CHAPTER ASSESSMENT OF THE FIRM’S OPERATING EFFICIENCY AND FINANCIAL POSITION THROUGH FINANCIAL STATEMENTS ANALSYSIS Expected Learning Outcomes After studying Chapter 6, you should be able to: 1. Define financial statements analysis. 2. Understand the need to analyze the broader business environment. 3. Know the basics of profitability analysis. 4. Realize the limitations of financial statements analysis. 5. Analyze a business firm's short-term financial Position, asset liquidity and management, long- term financial position and Profitability using financial ratios. 6. Apply the DuPont Disaggregation Analysis. O00CHAPTER 6 ASSESSMENT OF THE FIRM’S OPERATING EFFICIENCY AND FINANCIAL POSITION THROUGH FINANCIAL STATEMENTS ANALYSIS Financial statement analysis is the process of extracting information from financial statements to better understand a company’s current and future performance and financial condition, ANALYZING THE BROADER BUSINESS ENVIRONMENT Quality analysis depends on an effective business analysis. The broader business context in which a company operates must be assessed as its financial statements are read and interpreted. A review of financial statements which reflect business activities is contextual and can only be effectively undertaken within the framework of'a thorough understanding of the broader forces that impact company performance. Some of these questions about a company’s business environment are: © Life cycle. At what stage in its life is this company? Is it a startup, experiencing growing pains? Is it strong and mature, reaping the benefits of competitive advantages? Is it nearing the end of its life, trying to milk what it can from stagnant product lines? © Outputs, What products does it sell? Are its products new, established or dated? Do its products have substitutes? How complicated are its products to produce? = Buyers. Who are its buyers? Are buyers in good financial condition? Do buyers have substantial purchasing power? Can the seller dictate sales terms to buyers? ‘* Inputs, Who are its suppliers? Are there many supply sources? Does the company depend on a few supply sources with potential for high input costs?82_ Chapter 6 Competition. In what kind of markets does it operate? Are markets open Is the market competitive? Does the company have competitive advantages? Can it protect itself from new entrants? At what cost? How must it compete to survive? © Financing. Must it seek financing from public markets? Is it going public? Is it seeking to use its stock to acquire another company? Is it in danger of defaulting on debt covenants? Are there incentives to tell an overly optimistic story to attract lower cost financing or to avoid default ‘on debt? Labor, Who are its managers? What are their backgrounds? Can they be trusted? Are they competent? What is the state of employee relations? Is labor unionized? * Governance. How effective is its corporate governance? Does it have a strong and independent board of directors? Does a strong audit committee of the board exist, and is it populated’ with outsiders? Does management have a large portion of its wealth tied to the company’s stock? © Risk. Is it subject to lawsuits from competitors or shareholders? Is it under investigation by regulators? Has it changed auditors? If so, why? Are its auditors independent? Does it face environmental and/or political risks? We must assess the broader business context in which a company operates as we read and interpret its financial statements. A review of financial statements, which reflect business activities, cannot be undertaken in a vacuum. It is contextual and can only be effectively undertaken within the framework of a thorough understanding of the broader forces that impact company performance. . BASICS OF PROFITABILITY ANALYSIS The primary goal of financial management is to maximize shareholders” wealth, not accounting measures such as net income or earnings per share (EPS). However, accounting data influence stock ‘prices and this data can be used to see why a company is performing the way it is and where it is heading, The previous section described the key financial statements and should how they change as a firm’s operations change. : In the succeeding section, we shall show the statements are used by managers t0 improve the firm’s stock price; by lenders to evaluate the likelihood that borrowers awrier Assessment of the Firm's Operating ..__ 83 will be able to pay off loans; and by security analysts to forecast earnings, dividends and stock prices. If management is to maximize a firm’s value, it must take advantage of the firm’s strengths and correct its deficiencies and weaknesses. Financial Analysis involves * comparing the firm’s performance to that of other firms in the same industry, and * evaluating trends in the firm’s financial position over time. These studies help managers identify deficiencies and take corrective actions. LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS Although financial statement analysis is a highly useful tool, the analyst should consider its limitations. The limitations involve the comparability of financial data between companies and the need to look beyond ratios: These limitations are: 1. Information derived by the ‘analysis are inot absolute measures of performance in any and all of the areas of business operations. They are only indicators of degrees of profitability and. financial strength of the firm. 2. Limitations inherent in the accounting data the analyst works with. These are brought about by among others: (a) variation and lack of consistency in the application of accounting principles, policies and procedures, (b) too-condensed presentation of data, and (c) failure to reflect change in purchasing power. 3. Limitations of the performance measures or tools and techniques used in the analysis, Quantitative measurements are not absolute measures but should be interpreted relative to the nature of the business and in the light of past, current and future operations. Timing of transactions and the use of averages can also affect the results obtained-in applying the techniques in financial analysis. 4. Analysts should be alert to the potential for management to influence the - outcome of financial statements in order to appeal to creditors, investors and others.84_Chapter 6 Limitations of analysis may be overcome to some extent by finding appropriate benchmarks used by most analysts such as the performance of comparable components and the average performance of several companies. in the same industry. FINANCIAL RATIO ANALYSIS There are a number of different ways to analyze financial statements. The most applied is the financial ratio. Financial ratio is a comparison in fraction, proportion, decimal or percentage of two significant figures taken from financial statements, It expresses the direct relationship between two or more quantities in the statement of financial position and statement of comprehensive income of a business firm. The ratio can be categorized as follows: 1. Liquidity ratios. These ratios give us an idea of the firm’s ability to pay off debts that are maturing within a year or within the next operating cycle. Satisfactory, liquidity ratios are necessary if the firm is to continue operating. 2, Asset management ratios. These ratios give us an idea of how efficiently the firm is using its assets. Good asset management ratios are necessary for the firm to keep its costs low and thus, its net income high. 3. Debt management ratios. These ratios would tell us how the firm has financed its assets as well as the firm’s ability to repay its long-term debt. Debt management ratios indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders. 4. Profitability. These ratios give us an idea of how profitability the firm is operating and utilizing its assets. Profitability ratios combine the asset and debt management categories and show their effects on return on equity. 5.. Market book ratios. These ratios which consider the stock price give us _ an idea of what investors think about the firm and its future prospects. Market book ratios tell us what investors think about the company and its prospects. All of the ratios are important, but different ones are more important for some companies than for others. For example, if a firm borrowed too much in the past and its debt now threatens to drive it into bankruptcy, the debt ratios are the key |Woe Assessment of the Firm's Operating .._ 85 Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and manufacturing capacity, the asset management ratios take center stage. The ROE is always important, but a high ROE depends on maintaining liquidity, on efficient asset management, and on the proper use of debt. Managers are, of course, vitally concerned with the stock price, but managers have little direct control over the stock market’s performance while they do have control over their firm’s ROE. So ROE tends to be the main focal point. A summaty of the ratios, their formula and significance is presented in Figure 6- 1 I. Ratios Used To Evaluate Short-Term Financial Position *(Short-Term Solvency and Liquidity) Name Formula Significance 1. Current ratio Total Current Assets Primary test of Total Current solvency to meet current obligations from current assets as a going concern; measure of adequacy of working capital. 2. Acid-test ratio or Total Quick Assets* Amore severe test of quick ratio Total Current Liabil immediate solvency; test of ability to meet demands from current assets. 3. a) Working Working Capital Indicates relative Capital to Total Assets liquidity of total assets total assets and distribution of resources employed. b) Working Current Assets /ess Capital Current Liabilities 4. Cash Flow Cash + Marketable Measures short-term Liquidity ratio Securities + Cash Flow liquidity by considering from Operating as cash resources Activities (numerator) cash plus Current Liabil cash equivalents plus cash flow from operating activities. *Cash + Marketable Securities + Accounts receivable86 Chapter 6 5. Defensive Interval ratio Quick Assets Projected Daily Operational Expenses > Measures length of ting in days the firm can operate on its present liquid resources, Il. Ratios Used To Evaluate Asset Liquidity and Management Efficiency Name Formula Significance 1. a) Trade Net credit sales * Velocity of collection of receivable ‘Average Trade ae Garey and turnover Receivable (net) notes; test of efficie cammee ae ofcolection, b) Average 360 days Evaluates the liquidity Collection Receivable Turnover of accounts receivable period or or and the firm’s credit number of Accounts Receivable policies. days’ sales Net Sales / 360 uncollected ot Sales / 2. Inventory Turnover a) Merchandise Cost of goods sold Measures efficiency of tumover “Average Merchandise the firm in managing Inventory and selling inventories, b) Finished Cost of goods sold -do- goods Average Finished goods inventory Inventory ) Goods in Cost of goods Measures efficiency of process manufactured the firm in managing turnover Average Goods-in and selling inventories. Process Inventory d) Raw materials Raw Materials Used Number of times raw turnover ‘Average Raw Materials _materials inventory was Inventory used and replenished during the period, e) Days supply 360 days Measures average in inventory Inventory Turnover number of days to sell or consume the average inventory. * or Net Sales if net credit sales figure is not available10. iL. Working Capital turnover, Percent of each current asset to total current assets Current assets turnover Payable turnover Operating cycle Days cash Free cash flow Investment or assets turnover Sales to fixed assets (plant assets turnover) Assessment of the Firm's Operating .._ 87 Net Sales Ave. Working Capital Amount of each current asset item Total Current Assets Cost of Sales + Operating Expenses + Income Taxes + Other Expenses (net) (excluding depreciation and amortization) ‘Ave. Current Assets Net purchases Average Accounts Payable ‘Average Conversion Period of Inventories + Average Collection Period of Regeivable + Days Cash ‘Ave. Cash balance Cash operating costs + 360 days Net cash from operating activities ~ Cash used for investing activities and Dividends Net Sales ‘Ave. Total Investment or Total Assets Net Sales ‘Ave. Fixed Assets (net) Indicates adequacy and activity of working capital, Indicates relative in- vestment in each current asset. Measures movement and utilization of current resources to meet operating requirements. Measure efficiency of the company in meeting trade payable. Measures the length of time required to convert cash to finished goods; then to receivable and then. back to cash. Measures availability of cash to meet average daily cash requirement. Excess of operating cash flow over basic needs. Measures efficiency of the firm in managing all assets. Tests roughly the efficiency of ‘management in keeping plant properties employed.88 Chapter 6 12, Capital intensity ratio Total A Net Sales Measures efficen the firm to generate sales through employment of its resources, Ill. Ratios Used To Evaluate Long-Term Financial Position or Stability / Leverage Name 1. Debt ratio 2. Equity ratio 3. Debt to equity ratio 4. Fixed Assets to long-term liabilities 5. Fixed assets to total equity 6. Fixed assets to total equity 7. Book value per share of ordinary shares 8. Times interest earned Formula Total Liabilities Total Assets Total Equity Total Assets Total Liabilities Total Equity Fixed Assets (net) Total Long-term Liabilities Fixed Assets (net) Total Equity Fixed Assets (net) Total Assets Ordinary shareholde! No. of outstanding ordinary shares Net Income before Interest and Taxes Annual Interest Charges —— Significance Shows proportion of a assets that are finance with debt. Indicates proportion of assets provided by owners. Reflects financial strength and caution to creditors. Measures debt relative to amounts of resources provided by owners. Reflects extent of investment in long-term assets financed from long-term debt. Measures the proportion of owners’ capital invested in fixed assets. Measures investment in long-term capital assets. Measures recoverable amount in the event of liquidation if assets are realized at their book values. Measures how many times interest expense Is covered by operating profit.Assessment of the Firm's Operating ..__ 89 9. Times preferred Net Income Indicates ability to dividend After Taxes provide dividends for requirement Preferred Dividends preference eared Requirement shareholders. 10. Times fixed Net Income before Measures coverage charges earned Taxes and Fixed capability more broadly Charges than times interest Fixed Charges earned by including (Rent + Interest + other fixed charges. Sinking Fund payment before taxes*) IV. Ratios Used To Measure Profitability and Returns to Investors Name Formula Significance 1. Gross profit Gross Profit Measures profit margin Net Sales ~ generated after consideration of cost of product sold. 2. Operating profit Operating Profit Measures profit margin Net Sales ~—=sogenerated after consideration of ‘operating costs. 3. Net profit margin Net Profit Measures profit (Rate of returnon Net Sales. —~=S«generated after net sales) consideration of all expenses and revenues. 4. Cash Flow Margin Cash Flow for Measures ability of the . operating activities firm to translate sales to Net Sales cash. 5. Rate of return on Net Profit, Measures overall assets (ROA) * ‘Ave. Total Assets efficiency of the firm in “managing assets and Altemative formula: generating profits. Asset Turnover x Net Profit margin 6, Rate of return on Net Income Measures rate of retum equity ** ‘Ave. Ordinary on resources provided Equity by owners. * Sinking fund payment before taxes = Sinking fund payment after taxes . 1 - Tax rate90 Chapter 6 + 7. Earnings per share 8. Price/earnings ratio 9. Dividend Payout Dividend Yield 5 Dividends per share i. 12. Rate of return on average current assets Rate of return per turnover of current assets 13. B Net income less preference dividends requirement Ave. ordinary shares outstanding Market Value per Share of Ordinary Shares Eamings per share of Ordinary Shares Dividends per share Earnings per share . Annual Dividends per share Market Value per share of Ordinary Shares Dividends Paid/Declared Ordinary shares outstanding Net Income ‘Ave. Current Assets Rate of return on Ave. Current assets Current Assets turnover Peso return on each ordinary share. Indicative of ability tp pay dividends, Measures relationship between price of ordinary shares in the open market anid prof earned on a per share basis. Shows percentage of earnings paid to shareholders. Shows the rate eamed by shareholders from dividends relative to current price of stock, Shows portion of income distributed to shareholders on a per share basis. Measures the profitability of current assets invested. Shows profitability of seach turnover of current assets. * If there Is interest-bearing debt, Rate of return on assets is computed as follows: Net Income + [Interest expense (1 - Tax rate)] Average Total Assets May also be computed as follows: ROE = Return on Assets x Equity Multiplier Equity Multiplier = 1 Equity Ratio ay A measure of the productivity of assets regardless of how the assets are financed, Figure 6-1, Sure. Summary of Most Commonly Used Ratios: ‘Their Formulas and Basic SignificanceAssessment of the Firm’s Operating ... Illustrative Case 6-1. 91 The financial statements of EBC Enterprises, Inc. will be used to illustrate the use of financial ratios in analyzing the company’s (1) liquidity, (2) activity or efficiency in managing resources, (3) leverage, and (4) profitability. Liquidity ratios are ratios that measure the firm’s ability to meet cash needs as they arise (e.g., payment of accounts payable, bank loans and operating costs). Activity ratios are ratios that measure the liquidity of specific assets and efficiency in managing assets such as accounts receivable, inventory and fixed assets. Leverage ratios are ratios that measure the extent of a firm’s financing, with debt relative to equity and its ability to cover interest and other fixed charges such as rent and sinking fund payments. Profitability ratios are ratios that measure the overall performance of the firm and its efficiency managing assets, liabilities and equity. The Statements of Financial Position as of December 31, 201X4 and 20X3, Income Statements and Statements of Cash Flows of EBC Enterprises, Inc. for years 20X4, 20X3 and 20X2 are given below: EBC Enterprises, Inc. ‘Statements of Financial Position at December 31, 20X4 and 20X3 (in thousands) 0x4 203 ‘Assets Current Assets Cash 2.0005 1,191.0 Marketable securities 2636.0 4,002.0 ‘Accounts receivable 4,7040 4383.5 ‘Allowance for doubtful accounts (2240) (208.5) Inventories 235205 18,3845 Prepaid expenses, 256.0 3795 Total current assets 32,9230 728.1320 Property, Plant and Equipment at sh 4055 405.5 Buildings and leasehold improvernents 9.1365 5.9640 Equipment 407615 6,884.0 20,3035 13,2535 Less Acciumulated depreciation and amortization 15.7640) (3765.0) Net property plant and equipment 145305 9,488.5 Other Assets 86.5, 334.0 Total Assels Paz 8420 PRGA92 Chapter 6 Liabilities and Equity Current Liabilifes P 7,147.0 P 3.7955 ‘Accounts payable 2,807.0 3,008.9 Notes payable - banks 942.0 758.0 Current matures of long-term debt 2,834.5 2.6565 Acorved labities 13,7305 P10.2160 Total curent liabilities 4216 3175 Taxes SD ‘ 10,5295 8.4875 4 1. Total atities 24,6815 19021 Equiy (Ordinary shares, par value P1, Gotan 1000000) ee, 4 and 2,401,500 st issued, 227,00 shares in 20X42 pods P2270 hata paidhin capital 478.5 4550 Retained earings 20,0875 16,1815 Total equity “9675 “18.9335 Total Liabilities and Equity 47,649.0 P37,954.5 EBC Enterprises, Inc. Income Statements and Retained Eamings For the Years Ended December 31, 20X4, 20X3 and 20X2 20K4 20K3 202 Net Sales 107 800.0 76,5000 70,3500 Cost of goods sold 64,682.0 45,939.5 40,802.0 Gross profit 29,547.0 Seling and administrative expenses 12,7490 Advertising 47705 Lease payments 3.6335 Depreciation and amortization 4.2505 Repais aid maintenance 115155 fost 23,9190 Operating profit 56280 (Other income (expenses) Interest income 369.0 Interest expense ° 70) Eamings before income taxes ie Income taxes . Net Income 2412 Earnings per common share ete Satereis of Retained Earnings — eamings at begir Nine. heonna year 16,181.5 14,1875 12,1300 Cash dividends (204 - 4697.0 2,955.0 2,948.0 POAT por Pt 0.33 per share; 20X3 - Retained earnings al end of year == 791.0) (931.0) (9205) 20,087.5 P16.181.5 P1455Assessment of the Firm's Operating... _93 EBC Enterprises, nc. ‘Statements of Cash Flows for the Years Ended December 31, 20X¢ and 20X3 (in thousands) 20KE TOE Cash Flow from Operating Activities - Direct Method Cash received from customers 107 495.0 P4305 Interest received 419 Cash paid to suppliers for inventory (664865) (49,9880) Cash paid to employees (S8A expenses) (18.3820) _(13,191.0) Cash paid for other operating expenses (148640) (10,6750) Interest paid (1,282.5) (1,138.5) Taxes paid (3,739.0) (2,160.5) ‘Net cash provided (used) by operating actities 5,012.0 18835) Cash Flow from Investing Activities Additions to property, plant and equipment (2,386.5) Other investing activities 8 Net cash provided (used) by investing activities 6.9025) (2,386.5) Cash Flow from Financing Activities «Sales of ordinary shares 1280 915 Increase (decrease) in short-term borrowings (includes current maturiies of long-term debt) (150) 927.0 Additions to long-term borrowings 2,800.0 3,941.0 Reductions of long-term borrowings (7580) (7965) Dividends paid (731.0) (931.0) Net cash provided (used) by financing activities “i640 32320 Increase (decrease) in cash & marketable securities (5285) (1,038.0) ‘Supplementary Schedule Cash Flow from Operating Activities - Indirect Method nosso Nene 4 inctded in net income: oe -— Noneash revenue and expense i Depreciation tage sz Poned (Wed yoy curren assets and iaites Cash provided (used) by current assets ties: Soe Gan fang 1475 fons ayate aust (6255) ‘Acerued liabilities ; ait wee Nt cash provided (used) by operations Additional information: Market price per share ~ 20X4: 30; 2013: P1794 Chapter 6 REQUIRED: Using the financial ratios, evaluate the company's financial position and operating results for years 20X4 and 20X3. Solution: EBC Enterprises, Inc. I. Analysis of Liquidity or Short-Term Solvency Current ratio Current Assets Current Liabilities 32.923 13,703.5 Formula: 20X4: 2.40 times : — 28,132 20X3: 10216 0 2.75 times Current ratio is widely regarded as a measure of short-term debt-paying ability. Current liabilities are used as the denominator because they are considered to represent the most urgent debts requiring retirement within one year or one operating cycle. A declining ratio could indicate a deteriorating financial condition or it might be the result of paring of obsolete inventories or other stagnant current assets. An increasing ratio might be the result of an unwise stock piling of inventory or it might indicate an improving financial situation. The current ratio is useful but tricky to interpret and therefore, the analyst must look closely at the individual assets and liabilities involved. Some analysts eliminate prepaid expenses from the numerator because they are not potential sources of cash but, rather, represent future obligations that have already been satisfied. EBC’s current ratio indicates that at year-end 20X4 current assets covered current liabilities 2.4 times down from 20X3. Its significance could be "best evaluated by comparing this with industry competitors or the company’s trend of liquidity over a longer period. AAssessment of the Firm's Operating .._95 As a measure of short-term liquidity, the current ratio is limited by the nature of the component. he liquidity of the assets may vary considerably from the date on which the statement of financial position is prepared. Furthermore, it could have a relatively high current ratio but not be able to meet the demands for cash because the accounts receivable are of inferior quality or the inventory is saleable only at discounted price. Quick or Acid test ratio Formula: Quick Assets . (Cash + Marketable Securities + Accounts Receivable, net) Current Liabilities 9,146.5 , 20X4: 6S = 4: 13.7033 0.67 times 9,368 4 20X3: — 2368 = : 3 70.216 0.92 times The acid-test (quick) ratio is a much more rigorous test of a company's ability to meet its short-term debts. Inventories and prepaid expenses are excluded from total current assets leaving only the more liquid assets to be divided by current liabilities. This is designed to measure how well a company can meet its obligations without having to liquidate or depend too heavily on its inventory. Since inventory is not an immediate source of cash and may not even be saleable in times of economic stress, it is generally felt that to be properly protected; each peso of liabilities should be backed by at least PI of quick assets. EBC’s quick ratio indicates deterioration between year 20X4 and year 20X3. An analyst might be quite concerned about several disquieting trends revealed in rising short-term debts and increasing inventories. The acid-test ratio must also be examined in relation to other firms in the same industry.96_Chaprer 6 Cash-Flow Liquidity Ratio + Marketable Securities + Formula: rom Operating Activities nt Liabilities . 2,030.5 +2,636+ 5,012 _ 0.70 times 20X42 13,703.5 1,191 + 4,002 + (1,883.5) _ 0.32 times 10,216 The cash flow liquidity ratio considers cash flow from operating activities (from the statements of cash flows) in addition to the truly liquid assets, cash and marketable securities. EBC’s current ratio and acid-test ratio both decreased between 20X3 and 20X4 which could be interpreted as a deterioration of liquidity. But the cash flow ratio increased indicating an improvement in short-term solvency. Furthermore, the reason for the decline in the current ratio and acid-test ratio could be traced to the 88% increase in accounts payable which could actually be a plus if it means that EBC, Inc. strengthened its ability to obtain supplier credit. Also, the firm’s cash flow from operating activities turned around from negative to positive amount which contributed to the stronger short-term solvency in 20X4. IL, Analysis of Asset Liquidity and Asset Management Efficiency Accounts Receivable Turnover Net Sales * Average Accounts Receivable balance 107,800 $4804 4.175 So 24.90 times Formula: 20X4: . 76,500 20X3: 4175" = 18.32 times * When available, credit sales can be substituted for net sales since credit sales produce receivable, ** Assumed average for 20X3,Assessment of the Firm's Operating... _97 The accounts receivable turnover roughly measures how many times a company’s accounts receivable have been turned into cash during the year. EBC, Inc. converted accounts receivable into cash 24.9 times in 20X4, up from 18 times in 20X3. The turnover if receivable has improved and this may indicate better quality of receivable and improvement of the firm's collection and credit policies. Generally, a high turnover is good because it could indicate efficiency in the collection of receivable, but a very high turnover may not be favorable because it may indicate that credit and collection policies are overly restrictive. Average Collection Period 365 days Accounts Receivable Turnover or Average Accounts Receivable ‘Average daily sales 20X4: a Formula: 14.6 days or 15 days y = Bo " 20X3: 19.9 days or 20 days = 8 1 The average collection period helps evaluate the liquidity of accounts receivable and the firm’s credit policies. The long collection period may be a result of the presence of many old accounts of doubtful collectibility, or it may be the result of poor day-to-day credit management such as inadequate checks on customers or perhaps no follow-ups are being made ‘on slow accounts. There could be other explanations such as temporary problem caused by a dépressed economy. The average collection period of accounts receivable is the average number of days required to convert receivable into cash. The ratios for EBC, Inc. indicate that during 20X4, the firm collected its accounts in 15 days on average, an improvement over the 20-day collection period in 20X3. Whether the average of 15 days taken to collect an account is good or bad depends on the credit terms EBC is offering its customers. If the credit terms are 10 days, then a 15-day average collection period would be viewed as good. Most customers will tend to withhold payment for as long as the credit terms will allow and may even go over a few days. This98 _ Chapter 6 a slow-paying ct Stomers, factor, added to ever-present problems with a few ng ¢ can cause the average collection period to exceed normal credit terms by aweek or so and should not cause great alarm. Inventory Turnover Cost of good sold Average inventory balance 64,682 204: SAIS AnIe Rn Slagaisk = 3.09 times + 18,384.; Sg Formula: —45.939.5 _ = 2.50 times 18,384.5* * Assumed average for 20X3. The inventory turnover measures the efficiency of the firm in managing and'selling inventory. It is computed by dividing the cost of goods sold by the average level of inventory on hand. The ratio is sometimes calculated with net sales as the numerator and the average level of inventory as the denominator. The inventory turnover of EBC, Inc. was 3.09 times in 20X4, an improvement over 20X3’s 2.50 times. Generally a high turnover is preferred because it is a sign of efficient inventory management and profit for the firm, But a high turnover could also mean underinvestment in inventory and lost orders, a decrease in prices, a shortage of materials or more sales than planned. A relatively low turnover could mean that the company is carrying too much inventory or it has obsolete, slow-moving or inferior inventory stock. The inVentory turnover varies, from industry to industry. Flowers and vegetable sellers would have a relatively high inventory turnover because they deal with perishable products but a jewelry store would have lower turnover but high profit margin.Ml ll lls A ied Babli Assessment of the Firm's Operating .. 99 Average Sale Period Formula: ——265 days _ Inventory turnover < 365, 20X4: ey re = 118 days 20X3: ta a : = 146 days The number of days being taken to sell the entire inventory one time (called the average sale or conversion period) is computed by dividing 365 days by the inventory tumover period. Generally, the faster inventory sells, the fewer funds are tied up in inventory and more profits are generated. EBC’s average sale or conversion period decreased from 146 day in 20X3 to 118 days in 20X4, This is evidence of efficiency in managing the inventories in 20X4. Fixed Asset Turnover Formula: Net Sales Average net property, plant and equipment 107,800 20x4: a E 14,539.5 + 9,488.5 = 8.97 times 2 _-— 20%: 9,488.5" * Assumed average for 20X3. 8.06 times The fixed asset turnover is another approach to assessing management's effectiveness -in generating sales from investments in fixed assets particularly for a capital-intensive firm. For EBC, Inc. the fixed asset turnover improved slightly because of the 41% in sales as compared with 26% increase in average fixed assets. This occurrence however should be further examined within the framework of the overall analysis of the company as well as that of the industry.100 _ Chapter 6 Total Asset Turnover Net sales Average Total Assets 107,800 47,649 + 37,9545 = 2.52 times 2 Formula: 20X4: = 76,500 = i 20X3: ar esase 2.02 times * Assumed average for 20X1. The total asset turnover is a measure of the efficiency of management to generate sales and thus earn more profit for the firm. When the asset turnover ratios are low relative to the industry or the firm’s historical record, it could mean that either the investment in assets is too heavy or sales are sluggish. There may however be justification for the low turnover. For example, the firm may have undertaken an extensive plant modernization or placed in assets is service at year-end which will generate positive results in the long-term. For EBC, Inc. the total asset turnover has improved primarily because of the improvement in fixed assets, inventory and accounts receivable turnover. IIL Analysis of Leverage: Debt Financing and Coverage Debt Ratio Total Liabilities Total Assets Formula: ‘ 24,681.5 20X4: t6N = 51.8% 19,021 20X3: “aa ota a” 37,9545 = 50.1% The debt ratio measures the proportion of all assets that are financed wit! debt. Generally, the higher the proportion of debt, the greater the risk because creditors must be satisfied before owners in the event o bankruptcy.Assessment of the Firm's Operating ... 101 The use of debt involves risk because debt carries a fixed obligation in the form of interest charges and principal repayment. Failure to satisfy the fixed charges associated with debt will ultimately result in bankruptcy. EBC’s debt ratios in 20X4 and 20X3 indicate relatively heavy reliance on borrowed capital and they have reached the generally considered maximum ratio of 50% debt and 50% equity. Too much debt would pose difficulty in obtaining additional debt financing when needed or that credit is available only at extremely high rates of interest and most onerous terms. Debt to Equity Ratio Total Liabilities Formula: Total Equity 24,681.5 20X4: 24.6815 e *% 22,967.5 te : 19,021 E ; 20X3: 8,933.5 1oOsGye The amount and proportion of debt and equity in a company’s capital structure are extremely important to the financial analyst because of the trade off between risk and return, While debt implies risk, it also provides the potential for increased benefits to the firm’s owners. When debt is used successfully, operating earnings exceed the fixed charges associated with debt, the return to the stockholders are magnified through financial leverage or “trading on the equity.” The debt to equity ratio measures the riskiness of the firm’s capital structure in terms of relationship between the funds supplied by creditors (debt) and investors (equity). EBC’s debt to equity ratio has increased between 20X4 and 20X3, implying a slightly riskier capital structure.102 Chapter 6 Times Interest Earned Operating Profit Formula: Interest Expense . 9,621.5 E 7A4 ti 20X4: nzon's A4 times . 5,903 Sea 20X3: 1,138.5 18 times Times interest earned ratio is the most common measure of the ability of a firm’s operations to provide protection to long-term creditors. The more times a company can cover its annual interest expense from operating earnings, the better off will be the firm’s investors. While EBC, Inc. increased its use of debt in 20X4, the company improved its ability to cover interest payment from operating profits. Fixed Charge Coverage Rodale: Operating Profit + Lease payments Interest Expense + Lease payments : 9,621.5 + 6,529 i 20X4: 9,621.5 + 6529 0 = 1,292.5 + 6,529 2.06 times 20X3: 5,903 + 3,555.5 rie 1,138.5 + 3,555.5 The fixed charge coverage measures the firm’s coverage capability t0 cover not only interest payments but also the fixed payment associated with leasing which must be met annually. This ratio is particularly important for firms that operate extensively with leasing arrangements, whether operating leases or capital leases. EBC, Inc. experienced a significant increase in the amount of annual lease payment in 20X4 but was still able to improve its fixed charge coverage- SWOI072 eseAssessment of the Firm's Operating ... _103 IV. Operating Efficiency and Profitability Gross Profit Margin Formula: . —Gross Profit__ Net Sales 20X4: — 43.118 107,800 40% 20X3: 30,560.5 76,500 " 39.95% Gross profit margin which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs and inventories or manufacturing of products and to pass along price increases through sales to customers. EBC’s gross profit margin for both 20X4 and 20X3 have been stable which is considered a positive sign even if the company had to offer probably discounted items to attract customers or feature “sale” to hasten up inventory turnover. Operating Profit Margin Operating Profit Net Sales 9,625 . . 107,800 te 5,903 76,500 Formula: 20X4: 20X3: 1.1% The operating profit margin is a measure of overall operating efficiency and incorporates all of the expenses associated with ordinary or normal business activities. EBC’s operating profit margin improved from 7.7% in 20X3 to 8.9% in 20X4. This is favorable because it indicates ability of the company to control its operating expenses while sharply increasing sales.104 Chapter 6 Net Profit Margin Formula: __Net Income __ , Net Sales 4,697 : 707,800 = 4.36% ae 107,800 ‘ 2,955 76500 = 3.87% as 76,500 ‘ Net profit margin measures profitability after considering all revenue and expenses, including interest, taxes and nonoperating items such as extraordinary items, cumulative effect of accounting change, etc. EBC’s net profit margin slightly increased despite increased interest and tax expenses and a reduction in interest revenue for marketable security investment. Cash Flow Margin Formula: Cash flow from operating activities Net Sales : 5,012 _ 20x4: 107,800 = 4.65% : (1,883.5) _ 20X3: . 76,500 = (2.5%) Cash flow margin is another important measure or perspective on operating performance. This measures the ability of the firm to translate sales to cash to enable it to service debt, pay dividends or invest in new capital assets. EBC’s cash flow margin in 20X4 was higher than the operating margin. This indicates a strong positive generation of cash. The performance if 20X4 represents a solid and impressive improvement over 20X3 when the firm failed to generate cash from operations and had a negative cash flow margin.ROA) Return on Investment on A; Net Income age Total Assets or Formula; Av Net Profit Margin x Total Asset Turnover iets firm has interest-bearing debt, ROA is computed using the following, formu Net Income + [ Interest (1- Tax rate)] Average Total Assets 20x4: 4,697 + [127.5 (1-45%)]_ 6,502 10.88% 33 2.955 + [1,138.5 (1- 43%). 20X3: Se SET Y 39,955 9.02% Return on Equity (ROE) Net Income ‘Average Stockholders’ Equity or Return on Assets x Financial Leverage or Equity Multiplier —_1 Equity Ratio Formula: Equity Multiplier 4,697 R9GTS+IB9BS = 22.42% 20X4: 2,955 oe 18,933.5 4 15.60% Return on assets and return on equity are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating return to shareholders. These ratios indicate the amount of profit earned relative to the level of investment in total assets and investment of common shareholders.106 Chapter 6 These ratios will also measure how effectively the company is using financial leverage. The Financial Leverage Index (FLI) is computed as follows: Return on Equity Return on Assets If the FLI is greater than | indicating the return on equity exceeds retum on assets, the firm is using debt effectively. If FLI is less than 1, the financial leverage is negative which means that the firm is not using debt successfully. EBC’s registered a solid improvement in 20X4 of both return ratios, Financial Leverage Index is calculated as follows: . 22.42% “ 20x4: cr 2.06 15.60% 2 20X3: Oat 1.73 EBC’s FLI of 2.06 in 20X4 and 1.73 in 20X3 indicates a successful use of financial leverage although borrowing increased. The firm has generated sufficient operating returns to more than cover the interest payments on borrowed funds. Other Ratios used to Measure Returns to Investors a) Earnings per share (EPS) Formula: Basic EPS = Net Income Weighted Average number of ordinary shares outstanding Diluted EPS = Net Income (as adjusted) Weighted Average number of ordinary shares outstanding and potential diluters \ anb) Assessment of the Firm's Operating ..__ 107 Basic EPS 4,697,000 20X4: —— 4,697,000, 2,401,500 + 2.297.000 = P2.00 2 2.955.900. 20X3: —2.955,900__ 3 2,297,000 P1.29 The Diluted EPS need not be computed because there are no potential diluters (e.g., convertible bonds, convertible preference shares or stock options and warrants) outstanding. PAS 33 issued by the ASC in 2008 is used to compute the Earnings per share. EBC’s earnings per ordinary share increased from P1.29 in 20X3 to P2.00 in 20X4 which is a clear indication in the improvement on the investment return of ordinary shareholders. Price Earnings Ratio (P/E) Market Price of ordinary shares Formula: — Earnings per share P — 30. = 20X4: : 15 —1L = 20X3: 127 13.39 The P/E ratio relates earnings per ordinary share to the market price at which the stock trades, expressing the “multiple” which the stock market places on a firm’s earnings. It is a combination of a number of factors such as the quality of earnings, future earnings, potential and performance history of the company. EBC’s price to earnings ratio is higher in 20X4 than in 20X3. This could be because the market is reacting favorably to the firm’s good year.108 Chapter 6 ©) Dividend payout ratio Formula: 20x4: ememlcnsze 0.41 = 31.78% 20X3: 1.29 EBC, Ine. reduced its cash dividend payment in 20X4._It is particularly unusual for a firm to reduce dividends during a good year. A possible explanation for this though may be the adoption of a new policy that will lower dividend payments in order to increase the availability of funds that may be reinvested for expansion purposes. d) Dividend yield . Dividends per share re: Market value per share 7 0.33 = ¥ 20X4: a 11% 20X3: a = 241% A low dividend yield would indi Inc. as an investment more for i its dividend yield, cate that an investor would choose EBC, its long-term capital appreciation than for Summary of Financial Statements Analysis of EBC, Inc. Short-Term Liquidity and Activity Short-term liquidity term creditors, mana fir analysis is of particular significance to trade and short- Bement and other parties concerned with the ability of @ rm to meet near-term demands for cash. EBC's Current and quick ratios decreased ind term liquidity. However, the cash flow Si 4 negative cash generation in 20X3, icating a deterioration of short- iquidity ratio improved in 20X4 after RET rement of the 109, The average collection period for accounts receivable and the inventory turnover improved in 20X4 which could indicate improvement in the quality of accounts receivable and liquidity of inventory. ‘The increase in inventory level has been accomplished by reducing holdings of cash and cash equivalents. This represents a trade-off of highly liquid assets for potentially less liquid assets. The efficient management of inventories is critical for the firm's ongoing liquidity. Presently, there appears to be no major problems with the firm’s short-term liquidity position. Long-Term Solvency The debt ratios for EBC show a steady increase in the use of borrowed funds. Total debt has increased relative to total assets, long-term debt has increased as a proportion of the firm's permanent financing and external or debt financing has risen relative to internal financing, Why has debt increased? The statement of cash flows shows that EBC has substantially increased its investment in capital or fixed assets and their investments have been financed largely by borrowing especially in 2013 when the firm had a rather sluggish operating performance and no internal cash generation. Given the increased level of borrowing, the times interest earned and fixed charge coverage improved slightly in 20X4, These ratios should however be monitored closely in the future particularly if EBC continues to expand, Operating Efficiency and Profitability As noted earlier, EBC has increased its investment in fixed asset as a result of store expansion. ‘The asset turnover increased in 20X4, the progress traceable to improved management of inventories and receivable, There has been substantial sales growth which suggests future performance potential. The gross profit margin was stable, a positive sign in the light of new store openings featuring discounted and “sale” items to attract customers. The firm also managed to improv: its operating profit margin in 20X4 principally due to the firm’s ability to control operating costs. The net profit margin also improved despite increased interest and tax expenses and a reduction in interest income from marketable security investment.