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Understanding Financial Statements and Cash Flows &

Evaluating a Firms Financial Performance

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Learning Objectives
1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager. 2. Evaluate firm profitability using the income statement. 3. Explain what we can learn by analyzing a firms financial statements.
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Learning Objectives
4. Use common size financial statements as a tool of financial analysis. 5. Calculate and use a comprehensive set of financial ratios to evaluate a companys performance. 6. Select an appropriate benchmark for use in performing a financial ratio analysis. 7. Describe the limitations of financial ratio analysis.
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Principles Used in this Chapter


Principle 1: Money has a Time Value.
Financial statements typically ignore time value of money. Thus financial managers and accountants may view financial statements very differently.

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Principles Used in this Chapter (cont.)


Principle 2: There Is a Risk-Return Tradeoff.
Financial statement analysis can yield important information about the strengths and weaknesses of a firms financial condition. The analysts can use such information to infer the risk-return tradeoff in a firm.
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Principles Used in This Chapter (cont.)


Principle 3: Cash Flows Are the Source of Value.
Financial statements provide an important starting point in determining the firms cash flow. An important use of a firms financial statements involves analyzing past performance as a tool for predicting future cash flows. We should distinguish between reported earnings and cash flow. It is possible for a firm to report positive earnings but have no cash!
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Principles Used in This Chapter (cont.)


Principle 4: Market Prices Reflect Information.
Firms financial statements provide important information that is used by investors in forming expectations about firms future prospects and subsequently, the market prices. Financial statement analysis requires gathering information about a firms financial condition, which is important to the valuation of the firm.
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An Overview of the Firms Financial Statements

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements


Following four types of financial statements are mandated by the accounting and financial regulatory authorities:
1. 2. 3. 4. Income statement Balance sheet Cash flow statement Statement of shareholders equity

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Basic Financial Statements (cont.)


1. Income Statement:
An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months):
Revenue, Expenses, and Profit.

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Basic Financial Statements (cont.)


2. Balance sheet:
Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010)
Assets (value of what the firm owns), Liabilities (value of firms debts), and Shareholders equity (the money invested by the company owners).

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Basic Financial Statements (cont.)


3. Cash flow statement:
It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).

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Basic Financial Statements (cont.)


4. Statement of shareholders equity:
It provides a detailed account of the firms activities in the following accounts over a period of time (for example, last six months):
Common stock account, Preferred stock account, Retained earnings account, and Changes to owners equity.

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Why Study Financial Statements?


Analyzing a firms financial statement can help managers carry out three important tasks: 1. Assess current performance through financial statement analysis, 2. Monitor and control operations, and 3. Forecast future performance.

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Why Study Financial Statements? (cont.)


1. Financial statement analysis:
Financial statement analysis allows us to assess the present financial condition of a firm. Chapter 4 introduces the tools and techniques used to carry out financial statement analysis.

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Why Study Financial Statements? (cont.)


2. Financial control:
Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firms operations. For example, a creditor may analyze a firms financial statements to decide whether or not to renew companys loan.

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Why Study Financial Statements? (cont.)


3. Financial forecasting and planning:
Financial planning models are typically built using the financial statements. Financial planning is covered in chapter 17.

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What are the Accounting Principles Used to Prepare Financial Statements?

The following three fundamental principles are adhered to by accountants when preparing financial statements: 1. The revenue recognition principle, 2. The matching principle, and 3. The historical cost principle. An understanding of these basic principles allows us to be a more informed user of financial statements.
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What are the Accounting Principles Used to Prepare Financial Statements? (cont.)

1. The revenue recognition principle:


It states that the revenue should be included in the firms income statement for the period in which:
Its goods and services were exchanged for cash or accounts receivable; or The firm has completed what it must do to be entitled to the cash.

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What are the Accounting Principles Used to Prepare Financial Statements? (cont.)

2. The matching principle:


This principle determines whether specific costs or expenses can be attributed to this periods revenues. The expenses are matched with the revenues they helped produce.
For example, employees salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.

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What are the Accounting Principles Used to Prepare Financial Statements? (cont.)

3. The historical cost principle:


This principle provides the basis for determining the dollar values the firm reports in its balance sheet. Most assets and liabilities are reported in the firms financial statements at historical cost i.e. the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities.
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An Income Statement
An income statement is also called a profit and loss statement. An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).
Revenues (or Sales) Expenses = Profits
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An Income Statement (cont.)


An income statement will contain the following basic elements:
1. Revenues 2. Expenses
Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense

1. Profits
Gross profit, net operating income (also known as EBIT), earnings before taxes (EBT), and net income
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An Income Statement (cont.)


Sales
Minus Cost of Goods Sold

= Gross Profit Minus Operating Expenses


Selling expenses General and Administrative expenses Depreciation and Amortization Expense

= Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes
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= Net income (EAT)

Sample Income Statement

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Evaluating a Firms EPS and Dividends


We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income Number of shares outstanding

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Evaluating a Firms EPS and Dividends (cont.)


Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)? EPS = Net income Number of shares = $90 million $35 million = $2.57
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Evaluating a Firms EPS and Dividends (cont.)


We can determine the dividends paid by the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding. Dividends per share = Net income Number of shares
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Evaluating a Firms EPS and Dividends (cont.)


Example 2: A firm reports dividend payment of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share? Dividends per share = Net income Number of shares = $20 million $35 million = $0.57
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Connecting the Income Statement and the Balance Sheet


What can the firm do with the net income?: 1. Pay dividends to shareholders, and/or 2. Reinvest in the firm

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Connecting the Income Statement and the Balance Sheet (cont.)

Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? Amount retained = Net Income Dividends = $90m - $20m = $70m The firms balance on retained earnings will increase by $70 million on the balance sheet.
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Interpreting Firm Profitability using the Income Statement


What can we learn from H.J. Boswell Inc.s income statement (Table 3-1)?
1. The firm has been profitable as its revenues exceeded its expenses.

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Interpreting Firm Profitability using the Income Statement (cont.)


2. The gross profit margin (GPM) = gross profits sales = $675 million $2,700 million = 25%

GPM indicates the firms mark-up on its cost of goods sold per dollar of sales.
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Interpreting Firm Profitability using the Income Statement (cont.)


3. The operating profit margin = net operating income sales = $382.5 million $2,700 million = 14.17%
The operating profit margin is equal to the ratio of net operating income or EBIT divided by firms sales.
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Interpreting Firm Profitability using the Income Statement (cont.)


Net profit margin: = net profits sales = $204.75 million $2,700 million = 7.58%
Net profit margin indicates the percentage of revenues left after all expenses (including interest and taxes) have been considered.
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Interpreting Firm Profitability using the Income Statement (cont.)


These profit margins (gross profit margin, operating profit margin, and net profit margin) should be closely monitored and compared to previous years and those of competing firms.

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GAAP and Earnings Management


While the firms must adhere to set of accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firms reported earnings. Managers have an incentive to tamper with reported earnings as their pay depends upon it and investors care about it.
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The Balance Sheet


The balance sheet provides a snapshot of the firms financial position on a specific date. The balance sheet is defined by the following equation:
Total Assets = Total Liabilities + Total Shareholders Equity

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The Balance Sheet (cont.)


Total assets represents the resources owned by the firm. Total liabilities represent the total amount of money the firm owes its creditors Total shareholders equity refers to the difference in the value of the firms total assets and the firms total liabilities.
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The Balance Sheet (cont.)


In general, GAAP requires that the firm report assets on its balance sheet using the historical costs. Cash and assets held for sale (such as marketable securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.

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The Balance Sheet (cont.)


Assets whose value is expected to decline over time (such as equipment) is reported as net equipment which is equal to the historical cost minus accumulated depreciation. Note, the net value reported on balance sheet could be significantly different from the market value of the asset.

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The Balance Sheet (cont.)

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The Balance Sheet (cont.)


The balance sheet includes the following main components: 1.Assets Found on the left-hand side of the balance sheet. It includes current assets and fixed assets. 2.Sources of financing Found on the right-hand side of the balance sheet. It includes current liabilities, long-term liabilities, and owners equity.
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The Balance Sheet (cont.)


Current assets consists of firms cash plus other assets the firm expects to convert to cash within 12 months or less, such as receivables and inventory. Fixed assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.
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The Balance Sheet (cont.)


Current liabilities represent the amount that the firm owes to creditors that must be repaid within a period of 12 months or less such as accounts payable, notes payable. Long-term liabilities refer to debt with maturities longer than a year such as bank loans, bonds.
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The Balance Sheet (cont.)


The stockholders equity is broken down into two components:
(1) The amount the company received from selling stock to investors. It may be shown as common stock in the balance sheet or it may be divided into two components: par value and additional paid in capital above par. Par value is the stated or face value a firm puts on
each share of stock. Paid in capital is the additional amount the firm raised when it sold the shares.

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The Balance Sheet (cont.)


For example, DLK corporations par value per share is $2.00 and the firm has 30 million shares outstanding such that the par value of the firms common equity is $60 million. If the stocks were issued to investors for $240 million, $180 million represents paid in capital.

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The Balance Sheet (cont.)


(2) The amount of the firms retained earnings. Retained earnings are the portion of net income that has been retained (i.e. not paid in dividends) from prior years operations. Thus stockholders equity = Par value of common stock + Paid in Capital + Retained Earnings
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The Balance Sheet (cont.)


We can also express stockholders equity as follows:
Shareholders' equity = Total Assets Total Liabilities

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Firm Liquidity and Net Working Capital


Liquidity refers to the speed with which an the asset can be converted to cash without loss of value. For example, a firms bank account is perfectly liquid. Other types of assets are less liquid as they more difficult to sell and convert to cash such as PPE (property, plant and equipment).
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Firm Liquidity and Net Working Capital


For the overall firm, liquidity generally refers to the firms ability to covert its current assts (accounts receivable and inventories) into cash so that it can pay its bills (current liabilities) on time. We can thus measure a firms liquidity by computing the net working capital = current assets current liabilities

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Firm Liquidity and Net Working Capital (cont.)


If a firms net working capital is significantly positive, it is in a good position to pay its debts on time and is consequently very liquid. Lenders consider the net working capital as an important indicator of firms ability to repay its loans.
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The Balance Sheet

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Debt and Equity Financing


The right-hand side of the balance sheet reveals the sources of money used to finance the purchase of the firms assets listed on the left-hand side of the balance sheet. It shows how much was borrowed (debt financing) and how much was provided by firms owners (equity financing, through the sale of equity or retention of prior years earnings).
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Debt versus Equity


Payment: Payment for debt holders is generally fixed (in the form of interest); Payment for equity holders (dividends) is not fixed nor guaranteed. Seniority: Debt holders are paid before equity holders in the event of bankruptcy. Maturity: Debt matures after a fixed period while equity securities do not mature.
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Book Values, Historical Costs, and Market Values


Book values (based on historical cost) reported in the balance sheet can differ from market values. The gap between book value and market value is likely to be higher for fixed assets relative to current assets for two reasons:
Inflation affects the market price of asset; and Depreciation adjustments in the balance sheet do not reflect actual changes in market values.
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The Cash Flow Statement


The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash.

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Sources and Uses of Cash


Source of cash is any activity that brings cash into the firm. For example, sale of equipment. Use of cash is any activity that causes cash to leave the firm. For example, payment of taxes.

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Balance Sheet for H.J. Boswell, Inc.

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Cash Flow Analysis


Why did the cash balance decline by $4.5 million from 2009 to 2010? 1.Accounts receivable increased by $22.5 million representing an increase in uncollected cash from credit sales. Thus it represents $22.5m of use of cash to invest in accounts receivable.

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Cash Flow Analysis (cont.)


2. Inventory increased by $148.50 million indicating use of cash to procure inventory. 3. Equipment increased by $175.50 million indicating use of cash to invest in equipment. In general,
an increase in an asset account = use of cash a decrease in an asset account = source of cash
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Cash Flow Analysis (cont.)


4. Accounts Payable, credit extended to the firm, increased by $4.5million. Thus source of cash increased by $4.5million due to accounts payable. 5. Long-term debt increased by $51.75 million indicating a source of cash. 6. Short-term debt decreased by $9 million indicating use of cash to pay off the debt.
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Cash Flow Analysis (cont.)


7. Retained earnings increased by $159.75 million representing a source of cash to the firm from the firms operations. In general,
An increase in a liability account = source of cash A decrease in a liability account = use of cash
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Cash Flow Analysis (cont.)


Change in cash balance = Sources of cash Use of Cash = $216 - $220.50 = -$4.50
Sources of Cash
Increase in Accounts Payable = $4.50

Uses of Cash
Increase in Accounts Receivable $22.50

Increase in long-term debt =$51.75 Increase in inventory = $148.50 Increase in retained earnings = $159.75 Increase in net plant and equipment = $40.50 Decrease in short-term notes = $9 Total Sources of cash = $216.00 Total Uses of cash = $220.50

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Cash Flow Analysis (cont.)


An analysis of H.J. Boswells operations reveals the following for 2010:

The firm used more cash than it generated, resulting in a deficit of $4.5 million The primary source of cash flow was retained earnings ($159.75 million) followed by long-term debt ($51.75 million) The largest use of cash was for acquiring inventory at $148.5 million.

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Cash Flow Analysis Summary


Sources of Cash
Decrease in an asset account Increase in a liability account Increase in an owners equity account

Uses of Cash
Increase in an asset account Decrease in a liability account Decrease in an owners equity account

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Cash Flow Statement


The format for a traditional cash flow statement is as follows: Beginning Cash Balance Plus: Cash Flow from Operating Activities Plus: Cash Flow from Investing Activities Plus: Cash Flow from Financing Activities Equals: Ending Cash Balance
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Cash Flow Statement (cont.)


Operating activities represent the companys core business including sales and expenses. Basically any activity that affects net income for the period. Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment.
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Cash Flow Statement (cont.)


Financing activities represent changes in the firms use of debt and equity such as issue of new shares, payment of dividends.

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H.J. Boswell, Inc. Statement of Cash Flows

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Interpreting the Statement of Cash Flow


You are in your second rotation in the management training program at a regional brokerage firm and your supervisor calls you into her office on Monday morning to discuss your next training rotation. When you enter her office you are surprised to learn that you will be responsible for compiling a financial analysis of Chesapeake Energy Inc. (CHK). Chesapeake is the largest producer of natural gas in the United States and is headquartered in Oklahoma City. Your boss suggests that you begin your analysis by reviewing the firms cash flow statements for 2004 through 2007 (found below):

Checkpoint 3.3

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Checkpoint 3.3

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Checkpoint 3.3

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Checkpoint 3.3

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Checkpoint 3.3

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Why Do We Analyze Financial Statements?


A firms financial statements can be analyzed internally (by employees, managers) and externally (by bankers, investors, customers, and other interested parties).

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Why Do We Analyze Financial Statements? (cont.)


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 firms different divisions. To prepare financial projections, such as those associated with the launch of a new product. To evaluate the firms financial performance in light of its competitors and determine how the firm might improve its operations.

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Why Do We Analyze Financial Statements? (cont.)


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 firms creditworthiness.
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Why Do We Analyze Financial Statements? (cont.)


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.

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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 firms financial statements, even if the firms are not of equal size.
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Common Size Statements Standardizing Financial Information (cont.)

How to prepare a common size financial statement?


For a common size income statement, divide each entry in the income statement by the companys sales. For a common size balance sheet, divide each entry in the balance sheet by the firms total assets.

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Common Size Income Statement (H. J. Boswell, Inc.)

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Table 4-1 Observations


Table 4-1 is created by dividing each entry in the income statement found in Table 3-1 by firm sales for 2010. Cost of goods sold make up 75% of the firms sales resulting in a gross profit of 25%. Selling expenses account for about 3% of sales. Income taxes account for 4.1% of the firms sales. After accounting for all expenses, the firm generates net income of 7.6% of firms sales.
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Common Size Balance Sheet (H. J. Boswell, Inc.)

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Table 4-2 Observations


Table 4-2 is created by dividing each entry in the balance sheet found in Table 3-2 by total assets for the year.
Total current assets increased by 5.6% in 2010 while total current liabilities declined by 2%. Long-term debt account for 39.2% of firms assets, showing a decline of 1.7%. Retained earnings increased by 5.8% in 2010.
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Using Financial Ratios


Financial ratios provide a second 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.
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Using Financial Ratios (cont.)


Question
1. How liquid is the firm? Will it be able to pay its bills as they become due? 2. How has the firm financed the purchase of its assets? 3. How efficient has the firms management been in utilizing it assets to generate sales? 4. Has the firm earned adequate returns on its investments? 5. Are the firms managers creating value for shareholders?

Category of Ratios Used Liquidity ratios

Capital structure ratios Asset management efficiency ratios Profitability ratios Market value ratios

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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 firms liquidity from two perspectives:
Overall or general firm liquidity Liquidity of specific current asset accounts

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Liquidity Ratios (cont.)


Overall liquidity is analyzed by comparing the firms current assets to the firms current liabilities. Liquidity of specific assets is analyzed by examining the timeliness in which the firms primary liquid assets accounts receivable and inventories are converted into cash.
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Liquidity Ratios: Current Ratio


The overall liquidity of a firm is analyzed by computing the current ratio and acidtest ratio. Current Ratio: Current Ratio compares a firms current (liquid) assets to its current (short-term) liabilities.

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Liquidity Ratios: Current Ratio (cont.)


The text computes the current ratio for H.J. Boswell, Inc. for 2010. What is the current ratio for 2009?

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Liquidity Ratios: Current Ratio (cont.)


Current Ratio = $477 292.5 = 1.63 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.

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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.

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Liquidity Ratios: Quick Ratio (cont.)


The text computes the quick ratio for H.J. Boswell, Inc. for 2010. What is the quick ratio for 2009?

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Liquidity Ratios: Quick Ratio (cont.)

Quick Ratio = ($477-$299.50) ($292.50) = 0.63 times


The firm is clearly less liquid using quick ratio as the firm has only $0.63 in current assets (less inventory) to cover $1 in current liabilities. The quick ratio improved in 2010 to 0.94 times largely due to an increase in current assets.
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Liquidity Ratios: Individual Asset Categories


We can also measure the liquidity of the firm by examining the liquidity of individual current asset accounts, including accounts receivable and inventories. We can assess the liquidity of the firm by measuring how long it takes the firm to convert its accounts receivables and inventories into cash.
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Liquidity Ratios: Accounts Receivable

Average Collection Period measures the number of days it takes the firm to collects its receivables.

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Liquidity Ratios: Accounts Receivable (cont.)

The text computes the average collection period for H.J. Boswell, Inc. for 2010. What will be the average collection period for 2009 if we assume that the annual credit sales were $2,500 million in 2009?

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Liquidity Ratios: Accounts Receivable (cont.)

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.
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Liquidity Ratios: Accounts Receivable Turnover Ratio


Accounts Receivable Turnover Ratio measures how many times accounts receivable are rolled over during a year.

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Liquidity Ratios: Accounts Receivable Turnover Ratio


The text computes the accounts receivable turnover ratio for H.J. Boswell, Inc. for 2010. What will be the accounts receivable turnover ratio for 2009 if we assume that the annual credit sales were $2,500 million in 2009?
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Liquidity Ratios: Accounts Receivable Turnover Ratio

Accounts Receivable Turnover = $2,500 million $139.50 = 17.92 times The firms accounts receivable were turning over at 17.92 times per year.
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Liquidity Ratios: Inventory Turnover Ratio

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.

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Liquidity Ratios: Inventory Turnover Ratio


The text computes the inventory turnover ratio for H.J. Boswell, Inc. for 2010. What will be the inventory turnover ratio for 2009 if we assume that the cost of goods sold were $1,980 million in 2009?

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Liquidity Ratios: Inventory Turnover Ratio (cont.)

Inventory Turnover Ratio = $1,980 $229.50 = 8.63 times The firm turned over its inventory 8.63 times per year.
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Liquidity Ratios: Days Sales in Inventory


We can express the inventory turnover ratio in terms of the number of days the inventory sits unsold on the firms 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.

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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.
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Checkpoint 4.1
Evaluating Dell Computer Corporations (DELL) Liquidity You work for a small company that manufactures a new memory storage device. Computer giant Dell has offered to put the new device in their laptops if your firm will extend them credit terms that allow them 90 days to pay. Since your company does not have many cash resources, your boss has asked that you look into Dells liquidity and analyze its ability to pay their bills on time using the following accounting information for Dell and two other computer firms (figures in thousands of dollars):

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Checkpoint 4.1

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Checkpoint 4.1

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Checkpoint 4.1

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Checkpoint 4.1: Check Yourself

Calculate HPs inventory turnover ratio. Why do you think this ratio is so much lower than Dells inventory turnover ratio?

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Step 1: Picture the Problem


One of the indicators of liquidity of the firm is the inventory turnover ratio. This ratio will measure how many days items remain in inventory before being sold. Inventory turnover ratio is important as it has implications for cash flows and profitability of a firm.

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Step 2: Decide on a Solution Strategy


We will use the inventory turnover ratio to determine HPs inventory turnover ratio. This will give us clues about inventory practices at HP. We will use the following equation to compute the Inventory Turnover (IT) ratio
IT ratio = Cost of Goods Sold Inventories

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Step 3: Solve
Inventory Turnover Ratio for HP
= Cost of Goods Sold Inventories = $69,178,000 7,750,000 = 8.93

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Step 4: Analyze
HPs inventory turnover ratio indicates that the inventory at HP remains on shelf for (365 8.93) days or 40.87 days. This is much higher than Dell that has an inventory turnover ratio of 79.79 or shelf life of only 4.57 days. The significant difference must be investigated further as the two firms are in the same industry.

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Step 4: Analyze (cont.)


There are two reasons why HP has a lower turnover of inventories relative to Dell:
HP sells computers out of inventory of computers while Dell builds computers only when orders are received. HP carries more parts inventory on hand than does Dell

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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.
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Capital Structure Ratios (cont.)


Debt ratio measures the proportion of the firms assets that are financed by borrowing or debt financing.

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Capital Structure Ratios (cont.)


The text computes the debt ratio for H.J. Boswell, Inc. for 2010. What will be the debt ratio for 2009?

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Capital Structure Ratios (cont.)

Debt Ratio
= $1,012.50 million $1,764 million = 57.40%

The firm financed 57.39% of its assets with debt.


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Capital Structure Ratios (cont.)


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.
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Capital Structure Ratios (cont.)


The text computes the times interest earned ratio for H.J. Boswell, Inc. for 2010. What will be the times interest earned ratio for 2009 if we assume interest expense of $65 million and EBIT of $350 million?
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Capital Structure Ratios (cont.)


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% (10018.58), the firm will be able to pay its interest expense.
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Checkpoint 4.2
Comparing the Financing Decisions of Home Depot (HD) and Lowes Corporation (LOW)
You inherited a small sum of money from your grandparents and currently have it in a savings account at your local bank. After enrolling in your first finance class in business school you have decided that you would like to begin investing your money in the common stock of a few companies. The first investment you are considering is stock in either Home Depot or Lowes. Both firms operate chains of home improvement stores throughout the United States and other parts of the world. In your finance class you learned that an important determinant of the risk of investing in a firms stock is driven by the firms capital structure, or how it has financed its assets. In particular, the more money the firm borrows, the greater is the risk that the firm may become insolvent and bankrupt. Consequently, the first thing you want to do before investing in either companys stock is to compare how they financed their investments. Just how much debt financing have the two firms used?

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Checkpoint 4.2

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Checkpoint 4.2

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Checkpoint 4.2

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Checkpoint 4.2: Check Yourself


What would be Home Depots times interest earned ratio if interest payments remained the same, but net operating income dropped by 80% to only $1.9346 billion? Similarly if Lowes net operating income dropped by 80%, what would its times interest earned ratio be?

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Step 1: Picture the Problem


Times interest earned ratio is an important ratio for firms that use debt financing. It measures the firms ability to service its debt. The ratio requires comparing net operating income or EBIT with Interest expense. Both items are found on the income statement.
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Step 1: Picture the Problem (cont.)


Picture an Income Statement
Sales

EBIT

Less: Cost of Good Sold Equals: Gross Profit Less: Operating Expenses Equals: Net Operating Income (EBIT) Less: Interest Expense Equals: Earnings before Taxes Less: Taxes Equals Net Income

Interest Expense

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Step 2: Decide on a Solution Strategy


Here we are considering the impact of a drop in EBIT on the times interest earned ratio of Home Depot and Lowes. We will use the following ratio to measure the times interest earned (TIE) ratio. TIE = EBIT Interest Expense

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Step 3: Solve
Times Interest Earned (TIE)
= EBIT Interest Expense

TIE (Home Depot)


= $1.9346 billion $0.392 billion = 4.94 times

TIE (Lowes)
= $1.03 billion $0.154 billion = 6.69 times
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Step 4: Analyze
We observe that a drop in net operating income leads to a significant drop in times interest earned ratio for both the firms. The times interest earned ratio drops from 24.68 to 4.94 for Home Depot and from 33.45 to 6.69 for Lowes. Should creditors be worried by this drop?

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Step 4: Analyze (cont.)


The ratio is still reasonably safe. For example, for Home Depot, it indicates that the firm can pay its interest expense 4.94 times out of its EBIT. Thus, even if the EBIT shrank further by 79.75% (11/4.94 = 1-.2025 or 79.75%), it can still pay its interest expense.
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How does Leverage work?


Suppose we have an all equityfinanced firm worth $100,000. Its earnings this year total $15,000.

ROE =

15,000 100,000

= 15%

(ignore taxes for this example)


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How does Leverage work?


Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.

ROE =

15,000 - 4,000 = 50,000

22%

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Asset Management Efficiency Ratios


Asset management efficiency ratios measure a firms 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.

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Asset Management Efficiency Ratios (cont.)


Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in firms assets.

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Asset Management Efficiency Ratios (cont.)


The text computes the total asset turnover ratio for H.J. Boswell, Inc. for 2010. What will be the total asset turnover ratio for 2009 if we assume the total sales in 2009 were $2,500 million?

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Asset Management Efficiency Ratios (cont.)

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.
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Asset Management Efficiency Ratios (cont.)


Fixed asset turnover ratio measures firms efficiency in utilizing its fixed assets (such as property, plant and equipment).

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Asset Management Efficiency Ratios (cont.)


The text computes the fixed asset turnover ratio for H.J. Boswell, Inc. for 2010. What will be the fixed asset turnover ratio for 2009 if we assume sales of $2,500 million for 2009?

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Asset Management Efficiency Ratios (cont.)

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.
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Asset Management Efficiency Ratios (cont.)


We could similarly compute the turnover ratio for other assets. We had earlier computed the receivables turnover and inventory turnover, which measured firm effectiveness in managing its investments in accounts receivables and inventories.
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Asset Management Efficiency Ratios (cont.)


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 =
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Asset Management Efficiency Ratios (cont.)


For Boswell, 2010 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

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Asset Management Efficiency Ratios (cont.)


The following grid summarizes the efficiency of Boswells management in utilizing its assets to generate sales in 2010.
Turnover Ratio Total Assets Fixed Assets Receivables Inventory Boswell 1.37 2.03 16.67 5.36 Peer Group 1.15 1.75 14.60 7.0 Assessment Good Good Good Poor
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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 firms profit margin, which predict the ability of the firm to control its expenses, and the firms rate of return on investments.
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Profitability Ratios (cont.)


Two fundamental determinants of firms 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?

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Profitability Ratios (cont.)


Gross profit margin shows how well the firms management controls its expenses to generate profits.

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Profitability Ratios (cont.)


The text computes the gross profit margin ratio for H.J. Boswell, Inc. for 2010. What will be the gross profit margin ratio for 2009 if we assume sales of $2,500 million and gross profit of $650 million for 2009?

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Profitability Ratios (cont.)

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.
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Profitability Ratios (cont.)


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.

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Profitability Ratios (cont.)


The text computes the operating profit margin ratio for H.J. Boswell, Inc. for 2010. What will be the operating profit margin ratio for 2009 if we assume sales of $2,500 million and net operating income of $350 million for 2009?
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Profitability Ratios (cont.)

Operating Profit Margin = $350 million $2,500 million = 14% Thus the firm generates $0.14 in operating profit for each dollar of sales.
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Profitability Ratios (cont.)


Net Profit Margin measures how much income is generated from each dollar of sales after adjusting for all expenses (including income taxes).

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Profitability Ratios (cont.)


The text computes the net profit margin ratio for H.J. Boswell, Inc. for 2010. What will be the net profit margin ratio for 2009 if we assume sales of $2,500 million and net income of $217.75 million for 2009?

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Profitability Ratios (cont.)

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.
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Profitability Ratios (cont.)


Operating Return on Assets ratio is the summary measure of operating profitability, which takes into account both the managements success in controlling expenses, contributing to profit margins, and its efficient use of assets to generate sales.

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Profitability Ratios (cont.)


The text computes the operating return on assets ratio for H.J. Boswell, Inc. for 2010. What will be the operating return on assets ratio for 2009 if we assume EBIT or net operating income of $350 million for 2009?
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Profitability Ratios (cont.)

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.

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Profitability Ratios (cont.)


Decomposing the OROA ratio: We can use the following equation to decompose the OROA ratio that allows us to analyze the firms ability to control costs and utilize its investments in assets efficiently.

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Profitability Ratios (cont.)

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Figure 4-1 Observations


Firms OROA (operating return on assets) is better than its peers. Thus the firm earned more net operating income per dollar invested in assets. Firms OPM (operating profit margin) is lower than its peers. Thus the firm retained a lower percentage of its sales in net operating income. Firms TATO (total asset turnover ratio) is higher than its peers. Thus the firm generated more sales from its assets.

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Figure 4-1 Recommendations


The firm has two opportunities to improve its profitability: 1.Reduce costs - The firm must investigate the cost of goods sold and operating expenses to see if there are opportunities to reduce costs. 2.Reduce inventories The firm must investigate if it can reduce the size of its inventories.
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Checkpoint 4.3
Evaluating the Operating Return on Assets Ratio for Home Depot (HD) and Lowes (LOW)
In Checkpoint 4.2 we evaluated how much debt financing Home Depot and Lowes used. We continue our analysis by evaluating the operating return on assets (OROA) earned by the two firms. Calculate the net operating income each firm earned during 2007 relative to the total assets of each firm using the information found below:

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Checkpoint 4.3

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Checkpoint 4.3

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Checkpoint 4.3

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Checkpoint 4.3: Check Yourself


If Home Depot were able to raise its total asset turnover ratio to 2.5 while maintaining its current operating profit margin, what would happen to its operating return on assets?

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Step 1: Picture the Problem


The operating return on assets ratio for a firm is determined by two factors: cost control and efficiency of asset utilization. It is expressed by equation 4-13a. Here the focus is on asset utilization i.e. improvement in total asset turnover ratio.

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Step 2: Decide on a Solution Strategy


We will analyze the impact on operating return on assets of improvement on the total asset turnover ratio by using the following equation: Operating Return on Assets (OROA)
= Total Asset Turnover Operating Profit Margin

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Step 3: Solve
Operating Return on Assets (OROA)
= Total Asset Turnover Operating Profit Margin

Before = 1.74 10.65% = 18.53% Now = 2.5 10.65% = 26.63%

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Step 4: Analyze
An improvement in total asset turnover ratio has a favorable impact on Home Depots operating return on assets (OROA). If Home Depot wants to increase its OROA more, it should focus on cost control that will help improve the net operating profit.
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Is the Firm Providing a Reasonable Return on the Owners Investment? A firms net income consists of earnings that is available for distribution to the firms shareholders. Return on Equity ratio measures the accounting return on the common stockholders investment.

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Is the Firm Providing a Reasonable Return on the Owners Investment (cont.)

The text computes the return on equity ratio for H.J. Boswell, Inc. for 2010. What will be the return on equity ratio for 2009 if we assume net income of $217.75 million for 2009?

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Is the Firm Providing a Reasonable Return on the Owners Investment (cont.)

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 firms retained earnings.

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Using the DuPont Method for Decomposing the ROE ratio


DuPont method analyzes the firms 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 firms use of debt financing on its return on equity. The equity multiplier increases in value as the firm uses more debt.

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Using the DuPont Method for Decomposing the ROE ratio (cont.)
ROE = Profitability Efficiency Equity Multiplier

ROE = Net Profit Margin Total Asset Turnover Ratio 1/(1-debt ratio)
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Using the DuPont Method for Decomposing the ROE ratio (cont.) The following table shows why Boswells return on equity was higher than its peers.
Return on Equity H. J. Boswell, Inc. Peer Group 22.5% Net Profit Total Asset Equity Margin Turnover Multiplier 7.6% 1.37 2.16

18.0%

10.2%

1.15

1.54

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Using the DuPont Method for Decomposing the ROE ratio (cont.)
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. Impact of financial leverage is discussed in detail in chapter 15.
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Using the DuPont Method for Decomposing the ROE ratio (cont.)

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Market Value Ratios


Market value ratios address the question, how are the firms shares valued in the stock market? Two market value ratios are:
Price-Earnings Ratio Market-to-Book Ratio

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Market Value Ratios (cont.)


Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1 of reported earnings.

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Market Value Ratios (cont.)


The text computes the PE ratio for H.J. Boswell, Inc. for 2010. What will be the PE ratio for 2009 if we assume the firms 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?
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Market Value Ratios (cont.)

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.

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Market Value Ratios (cont.)


Market-to-Book Ratio measures the relationship between the market value and the accumulated investment in the firms equity.

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Market Value Ratios (cont.)


The text computes the market-to-book ratio for H.J. Boswell, Inc. for 2010. What will be the market-to-book ratio for 2009 given that the current market price of the stock is $22 and the firm has 90 million shares outstanding?

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Market Value Ratios (cont.)


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
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Checkpoint 4.4
Comparing the Valuation of Dell (DELL) to Apple (APPL) Using Market Value Ratios
The following information on Dell and Apple was gathered on April 9, 2010:

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Checkpoint 4.4

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Checkpoint 4.4

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Checkpoint 4.4: Check Yourself

What price per share for Dell would it take to increase the firms price-toearnings ratio to the level of Apple?

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Step 1: Picture the Problem


Price-to-earnings (PE) ratio depends on earnings per share and price per share, pictured as follows:

Price per share standardized by

EPS = Net income number Of shares outstanding

PE Ratio = Price per share Earnings per share

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Step 2: Decide on a Solution Strategy


We need to determine the price per share that will make PE ratio of Dell equal to the PE ratio of Apple. PE ratio of Dell has to increase from 11.04 to 18.20. PE ratio = Price per share Earnings per share ==> 18.20 = ? 1.14
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Step 3: Solve
PE ratio = Price per share Earnings per share 18.20 = Price per share $1.14 Price per share = 18.20 1.14 = $20.75

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Step 4: Analyze
PE ratio allows us to compare two stocks with different prices by standardizing the stock prices by earnings. Apple has a much higher PE ratio. To reach the same PE valuation, the stock price of Dell will have to increase from $12.54 to $20.75.
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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.
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Summing up the Financial Analysis of H. J. Boswell, Inc.


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.
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Selecting a Performance Benchmark


There are two types of benchmarks that are commonly used:
Trend Analysis involves comparing a firms financial statements over time. Peer Group Comparisons involves comparing the subject firms 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.
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Trend Analysis

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Financial Analysis of the Gap, Inc., June 2009

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The Limitations of Ratio Analysis


1. Picking an industry benchmark can sometimes be difficult. 2. Published peer-group or industry averages are not always representative of the firm being analyzed. 3. An industry average is not necessarily a desirable target or norm.

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The Limitations of Ratio Analysis (cont.)


4. Accounting practices differ widely among firms. 5. Many firms experience seasonal changes in their operations. 6. Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios. 7. The results of financial analysis are dependent on the quality of the financial statements.
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Practice Problems
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Example #1 Assume you are given the following relationships for the Brauer Corporation:
Sales / Total Assets 1.5x Return on Assets (ROA) 3% Return on Equity (ROE) 5%

Calculate Brauers profit margin and debt ratio.


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Example #1
ROA = Profit margin Total assets turnover 3% = Profit margin x 1.5 Profit margin = 3% / 1.5 = 2% ROE = ROA TA/E 5% = 3% TA/E TA/E = 5% / 3% E/TA = 3/5 = 60% therefore, D/TA = 1 - 0.60 = 0.40 = 40%
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Team Assignment
Complete the balance sheet and sales information in the table that follows for Hoffmeister Industries using the following financial data (all sales are on credit):
Debt Ratio: 50% Current Ratio: 1.8x Total assets turnover: 1.5x Accounts receivable turnover: 10x Gross profit margin on sales: 25% Inventory turnover ratio: 5x
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Team Assignment
BALANCE SHEET C ash A c c o u n ts re c e iv a b le In v e n to rie s F ix e d a s s e ts T o ta l a s s e ts S a le s A c c o u n ts p a y a b le L o n g -te rm d e b t C o m m o n s to c k R e t a i n e d e a r n i n g s 66 666 , $6 6 ,6 6 T o t a l l i a b i l i t i e s & e q u i t y 6 6 C o s t o f g o o d s s o ld
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66 666 ,

Team Assignment
1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000. 2. Accounts payable = Debt Long-term debt = $150,000 - $60,000 = $90,000. 3. Common stock = Total liabilities & equity - Debt Retained earnings = $300,000 - $150,000 - $97,500 = $52,500. 4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000. 5. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500 6. Inventories = Cost of goods sold /5 = $337,500/5 = $67,500.
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Team Assignment
7. Accounts receivable = Credit Sales / Accounts receivable turnover = ($450,000/10) = $45,000. 8. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable) Cash + $45,000 + $67,500 = (1.8)($90,000) Cash + $112,500 = $162,000 Cash = $49,500. 9. Fixed assets = Total assets - (Cash + Accts rec. + Inventories) Fixed assets = $300,000 - ($49,500 + $45,000 + $67,500) = $138,000. AFS-216