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Introduction to Financial Statement Analysis 7

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220 Chapter 7 Introduction to Financial Statement Analysis 1. Understand the purpose and content of three principal financial statements and related notes. Our financial statement analysis considers the balance sheet, income statement, and state-ment of cash flows, discussed in Chapters 4, 5, and 6, respectively. 2. Identify the economic ...



220 Chapter 7 Introduction to Financial Statement Analysis
FIGURE 7 1 Overview of Financial Statement Analysis
Cengage Learning 2014
Understand Identify Identify Analyze
Pro Forma Value
the Financial Economic Company Profitability
Financial the Firm
Statements Characteristics Strategy and Risk
Statements
1 Understand the purpose and content of three principal financial statements and related notes
Our financial statement analysis considers the balance sheet income statement and state
ment of cash flows discussed in Chapters 4 5 and 6 respectively
2 Identify the economic characteristics of the industry We begin by identifying the charac
teristics of the firm s industry Great Deal is a U S retailer of consumer electronics home
office products entertainment software appliances and related services The principal eco
nomic characteristics of this industry are as follows
Nature of products Great Deal offers products and services that are similar to the offer
ings of its competitors Common terminology refers to such products as commodities
Extent of competition The industry is competitive with many firms offering similar
products Barriers to entry for new competitors include size distribution network and
market penetration
Growth characteristics The U S market is saturated so further growth must come from
introducing new store concepts and expanding internationally
3 Identify the company s strategy Next we identify the firm s strategy to compete in its indus
try and gain competitive advantage Great Deal emphasizes a broad product offering rela
tively low prices and superior service Great Deal also sells through both physical stores
and the internet
4 Calculate and interpret profitability and risk ratios Most financial statement analyses exam
ine ratios that capture either profitability or risk Ratios based on financial statement data
provide one analytical tool used to evaluate profitability and risk This chapter describes
and illustrates key profitability and risk ratios
In analyzing a firm s profitability or risk it is often helpful to compare the firm s
performance to a benchmark Two common benchmarks are the firm s own performance
in a prior period time series analysis and competitors performance in the same period
cross sectional analysis We illustrate both types of analyses later in this chapter
5 Prepare pro forma or projected financial statements After studying the profitability and
risk of a firm in the recent past the analyst often prepares pro forma or projected finan
cial statements for the next three to five years using assumptions about economic industry
and firm specific conditions 1
6 Value the firm Analysts use projected net income cash flows and other items from the
financial statements to value the firm This textbook does not consider valuation which is
an advanced topic in accounting and finance
OBJECTIVES OF FINANCIAL
STATEMENT ANALYSIS
The first question the analyst asks in analyzing a set of financial statements is What do I look
for The response to this question requires an understanding of investment decisions To illus
trate assume that you must decide how to invest a recent gift of 25 000 You narrow the invest
ment decision to purchasing either a certificate of deposit at a local bank or the common stock
Appendix 7 1 to this chapter illustrates the preparation of pro forma financial statements for Great Deal for
fiscal year 2013 the year ended February 27 2014
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Objectives of Financial Statement Analysis 221
of Great Deal Inc Great Deal shares currently sell for 25 per share You will base your deci
sion on the return you anticipate from each investment and the risk associated with that return
The bank currently pays interest at the rate of 3 annually on certificates of deposit
Because the bank will likely remain in business you feel confident you will earn 3 each year
The return from investing in Great Deal s common stock has two components First you antic
ipate that Great Deal will continue to pay a cash dividend of at least 0 15 per share Also the
market price of Great Deal s stock will likely change between the time you purchase the shares
and the time you sell them in the future The difference between the eventual selling price and
the purchase price often called price appreciation or price depreciation if negative is the sec
ond component of the return from buying the stock
The common stock investment involves more risk that is more variability of outcomes
than does the certificate of deposit investment This is because Great Deal s future profitabil
ity will affect its future dividends and market price changes If competitors open new stores or
introduce new products or services that erode Great Deal s market share future income might
be less than you currently anticipate On the other hand if Great Deal opens new stores or
introduces successful new products or services its future income might be greater than you cur
rently anticipate Economy wide factors such as inflation and unemployment will also affect the
market price of Great Deal s shares as will factors such as changes in exchange rates that affect
the cost of imported merchandise or government regulatory actions Because most individu
als prefer less risk to more risk you will want a higher expected return if you purchase Great
Deal s shares than if you invest in a certificate of deposit
Theoretical and empirical research has shown that the expected return from investing in a
firm relates in part to the expected profitability of the firm The analyst studies a firm s past
earnings to understand its operating performance and to help forecast its future profitability
Investment decisions also require assessing risk A firm may find itself short of cash and unable
to pay its suppliers on a timely basis Or it may have issued so much debt that it has diffi
culty meeting the required interest and principal payments The financial statements provide
information for assessing how these and other risk elements affect expected return Most finan
cial statement analysis therefore explores some aspect of a firm s profitability or its risk or
both Figure 7 2 summarizes the relation between financial statement analysis and investment
THE ROLE OF FINANCIAL STATEMENTS IN ASSESSING PROFITABILITY AND RISK
Readers cannot easily answer questions about a firm s profitability and risk from the raw
information in financial statements Nor can they easily compare two firms using these data
For example one cannot assess profitability by examining the amount of net income This is
because a large amount of net income could result from a large firm earning small profits or
Relation Between Financial Statement Analysis
FIGURE 7 2
and Investment Decisions
Time Dimension
Past Present Future
Financial Statement
Profitability Expected Return
Risk Short term
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and Long term
Investment Decision
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222 Chapter 7 Introduction to Financial Statement Analysis
from a small firm earning large profits Similarly it would not be wise to conclude that two
firms are of equivalent financial health simply because they report the same amount of income
Rather it is important to consider the size of the firm when assessing its profitability or when
comparing two firms Financial analysis uses financial ratios and common size financial
statements to deal with size or scale differences in a firm s operations Common size income
statements express each line in the income statement as a percentage of sales revenues Com
mon size balance sheets express each line in the balance sheet as a percentage of total assets
We discuss common size financial statements later in this chapter
FINANCIAL R ATIOS
Financial ratios incorporate the scale of operations by for example relating the amount of
income the firm generates to the amount of investment in assets The analyst expresses the rela
tion between two financial statement items income and investment for example in the form of
a ratio Some ratios compare items within the income statement some use only balance sheet
data others relate items from multiple financial statements Ratios aid financial statement anal
ysis because they summarize data in a form easy to understand interpret and compare After
calculating the ratios the analyst must compare them with a benchmark The following list pro
vides several possible benchmarks for a financial ratio
1 The planned ratio for the period
2 The corresponding ratio during the preceding period for the same firm
3 The corresponding ratio for a similar firm in the same industry
4 The average ratio for other firms in the same industry
To demonstrate the calculation of financial ratios we use the financial statement data for
Great Deal Inc for fiscal years 2010 2011 and 2012 appearing in Exhibit 1 1 balance sheet
Exhibit 1 2 income statement and Exhibit 1 3 statement of cash flows We recommend that
you trace the amounts in the financial ratios discussed in this chapter to the amounts in Great
Deal s financial statements
ANALYSIS OF PROFITABILITY
A firm engages in operations to generate net income For example Great Deal sells electronics
office equipment and home appliances to consumers to generate net income This section dis
cusses two measures of profitability return on equity and return on assets and how these ratios
relate to each other
RETURN ON EQUITY
Return on equity ROE measures a firm s performance in using the resources provided by
shareholders to generate net income This measure of profitability links net income to the por
tion of the firm s assets that shareholders have financed
Net Income
Average Shareholders Equity
The numerator of the ROE ratio is net income as reported in the income statement
Because net income includes payments to creditors in the form of interest expense net income
can be thought of as the profits that are available to shareholders We do not subtract dividends
declared and paid to shareholders because dividends are distributions to shareholders of a por
tion of the returns generated for them during the period The firm s board of directors makes
the decision whether to pay dividends and specifies the amount The denominator of the ROE
ratio is the average amount of shareholders equity for a period 2 The average is taken over the
time period in which net income the numerator was generated For example if the numerator
The measure of shareholders equity used in the ROE formula should be the balance sheet carrying value of
the firm s common shareholders equity Thus any preferred equity should be excluded Chapter 15 discusses
preferred equity
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Analysis of Profitability 223
captures yearly net income then the denominator should be the average of the beginning of
year and end of year amounts of shareholders equity
Based on information from Great Deal s balance sheet Exhibit 1 1 and income statement
Exhibit 1 2 Great Deal s ROE in fiscal 2012 is 21 7
1 317 1 317
0 5 5 156 6 964 6 060
Great Deal s 21 7 ROE means that each dollar of shareholders equity generated 21 7 cents
in net income To determine whether an ROE of 21 7 indicates good or bad performance we
might compare Great Deal s 2012 ROE to Great Deal s ROE for the prior year Great Deal s
ROE for fiscal 2011 was 20 7
1 003 1 003
0 5 4 524 5 156 4 840
Great Deal s profitability as measured by ROE increased between 2011 and 2012
RETURN ON ASSETS
Return on assets ROA measures a firm s performance in using assets to generate net income
independent of how those assets are financed that is with debt versus equity ROA differs
from ROE because ROE measures profitability for a specific form of financing the portion
provided by shareholders The ROA formula is as follows
Net Income
Average Total Assets
ROA is the ratio of net income for a given period to average total assets for that same period
We use the data in Exhibit 1 1 and Exhibit 1 2 to calculate Great Deal s ROA for fiscal 2012 as
Net Income 1 317
Average Total Assets 0 5 15 826 18 302
Great Deal s ROA indicates that Great Deal earned 0 077 for each dollar of assets in fiscal
2012 To determine whether this return indicates good or poor performance we might compare
Great Deal s 2012 ROA with its ROA for the previous year We calculate Great Deal s ROA for
fiscal 2011 as follows
Net Income 1 003
Average Total Assets 0 5 12 758 15 826
These results indicate that Great Deal improved its use of assets between 2011 and 2012 ROA
increased from 0 07 per dollar of assets to 0 077 per dollar of assets or a 10 increase in
ROA 10 0 077 0 07 0 07
RELATION BETWEEN RETURN ON EQUITY AND RETURN ON ASSETS
Our previous analysis indicates that Great Deal s ROE exceeds its ROA For example in fiscal
2012 ROE was 21 7 compared to an ROA of 7 7 What accounts for this relation a common
one for profitable firms The key to understanding the relation between ROE and ROA lies in
understanding financial leverage Financial leverage measures the degree to which a firm s assets
are financed with debt Financial leverage links return on equity and return on assets as follows
ROE ROA Financial Leverage
Net Income Net Income Average Total Assets
Average Shareholders Equity Average Total Assets Average Shareholders Equity
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224 Chapter 7 Introduction to Financial Statement Analysis
This formula shows that return on equity equals return on assets multiplied by financial lever
age equal to the ratio of average total assets to average total shareholders equity 3 If a firm is
100 equity financed i e no assets are financed by debt its financial leverage ratio is 1 or
100 In contrast a firm that financed 50 of its assets with equity would have a financial
leverage ratio of 2 or 200
Exhibit 7 1 shows the components of Great Deal s ROE for fiscal years 2011 and 2012
Great Deal s financial leverage ratio average total assets divided by average shareholders
equity is 2 82 for fiscal 2012 0 5 15 826 18 302 0 5 5 156 6 964 A
financial leverage ratio of 2 82 means that each dollar of equity finances about 2 82 of assets
The deviation of this ratio from 1 0 captures the degree to which assets are financed by non
equity source of funds We also see that the product of Great Deal s ROA ratio 7 7 and its
financial leverage ratio 2 82 equals its ROE for 2012 21 7
Comparing Great Deal s ROE and ROE components in 2012 to those in 2011 reveals that
the increase in ROE between 2011 and 2012 resulted from two offsetting effects First Great
Deal s ROA increased from 7 0 to 7 7 Second Great Deal s financial leverage declined
from 2 95 to 2 82 Because ROE increased overall we can conclude that the first effect the
increase in ROA exceeded the second effect the decline in financial leverage
C O N C E P T U A L N O T E
The use of average total assets as the denominator in the an adjustment to income for the effects of the firm s
ROA ratio means that the firm s financing decisions do financing choices the adjusted ROA formula is the
not affect the denominator of this ratio Those financing technically correct formula for calculating ROA Great
decisions do however affect the numerator of ROA net Deal s adjusted ROA for fiscal 2012 and fiscal 2011
income because interest expense reduces net income are calculated as follows 4
To incorporate the effect of interest costs the analyst
adjusts the numerator of the ROA formula for the effects
Net Income After tax Interest Expense
of financing choices This adjustment results in the ROA
Average Total Assets
following adjusted ROA formula
1 317 1 0 365 94
Net Income After tax Interest Expense 0 5 15 826 18 302
Average Total Assets
The adjusted ROA formula adds back interest expense Net Income After tax Interest Expense
adjusted for its tax effects to net income Interest Average Total Assets
expense is deducted on the firm s tax return in 1 003 1 0 396 94
calculating taxable income which is the income on 0 5 12 758 15 826
which the firm pays taxes Other things equal interest
expense benefits the firm by reducing its taxable income Although the adjusted formula is the correct formula
and therefore reducing its taxes paid The amount of to use when ROA is calculated on a standalone basis it
taxes saved or shielded because of the tax deductibility is not the formula that is used in the decomposition of
of interest expense is the amount of interest expense ROE Therefore for purposes of this chapter we use the
times one minus the firm s tax rate Because it includes unadjusted formula when we refer to the ROA ratio
Financial leverage can be measured in a number of ways including the ratio of average total debt to average
total assets the ratio of average shareholders equity to average total assets and the inverse of either of these
ratios The formula above uses the ratio of average total assets to average shareholders equity
Great Deal s tax rate is 39 6 in fiscal 2011 and 36 5 in fiscal 2012
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Analysis of Profitability 225
Great Deal Inc
EXHIBIT 7 1
Components of the Return on Equity
Return on Financial
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ROE Assets Leverage
2012 21 7 7 7 2 82
2011 20 7 7 0 2 95
PROBLEM 7 1 FOR SELF STUDY
Analyzing return on equity Balance sheets and income statements for Markum
Corporation are provided in Exhibits 7 2 and 7 3 respectively Using the information in
these financial statements answer the following questions about Markum s profitability
a What was Markum s return on equity ROE for 2013
b What was Markum s return on assets ROA for 2013
c Why is Markum s ROE different from its ROA in 2013
Markum Corporation
Consolidated Balance Sheets
EXHIBIT 7 2
For Years 2012 and 2013
in millions of US
Cash and Cash Equivalents 6 000 4 8 4 000 4 0
Receivables 15 000 12 1 12 000 12 0
Merchandise Inventories 28 000 22 6 20 000 20 0
Total Current Assets 49 000 39 5 36 000 36 0
Property Plant and Equipment Net 75 000 60 5 64 000 64 0
Total Assets 124 000 100 0 100 000 100 0
Liabilities and Shareholders Equity
Accounts Payable 31 000 25 0 24 800 24 8
Accrued Wages and Other 19 000 15 3 16 000 16 0
Total Current Liabilities 50 000 40 3 40 800 40 8
Long Term Debt 18 000 14 5 12 000 12 0
Shareholders Equity
Common Stock 1 500 1 2 1 000 1 0
Additional Paid in Capital 24 500 19 8 18 000 18 0
Retained Earnings 30 000 24 2 28 200 28 2
Total Shareholders Equity 56 000 45 2 47 200 47 2
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Total Liabilities and Shareholders Equity 124 000 100 0 100 000 100 0
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226 Chapter 7 Introduction to Financial Statement Analysis
Markum Corporation
Consolidated Income Statements
EXHIBIT 7 3
For Years 2012 and 2013
amounts in millions of US
Revenue 92 000 100 0 85 000 100 0
Cost of Goods Sold 67 000 72 8 70 000 82 4
Gross Profit 25 000 27 2 15 000 17 6
Selling General and Administrative Expenses 8 000 8 7 6 000 7 0
Research and Development Expenses 7 000 7 6 5 000 5 9
Operating Income 10 000 10 9 4 000 4 7
Interest Expense 2 000 2 2 1 000 1 2
Income Before Income Tax Expense 8 000 8 7 3 000 3 5
Income Tax Expense 3 200 3 5 1 200 1 4
Net Income 4 800 5 2 1 800 2 1
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Tax Rate 40 0 40 0
DUPONT DECOMPOSITION ANALYSIS
A useful tool for understanding the sources of a firm s profitability as measured by ROE and
ROA is the DuPont Decomposition Analysis This analysis disaggregates ROE into the financial
leverage and ROA components as we did in the previous section and then disaggregates ROA
further into the product of two other ratios the profit margin ratio and the asset turnover ratio
also called the total assets turnover Figure 7 3 illustrates this breakdown
The ROA disaggregation is as follows
ROA Profit Margin Asset Turnover Ratio
Net Income Net Income Sales
Average Total Assets Sales Average Total Assets
FIGURE 7 3 DuPont Decomposition of ROE and ROA
Return on Equity
Return on Assets
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Asset Turnover
Profit Margin
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Analysis of Profitability 227
The profit margin ratio net income divided by sales revenue measures a firm s ability to
control the level of expenses relative to sales to increase selling prices relative to the level of
expenses incurred or a combination of the two By controlling expenses or increasing selling
prices a firm can increase the profits from a given amount of sales activity and improve its
profit margin
The asset turnover ratio measures a firm s ability to generate sales from its investment in
assets or alternatively to control the amount of assets it uses to generate a particular level of
sales revenues The smaller the amount of assets the firm needs to generate a given level of
sales the better larger its assets turnover and the more profitable the firm
Exhibit 7 4 presents the disaggregation of ROA for Great Deal into the profit margin ratio
and asset turnover ratio for fiscal years 2011 and 2012 The data show that the previously noted
increase in ROA from 7 0 in 2011 to 7 7 in 2012 is the result of two offsetting factors
An increase in profit margin from 2 22 to 2 65 and
A decline in asset turnover from 3 15 to 2 91
To pinpoint the causes of these changes we analyze the changes in the profit margin and asset
turnover ratios in the next section
A firm can improve its ROA by increasing the profit margin ratio the rate of asset turnover
or both It may be difficult to alter one or the other of these components For example a firm
that sells commodity products in a competitive market likely has little opportunity to increase
its profit margin by increasing prices Such a firm would need to improve its total assets turn
over for example shortening the holding period for inventories by imposing tighter inventory
controls to increase its ROA A firm whose activities require substantial investments in prop
erty plant and equipment and that operates efficiently near its capacity has limited ability to
increase its ROA by increasing its total assets turnover Such a firm might have more flexibility
to take actions that increase the profit margin for example by creating brand loyalty for its
products to increase sales
The profit margin and asset turnover ratios are also related to each other Holding other
factors constant we would expect that reducing the selling prices of products thus reducing
the profit margin would increase sales of those products thus increasing the asset turnover
ratio Conversely raising selling prices thus increasing the profit margin would reduce sales
volumes thus reducing the asset turnover ratio
ANALYZING CHANGES IN THE PROFIT MARGIN R ATIO
Changes in a firm s expenses relative to sales cause the profit margin ratio to change To see the
relation we express the individual line items on the income statement as a percentage of sales
These percentages for each individual expense and net income are collectively referred to as a
common size income statement The common size income statements for Great Deal for fiscal
years 2010 2012 are shown in Exhibit 7 5 Exhibit 7 5 indicates that Great Deal s profit margin
increased between 2011 and 2012 because of the following effects
Cost of sales as a percentage of sales declined from 75 6 to 75 5 Possible reasons for
this decline include
Great Deal s increasing size as measured by the growth in total assets between 2011
and 2012 may have allowed it to purchase merchandise at lower cost either because of
quantity discounts or greater bargaining power over suppliers
Great Deal Inc
EXHIBIT 7 4
Disaggregation of ROA for 2011 and 2012
Profit Turnover
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ROA Margin Ratio
2012 7 7 2 65 2 91
2011 7 0 2 22 3 15
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228 Chapter 7 Introduction to Financial Statement Analysis
Great Deal Inc
Common Size Income Statements
EXHIBIT 7 5
For Years 2012 2011 and 2010
amounts in millions of US
2012 2011 2010
Revenue 49 694 100 0 45 015 100 0 40 023 100 0
Cost of Goods Sold 37 534 75 5 34 017 75 6 30 477 76 1
Gross Profit 12 160 24 5 10 998 24 4 9 546 23 9
Selling General and Administrative Expenses 9 873 19 9 8 984 20 0 7 385 18 5
Restructuring Charges 52 0 1 78 0 2 0 0 0
Goodwill and Trade Name Impairment 0 0 0 66 0 1 0 0 0
Operating Income 2 235 4 5 1 870 4 1 2 161 5 4
Other Income Expense
Investment Income and Other 54 0 1 35 0 1 129 0 3
Investment Impairment 0 0 0 111 0 2 0 0 0
Interest Expense 94 0 2 94 0 2 62 0 2
Earnings Before Income Tax Expense and Equity
in Income Loss of Affiliates 2 195 4 4 1 700 3 8 2 228 5 5
Income Tax Expense 802 1 6 674 1 5 815 2 0
Equity in Income Loss of Affiliates 1 0 0 7 0 0 3 0 0
Net Earnings Including Noncontrolling Interests 1 394 2 8 1 033 2 3 1 410 3 5
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Net Earnings Attributable to Noncontrolling Interests 77 0 2 30 0 1 3 0 0
Net Earnings Attributable to Great Deal Inc 1 317 2 6 1 003 2 2 1 407 3 5
Great Deal may have shifted its sales mix toward products or geographical markets with
lower cost of goods sold to sales percentages
Great Deal may have improved its controls over the purchase storage and delivery of
merchandise reducing the cost of storage and obsolescence
Selling general and administrative SG A expenses as percentages of sales declined
from 20 0 to 19 9 Possible reasons for this decline include
A competitor s bankruptcy may have reduced competition permitting Great Deal to
reduce advertising and other marketing costs
Great Deal may have improved its distribution channels resulting in lower SG A
Great Deal may have shifted its sales mix toward products or geographical markets with
lower levels of selling or administrative expenses
Both restructuring charges and impairment charges declined as a percentage of sales
Restructuring charges declined from 0 2 to 0 1 and impairment charges declined from
0 1 to 0 0 The declines in these percentages indicate that Great Deal had fewer restruc
turing events and fewer impairments in fiscal 2012 compared to fiscal 2011
ANALYZING CHANGES IN THE ASSET TURNOVER R ATIO
Changes in the rate of turnover of specific types of assets result in changes in the total assets
turnover ratio The analyst generally calculates separate turnover ratios for three types of
assets accounts receivable inventory and fixed assets
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Analysis of Profitability 229
Accounts Receivable Turnover The rate at which accounts receivable turn over indi
cates how quickly a firm collects cash from credit sales The accounts receivable turnover ratio
equals sales revenue divided by average accounts receivable during the period 5
Average Accounts Receivable
The accounts receivable turnover ratio for Great Deal in fiscal 2012 is as follows
Sales 49 694
25 6 times per year
Average Accounts Receivable 0 5 1 868 2 020
The analyst often expresses accounts receivable turnover in terms of the average number
of days that elapse between the time the firm makes the sale and the time it later collects the
cash This calculation is called days accounts receivable are outstanding or days outstanding for
receivables To calculate this ratio divide 365 days by the accounts receivable turnover ratio
The days outstanding for accounts receivable for Great Deal during fiscal 2012 was 14 3 days
365 days 25 6 times per year During fiscal 2011 its accounts receivable turnover was 37 2
or 9 8 days The declining accounts receivable ratios and the increasing days outstanding for
receivables indicate that Great Deal has been slower to convert sales into cash collections in
fiscal 2012 compared to fiscal 2011 The declining accounts receivable turnover and increased
number of days on average to collect accounts receivable may result from the following factors
Great Deal may over time be increasing the fraction of its sales made on credit versus
cash Because our calculation includes cash sales erroneously in the numerator but not
the denominator of the accounts receivable turnover ratio a shift in the portion of cash
sales over time will create shifts in the ratio itself
Great Deal may be offering customers more attractive to the customer payment terms in
order to increase sales All else equal customers would prefer to pay for sales later rather
than earlier
Most firms that sell to other businesses as opposed to consumers sell on account and col
lect within 30 to 90 days Interpreting any particular firm s accounts receivable turnover and
days receivable outstanding requires knowing the terms of sale If a firm s terms of sale are
net 30 days and the firm collects its accounts receivable in 45 days then collections do not
match the stated terms Such a result warrants a review of the credit and collection activity to
ascertain the cause and to guide corrective action If the firm offers terms of net 45 days a
days receivable outstanding of 45 days indicates that the firm handles accounts receivable in
accord with stated terms
Many firms sell to customers on account as a strategy to stimulate sales Customers may
purchase more willingly and purchase more if they are provided credit Such firms may also
encourage customers to delay paying for their purchases as a means for the selling firm to
generate interest revenue through finance charges on the unpaid amounts Thus comparing
accounts receivable turnovers over time or across firms requires an analysis of the growth rate
in sales the amount of interest revenue generated the cost of administering the credit granting
activity and the losses from uncollectible accounts
Inventory Turnover The inventory turnover ratio indicates how fast firms sell their inven
tory measured in terms of the rate of movement of goods into and out of the firm Inventory
turnover equals cost of goods sold divided by the average inventory during the period
Cost of Goods Sold
Average Inventory
In theory the numerator should include only credit sales i e exclude cash sales if the objective is to measure
how quickly a firm collects its accounts receivable Many firms except some retailers that deal directly with
consumers such as fast food outlets sell their goods and services on credit Other firms such as Great Deal
have both cash sales and credit sales Firms seldom disclose the proportions of cash and credit sales in their
financial reports Thus the analyst uses sales revenue in the numerator of the accounts receivable turnover
ratio recognizing that the inclusion of cash sales increases the numerator and thereby overstates the receivables
turnover ratio
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230 Chapter 7 Introduction to Financial Statement Analysis
The numerator equals the cost of inventories sold during the period 6 The denominator
equals the average cost of inventories on hand during the period The inventory turnover ratio
for Great Deal for fiscal 2012 is as follows
Cost of Goods Sold 37 534
7 3 times per year
Average Inventory 0 5 4 753 5 486
Items remain in inventory an average of 50 0 days 365 days 7 3 times per year before sale
In fiscal 2011 Great Deal s inventory turnover ratio was 7 2 times or 50 7 days The increasing
inventory turnover ratio and declining days inventory might result from the following factors
Improved inventory control systems which would reduce the levels of inventory and the
cost of storage and obsolescence This explanation is consistent with the decreased cost of
goods sold to sales percentage discussed earlier
A shift in sales mix toward DVDs or CDs or other products that turn over more quickly
Managing inventory turnover involves two opposing considerations On the one hand for
a given amount of profit margin on the goods firms prefer to sell as many goods as possible
with a minimum of assets tied up in inventories An increase in the rate of inventory turnover
between periods indicates reduced costs of financing the inventory On the other hand man
agement does not want to have so little inventory on hand that shortages result in lost sales
Increases in the rate of inventory turnover caused by inventory shortages could signal a loss of
customers thereby offsetting any advantage gained by decreased investment in inventory Firms
must balance these opposing considerations in setting the level of inventory and thus the rate
of inventory turnover
Fixed Asset Turnover The fixed asset turnover ratio measures the relation between sales
and the investment in fixed assets property plant and equipment It is more difficult to under
stand the notion that fixed assets turn over than to understand turnover for inventory A more
appropriate title for the fixed asset turnover ratio might be the fixed asset productivity ratio
because it measures the sales generated from a particular level of investment in fixed assets
Average Fixed Assets
The fixed asset turnover ratio for Great Deal for fiscal 2012 is as follows
Sales 49 694
12 1 times per year
Average Fixed Assets 0 5 4 174 4 070
Thus 1 00 invested in fixed assets during fiscal 2012 generated 12 10 in sales In fiscal 2011
1 00 invested in fixed assets generated 12 00 in sales Thus the fixed asset turnover increased
between 2011 and 2012 The analyst should interpret changes in the fixed asset turnover ratio
cautiously Firms often invest in fixed assets for example new production facilities well before
these assets generate sales from products manufactured in their plants or sold in their stores
Thus a low or decreasing fixed asset turnover ratio may indicate an expanding firm preparing
for future growth On the other hand a firm anticipating a decline in product sales could cut
back its expenditures on fixed assets thus increasing the fixed asset turnover ratio
Some analysts find the reciprocal of the fixed asset turnover ratio helpful in comparing
the operating characteristics of different firms The reciprocal ratio measures the investment
in fixed assets required to generate sales For Great Deal this reciprocal for 2012 is 0 08
Some analysts calculate the inventory turnover ratio using sales rather than cost of goods sold as the numera
tor As long as the ratio of selling price to cost of goods sold remains relatively constant either measure will
identify changes in the trend of the inventory turnover ratio Using sales in the numerator however will lead to
incorrect measures of the inventory turnover ratio for calculating the average number of days that inventory is
on hand until sale
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Analysis of Profitability 231
1 0 12 1 times This calculation implies that Great Deal required 0 08 of fixed assets to
generate 1 00 of sales in fiscal 2012
Summary of Asset Turnover Ratios Exhibit 7 6 presents the four turnover ratios
discussed for Great Deal for fiscal years 2011 and 2012 We noted earlier that the asset turn
over ratio for Great Deal declined between 2011 and 2012 The accounts receivable turnover
ratio decreased from 37 2 to 25 6 between 2011 and 2012 Accounts receivable represent 11
2 020 18 302 of Great Deal s total assets in fiscal 2012 The decreasing accounts receiv
able turnover ratio taken alone would decrease the total assets turnover Inventory and fixed
assets on the other hand together comprise approximately 52 of total assets 5 486
4 070 18 302 and both of these ratios increased by small amounts The small changes in the
inventory turnover ratio and the fixed asset turnover ratio coupled with the larger amounts
of these assets do not offset the effects of the decline in the accounts receivable turnover ratio
The offsetting effects of changes in these three asset turnover ratios led to the decline in the
total assets turnover ratio between 2011 and 2012
SUMMARY OF THE DUPONT DECOMPOSITION ANALYSIS
The DuPont decomposition analysis helps the analyst understand the sources of a firm s per
formance as measured by return on equity The DuPont analysis shows the following
ROE results from the interaction of its components ROA and financial leverage Financial
leverage captures the choice about the portion of assets to finance through debt versus
ROA results from the interaction of its components profit margin and asset turnover
The profit margin results from the relation of expenses to sales Asset turnover reflects the
effects of turnover ratios for accounts receivable inventory and fixed assets
PROBLEM 7 2 FOR SELF STUDY
Analyzing the return on assets Refer to the information for Markum Corporation
provided in Problem 7 1 for Self Study Identify the likely reasons for the increasing
return on assets ratio for 2013 Use common size income statement percentages and
individual asset turnover ratios in your interpretations
SUMMARY OF PROFITABILITY ANALYSIS
This chapter introduces two broad measures for assessing profitability ROE and ROA
Figure 7 4 summarizes the discussion At Level 1 ROA and ROE measure overall profitabil
ity and the effect of financial leverage At Level 2 we disaggregate ROA into its profit margin
and asset turnover components At Level 3 we further disaggregate the profit margin and asset
turnover ratios to gain additional insights into reasons for changes in profitability
Great Deal Inc
EXHIBIT 7 6
Asset Turnover Ratios
Total Assets Turnover 2 9 3 2
Cengage Learning 2014
Accounts Receivable Turnover 25 6 37 2
Inventory Turnover 7 3 7 2
Fixed Asset Turnover 12 1 12 0
23450 ch07 ptg02 lores 219 274 indd 231 10 09 15 2 40 PM
232 Chapter 7 Introduction to Financial Statement Analysis
FIGURE 7 4 Complete DuPont Decomposition
Return on Equity
Level 1 Return on Assets
Asset Turnover
Level 2 Profit Margin
Cengage Learning 2014
Various Expense Inventory Fixed Asset
Level 3 Receivable
Percentages Turnover Turnover
ANALYSIS OF RISK
Investors deciding among potential investments must consider the comparative risks of those
investments Various factors affect the risk of a business enterprise
1 Macroeconomic factors such as inflation interest rates and unemployment rates
2 Industry factors such as competition changes in technology and changes in regulations
3 Firm specific factors such as labor strikes loss of facilities due to fire or other casualty or
key skills and talents of the management team
An important risk assessment concerns liquidity which refers to whether the firm is able to
pay its bills in a timely manner Assessing liquidity requires a time horizon Consider the three
questions that follow
1 Does a firm have sufficient cash to pay its employees tomorrow
2 Will the firm have sufficient cash to pay its suppliers in six months
3 Will the firm have sufficient cash to repay a loan due in five years
To answer the first question we examine whether the amount of cash on hand and in the
bank is sufficient to pay amounts owed to employees tomorrow To answer the second question
we need to know the amount of cash the firm expects to generate from operations during the
next six months as well as the amount of any new borrowing that the firm expects to undertake
Cash obtained from either of these sources could be used to pay suppliers To answer the third
question we focus on the long run cash generating ability of the firm and determine whether the
amount of cash generated is sufficient to repay long term debt as it comes due Questions 1 and
2 capture the firm s short term liquidity risk Question 3 captures the firm s long term liquidity
risk We turn next to financial ratios that capture short term and long term liquidity risk
MEASURES OF SHORT TERM LIQUIDITY RISK
This section discusses four measures for assessing short term liquidity risk
1 Current ratio
2 Quick ratio
3 Cash flow from operations to current liabilities ratio and
4 Working capital turnover ratios
23450 ch07 ptg01 lores 219 274 indd 232 10 1 12 9 43 AM
Analysis of Risk 233
Current Ratio The current ratio equals current assets divided by current liabilities Current
assets comprise cash and assets that a firm expects to turn into cash or sell or consume within
approximately one year of the balance sheet date Current liabilities include obligations that
will require cash or the rendering of services within approximately one year Thus the current
ratio indicates a firm s ability to meet its short term obligations A current ratio of at least 1 0
indicates that the firm has sufficient current assets on hand to cover its obligations due in the
coming year As shown below Great Deal s current ratio increased between fiscal years 2011
and 2012 from 0 97 to 1 18
Current Assets
Current Ratio Current Liabilities
2012 10 566 8 978 1 18
2011 8 192 8 435 0 97
Changes in the trend of the current ratio can mislead For example when the current ratio
exceeds 1 0 an increase of equal amount in both current assets and current liabilities results in
a decline in the ratio whereas equal decreases result in an increased current ratio 7 An implica
tion of this arithmetic relation is that during a recession when there are fewer growth opportu
nities a firm may use its cash to pay its current liabilities causing the current ratio to increase
In contrast during a boom period a firm may conserve cash in order to finance growth
opportunities by delaying payment of current liabilities causing the current ratio to decrease
Thus a high current ratio may accompany deteriorating business conditions whereas a falling
ratio may accompany profitable operations
Furthermore management can take actions to present a better current ratio at the balance
sheet date than the normal current ratio during the rest of the year For example near the end of
its accounting period a firm might delay purchases of inventory on account Or it might hasten
the collection of a noncurrent loan receivable and use the proceeds to reduce current liabilities
Such actions will increase the current ratio Analysts refer to such actions as window dressing
Quick Ratio A variation of the current ratio is the quick ratio sometimes called the
acid test ratio The quick ratio includes in the numerator only current assets that a firm could
convert quickly into cash typically cash marketable securities and accounts receivable Some
businesses can convert their inventory into cash more quickly than other businesses can convert
their receivables The facts in each case will indicate whether the analyst should include receiv
ables or exclude inventories For purposes of this textbook assume the numerator includes
accounts receivable and excludes inventories The denominator includes all current liabilities A
quick ratio approximately one half of the current ratio is typical although this varies by industry
Assuming the quick ratio of Great Deal includes accounts receivable and excludes inven
tory the quick ratios for fiscal 2011 and 2012 are as follows
Cash Marketable
Securities Accounts
Receivable
Quick Ratio Current Liabilities
2012 1 826 90 2 020 8 978 0 44
2011 498 11 1 868 8 435 0 28
Great Deal s quick ratio like its current ratio increased between 2011 and 2012 because of
increases in cash marketable securities and accounts receivable For both years Great Deal s
quick ratio is below the benchmark of one half the current ratio This is likely because Great
Deal s largest current asset inventory is not reflected in the quick ratio Because it is reasonable
The general rule is that adding equal amounts to both the numerator and the denominator of a fraction moves
that fraction closer to 1 0 whereas subtracting equal amounts from both the numerator and the denominator
of a fraction makes that fraction diverge from 1 0
23450 ch07 ptg01 lores 219 274 indd 233 03 03 15 6 25 PM


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