NOTE ON EVALUATING FINANCIAL PERFORMANCE
If we are to be effective as
an entrepreneur, there is a certain body of knowledge and skills that we must
master. Otherwise, we will be at a
distinct disadvantage in operating a going concern. Understanding the informational content of
financial statements is one such area.
This note has been written in the hopes of providing a basic common body
of knowledge in this regard. We will first
look at the format of the financial statements typically used in business. Second, we will then use ratio analysis as a
way to evaluate a company's financial position.
UNDERSTANDING FINANCIAL STATEMENTS
Think of financial statements
as consisting of certain pieces of important information about the firm's
operations that are reported in the form of (1) an income statement, (2) a
balance sheet, and (3) a cash flow statement.
We will look at each of these statements in turn.
The Income
Statement
The main elements of an income
statement, or profit and loss statement as some call it, are shown in Exhibit
1. In this exhibit, we observe that the top part of the income statement,
beginning with sales and continuing down through the operating income or earnings
before interest and taxes, is affected solely by the firm's operating decisions. These decisions involve such matters as
sales, cost of goods sold, marketing expenses and general and administrative
expenses. However, no financing costs
are included to this point.
Below the line reporting
operating income, we see the results of the firm's financing decisions, along
with the taxes that are due on the company's income. Here the company's interest expense is shown, which is the direct result of the amount
of debt borrowed and the interest rate charged by the lender (Interest expense
= amount borrowed x interest rate). The
resulting profits before tax and the
tax rates imposed on the company then determine the amount of the tax
liability, or the income tax expense. The final number, the net profits after taxes, is the income that may be distributed to
the company's owners or reinvested in the company, provided of course there is
cash available to do so. (As we shall
see later, merely because there are profits does not necessarily mean there is
any cash - possibly a somewhat surprising fact to us, but one we shall come to
understand.)
EXHIBIT 1
The Income Statement:
An Overview
Sales
Gross profit
Operating expenses:
Marketing and selling expenses and general and administrative
expenses
Operating income (Earnings
before interest and taxes)
Profits before taxes
Profits after taxes
An example of an income
statement is provided in Exhibit 2 for the LM Manufacturing Company. As shown in the exhibit, the firm had sales
of $830,000 for the 12-month period ending December 31, 2006. The cost of manufacturing their product was
$539,000, resulting in a gross profit of $291,000. The firm then had $190,000 in operating
expenses, which involved selling expenses, general and administrative expenses,
and depreciation expenses. After
deducting the operating expenses, the firm's operating profits (earnings before
interest and taxes) amounted to $101,000.
This amount represents the income generated as if LM Manufacturing was
an all-equity company. To this point, we
have calculated the profits resulting only from operating activities, as
opposed to financing decisions, such as how much debt or equity is used to
finance the company's operations.
We next deduct LM's interest
expense (the amount paid for using debt financing) of $20,000 to arrive at the
company's profit before tax of $81,000.
Lastly, we deduct the income taxes of $17,000 to leave the net profit
after tax of $64,000. At the bottom of
the income statement, we also see the amount of common dividends paid by the
firm to its owners in the amount of $15,000, leaving $49,000, which eventually
increases retained earnings in the balance sheet.
EXHIBIT 2
Income
Statement (figures in $ thousands)
The LM
Manufacturing Company
For the Year Ending December 31, 2006
Sales $830
Cost of Goods Sold $539
Gross Profit on Sales $291
Operating Expenses:
Marketing Expenses $91
General and Administrative
Expenses $71
Depreciation $28
Total Operating Expenses $190
Operating Income (EBIT) $101
Interest Expense $20
Earnings Before tax $81
Income Tax $17
Earnings after Tax $64
Dividends Paid $15
Change in Retained Earnings $49
TESTING YOUR UNDERSTANDING
The Income Statement
Given the information below,
see if you can construct an income statement. What are the firm’s gross
profits, operating income, and net income? Which expense is a non-cash expense?
(The solution to this problem is given a few pages later.)
Interest
expense $10,000 Sales $400,000
Cost of Goods
Sold $160,000 Stock Dividends $5,000
Selling
expenses $70,000 Income Taxes $20,000
Administrative
expenses $50,000 Depreciation expense $20,000
The Balance
Sheet
While the income statement
reports the results from operating the business for a period of time, such as a
year, the balance sheet provides a snapshot in time of the firm's financial position.
Thus, a balance sheet captures the cumulative effect of prior decisions down to
a single point in time.
The relationship between the
timing of an income statement and a balance sheet is represented graphically in
Exhibit 3.
EXHIBIT 3
Visual
Perspective of the Relationship
Between the Balance Sheet and Income Statement
Here we see two periods of operations, 2005 and 2006. There would be an income statement for the
period of January 1 through December 31 for the operations of the year 2006 and
a balance sheet reporting the company's financial position as of December 31 of
each year, i.e. 2005 and 2006. Thus, the
balance sheet on December 31, 2006 is a statement of the company's financial
position at that particular date in time, which is the result of all financial
transactions since the company began its operations.
Testing Your Understanding:
The Income Statement:
How Did You Do?
Earlier on, we provided data
and asked you to prepare an income statement based on the information. Your results should be as follows:
Sales $400,000
Cost
of goods Sold $160,000
Gross
profit $240,000
Operating expenses:
Selling
expenses $70,000
Administrative
expenses $50,000
Depreciation
expense $20,000
Total
operating expenses $140,000
Operating
income $100,000
Interest
expense $10,000
Earnings
before tax $90,000
Tax
expense $20,000
Net
income $70,000
Notice that we did not
include the $10,000 stock dividends included in the problem, which is
considered a return on the stockholder’s capital and deducted from retained
earnings.
Exhibit 4 gives us the basic
ingredients of a balance sheet. The
assets fall into three categories:
1.
Current assets,
such as cash, accounts receivable, and inventories;
2.
Fixed or
long-term assets, such as equipment, buildings, and land; and
3.
Any other assets
used by the company.
In reporting the dollar amounts of these various
assets, the conventional practice is to report the value of the assets and
liabilities on a historical cost basis.
Thus, the balance sheet is not intended to represent the current market
value of the company, but rather merely reports the historical transactions at
cost. Determining a fair value of the
business is a more complicated matter than captured by the balance sheet.
The remaining part of the
balance sheet, headed "liabilities and equity" indicates how the firm
has financed its investments in assets.
That is, assets must be financed either with debt (liabilities) or
equity capital. The debt consists of such sources as credit extended from suppliers
or a loan from a bank. If the firm is a
sole proprietorship, the equity is
the owner's personal investment in the company and also the profits that have
been retained within the business from all prior periods. Here the terms equity and net worth are frequently used
interchangeably. If it is a partnership,
the equity comprises the partners' contribution to the business and the
retained profits. Finally, for a
corporation, equity includes the purchase of the company's stock by the
investor (including both par value and paid in capital) and the retained
profits to that point in time.
EXHIBIT 4
The Balance Sheet:
An Overview
ASSETS
Current assets
Fixed or long-term assets
Other assets
Total assets
LIABILITIES (DEBT) AND EQUITY (NET WORTH)
Current (short-term) liabilities (debt)
Long-term liabilities (debt)
Total liabilities (debt)
Equity (net worth)
Total liabilities (debt) and equity (net worth)
Balance sheets for the LM
Manufacturing Company are presented in Exhibit 5, both on December 31, 2005 and
December 31, 2006. We have included two
balance sheets so that we may see the financial position of the firm at the
beginning and end of 2006. By examining
these two balance sheets, along with the income statement for 2006, we will
have a more complete picture of the firm's operations, as reflected in its
financial statements. We are then able
to see what the firm looked like at the beginning of 2006 (balance sheet on
December 31, 2005); what happened during the year (income statement for 2006),
and the final outcome at the end of the year (balance sheet on December 31, 2006).
The balance sheet data for the
LM Manufacturing Company shows the firm having begun the year with $804,000 in
total assets and concluding the year with total assets of $927,000. Most of the assets are invested in plant and
equipment, amounting to $404,000 in 2005 and $455,000 in 2006. Next, the investments in inventories were
$177,000 and $211,000 in 2005 and 2006, respectively. It was also in these two accounts that most
of the growth in the firm's assets occurred.
Finally, the financing of the growth in assets came mostly from borrowing
more long-term debt (long-term notes payable) and from the company's 2006
profits, as reflected in the increase in retained earnings.
EXHIBIT 5
Balance
Sheets (figures in $ thousands)
The LM
Manufacturing Company
December 31, 2005 and 2006
2005 2006
Current Assets
Cash $39 $44
Accounts receivable $70 $78
Inventories $177 $210
Prepaid expenses $14 $15
Total current assets $300 $347
Fixed assets:
Gross plant and equipment $759 $838
Accumulated depreciation $355 $383
Net plant and equipment $404 $455
Land $70 $70
Total fixed assets $474 $525
Patents $30 $55
Total assets $804 $927
Liabilities and equity
Current Liabilities:
Accounts Payable $61 $76
Income tax payable $12 $17
Accrued wages and salaries $4 $4
Interest payable $2 $2
Total Current liabilities $79 $99
Long-term notes payable $146 $200
Total liabilities: $225 $299
Common stock $300 $300
Retained Earnings $279 $328
Total Stockholders' equity $579 $628
Total liabilities and equity $804 $927
The Balance Sheet:
Testing Your Understanding
Given the information below,
construct a balance sheet. What are the
firm’s current assets, net fixed assets, total assets, current or short-term
debt, long-term debt, total equity, and total debt and equity? (Check your solution to this problem with the
answer shown a few pages later.)
Gross fixed assets $75,000
Accounts receivables $50,000
Cash $10,000
Long-term notes $5,000
Other Assets $15,000
Mortgage $20,000
Accounts payable $40,000
Common stock $100,000
Retained Earnings $15,000
Inventories $70,000
Accumulated Depreciation $20,000
Short-term notes $20,000
Measuring
Cash Flows: Free Cash Flows, That Is
We now want to consider how to
determine cash flows, an important issue to any firm, small or large. Failure to understand a company’s cash flows
can be a fatal error, and one that cannot be overcome. Often entrepreneurs fail to understand the
difference between profits and cash flows.
Some wrongly assume that if the firm is profitable, then cash flows will
be positive, especially for a company experiencing growth. Or they may think that income plus
depreciation determines cash flows. That
view is too simplistic as well.
In measuring cash flows, we
could use the conventional accountant’s presentation called a cash flow
statement. However, we are more
interested in considering cash flows from the perspective of the firm’s
management and its investors, rather than from an accounting view. Thus, what follows is similar to the cash
flow statement presented as part of a company’s financial statements, but “not
exactly.”
We should begin by recognizing
an important financial fact. The cash flows that are generated through a
firm’s operations and investments in assets will always equal its cash flows
paid to the company’s investors (both creditors and stockholders). They have to equal. That is,
Firm's free cash flows = financing cash flows.
Testing Your Understanding:
The Balance Sheet:
How Did You Do?
Earlier on, we provided
balance sheet data and asked you to develop the balance sheet based on the
information. Your results should be as
follows:
Cash $10,000
Accounts receivables $50,000
Inventories $70,000
Total current assets $130,000
Gross fixed assets $75,000
Accumulated
depreciation $20,000
Net fixed assets $55,000
Other assets $15,000
Total assets $200,000
Accounts payables $40,000
Short-term notes $20,000
Total short-term debt $60,000
Long-term note $5,000
Mortgage $20,000
Total long-term debt $25,000
Total debt $85,000
Common stock $100,000
Retained earnings $15,000
Total equity $115,000
Total debt and equity $200,000
Calculating a Firm’s Free Cash Flows
For our purposes, we define free cash flows as equal
to the:
After-tax cash flow generated from
operations
less
the increase in net operating working capital
and
less
increase in gross fixed assets
Furthermore, after-tax cash flows from operations are
determined as follows:
Operating
income
+ depreciation
= Earnings
before interest, taxes, depreciation and amortization (EBITDA)
- cash
tax payments
= After-tax
cash flows from operations
In the foregoing calculation, we have added back
depreciation to operating income since depreciation is not a cash expense. Also, we should note that cash tax payments
are not necessarily equal to the tax expense reported in the income
statement. The provision for taxes in
the income statement is the amount attributable to income reported, but the
company may be permitted to defer the payment.
Thus, the cash tax payment would equal the provision for taxes reported
in the income statement less (plus) any increase (decrease) in accrued or
deferred taxes in the balance sheet.
To continue, the increase in net operating working
capital is equal to the:
Change in current assets – the
change in non-interest bearing operating current liabilities
Notice that not all the current liabilities are
included here, but only the non-interest bearing debt incurred in the normal
day-to-day operating activities of buying and selling the firm's goods, such as
accounts payables and accrued wages.
The final step involves computing the increase in
gross fixed assets (not net fixed assets). Another way to arrive at the same
result would be to find the increase in the net fixed assets and then add back
the accumulated depreciation.
Returning to LM Manufacturing, let’s now compute the
free cash flows. These calculations are
presented in Exhibit 6.
EXHIBIT 6
Free cash
flows for year ending 2006 (figures in $ thousands)
LM Manufacturing Company
Operating income $101
Depreciation $28
Earnings before interest, tax, depreciation and
amortization (EBITDA) $129
Tax expense $17
Less the change in income
tax payable $5
Cash taxes ($12)
Cash flows from
operations $117
Change in current assets:
Change
in cash $5
Change
in accounts receivable $8
Change
in inventories $33
Change
in prepaid expenses $1
Change in current assets $(47)
Change in non-interest bearing operating current debt:
Plus the
change in accounts payable $15
Plus the
change in accrued wages $0
Change
in non-interest bearing current debt $15
Change in
net operating working capital ($32)
Cash flows - investment activities:
Increase
in fixed assets $79
Increase
in patents $25
Net cash
used for investments ($104)
Free
cash flows ($19)
We see that the free cash flows are negative in the
amount of $19,000. While $117,000 was generated from operations, this amount
was more than consumed by the increases in net operating working capital and
investments in long-term assets. We
should question where the firm found the cash to invest in assets when it did
not generate enough from operations to make all its investments. How about from the investors? Let’s compute the financing cash flows to see
if the firm’s investors provided the money.
... Now About
Your Brother-In-Law!
With an understanding of the
income statement and balance sheet, let’s return to your brother-in law’s
proposition to become a partner with him in the clothing business. You have constructed the income statement and
the balance sheet from the fragments of your dog-chewed papers. When you do, you get the following results
(in $ thousands):
Projected Income Projected
Balance
Statement Sheet
Sales $75
Cash needed in the business $6
Cost of goods sold $40
Inventories $14
Gross profits $35
Equipment $10
Operating expenses: Total
Assets $30
Office overhead $14
Accounts Payable $6
Advertising expense $16
90 day bank loan $10
Rent expense $4
Total Debt $16
Depreciation expense $10
Equity
Total operating expenses $44 Brother-in-law $3
Operating income ($9) Your Investment $2
Interest expenses $1
Total Equity $5
Earnings before taxes ($10) Total projected debt and equity $21
Taxes $0
Additional financing needed $9
Net income ($10) Total debt and equity needed $30
So, based on your estimates,
the venture would expect to incur a loss of $10,000. Furthermore, the balance sheet suggests that
the business will need $30,000 for investments in assets, which would come from
debt financing of $16,000 (you hope); $3,000 from the brother-in-law (if he has
it), and $2,000 from you, which totals $21,000, and not the $30,000 you
actually need. Thus, the business will need an additional $9,000. Maybe, just maybe, this is not quite the
opportunity your brother-in-law perceives it to be.
Calculating Financing Cash Flows
We will now compute the cash
flows to the firm’s investors, or what we call the financing cash flows. The cash flows from financing the business is
equal to:
+ increase
in debt principal
or
- decrease
in debt principal
+ increase
in stock
or
- decrease
in stock
Less
interest payments to creditors
less
dividends paid to stockholders
Thus, the financing cash
flows are simply the net cash flows received from or paid to the firm’s investors. If negative, then the cash flows that are
being paid to the firm’s investors, but if positive, then the investors are
providing cash to the firm. In the latter
situation where the investors are putting money into the firm, it will be
because the free cash flows are negative, thereby requiring an infusion of
capital—as is the case for LM Manufacturing.
Specifically, financing cash flows for the company are determined as
follows:
Increase in long-term debt $54
Interest exposure ($20)
Less change in interest
payable 0
Interest paid to investors ($20)
Common stock dividends ($15)
Net cash flows received from investors (paid to
investors) $19
As we expected, the investors, in net, invested more
money into the company than they received.
In fact, they provided $19,000—the exact amount of the firm’s negative
cash flows. As we noted earlier, the
cash flows generated by a company must equal the cash provided by the investors
or paid to the investors.
To conclude a firm's free cash
flows are more complicated than merely taking income and adding back
depreciation. The changes in asset
balances resulting from growth is just as important in determining the free
cash flows as is profits, maybe even more important sometimes. Hence, the owner-manager of a company is well
advised to think about profits and cash flows both, and if we can only watch
one, watch the cash flows, because if we run out of cash, they don't let us
play the game any longer.
Testing Your Understanding: Measuring Cash Flows
Given the following
information, compute the firm’s free cash flows and the investors’ cash flows.
Change in current
assets $25
Operating income $50
Interest expense $10
Increase in accounts
payables $20
Change in notes
payables $30
Dividends $5
Change in common stock $0
Increase in fixed
assets $55
Depreciation expense $7
Income taxes $12
FINANCIAL
RATIO ANALYSIS
Now that we have looked
carefully at the three primary financial statements used in understanding the
financial position of the company, we next want to restate the data in relative
terms (ratios) so that we may more effectively compare our company with
"comparable firms." The
purpose of using ratios is to identify the financial strengths and weaknesses
of a company, as compared to an industry norm or by looking at the ratios over
time. Typically, we use industry norms
published by firms such as Dun & Bradstreet or Robert Morris Associates[1].
In learning about ratios, we
could simply study the different types or categories of ratios, or we may use
ratios to answer some important questions about a firm's operations. We prefer the latter approach, and choose the
following four questions as a map in using financial ratios:
1.
How liquid is the
firm?
2.
Is management
generating adequate operating profits on the firm's assets?
3.
How is the firm
financed?
4.
Are the common
stockholders receiving sufficient return on their investment?
How liquid
is the company?
The liquidity of a business is
defined as its ability to meet maturing debt obligations. That is, does the firm here have the
resources, either in place or avail-
able, to pay the creditors when the debt comes due and
must be paid?
There are two ways to answer
the question. First, we can look at the
firm's assets that are relatively liquid in nature and compare them to the
amount of the debt coming due in the near term.
Second, we can look at the timeliness with which such assets are being
converted into cash.
Testing Your Understanding:
Measuring Cash Flows:
How Did You Do?
Earlier on, we asked you to
calculate a firm’s free cash flows and its investors’ cash flows. Your results should be as follows:
Free cash flows:
Operating income $50
Depreciation expense $7
Earnings before interest, taxes, depreciation
and amortization $57
Income taxes $12
After-tax cash flows from operations $45
Investments in net working capital:
Change in current assets $25
Change in accounts payables $20
Investments in net working capital: $5
Investment in fixed assets $55
Total investments $60
Free cash flows ($15)
Investors' cash flows:
Interest expense ($10)
Dividends ($5)
Increase in notes payables $30
Increase in common stock $0
Investors' cash flows $15
Measuring Liquidity:
Approach 1
The first approach compares
(a) cash and the assets that should be converted into cash within the year
against (b) the debt (liabilities) that is coming due and payable within the
year. The assets here are the current
assets, where the debt coming due is the current liabilities in the balance
sheet. Thus, we could use the following
measure, called the current ratio,
to estimate a company's relative liquidity:
Current ratio = (Eq.
1)
Furthermore, remembering that the three primary
current assets include (1) cash, (2) accounts receivable, and (3) inventories,
we could make our measure of liquidity more restrictive by excluding
inventories, the least liquid of the current assets, in the numerator. This revised ratio is called the acid-test (or quick) ratio, and is
measured as follows:
Acid-test ratio = (Eq. 2)
We can demonstrate the computations of the current
ratio and the acid-test ratio by using the LM Manufacturing Company's 2006
balance sheet (Exhibit 5). These
calculations and the industry norms or averages, as reported by Robert Morris
Associates, are as follows:
Industry
LM Average
Current ratio =
=
3.51
Acid-test
ratio =
=
1.38
Thus, in terms of the current ratio and the acid-test
ratio, LM Manufacturing is more liquid than the average firm in their industry. LM Manufacturing has $3.51 in current assets
relative to every $1 in current liabilities (debt), compared to $2.70 for a
"typical" firm in the industry; and the firm has $1.38 in current
assets less inventories per $1 of current debt, compared to $1.25 for the
industry norm. While both ratios suggest
that the firm is more liquid, the current ratio appears to suggest more
liquidity than the acid-test ratio. Why
might this be the case? Simply put, LM
has more inventories relative to current debt than do most other firms. Which ratio should be given greater weight
depends on our confidence in the liquidity of the inventories. We shall return to this question shortly.
Measuring Liquidity:
Approach 2
The second view of liquidity
examines the firm's ability to convert accounts receivables and inventory into
cash on a timely basis. The conversion
of accounts receivable into cash may be measured by computing how long it takes
to collect the firm's receivables; that is, how many days of sales are
outstanding in the form of accounts receivable?
We may answer this question by computing the average collection period:
Average collection period = (Eq. 3)
For LM Manufacturing, the average collection period,
if we assume that all sales are credit sales, as opposed to some cash sales, is
34.3 days, compared to an industry norm of 35 days:
LM
Industry
= 
= 
=
34.30
=
34.30
Thus, the company collects its receivable in about the
same number of days as the average firm in the industry. Accounts receivable it would appear are of
reasonable liquidity when viewed from the perspective of the length of time
required to convert receivables into cash.
We could have reached the same
conclusion by measuring how many times accounts receivable are "rolled
over" during a year, that being the accounts
receivable turnover. For instance,
LM Manufacturing turns its receivables over 10.64 times a year, that being[2].
=
=
=
10.64
=
10.64
Whether we use average collection period or the
accounts receivable turnover, the conclusion is the same: LM Manufacturing is comparable to the average
firm in the industry when it comes to the collection of receivables.
We now want to know the same
thing for inventories that we just determined for accounts receivable: How many times are we turning over
inventories during the year? In this
manner, we gain some insight about the liquidity of the inventories. The inventory
turnover ratio is calculated as follows:
=
(Eq.
4)
Note that sales in this ratio are being measured at
the firm's cost, as opposed to the full market value when sold. Since the inventory (the denominator) is at
cost, we want to measure sales (the numerator) also on a cost basis. Otherwise,
our answer would be biased[3].
The inventory turnover for LM
Manufacturing, along with the industry norm, is as follows:
LM
Industry
=
=
= 2.55
= 2.55
We may have just discovered a
significant problem for LM Manufacturing.
It would appear that the firm carries excessive inventory. That is, LM generates only $2.55 in sales (at
cost) for every $1 of inventory, compared to $4 in sales for the average
firm. Going back to the current ratio
and the acid-test ratio, we remember that the current ratio made the firm look
better than did the acid-test ratio, which means that the inventory is a larger
component of the current ratio than for other firms. Now we see that we are carrying excessive
inventory, maybe even some obsolete inventory.
These findings suggest that the inventory is not of the same quality on average
as for other firms in the industry.
Thus, the current ratio is probably a bit suspect.
Testing Your Understanding: Evaluating Watson’s Liquidity
The following information is taken from the Watson Company’s financial
statements:
Current
assets
$8,314
Accounts
receivables $4,238
Cash $1,583
Inventories $1,271
Sales
(all credit) $23,373
Cost
of goods sold $19,097
Total
current liabilities $8,669
Evaluate Watson’s liquidity based on the following norms in the
entertainment industry, found below:
Current
ratio 1.17
Acid-test
ratio 0.92
Accounts
receivable turnover 10.08
Inventory turnover 18.32
Check your answer a few pages later.
Question
2: Is management generating adequate
operating profits on the firm's assets?
We now begin a different line
of thinking that will carry us through all the remaining questions. At this point, we want to know if the profits
are sufficient relative to the assets being invested. We could compare our question somewhat to the
interest rate we earn on a savings account at the bank. When you invest $1,000 in a savings account,
and receive $60 in interest during the year, you are earning a six-percent
return on your investment ($60 ÷ $1,000 = 6%).
With respect to LM Manufacturing, we want to know something similar to
the return on our savings account, that being the rate of return management is earning
on the firm's assets.
In answering this question, we
have several choices as to how we measure profits: gross profits, operating profits, or net
profits after tax. Gross profit is not an acceptable choice because it does not
include some important information, such as the cost of marketing and
distributing the firm's product. Thus,
we should choose between operating profits and net profits. For our purposes, we prefer to use operating
profits, because it is independent of the company's financing policies. Since financing is explicitly considered in
our next question, we want to isolate only the operating aspects of the
company's profits at this point. In this
way, we are able to compare the profitability of firms with different
debt-to-equity mixes. Therefore, to
examine the level of operating profits relative to the assets, we like to use
the operating return on assets (OROA):
=
(Eq. 5)
LM’s profits
to assets relationship is presented in Exhibit 7.
EXHIBIT 7
LM
Manufacturing Profits to Assets Relationship for Fiscal Year Ended
December 31, 2006
The operating return on assets
for LM Manufacturing, and the corresponding industry norm, is shown below:
LM
Industry
=
= 
= 10.89%
= 10.89%
Hence, we see that LM
Manufacturing is not earning an equivalent return on investment to the average
firm in the industry. For some reason,
management is not generating as much income on $1 of assets as is their
competitors.
Evaluating Watson’s Liquidity: How Did You Do?
Watson Industry
Current ratio 0.96 1.17
Acid-test ratio 0.81 0.92
Accounts
receivable turnover 5.52 10.08
Inventory
turnover 15.03 18.32
Watson is not as liquid
as the average firm in the industry—no matter how you measure it! They do not have the liquid assets to cover
current liabilities, nor do they convert receivables and inventories to cash as
quickly.
If we were the managers of LM
Manufacturing, we would not be satisfied with merely knowing that we are not
earning a competitive return on the firm's assets. We would also want to know why we are below
average. For more understanding, we may
separate the operating return on assets, OROA, into two important pieces, these
being the operating profit margin and the total asset turnover. The firm's OROA is a multiple of these two
ratios, and may be shown algebraically as follows:
OROA = X (Eq.
6a)
or more completely,
OROA = X (Eq.
6b)
Looking at the first component
of the OROA, operating profit margin, we can know that five factors or
"driving forces" affect this ratio.
The driving forces include:
1.
The number of
units of product sold.
2.
The average
selling price for each product unit.
3.
The cost of
manufacturing or acquiring the firm's product.
4.
The ability to
control general and administrative expenses.
5.
The ability to
control the expenses in marketing and distributing the firm's product.
These influences should become apparent if we look at
the income statement and think about what is involved in determining the firm's
operating profits or income.
Total Asset turnover is a
function of how efficiently management is using the firm's assets to generate
sales. If Company A can generate $3 in
sales with $1 in assets compared to $2 in sales per asset dollar by Company B,
we may say that Company A is using its assets more efficiently in generating
sales, which is a major determinant in the return on investment.
Let's turn now to LM
Manufacturing to see what we can learn. We would compute LM's operating profit
margin and total asset turnover as follows:
LM
Industry
=
= 
= 12.16%
= 12.16%
=
= 
= 0.89
= 0.89
Recalling that:
OROA = X (Eq.
6a)
We see that for LM Manufacturing,
OROALM = 12.16%
X 0.89 = 10.89%
and for the industry,
OROAInd = 11% X 1.20
= 13.2%
Clearly, LM Manufacturing is
competitive when it comes to keeping costs and expenses in line relative to
sales, as reflected by the operating profit margin. In other words, management is performing
satisfactorily in managing the five "driving forces" of the operating
profit margin listed above. However,
when we look at the total asset turnover, we can see why management is less
than competitive on its operatinag return on assets. The firm is not using its assets
efficiently. LM Manufacturing only
generates $.89 in sales per one dollar of assets, while the competition is able
to produce $1.20 in sales from every dollar investment in assets. Here is the company's problem.
Testing Your Understanding: Evaluating Watson’s Operating Return on
Assets
Given the following
financial information for the Watson Company (expressed in $ thousands),
evaluate the firm’s operating return on assets (OROA).
Accounts
receivables $4,238
Inventories $1,271
Sales $23,373
Operating
profits $2,314
Cost of goods
sold $19,097
Gross fixed
assets $27,677
Accumulated
depreciation $12,482
Net fixed assets $15,195
Total assets $49,988
The peer group norms
are as follows:
Operating return
on assets 4.63%
Operating profit
margin 11.30%
Total asset turnover 0.34
Accounts
receivable turnover 10.08
Inventory
turnover 18.32
Fixed assets
turnover 1.05
Check your answers a
few pagers later.
We should not stop here with
our analysis. We now know the basic
problem, but we should dig deeper. We
have concluded that the assets are not being used efficiently, but now we
should try to determine which assets are the problems. Are we over invested in all assets, or more
so in accounts receivable or inventory or fixed assets? To answer this question, we merely examine
the turnover ratios for each respective asset.
Turnover ratio for: LM
Industry
Accounts
receivable
= =10.64
=10.64
Inventories
= 2.55
Fixed assets
= 1.58
LM Manufacturing's problems
are now even clearer. The company has
excessive inventories, which we had known from our earlier discussions, and
also there is too large an investment in fixed asset for the sales being
produced. It would appear that these two
asset categories are not being managed well and the consequence is a lower operatinag
return on assets. A detailed analysis of LM’s OROA is presented in Exhibit 8.
EXHIBIT 8
Analysis of LM Manufacturing Operating Return on
Assets (OROA)
= 
LM Mfg 10.89%
Industry 13.2%
= 
x 
LM Mfg 12.16% LM Mfg 0.89X
Industry 11% Industry 1.20X
 |
 |
||
LM Mfg 10.64 LM Mfg 2.55X LM Mfg 1.58X
Industry 10.43 Industry 4.00X Industry 2.50X
Question 3: How is the firm
finaning its assets?
We now turn our attention for
the moment (we shall return to the firm's profitability shortly) to the matter
of how the firm is financed. The basic
issue is the use of debt versus equity.
Do we finance the assets more by debt or equity? In answering this question, we will use two
ratios (many more could be used). First,
we will simply ask what percentage of the firm’s assets is financed by debt,
including both short-term and long-term debt, realizing the remaining
percentage has to be financed by equity.
We would compute the debt ratio as follows[4]:
Debt ratio = (Eq.
7)
For LM Manufacturing, debt as
a percentage of total assets is 32 percent, compared to an industry norm of 40
percent. The computation is as follows:
LM
Industry
Debt Ratio =
= 
= 32%
= 32%
Thus, LM Manufacturing uses somewhat less debt than
the average firm in the industry.
Evaluating Watson’s Operating Return on Assets How Did
You Do?
Watson generates a
slightly higher return on it assets than the average firm in the industry, 4.63
percent compared to 3.84 percent.
Watson provided a
higher operating return on assets, not by managing its operations better (lower
operating profit margin), but by making better use of its assets (higher total
asset turnover). The higher total asset
turnover is due to a higher fixed asset turnover, which makes up for the less efficient
management of accounts receivables and inventories (low turnovers).
Watson Industry
Operating return on
assets 4.63% 3.84%
Operating profit
margin 9.90% 11.30%
Total asset
turnover 0.47
0.34
Accounts receivable
turnover 5.52 10.08
Inventory turnover 15.03 18.32
Fixed assets
turnover 1.54 1.05
Our second perspective
regarding the firm's financing decisions comes by looking at the income
statement. When we borrow money, there
is a minimum requirement that the firm pay the interest on the debt. Thus, it is informative to compare the amount
of operating income that is available to service the interest with the amount
of interest that is to be paid. Stated
as a ratio, we compute the number of times we are earning our interest. Thus, a times interest earned ratio is
commonly used when examining the firm's debt position, and is computed in the
following manner:
= 
(Eq.
8)
(Eq.
8)
For LM Manufacturing,
LM
Industry
=
= 
= 5.05
= 5.05
LM Manufacturing is able to
service its interest expense without any great difficulty. In fact, the firm's profit could fall by as
much as 80 percent (($101,000 - $20,000) ÷ $101,000) and still have the income
to pay the required interest. We should
remember, however, that interest is not paid with income, but with cash and
that the firm may be required to repay some of the debt principal as well as
the interest. Thus, the times interest
earned is only a crude measure of the firm's capacity to service its debt. Nevertheless, it does give us a general
indication of a company's debt capacity.
Testing Your Understanding: Evaluating Watson’s Financing Policies
Given the information
below for Watson, calculate the firm’s debt ratio and the times interest
earned. How does Watson’s practices
compare to the industry. What are the
implications of your findings?
Total debt $26,197
Equity
Common
stock $10,627
Retained
earnings $13,164
Total liabilities
and equity $49,988
Operating profits $2,314
Interest expense $793
Industry norms:
Debt ratio 34.21%
Times interest earned 4.50X
Question
4: Are the owners (stockholders)
receiving a reasonable and adequate return on their investment in the firm?
Our last remaining question
looks at the accounting return on the equity investment; that is, we want to
know if the earnings available to the firm's owners or common equity investors
is attractive when compared to the returns of owners of similar companies in
the same industry.
We measure the return to the
owners as follows:
Return on equity
= 
(Eq. 9)
(Eq. 9)
The return on equity for LM Manufacturing and the
industry are 9.94 percent and 12.5 percent, respectively:
LM
Industry
=
=
= 10.1%
= 10.1%
It would appear that the
owners of the LM Manufacturing Company are not receiving a return on their
investment equivalent with owners involved with competing businesses. However, we may also ask the question,
"Why not?" In this case, the
answer would be twofold: First, LM Manufacturing is not as profitable in its
operation as its competitors. (Remember
the operatinag return on assets of 10.89 percent for LM Manufacturing, compared
to 13.2 percent for the industry.)
Second, the average firm in the industry uses more debt, which causes
the return on common equity to be higher, provided of course that the company
is earning a return on its investments that exceeds the cost of debt (the
interest rate). The use of the debt, we
must also note, increases the risk. An
example will help us understand this point.
Evaluating Watson’s Financing Policies: How Did You Do?
Watson Industry
Debt ratio 52.41% 34.21%
Times interest
earned 2.92X 4.50X
Watson uses
significantly more debt financing than the average firm in the industry. It also has lower interest coverage. The higher debt ratio implies that the firm
has greater financial risk. The lower
interest coverage is the result of Watson borrowing more debt, resulting in a
higher interest expense.
The Effect of Using Debt: An Example.
Assume that we have two
companies, Firm A and Firm B. These two
firms are identical in size, both having $1,000 in total assets and they both
have an operatinag return on assets of 14 percent. However, they are different in one
respect: Firm A uses no debt, while Firm
B finances 50 percent of its investments with debt at an interest cost of 10
percent. Assuming there to be no taxes
for the sake of simplicity, the financial statements for the two companies are
as follows:
Firm A Firm
B
Total assets $1,000 $1,000
Debt (10% interest rate) $0 $500
Equity 1,000 500
Total $1,000 $1,000
Operating income $140 $140
Interest expense 0 50
Net profit $140 $ 90
Computing the return on common equity for both companies, we see that
Firm B has a much more attractive return to its owners, 18 percent compared to
Firm A's 14 percent:
=
Firm
A: 
= 14% Firm B: = 18%
= 14% Firm B: = 18%
Why the difference? The answer is straight
forward. Firm B is earning 14 percent on
its investments, but only having to pay 10 percent for its borrowed money. The difference between the return on the
assets and the interest rate, that being 14 percent less the 10 percent, flows
to the owners. We have just seen the
results of financial leverage at work, where we borrow at a low rate of return
and invest at a high rate of return. The
result is magnified returns to the owners.
Testing Your Understanding: Evaluating Watson’s Return on Equity
The net income and also
the common equity invested by Watson’s shareholders (expressed in $ thousands)
are provided below, along with the average return on equity for the
industry. Evaluate the rate of return
being earned on the common stockholders’ equity investment. In addition to comparing Watson’s return on
equity to the industry, consider the implications of Watson’s operating return
on assets and its debt financing practices for the firm’s return on equity.
Net income $
1,300
Equity
Common
stock $10,627
Retained
earnings $13,164
Industry average
return on equity 2.31%
If debt is so attractive in terms of its ability to
enhance the owners' returns, why would we not use lots of it all the time? We may continue our example to find the
answer. Assume now that the economy
falls into a deep recession, business declines sharply, and Firms A and B only
earn 6 percent operatinag return on assets.
Let us recompute the return on common equity now.
Operating income $60 $60
Interest expense 0 50
Net profit $60 $ 10
Firm A: 
= 6% Firm B: = 2%
= 6% Firm B: = 2%
Now the use of leverage is
negative in its influence, with Firm B earning less than Firm A for its
owners. The problem comes from Firm B
earning less than the interest rate of 10 percent and the owners having to make
up the difference. We are now seeing the
negative aspect of financial leverage.
In other words, financial leverage is a two-edged sword; when times are
good, financial leverage can make them very, very good, but when times are bad,
financial leverage makes them very, very bad.
Thus, we see that the use of financial leverage can potentially enhance
the returns of the owners, but it also increases the uncertainty or risk for
the owners.
In conclusion, we see that the return on equity is a
function of:
1.
The difference
between the operatinag return on assets and the interest rate.
2.
The amount of
debt used in the capital structure relative to the firm size.
These relationships are also shown in Exhibit 9.
EXHIBIT 9
Analysis of LM Manufacturing Return on Equity
Relationships
Returning to the LM Manufacturing Company, we will
remember that the operating return on investment is less than that of competing
firms, so if the competing firms are paying comparable interest rates, the
return on equity for LM Manufacturing will by necessity be less. Also, we observed that the average firm in
the industry uses more debt, which magnifies the return on equity, but also
exposes the owners to additional risk.
So the return on equity for LM Manufacturing is less than competing
firms for two reasons: (1) it has less
operating profits, and (2) it uses less debt.
The first reason needs to be corrected by improved management of the
firm's assets. The second reason may be
a conscious decision of management not to assume as much risk as other firms
do. This latter issue is a matter of
"tastes and preferences."
Evaluating Watson’s Return on Equity: How Did You Do?
Watson’s return on
equity is 5.46 percent (5.46% = $1,300 million / $23,791 million common
equity), compared to 2.31 percent for the industry average. Watson’s return on equity is due to the firm
having a higher operating return on assets and using a lot more debt financing
than the average firm in the industry.
While Watson certainly provides it stockholders a higher return on
equity than other firms in the industry on average, it is still low compared to
the Standard & Poor’s 500 firms, which have historically had an average
return on equity of about 18 percent.
Thus, the entire industry is struggling to give attractive returns to
stockholders.
To review what we have learned
about the use of financial ratios in evaluating a company's financial position,
we have presented all the ratios for the LM Manufacturing Company in Exhibit 10. The ratios are grouped by the issue being
addressed, that being liquidity, operating profitability, financing, and
profits for the owners. As before, we
use some ratios for more than one purpose, namely the turnover ratios for
accounts receivables and inventories.
These ratios have implications both for the firm's liquidity and its
profitability; thus, they are listed in both areas. Also, we have shown both average collection
period and accounts receivable turnover; typically, we would only use one in
our analysis, since they are just different ways to measure the same
thing. Hopefully, seeing the ratios
together will help us to see the overview of what we have done.
EXHIBIT 10
LM Manufacturing, Company
Financial Ratio Analysis
Financial Ratios LM
Manufacturing Industry
1. Firm
liquidity
: 
= 3.51 
= 1.38 
= 34.30 
= 10.64 
= 2.55
2. Operating profitability
= 10.89% 
= 12.16% 
= 0.89 = 10.64 = 2.55 
= 1.58
3. Financing decisions
= 32% 
= 5.05
4. Return on equity
= 10.1%
STUDY PROBLEMS
1. (Ratio Analysis) Using Pamplin Inc.'s financial statements for the two most recent
years:
a. Compute
the following ratios for both 2005 and 2006 for Pamplin, Inc., from the
financial statements provided.
Industry Norm
2006
Current ratio 3.25
Acid test (quick) ratio 2.75
Inventory turnover 2.2
Average collection period 90
Debt ratio .20
Times interest earned 7.0
Total asset turnover .75
Fixed asset turnover 1.0
Operating profit margin 20%
Return on common equity 9%
b. How
liquid is the firm?
c. Is
management generating adequate operating profit on the firm’s assets?
d. How
is the firm financing its assets?
e. Are
the common stockholders receiving a good return on their investment?
Pamplin, Inc., Balance Sheet
at 12/31/02
and 12/31/03
ASSETS
2005 2006
Cash $150 $125
Accounts Receivable 350 375
Inventory 475 550
Current assets 975 1,050
Plant and equipment 2,425 2,750
Less:
accumulated depreciation (1,000) (1,200)
Net plant and equipment 1,425 1,550
Total assets $2,400 $2,600
LIABILITIES AND OWNERS’ EQUITY
2005 2006
Accounts payable $200 $150
Notes payable--current (9%) 0 150
Current liabilities 200 300
Long-term debt 600 600
Owners’ equity
Common stock 300 300
Paid-in capital 600 600
Retained earnings 700 800
Total owners’ equity 1,600 1,700
Total liabilities and
owners’ equity 2,400 2,600
Pamplin, Inc., Income Statement
for years ending 12/31/01
and 12/31/02
2005 2006
Sales $ 1,200 $ 1,450
Cost of goods sold 700 850
Gross profit 500 600
Operating expenses 30 40
Depreciation 220 200
Net operating income 250 360
Interest expense 50 64
Net income before taxes 200 296
Taxes (40%) 80 118
Net income 120 178
2. (Cash Flow Statement) Compute the cash flow for Pamplin, Inc., for
the year ended December 31, 2006, both for the firm and for the investors.
3. For the Jarmon Company, compute the free cash flows and
answer the “four questions.” For year ending June 30, 2007.
T. P. Jarmon Company Balance
Sheets
For 6/30/03 and 6/30/04
2006 2007
Cash $ 15,000 $ 14,000
Marketable securities 6,000 6,200
Accounts receivable 42,000 33,000
Inventory 51,000 84,000
Prepaid rent 1,200 1,100
Total current
assets $ 115,200 $ 138,300
Net plant and equipment 286,000 270,000
Total assets $ 401,000 $ 408,300
2006 2007
Accounts payable $ 48,000 $ 57,000
Notes payable 15,000 13,000
Accruals 6,000 5,000
Total current
liabilities $ 69,000 $ 75,000
Long-term debt $ 160,000 $ 150,000
Common stockholder’s equity $ 172,200 $ 183,300
Total liabilities
and equity $ 401,200 $ 408,300
T. P. Jarmon Company Income
Statement
For the Year Ended 6/30/04
Sales $600,000
Less: cost of
goods sold 460,000
Gross profits $140,000
Less: expenses
General and
administrative $30,000
Interest 10,000
Depreciation 30,000
Total 70,000
Earnings before taxes 70,000
Less: taxes 27,100
Net income avail. to common 42,900
Less: cash
dividends 31,800
To retained earnings $
11,100
INDUSTRY NORMS
Current Ratio 1.8
Acid Test Ratio .9
Debt Ratio .5
Times Interest Earned 10
Average Collection Period 20, days
Inventory Turnover 7
Oper. Income Return on Invest. 16.8%
Operating Profit Margin 14%
Gross Profit Margin 25%
Total Asset Turnover 1.2
Fixed Asset Turnover) 1.8
Return on equity 12%
[1]Dun and Bradstreet annually
publishes a set of 14 key ratios for each of the 125 lines of business. Robert
Morris Associates, the association of bank loan and credit officers, publishes
a set of 16 key ratios for over 350 lines of business. In both cases the ratios
are classified by industry and by firm size to provide the basis for more
meaningful comparisons.
[2]We could also measure the
accounts receivable turnover by dividing 365 days by the average collection
period: 365/34.30 = 10.64.
[3]While our logic may be
correct to use cost of goods sold in the numerator, practicality may dictate
that we use sales instead. Most
suppliers of industry norm data use sales in the numerator. Thus, for consistency in our comparisons, we
too may need to use sales.
[4]We will often see the
relationship stated in term of debt to equity, rather than debt to total
assets. We come to the same conclusion
with either ratio.
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