CA. Sonali Jagath Prasad ACA, ACMA, CGMA, B. Com.
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1 MANAGEMENT OF FINANCIAL RESOURCES AND PERFORMANCE SESSIONS 5 & 6 FINANCIAL DATA, PERFORMANCE ANALYSIS & MANAGEMENT AND DECISION MAKING June 10 to 24, 2013 CA. Sonali Jagath Prasad ACA, ACMA, CGMA, B. Com. WESTFORD 2008 Thomson SCHOOL South-Western OF MANAGEMENT 1
2 Session Learning Outcome Know how to assess the performance of organisations
3 Session -Takeaways Understand sources of financial data and justify selection of data Evaluate performance using various analytical tools Analyse business information to support strategic decisions Make recommendations on improving business performance
4 I. SOURCES OF FINANCIAL DATA
5 Need for Data Data is required to : Apply performance analytical tools Understand market trends Compare historical performance of company to see trends Compare a company s performance with industry Compare performance with competitor Analyse areas of improvements in revenues or costs Data/information is also required for taking strategic management decisions like: Expansion Capital budgeting Lease or buy an asset make or buy product or sub-component Discontinue a product or service etc. Evaluate managerial or divisional performance
6 Sources of Data Internal Sources of Data: Financial Statements Cost reports Sales reports Management reports Internal audit reports External Sources of Data Market intelligence Government agencies such as Ministry of Industry, Central Banks Industry associations Stock markets for listed companies
7 II. PERFORMACE ANALYSIS TOOLS
8 Basics of Analysis Application of analytical tools Reduces uncertainty Involves transforming data
9 Purpose of Analysis Financial statement analysis helps users make better decisions. Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers
10 Objectives of Performance Analysis What are the assets that the firm has in place already, and how much are they worth? What are the growth assets of the firm and what is their value? What is the mix of debt and equity that the firm is using to finance these assets? What is the firm earning on its assets in place, and what can it expect to earn on these same assets as well as its growth assets? How much risk is there in this firm? What is the growth potential of the firm? What is the cost of its debt and equity financing? Is the firm earning enough for its stakeholders? Is the firm doing as well as its peers? Is the market valuing the firm as well as its peers?
11 Comparative Analysis There are three types of comparisons to improve decision usefulness of financial information: Intra company basis Inter company basis Industry averages
12 Intracompany Basis Comparisons within a company are often useful to detect changes in financial relationships and significant trends. A comparison of Microsoft's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. A comparison of Microsoft's year-end cash amount with the amount of total assets at yearend shows the proportion of total assets in the form of cash.
13 Intercompany Basis Comparisons with other companies provide insight into a company's competitive position. Microsoft's total sales for the year can be compared with the total sales of its competitors such as Apple Inc., Google Inc, Oracle Corporation etc.
14 Microsoft's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. Industry Averages Comparisons with industry averages provide information about a company's relative position within the industry.
15 Statements in Comparative and Common-Size Form Dollar and percentage changes on statements Analytical techniques used to examine relationships among financial statement items Common-size statements Ratios
16 Dollar and Percentage Changes on Statements Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future. Horizontal analysis Trend analysis
17 Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.
18 Horizontal Analysis Example The following slides illustrate a horizontal analysis of Clover Corporation s December 31, 2000 and 1999 comparative balance sheets and comparative income statements.
19 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 Accounts receivable, net 60,000 40,000 Inventory 80, ,000 Prepaid expenses 3,000 1,200 Total current assets 155, ,700 Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160, ,000 Total assets $ 315,000 $ 289,700
20 Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change Current Year = Figure Base Year Figure The dollar amounts for 1999 become the base year figures.
21 Horizontal Analysis Calculating Change as a Percentage Percentage Change Dollar Change = Base Year Figure 100%
22 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80, ,000 Prepaid expenses 3,000 1,200 Total current assets $12, ,000 $23, ,700 = $(11,500) Property and equipment: Land 40,000 40,000 ($11,500 $23,500) 100% = 48.9% Buildings and equipment, net 120,000 85,000 Total property and equipment 160, ,000 Total assets $ 315,000 $ 289,700
23 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 20, Inventory 80, ,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1, Total current assets 155, ,700 (9,700) (5.9) Property and equipment: Land 40,000 40, Buildings and equipment, net 120,000 85,000 35, Total property and equipment 160, ,000 35, Total assets $ 315,000 $ 289,700 $ 25,
24 Horizontal Analysis We could do this for the liabilities & stockholders equity, but now let s look at the income statement accounts.
25 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) Amount % Net sales $ 520,000 $ 480,000 $ 40, Cost of goods sold 360, ,000 45, Gross margin 160, ,000 (5,000) (3.0) Operating expenses 128, ,000 2, Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
26 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) Amount % Net sales $ 520,000 $ 480,000 $ 40, Cost of goods sold 360, ,000 45, Gross margin 160, ,000 (5,000) (3.0) Operating expenses Sales increased 128,600 by 8.3% yet 126,000 2, Net operating net income income decreased 31,400 by 21.9%. 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
27 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) Amount % Net sales $ 520,000 $ 480,000 $ 40, Cost of goods sold 360, ,000 45, Gross margin 160, ,000 (5,000) (3.0) Operating expenses 128, ,000 2, Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9) There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.
28 Trend Percentages Trend percentages state several years financial data in terms of a base year, which equals 100 percent.
29 Trend Analysis Trend = Current Year Amount 100% Percentage Base Year Amount
30 Trend Analysis Example Look at the income information for Berry Products for the years 1998 through We will do a trend analysis on these amounts to see what we can learn about the company.
31 Trend Analysis Berry Products Income Information For the Years Ended December 31, Year Item Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000 Cost of goods sold 285, , , , ,000 Gross margin 115, ,000 95,000 92,000 85,000 The base year is 1998, and its amounts will equal 100%.
32 Trend Analysis Berry Products Income Information For the Years Ended December 31, Year Item Sales 105% 100% Cost of goods sold 104% 100% Gross margin 108% 100% 1999 Amount 1998 Amount 100% ( $290,000 $275,000 ) 100% = 105% ( $198,000 $190,000 ) 100% = 104% ( $ 92,000 $ 85,000 ) 100% = 108%
33 Trend Analysis Berry Products Income Information For the Years Ended December 31, Year Item Sales 145% 129% 116% 105% 100% Cost of goods sold 150% 132% 118% 104% 100% Gross margin 135% 124% 112% 108% 100% By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.
34 Trend Analysis 160 We can use the trend percentages to construct a graph so we can see the trend over time. Percentage Sales COGS GM Year
35 Common-Size Statements Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.
36 Vertical Analysis (Cross Sectional Analysis) Shows relationship of each item to a base amount on financial statements Income statement each item expressed as percentage of net sales Balance sheet each item expressed as percentage of total assets
37 Common-Size Statements Example Let s take another look at the information from the comparative income statements of Clover Corporation for 2000 and This time let s prepare common-size statements.
38 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size Percentages Net sales $ 520,000 $ 480, Cost of goods sold 360, ,000 Gross margin 160, ,000 Operating expenses 128, ,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400 Net sales is usually the base and is expressed as 100%.
39 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size Percentages Net sales $ 520,000 $ 480, Cost of goods sold 360, , Gross margin 160, ,000 Operating expenses 128, , COGS 2000 Net Sales 100% Net operating income 31,400 39,000 ( $360,000 $520,000 ) 100% = 69.2% Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income 1999 taxes COGS (30%) 1999 Net 7,500 Sales 100% 9,600 ( $315,000 $480,000 ) 100% = 65.6% Net income $ 17,500 $ 22,400
40 Gross Margin Percentage Gross Margin Percentage = Gross Margin Sales This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover operating expenses and a profit.
41 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size What conclusions can we draw? Percentages Net sales $ 520,000 $ 480, Cost of goods sold 360, , Gross margin 160, , Operating expenses 128, , Net operating income 31,400 39, Interest expense 6,400 7, Net income before taxes 25,000 32, Less income taxes (30%) 7,500 9, Net income $ 17,500 $ 22,
42 Financial Ratios Financial Ratios can be used to compare performance of A company at a current point of time on a stand-alone basis A company over a period of time A company with its peers or with other companies Different industries A company and its industry average Financial Ratios, per se, may have no meaning, unless, benchmarked or compared with something When doing ratio analysis, be careful of Changes in accounting policies across a company s history Differences in accounting policies between companies Differences across geographies Accounting earnings v/s financial earnings
43 Building Blocks of Analysis Ability to meet short-term obligations and to efficiently generate revenues Liquidity and Efficiency Solvency Ability to generate future revenues and meet long-term obligations Ability to provide financial rewards sufficient to attract and retain financing Profitability Market Prospects Ability to generate positive market expectations
44 Information for Analysis Income Statement Balance Sheet Notes Statement of Changes in Stockholders Equity Statement of Cash Flows
45 Liquidity and Efficiency Current Ratio Inventory Turnover Acid-test Ratio Days Sales Uncollected Accounts Receivable Turnover Days Sales in Inventory Total Asset Turnover
46 NORTON CORPORATION Balance Sheet December 31, Assets Current assets: Cash $ 30,000 $ 20,000 Accounts receivable, net 20,000 17,000 Inventory 12,000 10,000 Prepaid expenses 3,000 2,000 Total current assets $ 65,000 $ 49,000 Property and equipment: Land 165, ,000 Buildings and equipment, net 116, ,000 Total property and equipment $ 281,390 $ 251,000 Total assets $ 346,390 $ 300,000
47 NORTON CORPORATION Balance Sheet December 31, Liabilities and Shareholders' Equity Current liabilities: Accounts payable $ 39,000 $ 40,000 Notes payable, short-term 3,000 2,000 Total current liabilities $ 42,000 $ 42,000 Long-term liabilities: Notes payable, long-term 70,000 78,000 Total liabilities $ 112,000 $ 120,000 Shareholders' equity: Common stock, $1 par value 27,400 17,000 Additional paid-in capital 158, ,000 Total paid-in capital $ 185,500 $ 130,000 Retained earnings 48,890 50,000 Total shareholders' equity $ 234,390 $ 180,000 Total liabilities and shareholders' equity $ 346,390 $ 300,000
48 NORTON CORPORATION Income Statement For the Years Ended December 31, Revenues $ 494,000 $ 450,000 Cost of sales 140, ,000 Gross margin $ 354,000 $ 323,000 Operating expenses 270, ,000 Net operating income $ 84,000 $ 74,000 Interest expense 7,300 8,000 Net income before taxes $ 76,700 $ 66,000 Less income taxes (30%) 23,010 19,800 Net income $ 53,690 $ 46,200
49 Current Ratio Current Ratio = Current Assets Current Liabilities Current Ratio $65,000 = = 1.55 : 1 $42,000 This ratio measures the short-term debt-paying ability of the company.
50 Acid-Test Ratio / Quick Ratio Acid-Test Ratio = Quick Assets Current Liabilities Quick assets are Cash, Short-Term Investments, and Current Receivables (excl. inventory) Acid-Test Ratio = $53,000 $42,000 = 1.26 : 1 This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.
51 Cash Ratio Cash Ratio = Cash + Marketable securities Current Liabilities Current Ratio $30,000 = = 0.71 : 1 $42,000 This ratio is an indication of the firm s ability to pay off its current liabilities If for some reason immediate payment were demanded
52 Net Working Capital ratio NWC Ratio = Net Working Capital Total Assets Current Ratio $23,000 = = 0.07 : 1 $346,390 This ratio is an indication of the firm s ability to pay off its current liabilities If for some reason immediate payment were demanded
53 Accounts Receivable Turnover Accounts Receivable Turnover = Sales on Account Average Accounts Receivable Accounts Receivable Turnover = $494,000 ($17,000 + $20,000) 2 = 26.7 times This ratio measures how many times a company converts its receivables into cash each year.
54 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory Inventory Turnover = $140,000 ($10,000 + $12,000) 2 = times This ratio measures the number of times merchandise is sold and replaced during the year.
55 Days Sales Uncollected / Average Collection period Days Sales Uncollected = Accounts Receivable Net Sales 365 Days Sales Uncollected = $20,000 $494, = 14.8 days This ratio measures the liquidity of receivables.
56 Days Sales in Inventory / Inventory period Days Sales in Inventory = Ending Inventory Cost of Goods Sold 365 Days Sales in Inventory = $12,000 $140, = days This ratio measures the liquidity of inventory.
57 Total Asset Turnover Total Asset Turnover = Net Sales Average Total Assets Total Asset Turnover $494,000 = ($300,000 + $346,390) 2 = 1.53 times This ratio measures the efficiency of assets in producing sales.
58 Operating Cycle Operating cycle = Days in Cash + Days In Accounts Receiveable + Days in Inventory - Days in Accounts Payable The average time between purchasing or acquiring inventory and receiving cash proceeds from its sale. A long operating cycle tends to reduce profitability by increasing borrowing requirements and interest expense
59 Debt Ratio Solvency / Financial Leverage Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned
60 Solvency Use this information to calculate the solvency ratios for Norton Corporation. NORTON CORPORATION 2004 Net income before interest expense and income taxes $ 84,000 Interest expense 7,300 Total shareholders' equity 234,390 Total liabilities 112,000 Total assets 346,390
61 Debt Ratio Debt Ratio = Total debt Total Assets Debt Ratio = $112,000 $346,390 = 32.3% This ratio measures what portion of a company s assets are contributed by creditors.
62 Equity Ratio Equity Ratio Total Equity = Total Assets Equity Ratio = $234,390 $346,390 = 67.7% This ratio measures what portion of a company s assets are contributed by owners.
63 Debt-Equity Ratio Debt- Equity Ratio Total Debt = Total Equity
64 Pledged Assets to Secured Liabilities Pledged Assets to Secured Liabilities Book Value of Pledged Assets = Book Value of Secured Liabilities This ratio measures the protection to secured creditors.
65 Times Interest Earned / Interest coverage Times Interest Earned = Net Income before Interest Expense and Income Taxes Times Interest Earned Interest Expense $84,000 = = $7,300 This is the most common measure of the ability of a firm s operations to provide protection to the long-term creditor.
66 Profitability Profit Margin Basic Earnings per Share Gross Margin Book Value per Common Share Return on Total Assets Return on Common Stockholders Equity
67 Profit Margin Profit Margin = Net Income Net Sales Profit Margin = $53,690 $494,000 = 10.87% This ratio describes a company s ability to earn a net income from sales.
68 Gross Margin Gross Margin = Net Sales - Cost of Sales Net Sales Gross Margin = $494,000 - $140,000 $494,000 = 71.66% This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales.
69 Return on Total Assets Return on Total Assets = Net Income Average Total Assets Return on Total Assets $53,690 = ($300,000 + $346,390) 2 = 16.61% This ratio is generally considered the best overall measure of a company s profitability.
70 Return on Common Stockholders Equity / Return on equity Return on Common Stockholders Equity Return on Common Stockholders Equity = = Net Income - Preferred Dividends Average Common Stockholders Equity $53,690-0 ($180,000 + $234,390) 2 = 25.9% This measure indicates how well the company employed the owners investments to earn income.
71 Book Value per Common Share Book Value per Common Share = Shareholders Equity Applicable to Common Shares Number of Common Shares Outstanding This ratio measures liquidation at reported amounts.
72 Basic Earnings per Share Basic Earnings per Share = Net Income - Preferred Dividends Weighted-Average Common Shares Outstanding Basic Earnings per Share $53,690-0 = = $1.96 per share 27,400 This measure indicates how much income was earned for each share of common stock outstanding.
73 Market Prospects / Dividend Policy Price-Earnings Ratio Dividend Yield Dividend Payout
74 Market Prospects Use this information to calculate the market ratios for Norton Corporation. NORTON CORPORATION December 31, 2004 Earnings per Share $ 1.96 Market Price Annual Dividend per Share 2.00
75 Price-Earnings Ratio Price-Earnings Ratio = Market Price Per Share Earnings Per Share Price-Earnings Ratio $15.00 = = 7.65 times $1.96 This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.
76 Dividend Yield Dividend Yield = Annual Dividends Per Share Market Price Per Share Dividend Yield $2.00 = = 13.3% $15.00 This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
77 Dividend Payout Dividend Payout = Annual Dividends Per Share Earnings Per Share Dividend Payout $2.00 = = 20% $10.00 It is important to consider the prospects for continuing and increasing dividend in future
78 Market to book ratio Market To book = Market price per share Book value Per Share Market To book $2.00 = = 20% $10.00 This ratio indicates the market sentiment
79 DuPont Analysis The DuPont model separates finance from operations. It has three primary components: Financial analysis using the DuPont model Profitability Activity ROCE - Return on capital employed By examining each input individually, we can discover the sources of a company's return on equity and compare it to its competitors.
80 DuPont Analysis The DuPont model financial components are discussed below. Income Statement Balance sheet ROCE = ROE Performance measure is : Profitability Performance measure is : Activity = Profitability x Activity
81 Cash flow ratios Cash Flow from Operations to Net Income = (cash flow from operations) / net income The cash flow from operations to net incomes ratio indicates the extent to which net income generates cash in a business. Cash Flow from Sales to Total Sales = (cash flow from operations - dividends) / total sales The cash flow from sales to sales ratio indicates the degree to which sales generate cash retained by the business Cash Flow Coverage Ratio = net income + depreciation and amortization /total debt payments. The cash flow coverage ratio indicates the ability to make interest and principal payments as they become due. A cash flow coverage ratio of less than one indicates bankruptcy within two years.
82 III. STRATEGIC DECISION MAKING
83 Types of Strategic Decisions Typical management decisions required to be made include: Restructuring the Company What should be the optimal capital structure? Optimal level of dividends to be paid Make or Buy a product/service How to price a product or service Adding or dropping a product or service Accepting or rejecting a one-time special order
84 Types of Restructurings
85 Restructuring - Mergers Rationale for Mergers Economies of scale Complementary resources Use of surplus funds Sales enhancement Management improvements Tax reasons Financial leverage Types of Merger Horizontal Merger Vertical Merger Conglomerate Merger Modes of Mergers Combination Acquisition of Shares
86 Restructuring - Others Rationale for Acquisition Integrate forward or backward Obtain a source of material or other resource Obtain economies of scale Tap into newer markets, products etc. Rationale for Divestment Sell non core businesses Raise cash for other uses Spin-offs Unlock value Induction of strategic/financial investors Regulatory reasons
87 Optimal Capital Structure The optimal allocation of financing between the different types of capital takes many different factors into account: Future prospects of the company State of Equity Markets : if the equity market is doing poorly, the cash received from the sale of stock will be less than in a period of a strong market Composition of the company s assets Amount of risk that the company is willing to accept : Debt is inherently more risky to the firm than equity Reputation of the issuer (company) The cost of each source of capital
88 Optimal Dividend Policy The optimal dividend policy would be arrived at after considering: Shareholder preferences : current income v/s growth Liquidity requirements Debt/borrowing capacity Earnings stability Growth opportunities Restrictive covenants
89 Pricing a product/service Pricing Parameters Profit maximisation Returns on investment/ shareholders' funds Achieving a target sales volume Achieving target market shares Keeping in line with competition Control competition Entering new markets Stabilising prices and margins Pricing Methods Cost based Demand based Target pricing
90 Make or Buy Decision Make-or-buy decisions usually involve whether the company should produce something itself or by it from outside If the cost to purchase the product from outside is lower that the avoidable cost of internal production, the company should buy the product from the outside. Relevant costs to be considered for analysis: Direct variable cost of in-house production Avoidable fixed costs saving Qualitative Issues to be considered Allows access to specialized knowledge or technology Benefit from economies of scale of the supplier Access to raw materials Quality control Supply chain management
91 Make or Buy Decision - Example
92 Special Orders Special orders revolve considers whether to accept a one-off order at lower than normal selling price Key considerations for the decision: Difference in prices The opportunity cost of accepting the order Is the company operating at below or at full capacity Break-up of costs between variable and fixed costs
93 Special Orders - Example
94 Continue or Drop a Product
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