Understanding Corporate Finance Chapter 1 PDF

Chapter 1 Analyzing Financial Statements INTRODUCTION Financial statements can be the source of information for several dissimilar groups. Banks may wish to examine a firm's reports to ma...

Chapter 1 Analyzing Financial Statements INTRODUCTION Financial statements can be the source of information for several dissimilar groups. Banks may wish to examine a firm's reports to make lending decisions, or union locals may want to know how their company is performing in order to structure an upcoming round of contract negotiations−−the users of a company's external financial reports can be found both inside and outside the firm and can be friendly or hostile. The basic quantitative tools that analysts use to interpret a firm's reports are not difficult to grasp. As long as the statements that are being used are comparable, performance measures can be easily calculated. Today, government agencies and certain professional organizations oversee the form and content of external financial statements so that they can be successfully compared. This ability for an analyst to easily compare financial reports has not always been possible. In 1934, because of the disparities that existed in financial reports and other reasons, Congress created the Securities and Exchange Commission (SEC). The SEC was charged with regulating all companies that have publicly traded securities. Since the creation of the SEC, only such "public" companies have been required to publish external financial statements. Private companies, although not required to do so, prepare financial statements for external users, if not the public as a whole. A bank, for instance, often requires private companies to provide it with financial reports before it considers issuing loans. One of the primary objectives of the SEC is to ensure that a firm's external statements contain accurate financial information that fairly represents underlying economic reality. In order to execute this basic philosophy, the SEC periodically publishes Accounting Series Releases (ASRs), which dictate the standards to be followed by the accounting profession. Although the SEC has the Congressional authority to set accounting standards, it has through the years allowed the accounting profession to regulate itself, subject, naturally, to the SEC's approval. Since 1934, various committees of accounting professionals have provided this service. Today, the principal organization to which the SEC has implicitly granted authority to monitor accounting standards is the Financial Accounting Standards Board (FASB). The FASB has outlined a set of major goals for financial accounting: The objectives [of external financial reporting] stem primarily from the informational needs of external users who lack the authority to prescribe the financial information they want from an enterprise and therefore, must use the information that management communicates to them. Financial reporting should provide information that is useful to present and potential investors, creditors and other users in making rational investment, credit and similar decisions. 1  The role of financial reporting in the economy is to provide information that is useful in making business and economic decisions, not to determine what those decisions should be. The role of financial reporting requires it to provide evenhanded, neutral or unbiased information.1 The FASB further indicates that financial statements should report not only a firm's economic resources, but claims on those resources by creditors and investors as well. It is important to realize that the SEC and FASB do not precisely delineate all accounting standards, but rather they choose to provide flexible guidelines in many cases. Flexibility in accounting standards is desirable because there are vast differences among firms. A body of customs, not unlike English common law, has evolved and comprise what is known as Generally Accepted Accounting Principles (GAAP). One of the fundamental goals of GAAP is to provide a framework for financial reporting so that the statements of very different firms can be compared. Other goals of GAAP include rules governing: Accounting Periods ⎯ financial reports should be prepared periodically, and cover periods of equal length. Companies may choose the time of year that they desire their accounting periods to end (the SEC requires a report at least annually). Matching ⎯ in their statements, firms should include all expenses incurred to realize the revenues that they report. Conservatism ⎯ firms, given a situation where measurement uncertainties produce equally likely profit figures, should report the lowest figure. Firms should strive to anticipate all expenses, and not report revenues until they can be properly recognized. Deliberate understatement is forbidden. Understandability ⎯ the information contained in reports should be written at a level that a reader with a reasonable comprehension of business principles can understand. Relevance ⎯ reports should contain information that is relevant to the decisions at hand, and be user- oriented. Reliability ⎯ information that is provided must be complete and verifiable. Consistency ⎯ firms should strive to use consistent accounting methods so that their statements can be compared over time. The preceding list of concepts does by no means include all of the GAAP, but rather those that are especially relevant to external reporting. In addition to these principles, the FASB has identified specific requirements that apply to the external reports of all firms. These requirements include that all firms must report The Financial Position at Period's End 1 FASB, Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises" (Stanford, Conn.: 1978), pars. 28, 33, 34. 2  The Cash Flows for the Period The Earnings for the Period The Comprehensive Income for the Period The Investments by and Distributions to Owners for the Period In the next section, the financial statements which fulfill these requirements will be introduced. THE FINANCIAL STATEMENTS Before the statements can be presented, a few general concepts about financial statements should be understood. Since accounting principles allow a certain degree of leeway in external reporting, an analyst should become acquainted with the particular methods that the company under study has chosen to use in its reports. For example, a firm recently may have switched from the First-In-First-Out (FIFO) method of valuing inventory to the Last-In-First-Out (LIFO) method. In inflationary times this switch would result in the firm assigning a higher cost to the goods sold than it would have under the previous method. This in turn would cause the reported income to appear lower under the new method, given an equal sales level in the two years, and the analyst might err in his conclusion about the cause of the lower earnings unless it is realized that the switch has occurred. In addition to understanding the accounting principles that are being used, the analyst must look beyond the mere statements themselves to the footnotes of the reports. Frequently, the footnotes contain the clues that are necessary to understand which accounting principles apply. A third consideration for an analyst is whether the statements have been independently audited. Quarterly statements frequently are not examined. Where reports have been independently audited, the auditor's report should be read carefully. A qualified opinion attached to an annual report, where the auditor qualifies the company's application of accounting principles, may be cause for serious concern. It may, however, merely indicate one of several conditions, such as industry practice, that cannot be verified by the auditors using Generally Accepted Auditing Standards. With the idea that the statements of real companies should be approached somewhat cautiously, we are ready to proceed to the financial statements of a fictional toy manufacturer. The Balance Sheet The balance sheet, or statement of financial position, fulfills the FASB requirement that a firm report its financial position at period's end. It records a firm's assets, liabilities, and owners' equity at a point in time, the last day of the reporting period, in accordance with the universal accounting convention: Assets = Liabilities + Owners' Equity As mentioned earlier, reporting periods are chosen at management's discretion, but must be consistent from year to year. Firms ordinarily choose to end their fiscal years in a month where their statements will record their most favorable financial position, or the season which most accurately reflects their typical financial situation. As shown in Figure 1.1, the Clever Toy Company has chosen to end its reporting period on December 31st. At this time of year, as a company with seasonal sales, Clever Toy has much lower inventory levels than it would during the peak production months of the summer, when inventory is allowed to build for the heavy fall sales season. By December, large inventories have been converted to sales. A balance sheet prepared in June would record a very different picture. 3  Examine Figure 1.1 for a moment. Notice that the heading indicates that this report represents the financial position on a particular day. The accounts have been arranged into "current" (having due dates less than one year or reporting period) and "noncurrent" (having due dates greater than one year or reporting period) portions. Accounts are conventionally listed in order of decreasing liquidity. Liquidity is a measure of how easily an item may be converted to cash⎯the greater an item's liquidity, the easier it can be converted to cash. Since the financial position is displayed for more than one year, the report shown is called a comparative balance sheet Figure 1.1 The Clever Toy Company Balance Sheet As of December 31 ASSETS 2020 2019 Current Assets Cash $ 160,000 $ 88,000 Marketable Securities 146,000 42,000 Accounts Receivable 390,000 376,000 Inventories 372,000 404,000 Prepaid Expenses and Other Assets 97,000 128,000 Total Current Assets $1,165,000 $1,038,000 Long-Term Assets Investments 367,000 337,000 Land 64,000 64,000 Buildings 309,000 301,000 Equipment 708,000 720,000 Total Assets $2,613,000 $2,460,000 LIABILITIES AND OWNERS' EQUITY Current Liabilities Bank Notes Payable $ 42,000 $ 35,000 Current Portion - Long Term Debt 11,000 25,000 Accounts Payable and Accrued Expenses 532,000 473,000 Accrued Taxes 109,000 129,000 Total Current Liabilities $ 694,000 $ 662,000 Long-Term Liabilities Long Term Debt 370,000 326,000 Deferred Income Taxes 88,000 87,000 Total Liabilities $1,152,000 $1,075,000 Owners' Equity Common Stock (100,000 shares) 235,000 235,000 Paid-in Capital 50,000 50,000 Retained Earnings 1,176,000 1,100,000 Total Liabilities and Owners' Equity $2,613,000 $2,460,000 4 The Income Statement The income statement, also referred to as a statement of earnings or profit and loss (P&L) statement, fulfills the requirement that a firm disclose its earnings for a period and show a comprehensive report of the factors that influenced those earnings during that period. Therefore, the intent of the income statement is to match a company's expenses with its revenues for an entire reporting period, whether that is a week, month, quarter or fiscal year. The difference between the firm's revenues and all expenses, including taxes, is the firm's net income for the period. Net income is also referred to as net profit, net earnings, or profit after tax in various circles. It is very important to realize that the company's net income and its cash flow for the same period are rarely the same figure. When they are equivalent, it is purely coincidental. There are certain noncash expenses, such as depreciation and amortization, which reduce net income but do not reduce a firm's cash position, because noncash expenses do not involve a transfer of cash. All expenses are deducted from a firm's revenues to arrive at a net income figure, but all expenses do not use cash. Neither are all cash outlays recorded as expenses: purchases of inventory or property, plant, and equipment are not expenses. The Clever Toy Company's income statement is shown in Figure 1.2. Examine that statement for a moment. Notice that the heading clearly indicates that the report covers a period of time, in this case a full year. An income statement by convention begins with a figure representing the company's revenues (or sales) for the period. From this figure, the cost of producing the company's goods or services, which is the cost of goods sold or cost of sales, is then deducted. The remaining subtotal is referred to as the gross margin or gross profit. From the gross margin, the remaining expenses which the company chooses not to directly allocate to the cost of sales, are subtracted. These expenses include operating expenses, interest on loans, and taxes. Notice the presence of the noncash expense, depreciation. Financial analysts use certain subtotals from income statements in their calculations. Unfortunately, often there are variations in the statements which force analysts to perform detective work to ascertain what these subtotals are. Some of the more popular subtotals from income statements that have not been previously discussed include: Operating Income ⎯ The firm's income after operating expenses from its main line of business, before inclusion of income from investments, and before interest or taxes have been deducted. Earnings Before Interest and Taxes (EBIT) ⎯ The firm's total income from all sources before interest or taxes have been deducted. Earnings Before Tax (EBT) ⎯ The firm's EBIT, less interest charges. When examining income statements, analysts must be as familiar with the company's preparation methods as they are when they examine the firm's balance sheets. 5  Figure 1.2 The Clever Toy Company Income Statement For the Year Ended December 31 2020 2019 Net Revenues $3,414,000 $3,010,000 Less Cost of Goods Sold 1,886,000 1,580,000 Gross Profit 1,528,000 1,430,000 Less Operating Expenses Salaries 300,000 280,000 Sales and Administration 680,000 640,000 Other Expenses 80,000 79,000 Depreciation 175,000 175,000 Operating Income 293,000 256,000 Plus Income from Investments 26,000 18,000 Less Interest Expense 35,000 27,000 Operating Income Before Taxes 284,000 247,000 Less Income Taxes 120,000 104,000 Net Income $ 164,000 $ 143,000 Statement of Owners' Equity The statement of owners' equity, or statement of stockholders' equity, fulfills the requirement that a company publicize all investments in the firm, and all distributions to owners, during the course of the reporting period. Stated in other words, the purpose of this statement is to describe all changes which have occurred in the owners' equity accounts. Sources of new equity, or investments in the firm, include the firm's earnings and proceeds from the sale of stock during the reporting period, if any. Reductions in equity include the distribution of dividends, and the purchase and retirement of outstanding stock (outstanding shares which have been purchased but not yet retired are referred to as treasury stock). As in all financial statements, formats vary in statements of owners' equity. The format illustrated in Figure 1.3 is typical. Notice the entries in Figure 1.3. As in the income statement, this report clearly indicates that the statement covers an entire period. The three columns of figures listed make up all of the components of owners' equity, as listed on the balance sheet. Beneath the beginning balances, figures are entered only where they are appropriate. The dashed lines mean "not applicable". Notice which entries define sources, and which ones are uses of owners' equity, as discussed earlier in this section. Refer back to Figure 1.1, and compare the owners' equity entries on the balance sheet to this statement. A subset of this statement, which only includes the changes in the firm's retained earnings account for the period, is often included in a company's financial statements. It is referred to as a statement of retained earnings, and may be incorporated in the income statement. 6  Figure 1.3 The Clever Toy Company Statement of Owners’ Equity For the Year Ended December 31, 2020 Common Stock Paid-in Capital Retained Earnings Balance December 31, 2019 $235,000 $50,000 $1,100,000 Add: Net Income - - 164,000 Proceeds from Sale of Stock 0 0 - Subtract: Dividends - - 88,000 Increase in Treasury Stock 0 0 - Balance December 31, 2020 $235,000 $50,000 $1,176,000 Perhaps you have realized that the reason "retained earnings" are so named is that they are earnings that the firm has "retained" and not distributed in the form of dividends. Retained earnings are not cash. Compare the cash balance with the retained earnings entry on Clever Toy's balance sheet. The retained earnings entry represents the cumulative total of net income that the company has earned, and not distributed, since it came into being. The Statement of Cash Flows In December 1987, the Financial Accounting Standards Board (FASB) published Statement of Financial Accounting Standards No. 95, Statement of Cash Flows. This pronouncement requires for the first time that companies present a statement of cash flows in published financial statements. Prior to this announcement, companies presented a statement of changes in financial position (often referred to as a "funds statement"). The statement of changes in financial position could be presented on either a working capital flow basis or a cash flow basis. The working capital approach explained the changes in working capital, whereas the cash basis explained the changes in cash during a period. The current format of the statement of cash flows is shown in Figure 1.4. There are three major headings in Figure 1.4: (1) Cash Flow from Operating Activities, (2) Cash Flow from Investing Activities and (3) Cash Flow from Financing Activities. Cash Flow from Operating Activities begins with net income and proceeds to add noncash expenses and in addition shows certain other adjustments. Depreciation is added to net income since depreciation is a noncash expense. In other words, depreciation requires no cash outlay, yet it is an expense and does reduce net income. Adding it back to net income is justified since we are trying to translate net income to cash. Changes in current assets and liabilities is the next major section of the statement. As sales increase, one would expect to see increases in accounts receivable and inventories to support these sales. Unfortunately as receivables and/or inventories increase, cash is "used up." In this case receivables increased by $14,000 - See figure 1-1. An increase in inventories from one year to the next indicates that cash has been invested in the inventory increase. On the other hand, if inventories decrease, cash is "freed up." The inventory decrease from one year to the next indicates a disinvestment in this asset. In this case, inventories decreased by $32,000. For current liabilities such as accounts payable, the opposite entails. If an accounts payable increases, cash is "freed up" since the payment is delayed. If an accounts payable balance decreases from one year to the next, cash is "used up," since the company repaid more debt than it incurred during the year. In this case, the total current liabilities increase (other than taxes) was $52,000. 7  The second section of the statement of cash flows is cash flow from investing activities and presents cash flows related to the purchase and sale of property, plant and equipment and other noncurrent assets such as long- term investments. To some extent these purchases and sales are discretionary, since management may postpone the purchase of assets or even sell assets when the economic or business outlook is poor and cash is scarce. According to Clever Toy Company's balance sheet, building and equipment acquisitions net of dispositions was $171,000. This is calculated by taking the 2020 ending balance of buildings and equipment ($1,017,000) and adding to it the depreciation for 2020 ($175,000). The result is all buildings and equipment subject to depreciation during the year. The total is $1,192,000. Subtracting the beginning balance of the buildings and equipment for 2019 ($1,021,000) gives the acquisitions net of dispositions (171,000). In addition, the long-term investments increased by $30,000. Cash flows from financing activities shows the effects of financing transactions such as issuance and repayment of debt, issuance and repurchase of stock and payment of dividends. Clever Toy Company's long-term debt increased by $44,000 during 2020. This is reflected as a source of cash in the statement of cash flows. Had the long-term debt decreased during the year, this would have indicated that the company repaid more debt than it borrowed, and thus would have been a use of cash. The deferred income tax account (another long-term liability) increased by $1,000. The common stock paid-in capital accounts were unchanged indicating no new issuance of stock. The change in retained earnings of $76,000 has been partially explained by net income that was reported in the operating activities section. The remainder of the change in retained earnings is attributable to cash dividends paid of $88,000 as reported in the Statement of Owners' Equity. The dividends are a use of cash. The net cash used by financing activities was $43,000. The net increase in cash was $72,000. To summarize the cash flow statement, The Clever Toy Company earned $164,000 in 2020, but because of noncash expenses and changes in current assets and liabilities, it generated operating cash of $316,000. It obtained long-term financing of $44,000 and used the total cash generated of $360,000 to acquire buildings, equipment and long-term investments (net of dispositions) of $201,000. In addition, cash dividends of $88,000 were paid and cash increased by $72,000. 8  Figure 1.4 The Clever Toy Company Statement of Cash Flows (Indirect Method) For the year ended December 31, 2020 (dollars in thousands) Cash Flow From Operating Activities Net Income $ 164 Adjustment to Reconcile Net Income to Cash Provided by Operating Activities: Depreciation 175 Change in Current Assets and Liabilities Accounts Receivable (increase) decrease (14) Inventory (increase) decrease 32 Other current Assets (increase) decrease (73) Accounts Payable and Accrued Expenses increase (decrease) 52 Taxes Payable increase (decrease) (20) Cash Provided by Operating Activities $ 316 Cash Flow From Investing Activities Acquisition of Property, Plant and Equipment $ 201 Cash Provided by Investing Activities (201) Cash Flow from Financing Activities Issuance of Long-Term Debt $ 45 Cash Dividends Paid (88) Cash Provided (Used) by Financing Activities (43) Net Increase (Decrease) in Cash 72 Cash Balance at Beginning of Year 88 Cash Balance at End of Year $ 160 RATIO CALCULATION The balance sheet, income statement, owners' equity report, and cash flow statement often constitute the total amount of information that an analyst can obtain when researching a company. Through the years, certain ratios that can be derived from these statements have been developed. These ratios are easy to calculate, but can be deceptively difficult to interpret, especially when inferences must be made about the economic realities that lie beneath the numbers. The ratios that are used most often vary with the analysts' perspectives. An issuer of short-term credit will concentrate on numbers which indicate a firm's short-term health, for example. Ratios can be organized into three categories. Operating Performance ratios measure a firm's profitability and asset usage skill. Liquidity ratios measure a firm's ability to meet its short-term financial obligations, and its skill in managing working capital. Ratios of Financial Strength indicate the risk which can be associated with the way a company has packaged the debt and equity that it uses to finance its assets 9  The following ratios will be calculated from Clever Toy's financial statements. I. Operating Performance Ratios Profit Margin indicates a firm's ability to convert sales into earnings; also called return on sales. Clever Toy's profit margin for 2020 is $ 164,000 or 4.8%. $3,414,000 When considered alone, a profit margin of 4.8% might be deemed a small return on sales. However, the percentage must be considered within the context of the toy manufacturing industry. A 4.8% margin may be commendable for producers of toys. A retail grocer might be content with a profit margin of 1%. A software firm, on the other hand, may earn a 40% ROS. Gross Margin indicates the average percentage by which the sales price of a company's goods or services exceeds the cost of those goods or services. Clever Toy's gross margin for 2020 is $1,528,000 or 44.8%. $3,414,000 A manufacturing company's gross margin typically falls between 25 and 50%. Asset Turnover measures a firm's ability to generate sales through its assets; it is especially important to consider this ratio along with qualitative issues. For example, a high asset turnover may be the result of a company having neglected essential investments in new equipment rather than having highly productive assets. Our toy manufacturer's asset turnover equals $3,414,000 (net sales) divided by the average total assets for the year. The average total assets is the amount at the beginning of 2020, $2,460,000, plus the amount at the end of the year, $2,613,000, divided by 2. $3,414,000 divided by $2,536,500 is 1.35. Thus, Clever Toy "turns over" its assets 1.35 times per year. A capital-intensive firm such as an electric utility may have an asset turnover below one, while a service-oriented firm could turn its assets ten times in a year. Return on Assets (ROA) is considered by many to be the best indicator of a firm's asset usage skill, and is composed of two elements. ROA is also referred to as return on investment (ROI). Return on Assets = Profit Margin x Asset Turnover or: You can easily derive ROA by dividing net income by average total assets, but by examining the two components you can determine where changes in the firm's ROA may have come from. 10  Clever Toy's ROA for 2020 is 4.8% x 1.35 or 6.48%. In industrial settings, ROA figures between 5 and 10% are common. By contrast, a well-managed bank may have an ROA as low as 1.0%. Return on Equity (ROE) measures the return on investment for the firm's shareholders a bit more discretely than the ROA ratio. ROA includes the return for both owners and creditors (since assets are typically funded by a combination of debt equity). In this formula, net income (after interest and taxes) may be used unless there are holders of preferred stock. "Net income available to shareholders" is net income minus any dividends paid to preferred stockholders. Since Clever Toy has never issued preferred stock, its ROE for 2020 is $164,000 divided by the average owners' equity, $1,423,000, or 11.5%. This figure is in the range of a typical industrial company. Earnings per Share (EPS) is simply the company's net income available to shareholders divided by the average number of shares of common stock outstanding during the year; analysts use changes in this figure from period to period to measure a company's performance. Recent criticisms have been leveled at those who focus too closely on this measure, because of its short-term perspective. Nevertheless, it remains an extremely sensitive and influential measure. Clever Toy's EPS for 2020 is Since firms may have different numbers of common shares outstanding, it is not generally useful to compare EPS figures among companies. Price-Earnings Ratio (P/E) is the market price of the company's stock divided by EPS; it is the multiple of a firm's earnings per share that investors are willing to pay for one of the company's shares. The P/E indicates the stock market's opinion of a company's prospects for growth and earnings, as well as the market's perception of the firm's risk. If the market perceives that a company's earnings or growth potential has improved, then the P/E will generally rise. If a firm's prospects deteriorate, or its perceived risk in the eyes of the market increases, then the P/E will generally fall. Since our toy company's stock is currently trading at $30.00 per share, its P/E is A P/E is high or low with respect to an industry or stock exchange average. If the exchange on which Clever Toy's stock is traded has an average P/E of 12 for all companies, then 18.3 would be considered fairly high, though not extraordinarily so. Payout Ratio refers to the percentage of earnings per share that a company distributes in the form of dividends, or similarly, the percentage of net income that a company pays out in dividends. This percentage is influenced by the composition of the firm's shareholders, the type of industry that the firm is in, and the firm's growth prospects. Generally, young, high-growth companies pay few, if any, dividends, while more mature companies in mature industries tend to pay higher dividends. Clever Toy's payout ratio in 2020 is 11 A payout ratio of 55% is reasonably high and reflects the mature industry in which Clever Toy competes. Times Interest Earned is a ratio that indicates how many times a firm's earnings exceed its interest obligations, and is used by creditors as a rough estimate of the firm's ability to meet its payments. However, because earnings are not equivalent to cash flows, it is only an approximation. The numerator in this ratio, EBIT, is used instead of Net Income, because it is the intent of the ratio to reveal how many times interest charges could be covered by the annual income. Including interest expense or its affect on taxes in the numerator would double-count the coverage. The times interest earned ratio for Clever Toy is $293,000 + $26,000 divided by $35,000, or 9.11 in 2020. The firm's earnings have exceeded its interest obligations 9.11 times. There are variations on this ratio in which other obligations such as dividends, sinking funds, and various combinations may be substituted in the denominator. These kinds of calculations are collectively referred to as coverage ratios. II. Liquidity Ratios Current Ratio measures a company's ability to meet short-term obligations and unforeseen needs, and is stated in terms of working capital. Acceptable current ratios are varied because industries differ in their working capital requirements. Generally, creditors accept lower current ratios in stable industries than they do in others. Clever Toy's current ratio for 2020 is: Quick Ratio is a variation of the current ratio which uses only assets which can readily be converted into cash in the numerator; this ratio is sometimes referred to as the acid test ratio. Some analysts prefer this ratio because they question a firm's ability to convert assets other than cash equivalents (such as inventory) completely into cash, as the current ratio assumes. A quick ratio which is excessively high suggests that the firm may not be productively employing its cash. The quick ratio for Clever Toy in 2020 is As with the current ratio, industry specific figures are the only relevant guide for comparison of quick ratios. 12  Receivables Turnover indicates how quickly a company ordinarily converts accounts receivable into cash. This ratio can perhaps be one of the most misleading. One must remember that the balance sheet is a snapshot of the company's finances, which are likely to vary significantly during a year. Inventories build toward peak selling seasons and then are sold and converted to accounts receivable or cash. However, if one remembers this caveat, the ratio can be a useful tool. The ratio for this toy company in 2020 is $3,414,000 divided by the average accounts receivable figure for 2020, $383,000, or 8.91 times. Essentially, this ratio indicates that if the December 31 balance of accounts receivable is representative of the average balance throughout the year, then the receivables "turn over" about 9 times during the year. Days Sales Outstanding (DSO) merely converts the receivables turnover figure into the equivalent number of days. The receivables turnover figure for Clever Toy calculated above is an annual one. Therefore, the DSO is 365 days divided by 8.91 times, or 40.96. The average age of an uncollected account is therefore about 41 days. The most useful comparisons of DSO figures are ordinarily conducted within a firm. If, for instance, a firm's stated collection policy is terms of 30 days, and the average "age" of the company's receivables exceeds that by several weeks, then actions should be taken to bring the receivables into line. Inventory Turnover is another indicator of how well a company is managing its working capital accounts, in this case its investment in inventory; in managing inventory, a company must solve the dilemma of over- investment in inventory versus the risk of stockouts. Generally, companies strive to maximize this ratio. Cost of goods sold is used in the numerator rather than sales because cost of goods sold represents the total amount of inventory that was sold during the period. Sales figures include markups over the cost of goods sold. As with the receivables turnover, the calculation of inventory turnover can be misleading when annual figures are used. Clever Toy's turnover ratio is: $𝟏, 𝟖𝟖𝟔, 𝟎𝟎𝟎 𝒐𝒓 𝟒. 𝟖𝟔 𝒕𝒊𝒎𝒆𝒔 𝒊𝒏 𝟐𝟎𝟐𝟎 $𝟑𝟖𝟖, 𝟎𝟎𝟎 You should look for trends within a company when you consider this ratio. As with DSO, an inventory turnover figure that is slipping (increasing disproportionately to an increase in sales, for instance) should be regarded with concern. Days Inventory converts the above ratio into days in the same manner as DSO. Therefore, our toy company's average days inventory is 13 Operating Cycle calculations allow an analyst to estimate how long it takes a business to complete the cycle of (1) purchase of inventory, (2) conversion of inventory to finished goods, (3) sale of finished goods, and (4) collection of the ensuing receivable. It should be a corollary to the calculation of a current ratio. Operating Cycle = DSO + Days Inventory The operating cycle for our company in 2020 is 75 + 41 = 116 days. A firm which is reducing the length of this cycle would be improving its performance. Accounts Payable Turnover indicates how far a company is "stretching" its trade payable obligations. Since companies are not required to divulge their purchases during a reporting period, the cost of goods sold plus changes in inventory levels between periods is used as a proxy by many analysts. For Clever Toy this proxy figure is the COGS, $1,886,000, minus the decrease in the inventory level from 2019 to 2020, $32,000, which nets $1,854,000. The average accounts payable for the year is $502,500. The turnover ratio is thus 3.68 times for 2020. A company's discretion in controlling this ratio depends on its creditors, and to what extent its payables have been previously extended. Days Payable converts the above ratio into the appropriate number of days in exactly the same way as DSO is calculated. Our example is The operating cycle described earlier can be modified to include the number of days that payables are extended. This figure, DSO + Days inventory - DPO, is referred to as the working capital cycle. For Clever Toy the working capital cycle is 75 days + 41 days - 99 days or 17 days net. III. Financial Strength Ratios Debt to Total Assets calculations indicate the percentage of the company's assets which is being provided by creditors. The debt to assets ratio for Clever Toy is Aggressively managed firms will attempt to maximize this ratio, confident that the earnings of the company will more than cover the fixed cost of the debt. Acceptable maximums range from as low as.3 to over 1.0. As with most of these ratios, industry-specific norms are better guides than a general industry average. 14  Stockholders' Equity to Assets is the percentage which complements the ratio above by describing the percentage of assets paid through contributions of the firm's shareholders. The equity to assets ratio for Clever Toy is An investor in the equity of a company feels "safer" as this ratio approaches the theoretical limit of 1.0, because at that level a firm would have no liabilities. For years, the management of E. I. duPont deNemours held fast to the principle that debt was to be avoided; duPont's equity to assets ratio was consistently near 1.0. However, today the equity markets (and even duPont) believe that a firm should use a certain level of debt in its capital structure in order to financially lever the firm's earnings. Financial leverage will be discussed more fully in the next chapter. The result of these two opposing forces is that this ratio falls somewhere between the extremes, and an acceptable figure is industry-specific. Debt to Capitalization is a popular ratio calculated in many ways; as with all of these financial strength ratios, it is more useful when compared to other companies with similar characteristics in the same industry. The numerator of this ratio differs from that of debt to total assets in that the former includes only long term debt, i.e., that which will not mature within one year. Many debts can be classified as "long term", and therein lies the source of differences in the calculation. The important rule is for the analyst to be consistent. A popular method among financial analysts is to include deferred income taxes with long term debt in this ratio. Clever Toy's ratio thus calculated is Debt to Equity indicates the proportion of borrowing to equity in the capital structure. The ratio is calculated accordingly: Clever Toy's ratio is There are several other ratios of financial strength, and variations of the ones presented here, that may have the same names. When a particular ratio is quoted, therefore, a prudent analyst always determines how the ratio was calculated. 15 The duPont Formula The ratios described here under the categories of operating performance, liquidity, and financial strength do by no means exhaust the total number that are available. Analysts are always free to create ratios that best suit their purposes. Neither are ratios examined singly all the time. There are various combinations and series which are useful. One such series allows an analyst to investigate the components of a firm's return on equity. First developed at E.I. duPont deNemours, this famous series has come to be referred to as the "duPont Formula". To an informed analyst, the duPont formula presents a snapshot of almost every key ingredient of a firm's financial performance. The formula is calculated as follows: By examining changes in the components over a series of accounting periods, an analyst can determine which figures have most influenced the firm's profitability, or determine what may have caused changes. For example, if in the analysis of two years' financial statements you see that ROE has increased dramatically, you should know that: 1) the firm reaped more profit out of each dollar of sales, 2) assets were used more efficiently, thereby generating increased revenues, or 3) the financial leverage of the firm increased. The duPont methodology allows you to isolate which of these factors is responsible for the boost in ROE. Sustainable Growth Another widely used series of ratios is used to calculate a firm's sustainable rate of growth. Often, managers wish to know to what extent their company can grow without having to obtain outside financing. A company's sales cannot expand without commensurate growth in the level of inventory that the company must carry, or without the size of the company's investment in accounts receivable having to expand to accommodate additional customers. Not only does the asset base which generates sales have to expand, but as the logic of the fundamental accounting concept that: Assets = Liabilities + Owners' Equity suggests, the size of the debt or equity financing the assets must increase by the same degree. This internally funded sustainable growth rate (G) can be determined by making a few assumptions and then examining the following series of ratios, some of which have been introduced: If one assumes that in the coming year, the company will attempt to keep these ratios consistent with the current year, then the product of these ratios yields the internally funded sustainable rate of growth. For Clever Toy, the sustainable rate of growth is calculated as follows (numbers represent thousands of dollars). 16 In this example, Clever Toy would be able to expand its asset base by only 5% in the coming year without obtaining outside funds (either debt or equity). Take a few minutes and consider the relationships in the sustainable growth formula. As one can do in the duPont formula, it is quite easy to cancel terms and simplify this equation, to "ROE times the retention ratio (one minus the payout ratio)". Often this abbreviated form of the equation suits an analyst's needs adequately. However, an understanding of the components which make up the expanded version enables a manager to see the relationships among the firm's assets, liabilities, equity, and dividend policy. Moreover, the complete formula can reveal how certain decisions can influence the growth of a firm. This relationship will be explored further in a later chapter. FINANCIAL ANALYSIS Ratios from financial statements provide concise measures for business performance. However, ratios can have meaning only when they can be compared to something. Percentage changes in various components of financial statements are also sources of information for analysts, and they, too, require comparisons. Horizontal percentage changes measure differences from year to year in discrete components of financial statements. For example, a horizontal analysis of Clever Toy's income statement reveals the following changes from 2019 to 2020: Percentage increase Net Revenues 13.4% Cost of Goods Sold 19.4 Gross Profit 6.8 Total Operating Expenses 5.2 Operating Income 15.0 Net Income 14.7 Vertical Percentage analyses reveal percentage changes in another way. In this type of analysis, one component (usually sales) is chosen as a benchmark and used to express other components. A vertical analysis of Clever Toy's income statement for the years 2019 and 2020 reveals the following: Components as a Percent of Sales 2018 2017 Cost of Goods Sold 55.2% 52.5% Gross Profit 44.7 47.5 Total Operating Expenses 36.2 39.0 Operating Income 8.6 8.5 Net Income 4.8 4.7 The percentage changes in both kinds of analyses raise questions to which answers must be found. For example, the company reduced its operating expenses by nearly 3% of sales. Why did its net income increase by only one tenth of a percent of sales? 17  As mentioned previously, one of the fundamental goals of financial accounting is to ensure that financial statements are comparable. That comparability is possible not only within a firm, but between firms and industries, and over the course of years. Trend Analysis Many analysts are interested in how a company has performed over time. Such historical comparisons are used to judge how management has met its obligations in the past, and also as a basis to project how management may perform in the future. While year to year changes can be very important, trends are preeminent. Comparing various ratios in successive years is one way that trends may be discovered. Performing percentage analyses as illustrated above is another. Comparative Analysis An investor may have chosen a particular industry in which he plans to purchase stock, but still must choose a company, or a manager may wish to know how his company is performing compared to his company's chief competitor. Such situations provide opportunities for intercompany analyses. The same kinds of techniques that are used in intracompany analyses are appropriate. However, the most useful comparisons are made between companies of similar size. Also, you must be wary of the different accounting methods which may have been used. Finally, you should be aware of the different strategies that the companies are pursuing before drawing conclusions. For example, one company may have decided to produce its product as inexpensively as possible and to rely on advertising expenditures for sales. Its competitor may be producing a very expensive product which it believes will intrinsically attract customers. These two companies might be of equal size, have equal sales and incomes, yet have very different expense figures on their income statements. Comparison to Industry Extremely useful comparisons can be drawn between a company and the industry in which it competes. Industry figures are widely available from such publishers as Robert Morris Associates and Standard and Poor. One must realize, however, that several accounting practices are represented in industry composites. Nevertheless, a firm's performance relative to its industry has consequences as far reaching at its bond rating and the price its stock can command on Wall Street. A Final Word on Financial Analysis No financial analysis is complete that is comprised of mere numbers. A quantitative analysis must be balanced with serious consideration of the galaxy of qualitative issues in which companies exist. It is essential that an analyst understand how changes in the general and sectoral portions of the economy will affect an industry in general and a firm in particular. Changes in price levels, raw material availability, and interest rates can all have significant impact. An investigation of how a firm fared in the past when faced with such changes can be extremely rewarding to an observer. No less important than economic considerations is an understanding of the bases of competition within an industry, and an assessment as to whether the subject company has identified those "keys to success". A company may understand the keys to success yet still have a poor record of execution. A qualitative analysis should precede the quantitative portion, because it may highlight the numbers which should be of greatest interest. 18