New Portable MBA

8/9/2019 New Portable MBA

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244 The Functions of a BusinessWhile Pat was summarizing what she had learned about balance sheets andicome statements, the loan officer was preparing for her next day. She knewshe would be analyzing the cash flow for a well-established large compar)'-she reviewed some guidelines that the bank had given out on reading cashstatements.In reading a cash flow statement, be alert to the following indicators:

l. Is cash from operations positive? Is it growing from one period tonext? Is the increase in working capital growing faster than sales, and ifwhy?2. Are cash withdrawals by owners (or dividends) only a small fractioncash from operations? If cash withdrawals are too large a share ofgenerated from operations, then the business is being milked of cashwill not be able to finance its future growth.3. Of the total sources of cash, how much is generated inside thethrough operations, and how much is obtained from outside fiThere are exceptions, but it is normally wise for businesses to relyon internal cash generation than on outside financing to fund their figrowth.4. Of the outside financing, how much is equity and how much ismoney? While there are exceptions, it is wise to use more equity thanfunds for growth.

,). How much of its total sources of cash is the company using to ifor growth, and how much to increase its cash resources, or liquidity?overinvesting (total uses greater than total sources ofcash) oring (total sources greater than total uses) by too wide a margin?fust what is the company investing in? Is it likely that these investwill be profitable? How long will it take for these investments totheir cost, and then to earn a return?

These sample questions reminded the loan officer that the cash flowsupplies valuable information that goes to the core of the company's busstrategy and to the effectiveness of its management. She felt ready forand decided to end her business day.

The Auditor's KeportIn our opening story, Ebis received the account of Seluk's managementPharaoh's goats. Ebis checked Seluk's report by asking important questions.served Pharaoh as a true watchdog, by verifying that Seluk had made a full

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246 The Functions of a Business5. Rating agencies (such as Standard & Poor's, Moody's, and Dun & Brad-street), to assign credit ratings.

Major suppliers and customers, to evaluate the strength and financial stav-ing power of the company as a long-term resource for their business.Labor unions and employee associations, to assess what the company mavbe able to afford to pay in upcoming labor negotiations.Management, to assess the company's standing with the present and poten-tial investors, bankers, the financial community, customers, suppliers, andworkers.Management, to review their effectiveness in running the business, and toplan the future of the company.Corporate raiders, seeking hidden value in companies with underpricedstock.Competitors, to benchmark their own progress in the industry againstwhat the company has achieved.Potential competitors, to assess how profitable it may be to enter the in-dustry, and how strong a competitor the company would be.Government agencies who are responsible for taxing, regulating, or investi-gating the company.Politicians, consumer advocates, single issue groups, lobbyists, environ-mental activists, foundations, and other parties who are either promotingor fighting a particular cause.Joint venture partners, trade associations, franchisors or franchisees, andother present or potential business associates who have an interest in thecompany and its financial position.

This brief list shows how important and useful the roles are that financial state"ments play in the business world. It also shows how essential it is for managers tomaster the understanding, analysis, and use of financial statements for makingbusiness decisions.

IIow to Analyze Financial StatementsImagine that you are a physician, working in the emergency room of a large hm-pital. Some patients arrive with serious injury or illness, some barely alive reven dead, some with minor problems, and some with only imagined ailments-Your training and experience have taught you to make a careful diagnosis, basedon certain tests. In a case that appears serious, you check the vital signs: pulse-blood pressure, respiration, temperature, and EKG.

We check the financial health of a company in much the same way, usrngthe financial statements for our examination. The tests that business doctors use

rre mostly based cr-afiix into three cil" Short-term st3. Long-term sc.i- Profitability

UIF \r'ill describe eSort-Term S(Ulb must emphasi;sfi-rch enables a comn-ival, and insufitrnl nature of liquiimd current liabilirryarately on balarmred with the foll

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24A The Functions of a tsusinessNext, we consider turnover in relation to liquidity. Faster turnover of as-sets allows us to do more business without an equivalent increase in assets.Speedier asset turnover means that we tie up less cash in assets, which in turnhelps liquidity. By the same token, slower turnover of liabilities assists liqui&tr-.However, too slow a liabllity turnover may reflect lack of enough cash to pay thebills. Three ratios are commonly used to measure turnover of accounts receir--able, inventories, and accounts payable, respectively.

o Accounts receiuable is:Accounts receivableturnover Credit salesAccounts receivable

Suppose that credit sales for the year are $120,000, and accounts receiv-able are $30,000. Then the receivables turnover is 120,000/30,000, or 4which shows that receivables are "turning over" on average four times ayear. It can also be expresse d as days' sales, by dividing 365 days (in a year'lby 4 to get an average of 91 days. This expression says we are carrying re.ceivables averaging 91 days sales. That is fine if our credit terms call fapayment 90 days from invoice. It is not fine if our terms are 60 days, and itis alarming if terms are 30 days. unlike vintage wine or great works of arrreceivables do not improve with age! Slow receivables turnover signakdanger to liquidity.lnoentory turn is cost of goods sold divided by inrsentorip.s. unlike receir--ables, the numerator here is cost of goods sold rather than sales. The rea-son is that inventories are carried on the balance sheet at cosf (not sel\price: check back to the Mcsoft balance sheets to verify this fact). so, bhave a consistent "apples to apples" ratio, both numerator (cost of goo&sold) and denominator (inventory) must be in the same terms, namely cd-

In this example, cost of goods sold this year is $100,000, and inven-tory is $33,333. Then, inventory turn is f00,000/33,333, or 3 times peryear. This figure can be expressed as 365/3 : r22 days supply ofinventcrvon hand. In the auto manufacturing business, 60 days supply of cars irabout normal, and L22 days would be regarded an unacceptable. Throversupply would trigger a vigorous rebate campaign to clear out the er-cess vehicles. slow inventory turnover is a serious red flag for liquidr'tr--Accounts payable turnooer indicates the extent to which a firm is keepirycurrent in paying its suppliers. This ratio is:

Accounts payable - Cost ofgoods soldturnover Accounts payablecost is used in the numerator for the same reason as in inventory turn: Theaccounts payable are owed to suppliers ofgoods for resale and are recorded

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The item of concern may be measured as the dnbt-to-equity ratio-30,000:29,000 which is approximately one. Alternatively, it may be mlasuredas the proportion of long-term debt in the total capiial structure, the d&tto dnbt-plus-equity ratio of 30,000:5g,000, which is approximately 50 perced-Either approach is commonly used. This option m"k"r it important to clarift-which method is being applied in a particular case to avoid ^any possible mis-understanding.An acceptable level of this ratio causes little worry, but too hlgh a ler,.el *grounds for concern. when it exceeds the comfort level, the large"r this ratil(whtchever way it is measured), the riskier the enterprise. This increased. riskresults because the debt is senior to the equity (meaning that interest must bepaid before dividends can be paid). In liquidation, the piincipal and interest ofthe debt must first be paid in full before atry cash rema^ining "u'b" paid to tbeequity holders.The comfort level of the debt-to-equity ratio varies from one industrr.toanother and depends on the stability or volatility ofthe industry, and the value d

250^ The Functions of a Business

the collateral (if any) securing the debt. So-calied ..ire collarerar 1rr any/ securing the debt. so-called "junk bonds,'are regarded arjunk" because their issuers often have poor debt-tt-equity ratios. This discus-sion concludes the long-term solvency tests. o-equity ratios. This discus-The third and final group of tests examines profitability.Profitability Katiostl*-" are two cat"gori":. of profitability ratios. The first category is percentagrof sales. Consider the following income statements:

1993 1994Sales revenuesCost of goods soldGross profitOperating expensesSelling, general, andadministrative expensesOperating profitInterest expenseIncome before taxesIncome taxesNet income

What do these income statements reveal about the financial results f.r1994 versus 1993? The good news is that sales increased. by about gg00; tlr

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252 The Functions of a Business Ac

The use of percent of sales ratios is aexamining the behavior of gross profit andmain ratios of this kind are:

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254 The Functions of a Businessadvantage of tax deductibility makes debt interest relatively less expensire bthe firm. Second, debt is senior to equity and is thus less risky to the inresm.Investors are able to demand a higher return for riskier investment securititxThis ability makes the required rate of return on a firm's equity securiBhigher than on its debt securities. For these reasons, debt is usually less cmth-to a firm than equity.

The example financial statements reflect such a tendency. Note that inter-est after tax is $121 on the long-term debt of $1,600 or7.6 percent, but recdilthat ROTAAT was 12.1 percent. Therefore, the firm earns 12.1 percent, e'rdafter paying the holders of long-term debt their 7.6 percent, the firm benefits brthe difference between the 12.1 percent earned and the 7.6 percent paid mdebt financing. How much is this benefit? We measure it by the next ratio-return on equity.

Note that there are two kinds of equity. Preferred stock usually has a firedrate of dividend, like a fixed rate of interest on long-term debt, and it is senirto the other kind of equity: common stock. Common stock has no fixed rate ddividend, and it is always the most junior form of long-term capital. Some com-panies do not have preferred stock, but all companies have common stoc'liWhen people luse return on equi,ty, they usually mean return on the commo$equity.

Return dn equity (ROE) is probably the most important ratio to the com-mon stockholders. It indicates the return on their equity investment in the com-pany. Return on equity is the net income (less preferred dividends) divided bncornnon equity, which in our example is 24L/I,400 : L7.2 percent. We recallthat ROTAAT is l2.l percent. Therefore, if there were no long-term debt, thenROE would also be l2.l percent. However, the long-term debt, costing only 7.6percent after tax, enables ROE to be booste dto 17 .Z percent. The benefit to theowners is their hlgher ROE of lT.2percent versus the 12.1 percent that therwould have earned without the debt. This tactic is known as lerserage.

Leverage is regarded by some investors as a turbobooster to earninqs.Therefore, it is no wonder that debt financing is in vogue and that junk bondshave become so popular. Also popular are leveraged buyouts-purchases ofbusinesses financed heavily by debt and with abnormally low equity. Leveragegives a higher return on equity so long as profits are large. On the other hand-if profits shrink, leverage has the opposite effect.

Recall in our sample income statement that net income fell from $24f in1993 to $63 in 1994. The 1994 ROE is 63/1,600 : 3.9 percent, compared vvith17 .2 percent in 1993. This is reverse leveragel 1994 ROTAAT is 6.1 percent, cal-culated as follows:

Net income ($63) + Interest after tax ($201 - $80 : $12i)

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256 The Functions of a Businessthe number of common shares outstanding. It simply translates common equity"into a per share basis. The ratio indicates whether a company is worth more inmarket value than the cost it paid for its assets (less its liabilities).

A ratio greater than one means that market value exceeds the book value-This excess may be taken as a sign that management (and possibly good fortune)have created stockholder value over and above the acquisition cost ofthe assets.Many experts in business strategy say that the ultimate goal of management is tomaximize stockholder value. The market-to-book ratio is one indicator of suc-cess in achieving this objective.

For some regulated companies, regulation is based on a fair rate of return.Then, the market-to-book ratio indicates the extent to which regulation is in-deed fair. A market-to-book ratio of approximately one indicates 100 percentfairness. (The regulator is allowing the company to earn the market rate of re-turn.) A market-to-book ratio significantly above one suggests overgenerosity bythe regulator (allowing an excessive return), and a ratio substantially below oneis a sign of a regulator allowing an inferior rate of return.

We have now discussed all the main financial ratios, and they are summa-rized in Table 10-1.Practical Use of Financial RatiosKeep in mind a number of important points for the effective use of ratios. First,the ratios can never be more reliable than the data on which they are based-Therefore, it is essential to check the reliability of the basic data. RemembenGarbage in, garbage out! Beware ofi Garbage in, gospel out!

Remember that our discussion of financial statements has dealt with funda-mentals; some of the highly technical aspects can challenge even the experts.For example, financial statements include footnotes that can contain importantinformation affecting the interpretation of those statements. Some of these foot-notes are complex, and you should seek professional advice if you come acrossanything that you do not fully understand.

Be aware of areas where the accounting treatment of certain items is notcut and dried. Two ways of accounting may be equally acceptable methods oftreating the same item but give very different results. These diverse resultscan, in turn, affect the financial ratios and make them better or worse thanthey might otherwise be.

Often, the ratios will not provide a decisive answer. Do not be surprised ifthis happens. Uncertainty is a signal to investigate further by gathering morefacts and by using other suitable techniques.

Ratios can be affected by seasonal factors. For instance, retailers com-monly end their financial years on January 31, when business is slack and the

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25,8 The Functions of a Businessinventories are low. Since inventories are at their seasonal low, the inventcn'turnover ratios look faster than they normally are. Remember to keep seasmrlleffects on ratios in mind.

Few financial ratios are meaningful when considered in a vacuum. Therneed to be measured in relation to a standard or appropriate yardstick. Thesimplest yardstick is to compare ratios for a firm against its ratios for previrnuperiods. One firm may be compared with another firm in the same industn'-or against composite ratios for the industry as a whole. The industry ratios areoften available from firms specializing in financial statistics, such as Dun &Bradstreet, Standard & Poor's, and Moody's, among others.

Keep in mind that the trend over time is critical in considering ratios. fuexample, a current ratio of 1.5 may seem barely satisfactory. However, if it uuonly 1.0 last year, then this year's 1.5 may be a substantial improvement. On tlnother hand, if the ratio last year was 2.5, this year's 1.5 is not good news.

Some companies helpfully include ratios with their financial staterneffiThble l0-2 shows such an example from an annual report of Sega Enterprises- nJapanese maker of video games.

FINANCIAL ANALYSIS AND BUSINESS STRATEGYFinancial ratios can be combined into a DuPont chart. The DuPont method rrz*originally developed at the DuPont Company for financial planning and contndpurposes. It shows how the key financial ratios are logically interrelated. Also. ilreflects how the ratios interact to determine profitability measured as return mequity. The brief form of the DuPont formula is:

Profit Margin Asset Turnover Return on AssetsNet income

SalesSalesT"t.t *r*.tt Net incomeT"t"t "r*tt

Return on Assets(ROA) FinancialLeverage Return on Equity(RoE) d@met income Total assets Net incomeTotal assets Common equity Common equity

In turn, these ratios can be broken down again into their component ratioparts for further analysis, as we shall see.The DuPont formula is a financial X-ray of the business that reveals hou-the key ratios link with each other to govern total business profitability. As an

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New Portable MBA