A total asset turnover ratio of 2.8 indicates that

Copyright Information (bibliographic)

Document Type: Book Chapter

Title of Book: Financial Management Theory and Practice (16th Edition)

Author(s) of Book: Eugene F. Brigham, Michael C. Ehrhardt

Chapter Title: Chapter 3 Analysis of Financial Statements

Author(s) of Chapter: Eugene F. Brigham, Michael C. Ehrhardt

Year: 2020

Publisher: Cengage Learning

Place of Publishing: the United States of America

The copyright law of the United States (Title 17, United States Code) governs the making of photocopies or other reproductions of copyrighted materials. Under certain conditions specifies in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these conditions is that the photocopy or reproduction is not to be used for any purpose other than private study, scholarship, or research. If a user makes a request for, or later uses, a photocopy or reproduction for purposes in excess of fair use, that user may be liable for copyright infringement.

Analysis of Financial Statements

Even though Twitter Inc. had not yet had a profitable quarter based on generally

accepted accounting principles (GAAP), its stock price jumped by 18% on September

26, 2017, when it reported minus $21 million in earnings before interest, taxes,

depreciation, and amortization (EBITDA). The reason for the positive stock reaction?

First, a loss of $21 million was better than the $103 million loss it reported in the

previous quarter. Second, Twitter stated that it might report positive EBITDA in its

next report.

Most companies guide analysts by providing estimates of future revenues.

According to a survey by the National Investors Relations Institute, 94% of respondents

in 2014 provided some form of guidance for analysts and investors. Despite the high

proportion of companies that provide guidance, a 2015 survey by Integrated Corporate

Relations reports that over half of the responding investment professionals don't think

guidance is vital for determining whether to recommend purchasing a company's

stock. It appears as though many investors rely on other types of information, including

ratio analysis.

Source: See the reports at www.cnbc.com/2017/10/26/twitter-earnings-q3-revenue-eps-and-maus.html,

http://files.shareholder.com/downloads/AMDA-2FS26X/5619402910x0x961127/658476E7-9D8B

-4 B 17-BES D-B 77034D21FC E/TWTR_ Q3 _17 _Earn in gs_Press_Release. pdf, www. ma rketwatch .com

/news/markets/earningswatch.asp, http://niri.org/Main-Menu-Category/resource/publications/Executive

-Alert/2014-Executive-Alert-Archive/NIRI-Guidance-Practices-Survey-2014-Report-102214.aspx, and

http://icrinc.com/en/pdfs/xchange/XChange_2015_ICR_Survey.pdf.

101

102 Part 1 The Company and Its Environment

Intrinsic Value,Free Cash Flow, and Financial Statements

The intrinsic value of a firm is determined by the present This chapter explains how to use financial statements to

value of the expected future free cash flows (FCFs) when evaluate a company's profitability, required capital invest-

discounted at the weighted average cost of capital (WACC). ments, business risk, and mix of debt and equity .

• Net operating profit after taxes

Required investments in operating capital

Free cash flow (FCF)

FCF1 FCF2 · FCF., Value=-----+-----+ ... +-----

(1 + WACC)l (1 + WACC)2 (1 + WACC) °'

Weighted average cost of capital (WACC)

•

Market interest rates Cost of debt

Cost of equity

Firm's debt/equity mix •

• Market risk aversion Firm's business risk

!JJ(Ce

The textbook's Web site

contains on Excel file that

will guide you through the

chapter's co/cu/otions.

The file for this chapter is

Ch03 Tool Kit.xlsx, and

we encourage you to open

the file and follow along

as you read the chapter.

WWW

See www.zacks.com for

o source of standardized

financial statements.

Financial statement analysis involves (1) comparing a firm's performance with that of other firms in the same industry and (2) evaluating trends in the firm's financial posi­ tion over time. Managers use financial analysis to identify situations needing attention, potential lenders use financial analysis to determine whether a company is creditworthy, and stockholders use financial analysis to help predict future earnings, dividends, and free cash flow. This chapter will explain the similarities and differences among these uses.

3-1 Financial Analysis When we perform a financial analysis, we conduct the following steps.

3-la Gather Data

The first step in financial analysis is to gather data. As discussed in Chapter 2, financial statements can be downloaded from many different Web sites. One of our favorites is Zacks Investment Research, which provides financial statements in a standardized for­ mat. If you cut and paste financial statements from Zacks into a spreadsheet and then perform a financial analysis, you can quickly repeat the analysis on a different company by pasting that company's financial statements into the same cells of the spreadsheet. In other words, you do not need to reinvent the wheel every time you analyze a company.

3-lb Examine the Statement of Cash Flows

Some financial analysis can be done with virtually no calculations. For example, we always look to the statement of cash flows first, particularly the net cash provided by

0

0

(

Chapter 3 Analysis of Financial Statements 103

operating activities. Downward trends or negative net cash flow from operations almost always indicates problems. The statement of cash flows section on investing activities shows whether the company has made a big acquisition, especially when compared with prior years' net cash flows from investing activities. A quick look at the section on financ­ ing activities also reveals whether a company is issuing debt or buying back stock; in other words, is the company raising capital from investors or returning it to them?

Recall from the previous chapter (Figure 2-4) that MicroDrive generated $163 million from its operating activities but invested $420 million in new fixed assets. To make these purchases, MicroDrive borrowed heavily.

3-1c Calculate and Examine the Return on Invested Capital and Free Cash Flow

After examining the statement of cash flows, we calculate the net operating profit after taxes (NOPAT) and the total net operating capital. We use these measures to calculate the operating profitability ratio (OP), the capital requirement ratio (CR), the return on in­ vested capital (ROIC), and the free cash flow (FCF), as described in Chapter 2.

The ROIC provides a vital measure of a firm's overall performance. If the ROIC is greater than the company's weighted average cost of capital (WACC), then the company usually is adding value. If the ROIC is less than the WACC, then the company usually has serious problems. No matter what the ROIC tells us about overall performance, it is important to examine specific activities with different financial ratios.

We calculated these measures for MicroDrive in the previous chapter (see Figure 2-6) and report them here for convenience:

MicroDrive (Millions of Dollars)

Net operating working capital (NOWC) =

Total net operating capital =

Net operating profit after taxes (NOPAT) =

Operating profitability ratio (OP) = NOPAT/Sales =

Capital requirement ratio (CR) = (Total net operating capital/Sales) =

Return on invested capital (ROIC) = NOPAT/Total net operating capital =

Free cash flow (FCF) = NOPAT - Net investment in operating capital =

2018

$710

$2,490

$330

6.88%

51.88%

13.3%

NIA

2019

$1,000

$3,000

$300

6.00%

60.00%

10.0%

-$210

MicroDrive's operating profitability fell from 6.88% to 6.00%, and its capital require­ ment ratio increased from 51.88% to 60%, indicating that MicroDrive is not generating enough in sales from its operating capital. The result is a decline in its ROIC from 13.3% to 10.0%, which is less than MicroDrive's 11.5% cost of capital. We will use ratio analysis in the following sections to identify the root causes of the ROI C's decline.

3-1d Begin Ratio Analysis

Financial ratios are designed to extract important information that might not be obvi­ ous simply from examining a firm's financial statements. For example, suppose Firm A owes $5 million in debt while Firm B owes $50 million. Which company is in a stronger financial position? It is impossible to answer this question without first standardizing each firm's debt relative to total assets and earnings. Such standardized comparisons are provided through ratio analysis.

104 Part l The Company and Its Environment

We will calculate the 2019 financial ratios for MicroDrive Inc. using data from the balance sheets and income statements given in Figure 3-1; dollar amounts are in millions. Recall from Chapter 2 that MicroDrive reports only net plant, property, and equipment (PP&E) on its balance sheets instead of separately reporting cumulative depreciation and cumulative PP&E. For the sake of clarity, we break down the income statement's costs of goods sold into two components: (1) costs of goods sold excluding depreciation and (2) depreciation (MicroDrive has no amortization charges).

SELF -TEST

What insights does the Statement of Cash Flows provide regarding financial analysis?

What insights are provided by the (1) net operating profit after taxes (NOPAT); (2) operating

profitability ratio (OP); (3) capital requirement ratio (CR); (4) return on invested capital (ROJC);

and (5) free cash flow (FCF)?

3-2 Profitability Ratios Profitability is the net result of a number of policies and decisions. The ratios examined thus far provide an overview of a firm's operations, but the profitability ratios go on to show the combined effects of liquidity, asset management, and debt on operating and financial results.

3-2a Net Profit Margin

The net profit margin, also called the profit margin on sales or just the profit margin, is calculated by dividing net income by sales. It gives the profit per dollar of sales:

Net income available to common stockholders

Net profit margin = Sales

MicroDrive's net profit margin is:

$248 Net profit margin = -

$ -- = 4.96 = 5.0% 5,000

Industry average = 6.2%

MicroDrive's net profit margin is below the industry average, but why is this so? Is it due to inefficient operations, high interest expenses, or both?

Instead of just comparing net income to sales, many analysts also break the income statement into smaller parts to identify the sources of a low net profit margin. For exam­ ple, the operating profit margin is defined as:

EBIT Operating profit margin = -

al S es

The operating profit margin identifies how a company is performing with respect to its operations before the impact of interest expenses is considered.

Chapter 3 Analysis of Financial Statements

FIGURE3-1

MicroDrive Inc.: Balance Sheets and Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per Share Data)

A B C D E

15 Balance Sheets 2019 2018

16 Assets 17 Cash and equivalents $100 $102

18 Short-term investments 10 40

19 Accounts receivable 500 384

20 Inventories 1,000 774 21 Total current assets $1,610 $1,300

22 Net property, plant & equipment (PP&E) 2,000 1,780 23 Total assets $3,610 $3,080

24 25 Liabilities and Equity

26 Accounts payable $200 $180

27 Notes payable 150 28

28 Accruals 400 370 29 Total current liabilities $750 $578

30 Long-term bonds 520 350 31 Total liabilities $1,270 $928

32 Preferred stock 100 100

33 Common stock 500 500

34 Retained earnings 1,740 1,552

35 Total common equity $2,240 $2,052 36 Total llablllties and equity $3,610 $3,080

37

38 Income Statements 2019 2018

39 Net sales $5,000 $4,800

40 Costs of goods sold except depreciation 3,900 3,710

41 Depreciation" 200 180

42 Other operating expenses 500 470

43 Earnings before interest and taxes (EBIT) $400 $440

44 Less Interest 60 40

45 Pre-tax earnings $340 $400

46 Taxes (25%) 85 100

47 Net income before preferred dividends $255 $300

48 Preferred dividends 7 7 49 Net income available to common stockholders $248 $293

so

51 Additional Information 52 Common dividends $60.0 $59.4

53 Addition to retained earnings $188.0 $233.6

54 Number of common shares 60 60

55 Common stock price per share $31.00 $45.00

56 Lease payments $28 $28

57 Bonds' required sinking fund payments $20 $20

58 Tax rate 25% 25%

Source: See the file Ch03 Tool Klt.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values will be inexact.

Note:

'MicroDrive has no amortization charges, so we omit them from the item name.

105

106

I

Part l The Company and Its Environment

MicroDrive's operating margin is:

$400 Operating profit margin = -

$ -- = 8.0% 5,000

Industry average = 9.0%

Some analysts drill even deeper by breaking operating costs into their components. For example, the gross profit margin is defined as:

. Sales - Cost of goods sold including depreciation Gross profit margm =

al IS es The gross profit margin identifies the gross profit per dollar of sales before any other expenses are deducted.

Rather than calculate each type of profit margin here, later in the chapter we will use common size analysis and percent change analysis to focus on different parts of the income statement. In addition, we will use the DuPont equation to show how the ratios interact with one another.

Sometimes it is confusing to have so many different types of profit margins. To sim­ plify the situation, we will focus primarily on the net profit margin throughout the book and call it the profit margin.

3-2b Basic Earning Power (BEP) Ratio

The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes (EBIT) by total assets:

EBIT Basic earning power (BEP) ratio =

al Tot assets I The World Might Be Flat, but Global Accounting Is Bumpy! The Case of IFRS versus FASB

In a flat world, distance is no barrier. Work flows to where it

can be done most efficiently, and capital flows to where it can

be invested most profitably. If a radiologist in India is more

efficient than one in the United States, then images will be

e-mailed to India for diagnosis; if rates of return are higher in

Brazil, then investors throughout the world will provide fund­

ing for Brazilian projects. One key to "flattening" the world

is agreement on common standards. For example, there are

common Internet standards so that users throughout the

world are able to communicate.

A glaring exception to standardization is in accounting.

The Securities and Exchange Commission (SEC) in the United

States requires firms to comply with standards set by the Fi­

nancial Accounting Standards Board (FASB). But the European

Union requires all EU-listed companies to comply with the

International Financial Reporting Standards (IFRS), as defined

by the International Accounting Standards Board (IASB).

IFRS tends to rely on general principles, whereas FASB

standards are rules-based. As we write this in 2018, some prog­

ress toward standardizing accounting rules has been made,

but it does not seem likely that the United States and the EU

will be using the same accounting rules in the near future.

To keep abreast of developments in IFRS/GAAP convergence, visit the IASB

Web site at www.iasb.org and the FASB Web site at www.fasb.org.

Chapter 3 Analysis of Financial Statements

For MicroDrive, the ratio is:

$400 Basic earning power (BEP) ratio= --- = 11.1%

$3,610

Industry average = 13.8%

107

This ratio shows the earning power of the firm's assets before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage. MicroDrive has a lower BEP than its peers, partly because its profit margin is low and partly because it manages assets inefficiently, as we show in Section 3-3.

3-2c Return on Total Assets

The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes. This ratio is also called the return on assets and is defined as follows:

Net income available to common stockholders

Return on assets = ROA = --------­ Total assets

For MicroDrive, the ROA is:

$248 Return on assets = -- = 6.87% = 6.9%

$3,610

Industry average = 9.6%

MicroDrive's 6.9% return is well below the 9.6% average for the industry. This low return is due to (1) the company's low basic earning power and (2) high interest costs resulting from its above-average use of debt. Both of these factors cause MicroDrive's net income to be relatively low.

3-2d Return on Common Equity

The ratio of net income to common equity measures the return on common equity (ROE), which is often called just the return on equity:

Net income available to Return on

. = ROE = common stockholders

common equity Common equity

MicroDrive's ROE is:

$248 Return on equity=-

$ --= 11.1% 2,240

Industry average = 13.6%

Stockholders invest to earn a return on their money, and this ratio tells how well they are doing in an accounting sense. MicroDrive's 11.1% return is below the 13.6% industry average but not as far below as its return on total assets. This somewhat better result is due to the company's greater use of debt, a point that we explain later in the chapter.

108 Part 1 The Company and Its Environment

SELF -TEST

Identify and write out the equations for four profitability ratios.

Why is the basic earning power ratio useful?

Why does the use of debt lower ROA?

What does ROE measure?

Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt= $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest expense = $20, and tax rate = 25%. Calculate the following ratios: Net profit margin (18.3%), operating profit margin (26.8%), basic earning power ratio (32.8%), return on total assets (22.4%), and return on common equity (36.1%).

A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. What is its profit margin? (5%) What is its ROA? (10%) What is its ROE? (20%) Would ROA increase if the firm used less leverage? (Yes) Would ROE increase? (No)

3-3 Asset Management Ratios Asset management ratios measure how effectively a firm is managing its assets. For this reason, they are also called efficiency ratios. If a company has excessive investments in assets, then its operating capital is unduly high, which reduces its free cash flow and ultimately its stock price. On the other hand, if a company does not have enough assets, then it may lose sales, which would hurt profitability, free cash flow, and the stock price. Therefore, it is important to have the right amount invested in assets. Ratios that analyze the different types of assets are described in this section.

3-3a Evaluating Total Assets: The Total Assets Turnover Ratio

The- total assets turnover ratio measures the dollars in sales that are generated for each dollar that is tied up in assets:

Sales Total assets turnover ratio =

al Tot assets

For MicroDrive, the ratio is:

$5,000 Total assets turnover ratio = --- = 1.39 = 1.4

$3,610

Industry average = 1.5

I

MicroDrive's ratio is somewhat below the industry average, indicating that the com­ pany is not generating as much business (relative to its peers), given its total asset invest­ ment. In other words, MicroDrive uses its assets relatively inefficiently. The following ratios can be used to identify the specific asset classes that are causing this problem.1

'Sales occur throughout the year, but assets are reported at end of the period. For a growing company or a company with seasonal variation, it would be better to use average assets held during the year when calculating turnover ratios. However, we use year-end values for all turnover ratios so that we are more comparable with most reported industry averages.

(

Chapter 3 Analysis of Financial Statements

3-3b Evaluating Fixed Assets: The Fixed Assets Turnover Ratio

109

The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It is the ratio of sales to net fixed assets:

Sales Fixed assets turnover ratio =

fix d Net e assets

MicroDrive's fixed assets turnover ratio is:

$5,000 Fixed assets turnover ratio = -- = 2.5

$2,000

Industry average = 2.7

I

MicroDrive's ratio of 2.5 is a little below the industry average, indicating that the firm is using its fixed assets less intensively than its peers.

Inflation can cause problems when interpreting the fixed assets turnover ratio because fixed assets are reported using the historical costs of the assets instead of current replace­ ment costs that may be higher due to inflation. Therefore, a mature firm with fixed assets acquired years ago might well have a higher fixed assets turnover ratio than a younger company with newer fixed assets that are reported at inflated prices relative to the histori­ cal prices of the older assets. However, this would reflect the difficulty accountants have in dealing with inflation rather than inefficiency on the part of the new firm. You should be alert to this potential problem when evaluating the fixed assets turnover ratio.

3-3c Evaluating Receivables: The Days Sales Outstanding

Days sales outstanding (DSO), also called the average collection period (ACP), is used to appraise accounts receivable, and it is calculated by dividing accounts receivable by aver­ age daily sales to find the number of days' sales that are tied up in receivables. Thus, the DSO represents the average length of time that the firm must wait after making a sale be­ fore receiving cash, which is the average collection period. MicroDrive's DSO is 37, above the 29-day industry average:

Days sales Receivables Receivables DSO = = -------- = ------- outstanding Average sales per day Annual sales/365

MicroDrive's DSO is about 37 days:

$500 $500 DSO =

$ / = -

$ - = 36.50 days = 37 days

5,000 365 13.7

Industry average = 29 days

I

MicroDrive's sales terms call for payment within 30 days. The fact that 37 days of sales are outstanding indicates that customers, on average, are not paying their bills on time. As with inventory, high levels of accounts receivable cause high levels of net operating work­ ing capital (NOWC), which hurts FCF and stock price.

110 Part 1 The Company and Its Environment

A customer who is paying late may be in financial trouble, which means MicroDrive may have a hard time collecting the receivable. Therefore, if the trend in DSO has been rising unexpectedly, steps should be taken to review credit standards and to expedite the collection of accounts receivable.

3-3d Evaluating Inventories: The Inventory Turnover Ratio

The inventory turnover ratio is defined as costs of goods sold (COGS) divided by inven­ tories. 2 The previous ratios use sales instead of COGS. However, sales revenues include costs and profits, whereas inventory usually is reported at cost. Therefore, the inventory turnover ratio compares inventory with costs rather than sales:

COGS Inventory turnover ratio = ----­

Inventories I MicroDrive's income statement in Figure 3-1 separately reports depreciation and the

portion of costs of goods sold that is not comprised of depreciation, which is helpful when calculating cash flows. However, we need the total COGS for calculating the inventory turnover ratio. MicroDrive has no amortization charges, and virtually all depreciation is associated with producing its products. MicroDrive's COGS is:

COGS = Costs of goods sold except depreciation + Depreciation

= $3,900 + $200 = $4,100 million

We can now calculate MicroDrive's inventory turnover:

COGS $4,100 Inventory turnover ratio = = -

$ -- = 4.1

Inventory 1,000

Industry average = 5.3

As a rough approximation, each item of MicroDrive's inventory is sold out and restocked, or "turned over," 4.1 times per year.

MicroDrive's turnover of 4.1 is lower than the 5.3 industry average. This suggests that MicroDrive is holding too much inventory. High levels of inventory add to net operat­ ing working capital, which reduces FCF, which leads to lower stock prices. In addition, MicroDrive's low inventory turnover ratio makes us wonder whether the firm is holding obsolete goods not worth their stated value.

In summary, MicroDrive's low fixed assets turnover ratio, high DSO, and low inven­ tory turnover ratio each cause MicroDrive's total assets turnover ratio to be lower than the industry average.

SELF -TEST

Identify four ratios that measure how effectively a firm is managing its assets, and write out

their equations.

What problem might arise when comparing firms' fixed assets turnover ratios?

'We calculate the turnover ratio using the ratio of COGS to inventories because most sources report the turn­

over ratio this way. However, you should be aware that a few sources, such as Dun & Bradstreet, define inven­

tory turnover as the ratio of sales to inventories.

(

esource

See Ch03 Tool Kit.xlsx

for alt calculations.

Chapter 3 Analysis of Financial Statements

Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20,

111

accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest expense = $20, and tax rate = 25%. Calculate the following ratios: total assets turnover (1.2), fixed assets turnover (1.6), days sales outstanding (based on a 365-day year) (13.4), inventory turnover (5.0). (Hint: This is the same company used in the previous Self-Test.)

A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory, and $60 million of accounts receivable. What is its inventory turnover ratio? (4.5) What is its DSO based on a 365-day year? (109.5 days)

3-4 Liquidity Ratios As shown in Figure 3-1, MicroDrive has current liabilities of$750 million that it must pay off within the coming year. Will it have trouble satisfying those obligations? Liquidity ratios attempt to answer this type of question. We discuss two commonly used liquidity ratios in this section.

3-4a The Current Ratio

Current assets normally include cash, marketable securities, accounts receivable, and in­ ventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses. The current ratio measures liquidity by comparing the current assets to the current liabilities: