarizes the efficiency of Boswell’s management in utilizing
its assets to generate sales in 2010.
Profitability
Ratios
Profitability ratios address a very fundamental question: Has the firm earned adequate
returns on its investments?
We
answer this question by analyzing the firm’s profit margin, which
predict the ability of the firm to control its expenses, and the firm’s rate
of return on investments.
Two
fundamental determinants of firm’s profitability and returns on investments are
the following:
–
Cost
Control
Is
the firm controlling costs and earning reasonable profit margin?
–
Efficiency
of asset utilization
Is
the firm efficiently utilizing the assets to generate sales?
Gross
profit margin shows how well the firm’s management controls its expenses to
generate profits.
Example:
What will be the gross profit
margin ratio for H.J. Boswell, Inc. for 2009 if we assume sales of $2,500
million and gross profit of $650 million for 2009?
Gross Profit Margin
= $650 million ÷ $2,500 million
= 26%
The firm spent $0.74 for cost of
goods sold for each dollar of sales. Thus, $0.26 out of each dollar of sales
goes to gross profits.
Operating Profit Margin measures how much profit is generated from each dollar of sales after
accounting for both costs of goods sold and operating expenses. It thus also
indicates how well the firm is managing its income statement.
Example:
What will be the operating
profit margin ratio for H.J. Boswell, Inc. for 2009 if we assume sales of
$2,500 million and net operating income
of $350 million for 2009?
Operating Profit Margin = $350
million ÷ $2,500 million = 14%
Thus the firm generates $0.14 in
operating profit for each dollar of sales.
Net Profit Margin measures how much income is generated from each dollar of sales after
adjusting for all expenses (including income taxes).
Example:
What will be the net profit
margin ratio for H.J. Boswell, Inc. for 2009 if we assume sales of $2,500
million and net income of $217.75 million for 2009?
Net Profit Margin = $217.75
million ÷ $2,500 million = 8.71%
The firm generated $0.087 for
each dollar of sales after all expenses (including income taxes) were accounted
for.
Operating Return on Assets ratio is the summary measure of operating
profitability, which takes into account both the management’s success in
controlling expenses, contributing to profit margins, and its efficient use of
assets to generate sales.
Example:
What will be the operating
return on assets ratio for H.J. Boswell, Inc. for 2009 if we assume EBIT or net
operating income of $350 million for 2009?
Operating Return on Assets =
$350 million ÷$1,764 million = 19.84%
The firm generated $0.1984 of
operating profits for every $1 of its invested assets.
Decomposing the OROA ratio: We can
use the following equation to decompose the OROA ratio that allows us to
analyze the firm’s ability to control costs and utilize its investments in
assets efficiently.
Figure 4-1
Observations
Firm’s
OROA (operating return on assets) is better than its peers. Thus the firm
earned more net operating income per dollar invested in assets.
Firm’s
OPM (operating profit margin) is lower
than its peers. Thus the firm retained a lower percentage of its sales in net
operating income.
Firm’s
TATO (total asset turnover ratio) is higher than its peers. Thus the firm
generated more sales from its assets.
Figure 4-1
Recommendations
The
firm has two opportunities to improve its profitability:- Reduce costs - The firm must investigate the
cost of goods sold and operating expenses to see if there are
opportunities to reduce costs.
- Reduce inventories – The firm must investigate if
it can reduce the size of its inventories.
Is the Firm
Providing a Reasonable Return on the Owner’s Investment?
A
firm’s net income consists of earnings that is available for distribution to
the firm’s shareholders. Return on Equity ratio measures the accounting
return on the common stockholders’ investment.
Example:
What will be the return on
equity ratio for H.J. Boswell, Inc. for 2009 if we assume net income of $217.75
million for 2009?
Return on Equity = $217.75
million ÷ $751.50 million = 28.98%
Thus the shareholders earned
28.97% on their investments.
Note common equity includes both
common stock plus the firm’s retained earnings.
Using the
DuPont Method for Decomposing the ROE ratio
DuPont method analyzes
the firm’s ROE by decomposing it into three parts: profitability, efficiency
and an equity multiplier.
ROE = Profitability × Efficiency × Equity
Multiplier
Equity
multiplier captures the effect of the firm’s use of debt financing on its
return on equity. The equity multiplier increases in value as the firm uses
more debt.
ROE = Net
Profit Margin × Total Asset Turnover Ratio × 1/(1-debt ratio)
The
following table shows why Boswell’s return on equity was higher than its peers.
The
table suggests that Boswell had a higher ROE as it was able to generate more
sales from its assets (1.37 versus 1.15 for peers) and used more leverage (2.16
versus 1.54).
Note
use of financial leverage may not always generate value for shareholders. 
Market Value Ratios
Market value ratios address the question, how are the firm’s shares valued in the stock
market?
Two
market value ratios are:
–
Price-Earnings
Ratio
–
Market-to-Book
Ratio
Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1 of
reported earnings.
What
will be the PE ratio for H.J. Boswell, Inc. for 2009 if we assume the firm’s
stock was selling for $22 per share at a time when the firm reported a net
income of $217.75 million, and the total number of common shares outstanding
are 90 million?
Earnings
per share
= $217.75 million ÷ 90 million =
$2.42
PE
ratio = $22 ÷ $2.42 = 9.09
The
investors were willing to pay $9.09 for every dollar of earnings per share that
the firm generated.
Market-to-Book Ratio measures the relationship between the market value and the accumulated
investment in the firm’s equity.
What
will be the market-to-book ratio for H.J. Boswell, Inc. for 2009 given that the
current market price of the stock is $22 and the firm has 90 million shares
outstanding?
Book Value
per Share = 751.50 million ÷ 90
million = $8.35 per share
Market-to-Book
Ratio = Market price per share ÷ Book value per share
= $22 ÷ $8.35 = 2.63 times
Summing up the Financial Analysis of H. J.
Boswell, Inc.
Liquidity:
With the exception of inventory turnover ratio, liquidity ratios were adequate
to good. The next step will be to see how inventory management can be improved.
Financial Leverage: The firm uses more debt than its peers, which exposes the firm to a
higher degree of financial risk or potential default on its debt in the future.
Profitability:
H.J. Boswell had favorable net operating income despite lower profit margins,
largely due to its higher asset turnover ratio. The return on equity was also
higher than the peer group due to use of more debt.
Market Value Ratios: These ratios suggest that the market is pleased with the firm as
indicated by higher stock valuations.Selecting a Performance Benchmark
There are two
types of benchmarks that are commonly used:
–
Trend Analysis – involves comparing a firm’s financial statements over time.
–
Peer Group Comparisons – involves comparing the subject firm’s financial statements with those
of similar, or “peer” firms. The benchmark for peer groups typically consists
of firms from the same industry or industry average financial ratios.
Trend
Analysis
Financial Analysis of the Gap, Inc., June 2009
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