Business Strategy Using

Financial Statements
Chapter 8
Financial Analysis
 Overview of Financial Analysis
• The goal of financial analysis is to use
financial data to evaluate the current
and past performance of a firm and to
assess its sustainability.
• Ratio analysis and cash flow analysis
are the two most commonly used
financial tools
 Drives of a firm’s profitability and growth
Growth and Profitability

Product Market Financial Market

Strategies Policies

Operating Investment Financial Dividend

Management Management Decision Policy

Managing Managing Managing

Working Managing
Revenue and Liabilities and
Capital and Payout
Expenses Equity
Fixed Asset
 Ratio analysis
• Ratio analysis involves assessing how various line items
in a firm’s financial statements relate to one another.
• Financial ratios are used to compare the risk and return of
different firms in order to help equity investors and
creditors make investment and credit decision
• In a ratio analysis, the analyst can
(1) Compare ratios for a firm over several years
(2) Compare ratios for the firm and other firms in the
industry
(3) Compare ratios to some absolute benchmark
 ROE—Measuring Overall Profitability

• ROE=Net income/Shareholder’s equity

• ROE is a measure of return a company generates on
shareholder equity
• When to use indicator: Investor can use this ratio to
determine how productively a company employs
shareholder’s equity to generate income
• A comparison of ROE with the cost of capital is
useful not only for contemplating the value of the
firm but also in considering the path of future
profitability
 Example: Nordstrom and TJX
• Nordstrom is a leading fashion retailer, offering a wide variety
of high-end of apparel, shoes and accessories.
(1) pursues a strategy of high quality, extraordinary service and
premium price.
(2) make significant investment in its store
(3) have a credit card operation
• TJX operates off-price apparel and home fashions retail stores
(1) offer brand name goods at 20-60 percent below regular pric
es
(2) with a highly efficient distribution network and low cost str
ucture
(3) lease its store
 ROE for Nordstrom and TJX
Nordstrom TJX
1998 1997 1998
ROE 15.6% 12.6% 34.5%
(1) Nordstrom’s ROE show a significant
improvement.
(2) Nordstrom’s ROE is far behind TJX’s ROE
(3) This is reflected in the difference in the two
companies ratio of market value of equity to its
book value
 Decomposing profitability:
Traditional Approach
ROE = NI/Assets * Assets/SE
= ROA * Financial leverage
=NI/Sales * Sales/Assets * Assets/SE
= Net Profit margin * Asset turnover *

Financial leverage
 For example: traditional
decomposition of ROE
Ratio Nordstrom TJX
1998 1997 1998
Net profit margin (ROS) 4.1% 3.85% 5.3%
* Asset turnover 1.61 1.68 2.89
= ROA 6.6% 6.5% 15.3%
* Financial leverage 2.37 1.95 2.25
= ROE 15.6% 12.6% 34.5%
(1) Nordstrom’ ROE increase is largely driven by an increase in financi
al leverage and by an increase in net profit margin.
(2) TJX’ ROE is driven by higher profit margins and better asset utiliza
tion
 Decomposing Profitability: Alternative Approach
• ROE=NOPAT/Equity—Net interest expense after tax/Equity
=NOPAT/Net assets * Net assets/Equity—Net interest
expense after tax/Net asset * Net debt/Equity
=NOPAT/Net assets * (1+Net debt/Equity)—Net interest after
tax/Net debt * Net debt/Equity
=Operating ROA + (Operating ROA—Effective interest after
tax/Net debt ) * Net financial leverage
=Operating ROA + Spread * Net financial leverage
Operating ROA is a measure of how profitably a company is able t
o deploy its operating assets to generate operating profits;
Spread is the incremental economic effect from introducing debt int
o the capital structure
• Operating ROA=NOPAT/Sales * Sales/Net assets
=Net operating profit margin * Net operating asset turnover
 For example—Distinguishing Operating and Financing
Components in ROE Decomposition
Nordstrom TJX Average
Ratio 1998 1997 1998 standard
Net operating profit margin 4.7% 4.3% 5.3%
*Net operating asset turnover 2.49 2.27 8.11
=Operating ROA 11.7% 9.8% 43.0% 9%-11%
Spread 7.3% 6.4% 42.9%
*Net financial leverage 0.54 0.45 (0.20)
=Financial leverage gain 3.9% 2.8% (8.5%)
ROE=Operating ROA+Financial
Leverage gain 15.6% 12.6% 34.5%
• Nordstrom’s operating ROA is in average level and TJX is far larger than Nordstro
m and average level.
• TJX has a better NOPAT margin and a dramatically higher operating asset turnover
• Nordstrom is able to create shareholder value through its financing strategy
• TJX has a negative net financial leverage because the firm had a large cash balance i
n 1998. As a result, the firm had a lower ROE than its operating ROA.
 Assessing Operating Management:
Decomposing Net Profit Margins
• Net profit margin(ROS) shows the profitability of the com
pany’s operating activities.
• Decomposing net profit margins makes an analyst to asses
s the efficiency of the firm’s operating management
• Analytic tool—common-sized income statement
Common-sized income statement is a statement in which al
l the line items are expressed as a ratio of sales revenues
Common-sized income statement makes it possible to com
pare trends in income statement relationships over time fo
r the firm, and trends across different firms in the industry.
 Gross Profit Margins
• Gross profit margin is an indication to the extent
to which revenues exceed direct costs associated
with sales.
Gross profit margin =( Sales-Cost of Sales)/Sales
• Gross profit margin is influenced by two factors
(1) the price premium
(2) the efficiency of the procurement and
production process
 Selling, General, and
Administrative expense (SG&A)
• SG&A expenses are influenced by the operating
activities
The firms have to undertake SG&A expenses to
implement its competitive strategy.
• SG&A expenses are also influenced by the
efficiency
The control of operating expenses is important for
firms competing on the basis of low cost.
 Net operating profit margin ratio
and EBITDA margin
• NOPAT margin is a measure of how profitable a company’
s sales are from an operating perspective.
NOPAT=NOPAT/Sales
It reflects all operating policies and eliminates the effects
of debt policy
• EBITDA margin provides a comprehensive indication of t
he operating performance except that it includes depreciati
on and amortization expense
EBITDA margin=Earning before interest, taxes, depreciati
on, and amortization/Sales
It focus on “cash” operating items.
 Tax expense
• Firms attempt to reduce their tax expenses
through tax planning techniques.
• There are two measures to evaluate a firm’s
tax expense
(1) the ratio of tax expense to sales.
(2) the ratio of tax expense to earnings
before taxes.
 For example—common-sized income statement
Nordstrom TJX
1998 1997 1998
Line Items as a Percent of Sales
Sales 100% 100% 100%
Cost of Sales (66.5) (67.9) (74.9)
Selling, general, and admin. Expense (28.0) (27.3) (16.2)
Other income/expense 2.1 2.2 ---
Net interest expense/income (0.9) (0.7) ---
Income taxes (2.6) (2.5) (3.4)
Unusual gains/losses, net of taxes --- --- (0.1)
Net income 4.1% 3.8% 5.3%

We can use this common-sized income statement to investigate why Nordstro

m had a net income margin of 4.1% in 1998 and 3.8% in 1997, while TJX
had a net margin of 5.3%.
 For example—Profitability Ratios
Key Profitability Ratios Nordstrom TJX
1998 1997 1998
Gross profit margin 33.5% 32.1% 25.1%
EBITDA margin 10.4% 9.7% 10.6%
NOPAT margin 4.7% 4.3% 5.3%
Net Margin 4.1% 3.8% 5.3%
• Nordstrom’s gross margins are significantly highly than TJX.
It reflects Nordstrom’s premium price strategy
• TJX has a slightly better EBITDA margin than Nordstrom
TJX leases most of its stores and leasing expense is deducted in the cal
culation of EBITDA.
• Nordstrom’s NOPAT margin and Net margin has improved a little betw
een 1997 and 1998.It is primarily driven by a reduction of cost of sales
.
• TJX has a better NOPAT margin and Net margin because it is able to sa
ve significantly on SG&A expenses.
 Evaluating Investment Management:
Decomposing Asset Turnover
• Asset turnover is the second drive of a
firm’s return on equity.
• An analysis of asset turnover can estimate
the effectiveness of a firm’s investment
management.
• There are two primary area management
(1) working capital management
(2) management of long-term asset
 Working capital management
• Operating working capital-to-sales ratio=Operating working
capital/sales
• Operating working capital=(current assets-cash & marketable
securities)-(current liabilities-short term & current portion of long-
term debt)
• Operating working capital turnover=Sales/operating working capital
• Account receivable turnover=sales/accounts receivable
• Inventory turnover=Cost of goods sold/inventory
• Accounts payable turnover=COGS/Accounts payment
• Day’s receivables=Accounts receivable/Average sales per day
• Day’s inventory=Inventory/ COGS per day
• Day’s payable=Accounts payable/COGS per day
 Long-term asset management
• Net long-term asset
turnover=Sales/Net long-term assets
Net long-term assets=(Total long term
assets -Non interest bearing long term
liabilities)
• PP&E turnover=Sales/PP&E(net)
 For example: Asset Management Ratios
Ratio Nordstrom TJX
1998 1997 1998
Operating working capital/Sales 16.2% 20.8% (0.3%)
Net long term assets/Sales 24.0% 23.2% 12.6%
PPE/Sales 27.1% 25.8% 9.5%
Operating working capital turnover 6.17 4.81 not meaningful
Net long term assets turnover 4.17 4.31 7.94
PPE turnover 3.69 3.88 10.52
Accounts receivable turnover 8.56 7.30 117.9
Inventory turnover 4.46 3.99 5.0
Accounts payable turnover 9.85 10.26 9.6
Day’s accounts receivable 42.6 50 3.1
Day’s inventory 81.8 91.5 73
Day’s accounts payment 37.1 35.6 38
 For example: Asset Management
Ratios(cont.)
• Nordstrom achieved an improvement in working capital management
between 1997and 1998.
a reduction of operating working capital as a percent of sales and an
increase in operating working capital turnover.
• Nordstrom’s improvement is attributable to a reduction in A/R and
better inventory management.
• Nordstrom’s long term asset utilization declined a little.
Net long term asset turnover and PPE turnover showed marginal declines.
• TJX achieved dramatically better asset utilization ratios
Taking full advantage of trade credit
Managing inventory more efficiently
Operating leases to lower capital in stores and improving PPE turnover
 Evaluating Financial Management:
Financial Leverage
• Financial leverage—debt in relation to equity in a
firm’s capital structure
• Financial leverage increases a firm’s ROE as long as
the cost of the liabilities is less than the return from
investing these funds.
• There are a number of ratios to evaluate the degree of
risk arising from a firm’s financial leverage
(1) Current liabilities and short term liquidation
(2) Debt and long term solvency
(3) Ratio of disaggregated data
 Current liabilities and short term liquidity

• Current ratio = current assets/current liabilities

A key index of a firm’s short term liquidation
• Quick ratio = (cash+short term investment+account
receivables)/current liabilities
• Cash ratio = (cash+marketable securities)/current liabilities
Quick ratio and Cash ratio capture the firm’s ability to cover
current liabilities from liquid asset
• Operating cash flow ratio = cash flow from
operations/current liabilities
Measure of the firm’s ability to cover current liabilities
from cash generated from operation
 For example: Liquidity ratios
Nordstrom TJX
Ratio 1998 1997 1998
Current ratio 2.19 1.71 1.33
Quick ratio 1.08 0.73 0.40
Cash ratio 0.31 0.03 0.35
Operating cash flow ratio 0.78 0.32 0.49
• Nordstrom’s liquidity ratio improved in 1998.
Accumulated a large cash balance and improved cash flow from operati
on
• TJX has a comfortable liquidity position.Because of tight management
of operating working capital, however, TJX’current and quick ratios ar
e smaller than Nordstrom’s
 Debt and long-term solvency
• A firm’s financial leverage is influenced by its
financing policy.
Benefits from debt financing—cheaper than equity,
tax deductible, impose discipline on management
and financing easily.
• The optimal capital structure for a firm is
determined primarily by its business risk.
Low business risk can rely heavily on debt
financing.
 Debt and long-term solvency(cont.)
The following ratios are used to estimate a firm’s long-term solvency
• Liabilities to equity ratio: Asset to equity ratio
• Debt to equity ratio
• Net debt to equity ratio
Net debt = debt-cash and marketable securities
• Debt to capital ratio=debt/(debt+equity)
• Net debt to net capital ratio=(interest bearing liabilities-cash and
marketable securities)/(interest bearing liabilities-cash and marketable
securities+shareholders’ equity)
• Interest coverage(earning basis)=EBIT/interest expense
• Interest coverage(cash flow basis)=(cash flow from operation+interest
expense+taxes paid)/interest expense
 For example:debt and coverage ratio
Nordstrom TJX
Ratio 1998 1997 1998
Liabilities to equity 1.37 0.95 1.25

Debt to equity 0.72 0.46 0.18

Net debt to equity 0.54 0.48 (0.20)
Debt to capital 0.42 0.38 0.15
Net debt to net capital 0.35 0.31 (0.25)
Net debt to equity
(including operating lease) Not available Not available 1.19
Interest coverage(earning basis) 8.2 9.6 410
Interest coverage(cash flow basis) 16.4 13.4 541.2
Fixed charges coverage, including
lease payments (earning basis) 4.6 4.8 3.17
Fixed charges coverage, including
lease payments (cash flow basis) 8.7 6.2 3.87
 For example:debt and coverage
ratio(cont.)
• Nordstrom adopted a fairly conservative debt policy.
An increase in liabilities to equity and debt to equity ratios, net
financial leverage.
Interest coverage also remained at comfortable level
• TJX’s debt ratios confirm that it is primarily relying on non-
interest liabilities such as A/P and accrued expenses to finance
its operation
Given its large cash balance, net debt is negative
Interest coverage ratios are high
Because of operating lease, net-debt-to-equity ratio increases
dramatically. At the same time TJX’s coverage drops
dramatically.
 Assessing Sustainable Growth Rate

• A firm’s sustainable growth rate is defined as:

Sustainable growth rate = ROE * (1-Dividend payout
ratio)
• A firm’s dividend payout ratio is a measure of its
dividend policy
Dividend payment ratio = cash dividends paid/Net
income
• Sustainable growth rate is the rate at which a firm
can grow while keeping its profitability and financial
policies unchanged.
 Sustainable Growth Rate Framework for Financial Ratio Analysis

SUSTAINABLE
GROTH RATE
Dividend Payout
ROE

Operating ROA Financial

Leverage Effect

Net Operating Operating Asset Net Financial

Profit Margin Turnover Spread
Leverage
 For example: Sustainable growth rate
Nordstrom TJX
Ratio 1998 1997 1998
ROE 15.6% 12.6% 34.5%
Dividend payment ratio 0.21 0.22 0.09
Sustainable growth rate 12.3% 9.8% 31.4%
• Nordstrom had a lower ROE and a higher dividend payout
ratio relative to TJX, leading to a significantly lower
sustainable growth rate in both 1998 and 1997.
• Nordstrom improved its sustainable growth because of its
improved ROE and a marginal decline in its payout ratio.
 Chapter quiz
Selected data from Sheridan Corporation’s year-end financial statements
are presented below. The difference between average and ending
inventory is immaterial.
Current ratio 2.0
Quick ratio 1.5
Current liabilities $120,000
Inventory turnover(based on COGS) 8
Gross profit margin 40%
Sheridan’s net sales for the year were:
a. $240,000 b. $480,000
c. $800,000 d. $1,200,000
 Chapter quiz
In a period of rising prices, how would the
following ratios be affected by the accounting
decision to select LIFO, rather than FIFO, for
inventory valuation?
• Gross margin
• Current ratio
• Asset turnover
• Debt-to-equity ratio
• Average tax rate
 Chapter quiz (cont.)
• Gross margin is lower for the LIFO firm
The LIFO firm has higher COGS which makes its gross margin appear
lower than the FIFO firm.
• Current ratio falls
Current asset is lower under LIFO
• Asset turnover increases
Assets are lower under LIFO
• Debt-to-equity ratio increase
Under LIFO, the higher COGS leads to lower net income which in turn
leads to a decrease in equity.
• Average tax rate remains the same.
Under the LIFO, it has less taxable income but the average tax rate is
likely to remain the same.