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Description Please read the Astral Record Case (available via the Harvard Business School coursepack link on Blackboard). Comment on any trends you notice or areas of concern based on Income Statement (Exhibit 1) and Balance Sheet (Exhibit 2) - thinking especially about what you know about how to perform financial statement analysis using tools we began to develop in Chapter 7. Please provide at least 4 different bullet points for each financial statement for a total of 8 bullet points. 3 attachmentsSlide 1 of 3attachment_1attachment_1attachment_2attachment_2attachment_3attachment_3.slider-slide > img { width: 100%; display: block; } .slider-slide > img:focus { margin: auto; } Unformatted Attachment Preview For the exclusive use of Y. Yan, 2020. UV0076 Version 1.5 ASTRAL RECORDS LTD., NORTH AMERICA: SOME FINANCIAL CONCERNS On August 24, 1993, her first day as chief executive officer (CEO) of Astral Records Ltd., North America (Astral NA), Sarah Conner confronted a host of management problems at the company. One week earlier, Astral NA’s president and CEO had been killed in a tragic accident. Soon thereafter, Conner was appointed to fill the position immediately. Several issues in her in-box that first day were financial in nature, either requiring a financial decision, or with outcomes that would have major financial implications for the firm. That evening, Conner asked to meet with her assistant, Louis Tang, to begin addressing the most prominent issues. Astral Records and the Compact-Disk Manufacturing Industry Astral Records North America had been founded as a joint venture between Astral Records Ltd., U.K., and an American venture-capital firm, Bendini, Lambert, and Locke (BLL). Astral NA’s sole business mission was to manufacture compact disks mainly as a subcontractor to major recording companies. Astral NA was known for producing the highest-quality compact disks in the industry. Compact disks were first mass-produced in 1980. By 1993, the manufacturing technology was fairly mature. Accordingly, small manufacturers had proliferated in the industry, exploiting the low entry barriers: a new, small plant would cost between $8 million and $10 million. Easy entry had led to price competition in recent years among disk replicators. One analyst said, The gross margins on CDs have eroded tremendously over the past five years. I don’t see that there’s any more maneuvering left on the price. This case was prepared by Robert Bruner, Robert Conroy, and Kenneth Eades. The firms and individuals in this case are fictional. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 1993 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 2/98. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. For the exclusive use of Y. Yan, 2020. -2- UV0076 Financial Questions Facing Sarah Conner That evening, Conner met with Louis Tang, a promising new associate whom she had brought along from BLL. Conner’s brief discussion with Tang went as follows: Conner: Back at BLL we looked at Astral as one of our most promising venture-capital investments. Now it seems that such optimism may not be warranted—at least until we get a solid understanding of the firm’s past performance and its forecasted performance. Did you have any success with this? Tang: Yes, the bookkeeper gave me these: the historical-income statements (Exhibit 1) and balance sheets (Exhibit 2) for the last four years. The accounting system here is still pretty primitive. However, I checked a number of the accounts, and they look orderly. So I suspect that we can work with these figures. From those statements, I calculated a set of diagnostic ratios (Exhibit 3). Conner: I see that you have been busy. Unfortunately, I can’t study them right now. I need you to review the historical performance of Astral NA for me, and to give me any positive or negative insights that you think are significant. Tang: When do you need this? Conner: At 7:00 a.m. tomorrow. I want to call on our banker tomorrow morning to get an extension on Astral’s loan. Tang: The banker, Farmington, said that Astral was “growing beyond its financial capabilities.” What does that mean? Conner: It probably means that he doesn’t think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performance for the next two years (ignore seasonal effects) and show me what our debt requirements will be at the fiscal years-ended 1994 and 1995. I think it is reasonable to expect that Astral’s sales will grow at 15% each year. Use whatever assumptions seem appropriate to you based on your historical analysis of the results. For this forecast, you should assume that any external funding is in the form of debt. Tang: But what if the forecasts show that Astral cannot repay the loan? Conner: Then we’ll have to go back to Astral NA’s owners, BLL and Astral Records U.K.,1 for an injection of equity. Of course, BLL would rather not invest more funds unless we can show that the returns on such an investment would be very attractive, and/or 1 Bendini, Lambert, and Locke owned a 60% interest in the equity of Astral NA. Astral Records Ltd., U.K., owned the remaining 40% interest. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. For the exclusive use of Y. Yan, 2020. -3- UV0076 that the survival of the company depends upon it. Thus, my third request is for you to examine what returns on book assets and book equity Astral NA will offer in the next two years and to identify the key driver assumptions of those returns. Finally, let me have your recommendations about operating and financial changes I should make based on the historical analysis and the forecasts. Tang: The plant manager revised his request for a new packaging machine and thinks that these are the right numbers (see the plant manager’s memorandum in Exhibit 4). Essentially, the issue is whether to invest now or to wait three years to buy the new packaging equipment. The new equipment can save significantly on labor costs, but carries a price tag of $1 million. My hunch is that our preference between investing now versus waiting three years will hinge on the discount rate. Conner: [laughing] The joke in business school was that the discount rate was always 10%. Tang: That’s not what my business school taught me! BLL always uses a 40% discount rate to value equity investments in risky start-up companies. But Astral is reasonably well established now and shouldn’t require such a high-risk premium. I managed to pull together some data (Exhibit 5) on comparable companies with which to estimate the required rate of return on equity. Conner: Fine. Please estimate Astral’s weighted-average cost of capital (WACC) and assess the packaging-machine investment. I would like the results of your analysis tomorrow morning at 7:00 a.m. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. 13,380 5,967 2,367 (21,714) 11,950 5,734 2,376 (20,060) 6,142 (2,427) 3,715 (1,647) 2,068 1,000 $1,068 6 Operating margin 7 Interest expense 8 Earnings before taxes 9 Income taxes 10 Net earnings Dividends on: 11 Dividends to all common shares 12 Retentions of earnings 1,000 $1,729 4,574 (1,845) 2,729 7,109 (2,535) $28,822 $26,202 1991 (actual) 1 Sales Operating expenses: 2 Production costs and expenses 3 Admin. and selling expenses 4 Depreciation 5 Total operating expenses 1990 (actual) Historical Income Statements (fiscal year ended August 23; all figures in thousands of dollars) 1,000 $ 943 3,212 (1,269) 1,943 6,476 (3,265) 17,847 7,020 2,667 (27,534) $34,010 1992 (actual) ASTRAL RECORDS LTD., NORTH AMERICA: SOME FINANCIAL CONCERNS Exhibit 1 -4- 1,000 $1,195 3,598 (1,403) 2,195 6,820 (3,222) 22,335 7,970 2,667 (32,972) $39,792 1993 (actual) UV0076 For the exclusive use of Y. Yan, 2020. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. 12,060 4,511 9,014 25,585 10,000 11,315 $46,900 Liabilities and stockholders’ Equity: Short-term borrowings (bank)1 Accounts payable Other current liabilities Total current liabilities Long-term debt2 Shareholders’ equity Total liabilities & stockholders’ equity 9 10 11 12 13 14 15 13,042 4,607 9,414 27,063 10,000 13,044 $50,107 $2,040 9,125 17,147 28,312 26,667 (4,872) 21,795 50,107 1991 (actual) 19,680 4,705 9,616 34,001 10,000 13,987 $57,988 $2,905 10,311 25,643 38,859 26,667 (7,538) 19,129 57,988 1992 (actual) 25,802 5,328 9,723 40,853 10,000 15,182 $66,035 $1,540 13,316 34,717 49,573 26,667 (10,205) 16,462 66,035 1993 (actual) UV0076 Short-term debt was borrowed from Yurbank at an interest rate equal to LIBOR + 1%. LIBOR (London Interbank Offered Rate) was a common benchmark for expressing the floating rate of interest on bank loans. 2 The company’s long-term debt of $10 million had been issued privately in 1989 to Bendini, Lambert, and Locke and to Astral Records Ltd., U.K. This debt was subordinate to any bank debt outstanding. 1 $1,764 8,113 15,861 25,738 23,667 (2,505) 21,162 46,900 Assets: Cash Accounts receivable Inventories Total current assets Gross property, plant, & equipment Accumulated depreciation Net property, plant, & equipment Total assets 1 2 3 4 5 6 7 8 1990 (actual) Historical Balance Sheets (fiscal year ended August 23; all figures in thousands of dollars) ASTRAL RECORDS LTD., NORTH AMERICA: SOME FINANCIAL CONCERNS Exhibit 2 -5- For the exclusive use of Y. Yan, 2020. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. For the exclusive use of Y. Yan, 2020. -6- UV0076 Exhibit 3 ASTRAL RECORDS LTD., NORTH AMERICA: SOME FINANCIAL CONCERNS Ratio Analyses of Historical Financial Statements (fiscal year ended August 23) Profitability: 1 Operating profit margin 2 Average tax rate 3 Return on sales 4 Return on equity 5 Return on assets Leverage: 6 Debt/equity ratio 7 Debt/total assets 8 EBIT/interest (×) Asset utilization: 9 Sales/assets 10 Sales growth rate 11 Assets growth rate 12 Days in receivables 13 Payables to COGS 14 Inventories to COGS Liquidity: 15 Current ratio 16 Quick ratio 1990 (actual) 1991 (actual) 1992 (actual) 1993 (actual) 23.4% 44.3% 7.9% 18.3% 4.4% 24.7% 40.3% 9.5% 20.9% 5.4% 19.0% 39.5% 5.7% 13.9% 3.4% 17.1% 39.0% 5.5% 14.5% 3.3% 1.95 0.47 2.53 1.77 0.46 2.80 2.12 0.51 1.98 2.36 0.54 2.12 55.9% 4.0% 6.0% 113.0 17.2% 60.5% 57.5% 10.0% 6.8% 115.6 16.0% 59.5% 58.7% 18.0% 15.7% 110.7 13.8% 75.4% 60.3% 17.0% 13.9% 122.1 13.4% 87.2% 1.01 0.39 1.05 0.41 1.14 0.39 1.21 0.36 This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. For the exclusive use of Y. Yan, 2020. -7- UV0076 Exhibit 4 ASTRAL RECORDS LTD., NORTH AMERICA: SOME FINANCIAL CONCERNS O’Rourke’s Memo re: New Packaging Equipment MEMORANDUM TO: Sarah Conner, President and CEO, Astral Records FROM: Harvey O’Rourke, Plant Manager DATE: August 24, 1993 SUBJECT: New Packaging Equipment Although our CD packaging equipment is adequate at current production levels, it is terribly inefficient. The new machinery on the market can give us significant labor savings as well as increased flexibility with respect to the type of packaging used. I recommend that we go with the new technology. The considerations relevant to the decision are included in this memo. Our current packaging equipment was purchased five years ago as used equipment in a liquidation sale of a small company. Although the equipment was inexpensive, it is slow, requires constant monitoring, and is frequently down for repairs. Since the packaging equipment is significantly slower than the production equipment, we routinely have to use overtime labor to allow packaging to catch up with production. When the packager is down for repairs, the problem is exacerbated and we may spend several two-shift days catching up with production. I cannot say that we have missed any deadlines because of packaging problems, but it is a constant concern around here and things would run a lot smoother with more reliable equipment. In 1994, we will pay about $5,000 per year for maintenance costs. The operator is paid $30,000 per year for his regular time, but he has been averaging $40,000 per year because of the overtime he has been working. The equipment is on the tax and reporting books at $100,000 and will be fully depreciated in three years’ time (we are currently using the straight-line depreciation method for both tax and reporting purposes and will continue to do so). Because of changes in packaging technology, the equipment has no market value other than its worth as scrap metal. But its scrap value is about equal to the cost of having it removed. In short, we believe the equipment has no salvage value at all. The new packager offers many advantages over the current equipment. It is faster, more reliable, more flexible with respect to the types of packaging it can perform, and will provide enough capacity to cover all our packaging needs in the foreseeable future. With suitable maintenance, we believe the packager will operate indefinitely. Thus, for the purposes of our analysis, we can assume that this will be the last packaging equipment we will ever have to purchase. Because of the anticipated growth at Astral, the current equipment will not be able to handle our packaging needs by the end of 1996. Thus, if we do not buy new packaging equipment by this year’s end, we will have to buy it after three years’ time anyway. Since the speed, capacity, and reliability of the new equipment will eliminate the need for overtime labor, we feel strongly that we should buy now rather than wait another three years. The new equipment currently costs $1 million, which we would depreciate over 10 years at $100,000 per year. It comes with a life-time factory maintenance contract that covers all routine maintenance and repairs at a price of $2,000 for the initial year. The contract stipulates that the price after the first year will be increased by the same percentage as the rate of increase of the price of new equipment. Thus, if the manufacturer continues to increase the price of new packaging equipment at 5% per annum as it has in the past, our maintenance costs will rise by 5% also. We believe that this sort of regular maintenance should insure that the new equipment will keep operating in the foreseeable future without the need for a major overhaul. Astral’s labor and maintenance costs will continue to rise due to inflation at approximately 5% per year over the long term. Because the manufacturer of the packaging equipment has been increasing its prices at about 5% per year, we can expect to save $157,625 in the purchase price by buying now rather than waiting three years. The marginal tax rate for this investment would be 40%. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. 1-year 3-year 5-year 10-year 30-year U.S. Treasury bills U.S. Treasury bills U.S. Treasury bills U.S. Treasury bonds U.S. Treasury bonds Source: Case writers’ estimates. 2.8% 3-month U.S. Treasury bills 6.2% 6.0% 5.1% 4.6% 3.0% 5.0% LIBOR ZEPORT IBBEX Corp. Donaldson, Inc. Harris-Beshel Dickenson ,Inc. 9.0% 8.0% 8% 7% 7.2% 2008 2003 2008 2013 1998 $100.00 100.00 109.20 100.00 $102.95 B Baa AA AA A Rating B 7 $2.20 10.0 $40.00 $25.00 1.30 1.60 10 60% ZEPORT Price Baa 10 0.00 15.0 20.00 16.80 0.10 1.45 16 40% IBBEX Corp. Maturity AA 8 0.75 10.0 18.00 5.25 1.40 1.20 12 90% Donaldson, Inc. Coupon AA 6 1.00 7.5 14.00 12.75 0.70 1.30 8 95% Harris-Beshel Recently Issued Bonds (as of 8/24/93) A 4 $0.95 5.0 $10.00 Bond Rating $ 5.50 Analysts’ 5-Year Earnings Growth Forecast (%) 0.45 Book Value per Share Last Annual Dividend per Share 1.50 Book D/E Number of Shares Outstanding (Millions) 9 Beta Market Price per Share 20% Price/ Earnings Ratio Dickenson, Inc. Name Percentage of Sales from CD Production Data on Comparable Companies and Capital-Market Conditions ASTRAL RECORDS LTD., NORTH AMERICA: SOME FINANCIAL CONCERNS Exhibit 5 -8- UV0076 For the exclusive use of Y. Yan, 2020. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. For the exclusive use of Y. Yan, 2020. -9- UV0076 Exhibit 5 (continued) Description of companies: Dickenson, Inc. This company was founded 50 years ago in Detroit. Its major business activities historically have been the production of original artist recordings, management and production of rock-and-roll road tours, and personal management of artists. It only recently has entered the CD production market. Harris-Beshel This company was a spin-off from a large conglomerate in 1978. Although the company was a leader in the production of CDS, it recently suffered a decline in sales. Infighting among the principal owners has fed concerns about the firm’s prospects. Donaldson, Inc. This company, founded only two years ago, has emerged as a very aggressive competitor in the area of CD production. It is Astral’s major competitor and its sales level is about the same. IBBEX Corp. This company has recently been an innovator in the production of CDs. Although CD manufacturing is not a majority of its business (film production is its main focus), the company is projected to be a major competitor within the next three years. ZEPORT This company was an early pioneer in the CD industry. Recently, however, it began to invest in new areas and has been moving away from CD production as its main focus of business. This document is authorized for use only by Yunting Yan in BU 620 Fall 2020 taught by Jordan Rippy, Johns Hopkins University from Aug 2020 to Oct 2020. ASTRAL.XLS This Spreadsheet supports STUDENT analysis of the case, "Astral Records Ltd., North America: Some Financial Concerns." (UVA -F1065, v. 1.5 ) Please note: 1) This is a working model. Assumptions / Inputs presented can be changed to vary the results. 2) As long as default spreadsheet calculation is "automatic" the impact of changing assumptions will be computed in real time. If calculation is set as "manual" you should press the F9 function key to recalculate results. To set numerical calculation settings to automatic look under tools, options, calculations menu. 3) This model intentionally incorporates a circular reference in its logic. In order to resolve this circularity, please instruct Excel to "iterate" 20 or so times in recalculating the model. This may be done by clicking on Tools/Options/Calculation, and then on Iteration. Revised: 7/7/98. Copyright (C) 1998, by the University of Virginia Darden School Foundation. Exhibit 1 ASTRAL RECORDS Historical and Projected Income Statements Fiscal Year Ended August 23 1 Sales Operating Expenses: 2 Production Costs and Expenses 3 Admin. and Selling Expenses 3 Depreciation 4 Total Operating Expenses 5 Operating Margin 6 Interest Expense 7 Earnings Before Taxes 8 Income Taxes 9 Net Earnings Dividends on : 15 Dividends to All Common Shs 16 Retentions of Earnings 1990 (Actual) 26,202 1991 (Actual) 28,822 1992 (Actual) 34,010 11,950 5,734 2,376 (20,060) 6,142 (2,427) 3,715 (1,647) 2,068 13,380 5,967 2,367 (21,714) 7,109 (2,535) 4,574 (1,845) 2,729 17,847 7,020 2,667 (27,534) 6,476 (3,265) 3,212 (1,269) 1,943 1,000 1,068 1,000 1,729 1,000 943 1993 (Actual) 39,792 22,335 7,970 2,667 (32,972) 6,820 (3,222) 3,598 (1,403) 2,195 1,000 1,195 Exhibit 2 ASTRAL RECORDS Historical and Projected Balance Sheets (fiscal year ended August 23; all figures in $ thousands) 1990 (Actual) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1991 (Actual) 1992 (Actual) Assets Cash Accounts Receivable Inventories Total Current Assets Gross Property Plant & Equipt. Accumulated Depreciation Net Property Plant & Equipt. Total Assets 1,764 8,113 15,861 25,738 23,667 (2,505) 21,162 46,900 2,040 9,125 17,147 28,312 26,667 (4,872) 21,795 50,107 2,905 10,311 25,643 38,859 26,667 (7,538) 19,129 57,988 Liabilities and Stockholders' Equity: Short Term Borrowings (Bank) Accounts Payable Other Current Liabilities Total Current Liabilities Long Term Debt Shareholders' Equity Total Liabs. & Stkhldrs' Eq. 12,060 4,511 9,014 25,585 10,000 11,315 46,900 13,042 4,607 9,414 27,063 10,000 13,044 50,107 19,680 4,705 9,616 34,001 10,000 13,987 57,988 1993 (Actual) 1,540 13,316 34,717 49,573 26,667 (10,205) 16,462 66,035 25,802 5,328 9,723 40,853 10,000 15,182 66,035 Exhibit 3 ASTRAL RECORDS Ratio Analyses of Historical and Projected Financial Statements (fiscal year ended August 23) 1990 (Actual) Profitability 1 Operating Profit Margin 2 Average Tax Rate 3 Return on Sales 4 Return on Equity 5 Return on Assets 1991 (Actual) 1992 (Actual) 23.4% 44.3% 7.9% 18.3% 4.4% 24.7% 40.3% 9.5% 20.9% 5.4% 19.0% 39.5% 5.7% 13.9% 3.4% 1.95 0.47 2.53 1.77 0.46 2.80 2.12 0.51 1.98 Leverage 6 Debt/Equity Ratio 7 Debt/Total Assets 8 EBIT/Interest (x) Asset Utilization 9 Sales/Assets 10 Sales Growth Rate 11 Assets Growth Rate 12 Days in Receivables 13 Payables to COGS 14 Inventories to COGS Liquidity 15 Current Ratio 16 Quick Ratio 55.9% 4.0% 6.0% 113.0 37.7% 132.7% 1.01 0.39 57.5% 10.0% 6.8% 115.6 34.4% 128.2% 1.05 0.41 58.7% 18.0% 15.7% 110.7 26.4% 143.7% 1.14 0.39 1993 (Actual) 17.1% 39.0% 5.5% 14.5% 3.3% 2.36 0.54 2.12 60.3% 17.0% 13.9% 122.1 23.9% 155.4% 1.21 0.36 Exhibit 5 ASTRAL RECORDS Data on Comparable Companies and Capital Market Conditions Name Dickenson Inc. Harris-Beshel Donaldson Inc. IBBEX Corp. ZEPORT % of Sales from CD Price/Earnings Value Line Production Ratio Beta 20% 9 1.5 95% 8 1.3 90% 12 1.2 40% 16 1.45 60% 10 1.6 Book Book Value D/E per Share 0.45 5.5 0.7 12.75 1.4 5.25 0.1 16.8 1.3 25 Market Price per Share 10 14 18 20 40 Number of Value Line Shares 5-Year Outstanding Last AnnualEarnings Growth Bond (millions) Dividend Forecast Rating 5 $0.95 4% A 7.5 $1.00 6% AA 10 $0.75 8% AA 15 $0.00 10% Baa 10 $2.20 7% B Introduction to Financial Statement Analysis COPYRIGHT © 2013 South-Western/Cengage Learning 1 Financial Statement Analysis— Overview • Steps involved in financial statement analysis and valuation COPYRIGHT © 2013 South-Western/Cengage Learning 2 Relation Between Financial Statement Analysis and Investment Decisions Time Dimension Past Present Future Financial Statement Analysis Profitability Expected Return Risk (Short-term and Long-term Liquidity) Risk Investment Decision COPYRIGHT © 2013 South-Western/Cengage Learning 3 Analysis of Profitability • Two measures of profitability – Return on equity – Return on assets COPYRIGHT © 2013 South-Western/Cengage Learning 4 Return on Equity (ROE) • Measures a firm’s performance in using the resources provided by shareholders to generate net income ROE = Net Income Average Shareholders' Equity COPYRIGHT © 2013 South-Western/Cengage Learning 5 Return on Assets (ROA) • Measures a firm’s performance in using assets to generate net income ROA = Net Income Average Total Assets COPYRIGHT © 2013 South-Western/Cengage Learning 6 Relation between Return on Equity and Return on Assets • Financial leverage is key in understanding the relation between ROE and ROA – Links return on equity and return on assets as follows ROE = ROA × Financial Leverage Net Income Average Shareholders' = Equity Net Income Average Total Assets COPYRIGHT © 2013 South-Western/Cengage Learning Average Total Assets × Average Shareholders' Equity 7 DuPont Decomposition of ROE and ROA COPYRIGHT © 2013 South-Western/Cengage Learning 8 Profit Margin Ratio • Measures a firm's ability to : – Control the level of expenses relative to sales – Increase selling prices relative to the level of expenses incurred – Or a combination of the two Net Income Profit Margin Ratio = Sales Revenue COPYRIGHT © 2013 South-Western/Cengage Learning 9 Analyzing Changes in Profit Margin Ratio • Changes in a firm’s expenses relative to sales cause the profit margin ratio to change • Common-size income statement: Individual income statement line items expressed as percentage of sales to explain the relation COPYRIGHT © 2013 South-Western/Cengage Learning 10 Total Assets Turnover • Measures a firm's ability to: – Generate sales from its investments in assets – Control the amount assets needed to generate a particular level of sales revenues • The smaller the assets needed to generate sales, the better COPYRIGHT © 2013 South-Western/Cengage Learning 11 Analyzing Changes in the Asset Turnover Ratio • Changes in turnover of specific asset types changes total assets turnover ratio – Accounts receivable turnover – Inventory turnover – Fixed assets turnover COPYRIGHT © 2013 South-Western/Cengage Learning 12 Accounts Receivable Turnover • Measures how quickly a firm collects cash • Days A/R Outstanding: the average number of days that elapse between the time of sale and the time to collect cash Accounts Receivable turnover Days A/R Outstanding COPYRIGHT © 2013 South-Western/Cengage Learning Sales = Average Accounts Receivable 365 = Accounts Receivable Turnover 13 Inventory Turnover • Indicates how fast firms sell their inventory • Increase in inventory turnover indicates reduced costs of inventory financing – Increase in inventory turnover caused by inventory shortages could signal a loss of customers Inventory Turnover = Ratio Cost of Goods Sold Average Inventory 365 Days Held in Inventory = Inventory Turnover Ratio COPYRIGHT © 2013 South-Western/Cengage Learning 14 Fixed Asset Turnover • Measures the relation between sales and investment in fixed assets • Low or decreasing fixed-asset turnover ratio may indicate an expanding firm Fixed-Asset Turnover Ratio = COPYRIGHT © 2013 South-Western/Cengage Learning Sales Average Fixed Assets 15 Complete DuPont Decomposition COPYRIGHT © 2013 South-Western/Cengage Learning 16 Analysis of Risk • Factors affecting risk: Macroeconomic factors Industry factors COPYRIGHT © 2013 South-Western/Cengage Learning Firm-specific factors 17 Liquidity Risk • Liquidity: Refers to whether the firm is able to pay its bills in a timely manner • Assessing liquidity requires a time horizon – Does a firm have sufficient cash to pay its employees tomorrow? – Will the firm have sufficient cash to pay its suppliers in six months? – Will the firm have sufficient cash to repay a loan due in five years? COPYRIGHT © 2013 South-Western/Cengage Learning 18 Measures of Short-Term Liquidity Risk • Current ratio • Quick ratio • Cash flow from operations to current liabilities ratio • Working capital turnover ratios COPYRIGHT © 2013 South-Western/Cengage Learning 19 Current ratio • Indicates a firm’s ability to meet its short-term obligations – Changes in the trend of the current ratio can mislead • Ratio of at least 1.0 indicates sufficient current assets to cover its obligations due within next year Current Assets Current Ratio = Current Liabilities COPYRIGHT © 2013 South-Western/Cengage Learning 20 Quick Ratio • Variation of the current ratio is the quick ratio • Numerator only includes current assets that a firm could convert quickly into cash Quick Ratio = Cash, Marketable Securities, Accounts Receivable Current Liabilities COPYRIGHT © 2013 South-Western/Cengage Learning 21 Cash Flow from Operations to Current Liabilities Ratio • Cash flow from operations to current liabilities ratio overcomes the following deficiencies: – Unusually large or small amounts -> resulting ratios could reflect abnormal conditions – Helps identify possible “window dressing” of ratios COPYRIGHT © 2013 South-Western/Cengage Learning 22 Working Capital Turnover Ratio • Help assess a firm’s operating cycle • Time period between cash outlays to purchase or produce products for sale and collections from customers and payments to suppliers COPYRIGHT © 2013 South-Western/Cengage Learning 23 Measures of Long-Term Liquidity Risk • Evaluates a firm’s ability to meet interest and principal payments on long-term debt and similar obligations • Measured with: – Debt ratios – Cash flow from operations to total liabilities ratio – Interest coverage ratio COPYRIGHT © 2013 South-Western/Cengage Learning 24 Debt Ratios • Liabilities to assets ratio = Total liabilities ÷ Total assets – Portion of assets financed with liabilities • Long-term Debt ratio = Long-term debt ÷ Total assets – Portion of assets financed with long-term debt • Debt-equity ratio = Long-term debt ÷ Shareholders’ equity – Financing obtained from long-term debt relative to shareholders’ equity COPYRIGHT © 2013 South-Western/Cengage Learning 25 Cash Flow from Operations to Total Liabilities Ratio • Measures the ability to pay all liabilities from cash without new debt or additional investment • Resembles the ratio for assessing short-term liquidity risk – Here the denominator includes all liabilities • Ratio of 20% or more is typical of financially healthy company COPYRIGHT © 2013 South-Western/Cengage Learning 26 Interest Coverage Ratio • Indicates the relative protection that operating profitability provides debt holders • Ratio of 3.0 means that the firm has three times the income before interest expense and income taxes to pay current interest charges Interest Coverage Ratio = Income before interest expense and income tax expense Interest Expense COPYRIGHT © 2013 South-Western/Cengage Learning 27 Limitations of Ratio Analysis • Factors that cause shortcomings in financial statements will affect the ratios computed from them • Changes in many ratios correlate with each other and thus do not provide independent insights • When comparing ratios between periods for the same firm, the analyst must recognize changes in economic conditions COPYRIGHT © 2013 South-Western/Cengage Learning 28 Limitations of Ratio Analysis • When comparing ratios of a particular firm with those of similar firms, the analyst must recognize differences among the firms • Financial ratios alone do not indicate good or poor management – They indicate areas that the analyst should investigate further COPYRIGHT © 2013 South-Western/Cengage Learning 29 Common-size Financial Statements • Shows each item included on the statement as a percentage of some amount – Common-size balance sheets express each item as a percentage of total assets – Common-size income statements express each item as a percentage of revenues • Useful for analyzing a particular firm over time or for comparing firms of different sizes COPYRIGHT © 2013 South-Western/Cengage Learning 30 Analyzing Firm Performance Using Financial Ratios • Two common approaches for evaluation involve comparing that firm to: – Its own performance, in an earlier time period • Time-series analysis – Other firms’ performance, over the same time period as performance is measured • Cross-section analysis COPYRIGHT © 2013 South-Western/Cengage Learning 31 Group Work – 7.30 • Using the common size B/S and I/S on page 272, match the company to the set of financial statements that most likely represent that company. • Hint: Look for unusually small or large line items and think about what kind of company that most likely represents. – For example, 2, 3, 5, and 9 all have R&D. What kinds of companies would have R&D Expense? COPYRIGHT © 2013 South-Western/Cengage Learning 32 Chapter 7 Homework • Costco Case COPYRIGHT © 2013 South-Western/Cengage Learning 33 Purchase answer to see full attachment Tags: financial statement financial ratio profit margin Liquidity Ratio Profitability Ratio User generated content is uploaded by users for the purposes of learning and should be used following Studypool's honor code & terms of service.
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