Accounting and Ratio Analysis

Transcription

1 Accounting and Ratio Analysis Essentials in Management Prof. Sudhakar Balachandran Understanding Financial Performance: Ratio Analysis 1

2 Objectives: Understanding Financial Performance 1) Introduce the basic structure of the financial statements 2) Understand the traditional approach to ratio analysis 3) Use ratio analysis to explain a given company s financial performance 4) Understand the most common variation to the traditional approach 5) Examine other important ratios for short term liquidity long term solvency, growth, and earnings quality 6) Consider other common measures of performance beyond the ratios A Tale of Two Companies: Nordstrom vs. TJX Nordstrom Leading fashion specialty retailer High end apparel, shoes, and accessories Known for excellent customer service TJX Off-price apparel stores Operate TJ Maxx, Marshalls and HomeGoods Stores among others Businesses that follow distinctly different business strategies, which is more successful? 2

3 Ratio Analysis Typically Focuses on Two Financial Statements Balance Sheet Assets Liabilities Shareholders Equity Assets are What the Company Owns Liabilities and Shareholders Equity Tell us Who Owns it Ratio Analysis Typically Focuses on Two Financial Statements Current Assets Cash and Cash Equivalents Short term Investments Accounts Receivable Inventories Prepaid Expenses Deferred Tax Assets Long term Assets Long term Investments in Securities Property, Plant, and Equipment, Net Natural Resources Equity Method Investments Intangible Assets Deferred Tax Assets Capitalized Lease Assets Other Long term Assets GAAP Balance Sheet Nonoperating (Financial) Items Highlighted Current Liabilities Accounts Payable Accrued Liabilities Short term Notes and Interest Payable Deferred Tax Liabilities Current Maturities of Long term Debt Long term Liabilities Bonds and Notes Payable Capitalized Lease Obligations Pension and Other Postretirement Liabilities Deferred Tax Liabilities Minority Interest Total Stockholders Equity We want to distinguish between operating and nonoperating assets and liabilities. 3

4 Ratio Analysis Typically Focuses on Two Financial Statements Simplified Income Statement Revenue XXXX - Expenses YYYY Profits ZZZZ Ratio Analysis Typically Focuses on Two Financial Statements A more typical income statement Revenues - Cost of Goods Sold ( COGS ) - Research and Development Costs ( R&D ) - Selling, General and Admin. Costs ( SGA ) = Operating Income( EBIT ) - Interest Expense = Pre-tax Income - Income taxes = Net Income 4

5 Ratio Analysis Typically Focuses on Two Financial Statements Income Statement Operating Revenue Operating Expense Operating Income Financial Expense Financial Income Net Financial Expense FE (FI) OR (OE) OI (NFE) Earnings The typical income statement has operating and nonoperating revenues and expenses. Reformulating Financial Statements Income Statement Operating Nonoperating Core Sales, COGS, SG&A Expenses, R&D Expenses, Income Taxes Dividend Income, Interest Income and Expense, Hedging Gains and Losses Transitory Operating Asset Write Offs, Nonrecurring Restructuring Charges, Gains/Losses from Operating Asset Sales Debt Retirement Gains/Losses, Gains/Losses on Discontinued Operations 5

6 Financial Statement Analysis Investors, creditors and other users of the financial statements are interested in evaluating the firm s: Profitability Growth prospects Short term liquidity risk Long term solvency risk These dimensions have implications for equity valuation, credit evaluation, and the prediction of financial distress. Financial Statement Analysis Ratio Analysis Time series analysis: Useful in identifying trends and assessing the permanency of recent ratio changes. Cross sectional analysis: Useful for evaluating the performance of a firm relative to its competitors. Typically analyze historical data, but can apply to forecasts. 6

7 Different Types of Ratios Profitability (The Primary Focus) Liquidity Solvency Growth Earnings Quality Profitability Analysis Ratios used to analyze profitability given reported earnings and other financial information. Four levels: 1) Shareholder profitability 2) Profitability of assets versus the leverage effect 3) Profit margin versus asset turnover 4) Common size income statement and individual turnover ratios 7

8 Traditional Ratio Analysis of Profitability: ROE Decomposition Return on Equity Return on Assets Financial Leverage Asset Turnover Margin Do you have the appropriate leverage? This Traditional Approach is Sometimes Called Dupont Analysis Shareholder Profitability ROE = Net Income Shareholders Equity Net income the return on shareholders investments. Book Value of equity is a measure of shareholders investments. ROE measures the rate of return on shareholders investments and reflects all business activities (operating, investing, and financing). 8

9 Shareholder Profitability ROE = Net Income Shareholders Equity Nordstrom ROE in the Year 2000 was 8.6% Nordstrom ROE in the Year 2001 rose to 10.1% TJX ROE in the Year 2001 was 41.1% What are the drivers of this huge difference in performance??? Decomposing ROE into ROA and Leverage ROE = Net Income Shareholders Equity ROE = Net Income Assets X Assets Shareholders Equity ROE = ROA X Leverage 9

10 Decomposing ROE into ROA and Leverage ROE = Net Income Assets X Assets Shareholders Equity Ratio Nord Nord TJX 2001 ROE 10.1% 8.6% 41.1% ROA 3.4% 3.3% 17.3% Leverage Approaches to Understandign Margins and Turnover Margins analysis Common Sized income statement approach Understand income statement as a percent of sales Turnover analysis Accounts Receivable Inventory Payables Long Term Assets 10

11 Decomposing ROA into Margins and Turnover ROA = Net Income Assets ROA = Net Income Sales X Sales Assets ROA = Margin X Asset Turnover A Tale of Two Companies: Nordstrom vs. TJX Which Company Would You Expect to Have Higher Margins? Which Company Would You Expect to Have Higher Turnover? 11

12 The Tale of the Numbers: ROE Decomposition Nordstrom vs. TJX ROA = Net Income Sales X Sales Assets Ratio Nord Nord TJX 2001 ROA 3.4% 3.3% 17.3% Margin 2.2% 1.8% 4.67% Turnover Approaches to Understanding Margins and Turnover Margins analysis Common Sized income statement approach Understand income statement as a percent of sales Turnover analysis Accounts Receivable Inventory Payables Long Term Assets 12

13 Nordstrom vs. TJX: Common Size Income Statements Percent of Sales Nord Nord TJX 2001 Sales 100% 100% 100% Cost of Sales (66.8%) (66.0%) (75.9%) Gross Margin 33.2% 34.0% 24.1% SG&A (30.6%) (31.6%) (15.7%) Other Income 2.4% 2.4% 0.0% Unusual items 0.0% 0.0% (0.4)% Net Income 2.2% 1.8% 4.7% Important Turnover Ratios Turnover analysis Accounts Receivable Turnover = (Receivables/Sales) Days in Rec. = (Receivables/(Sales/365)) Inventory Days of Inventory = (Inventory/(COGS/365)) Payables Days of Payables = (A.P./(COGS/365) Long Term Assets Turnover=(LTA/Sales) 13

14 Nordstrom vs. TJX: Turnover Ratios Ratios Nord Nord TJX 2001 Receivable Days Inventory Days Payables Cash Cycle LTA Turnover Using The Traditional Approach Return on Equity (2005) Return on Assets Financial Leverage Return on Equity Altria Group 9.7% % DaimlerChrysler 1.4% % Intel 17.9% % Nokia 16.1% % Novartis 9.0% % Procter & Gamble 11.8% % Sony 1.2% % Vodaphone -9.4% % Wal-Mart Stores 8.1% % 14

15 Using The Traditional Approach Return on Assets (2005) Profit Margin Asset Turnover Return on Assets Altria Group 10.7% % DaimlerChrysler 1.9% % Intel 22.3% % Nokia 10.5% % Novartis 16.0% % Procter & Gamble 12.8% % Sony 1.7% % Vodaphone -40.4% % Wal-Mart Stores 3.6% % Using the Traditional Approach Operating Margins yr avg Industry 5-yr avg Altria Group 16.7% 19.2% 17.7% DaimlerChrysler 2.2% 1.5% 2.1% Intel 28.1% 23.3% 8.3% Nokia 13.5% 14.3% 7.0% Novartis 21.2% 22.5% 24.9% Procter & Gamble 19.5% 17.3% 15.2% Sony 2.5% 1.8% -2.3% Vodaphone -23.2% -15.8% 10.9% Wal-Mart Stores 5.9% 5.8% 5.8% 15

16 Using The Traditional Approach Turnover Ratios (2005) Sales / Assets Days Receivables Days Inventory Altria Group DaimlerChrysler Intel Nokia Novartis Procter & Gamble Sony Vodaphone Wal-Mart Stores Improving on Tradition, Revising The Approach ROE = Net Income Shareholders Equity The Approach that we have used to decompose ROE is a very common approach The big benefit of the approach is that it is relatively simple It does have 2 important limitations It combines operating and financing results When we decompose to ROA, we begin comparing apples with oranges The numerator of ROA is earnings which are only available to shareholders The denominator is total assets which are available to both debt and equity holders 16

17 Isolating These Effects Begins With Separating Operations From Financing Balance Sheet Assets Liabilities Net Operating Assets (NOA) (Assets Liabilities ) Current Operating Assets Long-Term Operating Assets Current Operating Liabilities Long-Term Operating Liabilities Net Financial Obligations (NFO) (Liabilities Assets) Financial Assets (Nonoperating) Financial Obligations (Nonoperating) Equity Equity (NOA NFO) Stockholders Equity Total Assets Total Liabilities and Equity We want to distinguish between operating and nonoperating assets and liabilities. Isolating These Effects Begins With Separating Operations From Financing Income Statement Operating Revenue Operating Expense Operating Income Financial Expense Financial Income Net Financial Expense FE (FI) OR (OE) OI (NFE) Earnings The typical income statement has operating and nonoperating revenues and expenses. 17

18 Accounting For Operating vs. Non Operating Activities Level 1 Level 2 Level 3 Level 4 Profitability of Assets vs. Leverage ROE = Return from Operating Activities + Return from Nonoperating Activities = RNOA + (FLEV Spread) RNOA = Return on Net Operating Assets RNOA = NOPAT Average NOA NOPAT = Operating Income * [1 ETR] NOA = Operating Assets Operating Liabilities ETR = Tax Expense Pretax Income 35% if NI > 0 0% if NI < 0 18

19 Profitability of Assets vs. Leverage ROE = Return from Operating Activities + Return from Nonoperating Activities = RNOA + (FLEV Spread) FLEV = Financial Leverage FLEV = Average NFO Average Equity NFO = Financial Obligations Financial Assets FLEV reflects the effect of financing activities. Profitability from RNOA (i.e., operating and investing activities) is typically more persistent and less volatile than profitability from FLEV (financing activities). FLEV increases financial risk, so it should be associated with higher profitability on average. Profitability of Assets vs. Leverage ROE = Return from Operating Activities + Return from Nonoperating Activities = RNOA + (FLEV Spread) Spread Spread = RNOA NBC NBC = NFE Average NFO NFE = Financial Expenses Financial Income ROE increases with FLEV as long as Spread is positive Spread determines the increase in ROE due to FLEV NBC is net borrowing cost, NFE is net financing expense 19

20 Nordstrom vs. TJX: Modified ROE Decomp Percent of Sales Nord Nord TJX 2001 ROE 10.1% 8.6% 41.1% ROA 3.4% 3.3% 17.3% RNOA 7.1% 7.0% 35.7% SPREAD 3.2% 2.3% 28.7% FLEV Net Fin Effect= SPRED*FLEV RNOA+Net Fin = ROE 3.0% 1.6% 5.3% 10.1% 8.6% 41.1% Profitability of Assets vs. Leverage Industry/ Firm RNOA ROA Biotech Operating Liability Leverage (OLLEV) Financial Assets Total Assets Source: Penman (2004, p. 357) Genentech, Inc. 11.2% 5.7% % Amgen, Inc. 63.5% 26.2% % Chiron Corp. 6.2% 3.8% % High Tech Microsoft Corp % 25.4% % Oracle Corp. 68.4% 21.0% % Cisco Systems, Inc % 32.5% % Retailers Wal-Mart Stores 12.7% 9.3% % Kmart Corp. 0.5% 0.4% % The Gap, Inc. 39.7% 30.1% % Oil Producers and Refiners Exxon Corp. 14.8% 8.3% % Chevron Corp. 13.9% 8.2% % Footwear and Apparel Manufacturers Nike, Inc. 22.6% 16.3% % Reebok Int l, Ltd. 14.1% 9.8% % 20

21 Profitability of Assets vs. Leverage ROE = Return from Operating Activities + Return from Nonoperating Activities = RNOA + (FLEV Spread) RNOA ROA Source: Nissim and Penman (2001, p. 135) Profitability of Assets vs. Leverage ROE = Return from Operating Activities + Return from Nonoperating Activities = RNOA + (FLEV Spread) ROE RNOA NBC Source: Nissim and Penman (2001, p. 134) 21

22 Profit Margin vs. Asset Turnover RNOA = Net Operating Profit Margin Net Operating Asset Turnover = NOPM NOAT Source: Nissim and Penman (2001, p. 137) Profit Margin vs. Asset Turnover RNOA = Net Operating Profit Margin Net Operating Asset Turnover = NOPM NOAT NOPM = Net Operating Profit Margin NOPM = NOPAT Sales NOPM reflects the efficiency in controlling costs, product market strategies (cost leadership or product differentiation), and accounting choices and distortions. NOPM primarily reflects operating activities. Source: Nissim and Penman (2001, p. 137) 22

23 Profit Margin vs. Asset Turnover RNOA = Net Operating Profit Margin Net Operating Asset Turnover = NOPM NOAT NOAT = Net Operating Asset Turnover NOAT = Sales Average NOA NOAT reflects asset utilization and product market strategies (cost leadership or product differentiation). NOAT primarily reflects investing activities. Changes in NOAT are more persistent than changes in NOPM because net income is generally more volatile than sales or assets. Profit Margin vs. Asset Turnover RNOA = Net Operating Profit Margin Net Operating Asset Turnover = NOPM NOAT Source: Nissim and Penman (2001, pp. 145, 146) 23

24 Disaggregating Margin and Turnover NOPM Drivers NOAT Drivers Level 3 Level 4 Common Size Income Statements Common size Income Statements: Divide each IS item by sales. NOPM Drivers Gross Profit Margin = Gross Profit Sales Operating Profit Margin = Operating Profit Sales Expense Ratios COGS Sales SG&A Sales R&D Sales 24

25 Individual Turnover Ratios NOAT Drivers AR Turnover = Sales Average AR Inventory Turnover = COGS Average Inventory AP Turnover = COGS Average AP LT Operating Asset Turnover = Sales Average LTOA Net Operating WC Turnover = Sales Average OWC AR Days = 365 AR Turnover Inventory Days = 365 Inventory Turnover AP Days = 365 AP Turnover Liquidity Risk Short term Liquidity Risk Operating Cycle = Inventory Days + AR Days Measures the time from the purchase of inventory to the collection of the AR generated by the sale of inventory. Cash to Cash Cycle = Operating Cycle AP Days Measures the time a firm is down cash. Dell has a negative cash to cash cycle it collects AR before it pays its suppliers (Dell does not need to finance any of its investment in inventory or AR with interest bearing debt or common stock)! 25

26 Liquidity Risk Short term Liquidity Risk Current Ratio = Current Assets Current Liabilities Indicates the amount of current assets available to settle current liabilities. Quick Ratio = Quick Assets Current Liabilities Quick assets can be converted to cash quickly (cash, marketable securities, AR) OCF Ratio = OCF Current Liabilities Indicates the amount of OCF available to settle current liabilities. Solvency Risk Long term Solvency Risk Operating Leverage = Fixed Costs Total Costs Variability Measures High OL [variability (volatility)] = higher chance of losses [financial distress]. Debt to Equity = Long term Debt Total Equity Debt to Assets = Long term Debt Total Assets Indicates the amount of debt in a firm s capital structure Interest Coverage = EBIT Interest Expense Indicates the amount of income available to service debt 26

27 Growth Measures Past and Current Revenue, Asset, Equity, and Earnings Growth Growth is often associated with lower profitability due to conservative accounting and the revenue recognition principle. Investment Intensity Ratios Compare investments (i.e., capex) with revenue or assets. Forward looking measure. Internal vs. external growth has important value implications. Sources of growth have important life cycle implications. Earnings Quality Analysis By Definition, Net Income = Cash Flow + Accruals (Net Income OCF) Net Income Indicates the relative size of the accrual component of earnings. All else equal, analysts prefer cash earnings vs. accruals (i.e., net income = OCF). Substantial body of research [Sloan 1996, etc.] finds that accruals are less persistent than OCF. Further, investors act as if accruals are more persistent, consequently firms with relatively high (low) accruals experience predictable negative (positive) future abnormal stock returns. 27

28 Earnings Quality Analysis Source: Sloan (1996, p. 309) Earnings Quality Analysis Unusual Items Sales Unusual items include restructuring charges, impairment charges, write downs, special items. Unusual items are less likely to recur. Expenses Recognized due to Conservatism Sales Primarilly R&D and marketing expenses. Cutting R&D and marketing increases current earnings, but may erode future earnings. 28

29 Other Terms You Might Hear Cash Flow Operating Cash Flow = Net income + non-cash items (depreciation, amortization, deferred taxes) - investments in current assets (net of current liabilities) Free Cash Flow = Operating cash flow - investments in fixed assets Other Terms You Might Hear EBIT EBIT = Earnings Before Interest and Taxes EBIT is a measure of operations The three claimants on EBIT: Debtholders EBIT Government Stockholders 29

30 Other Terms You Might Hear EBITDA Revenues Less operating costs = EBIT Add back depreciation and amortization = EBITDA Depreciation and amortization are non-cash deductions Adding them back gives a cash version of EBIT Objectives: Understanding Financial Performance 1) Introduce the basic structure of the financial statements 2) Understand the traditional approach to ratio analysis 3) Use ratio analysis to explain a given company s financial performance 4) Understand the most common variation to the traditional approach 5) Examine other important ratios for short term liquidity long term solvency, growth, and earnings quality 6) Consider other common measures of performance beyond the ratios 30

31 Summary and Key Takeaways Ratio analysis helps us assess Profitability and its sources Liquidity Solvency Growth Earnings Quality Ratios have predictable behaviors and interpretations which makes them useful for management Each company may have differences in ratio names and calculations, these are often not trivial Companies as a combination of operation and financing activities and these need to be separated to get a clear picture 31