Measuring Vendor Financial Strength Presented by Michael Greene, City of Tempe Presentation Overview Why is it important to consider a firm s financial strength Review the three typical financial statements: Balance Sheet Income Statement Cash Flow Statement Discuss Concept of Ratio Analysis Perform Ratio Analysis on Procter and Gamble Other available resources Why Do We Evaluate Financial Strength? To control risk of contract failure To ensure long term viability of supplier To avoid the additional cost of re-solicitation and operational disruption if an awarded firm fails To ensure the organization selects a healthy and viable firm that can weather economic turbulence Gain more thorough understanding on how the firm operates and how well it is managed 1
Limitations of Financial Analysis The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing. Accounting and finance are not reality, they are a reflection of reality, and the accuracy of that reflection depends on the ability of accountants and finance professionals to make reasonable assumptions and to calculate reasonable estimates. (Berman and Knight Financial Intelligence, 2006 Financial Statement Principles Matching Principle Expense are recorded in the period in which they support service Revenue Recognition Revenue is recognized when ownership changes hands goods delivered (cash vs. accrual) Financial Statement Principles Conservatism Revenues are recognized when reasonably certain; Expenses are recognized when reasonably possible. Cost Balance sheet items are carried at actual cost (objective) and not marked up to market value (subjective) Monetary Unit Only items which can be measured in monetary terms are recorded on the balance sheet 2
Financial Statement Principles Consistency For comparability, accounting choices must be consistent over time. If changes are made you must show that on financial statements What Financial Statement Analysis Reveals How profitable is this company? Is the firm able to pay day to day bills or is there trouble brewing? Is the firm using its assets efficiently or is there slack in system? Does the firm have too much debt? (or too little?) Is the firm getting a good return on the investment made on its assets? Is the firm generating a good return for owners? Audited Financial Statements Prefer audited financial statement that indicate an unqualified opinion. Audit opinion should say three things: The audit steps taken to verify the financial statements meet the auditing profession s approved standards of practice The statements prepared by management are management s responsibility and follow generally accepted accounting principles There is no material misstatement 3
Audited Financial Statements If the independent auditor s report contains the qualifying words except for, the reader should be on the alert Any qualifications should be summarily explained by the auditor Watch for unqualified opinions that go into separate detail or devote emphasis about an important item The Balance Sheet Portrays the fundamental soundness of a company by showing what the company owns and what it owes at a particular point in time (snap shot) Assets = Liabilities + Shareholders Equity or (Owns = Owes + Net Worth) They balance because each dollar of assets must be funded by a dollar of liabilities or equity The Balance Sheet Definitions Assets = something that will provide some future economic benefit Liabilities = an economic obligation to someone else Equity = represents retained earnings and funds contributed by its shareholders 4
The Balance Sheet Current Assets Types of Assets: Current Assets Cash and Cash Equivalents Marketable Securities Accounts Receivable or A/R Inventory (finished goods, work in process, and raw materials) Prepaid expenses The Balance Sheet Non Current Assets Non Current Assets Property Plant and Equipment Goodwill Intellectual property, patents, and other intangibles Less: accumulated depreciation Net Property Plant and Equipment The Balance Sheet Liabilities and Equity Current Liabilities Accounts Payable Accrued Expenses and Other Short-Term Liabilities Short Term Loans Current Portion of Long-Term Debt Long-Term Liabilities Loans Deferred bonuses, taxes Owners Equity Preferred shares Common shares Additional paid in capital Retained earnings 5
The Balance Sheet Assessments to be Made Is the company solvent? Do its assets outweigh its liabilities, so that owners equity is a positive number? Can the company pay its bills? Measured by whether a firm has more current assets than current liabilities Has owners equity been growing over time? A comparison of balance sheets over time will reveal this answer The Income Statement Matches the revenues earned from selling goods and services or other activities against all the costs and outlays incurred to operate the company Displays three different levels of profit: Gross Profit (or Gross Margin) Operating Profit (or Operating Margin) Net Profit (or Bottom Line) The Income Statement Gross Profit Calculated by removing Cost of Goods Sold (COGS) from Revenue (Sales) Demonstrates the firm s ability to be successful in the production of their goods or services Must be sufficient to cover a business s operating expenses, taxes, financing costs, and net profit 6
The Income Statement Operating Profit (EBIT) Calculated by removing operating expenses, including depreciation and amortization, from gross profit Operating profit does not include expenses for interest and taxes. Operating profit is a good gauge of how well a company is being managed It measures both overall demand for the company s products or services (Sales) and the company s efficiency in delivering those products or services. Net Profit The Income Statement Calculated by removing all remaining costs from operating profit to include interest expense, taxes, one-time charges, etc. Net profit is the bottom line of the income statement: what s left after all costs and expenses are subtracted from revenue The Income Statement Assessments to be Made It answers the key question, How good is this firm at what they do? It looks at a firm s profitability and operations over a period of time usually one year. A statement of profitability and operating capabilities Were sales higher or lower than the last period? If sales were higher, did the growth flow down to profits? If sales were lower, was the company able to maintain profits? Did the firm control overhead? Did any expenses grow more than expected? How profitable was the firm? 7
Cash Flow Statement The statement of cash flows presents the changes in cash resulting from business activities (in flow and out flow) Presented in three main categories: Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities Cash Flow Statement Cash From or Used in Operating Activities This category includes all the cash flow, in and out, that is related to the actual operations of the business Cash From or Used in Investing Activities This category includes those activities relating to asset acquisition or disposal Cash Flow Statement Cash From or Used in Financing Activities Includes those activities relating to the receipt and repayment of funds provided by creditors and investors Could include the issuance of debt or equity securities, the repayment of funds provided by creditors and investors 8
Cash Flow Statement Assessments to be Made How much cash did the firm generate from operations and was it sufficient to fund business needs? Did the firm take steps to ensure they would be in business over the long term by replacing assets? Did the firm invest in anything? Did the firm borrow money or pay down debt? Did the firm sell any new shares or buy back shares? How much free cash flow was generated? Ratio Analysis Ratios indicate the relationship of one number to another Ratios offer points of comparison and can tell you more than the raw number alone Four main ratio categories: profitability, leverage, liquidity and efficiency Profitability Ratios Success at Generating Profits Gross Margin = Gross Income/Revenue For every dollar of revenue after all production costs are paid the firm has $ cents to pay for all other costs including profit. Operating Margin = Operating Income/Revenue For every dollar of revenue after all production, operations, and overhead costs are paid the firm is left with $ cents to cover non-operating costs including interest and taxes. Net Margin = Net Income/Revenue This measures the bottom line profitability of a company. For every dollar of revenue after you pay all expenses you have $ cents for shareholders. Return on Investment = Net Income/Average Total Assets For every $1.00 of assets the company is earning $ cents of net income. Return on Equity = Net Income/Average Equity for every $1.00 of equity the company is earning $ cents of net income. 9
Leverage Ratios Measure Long Term Solvency Debt Ratio = Total Liabilities /Total Owner s Equity For every dollar of equity the firm has $ in total debt (1 to 1 is norm) Debt to Equity Ratio = Short Term Debt + Long Term Debt/Total Owner s Equity For every dollar of owner s equity the firm has $ in total debt Lower ratio is generally better Interest Coverage or Times Interest Earned = Operating Income/Interest Expense For every dollar of interest expense the firm has $ to pay it off Higher ratio is better Liquidity Ratios Measure Short Term Solvency Net Working Capital = TCA TCL Current Ratio = TCA/TCL For every dollar of liabilities the firm has $ dollars of assets to pay for them. Rule of thumb is 2 to 1. Quick Ratio (The Acid Test) Quick Assets/Current Liabilities For every dollar of CL, the firm has $ dollars in quick assets to pay them off (inventory is removed from CA) Efficiency Ratios Making the Most of Your Assets Inventory Turnover = COGS/Average Inventory (for the two years of data shown) This measures the number of times per year that the inventory was turned. To convert to days you need to divide the number arrived at above into 365 days. Accounts Receivable Turnover = Revenue/Average Accounts Receivable (for the two years shown). This number indicates the number of times that AR was turned over during the year. To convert to days you would need to divide the number above into 365 days. This number will tell you the average number of days it takes to collect on accounts. Total Asset Turnover = Revenue/Average Total Assets (for the two years shown) For every dollar of assets the firm is generating $ of revenue. 10
Use and Limitations of Ratios A reference point is needed. To be meaningful, most ratios must be compared to historical values of the same firm, the firm s forecasts, or ratios of similar firms Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of a firm s situation Ratios are subject to the limitations of accounting methods. Different accounting choices may result in different ratio values Review Procter and Gamble Financial Statements Balance Sheet Income Statement Cash Flow Statement Procter & Gamble Evaluation Profitability Ratios Gross Margin = Gross Income/Revenue $41,289/$83,680 =.49 Operating Margin = Operating Income/Revenue $13,292/$83,680 =.16 Net Margin = Net Income/Revenue $9,317/$83,680 =.11 Return on Assets = Net Income/Average Total Assets $9,317/($132,244 + $138,354/2) =.07 Return on Equity = Net Income/Average Equity $9,317/($64,035 + $67,640/2) =.14 11
Procter & Gamble Evaluation Leverage Ratios Debt Ratio = Total Liabilities/Total Owners Equity $68,209/$64,035 = 1.07 Debt to Equity Ratio = Current Debt + Long Term Debt/Total Owner s Equity $29,778/$64,035 =.47 Interest Coverage or Times Interest Earned = Operating Income/Interest Expense $13,292/$769 = 17.28 Procter & Gamble Evaluation Liquidity Ratios Net Working Capital = TCA TCL $21,910 $24,907 = -$2,997 Current Ratio = TCA/TCL $21,910/$24,907 =.88 Quick Ratio (The Acid Test) Quick Assets/Current Liabilities ($21,910 - $6,721)/$24,907 =.61 Procter & Gamble Evaluation Efficiency Ratios Inventory Turnover = COGS/Average Inventory $42,391/($6,721 + $7,379)/2 = 6.01 Accounts Receivable Turnover = Revenue/Average Accounts Receivable $83,680/($6,068 + $6,275)/2 = 13.56 or 365/13.56 = 27 days Total Asset Turnover = Revenue/Average Total Assets $83,680/($132,244 + 138,354)/2 =.62 12
Final Points Review the numbers presented on the statements looking for changes and trends Perform trend analysis on key data such as gross margin, operating margin and net margin Develop ratios Compare results to industry and remember, the information you are reviewing is only a reflection of reality Additional Resources Public Company s web site click on Investor Relations for access to financials Reuters Stock Analysis http://www.reuters.com/finance/stocks Yahoo Stocks Research Center http://biz.yahoo.com/q/ Financial Intelligence, Karen Berman and Joe Knight, ISBN-13:978-1-59139-764-9 Thank you for Attending 13