Georgia Banking School Financial Statement Analysis. Dr. Christopher R Pope Terry College of Business University of Georgia

Transcription

1 Georgia Banking School Financial Statement Analysis Dr. Christopher R Pope Terry College of Business University of Georgia

2 Introduction Objective My objective is to introduce you to the analysis of financial statements. The goal of the analysis is to obtain information about the timing, magnitude, and riskiness of future cash flows. This information can then be combined with other qualitative information to determine a firm s creditworthiness. Perspective Last year, you learned to analyze the financial statements of a commercial bank to determine the bank s strengths and weaknesses and to provide direction for future policy decisions. This year, we will use a similar set of tools in the assessment of credit risks for commercial loan customers. We will end our discussion with a loan analysis for Butler Lumber Company, a small, growing firm that is looking for financing. Financial Statement Analysis 2

3 Determining Credit Risk Our objective is to use quantitative analysis to determine the credit worthiness of the applicant firm. One of the most important questions from the lender s perspective is Will the customer be able to repay the loan from operating cash flows? This analysis provides several benefits: It helps separate good credits from bad credits. We do not want to extend credit to a customer who will default. However, it is also costly to deny credit to a customer who can repay. It identifies the borrower s strengths and weaknesses and possible sources of risk It provides information to loan officers that helps them set up the terms of the loan Financial Statement Analysis 3

4 Analysis of Financial Statements Important Points It is necessary to compare performance to various benchmarks Trends: Generally 3 to 5 years worth of data is necessary to ascertain how the firm s financial performance is changing over time. Industry: It is helpful to compare the firm s performance to that of the industry (or industries) in which it operates. Although industry averages may not indicate where a firm wants to be, the comparison is helpful in analyzing trends. Competitors: It is also useful to compare the firm s performance to that of specific firms, such as the direct competition. These may be more comparable than the overall industry. It is extremely important to carefully read and analyze the annual report - including the footnotes to the financial statements. Often these will point to other factors, such as contractual obligations, past and future financing policies, plans for further expansion or restructuring, or the sale of part of the firm s assets - that significantly affect the entire financial analysis. Off balance-sheet activity Financial Statement Analysis 4

5 Analysis of Financial Statements Important Points (cont d) The analysis may raise further questions for which additional information must be obtained (either from more in depth analysis or by asking firm management). The important point is not to view the financial analysis as an end in itself. Also note: accounting conventions and window dressing. Financial Statement Analysis 5

6 Tools of Financial Analysis Common-Size Financial Statements Common-Size Financial Statements are a popular way to convert dollar figures to relative (%) figures. They are routinely used with income statements and balance sheets. Income Statement A common-size income statement is constructed by dividing the various components of the income statement by net sales. Hence, net sales equals 100% and everything else is presented as a percentage of net sales. Balance Sheet A common-size balance sheet is calculated in the same manner, except that all the statement components are divided by total assets to put them on a common percentage basis. Financial Statement Analysis 6

7 Common Size Financial Statements Selected Numbers: Barnes & Noble and Borders Common-Size Balance Sheet Barnes & Noble Borders Group Inventory 1, % 1, % 1, % 1, % Total Current Assets 1, % 1, % 1, % 1, % Property & Equipment % % % % Total Assets 2, % 2, % 2, % 0.0% 2, % Accounts Payable % % % % Notes Payable % % % % Total Current Liabilities 1, % % 1, % 1, % Long-Term Debt % % % % Total Liabilities 1, % 1, % 1, % 1, % Common-Size Income Statement Barnes & Noble Borders Group Sales 5, % 4, % 3, % 3, % COGS 3, % 3, % 2, % 2, % Gross Profit 1, % 1, % 1, % % Interest Expense % % % % Pretax Income % % % % Taxes % % % % Net Income % % % % Financial Statement Analysis 7

8 Tools of Financial Analysis Financial Ratio Analysis Financial Ratio Analysis is the study of the relationships that exist among and between various financial statement accounts at a given point in time. It expands the information content of financial statements. In essence, the financial statements are converted into more useable information so that a better understanding can be obtained about the company. Some uses of financial ratios Enable an analyst to understand a firm s risk and future cash flow generating ability Enable a banker to asses a firm s creditworthiness The mechanics are simple Selected information is gathered from the financial statements and used to compute a set of ratios Ratios are then compared to benchmarks. Financial Statement Analysis 8

9 Financial Ratio Analysis Benchmarks Revisited Financial ratios provide useful tools for analysis when compared against a standard or norm. Two such norms are commonly used. Trend Analysis Compare the firm s financial ratios to a similar set of ratios from previous financial statements. Industry Averages Compare the firm s financial ratios to a similar set of ratios computed for a comparable group of firms. Sources of industry average ratios include: Dun and Bradstreet publishes annually a set of 14 key ratios for 125 lines of business. Robert Morris Associates, the national association of bank loan and credit officers, publishes a set of 16 key ratios for 350 lines of business. Many are also available on the internet Financial Statement Analysis 9

10 Financial Ratios Categories We will discuss five categories of financial ratios, each representing an important aspect of the firm s financial condition. Internal liquidity Operating performance Risk profile Growth potential External liquidity Note: Exact definitions of many ratios (and categories for that matter) vary from publication to publication and user to user. To illustrate the ratios, we will use the financial statements of Barnes & Noble and Borders Group Two major booksellers Financial Statement Analysis 10

11 Financial Ratios Categories (cont d) Internal Liquidity Indicates the ability of the firm to meet future short term financial obligations. These compare near term financial obligations, such as accounts payable or notes payable to current assets or cash flows that will be available to meet these obligations. Examples: current ratio, quick ratio, AR & Inventory turns Operating performance Operating efficiency ratios examine how management uses its assets and capital, measured in terms of the dollars of sales generated by various asset or capital categories Examples: Total asset turnover, equity turnover Operating profitability ratios analyze profits as a percentage of sales and as a percentage of the assets and capital employed Examples: gross margin, net profit margin Financial Statement Analysis 11

12 Financial Ratios Categories (cont d) Risk profile Relates to the uncertainty of income flows for both the entire firm and to individual providers of capital (equity investors, debt holders, etc). Comprised of business risk (variability of firm due to industry and economy) and financial risk (variability brought on by introducing debt into capital structure). Growth potential Indicates how fast a firm can/should grow without raising external capital. Determined by the amount of resources retained and reinvested in the business and the rate of return earned on these resources. External liquidity Market liquidity is ability to buy or sell an asset quickly with little price change from the last transactions. Market liquidity is determined by the number of shares (or dollar value) traded, and a smaller bid ask spread. Corporate variables that are proxies for market liquidity are total market value and number of security holders, along with trading turnover as a % of shares outstanding that trade in a given year. Financial Statement Analysis 12

13 Internal Liquidity Ratios Liquidity ratios help the financial analyst answer the following question: Does the firm have sufficient cash and liquid assets to pay bills on time? Current Ratio Current liabilities represent the firm s maturing financial obligations. The firm s ability to repay these obligations when due depends largely on whether it has sufficient cash together with assets that can be converted into cash before the current liabilities mature. The firm s current assets are the primary sources of funds to repay current and maturing financial obligations. Current Assets Current Ratio Current Liabilities Financial Statement Analysis 13

14 Internal Liquidity Ratios Current Ratio Barnes & Noble, 2001: Current Current Assets Ratio Current Liabilitie s 1, Barnes & Noble Borders 1,887 1,231 1,543 1, ,591 1,140 1,455 1,107 1, ,335 =1.19 1,118 Industry Financial Statement Analysis 14

15 Internal Liquidity Ratios Quick Ratio Quick Ratio Since inventories are generally the least liquid of the firm s current assets, it may be desirable to remove them from the numerator in the current ratio, thus obtaining a more refined liquidity measure. Quick Ratio Current Assets Inventories Current Liabilitie s Quick Ratio Cash Mktble Secs + AR Current Liabilities Financial Statement Analysis 15

16 Internal Liquidity Ratios Quick Ratio Barnes & Noble, 2001: Quick Current Assets - Inventory Ratio Current Liabilitie s 1, Barnes & Noble 1,887 1,396 1, ,591 1,285 1, ,455 1, Borders 1,543 1,183 1, ,455 1,179 1, ,335 1, ,118 Industry Financial Statement Analysis 16

17 Internal Liquidity Ratios Cash Ratio Cash Ratio The most conservative liquidity measure only the most liquid assets Cash Ratio Cash Mktble Secs Current Liabilities Financial Statement Analysis 17

18 Internal Liquidity Ratios Efficiency: A/R Turnover How effectively is the firm using its assets to generate sales? Accounts Receivable Turnover This ratio allows us to assess whether the firm s sales are being tied up in receivables? How quickly are receivables converted to cash Accounts Receivable Turnover 365 Avg Collection Period = A/R Turnover Net Sales Avg Accounts Receivable Financial Statement Analysis 18

19 Internal Liquidity Ratios Efficiency: Average Collection Period Barnes & Noble, 2001: $4,375.8k A/R Turnover = = 61.3 Avg($84.5k, $58.2) Average Collection Period = = 6.0 A/R Turnover Barnes & Noble Borders Industry Financial Statement Analysis 19

20 Internal Liquidity Ratios Efficiency: Inventory Turnover How effectively is the firm using its assets to generate sales? For example, a firm that produces $8 million in sales using $2 million in inventory is using its inventory more efficiently than a similar firm that had $4 million invested in inventory. Inventory Turnover The efficiency with which a firm is managing its investment in inventories is reflected in the number of times that its inventories are turned over during the year. Cost of Goods Sold Inventory Turnover Avg Inventory 365 Days in Inventory= Inventory Turnover Financial Statement Analysis 20

21 Efficiency Ratios (continued) Inventory Turnover Barnes & Noble, 2001: COGS Inventory Turnover Avg Inventory Days in Inventory 365 Inventory Turnover 3,169.7m Avg( 1,238.6m,1,102.5m ) Barnes & Noble Borders Industry Financial Statement Analysis 21

22 Internal Liquidity Ratios Efficiency: A/P Turnover Accounts Payable Turnover Note: Purchases = COGS + Ending Inventory Beginning Inventory How quickly does the firm pays its bills? Accounts Days in Payable Turnover A/P 365 A/P Turnover * COGS Avg A/P * Sometimes estimated as Purchases Avg A/P Financial Statement Analysis 22

23 Efficiency Ratios (cont d) Efficiency: A/P Turnover Barnes & Noble, 2001: COGS Accounts Payable Turnover Avg A/P Days in A/P A/P Turnover , Barnes & Noble Borders Industry Financial Statement Analysis 23

24 Internal Liquidity Ratios Efficiency: Cash Conversion Cycle Cash Conversion Cycle Measures how long and where cash is tied up (in days) Cash Conversion Cycle A/R Days + Inventory Days - A/P Days Financial Statement Analysis 24

25 Operating Performance Ratios Efficiency: Total Asset Turnover How effectively is the firm using its assets to generate sales? Total Asset Turnover This ratio measures the efficiency with which the firm uses all of its assets to generate sales. Total Asset Turnover Net Sales Avg Total Assets Financial Statement Analysis 25

26 Operating Performance Ratios Efficiency: Total Asset Turnover Barnes & Noble, 2001: Net Sales Total Asset Turnover = Avg Total Assets 4,375.8k = =1.8 2,485.6k Barnes & Noble 5, , , , ,485.6 Borders 3, , , , , Industry Financial Statement Analysis 26

27 Operating Performance Ratios Efficiency: Net Fixed Asset Turnover How effectively is the firm using its assets to generate sales? Net Fixed Asset Turnover This ratio measures the efficiency with which the firm uses its investment in fixed assets to generate sales. Fixed Asset Turnover Net Sales Avg Net Fixed Assets Financial Statement Analysis 27

28 Efficiency Ratios (continued) Net Fixed Asset Turnover Barnes & Noble, 2001: Net Sales Fixed Asset Turnover = Avg Net Fixed Assets 4,375.8k = = k Barnes & Noble Borders 5, , , , , , Industry Financial Statement Analysis 28

29 Operating Performance Ratios Equity Turnover Equity Turnover Equity includes preferred and common stock Could also compute common equity ratio Measures the level of sales for each dollar of equity investment Not particularly insightful Equity Turnover Net Sales Avg Equity Financial Statement Analysis 29

30 Operating Performance Ratios Profitability Profitability ratios help us answer some very important questions regarding the effectiveness of the firm s management in producing profits from the resources entrusted to them. Profitability ratios often fall under two categories Profitability in relation to sales These ratios can be used to asses the ability of the firm s management to control various expenses in generating sales. These ratios are commonly referred to as Profit Margins. Profitability in relation to investment These ratios measure firm profits in relation to the funds invested to generate those profits. They are useful in assessing the overall effectiveness of the firm s management. Financial Statement Analysis 30

31 Operating Performance Ratios Profitability: Gross Profit Margin Gross Profit Margin This ratio reflects the firm s markup on its cost of goods sold (its pricing policy) as well as the ability of the management to minimize the firm s cost of goods sold in relation to sales. Gross Profit Margin Gross Profit Net Sales Financial Statement Analysis 31

32 Operating Performance Ratios Profitability: Gross Profit Margin Barnes & Noble, 2001: Gross Profit 1,206,080 Gross Profit Margin= = =27.6% Net Sales 4,375,804 Barnes & Noble Borders 1, , , , % 1, , % 27.6% 4, , % 28.7% 28.0% 3, ,271.2 Industry 41.4% Financial Statement Analysis 32

33 Operating Performance Ratios Profitability: Operating Profit Margin Operating Profit Margin Operating Profit is gross profit less SG&A expenses This margin reflects the firm s operating expenses as well as its cost of goods sold. This ratio serves as an overall measure of operating effectiveness. Operating Profit Margin Operating Profit Net Sales Financial Statement Analysis 33

34 Operating Performance Ratios Profitability: Operating Profit Margin Barnes & Noble, 2001: Operating Profit Operating Profit Margin = Net Sales 133,826 = =3.1% 4,375, Barnes & Noble Borders , , % % 3.1% 4, , % % 3.9% 3, ,271.2 Industry 11.3% Financial Statement Analysis 34

35 Operating Performance Ratios Profitability: Net Profit Margin Net Profit Margin This margin tells us how much of each sales dollar is converted to profits after taxes. This margin reflects the firm s cost of goods sold, operating expenses, finance charges, and taxes. How much of each sales dollar drops to the bottom line? Should exclude one-time charges Net Profit Margin = Net Income Net Sales Financial Statement Analysis 35

36 Operating Performance Ratios Profitability: Net Profit Margin Barnes & Noble, 2001: Net Income -51,966 Net Profit Margin = = =-1.2% Net Sales 4,375,804 Barnes & Noble 119 5, % , % 1.2% 4,375.8 Borders , % 2.6% 1.7% 3, ,271.2 Industry 1.4% 1.1% 1.8% Financial Statement Analysis 36

37 Operating Performance Ratios Profitability: Return on Total Capital Profitability in Relation to Investment: How much profit did the firm earn on each dollar of assets under its control? Return on Tot Capital and/or Return on Tot Assets This ratio provides an indication of the ability of the firm to earn a satisfactory return on all of the capital it employs. Capital is debt, preferred stock, common stock Note: Typically want to use net income before extraordinary items Return on Total Capital = Net Income + Interest Expense Avg Total Capital Return on Assets = Net Income + Interest Expense Avg Total Assets or Net Income Avg Total Assets Financial Statement Analysis 37

38 Operating Performance Ratios Profitability: Return on Assets Barnes & Noble, 2001: Return on Assets = Barnes & Noble Net Income + Interest Expense Avg Total Assets Net Income -52.0m or = = -2.1% Avg Total Assets 2,485.6m , % 2.5% 2.1% 2, ,485.6 Borders , % 4.1% 2.7% 2, ,981.0 Industry 3.3% 2.1% 4.3% Financial Statement Analysis 38

39 Operating Performance Ratios Profitability: Return on Owner s Equity Return on Equity This ratio provides an indication of how effective the management is from all equity holders point of view. It is directly affected by the return on total assets and the amount of financial leverage employed. This ratio, although helpful, does not focus on the returns that actually flow to the investor in terms of cash dividends and/or market appreciation. For this reason, return on equity is not a reliable measure of returns from the investors viewpoint. Note: Typically want to use net income before extraordinary items Net Income Return on Owner's Equity= Avg Total Equity Financial Statement Analysis 39

40 Operating Performance Ratios Profitability: Return on Owner s Equity Barnes & Noble, 2001: Net Income -52.0k Return on Owner's Equity = = =-6.4% Avg Total Equity 812.0k Barnes & Noble Borders % 7.7% 6.4% % 9.7% 6.6% Industry Financial Statement Analysis 40

41 Operating Performance Ratios Profitability: Return on Common Equity Return on Common Equity This ratio provides an indication of how effective the management is from the common stockholders point of view. It too is directly affected by the return on total assets and the amount of financial leverage employed. This ratio suffers from the same problems as other accounting measures of return on equity. Note: Typically want to use net income before extraordinary items Return on Common Equity= Net Income - Preferred Divs Avg Common Equity Financial Statement Analysis 41

42 Operating Performance Ratios Profitability: Return on Owner s Equity Barnes & Noble, 2001: Net Income - Preferred Divs -52.0k Return on Common Equity= = =-6.4% Avg Common Equity 812.0k Barnes & Noble Borders % 6.4% % 6.6% Industry 7.2% 4.1% 8.7% Financial Statement Analysis 42

43 Risk Analysis Business Risk: Operating Earnings Variability Business Risk Defined as the uncertainty of income caused by the firm s industry. In turn, this uncertainty is due to the firm s variability of sales caused by its products, customers and the way it produces its products. Generally measured by the variability of the firm s operating income over time. Std Dev Oper Earnings Business Risk = Mean Operating Earnings Sales Variability Prime determinant of earnings variability Sales Variability = Std Dev of Sales Mean Sales Financial Statement Analysis 43

44 Risk Analysis Business Risk: Operating Leverage Operating leverage refers to the use of fixed production costs Fixed production costs cause operating profits to vary more than sales over the business cycle. During slow periods, profits decline by a larger percentage than sales; during an expansion, profits will increase by a larger percentage than sales. Operating Leverage = Change in Operating Earnings Change in Sales Financial Statement Analysis 44

45 Risk Analysis Leverage Ratios How has the firm financed its assets? Can the firm afford the level of fixed charges associated with its use of non-owner supplied funds such as bond interest and principal repayment? We define leverage as resulting from the firm s use of debt, financial leases, and preferred stock. These sources all require a fixed cash payment or return for their use. If the firm earns a return higher than that which is required by the suppliers, then the excess goes to the owners. However, should the return of the firm fall below the required return, then the owners get nothing. Financial Statement Analysis 45

46 Risk Analysis Leverage Ratios: Debt to Equity Ratio Where did the firm obtain financing for its investments? Here we are using information from the balance sheet only. Debt to Equity Ratio A measure of risk due to capital structure choices Higher proportion of debt to equity makes earnings more volatile If the firm cannot meet its interest payments, it leads to financial distress Total Long Term Debt Debt to Equity Ratio= Total Equity Financial Statement Analysis 46

47 Risk Analysis Leverage Ratios: Debt to Long Term Capital Debt to Long Term Capital A different way to measure the debt to equity ratio Long Term Capital is Debt + Equity Total Long Term Debt Long Term Debt to Long Term Capital = Total Long Term Capital Financial Statement Analysis 47

48 Risk Analysis Leverage Ratios: Debt to Long Term Capital Barnes & Noble, 2001: Total Long Term Debt Debt to Long Term Capital = Total Long Term Capital 666.9k = =0.46 sum(666.9k, 777.7k) Barnes & Noble , Borders , Industry Financial Statement Analysis 48

49 Risk Analysis Leverage Ratios: Total Debt Ratios Total Debt Ratio Useful for a firm that derives substantial capital from short-term borrowing Total Interest Bearning Debt Total Debt Ratio: Total Capital - Non Interest Bearing Liabilities Financial Statement Analysis 49

50 Earnings Flow Ratios Leverage: Interest Coverage Can the firm afford the level of fixed charges associated with its use of non-owner supplied funds such as bond interest and principal payments (or lease payments)? Here we are using earnings information. These ratios are sometimes referred to as Coverage Ratios. Interest Coverage This ratio indicates the firm s ability to meet its interest payments out of its annual operating earnings. It measures the number of times the firm is covering its interest. Interest Coverage = Earnings Before Interest and Taxes (EBIT) Interest Charges Financial Statement Analysis 50

51 Earnings Flow Ratios Leverage: Total Fixed Charge Coverage Total Fixed Charge Coverage Measure of all fixed obligations by the firm Income Before Interest, Taxes and Lease Payments Total Fixed Charge Coverage= Interest + Lease Payments + Preferred Divs (1-Tax Rate) Financial Statement Analysis 51

52 Cash Flow Ratios Leverage: Cash Flow Leverage and Coverage Cash Flow Ratios are used as alternative to earnings flow ratios E.g., cash flow to outstanding debt has been used for predicting bankruptcies and bond ratings. Cash Flow + Int Exp + 1/3 of Lease Payments Cash Flow Coverage = Int Exp + 1/3 of Lease Payments where Cash Flow = NI + Depr + Change in Deferred Taxes Cash Flow / LT Debt = Cash Flow / Total Debt = NI + Depr + Change in Deferred Taxes BV of Long Term Debt NI + Depr + Change in Deferred Taxes BV of Long Total Debt Financial Statement Analysis 52

53 Growth Potential Sustainable Growth Long-term Sustainable Growth Maximum long-term growth rate that can be self-financed Retention Ratio Amount of earnings held for reinvestment in the business Long-term Sustainable Growth = Retention Ratio x ROE Dividends Declared Retention Ratio = 1 - Operating Income After Taxes Financial Statement Analysis 53

54 Du Pont Analysis Profitability, Efficiency Du Pont Analysis To improve its financial analysis, Du Pont introduced a system that ties together relationships that might otherwise be missed. It ties: Net Profit Margin, Total Asset Turnover, and Debt to Total Assets This system focuses attention on the separate ideas of profitability and asset utilization (efficiency). Using Du Pont Analysis, we can also see how the firm s use of leverage affects the return on equity. Anything that changes net profit margin, total asset turnover, or debt to total assets will affect return on equity. Breaking down ROE (Net Income / Equity) Net Income Sales Total Assets ROE = Sales Total Assets Common Equity = Profit Margin x Total Asset Turnover x Financial Leverage = ROA Leverage Financial Statement Analysis 54

55 DuPont Analysis Profitability, Efficiency Barnes and Noble ROE = 2003: Profit Margin = Total Asset Turnover = Financial Leverage = 12.4% 2.3% : Borders ROE = 2003: 7.3% 1.3% Profit Margin = Total Asset Turnover = Financial Leverage = 11.1% 3.2% : 9.5% 2.6% Financial Statement Analysis 55

56 Barnes and Noble, Borders Summary Financial Ratios Barnes and Noble Borders 2/3/01 02/03/02 02/03/03 1/28/01 1/27/02 1/26/03 Liquiditity Ratios Current Ratio Quick Ratio Cash Ratio Avg Coll Period Days in Inventory Days in A/P (COGS) Cash Conversion (COGS) Operating Performance Ratios Asset Turnover Net FA Turnover Gross Profit Margin 27.6% 26.9% 26.8% 28.0% 28.7% 28.5% Operating Profit Margin 3.1% 5.0% 5.0% 3.9% 4.6% 5.5% Net Profit Margin -1.2% 1.3% 2.3% 1.7% 2.6% 3.2% Return on Total Capital 0.1% 7.2% 10.6% 5.5% 8.4% 9.7% ROA (NI + Int Exp) 0.1% 3.9% 5.0% 2.7% 4.1% 5.0% ROA (NI) -2.1% 2.5% 4.2% 2.7% 4.1% 5.0% Return on Owner's Equity -6.4% 7.7% 12.4% 6.6% 9.7% 11.3% Return on Common Equity -6.4% 7.0% 12.3% 6.6% 9.7% 16.9% Financial Statement Analysis 56

57 Barnes and Noble, Borders Summary Financial Ratios (cont d) Barnes and Noble Borders 2/3/01 02/03/02 02/03/03 1/28/01 1/27/02 1/26/03 Business and Financial Risk Oper Income Variability 27.9% 26.6% 24.8% 19.2% 11.4% 14.4% Sales Variability 23.2% 24.0% 22.5% 20.3% 16.3% 11.7% LT Debt / LT Capital Interest Coverage nm nm nm Growth Ratios Sustainable growth rate -6.9% 7.3% 12.4% 6.6% 9.5% 11.1% DuPont Analysis Net Income / Sales (Profit Margin) -1.2% 1.3% 2.3% 1.7% 2.6% 3.2% Sales / Total Assets Total Assets / Equity = ROE -6.9% 7.3% 12.4% 6.6% 9.5% 11.1% Financial Statement Analysis 57

58 Barnes and Noble, Borders Summary Financial Ratios - Interpretation Liquidity Short-term liquidity is increasing for Borders, increased from 2002 for Barnes and Noble Both holding more cash in 2003 Efficiency BKS appears better at inventory management, both improved in 2003 Possibly the nature of the products they are selling Borders takes longer to pay their bills, although it is paying faster in 2003 than 2002 Also possibly the nature of the products they are selling Financial Statement Analysis 58

59 Barnes and Noble, Borders Summary Financial Ratios - Interpretation Efficiency (cont d) Overall takes borders longer to convert products into cash BKS uses fewer assets per sales dollar Profitability From 2001 to 2003 net and operating margins increased for both BKS and Borders, albeit more dramatically for BKS. Gross margins remained fairly constant. Borders has slightly higher gross margin (more specialized products?). ROA and ROE increase for both firms in 2003 both have similar ROA for the year ended in Note that BKS uses significantly more leverage than Borders, affecting the variability of many of these performance measures. Financial Statement Analysis 59

60 Barnes and Noble, Borders Summary Financial Ratios - Interpretation Leverage BKS uses much more long-term debt than Borders, although this amount has been decreasing Borders has very little long-term debt Summary/DuPont Borders has somewhat higher margins, uses slightly less leverage and requires more asset investment as compared to BKS Financial Statement Analysis 60

61 Limitations of Ratio Analysis It is sometimes difficult to identify the industry category to which a firm belongs when the firm engages in multiple lines of business. Published industry averages are only approximations and provide the user with general guidelines rather than scientifically determined averages of the ratios of all or even a representative sample of the firms within the industry. Financial Statement Analysis 61

62 Limitations of Ratio Analysis (cont d) Accounting practices differ widely across firms and can lead to differences in computed ratios. Also note: Definitions of ratios vary slightly from publication to publication and user to user. Many firms experience seasonality in their operations. Some ratios meaningless over short horizons Window dressing and earnings management Financial Statement Analysis 62

63 Other measures of cash flow for the firm? The statement of cash flows for a firms tracks cash in three areas: operations, financing, and investing. The cash flow from operations is essentially net income with adjustments for depreciation and working capital. Investing cash flow tracks expenditures on plant, property, and equipment. Financing cash flow tracks cash from the purchase and sale of liabilities and equity. Financial Statement Analysis 63

64 FINANCIAL STATEMENT ANALYSIS EXAMPLE: Big Dawg Incorporated Consolidated Balance Sheet Assets Current Assets Cash $4,061 $2,382 Marketable securities 5,272 8,004 Accounts Receivable (Net) 8,960 8,350 Inventories 47,041 36,769 Prepaid expenses Total current assets 65,846 56,264 Property, Plant, and Equipment Land Buildings and leasehold improvements 18,273 11,928 Equipment 21,523 13,768 40,607 26,507 Less accumulated depreciation and amortization 11,528 7,530 NET Property, plant and equipment 29,079 18,977 Other Assets TOTAL ASSETS $95,298 $75,909 Liabilities and Stockholders' Equity Current Liabilities Accounts payable $14,294 $7,591 Notes payable-banks 5,614 6,012 Current maturities of long-term debt 1,884 1,516 Accrued liabilities 5,669 5,313 Total current liabilities 27,461 20,432 Deferred Federal income taxes Long term debt 21,059 16,975 Total liabilities 49,363 38,042 Stockholders' equity Common stock, par value $1 4,803 4,594 Additional paid in capital Retained Earnings 40,175 32,363 Total stockholders' equity 45,935 37,867 Total liabilities and stockholders' equity $95,298 $75,909

65 Big Dawg Statements of Earnings for the years ended 12/31/10, 12/31/09,/12/31/ Net sales $215,600 $153,000 $140,700 Cost of goods sold 129,364 91,879 81,606 Gross Profit 86,236 61,121 59,094 Selling and administrative expenses 45,722 33,493 32,765 Advertising 14,258 10,792 9,541 Depreciation and amortization 3,998 2,984 2,501 Repairs and maintenance 3,015 2,046 3,031 Operating profit 19,243 11,806 11,256 Other income (expense) Interest income Interest expense (2,585) (2,277) (1,274) Earnings before income taxes 17,080 10,367 10,720 Income taxes 7,686 4,457 4,824 Net Earnings $9,394 $5,910 $5,896 Basic earnings per common share $1.96 $1.29 $1.33 Diluted earnings per common share $1.92 $1.26 $1.31 GOALS: Assess liquidity Assess operating efficiency Assess capital structure and long term solvency Assess profitability Assess cash flow Assess overall picture of firm s health