Using the financial statements for the snider corporation

3

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.

Page 57

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

We will separate 13 significant ratios into four primary categories.

A. Profitability ratios

  1. Profit margin

  2. Return on assets (investment)

  3. Return on equity

Page 58

B. Asset utilization ratios

  4. Receivable turnover

  5. Average collection period

  6. Inventory turnover

  7. Fixed asset turnover

  8. Total asset turnover

C. Liquidity ratios

  9. Current ratio

10. Quick ratio

D. Debt utilization ratios

11. Debt to total assets

12. Times interest earned

13. Fixed charge coverage

The first grouping, the profitability ratios, allows us to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital. Many of the problems related to profitability can be explained, in whole or in part, by the firm’s ability to effectively employ its resources. Thus the next category is asset utilization ratios. Under this heading, we measure the speed at which the firm is turning over accounts receivable, inventory, and longer-term assets. In other words, asset utilization ratios measure how many times per year a company sells its inventory or collects all of its accounts receivable. For long-term assets, the utilization ratio tells us how productive the fixed assets are in terms of generating sales.

In category C, the liquidity ratios, the primary emphasis moves to the firm’s ability to pay off short-term obligations as they come due. In category D, debt utilization ratios, the overall debt position of the firm is evaluated in light of its asset base and earning power.

The users of financial statements will attach different degrees of importance to the four categories of ratios. To the potential investor or security analyst, the critical consideration is profitability, with secondary consideration given to such matters as liquidity and debt utilization. For the banker or trade creditor, the emphasis shifts to the firm’s current ability to meet debt obligations. The bondholder, in turn, may be primarily influenced by debt to total assets—while also eyeing the profitability of the firm in terms of its ability to cover debt obligations. Of course, the experienced analyst looks at all the ratios, but with different degrees of attention.

Ratios are also important to people in the various functional areas of a business. The marketing manager, the head of production, the human resource manager, and many of their colleagues must all be familiar with ratio analysis. For example, the marketing manager must keep a close eye on inventory turnover; the production manager must evaluate the return on assets; and the human resource manager must look at the effect of “fringe benefits” expenditures on the return on sales.

The Analysis

Page 59

Definitions alone carry little meaning in analyzing or dissecting the financial performance of a company. For this reason, we shall apply our four categories of ratios to a hypothetical firm, the Saxton Company, as presented in Table 3-1. The use of ratio analysis is rather like solving a mystery in which each clue leads to a new area of inquiry.

Table 3-1 Financial statement for ratio analysis

SAXTON COMPANY Income Statement For the Year Ended December 31, 2015

Sales (all on credit)

$4,000,000

Cost of goods sold

  3,000,000

Gross profit

$1,000,000

Selling and administrative expense*

     450,000

Operating profit

$ 550,000

Interest expense

50,000

Extraordinary loss

     200,000

Net income before taxes

$ 300,000

Taxes (33%)

     100,000

Net income

$ 200,000

*Includes $50,000 in lease payments.

Balance Sheet As of December 31, 2015

Assets

Cash

$ 30,000

Marketable securities

50,000

Accounts receivable

350,000

Inventory

     370,000

Total current assets

$ 800,000

Net plant and equipment

800,000

Net assets

$1,600,000

Liabilities and Stockholders’ Equity

Accounts payable

$ 50,000

Notes payable

     250,000

Total current liabilities

$ 300,000

Long-term liabilities

     300,000

Total liabilities

$ 600,000

Common stock

400,000

Retained earnings

     600,000

Total liabilities and stockholders’ equity

$1,600,000

A. Profitability Ratios We first look at profitability ratios. The appropriate ratio is computed for the Saxton Company and is then compared to representative industry data.

Page 60

In analyzing the profitability ratios, we see the Saxton Company shows a lower return on the sales dollar (5 percent) than the industry average of 6.7 percent. However, its return on assets (investment) of 12.5 percent exceeds the industry norm of 10 percent. There is only one possible explanation for this occurrence—a more rapid turnover of assets than that generally found within the industry. This is verified in Ratio 2b, in which sales to total assets is 2.5 for the Saxton Company and only 1.5 for the industry. Thus Saxton earns less on each sales dollar, but it compensates by turning over its assets more rapidly (generating more sales per dollar of assets).

Return on total assets as described through the two components of profit margin and asset turnover is part of the Du Pont system of analysis.

Return on assets (investment) = Profit margin × Asset turnover

The Du Pont company was a forerunner in stressing that satisfactory return on assets may be achieved through high profit margins or rapid turnover of assets, or a combination of both. We shall also soon observe that under the Du Pont system of analysis, the use of debt may be important. The Du Pont system causes the analyst to examine the sources of a company’s profitability. Since the profit margin is an income statement ratio, a high profit margin indicates good cost control, whereas a high asset turnover ratio demonstrates efficient use of the assets on the balance sheet. Different industries have different operating and financial structures. For example, in the heavy capital goods industry the emphasis is on a high profit margin with a low asset turnover—whereas in food processing, the profit margin is low and the key to satisfactory returns on total assets is a rapid turnover of assets.

Equally important to a firm is its return on equity or ownership capital. For the Saxton Company, return on equity is 20 percent, versus an industry norm of 15 percent. Thus the owners of Saxton Company are more amply rewarded than are other shareholders in the industry. This may be the result of one or two factors: a high return on total assets or a generous utilization of debt or a combination thereof. This can be seen through Ratio 3b, which represents a modified or second version of the Du Pont formula.

Page 61

Note that the numerator, return on assets, is taken from Ratio 2b, which represents the initial version of the Du Pont formula (Return on assets = Net income/Sales × Sales/Total assets). Return on assets is then divided by [1 − (Debt/Assets)] to account for the amount of debt in the capital structure. In the case of the Saxton Company, the modified version of the Du Pont formula shows:

Actually the return on assets of 12.5 percent in the numerator is higher than the industry average of 10 percent, and the ratio of debt to assets in the denominator of 37.5 percent is higher than the industry norm of 33 percent. Please see Ratio 3b to confirm these facts. Both the numerator and denominator contribute to a higher return on equity than the industry average (20 percent versus 15 percent). Note that if the firm had a 50 percent debt-to-assets ratio, return on equity would go up to 25 percent.1