Zombie corp has a profit margin

Working with Financial Statements

3

THE PRICE OF A SHARE OF COMMON STOCK in cereal maker General Mills closed at about $49 on January 8, 2014. At that price, General Mills had a price–earnings (PE) ratio of 18. That is, investors were willing to pay $18 for every dollar in income earned by General Mills. At the same time, investors were willing to pay $105, $31, and $11 for each dollar earned by Adobe Systems, Google, and Ford, respectively. At the other extreme were Blackberry and Twitter. Both had negative earnings for the previous year, yet Blackberry was priced at about $9 per share and Twitter at about $59 per share. Because they had negative earnings, their PE ratios would have been negative, so they were not reported. At the time, the typical stock in the S&P 500 index of large company stocks was trading at a PE of about 16, or about 16 times earnings, as they say on Wall Street.

Price-to-earnings comparisons are examples of the use of financial ratios. As we will see in this chapter, there are a wide variety of financial ratios, all designed to summarize specific aspects of a firm’s financial position. In addition to discussing how to analyze financial statements and compute financial ratios, we will have quite a bit to say about who uses this information and why.

For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com .

Learning Objectives

After studying this chapter, you should understand:

LO1

How to standardize financial statements for comparison purposes.

LO2

How to compute and, more importantly, interpret some common ratios.

LO3

The determinants of a firm’s profitability.

LO4

Some of the problems and pitfalls in financial statement analysis.

In Chapter 2 , we discussed some of the essential concepts of financial statements and cash flow. Part 2 , this chapter and the next, continues where our earlier discussion left off. Our goal here is to expand your understanding of the uses (and abuses) of financial statement information.

Financial statement information will crop up in various places in the remainder of our book. Part 2 is not essential for understanding this material, but it will help give you an overall perspective on the role of financial statement information in corporate finance.

A good working knowledge of financial statements is desirable simply because such statements, and numbers derived from those statements, are the primary means of communicating financial information both within the firm and outside the firm. In short, much of the language of corporate finance is rooted in the ideas we discuss in this chapter.

Page 50Furthermore, as we will see, there are many different ways of using financial statement information and many different types of users. This diversity reflects the fact that financial statement information plays an important part in many types of decisions.

In the best of all worlds, the financial manager has full market value information about all of the firm’s assets. This will rarely (if ever) happen. So, the reason we rely on accounting figures for much of our financial information is that we are almost always unable to obtain all (or even part) of the market information we want. The only meaningful yardstick for evaluating business decisions is whether they create economic value (see Chapter 1 ). However, in many important situations, it will not be possible to make this judgment directly because we can’t see the market value effects of decisions.

We recognize that accounting numbers are often just pale reflections of economic reality, but they are frequently the best available information. For privately held corporations, notfor-profit businesses, and smaller firms, for example, very little direct market value information exists at all. The accountant’s reporting function is crucial in these circumstances.

Clearly, one important goal of the accountant is to report financial information to the user in a form useful for decision making. Ironically, the information frequently does not come to the user in such a form. In other words, financial statements don’t come with a user’s guide. This chapter and the next are first steps in filling this gap.

3.1 Cash Flow and Financial Statements: A Closer Look

At the most fundamental level, firms do two different things: They generate cash and they spend it. Cash is generated by selling a product, an asset, or a security. Selling a security involves either borrowing or selling an equity interest (shares of stock) in the firm. Cash is spent in paying for materials and labor to produce a product and in purchasing assets. Payments to creditors and owners also require the spending of cash.

In Chapter 2 , we saw that the cash activities of a firm could be summarized by a simple identity:

Cash flow from assets = Cash flow to creditors + Cash flow to owners

This cash flow identity summarizes the total cash result of all transactions a firm engages in during the year. In this section, we return to the subject of cash flow by taking a closer look at the cash events during the year that lead to these total figures.

SOURCES AND USES OF CASH

Activities that bring in cash are called sources of cash. Activities that involve spending cash are called uses (or applications) of cash. What we need to do is to trace the changes in the firm’s balance sheet to see how the firm obtained and spent its cash during some period.

To get started, consider the balance sheets for the Prufrock Corporation in Table 3.1 . Notice that we have calculated the change in each of the items on the balance sheets.

Looking over the balance sheets for Prufrock, we see that quite a few things changed during the year. For example, Prufrock increased its net fixed assets by $149 and its inventory by $29. (Note that, throughout, all figures are in millions of dollars.) Where did the money come from? To answer this and related questions, we need to first identify those changes that used up cash (uses) and those that brought cash in (sources).

A little common sense is useful here. A firm uses cash by either buying assets or making payments. So, loosely speaking, an increase in an asset account means the firm, on a net basis, bought some assets—a use of cash. If an asset account went down, then on a net basis, the firm sold some assets. This would be a net source. Similarly, if a liability account goes down, then the firm has made a net payment—a use of cash.

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sources of cash A firm’s activities that generate cash.

uses of cash A firm’s activities in which cash is spent. Also called applications of cash.

TABLE 3.1

Page 51

Given this reasoning, there is a simple, albeit mechanical, definition you may find useful. An increase in a left-side (asset) account or a decrease in a right-side (liability or equity) account is a use of cash. Likewise, a decrease in an asset account or an increase in a liability (or equity) account is a source of cash.

Looking again at Prufrock, we see that inventory rose by $29. This is a net use because Prufrock effectively paid out $29 to increase inventories. Accounts payable rose by $32. This is a source of cash because Prufrock effectively has borrowed an additional $32 payable by the end of the year. Notes payable, on the other hand, went down by $35, so Pru-frock effectively paid off $35 worth of short-term debt—a use of cash.

Based on our discussion, we can summarize the sources and uses of cash from the balance sheet as follows:

Company financial information can be found in many places on the Web, including finance.yahoo.com , finance.google.com , and money.msn.com .

TABLE 3.2

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The net addition to cash is just the difference between sources and uses, and our $14 result here agrees with the $14 change shown on the balance sheet.

This simple statement tells us much of what happened during the year, but it doesn’t tell the whole story. For example, the increase in retained earnings is net income (a source of funds) less dividends (a use of funds). It would be more enlightening to have these reported separately so we could see the breakdown. Also, we have considered only net fixed asset acquisitions. Total or gross spending would be more interesting to know.

To further trace the flow of cash through the firm during the year, we need an income statement. For Prufrock, the results for the year are shown in Table 3.2 .

Notice here that the $242 addition to retained earnings we calculated from the balance sheet is just the difference between the net income of $363 and the dividends of $121.

THE STATEMENT OF CASH FLOWS

There is some flexibility in summarizing the sources and uses of cash in the form of a financial statement. However it is presented, the result is called the statement of cash flows.

We present a particular format for this statement in Table 3.3 . The basic idea is to group all the changes into three categories: operating activities, financing activities, and investment activities. The exact form differs in detail from one preparer to the next.

Don’t be surprised if you come across different arrangements. The types of information presented will be similar; the exact order can differ. The key thing to remember in this case is that we started out with $84 in cash and ended up with $98, for a net increase of $14. We’re just trying to see what events led to this change.

Going back to Chapter 2 , we note that there is a slight conceptual problem here. Interest paid should really go under financing activities, but unfortunately that’s not the way the accounting is handled. The reason, you may recall, is that interest is deducted as an expense when net income is computed. Also, notice that the net purchase of fixed assets was $149. Because Prufrock wrote off $276 worth of assets (the depreciation), it must have actually spent a total of $149 + 276 = $425 on fixed assets.

Once we have this statement, it might seem appropriate to express the change in cash on a per-share basis, much as we did for net income. Ironically, despite the interest we might have in some measure of cash flow per share, standard accounting practice expressly prohibits reporting this information. The reason is that accountants feel that cash flow (or some component of cash flow) is not an alternative to accounting income, so only earnings per share are to be reported.

As shown in Table 3.4 , it is sometimes useful to present the same information a bit differently. We will call this the “sources and uses of cash” statement. There is no such statement in financial accounting, but this arrangement resembles one used many years ago. As we will discuss, this form can come in handy, but we emphasize again that it is not the way this information is normally presented.

statement of cash flows A firm’s financial statement that summarizes its sources and uses of cash over a specified period.

Page 53TABLE 3.3

TABLE 3.4

Page 54Now that we have the various cash pieces in place, we can get a good idea of what happened during the year. Prufrock’s major cash outlays were fixed asset acquisitions and cash dividends. It paid for these activities primarily with cash generated from operations.

Prufrock also retired some long-term debt and increased current assets. Finally, current liabilities were not greatly changed, and a relatively small amount of new equity was sold. Altogether, this short sketch captures Prufrock’s major sources and uses of cash for the year.

Concept Questions

3.1a What is a source of cash? Give three examples.

3.1b What is a use, or application, of cash? Give three examples.

3.2 Standardized Financial Statements

The next thing we might want to do with Prufrock’s financial statements is compare them to those of other similar companies. We would immediately have a problem, however. It’s almost impossible to directly compare the financial statements for two companies because of differences in size.

For example, Ford and GM are serious rivals in the auto market, but GM is bigger (in terms of market share), so it is difficult to compare them directly. For that matter, it’s difficult even to compare financial statements from different points in time for the same company if the company’s size has changed. The size problem is compounded if we try to compare GM and, say, Toyota. If Toyota’s financial statements are denominated in yen, then we have size and currency differences.

To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements. One common and useful way of doing this is to work with percentages instead of total dollars. In this section, we describe two different ways of standardizing financial statements along these lines.

COMMON-SIZE STATEMENTS

To get started, a useful way of standardizing financial statements is to express each item on the balance sheet as a percentage of assets and to express each item on the income statement as a percentage of sales. The resulting financial statements are called common-size statements. We consider these next.

Common-Size Balance Sheets One way, though not the only way, to construct a common-size balance sheet is to express each item as a percentage of total assets. Pru-frock’s 2014 and 2015 common-size balance sheets are shown in Table 3.5 .

Notice that some of the totals don’t check exactly because of rounding. Also notice that the total change has to be zero because the beginning and ending numbers must add up to 100 percent.

In this form, financial statements are relatively easy to read and compare. For example, just looking at the two balance sheets for Prufrock, we see that current assets were 19.7 percent of total assets in 2015, up from 19.1 percent in 2014. Current liabilities declined from 16.0 percent to 15.1 percent of total liabilities and equity over that same time. Similarly, total equity rose from 68.1 percent of total liabilities and equity to 72.2 percent.

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common-size statement A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

Page 55TABLE 3.5

Overall, Prufrock’s liquidity, as measured by current assets compared to current liabilities, increased over the year. Simultaneously, Prufrock’s indebtedness diminished as a percentage of total assets. We might be tempted to conclude that the balance sheet has grown “stronger.” We will say more about this later.

Common-Size Income Statements A useful way of standardizing the income statement is to express each item as a percentage of total sales, as illustrated for Prufrock in Table 3.6 .

This income statement tells us what happens to each dollar in sales. For Prufrock, interest expense eats up $.061 out of every sales dollar and taxes take another $.081. When all is said and done, $.157 of each dollar flows through to the bottom line (net income), and that amount is split into $.105 retained in the business and $.052 paid out in dividends.

These percentages are useful in comparisons. For example, a relevant figure is the cost percentage. For Prufrock, $.582 of each $1 in sales goes to pay for goods sold. It would be interesting to compute the same percentage for Prufrock’s main competitors to see how Prufrock stacks up in terms of cost control.

Page 56TABLE 3.6

Common-Size Statements of Cash Flows Although we have not presented it here, it is also possible and useful to prepare a common-size statement of cash flows. Unfortunately, with the current statement of cash flows, there is no obvious denominator such as total assets or total sales. However, if the information is arranged in a way similar to that in Table 3.4 , then each item can be expressed as a percentage of total sources (or total uses). The results can then be interpreted as the percentage of total sources of cash supplied or as the percentage of total uses of cash for a particular item.

COMMON-BASE YEAR FINANCIAL STATEMENTS: TREND ANALYSIS

Imagine we were given balance sheets for the last 10 years for some company and we were trying to investigate trends in the firm’s pattern of operations. Does the firm use more or less debt? Has the firm grown more or less liquid? A useful way of standardizing financial statements in this case is to choose a base year and then express each item relative to the base amount. We will call the resulting statements common-base year statements.

For example, from 2014 to 2015, Prufrock’s inventory rose from $393 to $422. If we pick 2014 as our base year, then we would set inventory equal to 1.00 for that year. For the next year, we would calculate inventory relative to the base year as $422/393 = 1.07. In this case, we could say inventory grew by about 7 percent during the year. If we had multiple years, we would just divide the inventory figure for each one by $393. The resulting series is easy to plot, and it is then easy to compare companies. Table 3.7 summarizes these calculations for the asset side of the balance sheet.

COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS

The trend analysis we have been discussing can be combined with the common-size analysis discussed earlier. The reason for doing this is that as total assets grow, most of the other accounts must grow as well. By first forming the common-size statements, we eliminate the effect of this overall growth.

For example, looking at Table 3.7 , we see that Prufrock’s accounts receivable were $165, or 4.9 percent of total assets, in 2014. In 2015, they had risen to $188, which was 5.2 percent of total assets. If we do our analysis in terms of dollars, then the 2015 figure would be $188/165 = 1.14, representing a 14 percent increase in receivables. However, if we work with the common-size statements, then the 2015 figure would be 5.2%/4.9% = 1.06. This tells us accounts receivable, as a percentage of total assets, grew by 6 percent. Roughly speaking, what we see is that of the 14 percent total increase, about 8 percent (= 14% – 6%) is attributable simply to growth in total assets.

common-base year statement A standardized financial statement presenting all items relative to a certain base year amount.

Page 57TABLE 3.7

NOTE: The common-size numbers are calculated by dividing each item by total assets for that year. For example, the 2014 common-size cash amount is $84/3,373 = 2.5%. The common-base year numbers are calculated by dividing each 2015 item by the base year (2014) dollar amount. The common-base cash is thus $98/84 = 1.17, representing a 17 percent increase. The combined common-size and base year figures are calculated by dividing each common-size amount by the base year (2014) common-size amount. The cash figure is therefore 2.7%/2.5% = 1.08, representing an 8 percent increase in cash holdings as a percentage of total assets. Columns may not total precisely due to rounding.

Concept Questions

3.2a Why is it often necessary to standardize financial statements?

3.2b Name two types of standardized statements and describe how each is formed.

3.3 Ratio Analysis

Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. Using ratios eliminates the size problem because the size effectively divides out. We’re then left with percentages, multiples, or time periods.

There is a problem in discussing financial ratios. Because a ratio is simply one number divided by another, and because there are so many accounting numbers out there, we could examine a huge number of possible ratios. Everybody has a favorite. We will restrict ourselves to a representative sampling.

In this section, we only want to introduce you to some commonly used financial ratios. These are not necessarily the ones we think are the best. In fact, some of them may strike you as illogical or not as useful as some alternatives. If they do, don’t be concerned. As a financial analyst, you can always decide how to compute your own ratios.

What you do need to worry about is the fact that different people and different sources seldom compute these ratios in exactly the same way, and this leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are ever using ratios as a tool for analysis, you should be careful to document how you calculate each one. And if you are comparing your numbers to numbers from another source, be sure you know how those numbers are computed.

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financial ratios Relationships determined from a firm’s financial information and used for comparison purposes.

Page 58We will defer much of our discussion of how ratios are used and some problems that come up with using them until later in the chapter. For now, for each of the ratios we discuss, we consider several questions:

1. How is it computed?

2. What is it intended to measure, and why might we be interested?

3. What is the unit of measurement?

4. What might a high or low value tell us? How might such values be misleading?

5. How could this measure be improved?

Financial ratios are traditionally grouped into the following categories:

1. Short-term solvency, or liquidity, ratios.

2. Long-term solvency, or financial leverage, ratios.

3. Asset management, or turnover, ratios.

4. Profitability ratios.

5. Market value ratios.

We will consider each of these in turn. In calculating these numbers for Prufrock, we will use the ending balance sheet (2015) figures unless we say otherwise. Also notice that the various ratios are color keyed to indicate which numbers come from the income statement and which come from the balance sheet.

SHORT-TERM SOLVENCY, OR LIQUIDITY, MEASURES

As the name suggests, short-term solvency ratios as a group are intended to provide information about a firm’s liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm’s ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities.

For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. Because financial managers work constantly with banks and other short-term lenders, an understanding of these ratios is essential.

One advantage of looking at current assets and liabilities is that their book values and market values are likely to be similar. Often (though not always), these assets and liabilities just don’t live long enough for the two to get seriously out of step. On the other hand, like any type of near-cash, current assets and liabilities can and do change fairly rapidly, so today’s amounts may not be a reliable guide to the future.

Current Ratio One of the best known and most widely used ratios is the current ratio. As you might guess, the current ratio is defined as follows:

Here is Prufrock’s 2015 current ratio:

Because current assets and liabilities are, in principle, converted to cash over the following 12 months, the current ratio is a measure of short-term liquidity. The unit of measurement is either dollars or times. So, we could say Prufrock has $1.31 in current assets for every $1 in current liabilities, or we could say Prufrock has its current liabilities covered 1.31 times over.

To a creditor—particularly a short-term creditor such as a supplier—the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. Absent some extraordinary circumstances, we would expect to see a current ratio of at least 1 because a current ratio of less than 1 would mean that net working capital (current assets less current liabilities) is negative. This would be unusual in a healthy firm, at least for most types of businesses.

Go to www.reuters.com to examine comparative ratios for a huge number of companies.

Page 59The current ratio, like any ratio, is affected by various types of transactions. For example, suppose the firm borrows over the long term to raise money. The short-run effect would be an increase in cash from the issue proceeds and an increase in long-term debt. Current liabilities would not be affected, so the current ratio would rise.

Finally, note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power.

EXAMPLE 3.1 Current Events

Suppose a firm pays off some of its suppliers and short-term creditors. What happens to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens if a firm sells some merchandise?

The first case is a trick question. What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger. But if it is less than 1, it will get smaller. To see this, suppose the firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. If we use $1 in cash to reduce current liabilities, then the new current ratio is ($4 – 1)/($2 – 1) = 3. If we reverse the original situation to $2 in current assets and $4 in current liabilities, then the change will cause the current ratio to fall to 1/3 from 1/2.

The second case is not quite as tricky. Nothing happens to the current ratio because cash goes down while inventory goes up—total current assets are unaffected.

In the third case, the current ratio will usually rise because inventory is normally shown at cost and the sale will normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises.

The Quick (or Acid-Test) Ratio Inventory is often the least liquid current asset. It’s also the one for which the book values are least reliable as measures of market value because the quality of the inventory isn’t considered. Some of the inventory may later turn out to be damaged, obsolete, or lost.

More to the point, relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory.

To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted:

Notice that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash.

For Prufrock, this ratio for 2015 was:

The quick ratio here tells a somewhat different story than the current ratio because inventory accounts for more than half of Prufrock’s current assets. To exaggerate the point, if this inventory consisted of, say, unsold nuclear power plants, then this would be a cause for concern.

Page 60To give an example of current versus quick ratios, based on recent financial statements, Walmart and Manpower Inc. had current ratios of .83 and .14, respectively. However, Manpower carries no inventory to speak of, whereas Walmart’s current assets are virtually all inventory. As a result, Walmart’s quick ratio was only .22, whereas Manpower’s was .14, the same as its current ratio.

Other Liquidity Ratios We briefly mention three other measures of liquidity. A very short-term creditor might be interested in the cash ratio:

You can verify that for 2015 this works out to be .18 times for Prufrock.

Because net working capital, or NWC, is frequently viewed as the amount of short-term liquidity a firm has, we can consider the ratio of NWC to total assets:

A relatively low value might indicate relatively low levels of liquidity. Here, this ratio works out to be ($708 − 540)/$3,588 = 4.7%.

Finally, imagine that Prufrock was facing a strike and cash inflows began to dry up. How long could the business keep running? One answer is given by the interval measure:

Total costs for the year, excluding depreciation and interest, were $1,344. The average daily cost was $1,344/365 = $3.68 per day. 1 The interval measure is thus $708/$3.68 = 192 days. Based on this, Prufrock could hang on for six months or so. 2

The interval measure (or something similar) is also useful for newly founded or start-up companies that often have little in the way of revenues. For such companies, the interval measure indicates how long the company can operate until it needs another round of financing. The average daily operating cost for start-up companies is often called the burn rate, meaning the rate at which cash is burned in the race to become profitable.

LONG-TERM SOLVENCY MEASURES

Long-term solvency ratios are intended to address the firm’s long-term ability to meet its obligations, or, more generally, its financial leverage. These are sometimes called financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations.