Financial Statement Analysis Citibank

Financial Statement Analysis April 1995 Financial Statement Analysis Warning This workbook is the product of, and cop...

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Financial Statement Analysis April 1995

Financial Statement Analysis

Warning This workbook is the product of, and copyrighted by, Citibank North America, Inc. It is solely for the internal use of Citibank, North America, Inc. and may not be used for any other purpose. It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of the Training and Development Centers for Latin America, Asia/Pacific and CEEMEA. Please sign your name in the space below.

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Table of Contents

TABLE OF CONTENTS

Introduction Course Overview ......................................................................................... vii Course Objectives ...................................................................................... viii The Workbook...............................................................................................ix

Unit 1: Accounting Issues in Financial Analysis Introduction..................................................................................................1-1 Unit Objectives ............................................................................................1-1 Branches of Accounting..............................................................................1-2 Managerial Accounting ....................................................................1-2 Tax Accounting................................................................................1-2 Financial Accounting .......................................................................1-3 Generally Accepted Accounting Principles ........................1-3 Effects of Inflation................................................................1-4 Financial Accounting Basics...............................................1-5 Accounting Exercise .......................................................................1-6 “Getting Behind the Numbers” ....................................................................1-9 Contextual Factors..........................................................................1-9 Macroeconomic Effects......................................................1-9 Sector Accounting Norms ................................................1-10 Consolidated Numbers .....................................................1-10 Seasonality........................................................................1-11 Asset / Liability Valuation...............................................................1-12 Intangible Assets ...........................................................................1-13 Contingent Liabilities .....................................................................1-15 Summary...................................................................................................1-16 Progress Check 1 .....................................................................................1-19 Adjusting for Inflation .....................................................................1-25 Effects of Inflation on the Balance Sheet..........................1-25 Effects of Inflation on the Income Statement....................1-26 Inflationary Accounting......................................................1-27

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Unit 1: Accounting Issues in Financial Analysis (Continued) Constant Currency Accounting ........................................1-28 Comprehensive Monetary Correction (MC).....................1-29 Additional Adjustments for Inflation...................................1-31 Comparative Financial Statements ..................................1-32 The Brazilian Experience..................................................1-32 Financial Analysis Spreadsheets ..............................................................1-33 Summary.......................................................................................1-35 Progress Check 1.2 ..................................................................................1-37

Unit 2: Basic Concepts of Financial Analysis Introduction..................................................................................................2-1 Unit Objectives ............................................................................................2-1 Liquidity........................................................................................................2-2 Degree of Liquidity...........................................................................2-2 Importance of Liquidity ....................................................................2-2 Increasing Liquidity..........................................................................2-3 Liquidity and Balance Sheet Structure............................................2-3 Types of Capital ..........................................................................................2-3 Working Capital...............................................................................2-3 Permanent Capital ..........................................................................2-6 Third Party and Own Capital...........................................................2-7 Third Party Capital ..............................................................2-8 Own Capital .........................................................................2-8 Difference Between Liability and Net Worth Financing...................2-9 Summary...................................................................................................2-10 Progress Check 2.1 ..................................................................................2-13 Sources and Uses of Funds .....................................................................2-27 Sources and Uses in the Balance Sheet......................................2-27 Operating / Non-Operating............................................................2-29 Operating Sources and Uses ...........................................2-29 Non-Operating Sources and Uses ...................................2-30 Sources and Uses in the Income Statement................................2-30

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Unit 2: Basic Concepts of Financial Analysis (Continued) Funds Generation Statement........................................................2-31 Summary of Sources and Uses ...................................................2-33 Funds Flow Analysis .....................................................................2-33 Summary...................................................................................................2-34 Progress Check 2.2 ..................................................................................2-35

Unit 3: Financial Statement Analysis Introduction..................................................................................................3-1 Unit Objectives ............................................................................................3-1 Financial Statement Limitations ..................................................................3-2 Business Risk Assessment........................................................................3-3 Economic Environment...................................................................3-3 Market Conditions............................................................................3-4 Type of Business ............................................................................3-4 Management....................................................................................3-5 Progress Check 3.1 ....................................................................................3-7 Analysis Techniques ...................................................................................3-9 Vertical Analysis ........................................................................................3-10 Purpose.........................................................................................3-10 Balance Sheet...............................................................................3-10 Income Statement.........................................................................3-12 Summary.......................................................................................3-13 Progress Check 3.2 ..................................................................................3-15 Horizontal Analysis ....................................................................................3-25 Purpose.........................................................................................3-25 Technique......................................................................................3-26 Sales Growth.................................................................................3-27 Analyzing Net Sales Growth..........................................................3-27 Progress Check 3.3 ..................................................................................3-29

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Unit 4: Financial Ratios — Liquidity Introduction..................................................................................................4-1 Unit Objectives ............................................................................................4-1 Financial Ratios...........................................................................................4-2 Types of Financial Ratios................................................................4-2 Liquidity Ratios ............................................................................................4-3 Current Ratio...................................................................................4-3 Acid Test .........................................................................................4-6 Other Liquidity Indicators.................................................................4-8 Progress Check 4.1 ....................................................................................4-9 How Liquidity Ratios Change ....................................................................4-17 Progress Check 4.2 ..................................................................................4-21

Unit 5: Financial Ratios — Leverage Introduction..................................................................................................5-1 Unit Objectives ............................................................................................5-1 Total Indebtedness (Leverage) ...................................................................5-2 Calculation.......................................................................................5-2 Leverage Analysis ...........................................................................5-3 Incidence of Fixed Assets ..................................................5-3 Effect of Seasonality ...........................................................5-4 Financial Leverage..............................................................5-5 Tangible Net Worth .............................................................5-7 Revaluation Surplus ............................................................5-8 Other Adjustments ..............................................................5-9 Consolidations and Minority Interest ................................5-10 Current and Long-Term Indebtedness Ratios ..........................................5-12 Fixed Assets Covered by Own Resources ..............................................5-13 Coverage Ratios .......................................................................................5-14 Funds From Operations — Interest Coverage .............................5-14 Funds From Operations — Long-Term Debt Coverage ..............5-15 Debt Service Ratio ........................................................................5-15 Summary.......................................................................................5-16 Progress Check 5 .....................................................................................5-19

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Unit 6: Financial Ratios — Turnover Introduction..................................................................................................6-1 Unit Objectives ............................................................................................6-2 Receivables Turnover / Days Receivable...................................................6-2 Receivables Turnover Ratio............................................................6-2 Days Receivable .............................................................................6-4 Summary.........................................................................................6-6 Progress Check 6.1 ........................................................................6-9 Inventory Turnover or Days Inventory .......................................................6-13 Inventory Turnover.........................................................................6-13 Days Inventory...............................................................................6-14 Summary.......................................................................................6-17 Progress Check 6.2 ..................................................................................6-19 Payables Turnover or Days Payable ........................................................6-23 Payables Turnover ........................................................................6-23 Days Payable ................................................................................6-24 Common Variation ............................................................6-25 Seasonality........................................................................6-26 Interpreting the Number ....................................................6-27 Summary.......................................................................................6-28 Progress Check 6.3 ..................................................................................6-29

Unit 7: Financial Ratios — Profitability Introduction..................................................................................................7-1 Unit Objectives ............................................................................................7-1 Profitability Ratios........................................................................................7-2 Return on Sales ..............................................................................7-2 Return on Assets ............................................................................7-3 Return on Equity (Return on Capital)..............................................7-4 Progress Check 7.1 ....................................................................................7-7 Integrated Analysis ....................................................................................7-11 Return on Assets ..........................................................................7-11 Return on Equity............................................................................7-12 Application of DuPont Formulas ...................................................7-12

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Unit 7: Financial Ratios — Profitability (Continued) Summary.......................................................................................7-15 Progress Check 7.2 ..................................................................................7-17 Summary of Financial Ratios....................................................................7-21

Unit 8: Applied Financial Analysis — Case Studies Introduction..................................................................................................8-1 Unit Objectives ............................................................................................8-1 The Bank Spreadsheet Financial Analysis Model.......................................8-2 Case Study: Mindy Garment Factory.........................................................8-9 Exercise 8.1 ..................................................................................8-15 Case Study: The Tower Stores ...............................................................8-39 Exercise 8.2 ..................................................................................8-51

Appendices Appendix A...................................................................................................A-1 Appendix B ..................................................................................................B-1 Appendix C — Glossary..............................................................................C-1

Index

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Introduction

INTRODUCTION

COURSE OVERVIEW

Welcome! You are about to learn the basic financial concepts and techniques used to interpret and analyze the financial and economic position of a company. These techniques form the foundation of financial statement analysis. After completing the course, you should be able to apply financial analysis techniques to perform an in-depth quantitative analysis of a company’s financial situation. This course is useful for relationship manager trainees and others working in the credit area who wish to improve their credit analysis capabilities in order to support individual credit decisions. The opening unit of this workbook deals with accounting issues as they pertain to financial statement analysis. The workbook does not teach accounting. If the reader has very little exposure to accounting, it may be more productive to first upgrade accounting skills through an accounting textbook or self-instruction workbook (e.g. Robert N. Anthony’s Essentials of Accounting). If you do not have the Anthony self-instruction book available, contact your Training Coordinator or the PDC. A brief section on financial statement structure is included in Appendix A, along with some short exercises, to provide support for readers with an incomplete knowledge of accounting. The material may be helpful to refresh some concepts, but it is insuffient to teach the subject. The course is divided into eight units: Unit 1 — Accounting Issues In Financial Analysyis Unit 2 — Basic Concepts of Financial Analysis Unit 3 — Financial Statement Analysis Unit 4 — Financial Ratios – Liquidity Unit Five — Financial Ratios – Leverage

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INTRODUCTION

Unit Six — Financial Ratios – Turnover Unit Seven — Financial Ratios – Profitability Unit Eight — Applied Financial Analysis – Case Studies We have designed this course in workbook form which follows a logical sequence using a self-instructional format. You should work through the units at your own pace in the order they're presented, because each contains information that builds from previous units. For your convenience, we have included a glossary of terms at the back of the workbook.

COURSE OBJECTIVES

When you complete this workbook, you will be able to: +

Identify accounting issues that impact the financial analysis process

+

Recognize some basic concepts that help an analyst form a more complete picture of a company’s financial health

+

Apply techniques that are used to evaluate a company’s financial condition

+

Calculate financial ratios to understand the relationships among various financial statement accounts

+

Apply the financial anlysis procedures using a bank spreadsheet model

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INTRODUCTION

ix

THE WORKBOOK

This workbook is designed to give you complete control over your own learning. The material is divided into workable sections, each containing everything you need to master the content. You can move through the workbook at your own pace and go back to review ideas that you didn’t completely understand the first time. Each unit contains:

þ

Objectives –

which point out important elements in the lesson that you are expected to learn.

Text –

which is the "heart" of the workbook. These sections explain the content in detail.

Key Terms –

which also appear in the Glossary. They appear in bold face the first time they appear in the text.

Instructional Mapping –

terms or phrases in the left margin which highlight significant points in the lesson.

Progress Checks –

which do exactly what they say — check your progress. Appropriate questions are presented at the end of each unit, or within the unit in some cases. You will not be graded on these by anyone else; they are to help you evaluate your progress. Each set of questions is followed by an Answer Key. If you have an incorrect answer, we encourage you to review the corresponding text and find out why you made an error.

In addition to these unit elements, the workbook includes:

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Appendix A

Unit One Accounting Exercise Answer Key

Appendix B

Financial Statement Structure

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x

INTRODUCTION

Appendix C — Glossary

Definitions of all key terms used in the workbook.

Index –

Guide for locating glossary items in the workbook.

Since this is a self-instructional course, your progress will not be supervised. We expect you to complete the course to the best of your ability and at your own speed. Now that you know what to expect, please begin with Unit One. Good luck!

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Unit 1

UNIT 1: ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

INTRODUCTION

A business is a collection of economic and human resources devoted to a particular purpose or goal. This business may be in the commercial, industrial, agricultural, service, or other sectors. Whatever its purpose, every business organization must measure its efforts in monetary terms for both legal and business reasons. “Accounting” is the systematic recording and presenting of daily transactions that occur in any business organization. “Bookkeeping” — the process of recording daily transactions through the use of debits and credits, journals, and ledgers — is a part of accounting. But accounting is much broader than compiling these financial details. Together with financial analysis, accounting encompasses an understanding of what is behind the numbers and an interpretation of them to get an even and comprehensive picture of the financial position of a company.

UNIT OBJECTIVES

When you complete this unit, you will be able to: n

Differentiate between managerial accounting, tax accounting, and financial accounting

n

Recognize the use of rules and guidelines for reporting financial results

n

Recognize five issues to consider in the financial analysis process

n

Calculate monetary corrections of a company in a high inflationary economy and show the adjustments as a gain or loss

n

Explain the impact of inflation on determining a company's financial position and the results of its operations

n

Recognize some features of an electronic spreadsheet model for financial analysis

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1-2

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

BRANCHES OF ACCOUNTING

In a broad sense, accounting can be separated into three major branches: 1. Managerial accounting 2. Tax accounting 3. Financial accounting

Managerial Accounting Financial information for internal use only

Managerial accounting provides information to management, for internal use only, based on guidelines and rules established by management to accommodate the company’s specific needs. For example, it may account for internal redistributions of revenue or cost allocations between business units to enable more accurate measurement of a unit’s profits. You can learn more about Citicorp / Citibank’s managerial accounting in the Citicorp MIS self-instructional workbook, which is written for the Financial Control professional.

Tax Accounting Information to facilitate assessment of tax implications

Tax accounting is governed by legislation in the applicable legal jurisdiction. Tax implications may have a profound effect on how companies organize themselves and do business. Counsel in the tax area may be provided to management by lawyers or accountants skilled in these matters, or by internal experts within a company.

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1-3

Financial Accounting Financial information reported outside the company

Financial accounting provides information on the results of a company’s operations to people outside of management, such as creditors, investors, stockholders, and government agencies. Citibankers or other credit analysts use this information to assess the historical cash generation and financial position of a company. From this information base, the analyst can build projected numbers, based on historical trends and prudent economic and business assumptions, to measure the business risk of dealing with this actual or potential client. It is this type of accounting that concerns us in this workbook. Generally Accepted Accounting Principles

Since financial accounting results are used by people outside of the business to assess the financial position of a company, it is necessary for these results to be reported according to a set of standards. The rules and guidelines for reporting financial results are known as Generally Accepted Accounting Principles ( GAAP). In the United States, these principles are defined by the Financial Accounting Standards Board ( FASB). Each country has its own equivalent of the FASB composed of professional accountants who define the accounting principles to be followed in presenting financial accounts within their jurisdiction. Example

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While many of the principles are universal, others may vary from country to country or region to region. The impact of area-specific principles can be demonstrated with an example. Only one European firm (Daimler Benz) is now listed on the New York Stock Exchange because it is the only European company that has been willing to express its financial statements in accordance with the requirements of the FASB in the United States. Currently, there may be fundamental differences in accounting principles applied from country to country, but the trend internationally is to unify standards over time.

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Effects of Inflation

The major difference between Latin American accounting principles and GAAP applied in the United States is a response to the high inflation experienced in many Latin countries. This situation has created a need in several Latin American countries to develop an indexing scheme in order to provide a meaningful framework for financial accounting and for the analysis of financial statements. While the level of inflation recently has been reduced in most Latin countries, many of these countries (Brazil, Chile, Peru, Mexico, etc.) still maintain a monetary correction scheme that is at variance with the GAAP of the United States. This scheme may be in place for some time due to the fact that inflation levels, which are considerably lower than in the past, are still high by US standards. If lower inflation becomes a permanent feature, the need for monetary correction will be eliminated and use of this methodology may be phased out in many of these Latin countries (as occurred in Argentina in late 1995). As this occurs in other countries as well, unification of standards with the US may become possible in the future. There are other differences between GAAP in the US and in Latin America; for example, intangible assets such as deferred expenses and goodwill (discussed on page 1-13—1-15). The financial analyst must understand these differences since it may be necessary to adjust the financial numbers presented by a company for analysis purposes. Financial Accounting Basics

To interpret financial statements and make the necessary adjustments to accommodate differences in accounting principles, a financial analyst must understand the basics of accounting. This involves a thorough understanding of the composition of the balance sheet and income statement.

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1-5

An analyst must also understand the basics of balance sheet and income statement accounts and how each account fits within the overall structure of the respective financial statement. Without a basic understanding of accounting, it may be difficult for you to understand the material in the remainder of this workbook. To check your accounting knowledge, please complete the brief exercise that begins on the next page. When you have completed the exercise, check your answers with the answer key in Appendix A. If your level of understanding is insufficient to complete the exercise with substantially correct numbers, we recommend upgrading your accounting knowledge, perhaps through an accounting textbook or self-instruction workbook (e.g. Robert N. Anthony’s Essentials of Accounting) or refreshing your skills by working through Appendix B — Financial Statement Structure.

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1-6


Accounting Exercise PART 1: Use the indivi dual accounts below to create a balance sheet and an income statement. Fill in the blanks on the next two pages and calculate the subtotals and totals. • • • • • • • • • • • • • • • • • • • • • • • • • • • •

Due banks short term Inventory Other current liabilities Capital stock Accounts payable Prior year ending retained earnings Current portion of long-term debt Sales Cash and banks Income tax expense Long-term debt (not including current portion) Selling, general, administrative expenses Prepaid expenses Accounts receivable Taxes payable Other expense Depreciation Net fixed assets Interest expense Other current assets Accruals Marketable securities Cost of goods sold Legal reserve Long-term investments Obligation for employee pensions Dividends paid License rights

-?600 100 800 250 350 50 3,000 50 100 200 300 100 500 50 50 100 1,000 150 100 150 150 2,000 100 300 100 50 200

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1-7

BALANCE SHEET Assets __________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________

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Liabilities __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __

___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________ ___________________________

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__ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __

1-8


INCOME STATEMENT ____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

____________________________

____

Net Income

_______

PART 2: What are the short-term bank debt, ending retained earnings, balance sheet totals, and income statement subtotals? • • • • • • • • • • • • •

Short-term bank debt.....................................................________ Ending retained earnings .................................................________ Total current assets ........................................................________ Total non-current assets .................................................________ Total assets....................................................................________ Total current liabilities.....................................................________ Total non-current liabilities..............................................________ Total liabilities ................................................................________ Total net worth (stockholders’ equity).............................________ Gross margin..................................................................________ Operating margin............................................................________ Profit before taxes..........................................................________ Net income ....................................................................________

Check your answers with the Answer Key in Appendix A.

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1-9

“GETTING BEHIND THE NUMBERS” Special accounting issues to consider

The objective of a good financial analyst should be to “get behind the numbers” to achieve greater depth and quality in risk and needs assessment. There are many special accounting issues and areas that should be considered, including: n

Contextual factors

n

Asset / liability valuation

n

Intangible assets

n

Contingent liabilities

n

Adjustments for inflation

Contextual Factors It is necessary to understand the business environment in which a company operates to permit judging the sufficiency or appropriateness of the numbers and the ratios calculated from them. Contextual factors that impact financial statements include macroeconomic effects, sector accounting norms, consolidated numbers, and seasonality. Macroeconomic Effects Changes in a country’s economy

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Inflation and economic growth are examples of macroeconomic factors that may affect financial numbers and which must be considered when interpreting the “sufficiency” of the numbers. Indexation schemes attempt to deal with inflation, but even where there is no formal indexation, as in the US, the effects of inflation must be considered when interpreting numbers and growth rates.

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Sector Accounting Norms Shaped by economic activity

Different economic sectors have different norms for accounting numbers and ratios. These norms are the result of the economic activity of the companies within the sector, and the assets they require to pursue these activities.

Examples

For example, heavy industrial companies normally require a large amount of fixed assets for their production, and these fixed assets require substantial amounts of capital to sustain them on the balance sheet. On the other hand, a trading company needs little more than office equipment to run its operations, probably renting its office space. This means that it needs relatively lower levels of capital and can assume greater debt relative to capital. These differences in fixed asset needs can have major repercussions in the asset structure and distribution within the balance sheet, which can affect margins and economic performance (Refer to Unit Two). The level of capital that is appropriate for one company may be inappropriate for another and, to enable a thorough analysis, the analyst should understand the difference. Consolidated Numbers

Combined financial statements

The analyst’s job may become more complex when analyzing consolidated financial numbers for a group of companies. Consolidated numbers represent the combined financial statements of a group of interrelated companies that report as if they are one company. From the analyst’s point of view, it is important to get this overview since the funds generation of the group of companies may be involved in repayment, or since funds may be more easily diverted to related companies when dealing with groups.

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1-11

At the same time, it may be more difficult to understand the numbers since many other factors may have an impact. If the group is vertically integrated, then the numbers often will include producers and commercial companies. The final result, in terms of a consolidated financial statement profile, will be to “average everything out” so that ratios are not typical of any specific type of company. In such situations, it is more difficult to assess propriety of numbers, performance, and risk. With the possibility of many companies being involved in group funds generation, it is more difficult to understand the various critical risk factors and the basis for the numbers of each individual company. The analysis then requires much greater depth to be effective in assessing risk. Seasonality Seasonal business activity

Many companies have to deal with seasonal production or sales. For some companies, the seasonality of their activity is obvious, as in the agricultural or agroindustrial sectors; for other companies, the effect may be less pronounced. For still others, seasonality may not be a factor. The extent to which a company’s operations are seasonal can have a major impact on the analysis of its financial statements. Since the balance sheet is a “snapshot” of the company at a certain date, some accounts (receivables, inventory, short-term bank debt, payables) may be at increased, reduced, or average levels. It is very important for the analyst to recognize the seasonality of a company’s business since several ratios (particularly turnover ratios) may be impacted to the point where they may lead to false conclusions. We will discuss examples of this later.

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1-12


Asset / Liability Valuation Application of appropriate GAAP

The applicable GAAP should govern the valuation methodology used for preparing the numbers and, theoretically, if the correct principle is followed, the numbers should be trustworthy. Sometimes, however, the principles are not applied evenly and the analyst must assess the value of the asset or liability as listed on the balance sheet.

Examples

One example may be to question whether receivables have been properly recorded to reflect uncollectables, particularly in economically difficult times. When dealing with vulnerable products such as high tech products that often have short life cycles, check to see if inventory obsolescence has been factored in. Another example is inventories of commodities (coffee, fruit concentrate, cotton, minerals, etc.) which should be valued at “the lower of cost or market” on a continual basis but, perhaps, may not be adjusted properly. While the accounting cost principle states that all items will be recorded at original cost, the accounting profession also recognizes the need to reflect an updated value where accumulated inflation may cause historical cost to be misleading. For example, in most (if not all) Latin American countries, it would be inappropriate to value fixed plant and equipment that was acquired in the mid 1970s, with a useful life of 40 years, at present depreciated cost valuation. This would be misleading when the analyst considers that accumulated inflation during these intervening 20 years may exceed 20,000% in some countries.

Revaluation in Latin America

Revaluation of fixed assets within specific guidelines is generally permitted in Latin America. The guidelines stipulate the minimal amounts of accumulated increase in price indices that can trigger the change, and the valuation methodologies that may be used to “update” these fixed assets. Tax treatment for revaluation of assets may vary from country to country but, where it is taxed, it obviously is a disincentive to revalue.

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1-13

In a revaluation, the corresponding entry to the net increase in fixed assets is an equal increase in the net worth account revaluation surplus. Therefore, the direct result of a revaluation is to increase net worth. If an analyst reviews the net worth accounts of most companies listed on stock exchanges in Latin America, well over half the amounts may be the result of revaluation surplus. This is a legacy of the high inflation environment of the 1980s. Nevertheless, fixed asset revaluations should be questioned for propriety since the methodology used may impact the numbers, affecting the total net worth and the leverage ratios. On the liability side, foreign currency debt must be listed on the balance sheet at the equivalent in local currency, as of the balance sheet date. In some cases, this account may not be updated as required, or a subsequent devaluation may render the numbers out of sync with current reality.

Intangible Assets Adjust for unrealizable assets

According to standard financial analysis theory, for purposes of computing an adjusted leverage position, intangible assets should be subtracted from net worth to compute tangible net worth. This adjustment recognizes that very often these assets cannot be realized (unless the company itself is sold) and, therefore, do not provide coverage of assets to pay out liabilities.

Example: Deferred expenses

This theory usually is applicable for intangibles such as deferred expenses and goodwill. Deferred expenses, such as start up costs that are capitalized instead of written off against earnings, is another area where there is a general variance between Latin American and US GAAPs.

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In Latin America, start-up costs may be capitalized and amortized over several years. The theory is that start-up costs benefit the company over time and not just in the year incurred. The effect of this is to significantly reduce a loss (or overbook a profit), thereby overbooking net worth and improving the debt / equity position of the company. It also results in a greater variance between the cash position of the company and the reported net income figure. US GAAP requires writing off start-up costs against earnings in the

period in which they are incurred. The result is reduced earnings (or a loss) which immediately impacts net worth, reflecting a stricter view of the company’s capital account position. This position is consistent with netting intangibles against net worth for calculating tangible net worth, and is appropriate for this type of intangible. Example: Licenses

Having said this, however, we must understand the logic and apply it to other intangibles. Consider patents, copyrights, and licensing agreements. What is a brewery or soft drink bottling company’s most valuable asset when it produces someone else’s branded product? What is the most valuable asset for a distiller, a perfume / cosmetics producer, or a cigarette manufacturer? Answer: The license to produce the branded product. Yet, a license is an intangible. So, why should we automatically net this most valuable asset against net worth to calculate tangible net worth? This would not be logical because, even though the asset is an intangible, it has a market value; in many instances, it could be sold for greater than its listed value on the balance sheet.

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1-15

By the way, let’s remember a small but important issue here. A brewery with its own brand does not necessarily have this reported on the balance sheet as an intangible asset. US GAAP, as in many other countries, requires that unless the brand or company has been sold in an open market, the value of the brand name does not appear on the balance sheet. A sale on the open market involves a specific cost to the buyer and, without it, it is too subjective to value the item. Some accountants feel that some formula should be developed for this type of valuation, but GAAP currently stipulates that the item does not appear on the balance sheet at an arbitrary market value. Example: Goodwill

Another example is goodwill that is reflected on the balance sheets of recently privatized companies. In these cases, the capital market in the respective country has quite recently set the value of the asset, proving its worth on an open market. We can see the need for discriminating between categories of intangibles before making automatic adjustments on the balance sheet. This discrimination will enable a higher quality of analysis.

Contingent Liabilities Contingent liabilities, when added to direct liabilities, sometimes can have a major impact on how an analyst judges the overall financial position of a company. The analyst should, therefore, consider the possible impact of contingencies — particularly when judging the capital sufficiency of a company. The most common contingent liabilities probably are corporate guarantees and open foreign currency positions. Another off balance sheet “liability” — lease obligations — should also be considered. It is important for analysts to give appropriate consideration to all of these items in order to permit an understanding of the company’s overall financial position and business risk.

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There may be a significant difference in the perception of the balance sheet when contingent liabilities are included and when they are not included, particularly in the case of leased assets and their corresponding payment obligations. There may be major swings in asset turnover and capital adequacy ratios. Airlines and transport companies may be especially noteworthy examples, since these types of companies often lease major amounts of fixed assets. This is another area where US and Latin American GAAP may differ. US GAAP require capitalization on the balance sheet of all items acquired as capital leases, along with the corresponding liabilities, valued at the net present value of the lease. Operating leases are charged to expenses. Some countries in Latin America require similar treatment, but others may not. The analyst should clearly understand how these rules apply within his/her jurisdiction. Some questions to ask include: What are the specific rules? What is a capital lease and what is an operating lease? Where there are ambiguities or an alternative accounting treatments, these ambiguities or alternatives should be clearly understood.

SUMMARY

Accounting, the systematic tracking and reporting of daily financial activity in a company, may be separated into three major branches: 1. Managerial accounting for internal use 2. Tax accounting for calculating tax liabilities 3. Financial accounting for presenting a financial accounting of a company to outside parties

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Financial analysis is an effort to interpret the numbers reported in financial statements. Several issues must be considered when analyzing the numbers, including the general business environment in a country, methodology applied to the valuation of assets, reporting of intangible assets and contingent liabilities, and adjusting for inflation. In this section, we discussed four of these accounting issues. Please complete Progress Check 1.1 to check your understanding of these concepts and then continue on to the section on “Adjusting for Inflation.”

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PROGRESS CHECK 1.1

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material.

Question 1: A company is producing financial statements for publication in its annual report. This is an example of: ____ a) managerial accounting. ____ b) financial accounting. ____ c) tax accounting. Question 2: A company wants to know how much it will have to pay the local regulatory agency if it implements a new product that is profitable. This is an example of: ____ a) managerial accounting. ____ b) financial accounting ____ c) tax accounting. Question 3: A company has restructured its accounting procedures to accommodate a need for business units to know individually the amount of their monthly expenses. This is an example of: ____ a) financial accounting. ____ b) tax accounting. ____ c) managerial accounting.

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ANSWER KEY

Question 1: A company is producing financial statements for publication in its annual report. This is an example of: b) financial accounting.

Question 2: A company wants to know how much it will have to pay the local regulatory agency if it implements a new product that is profitable. This is an example of: c) tax accounting.

Question 3: A company has restructured its accounting procedures to accommodate a need for business units to know individually the amount of their monthly expenses. This is an example of: c) managerial accounting.

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PROGRESS CHECK 1.1 (Continued)

Question 4: The responsibility of the FASB or its equivalent in other countries is to: ____ a) unify global standards for presenting financial accounts. ____ b) define the principles to follow for financial accounting within its jurisdiction. ____ c) develop an indexing scheme for financial reporting. ____ d) monitor the compliance of non- US companies with GAAP in order to qualify for listing on the New York Stock Exchange.

Question 5: Identify three business factors that may affect the interpretation of a company’s financial statements. ____ a) Low inflation ____ b) Internal cost allocations between related companies ____ c) High level of leased fixed assets ____ d) Increased sales in the fourth quarter for a Christmas tree ornament company ____ e) Internal capital use charges

Question 6: When Generally Accepted Accounting Principles are not evenly applied: ____ a) the value of fixed assets must be adjusted to account for inflation. ____ b) the taxes applied to the revaluation of assets must be considered. ____ c) there is no impact on the balance sheet. ____ d) the resulting numbers may not fairly reflect the financial position of the company.

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ANSWER KEY

Question 4: The responsibility of the FASB or its equivalent in other countries is to: b) define the principles to follow for financial accounting within its jurisdiction.

Question 5: Identify three business factors that may affect the interpretation of a company’s financial statements. a) Low inflation c) High level of leased fixed assets d) Increased sales in the fourth quarter for a Christmas tree ornament company

Question 6: When Generally Accepted Accounting Principles are not evenly applied: d) the resulting numbers may not fairly reflect the financial position of the company.

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Question 7: Intangible “assets” such as brand names developed by a company are difficult to value because: ____ a) they cannot be changed. ____ b) they cannot be sold. ____ c) their values may not have been tested on the open market. ____ d) they have no value.

Question 8: Identify two common contingent liabilities. ____ a) Open foreign currency position ____ b) Corporate guarantee ____ c) Purchase of large amounts of fixed assets ____ d) Monthly office rent

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ANSWER KEY

Question 7: Intangible assets are difficult to value because: c) their values may not have been tested on the open market.

Question 8: Identify two common contingent liabilities. a) Open foreign currency position b) Corporate guarantee

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Adjusting for Inflation Before the progress check, we discussed four accounting issues that are of special concern to the financial analyst: contextual factors, asset valuation, intangibles, and contingencies. The final area of concern includes the issues associated with adjusting for inflation. Example

Inflation is a general increase in prices or a general shrinkage in the purchasing power of the currency. For example, in an inflationary environment, if a liter of gas costs 100 Lcy today, it will take more currency in the future to buy the same amount of gas. In accounting, all transactions are measured in monetary terms. Consequently, the accuracy of accounting depends on the stability of the currency's purchasing power. After prolonged periods of inflation, or periods of high inflation, figures reported in financial statements are meaningless unless adjustments are made to reflect the effects of inflation. Effects of Inflation on the Balance Sheet

According to GAAP, accounts must be stated at historical cost. However, in times of high inflation, figures reported in the balance sheet may actually reflect historical value, present value, or even future value. Let's see why this occurs. Accounts stated at historical value

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Although all items are exposed to inflation, the impact can be low or high depending on the turnover of the item. Inventories is one example. If a company has a high turnover of inventories, the cost reported in the balance sheet will be relatively close to current or replacement cost. Conversely, if the turnover is low, considering that historical cost is used to value inventories, the reported cost will be lower than the current or replacement cost.

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It is easy to imagine that inflation has the greatest impact on permanent assets and equity. For example, land purchased decades ago is reflected in the balance sheet as its cost at the time of purchase. Accounts stated at future value

In countries where inflation has been high for a long time, a significant distortion is created in the form of “expected inflation.” This occurs when the price for a credit sale is significantly higher than the price for a cash sale. In this situation, the accounts receivable in the seller's books and the accounts payable in the buyer's books are reported in future value terms.

Accounts stated at present value

When balances in accounts are stated at present value, they are expressed in terms of their purchasing power as of the date of the financial statements. The best example of a present-value account is Cash, which includes all funds immediately available to the company. Effects of Inflation on the Income Statement

Reflects a period of growth

Inflation impacts the income statement in a different way. The income statement reports the results accumulated over a period of time and, therefore, even when operating volumes remain constant, income and expense figures grow from year to year. Earnings per share also become proportionally higher, unless the company issues additional shares at inflated prices. In inflationary environments, companies seem to grow all the time. Judging only from a series of consecutive income statements, bankers would be very happy to grant credit to many of them.

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Uneven measurements resulting from seasonality

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But, this is not the only problem. Since income statements compile data from several months, the aggregate measurements are made with quite different yardsticks. This is not so important when sales and expenses are relatively even throughout the year, but seasonal flows are quite common for many companies. Consequently, revenues of companies with sales concentrated in the beginning of the year are understated and revenues of companies with sales concentrated in the end of the year are overstated. The same applies to expenses. Inflationary Accounting

Problems

All accountants agree that the effects of inflation must be measured, but most also agree that existing methods are experimental, involve too many assumptions and judgments, and results are only estimates. Also, GAAP and income tax regulations vary from country to country. In some cases, even inflation indices published by the government agencies are not reliable.

Solutions

There are two ways of overcoming these problems:

Foreign currency accounting

n

Foreign currency accounting, often using the US dollar

n

Constant currency accounting

For several countries, the US dollar is more stable than local currency and, therefore, many companies keep unofficial accounts in US dollars. These accounts usually have no legal value, but they can help the analyst make better judgments, even though inflation also affects US dollars. When analyzing a company that is a subsidiary of a foreign company, the analyst should obtain financial statements sent to the head office. These statements are prepared using a stable currency (e.g. US dollars) which facilitates a better understanding of the company's financial position. They are also more reliable, because local financial statements are not always audited.

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Constant currency accounting


Constant currency accounting uses a form of strong currency, usually hypothetical, as a unit of measurement. In practice, this means keeping accounts in an indexed “currency.” This comprehensive procedure is designed to produce comparable financial statements. In the next section, we will see how this is accomplished. Constant Currency Accounting

Before we discuss indexation, it is fundamental that we understand what should be indexed and why — which brings us to the concept of monetary and non-monetary items under assets, liabilities, and equity. Monetary items

The nominal value of monetary items, such as cash, accounts receivable, accounts payable, and bank debt, remains constant over time. Obviously, in an inflationary environment, the associated purchasing power of these items decreases over time. Monetary assets generate losses due to the reduction in purchasing power of cash or future cash inflows, such as accounts receivable. Conversely, monetary liabilities generate gains due to the reduction in purchasing power of future cash outflows, such as accounts payable and bank debt.

Non-monetary items

Non-monetary items maintain their actual, intrinsic value over time. Examples of these items are fixed assets, long-term investments, inventories, and equity. Since these items have been acquired some time in the past, their historical cost is lower than their present value in an inflationary environment. Comprehensive Monetary Correction (MC)

Let's look at the basic mechanics of monetary correction of financial statements. Monetary items reflected in the Income Statement

Since monetary items are already expressed at their present value, no monetary correction should be calculated for the purpose of disclosure in the balance sheet. On the other hand, since assets generate monetary losses and liabilities generate monetary gains, these variances should be calculated and reclassified on the income statement.

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Example

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For example, let's examine the transactions for one specific month, based on the following assumptions: n

10% inflation for the period

n

All monetary items were exposed to inflation during the whole month

n

The sale was effected on the first of the month

You can see this reflected in the adjusted financial statement in Exhibit 1.1.

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Earnings impact adjustments

Balances before MC

MC

Cash Receivables Inventories Fixed Assets

100 200 180 430

10 20 18 43

(10) (20)

100 200 198 473

Total

910

91

(30)

971

Payables Capital Retained Earnings - Opening Balance - Income of the period

360 150

36 15

(36)

360 165

210 190

21 19

6

231 215

Total

910

91

(30)

971

Income for the period Sales Cost of Sales

320 130

32 13

352 143

Net Profit

190

19

209

Account

Gain on Net Monetary Items Net Income

l 190

l 19

6i 6

Balances after MC

6 215

Exhibit 1.1: Financial statement adjusted for inflation

You can see that the company reports a gain on net monetary items of 6 Lcy, which is the net result of: n

Loss on monetary assets: • Cash

(10)

•

(20)

Receivables

n

Gain on monetary liabilities • Payables 36

n

Net gain on monetary items

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Non-monetary items

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Since there are no monetary gains or losses from non-monetary items, monetary correction of these items will not affect the income statement. However, since they were acquired in the past, the asset or equity balance for each of these items should be restated to current price levels in the balance sheet. Additional Adjustments for Inflation

Remunerated monetary items

In countries where inflation has been constant for a long time, it is difficult to find true monetary items. Most assets and liabilities are protected from inflation with instruments and contracts that adjust their values according to the official inflation indices. These are remunerated monetary items.

Example

For instance, a company invests excess cash in a certificate of deposit (CD) that pays interest at 12% p.a. and also pays the variance in the official inflation indices. When making accruals, the amount recorded as financial income is a combination of actual interest and monetary correction. To really measure the effects of inflation in the financial statements, the monetary correction paid on the CD should be transferred from Financial Income to Gain on Monetary Assets. Similarly, for a loan in foreign currency, the company has to pay the interest, which is the actual financial expense, and also the exchange variances. All exchange losses incurred on this loan should be reclassified from Financial Expense to Losses on Monetary Items.

Discounting receivables / payables to present value

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Since credit sales include expected future inflation, they should be adjusted as follows. Accounts Receivable in the seller's books should be discounted to present value and the difference adjusted to Net Sales. Payables in the buyer's books should be discounted to present value and the difference adjusted to Inventories.

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Comparative Financial Statements

The comparative financial statements for the previous year should be restated by applying the annual variation in the official inflation index to each item in order to ensure they are comparable under a constant currency. The Brazilian Experience Companies on the stock exchange

In Brazil, the concepts of monetary correction discussed above are valid only for companies listed in the stock exchange, since these accounting principles are endorsed by the CVM (The Brazilian Exchange Commission).

Companies not on the stock exchange

For companies not listed in the stock exchange, the GAAP governing monetary correction of financial statements as specified by the “Corporations Law” is less complete. In these cases, only Permanent Assets and Equity accounts are monetarily corrected, with the difference between original and restated value grouped under the heading of Result of the Monetary Correction of the Balance Sheet. For comparison purposes, income for the current year and the previous year's figures are not restated. Therefore, financial statements prepared in accordance with the Corporations Law only partially reflect the effects of inflation. To gain a thorough understanding of a company's financial position, the analyst will have to make the additional adjustments described above in the comprehensive monetary correction procedure.

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FINANCIAL ANALYSIS SPREADSHEETS Used by banks to “spread” client financial numbers

For many years, virtually all banks have used a financial analysis spreadsheet to “spread” client financial numbers into a more manageable, useful, and standardized format. The spreadsheet captures client information in separate columns for each year or period, thereby facilitating comparison and enabling trend analysis. For most types of companies, the standard spreadsheet contains: n

A balance sheet

n

An income statement

n

Fixed asset and net worth reconciliations

n

Ratios and percentages

n

A funds flow statement (in many cases)

Fundamentally different businesses (banks or insurance companies, for example) may require different spreadsheets to facilitate numbers analysis. Before the arrival of the personal computer in the early 1980s, this process was done entirely by hand on a sheet of paper. Now, it is done electronically on a computer screen using sophisticated software (such as Microsoft Excel), enabling a tremendous jump in productivity and depth over earlier manual processes.

Changed 07/02/96

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Citibank electronic spreadsheet model

In late 1995, after many years of using a standard format either on paper or by electronic means derived from the original manual format, Citibank in Latin America developed a new and more comprehensive electronic spreadsheet model. The new model goes beyond capturing numbers for analysis; it incorporates business risk assessment and financial risk rating. It also features indexing of accounts and includes greater detail in certain account reconciliations and ratio calculations.

Know how the model works

To make optimal use of these formats, the analyst should clearly understand the details and nuances of how they work. Calculations are the result of formulas, not magic, and it is important to understand that designing a model involves some trade offs. As we discuss ratios in a later unit, you will see that there may be more than one way to calculate a ratio. Some calculations give more accurate results than others; but, if the necessary information is unavailable, we may have to settle for a second choice. In certain cases, the method used for calculating a ratio may make a significant difference in the results. It is up to the analyst to get the additional information and make the appropriate calculations to achieve a more in-depth, meaningful financial analysis. The analyst must understand where the numbers come from and where the weak points of the model may leave results open to questionable interpretation. An example of this may be seasonality of financial numbers, where ratios calculated from end-of-period numbers may be distorted from reality. Improper conclusions may result if the analyst does not understand the effect. We will discuss this point later in the units dealing with financial ratios.

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Summary In an environment of prolonged periods of inflation or high inflation rates, financial statements have meaning only when they are adjusted to recognize the effects of inflation. Problems

In periods of high inflation, the balance sheet may reflect historical values, present value, or future value. As a result, accounts may be either overstated or understated. In inflationary environments, results reported in the income statement appear to grow over time. Even when operating volumes remain constant, income and expense figures continue to grow.

Solutions

These problems are solved by using either foreign currency (e.g. US dollars) accounting or constant currency accounting. US dollar accounting is an unofficial accounting method used by companies in countries where the US dollar is more stable than local

currency. Constant currency accounting is a method of keeping accounts in an indexed, hypothetical “currency.” Adjustments

As a result of inflation, monetary assets generate losses; monetary liabilities generate gains. These variances should be calculated and accounted for in the income statement. The asset or equity balance for non-monetary items should then be restated to current price levels in the Balance Sheet.

Remunerated monetary items

When inflation has been constant for a long time, assets and liabilities must be protected with instruments requiring compensation for variance in the official inflation indices to prevent the loss of value.

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Adjustments to expected inflation

When receivables and payables include expected future inflation, they should be discounted to present value and adjusted to Net Sales and Inventories, respectively, to reflect the actual value of the obligation.

Restatement for comparative analysis

Comparative financial statements from the previous year should be restated to reflect the annual variation in the official inflation index for purposes of comparative analysis.

You have completed Unit One: Accounting Issues in Financial Analysis. Please answer the questions in Progress Check 1.2 to check your understanding of the material before proceeding to Unit Two: Basic Concepts of Financial Analysis.

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PROGRESS CHECK 1.2

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 9: Monetary gains on remunerated items are a type of: ____ a) income that originates from monetary correction of liabilities. ____ b) expense that originates from monetary correction of liabilities. ____ c) income that originates from monetary correction of assets. ____ d) expense that originates from monetary correction of assets. Question 10: If a company takes a $100 loan at the beginning of 19X0, monetary correction for that year is 250%, and losses are adjusted to official inflation indices, we may say that the company owes: ____ a) $250 at the end of the year and has incurred a remuneration of $150 (expense). ____ b) $250 at the end of the year and has been remunerated $150 (income). ____ c) $350 at the end of the year and has been remunerated $250 (income). ____ d) $350 at the end of the year and has incurred a remuneration of $250 (expense). Question 11: Read the following statements about constant currency accounting then indicate whether they are true or false by marking with a "T" or "F." ____ a) The nominal value of monetary items remains constant over time. ____ b) Accounts payable are non-monetary items. ____ c) Inventories are monetary items. ____ d) Non-monetary items maintain their actual (intrinsic) value.

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ANSWER KEY

Question 9: Monetary gains on remunerated items are a type of: a) income that originates from monetary correction of liabilities.

Question 10: If a company takes a $100 loan at the beginning of 19X0, monetary correction for that year is 250%, and losses are adjusted to official inflation indices, we may say that the company owes: d) $350 at the end of the year and has incurred a remuneration of $250 (expense).

Question 11: Read the following statements about constant currency accounting then indicate whether they are true or false by marking with a "T" or "F." T

a) The nominal value of monetary items remains constant over time.

F

b) Accounts payable are non-monetary items.

F

c) Inventories are monetary items.

T

d) Non-monetary items maintain their actual (intrinsic) value.

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Question 12: When goods are sold for payment in 60 days: ____ a) the total of trade receivables undergoes monetary correction every month, and the difference is accounted for as financial income. ____ b) the amount of the bill remains the same until payment. ____ c) after 60 days, the company records a loss caused by inflation for the period. ____ d) there are no inflation gains or losses, since the company could sell for cash and invest the proceeds in the money market.

Question 13: Monetary correction is a methodology used to index prices in an inflationary economy. Indicate whether the following statements are true or false by marking "T" for true or "F" for false. ____ a) Inflation gains and losses do not necessarily reflect cash inflows and outflows during the year in which they occur. ____ b) The values of inventories which remain with the company for long periods are lower than current market prices. ____ c) Monetary correction of remunerated liabilities generates financial expense. ____ d) Effects of inflation are the net of gains and losses on monetary items.

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ANSWER KEY

Question 12: When goods are sold for payment in 60 days: b) the amount of the bill remains the same until payment.

Question 13: Monetary correction is a methodology used to index prices in an inflationary economy. Indicate whether the following statements are true or false by marking "T" for true or "F" for false. T

a) Inflation gains and losses do not necessarily reflect cash inflows and outflows during the year in which they occur.

T

b) The values of inventories which remain with the company for long periods are lower than current market prices.

T

c) Monetary correction of remunerated liabilities generates financial expense.

T

d) Effects of inflation are the net of gains and losses on monetary items.

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Use the information which follows to complete both Questions 14 and 15. Question 14: Fill in the blanks on the following calculation of the effects of inflation. Assume that: n

The inflation index for the period is 10%

n

Both the marketable securities and loans payable are subject to monetary correction

Opening balances: Assets

Liabilities

Cash Marketable Securities Fixed Assets

60 100 780

Total

940

Accounts Payable Loans Equity

160 300 480 940

Calculations: Gains on remunerated monetary assets Losses on remunerated monetary liabilities

____________ (___________)

Monetary correction of fixed assets Monetary correction of equity

____________ (___________)

Total effect of inflation

____________

Represented by: Losses on non-remunerated monetary assets Gains on non-remunerated monetary liabilities

(___________) ____________

Net gain on monetary items

____________

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ANSWER KEY

Question 14: Fill in the blanks on the following calculation of the effects of inflation. Assume that: n

The inflation index for the period is 10%

n

Both the marketable securities and loans payable are subject to monetary correction

Opening balances: Assets

Liabilities


60 100 780

Total

940


160 300 480 940

Calculations: Gains on remunerated monetary assets Losses on remunerated monetary liabilities Monetary correction of fixed assets Monetary correction of equity

(

10 30

)

(

78 48

)

Total effect of inflation

10

Represented by: Losses on non-remunerated monetary assets Gains on non-remunerated monetary liabilities Net gain on monetary items

(

6 16

)

10

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Question 15: After all adjustments are made, the balance sheet will appear as follows: Assets

Liabilities


_____ _____ _____

Total

_____


_____ _____ _____ _____

Question 16: Select three features of the electronic spreadsheet model developed by Citibank in Latin America. ____ a) Formula selection ____ b) Business risk assessment ____ c) Automatic monetary corrections ____ d) Financial risk rating ____ e) Account indexing

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ANSWER KEY

Question 15: After all adjustments are made, the balance sheet will appear as follows: Assets Cash Marketable Securities Fixed Assets Total

Liabilities 60 110 858


1,028

160 330 538 1,028

Composition of Equity Opening Balance + Monetary Correction + Net Income

480 48 10

Closing Balance

538

Question 16: Select three features of the electronic spreadsheet model developed by Citibank in Latin America. b) Business risk assessment d) Financial risk rating e) Account indexing

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Unit 2

UNIT 2: BASIC CONCEPTS OF FINANCIAL ANALYSIS INTRODUCTION

In Unit One, we discussed some of the accounting issues that affect the preparation of financial statements. By now, you should recognize that financial analysts must “get behind the numbers” by considering certain accounting-related issues to understand the true financial picture of a company. In this unit, we will focus on other areas of consideration, including analyzing the funds flow within a company and measuring its working capital needs. These basic concepts will enable you, the analyst, to probe deeper in search of more reliable conclusions concerning a company's financial health.

UNIT OBJECTIVES


Define “liquidity” and recognize its impact on the financial position of a company

n

Compute working capital and determine whether it is positive or negative

n

Distinguish between “third party” capital and “own” capital

n

Classify assets, liabilities, and net worth accounts as either a use or source of funds

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BASIC CONCEPTS OF FINANCIAL ANALYSIS

LIQUIDITY

Degree of Liquidity Varies with type of asset

The liquidity of an asset, as determined by economic factors affecting supply and demand, varies with the type of asset and, in some cases, with time. For example, certain government securities can be realized overnight, some receivables can be realized in 30 days or less, but it takes longer to sell a large industrial building. The seasonality of an item may also affect its liquidity; for example, a heavy coat will be more marketable during the winter season than in the hot summer months. Some assets, such as claims, are liquid by nature. These include checks, trade bills, and contracts where liquidity is determined by the parties. For instance, a check is a claim to receive cash at sight — all the holder has to do in order to realize it is to present it at the bank. A sale that is negotiated for payment in 10, 30, or 60 days generates a trade bill that expresses the claim to receive cash at the specified time.

Importance of Liquidity Company’s ability to meet obligations on time

Liquidity is important because it sustains the ability of an enterprise to meet its obligations in a timely manner. As an analyst, it is vital to understand this concept since the definition of insolvency is the inability of a firm to meet its obligations as they mature. The penalty for lack of liquidity is very high, including the possibility of bankruptcy if the creditors attempt to collect through the courts.

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2-3

Increasing Liquidity Timely management strategies

Installing timely management strategies can increase asset liquidity. For example: n

Payment delays may be reduced by efficient credit and collection procedures.

n

Inventories may be sold faster if they are advertised and promoted or if they are perceived to be of higher quality than the competition.

Liquidity and Balance Sheet Structure Liquidity also affects the structure of the balance sheet. The asset accounts are listed in the order of their liquidity — current assets first, fixed assets second, and other assets last. Individual current accounts are also ranked by their degree of liquidity. For instance, cash is the most liquid account and is, therefore, listed first among the current assets.

TYPES OF CAPITAL

Working Capital Resources to meet day-today needs

Working capital is the amount of resources available to meet a company's day-to-day needs, such as paying expenses or debts incurred to purchase current assets. The difference between current assets and current liabilities determines the amount of working capital — the net current assets on the balance sheet. In accounting terms, it is the part of current assets that is not financed by current liabilities. In general, the greater the amount of working capital, the greater the liquidity. In Unit Four, we will demonstrate that the current ratio, which represents the coverage of current assets over current liabilities, is a traditional measure of liquidity.

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Working capital from the funds flow perspective


In Figure 2.1, you can see the concept of working capital from the funds flow perspective of how funds actually flow within a company. We will discuss funds flows in greater detail later in this unit.

Supplier

Payroll

Inventories

Income

Cash

Receivables

Bank Loans

Figure 2.1: Working capital

Working capital flows are not homogeneous; funds flow in and out in different volumes and at different times in response to seasonality of sales, purchases, and work flow. Positive / negative working capital

The amount of a company’s working capital may be positive or negative. We can determine this by subtracting current liabilities from current assets. Working Capital = Current Assets – Current Liabilities

If current assets are greater than current liabilities, working capital is positive. If current assets are less than current liabilities, working capital is negative. These concepts are shown in Figures 2.2 and 2.3.

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CURRENT ASSETS

2-5

CURRENT LIABILITIES Positive working capital

Figure 2.2: Positive working capital — current assets > current liabilities

CURRENT ASSETS

CURRENT LIABILITIES

Negative working capital

Figure 2.3: Negative working capital — current assets < current liabilities

Timing of cash flows

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The definition of working capital is somewhat generalized because it is based on volume only. A better measure of a company's working capital also includes the element of time. Time indicates when inflows and outflows will take place in all asset and liability accounts. Time and volume together provide a more exact picture of a company's working capital.

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Permanent Capital Non-current assets funded by long-term debt

Permanent capital, in a generic sense, is comprised of non-current assets (e.g., land, buildings, furniture, equipment, etc.) in relation to long-term liabilities (e.g., long-term debt, etc.) and shareholders’ equity (net worth). Non-current assets should be funded by long-term financing or permanent funds. This is illustrated in Figure 2.4, below.

LIABILITIES & NET WORTH

ASSETS

Long-term assets

Permanent

Long-term debt

or Fixed Assets PPE Investments Deferred charges

NonCurrent Capital

Shareholders’ Equity Capital stock Reserves Retained earnings

Figure 2.4: Permanent capital – Non-current assets funded by long-term debt

We know that net worth is the interest investors have in the assets of an enterprise after satisfaction of liabilities owed to the company's creditors. Net worth represents an important part of a company's permanent capital and should be used to support fixed assets and investments. Any excess of net worth over fixed and other non-current assets is then available for funding working capital. If net worth is lower than permanent assets (fixed assets), the difference on the balance sheet will be funded by outside capital. This outside source of funds will also cover the working capital financing needs. The following example of Alpha Company illustrates this point. Current Assets Fixed Assets Total

$200 300 $500

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Current Liabilities Net Worth Total

$150 350 $500

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2-7

Notice that there is a $50 difference between net worth and fixed assets. Since net worth is greater, the difference ($50) in effect serves to provide funds for working capital. The proportion of a company’s own resources used for funding fixed assets is greater than 100%, so 14% of net worth is used to fund the company's working capital. Now suppose Alpha Company purchases a new plant for $100 that is financed by long-term loans. Current Asset Fixed Assets Total

$200 400 $600

Current Liabilities Long-term Liabilities Net Worth Total

$150 100 350 $600

Fixed assets increase from $300 to $400 and total long-term liabilities increase by the same $100. Fixed assets are now covered by $350 in net worth and by $50 in long-term debt. Since the entire net worth is used to cover fixed assets, current assets are funded entirely by outside capital.

Third Party and Own Capital Another way to look at liabilities and net worth is to see liabilities as third party capital and net worth as own capital. These concepts are discussed below and illustrated in Figure 2.5.

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Third Party Capital

Outside capital represents the company's indebtedness to third parties and represents obligations to pay sums of money at some future date. Third party capital may be classified as: n

Current liabilities — liabilities maturing within one year

n

Long-term liabilities — liabilities maturing after one year

Third party capital also may be divided into: n

Operating credits, which arise from a company's operations and include trade payables as well as accrued taxes and similar obligations

n

Financial credits, which reflect loans from financial institutions, bond holders, shareholders, or affiliates

Own Capital

Own capital represents the owners' investment in the company plus the wealth accumulated by the company from its business earnings. It is divided into: n

Paid-in capital — the amount actually invested by the owners which usually remains in the company forever. It is only returned to the owners, in whole or in part, in very rare cases when a company is dissolved or its capital reduced.

n

Retained earnings — the wealth accumulated by the company as a consequence of its profitable operations over a number of years. Eventually, retained earnings are capitalized or paid out as dividends. Companies with unprofitable operations have accumulated losses. Many companies have unprofitable periods now and then, but in grave situations, the company may need additional capital injections to prevent insolvency.

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Current Liabilities Long-Term Liabilities

Operating Credits OR

Financial Credits

Third Party Capital

Paid-in Capital Own Capital Retained Earnings

Figure 2.5: Third party capital and own capital

Difference Between Liability and Net Worth Financing A company may finance its operations by increasing liabilities by increasing net worth. Both methods have advantages and disadvantages and they must be skillfully combined by management to optimize sourcing. Own capital is always the basic source of financing because it represents the owners' commitment. No financial institution will lend money to a company if the owners are not sufficiently committed. Net worth financing does not bear interest and does not have to be repaid. But it would be an error to finance a company solely with the owners' resources. Here are several reasons:

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n

Interest is a cost of doing business and is, therefore, taxdeductible. This means that interest expense is always lower than a first look at the income statement would lead us to think.

n

Liability financing does not tie up owners' capital. This means that a financial manager can attain greater flexibility to cover temporary cash needs.

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n

Own capital dilutes earnings per share and dividends. A company whose profit ratios are higher than interest rates can usually maximize earnings per share by using bank and suppliers' credits. This is the concept of leverage that will be covered in Unit Three: Financial Statement Analysis.

SUMMARY

Liquidity is the ability of an enterprise to convert assets into cash or equivalent, without significant loss, to meet the financial obligations of the debtor. Asset realization times may be affected by economic issues and by seasonal factors affecting supply and demand. As an analyst, you should have a feeling for the liquidity of a company when evaluating its financial health because liquidity determines the company's viability on a short-term basis. Management strategies such as these will help increase asset liquidity: n

Effective credit and collection procedures to prevent receivables backlogs

n

Advertising and promotions to increase inventory turnover

In most countries, asset accounts appear in the balance sheet in the order of their liquidity — current assets are listed first. The same order is followed within account groups — the most liquid account is listed first. If this is not the system used in your country, you should reclassify the accounts for analysis purposes.

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Working capital is the difference between current assets and current liabilities. It represents the resources available to meet the company’s day-to-day needs. In general, the greater the amount of working capital, the greater the liquidity. Sources of funds are classified on the balance sheet as either: n

Third party capital

n

Own capital

Third party capital represents the company's indebtedness and claims to future payments. These include: n

Operating credits — such as trade bills, accrued payroll, or taxes

n

Financial credits — such as loans granted by banks, shareholders, affiliates, or debentures

Own capital represents the owners' investment in the company and the accumulated wealth generated from doing business. Own capital includes: n

Paid-in capital

n

Retained earnings

Distinctions between third party capital and own capital are important because of the obligations and privileges associated with them. Third party capital is an obligation to be paid, while paid-in capital carries incidence of ownership and the right to profits. As an analyst, you also need to be aware of a company's working and permanent capital. Working capital is the difference between current assets and current liabilities; whereas permanent capital is the relationship between non-current assets, long-term liabilities, and shareholders' equity.

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You have completed the first section of Unit Two. Please complete Progress Check 2.1 before continuing to the final section of this unit which covers “Sources and Uses of Funds.”

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PROGRESS CHECK 2.1

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 1: Liquidity is: ____ a) the ability of an enterprise to meet its obligations without delay. ____ b) all measurable resources available to the company for use in its operation. ____ c) the cash value of the company's assets. ____ d) the net income of an enterprise.

Question 2: The degree of liquidity of an asset is determined by its: ____ a) cost. ____ b) market value. ____ c) degree of convertibility to cash. ____ d) age.

Question 3: Number the following assets (1-3) to indicate the degree of liquidity. (1 for most liquid) ____ Ten-floor city building ____ Balances on demand deposits ____ Car

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ANSWER KEY

Question 1: Liquidity is: a) the ability of an enterprise to meet its obligations without delay.

Question 2: The degree of liquidity of an asset is determined by its: c) degree of convertibility to cash.

Question 3: Number the following assets (1-3) to indicate the degree of liquidity. (1 for most liquid) 3

Ten-floor city building

1

Balances on demand deposits

2

Car

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Question 4: A lack of liquidity may lead a company to: ____ a) prepay its obligations. ____ b) acquire fixed assets. ____ c) make sales with greater credit terms. ____ d) bankruptcy.

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ANSWER KEY

Question 4: A lack of liquidity may lead a company to: d) bankruptcy.

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Question 5: Look at the following list of funds movements that relate to working capital. Write the letter of each item in the appropriate circle in the diagram below. The first one serves as an example. a) Raw materials purchased on credit

h) Payment to suppliers

b) Factory payroll (blue collar workers)

i) Repayment of bank loans

c) Working capital loans d) Work in process (unfinished goods)

j) Total payroll (white and blue collar workers)

e) Goods sold on credit

k) Commissions paid to salespersons

f) Profit from sales

l) Goods sold on cash basis

g) Collection of trade receivables

m) Sale of finished goods n) Raw materials used in production

BANK LOANS

SUPPLIERS

a RAW MATERIALS INVENTORIES

WORK IN PROCESS INVENTORIES

CASH PAYROLL

FINISHED GOODS CUSTOMERS

SALES

COMMISSIONS PAID TO SALESPERSONS

PROFITS

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ANSWER KEY

Question 5: Look at the following list of fund movements that relate to working capital. Write the letter of each item in the appropriate circle in the diagram below. The first one serves as an example.

BANK LOANS

i

h

SUPPLIERS

a c

RAW MATERIALS INVENTORIES

n

WORK IN PROCESS INVENTORIES

CASH

j

PAYROLL

b d

g

l

k

FINISHED GOODS CUSTOMERS

e

COMMISSIONS PAID TO SALESPERSONS

SALES

m

f PROFITS

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Question 6: Look at the current assets and current liabilities from the balance sheet of ABC, Inc. Using this information, calculate the working capital for each year. ABC, Inc. ASSETS

19X1

19X2

LIAB. & NET WORTH

19X1

19X2

Cash Receivables Inventories Other

24 93 126 15

42 119 109 37

Suppliers Loans Payroll Other

33 38 34 11

26 82 40 31

Current Assets

258

307

Current Liabilities

116

179

Legal Deposits Inter-company Loans

109 6

125 31

Loans Debenture Bonds

109 6

94 36

Other Assets

115

156

Long-term Liabilities

115

130

169 276 137

169 287 152

Investments PPE Deferred Charges

33 374 33

46 357 51

Capital Stock Reserves Retained Earnings

Fixed Assets

440

454

Net Worth

582

608

TOTAL LIAB. & NET WORTH

813

917

TOTAL ASSETS 813

917

19X1

19X2

Working Capital

$______

$______

Is the working capital positive or negative?

19X1 _______________ 19X2 _______________

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ANSWER KEY

Question 6: Look at the current assets and current liabilities from the balance sheet of ABC, Inc. Using this information, calculate the working capital for each year. 19X1

19X2

Working Capital

$_142__

Is the working capital positive or negative?

19X1

positive

a

19X2

positive

a

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$_128_

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Question 7: Look at the following list of movements that relate to permanent capital. Write the letter for each item in the appropriate circle in the diagram below. a) Capital investments by shareholders b) Obtaining a fixed asset loan c) Investments in affiliates d) Loans to affiliates e) Loan repayments f) Dividend payments

SHAREHOLDERS

LOANS TO ASSOCIATED AND CONTROLLED COMPANIES

CASH

STOCK IN OTHER COMPANIES

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BANK LOANS

MACHINERY AND EQUIPMENT

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ANSWER KEY

Question 7: Look at the following list of movements that relate to permanent capital. Write the letter for each item in the appropriate circle in the diagram below. a) Capital investments by shareholders b) Obtaining a fixed asset loan c) Investments in affiliates d) Loans to affiliates e) Loan repayments f) Dividend payments

f

SHAREHOLDERS

a

LOANS TO ASSOCIATED AND CONTROLLED COMPANIES

d

CASH

c

STOCK IN OTHER COMPANIES

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e

BANK LOANS

b

MACHINERY AND EQUIPMENT

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Question 8: Classify the following accounts as either (T) third party capital or (O) own capital. The first one serves as an example. T

Accrued payroll and taxes Notes payable Capital stock Trade bills (accounts payable) Bank loans Reserves Inter-company loans Retained earnings Rent and utilities

Question 9: Classify the following accounts as either (O) operating credits or (F) financial credits. ____ Loans ____ Accrued taxes ____ Debenture bonds ____ Trade bills ____ Accrued payroll and payroll taxes ____ Inter-company credits

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ANSWER KEY

Question 8: Classify the following accounts as either (T) third party capital or (O) own capital. The first one serves as an example. T

Accrued payroll and taxes

T

Notes payable

O

Capital stock

T

Trade bills (accounts payable)

T

Bank loans

O

Reserves

T

Inter-company loans

O

Retained earnings

T

Rent and utilities

Question 9: Classify the following accounts as either (O) operating credits or (F) financial credits. F

Loans

O

Accrued taxes

F

Debenture bonds

O

Trade bills

O

Accrued payroll and payroll taxes

F

Inter-company credits

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Question 10: Study the liabilities of the following companies and fill in the blanks below. COMPANY A Liabilities & Net Worth Current Liabilities Long-term Liabilities Shareholder’s Equity Total

COMPANY B Liabilities & Net Worth

$350 $300 $550 $1,200

Current Liabilities

$500

Shareholder’s Equity

$700

Total

$1,200

a) Third party capital:

Company A $___________________ Company B $___________________

b) Own capital:

Company A $___________________ Company B $___________________

c) Company

uses a larger proportion of third party capital than Company

d) The current liabilities of Company e) The own capital of Company

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are lower than those of Company

is higher than the own capital of Company

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ANSWER KEY

Question 10: Study the liabilities of the following companies and fill in the blanks below. COMPANY A Liabilities & Net Worth Current Liabilities Long-term Liabilities Shareholder’s Equity Total

COMPANY B Liabilities & Net Worth

$350 $300 $550 $1,200

Current Liabilities

$500

Shareholder’s Equity

$700

Total

a) Third party capital:

Company A $ 650 Company B $ 500

b) Own capital:

Company A $ 550 Company B $ 700

$1,200

c) Company A uses a larger proportion of third party capital than Company B . d) The current liabilities of Company A are lower than those of Company B . e) The own capital of Company B is higher than the own capital of Company A .

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SOURCES AND USES OF FUNDS

Sources and Uses in the Balance Sheet Assets as funds uses

Some uses of funds are obvious. For example, a company uses funds to increase assets, such as the purchase of inventories or a new plant building. However, not all uses of funds are so obvious; a company may use funds to extend credit to its customers, or just to increase its bank balances.

Liabilities and net worth as funds sources

The funds used to purchase or acquire assets are sourced from bank loans, supplier credit, stockholders' equity, etc. These sources of funds are the liabilities and net worth accounts listed in the balance sheet. This concept is illustrated in Figure 2.6.

ASSETS

Uses of Funds


Sources of Funds

Figure 2.6: Funds uses and sources

Taking a closer look, you can see that assets, liabilities, and net worth can be both sources and uses of funds. In Figure 2.7, we show that assets can be sources if they are reduced — e.g., reducing a checking account balance to purchase a property. In this example, one asset account (cash) is reduced in exchange for another asset account (property), but the total assets remain the same.

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An asset reduction may also be a source for reducing a liability — e.g., using cash to pay a bank loan. In this case, as you can also see in Figure 2.7, a reduction in the liability is a use of funds because resources (assets) are reduced to repay the loan.

ASSETS Buy Property

Decrease Resources

Increase Assets

Sell Property

Decrease Assets

Increase Resources

Source of Funds

Use of Funds

LIABILITIES & NET WORTH Borrow Funds

Increase Liabilities & Net Worth

Repay Loan

Decrease Liabilities & Net Worth

Increase Resources

Sources of Funds

Reduce Resources

Use of Funds

Figure 2.7: Assets, liabilities, and net worth can be both uses and sources of funds

On the asset side of the balance sheet, the purchase of an asset is a use of funds; sale of an asset is a source of funds. On the liabilities and net worth side of the balance sheet, an increase in liabilities or net worth is a source of funds; a reduction in liabilities or net worth is a use of funds. A use of fund, therefore, is an increase in an asset account or a decrease in a liability or net worth account. Conversely, a source of funds is a decrease in an asset or an increase in a liability or equity account.

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BALANCE SHEET ASSETS


Use of Funds:

(+) Increase

(-) Decrease

Source of Funds:

(-) Decrease

(+) Increase

Figure 2.8: Effect on the balance sheet of uses and sources of funds

Operating / Non-Operating We have seen that changes in assets, liabilities, and net worth accounts can be identified as sources or uses. Let’s add another concept to this. These changes also can be identified as operating sources / uses or non-operating sources / uses, depending on the type of account. Operating Sources and Uses Normal day-today operations of the company

Operating sources and uses refer to those assets and liabilities principally associated with the normal day-to-day operations of the company. These are basically current assets or current liabilities, with some exceptions. We do not include cash or cash equivalent assets within the current assets and we do not include short-term bank debt within the current liabilities. You will see the reason for these exclusions as you continue to read. The most typical examples of operating sources and uses are:

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n

Increase / decrease in accounts receivable

n

Increase / decrease in inventory

n

Increase / decrease in accounts payable

n

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Non-Operating Sources and Uses All other accounts

Non-operating sources and uses pertain to practically all other assets, liabilities, and equity accounts, including one of the exceptions listed above — short-term bank debt. The most common examples are: n

Plant and equipment (P+E) expenditures

n

Increase in long-term investments

n

Takedown or repayment of short-term bank debt

n

Take down or repayment of long-term bank debt

n

Dividends

By describing the changes in the balance sheet accounts as sources and uses, and as operating and non-operating, we can construct a funds generation statement which allows a better understanding of past funds generation ability and future capacity. In doing this, we are able to isolate the funds generated from normal operations that enable the payment of bank debt and dividends, and contribute to plant and equipment expenditures and other non-operating needs. First, let’s consider the income statement from the sources / uses perspective as well.

Sources and Uses in the Income Statement Sales revenues vs. costs and expenses

Sources and uses of funds also appear in the income statement: sales represent revenues, which are sources of funds; costs and expenses represent uses of funds. The net result of revenues minus expenses is either a profit (a source of funds) or a loss (a use of funds). The flows are the same for all companies, but volumes of funds, maturities, and realization times will vary from firm to firm.

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INCOME STATEMENT

Depreciation and other noncash charges

Revenue

(+) Source of Funds

Expense

(-) Use of Funds

Depreciation also plays an important role within the income statement. Depreciation is a non-cash charge against earnings for which there is no corresponding outflow of funds. However, since the amount is charged against earnings, from the funds flow perspective, the net income is understated by this amount. Therefore, for purposes of funds flow analysis, the depreciation must be added back to the net income as if it were a source of funds. Together, net income, depreciation, and other non-cash charges are considered to be the gross operating funds generation of the company. Examples of other non-cash charges include depletion of wasting fixed assets, amortization of intangibles, bad debt and inventory write-offs, foreign exchange losses, and certain inflation adjustments.

Funds Generation Statement Gross operating funds generation

Putting all this together, we can construct a funds generation statement. We start with net income (the net sources from the income statement) and add depreciation to obtain gross operating funds generation. We also add other non-cash charges, if there are any.

Net operating funds generation

Next, we subtract operating uses and add operating sources to determine net operating funds generation. This is the most important number because it tells the analyst the amount of funds the company has generated (or will be generating if the numbers are projections) to pay bank debt and dividends, and contribute to other non-operating needs such as plant and equipment expenditures.

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Free operating cash flow


Note that the new Citibank spreadsheet now includes a certain portion of plant and equipment expenditures in a special maintenance category to reflect that P+E must normally be replenished to maintain existing operational levels. Subtracting maintenance capital expenditures from net operating funds generation results in the figure for free operating cash flow. P+E expenditures are separated between maintenance and expansion. P+E expenditures for expansion are included within non-operating uses along with dividends, payment of bank debt, and other such uses.

Increase / decrease in cash and cash equivalent

The final number must be close to the increase or decrease in cash and cash equivalent accounts from one accounting period to the other. This is the check on the exercise. If the numbers do not check, a mistake has been made by inputting incomplete or incorrect data. + + + =

Net income Depreciation Other non-cash charges Gross operating funds generation

– Operating uses (usually receivables and inventory) + Operating sources (usually payables and accruals) = Net operating funds generation – Maintenance capital expenditures = Free operating cash flow – Non-operating uses (usually P+E, dividends, bank debt payment) + Non-operating sources (usually new bank debt) = Net increase / Decrease in cash and cash equivalents

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Summary of Sources and Uses These relationships may be summarized as follows:

ASSET DECREASE

REVENUE

LIABILITIES & NET WORTH INCREASE

Source

Source

Source

FUNDS

Use

Use

Use

ASSET INCREASE

EXPENSE

LIABILITIES & NET WORTH DECREASE

Figure 2.9: Flow of funds summary for balance sheet and income statement

Funds Flow Analysis Focuses on account movements

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This type of analysis is extremely important because it focuses on account movements from one period to another, rather than on static numbers. It evaluates a company's financial statements from a funds flow perspective (how funds are obtained, how they are deployed in the company's operations, and how they are returned to the entities that provided them). It also enables the analyst to determine where the company's resources have been invested (uses of funds) and to identify the sources of funding.

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This focus will then help answer the following questions: 1) What are the company's needs for financing working capital? 2) How have these needs been financed in the past? 3) What is the ability of the enterprise to replace fixed assets or to cover debt service? 4) What is the recent situation with respect to cash generation capacity?

SUMMARY

Analysis of sources and uses of funds is another way to look at a company's accounts. Funds are sourced by borrowing, increasing capital, or converting assets; funds are used to increase assets, reduce liabilities, or pay dividends. Sources and uses of funds are also reflected in the income statement. Sales (revenues) represent sources of funds, whereas costs and expenses represent uses of funds. A funds flow analysis focuses on account movements from one period to another. It helps to answer such questions as: n

What are the company's needs for financing working capital?

n

How have these needs been financed in the past?

n

What is the ability of the enterprise to replace fixed assets or to cover debt service?

n

What is the recent situation with respect to cash generation capacity?

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PROGRESS CHECK 2.2


Question 11: Mark each statement (T) true or (F) false. ____ a) For each use of funds, there is one or more source. ____ b) Changes in assets are always uses of funds. ____ c) A balance sheet does not show the daily flow of resources in a company, but we may say that assets are uses of funds and liabilities are sources of funds. ____ d) A decrease in assets is a source of funds. ____ e) A reduction in liabilities is a use of funds. ____ f) Revenues are a source of funds and expenses are uses of funds.

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ANSWER KEY

Question 11: Mark each statement (T) true or (F) false. T

a) For each use of funds, there is one or more source.

F

b) Changes in assets are always uses of funds.

T

c) A balance sheet does not show the daily flow of resources in a company, but we may say that assets are uses of funds and liabilities are sources of funds.

T

d) A decrease in assets is a source of funds.

T

e) A reduction in liabilities is a use of funds.

T

f) Revenues are a source of funds and expenses are uses of funds.

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Question 12: Identify the following as either a (S) source of funds or (U) use of funds. The first one serves as an example. S

Capital increase Supplier payments Raw materials purchases Bank loans Collection of trade bills Advances from customers Dividend payments Net income Purchase of marketable securities Profit on real estate sales Tax payments Purchase of affiliates' shares Payroll disbursements

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ANSWER KEY

Question 12: Identify the following as either a (S) source of funds or (U) use of funds. The first one serves as an example. S

Capital increase

U

Supplier payments

U

Raw materials purchases

S

Bank loans

S

Collection of trade bills

S

Advances from customers

U

Dividend payments

S

Net income

U

Purchase of marketable securities

S

Profit on real estate sales

U

Tax payments

U

Purchase of affiliates' shares

U

Payroll disbursements

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Question 13: Look at the example and fill in the statements below: Purchase

INVENTORIES

Consumption

Use $300

a)

$

Source $200

of resources were used to purchase inventories.

b) Funds created by consumption of inventory totaled $ c) The balance of inventories, $ inventories.

.

, represents the net amount of resources applied in

Question 14: Look at the example and fill in the statements below: Sales on Credit

TRADE RECEIVABLES

Source $100

Use $150

a)

Collection

The increase in trade receivables generated by sales on credit totals $ of funds because the company uses its resources to finance its clients.

b) Collection of trade bills creates a source of funds in the amount of $

and is a .

c) The resulting balance of $ from the above transactions represents the net amount of resources which remain in use to finance customers.

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ANSWER KEY

Question 13: Look at the example and fill in the statements below: Purchase

INVENTORIES

Use $300

a)

Consumption Source $200

$ 300 of resources were used to purchase inventories.

b) Funds created by consumption of inventory totaled $ 200 . c) The balance of inventories, $ 100 , represents the net amount of resources applied in inventories.

Question 14: Look at the example and fill in the statements below: Sales on Credit

TRADE RECEIVABLES

Source $100

Use $150

a)

Collection

The increase in trade receivables generated by sales on credit totals $ 150 and is a use of funds because the company uses its resources to finance its clients.

b) Collection of trade bills creates a source of funds in the amount of $ 100 . c) The resulting balance of $ 50 from the above transactions represents the net amount of resources which remain in use to finance customers.

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Question 15: Look at the example and fill in the statements below: Credit Purchases Source $200

SUPPLIERS

Payments Use $180

a) A credit purchase is a source of funds, because suppliers are financing raw materials in the amount of $ . b) Payments to suppliers in the amount of $

represent a use of funds.

c) The resulting balance, $ , from the above transactions represents a source of funds which remains in the hands of the company to finance inventories.

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ANSWER KEY

Question 15: Look at the example and fill in the statements below: Credit Purchases Source $200

SUPPLIERS

Payments Use $180

a) A credit purchase is a source of funds, because suppliers are financing raw materials in the amount of $ 200 . b) Payments to suppliers in the amount of $ 180 represent a use of funds. c) The resulting balance, $ 20 , from the above transactions represents a source of funds which remains in the hands of the company to finance inventories.

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Question 16: The following flowchart shows the movement of funds among several balance sheet accounts. Indicate whether each item is a (U) use of funds or (S) source of funds and enter the balance for each account. $5

SHAREHOLDERS

$ 135

SUPPLIERS

$ 50 CASH

$ 200

$ 100 TRADE RECEIVABLES

a) CASH

Balance

( ( ( ( (

) $100 ) 50 ) 5 ) 135 ) $

INVENTORIES

d) TRADE RECEIVABLES ( ) $150 ( ) 100 Balance

b) SUPPLIERS Balance

$ 150

( ) $

e) SHAREHOLDERS ( ) $50 ( ) 5 Balance ( ) $

( ) $200 ( ) 135 ( ) $

c) INVENTORIES ( ) $200 ( ) 150 Balance ( ) $

Question 17: Based on Question 16, write in the missing values: USES Cash Trade Receivables Inventories TOTAL

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$ $ $ $

SOURCES Suppliers Shareholders

$ $

TOTAL

$

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ANSWER KEY Question 16: The following flowchart shows the movement of funds among several accounts. Indicate whether each item is a (U) use of funds or (S) source of funds and enter the balance for each account. $5

SHAREHOLDERS

$ 135

SUPPLIERS

$ 50 CASH

$ 200

$ 100 TRADE RECEIVABLES

a) CASH

Balance

$ 150

( U ) $100 (U) 50 (S) 5 ( S ) 135 ( U ) $ 10

d) TRADE RECEIVABLES ( U ) $150 ( S ) 100 Balance

b) SUPPLIERS

Balance

( U ) $ 50

e) SHAREHOLDERS ( S ) $50 (U) 5 Balance ( S ) $45

( S ) $200 ( U ) 135 ( S ) $ 65

c) INVENTORIES ( U ) $200 ( S ) 150 Balance ( U ) $ 50

INVENTORIES

Remember, cash in hand is an asset and, therefore, a use of funds. Reduction of cash is a source of funds to reduce debt or other obligations of the enterprise.

Question 17: Based on Question 16, write in the missing values: USES Cash Trade Receivables Inventories

$ 10 $ 50 $ 50

TOTAL

$ 110

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SOURCES Suppliers Shareholders

$ 65 $ 45

TOTAL

$ 110

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Question 18: Consider the following funds movements and arrange them in order to calculate: Gross operating funds generation

__________

Net operating funds generation

__________

Free operating funds generation

__________

Net increase / decrease in cash and cash equivalent

__________

Funds Movements: Increase in accounts payable Increase in accounts receivable Maintenance P+E expenditures Depreciation Dividends Net income

200 300 200 150 100 500

Increase in inventory Other non-cash charges Payment of long-term bank debt Increase in accruals Expansionary P+E expenditures Increase in short-term bank debt

___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ v04/30/95 p05/22/00

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400 100 100 100 200 200

____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________

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ANSWER KEY

Question 18: Consider the following funds movements and arrange them in order to calculate: + Net income + Depreciation + Other non-cash charges = Gross operating funds generation

500 150 100 750

- Operating uses Increase in accounts receivable Increase in inventory

300 400

700

+ Operating sources Increase in accounts payable Increase in accruals

200 100

300

= Net operating funds generation

350

- Maintenance P+E expenditures

200

= Free operating funds generation

150

- Non-operating uses Expansionary P+E expenditures Dividends Payment of long-term debt

200 100 100

400

+ Non-operating sources Short-term bank debt

200

200

= Net Increase / Decrease in cash + Cash equivalent

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Unit 3

UNIT 3: FINANCIAL STATEMENT ANALYSIS

INTRODUCTION

Financial statement analysis is a set of techniques used to evaluate a company's financial and economic condition. The analysis begins with a firm's financial statements, but also includes consideration of other issues such as the economy, political situations, markets, products, competition, etc. These additional areas of focus provide a better understanding of the firm's situation and facilitate the correct interpretation of a company's financial position.

UNIT OBJECTIVES


Recognize financial statement limitations and how they can affect credit decisions

n

Identify the techniques commonly used to analyze balance sheets and income statements

n

Apply vertical analysis and horizontal analysis techniques to analyze a company's financial condition

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FINANCIAL STATEMENT ANALYSIS

FINANCIAL STATEMENT LIMITATIONS Imposed by rules and standards

Financial statements conform to certain rules and standards that allow for easy reading and comprehension. These rules also impose some limitations for a correct financial statement interpretation that may affect credit decisions. 1) Financial statements show only facts that can be measured in financial terms and, therefore, may not always present an accurate picture. For example, trademarks and patents could have greater market values than their book values indicate. Also, employees may be a company's greatest asset, but their value is never shown in the balance sheet. 2) Preparation of financial statements is based on prices at the time events occur and, as a result of inflation, those prices may not be applicable at the balance sheet date. This limitation can be significant in high inflationary environments where prices can change daily. Indexation systems, such as the one used in Brazil, have been instituted to partly counteract the effects of these price changes — see Unit One for more information on monetary correction. 3) Company balance sheets are similar to snapshots taken on a particular day, even though their resources are continually flowing. Therefore, a balance sheet does not reflect the company's financial situation for the entire year. 4) Financial statements are prepared for tax reasons, and many companies will use every legal means to reduce their tax burden — a policy that may sometimes result in a distorted earnings and financial picture.

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BUSINESS RISK ASSESSMENT Factors to consider

In addition to the limits imposed by the rules and standards for preparing financial statements, analysts must recognize that financial statements reflect only a portion of a company's condition. The analyst must also consider the issues associated with Citibank’s business risk assessment process, including: n

Economic environment

n

Market conditions

n

Type of business

n

Management

Economic Environment Context for financial decisions

The objective of an analysis is to understand a company's financial decisions and determine their impact. The overall economic context in which those decisions are made must be noted. To achieve this, the analyst should ask questions such as: 1) What is the economic situation of the country? 2) What economic policies were in force during the analysis period? 3) Are the same economic policies still in effect? 4) Have those policies affected the company? Its income?

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Market Conditions Performance of the market

The performance of the market is an influencing factor when making judgments concerning a company's performance. The analyst should ask questions such as: 1) How did the market behave? 2) What are the demand and market characteristics? 3) Who are the competition and what are their strengths and weaknesses?

Type of Business Products, trade terms, seasonality

Understanding the firm's business provides greater depth to the analysis and a more accurate conclusion about its financial and economic situation. Again, the analyst needs to ask pertinent questions such as: 1) What is the nature of the firm's product? How does it affect the financial statements? 2) What are the norms in the economic sector for trade terms? 3) How seasonal is the firm's business? 4) If the business is seasonal, is the balance sheet date in the peak season or in the slow season? For instance, are inventories at their highest or lowest level?

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Management Organization, adaptability, capability

The analyst needs to assess the capabilities of management in order to understand the firm's financial strategies and draw conclusions regarding the company's ability to achieve its stated financial objectives. The analyst should ask questions such as: 1) How is management organized and how does it function? 2) How flexible is management in coping with changing economic and market situations? 3) Is management effective and capable of taking the enterprise forward?

You have just completed the first section of Unit Three. Please complete the following Progress Check before continuing to the next section, "Analysis Techniques."

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PROGRESS CHECK 3.1


Question 1: Indicate whether the following statements are (T) true or (F) false. ____ a) The balance sheet presents a "static picture" of a company since it shows assets and liabilities at a certain date, while cash flows are dynamic and could show a different situation at another date. ____ b) Assets are always recorded at market value, which provides the most accurate account of a company's worth. ____ c) Balance sheets are prepared based on historical data. ____ d) A deep analysis requires more than financial statement data. It involves examining the company's market position, its dependence on raw materials, and its customer base. ____ e) It is not necessary to evaluate the firm's management to accurately assess its financial situation. ____ f) A solid company will not be shaken by government policies; it will automatically adjust to changing market situations with no need for internal changes.

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ANSWER KEY

Question 1: Indicate whether the following statements are (T) true or (F) false. T

a) The balance sheet presents a "static picture" of a company since it shows assets and liabilities at a certain date, while cash flows are dynamic and could show a different situation at another date.

F

b) Assets are always recorded at market value, which provides the most accurate account of a company's worth.

T

c) Balance sheets are prepared based on historical data.

T

d) A deep analysis requires more than financial statement data. It involves examining the company's market position, its dependence on raw materials, and its customer base.

F

e) It is not necessary to evaluate the firm's management to accurately assess its financial situation.

F

f) A solid company will not be shaken by government policies; it will automatically adjust to changing market situations with no need for internal changes.

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ANALYSIS TECHNIQUES Common techniques

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The financial analyst uses certain techniques to assess a company’s financial and economic condition. In the remainder of this unit, we cover the first two of these methodologies: vertical analysis and horizontal analysis. In Units Four through Seven, we explain the various types of financial ratios and how they are applied in the analysis process. Finally, in Unit Eight, we use case studies to demonstrate how the last three techniques are applied. n

Vertical analysis — Converts financial statement accounts of a period into percentages for comparison of one accounting period to another

n

Horizontal analysis — Tracks individual account growth rates from one period to another, acting as an implicit indexation which is useful in countries with high inflationary environments

n

Financial ratio analysis — Universally accepted techniques that focus on the relationships between accounts in the financial statements; these techniques constitute the basis for most financial analysis done by banks

n

Operating / non-operating funds generation analysis — Breaks down funds flows from one period to another into operating and non-operating sources and uses of funds to detect funds movements

n

Trends analysis and financial projection — Technique to project the basic financial statements using logical assumptions based on trend analysis and specific expectations; financial projections are done to anticipate future funds needs and measure expected future solvency and cash generation capabilities

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n

Cash flow budgeting — Technique used to measure anticipated cash needs and the timing of these needs by focusing only on cash movements at shorter (weekly, monthly) time intervals; this is especially useful for measuring seasonal cash needs and repayment capabilities

VERTICAL ANALYSIS

Purpose Identifies application of resources

Vertical analysis is a technique used to identify where a company has applied its resources and in what proportions those resources are distributed among the various balance sheet and income statement accounts. The analysis determines the relative weight of each account and its share in asset resources or revenue generation.

Balance Sheet Percentage of total assets

On the balance sheet, vertical analysis consists of converting each item to a percentage of total assets. Let's look at the following example:

ASSETS

19X0

%

19X1

%

19X2

%

108 972 541

3 25 13

309 1,084 1,186

6 21 22

248 1,667 1,328

4 28 22

TOTAL CURRENT ASSETS

1,621

41

2,579

49

3,243

54

Non-Current Assets PPE Deferred Charges

2,107 209

54 5

2,585 52

50 1

2,685 127

44 2

TOTAL NON-CURRENT ASSETS

2,316

59

2,637

51

2,812

46

TOTAL ASSETS

3,937

100

5,216

100

6,055

100

Current Assets Cash Trade Receivables Inventories

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Rounding off to the nearest whole number, we find that the cash account for 19X0 has a 3% share of total assets. The same analysis is applied to the other asset accounts and to the liability and net worth accounts. The results, expressed as percentages, can then be compared from year to year. This comparative analysis is useful since it highlights relative account movements that absolute figures may not detect. (NOTE: In some of the following examples, the percentage figures may not add up due to rounding.)


19X0

%

19X1

%

19X2

%

Current Liabilities Due to Banks Trade Payables Accruals

1,041 488 112

26 12 3

1,479 675 196

28 13 4

1,850 840 256

31 14 4

TOTAL CURRENT LIABILITIES

1,641

41

2,350

45

2,946

49

840

21

1,228

24

1,044

17

TOTAL LIABILITIES

2,481

63

3,578

69

3,990

66

Net Worth Capital Stock Retained Earnings

1,000 456

25 12

1,000 638

19 12

1,000 1,065

17 18

TOTAL NET WORTH

1,456

37

1,638

31

2,065

35

TOTAL LIABILITIES & NET WORTH

3,937

100

5,216

100

6,055

100

Long-Term Liabilities Long-Term Debt

This type of analysis is similar to funds flow analysis (discussed in Unit Two) because it permits spotting relative movements on a comparative basis. Vertical analysis is useful in highlighting relative account changes and should be complemented by the funds flow analysis which pinpoints the sources of the changes.

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Income Statement On the income statement, vertical analysis is a universal tool for measuring the firm's relative performance from year to year in terms of cost and profitability. It should always be included as part of any financial analysis. Here, percentages are computed in relation to net sales which are considered to be 100%. This vertical analysis effort in the income statement is often referred to as margin analysis, since it yields the different margins in relation to sales.

Percentage of net sales

Let's look at an example:

19X0

%

19X1

%

19X2

%

5,421 3,324 1,292

100 61 24

6,728 3,983 1,511

100 59 22

8,146 4,729 1,668

100 58 20

805

15

1,234

18

1,749

21

342 313 152

6 6 3

410 487 -88

6 7 -1

440 498 57

5 6 1

Earnings Before Tax

302

6

249

4

868

11

– Income Tax

42

1

67

1

221

3

260

5

182

3

647

8

Net Sales – Cost of Goods Sold – SGA Expenses Operating Profit – Depreciation – Financial Expense + Other Income, Net

Net Income

In the above income statement, the relative percentage numbers (rounded to the nearest whole number) tell us more than the absolute figures. On a comparative basis, the analyst can clearly discern the cost relationships and trends from year to year. The causes of these changes can then be more easily investigated.

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Summary Our example of vertical analysis of the balance sheet and income statement shows how much easier and faster it is to compare results using this technique. This technique only identifies symptoms and, by itself, is not enough to draw accurate conclusions. Its purpose is to identify situations that require further analysis and more probing questions, with the objective of understanding why an event has occurred and what it means to the company's financial situation. This analysis can then be complemented using additional financial statement analysis techniques such as ratio and funds flow analysis.

Before proceeding to the section on "Horizontal Analysis," please check your understanding of "Vertical Analysis" by completing the following Progress Check.

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PROGRESS CHECK 3.2


Question 2: Write the letter of the definition next to the type of analysis it describes. ____ Vertical analysis ____ Horizontal analysis ____ Financial ratio analysis ____ Operating / non-operating funds generation analysis ____ Trends analysis and financial projection a) Identifies types of cash flows from one period to another b) Focuses the analysis on relationships between financial statement accounts c) Creates assumptions about funding needs in the future based on cash generation capabilities d) Indicates changes in accounts from one period to the next e) Focuses on the application of resources within an accounting period

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ANSWER KEY

Question 2: Write the letter of the definition next to the type of analysis it describes. e

Vertical analysis

d

Horizontal analysis

b

Financial ratio analysis

a

Operating / non-operating funds generation analysis

c

Trends analysis and financial projection

a) Identifies types of cash flows from one period to another b) Focuses the analysis on relationships between financial statement accounts c) Creates assumptions about funding needs in the future based on cash generation capabilities d) Indicates changes in accounts from one period to the next e) Focuses on the application of resources within an accounting period

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Use this balance sheet for Question 3. Jurure Company: Balance Sheet for 19X1 ASSETS

19X0

%

19X1

%

40 200 760 320 80 200

1 5 19 8 2 5

64 576 1,408 384 192 128

1 9 22 6 3 2

1,600

40

2,752

43

160 200

4 5

256 0

4 0

360

9

256

4

Investments PPE Deferred Charges

200 1,640 200

5 41 5

320 2,820 252

5 44 4

Non-Current Assets

2,040

51

3,392

53

TOTAL ASSETS

4,000

100

6,400

100

480 ---120 480 200 120

12 ---3 12 5 3

640 128 256 832 192 64

10 2 4 13 3 1

1,400

35

2,112

33

400 400

10 10

576 192

9 3

800

20

768

12

1,200 200 400

30 5 10

2,496 320 704

39 5 11

Net Worth

1,800

45

3,520

55


4,000

100

6,400

100

Cash Marketable Securities Trade Receivables Inventories Advances to Suppliers Other Current Assets Legal Deposits Inter-company Receivables Long-term Receivables

LIABILITIES AND NET WORTH Suppliers Bank Loans Accrued Payroll Accrued Taxes Dividends Accounts Payable Current Liabilities Loans Stockholders’ Credits Long-term Liabilities Capital Stock Reserves Retained Earnings

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Question 3: Based on the vertical analysis of the financial statements of Jurure Company, complete the following questions. a)

In 19X0 and 19X1, most of the resources are applied to: ____ current assets. ____ property, plant, and equipment. ____ long-term receivables.

b) The percentage of own and outside capital in 19X0 and 19X1 is: 19X0 Outside Capital Own Capital Total Liabilities & Net Worth

19X1

_____% _____% 100%

_____% _____% 100%

c) The share of own capital from 19X0 to 19X1 increased from ____% to ____%. This shows that the increase in own resources was proportionally (larger / smaller) _________________ than the increase in outside resources.

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ANSWER KEY

Question 3: Based on the vertical analysis of the financial statements of Jurure Company, complete the following questions. a)

In 19X0 and 19X1, most of the resources are applied to: property, plant, and equipment.

b) The percentage of own and outside capital in 19X0 and 19X1 is: Outside Capital Own Capital Total Liabilities & Net Worth

19X0

19X1

55% 45% 100%

45% 55% 100%

c) The share of own capital from 19X0 to 19X1 increased from 45% to 55% . This shows that the increase in own resources was proportionally larger than the increase in outside resources.

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Jurure Company: Income Statement for 19X1 19X0

%

19X1

%

Net Sales – Cost of Goods Sold – SGA Expenses

3,000 1,280 480

100 43 16

5,100 2,460 1,071

100 48 21

Operating Profit

1,240

41

1,569

31

220 510 180

7 17 6

345 510 255

7 10 5

Earnings Before Tax

690

23

969

19

– Income Tax

240

8

408

8

450

15

561

11

– Depreciation – Financial Expense + Financial Income

Net Income

Question 4: Based on the vertical analysis of Jurure Company’s income statement, complete the following questions. a)

In 19X1 , cost of goods sold ____________________ than net sales. ____ increased more slowly ____ decreased more slowly ____ increased faster ____ decreased faster

b) In 19X1 , operating profit decreased on a relative basis because net sales increased ________ than cost of goods sold. ____ faster ____ slower c) In 19X1 , selling, general, and administrative ( SGA) expense ________ on a relative basis. ____ increased ____ decreased

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Question 4: (Continued) d) In 19X1, there was a(n) ______________ in financial expense in relation to net sales. ____ increase ____ decrease

e) Whenever expenses increase faster than income, profits _____________. ____ increase ____ decrease

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ANSWER KEY

Question 4: Based on the vertical analysis of Jurure Company’s income statement, complete the following questions. a)

In 19X1 , cost of goods sold increased faster than net sales.

b) In 19X1 , operating profit decreased on a relative basis because net sales increased slower than cost of goods sold. c) In 19X1 , selling, general, and administrative ( SGA) expense increased on a relative basis. d) In 19X1 , there was a(n) decrease in financial expense in relation to net sales. e) Whenever expenses increase faster than income, profits decrease .

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HORIZONTAL ANALYSIS

Purpose Evaluate trends over time

Horizontal analysis is a technique used to evaluate trends over time by computing percentage increases or decreases relative to a base year. It provides an analytical link between accounts calculated at different dates using currency with different purchasing powers. In effect, this analysis indexes the accounts and compares the evolution of these over time. As with the vertical analysis methodology, issues will surface that need to be investigated and complemented with other financial analysis techniques. The focus is to look for symptoms of problems that can be diagnosed using additional techniques. Let's look at an example.

Current Assets Fixed Assets Other Assets TOTAL

*

19X0

19X1

*%

19X2

**%

$ 300 400 50

$ 450 600 100

50 50 100

$ 950 600 80

111 0 -20

$750

$1,150

53

$1,630

42

Percent change between 19X0 and 19X1

** Percent change between 19X1 and 19X2

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Technique Comparing two time periods

To compute the percentage of increase compared to the prior year, we calculate the percentage growth for each account and subtract 100. For example: Current Assets 19X1 = Current Assets 19X0 Total Assets 19X1 Total Assets 19X0

450 300

= 150% – 100% = 50%

= 1,150 750

= 153% – 100% = 53%

The analysis also works when account balances decrease. In these situations, the growth rate will be negative as with "Other Assets" for 19X2. The computation for 19X2 is as follows: Other Assets 19X2 Other Assets 19X1

Comparing more than two time periods

=

80 100

=

80% – 100% = -20%

When a horizontal analysis involves more than two periods, the basis may be defined as the preceding period for each successive period of analysis, as in the above example — 19X1 compared to 19X0; 19X2 compared to 19X1. Another possibility is to define the basis as the growth in following periods measured against a designated base year, as below — both 19X1 and 19X2 compared to 19X0:

Current Assets

*

19X0

19X1

*%

19X2

**%

$300

$450

50

$950

217

Percent change between 19X0 and 19X1

** Percent change between 19X0 and 19X2

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Sales Growth Key account to analyze

Net sales is one of the most important individual accounts to be analyzed by the horizontal methodology. It is a universal part of financial analysis and often is the only account measured in terms of percentage growth from one year to another. The calculation of the sales growth rate is the same as the normal horizontal technique. If we assume net sales of 1,000 in 19X0 and of 1,200 in 19X1, the sales growth is: Sales Growth =

Sales 19X1 Sales 19X0

=

1,200 1,000

= 120% – 100% = 20%

Analyzing Net Sales Growth Increased sales vs. inflation

When we analyze the net sales growth figure, it is important to determine how much of the increase is due to inflation and how much is due to increased unit sales. An apparently strong sales increase from one period to another could be entirely due to inflation. In fact, volume sales could drop from one period to another, but increased pricing could mask the drop as a reported sales increase in monetary terms.

Increased sales vs. competitors

You can also judge whether a company's sales are growing fast enough by comparing them to the growth of sales for the industry as a whole. If the real growth is eight percent for a certain sector, and a firm within this sector experiences a volume sales growth of only three percent, then this indicates a loss of market share. So, sales growth helps measure the performance of a company over time and also its performance relative to the performance of its competitors.

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Assumptions for future growth


The sales growth rate is also very important for compiling projected financial statements for a firm because it is the starting point for the projection exercise. The sales growth assumption determines the projected sales level which leads to other assumptions that determine the rest of the income statement, then the current asset levels, and finally, the rest of the balance sheet.

Please check your understanding of "Horizontal Analysis" by completing the following Progress Check. You may then proceed to Unit Four: Financial Ratios — Liquidity.

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PROGRESS CHECK 3.3

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 5: Compute percentage increases and decreases in current assets for the Cristina Company. 31 DEC 19X0 Cash Marketable Securities Trade Receivables Inventories Current Assets

31 DEC 19X1

$ 30 180 240 150 $ 600

$ 40 120 380 440 $ 980

% ___ ___ ___ ___ ___

a) Which account grew at the slowest rate? ____________________ b) Which account grew at the fastest rate? ____________________ Question 6: Compare the percentage growths in the income statement for Cristina Company and answer the questions below. 31 DEC 19X0

31 DEC 19X1

%

Sales Cost of Goods Sold SGA Expenses

$ 1,400 900 200

$ 1,800 1,080 280

29 20 40

Operating Income

$

$

440

47

90 40

160 70

78 75

170

210

24

Income Tax

40

60

50

Net Income

130

150

15

Financial Expense Other Expense Earnings Before Tax

300

a) Which account had the lowest percentage growth? _______________ b) Which account had the highest percentage growth? _______________

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ANSWER KEY

Question 5: Compute percentage increases and decreases in current assets for the Cristina Company. 31 DEC 19X0 Cash Marketable Securities Trade Receivables Inventories Current Assets

$ 30 180 240 150 $ 600

31 DEC 19X1 $ 40 120 380 440 $ 980

% 33 -33 58 193 63

a) Which account grew at the slowest rate? Marketable Securities a b) Which account grew at the fastest rate? Inventories a

Question 6: Compare the percentage growths in the income statement for Cristina Company and answer the questions below. a) Which account had the lowest percentage growth? Net Income a b) Which account had the highest percentage growth? Financial Expense a

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Question 7: Based on the summary of accounts for Cristina Co. and the numbers in Question 5, indicate whether the following statements are (T) true or (F) false. 31 DEC 19X0 Current Assets Sales Net Income

$ 600 1,400 130

31 DEC 19X1 $ 980 1,800 150

% 63 29 15

____ a) Sales grew by 29%, jeopardizing both profit margins and liquidity. ____ b) Current assets grew faster than sales, mainly due to a build up of inventories. ____ c) Net income grew less than sales because expenses grew faster. Question 8: A strong net sales growth figure may be misleading if it primarily results from: ____ a) increased inventory. ____ b) inflation. ____ c) increased sales volume. ____ d) reduced prices. Question 9: An industry growth of ten percent compared to a firm's growth of four percent indicates that the firm is: ____ a) losing market share. ____ b) gaining market share. ____ c) declining compared to the last period. ____ d) growing despite the competition.

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ANSWER KEY

Question 7: Based on the summary of accounts for Cristina Co. and the numbers in Question 5, indicate whether the following statements are (T) true or (F) false. 31 DEC 19X0 Current Assets Sales Net Income

$ 600 1,400 130

31 DEC 19X1 $ 980 1,800 150

% 63 29 15

F

a) Sales grew by 29%, jeopardizing both profit margins and liquidity.

T

b) Current assets grew faster than sales, mainly due to a build up of inventories.

T

c) Net income grew less than sales because expenses grew faster.

Question 8: A strong net sales growth figure may be misleading if it primarily results from: b) inflation.

Question 9: An industry growth of ten percent compared to a firm's growth of four percent indicates that the firm is: a) losing market share.

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Unit 4

UNIT 4: FINANCIAL RATIOS — LIQUIDITY

INTRODUCTION

An analyst uses financial ratios to understand the relationships among various financial statement accounts. These ratios yield information about a company’s ability to meet shortterm obligations on time, remain solvent over a long period, manage assets, and operate efficiently. In this unit, we demonstrate the calculation of two liquidity ratios: the current ratio and the acid test (or quick asset) ratio. The current ratio tells us the amount of current assets that are available to cover current liabilities. The acid test accomplishes the same purpose as the current ratio, but it yields more precise information because it considers only the most liquid assets. Finally, we will look at two situations that demonstrate how a company’s decisions can affect its liquidity ratios.

UNIT OBJECTIVES


Recognize the different types of financial ratios

n

Calculate a current ratio and an acid test (quick asset) ratio

n

Recognize how a company’s decisions can affect its liquidity ratios

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FINANCIAL RATIOS — LIQUIDITY

FINANCIAL RATIOS Relationships within accounts

The use of ratios and margins in financial analysis enables the analyst to interpret the financial situation of an enterprise in a more meaningful manner than by just looking at the absolute numbers. Financial ratios consider the relationships that exist within various accounts and, thus, facilitate an understanding of a company’s financial condition with greater depth and clarity. Ratio analysis is another tool that helps identify changes in a company's financial situation. A single ratio is not sufficient to adequately judge the financial situation of the company. Several ratios must be analyzed together and compared with prior-year ratios, or even with other companies in the same industry. This comparative aspect of ratio analysis is extremely important in financial analysis. It is important to note that ratios are parameters and not precise or absolute measurements. Thus, ratios must be interpreted cautiously to avoid erroneous conclusions. The analyst should attempt to get behind the numbers, place them in their proper perspective and, if necessary, ask the right questions for further clarification.

Types of Financial Ratios There are several types of ratios or relationships. They are categorized as follows: n

Liquidity ratios — measure the ability of the enterprise to meet its short-term financial obligations in a timely manner

n

Leverage ratios — measure the solvency or viability of the enterprise on a long-term basis

n

Turnover ratios — measure how effectively the company's assets are managed

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n

4-3

Profitability ratios — measure the efficiency of operations within the enterprise

We begin our discussion of financial ratios in this unit with liquidity ratios. The remaining ratios are the subject of Units Five through Seven. For future reference, you will find a Financial Ratio Summary sheet at the end of Unit Seven. You may find it useful as a quick reference as you work through these units.

LIQUIDITY RATIOS

Liquidity ratios measure the relationship of the more liquid assets of an enterprise (the ones most easily convertible to cash) to current liabilities. The most common liquidity ratios are: n

Current ratio

n

Acid test (or quick asset) ratio

Current Ratio Quantitative relationship between current assets and current liabilities

The current ratio is frequently used to measure liquidity because it is a quick and easy way to express the quantitative relationship between current assets and current liabilities. It answers the question: "How many dollars in current assets are there to cover each $1.00 in current liabilities?" To calculate the current ratio, divide current assets by current liabilities. Current Ratio

=

Current Assets Current Liabilities

A rule of thumb is that a current ratio close to 2.0 is good, but this is a very generalized statement. Let's look at an example.

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COMPANY A

COMPANY B


$150 $100

$ 80 $110

COMPANY C $400 $180

Current Ratio

1.50

0.73

2.22

Company C has $2.22 in current assets for each $1.00 in current debt. It apparently has more liquidity and, therefore, appears to be in a better position to pay its short-term debts than either Company A or B. Interpreting the ratio

The current ratio must be interpreted with caution. An absolute number by itself may not present a strong enough basis to draw conclusions. The analyst must attempt to get behind the numbers and verify that the current assets, which substantiate the ratio, are indeed fully realizable. For example, if a relatively high current ratio index is based on large amounts of trade receivables, the collectability of these accounts should be investigated. If a large proportion of receivables is delinquent, or if the current economic situation could adversely affect timely collection efforts, then a high current ratio will not necessarily indicate strong liquidity. The same type of analysis should be made for inventories. When excessive inventory levels on the balance sheet are the basis for a high current ratio, the analyst should question whether obsolescence, changes in style, physical deterioration, or changes in market prices have affected the realization value of this inventory. When it seems impossible to realize inventories in full, their value should be reduced and the current ratio adjusted accordingly.

Testing the ratio

It is advisable to test the strength of the current ratio by carefully examining the enterprise's accounts receivable and inventory levels, or by focusing on the turnover ratios discussed in Unit Six. This provides a stronger feeling for the realization value of these two important current assets.

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Another consideration is the average maturity dates for the current assets and liabilities. If most of the current liabilities mature next week, then significant amounts of trade receivables due in 60 days will not provide the desired liquidity level. Since maturities of receivables and payables seldom match, most companies are constantly dealing with too little or too much liquidity. The current ratio should, therefore, be used as a rough indicator and never as an accurate statement of the company's actual ability to pay. Financing patterns

The financing methodology normal to a sector can also have a major impact on current ratio levels. This is part of what the analyst considers in norms for specific sectors. For example, look at two types of companies: a shoe producer and a supermarket chain.

Example: Shoe producer

The shoe producer has major needs for inventory — both raw materials and finished goods — because the nature of the business is to produce many styles, sizes, and colors. In the real world, the shoe company must also sell on a credit basis to entice shoe stores to purchase its product. The business can, thus, be considered working capital intensive. In such cases, a significant portion of the company’s own capital may be invested in financing working capital needs — since suppliers will not finance either finished goods or receivables. The shoe producer’s probable current ratio is around 1.5, or maybe a little higher.

Example: Supermarket chain

The supermarket sells on a cash basis and, therefore, does not have a need to book receivables. The supermarket chain is also in a strong position on purchasing and can often negotiate longer credit terms than needed. The supermarket may take 60 day terms and turn over the goods in 30 days, investing the funds for the other 30 days. The supermarket chain’s probable current ratio is around 1.0, since there is little or none of the supermarket’s own capital invested in current assets.

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Which of the two companies is more liquid? If you say the supermarket, you are right because its products (mainly food) can be sold more quickly than shoes. Yet its “normal” current ratio of around 1.0 is much lower than the shoe producer’s 1.5. Be careful about coming to quick conclusions about liquidity by looking solely at the current ratio as a liquidity indicator. The analyst should also consider financing patterns.

Acid Test Considers most liquid current assets

The second commonly used liquidity ratio is the quick asset ratio, often called the acid test. This ratio presents a more precise liquidity test by considering only the more liquid current assets, thereby excluding inventories, prepaid expenses, and other current assets from the calculation. In this way, the index places greater emphasis on the more immediate conversion of current assets to provide coverage of short-term obligations. The rule of thumb for a healthy acid test index is 1.0. The calculation for this ratio is: Acid Test

=

Cash + Near Cash Assets + Trade Receivables Current Liabilities

The acid test presumes that trade receivables are more liquid than inventories. Trade receivables are directly converted to cash; inventories are first converted to trade receivables (if sales are made on a credit basis) and then to cash. In addition, there is some uncertainty of the value at which inventories will be realized, since some items may become damaged, lost, or obsolete. Two ratios are complementary

Let's look at the current ratio example and see how the two ratios complement each other.

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4-7

COMPANY A

COMPANY B

COMPANY C

Current Assets Inventories Current Liabilities

$150 $ 20 $100

$ 80 $ 30 $110

$400 $300 $180

Current Ratio Acid Test

1.50 1.30

0.73 0.45

2.22 0.55

Company C has the highest current ratio, but it relies on realization of inventories to cover its short-term liabilities. If it is unable to convert the inventories to cash, it will only have $0.55 (400 – 300 ÷ 180) in quick assets to meet each $1.00 of current liabilities. Company A probably has the best liquidity of all because it does not depend on inventory realization to meet its debts. Even without selling inventories, it has $1.30 in current assets to meet every $1.00 in current debt. Similar to the current ratio, the analyst must attempt to get behind the acid test computed index and verify that the trade receivables substantiating the ratio are fully realizable at the agreed upon term. The analyst also must consider the firm's line of business since companies that sell on a cash basis (such as supermarkets) have no receivables on the balance sheet. The result is a very low quick asset ratio even though the type of inventory sold (food, in the case of a supermarket) may be very liquid. The company's liquidity situation could be quite good despite a low acid test figure.

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Other Liquidity Indicators Associated with levels of cash

Besides the current ratio and acid test, there may be other liquidity indicators. These could be associated with cash levels, such as: n

Cash + Near Cash as % of Current Assets

n

Cash + Near Cash as % of Working Capital

n

Days Cash

The first two ratios are simple percentages. Days cash is a comparison of cash to sales, with the resulting decimal figure multiplied by the number of days in the period, 360 days for a yearly calculation, to get the proportion of cash as of the balance sheet date to the accumulated yearly sales figure. The new Citibank spreadsheet includes days cash, along with days receivable, days inventory, and days payable as liquidity ratios. This recognizes that the turnover of these current assets is closely linked to a company’s liquidity position. However, these balance sheet figures in terms of days of sales / production have traditionally been considered turnover ratios, where the analyst contrasts these balance sheet accounts with income statement figures. We will consider these ratios later. You have completed the sections on “Current Ratio”, “Acid Test,” (quick asset ratio) and “Other Liquidity Indicators.” Please complete the following Progress Check before continuing a further study of liquidity ratios.

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þ

PROGRESS CHECK 4.1

Directions: Enter the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 1: Write the letter of the definition next to the type of financial ratios it describes. ____ Liquidity ratios ____ Leverage ratios ____ Turnover ratios ____ Profitability ratios a) Measures effectiveness of company’s use of assets b) Measures the efficiency of a company’s operations c) Measures the ability of a company to meet short-term obligations on time d) Measures the ability of a company to remain viable over a long period of time

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ANSWER KEY

Question 1: Write the letter of the definition next to the type of financial ratios it describes. c

Liquidity ratios

d

Leverage ratios

a

Turnover ratios

b

Profitability ratios

a) Measures effectiveness of company’s use of assets b) Measures the efficiency of a company’s operations c) Measures the ability of a company to meet short-term obligations on time d) Measures the ability of a company to remain viable over a long period of time

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Question 2: Based on the following information, complete the statements below. Cash Trade Receivables Inventories

625 1,920 2,360

Suppliers Bank Loans Accrued Taxes

460 350 90

Current Assets

4,905

Current Liabilities

900

a) By dividing current assets by current liabilities, we find a current ratio of _______. We can say that the company has $ ____ in current assets to pay each $1.00 in current liabilities. b) This liquidity ratio is considered to be: ____ excellent. ____ good. ____ poor.

Question 3: The balance sheet of Toy Co., Inc., shows that for each $1.00 in current liabilities there is $1.45 in current assets. a) The current ratio is ___________. b) The ratio is considered to be: strong. adequate. weak. Question 4: The current ratio only gives a rough quantitative idea of the relationship between current assets and current liabilities because it disregards the different payment and collection times. ____ True ____ False

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ANSWER KEY

Question 2: Based on the following information, complete the statements below.

a)

Cash Trade Receivables Inventories

625 1,920 2,360

Suppliers Bank Loans Accrued Taxes

460 350 90

Current Assets

4,905

Current Liabilities

900

By dividing current assets by current liabilities, we find a current ratio of 5.45 . We can say that the company has $5.45 in current assets to pay each $1.00 in current liabilities.

b) This liquidity ratio is considered to be: X

excellent. good. poor.

Question 3: The balance sheet of Toy Co., Inc., shows that for each $1.00 in current liabilities there is $1.45 in current assets. a) The current ratio is 1.45. b) The ratio is considered to be: strong. X

adequate. weak.

Question 4: The current ratio only gives a rough quantitative idea of the relationship between current assets and current liabilities because it disregards the different payment and collection times. X

True False

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Question 5: Look at the relevant portion of the balance sheet of TWR Company.

a)

Cash Marketable Securities Trade Receivables Inventories

3,120 3,000 7,300 20,000

Suppliers Loans Accrued Taxes Accrued Payroll

4,200 5,000 1,600 1,500

Current Assets

33,420

Current Liabilities

12,300

The current ratio is _____; the acid test is _____.

b) In both cases, the company will be able to pay its debts from current assets. ____ True ____ False

Question 6: Based on the following data, complete the statements below. Current Assets Current Liabilities Inventories Current Ratio Acid Test

a)

Company B

Company C

10,600 6,500 4,700

5,100 3,800 400

1.63 0.91

1.34 1.24

Company ____ has a higher current ratio than Company ____.

b) The current ratio depends on the ability to sell inventories. If we exclude inventories from current assets, liquidity falls to ____ for Company B and ____ for Company C. c) The liquidity of Company C is more balanced since it does not depend so much on the ability to sell inventories to meet current liabilities. ____ True ____ False

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ANSWER KEY

Question 5: Look at the relevant portion of the balance sheet of TWR Company.

a)


3,120 3,000 7,300 20,000

Suppliers Loans Accrued Taxes Accrued Payroll

4,200 5,000 1,600 1,500

Current Assets

33,420

Current Liabilities

12,300

The current ratio is 2.72 ; the acid test is 1.09 .

b) In both cases, the company will be able to pay its debts from current assets. X

True False

Question 6: Based on the following data, complete the statements below.

Current Assets Current Liabilities Inventories Current Ratio Acid Test

a)

Company B

Company C

10,600 6,500 4,700

5,100 3,800 400

1.63 0.91

1.34 1.24

Company B has a higher current ratio than Company C .

b) The current ratio depends on the ability to sell inventories. If we exclude inventories from current assets, liquidity falls to 0.91 for Company B and 1.24 for Company C. c) The liquidity of Company C is more balanced since it does not depend so much on the ability to sell inventories to meet current liabilities. X

True False

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Question 7: Mark the following statements (T) true or (F) false. ____ a) Liquidity ratios are always accurate statements of whether or not a company can meet its debts. ____ b) The higher a company's liquidity ratio, the less chance it has to pay its debts. ____ c) Current ratio shows how many dollars in current assets a company has to meet each $1.00 in current liabilities. ____ d) The acid test shows how many dollars the company has in quick assets to cover each $1.00 in current liabilities. ____ e) The acid test ignores inventories because of the uncertainty of their value until realized.

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ANSWER KEY

Question 7: Mark the following statements (T) true or (F) false. F

a) Liquidity ratios are always accurate statements of whether or not a company can meet its debts.

F

b) The higher a company's liquidity ratio, the less chance it has to pay its debts.

T

c) Current ratio shows how many dollars in current assets a company has to meet each $1.00 in current liabilities.

T

d) The acid test shows how many dollars the company has in quick assets to cover each $1.00 in current liabilities.

T

e) The acid test ignores inventories because of the uncertainty of their value until realized.

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HOW LIQUIDITY RATIOS CHANGE Example

There are many factors that can change a company's liquidity. Let's look at the following example: ASSETS


Current Assets Fixed Assets

$3,000 2,000

Current Liabilities Net Worth

$2,500 2,500

TOTAL

$5,000

TOTAL

$5,000

In this case, the company's current ratio is 1.20. Let's see how different financial decisions can affect this current ratio.

Situation 1: Short-term loan

The company takes a short-term loan of $800, increasing its current liabilities. Let's see what happens if the company uses the proceeds to (a) purchase inventories or (b) purchase equipment. a) If the company purchases inventories, current assets will increase and the balance sheet will look like this: ASSETS



$3,800* 2,000


$3,300* 2,500

TOTAL

$5,800

TOTAL

$5,800

* An $800 increase over the starting point.

The current ratio for this balance sheet is 1.15. Conclusion: If the current ratio is greater than 1.00, and

current assets increase while current liabilities increase by the same amount, the current ratio decreases.

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b) If the proceeds of the loan are used to buy machinery, fixed assets will increase. ASSETS



$3,000 2,800*


$3,300* 2,500

TOTAL

$5,800

TOTAL

$5,800


The current ratio is now 0.91. Conclusion: Using short-term loans (current liabilities) to buy

fixed assets causes liquidity to deteriorate.

Situation 2: Increased capital

The owners decide to increase capital by $800, thus increasing net worth. The proceeds may be used to (a) add to inventories or (b) add to machinery. a) If the additional capital is used to purchase inventories, current assets increase and current liabilities remain the same. ASSETS



$3,800* 2,000


$2,500 3,300*

TOTAL

$5,800

TOTAL

$5,800


The current ratio is now 1.52. Conclusion: Applying long-term resources (net worth) to

current assets improves liquidity.

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b) If the increase in capital is used to purchase machinery, fixed assets increase while current assets and current liabilities remain the same. ASSETS



$3,000 2,800*


$2,500 3,300*

TOTAL

$5,800

TOTAL

$5,800


The liquidity ratio is 1.20. Conclusion: Using long-term sources to finance long-term

uses does not affect the current ratio since the ratio only measures current liquidity.

The examples demonstrate that the current ratio may vary according to the situation. This ratio is only one source of information about a company's financial status.

Please complete the following Progress Check before continuing to Unit Five: Financial Ratios — Leverage.

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þ PROGRESS CHECK 4.2 Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 8: The following data reflect the situation of M&M, Inc. a few days before balance sheet date. ASSETS


Current Assets Fixed Assets TOTAL

$ 8,000 6,000 $14,000


$ 4,000 10,000

TOTAL

$14,000

The financial department of M&M is analyzing several proposals. The department values liquidity highly and plans to recommend the proposal that results in the best current ratio. Decide which proposal is the best by calculating the resulting current ratios. Proposal A

Before balance sheet date, take a short-term loan of $1,200 and buy additional inventories. Current ratio: ______

Proposal B

Before balance sheet date, take a short-term loan of $1,200 and buy machinery and vehicles. Current ratio: ______

Proposal C

After balance sheet date, take the loan and buy inventories. Current ratio: ______ Which is the best proposal? a) Proposal A b) Proposal B c) Proposal C

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ANSWER KEY

Question 8: The following data reflect the situation of M&M, Inc. a few days before balance sheet date. ASSETS



$ 8,000 6,000

TOTAL

$14,000


$ 4,000 10,000

TOTAL

$14,000

The financial department of M&M is analyzing several proposals. The department values liquidity highly and plans to recommend the proposal that results in the best current ratio. Decide which proposal is the best by calculating the resulting current ratios. Proposal A

Before balance sheet date, take a short-term loan of $1,200 and buy additional inventories. Current ratio:

Proposal B

i

Before balance sheet date, take a short-term loan of $1,200 and buy machinery and vehicles. Current ratio:

Proposal C

1.77

1.54

i

After balance sheet date, take the loan and buy inventories. Current ratio:

2.00

i

Which is the best proposal? a) Proposal A b) Proposal B X

c) Proposal C

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Question 9: A few days before balance sheet date, Alpha Company and Beta Company were in the following situations: Alpha Company

Beta Company

Current Assets $1,500 Current Liabilities 1,000

Current Assets $6,000 Current Liabilities

4,700

On the last day of the period: +

Alpha took a short-term loan of $500 and purchased $500 in inventories.

+

Beta converted marketable securities of $2,000 into cash and repaid $2,000 in current loans, thus reducing both assets and liabilities.

Calculate the resulting current ratios: Alpha

Beta

__________

________

b) Current ratio at balance sheet date:

__________

________

c) Company that made the best decision in terms of improving liquidity:

__________

________

a)

Current ratio a few days before balance sheet date:

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ANSWER KEY

Question 9: A few days before balance sheet date, Alpha Company and Beta Company were in the following situations: Alpha Company

Beta Company

Current Assets $1,500 Current Liabilities 1,000

Current Assets $6,000 Current Liabilities

4,700

On the last day of the period: +

Alpha took a short-term loan of $500 and purchased $500 in inventories.

+

Beta converted marketable securities of $2,000 into cash and repaid $2,000 in current loans, thus reducing both assets and liabilities.

Calculate the resulting current ratios: a)

Current ratio a few days before balance sheet date:

b) Current ratio at balance sheet date: c) Company that made the best decision in terms of improving liquidity:

v-2.0

Alpha

Beta

1.50

1.28

i

1.33

1.48

i

4

i

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Unit 5

UNIT 5: FINANCIAL RATIOS — LEVERAGE

INTRODUCTION

In general, leverage ratios focus on the sufficiency of assets, or generation from assets, to cover the company’s pending short- and long-term obligations. The liquidity ratios discussed in Unit Four are similar in this regard but they are more concerned with the urgency of coverage; leverage ratios are more concerned with overall volume of coverage. Leverage ratios, also called capital structure ratios or solvency ratios, measure the relationship between outside capital and shareholder capital. Leverage ratios include: n

Total indebtedness ratio, or leverage

n

Current and long-term indebtedness ratios

n

Fixed assets to net worth ratio

n

Interest or debt service coverage ratios

UNIT OBJECTIVES


Calculate a total indebtedness ratio

n

Recognize the significance of a company’s leverage ratios

n

Identify generally appropriate leverage figures for different businesses

n

Calculate adjusted leverage

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5-2

FINANCIAL RATIOS — LEVERAGE

TOTAL INDEBTEDNESS (LEVERAGE)

The total indebtedness ratio, often called leverage, is one of the most important ratios for a banker. It is a good indicator of company solvency (ability to pay all debts) and a general index of the borrower’s creditworthiness. From a banker’s perspective, the lower the ratio within an appropriate range, the better. A low ratio indicates a greater asset coverage of liabilities and, therefore, a greater “cushion” of capital to cover unforeseen difficulties. A company with a low index denotes stronger capitalization which can absorb greater risk.

Calculation Standard leverage calculation

Outside capital is comprised of current and long-term liabilities that represent resources loaned to the company by third parties. Own capital is net worth. It represents the resources that stockholders have invested and earned in the firm. We divide outside capital by own capital to determine the total indebtedness of a company. Outside Capital Calculation:

Asset leverage

Own Capital

Total Liabilities / Total Net Worth

Another way of computing leverage is: Total Assets / Total Net Worth

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This calculation emphasizes the concept of asset coverage for payment of a company’s liabilities. It is really a variation on the standard or normal leverage, rather than a separate ratio. As you can see in Table 5.1, the result of asset leverage always will be 1.0 more than the result of standard leverage, so there is little to be gained by computing both variations. Banks use one or the other — the great majority of banks use the standard leverage calculation. Company A Assets Liabilities Net Worth Standard Leverage Asset Leverage

Company B

Company C

1000 500 500

1000 600 400

1000 800 200

1.0 2.0

1.5 2.5

4.0 5.0

Table 5.1: Comparison of standard leverage and asset leverage

Leverage Analysis Leverage should be analyzed within the context of the economic sector of the borrower since the appropriate leverage figure may vary from sector to sector. Incidence of Fixed Assets

The amount of fixed assets on the balance sheet is one of the major determinants of appropriate leverage. A heavy industry with major fixed asset needs will require greater capital levels to sustain its illiquid assets. The total debt for these types of companies will be relatively low in comparison to net worth, resulting in relatively low leverage levels. On the other hand, highly liquid companies with little need for fixed assets (such as wholesalers or trading companies) normally will operate at debt levels that are multiples of net worth, resulting in leverage of two or three, or perhaps greater. In Table 5.2, we show a comparison of the leverage for these two types of companies.

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Heavy Industrial Co.

Trading Co.

Fixed assets

700

100

Total assets

1000

1000

Liabilities

400

800

Net worth

600

200

Leverage

0.67

4.0

Table 5.2: Leverage relative to the amount of fixed assets

Effect of Seasonality

The leverage figure should also be measured within the context of seasonal borrowing patterns, if any, since these may distort the analysis. For example, a food processing company may be forced to take on debt at harvest time to enable payment to farmers. When the processed goods are sold, the company can repay the loans. Measuring leverage at the point of higher debt will result in a higher figure than at other times during the year. So, the timing of the balance sheet analysis should also be considered. In Table 5.3, you can see how the leverage ratio for a company with seasonal borrowing needs may vary for different periods during the year.

12/31

3/31

6/30

1000

800

1500

Liabilities

500

300

950

Net Worth

500

500

550

Leverage

1.0

0.6

1.7

Total Assets

Table 5.3: Leverage ratios for different periods

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Financial Leverage

Earlier, we said that from the lender’s perspective, the lower the leverage ratio for a company, the better. But, the borrower’s interest, in the case of capital sufficiency, may differ from the banker’s. From the shareholder’s point of view, if leverage is too low, profits may be insufficient for the level of equity in the company, resulting in a poor return on equity. Borrower’s point of view

An obvious way to improve return on equity is to increase earnings. Perhaps a less obvious way is to have less equity or net worth, which means higher leverage. For this reason, from the borrower’s point of view, it may be more convenient to “leverage up” a business, within reasonable parameters, in order to improve earnings per share. This is the concept of financial leverage, which is illustrated in Table 5.4.

Reasonably Conservative Total Assets

Aggressively Leveraged

Leveraged

1000

1000

1000

Liabilities

400

500

600

Net Worth

600

500

400

Earnings

100

100

100

0.67 16.7%

1.00 20.0%

1.50 25.0%

Leverage Return on Equity

Table 5.4: Financial leverage — borrower’s perspective

Lender’s viewpoint

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From the lender’s point of view, risk increases as liabilities substitute for equity. Take the case of a heavy industrial company with norms as listed in the first column of Table 5.4. If the company is well run and has a strong position in its market, a lender may tolerate a reasonable increase in leverage. However, as the company leverages more aggressively, the banker will be less tolerant from a risk perspective.

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“Correct” leverage figure


The “correct” leverage figure for each company, then, may vary considerably, depending on the liquidity of the assets, stability of the economic sector, and factors within the market. But, it is safe to say that the greater the amount of fixed assets, the greater the capital needs and, therefore, the lower the normal leverage level.

In summary, the normal leverage ratios generally are as follows:

Information resources

n

Heavy industries — less than 1.0

n

Medium industries — about 1.0 to 1.5

n

Retailers — slightly higher, maybe at 2.0

n

Wholesalers — slightly higher than retailers, perhaps 2.5 to 3.0 or higher

n

Financial services companies — 10.0 times or greater, sometimes as high as 20.0 (not to be confused with capital adequacy which has its own rules regarding assets that do not require capital backing).These companies tend to operate with small amounts of fixed assets on their balance sheets (generally less than 5% of total assets).

It is recommended that the analyst look up some figures within his/her respective market to confirm these numbers, perhaps business magazine listings of the “top 100” companies in their market. Industry averages, if available, are especially valuable for this purpose. Whatever the source, it is important for the analyst to get a feeling for the “right” figure for this important ratio to permit greater depth in financial analysis and better judgment as to capital adequacy among different types of borrowers.

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Tangible Net Worth Net of nonconvertible assets

When analyzing a company’s balance sheet, keep in mind that it may show assets that are difficult or impossible to convert into cash, such as pre-operating expenses or other intangibles, stale receivables, obsolete inventories, etc. These assets should be deducted from net worth for calculating leverage in order to present a more realistic or conservative scenario. The result of this “write down” is called tangible net worth.

Example

Let’s look at an example for Company X: Total assets Current liabilities Long-term liabilities Net worth

$M 500 200 50 300

Utilizing stated net worth, the total indebtedness ratio is 0.83: (200 + 50) / 300 = 0.83

However, Company X has some liquidity problems and $50,000 of its assets cannot be converted into cash. If we calculate tangible net worth, we see a different picture of the company: (200 + 50) / (300 - 50) = 1.00

Utilizing tangible net worth (net of nonconvertible assets), we now get an indebtedness ratio of 1.00. This means that outside capital represents 100% of own capital.

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As we discussed in Unit One, standard financial analysis theory recognizes that intangibles may not be convertible into cash and eliminates these assets against net worth for calculating tangible net worth. But this “write down” is not automatic. It should be done only if the intangibles are determined to be of dubious value and unrealizable. Other intangibles may be very valuable (examples: licenses to produce international brands, goodwill resulting from a recent privatization) and have a defined market value. In these cases, it would not necessarily be appropriate to net these assets since they may provide a major support to the net worth and value of the company. It is up to the analyst to make this determination. Revaluation Surplus Result of revaluing fixed assets

Since a revaluation of fixed assets results in a corresponding increase in revaluation surplus (a net worth account), net worth is increased by the net amount of a revaluation. In many cases, this increase may be justified by market conditions; but when the practice is unevenly applied, it can also lend itself to manipulation of numbers. Therefore, for purposes of calculating tangible net worth, it also may be appropriate to “write down” the amount of revaluation surplus. This is a judgment call for the analyst. At the very least, an analyst can calculate leverage with and without revaluation surplus to highlight the impact of revaluation on the leverage calculation as shown in Table 5.5.

Fixed assets Total assets Liabilities Net worth Computed leverage Adjusted leverage

Before

After Revaluation

500 1,000 500 500

700 1,200 500 700

1.00 1.00

0.71 1.00

Table 5.5: Leverage with and without revaluation surplus

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Other Adjustments Contingent liabilities

Contingent liabilities, such as corporate guarantees, discounted receivables with recourse, lease obligations, and open foreign currency positions, should also be considered by the analyst when studying a company’s leverage position. If a certain event occurs, a contingent liability may become direct (for example, a default by the principal borrower where the company analyzed is a guarantor). In Table 5.6, you can see that leverage increases if default occurs and the guarantee becomes a liability.

Before

After Default

Liabilities Net worth

500 500

700 500

Corporate guarantee

200

0

Leverage

1.0

1.4

Table 5.6: Increased leverage after default

Operating leases

A similar situation may occur with operating leases where the acquired assets are not booked on the user company’s balance sheet. By definition, the lease payments are expensed and there is no listed liability. But, if we look at the case of an airline, we see that the company cannot operate without the leased aircraft — and lease payments are really liabilities if the company plans to keep doing business. Omitting these “liabilities” from the balance sheet distorts reality, overstates the capital position, and severely understates the generic leverage of the company. Therefore, from the analyst’s point of view, it probably would be prudent to include several years’ worth of lease obligations on the balance sheet as a “liability.” How many years? This, again, is a judgment call, but the Citibank Airlines and Aerospace Unit has used up to seven years for this type of analysis. You can see the effect of this leverage adjustment in Table 5.7.

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Total assets Liabilities Net worth

Unadjusted

Adjusted

1,000 600 400

2,400 2,000 400

Annual lease obligation Average no. of years

200 7

Leverage

1.5

5.0

Table 5.7: Effect on leverage of liabilities adjusted for operating leases

In this situation, the shift to adjusted numbers results in major changes in the perception of the capital sufficiency of the company. Consolidations and Minority Interest Consolidated financial statements

Consolidated financial statements present the accounts of a group of interrelated companies as if they constitute only one company. With this overview, the analyst can assess the financial position and prospects of the entire group. In the case of consolidated numbers, the auditor lists assets on the left side, and liabilities, minority interest, and net worth accounts on the right side of the balance sheet. But, what is minority interest? Is it debt or equity? What should the analyst do with the minority interest account in terms of analysis? If you said that minority interest represents the portion of the group of companies that is owned by minority shareholders, you are correct. But, if this is ownership (i.e. net worth), why is the account not included within the net worth section of the consolidated balance sheet?

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The answer is that, by accounting conventions, consolidated figures include all the assets under the control of the group, even those that belong to third parties. The amount that the third party claims to ownership is then segregated on the right side of the balance sheet since it is not owned or controlled by the majority shareholders. The stated net worth is the net worth of the controlling shareholders, to whom the auditor’s report is addressed. The analyst should be careful when considering these numbers — sometimes it appears from the presentation that minority interest is a liability. But, it is not. What should be done with minority interest for the purposes of calculating leverage? Answer: It should be aggregated to net worth. Minority interest is, after all, legal equity. This aggregation is precisely the methodology used in the new Citibank spreadsheet. Incorrect and correct calculations of leverage are compared in Table 5.8.

Incorrect Total assets Liabilities Minority interest Net worth Leverage

Correct

1,000 500 100 400

1,000 500 100 400

1.50

1.00

Table 5.8: Aggregating minority interest with net worth to calculate leverage

The total indebtedness ratio compares outside capital to own capital to indicate a company’s leverage position. From the lender’s point of view, low leverage indicates strong capitalization and less business risk. From the borrower’s point of view, it may be more convenient to be more highly leveraged. The analyst must “get behind the numbers” to understand the impact of the leverage figure on the perceived business risk of a company. In the next section, we discuss two ratios that separate short-term liabilities from long-term liabilities to give a clearer picture of a company’s financial situation. v04/30/95 p05/22/00

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CURRENT AND LONG-TERM INDEBTEDNESS RATIOS

The total indebtedness ratio shows the relationship of total indebtedness to own capital. The current indebtedness ratio shows the proportion of current indebtedness to own capital (net worth), and the long-term indebtedness ratio shows the proportion of long-term indebtedness to own capital. Added together, the figures should equal the total indebtedness ratio. Example

Let’s look at an example that compares the indebtedness ratios for two companies. Even though the total indebtedness ratio is the same, the current and long-term ratios provide more in-depth information about leverage for these companies.

Company A

Company B

Current liabilities Long-term liabilities Total liabilities

100 100 200

180 20 200

Net worth

200

200

0.50 0.50 1.00

0.90 0.10 1.00

Current indebtedness ratio Long-term indebtedness ratio Total indebtedness ratio

Table 5.9: Indebtedness ratios for two companies

In Table 5.9, Company B may be in a less comfortable situation because most of its indebtedness is short-term, while Company A has at least one year to start paying 50% of its debts.

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A high current indebtedness ratio may be a cause for concern if a large part of it is currently due for payment. Whether it is actually a cause for concern or not will be dictated by the purpose of the indebtedness. For example, if indebtedness is financing fixed assets, it obviously is appropriate for this to be long-term financing. On the other hand, if a trading company with practically no fixed assets is financing receivables, it is appropriate for its entire debt to be shortterm. Here we see an overlap between leverage and liquidity concepts. A higher long-term indebtedness ratio results in greater liquidity as the amount of short-term obligations are reduced relative to total debt.

FIXED ASSETS COVERED BY OWN RESOURCES

Fixed assets covered by own resources is the ratio that measures the relationship between fixed assets and net worth. Calculation: Fixed Assets / Net Worth

Net worth represents a company’s permanent capital and should be used to support fixed investments. Any excess of net worth over fixed assets is used to fund working capital. If net worth is lower than fixed assets, the difference is funded by outside capital. Let’s look at two situations for Alpha Company. SITUATION A

Percentage of net worth funds working capital

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Current assets Fixed assets

200 300

Current liabilities Net worth

150 350

TOTAL

500

TOTAL

500

There is a difference of 50 between net worth and fixed assets. Since net worth is greater, the difference of 50 is used to fund working capital. In other words, the proportion of fixed assets to own resources is 86%, and the remaining 14% of net worth is used to fund the company’s working capital.

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Now, suppose Alpha Company purchases a new plant for 100 that is funded by long-term loans. The new situation is: SITUATION B

Current assets funded by outside capital

Current assets Fixed assets

200 400

Current liabilities Long-term liabilities Net Worth

150 100 350

TOTAL

600

TOTAL

600

Fixed assets increase from 300 to 400 and total long-term liabilities increase by 100. Fixed assets are covered by 350 in net worth and by 50 in long-term debt. Since the entire net worth is used to cover fixed assets, current assets are funded entirely by outside capital.

COVERAGE RATIOS

Coverage ratios indicate the amount of funds generated by operations to cover interest expense, long-term indebtedness, and the current portion of long-term debt.

Funds From Operations — Interest Coverage This calculation finds the coverage existing from gross operating cash flow ( GOCF or FFO, funds from operations) to enable payment of interest expenses. Calculation: GOCF / Gross interest expense

Remember, GOCF is operating profit (net sales - cost of goods sold selling and administrative expenses) plus depreciation, amortization, and other non-cash charges. Therefore, GOCF may be significant, in some cases, despite poor earnings. Capital intensive companies that generate a great deal of depreciation or amortizations may find these amounts of greater importance than operating profit.

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The higher the number for this ratio, the better, since it means greater ease of payment of interest. A number lower than one indicates an inability to pay out interest expense from operations, requiring nonoperating sources to cover interest needs. An over-leveraged firm will find this ratio to be low, perhaps near one, leaving it vulnerable to an increase in interest rates or an economic downturn. Companies that over leveraged themselves on Wall Street in the 1980s, such as Macy’s and Bloomingdales, paid a heavy price for this, requiring Chapter 11 protection from creditors to survive.

Funds From Operations — Long-Term Debt Coverage This ratio is similar to the previous one, but includes payment of longterm debt as well: Calculation: GOCF / (Gross interest expense + Total LTD)

The number here will be greatly influenced by the amount of longterm debt, if any, on the balance sheet. It measures the coverage of operational cash generation to contribute to interest and long-term debt obligations. Since it does not take into consideration the payment schedule of the long-term debt, this ratio is perhaps less useful than the following ratio.

Debt Service Ratio This ratio is similar to the previous two, but includes payment of the current portion of long-term debt instead of total long-term debt: Calculation: GOCF / (Gross interest expense + Current portion LTD)

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Here again, the higher the number for this ratio, the better, since it means greater ease of debt service. A number lower than one indicates an inability to pay out debt service from operations, requiring reduction of working capital or non-operating sources to cover interest needs. In such a case, the funding source will probably be additional debt, if credit can be obtained. Again, an over-leveraged firm will find this ratio to be low, leaving it vulnerable to an increase in interest rates or an economic downturn. This is precisely the risk of higher leverage for any company.

Summary Leverage ratios measure the relationship between outside capital and own capital. They focus on the sufficiency of assets to cover shortand long-term obligations. Total indebtedness ratio (leverage) — measures the relationship of net worth to liabilities or assets. Total liabilities / Total net worth Total assets / Total net worth

The analyst may have to adjust the leverage figure for a company to account for such factors as seasonality and liquidity of the assets. From the lender’s perspective, a lower ratio indicates lower risk. Current and long-term indebtedness ratios show the relationship between net worth and current or long-term debt. Current liabilities / Total net worth Long-term liabilities / Total net worth

Fixed assets covered by own resources measure the relationship between fixed assets and net worth. Fixed assets / Net worth

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Any excess of net worth over fixed assets is used to fund working capital. Coverage ratios measure the amount of funds generated from operations to cover interest payments and the total or current portion of long-term debt. The higher the number for these ratios, the greater the ease of interest and long-term debt service. Gross operating cash flow (GOCF) / Gross interest expense GOCF / Gross interest expense + Total long-term debt GOCF / Gross interest expense + Current portion of long-term debt

You have completed Unit Five: Financial Ratios — Leverage. Please answer the questions in Progress Check 5 to check your understanding of the material before proceeding to Unit Six: Financial Ratios — Turnover.

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þ

PROGRESS CHECK 5

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 1: Based on the data supplied by Parker Company, complete the following statements. Current liabilities Long-term liabilities Net worth

$100,000 $ 50,000 $200,000

a) The total indebtedness ratio is ________. b) Outside capital represents _____ % of own capital.

Question 2: Check the statement(s) below that apply to Parker Company. ____ a) Most of the funds used by the company are provided by the owners. ____ b) There is $1 in own capital for each $0.75 in outside capital. ____ c) Indebtedness is high.

Question 3: From the borrower’s point of view, the concept of financial leverage means: ____ a) lower leverage to reduce risk. ____ b) lower leverage to increase return on equity. ____ c) higher leverage to increase return on equity. ____ d) higher leverage to reduce risk.

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ANSWER KEY

Question 1: Based on the data supplied by Parker Company, complete the following statements. Current liabilities Long-term liabilities Net worth

$100,000 $ 50,000 $200,000

a) The total indebtedness ratio is .75 . b) Outside capital represents 75% of own capital.

Question 2: Check the statements below that apply to Parker Company. a) Most of the funds used by the company are provided by the owners. b) There is $1 in own capital for each $0.75 in outside capital.

Question 3: From the borrower’s point of view, the concept of financial leverage means: c) higher leverage to increase return on equity.

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PROGRESS CHECK 5 (Continued)

Question 4: Match the type of borrower with the general appropriate leverage figure. a) 0.5 to 1.0

_____

wholesaler

b) 1.0 to 1.5

_____

heavy industry

c) 2.5 to 3.0

_____

financial services

d) 10.0 or >

_____

medium industry

Question 5: Company K and Company L make ceramic floor tiles. From the data supplied below, complete the following statements.

Current assets Fixed assets Total assets Current liabilities Long-term liabilities Outside capital Net worth Total liabilities & Net worth

Company K

Company L

$ 898,000 1,291,000

$ 2,694,000 3,873,000

2,189,000

6,567,000

484,000 544,000

1,452,000 2,147,000

1,028,000 1,161,000

3,599,000 2,968,000

$ 2,189,000

$ 6,567,000

a) Total indebtedness ratio for Company K is ____. b) Total indebtedness ratio for Company L is ____. c) Company ____ has a stronger capital structure, because it has less outside capital. d) Both companies have a collection problem as $100,000 of assets cannot be realized. Based on tangible net worth, the new total indebtedness ratios for Company K and Company L are ____ and ____, respectively.

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ANSWER KEY

Question 4: Match the type of borrower with the general appropriate leverage figure. a) 0.5 to 1.0

c Iwholesaler

b) 1.0 to 1.5

a i heavy industry

c) 2.5 to 3.0

d i

financial services

d) 10.0 or >

b i

medium industry

Question 5: Company K and Company L make ceramic floor tiles. From the data supplied below, complete the following statements.

Current assets Fixed assets Total assets Current liabilities Long-term liabilities Outside capital Net worth Total liabilities & Net worth

Company K

Company L

$ 898,000 1,291,000

$ 2,694,000 3,873,000

2,189,000

6,567,000

484,000 544,000

1,452,000 2,147,000

1,028,000 1,161,000

3,599,000 2,968,000

$ 2,189,000

$ 6,567,000

a) Total indebtedness ratio for Company K is 0.89 . b) Total indebtedness ratio for Company L is 1.21 . c) Company K has a stronger capital structure, because it has less outside capital. d) Both companies have a collections problem as $100,000 of assets cannot be realized. Based on tangible net worth, the new total indebtedness ratios for Company K and Company L are 0.97 and 1.25 , respectively.

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Question 6: Delta Company presents the following balance sheet. Cash Receivables Inventory Fixed assets Intangibles

25 100 300 500 75 1,000

Leverage:

1.00

Short-term bank debt Payables Accruals Long-term debt Net worth

200 150 50 100 500 1,000

In studying these numbers, the financial analyst finds out the following: n

One week prior to the balance sheet closing, Delta discounted receivables, with recourse, for 100.

n

There is an obsolete inventory of 50 on Delta’s balance sheet.

n

Fixed assets recently were revalued by 100, following dubious practices.

n

Intangibles include deferred pre-operating expenses of 25.

n

Intangibles also include a valuable license recently bought for 50.

n

Delta is a guarantor of a weak company’s short-term debt of 100.

n

Delta leases 200 in fixed assets not listed on the balance sheet, payable in lease obligations over four years.

Calculate the appropriate adjusted leverage for Delta Company. Remember, every adjustment to a balance sheet account has a corresponding counter entry, so you should first adjust the entire balance sheet and then calculate leverage.

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Cash Receivables Inventory Fixed assets Intangibles

____ ____ ____ ____ ____ ____

Adjusted Leverage:

____

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ANSWER KEY

Question 6: Calculate the appropriate adjusted leverage for Delta Company. Remember, every adjustment to a balance sheet account has a corresponding counter entry, so you should first adjust the entire balance sheet and then calculate leverage. Cash Receivables Inventory Fixed assets Intangibles Adjusted Leverage:

25 300 250 600 50 1,225


450 150 50 250 325 1,225

2.77

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Question 7: Use the data supplied by Gamma and Beta to complete the following statements. Gamma Company Current liabilities Long-term liabilities Net worth

Beta Company

$ 250,000 $ 50,000 $ 230,000

$ 158,000 $ 160,000 $ 241,000

a) The total indebtedness ratios for Gamma and Beta are ____ and ____, respectively. b) The current indebtedness ratios for Gamma and Beta are ____ and ____, respectively. c) _______ Company has the better capital structure because most of its liabilities are long-term. Question 8: Use the data supplied below to complete the following statements. SITUATION A

SITUATION B

ASSETS

LIABILITIES

ASSETS

LIABILITIES

Current Assets $350

Current Liabilities $300

Current Assets $350

Current Liabilities $300 Long-term Liabilities $100

Fixed Assets $425

Net Worth $475

Fixed Assets $525

Net Worth $475

TOTAL $775

TOTAL $775

TOTAL $875

TOTAL $875

a) Is working capital the same for both situations? ____ (Yes / No) b) Situation ____ uses a portion of outside resources to cover fixed assets. c) Situation ____ shows a portion of stockholders' resources funding working capital. d) Situation A uses ____ % of own resources to fund fixed assets. e) Situation A uses ____ % of own resources to fund current assets. f) Situation B uses ____ % of own resources to fund fixed assets. The remainder of fixed assets is funded by _____________ resources. v04/30/95 p05/22/00

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ANSWER KEY Question 7: Use the data supplied by Gamma and Beta to complete the following statements. Gamma Company Current liabilities Long-term liabilities Net worth

a)

Beta Company

$ 250,000 $ 50,000 $ 230,000

$ 158,000 $ 160,000 $ 241,000

The total indebtedness ratios for Gamma and Beta are 1.30 and 1.32 , respectively

b) The current indebtedness ratios for Gamma and Beta are 1.09 and 0.66 , respectively. c)

Beta Company has the better capital structure because most of its liabilities are longterm.

Question 8: Use the data supplied below to complete the following statements. SITUATION A

SITUATION B

ASSETS

LIABILITIES

ASSETS

LIABILITIES

Current Assets $350

Current Liabilities $300

Current Assets $350

Current Liabilities $300 Long-term Liabilities $100

a)

Fixed Assets $425

Net Worth $475

Fixed Assets $525

Net Worth $475

TOTAL $775

TOTAL $775

TOTAL $875

TOTAL $875

Is working capital the same for both situations? Yes i

b) Situation B uses a portion of outside resources to cover fixed assets. c) Situation A shows a portion of stockholders' resources funding working capital. d) Situation A uses 89% of own resources to fund fixed assets. e) Situation A uses 11% of own resources to fund current assets. f)

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Question 9: The calculation for the funds from operations interest coverage ratio is: ____ a) GOCF / gross interest expense. ____ b) NOCF / net interest expense. ____ c) GOCF / net interest expense. ____ d) NOCF / gross interest expense.

Question 10: If the debt service ratio is less than one, which of the following may be sources of repayment of the debt? (You may select more than one answer.) ____ a) Operations ____ b) Reduction in receivables ____ c) Reduction in inventory ____ d) Additional bank debt

Question 11: From the lender’s point of view, which of the following is the best combination? ____ a) High leverage and high coverage ratio ____ b) Low leverage and low coverage ratio ____ c) High leverage and low coverage ratio ____ d) Low leverage and high coverage ratio

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ANSWER KEY

Question 9: The calculation for the funds from operations interest coverage ratio is: a) GOCF / gross interest expense.

Question 10: If the debt service ratio is less than one, which of the following may be sources of repayment of the debt? (You may select more than one answer.) b) Reduction in receivables c) Reduction in inventory d) Additional bank debt

Question 11: From the lender’s point of view, which of the following is the best combination? d) Low leverage and high coverage ratio

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Question 12: From the lender’s point of view, which of the following is the worst combination? ____ a) High leverage and high coverage ratio ____ b) Low leverage and low coverage ratio ____ c) High leverage and low coverage ratio ____ d) Low leverage and high coverage ratio

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ANSWER KEY

Question 12: From the lender’s point of view, which of the following is the worst combination? c) High leverage and low coverage ratio

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Unit 6

UNIT 6: FINANCIAL RATIOS — TURNOVER

INTRODUCTION

Liquidity ratios try to answer the question, “What is the degree of coverage of liquid assets for short-term obligations?” Turnover ratios try to answer the question, “How long does it take the firm to realize receivables or inventories, or to pay its trade suppliers?” In this unit, we will see how turnover ratios complement liquidity ratios by informing the analyst of the time it takes a company to convert trade receivables and inventory into cash, or the amount of funds that has been provided by trade receivables. Correct reading of the ratios, along with additional information about a company’s business, may also help the analyst to evaluate the quality of current assets. This determination is important in judging liquidity, since current ratio coverage of liquid assets over short-term obligations presupposes timely liquidation of receivables and inventory. Some turnover ratios may be calculated in two ways: either as a straight turnover or converted to days. The commonly used turnover ratios include: n

Receivables turnover, or days receivable

n

Inventory turnover, or days inventory

n

Payables turnover, or days payable

n

Sales to assets turnover

Other turnover ratios may also be calculated, including days cash and securities or days accruals, but the ratios listed above are the most common.

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FINANCIAL RATIOS — TURNOVER

UNIT OBJECTIVES


Calculate the receivables turnover ratio (turnover periods in a year)

n

Calculate days receivable (average collection time)

n

Calculate the inventory turnover ratio (turnover periods in a year)

n

Calculate days inventory (amount of inventory on the balance sheet date relative to the annual production)

n

Calculate the payables turnover ratio (turnover periods in a year)

n

Calculate days payable (average payment time)

n

Calculate the sales to asset turnover ratio

RECEIVABLES TURNOVER / DAYS RECEIVABLE

Receivables Turnover Ratio Calculation

The receivables turnover ratio is calculated by dividing net credit sales from the income statement by trade receivables from current assets in the balance sheet. Calculation:

Net Credit Sales / Trade Receivables

The sales figure should represent the entire year to prevent distortion and to allow comparison to prior annual figures. For interim calculations, the sales figure should be annualized, taking into account any seasonal factors in the sales.

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Net credit sales not itemized in income statement

Notice that the correct figure for sales is net credit sales, not total net sales, because receivables, by definition, are sales made on a credit basis. Sales made on a cash basis do not generate accounts receivable. Yet, the Citibank spreadsheet calculates on the basis of net sales (as is the case with the spreadsheet of most banks). If this is technically incorrect, why do banks calculate this way? The reason is that the income statement does not tell us what percentage of sales is on a credit basis and what percentage is on a cash basis.

Use approximate percentages

Many companies that sell on credit terms do so for 100% of their sales. In these cases, net credit sales and total net sales are the same. If an analyst studies the financial statements of a company with significant amounts of both credit and cash sales, he/she should find out the approximate percentages and calculate an adjusted turnover. Another point worth noting is the effect of value added taxes. If sales taxes are included within the sales figure, then these must be netted out as well.

Net out other receivables

Note, also, that we use trade receivables for this calculation. This means that other receivables, those not generated from normal trade operations of the company, should be netted out to avoid distortion of the numbers.

Examples

Let’s look at the example of receivables turnover for two companies in Table 6.1.

Net credit sales Trade receivables Turnover (times per year)

Company A

Company B

400 100 4.0

720 60 12.0

Table 6.1: Receivables turnover for two companies

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From these numbers, we can see that Company A turns over its trade receivables four times per year while Company B turns over its trade receivables twelve times per year. Therefore, Company B collects much faster than Company A.

Days Receivable Expresses turnover in terms of days

Most banks prefer to calculate days receivable, instead of receivable turnover. Days receivable is another way of stating the same information, but perhaps in more useful form. This methodology takes the turnover number and expresses it in terms of the number of days in a year.

Period of one year

Taking the example in Table 6.1, a turnover of 4.0 means 90 days, because 90 days is 1/4 of a year. A turnover of 12 times means 30 days, because 30 is 1/12 of a year. So days can be calculated by dividing 360 by the turnover. The following calculation is a more direct approach: (Trade Receivables / Net Credit Sales) x 360

Period of less than one year

If we are calculating turnover for a period of less than one year, we substitute the appropriate number of days in the period for the 360. For example, if the period is six months, we substitute 180 in the formula. In Table 6.2, you can see the calculation of days receivable for the companies from Table 6.1.

Net credit sales Trade receivables Calculation Days receivable

Company A

Company B

400 100 (100 / 400) x 360 90

720 60 (60 / 720) x 360 30

Table 6.2: Calculation of days receivable for two companies

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The figure for days receivable represents the collection period for each company. Collection period relative to credit terms

In studying the companies, the analyst should compare these numbers to the average credit terms granted by the company. If Company A in the example, grants credit terms of 90 days and Company B grants 30 days, then both are collecting well and probably have good quality receivables on the balance sheet. However, if Company A grants terms of 60 days, but is collecting in 90 days, then we question the quality of the receivables — apparently there are significant amounts of past due accounts within the balance sheet.

Average receivables for the year

Note that these calculations are based on year end numbers. Use of average numbers for the year would be more precise, and would provide the average collection period for the year. If we have monthly balance sheets, we can obtain a more precise average receivables figure during the year for this computation — but an analyst rarely has the luxury of monthly figures.

Seasonality effect

We can calculate averages from quarterly figures, which is more practical, or from beginning and ending year figures. This latter calculation is not too helpful because it does not capture any seasonality during the year. In practical terms, most banks, including Citibank, simply use year-end figures for calculating days receivable. The resulting figure can be affected by seasonal factors, which, conceivably, can lead to a wrong interpretation of the result.

Example

Let’s look at an example. Omega Company produces clothing and sells to distributors on 90-day terms. All sales are on a credit basis. Total annual sales are 12,000, but sales in the October to December quarter constitute 40% of total annual sales. These sales are spaced evenly per month, i.e. 1,600 in October, 1,600 in November, and 1,600 in December.

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With this information, we know that accounts receivable at 12/31 should be entirely constituted by sales for the 90-day period between October to December, i.e. 4,800. If we do a spreadsheet analysis of the 12/31 balance sheet, what is the calculation for days receivable? Calculation: (4800 / 12,000) x 360 = 144 days

In judging this number, the analyst can easily compare it to the 90-days credit terms and conclude there are problems with collectibility of receivables. Wrong conclusion! What we see here is the effect of seasonality. We have sales in this quarter greater than the average sales per quarter for the year. The sales total of 4,800 in the last quarter constitutes 4.8 months (144 days) of the total sales of the year, but they are collected in only 3.0 months. During other quarters, the sales are less than the average for the year. In these other months, the days receivable calculation could be 54 days (quarterly sales of 1,800), 72 days (quarterly sales of 2,400), or other numbers. The analyst should recognize that the calculation of the days receivable figures by the spreadsheet software could be misleading and should interpret the numbers accordingly. In particular, the analyst should understand whether the last quarter sales figures are average or out of the ordinary.

Summary Receivables turnover tells us how many turnover periods for receivables a company has in one year. The calculation is: Net Credit Sales / Trade Receivables

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A more direct approach is to calculate the number of days in one collection period. The calculation is: (Trade Receivables / Net Credit Sales) x 360

This figure is significant when compared to the credit terms granted by a company. The analyst can draw some conclusions about the quality of the receivables on the balance sheet and the company’s ability to collect them. Judgment should be based on calculations using average numbers for the year, which give a more precise result than using yearend figures.

You have now completed the section on “Receivables Turnover / Days Receivable.” Please complete Progress Check 6.1 before continuing on to the next section, “Inventory Turnover or Days Inventory.”

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PROGRESS CHECK 6.1


Question 1: On December 31, 19X6, ABC Company's trade receivables totaled $50,000 and net sales totaled $400,000. All sales are made on credit terms. a) ABC Company's receivables turnover ratio is _____ times. b) Their average collection time is ____ days.

Question 2: If the average collection time is 30 days, what is the turnover? ____ a) 8 times ____ b) 10 times ____ c) 12 times ____ d) 14 times

Question 3: The correct formula for calculating days receivable for one year numbers is: ____ a) (Total Net Sales / Total Receivables) x 360. ____ b) (Net Credit Sales / Trade Receivables) x 360. ____ c) (Trade Receivables / Total Net Sales) x 360. ____ d) (Trade Receivables / Net Credit Sales) x 360.

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ANSWER KEY

Question 1: On December 31, 19X6, ABC Company's trade receivables totaled $50,000 and net sales totaled $400,000. All sales are made on credit terms. a) ABC Company's receivables turnover ratio is 8 times. b) Their average collection time is 45 days.

Question 2: If the average collection time is 30 days, what is the turnover? c) 12 times

Question 3: The correct formula for calculating days receivable for one year numbers is: d) (Trade Receivables / Net Credit Sales) % 360.

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Question 4: Kappa Company’s annual sales are 240 million pesos, 75% of which are made on credit terms of 60 days. The year end trade receivables are 30 million. Calculate the days receivable. Calculation:__________________ Days receivable:______________

Question 5: Gamma Company’s annual sales are 480 million pesos, half of which are on credit terms of 90 days. Sales are made evenly during the year and there are no problems with past due accounts. Calculate the year end balance sheet figure for trade receivables. Calculation:___________________ Trade receivables:______________

Question 6: Based on the data from Company A, complete the following questions. Company A Cash Marketable Securities Trade Receivables Inventories

2,600 1,500 8,200 13,000

Current Assets

25,300

Current Liabilities

11,000

Net Credit Sales

72,000

a) The current ratio is __________. b) The acid test is __________. c) The collections turnover is __________. d) The average collection period is __________days.

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ANSWER KEY

Question 4: Kappa Company’s annual sales are 240 million pesos, 75% of which are made on credit terms of 60 days. The year end trade receivables are 30 million. Calculate the days receivable. Calculation: (30 / (240 % .75)) % 360 Days receivable:

60

i

i

Question 5: Gamma Company’s annual sales are 480 million pesos, half of which are on credit terms of 90 days. Sales are made evenly during the year and there are no problems with past due accounts. Calculate the year end balance sheet figure for trade receivables. Calculation: (480 x .5) % (90/360) i Trade receivables: 60 i

Question 6: Based on the data from Company A, complete the following questions. Company A Cash Marketable Securities Trade Receivables Inventories

2,600 1,500 8,200 13,000

Current Assets

25,300

Current Liabilities

11,000

Net Credit Sales

72,000

a) The current ratio is 2.30 . b) The acid test is 1.12 . c) The collections turnover is 8.78 times. d) The average collection period is 41 days.

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INVENTORY TURNOVER OR DAYS INVENTORY

Inventory Turnover Number of times inventories are replenished

The inventory turnover ratio indicates the number of times inventories are replenished during the period. It is calculated by dividing cost of goods sold (an income statement account) by inventory (a current asset account). Calculation: Cost of Goods Sold / Inventory

Notice that when we calculate receivables turnover we measure against sales, whereas inventory turnover is calculated against cost of sales. Why is this? Receivables literally are sales made on a credit basis; they must be booked at the sales price. But inventories have not been sold. By accounting convention, these are carried on the balance sheet at cost. Therefore, we calculate inventory turnover against cost. Example

Let’s look at an example.

Cost of goods sold Inventory Turnover (times per year)

Company X

Company Y

600 100 6.0

900 300 3.0

Table 6.3: Inventory turnover for two companies

From these numbers, we can see that Company X turns over its inventory twice as fast as Company Y.

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The comments about average and year-end figures made in the receivables discussion apply equally to inventory. Averaged monthly figures are ideal, but the analyst rarely has this luxury — quarterly or semiannual figures may be more feasible. Yet, the Citibank spreadsheet calculations are based on year-end figures only. Why? It is simply more convenient to program it this way. If the analyst has additional information (for example, quarterly figures) he/she can make the calculation manually and compare it to the year-end inventory figure.

Days Inventory Inventory in terms of days

Most banks prefer to calculate days inventory instead of inventory turnover. Days inventory is another way of stating the same information in a more useful format. This methodology takes the turnover number and expresses it in terms of the number of days in a year. Taking the previous example, a turnover of 6.0 means 60 days, because 60 days is 1/6 of a year. A turnover of 3.0 times means 120 days, because 120 is 1/3 of a year. So, days can be calculated by dividing 360 by the turnover. As with receivables, there is a more direct approach. (Inventory / Cost of Goods Sold) % 360

However, if we’re dealing with a period of less than one year, then we substitute the appropriate number of days in the period for the 360. For example, for six month figures, we substitute 180 in the formula.

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Example

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In Table 6.4, we calculate the days inventory for the same two companies that we saw in the inventory turnover example.

Cost of goods sold Inventory Calculation Days inventory

Company X

Company Y

600 100 (100 / 600) × 360 60

900 300 (300 / 900) × 360 120

Table 6.4: Days inventory for two companies

Length of time company can operate without production

The figure for days inventory represents the amount of inventory at the balance sheet cutoff date relative to annual production costs. This indicates approximately how many days the company can operate without additional production before closing its doors. For a commercial company where the entire inventory is finished goods, this approximate number may be close to reality — as long as there are no major seasonal effects. For an industrial company, this is a very rough estimate because inventory is composed of both finished goods and raw materials.

Consider type of inventory

Actually, for an industrial company, the type of inventory should be considered in the calculation of days inventory because the cost element is different. Finished goods are valued at cost of goods sold (raw material, labor, and overhead), but raw materials are valued at purchase cost (or market, whichever is lower). This means that if inventory is composed mostly of finished goods, the traditional calculation can be quite accurate. If the inventories are essentially raw materials (RM), the following calculation may be more appropriate: (Raw Material Inventory / (Initial RM + Purchases - End RM)) % 360

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Where most of the inventories are raw materials, this is a more accurate calculation. However, it is not the formula calculated by bank spreadsheets because the income statement normally does not indicate the amount of annual purchases of raw materials. If the analyst can obtain this information, in some cases it may be useful to make this extra calculation for a more precise evaluation of the numbers. Inventory judging appropriate levels

In studying the numbers, the analyst likes to compare them to something. The days receivable number is compared to credit terms. What can days inventory be compared to? This is a difficult question, but there are some factors to consider. The analyst must first understand the business fundamentals to judge inventory sufficiency.

Type of company

The type of company will determine the inventory an analyst should consider. A shoe producer may have different styles, sizes, and colors of products in stock, besides considerable amounts of raw materials. It is a working capital intensive business. Commercial companies also are inventory intensive, by nature, so these types of companies will tend to have greater amounts of inventory on their balance sheets. On the other hand, transport companies, and other service companies such as hotels, have little need for inventory and will, therefore, have lower levels on their balance sheet.

Selling methodology

Selling methodology also has an impact. Does the firm sell on a specific contract basis, or does it sell from stock? The first case may involve little need for finished goods, while the second will have greatly increased needs. When considering the appropriate level of inventory, the analyst must also take into account any potential seasonality. Clients that sell, purchase, and produce the same amount every month are rare, so inventory levels for most companies will vary from month to month or quarter to quarter. The analyst should try to understand these seasonal effects to more accurately interpret the days inventory figure at the balance sheet date.

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There are no easy answers to enable precision in judging the appropriate level of inventory for a company. The analyst should get a feeling for what is appropriate from management and then look at similar firms for comparison, remembering that no two firms are exactly alike. Generally, less inventory is better

We do know that within reasonable limits, from a financial perspective, it is better to operate with less inventory. Why? Inventory has carrying costs (space, control systems, pilferage, obsolescence, security, insurance, etc.) and it also has financing costs — either debt interest or equity expectations. Therefore, holding inventory is an expensive proposition; and that is why the theory of “just in time inventory” was developed.

Reasons for higher inventory

Some clients say they prefer to maintain higher inventory levels “to protect themselves against inflation,” “to get volume discounts on purchases,” or “to nail down a lower exchange rate.” All of these may be true in specific cases, if the savings from lower prices at purchase compensate for inventory carrying and financial costs. With the current significantly reduced inflation levels and greater economic stability in Latin America, these client comments are heard less and less.

Summary The inventory turnover ratio calculates the number of times inventories are replenished during the period. The calculation is: Cost of Goods Sold / Inventory

Days inventory is another way of stating the same information, but is the number most banks prefer to use. It expresses the turnover number in terms of days in a year. The calculation is: (Inventory / Cost of Goods Sold) % 360

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For periods of less than one year, the correct number of days is used in place of 360. In assessing the days inventory number, the analyst must consider the following issues: n

Type of inventory — finished goods or raw materials

n

Appropriate level of inventory — depends on type of company, selling methodology, and seasonality

You have now completed the section on “Inventory Turnover or Days Inventory.” Please complete Progress Check 6.2 before continuing on to the next section, “Payables Turnover or Days Payable.”

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PROGRESS CHECK 6.2

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 7: If the cost of goods sold equals $2,400,000 and inventories equal $600,000, the inventory turnover is _____ times and the inventory turnover time is _____ days.

Question 8: Use the data below to complete the following questions. Monthly Inventories — 19X5 December, 19X4 January, 19X5 February March April May June July August September October November December

145,000 152,000 180,000 190,000 122,000 158,000 205,000 342,000 528,000 548,000 322,000 298,000 194,000

Cost of Goods Sold: $1,428,000 a)

Using average monthly inventories, we compute an inventory turnover of ____ times, and an inventory turnover time of ____ days.

b) Using the average inventories of December 31, 19X4 and 19X5, we compute an inventory turnover of ____ times, and an inventory turnover time of ____ days. c) Using the ending inventory for December 31, 19X5 only, the figure for days inventory indicating the days of stock in existence is ____ days.

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ANSWER KEY

Question 7: If the cost of goods sold equals $2,400,000 and inventories equal $600,000, the inventory turnover is 4 times and the inventory turnover time is 90 days.

Question 8: Use the data below to complete the following questions. Monthly Inventories — 19X5 December, 19X4 January, 19X5 February March April May June July August September October November December

145,000 152,000 180,000 190,000 122,000 158,000 205,000 342,000 528,000 548,000 322,000 298,000 194,000

Cost of Goods Sold: $1,428,000 a) Using average monthly inventories for 19X5, we compute an inventory turnover of 5.29 times, and an inventory turnover time of 68 days. b) Using the average inventories of December 31, 19X4 and 19X5, we compute an inventory turnover of 8.42 times, and an inventory turnover time of 43 days. c) Using the ending inventory for December 31, 19X5 only, the figure for days inventory indicating the days of stock in existence is 49 days.

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Question 9: Gamma company’s inventory is entirely made up of raw materials. Movements for the year are as follows: Initial raw materials: Purchases: Ending raw materials: Cost of goods sold:

100 900 200 1,200

Using the most precise formula, calculate the days inventory at the balance sheet date. ____ a) 72 days ____ b) 60 days ____ c) 80 days ____ d) 90 days Question 10: Which type of company will tend to have the greatest inventory needs as a percentage of total assets? ____ a) Hotel ____ b) Plastics producer ____ c) Department store ____ d) Mail courier Question 11: Indicate whether the following statements are (T) true or (F) false. ____ a) It is usually better for a company to have higher inventory levels. ____ b) The Citibank spreadsheet calculates days inventory based on average inventory levels, taking beginning and year end figures. ____ c) Inventory turnover of 10 times is the same as 36 days. ____ d) The selling methodology of a company may affect appropriate inventory levels.

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ANSWER KEY

Question 9: Gamma company’s inventory is entirely made up of raw materials. Movements for the year are as follows: Initial raw materials: Purchases: Ending raw materials: Cost of goods sold:

100 900 200 1,200

Using the most precise formula, calculate the days inventory at the balance sheet date. d) 90 days

Question 10: Which type of company will tend to have the greatest inventory needs as a percentage of total assets? c) Department store

Question 11: Indicate whether the following statements are (T) true or (F) false. F

a) It is usually better for a company to have higher inventory levels.

F

b) The Citibank spreadsheet calculates days inventory based on average inventory levels, taking beginning and year end figures.

T

c) Inventory turnover of 10 times is the same as 36 days.

T

d) The selling methodology of a company may affect appropriate inventory levels.

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PAYABLES TURNOVER OR DAYS PAYABLE

Payables Turnover Measured against purchases

Payables turnover indicates the number of times that payables are rotated during the period. It is best measured against purchases, since purchases generate accounts payable. Calculation: Total Purchases / Trade Payables

The purchases figure should represent the entire year, or the ratio will be distorted and not comparable to prior annual figures. For interim calculations, the purchases figure should, therefore, be annualized, taking into account any seasonal factors in purchasing. Example

Let’s look at an example:

Total purchases Trade payables Turnover (times per year)

Company E

Company F

1,200 100 12.0

960 160 6.0

Table 6.5: Payables turnover for two companies

Company E has a higher rotation than Company F. This means that Company F’s trade suppliers probably offer more generous credit terms.

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Days Payable Most banks prefer to calculate days payable, instead of payable turnover. Days payable is another way of stating the same information in a more useful form. This methodology takes the turnover number and expresses it in terms of the number of days in a year. In the previous example, a turnover of 12.0 means 30 days, because 30 days is 1/12 of a year. A turnover of 6.0 times means 60 days, because 60 is 1/6 of a year. So, days can be calculated by dividing 360 by the turnover. As with the other turnover ratios, there is a more direct approach. (Trade Payables / Total Purchases) x 360

However, if we are dealing with a period of less than one year, we substitute the appropriate number of days in the period for the 360. For example, we substitute 180 in the formula for six month figures. Let’s calculate the days payable for the same two companies: Company E Total purchases Trade payables

1,200 100

Calculation Days payable

(100 / 1200) x 360 30

Company F 960 160 (160 / 960) x 360 60

Table 6.6: Days payable for two companies

Average payment period

The figure for days payable represents the average payment period for the company. In studying the companies, the analyst would like to compare these numbers to the average credit terms received by the company.

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Common Variation

The days payable calculation is correct in theory, yet more often (including the Citibank spreadsheet) we see the less precise calculation for days payable: Calculation: (Trade Payables / Cost of Goods Sold) x 360

Substitutes cost of goods sold

The reason is that the figure for purchases normally is not specified in the income statement, so we use the second best alternative as a default. Notice that for a commercial firm this distinction is not relevant. There is no processing of the goods and, therefore, the figure for purchases is essentially the same as cost of goods sold. For an industrial firm, there may be a significant difference. Let’s look at the same two companies, but this time we will include a figure for cost of goods sold.

Cost of goods sold Total purchases Trade payables

Company E

Company F

1,800 1,200 100

1,200 960 160

Calculation #1 Days payable (purchase basis)

(100 / 1200) x 360 30

(160 / 960) x 360 60

Calculation #2 Days payable (cgs basis)

(100 / 1800) x 360 20

(160 / 1200) x 360 48

Variance from # 1

33%

20%

Table 6.7: Comparison of days payable calculation using purchases as a basis vs. using cost of goods sold as a basis

Notice that these numbers are quite reasonable for industrial companies. For Company E, purchases is 67% of CGS; for Company F, the figure is 80%.

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Implicit error using CGS basis


In the first case, the variance, or implicit error in calculating by the CGS basis, is 33%, in the second case, it is 20%. The analyst, therefore, must understand how the spreadsheet calculates and recognize this implicit error when interpreting the spreadsheet calculations. This applies to days payable for industrial companies or for any other companies that have a significant amount of value added to their products.

Seasonality

Similar to the situation with receivables, payables figures can be significantly impacted by seasonality. Average payables figures are useful but, as a practical matter, most banks (including Citibank) simply use year-end figures for calculating days payable on the spreadsheet. Purchasing frequency varies

Many companies, especially retailers, purchase several times during the year at specified intervals, instead of making equal purchases every month. The resulting days receivable figure, therefore, can be affected considerably by seasonal factors. Conceivably, this may lead to an incorrect interpretation of the result. Let’s look at an example.

Example

Theta Company sells clothing to the general public. All purchases are on a credit basis, with average terms of 60 days. Total annual purchases are 1,000, but purchases in November and December together constitute 30% of this total. With this information, accounts payable at 12/31 should be constituted by the November and December purchases, i.e. 300. If we do a spreadsheet analysis of the 12/31 balance sheet, what is the calculation for days payable? Calculation: (300 / 1000) x 360 = 108 days

In judging this number, the analyst can easily compare it to the credit terms of 60 days and conclude that there are problems with payment of receivables. Wrong conclusion!

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What we see here is the effect of seasonality. The purchase total of 300 in the last quarter constitutes 3.6 months (108 days) of the total purchases of the year, but these are made in only 2.0 months. In other words, we have purchases in November and December greater than the average purchases for any other two months of the year. During other two month periods, the purchases are less than the average for the year, and the days payable calculation may vary — for example, 36 days (two month purchases of 100), 48 days (two month purchases of 133), etc. Spreadsheet calculations may be misleading

As with the receivables calculation, the analyst should be careful because the calculation of the days payable figures by the spreadsheet software may be misleading. The analyst must understand this effect and interpret the numbers accordingly. In particular, the analyst should understand whether the last months’ purchase figures are average or out of the ordinary.

Interpreting the Number Recognize reasons behind the numbers

The higher the days payable, the better from a funds flow point of view. However, if the numbers for this ratio, adjusted for seasonality, are too high, this may indicate delayed payments to suppliers, possibly due to cash flow difficulties. This could indicate serious trouble in a very short period of time. A very low number should also be analyzed to determine why this usually cheaper source of funding is not being maximized. Are suppliers cutting back on credit? If so, what is the reason for this?

Shorthand funds flow analysis

The days payable number is often analyzed in tandem with days receivable and days inventory for a shorthand funds flow analysis. This very generalized analysis may be used to estimate the working capital requirements for a company. Remember, this is very generalized because, all of these funds flows may be measured against a different base (i.e. receivables vs. sales, inventory vs. cgs, payables vs. purchases) so that each of the “days” has a different value.

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+ Days receivable + Days inventory - Days payable = Operational working capital

Summary Payables turnover is the average number of payment periods in a year and should be measured against purchases. The calculation is: (Total Purchases / Trade Payables)

Days payable is the average payment period for a company and may be compared to credit terms to evaluate a company’s payment of receivables. The most common calculation is: (Trade Payables / Cost of Goods Sold) × 360

A more accurate calculation is: (Trade Payables / Total Purchases) × 360

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PROGRESS CHECK 6.3

Question 12: If an industrial firm's cost of goods sold is $9,600,000, raw materials constitute 75% of cost of goods sold, and payables equal $1,600,000, the more exact figure for payables turnover is _____ times and the corresponding days payable is _____.

Question 13: The formula for calculating days payable for one year figures with the most precision is: ____ a) (Trade Payables / Cost of Goods Sold) x 360. ____ b) (Trade Payables / Total Purchases) x 360. ____ c) (Cost of Goods Sold / Trade Payables) x 360. ____ d) (Total Purchases / Trade Payables) x 360.

Question 14: The formula for calculating days payable for one year figures used within the Citibank spread sheet is: ____ a) (Trade Payables / Cost of Goods Sold) x 360. ____ b) (Trade Payables / Total Purchases) x 360. ____ c) (Cost of Goods Sold / Trade Payables) x 360. ____ d) (Total Purchases / Trade Payables) x 360.

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ANSWER KEY

Question 12: If an industrial firm's cost of goods sold is $9,600,000, raw materials constitute 75% of cost of goods sold, and payables equal $1,600,000, the more exact figure for payables turnover is 4.5 times and the corresponding days payable is 80 .

Question 13: The formula for calculating days payable for one year figures with the most precision is: b) (Trade Payables / Total Purchases) x 360.

Question 14: The formula for calculating days payable for one year figures used within the Citibank spreadsheet is: a) (Trade Payables / Cost of Goods Sold) x 360.

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Question 15: Indicate whether the following statements are (T) true or (F) false. ____ a) Payables turnover indicates the number of times payables are rotated during the period. ____ b) Company M has payables turnover of 10 times and Company N has payables turnover of 6 times. Company M’s trade suppliers probably offer more generous credit terms. ____ c) Payables turnover of 12 times is the same as 24 days receivable. ____ d) The figure for days payable represents the average payment period for a company.

Question 16: Beta Company, an industrial firm, receives average credit terms of 60 days from its suppliers, but the year-end balance sheet indicates 108 days payable. What are possible explanations of this situation, in whole or in part? ____ a) The high value added content of Beta’s production results in an implicit error when calculating on a cgs basis. ____ b) Seasonal purchases at the end of the year distort the calculated ratio. ____ c) Beta Company has just increased its credit terms to buyers. ____ d) Beta Company pays late.

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ANSWER KEY

Question 15: Indicate whether the following statements are (T) true or (F) false. T

a) Payables turnover indicates the number of times payables are rotated during the period.

F

b) Company M has payables turnover of 10 times and Company N has payables turnover of 6 times. Company M’s trade suppliers probably offer more generous credit terms.

F

c) Payables turnover of 12 times is the same as 24 days receivable.

T

d) The figure for days payable represents the average payment period for a company.

Question 16: Beta Company, an industrial firm, receives average credit terms of 60 days from its suppliers, but the year-end balance sheet indicates 108 days payable. What are possible explanations of this situation, in whole or in part? a) The high value added content of Beta’s production results in an implicit error when calculating on a cgs basis. b) Seasonal purchases at the end of the year distort the calculated ratio. d) Beta Company pays late.

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SALES TO ASSETS TURNOVER RATIO Efficiency of asset utilization

The asset turnover ratio is a comparison of sales to total assets. This ratio is used less frequently in financial analysis than the other turnover ratios, but is nonetheless very useful. It provides a shorthand indicator of the efficiency with which assets are being utilized in the business. Calculation: Total Net Sales / Total Assets

Spreadsheet calculation

It is best calculated against average total assets but, here again, spreadsheets usually make a trade-off by calculating against endof-period total assets. If there has been considerable growth in assets during the year, or if the company’s business is very seasonal, resulting in major swings in asset totals during the year, then the analyst should obtain some additional numbers to enable calculating average figures.

Example

Let’s look at an example: Company J

Company K

400 320

600 720

1.25

0.83

Net sales Total assets Turnover (times)

Table 6.8: Use of assets to support sales

Company K sells more, but Company J is more efficient because it needs less asset resources per $1.00 of sales.

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Interpreting the Ratio The higher, the better

Generally, the higher the asset turnover the better — more sales are achieved with a given amount of asset resources. Where the turnover is higher, there is greater operational efficiency.

Compare with similar firms

Companies probably experience relatively little fluctuation in this ratio from year to year. It is often best to measure this ratio against similar firms in the market for a comparison of how efficient individual companies are in using available resources. The indicator may vary considerably from sector to sector, depending on certain factors such as whether the firm must offer credit, and how much. Perhaps the most significant factor is, as in the case with leverage, the incidence of fixed assets. Companies that need a great deal of fixed assets will have low ratios, and vice versa. Fixed assets will act as a drag on this ratio and, in many cases, the actual numbers for this ratio will be similar to the leverage figure. It should be noted that leased assets off the balance sheet will distort the asset turnover ratio by reporting a higher turnover than a “real” figure would indicate. Therefore, if significant amounts of such assets are used by the company, the analyst should adjust the balance sheet by including these assets and recalculating this ratio.

You have completed Unit Six: Financial Ratios — Turnover. Please answer the questions in Progress Check 6.4 to check your understanding of the material before proceeding to Unit Seven: Financial Ratios — Profitability.

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PROGRESS CHECK 6.4


Question 17: The sales / average total assets ratio measures the: ____ a) number of days of sales. ____ b) amount of assets sold. ____ c) relative efficiency with which assets are utilized in a business. ____ d) growth in sales from one period to another.

Question 18: Calculate the asset turnover ratio for Companies Q and R. Sales Total Assets

Company Q 800 600

Company R 1200 1500

a) The ratio for Company Q is ____. b) The ratio for Company R is ____. c) Which company is more efficient in usage of its assets?_____

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ANSWER KEY

Question 17: The sales / average total assets ratio measures the: c) relative efficiency with which assets are utilized in a business.

Question 18: Calculate the asset turnover ratio for Companies Q and R. Sales Total Assets

Company Q 800 600

Company R 1200 1500

a) The ratio for Company Q is 1.3 . b) The ratio for Company R is 0.8 . c) Which company is more efficient in usage of its assets?

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Question 19: Of the following types of companies, which would tend to have the highest (H) and the lowest (L) asset turnover? ____ Hotel ____ Medium industry ____ Trading company

Question 20: Which of the following would tend to increase the sales / total assets ratio? ____ a) Acquisition of new machinery ____ b) Price increase on products sold ____ c) Decrease in days inventory ____ d) Extend credit terms offered from 60 to 90 days

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ANSWER KEY

Question 19: Of the following types of companies, which would tend to have the highest (H) and the lowest (L) asset turnover? L

Hotel

H

Medium industry

Question 20: Which of the following would tend to increase the sales / total assets ratio? b) Price increase on products sold c) Decrease in days inventory

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Question 21: Use the following data to calculate the information requested for Company C and Company D. Company C

Company D

21,000 2,000 46,000 71,000

18,000 1,000 53,000 78,000

Current Assets

140,000

150,000

Total Assets

300,000

400,000

84,000 40,000

82,000 35,000

485,000 462,000

569,000 540,000


Current Liabilities Trade Payables Net Sales Cost of Goods Sold

Fill in the blanks based on the above information: Company C Current Ratio Acid Test Receivables Turnover (Times) Average Collection Times (Days) Inventory Turnover (Times) Average Inventory Turnover Period (Days) Payables Turnover (CGS Basis) Days Payable Sales to Assets Turnover

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ANSWER KEY Question 21: Use the following data to calculate the information requested for Company C and Company D. Company C

Company D

21,000 2,000 46,000 71,000

18,000 1,000 53,000 78,000

Current Assets

140,000

150,000

Total Assets

300,000

400,000

84,000 40,000

82,000 35,000

485,000 462,000

569,000 540,000


Current Liabilities Trade Payables Net Sales Cost of Goods Sold

Fill in the blanks based on the above information:

Current Ratio Acid Test Receivables Turnover (Times) Average Collection Times (Days) Inventory Turnover (Times) Average Inventory Turnover Period (Days) Payables Turnover (CGS Basis) Days Payable Sales to Assets Turnover

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Company D

1.67

1.83

.82

.88

10.5

10.7

34

34

6.5

6.9

55

52

11.6

15.4

31

23

1.6

1.4

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Question 22: Indicate whether the following statements are (T) true or (F) false. ____ a) Company C probably has a stronger liquidity position than Company D. ____ b) The difference between the frequency with which inventory is converted into cash, shown by Company C and Company D, is not very large. ____ c) On the average, Companies C and D collect their receivables within 34 days. Consequently, their billing terms must be 34 days. ____ d) Company C makes better use of its assets.

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ANSWER KEY

Question 22: Indicate whether the following statements are (T) true or (F) false. F

a) Company C probably has a stronger liquidity position than Company D.

T

b) The difference between the frequency with which inventory is converted into cash, shown by Company C and Company D, is not very large.

F

c) On the average, Companies C and D collect their receivables within 34 days. Consequently, their billing terms must be 34 days.

T

d) Company C makes better use of its assets.

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Unit 7

UNIT 7: FINANCIAL RATIOS — PROFITABILITY

INTRODUCTION

Companies are in business for one purpose — to make profits. If a company accumulates considerable losses year after year, it will not stay in business for long. Profits are the driving force of growth and are the main source for repaying loans, making new investments, and providing an adequate return to owners so they retain their interest and financial backing. Profits are important for another reason — they measure the relative success of a company and can readily be compared to other companies and to the capital market. Therefore, profits reflect (and profit ratios measure) the effectiveness and efficiency of management. The common profitability ratios are: n

Return on Sales

n

Return on Assets

n

Return on Equity

UNIT OBJECTIVES


Calculate the three profitability ratios: return on sales, return on assets, and return on equity

n

Recognize the DuPont formula for calculating ROE

n

Calculate ROE using the DuPont formula

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FINANCIAL RATIOS — PROFITABILITY

PROFITABILITY RATIOS

Return on Sales Dollar profit per $100 in sales

The return on sales ratio (profit on sales) measures how many dollars of profit are made for every $100 in net sales. The figure is a percentage and is calculated as: Net Income Return on Sales =

x 100 Net Sales

Let's compare the profits for Company A and Company B. Company A

Company B

$ 20 $200 10.0%

$ 100 $4,000 2.5%

Net income Net sales Ratio Table 7.1: Profit comparison

We can see that Company A earned $20 for every $200 in sales, a profit of 10%. Profits earned by Company B were higher in monetary terms; but at 2.5% of net sales, they were proportionally lower than those earned by Company A. Therefore, Company A generates more income on each $1.00 in sales than Company B. This is an indication that Company A generates profits more efficiently. More conservative calculation

A conservative way to evaluate sales profit is to exclude extraordinary items from net income. For example, if Company A had extraordinary income of $5 and we subtracted this amount from net income, the profit on sales would decrease to 7.5%.

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Return on Assets Relationship between profits and resources invested

Return on assets is a good indicator of the productivity of the firm and of management's abilities and efficiency. The index measures the relationship between profits and total resources invested. It is a percentage and is computed as: Net Income Return on Assets =

x 100 Average Assets

Since asset values vary during the year, the best measure is based on an average of beginning-of-year assets and end-of-year assets. Let's look at an example and compare the ratios calculated two ways. End-of-year assets

First, we calculate the return on assets based on end-of-year assets only. For 19X1, $ 150 / $ 6,000 = 2.5%

Average of beginning and ending assets

The more accurate method is to calculate return on assets based on the average of beginning-of-year and end-of-year figures. For 19X1, $ 150 / [($ 4,000 + $ 6,000) / 2] = 3.0%

However, as a practical matter, this ratio often is calculated based on year-end figures only. This avoids calculating year one on a year-end basis and subsequent years on an average basis, since averages cannot be computed for year one. The Citibank spreadsheet calculates against beginning totals. For calculations utilizing interim figures, net income should be annualized. In seasonal situations, this factor should be considered in the annualization to avoid distortions in the full year net income figure.

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The higher, the better


Return on assets is best measured against prior period results from the same firm or against similar enterprises. The higher the result, the better, since a good return on assets indicates efficient use of the firm's resources.

Return on Equity (Return on Capital) Profits generated by each $1 invested

Return on equity ( ROE) measures the profits generated by each dollar accumulated in the business by stockholders. The figure is a percentage and is computed as: Net Income Return on Equity =

x 100 Average Net Worth

Return to stockholders

Determining return on equity is important for measuring the degree to which the profits of the firm provide a return to the shareholders. The figure can be compared to a marginal investment rate in the community, such as a time deposit rate in a local bank. ROE measures whether the enterprise can produce an amount sufficient to cross this hurdle rate and provide an incentive to take on additional risks of equity investment. If the ROE figure is very low in comparison to time deposit rates, the owner is further ahead to liquidate the company's assets and deposit the money in a bank. In these situations, the creditor should question the owner's commitment to the firm, especially if the financial situation deteriorates further.

Understand the client’s situation

In order to avoid some distortion in interpreting the figure, the practical situation of the client should be understood. For example, in a family enterprise, the analyst should consider (depending on the market) that profits may be underestimated for tax purposes. In these situations, the ROE figure is negatively impacted, and comparison to other potential investments will be less valid.

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7-5

On the other hand, in situations where farms or valuable properties have been held for many years and are undervalued on a balance sheet, the net worth figure may be understated with reference to present land values. In these situations, an adjusted return on equity figure may be worse than what has been computed and what other market alternatives provide. Since the income was generated during the whole period, and not just at the end, the average net worth should be used when computing the figure. However, if prior period figures are not available, ending period figures may be applied instead. For interim figures, net income should be annualized. In seasonal situations, this factor should be considered within the annualization to avoid distortions in the net income figure. Example

Let's look at the difference between using only the ending balance and an average of the beginning and ending balance.

Net income Stockholders’ equity

19X0 $ 20 $2,000

19X1 $ 60 $2,400

First method (using ending balance only): For 19X1, $60 / $2,400 = 2.5%

Second method (using averages): For 19X1, $60 / [($2,000* + $2,400*) / 2] = 2.73% * Since the beginning value is $ 2,000 and the ending value $ 2,400, we may presume that the owners' investment for the year averaged $ 2,200.

The Citibank spreadsheet calculates this ratio against beginning equity. Assuming profitable operations, this results in a higher figure than calculating an average equity.

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The appropriate level for return on capital is determined by relative factors such as economic benchmarks, inflation, and local bank deposit rates. Normally, the higher the ratio, the better the return on capital. However, an abnormally high return-on-equity figure might simply indicate deficiencies in the amount of capital within the firm. Before proceeding to the final section of this unit, “Integrated Analysis,” please check your understanding by completing Progress Check 7.1.

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7-7

PROGRESS CHECK 7.1


Question 1: “Return on sales” measures: ____ a) the percentage of items returned to the seller because of defects. ____ b) net sales divided by net income. ____ c) how many dollars of profit are made for every $100 of sales. ____ d) the effective use of invested resources. Question 2: Please indicate whether each item is (T) true or (F) false. Return on assets is: ____ a) calculated as Net Sales / Fixed Assets. ____ b) best calculated against asset averages. ____ c) good indicator of productivity of the firm. ____ d) not affected by seasonality. Question 3: Select all that apply. A high return on equity for a firm may indicate: ____ a) undercapitalization of the firm. ____ b) that shareholders have made a good investment in the firm. ____ c) a need for liquidating the company. ____ d) that profits may be understated for tax purposes.

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ANSWER KEY

Question 1: “Return on sales” measures: c) how many dollars of profit are made for every $100 of sales.

Question 2: Please indicate whether each item is (T) true or (F) false. Return on assets is: F

a) calculated as Net Sales / Fixed Assets.

T

b) best calculated against asset averages.

T

c) a good indicator of productivi ty of the firm.

F

d) not affected by seasonality.

Question 3: Select all that apply. A high return on equity for a firm may indicate: a) undercapitalization of the firm. b) that shareholders have made a good investment in the firm.

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Question 4: Let’s look at selected numbers from the financial statements of Companies S, T, and U. Net Sales Average Assets Average Net Worth Net Income

Company S 1,000 1,500 900

Company T 1,000 800 400

200

120

Company U 1,000 400 100 40

Calculate the following ratios for each company: Return on Sales

_____

_____

_____

Return on Asset

_____

_____

_____

Return on Equity

_____

_____

_____

Question 5: From the numbers in the previous question, answer each question by entering the correct company. ____ a) Which company has the best investment return? ____ b) Which company makes the best use of its assets? ____ c) Which company has the best cost efficiency? ____ d) Which company has the overall best earnings?

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ANSWER KEY

Question 4: Let’s look at selected numbers from the financial statements of Companies S, T, and U. Net Sales Average Assets Average Net Worth Net Income

Company S 1,000 1,500 900

Company T 1,000 800 400

200

120

Company U 1,000 400 100 40

Calculate the following ratios for each company: Return on Sales 4.0%

20.0%

12.0%

Return on Asset 10.0%

13.3%

15.0%

Return on Equity 40.0%

22.2%

30.0%

Question 5: From the numbers in the previous question, answer each question by entering the correct company. U

a) Which company has the best investment return?

T

b) Which company makes the best use of its assets?

S

c) Which company has the best cost efficiency?

U

d) Which company has the overall best earnings?

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7-11

INTEGRATED ANALYSIS Integrate financial ratio concepts

Let’s consider some theories used to integrate several of the main concepts encountered in the units covering financial ratios. These ideas also will tie together the profitability ratios we have just considered. They are taken from financial relationships known as a DuPont Analysis.

Return on Assets We have seen that return on sales informs us of the profitability of a company’s operations — how much it makes on every $1.00 of sales. Let’s take this a step further and consider this along with sales / assets turnover. As formulas, we put the two together and see that by multiplying, we obtain return on assets. Asset ROS Net Income Net Sales

Operational leverage

Turnover X

Net Sales Total Assets

=

ROA Net Income i Total Assets

ROS can be considered cost efficiency, while asset turnover can be considered a multiplier to achieve asset efficiency (which is ROA). So, the higher the asset turnover, the greater the ROA. This is the

concept of operational leverage. Note that asset turnover is increased either by increasing sales relative to assets, or reducing assets relative to sales, or both. This is one reason why it is better to operate with less assets — less cash, less receivables, less inventory, etc. This is also why it is so harmful to have past due receivables, excessive levels of inventory, or nonproductive assets on the balance sheet. These act as a brake on asset turnover and, hence, as a brake on ROA.

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Return on Equity Let’s take this another step. If we multiply return on assets by asset leverage, we obtain return on equity. Asset Leverage

ROA Net Income Total Assets

Financial leverage

X

Total Assets Net Worth

ROE

=

Net Income Net Worth

Here, again, we see that the beginning figure is multiplied by the next column (in this case leverage) to obtain the final column, in this case ROE. By multiplying ROA to obtain a figure for ROE, we can clearly see how greater debt levels actually “leverage” earnings. This is the concept of financial leverage. From this formula, we can appreciate that greater leverage will achieve greater earnings. This is correct as long as ROS is not adversely affected by greater interest expense. Remember your vantage point. The borrower uses this as an excuse to operate with greater debt levels. The lender is more interested in reducing risk. If the investor leverages up by taking on greater debt to finance capital expansion, this may yield greater financial returns, but leave the firm vulnerable to an economic downturn and/or higher interest rates. The credit risk increases.

Application of DuPont Formulas In total, the DuPont formulas can be summarized as follows:

ROS Net Income X Net Sales

Asset Turnover

ROA

Net Sales = Net Income ; Total Assets Total Assets

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ROE

X Total Assets = Net Worth


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7-13

Let’s apply these concepts to some numbers to see if we can obtain an idea of what is appropriate in terms of ROS, ROA, and ROE for different companies through the DuPont insights. Consider the following numbers for Companies X, Y, and Z.

Example

Company X Company Y Company Z 1000 1000 1000 1500 800 400 900 400 100

Net Sales Average Assets Average Net Worth Net Income

180

Return on Sales Return on Assets Return on Equity

18.0% 12.0% 20.0%

80 8.0% 10.0% 20.0%

20 2.0% 5.0% 20.0%

Table 7.2: Profitability ratios for three companies

What insights can we get from these numbers using the DuPont format? We have included the same numbers below. Remember, the figure for asset leverage is 1.0 more than the standard debt / equity leverage figure. Net Income Net Sales

X

Net Sales Total Assets

Company X

18.0%

X

0.67

=

Company Y

8.0%

X

1.25

Company Z

2.0%

X

2.50

Net Income Total Assets

X Total Assets Net Worth


12.0%;

X

1.67

=

20.0%

=

10.0%;

X

2.00

=

20.0%

=

5.0%;

X

4.00

=

20.0%

;

Company X

Why does Company X have the same ROE as Y and Z despite having the highest ROS by a wide margin? Because it has low multipliers — asset turnover is low. Why is it low? The reason is probably due to the nature of the company. It may be a heavy industry with heavy fixed asset needs that operate as a brake on the ROE ratio. Leverage is also low (debt / equity is 0.67), probably for the same reason.

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Lesson: We can see that heavy industries, or other companies with an intensive use of fixed assets, need high margins to compensate for poor multipliers. Company Y

Company Y’s multipliers are higher than X’s, but lower than Z’s. Why? It is probably a different type of company. With these numbers, it looks like a medium industry, with asset turnover just greater than 1.0 and leverage about the same (note: debt / equity = 1.00). Lesson: The multipliers are better, so margins can be lower than heavy industries to achieve the same ROE. Company Z

Company Z’s multipliers are very high, enabling an equal ROE despite a very low margin. Why? It is probably a company with low fixed asset needs and high liquidity of assets, permitting higher leverage (equivalent debt / equity = 3.00). As such, there are probably low barriers to entry in the business, which means it is probably a highly competitive sector with low margins. It probably is a wholesaler or trading company. Lesson: Low margins can mean good profits overall if the asset and leverage multipliers can be managed properly.

Conclusions What is an appropriate ROS?

We have been able to draw some conclusions from this analysis in terms of what is appropriate for ROS. If a company, by nature, has low multipliers, ROS must be high to achieve an acceptable ROE. As multipliers increase, ROS may be reduced, as well, and still achieve an acceptable ROE. Answer: The appropriate ROS depends on the multipliers. Changed 07/02/96

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It should be obvious that companies do not willingly reduce their ROS; this occurs as a result of competition. If Company Z can achieve a ROS of 10% and maintain the same multipliers, its owners will be very happy with its resulting ROE of 100%. This undoubtedly will attract the attention of potential competitors, and eventually drive down the ROS figure. Appropriate ROE determined by capital markets

From this viewpoint we also can appreciate that ROE sets the tone for the other ratios. The appropriate figure for ROS depends on the multipliers. The appropriate figure for ROA depends on the leverage multiplier. What is appropriate for ROE? Capital markets determine this, not multipliers. An acceptable ROE will be similar for all companies in the market (higher for riskier sectors), regardless of the multipliers. In the final analysis, the ROE figure will determine which company has the best earnings.

Summary In summary, integrated analysis helps us understand not only the relationships between earnings ratios and operational and financial leverage, but also provides insights into what is appropriate for return on sales for different types of companies. This knowledge then permits the analyst to obtain a deeper interpretation of the numbers, and a better appreciation of what is appropriate, so that he/she may judge the sufficiency of the numbers.

You have completed Unit Seven: Financial Ratios — Profitability. Please answer the questions in Progress Check 7.2 to check your understanding of these concepts. Following the Progress Check is a summary chart of the financial ratios we have presented in this workbook. Use it as a review for the final unit, Applied Financial Analysis – Case Studies, and also as a handy reference in the future.

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PROGRESS CHECK 7.2


Question 6: Which of the following is the DuPont formula? ____ a) ROE

X

Leverage = ROS;

X Asset Turnover

____ b) ROA

X

Asset Turnover = ROS;

____ c) ROS

X

Leverage = ROA;

____ d) ROS

X

Asset Turnover = ROA;

= ROA

X Leverage

= ROE

X Asset Turnover

= ROE

X Leverage

= ROE

Question 7: Please indicate whether each item is (T) true or (F) false. ____ a) In the DuPont formula, asset turnover demonstrates the concept of financial leverage. ____ b) In the DuPont formula, assets / net worth demonstrate the concept of operational leverage. ____ c) ROS X Asset Turnover = ROA ____ d) High ROS is more important than high ROE.

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ANSWER KEY

Question 6: Which of the following is the DuPont formula? d) ROS

X

Asset Turnover = ROA; X Leverage = ROE

Question 7: Please indicate whether each item is (T) true or (F) false. F

a) In the DuPont formula, asset turnover demonstrates the concept of financial leverage.

F

b) In the DuPont formula, assets / net worth demonstrate the concept of operational leverage.

T

c) ROS X Asset Turnover = ROA

F

d) High ROS is more important than high ROE.

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Question 8: Which type of company, by nature, should have the highest normal figure for ROS? ____ a) Heavy industry ____ b) Retailer ____ c) Medium industry ____ d) Trading company

Question 9: Which of the following companies, by nature, should have the lowest normal figure for ROS? ____ a) Heavy industry ____ b) Retailer ____ c) Medium industry ____ d) Trading company

Question 10: Company R has the following ratios. What is its ROE? Return on Sales:

10%

Total Asset Turnover:

1.5

Debt / Equity:

1.5

Return on Equity:

______

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ANSWER KEY

Question 8: Which type of company, by nature, should have the highest normal figure for ROS? a) Heavy industry

Question 9: Which of the following companies, by nature, should have the lowest normal figure for ROS? d) Trading company

Question 10: Company R has the following ratios. What is its ROE? Return on Sales:

10%

Total Asset Turnover:

1.5

Debt / Equity:

1.5

Return on Equity:

37.5%

SOLUTION: ROS 10%

×

Asset Turnover 1.5

=

ROA; 15%

v-2.0

×

Asset Leverage 2.5

=

ROE 37.5%

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7-21

The following chart is a summary of the financial ratios covered in the Financial Statement Analysis Workbook. Please review the chart before continuing to Unit Eight: Applied Financial Analysis — Case Studies. Also, use it as a convenient reference in the future.

SUMMARY OF FINANCIAL RATIOS RATIO LIQUIDITY Current Acid Test OPERATING Days Receivables

FORMULA

EVALUATION



Cash + Near Cash Assets + Trade Receivables Current Liabilities


Average Trade Receivables x 360 Net Credit Sales

Days Inventory

Average Inventories Cost of Goods Sold

x

Days Payables

Average Trade Payables Total Purchases

Assets Turnover

Net Sales I Average Total Assets

The lower, the better, generally

360

The lower, the better, generally

x 360

The higher, the better, generally The higher, the better, generally

LEVERAGE Total Indebtedness

Total Liabilities I Tangible Net Worth

The lower, the better

COVERAGE Interest Coverage

GOCF I Gross Interest Expense


Debt Service Ratio

GOCF I Gross Int Exp + Current Portion LTD


PROFITABILITY Return on Sales

Net Income Net Sales

I

x 100


Return on Assets

Net Income I Average Total Assets

x 100


Return on Equity

Net Income I Average Net Worth

x 100


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Unit 8

UNIT 8: APPLIED FINANCIAL ANALYSIS — CASE STUDIES

INTRODUCTION

In earlier units, we looked at accounting issues, basic analysis concepts, and financial statement analysis. In this unit, we will review this material and apply the analysis to case studies, using a bank spreadsheet financial analysis model.

UNIT OBJECTIVES

When you complete this unit, you will: n

Become familiar with a bank spreadsheet financial analysis model

n

Adapt client financial statements to the spreadsheet model

n

Discriminate the client numbers by making any adjustments necessary for the financial analysis

n

Compute the ratios in the bank spreadsheet model

n

Compute key reconciliations for fixed assets and net worth

n

Interpret the results of the financial analysis

n

Project some key numbers to measure funds flows and needs

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APPLIED FINANCIAL ANALYSIS — CASE STUDIES

THE BANK SPREADSHEET FINANCIAL ANALYSIS MODEL

Almost all banks utilize a standard form spreadsheet model for financial analysis. The purpose is both to standardize and to simplify financial analysis. Different banks use different formats, although most of them are similar in many ways. For conventional financial analysis of most types of companies, Citibank utilizes a form (or variation of the form) known internally as the OD-104. This form has been updated for LAGF use, incorporating some new features such as monetary correction, business risk assessment, and financial risk rating. For financial analysis purposes, the OD-104 includes separate pages for: n

Balance sheet

n

Income statement

n

Ratios

n

Certain account reconciliations

n

Funds flow analysis

n

Supplementary page, if needed, for more detailed breakdowns of certain accounts

Aside from the OD-104, there are other formats for specialized or non-conventional analysis. For example, analysis of banks and other financial institutions is done on a spreadsheet that is appropriate for bank financial statements. Beginning with Unit Four of this course, we introduced many financial ratios. The spreadsheet uses the most important of those ratios. In certain cases, more detailed account information may be advisable (for example, a breakdown of inventory or net fixed assets). The supplementary data section allows the analyst to include this or other appropriate information.

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The spreadsheet concept is applicable to both historical and projected figures. Spreading of historical (actual) figures is crucial to financial analysis, while projecting financial statements permits the analyst to anticipate future funds needs and to measure the anticipated future potential for cash generation. Traditionally, bank spreadsheets have been a pencil, paper, and calculator exercise. This can be tedious when spreading several years of figures or putting together projections. Some banks still operate this way but, with the recent advancements in microcomputers and commercial spreadsheet programs, the exercise can be greatly simplified. Use of these electronic microcomputer programs for spreading and financial analysis also permits greater customization and detail. The sample spreadsheet which follows is the new OD-104 Citibank format. You will see the balance sheet, income statement, reconciliation for net worth and fixed assets, other reconciliations, the funds flow statement, and a ratio section. The remainder of this unit includes two case studies. By reading them, and working through the practice exercises which follow, you will be able to employ the concepts you learned in Units One through Seven. The first case study in this unit — Mindy Garment Factory — focuses on analysis of the balance sheet, income statement, and financial ratios. The second case — Tower Stores — focuses on reconciliations and the op / non-op statement.

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APPLIED FINANCIAL ANALYSIS — CASE STUDIES Company Name: Country: Amounts in 1= mill, 2 = thous, 3 = actuals: Currency: Local Curr enter 0, US$ enter 1: Financials: Audited / Direct: Qualified / Unqualified:

(Insert spreadsheet -- Balance Sheet)

Statements Purchasing Power Date: Statement Date: No. of Months in Period:

Audited Unqualified Annual Data 1/0/00 1/0/00 0

Audited Unqualified

Audited Unqualified

INTERIMS 0 Quarterly 1/0/00 1/0/00 0

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

1/0/00 1/0/00 0

BALANCE SHEET Line # 1 2 3 4 5 6 7 8 9 10 11 12 13 14

15 16 17 18 19 20 21 22 23 24 25 26 27

ASSETS Cash Marketable Secs Acct Receivables Inventory Other Receivables - non-operating Other Current Assets - (operating) Other Current Assets - (non-operating) Total Current Assets Net Fixed Assets Investments in Subs & Affiliates Other LT assets Intangibles (inc. Goodwill) Deferred Assets Total Assets LIABILITIES Short-Term Debt Current maturities of LT debt Accts Payables - suppliers Interest Bearing Payables Income Taxes Payables Other current liabilities - (operating) Other current liabilities - (non-operating) Total Current Liabilities Long Term Senior Debt Long Term Subordinated Debt Capital Lease Obligations LT Deferred Taxes / Reserves Other LT Liabilities

28

Total Liabilities

-

-

-

-

29

Minority Interest

-

-

-

-

-

-

-

-

30 31 32 33 34 35 36

Preferred Stock Common Stock Capital Surplus Reserves Retained Earnings Capital Revaluation Other Capital Account

37

Total Net Worth

-

-

-

-

38

Total Liabilities + Min. Int. + N. Worth

-

-

-

-

39

***Balance Check Line

-

-

-

-

40 41

Contingent Liabilities Pledged Assets

-

-

-

-

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8-5

INCOME STATEMENT

Pesos Thousands Insert spreadsheet -- Income Statement Annual Data

Quarterly

Statement Date: No. of Months in Period:

42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

Pesos Thousands Net Sales Cost of Goods Sold (exclude Depreciation) Selling & Admin Expenses (exclude Depreciation) Operating Profit Bef Non-Cash Charges Depreciation & Amortization Operating Profit Interest Income Gross Interest Expense Inflation income / (loss) FX income / (loss) Integral financing income / (loss) Investment & Related Co income Other non-oper non-cash income (Expense) Other income / (Expenses) Net Income bef Extraordinary Items Extraordinary income (Loss) Employee Profit Sharing Minority interest

12

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

61

Income Tax

-

-

-

-

62 63

Net Income (Loss) Dividends (input negative)

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

64

65 66 67 68 69 70 71 72

73 74 75 76 77 78 79 80 81 82 83

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Net Income bef income taxes

12

Change to Retained Earnings

NET WORTH RECONCILIATION Opening Net Worth Net Income Dividends Net Sale of Equity (inc. tr. stock) Inflation adjustment B/S adjustments against N. Worth Other additions (checking account ) Ending Net Worth

FIXED ASSETS RECONCILIATION Opening Net Fixed Assets Depreciation Inflation adjustment Net Revaluation against Net Worth Net Revaluation / (w.o.) against I. Statement Net Capital Expenditure (checking account ) - Maintenance Capital Expenditures - Expansionary Capital Expenditures - Gross Capital Expenditures - Sale of assets (input negative) Ending Net Fixed Assets

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RECONCILIATION STATEMENTS

Pesos Thousands Statement Date:

Insert spreadsheet --Reconciliation Statements No. of Months in Period:

128 129 130 131 132 133 134 135

136 137 138 139 140 141 142 143 144 145

145 146 147 148 149

LT Debt Reconciliation (Senior + Subord. + cap. leas.) Opening Long Term Debt (inc. curr.) Inflation adjustment Foreign currency adjustment Gain in debt repurchase (input negative) Net change in debt (checking account ) - Gross new debt issued / contracted - Repayments / Amortization (at book value) Ending Long Term Debt Inv. in Subs. & Aff. Reconciliation Opening investments in Subs. & Aff. Accrued Profits Dividends received (input negative) Inflation adjustment Extraordinary revaluation (against net worth) Net Equity Contributions Net purchase of new investments - Gross purchases - Sale of investments Ending Investments in Subs. & Aff. Inflation Adjustment / Monetary Correction Breakdown Opening intangibles Amortization (I/S line 28) Inflation adjustment Net increase (additional payment for inv.) Ending Intangibles

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170

Intangibles Reconciliation (inc. Goodwill) Marketable Secs Acct Receivables Inventory Other Receivables - non-operating Other Current Assets - (operating) Other Curr Assets - (non-operating) Net Fixed Assets Investments in Subs & Affiliates Other LT assets Intangibles Deferred Assets Short-Term Debt Accts Payables - suppliers Interest Bearing Payables Income Taxes Payables Other current liabilities - (operating) Other current liabilities - (non-operating) Long Term Debt LT Deferred Taxes / Reserves Other LT Liabilities Net Worth Income Statement

-

-

-

171 172

Net Monetary Gain / (loss) FX GAIN (LOSS)

-

-

-

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8-7

Insert spreadsheet -- Cash Flow

CASH FLOW

Pesos Thousands


84 85 86 87 88 89 90

Pesos Thousands Operating Profit Depreciation & Amortization Other non-cash charges (Enter in section below) Gross Operating Cash Flow (GOCF or FFO) Changes in receivables Change in inventories Change in other current op.assets

-

-

-

90 91

Change in acc. & taxes payables Change in other current op. liabilities

-

-

-

92

Net Operating Cash Flow (NOCF)

-

-

-

93 94

Maintenance Capital Expenditures Free Operating Cash Flow (FOCF)

95 96 97 98 99 100 101 102 103 104 105

Net non-operating net income (net of non-cash) Increase (Decrease) in Capital Dividends from Subsidiaries & Affiliates Sale of investments in Subs. & Affil. Sale of fixed assets Increase in S.T. Bk. & Financ. Debt Increase in LT Bk. & Financ. Debt Change in non-oper-non-fin curr Liabs. Change in other LT liabilities Change in Minority Interest

105 106 107 108 109 110 111 112

Growth of inv. in Subs., Aff. & Intangibles Dividends Paid Expansionary Capital Expenditures Change in non-oper-non-fin curr assets Change in other LT assets Reduction in S.T. Bk. & Financ. Debt Reduction in LT Bk. & Financ. Debt Total Non-Operating Needs

112

Total Non-Operating Sources

Net Increase (Decrease) in Cash and Equivalents

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

112

CASH & EQUIV AT BEGINNING OF PERIOD

113

CASH & EQUIV END OF PERIOD

-

-

-

114

CASH & EQUIV AT END B/S

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

115 116 117

Unexplained Difference (CHECK) Non-Cash Charges Breakdown Total Other non-cash charges & B/S

118 119 120

Operational

121 122 123 124 125 126 127

Non Operational FX loss / (gain) Plus: Inf. Adjust. LT liabs. & N. worth Less: Accrued profit related companies Less: Other non-cash non-op income Plus: Net change def. reserves Less: Inf. Adjust. LT assets

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Allowance for Bad Debts Inventory Write-off

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RATIO ANALYSIS

Annual Data

Quarter

Statement Date:

Insert spreadsheet Ratio Analysis No. of Months in -Period: 191 192 193 194

FINANCIAL HIGHLIGHTS (In US$ millions) Total Assets Net Worth Tangible Net Worth Working Capital

195 196 197 198 199 200

Net Sales Operating Profit Net Income GOCF NOCF FOCF

201 202 203 204

OPERATING Net Sales Growth (%) Real Net Sales Growth (%) COGS / Net Sales (%) S.G. & Adm. Exp / Net Sales (%)

205 206 207 208 209 210 211 212

Op. Profit / Net Sales (%) Net Income / Net Sales (%) GOCF / Net Sales (%) ROE - Net Income / opening Net Worth (%) ROA - Net income / opening Total Assets (%) Net Sales / Total Assets (%) Dividend payout ratio FOCF / Expansionary Capex + Dividends LIQUIDITY

213 214 215 216 217 218 219

Current ratio Quick assets ratio (1 + dec.) Days receivables Days inventory Days payables Cash & Secs (% of Total Assets) Cash & Secs (Days Sales) LEVERAGE

220 221 222 223 224 225 226 227 228 229 230 231

Total Liab / N. Worth + Min. Int. (Leverage) Short Term Debt Concentration (max. 100%) Funds from Operations Interest Coverage Funds from Operations / Long Debt Debt Serv. Ratio (FFO / Int. exp. + l.t. debt curr p.) Tot. Gross debt (bk + oth Int. bearing) - Pesos thousands - Short Term Debt - Pesos thousands - Long Term Debt - Pesos thousands Total Net Worth - Pesos thousands Tangible Net Worth - Pesos thousands Total Capitalization - Pesos thousands Total Gross Debt to Capitalization

232 233

STOCK MARKET INDICATORS Common shares (numbers in thousands) Market Value - Pesos

234 235

P/E Ratio Market / Book value

236 237

MACROECONOMIC INDICATORS US$ value in Local Currency Avg. US$ value

238

Inflation rate - for B.S. adj. - (%)

1.00

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1.00

0.00

0.00

1.00

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8-9

CASE STUDY: MINDY GARMENT FACTORY

Introduction The Mindy Garment Factory case involves an industrial company that requests a short-term loan from a commercial bank to cover short-term operating needs. It is a new loan request that must be analyzed by the bank's credit staff. After reading the case study, you will be asked to perform a financial analysis of the company as a practice exercise. The first step in the exercise is to examine the financial statements submitted by the client, taking into consideration any additional verbal information. Then, make any necessary adjustments to the client's numbers before including them within the spreadsheet model. These adjustments, if any, pertain to the proper presentation of the financial statements and those adjustments that are necessary for calculating ratios. To do this, you must draw on basic accounting definitions and concepts covered in Units One through Seven. Once the adjustments have been made, you should compute the vertical analysis and financial ratios included in the spreadsheet. To do this, you will draw on knowledge of ratios and inter-account relationships covered in Units Four through Seven. When the numbers have been laid out and the ratios computed, you will interpret the figures to formulate financial conclusions and answer certain questions. Keep these steps in mind as you read the case study.

Background Yesterday, January 20, 19X4, the financial analyst of the Friendly Bank received the financial statements of the Mindy Garment Factory for the fiscal years ending September 30, 19X1, 19X2, and 19X3. The numbers submitted by the client are attached. The manager of the bank has asked his trusted analyst to immediately perform the financial analysis, since the credit request is to be considered in today's afternoon session of the credit committee.

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The company, which is not yet a client of the bank, requested a loan for Pesos 300,000 (exchange rate = Pesos 2/US$) for 180 days. The analyst has heard of the company, but has never been directly involved with them in business transactions. The reason for the expedited treatment of this credit is that the factory's owners are friendly with one of the bank's directors. The company has been established in the market for many years. It manufactures general clothing (men's, women's, and children's) for the domestic market (growth rate of about 5% annually), aimed at the middle and upper middle classes. The Mindy Garment Factory principally has dealt with the Uptown Bank and with a specialized public sector bank for long-term financing. It is owned by a respected and socially prominent local family that has a reputation for being very conservative and traditional in its business dealings.

Conversation with the General Manager Upon examining the financial statements, the analyst noted that the external auditor, the firm of Siego, Zordo, & Mutho, was unfamiliar to him. The analyst had questions about some of the numbers and called the general manager of Mindy for some clarifications. The general manager has been with the company for fourteen years and was promoted to his present position three years ago. Concerning the purpose of the loan, he said it was "for working capital purposes." With respect to sales, he indicated that “Sales are growing — following the same trends as last year” and that “Our policy is to raise prices along with inflation,” now estimated at 15% per year by the analyst. “We've never had problems with raising our prices due to the high quality of our brand names and our entrenched market position,” said the manager. “We sell 85% of our production at 90 day terms to strong distributors. The other 15% is sold on a cash basis through our own store, which is well located in the downtown shopping district. The July - August - September quarter constitutes about 25% of annual sales and production.” The analyst also asked why inventories were higher and payables lower in the past year. The general manager said that, in the case of inventories, “We wish to increase our stocks as a hedge on inflation.” Regarding payables, he said that “Our policy is to buy some raw materials on a cash basis to take advantage of discounts offered by some suppliers.”

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8-11

Credit References Before writing up his analysis, the analyst called an acquaintance at the Uptown Bank— a friend since university years. The Uptown banker indicated that the Mindy Factory had been a client of Uptown for eight years. The present owners were the second generation of the family to direct the company; they took over three years ago and installed the present general manager. The banker mentioned that, when the company was taken over with long-term notes by the present generation of owners, a certain amount of goodwill was put on the company's books. Also, about six months ago, the Mindy Factory sold an old warehouse for Pesos 210,000. Terms of the sale were three years, including 18 months grace. The Uptown Bank, because of traditional relationships, mainly dealt with the owners rather than the management; obligations were paid in a satisfactory manner, although rollovers (renewals) were frequent on the short-term loan. Six months ago, Uptown Bank approved a new credit facility, with full recourse to Mindy, of Pesos 400,000 for the discount of receivables. (A “discount facility” is one where the bank "buys" certain of the customer's trade receivables at a specified price, for example, at a 10% discount. This means that the customer receives $90 for every $100 of receivables. The bank collects the receivables when they are due for payment of the amount advanced to the customer, plus interest. Structuring with “full recourse” to Mindy means that Mindy guarantees payment of the transaction in case the trade receivables are not paid when they are due.) The credit facility was fully taken down almost immediately, and outstandings have not changed since then. The Uptown Bank also has financed equipment purchases for Mindy over the years, generally with good results. Uptown is now near its legal lending limit with Mindy.

Financial Statements The financial statements presented by the general manager of the Mindy Company follow.

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MINDY GARMENT FACTORY Financial Statements for Years Ending 9/30/X1, 9/30/X2, 9/30/X3 (Figures in Thousands of Pesos) 9/30/X1

9/30/X2

9/30/X3

BALANCE SHEET Cash & Banks Accounts Receivable Inventory Finished Goods Work in Process Raw Materials

85.7 1,012.2

102.7 1,267.6

121.6 993.7

369.4 34.0 648.2 1,051.6

623.2 44.6 658.2 1,326.0

1,056.2 49.0 702.4 1,807.6

Prepaid Expenses Other Current Assets Current Assets

42.5 33.8 2,225.8

46.0 28.4 2,770.7

52.4 245.6 3,220.9

Fixed Assets Land Buildings Machinery & Equipment Subtotal Less: Accum. Depreciation

176.4 442.0 800.6 1,419.0 862.0

176.4 442.0 832.6 1,451.0 937.7

168.0 316.4 955.1 1,439.5 1,028.5

557.0 148.8 705.8

513.3 148.8 662.1

411.0 148.8 559.8

TOTAL ASSETS

2,931.6

3,432.8

3,780.7

Bank Debt, Short-term Accounts Payable Accruals Other Current Liabilities Current Liabilities

625.2 548.6 40.2 36.4 1,250.4

928.8 689.1 46.2 42.0 1,706.1

1,417.0 461.5 54.7 30.3 1,963.5

260.0

220.0

280.0

TOTAL LIABILITIES

1,510.4

1,926.1

2,243.5

Common Stock Retained Earnings & Other

200.0 1,221.2

200.0 1,306.7

200.0 1,337.2

Owners’ Equity

1,421.2

1,506.7

1,537.2

LIABILITIES & OWNERS’ EQUITY

2,931.6

3,432.8

3,780.7

Net Fixed Assets Goodwill Non-current Assets

Long-term Debt

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8-13

MINDY GARMENT FACTORY 9/30/X1

9/30/X2

9/30/X3

INCOME STATEMENT Net Sales Cost of Goods Sold Selling, General, Admin. Expense Operating Margin Depreciation Interest Expense Earnings Before Taxes Income Taxes Net Income Dividends Paid

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3,501.5 2,667.0 395.6 438.9

3,934.0 3,059.0 435.5 439.5

4,358.9 3,438.8 492.4 427.7

73.8 116.4 248.7 94.5 154.2

75.7 151.1 212.7 87.2 125.5

90.8 279.2 57.7 17.2 40.5

40.0

40.0

20.0

8-14



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8-15

EXERCISE 8.1

Directions: You are the financial analyst for Friendly Bank and you have been asked to perform the financial analysis of the Mindy Garment Factory. This includes: n

Analyzing the figures submitted by the potential client for conformity to accounting conventions

n

Spreading the numbers onto the bank's own financial analysis form

n

Computing the ratios

n

Interpreting the figures

There are four parts to the exercise. Upon completion of each part, check your answers with the Answer Keys which follow. PART I

Refer to the client's financial statements and complete the Friendly Bank Financial Analysis Spreadsheet Model that appears on the next two pages. Check your spreadsheet with the suggestions for analysis and the spreadsheet solution that follow. Step 1:

For purposes of analysis, make any necessary adjustments to the client's financial statements — either to achieve conformity to accounting conventions or for purposes of financial analysis. There are three adjustments to be made; they pertain to the correct levels for trade receivables, other current assets, and tangible net worth.

Step 2:

Spread the numbers and calculate the percentages. Enter the figures, including the adjusted figures, onto the partial spreadsheet format on the following two pages. Ignore adjustments to the numbers for inflation.

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15 16 17 18 19 20 21 22 23 24 25 26 27

ASSETS Cash Marketable Secs Acct Receivables Inventory Other Receivables - non-operating Other Current Assets - (operating) Other Current Assets - (non-operating)

(to be supplied)

Total Current Assets Net Fixed Assets Investments in Subs & Affiliates Other LT assets Intangibles (inc. Goodwill) Deferred Assets Total Assets LIABILITIES Short-Term Debt Current maturities of LT debt Accts Payables - suppliers Interest Bearing Payables Income Taxes Payables Other current liabilities - (operating) Other current liabilities - (non-operating) Total Current Liabilities Long Term Senior Debt Long Term Subordinated Debt Capital Lease Obligations LT Deferred Taxes / Reserves Other LT Liabilities

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

28

Total Liabilities

-

-

-

-

29

Minority Interest

-

-

-

-

-

-

-

-

30 31 32 33 34 35 36


37

Total Net Worth

-

-

-

-

38


-

-

-

-

39


-

-

-

-

40 41


-

-

-

-

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8-17

INCOME STATEMENT

Pesos Thousands Annual Data

Quarterly


42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

Pesos Thousands Net Sales Cost of Goods Sold (exclude Depreciation) Selling & Admin Expenses (exclude Depreciation) Operating Profit Bef Non-Cash Charges Depreciation & Amortization Operating Profit Interest Income Gross Interest Expense Inflation income / (loss) FX income / (loss) Integral financing income / (loss) Investment & Related Co income Other non-oper non-cash income (Expense) Other income / (Expenses) Net Income bef Extraordinary Items Extraordinary income (Loss) Employee Profit Sharing Minority interest

12

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

61

Income Tax

-

-

-

-

62 63


-

-

-

-

-

-

-

-

64

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12


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8-18


ANSWER KEY PART I Suggestions for Analysis and Solution

Step 1:

For purposes of analysis, make any necessary adjustments to the client's financial statements — either to achieve conformity to accounting conventions or for purposes of financial analysis. There are three adjustments to be made which pertain to the correct levels for trade receivables, other current assets, and tangible net worth.

Adjusting the Numbers (figures below in thousands)

The first task of financial analysis is to look at the numbers submitted by the client and to make any necessary adjustments for purposes of analysis. This first step is important to avoid computing inappropriate figures and indices, and to avoid making erroneous conclusions based on incorrect ratios and data. The Mindy case offers three instances where adjustments should be made to the statements submitted. First Adjustment In 19X3 — Accounts Receivable: Bank Debt, Short-term:

from 993.7 to 1,393.7 from 1,417.0 to 1,817.0

The first adjustment — the most significant of the three — refers to the level of receivables in the third year, which seems to have declined considerably over levels of the previous two years. This "reduction" in 19X3 could lead the analyst to conclude that efforts to collect overdue receivables have met with some success in the last year. However, for purposes of financial analysis, we should add back to receivables the 400 of the receivables discount line opened and taken down about six months ago, prior to the balance sheet cutoff date. This is because the company is still liable for these receivables. Management has probably taken its best receivables to the Uptown Bank and discounted them to get these assets off its balance sheet. This strategy "improves" the receivables situation, but the overall situation really is the same or worse since the receivables left on the balance sheet are probably of inferior average quality.

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PART I: Step 1, Answer Key (Continued)

If we increase the asset receivables by 400, then we must also increase the liability side of the balance sheet. The liability adjustment should be to short-term bank debt, as if Uptown had made a straight loan instead of booking the facility as a discount line. These adjustments will have a major impact on the computation of days receivable (see below), and also on current ratio and leverage.

Second Adjustment

The second adjustment pertains to the sale of the warehouse, for Pesos 210, that occurred six months ago, prior to the balance sheet cutoff date. This should be listed on the balance sheet as non-current since terms of the sale included 18 months grace. This means that no money will be received until 18 months from the time of sale. Apparently, the sale amount has been included within other current assets, given the size of the increase in this account for 9/30/X3. This is inappropriate and raises doubts about the quality of the external auditor. The 9/30/X3 balance sheet should be adjusted to list this asset as long-term receivables on the non-current asset section. This will have an adverse impact on the current ratio for the year 19X3.

Third Adjustment In 19X1, 2, 3 — Goodwill:

from 148.8 to 0

Tangible Net Worth:

deduct 148.8 from N.W. each year

The third adjustment relates to the goodwill on Mindy’s books. This asset is an intangible and should be reduced from the owners’ equity section in each of the three years to compute the “tangible net worth.” This is because an intangible that is not readily salable should not be included as part of the capital “cushion” for creditors. Also, the item has been inappropriately booked. Goodwill resulting from the sale of the company for more than book value should be registered on the books of the acquiring company, not the company acquired. Leverage will then be adversely impacted.

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PART I: Step 1, Answer Key (Continued) Step 2:

Spread the numbers and calculate the percentages. Enter the figures, including the adjusted figures, onto the partial spreadsheet format of the Friendly Bank on the following two pages. Note that several boxes are blacked out.


15 16 17 18 19 20 21 22 23 24 25 26 27

9/30/X1

ASSETS Cash Marketable Secs Acct Receivables Inventory Other Receivables - non-operating Other Current Assets - (operating) Other Current Assets - (non-operating)

9/30/X2

857.0

Total Current Assets Net Fixed Assets Investments in Subs & Affiliates Other LT assets Intangibles (inc. Goodwill) Deferred Assets Total Assets LIABILITIES Short-Term Debt Current maturities of LT debt Accts Payables - suppliers Interest Bearing Payables Income Taxes Payables Other current liabilities - (operating) Other current liabilities - (non-operating)

102.2

33.8 42.5

23.4 46.0

35.6 52.4

-

2,225.8

2,770.7

3,410.9

-

557.0

513.3

411.0

-

-

1,012.2 1,051.6

1,267.6 1,326.0

1,393.7 1,807.6

-

-

-

-

-

210.0 -

-

2,782.8

3,284.0

4,031.9

-

928.8

-

625.2

-

-

1,817.0 461.5 85.0 -

1,250.4

1,706.1

2,363.5

-

548.6

-

689.1 -

76.6

Long Term Senior Debt Long Term Subordinated Debt Capital Lease Obligations LT Deferred Taxes / Reserves Other LT Liabilities

121.6

-

-

Total Current Liabilities

9/30/X3

88.2

280.0

-

260.0 -

220.0 -

-

28

Total Liabilities

1,510.4

1,926.1

2,643.5

-

29

Minority Interest

-

-

-

-

-

-

-

30 31 32 33 34 35 36


200.0

200.0

200.0

1,072.4 -

1,157.9 -

1,188.4 -

-

37

Total Net Worth

1,272.4

1,357.9

1,388.4

-

38


2,782.8

3,284.0

4,031.9

-

39


-

-

-

-

40 41


-

-

-

-

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INCOME STATEMENT

Pesos Thousands Annual Data Statement Date: No. of Months in Period:

42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

Pesos Thousands Net Sales Cost of Goods Sold (exclude Depreciation) Selling & Admin Expenses (exclude Depreciation)

12

12

12

3,501.5 2,667.0 395.6

3,934.0 3,059.0 435.5

4,358.9 3,438.8 492.4

-

438.9

439.5

427.7

-

Operating Profit

90.8

-

336.9

-

-

-

-

-

Net Income bef Extraordinary Items

212.7

248.7


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279.2 -

-

-


151.1

248.7

Extraordinary income (Loss) Employee Profit Sharing Minority interest


75.7 363.8

116.4

Investment & Related Co income Other non-oper non-cash income (Expense) Other income / (Expenses)

62 63

73.8 365.1 -

Integral financing income / (loss)

Income Tax

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9/30/X3

Depreciation & Amortization

61

64

9/30/X2

Operating Profit Bef Non-Cash Charges

Interest Income Gross Interest Expense Inflation income / (loss) FX income / (loss)

Quarterly

9/30/X1

57.7 -

212.7 -

-

57.7 -

-

248.7

212.7

57.7

-

94.5

87.2

17.2

-

154.2 40.0

125.5 40.0

40.5 20.0

-

114.2

85.5

20.5

-

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EXERCISE 8.1 PART II

Based on the numbers from the preceding pages, compute the financial ratios for 19X1, 19X2, and 19X3. Do not calculate ratios for the blacked out boxes. Note that to compute the days receivable number, you should remember that not all sales are made on a credit basis. RATIO ANALYSIS

Annual Data

Quarter


191 192 193 194


195 196 197 198 199 200


201 202 203 204


205 206 207 208 209 210 211 212

Op. Profit / Net Sales (%) Net Income / Net Sales (%) GOCF / Net Sales (%) ROE - Net Income / opening Net Worth (%) ROA - Net income / opening Total Assets (%) Net Sales / Total Assets (%) Dividend payout ratio* FOCF / Expansionary Capex + Dividends LIQUIDITY

213 214 215 216 217 218 219


220 221 222 223 224 225 226 227 228 229 230 231


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ANSWER KEY PART II RATIO ANALYSIS

Annual Data Statement Date: No. of Months in Period:

191 192 193 194


195 196 197 198 199 200


201 202 203 204


205 206 207 208 209 210 211 212

Op. Profit / Net Sales (%) Net Income / Net Sales (%) GOCF / Net Sales (%) ROE - Net Income / opening Net Worth (%) ROA - Net income / opening Total Assets (%) Net Sales / Total Assets (%) Dividend payout ratio* FOCF / Expansionary Capex + Dividends

Quarter

9/30/X1

9/30/X2

9/30/X3

12

12

12

2,782.8

3,284.0

4,031.9

1,272.4 975.4

1,357.9 1,064.6

1,388.4 1,047.4

3,501.5 365.1 154.2 228.0

3,934.0 363.8 125.5 201.2

4,358.9 336.9 40.5 131.3

76.2 11.3 10.4 4.4 6.5

12.4 (2.6) 77.8 11.1

10.8 (4.2) 78.9 11.3

125.8 25.9

9.3 3.2 5.1 9.9 4.5 119.8 31.9

7.7 0.9 3.0 3.0 1.2 108.1 49.4

1.78 0.88 122 142 74 3.1 9

1.62 0.80 136 156 81 3.1 9

1.44 0.64 135 189 48 3.0 10

1.19

1.42

1.90

1.96 0.88

1.33 0.91

0.47 0.47

885.2 625.2 260.0

1,148.8 928.8 220.0

2,097.0 1,817.0 280.0

1,272.4 200.0 4.43

1,357.9 200.0 5.74

1,388.4 200.0 10.49

LIQUIDITY 213 214 215 216 217 218 219


220 221 222 223 224 225 226 227 228 229 230 231


Remember: Funds from Operations (FFO) is the same as Gross Operating Cash Flow (GOCF). * Calculated: Dividends / Net Income

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EXERCISE 8.1 PART III

Interpret the results, focusing first on the income statement and then on the balance sheet. In so doing, consider the percentage to sales as well as the ratios. Compare your answers with the explanations on the following pages. INCOME STATEMENT

Question 1: How do sales increases compare to inflation? What does this mean?

Question 2: Based on the numbers in the case, what do you think Mindy's pricing policy situation might be?

Question 3: What do the numbers reveal about Mindy's operational efficiency?

Question 4: What effect are interest expenses having on profits?

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BALANCE SHEET

Question 5: What is the situation with receivables? What does it mean? n

Remember that you adjusted the receivables amount.

n

Compare days receivable to credit terms offered.

Question 6: What is the inventory situation? What does it mean? n

Calculate days of finished goods inventory.

n

Calculate days of raw materials inventory.

n

Contrast these numbers to the information provided by Mindy's general manager.

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PART III (Continued)

Question 7: What is the situation with fixed assets? What does it mean? n

Focus on accumulated depreciation.

n

What does this mean on the income statement?

Question 8: What is the situation with days payable? n

Why decrease payables when the company has high working capital needs?

n

Is Mindy really getting discounts for cash payment, or are trade creditors cutting back?

Question 9: What can be said about the relationship between retained earnings and capital of the firm?

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ANSWER KEY PART III Interpreting the Numbers

Interpretation of the numbers will be more meaningful if we consider some of the comments made by the manager of the Mindy Factory. By listening for clues, we can attempt to get behind the numbers and read between the lines. Let's start with the income statement. Income Statement

There is an obvious deterioration in the expense-to-sales relationships; each year is producing less income on greater revenues. Several things, or more likely a combination of several factors, could account for this.

Question 1: How do sales increases compare to inflation? What does this mean? First of all, sales increases are lagging behind inflation despite the general manager's assertion that price hikes are consistent with inflation. If what he said is true, Mindy is selling less volume than in prior years. The company is, therefore, losing market share since price increases account for the monetary increases in sales. If this is not true, it indicates that the manager has not been truthful or has insufficient control or understanding of his own company. In his favor, however, there could be some lag effect with rising prices and inflation. On the other hand, if these can be passed on easily to the company's buyers, as the manager asserts, then it should be factored into pricing policies. Apparently, this has not been done.

Question 2: Based on the numbers in the case, what do you think Mindy's pricing policy situation might be? All of this could mean that pricing policies within Mindy are inadequate. Either they have insufficient control of the company by not factoring all costs into their price, or they have inadequate management information systems.

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PART III ANSWER KEY (Continued) This could also indicate a highly competitive position within the industry that does not permit passing off the higher cost. However, this would contradict what the manager has said about being able to pass off increased costs because of their strong brand names and entrenched market position.

Question 3: What do the numbers reveal about Mindy's operational efficiency? Eroding margins could indicate less efficiency than the competition, but it is difficult to know this until we compare industry averages. Eroding margins, together with the breakdown on net fixed assets, could indicate increasing maintenance costs on aging machinery and equipment (the plant apparently is very old, given the high accumulated depreciation in relation to the booked fixed assets) and a competitive atmosphere that won't permit passing off increased costs to the consumer.

Question 4: What effect are interest expenses having on profits? Sharply increasing interest expenses reflect increased debt levels necessary to maintain increasing current asset levels. This, of course, results in reduced profits. Significant dividends relative to earnings levels also act as a brake on contributions to retained earnings, especially at a time when increased capitalization is becoming more and more necessary.

Balance Sheet

The balance sheet reflects persistent deterioration, although it is not as obvious as on the income statement. This deterioration is more pronounced after making the adjustments in Part I of this exercise. The adjustments accentuate the decline in balance sheet strength.

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PART III ANSWER KEY (Continued)

Question 5: What is the situation with receivables? What does it mean? For 9/30/X3, the computation for days receivables is: Sales of

4,359 x .85

Receivables of 1,394 x 360 3,705

= 3,705 = 135 Days

This level is significantly and uncomfortably higher than sales terms of 90 days. It is virtually the same as the previous year (19X2 = 136 days), instead of the apparent "improvement" from the reduced amounts of receivables on the balance sheet which would have computed to 97 days. Note, also, that the deviation from credit terms cannot be explained by seasonality, since the July to September quarter comprises 25% of total sales and production. In other words, the figures for the quarter should reflect average numbers for the year. This adjusted situation impacts heavily in terms of increased funds needs to maintain the higher asset levels on the balance sheet, higher than if days receivables were really 97 days. It also impacts profits negatively due to the resulting heavier interest costs on the debt that are necessary to sustain the larger assets. The worst part of this is that the situation probably indicates significant amounts of uncollectible funds.

Question 6: What is the inventory situation? What does it mean? Inventory levels have been steadily climbing, resulting in increased funds needs and increasing interest costs. The most alarming aspect of this situation is the growth in days of finished goods inventory, from 50 days in 19X1, to 73 days in 19X2, to 110 days in 19X3. This is alarming because of Mindy's product, which is susceptible to style changes. The finished goods build-up probably indicates stale merchandise that will require significant sacrificing to clear the shelves.

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PART III ANSWER KEY (Continued) Raw materials inventories have maintained a slightly decreasing trend (87, 78, and 74 days) which could indicate stronger inventory management or tight working capital that won't permit greater stocking. It is interesting to contrast this with the general manager's assertion that Mindy was stocking up as a hedge on inflation. Normally, this strategy would mean stocking up on raw materials which are more in the nature of commodities. These are more price sensitive than finished goods. Finished goods are also more sensitive to style changes, so why would Mindy stock up on finished goods? That market is not fast-growing, and Mindy appears to be losing market share.

Question 7: What is the situation with fixed assets? What does it mean? From the high amount of accumulated depreciation in relation to the total booked fixed assets (see the breakdown on the client financial statements), we can see that net fixed assets are aging rapidly. This probably indicates capital expenditure needs in the near future. The problem is, however, that at present declining levels of profitability, the company won't be able to pay out long-term debt, even at a long tenor. This situation also impacts costs due to increased needs for maintenance expenditures.

Question 8: What is the situation with days payable? Accounts payable show a disturbing trend (74, 81, and 48 days) from the cash flow perspective. We don't know what credit terms to the company are; but, at a time when current asset funding needs are increasing, this usually cheaper source of funds should certainly not be decreasing. The general manager says he's buying for cash to get discounts, but this sounds improbable. More likely, some suppliers are either declining to sell on credit or cutting back on credit terms.

Question 9: What can be said about the relationship between retained earnings and capital of the firm? On the equity side, it should be noted that capital is quite low in comparison to retained earnings. This could be a risk since retained earnings can more easily be taken out as dividends. Since the dividend policy has been reasonably generous in the past, this could indicate a willingness to take out more.

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EXERCISE 8.1 PART IV

Please answer the following five questions. Question 1: Are the following conclusions about Mindy's present financial situation probably (T) true or (F) false? ____ a) The company is losing market position. ____ b) Pricing policies are adequate. ____ c) Operations are becoming less efficient. ____ d) Current asset management is adequate. ____ e) The dividend payout ratio is too low. Question 2: Select three reasons why the Mindy cash generation capacity is highly suspect. ____ a) Very low profitability ____ b) Illiquid current assets ____ c) Low taxes ____ d) Improving margins ____ e) Declining trends

Question 3: The manager's stated purpose for requesting a loan is to increase “working capital.” The more precise purpose of the loan probably is to: ____ a) finance fixed assets. ____ b) finance a new product line. ____ c) pay creditors. ____ d) hedge long-term liabilities. PART IV (Continued)

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Question 4: Select three "clues" that indicate why the loan should not be granted. ____ a) Numbers sometimes contradict verbal information. ____ b) Owners are good friends of one of the bank directors. ____ c) There is a build up in potentially unrealizable current assets. ____ d) The company is a long-established business. ____ e) There are doubts regarding the manager's character and/or capacity to do his job.

Question 5: What lessons can be learned from this exercise? Check the statements that apply. ____ a) Numbers analysis, alone, is sufficient to make credit decisions. ____ b) Ratios are extremely useful, but there must be some discrimination of the numbers that determine results before the ratios are computed. ____ c) Financial analysis should consider qualitative factors which permit more meaning to be derived from otherwise sterile numbers. ____ d) Ratios never lie. Together, with the financial statements, they provide absolute determinations about the condition of a company. ____ e) The analyst should develop abilities to "read between the lines" to frame incisive questions that look for causes, not symptoms, and draw appropriate conclusions. ____ f) It does not matter who the external auditor is because client financial statements always comply with Generally Accepted Accounting Principles.

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ANSWER KEY PART IV

Question 1: Are the following conclusions about Mindy's present financial situation probably (T) true or (F) false? T

a) The company is losing market position. Real sales growth (normal less inflation) is negative.

F

b) Pricing policies are adequate. Pricing policies are inadequate, possibly due to:

T

n

Not enough management information

n

Inadequate cost accounting mechanisms

c) Operations are becoming less efficient. Possible reasons include:

F

n

Inadequate cost systems

n

High maintenance costs on an old plant

n

The age and inefficiency of the plant

d) Current asset management is adequate. We know that current asset management is inadequate because of:

F

n

Probable problems with uncollectible receivables

n

Probable stale finished goods inventory

n

Higher interest payments to sustain higher borrowing levels

n

Lower net income

e) The dividend payout ratio is too low. The dividend payout ratio is too high, especially now when growth of net worth is needed to build up capital, which raises doubts about shareholder backing.

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PART IV ANSWER KEY (Continued)

Question 2: Select three reasons why the Mindy cash generation capacity is highly suspect. a) Very low profitability b) Illiquid current assets e) Declining trends

Question 3: The manager's stated purpose for requesting a loan is to increase "working capital." The more precise purpose of the loan probably is to: c) pay creditors. The manager's stated purpose of "working capital" should never be accepted by a banker. This imprecise answer could indicate that a manager does not understand the real purpose for a loan, just that he needs money to keep the company going. From our analysis, we can appreciate that the real purpose of the loan probably is to pay creditors (suppliers or banks) who are pressing for payment.

Question 4: Select three “clues” that indicate why the loan should not be granted. a) Numbers sometimes contradict verbal information. c) There is a build up in potentially unrealizable current assets. e) There are doubts regarding the manager's character and/or capacity to do his job. In a couple of instances (market position, pricing, build up in finished goods instead of raw materials as a hedge on inflation), the numbers contradict what the general manager has indicated. This means that he is ignorant of the real situation or that he is trying to deceive the banker to get the loan. This raises questions about his competence and his ethics.

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PART IV ANSWER KEY (Continued) The analyst can also assume that if the manager is not entirely forthright with information before he receives the loan, there probably will be little cooperation (should the loan be given) if there are problems with the credit. And, it is likely that there will be immediate problems with the credit if the loan is made. The timing of the loan request should also be noted since this business is usually quite seasonal. January should be their best month for collecting from their distributors after the Christmas sales. Requesting a loan now, in January, is out of synchronization with their own business cycle. The analyst's verdict, therefore, should be to deny the credit. Mindy is not yet a client, and is not a desirable one either.

Question 5: What lessons can be learned from this exercise? Check the statements that apply. b) Ratios are extremely useful, but there must be some discrimination of the numbers that determine results before the ratios are computed. c) Financial analysis should consider qualitative factors which permit more meaning to be derived from otherwise sterile numbers. e) The analyst should develop abilities to "read between the lines" to frame incisive questions that look for causes, not symptoms, and draw appropriate conclusions.

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(This page is intentionally blank.)

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CASE STUDY: THE TOWER STORES

Introduction

In the Mindy case, you were introduced to the financial analysis spreadsheet model. You looked at a customer's financial statements, made the necessary adjustments, included these numbers within the model, and computed the ratios. This was done to perform a financial analysis of the firm's historical figures and to decide whether or not a loan request should be granted. This case, Tower Stores, Inc., involves a commercial enterprise where the management proposes a new sales strategy to promote greater growth and profits. The company requests its bank's backing through an increase in short-term credit facilities. You, as the bank's financial analyst, must measure the proposed strategies in light of historical trends to project some key numbers. You will determine if the request should be accepted and, if so, under what terms. In this exercise, you will utilize the spreadsheet model not only to measure and analyze past performance, but to project numbers into the future. Projections enable you to measure anticipated cash generation and financial strength. In preparing these projections, you will work with other sections of the spreadsheet that have not yet been covered. The projections will be based on past trends and proposed new strategies. In building them, you will draw on key financial concepts learned in Unit Two and on account relationships encountered in the financial ratios of Units Four through Seven. By understanding these relationships and the formulas for computing certain ratios, you will be able to project numbers based on key assumptions.

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In preparing these projections, you must first analyze the customer's basis for his/her projected figures to determine the feasibility of proposed financial strategies. In reaching this determination, you, the analyst, will prepare your own projections based on your own more pessimistic assumptions in an attempt to measure the sensitivity of the figures. This, then, will depict an alternate, more conservative picture of what might happen if the customer's financial strategies cannot be achieved and what this might mean in terms of cash flow and potential additional cash needs. With this information, you will be better prepared to reach conclusions and frame recommendations. NOTE:

Comparison of the customer's projected numbers with the bank's more conservative projected numbers is an important step in the credit process.

Mechanics of the Bank Spreadsheet Model

Before beginning the Tower case, let's review the format of the spreadsheet model. You will find it on the four pages following this section. The form begins with the balance sheet on the first page, then an income statement and certain reconciliations on the second page, the cash generation statement, and finally, a page with ratios. We have already worked with some of these parts, so let's discuss the other parts.

Reconciliations

There are two reconciliations: fixed assets and net worth. We will focus on these key accounts and "squeeze out" any items that should be considered later for calculating cash flows. Also, by focusing on these reconciliations, you will understand what is happening on the balance sheet with these important accounts. 1)

Fixed Asset Reconciliation

The fixed asset reconciliation begins with the opening net fixed assets for the period which are the net fixed assets from the prior balance sheet. If the prior balance sheet is not available, this computation cannot be made.

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After noting the opening net fixed assets, we subtract depreciation for the period. Depreciation is the same figure that appears on the income statement. The subtotal is then compared to the balance sheet net fixed assets. If the balance sheet number is greater (as it usually is), it means that some fixed assets were acquired (or revalued) during the period. The difference between the subtotal and the balance sheet net fixed asset figure constitutes the capital expenditures for property, plant, and equipment made during the period. Let's look at an example. Opening Fixed Assets Less: Period Depreciation

3,000 500

Subtotal Ending Fixed Assets

2,500 2,800

Capital Expenditures

300

In this example, the ending fixed assets are less than opening fixed assets, even though there was an increase in these assets during the period. If no other fixed assets had been bought or sold during the year, the ending fixed assets would be 2,500, which is less than the opening fixed assets by the factor of depreciation (500). If the subtotal was greater than ending fixed assets, it would mean that some fixed assets had been sold, or otherwise disposed of, during the period and had not been replaced. The net effect would be a reduction of the balance sheet net fixed asset account by an amount that is greater than depreciation. The above example is a simplification of the concepts involved. The new Citibank spreadsheet section for fixed asset reconciliation (below) covers the additional concepts of inflation adjustments, revaluation, and type of capital expenditure. It is important to consider these concepts. 73 74 75 76 77 78 79 80 81 82 83


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-

-

-

-

-

8-42


The inflation adjustment is for monetary correction of fixed assets. This is one of many such adjustments within a monetary correction scheme. As for revaluation, note that the previous simple calculation finds amounts of capital expenditures by difference. In reality the amount of capital expenditures often includes increases due to revaluation of fixed assets. These should be netted out, as in the new spreadsheet, because these are accounting entries and do not reflect actual acquisitions or cash movements. The type of capital expenditure is also relevant. Maintenance capital expenditures are for the purpose of replacing some fixed assets to enable continuing business at essentially the same level. Expansionary capital expenditures enable a significant increase in operational levels, such as installing new machinery to increase production levels, or opening an additional retail outlet.

2)

Net Worth Reconciliation

The concept here is similar to that of the fixed asset reconciliation. The analysis begins with the opening net worth figure, which is the same as the ending net worth of the prior period. Again, this does not appear on the balance sheet, but must be sourced from the prior period’s balance sheet. If the prior figure is not available, the computation cannot be made. The net income (or loss, expressed as negative income) for the period is added to the opening figure. The subtotal indicates what the ending net worth figure would be if no other adjustments were made. If the ending figure is greater than the opening figure plus net income, it means that capital was injected into the company during the period, or that net worth was increased in some other way, in the amount of the difference. If the ending figure is less than the opening figure plus net income, it means that capital was taken out or reduced. A reduction usually indicates payment of dividends, but there may be other reasons such as a write off of certain assets. Opening net worth Plus: net income Subtotal Difference Ending net worth

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4,000 800 4,800 300 4,500

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In this example, ending net worth is less than opening net worth plus net income, which means that there was a reduction of capital. We can assume that this was due to dividends, but the reason for the difference should be confirmed with the customer. It should be noted that these reconciliations are accounting exercises — we are dealing with arithmetical differences and not with theoretical possibilities. If the numbers signal a difference, these amounts must be considered for cash flow purposes regardless of the reason for the difference. The new Citibank spreadsheet is now more sophisticated in this area, including lines for inflation adjustments from monetary correction and balance sheet adjustments in the case of foreign currency long-term debt devaluations. The new net worth reconciliation looks as follows:

65 66 67 68 69 70 71 72


-

-

-

-

-

-

The Funds Generation Statement This page of the Citibank spreadsheet directly focuses on the sources and uses of funds concepts presented in Unit Two. The cash flow breaks down both sources into operational and non-operational funds flows. By separating the flows into these distinct categories, conclusions may be drawn about where funds have been used and about the sources for these resource allocations.

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The groupings on the new spreadsheet are as follows: + Operating profit (sales - cgs - sga - deprec) + Depreciation = Gross operating cash flow (GOCF or FFO) - Operating uses (increase in receivables, inventory, other current assets) + Operating sources (accounts & taxes payable, other current liabilities) = Net operating cash flow (NOCF) - Maintenance capital expenditures = Free operating cash flow (FOCF) + Non-operating sources (non-op income, fresh capital, new debt) - Non-operating needs (dividends, expans. cap. expend., debt reduc.) = Net increase / decrease in cash and equivalent

You will see an example of this in the case which follows. Notice that the customer’s financial statements have already been spread using this format.

Background — Tower Stores, Inc. Tower Stores, Inc., is a family-owned commercial enterprise founded in 1952 in the country of Casablanca. This third-world country has enjoyed relative economic and political stability for over 20 years. The currency unit of Casablanca is the Peso, and the exchange rate versus the US Dollar is Ps. 8.00 / US$1. The inflation level in Casablanca is about 15%. Tower Stores owns and manages several small department stores that sell clothing, shoes, cosmetics, toys, televisions, other consumer electronics goods, and small kitchen and household appliances. There are six stores, all well located throughout the country in prestigious shopping centers or districts. The firm has earned an established and respected market image by selling high quality products and by maintaining a reputation for administrative integrity.

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The firm has been conservatively managed with a deliberate, but steady growth in operations over the years. Several months ago, Teddy Tower, grandson of the founder, became general manager of the company. He has worked in the family enterprise for four years since graduating from a reputable business school in the USA where he specialized in marketing. During his time in the company, he has gained experience in most of the major departments of the firm, including the purchases, sales, finance, and administrative departments.

New Directions Teddy believes the firm has been managed too conservatively over the years, resulting in slim profitability. He thinks that the firm can achieve faster growth and greater profitability with more aggressive sales policies involving increased credit terms from present levels of about 25% (present maximum: 60 days) for the firm's select clientele. Teddy also feels that trendier products could increase margins on the income statement and accelerate inventory turnover. Teddy's idea is to cash in on the increasing purchasing power of the growing middle class of Casablanca. On the balance sheet, these changes would mean increased funding needs since considerable increases in accounts receivable could be anticipated as a result of these policies. This growth in receivables would result from the dual effect of the more accelerated sales growth and the greater proportion of credit sales. Teddy proposes to cover the anticipated increased funding needs from three sources: n

Higher net income levels (plus depreciation)

n

More favorable average credit terms on purchases

n

Increased short-term bank financing

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Specific Short-Term Objectives The financial statements for Towers Stores, Inc., have been spread and are attached. Based on his own analysis of the company's situation and his assessment of the market, Teddy Tower has just set goals for the year 19X4, which has just begun. Specifically, his 19X4 financial objectives for Tower Stores are to: n

Increase sales by 30% (about 15% above inflation levels) •

Credit sales to be 50% of total sales

•

Sales terms to average 60 days

n

Reduce cost of goods sold / sales to 62%

n

Maintain SGA expenses at 27% of sales

n

Increase inventory turnover to 3.5 times (103 days)

n

Increase purchase terms to an average of 45 days

Situation with Commerce Bank Commerce Bank is the principal bank for Tower Stores and currently offers them a credit facility for short-term borrowings of Ps. 5,000,000 ( US$ 625,000), with an average usage factor of about 80%. Teddy Tower has requested that the bank increase this line of credit to Ps. 8,000,000 to support the company's anticipated increase in working capital needs. The existing facility is offered without tangible collateral, but with personal guarantees of key shareholders. Tower Stores is a prime customer of Commerce Bank. The company provides strong account earnings through intensive use of the short-term facility and the significant volumes of trade and current account operations that are channeled through the bank. Although he did not anticipate consistent use of more than Ps. 5,000,000 of this line (the rest of the short-term needs would be supplied by other banks), Teddy requested the full amount to cover seasonal needs and to act as insurance in case the working capital needs turned out to be heavier than expected.

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Company Name: Country: Amounts in 1= mill, 2 = thous, 3 = actuals: Currency: Local Curr enter 0, US$ enter 1: Financials: Audited / Direct: Qualified / Unqualified:

TOWER STORES, INC. Casablanca 2 Pesos 0 Audited Audited Unqualified Unqualified Annual Data Statements Purchasing Power Date: 12/31/X1 12/31/X2 Statement Date: 12/31/X1 12/31/X2 No. of Months in Period: 0 0

Audited Unqualified 12/31/X3 12/31/X3 12


15 16 17 18 19 20 21 22 23 24 25 26 27

ASSETS Cash Marketable Secs Acct Receivables Inventory Other Receivables - non-operating Other Current Assets - (operating) Other Current Assets - (non-operating) Total Current Assets

15,907

19,228

21,363

5,157

5,028 226

360 -

21,531

24,482

27,160

2,151 880 2,827

3,957 880 3,696

5,240 880 3,909

320 612

-

-

9,430

-

11,318

12,122 -

-

9,000 621

2,551

-

880 -

9,000 550

-

11,242

1,760 -

-

446 767 -

9,558

2,640 -

9,000 705 -

3,543

5,333

-

15,038

37

Total Net Worth

12,101

13,164

38


21,531

24,482

27,160

39


-

-

-

40 41


-

-

-

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337 688

6,790


5,437 -

-

-

Long Term Senior Debt Long Term Subordinated Debt Capital Lease Obligations LT Deferred Taxes / Reserves Other LT Liabilities Total Liabilities

2,255 17,241 347 362

467


Minority Interest

262 327

2,627 14,958 505 301

-

LIABILITIES Short-Term Debt Current maturities of LT debt Accts Payables - suppliers Interest Bearing Payables Income Taxes Payables Other current liabilities - (operating) Other current liabilities - (non-operating)

1,158 -

-

Total Assets

28

837 -

1,512 12,984

Net Fixed Assets Investments in Subs & Affiliates Other LT assets Intangibles (inc. Goodwill) Deferred Assets

29 30 31 32 33 34 35 36

822 -

-

8-48


INCOME STATEMENT

Pesos Thousands Annual Data Statement Date: No. of Months in Period:

42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

Pesos Thousands Net Sales Cost of Goods Sold (exclude Depreciation) Selling & Admin Expenses (exclude Depreciation)

12/31/X1

12/31/X2

12

12

12

56,420 36,678 15,634

68,432 45,218 19,650

78,690 51,439 21,919

4,108

3,564

5,332

Operating Profit Bef Non-Cash Charges Depreciation & Amortization Operating Profit Interest Income Gross Interest Expense Inflation income / (loss) FX income / (loss)

844

912

982

3,264

2,652

4,350

-

460

-

Integral financing income / (loss)

-

-

Net Income bef Extraordinary Items

-

-


3,204 -

1,808 -

2,804

1,146 -

1,808

2,804

Extraordinary income (Loss) Employee Profit Sharing Minority interest

844

2,804

Investment & Related Co income Other non-oper non-cash income (Expense) Other income / (Expenses)

12/31/X3

3,204 -

1,808

3,204

61

Income Tax

1,262

745

1,330

62 63


1,542 0

1,063 0

1,872 0

1,542

1,063

1,874

12,101 1,063 0 0 0 0 0

13,164 1,874 0 0 0 0 0

13,164

15,038

64

65 66 67 68 69 70 71 72

73 74 75 76 77 78 79 80 81 82 83




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5,028 982 0 0 0 1,391 1,391 0 1,391 0

5,028

5,939

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CASH FLOW

Pesos Thousands Statement Date: No. of Months in Period:

84 85 86 87 88 89 90

Pesos Thousands Operating Profit Depreciation & Amortization Other non-cash charges (Enter in section below) Gross Operating Cash Flow (GOCF or FFO) Changes in receivables Change in inventories Change in other current op.assets

90 91 92 93 94

12

4,350 982 0 5,332 (372) 2,283 (158)

Change in acc. & taxes payables Change in other current op. liabilities

886 76

322 79

Net Operating Cash Flow (NOCF)

1,194

3,980

Maintenance Capital Expenditures Free Operating Cash Flow (FOCF) Net non-operating net income (net of non-cash) Increase (Decrease) in Capital Dividends from Subsidiaries & Affiliates Sale of investments in Subs. & Affil. Sale of fixed assets Increase in S.T. Bk. & Financ. Debt Increase in LT Bk. & Financ. Debt Change in non-oper-non-fin curr Liabs. Change in other LT liabilities Change in Minority Interest

105 106 107 108 109 110 111 112

Growth of inv. in Subs., Aff. & Intangibles Dividends Paid Expansionary Capital Expenditures Change in non-oper-non-fin curr assets Change in other LT assets Reduction in S.T. Bk. & Financ. Debt Reduction in LT Bk. & Financ. Debt Total Non-Operating Needs

Total Non-Operating Sources

783

1,391

411

2,589

(1,589) 0 0 0 0 1,806 0 0 0 0 217 0 0 0 (26) (241) 0 880

Net Increase (Decrease) in Cash and Equivalents

(2,476) 0 0 0 0 1,283 0 0 0 0 (1,193) 0 0 0 61 134 0 880

613

1,075

15

321

112

CASH & EQUIV AT BEGINNING OF PERIOD

113

CASH & EQUIV END OF PERIOD

822 837

837 1,158

114

CASH & EQUIV AT END B/S

837

1,158

115 116 117

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12

2,652 912 0 3,564 1,115 1,974 243

95 96 97 98 99 100 101 102 103 104 105

112

12/31/X2

Unexplained Difference (CHECK) Non-Cash Charges Breakdown Total Other non-cash charges & B/S

118 119 120

Operational

121 122 123 124 125 126 127

Non Operational FX loss / (gain) Plus: Inf. Adjust. LT liabs. & N. worth Less: Accrued profit related companies Less: Other non-cash non-op income Plus: Net change def. reserves Less: Inf. Adjust. LT assets

Allowance for Bad Debts Inventory Write-off

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0

0

0

0

0 0 0

0 0 0

0 0 0 0 0 0 0

0 0 0 0 0 0 0

8-50


RATIO ANALYSIS

Annual Data Statement Date:

12/31/X1

12/31/X2

12

12

12

21,531 12,101 12,101 9,117

24,482 13,164 13,164 9,670

27,160 15,038 15,038 10,121

56,420 3,264 1,542 4,108

68,432 2,652 1,063 3,564 1,194 411

78,690 4,350 1,874 5,332 3,980 2,589

No. of Months in Period:

191 192 193 194


195 196 197 198 199 200


201 202 203 204


205 206 207 208 209 210 211 212

Op. Profit / Net Sales (%) Net Income / Net Sales (%) GOCF / Net Sales (%) ROE - Net Income / opening Net Worth (%) ROA - Net income / opening Total Assets (%) Net Sales / Total Assets (%) Dividend payout ratio FOCF / Expansionary Capex + Dividends

65.0 27.7 5.8 2.7 7.3

2.62 0 -

12/31/X3

21.3 6.3 66.1 28.7

15.0 0 65.4 27.9

3.9 1.6 5.2 8.8 5.1 2.80 0

5.5 2.4 6.8 14.2 7.7 2.90 0

-

-

LIQUIDITY 213 214 215 216 217 218 219

Current ratio Quick assets ratio (1 + dec.) Days receivables Days inventory Days payables Cash & Secs (% of Total Assets) Cash & Secs (Days Sales)

2.34 0.34 39 127 28 3.8 5

2.01 0.36 55 119 29 3.4 4

1.90 0.30 41 121 27 4.3 5

0.78 0.53 8.9 1.6 3.1 5,671 3,031 2,640 12,101 12,101 9,000 0.63

0.86 0.73 4.2 2.0 2.1 6,597 4,837 1,760 13,164 13,164 9,000 0.73

0.31 0.87 4.7 6.1 2.6 7,000 6,120 880 15,038 15,038 9,000 0.78

LEVERAGE 220 221 222 223 224 225 226 227 228 229 230 231


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EXERCISE 8.2

Directions: You are the new financial analyst for Commerce Bank. Your boss has asked you to analyze Tower's financial statements and give an opinion about the company's historical financial soundness. You are also to determine the company's anticipated funds needs with their assumptions and with your own adjusted numbers to test the sensitivity of the projections. Then, your boss would like you to make conclusions about the overall financial analysis and anticipated financial directions. There are three parts to this exercise. Upon completion of each part, check your answers with the Answer Key which follows the exercise. PART I Based on your knowledge of the Tower Stores financial statements, answer these questions about the historical financial numbers included in the spreadsheet format. Question 1: What does the vertical analysis indicate on the income statement? a) Does it indicate major changes or stability? b) Are operations getting better or worse? c) Can definitive conclusions be reached? What does the vertical analysis indicate on the balance sheet? d) Does it indicate major changes or stability? e) What is the relative composition of assets? f) What is the relative composition of liabilities versus capital? g) What are the significant swings in composition from year to year?

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EXERCISE 8.2 (Continued)

Question 2: What does the ratio analysis indicate? a) What do liquidity ratios indicate about realizability of receivables and liquidity of inventory? b) Considering the type of enterprise, what do leverage ratios indicate about the relative amount of capitalization?

Question 3: What does the cash generation analysis indicate? a) What have been the principal operating cash needs? b) What have been the non-operating cash needs, and how have these been financed?

Question 4: Has financial performance been adequate? a) Have liquidity, solvency, and profitability been sufficient? b) Has return on sales been adequate? c) Has return on equity been sufficient? To what should ROE be compared?

Question 5: How can financial performance be improved? What should Tower focus on for improvement?

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ANSWER KEY PART I

Suggestions for Analysis Based on your knowledge of the Tower Stores financial statements, answer these questions about the historical financial numbers included in the spreadsheet format. Question 1: What does the vertical analysis indicate on the income statement? a) On the income statement, the vertical (or margin) analysis indicates stability from period to period since there are no major changes. b) The numbers demonstrate some recuperation in 19X3, relative to 19X2, as greater profits were achieved. c) It is difficult to achieve more meaningful analysis without industry or competitor figures.

What does the vertical analysis indicate on the balance sheet? d) On the balance sheet, the vertical analysis indicates stability with no major swings in account composition. e) Typically, for a commercial firm, current assets predominate over fixed and other non-current assets. This situation has been accelerated in the past two years. f) The composition of fewer liabilities than capital indicates a strong solvency, with a leverage figure of less than 1.00. We will discuss this further in the next answer about ratios. g) On the asset side, there has been a great deal of stability — with a slight build up in inventory and a relative reduction in net fixed assets in 19X3. On the liability side, the most notable swing has been a relative build up in short-term bank debt as long-term debt has been paid down.

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PART I: Answer Key (Continued) In summary, other than reflecting a great deal of stability within the company, the vertical analysis tells us relatively little without a further basis for comparison. However, the demonstrated stability is a useful observation when considered within the rest of the analysis. We can anticipate that, with the proposed changes, there is risk that this stability could be compromised in the future.

Question 2: What does the ratio analysis indicate? a) The ratios seem to indicate a historically strong liquidity and solvency position for the company, although liquidity has been decreasing. The decreased liquidity apparently is due to improved inventory turnover and to increased levels of short-term bank debt. The receivables turnover figures appear to be well within established credit terms and receivables are placed with an established clientele. The principal current assets of receivables and inventory, therefore, appear to support the liquidity situation with realizable assets.

b) Leverage is quite strong at less than 1.00. This ratio indicates that Tower is not a great credit risk since the creditors are amply covered by the firm's assets. This is especially true when you consider that Tower Stores is a commercial enterprise. Due to the liquidity of its assets, this type of firm normally reflects a higher range of debt to equity than industrial enterprises.

Question 3: What does the cash generation analysis indicate? a) The major funds needs in 19X2 were accounts receivable (34% of total operating needs) and inventory (59%), together totaling over three million pesos in funds needs for the year. In 19X3, the inventory increase was virtually all of the operating needs for the year.

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PART I: Answer Key (Continued)

b) Non-operating needs almost exclusively were for capital expenditures and reduction of long-term bank debt. These were funded by short-term bank debt in 19X2, and by net operating generation plus short-term bank debt in 19X3. While funding capital expenditures with short-term debt is not advisable, the amounts are small (3% of total assets in 19X2 and 5% in 19X3) and in the last year leverage was reduced.

Question 4: Has financial performance been adequate? a) Given that both liquidity and solvency of the firm appear to be strong, this question now revolves around the question of profitability.

b) On a comparative basis from year to year, the return on sales (ROS) percentage improved in year 19X3 (2.4%) after a decrease in 19X2 (1.6%). However, an outside reference is needed in order to gauge the validity of the present figure. To determine the adequacy of financial performance, you must focus on return on equity instead of return on sales.

c) The return on equity (ROE) figure should be compared to outside references, such as alternative investments in the marketplace and the inflation figure. It appears that Tower's ROE figure of 13.3% for 19X3 is about even with inflation, so from an investment point of view, the figure is approaching an adequate range, but cannot be considered strong. Because the ROE figure is at the lower range of acceptability, we may conclude that profitability performance has been acceptable, but could be better. At least profits have been highly stable. Teddy Tower may be correct in believing that the firm has been managed too conservatively, especially when considering that the 12/31/X3 leverage (debt / equity) figure of 0.81 is low for a commercial enterprise. If the ROS figure could be improved, and the firm leveraged up somewhat, the ROE could be boosted significantly.

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PART I: Answer Key (Continued)

Question 5: How can financial performance be improved? What should Tower focus on for improvement? To improve this ROE figure, management could focus on some key variables to improve overall ROE through greater operational and financial efficiency. This analysis is based on the relationships that exist between the profitability indicators and other key ratios, as follows: Asset Turnover

ROS ROE Net Income Net Sales

X

Asset Leverage

ROA

Net Sales = Net Income Total Assets Total Assets

X

Total Assets = Net Income Net Worth Net Worth

Notice that both asset turnover and asset leverage are multipliers. If these ratios can be increased without negatively impacting the ROS, then overall ROE will be increased. This is why it is important for all assets to contribute to sales, and why, therefore, it is important to avoid allocating resources to unproductive assets. Obviously, increasing ROS also will ultimately boost ROE if these multipliers do not decrease. The asset leverage figure is similar to the traditional debt / equity concept. Remember, the asset leverage will always be 1.00 greater than the debt leverage figure. For example, if debt / equity is 1.28, then the asset / equity figure will be 2.28, etc. From the investor's viewpoint, it is, therefore, more desirable to leverage up to produce a greater ROE figure. However, this must be done within an acceptably narrow range to avoid sacrificing profitability (because of higher interest expenses) and creditworthiness, thereby nullifying the intended effect. If we analyze the Tower numbers in this way, we get the following: Asset Turnover

ROS 2.4%

X

3.05

Asset Leverage

ROA =

7.3%

X

1.81

ROE =

13.3%

To improve the company performance, Teddy Tower could focus first on improving operational efficiency by lowering costs in relation to sales. Then, he could attempt to utilize total assets more efficiently (to improve the asset turnover) and fund asset growth with debt, thereby leveraging up somewhat.

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EXERCISE 8.2 PART II

Complete the following projection exercises for both the customer's assumptions and your own sensitivity analysis assumptions. Enter your figures on the abbreviated spreadsheets provided for each part of the exercise. Projection 1: Project the income statement accounts requested. Use the following customer assumptions for the first projection: n

Sales growth

30%

n

Cost of goods sold / sales

62%

n

Selling, general, and administrative expenses / sales

27%

n

Depreciation

Ps. 1,200,000

n

Interest expense

Ps. 2,000,000

n

Income tax rate

45%

For your own sensitivity analysis, assume instead:

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n

Sales growth

20%

n

Cost of goods sold / sales

65%

n

Selling, general, and administrative expenses / sales

28%

n

Depreciation

Ps. 1,200,000

n

Interest expense

Ps. 3,500,000

n

Income tax rate

45%

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EXERCISE 8.2 (Continued) Calculation

For each scenario, begin with the 12/31/X3 sales figure and increase by 30% and 20% respectively. Calculate the margins based on respective assumptions for CGS (e.g. 62% CGS / Sales for customer, 65% for sensitivity figures based on historical trends) and SGA expenses. Then insert the figures assumed for depreciation and interest and calculate the percentages.

12 Month Actual 12/31/X3 INCOME STATEMENT

12 Month Customer Projection

12 Month Sensitivity Projection

%

%

%

15

30

20

78,690 51,439 21,919 5,332

100 65 28 7

100

100

Depreciation Interest Expense

982 1,146

1 1

Earning Before Taxes Income Taxes Extraordinary Items

3,204 1,330 0

4 2 0

Net Income

1,874

2

Sales Growth Rate Net Sales Cost of Goods Sold Selling, General Admin. Expense Operating Margin

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ANSWER KEY PART II Calculation

For each scenario, begin with the 12/31/X3 sales figure and increase by 30% and 20%, respectively. Calculate the margins based on respective assumptions for CGS (e.g. 62% CGS / Sales for customer, 65% for sensitivity figures based on historical trends) and SGA expenses. Then, insert the figures assumed for depreciation and interest and calculate the percentages. PART II: Answer Key (Continued) 12 Month Actual 12/31/X3 INCOME STATEMENT Sales Growth Rate Net Sales Cost of Goods Sold Selling, General Admin. Expense Operating Margin



%

%

%

15

30

20

78,690 51,439 21,919 5,332

100 65 28 7

102,297 63,424 27,620 11,253

100 62 27 11

94,428 61,378 26,440 6,610

100 65 28 7

Depreciation Interest Expense

982 1,146

1 1

1,200 2,000

1 2

1,200 3,500

1 4

Earning Before Taxes Income Taxes Extraordinary Items

3,204 1,330 0

4 2 0

8,053 3,624 0

8 4 0

1,910 860 0

2 1 0

Net Income

1,874

2

4,429

4

1,050

1

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Projection 2: Project the accounts receivable, inventory, and payables accounts under the customer's assumptions and under your own sensitivity assumptions. Then, calculate the amount of increase over the 12/31/X3 numbers. Use the abbreviated format below. The methodology for this is based on the relationships in the formulas for days receivable, days inventory, and days payable. For example, once we have a figure for sales and the number of days receivable, we can project the accounts receivable as follows: Credit Sales 360

X Number of Days (Sales Terms)

We can also project the days inventory figure, now that we have determined the cost of goods sold and the number of days inventory. The calculation would be: Cost of Goods Sold 360

X Number of Days (Inventory)

The accounts payable calculation would be: Cost of Goods Sold 360

X Number of Days (Payable)

For these projections, the customer's assumptions are:

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n

Credit sale / sales

50%

n

Sales terms average

60 days

n

Average days inventory

103

n

Average days payable

45 days

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EXERCISE 8.2 (Continued) Your sensitivity figures should be based on: n

Credit sale / sales

50%

n

Sales terms average

75 days

n

Average days inventory

120

n

Average days payable

30 days

12 Month Actual 12/31/X3 BALANCE SHEET Accounts Receivable

%



%*

%*

2,255

8

xx

xx

17,241

63

xx

xx

3,909

14

xx

xx

Increase from 12/31/X3 Inventory Increase from 12/31/X3 Accounts Payable Increase from 12/31/X3

* These vertical analysis percentages cannot be computed until a figure for total assets is projected.

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ANSWER KEY PART II

Projection 2: Project the accounts receivable, inventory, and payables accounts under the customer's assumptions and under your own sensitivity assumptions. Then, calculate the amount of increase over the 12/31/X3 numbers. Use the abbreviated format below.

12 Month Actual 12/31/X3 BALANCE SHEET Accounts Receivable

% 2,255

8

Increase from 12/31/X3 Inventory

12 Month Customer Projection % 8,525

%

xx

9,836

6,270 17,241

63

18,146

Increase from 12/31/X3 Accounts Payable


7,581 xx

20,459

905 3,909

14

Increase from 12/31/X3

7,928

xx

xx

3,218 xx

4,019

5,115

xx

1,206

Calculations Accounts Receivable

(102,297 x .50) x 60 360

(94,428 x .50) x 75 360

Inventory

63,424 x 103 360

61,378 x 120 360

Accounts Payable

63,424 x 45 360

61,378 x 30 360

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Projection 3: Based on the projections you have calculated, and the following additional assumptions about the customer's and your own figures, calculate the projected net funds needs under both the customer's and your own sensitivity scenarios. The calculation should be Additional Funds Needs less Additional Funds Sources. Please note:

Customer

500

n

Ps. 500,000 for "increase in other current assets"

n

Ps. 200,000 for "increase in other current liabilities"

n

Ps. 2,000,000 in net "capital expenditures"

n

Ps. 880,000 in "long-term debt" payments

n

There is no new "long-term debt"

Sensitivity

500

+ Additional Funds Needs Operating: Increase in Receivables Increase in Inventory Increase in Other Current Assets Non-Operating: Capital Expenditures Reduction of Long-Term Debt Additional Funds Needs – Additional Funds Sources Net Income Depreciation Increase in Accounts Payable Increase in Other Current Liabilities Additional Funds Sources = Net Needs to Be Covered Net Additional Funds Needs

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ANSWER KEY PART II

Projection 3: Based on the projections you have calculated, and the following additional assumptions about the customer's and your own figures, calculate the projected net funds needs under both the customer's and your own sensitivity scenarios. The calculation should be Additional Funds Needs less Additional Funds Sources. Please note:

Customer

n

Ps. 500,000 for "increase in other current assets"

n

Ps. 200,000 for "increase in other current liabilities"

n

Ps. 2,000,000 in net "capital expenditures"

n

Ps. 880,000 in "long-term debt" payments

n

There is no new "long-term debt"

Sensitivity

6,270 905 500

7,581 3,218 500

+ Additional Funds Needs Operating: Increase in Receivables Increase in Inventory Increase in Other Current Assets

2,000 880

2,000 880

Non-Operating: Capital Expenditures Reduction of Long-Term Debt

10,555

14,179

4,429 1,200 4,019 200

1,050 1,200 1,206 200

9,848

3,656

707

10,523

Additional Funds Needs – Additional Funds Sources Net Income Depreciation Increase in Accounts Payable Increase in Other Current Liabilities Additional Funds Sources = Net Needs to Be Covered Net Additional Funds Needs

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Projection 4: Project the entire balance sheet using the numbers you developed earlier in this exercise. Enter the numbers in the appropriate boxes below. Note the following: n

The amount determined earlier for net additional funds needs should be added to the short-term bank debt account.

n

Net income should be added to retained earnings.

n

Fixed assets should be adjusted for depreciation.

n

Some balance sheet items must be bundled together for this format.

BALANCE SHEET

%

Accounts Receivable Inventory Cash & Other Current Assets

2,255 17,241 1,867

8 63 7

Current Assets

21,363

79

Net Fixed Assets Other Non-current Assets

5,437 360

20 1

Non-current Assets

5,797

21

TOTAL ASSETS Bank Debt, Short-term Accounts Payable Other Current Liabilities Current Portion LTD

27,160

100

5,240 3,909 1,213 880

19 14 4 3

11,242

41

880

3

12,122

45

9,000 705 5,333

33 3 20

TOTAL NET WORTH

15,038

55


27,160

100

Current Liabilities Long-term Debt TOTAL LIABILITIES Common Stock Surplus and Reserves Retained Earnings

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%

%

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ANSWER KEY PART II

Projection 4: Project the entire balance sheet using the numbers you developed earlier in this exercise. Enter the numbers in the appropriate boxes below. Note the following: n

The amount determined earlier for net additional funds needs should be added to the short-term bank debt account.

n

Net income should be added to retained earnings.

n

Fixed assets should be adjusted for depreciation.

n

Some balance sheet items must be bundled together for this format. 12 Month Actual 12/31/X3

BALANCE SHEET



%

%

%

Accounts Receivable Inventory Cash & Other Current Assets

2,255 17,241 1,867

8 63 7

8,525 18,146 2,367

24 51 7

9,836 20,459 2,367

25 52 6

Current Assets

21,363

79

29,038

81

32,662

83

Net Fixed Assets Other Non-current Assets

5,437 360

20 1

6,237 360

18 1

6,237 360

16 1

Non-current Assets

5,797

21

6,597

19

6,597

17

27,160

100

35,635

100

39,259

100

5,240 3,909 1,213 880

19 14 4 3

5,947 7,928 1,413 880

17 22 4 2

15,763 5,115 1,413 880

40 13 4 2

11,242

41

16,168

45

23,171

59

880

3

12,122

45

16,168

45

23,171

59

9,000 705 5,333

33 3 20

9,000 705 9,762

25 2 27

9,000 705 6,383

37 2 16

TOTAL NET WORTH

15,038

55

19,467

55

16,088

41


27,160

100

35,635

100

39,259

100

TOTAL ASSETS Bank Debt, Short-term Accounts Payable Other Current Liabilities Current Portion LTD Current Liabilities Long-term Debt TOTAL LIABILITIES Common Stock Surplus and Reserves Retained Earnings

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0

0

0

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Projection 5: Based on the new balance sheet figures, calculate the leverage, current ratio, and return on average equity figures for both the customer projection and the sensitivity projection. 12 Month Actual 12/31/X3 RATIO CALCULATIONS Leverage

12,122 / 15,038 0.81

Current Ratio

21,363 / 11,242 1.90

Return on Average Equity

1,874 / 14,101 13.3%

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ANSWER KEY PART II

Projection 5: Based on the new balance sheet figures, calculate the leverage, current ratio, and return on average equity figures for both the customer projection and the sensitivity projection.

12 Month Actual 12/31/X3



Leverage

12,122 / 15,038 0.81

16,168 / 19,467 0.83

23,171 / 16,088 1.44

Current Ratio

21,363 / 11,242 1.90

29,038 / 16,168 1.80

32,662 / 23,171 1.41

Return on Average Equity

1,874 / 14,101 13.3%

4,429 / 17,253 25.7%

1,050 / 15,563 6.7%

RATIO CALCULATIONS

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PART III

Directions: Check your understanding of the Tower Stores, Inc., case by answering the following questions. Check your answers with the Answer Key that follows.

Question 1: Select the best description of Tower's historical financial situation. ____ a) Adequate liquidity, but a weak capital position ____ b) Strong capitalization and considerable stability ____ c) Poor loan prospective due to relative instability ____ d) Strong according to customer projection, but weak according to the sensitivity projection

Question 2: Which account will incur the most significant changes in the company's future cash generation needs if Teddy Tower proceeds with his more aggressive marketing ideas? ____ a) Increased funding for accounts receivable ____ b) Decreased funding for capital expenditures ____ c) Increased funding for reduction of bank debt ____ d) Increased inventory funding needs

Question 3: Select the two principal funds sources that Teddy Tower is counting on, in accordance with his own projections. ____ a) Bank loans ____ b) Strong earnings ____ c) Significant increases in credit terms from suppliers ____ d) Capital investment

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Question 4: What is the advisability of approving the customer's request for the increase in credit facilities? ____ a) Approvable without reservation, due to the firm's strong capitalization ____ b) Not approvable because of the risk of future shortages of funding sources ____ c) Approvable with caution, due to the firm's ambitious marketing plans ____ d) Not approvable because Teddy Tower's reputation for sound business decisions is questionable

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ANSWER KEY PART III Suggestions for Analysis

Question 1: Select the best description of Tower's historical financial situation. b) Strong capitalization and considerable stability Summarizing our comments for Question 1 of Part I, we can conclude that the Tower firm has a strong balance sheet reflecting a healthy liquidity and a robust capital position. Earnings may be lagging behind expectations from an investor's point of view, perhaps due to overly conservative management. Nevertheless, from a creditor's perspective, the numbers indicate a strong potential for lending — primarily because of the strong capitalization relative to debt and the considerable stability reflected in the financial figures.

Question 2: Which account will incur the most significant changes in the company's future cash generation needs if Teddy Tower proceeds with his more aggressive marketing ideas? a) Increased funding for accounts receivable Without any changes in management focus or policies, the situation probably will continue as in the past. Steady profits and depreciation will be the major elements of coverage for the company's moderately increasing funds needs. The remaining funds needs probably will be covered by modest increases in debt, although leverage probably will remain at similar levels. If Teddy Tower proceeds with his more aggressive marketing ideas, there may be significant changes in the financial numbers. Major sales increases will have parallel (due to growth) and accelerated (due to increased credit sales and terms) effects on current assets, primarily receivables. These receivables increases will create funds needs in the range of six to seven million pesos (as calculated in the customer’s, and our own, sensitivity numbers).

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PART III: Answer Key (Continued) Teddy proposes to improve the inventory turnover ratio, which will only slightly increase inventory funds needs (Ps. 905,000 according to his figures). However, if this improved turnover cannot be achieved and historical ratios are maintained, the needs would be in the area of three million pesos.

Question 3: Select the two principal funds sources that Teddy Tower is counting on, in accordance with his own projections. b) Strong earnings c) Significant increases in credit terms from suppliers For sources of funds, Teddy counts on strong earnings increases and significant increases in credit terms from suppliers, as depicted in our answer to Part II — Projection Three. If both of these are achieved, then Teddy's outside funds needs will be minimal. If either of these sources fails by any significant amount, or if funds needs turn out to be much greater than anticipated, the balance will have to be covered with outside debt. In terms of total funds needs, the customer analysis and our own sensitivity analysis present a wide variance, from less than Ps. one million to ten million plus. On the asset side, the most critical needs are receivables and inventory; on the funding side, the most critical variables are earnings and supplier credit. Earnings may be the most critical variable of all, since higher anticipated debt levels will generate higher interest payment requirements that must be covered by increased earnings. If net income cannot be increased in proportion to sales, the new strategy will be a failure. The financial feasibility of attaining the customer's figures will then rest on management's and the firm's abilities to achieve the projected sales with increased margins, and to control the current assets within the constraints the customer has fixed for himself. To the extent that implementation of these policies falls short, funding needs may rise in direct proportion.

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PART III: Answer Key (Continued)

Question 4: What is the advisability of approving the customer's request for the increase in credit facilities? c) Approvable with caution, due to the firm's ambitious marketing plans From the financial perspective, Teddy Tower's request is "approvable," given the firm's strong capitalization that will permit absorption of greater debt levels and risk without adversely affecting the company's solvency. Ultimately, the advisability of approving the request depends on qualitative credit factors such as the banker's assessment of Teddy Tower's (and his firm's) capabilities to go forward with their ambitious plans. At this point, the firm has a steady record, an existing relationship with the bank, and a lot of credibility on its side — positive points in the overall credit determination. If there are doubts about the strategy, the banker should closely watch drawings under the existing (or increased) credit facility and monitor the pulse of the situation. This is especially true for the key variables of sales, the CGS / sales margin, and receivables, inventory, and payables levels to judge conformity with Tower plans.

Congratulations! You have completed the Financial Statement Analysis workbook. We suggest that you continue to refer to it as a ready reference — particularly the Summary of Financial Ratios at the end of Unit Seven.

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Appendices

APPENDIX A: ACCOUNTING EXERCISE ANSWER KEY Exercise Page 1-6

Part 1:

Balance Sheet

Assets

Liabilities

Cash Marketable securities Accounts receivable Inventory Other current assets Prepaid expenses Current Assets

50 150 500 600 100 100 1500

Short-term bank debt Accounts payable Accruals Taxes payable Other current liabilities Current portion LTD Current liabilities

Net fixed assets Investments License rights Non-current assets

1000 300 200 1500

Long term debt Oblig employee pension Non-current liabilities

Total assets

3000

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600 250 150 50 100 50 1200 200 100 300

Total liabilities

1500

Capital stock Legal reserve Retained earnings Total net worth

800 100 600 1500

Liabilities + Net worth

3000

A-2

ACCOUNTING EXERCISE

Part 1:

Income Statement

Net sales

+ 3000 - 2000 = 1000 - 300 = 700 - 100 - 150 50 = 400 - 100 = 300

Cost of goods sold Gross margin Selling, general, administrative expense Operating margin Depreciation Interest expense Other expense Profit before taxes Income tax expense Net Income

Part 2: Short term Bank Debt, Retained Earnings, Balance Sheet Totals, and Income Statement Subtotals? • • • • • • • • • • • • •

Short-term bank debt Ending retained earnings Total current assets Total non-current assets Total assets Total current liabilities Total non-current liabilities Total liabilities Total net worth (stockholders’ equity) Gross margin Operating margin Profit before taxes Net income

600 600 1500

300

300

l 1500 3000 1200 l 1500 1500 1000 700 400 l

l * l l l l l l l l

* NOTE: Ending retained earnings is calculated as: Prior year ending retained earnings + Net Income x Dividends 350 + 300 x 50 = 600

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APPENDIX B: FINANCIAL STATEMENT STRUCTURE

INTRODUCTION A business is a collection of economic and human resources devoted to a particular purpose or goal. This business may be in the commercial, industrial, agricultural, service, or other sectors. Whatever its purpose, every organization must measure its efforts in monetary terms, for both legal and business reasons. Accounting is the recording, summarizing, and reporting of transactions following certain generally accepted accounting principles. These principles are similar throughout the world, but vary in detail from country to country.

OBJECTIVES In this section we will examine the structure of the balance sheet and the income statement. When you complete this section, you will be able to: n

Define accounting and its importance in the financial world

n

Describe the purpose of the balance sheet and income statement and classify their accounts

n

Recognize three accounting principles that have special relevance to the income statement

n

Prepare a simple balance sheet and income statement

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B-2

FINANCIAL STATEMENT STRUCTURE

FINANCIAL STATEMENTS The information recorded during the accounting process is summarized and reported in the financial statements. There are two basic financial statements: n

Balance Sheet

n

Income Statement, also known as profit and loss statement

The balance sheet shows the financial position of a company at a given date; it is a "snapshot" of a company's financial situation. The income statement summarizes what has happened to the company during a specific period, usually one year or less, and, therefore, is a historical summary. Accrual basis

Today, financial statements are almost always prepared on an accrual basis, which means that events are recognized in the period to which they refer even if the related cash transaction takes place in another period. For example, if March rent is payable April 5, it is recognized as a March expense. If 1989 income tax is paid in 1990, it is still a 1989 expense.

Auditors The financial statements of many companies are examined by outside accountants, known as auditors. A company hires an outside auditing firm either to comply with a legal or regulatory requirement or because the company values their professional services. Because audited financial statements are usually more reliable, many bankers will not process a loan request unless it is accompanied by financial statements that have been examined by an acceptable auditing firm.

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Auditors' opinions

As a result of their work, auditors issue a report that presents their opinion on the reliability of a company's financial statements. It is not an opinion on the financial health of the company. The analyst determines whether or not the company is financially healthy.

Unqualified opinion

An auditor's opinion is called an "unqualified opinion" if it is similar to the following: "In our opinion, the financial statements present fairly, in all material respects, the financial position of the company at (date), the results of its operations, and the changes in its financial position for the year in conformity with generally accepted accounting principles."

An unqualified opinion means that the auditors believe the financial statements are reliable. Qualified opinions

Auditors also may qualify their opinions, stating that they do not agree with the manner in which the company accounted for certain transactions. In this case, the banker should carefully consider the qualification and adjust the financial statements for purposes of financial analysis. For example, if the auditors claim that the company failed to report certain losses, and the analyst agrees with them, the analyst must adjust the financial statements for those losses before performing an analysis. In the worst cases, the auditors also may disclaim an opinion on the financial statements or report that the statements do not fairly present the financial position of the company and the results of its operations. This means that the auditors consider the financial statements unreliable. In those cases, it is probably unwise to make any type of loan to the company.

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Impact of inflation


The effect of inflation on financial statements can be significant. The analyst must understand how the numbers are affected in order to draw the appropriate conclusions. In a higher inflationary environment, the numbers will grow much more rapidly, both on the balance sheet and the income statement. The analyst must thoroughly understand the interaction of the numbers to isolate the inflationary effects from the business activities of the enterprise. Issues pertaining to the effects of inflation on financial statements are covered in Unit One. In the remainder of this appendix, we will discuss the concepts and accounts of the balance sheet and income statement. Our example company is CPT, Inc., and we begin with the balance sheet for December 31, 19X1 and 19X2, which is presented on the next page.

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B-5

BALANCE SHEET — CPT, INC. DECEMBER 31, 19X1 AND 19X2 ASSETS

19X1

19X2

CURRENT ASSETS Cash Marketables Securities Trade Receivables, Net Inventory Prepaid Expenses Other Current Assets

1,122 1,820 12,204 17,037 1,603 756

1,861 1,200 14,859 20,018 1,922 560

Total Current Assets

34,542

40,420

Property, Plant, & Equipment Less: Accumulated Depreciation

22,533 5,821

23,305 7,915

PPE, Net

16,712

15,390

Other Non-current Assets Inter-Company Receivables Investments Intangibles Deferred Charges Other Accounts Receivable

422 1,716 744 301 269

387 1,858 1,018 360 359

Total Other Non-current Assets

3,452

3,982

54,706

59,792

Due to Banks Trade Payables Customer Advances Accruals Taxes Payable Other Current Liabilities Current Portion of Long-term Debt

12,522 7,341 1,421 990 456 558 1,845

11,580 9,194 1,988 1,148 892 376 2,110


NON-CURRENT ASSETS

TOTAL ASSETS LIABILITIES & NET WORTH CURRENT LIABILITIES

25,133

27,288

LONG-TERM LIABILITIES Long-term Debt Long-term Deferred Liabilities

8,845 1,863

7,355 2,289

Total Long-term Liabilities

10,708

9,644

TOTAL LIABILITIES

35,841

36,932

NET WORTH Capital Stock Capital Reserves Retained Earnings

10,000 1,667 7,198

12,000 1,882 8,978

TOTAL NET WORTH

18,865

22,860


54,706

59,792

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BALANCE SHEET The balance sheet shows a picture of the financial position of a company at a given date. It is divided into:

Basic accounting equation

n

Assets

n

Liabilities & Net Worth (owners' or shareholders' equity)

The basic structure of the balance sheet is always the same and can be translated into this equation: Assets = Liabilities + Net Worth

Look at the sample balance sheet on page B-5. Notice that assets and liabilities plus net worth reflect account balances at the end of a specific period. These accounts indicate the financial position of CPT, Inc. Let's take a closer look at these accounts.

ASSETS Assets include the resources owned by a company, such as cash, inventories, or buildings, plus the claims it has against the resources of other individuals or companies, such as accounts receivable. Asset valuation

One of the main accounting principles states that assets should generally be valued at the lower of cost or market. The principle works as follows: A company buys an asset for $1,000. As long as the market price is $1,000 or more, it must be shown in the balance sheet at cost. If the market price falls to less than the original cost, the item must be shown at the new market price.

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This is an additional protection for creditors who can be reasonably sure that assets are worth at least what the balance sheet says, and probably even more. However, when inflation rates become very high, marking assets at the lower of cost or market may distort asset values to the extent of causing the financial statements to be useless. This problem is so important that it will be covered separately in the section on inflation. Assets are usually classified in the balance sheet in the order they are realized. Realizing assets

“Realizing an asset” means to convert it into cash. For example, if you sell an item for cash, you are realizing it at the same time you are selling it. However, if you sell it on credit, you only realize it when the bill is collected. Asset realizations create an inflow of funds into the company. The earlier an asset can be realized, the more liquid it is.

Classifying assets

Based on intended realization times, assets may be classified as:

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n

Current Assets — assets that the company intends to realize within one year

n

Non-current Assets — assets the company intends to realize after one year. These are generally divided into: •

Long-term Receivables — receivables the company intends to realize after one year of balance sheet date.

•

Fixed Assets — assets acquired with the intention of keeping them on a permanent basis.

•

Investments — stock in other enterprises which the company intends to keep on a more or less permanent basis.

•

Deferred Assets — assets that will be amortized on a long-term basis.

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Of course, not all assets of the same group will be realized on the same date, which means that asset realizations may create an uneven inflow of funds.

Current Assets To be labeled as current, an asset must meet two conditions: 1. The company must intend to realize it within one year. 2. The company must be able to realize it within one year. Example: intend to realize

For example, a company may own shares in another company that can be sold immediately in the stock exchange. However, if the company intends to keep the shares for more than one year because the investment is considered profitable, then the shares cannot be labeled as current assets.

Example: be able to realize

Conversely, a company may own non-transferable bonds that mature after one year. The bonds can never be considered current because of the inability to realize within one year. Current assets include:

Accounts

Cash — Cash on hand plus demand bank deposits and items which will be converted into cash within approximately 48 hours (such as undeposited checks). Amounts in foreign currencies must be translated into local currency at the exchange rates prevailing at balance sheet date.

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Marketable Securities (or Cash Investments) — Liquid securities in which the company invests excess cash to earn interest. Often the securities are long-term government or private fixed-income securities. They are classified as current assets because the company does not intend to keep them until final maturity and they can be disposed of without any financial penalty. Receivables — Amounts due from clients for goods or services bought from the company (trade receivables). The total amount of trade receivables must be adjusted by an allowance for doubtful debtors to cover possible shortfalls on uncollectible accounts. In most cases, this allowance is set at the maximum allowed by income tax regulations. Companies expecting higher losses should increase the allowance so that net accounts receivable actually reflects the amount the company will collect. Receivables includes any amounts owed by related parties (companies in the same group, including shareholders, officers, or employees), which must be listed separately. The analyst should reclassify as longterm those accounts which probably will not be repaid within one year. Inventories — Raw materials, work in progress, and finished goods. This account is peculiar because market values of inventories may actually be lower than historical costs, as in the case of commodities whose prices may fluctuate widely. Prepaid Expenses — Amounts paid in advance for goods or services, such as insurance premiums and rent. Once the goods or services are used, the related amounts must be expensed (transferred from assets to an expense account). Other Current Assets — Any other assets that will be consumed or liquidated within one year. These usually include several rather insignificant accounts.

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Non-Current Assets Fixed Assets — Formally known to accountants as Property, Plant, and Equipment ( PPE), or Premises and Equipment, include all items used by the company to produce goods or render services, such as office and plant buildings, machinery, and furniture. Intended use matters more than type of asset. For instance, a car rental company owns cars as fixed assets, but a car dealer owns them as inventories. Fixed assets must be shown net of accumulated depreciation. Depreciation

Depreciation is an accounting procedure that allows the cost of a fixed asset to be charged to income earned during all the years the asset is expected to remain in use. For example, if an asset that has been purchased for $10,000 is expected to remain in use for 10 years, its book value is reduced by $1,000 a year. After that period, the asset will be fully depreciated and assigned a nominal value, such as $1, until it is sold or otherwise disposed of. The useful life of an asset is determined based on rules laid down by the accounting profession and/or income tax regulations. Usually, depreciation is applied by the straight-line method, which means that the asset is depreciated at the same rate during its entire life. Depreciation applies to all fixed assets except land. It has nothing to do with devaluation. Even a fully depreciated asset may be quite valuable at going market prices. Old machines, for instance, may by refurbished or sold as scrap for a lot more than their nominal book values. Accumulated Depreciation — An account that reflects the total depreciation deducted from the company's fixed assets since the assets were put into operation. This usually involves several years worth of annual depreciation. You will learn more about depreciation when we discuss the income statement.

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B-11

Other Non-current Assets — include the following sub-accounts: Sub-accounts

Long-term Receivables — Generally result from special operations, such as intercompany loans or loans to shareholders, officers, and employees which will not be collected within twelve months. The account seldom includes trade receivables and is usually only important for financial institutions that make longterm loans. This account may also include deposits at government banks in connection with imports and/or foreign loan operations. Although those deposits usually earn interest, they may tie up a large amount of cash and be a considerable hindrance to business in certain countries. Investments — Securities the company does not intend to dispose of. They usually comprise shares in associated and controlled companies. Investments may be valued in two different ways: n

At the lower of cost or market

n

At equity

The rule of “lower of cost or market” has already been explained and generally applies to lesser investments. More important investments are shown at equity, a method that better reflects their value because it is based on the owners' share in the net worth of the company in which the investment is maintained, in accordance with the investee company's own financial statements. Intangibles — Assets such as goodwill, patents, copyrights, and special licensing agreements. Special rules must be followed for valuation of these accounts.

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B-12


Deferred Charges — Items, such as preoperating expenses or research and development that will result in benefits to the company over a number of years. They are similar in nature to prepaid expenses, but are always non-current. Amortization

Amortization, an accounting procedure similar to depreciation, allows the cost of a fixed deferred charge to be allocated to income earned during all the years the asset is expected to remain in use. For example, if a company spends $10,000 in research for a product expected to be produced for ten years, it shows the expense as a deferred charge. Every year, the company will transfer $1,000 from the asset account to an expense account, until the asset is fully amortized and eliminated from the balance sheet.

SUMMARY The function of accounting is to systematically and consistently record all financial activities. These activities are summarized in the balance sheet and income statement. Inflation has a substantial effect on the financial position of a company. You, as an analyst, must be aware of these effects to obtain the appropriate conclusions. The balance sheet is a standard statement that presents the financial position of a company at a given time. It shows that total assets equal liabilities plus owners' equity. On the balance sheet, assets are accounts representing: n

Property owned by the company

n

Claims against third parties

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B-13

Asset accounts are classified on the balance sheet according to the time it takes to realize them and the time when the company intends to realize them. They are classified as either: n

Current assets

n

Non-current assets

Non-current assets are subdivided into: n

Fixed assets

n

Other assets

The asset accounts are: n

n

n

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Current assets •

Cash

•

Cash investments

•

Trade receivables

•

Inventories

•

Prepaid expenses

•

Other current assets

Fixed assets •

Property, plant, and equipment

•

Accumulated depreciation

Other non-current assets •

Long-term receivables

•

Investments

•

Intangibles

•

Deferred charges

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You have just completed the first section of this supplemental section. Please complete the following Progress Check before continuing to the next section, "Liabilities and Net Worth."

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B-15

PROGRESS CHECK B.1


Question 1: The process of systematically and consistently recording all financial activities is called: ____ a) record keeping. ____ b) bookkeeping. ____ c) financial analysis. ____ d) accounting. Question 2: What are the two most common statements used to determine the financial position of a company? ____ a) Balance sheet; source and applications of funds statement ____ b) Source and applications of funds statement; income statement ____ c) Income statement; trial balance ____ d) Balance sheet; income statement

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ANSWER KEY

Question 1: The process of systematically and consistently recording all financial activities is called: d) accounting.

Question 2: What are the two most common statements used to determine the financial position of a company? d) Balance sheet; income statement

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B-17

PROGRESS CHECK B.1 (Continued)

Question 3: Indicate whether the following assets are (P) property or (C) claim. The first one serves as an example. ____ P Vehicles ____ Trade receivables ____ Unfinished products ____ Advances to suppliers ____ Dividends receivable from affiliates ____ Land ____ Stock in other companies ____ Plant machinery ____ Inter-company receivables ____ Raw materials ____ Office building ____ Marketable securities

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ANSWER KEY

Question 3: Indicate whether the following assets are (P) property or (C) claim. The first one serves as an example. P

Vehicles

C

Trade receivables

P

Unfinished products

C

Advances to suppliers

C

Dividends receivable from affiliates

P

Land

P

Stock in other companies

P

Plant machinery

C

Inter-company receivables

P

Raw materials

P

Office building

C

Marketable securities

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Question 4: Match each of the following assets to its definition. ____ Marketable Securities ____ Trade Receivables ____ Prepaid Expenses ____ PPE ____ Investments ____ Deferred Charges ____ Inventory

a) Amounts due from buyers for sales made by the company on a credit basis b) Fixed assets that are depreciated on the balance sheet c) Capital costs that have not yet been expensed d) Liquid short-term investments of cash for the purpose of earning income in the form of interest or appreciation e) Purchased goods intended for processing and/or resale within one year from balance sheet date f) Amounts paid out in advance for goods or services g) Assets such as stock in subsidiaries or non-related companies, real estate not used for normal business operations, and other permanent or non-current holdings

Question 5: Inventories of raw materials used in manufacturing products are classified as current assets if they are intended for: ____ a) purchase within one year. ____ b) purchase after one year. ____ c) sale within one year. ____ d) sale after one year.

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ANSWER KEY

Question 4: Match each of the following assets to its definition. d

Marketable Securities

a

Trade Receivables

f

Prepaid Expenses

b

PPE

g

Investments

c

Deferred Charges

e

Inventory

a) Amounts due from buyers for sales made by the company on a credit basis b) Fixed assets that are depreciated on the balance sheet c) Capital costs that have not yet been expensed d) Liquid short-term investments of cash for the purpose of earning income in the form of interest or appreciation e) Purchased goods intended for processing and/or resale within one year from balance sheet date f) Amounts paid out in advance for goods or services g) Assets such as stock in subsidiaries or non-related companies, real estate not used for normal business operations, and other permanent or non-current holdings

Question 5: Inventories of raw materials used in manufacturing products are classified as current assets if they are intended for: c) sale within one year.

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B-21


Question 6: A marketable security is classified as an "other non-current asset" when it: ____ a) matures five days after balance sheet date. ____ b) matures within one year of balance sheet date and is readily marketable. ____ c) is intended to be converted to cash within one year. ____ d) matures one year or more after balance sheet date and is intended to be converted to cash at maturity.

Question 7: Real estate used in the business of an enterprise is classified as a fixed asset when: ____ a) the company intends to sell it more than one year from balance sheet date. ____ b) the company does not intend to sell it. ____ c) the company intends to sell it within one year of balance sheet date. ____ d) no buyer can be found.

Question 8: The charge for allocating the cost of a fixed asset over its estimated service life is called: ____ a) appreciation. ____ b) devaluation. ____ c) depreciation. ____ d) cost of doing business.

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ANSWER KEY

Question 6: A marketable security is classified as an "other non-current asset" when it: d) matures one year or more after balance sheet date and is intended to be converted to cash at maturity.

Question 7: Real estate used in the business of an enterprise is classified as a fixed asset when: b) the company does not intend to sell it.

Question 8: The charge for allocating the cost of a fixed asset over its estimated service life is called: c) depreciation.

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Question 9: Find four current assets in the list below and mark them with the letter "C." ____ Sales taxes due in 30 days ____ Demand bank deposits ____ Trade receivables due in 60 days ____ Bank loans repayable in four semi-annual installments ____ Raw materials inventories to be used next week ____ Real estate leased to third parties ____ Marketable security maturing in 120 days ____ Production machinery

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ANSWER KEY

Question 9: Find four current assets in the list below and mark them with the letter "C." Sales taxes due in 30 days C

Demand bank deposits

C

Trade receivables due in 60 days Bank loans repayable in four semi-annual installments

C

Raw materials inventories to be used next week Real estate leased to third parties

C

Marketable security maturing in 120 days Production machinery

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Question 10: Fill in the missing values using the assets section of CPT's balance sheet below. CPT, INC. — DECEMBER 31, 19X1 AND 19X2 ASSETS CURRENT ASSETS Cash Marketable Securities Trade Receivables, Net Inventory Prepaid Expenses Other Current Assets

19X1

19X2

1,122 1,820 12,204 17,037 1,603 756

1,861 1,200 14,859 20,018 1,922 560

34,542

40,420

22,533 5,821

23,305 7,915

16,712

15,390

Other Assets Inter-company Receivables Investments Intangibles Deferred Charges Other Accounts Receivable

422 1,716 744 301 269

387 1,858 1,018 360 359

Total Other Assets

3,452

3,982

54,706

59,792

Total Current Assets NON-CURRENT ASSETS Property, Plant, and Equipment Less: Accumulated Depreciation PPE, Net

TOTAL ASSETS

A) The balance sheet shows total assets of $ in 19X1 and $ in 19X2. This total is the sum of current, other, and fixed assets. B) Current assets totaled $ in 19X2. This represents the sum of cash, marketable securities, trade receivables, (net of the allowance for uncollectibles), inventories, prepaid expenses, and other current assets. C) Non-current assets totaled $ in 19X2. This represents the sum of property, plant, and equipment (PPE), investments, intangibles, and other noncurrent assets.

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ANSWER KEY

Question 10: Fill in the missing values using the assets section of CPT's balance sheet below. CPT, INC. — DECEMBER 31, 19X1 AND 19X2 ASSETS CURRENT ASSETS Cash Marketable Securities Trade Receivables, Net Inventory Prepaid Expenses Other Current Assets

19X1

19X2

1,122 1,820 12,204 17,037 1,603 756

1,861 1,200 14,859 20,018 1,922 560

34,542

40,420

22,533 5,821

23,305 7,915

16,712

15,390

Other Assets Inter-company Receivables Investments Intangibles Deferred Charges Other Accounts Receivable

422 1,716 744 301 269

387 1,858 1,018 360 359

Total Other Assets

3,452

3,982

54,706

59,792

Total Current Assets NON-CURRENT ASSETS Property, Plant, and Equipment Less: Accumulated Depreciation PPE, Net

TOTAL ASSETS

A) The balance sheet shows total assets of $54,706 in 19X1 and $ 59,792 in 19X2. This total is the sum of current, other, and fixed assets. B) Current assets totaled $40,420 in 19X2. This represents the sum of cash, marketable securities, trade receivables, (net of the allowance for uncollectibles), inventories, prepaid expenses, and other current assets. C) Non-current assets totaled $19,372 in 19X2. This represents the sum of property, plant, and equipment (PPE), investments, intangibles, and other non-current assets.

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Question 11: Classify the following assets as either (C) current, (F) fixed, or (O) other. The first one serves as an example. 19X1

19X2

400

768

80

64

_____ Inter-company loans

240

0

_____ Deferred charges

200

252

_____ Office building

600

900

_____ Legal deposits

160

256

_____ Cash

40

64

_____ Advances to suppliers

80

192

_____ Marketable securities

200

576

_____ Investment in affiliates

200

320

_____ Trade receivables

880

1,472

_____ Accumulated depreciation

(600)

(1,024)

_____ Property and plant

1,600

2,820

320

384

1,200

2,176

F _____ Transportation equipment _____ Prepaid expenses

_____ Inventories _____ Machinery and other equipment

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B-28


ANSWER KEY

Question 11: Classify the following assets as either (C) current, (F) fixed, or (O) other. The first one serves as an example. 19X1

19X2

400

768

80

64

F

Transportation equipment

C

Prepaid expenses

O

Inter-company loans

240

0

O

Deferred charges

200

252

F

Office building

600

900

O

Legal deposits

160

256

C

Cash

40

64

C

Advances to suppliers

80

192

C

Marketable securities

200

576

O

Investment in affiliates

200

320

C

Trade receivables

880

1,472

F

Accumulated depreciation

(600)

(1,024)

F

Property and plant

1,600

2,820

C

Inventories

320

384

F

Machinery and other equipment

1,200

2,176

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B-29


Question 12: Based on your answers to Question 11, prepare a list of assets for this company. (Hint: Use the balance sheet model on page B-25 for this exercise.) ASSETS

19X1

19X2

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

Total Current Assets

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

PPE, Net

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

Total Other Assets

_________

________

CURRENT ASSETS

NON-CURRENT ASSETS Fixed Assets

Other Assets

TOTAL ASSETS

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B-30


ANSWER KEY

Question 12: Based on your answers to Question 11, prepare a list of assets for this company. (Hint: Use the balance sheet model on page B-25 for this exercise.) CPT, INC. — DECEMBER 31, 19X1 AND 19X2 ASSETS

19X1

19X2

CURRENT ASSETS Cash Marketables Securities Trade Receivables, Net Inventory Prepaid Expenses Other Current Assets

40 200 880 320 80 80

64 576 1,472 384 192 64

1,600

2,752

1,600 1,200 400 600 (600)

2,820 2,176 768 900 (1,024)

3,200

5,640

Inter-Company Loans Legal Deposits Deferred Charges Investment in Affiliates

240 160 200 200

0 256 252 320

Total Other Assets

800

828

5,600

9,220

Total Current Assets NON-CURRENT ASSETS Fixed Assets Property and Plant Machinery and Other Equipment Transportation Equipment Office Buildings Accumulated Depreciation PPE, Net Other Assets

TOTAL ASSETS

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B-31

LIABILITIES AND NET WORTH Liabilities

Liabilities are the claims of others against the company for resources supplied to the company. An increase in liabilities reflects an increase in the resources available to the company and also the need to dispose of assets to settle the liabilities. Since most of those resources are in the form of money or of goods and services, liabilities basically fall into two categories:

Net worth

n

Claims for money lent, such as bank loans

n

Claims for credit sales, that is, for goods and services supplied to the company for later payment

Net worth reflects the wealth invested by shareholders and accumulated by the company from earnings.

Liabilities Liabilities are usually classified in the balance sheet in the order of their realization. Liability maturity

The maturity of a liability is the date on which it must be settled. If you buy something for cash, the liability matures at the time of purchase and does not appear on the balance sheet. On the other hand, if the asset is bought on credit, the liability is reflected in the balance sheet in the order of its maturity. Not all liabilities mature on the same date. Therefore, liability maturities can create an uneven outflow of funds.

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B-32

Liability classifications


Based on maturity dates, liabilities are classified in two groups: n

Current liabilities

n

Long-term liabilities

Current Liabilities Mature within one year

Current liabilities are obligations maturing within one year from balance sheet date. Current liabilities include: Due to Banks — All interest-paying, short-term bank debts Accounts Payable — All amounts owed to creditors. Since they usually refer to credit purchases, sometimes they are known as Trade Payables. Non-trade payables should be excluded for analysis purposes. Customer Advances — Amounts received from customers as deposits or down payments on the purchase of goods or services Accruals — Short-term items covering obligations such as payroll and social security taxes, utilities, sales taxes, etc. This account reflects costs already charged to income, but not paid. Taxes Payable — Income tax due, but not yet paid Current Portion of Long-term Debt — Installment payments on long-term loans falling due within one year Other Current Liabilities — Liabilities maturing within one year which do not fit into any of the above categories

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Long-Term Liabilities Mature in more than one year

Long-term liabilities are obligations maturing more than one year after balance sheet date. Long-term liabilities include: Long-term Debt — Installment payments on long-term loans that are due after one year Deferred Liabilities — Long-term accruals. Examples include income tax on profits earned in one year, but payable in later years because of favored tax treatment, or a company's obligations for workers' pensions. Other Long-term Liabilities — Liabilities maturing after one year which do not fit into any of the above categories

Net Worth (Shareholders' or Stockholders' Equity) Although this group of accounts is shown on the liability side, it reflects amounts which the company does not have to pay. It reflects resources invested by the owners or accumulated by the company through earnings. Net worth accounts

Capital Stock —Amount invested in the company by the owners, based on share par values, not market or liquidation value. Sometimes we should add to this the amount of paid-in surplus, which reflects the excess of the amount actually paid for the shares over the face value of those securities. Reserves — Portions of earnings not available for dividend payments, either because of legal restrictions, in which case they are called legal reserves, or as a result of managerial decisions, in which case they are called free reserves. The term may cause confusion because it may mislead the reader into thinking there actually is a pool of cash available to the company which is not always true.

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B-34


Retained Earnings or Earned Surplus — Past and current earnings which have not been capitalized or paid out as dividends. Part of the amount may be capitalized and the remainder paid out in the form of dividends. Again, this does not mean that cash is available for this or any other use. Not all companies have profits and, thus, "Accumulated Losses" may replace "Retained Earnings" on the balance sheet.

RELATED FINANCIAL STATEMENT CONCEPTS

Off-Balance-Sheet Assets / Liabilities Assets used but not owned

Off-Balance-Sheet Items are assets used, but not owned, by the company, and their related liabilities. This usually includes leased property on the asset side and the related leasing payments on the liability side. Companies enter into leasing agreements because they may be advantageous for tax purposes. Since tax regulations vary from country to country, so do the relative advantages of leasing / owning.

Contingencies May be assets or liabilities in the future

Contingencies are items which may become assets or liabilities depending on some future event. For instance, if Company A sues Company B for breach of contract claiming an indemnity of US$ 1 million, there are two possibilities: n

The court decides for Company B, and no indemnity is paid

n

The court decides for Company A, and the indemnity must be paid

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B-35

So, whether Company A has an asset (and Company B a liability) corresponding to indemnity or not depends on a court decision. Until the decision is made by the court, the US$ 1 million appears as a contingent asset in the books of Company A and as a contingent liability in the books of Company B.

Consolidated Financial Statements Companies in a group shown as a single entity

Consolidated Financial Statements are statements that show all companies belonging to the same group as if they were a single company. They are not additions of the figures shown for individual companies, because all intercompany operations are eliminated. This means that if Company X and Company Z belong to the same group, all sales made by Company Z to Company X are eliminated from the consolidated statements. This is required to prevent double counting of sales and expenses and of balance sheet accounts such as accounts receivable and accounts payable.

SUMMARY Liability accounts represent debts and obligations that a company incurs to acquire resources for its business. Liabilities are classified in two groups: n

Current liabilities

n

Long-term liabilities

The liability accounts are: n

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Current liabilities •

Due to banks or notes payable to banks

•

Accounts payable (trade payables)

•

Customer advances

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n

•

Accruals (accrued items)

•

Taxes payable

•

Current portion of long-term debt

•

Other current liabilities

Long-term liabilities •

Long-term debt

•

Deferred liabilities

•

Other long-term liabilities

Net Worth accounts reflect the invested and accumulated wealth of the stockholders in the enterprise. Net Worth or Owners' Equity Accounts are: n

Capital stock

n

Reserves

n

Retained earnings (earned surplus)

Analysts need to know how these accounts contribute to the financial picture of a company. In addition, they need to be aware of offbalance-sheet assets, contingencies, and the need for consolidated financial statements. You have now completed the section on "Liabilities and Net Worth." Please complete the following Progress Check before continuing to the section entitled "Income Statement."

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B-37

PROGRESS CHECK B.2


Question 13: Liability accounts represent unpaid and company incurs to acquire resources for its business. ____ a) debt / expenses ____ b) obligations / revenues ____ c) debt / obligations ____ d) expenses / revenues

Question 14: Resources available to the company are increased by: ____ a) capital investments in the company. ____ b) repayment of the company's borrowings. ____ c) selling inventory on a credit basis. ____ d) shareholders' dividends.

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that the

B-38


ANSWER KEY

Question 13: Liability accounts represent unpaid and company incurs to acquire resources for its business.

that the

c) debt / obligations

Question 14: Resources available to the company are increased by: a) capital investments in the company.

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B-39


Question 15: Match each of the following liability accounts with its definition. ____ Due Banks ____ Accounts Payable

a) Short-term items covering company obligations, such as payroll and social security taxes due

____ Customer Advances

b) Stated amount invested in the enterprise by the owners

____ Accruals

c) Interest paying short-term debts

____ Taxes Payable

d) Amounts received for production of goods or provision of services not yet made

____ Capital Stock ____ Retained Earnings ____ Additional Paid-in Capital

e) Amounts owed to trade suppliers for the purchase of inventories, raw materials, etc. f) Income taxes due, but not yet paid g) Difference between issue value and par value of a common stock h) Cumulative past earnings held within the firm but not yet capitalized

Question 16: Customer advances are classified as current liabilities when they mature: ____ a) after one year of balance sheet date. ____ b) within one year of balance sheet date. ____ c) after two years of balance sheet date. ____ d) between one and two years.

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B-40


ANSWER KEY

Question 15: Match each of the following liability accounts with its definition. c

Due Banks

a) Short-term items covering company obligations, such as payroll and social security taxes due

e

Accounts Payable

d

Customer Advances

b) Stated amount invested in the enterprise by the owners

a

Accruals

c) Interest paying short-term debts

f

Taxes Payable

b

Capital Stock

d) Amounts received for production of goods or provision of services not yet made

h

Retained Earnings

g

Additional Paid-in Capital

e) Amounts owed to trade suppliers for the purchase of inventories, raw materials, etc. f) Income taxes due, but not yet paid g) Difference between issue value and par value of a common stock h) Cumulative past earnings held within the firm but not yet capitalized

Question 16: Customer advances are classified as current liabilities when they mature: b) within one year of balance sheet date.

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B-41


Question 17: A loan repayable in twelve semi-annual installments is a loan. Since the first two installments mature within one year, they should be classified as . ____ a) short-term / current ____ b) long-term / current ____ c) short-term / long ____ d) long-term / long

Question 18: A loan maturing in five years is classified as long-term debt. After the fourth year, it will be: ____ a) forgiven. ____ b) paid off. ____ c) included within current liabilities. ____ d) reclassified as shareholders' equity (net worth).

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ANSWER KEY

Question 17: A loan repayable in twelve semi-annual installments is a loan. Since the first two installments mature within one year, they should be classified as . b) long-term / current

Question 18: A loan maturing in five years is classified as long-term debt. After the fourth year, it will be: c) included within current liabilities.

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B-43


Question 19: Using the liability section of the balance sheet below, fill in the missing values. LIABILITIES & NET WORTH

19X1

19X2

Due to Banks Trade Payables Customer Advances Accruals Taxes Payable Other Current Liabilities Current Portion of Long-term Debt

12,522 7,341 1,421 990 456 558 1,845

31,916 13,020 2,388 1,546 1,172 378 2,110


25,133

52,530

8,845 1,863

7,355 2,289

10,708

9,644

35,841

62,174

10,000 1,667 7,198

10,000 2,046 11,172

TOTAL NET WORTH

18,865

23,218


54,706

85,392

CURRENT LIABILITIES

LONG-TERM LIABILITIES Long-term Debt Long-term Deferred Liabilities Total Long-term Liabilities TOTAL LIABILITIES NET WORTH Capital Stock Capital Reserves Retained Earnings

A) Liabilities and Net Worth in 19X1 were $

and $

, respectively.

B) Current Liabilities totaled $ in 19X2. This represents the sum of Due to Banks, Trade Payables, Customer Advances, Accruals, Taxes Payable, Other Current Liabilities, and the Current Portion of Long-term Debt. C) Long-term Liabilities totaled $ in 19X1. This represents the sum of Longterm Debt and Long-term Deferred Liabilities. D) Stockholder's Equity (Net Worth) totaled $ in 19X2. This represents the sum of Capital Stock, Capital Reserves, and Retained Earnings. E) Liabilities and Net Worth combined totaled $

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in 19X2.

B-44


ANSWER KEY

Question 19: Using the liability section of the balance sheet below, fill in the missing values. A) Liabilities and Net Worth in 19X1 were $35,841 and $18,865 , respectively. B) Current Liabilities totaled $52,530 in 19X2. This represents the sum of Due to Banks, Trade Payables, Customer Advances, Accruals, Taxes Payable, Other Current Liabilities, and the Current Portion of Long-term Debt. C) Long-term Liabilities totaled $10,708 in 19X1. This represents the sum of Longterm Debt and Long-term Deferred Liabilities. D) Stockholder's Equity (Net Worth) totaled $23,218 in 19X2. This represents the sum of Capital Stock, Capital Reserves, and Retained Earnings. E) Liabilities and Net Worth combined totaled $85,392 in 19X2.

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B-45


Question 20: Classify the following liability accounts as either (C) Current, (L) Longterm, or (S) Shareholders' Equity (Net Worth). 19X1

19X2

0

176

____ Capital stock

800

1,260

____ Dividends payable

200

201

____ Fixed asset loan maturing in 3 years

400

512

____ Due to suppliers

480

640

____ Capital reserves

600

1,300

____ Payroll accruals

120

247

____ Income taxes due

240

408

____ Shareholders' loans without agreed maturity

400

168

____ Utility bills

120

72

____ Retained earnings

400

960

____ Other accruals

240

456

____ Bank loans maturing within 60 days

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B-46


ANSWER KEY

Question 20: Classify the following liability accounts as either (C) Current, (L) Longterm, or (S) Shareholders' Equity (Net Worth). 19X1

19X2

0

176

C

Bank loans maturing within 60 days

S

Capital stock

800

1,260

C

Dividends payable

200

201

L

Fixed asset loan maturing in 3 years

400

512

C

Due to suppliers

480

640

S

Capital reserves

600

1,300

C

Payroll accruals

120

247

C

Income taxes due

240

408

L

Shareholders' loans without agreed maturity

400

168

C

Utility bills

120

72

S

Retained earnings

400

960

C

Other accruals

240

456

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B-47


Question 21: Based on your answers to Question 20, prepare a list of Liabilities and Net Worth accounts for this company. (Hint: Follow the balance sheet model from Question 19.) LIABILITIES & NET WORTH

19X1

19X2

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________


_________

________

_____________________________________

_________

________

_____________________________________

_________

________


_________

________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_____________________________________

_________

________

_________

________

CURRENT LIABILITIES

LONG-TERM LIABILITIES

TOTAL LIABILITIES NET WORTH

TOTAL NET WORTH TOTAL LIABILITIES & NET WORTH

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B-48


ANSWER KEY

Question 21: Based on your answers to Question 20, prepare a list of Liabilities and Net Worth accounts for this company. (Hint: Follow the balance sheet model from Question 19.) LIABILITIES & NET WORTH

19X1

19X2

CURRENT LIABILITIES Bank Loans Maturing Within 60 Days Due to Suppliers Payroll Accruals Utility Bills Other Accruals Income Tax Due Dividends Payable

--480 120 120 240 240 200

176 640 247 72 456 408 201

1,400

2,200

Fixed Asset Loan Maturing in Three Years Shareholders’ Loans Without Agreed Maturity

400 400

512 168


800

680

2,200

2,880

800 600 400

1,2600 1,300 960

TOTAL NET WORTH

1,800

3,520


4,000

6,400

Total Current Liabilities LONG-TERM LIABILITIES

TOTAL LIABILITIES NET WORTH Capital Stock Capital Reserves Retained Earnings

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B-49

INCOME STATEMENT The income statement shows the results of the operations of a company by deducting expenses from matching income for a given period. It is sometimes called a profit and loss statement. The structure of the income statement reflects the following equation: Net Income = Revenues – Expenses

Positive / Negative Results When expenses are lower than income, results are positive and the company is said to have a profit. If income is lower than expenses, results are negative and the company is said to have a loss. Below is a sample income statement for CPT, Inc. CPT, INC. Income Statement Years ended December 31, 19X1 and 19X2 19X1

19X2

Net Sales – Cost of Goods Sold

66,540 43,715

85,362 60,077

Gross Profit – Selling, General Admin. Expenses

22,825 10,424

25,285 12,780

Operating Profit

12,401

12,505

1,988 4,255 -405

2,094 5,694 -904

5,753

3,813

1,640 0

1,088 1,440

4,113

4,165

– Depreciation – Financial Expense + Other Income, Net Earnings Before Taxes – Income Tax + Extraordinary Items Net Income

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Income Statement Structure The income statement is usually prepared in a single column. The top line shows net sales. In the following lines, other revenues are added and expenses subtracted, until a net income figure is reached. The net income figure is commonly referred to as the bottom line. In some income statements, the last line shows earnings per share, which is determined by dividing net income by the number of stock shares outstanding. The general structure is: Net Sales (Net of Any Returns, Discounts, or Sales Taxes) Minus: Cost of Goods Sold (CGS) =

Gross Profit Minus: Operating Expenses • Selling • General • Administrative

=

Operating Profit Minus: Depreciation Minus: Financial Expense (Net of Financial Income) Plus: Other Income (Net of Other Expense)

=

Pretax Income Minus: Income Tax Plus / Minus: Extraordinary Items

=

Net Income (After-tax Income)

This general structure is universal, although sometimes the gross margin may be computed after deduction of selling, general, and administrative expenses. The nomenclature, above, may vary as well, e.g. cost of goods sold ( CGS ) is sometimes called cost of sales. However, the basic concepts remain the same. Revenues are listed first and totaled to determine net sales; then expenses are deducted to determine net income or loss. Let's take a closer look.

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B-51

Income Statement Accounts Net Sales — Sales revenues net of returns, discounts, and sales taxes. Most companies sell on credit, and accrual basis accounting principles require them to recognize the sale when it is made, not when the cash is received. As a consequence, in those cases, net sales always reflect uncollected (unrealized) sales in the same amount as shown in accounts receivable. Cost of Goods Sold or Cost of Sales — For a service company, this basically includes labor; for a commercial company, it also includes the cost of goods bought for resale (plus insurance and freight); for an industrial company, it also includes materials and processing costs. Selling, General, and Administrative Expenses — Expenditures related to selling, marketing, and administrative activities. They include salaries of sales personnel, advertising, telephone, etc. Depreciation — We have already discussed depreciation as it relates to fixed assets. We should stress that since depreciation is a non-cash charge, it does not involve an actual outflow of funds. However, since it is reflected in pretax income, it does affect the income tax bill. In certain cases, accelerated depreciation is allowed. This means that the asset will be (a) depreciated over a term shorter than its useful life, or (b) depreciated at higher rates in the early years of its life and lower rates in the later years. Since depreciation reduces pretax income, higher initial depreciation means lower income tax during the first years an asset is used. Of course, this is compensated by higher income tax during later years. As a consequence, the real advantage to the company is that income tax payments are partially deferred. Accelerated depreciation is one of the factors that affect deferred liabilities.

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B-52


Financial Expense (Interest Expense) — Interest and commissions on loans and credit purchases. This account is generally shown net of financial income, such as interest earned on cash investments and credit sales. However, if financial income is material, it should be shown separately. Other Income — Items that cannot be classified within any of the above accounts. The amount is usually low and shown net of other expense. Income Tax — Amount of income tax owed by the company on its profits for the period Extraordinary Items — Items, such as property sales, segregated to show that they are not recurrent Net Income — Amount left after all expenses are deducted from revenues. This amount, less dividends paid, will be reflected in the net worth section of the balance sheet as a change in retained earnings.

Accounting Principles Financial statement preparation follows several accounting principles to achieve precision and clarity. The concepts have special relevance to the income statement. These principles include: • Cost principle • Realization principle • Matching principle

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B-53

Cost Principle All items recorded at original cost

The cost principle states that all items will be recorded at original cost (the amount paid for them). This principle ensures that all companies will be using cost value, not market value, when presenting their statements. This may sound strange at first, because market value is very important when determining the value of a business. However, there is no objective way for all companies to calculate the current market value of their properties. The valuation depends on which appraisal method is used. To eliminate subjectivity and ensure comparability for all financial statements, the accounting profession has established cost instead of market value as the standard to follow. Market value information, along with an explanation of the methodology used, may also be presented with a financial statement. In this way, the investor will have the information needed to make a wise investment decision. The cost principle implicitly recognizes another fundamental accounting assumption: accounts are prepared on the basis that the company is a going concern. As such, current market value is less relevant since the company has no interest in liquidating its assets. Having said this, however, the accounting profession does recognize that if the difference in the value of fixed assets valued at cost is too far removed from reality because of accumulated inflation, then a revaluation of these fixed assets may be done. The revaluation process must follow strict accounting rules which compensate for accumulated depreciation in addition to inflation. In this way, the value of fixed assets on the balance sheet may be updated on an infrequent basis.

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B-54


Realization Principle Recognize revenue when earned and expenses when incurred

The realization principle states that revenues should be recorded when earned, and expenses recorded when incurred; assets should be recorded when owned, and liabilities should be recorded when owed. With this principle, we recognize revenue as we earn it, even though we might not have received any payment. At the same time, we must recognize expenses as we incur them, even though we might not have made any payment. This method provides a more realistic picture of the business since it shows everything owned and owed. The realization principle helps prevent the intentional delay of payments and acceleration of receipts for the purpose of manipulating financial results. The quick reader will also realize another effect of the realization principle. Net income does not equal cash. A company may have a good net income on paper, but very little money in the bank. For example, the cash from sales has not yet been received since sales were made granting generous credit terms. In an opposite situation, a company may have little or no profit because it is liquidating inventory at cost or near cost, yet the company has a strong cash position as a result of this liquidation. Matching Principle

Revenues recognized in same period as expenses

The matching principle states that expenses incurred in generating a given income must be recognized (recorded) in the same accounting period as the revenue. When a revenue is earned, there are always certain expenses associated with it. We must record those expenses at the same time the revenue is recognized. That is, we “match” the revenues with the corresponding expenses. Again, this principle is intended to prevent possible manipulation of results.

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B-55

SUMMARY The income statement (or profit and loss statement) can be summarized by this equation: Net Income = Revenue – Expenses

Simply put: n

If income exceeds expenses, a profit results.

n

If expenses exceed income, a loss results.

The income statement structure begins with net sales and other revenues listed first. Expenses are then deducted to determine net income or loss. Financial statement preparation follows several accounting principles that have special relevance to the income statement. These principles include: • Cost principle • Realization principle • Matching principle

You have now completed the final section of Appendix B. Please complete the following Progress Check to make sure you understand the concepts presented in this section.

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B-56



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þ

B-57

PROGRESS CHECK B.3


Question 22: Indicate whether the following accounts are (I) income or (E) expense. ____ Payroll ____ Product sales ____ Cost of goods sold ____ Sales commissions ____ Building depreciation ____ Utilities ____ Investment profits ____ Cost of services ____ Selling of goods ____ Dividends received ____ Provision for income tax ____ Cost of maintenance

Question 23: Costs and expenses are deducted from revenues in the income statement to determine results. Positive results are called ; negative results are called .

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B-58


ANSWER KEY

Question 22: Indicate whether the following accounts are (I) income or (E) expense. E

Payroll

I

Product sales

E

Cost of goods sold

E

Sales commissions

E

Building depreciation

E

Utilities

I

Investment profits

E

Cost of services

I

Selling of goods

I

Dividends received

E

Provision for income tax

E

Cost of maintenance

Question 23: Costs and expenses are deducted from revenues in the income statement to determine results. Positive results are called profits ; negative results are called losses .

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B-59


Question 24: Gross sales on the income statement include: ____ a) cash sales only. ____ b) cash and credit sales. ____ c) credit sales only. ____ d) collected sales only.

Question 25: Sales affect certain balance sheet accounts. Cash sales increase the cash account. Credit sales increase: ____ a) marketable securities. ____ b) inventory. ____ c) trade receivables. ____ d) deferred credits.

Question 26: The income statement normally shows revenues, expenditures, and costs: ____ a) before receipt or payment. ____ b) only after they have been received or paid. ____ c) whether or not they have been received or paid. ____ d) upon receipt or payment.

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B-60


ANSWER KEY

Question 24: Gross sales on the income statement include: b) cash and credit sales.

Question 25: Sales affect certain balance sheet accounts. Cash sales increase the cash account. Credit sales increase: c) trade receivables.

Question 26: The income statement normally shows revenues, expenditures, and costs: c) whether or not they have been received or paid.

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B-61


Question 27: Match each of the following revenue and expense accounts to its definition. ____ Cost of Goods Sold

a) Sum of revenues minus expenses

____ Selling, General, and Adm.

b) Non-recurring gains or losses that result from activities that are not part of the normal operations of the business

____ Depreciation ____ Financial Expense ____ Extraordinary Gains / Losses ____ Net Income

c) Interest expense on interest-paying debt d) Non-cash charge that reduces the book value of the plant or equipment every year e) Expenses incurred such as management salaries, cost of advertising, telephones, etc. f) Cost of raw materials, labor, and overhead expenses attributed to the processing of goods

Question 28: Mark the following statements (T) true or (F) false. ____ a) The income statement only shows all income and expense received and paid during the period. ____ b) Cost of Goods Sold includes expenditures such as direct labor expenses, raw materials, and interest. ____ c) Certain asset and liability accounts are related to the income statement. For instance, credit sales are related to trade receivables; financial expense is related to bank loans. ____ d) Selling, General, and Administrative expenses represent expenditures such as advertising, sales commissions, and telephone. ____ e) Extraordinary gains result from normal business operations.

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B-62


ANSWER KEY

Question 27: Match each of the following revenue and expense accounts to its definition. f

Cost of Goods Sold

a) Sum of revenues minus expenses

e

Selling, General, and Adm.

d

Depreciation

b) Non-recurring gains or losses that result from activities that are not part of the normal operations of the business

c

Financial Expense

b

Extraordinary Gains / Losses

a

Net Income

c) Interest expense on interest-paying debt d) Non-cash charge that reduces the book value of the plant or equipment every year e) Expenses incurred such as management salaries, cost of advertising, telephones, etc. f) Cost of raw materials, labor, and overhead expenses attributed to the processing of goods

Question 28: Mark the following statements (T) true or (F) false. F

a) The income statement only shows all income and expense received and paid during the period.

F

b) Cost of Goods Sold includes expenditures such as direct labor expenses, raw materials, and interest.

T

c) Certain asset and liability accounts are related to the income statement. For instance, credit sales are related to trade receivables; financial expense is related to bank loans.

T

d) Selling, General, and Administrative expenses represent expenditures such as advertising, sales commissions, and telephone.

F

e) Extraordinary gains result from normal business operations.

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B-63


Question 29: Refer to the Income Statement for CPT, Inc. below and complete the following questions: A) Net Sales totaled $

in 19X1 and $

in 19X2.

B) Gross profit is the difference between: ____ a) Net Sales and Cost of Goods Sold. ____ b) Net Sales and Selling, General, and Administration Expense. ____ c) Operating Profit and Financial Expense. C) Net Income amounted to $ in 19X1 and to $ the net result of Revenues less Expenses.

in 19X2. This is

Sample Income Statement CPT, INC. Income Statement Years ended December 31, 19X1 and 19X2 19X1

19X2


66,540 43,715

85,362 60,077

Gross Profit – Selling, General, Admin. Expenses

22,825 10,424

25,285 12,780

Operating Profit

12,401

12,505

1,988 4,255 -405

2,094 5,694 -904

5,753

3,813

1,640 0

1,088 1,440

4,113

4,165

– Depreciation – Financial Expense + Other Income, Net Earnings Before Taxes – Income Tax + Extraordinary Items Net Income

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B-64


ANSWER KEY

Question 29: Refer to the Income Statement for CPT, Inc. below and complete the following questions: A) Net Sales totaled $66,540 in 19X1 and $85,362 in 19X2. B) Gross profit is the difference between: a) Net Sales and Cost of Goods Sold. C) Net Income amounted to $4,113 in 19X1 and to $85,362 in 19X2. This is the net result of Revenues less Expenses.

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B-65


Question 30: Fill in the blanks and compute net income or loss.

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$ 1,300 550


$

Operating Profit – Depreciation – Financial Expense – Other Income, Net

$

Earnings Before Taxes – Provision for Income Tax

$

Net Income

$

250 100 200 – 50 45

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B-66


ANSWER KEY

Question 30: Fill in the blanks and compute net income or loss. Net Sales – Cost of Goods Sold

$ 1,300 550


$

Operating Profit – Depreciation – Financial Expense – Other Income, Net

$

500 100 200 – 50

Earnings Before Taxes – Provision for Income Tax

$

150 45

Net Income

$

105

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750 250

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B-67


Question 31: Prepare an income statement based on the structure shown in Question 30. Use the data listed below: 19X1 Administrative Expense Net Sales Selling Expense Extraordinary Gain General Expense Cost of Goods Sold Net Income Income Tax Depreciation Net Financial Expense Other Income

120 3,000 290 180 55 1,400 678 207 100 350 20

19X2 276 5,100 514 0 74 2,700 784 321 105 357 31

19X1

19X2

_________

________

_______________________________

_________

________

Gross Profit _______________________________

_________ _________

________ ________

Operating Profit _______________________________

_________

________

_______________________________

_________

________

_______________________________

_________

________

Earnings Before Income Tax _______________________________

_________

________

_______________________________

_________

________

_________

________

Net Sales

Net Income

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B-68


ANSWER KEY

Question 31: Prepare an income statement based on the structure shown in Question 30. Use the data listed below: 19X1 Administrative Expense Net Sales Selling Expense Extraordinary Gain General Expense Cost of Goods Sold Net Income Income Tax Depreciation Net Financial Expense Other Income

120 3,000 290 180 55 1,400 678 207 100 350 20

19X2 276 5,100 514 0 74 2,700 784 321 105 357 31

19X1

19X2


3,000 1,400

5,100 2,700


1,600 465

2,400 864

Operating Profit – Depreciation – Net Financial Expense – Other Income, Net

1,135 100 350 20

1,536 105 357 31

Earnings Before Income Tax – Income Tax + Extraordinary Gain

705 207 180

1,105 321 0

678

784

Net Income

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B-69


Question 32: Match the accounting principle with its purpose. ____ Cost principle

a) Prevents the delay of payments and acceleration of receipts to enhance financial statements

____ Realization principle

b) Assures a true picture of a company’s revenues

____ Matching principle

c) Avoids an incorrect valuation of assets

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ANSWER KEY

Question 32: Match the accounting principle with its purpose. c

Cost principle

a) Prevents the delay of payments and acceleration of receipts to enhance financial statements

a

Realization principle

b) Assures a true picture of a company’s revenues

b

Matching principle

c) Avoids an incorrect valuation of assets

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APPENDIX C

GLOSSARY Accounting

System for recording and reporting transactions

Accounts Payable

Amounts owed by a company

Accounts Receivable

Amounts owed to a company

Acid Test

(Quick Asset Ratio) The sum of cash plus near current marketable securities plus receivables divided by current liabilities; liquidity ratio

Asset

Property of a company or a claim against third parties

Asset Turnover Ratio

Ratio obtained by dividing net sales by average total assets; it is an indicator of operating efficiency

Balance Sheet

Statement that provides a financial picture of a company at a given time and summarizes the fundamental accounting equation of assets = liabilities + owners' equity

Capital Stock

Balance sheet account showing the amount that shareholders contributed in exchange for stock

Collection Period

(Days Receivable) Operating ratio expressing in days the average time taken to turn over trade receivables from the balance sheet within the annual credit sales

Common Stock

Shares that confer voting rights to owners but not preferential treatment with regard to dividends

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GLOSSARY

Consolidated Financial Statement

Statement that aggregates data for several companies with significant inter-company ownership that are members of the same business group

Contingency

Potential asset or liability that depends on future events to become actual

Current Assets

Assets that are to be realized or consumed within one year

Current Indebtedness Ratio

Indebtedness ratio obtained by dividing current liabilities by net worth (owners' equity)

Current Liabilities

Liabilities to be paid within one year

Current Ratio

Liquidity ratio obtained by dividing current assets by current liabilities

Days Inventory

(Inventory Period) Operating ratio obtained by dividing inventory turnover by 360; expresses in days the average time taken to turn over inventory from the balance sheet within the annual cost of goods sold

Days Receivable

See "Collection Period"

Deferred Charges

Expenditures carried forward to be recognized as costs in future years

Depreciation

Non-cash charge on the income statement that reflects a cost allocation (made during the useful life of the asset) for plant and equipment expenditures

Earned Surplus

(Retained Earnings) Net income accumulated over time less all dividends paid to stockholders; owners' equity account

Financial Credits

Interest-bearing obligations that originate from a need for additional funds for operations

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GLOSSARY

C-3

Financial Ratio

Index or percentage that is derived from dividing one balance sheet or income statement account by another balance sheet or income statement account

Financial Statement

Summary of accounting records that consists primarily of the balance sheet and income statement

Fixed Asset

Asset which a company does not intend to realize — property, plant, and equipment

Fixed Assets to Net Worth Ratio

Ratio obtained by dividing fixed assets by net worth; measures the amount of fixed assets covered by own resources

Funds

All measurable assets that are available to the company for use in its operation

Horizontal Analysis

Technique used to track individual account growth rates from one period to another

Income Statement

Summary of a company's revenues and expenses for a given period

Indebtedness Ratio

(Leverage) Result of dividing liabilities by net worth to measure the relationship between outside capital and owners' equity; also may be called capital structure ratio or solvency ratio

Indexation

Technique used in an inflationary economy to reduce the effect of price differences between time of occurrence and time of recording

Intangibles

Assets that constitute nonphysical property, such as copyrights, patents, licensing rights, and preoperating expenses

Inventory

Goods purchased or manufactured by a company and kept for sale or use as inputs to its products — a current asset account

Inventory Period

See "Days Inventory"

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GLOSSARY

Inventory Turnover

Operating ratio obtained by dividing cost of goods sold for a period by the average inventory for the same period; expresses in times per year the average time taken to consume inventory

Invested Capital

Amount of resources invested and paid in by the shareholders in the company

Investments

Long-term assets not used in operations, such as shares in other companies

Legal Deposits

Deposit of funds in a bank or government agency to cover the cost of certain business transactions

Leverage

See "Indebtedness Ratio"

Liability

Claims against a company

Liquidity

Ability of an asset to be readily realized

Liquidity Ratio

Financial index that measures the ability of the enterprise to meet its short-term financial obligations in a timely manner without realizing fixed assets; indicates the relationship between current assets and current liabilities

Loans to Affiliates

(Inter-company Receivables) Loans made to affiliated companies; usually classified as non-current assets because they are usually disguised forms of long-term funding

Long-term Indebtedness Ratio

Ratio obtained by dividing long-term liabilities by net worth

Long-term Receivables

Obligations due from customers or others that mature after one year

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GLOSSARY

C-5

Margin Analysis

Technique for income statement analysis that breaks down individual revenue and expense accounts into percentages of net sales

Marketable Security

Money market securities held as very short term investments for the purpose of investing excess funds to maximize return on assets

Monetary Correction

Accounting techniques utilized in high inflationary environments to reflect the changes in the purchasing power of a currency

Monetary Items

Assets and liabilities realizable or payable in currency that can generate gains or losses resulting from inflation or foreign exchange transactions

Net Worth

(Owners' Equity, Shareholders' Equity) Balance sheet account that reflects the invested wealth and accumulated earnings; includes paid-in capital, retained earnings, and reserves

Non-current Assets

Fixed assets, long-term assets, and deferred charges

Non-current Liabilities

Debts and obligations that mature more than one year from the balance sheet date

Off-balancesheet Assets

Assets, such as leased property, that are used by a company but not shown on the balance sheet

Off-balancesheet Liabilities

Debts, such as those incurred in connection with leasing agreements, that are not shown on the balance sheet

Operating Credits

Liabilities originating in trade operations

Operating Ratio

Type of ratio that measures the efficiency and effectiveness of a company's utilization of its assets

Owners' Equity

See "Net Worth"

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GLOSSARY

Paid-in Capital

(Permanent Capital) Amount paid by investors in exchange for a company's stock; an owners' equity account

Paid-in Surplus

Excess of the actual amount of capital paid to the company by shareholders over the par value of purchased shares — an owners' equity account

Payables Turnover Ratio

Operating ratio indicating the number of times payables are rotated during the period within a firm's annual purchases or cost of goods sold; obtained by dividing total purchases by trade payables

Permanent Capital

See "Paid-in Capital"

PPE

Abbreviation for property, plant, and equipment

Preferred Stock

Shares that grant owners priority on receiving dividends but generally do not grant voting rights — an owners' equity account

Prepaid Expenses

Amounts paid in advance that are carried forward to be recognized as costs during the year after balance sheet date

Profit on Sales

(Return on Sales) Profitability ratio, expressed in percentage terms, obtained by dividing the annual profit (net income) by the net sales

Profitability Ratio

Any of the ratios used to measure the ability of a company to generate profits

Quick Asset Ratio

See "Acid Test"

Realizing

Converting an asset into cash

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GLOSSARY

C-7

Receivables Turnover Ratio

Operating ratio expressing in times per year the average time taken to collect receivables from the balance sheet within the annual net credit sales; obtained by dividing credit sales by trade receivables

Reserves

Portions of retained earnings set aside voluntarily or in compliance with legal requirements

Retained Earnings

See "Earned Surplus"

Return on Assets

Profitability ratio, expressed in percentage terms, obtained by dividing the annual profit (net income) by average total assets

Return on Capital

(Return on Equity) Profitability ratio, expressed in percentage terms, obtained by dividing the annual profit (net income) by average net worth

Return on Equity

See "Return on Capital"

Return on Sales

See "Profit on Sales"

Revaluation

Updating of asset values based on appraisal reports

Shareholders' Equity

See "Net Worth"

Tangible Net Worth

Net worth less intangible assets

Third Party Capital

Total owed to suppliers and financial institutions

Total Indebtedness Ratio

Ratio obtained by dividing total liabilities by owners' equity (net worth)

Trade Receivables

Accounts receivable from customers

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C-8

GLOSSARY

Vertical Analysis

Technique that breaks down individual assets, liabilities, equities, and expense accounts into percentages for comparison purposes; analysis of the financial statements of a single company or across several companies for a particular period

Working Capital

Excess of current assets over current liabilities

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Index

INDEX A Accounting

1-1—1-6, 1-9, 1-10, 1-12, 1-16, 1-17, 1-25, 1-27, 1-28, 1-32, 1-35, 2-1, 2-3, 2-31, 3-9, 5-10, 6-13, 8-19, 8-42, 8-43, B-1— B-3, B-6, B-10, B-12, B-51—B-55,

Accounts Payable

1-6, 1-26, 1-28, 2-28, 2-44, 6-23, 6-26, 8-12, B-32, B-35,

Accounts Receivable

1-26, 1-28, 1-31, 4-5, 6-3, 6-6, 8-12, 8-45, B-5, B-6, B-9, B-35, B-51, C-28, C-44

Acid Test

4-1, 4-3, 4-6—4-8, 7-21

Asset

1-4, 1-7, 1-9, 1-10, 1-12—1-17, 1-25, 1-26, 1-28—1-32, 1-35, 21—2-7, 2-10, 2-11, 2-26—2-30, 2-33, 3-2, 3-10, 3-11, 3-25, 326, 3-28, 4-1, 4-3, 4-17—4-19, 5-1—5-10, 5-12, 5-13, 5-15, 6-1, 6-33, 6-34, 7-3, 7-4, 7-11—7-14, 8-12, 8-41, 8-42, B-5—B-13, B-31, B-34, B-35, B-51, B-53, B-54,

Asset Turnover Ratio

1-11, 1-16, 4-3, 4-5, 4-8, 6-1, 6-2, 6-33, 6-34,

B Balance Sheet

1-5—1-8, 1-10—1-16, 1-25, 1-26, 1-29, 1-31—1-33, 1-35, 2-3, 2-10, 2-26—2-29, 2-32, 4-4, 4-7, 4-8, 4-17, 5-3, 5-4, 56, 5-9, 5-10, 5-14,6-2, 6-5—6-7, 6-13, 6-15, 6-16, 6-26, 634, 7-5, 7-11, 8-2—8-4, 8-12, 8-40—8-43, 8-45, 8-47, B-1, B-2, B-4—B-8, B-12, B-13, B-31—B-35, B-52, B-53,

C Capital Stock

1-6, 8-5, B-5, B-33, B-36

Collection Period

6-5, 6-6

Common Stock

8-12

Consolidated Financial Statement

1-11, 5-9, B-35, B-36

Contingency

B-34, B-36

Current Assets

1-6, 1-8, 2-3—2-7, 2-10, 2-28, 3-24, 3-25, 3-28, 4-1, 4-3—4-8, 4-17—4-19, 5-12, 5-13, 6-1, 6-2, 6-13, 7-21, 8-12, 8-44

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v-2.0

I-2

INDEX

C (Continued) Current Indebtedness Ratio

5-11, 5-12, 5-15

Current Liabilities

1-6, 1-8, 2-3—2-5, 2-7, 2-10, 2-11, 2-28, 3-11, 4-1, 4-3—47, 4-17—4-19, 5-6, 5-11—5-13, 5-15, 7-21, 8-12, 8-44,

Current Ratio

2-4, 4-1, 4-3—4-8, 4-17—4-19, 6-1,

D Days Inventory

4-8, 6-1, 6-2, 6-7, 6-13—6-18, 6-28, 7-21

Days Receivable

4-8, 6-1, 6-2, 6-4—6-7, 6-16, 6-26, 6-28, 7-21

Deferred Charges

3-10,B-5, B-12, B-13

Depreciation

1-6, 2-30, 2-31, 2-44, 3-12, 5-14, 8-12, 8-41, 8-44, 8-45, B-5, B-10, B-12, B-13, B-49—B-51, B-53,

E Earned Surplus

B-34, B-36

F Financial Credits

2-8, 2-9, 2-11

Financial Ratio

1-34,3-9, 3-28, 4-1—4-3, 4-19, 5-1, 5-16, 6-1, 6-34, 7-1, 711, 7-15, 7-21, 8-2, 8-3, 8-9, 8-39, 8-78

Financial Statement

1-4, 1-5, 1-9—1-11, 1-17, 1-25, 1-26, 1-28, 1-29—1-32, 1-35, 1-36, 2-1, 2-33, 3-1—3-4, 3-9, 3-19, 3-28, 4-1, 6-3, 8-1—8-3, 8-9—8-12, 8-39, 8-44, 8-46, B-1-—B-4, B-7, B-11, B-34— B-36, B-52, B-53, B-55

Fixed Asset

1-6, 1-10, 1-12, 1-13, 1-16, 1-28, 1-30, 1-33, 2-3, 2-6, 2-7, 230, 2-33, 3-25, 4-17—4-19, 5-1, 5-3—5-8, 5-12, 5-13, 5-15, 5-16, 6-34, 7-13, 7-14, 8-1, 8-3, 8-12, 8-40—8-42, B-7, B-10, B-13, B-51,B-53

Fixed Assets to Net Worth Ratio

5-1, 5-13, 5-14, 5-16, 5-17

Funds

1-10, 1-11, 1-26, 1-33, 2-1, 2-4, 2-6, 2-7, 2-11, 2-26—2-33, 3-9, 3-11, 3-13, 4-6, 5-13, 5-14, 5-16, 6-1, 6-27, 8-1—8-3, 8-43, B-7, B-8, B-31, B-51,

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INDEX

I-3

H Horizontal Analysis

3-1, 3-9, 3-13, 3-25—3-28

I Income Statement

1-5, 1-6, 1-8, 1-26, 1-27, 1-29, 1-31, 1-33, 1-35, 2-9, 2-29, 230, 2-32, 2-33, 3-1, 3-10, 3-12, 3-13, 3-28, 4-8, 6-2, 6-3, 613, 6-16, 6-25, 8-2, 8-3, 8-5, 8-13, 8-40, 8-41, 8-45, 8-48, B1, B-2, B-4, B-10, B-12, B-36, B-49—52, B-55

Indebtedness Ratio

5-1, 5-2, 5-7, 5-11, 5-12, 7-21

Indexation

1-9, 1-28, 3-2, 3-9

Intangibles

1-4, 1-9, 1-13—1-15, 1-17, 1-25, 2-30, 5-6, 5-7, B-5, B-11, B-13

Inventory

1-6, 1-11, 1-12, 2-10, 2-30, 2-31, 2-44, 3-4, 3-10, 4-4, 4-5, 47, 4-8 6-1, 6-2, 6-13—6-18, 6-28, 7-11, 8-3, 8-10, 8-12, 8-44, B-5, B-54

Inventory Turnover

2-10, 6-1, 6-2, 6-7, 6-13—6-15, 6-17, 6-18, 8-45, 8-46

Investments

1-6, 1-28, 2-6, 2-29, 5-13, 7-1, 7-4, 7-5, B-5, B-7, B-9, B-11, B-13, B-52, B-53

L Leverage

1-13, 2-9, 4-2, 4-19, 5-1—5-13, 5-15—5-17, 6-34, 7-11—7-15

Liability

1-9, 1-12, 1-13, 1-15, 2-5, 2-9, 2-27, 3-11, 5-8—5-10, 7-21, 8-12, B-5. B-6, B-12, B-14, B-31—B36, B-51, B-54

Liquidity

2-1—2-3, 2-10, 3-28, 4-2—4-8, 4-17—4-19, 5-5, 5-7, 5-12, 515, 6-1, 7-14, 7-21

Liquidity Ratio

4-1—4-3, 4-6—4-8, 4-17, 4-19, 5-1, 6-1

Long-term Indebtedness Ratio

5-1, 5-11—5-13, 5-15

Long-term Receivables

B-7, B-11, B-13

M Margin Analysis

3-12

Marketable Security

1-6, B-9

Monetary Correction

1-1, 1-4, 1-29, 1-31, 1-32, 3-2, 8-2, 8-42, 8-43

Monetary Items

1-28—1-31

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I-4

INDEX

N Net Worth

1-8, 1-13, 1-14, 1-33, 2-1, 2-6, 2-7, 2-9, 2-26—2-28, 3-11, 4-17—4-19, 5-1—5-13, 5-15, 5-16, 7-4, 7-5, 7-9, 7-10, 7-12, 713, 8-1, 8-3, 8-40—8-43, B-5, B-6, B-11, B-14, B-31, B-33, B36, B-52

Non-current Assets

1-8, 2-6, 3-10, 8-12, B-5, B-7, B-10, B-11, B-13

Non-current Liabilities

1-8

O Off-balance-sheet Assets

B-34, B-36

Off-balance-sheet Liabilities

B-34

Operating Credits

2-8, 2-11

Operating Ratio

7-21

Owners' Equity

8-12, B-6, B-12, B-36

P Paid-in Capital

2-8, 2-11

Paid-in Surplus

B-33

Payables Turnover Ratio

6-1, 6-2, 6-18, 6-23, 6-28

Permanent Capital

2-6, 2-11, 5-12

PPE

3-10, B-5, B-10

Prepaid Expenses

1-6, 4-6, 8-12, B-5, B-9, B-10, B-12, B-13

Profit on Sales

7-2

Profitability Ratio

4-3, 7-1, 7-2, 7-11, 7-13

Q Quick Asset Ratio

4-1, 4-3, 4-4—4-8

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INDEX

I-5

R Realizing

B-7

Receivables Turnover Ratio

6-1—6-3, 6-6, 6-7, 6-13

Reserves

B-5, B-33, B-36

Retained Earnings

1-6, 1-8, 1-30, 2-8, 2-11, 2-23, 3-11, 8-12, B-5, B-34, B-36, B-52

Return on Assets

7-1, 7-3, 7-4, 7-11—7-13, 7-15

Return on Capital

7-4, 7-6

Return on Equity

5-4, 5-5, 7-1, 7-4, 7-5, 7-12—7-15

Return on Sales

7-1, 7-2, 7-11—7-15

Revaluation

1-12, 1-13, 5-7, 5-8, 8-41, 8-42, B-53

S Shareholders' Equity

2-6, 2-11, B-6, B-33

T Tangible Net Worth

1-13, 1-14, 5-6—5-8, 7-21

Third Party Capital

2-7—2-11, 2-25, 5-10

Total Indebtedness Ratio

5-1, 5-2, 5-7, 5-11, 5-15, 7-21

Trade Receivables

3-10, 4-4—4-7, 6-1—6-4, 6-6, 6-7, 7-21, 8-11, B-5, B-9, B11, B-13

V Vertical Analysis

3-1, 3-9—3-13, 3-25, 8-9

W Working Capital

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2-1, 2-3—2-7, 2-10, 2-11, 2-33, 4-5, 4-8, 5-12, 5-13, 5-15, 5-16, 6-16, 6-27, 6-28, 8-10, 8-46

v-2.0

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