Business Strategy Using Financial Statements

Chapter 8

Financial Analysis

Overview of Financial Analysis

• The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to assess its sustainability.

• Ratio analysis and cash flow analysis are the two most commonly used financial tools

Drives of a firm’s profitability and growth

Growth and Profitability

Product MarketStrategies

Financial MarketPolicies

OperatingManagement

InvestmentManagement

Financial Decision

DividendPolicy

ManagingRevenue and

Expenses

ManagingWorking

Capital andFixed Asset

ManagingLiabilities and

Equity

ManagingPayout

Ratio analysis• Ratio analysis involves assessing how various line items

in a firm’s financial statements relate to one another.

• Financial ratios are used to compare the risk and return of different firms in order to help equity investors and creditors make investment and credit decision

• In a ratio analysis, the analyst can

(1) Compare ratios for a firm over several years

(2) Compare ratios for the firm and other firms in the industry

(3) Compare ratios to some absolute benchmark

ROE—Measuring Overall Profitability

• ROE=Net income/Shareholder’s equity• ROE is a measure of return a company generates

on shareholder equity• When to use indicator: Investor can use this ratio

to determine how productively a company employs shareholder’s equity to generate income

• A comparison of ROE with the cost of capital is useful not only for contemplating the value of the firm but also in considering the path of future profitability

Example: Nordstrom and TJX• Nordstrom is a leading fashion retailer, offering a wide variet

y of high-end of apparel, shoes and accessories. (1) pursues a strategy of high quality, extraordinary service an

d premium price. (2) make significant investment in its store (3) have a credit card operation• TJX operates off-price apparel and home fashions retail stores (1) offer brand name goods at 20-60 percent below regular pri

ces (2) with a highly efficient distribution network and low cost str

ucture (3) lease its store

ROE for Nordstrom and TJX

Nordstrom TJX 1998 1997 1998ROE 15.6% 12.6% 34.5%(1) Nordstrom’s ROE show a significant

improvement. (2) Nordstrom’s ROE is far behind TJX’s ROE(3) This is reflected in the difference in the two

companies ratio of market value of equity to its book value

Decomposing profitability: Traditional Approach

ROE = NI/Assets * Assets/SE

= ROA * Financial leverage

=NI/Sales * Sales/Assets * Assets/SE

= Net Profit margin * Asset turnover *

Financial leverage

For example: traditional decomposition of ROE

Ratio Nordstrom TJX

1998 1997 1998

Net profit margin (ROS) 4.1% 3.85% 5.3%

* Asset turnover 1.61 1.68 2.89

= ROA 6.6% 6.5% 15.3%

* Financial leverage 2.37 1.95 2.25

= ROE 15.6% 12.6% 34.5%

(1) Nordstrom’ ROE increase is largely driven by an increase in financial leverage and by an increase in net profit margin.

(2) TJX’ ROE is driven by higher profit margins and better asset utilization

Decomposing Profitability: Alternative Approach• ROE=NOPAT/Equity—Net interest expense after tax/Equity =NOPAT/Net assets * Net assets/Equity—Net interest expense after tax/Net asset * Net debt/Equity =NOPAT/Net assets * (1+Net debt/Equity)—Net interest after tax/Net debt * Net debt/Equity =Operating ROA + (Operating ROA—Effective interest after tax/Net debt ) * Net financial leverage =Operating ROA + Spread * Net financial leverage Operating ROA is a measure of how profitably a company is able t

o deploy its operating assets to generate operating profits; Spread is the incremental economic effect from introducing debt int

o the capital structure• Operating ROA=NOPAT/Sales * Sales/Net assets =Net operating profit margin * Net operating asset turnover

For example—Distinguishing Operating and Financing Components in ROE Decomposition

Nordstrom TJX Average

Ratio 1998 1997 1998 standardNet operating profit margin 4.7% 4.3% 5.3%*Net operating asset turnover 2.49 2.27 8.11=Operating ROA 11.7% 9.8% 43.0% 9%-11%Spread 7.3% 6.4% 42.9%*Net financial leverage 0.54 0.45 (0.20)=Financial leverage gain 3.9% 2.8% (8.5%)ROE=Operating ROA+Financial Leverage gain 15.6% 12.6% 34.5%• Nordstrom’s operating ROA is in average level and TJX is far larger than Nordstro

m and average level.• TJX has a better NOPAT margin and a dramatically higher operating asset turnover• Nordstrom is able to create shareholder value through its financing strategy• TJX has a negative net financial leverage because the firm had a large cash balance i

n 1998. As a result, the firm had a lower ROE than its operating ROA.

Assessing Operating Management: Decomposing Net Profit Margins

• Net profit margin(ROS) shows the profitability of the company’s operating activities.

• Decomposing net profit margins makes an analyst to assess the efficiency of the firm’s operating management

• Analytic tool—common-sized income statement Common-sized income statement is a statement in which al

l the line items are expressed as a ratio of sales revenues Common-sized income statement makes it possible to com

pare trends in income statement relationships over time for the firm, and trends across different firms in the industry.

Gross Profit Margins

• Gross profit margin is an indication to the extent to which revenues exceed direct costs associated with sales.

Gross profit margin =( Sales-Cost of Sales)/Sales• Gross profit margin is influenced by two factors

(1) the price premium

(2) the efficiency of the procurement and production process

Selling, General, and Administrative expense (SG&A)

• SG&A expenses are influenced by the operating activities

The firms have to undertake SG&A expenses to implement its competitive strategy.

• SG&A expenses are also influenced by the efficiency

The control of operating expenses is important for firms competing on the basis of low cost.

Net operating profit margin ratio and EBITDA margin

• NOPAT margin is a measure of how profitable a company’s sales are from an operating perspective.

NOPAT=NOPAT/Sales It reflects all operating policies and eliminates the effects

of debt policy• EBITDA margin provides a comprehensive indication of t

he operating performance except that it includes depreciation and amortization expense

EBITDA margin=Earning before interest, taxes, depreciation, and amortization/Sales

It focus on “cash” operating items.

Tax expense

• Firms attempt to reduce their tax expenses through tax planning techniques.

• There are two measures to evaluate a firm’s tax expense

(1) the ratio of tax expense to sales.

(2) the ratio of tax expense to earnings before taxes.

For example—common-sized income statement Nordstrom TJX

1998 1997 1998Line Items as a Percent of SalesSales 100% 100% 100%Cost of Sales (66.5) (67.9) (74.9)Selling, general, and admin. Expense (28.0) (27.3) (16.2) Other income/expense 2.1 2.2 --- Net interest expense/income (0.9) (0.7) ---Income taxes (2.6) (2.5) (3.4) Unusual gains/losses, net of taxes --- --- (0.1)Net income 4.1% 3.8% 5.3%

We can use this common-sized income statement to investigate why Nordstrom had a net income margin of 4.1% in 1998 and 3.8% in 1997, while TJX had a net margin of 5.3%.

For example—Profitability RatiosKey Profitability Ratios Nordstrom TJX 1998 1997 1998Gross profit margin 33.5% 32.1% 25.1%EBITDA margin 10.4% 9.7% 10.6%NOPAT margin 4.7% 4.3% 5.3%Net Margin 4.1% 3.8% 5.3%• Nordstrom’s gross margins are significantly highly than TJX. It reflects Nordstrom’s premium price strategy• TJX has a slightly better EBITDA margin than Nordstrom TJX leases most of its stores and leasing expense is deducted in the ca

lculation of EBITDA.• Nordstrom’s NOPAT margin and Net margin has improved a little bet

ween 1997 and 1998.It is primarily driven by a reduction of cost of sales.

• TJX has a better NOPAT margin and Net margin because it is able to save significantly on SG&A expenses.

Evaluating Investment Management: Decomposing Asset Turnover

• Asset turnover is the second drive of a firm’s return on equity.

• An analysis of asset turnover can estimate the effectiveness of a firm’s investment management.

• There are two primary area management (1) working capital management (2) management of long-term asset

Working capital management

• Operating working capital-to-sales ratio=Operating working capital/sales

• Operating working capital=(current assets-cash & marketable securities)-(current liabilities-short term & current portion of long-term debt)

• Operating working capital turnover=Sales/operating working capital• Account receivable turnover=sales/accounts receivable• Inventory turnover=Cost of goods sold/inventory• Accounts payable turnover=COGS/Accounts payment• Day’s receivables=Accounts receivable/Average sales per day• Day’s inventory=Inventory/ COGS per day• Day’s payable=Accounts payable/COGS per day

Long-term asset management

• Net long-term asset turnover=Sales/Net long-term assets

Net long-term assets=(Total long term assets -Non interest bearing long term liabilities)

• PP&E turnover=Sales/PP&E(net)

For example: Asset Management RatiosRatio Nordstrom TJX 1998 1997 1998Operating working capital/Sales 16.2% 20.8% (0.3%)Net long term assets/Sales 24.0% 23.2% 12.6%PPE/Sales 27.1% 25.8% 9.5%Operating working capital turnover 6.17 4.81 not meaningfulNet long term assets turnover 4.17 4.31 7.94PPE turnover 3.69 3.88 10.52Accounts receivable turnover 8.56 7.30 117.9 Inventory turnover 4.46 3.99 5.0Accounts payable turnover 9.85 10.26 9.6 Day’s accounts receivable 42.6 50 3.1Day’s inventory 81.8 91.5 73Day’s accounts payment 37.1 35.6 38

For example: Asset Management Ratios(cont.)

• Nordstrom achieved an improvement in working capital management between 1997and 1998.

a reduction of operating working capital as a percent of sales and an increase in operating working capital turnover.

• Nordstrom’s improvement is attributable to a reduction in A/R and better inventory management.

• Nordstrom’s long term asset utilization declined a little. Net long term asset turnover and PPE turnover showed marginal

declines.• TJX achieved dramatically better asset utilization ratios Taking full advantage of trade credit Managing inventory more efficiently Operating leases to lower capital in stores and improving PPE turnover

Evaluating Financial Management: Financial Leverage

• Financial leverage—debt in relation to equity in a firm’s capital structure

• Financial leverage increases a firm’s ROE as long as the cost of the liabilities is less than the return from investing these funds.

• There are a number of ratios to evaluate the degree of risk arising from a firm’s financial leverage

(1) Current liabilities and short term liquidation (2) Debt and long term solvency (3) Ratio of disaggregated data

Current liabilities and short term liquidity

• Current ratio = current assets/current liabilities

A key index of a firm’s short term liquidation

• Quick ratio = (cash+short term investment+account receivables)/current liabilities

• Cash ratio = (cash+marketable securities)/current liabilities

Quick ratio and Cash ratio capture the firm’s ability to cover current liabilities from liquid asset

• Operating cash flow ratio = cash flow from operations/current liabilities

Measure of the firm’s ability to cover current liabilities from cash generated from operation

For example: Liquidity ratios

Nordstrom TJX

Ratio 1998 1997 1998Current ratio 2.19 1.71 1.33Quick ratio 1.08 0.73 0.40Cash ratio 0.31 0.03 0.35Operating cash flow ratio 0.78 0.32 0.49• Nordstrom’s liquidity ratio improved in 1998. Accumulated a large cash balance and improved cash flow from operati

on• TJX has a comfortable liquidity position.Because of tight management

of operating working capital, however, TJX’current and quick ratios are smaller than Nordstrom’s

Debt and long-term solvency

• A firm’s financial leverage is influenced by its financing policy.

Benefits from debt financing—cheaper than equity, tax deductible, impose discipline on management and financing easily.

• The optimal capital structure for a firm is determined primarily by its business risk.

Low business risk can rely heavily on debt financing.

Debt and long-term solvency(cont.)

The following ratios are used to estimate a firm’s long-term solvency

• Liabilities to equity ratio: Asset to equity ratio

• Debt to equity ratio

• Net debt to equity ratio

Net debt = debt-cash and marketable securities

• Debt to capital ratio=debt/(debt+equity)

• Net debt to net capital ratio=(interest bearing liabilities-cash and marketable securities)/(interest bearing liabilities-cash and marketable securities+shareholders’ equity)

• Interest coverage(earning basis)=EBIT/interest expense

• Interest coverage(cash flow basis)=(cash flow from operation+interest expense+taxes paid)/interest expense

For example:debt and coverage ratio Nordstrom TJX

Ratio 1998 1997 1998Liabilities to equity 1.37 0.95 1.25

Debt to equity 0.72 0.46 0.18Net debt to equity 0.54 0.48 (0.20)Debt to capital 0.42 0.38 0.15Net debt to net capital 0.35 0.31 (0.25)Net debt to equity(including operating lease) Not available Not available 1.19Interest coverage(earning basis) 8.2 9.6 410 Interest coverage(cash flow basis) 16.4 13.4 541.2Fixed charges coverage, including lease payments (earning basis) 4.6 4.8 3.17Fixed charges coverage, includinglease payments (cash flow basis) 8.7 6.2 3.87

For example:debt and coverage ratio(cont.)

• Nordstrom adopted a fairly conservative debt policy. An increase in liabilities to equity and debt to equity ratios, net

financial leverage. Interest coverage also remained at comfortable level• TJX’s debt ratios confirm that it is primarily relying on non-

interest liabilities such as A/P and accrued expenses to finance its operation

Given its large cash balance, net debt is negative Interest coverage ratios are high Because of operating lease, net-debt-to-equity ratio increases

dramatically. At the same time TJX’s coverage drops dramatically.

Assessing Sustainable Growth Rate

• A firm’s sustainable growth rate is defined as: Sustainable growth rate = ROE * (1-Dividend

payout ratio)• A firm’s dividend payout ratio is a measure of its

dividend policy Dividend payment ratio = cash dividends paid/Net

income • Sustainable growth rate is the rate at which a firm

can grow while keeping its profitability and financial policies unchanged.

Sustainable Growth Rate Framework for Financial Ratio Analysis

SUSTAINABLEGROTH RATE

ROE

Dividend Payout

Operating ROA FinancialLeverage Effect

Net OperatingProfit Margin

Operating AssetTurnover Spread Net Financial

Leverage

For example: Sustainable growth rate

Nordstrom TJX

Ratio 1998 1997 1998

ROE 15.6% 12.6% 34.5%

Dividend payment ratio 0.21 0.22 0.09

Sustainable growth rate 12.3% 9.8% 31.4%

• Nordstrom had a lower ROE and a higher dividend payout ratio relative to TJX, leading to a significantly lower sustainable growth rate in both 1998 and 1997.

• Nordstrom improved its sustainable growth because of its improved ROE and a marginal decline in its payout ratio.

Chapter quiz

Selected data from Sheridan Corporation’s year-end financial statements are presented below. The difference between average and ending inventory is immaterial.

Current ratio 2.0

Quick ratio 1.5

Current liabilities $120,000

Inventory turnover(based on COGS) 8

Gross profit margin 40%

Sheridan’s net sales for the year were:

a. $240,000 b. $480,000

c. $800,000 d. $1,200,000

Chapter quiz

In a period of rising prices, how would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation?

• Gross margin• Current ratio• Asset turnover• Debt-to-equity ratio• Average tax rate

Chapter quiz (cont.)• Gross margin is lower for the LIFO firm

The LIFO firm has higher COGS which makes its gross margin appear lower than the FIFO firm.

• Current ratio falls

Current asset is lower under LIFO

• Asset turnover increases

Assets are lower under LIFO

• Debt-to-equity ratio increase

Under LIFO, the higher COGS leads to lower net income which in turn leads to a decrease in equity.

• Average tax rate remains the same.

Under the LIFO, it has less taxable income but the average tax rate is likely to remain the same.