Using the financial statements for the snider corporation

Financial Analysis

LEARNING OBJECTIVES

LO 3-1

Ratio analysis provides a meaningful comparison of a company to its industry.

LO 3-2

Ratios can be used to measure profitability, asset utilization, liquidity, and debt utilization.

LO 3-3

The Du Pont system of analysis identifies the true sources of return on assets and return to stockholders.

LO 3-4

Trend analysis shows company performance over time.

LO 3-5

Reported income must be further evaluated to identify sources of distortion.

If you’re in the market for dental products, look no further than Colgate-Palmolive. The firm has it all: every type of toothpaste you can imagine (tartar control, cavity protection, whitening enhancement), as well as every shape and size of toothbrush. While you’re getting ready for the day, also consider its soaps, shampoos, and deodorants (Speed Stick, Lady Speed Stick, etc.).

For those of you who decide to stay home and clean your apartment or dorm room, Colgate-Palmolive will provide you with Ajax, Fab, and a long list of other cleaning products.

All this is somewhat interesting, but why mention these subjects in a finance text? Well, Colgate-Palmolive has had some interesting profit numbers over the last three years. Its profit margin in 2014 was 13.5 percent, and its return on assets was 31.5 percent. While these numbers are higher than those of the average company, the 2014 number that blows analysts away is its return on stockholders’ equity of 167.8 percent (the norm is 15–20 percent). In fact, this ROE is so high and unrealistic that some financial services list the number as not meaningful (NMF). The major reason for this abnormally high return is its high debt-to-total-asset ratio of 81 percent. This means that the firm’s debt represents 81 percent of total assets and stockholders’ equity only 19 percent. Almost any amount of profit will appear high in regard to the low value of stockholders’ equity.

In contrast, its main competitor, Procter & Gamble, has only a 17.5 percent return on stockholders’ equity, partially because it is heavily financed by stockholders’ equity at 66.2 percent while its debt-to-asset ratio is 33.8 percent. This may be good or bad. This kind of analysis will be found in the financial ratios discussion in this chapter.

In Chapter 2 , we examined the basic assumptions of accounting and the various components that make up the financial statements of the firm. We now use this fundamental material as a springboard into financial analysis—to evaluate the financial performance of the firm.

The format for the chapter is twofold. In the first part we use financial ratios to evaluate the relative success of the firm. Various measures such as net income to sales and current assets to current liabilities will be computed for a hypothetical company and examined in light of industry norms and past trends.

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In the second part of the chapter we explore the impact of inflation and disinflation on financial operations. You will begin to appreciate the impact of rising prices (or at times, declining prices) on the various financial ratios. The chapter concludes with a discussion of how other factors—in addition to price changes—may distort the financial statements of the firm. Terms such as net income to sales, return on investment, and inventory turnover take on much greater meaning when they are evaluated through the eyes of a financial manager who does more than merely pick out the top or bottom line of an income statement. The examples in the chapter are designed from the viewpoint of a financial manager (with only minor attention to accounting theory).

Ratio Analysis

Ratios are used in much of our daily life. We buy cars based on miles per gallon; we evaluate baseball players by earned run and batting averages, basketball players by field goal and foul-shooting percentages, and so on. These are all ratios constructed to judge comparative performance. Financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the significance of the resultant number.

Financial ratios are used to weigh and evaluate the operating performance of the firm. While an absolute value such as earnings of $50,000 or accounts receivable of $100,000 may appear satisfactory, its acceptability can be measured only in relation to other values. For this reason, financial managers emphasize ratio analysis.

For example, are earnings of $50,000 actually good? If we earned $50,000 on $500,000 of sales (10 percent “profit margin” ratio), that might be quite satisfactory—whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have computed the appropriate ratio, we must compare our results to those achieved by similar firms in our industry, as well as to our own performance record. Even then, this “number-crunching” process is not fully adequate, and we are forced to supplement our financial findings with an evaluation of company management, physical facilities, corporate governance, sustainability, and numerous other factors.

Many libraries and universities subscribe to financial services such as Bloomberg, Standard & Poor’s Industry Surveys and Corporate Reports, the Value Line Investment Survey, Factset, and Moody’s Corporation. Standard & Poor’s also leases a computer database called S&P IQ to banks, corporations, investment organizations, and universities. Compustat contains financial statement data on over 16,000 companies for a 20-year period. Ratios can also be found on such websites as finance.yahoo.com . These data can be used for countless ratios to measure corporate performance. The ratios used in this text are a sample of the major ratio categories used in business, but other classification systems can also be constructed.

Classification System