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1

Financial Accounting V.G. Narayanan and Dennis Campbell, Co-Series Editors

+ INTERACTIVE ILLUSTRATIONS

Analyzing Financial Statements

V.G. NARAYANAN HARVARD BUSINESS SCHOOL

SURAJ SRINIVASAN HARVARD BUSINESS SCHOOL

5056 | Published: April 11, 2017

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 2

Table of Contents

1 Introduction ………………………………………………………………………………………………………………………………………………. 3 2 The Financial Analysis Framework …………………………………………………………………………………………….. 4

2.1 Understanding Return on Equity ………………………………………………………………………………………… 6 2.2 Profitability ……………………………………………………………………………………………………………………………………….. 8 2.3 Operating Efficiency ………………………………………………………………………………………………………………… 11

2.3.1 Return on Assets ……………………………………………………………………………………………………………. 12 2.3.2 Digging Deeper into Asset Turnover ……………………………………………………………….. 13 2.3.3 Inventory Turnover ………………………………………………………………………………………………………. 14 2.3.4 Accounts Receivable Turnover ……………………………………………………………………………. 16 2.3.5 Accounts Payable Turnover …………………………………………………………………………………… 18 2.3.6 Cash Conversion Cycle ……………………………………………………………………………………………… 20 2.3.7 Working Capital Turnover ………………………………………………………………………………………. 22

2.4 Financial Leverage …………………………………………………………………………………………………………………….. 23 2.4.1 Interest Coverage Ratio ……………………………………………………………………………………………. 27 2.4.2 Liquidity Ratios ………………………………………………………………………………………………………………. 28

3 Summary …………………………………………………………………………………………………………………………………………………… 30 4 Supplemental Reading …………………………………………………………………………………………………………………….. 32

4.1 Key Ratios ……………………………………………………………………………………………………………………………………….. 32 5 Key Terms ………………………………………………………………………………………………………………………………………………… 34 6 Endnotes …………………………………………………………………………………………………………………………………………………… 36 7 Index ……………………………………………………………………………………………………………………………………………………………. 37

This reading contains links to online interactive illustrations, denoted by the icon above. To access these exercises, you will need a broadband Internet connection. Verify that your browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/tech-specs.

V.G. Narayanan, Thomas D. Casserly, Jr. Professor of Business Administration, Harvard Business School, and Suraj Srinivasan, Philip J. Stomberg Professor of Business Administration, Harvard Business School, developed this Core Reading with the assistance of writer M. Penelope K. Rossano.

Copyright © 2017 Harvard Business School Publishing Corporation. All rights reserved.

For the exclusive use of L. Williams, 2022.

This document is authorized for use only by LaQuanda Williams in Copy of Accounting for Business Decisions-1 taught by Barbara Adams, South Carolina State University from Aug 2022 to Feb 2023.

5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 3

1 INTRODUCTION

he ability to analyze financial statements is essential for anyone trying to

understand a business and assess its performance. Managers can use

insights derived from financial analysis to inform their strategic decisions, and

outside stakeholders, such as debt and equity investors, can use the information

to evaluate a company’s performance. For example, managers might want to

assess an acquisition’s performance implications, a bank or supplier would need

to assess a client’s creditworthiness before granting a loan or extending credit,

and customers would like to understand a potential supplier’s long-term viability

before entering into a contract. In this reading, we will introduce financial

analysis tools that can be used to gain insights about a company’s business

model and financial performance. We will primarily use a ratio analysis method

called the DuPont framework. In this framework, one ratio tells us how efficiently

a company is utilizing its assets, while another ratio compares the company’s

cash to its upcoming liabilities to see if it will likely be able to pay its creditors.

Taken together, these ratios can be used to understand and assess the

company’s financial and operational performance.

Ratio analysis is useful in making comparisons across companies or in evaluating a company’s performance over time. In the former case, financial analysis can be used to assess the performance of managers across similar companies. In the latter case, time-series analysis allows us to assess how well managers are executing the desired strategy over time.

Throughout this reading, we will use the publicly available financial statements of several retail companies to provide examples of various types of ratio analyses and comparisons. They are Industria de Diseño Textil, S.A (Inditex Group), a Spanish fast-fashion retailer; Prada S.p.A. (Prada), a luxury retail brand with Italian roots and headquarters in Hong Kong; and three US-headquartered brands: The Gap, Inc.; Nordstrom, Inc.; and Urban Outfitters, Inc.

T

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 4

In 2015, Inditex was operating worldwide with over 6,600 stores1 of fast-fashion brand chains such as Zara, Pull & Bear, Stradivarius, and Massimo Dutti. It was known in the retail world for being innovative in managing its supply chain and for going very quickly from design to garment in about six weeks.

Founded in 1913 in Milan, by 2015 Prada was a luxury brand that produced and sold high-quality leather goods, clothing, footwear, and accessories including eyewear and fragrance for both men and women. It was operating internationally in more than 70 countries at more than 600 directly operated stores at prestigious locations.2 Prada executives carefully monitored both the creative and production processes to guarantee excellent quality and exclusivity in its products. The company’s business strategy combined its in-house design skill and industrial know-how to create inventive, high-quality, trend-setting products.3

The Gap, Inc., was a global retailer offering apparel, accessories, and personal products for men, women, and children under Gap, Banana Republic, Old Navy, Athleta, and Intermix brands. In 2015, the company operated more than 3,700 company-owned and franchise locations. Its brand appeal was targeted at younger customers.

In 2015, Urban Outfitters, Inc., operated under the Urban Outfitters, Anthro- pologie, Free People, Terrain, and BHLDN brands.4 The company targeted a broad range of culturally sophisticated customers: young adults aged 18–28 at Urban Outfitter stores, women aged 28–45 at Anthropologie, and young, contemporary women aged 25–30 at private label Free People.5

Nordstrom, Inc., founded in 1901 as a shoe store in Seattle, was committed to providing superior customer service and delivering the best possible shopping experience. In 2015, it was a leading fashion specialty retailer with an established e-commerce business. The company strived to maintain its reputation for its high level of integrity, excellent customer service, and quality merchandise by offering an extensive selection of high-quality, brand-name, private-label merchandise.6

2 THE FINANCIAL ANALYSIS FRAMEWORK

Financial statement information comes from the three key statements: the income statement, the balance sheet, and the statement of cash flows. The income statement documents the company’s financial activity over a given accounting period, say, a year. The balance sheet, on the other hand, reflects the company’s financial position, assets, liabilities, and shareholder equity as of a particular date, say, the end of the financial year. Like the income statement, the statement of cash flows also presents

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 5

the firm’s cash flows over a given period, such as a year. In calculating ratios, it is common to average the beginning and ending balance sheet amounts to measure the average level of assets used during the period. We use this convention because income statement items (e.g., revenues) are measured over the course of the year, so we assume that the average balance sheet values have been used throughout the year to generate a given level of revenues. However, some financial statement users may use beginning-of-the-year amounts if appropriate, such as when the ratios will be used for forecasting. Throughout this reading, we will use the average balance sheet amounts when comparing income statement and balance sheets in any ratio. Certain ratios may also be computed for shorter periods, such as quarters or months. For example, to plan inventory levels, it is important to understand seasonal cycles, so inventory ratios are often computed on a quarterly or monthly basis.

When conducting financial analysis, key questions an analyst typically asks relate to the company’s performance. For example, how well has the company executed its strategy? How well has it performed against its competitors? Does the performance arise from superior operating capability or because of its financing mix? We will begin our financial analysis of the company using two key metrics of performance: return on equity (ROE) and return on assets (ROA). Both of these metrics allow an analyst to assess how well a company has generated profits from the resources deployed.

ROE measures overall business performance, specifically management’s ability to generate profits for its shareholders. It is calculated by dividing net income by total shareholders’ equity (SE).

ROA, also referred to as “return on investment,” is an indicator of the company’s profitability relative to its assets or total capital employed in the firm (recall that assets = liabilities + equity); it indicates how efficiently management uses the company’s assets to generate earnings. ROA is calculated by dividing a company’s earnings by its total assets.

As we will see later, breaking down each of these ratios into its underlying components allows us to assess different aspects of a company’s performance relative to comparable companies as well as to the firm’s past results.

The DuPont framework, commonly used for financial analysis, originated at the DuPont Corporation in the 1920s. It decomposes ROE into subcomponents to provide a deeper look at how the profit (or loss) was generated. Systematic analysis of the ratios that make up the DuPont framework provide additional information about how a company manages its business. Similar to peeling an onion, conducting financial statement analysis that examines the most general ratios, then drills down to its more granular components facilitates the analyst’s understanding of the determinants of performance. For example, an analyst may ask whether a company’s

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 6

performance is primarily driven by profit margins (how much profit the company generates for its shareholders), asset turnover (how efficiently the company uses its assets to generate return), or financial leverage (the level of debt the company carries).

2.1 Understanding Return on Equity

Let’s start with the return on equity, which can be broken into three components:

• Profitability

• Operating efficiency

• Financial leverage

These values are derived by decomposing ROE into three parts:

ROE = net profit margin asset turnover financial leverage× ×

That is,

net income sales total assetsROE = sales total assets equity

× ×

Which simplifies to,

net incomeROE = sales

sales × total assets

total assets × equity

net income= equity

Interactive Illustration 1 demonstrates in a graphical format how the three components of ROE link together. Change the numerical values of net income, sales, assets, and equity, and observe their effects on the ROE “block,” as well as on the simplified income statement and balance sheet.

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 7

INTERACTIVE ILLUSTRATION 1 DuPont Framework

Managers can use the financial analysis framework to evaluate the sources of favorable or unfavorable performance in each of these three areas, which helps them take actions to increase the company’s overall ROE. In this reading, to demonstrate how each of the underlying factors contributes to a company’s ROE, we will calculate each ratio for Prada and then provide the ratios for the other companies described in the introduction. Prada’s financial statement numbers are given in Exhibit 1. All financial numbers are in millions of euros.

Note that we average the beginning and ending balances of shareholders’ equity for the period in which net income is earned for our analysis. To illustrate, we will plug in the values from Exhibit 1, as follows:

( )

( )

Prada's average shareholders' equity (SE) in 2015 beginning SE + ending SE

= 2

2,688 3,001 2

€ €

€2,845

+ =

=

451ROE for Prada in 2015 = 15.8% 2,84€ 5 € =

Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHtruh

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 8

Similarly, we calculate ROE for the other retailers for fiscal year 2015 as follows:

FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters

ROE 41.8% 25.4% 31.9% 15.8% 15.4%

Note that the ROEs for Prada and Urban Outfitters differ by less than half a percentage point. Gap is highly profitable, with ROE of 41.8%. Further analysis of the drivers of ROE will inform us about how these companies manage their business.

2.2 Profitability

The first component of the ROE decomposition is profitability, the profit margin that the company achieves from each dollar of sales after all expenses have been accounted for:

net incomeNet profit margin = sales

Using the values from Exhibit 1, we find:

Net profit margin for Prada €451 €3,

in 2015 552

= 12.7%=

Similarly, we calculate the net profit margin for the other retailers for fiscal year 2015 as follows:

FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters

Net Profit Margin 7.7% 13.8% 5.3% 12.7% 7.0%

The net profit margin for Urban Outfitters, 7%, and Prada, almost 13%, indicates that Prada would earn about twice Urban Outfitters’ profit for every dollar of sales after accounting for all costs. This margin structure fits their business models. Prada is a luxury brand that sells high-end specialty products, while Urban Outfitters’ products appeal to more cost-conscious customers. Gap, whose net profit margin of 7.7% is similar to that of Urban Outfitters, also has a similar customer profile. Urban Outfitters and Gap are both low-cost providers, whereas Prada’s more differentiated model operates at the higher end of the customer spectrum. Companies with a low-

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 9

cost model tend to sell larger quantities at lower margins, while companies with a differentiated strategy tend to have higher profit margins but sell lower volumes. Recall that the ROE for both Urban Outfitters and Prada is approximately 15%. We will discuss later what may account for this similarity in ROE despite the big difference in the two companies’ net profit margin.

A big advantage of the DuPont decomposition framework is that it lets us dig deeper into the components of ROE (“peeling the onion” analogy again), in this case, net income margin. For example, some investors may be interested in the gross profit margin, which represents the amount of profit that is left to cover other expenses after only the cost of goods sold is subtracted from revenues. This means that gross profit margin measures profit before operating expenses as a percent of sales. It is calculated by dividing the net revenue minus cost of goods sold, by sales.

gross profitGross profit margin = sales

Using the data from Exhibit 1, we get the following:

Gross profit margin for Prada €2,551 €3,

in 2015 = 7 52

% 5

1.8=

Similarly, we calculate gross profit margin for the other retailers for fiscal year 2015 as follows:

FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters

Gross Profit Margin 38.3% 58.3% 36.9% 71.8% 35.4%

As discussed earlier, Prada is a luxury brand; a gross margin at 72% is consistent with the higher price of its products. Urban Outfitters, on the other hand, is targeting a customer group of younger adults, so the lower gross margin of 35% will facilitate a more affordable price to their customers.

Examining a company’s expense structure can also help you better understand its performance. One common performance metric for a retail company is how efficient its selling, general, and administrative expenses (SG&A) are. SG&A margin is defined as the amount of SG&A expenses incurred by a company for every dollar of revenues earned. SG&A expenses are one component of operating expenses.

selling, general, and administrative (SG&A) expensesSG&A margin = sales

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 10

which, using the data in Exhibit 1, gives us the following:

Prada's SG&A margin in 20 €1,716 €3,552

15 = 48.3%=

Similarly, we calculate SG&A margin for the other retailers for fiscal year 2015 as follows:

FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters

SG&A Margin 25.7% 35.6% 27.2% 48.3% 24.4%

a For simplicity, this representation limits the range of possible values. For example, COGS, and operating expenses could both be larger than revenue, leading to a net loss.

Since SG&A includes expense items such as advertising and selling expenses, it is appropriate for Prada to have a higher expense level than Urban Outfitters and Gap given Prada’s higher-end advertising and likely greater selling expenses for its luxury brand compared to the fast-fashion retailers.

Review how these common profitability measurements are derived from the income statement in Interactive Illustration 2. Select one of the four metrics at the top of the graphic, and explore how those metrics would be affected by different performance scenarios (e.g., more annual revenue, reduced costs, etc).

INTERACTIVE ILLUSTRATION 2 Profitability Ratiosa

Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHtruh

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 11

2.3 Operating Efficiency

In addition to questions about profitability, analysts also often ask how efficiently a company is using its assets. The next component of the ROE decomposition, asset turnover, helps answer this question. Asset turnover tells us the extent of sales generated by a dollar (or euro in our example) of assets. The amount of sales generated by a unit of assets depends on the strategy the company uses to generate sales or deliver a service. This efficiency measure also depends on the technology the company is using. For instance, a retailer with greater percentage of online sales— ones where fixed assets are not needed to deliver revenues—will have a greater asset turnover than a purely brick-and-mortar retailer.

salesAsset turnover = average total assets

Applying this to our Prada example gives us the following:

( )

( )

Prada's average total assets in 2015 beginning total assets + ending total ass

€3 €4

ets =

2 ,888 ,739

2 314€4,

+ =

=

Prada's asset turnover in €3,552 €4,

2015 314

= 0.8=

Similarly, we calculate asset turnover for the other retailers for fiscal year 2015 as follows:

FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters

Asset Turnover 2.1 1.2 1.5 0.8 1.6

It is worthwhile to repeat why we have used average total assets rather than the beginning or ending value of assets in the denominator. A company records its sales at every point throughout the year using assets in place. Assets in place may change during the year depending on the company’s investments. Averaging the start- and end-of-year assets provides a basis for comparison when looking at assets that support the level of sales achieved over the year.

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5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 12

Urban Outfitters’ asset turnover is twice that of Prada’s, meaning the fast-fashion retailer sells twice as much per unit of assets as the more luxury-oriented brand. This is likely because Prada has to make larger investments for a given level of sales. Prada stores need to be located in more upscale areas and have more fashionable interiors than Urban Outfitters does. The value of inventory in a Prada store is also likely to be greater than that in an Urban Outfitters store. The difference in business models is apparent in the ratios: Prada, with its higher-end luxury brands, generates greater profit per unit of revenue than Urban Outfitters, but sells lower volume for the assets in place. Recall that the net profit margin for Prada was about twice that of Urban Outfitters, meaning that Urban Outfitters makes lower profit per unit of revenue but sells twice as much as Prada does per unit of assets that it uses. These two factors net each other out when we compare the two companies’ profitability per unit of asset utilized. This brings us to our next concept, return on assets.

2.3.1 Return on Assets

Return on assets (ROA) measures profits as a proportion of total resources used or financed by the firm. It is calculated by dividing net income by average total assets. ROA is the product of the first two terms of the DuPont decomposition: net profit margin × asset turnover.

Using our example, we find the following:

Prada's ROA in 2015 €451 €4,3

= 1 4

% 1

0.4=

Similarly, we calculate ROA for the other retailers for fiscal year 2015 as follows:

FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters

ROA 16.2% 17.2% 8.1% 10.4% 11.3%

As discussed earlier, while Prada and Urban Outfitters have distinctly different net profit margins and asset turnover ratios consistent with their differing market positions and business strategies, when we consider ROA, the two effects almost cancel each other out. Note here that Nordstrom’s ROA is 8.1%, which is somewhat lower than Prada’s 10

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