1 Mojtaba Salem, Jafar Kazemiyan, Ramazan Barbari, Jafar Mahmoodi Final Paper Financial Accounting Dr.

Rod Monger May 18, 2011 The US Software Industry: A Ratio Analysis of HP, IBM, and Microsoft Introduction In this paper, we study the financial performance of three major software companies: Hewlett-Packard (HP) Company, International Business Machines (IBM), and Microsoft Corporation. Using their financial statements, we analyze the companies levels of profitability and liquidity, assets and debt utilization, and dividend policy. Our analysis is comparative in that it compares the performance of three companies with each other and with the industry over three consecutive years of 2008, 2009, and 2010. We only attempt to identify where financial problems are. It should be noted that the interpretation of financial problems is beyond the scope of the current study. The first section of the paper is devoted to the ratio analysis of each company per se. We have three case studies in which profitability ratios, liquidity ratios, efficiency ratios, shareholder ratios, and capital structure ratios are calculated and briefly explained. Following the case studies, we have calculated industry norms for all categories of ratios. This is where we provide a comparative ratio analysis of the US software industry and its three major players.

2 Case Study 1: Hewlett-Packard (HP) Company I. The History of the Company In 1939, Hewlett-Packard Company, hereafter referred to as HP, was founded by two graduates of Stanford University: Bill Hewlett and Dave Packard. A decade after becoming a true corporation in 1947, HP went public and had its initial public offering of ordinary shares. It was not until the 1980s that HP took an active role in the mass production of personal computers and printers, which set the direction in which printers would evolve in the future (Dodge). Another crucial milestone in HPs history is the 2002 merger with Compaq Computer, which turned HP into one of the largest software companies in the world, operating in 160 countries and having around 150,000 employees. HPs corporate strategy is concentrated on market share growth and company profitability throughout the future of the business (Dodge). The executive management of the company attempts to operationalize the corporate strategy through employee empowerment and integration into the global market. The success with which the executive management could implement its corporate strategy has turned HP into a relatively safe investment. Standard and Poors has given HP an A credit rating and an A-1 commercial paper rating (Dodge). Yet, from the perspective of the firms executive managers, it is crucial to consistently watch the performance of the company as if they were potential investors. In this sense, the fundamental analysis of financial statements must be conducted. It must be noted that all financial data used in our calculations are taken from the annual reports available in HPs website. For further information, please visit http://h30261.www3.hp.com/phoenix.zhtml?c=71087&p=irol-reportsAnnual.

3 II. Ratio Analysis

Profitability Ratios: Before delving into the profitability analysis of HP, it is important to shed light on the method with which Return on Shareholders Funds (ROSF) and Return on Capital Employed (ROCE) are calculated. The general formula is the following:
 

Return =

X 100

i.

Return on Shareholders Funds (ROSF) a. Return is the net profit for the period b. Shareholder Funds means the book value of all things in the balance sheet that describe the owners capital and reserves. It should be noted that we use the average of two consecutive years common stock, paid-in capital, and retained earnings to calculate the return on shareholders funds.
      

ROSF =

X 100

ii. Return on Capital Employed (ROCE) a. Return means net profit for the period + any preference share dividends + loan notes and long-term loan interest b. Capital means common stock + reserves including retained earnings + preference shares + loan notes and long-term loans. In this case, we also use the average of two consecutive years total stockholder equity, long-term debts, and other long-term liabilities to calculate the return on capital employed.

4 ROCE =
         

X 100

It must be mentioned that the ratio analysis of 2007 is also included in order to show a rather big picture of HPs performance. The reason is that the fluctuation in certain ratios could be better seen if the 2007 analysis is included. This is true in HPs case, and the other two cases are analyzed from 2008 to 2010. Category/Year Return on shareholders funds Return on capital employed Gross profit* as percentage of sales Net profit as percentage of sales 2007 19.09% 2008 21.64% 2009 18.50% 2010 19.90%

38.03%

54.22%

58.91%

64.14%

24.35%

24.03%

23.59%

23.75%

6.96%

7.03%

6.68%

6.95%

* Gross profit = Total net revenue Cost of Sales Cost of Sales = Cost of products + Cost of services + Financing interest

HP seems to have a rather random return on shareholders funds (ROSF). In the time period from 2007 to 2010, ROSF once peaked at 21.64% in 2008, then fell to 18.50% in 2009, and went up to 19.90% in 2010. In contrast to ROSF, the return on capital employed (ROCE) has progressively grown since 2007. Such returns suggest that the company could effectively utilize its equity and obtain the possible maximum return on it. In order to see how HP manages its cost of goods sold (or cost of sales) over four years, it is important to look at the companys gross profit margin. In 2007, HP reached a peak of 24.35% yet its gross profit margin came slightly down. However, it maintained a relatively stable gross

5 profit thereafter, which might be an indication that the companys strategy to keep the cost low works well. To highlight the overall performance of HP, that is, to see how easy it was for HP to pay its interest and taxes, we also have to look at the figures of net profit margin. Here, we notice a big jump from 6.96% (2007s net profit margin) to 7.03% (2008s net profit margin). Though the companys net profit margin came back to 6.68% in 2009, it still increased to 6.95% in 2010. Considering the context in which the company performed, i.e., the 2008 financial crisis, HP could manage to maintain notable increases in the figures of net profit margin, which is a sign of increasing profitability. Liquidity Ratios Category/Year Current ratio Acid-test ratio Net working capital to total asset ratio Working capital 2007 1.20 1.02 0.09 8142 2008 0.97 0.82 -0.01 -1211 2009 1.22 1.07 0.08 9536 2010 1.09 0.96 0.03 4781

Liquidity ratios suggest how efficiently a company functions in short-term. Regarding its current ratio, HP experienced drops of 0.97 in 2008 and 1.09 in 2010 yet could be able to bid up the ratio to its normal level in 2009 and 2010. A higher current ratio makes the company capable of paying its short-term debt as they come due. In regard with the acid-test ratio, HP seemed to have problem paying its short-term obligations in 2008 and 2010 due to the raise in current liabilities and fall in current assets. Particularly, in line with a notable drop of current ratio and acid-test ratio in 2008, net working capital also fell to a negative amount. This might also be due to that years financial crisis.

6 Efficiency Ratios Category/Year Inventory turnover Accounts receivable to sales ratio Accounts payable to purchase* ratio 2007 9.99 times 0.12 (43.8 days) 0.14 (51.1 days) 2008 11.30 times 0.143 (52.1 days) 0.15 (54.75 days) 2009 12.49 times 0.144 (52.5 days) 0.17 (62.05 days) 2010 15.25 times 0.146 (53.29 days) 0.148 (54.02 days)

* Purchase = (Cost of sales + Closing inventory) Beginning inventory

Perhaps, as a result of HPs attempts to keep inventory as low as practical and enhance sales, we notice that inventory turnover obtains a faster pace year by year. It is suggestive of how successful the companys executive management is implementing its sales or inventory strategies. On the other hand, the analysis shows that the accounts receivable-to-sales ratio has taken an increasing pace from 2007 to 2010. The greater this ratio becomes, the more time it takes HP to collect its debt. In 2007, it took HP about 43 days to collect debts; in 2008, the time span increased to about 52 days, which might have contributed to the dramatic drop in the current ratio and the negative amount of net working capital of 2008. The accounts payable-to-purchase ratio measures how much time it takes HP to pay its creditors. As HP moved from 2007 towards 2010, it delayed the payment of its payables. In 2010, however, the time that it took HP to pay off its creditors dropped to 54 days, which is a drastic drop compared with the 62 days in 2009.

7 Shareholder Ratios Category/Year Earnings per share Price to earnings (P/E) ratio* Market price Dividends per share Dividends yield Dividends cover 2007 $2.76 18.08 $49.90 $0.32 0.64% 8.58 2008 $3.35 10.26 $34.37 $0.32 0.93% 10.46 2009 $3.21 15.60 $50.07 $0.32 0.63% 10 2010 $3.78 10.31 $38.97 $0.32 0.82% 11.79

* http://www.stock-analysis-on.net/NYSE/Company/Hewlett-Packard-Co/Valuation/Ratios#PE

From 2007 to 2010, with the exception of 2009, HPs earnings per share (EPS) have increased with slight proportions. EPS is an important determinant of the ordinary shares market price and P/E ratio. In 2007, HP had the P/E ratio of 18.08; it dropped to 10.26 in 2008 but became 15.60 in the next year. Once again, however, it fell to 10.31 in 2010. This abnormal instability of the price-earnings ratio might be due to the tremulous era following the 2008 financial crisis. The dividend yield is defined as part of the total return that an investor receives along with capital gains and losses (Dodge). By looking at the low level of HPs dividend yield, it becomes clear that one should purchase HPs common stock only if her investment objective is capital gain, not receiving a constant income. Gearing Ratio Category/Year Gearing*
*
   

2007 28.46%
X 100

2008 35.47%

2009 41.68%

2010 43.66%

8 In 2007, HP was considered to be a relatively low-geared company. From 2007 onwards, however, HPs gearing ratio has steadily increased. It signals that HP has been willing to accept a higher rate of debt, which could mean a higher rate of risk for potential investors. Case Study 2: International Business Machines (IBM) I. The History of the Company Hermand Hollerith founded Tabulating Machine Company in 1896. Later on, Computing Scale Corporation, Time Recording Company, and Tabulating Machine Company were merged together to form CTR. They changed their name to IBM after deciding to enter the Canadian market in 1914. Developing computer machines for the United State Air Force., IBM became the chief contractor of the defense industry. The world witnessed the first IBM PC in 1981. Since then, IBM played an important role in introducing new hardware systems and thus attracted the attention of potential investors. It must be noted that all financial data used in our calculations are taken from the annual reports available in IBMs website. For further information, please visit http://www.ibm.com/investor/financials/financial-reporting.wss. II. Ratio Analysis

Profitability Ratios: As is mentioned in the introduction, there are five main categories of ratios with which one analyzes how healthy a company is: profitability ratios, liquidity ratios, efficiency ratios, shareholder ratios, and capital structure ratios. Of the above-mentioned ratio categories, the most important one, from the standpoint of potential investors, is the profitability ratios. It could be divided into two parts: return on shareholders funds (ROSF) and return on capital employed (ROCE). We calculate ROSF based on the following formula:

9 ROSF =
      

X 100

To arrive at ROCE, we use the following formula:

         

ROCE =

X 100

It should also be noted that in the denominator of both formulas, we use the average capital of two consecutive years. Category/Year Return on shareholders funds Return on capital employed Gross profit as percentage of sales Net profit as percentage of sales 2008 12.02% 83.38% 44.06% 11.90% 2009 11.56% 90.29% 45.72% 14.02% 2010 11.38% 84.13% 45.07% 14.85%

The percentage of return on shareholders funds (ROSF) decreased from 2008 to 2010. The performance of the return on capital employed is rather random; IBM had the highest percentage of return on capital employed in 2009, 90.29%. The gross profit margin for 2008, 2009, and 2010 was 44.06%, 45.72%, and 45.07% respectively. It is clear that IBM had the highest gross profit as the percentage of sales in 2009. As the table shows, IBM had a progressing net profit margin from 2008 onwards. Liquidity Ratios Category/Year Current Ratio Acid Test Ratio 2008 1.15 1.09 2009 1.35 1.29 2010 1.18 1.12

10 Liquidity ratios indicate that whether the company has the capability to meet its current obligations. Under liquidity ratios, we calculate current ratio and acid test ratio. It is not so useful to compare the liquidity ratio of one company over different years. We need to compare the liquidity ratios with those of the industry in order to realize whether they are high or low. In the span of time under our consideration, IBM had a higher ratio of current ratio and acid test ratio in 2009. Efficiency Ratios: Category/Year Inventory Turnover Account Receivable/Sales Account Payable/ Purchase 2008 21.61 times 0.1165 (42.52) 0.1209 (44.13 days) 2009 20.01 times 0.1241 (45.30) 0.1436 (52.41 days) 2010 21.79 times 0.1198 (43.727) 0.1449 (52.89)

We calculate efficiency ratios in order to realize whether the collection and payment of debts are efficiently managed. The inventory period means how many days it takes IBM to sell its inventory. The account receivable period means how many days it takes IBM to collect its receivables; the account payable period indicates that how many days it will take the company to pay its payable accounts. IBM operated unsatisfactory in 2009 in terms of inventory turnover and accounts receivable to sales ratio. Shareholder Ratios: Category/Year Earnings Per Share Price/ Earnings Ratios Dividend Yield Dividend Cover 2008 $9.02 9.33 0.0226 4.77% 2009 $10.12 12.93 0.0164 4.69% 2010 $11.69 12.55 0.0170 4.67%

11 Based on the table, IBM had a progressing earning per share in the three consecutive years of 2008, 2009, and 2010. The P/E ratio measures the value that investors are assuming for every dollar of current earning. Therefore, the higher IBMs P/E ratio is, the more demand will be for its common stock. The dividend yield measures the exact rate of return to shareholders based on their investment. Thus, the greater the dividend yield, the more attractive the company will be for the potential investors. Dividend cover signals the available amount to pay shareholders declared dividends. As the table shows, in 2009, the dividend cover is 4.69, which implies that the company had 4.69 more times available capital to pay its dividend obligations. Gearing: Category/Year Gearing 2008 44.2% 2009 42.38% 2010 39.84%

12 Case Study 3: Microsoft Corporation I. History of the Company Microsoft is a multinational corporation headquartered in Washington, USA. Microsofts management attempts to enhance profitability as much as practical to encourage further investment. The board of directors, made up of mostly outsiders, monitors the performance of executive management. Microsoft lunched its Initial Public Offering (IPO) in 1986 with the opening stock price of USD 21. Microsoft started offering dividends in 2003. It must be noted that all financial data used in our calculations are taken from the annual reports available in Microsofts website. For further information, please visit

http://www.microsoft.com/investor/AnnualReports/default.aspx.

II.

Ratio Analysis

Profitability Ratios: Category/Year Return on shareholders funds Return on capital employed Gross profit* as percentage of sales Net profit as percentage of sales 2008 %29.26 %80.80 %60.41 %28.65 2009 %24.93 %79.12 %55.17 %23.26 2010 %30.02 %80.16 %58.45 %29.95

Profitability ratios provide the analyst with the net results of financing policies and decisions. We compare the profitability ratios of Microsoft Corporation over three consecutive years. By looking at Microsofts net profit margin, we can notice that it fell dramatically in 2009 perhaps due to the fact that operating expenses went up. While a high return on sales is good,

13 everything else equal, we should also be concerned with turnover. If a firm sets a very high price on its products, it may get a high return on each sale but not make many sales. Liquidity Ratios: Category/Year Current ratio Acid-test ratio 2008 1.44 1.41 2009 1.82 1.79 2010 2.12 2.10

If a company is faced with financial difficulties, it might delay the payment of debts. If current liabilities are rising faster than current assets, the current ratio will fall, and this is a negative sign. The current ratio of Microsoft Corporation has been increasing year by year. It means that the company is able to pay its short-term debts with enough ease. Acid-test ratio is the most used liquidity ratio, which is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities. Inventories are typically the least liquid asset of the company. Acid-test ratio measures a firms ability to pay off short-term obligations without relying on the immediate sales of inventories. In the case of Microsoft, this ratio increases in a decreasing rate. Efficiency Ratios: Category/Year Inventory turnover Accounts receivable to sales ratio Accounts payable to purchase* ratio 2008 11.77 times 0.2249 (82 days) 0.06676 (24.3 days) 2009 16.95 times 0.1915 (70 days) 0.05688 (20.7 days) 2010 16.75 times 0.2082 (76 days) 0.06441 (23.5 days)

Accounts receivable to sales ratio is also called average collection period. This ratio represents the average length of time that the firm must wait after making a sale to receive cash.

14 As the above table indicates, it takes less time (70 days) for Microsoft Corporation in 2009 to collect accounts receivable from debtors. In 2008, on the other hand, it took Microsoft 82 days to receive from debtors. Shareholder Ratios: Category/Year Earnings per share Price to earnings (P/E) ratio* Market price Dividends per share Dividends yield (%) Dividends cover 2008 $1.90 16.93 $32.18 0.44 1.367096 4.32% 2009 $1.63 13.30 $21.68 0.52 2.397971 3.15% 2010 $2.13 12.57 $26.79 0.052 0.194102 4.12%

In the financial statements of Microsoft Corporation, two numbers for earnings per share are disclosed: basic and diluted EPS. These numbers differ with respect to the definition of available net income and the number of shares outstanding. In this report, we consider the basic earnings per share. Apparently, this company does not hold a constant growth rate of EPS, and it varies in different years. P/E ratio shows how much the investor is willing to pay per dollar of reported profits. This ratio is higher for firms with strong growth prospects and relatively little risk. When comparing this ratio with that of the industry, if it is lower, it suggests that the company is regarded as being somewhat riskier. Dividend yield ratio shows how much the investor will be paid per dollar of reported profit. In order for us to understand the standard amount of dividend yield, it should be compared

15 with other companies in the industry. This ratio is also higher for firms with strong growth prospects and relatively little risk. Gearing Ratio Category/Year Gearing*
*
   

2008 9.530733
X 100

2009 15.33158

2010 17.74713

The Industry Analysis: A Comparative Study Profitability Ratios: a) Companies Category/Company Years Return on shareholders funds Return on capital employed Gross profit as percentage of sales Net profit as percentage of sales
HP 2008 % 21.64 2009 % 18.50 2010 % 19.90 2008 % 12.02 IBM 2009 % 11.56 2010 % 11.38 2008 % 28.65 Microsoft 2009 % 23.26 2010 % 29.95

54.22 24.03 7.03

58.91 23.59 6.68

64.14 23.75 6.95

36.68 44.06 11.90

33.60 45.72 14.02

30.89 45.07 14.85

60.41 80.8 29.26

55.17 79.1 24.93

58.45 80.16 30.02

In regard to the return on shareholders fund (ROSF), it is evident that Microsoft raced ahead of HP and IBM from 2008 to 2010. While HP and Microsoft experienced a slight decline in ROSF over the span of three years, Microsoft could manage to have a considerable increase in the rate of return on shareholders funds. Similarly, Microsoft could obtain the highest return on

16 capital employed (ROCE). In 2009, all three companies experienced a drop in ROSF and ROCE. Over the three years, the lowest return belonged to IBM. Microsoft could also be in a superior position regarding the gross profit margin. Microsofts gross profit margin fell in 2010, yet it is by far above that of IBM and HP. The lowest gross profit margin belong to HP. Reflecting a similar pattern, the net profit margin of Microsoft is greater than that of IBM HP whose net profit margin is surprisingly low. b) Industry Norms Years Return on shareholders funds Return on capital employed Gross profit as percentage of sales Net profit as percentage of sales 2008 % 20.77 50.44 27.16 9.81 2009 % 17.77 49.23 26.6 8.4 2010 % 20.41 51.16 26.95 10.08

The industry norm is calculated by the sum of companies profitability ratios divided over the number of companies. The company that has one or more ratios below the industry norm indicates the existence of a problem in its operation that must be identified and cured.

Liquidity Ratios: a) Companies

Category/Company Years Current Ratio Acid Test Ratio HP 2008 0.97 0.82 2009 1.22 1.07 2010 1.09 0.96 2008 1.15 1.09 IBM 2009 1.35 1.29 2010 1.18 1.12 Microsoft 2008 1.44 1.41 2009 1.82 1.79 2010 2.12 2.10

17 Moving from 2008 to 2010, Microsofts ability to pay off its short-term debts has increased. The immediate liquidity of the firm as measured by acid-test ratio has gone up in proportionate with the current ratio. Although being capable of paying its obligations, relative to IBM and Microsoft, HP has the weakest position regarding. b) Industry Norms Years
Current Ratio Acid Test Ratio 2008 1.19 1.10 2009 1.46 1.38 2010 1.45 1.39

Efficiency Ratios: a) Companies Category/Company Years Inventory turnover Accounts receivable to sales ratio Accounts payable to purchase ratio
HP 2008 11.3 0.143 2009 12.49 0.144 2010 15.25 0.146 2008 21.61 0.11 IBM 2009 20.01 0.12 2010 21.79 0.11 2008 11.77 0.22 Microsoft 2009 16.95 0.19 2010 16.75 0.20

0.15

0.17

0.14

0.12

0.14

0.14

0.06

0.05

0.06

IBM maintained a high level of inventory turnover. Microsoft and HP moved shoulder to shoulder with each other in this regard. Having a lower accounts receivable to sales ratio, IBM could also collect its debts much sooner than HP and Microsoft. On the other hand, Microsofts accounts payable to purchase ratio is low relative to that of HP and IBM, implying that Microsoft does not delay its creditors payments. HP seems to push back the payment to its creditors as much as practical.

18 b) Industry Norms Years Inventory turnover Accounts receivable to sales ratio Accounts payable to purchase ratio Shareholder Ratios: a) Companies Category/Company Years Earnings per share ($) Price to earnings (P/E) ratio* Market price ($) Dividends per share Dividends yield Dividends cover
HP 2008 2009 2010 2008 IBM 2009 2010 2008 Microsoft 2009 2010

2008
14.9 0.16 0.11

2009
16.48 0.15 0.12

2010
17.93 0.156 0.119

3.35 10.26 34.37 0.32 0.0093 10.46

3.21 15.6 50.07 0.32 0.0063 10

3.78 10.31 38.97 0.32 0.0082 11.79

9.02 9.33 84.15 1.93 0.0226 4.77

10.12 12.93 138.85 2.19 0.0164 4.69

11.69 12.55

1.90 16.94

1.63 13.3

2.13 12.58

146.71 32.18 21.68 26.79 1.77 0.017 4.67 0.44 1.37 4.33 0.42 2.38 3.15 0.052 0.19 4.13

It is evident that investors value each dollar of IBMs earnings much higher than the earnings of HP and Microsoft. In 2009, HPs and Microsofts EPS slightly dropped, but IBMs EPS continued to grow. In 2008, the average P/E ratio was 12.18. Microsofts P/E ratio stood above the industrys average in that year. HPs P/E ratio exceeded the industry P/E ratio in 2009. Regarding the dividend policy, Microsoft is also the most attractive option for potential investors.

19 b) Industry Norms Years Earnings per share Price to earnings (P/E) ratio Market price ($) Dividends per share Dividends yield Dividends cover 2008
3.64 12.18 50.23 0.89 0.47 6.52

2009
3.92 13.94 70.2 0.97 0.8 5.95

2010
4.61 11.81 70.82 0.71 0.07 6.86

Gearing: a) Companies Category/Company Years Gearing (%)

HP 2008 35.47 2009 41.68 2010 43.66 2008 44.20 IBM 2009 42.38 2010 39.84 2008 9.53 Microsoft 2009 15.33 2010 17.75

IBM is a highly geared company in the beginning of 2008, yet its gearing ratio decreased as it moved towards 2010. HP experienced an inverse course of action. In other words, as it moved towards 2010, its gearing ratio increased. Though its gearing ratio increased, Microsoft kept its financial leverage low compare to HP and IBM. b) Industry Norms Years Gearing (%) 2008 3.44 2009 5.39 2010 6.2

20 Work Cited:

I.

Dodge, Chad, and Joe Barnes. "Hewlett-Packard." Scribd. Hewlett-Packard, 14 Apr. 2008. Web. 18 May 2011. <http://www.scribd.com/doc/54882240/HP-Paper>.