What are the key areas of difference between the 3 companies’ cash flow statements?
part 1:
first, read these two cases
Cash Flow Statements and Analysis
The Statement of Income and Cash Flows (pp. 15-23)
second, answer these
What are the key areas of difference between the 3 companies’ cash flow statements?
What do you suspect may be drivers of these differences?
What elements of strategy of the business, if any, can be hypothesized based on observations?
Based on evidence, if you had to make an educated guess, are there any companies and/or sectors that come to mind that fit the cash flow profiles shared?
During the height of the COVID pandemic, which company, all things being considered, do you think would have been the most resilient and which do you think may be most vulnerable? Why?
part 2:
first, read these two case
Signet Jewelers: Assessing Customer Financing Risk
Analyzing Financial Statements
second, answer these
What are the key similarities and differences in the business models of Signet, Tiffany and Blue Nile? How are these factors reflected in their financial ratios? An Excel copy of the ratios is enclosed on Canvas in the spreadsheet “Signet Exhibits and Ratios.”
Which of the three companies is performing better? Why?
How do you assess the performance of Signet’s in-house financing program?
Do you think Signet should continue to offer an in-house financing program? What are the risks involved?
Do you agree with Cohode’s critique of Signet’s bad debt expense policy?
please each part has a different document.
Requirements: good
account arose from operating, investing, or financing activities. statement using the direct method, by identifying whether transactions that flowed through the cash cash flow 9 – 121 – 019 R EV : S EP T EM BER 1 6 , 2 020 P AUL H E AL Y Cash Flow Statements and Analysis In early April 2020, Alessandra Morales, an experienced analyst at a large U.S. brokerage firm was asked to provide an overview of cash flow statement analysis for the incoming cohort of new hires in the firm’s research department, most of whom had only limited financial background. Morales remembered that she had found it challenging to understand cash flow statements when she had joined the firm, so she decided to prepare a short summary of the statement and to provide three company examples of cash flow statements to use in the session. Constructing the Cash Flow Statement Morales recalled that one of her early questions about cash flow statements arose over differences between the direct and indirect cash flow statements. Direct Cash Flow Statement When she had first learned accounting, Morales had been shown how to prepare a To demonstrate to the new analysts how the direct cash flow statement was constructed, Morales constructed a simple example of an all-equity company that acquired inventory for cash, stored it in its warehouse, and sold it to customers for cash. At the end of a period the company paid dividends with surplus cash or issued new stock if it needed cash. As shown in the figure below, cash from operating activities (shaded in yellow) during the period was cash received from customers less cash outlays to merchandise suppliers. Cash for investing activities (shown in green) was cash outlays to acquire new warehouse assets less cash received from selling warehouse assets. And cash from financing activities (shown in grey) was cash received from new stock issues less any dividend payments. The sum of these amounts equaled the change in cash for the period (shaded in red). Each of these items could be identified by classifying entries recorded in the cash account during the period. Professor Paul Healy prepared this case. This case is not based on a single individual or company but is a composite based on the author’s general knowledge and experience. Funding for the development of this case was provided by Harvard Business School. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2020 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
121-019 Cash Flow Statements and Analysis Direct Cash Flow Statement Cash from operating activities = + Cash received from customers – Cash paid to merchandise suppliers + Cash for investing activities = – Purchase of warehouse assets + Cash from sale of warehouse assets = + Cash from financing activities = + Capital issues – Dividends = Cash More generally, cash from operating activities for the period includes any cash received from customers, less cash paid to suppliers of operational resources (e.g. the company’s workforce, merchandise suppliers, and external service providers of marketing, selling, and administrative services), as well as cash outlays for interest and taxes. Cash from investing activities were cash outlays made during the year to acquire plant, property and equipment, investments made in other companies, and cash acquisitions of other businesses, less cash received from selling these types of assets or businesses. Finally, cash from financing activities included cash paid to or received from all capital providers, such as cash outlays for dividends, stock repurchases or to repay borrowings, as well as cash received from new stock issues and new borrowing. Indirect Cash Flow Statement Morales had found the cash flow statements prepared using the direct method to be intuitive. However, she learned, accounting standards in most countries required that companies report using the indirect cash flow method. Understanding how these were prepared was more challenging. Cash from operating activities was computed indirectly (hence the name) by showing the reconciliation between the firm’s net income for the period and the cash generated from operations. To demonstrate to the new analysts how the indirect cash flow statement was constructed, Morales used the same simplified example of the all-equity company that acquired inventory for cash, stored it in its warehouse, and sold it to customers for cash. At the end of the period dividends were paid and any new capital raised. Rearranging the balance sheet equation (where assets are shaded in blue and equity in orange), the change in cash for the period can be written as the change in equity, less the changes in inventory and warehouse assets, as shown in the figure below: 2
Cash Flow Statements and Analysis 121-019 Cash = Equity = Net income – Dividends + Capital issues – Inventory – Warehouse asset = Purchases of warehouse assets – Depreciation expense – BV of warehouse assets sold The changes in equity for the period can be decomposed into net income less dividends plus new capital issues. Changes in warehouse assets for the period included new warehouse assets purchased, less depreciation expense, less the book value of warehouse assets sold. And finally, the change in inventory reflected the build-up or decrease in inventory given the company’s inventory purchases and sales for the period. By rearranging these terms, the foundation of the indirect cash flow statement can be constructed with cash from operating activities shaded yellow, cash for investing activities shaded green, the cash from financing activities shaded grey, and the bottom line change in cash shaded as red: + Cash from operating activities + Net income + Depreciation expense – Inventory + Cash for investing activities = – Purchase of warehouse assets + BV of warehouse assets sold + Cash from financing activities = + Capital issues – Dividends = Cash 3
121-019 Cash Flow Statements and Analysis One last adjustment was required to complete the indirect cash flow statement. To show the cash received from sale of warehouse assets, rather than their book value, any gains (losses) from the sale included in net income had to be subtracted from (added to) net income, and then added to (subtracted from) the book value of the sale. The final indirect cash flow statement therefore appeared as follows: Indirect Cash Flow Statement + Cash from operating activities = + Net income + Depreciation expense – Inventory -/+ Gains/losses on sale of warehouse assets + Cash for investing activities = – Purchase of warehouse assets + Cash from sale of warehouse assets = + BV of warehouse assets sold +/- Gains (losses) on sale of warehouse assets + Cash from financing activities = + Capital issues – Dividends = Cash This simple formulation demonstrates that three types of adjustments are required to reconcile net income and operating cash flows in an indirect cash flow statement: 1. Non-current accruals. These typically represent non-cash expenses, such as depreciation expense (covered in the simple example), amortization expense, any expenses paid in stock rather than cash, impairments or write-downs of assets, and any component of tax expense that was deferred. They can also include non-cash income, such as equity income from associated companies net of any cash dividends received, or changes in non-current unearned revenues. Each of these items affects the income statement, but none has any impact on the cash account. Consequently, operating cash flows under the indirect method add back depreciation expenses, amortization expenses, expenses paid in stock, asset impairment charges, the deferred component of tax expense, equity income net of dividends, and changes in non-current unearned revenues to reconcile net income and cash from operating activities. 4
Cash Flow Statements and Analysis 121-019 2. Current accruals. Current accruals are working capital adjustments. They can arise if customers pay in advance of revenues being recognized (shown by changes in deferred revenues), or if revenues recognized during the period have not yet been paid for (shown by changes in accounts receivable). They can also arise if the firm has not yet paid for expenses recorded during the period (reflected in changes in accounts payable or accrued liabilities), has prepaid for future period expenses (shown by changes in prepaid expenses), or purchased more or less inventory than it sold during the period (covered in the simple example). Changes in these working capital items are therefore adjustments to reconcile net income and cash from operations. 3. Gains and losses on sale of assets. Finally, the income statement includes any gains or losses from the sale of plant, property and equipment, investments in other companies, and other businesses. These gains and losses are eliminated from net income in the operating cash flow segment, and included in the investment activity section to show any asset sales at the cash received from these sales rather than their book values (also covered in the simple example). Analyzing the Cash Flow Statement Over the course of her career, Morales had found the cash flow statement to be a useful source of information on companies she covered. It allowed her to ask a series of questions about a company: • Did it generate positive cash from operations? Were they higher or lower than earnings, and what was the source of that difference? Was cash from operations increasing or decreasing? What was the source of the change – net income, changes in current accruals, changes in non- current accruals, or changes in gains and losses? • Was it reinvesting for the future to maintain or increase its productive assets, or was it selling assets? Was it making large cash acquisitions of new businesses or divesting businesses? • How was the business being financed? Was it through borrowing (and if so was it short-term or long-term), or through issuing new equity? How was the firm paying for distributions to shareholders, either in the form of dividends or stock repurchases? • And lastly, was the firm growing or reducing its cash balance? If increasing, did it seem to be holding more cash than it really needed? The answers to these questions painted a picture of how the company was being managed, and Morales had found that picture a useful starting point for a conversation with management about its future plans and their viability. Cash Flow Statement Examples As a basis for discussion, Morales selected three companies’ cash flow statements that she thought would provide the new recruits with opportunities for practice. Exhibit 1 shows the annual cash flow statements for the three companies, each of which faced very different opportunities and challenges. Morales was curious what the new hires would be able to learn about the companies from their cash flow statements. 5
121-019 Cash Flow Statements and Analysis Exhibit 1 Annual Cash Flow Statements COMPANY 1 CONSOLIDATED STATEMENTS OF CASH FLOWS Fiscal Fiscal Fiscal in millions 2017 2018 2019 Cash Flows from Operating Activities: Net earnings $ 2,877 $ 3,707 $ 3,747 Reconciliation of net earnings to net cash provided by operating activities: Depreciation and amortization 687 717 765 Stock-based compensation expense 91 94 84 Impairment loss – 82 – Changes in receivables, net 46 11 (57) Changes in merchandise inventories (28) (415) (198) Changes in other current assets (3) (86) (45) Changes in accounts payable and accrued expenses 117 248 23 Changes in deferred revenue 43 27 111 Changes in income taxes payable 10 (14) 15 Changes in deferred income taxes 31 9 67 Other operating activities 139 (34) 62 Net cash provided by operating activities 4,010 4,346 4,574 Cash Flows from Investing Activities: Capital expenditures (632) (814) (893) Payments for businesses acquired, net (125) (7) – Proceeds from sales of property and equipment 16 11 12 Other investing activities (2) 5 (3) Net cash used in investing activities (743) (805) (884) Cash Flows from Financing Activities: (Repayments of) proceeds from short-term debt, net 283 (73) (122) Proceeds from long-term debt, net of discounts and premiums 997 1,155 1,140 Repayments of long-term debt (181) (403) (357) Repurchases of common stock (2,667) (3,321) (2,322) Proceeds from sales of common stock 85 79 93 Cash dividends (1,404) (1,568) (1,986) Other financing activities (70) (9) (57) Net cash used in financing activities (2,957) (4,140) (3,611) Change in cash and cash equivalents 310 (599) 79 Effect of exchange rate changes on cash and cash equivalents 42 (6) 40 Cash and cash equivalents at beginning of year 846 1,198 593 Cash and cash equivalents at end of year $ 1,198 $ 593 $ 712 Fiscal 2019 and fiscal 2017 include 52 weeks. Fiscal 2018 includes 53 weeks. 6
Cash Flow Statements and Analysis 121-019 STATEMENT OF CASH FLOWS: COMPANY 2 (In millions) 2017 2018 2019 Cash flows – operating activities Net earnings (loss) ($2,950) ($7,481) ($1,637) (Earnings) loss from discontinued operations 104 454 1,778 Adjustments to reconcile net earnings (loss) to operating cash flows: Depreciation and amortization of property, plant and equipment 1,444 1,473 1,342 Amortization of intangible assets 621 721 523 Goodwill impairments 850 7,379 495 (Gains) losses on purchases and sales of business interests (341) (507) (18) Principal pension plans cost 1,229 1,409 1,293 Principal pension plans employer contributions (659) (2,094) (99) Other postretirement benefit plans (net) (296) (344) (409) Provision (benefit) for income taxes (936) 31 242 Cash recovered (paid) during the year for income taxes (641) (468) (650) Decrease (increase) in contract and other deferred assets (414) (27) 21 Decrease (increase) in current receivables (1,301) (119) (950) Decrease (increase) in inventories 108 (119) (370) Increase (decrease) in accounts payable 56 515 992 Increase (decrease) in progress collections 637 (190) 458 All other operating activities 4,436 439 463 Cash from (used for) operating activities – continuing operations 1,947 1,070 3,473 Cash from (used for) operating activities – discontinued operations 238 589 (549) Cash from (used for) operating activities 2,185 1,660 2,924 Cash flows – investing activities Additions to property, plant and equipment (2,214) (2,209) (1,938) Dispositions of property, plant and equipment 1,843 1,364 1,239 Additions to internal-use software (151) (107) (94) Net decrease (increase) in Capital financing receivables 268 599 372 Proceeds from sale of discontinued operations 488 10 1,955 Proceeds from principal business dispositions 1,069 2,808 1,561 Net cash from (payments for) principal businesses purchased (907) (0) (23) All other investing activities 1,846 3,843 489 Cash from (used for) investing activities – continuing operations 2,242 6,308 3,562 Cash from (used for) investing activities – discontinued operations (450) (215) (582) Cash from (used for) investing activities 1,793 6,093 2,980 Cash flows – financing activities Net increase (decrease) in borrowings (maturities of 90 days or less) 566 (1,448) 93 Newly issued debt (maturities longer than 90 days) 3,626 1,040 728 Repayments and other reductions (maturities longer than 90 days) (8,407) (6,773) (5,522) Net dispositions (purchases) of shares for treasury (850) (6) 10 Dividends paid to shareowners (2,883) (1,491) (216) All other financing activities (28) (437) (348) Cash from (used for) financing activities – continuing operations (7,976) (9,115) (5,255) Cash from (used for) financing activities – discontinued operations 1,814 (1,487) (123) Cash from (used for) financing activities (6,161) (10,602) (5,378) Effect of currency exchange rate changes on cash and restricted cash 297 (209) (17) Increase (decrease) in cash, cash equivalents and restricted cash (1,887) (3,059) 510 Cash, cash equivalents and restricted cash at beginning of year 16,795 14,908 11,849 Cash, cash equivalents and restricted cash at end of year 14,908 11,849 12,359 Less cash and restricted cash of discontinued operations at end of year 2,634 1,475 213 Cash and restricted cash of continuing operations at end of year $12,274 $10,375 $12,146 7
121-019 Cash Flow Statements and Analysis STATEMENT OF CASH FLOWS: COMPANY 3 (In millions) Year Ended December 31, 2017 2018 2019 Net income (loss) including non-controlling interests $ (1,344) $ 329 $ (2,837) Adjustments to reconcile net income (loss) to operating cash flows: Depreciation and amortization 170 142 157 Bad debt expense 27 24 31 Stock-based compensation 41 57 1,532 Gain on business divestitures – (1,071) – Deferred income tax (254) 12 (29) Loss on disposal of property and equipment 39 20 3 Impairment of long-lived assets held for sale 74 66 – Gain on debt and equity securities, net – (665) (1) Non-cash deferred revenue – – (17) Other 137 276 (112) Change in working capital: Accounts receivable (147) (93) (136) Prepaid expenses and other assets (40) (158) (159) Collateral held by insurer – – (400) Operating lease right-of-use assets – – 67 Accounts payable (26) (13) 32 Accrued insurance reserves 428 314 160 Accrued expenses and other liabilities 422 246 320 Operating lease liabilities – – (51) Net cash used in operating activities (473) (514) (1,440) Cash flows from investing activities Proceeds from sale and disposal of property and equipment 114 123 17 Purchase of non-current assets (276) (186) (196) Purchase of investments – (147) (180) Proceeds from business disposal, net of cash divested – – 98 Acquisition of businesses, net of cash acquired – (22) (2) Net cash used in investing activities (162) (232) (263) Cash flows from financing activities Proceeds from issuance of common stock – – 2,824 Taxes paid related to net share settlement of equity awards – – (524) Proceeds from issuance of subsidiary preferred stock units – – 333 Proceeds from exercise of stock options, net of repurchases 1 9 6 Proceeds from stock issuance from Employee Stock Purchase Plan – – 16 Repurchase of outstanding shares (44) (3) – Borrowings 67 1,155 396 Loan repayments (29) (200) (55) Proceeds from issuance of redeemable convertible preferred stock, net 336 583 – Other 7 3 (16) Net cash provided by financing activities 338 1,547 2,980 Effect of exchange rate changes on cash and restricted cash 8 (39) (2) Net increase (decrease) in cash and restricted cash (289) 762 1,275 Cash and restricted cash Beginning of period 2,275 1,943 2,737 Reclassification from (to) assets held for sale during the period (43) 32 11 End of period, excluding cash classified within assets held for sale $ 1,943 $ 2,737 $ 4,023 Source: Prepared by Casewriter from Company 10-K Statements. 8
Analyzing Financial Accounting V.G. Narayanan and Dennis Campbell, Co-Series Editors + INTERACTIVE ILLUSTRATIONS Financial Statements V.G. NARAYANAN HARVARD BUSINESS SCHOOL SURAJ SRINIVASAN HARVARD BUSINESS SCHOOL 5056 | Published: April 11, 2017
2 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 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. Table of Contents
3 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS T 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.
4 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 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
5 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 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
6 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 2.1 Understanding Return on Equity 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). 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, ROE = net income sales total assets sales total assets equity Which simplifies to, ROE = net income 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.
7 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS INTERACTIVE ILLUSTRATION 1 DuPont Framework Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHtruh 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 ROE for Prada in 2015 = €451 = 15.8% €2,845
8 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 2.2 Profitability 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. 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 profit margin = net income sales Using the values from Exhibit 1, we find: Net profit margin for Prada in 2015 = €451 = 12.7% €3,552 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-
9 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 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 profit margin = gross profit sales Using the data from Exhibit 1, we get the following: Gross profit margin for Prada in 2015 = €2,551 = 71.8% €3,552 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. SG&A margin = selling, general, and administrative (SG&A) expenses sales
10 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS which, using the data in Exhibit 1, gives us the following: Prada’s SG&A margin in 2015 = €1,716 = 48.3% €3,552 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% 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 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.
11 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 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. Asset turnover = sales 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 assets) 2 = (€3,888 + €4,739) 2 = €4,314 Prada’s asset turnover in 2015 = €3,552 = 0.8 €4,314 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. 2.3 Operating Efficiency
12 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 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. ROA = net income average total assets Using our example, we find the following: Prada’s ROA in 2015 = €451 = 10.4% €4,314 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 10.4%. Despite the lower ROA, Nordstrom’s ROE in the ROE
13 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS table in Section 2.1 is much higher, 31.9%, compared to Prada’s 15.8%. We will return to this apparent puzzle later when we discuss leverage. A firm’s total assets are financed by a mixture of debt and equity. Net income (the numerator in the ROA formula) includes interest expense, which is the financing cost of debt. If the analyst wishes to ignore the firm’s financing mix, he or she would eliminate the financing impact on net income, which would determine a pure return on investment before financing costs. ROA is often calculated by dividing after-tax net income before interest expense by average total assets. 2.3.2 Digging Deeper into Asset Turnover Companies need a mix of assets to drive their business performance. For example, retail companies need stores (long-term assets) as well as shorter-term assets such as inventories. By examining whether asset turnover efficiency is driven by short-term or long-term assets, an analyst can learn about how well managers are undertaking long-term investments versus how well they are handling the business’s day-to-day operational activities. Long-term asset turnover = sales average long-term assets Here are the long-term asset turnover numbers for our retail examples: Prada’s average long-term (LT) assets in 2015 = (beginning LT assets + ending LT assets) 2 = (€2, 427 + €2, 839) 2 = €2,633 Prada’s LT asset turnover in 2015 = €3,552 = 1.3 €2,633 Similarly, we calculate LT asset turnover for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters LT Asset Turnover 4.8 2.4 3.7 1.3 2.9
14 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS As with the total asset turnover ratios, Urban Outfitters uses its LT assets more efficiently than Prada does. Gap appears to be the most efficient in utilizing its long- term assets to produce sales revenues. Let’s turn to short-term operations. A company needs working capital to manage its day-to-day operations. Working capital is composed of receivables plus inventory less the amount the company owes to its vendors, such as accounts payable. Companies need smaller amounts of working capital if they can collect more quickly from their customers (lower receivables), hold lower levels of inventory for a given level of sales (faster inventory turnover), and receive greater financing from their vendors (greater accounts payable). Let’s examine each of these in turn. 2.3.3 Inventory Turnover Inventory turnover, calculated as cost of goods sold divided by the average inventory for the period, measures how often the inventory is sold during a given time period. It is useful in understanding how efficiently a business manages its inventory levels. Just as holding more assets for a given level of sales does, holding more inventory for a given level of sales decreases efficiency. Although businesses may prefer to hold lower inventory levels, the trade-off is to avoid running out of products available for customers. Inventory levels also depend on product characteristics (e.g., perishable products versus packaged goods), stocking efficiency, variation in product demand, and so forth. As when we calculate asset turnover, we use the average inventory balance rather than the ending balance. This is especially relevant for a firm that is growing quickly, as the level of inventory may have increased significantly during the year. Inventory turnover = cost of goods sold (COGS) average inventory Interactive Illustration 3 is a demonstration of inventory turnover in action. Start the animation of items moving through a warehouse facility over the course of two years of business operations. Reset the illustration and replay it with different assumptions about the firm’s average inventory and annual COGS. The effect of these parameters are reflected in the “Days Inventory” and “Inventory Turnover” outputs at the bottom.
15 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS INTERACTIVE ILLUSTRATION 3 Inventory Turnover and Days in Inventory Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2I9pGVd Applying the data from Exhibit 1 gives us the following: Prada’s average inventory in 2015 = (beginning inventory + ending inventory ) 2 = (€450 + €655) 2 = €552 Prada’s inventory turnover in 2015 = €1,001 = 1.8 €552 Similarly, we calculate inventory turnover for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Inventory Turnover 5.3 4.3 5.1 1.8 6.4 As a fast fashion business, it is no surprise that Urban Outfitters turns over its inventory faster (6.4 times a year) than Prada’s luxury products (1.8 times). Urban
16 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Outfitters is also somewhat more efficient in handling its inventory when compared to the other fast fashion business, Gap, whose inventory turnover is 5.3. Another metric for measuring inventory use is the days inventory held, the average number of days the inventory is held before it is sold, as opposed to the inventory turnover, which measures how many times the inventory turned over during the period. It is calculated dividing the COGS by 365 days, then dividing the average inventory by this number. Days inventory held = average inventory cost of goods sold 365 days or: Days inventory held = 365 inventory turnover Applying the data for our Prada example yields the following: Prada’s days inventory held in 2015 = 365 = 201 €1,001 €552 Similarly, we calculate days inventory held for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Days Inventory Held 69 86 72 201 57 Again it makes sense that Urban Outfitters turns its inventory faster than Prada because the average number of days that Urban Outfitters holds its inventory is substantially shorter—57 days versus Prada’s 201 days. 2.3.4 Accounts Receivable Turnover Accounts receivable (AR) turnover measures a company’s efficiency in collecting receivables from its customers. Companies often provide credit to their customers as a way to increase sales. However, this practice comes at the risk of having some customers be unable to pay when the bill comes due. The accounts receivable turnover is calculated by dividing sales revenues by the average accounts receivable (AR) balance. While AR turnover depends on the company’s credit practices, a
17 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS declining AR turnover indicates a weaker ability to collect cash from customers, which could indicate a business weakness. For example, it could mean that the company’s customers are having trouble paying what they owe. Accounts receivable turnover = sales average accounts receivable Prada’s average accounts receivable (AR) in 2015 = (beginning AR + ending AR) 2 = (€308 + €346) 2 = €327 Prada’s accounts receivable turnover in 2015 = €3,552 = 10.9 €327 Similarly, we calculate the AR turnover for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Accounts Receivable Turnover 44.6 54.3 6.0 10.9 52.9 A related metric is days sales outstanding (DSO), also referred to as the average collection period or days sales in receivables. It measures the average number of days it takes for a business to collect payment from a customer. Say the firm’s credit policy is to allow payment within 30 days. If, for example, the DSO is 40 days, it may indicate that there is a payment problem. The DSO is calculated by dividing the average accounts receivable by the sales per day, that is, sales divided by 365. Days sales outstanding = average accounts receivable sales 365 days or Days sales outstanding = 365 days accounts receivable turnover
18 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Using the data from Exhibit 1, we find the following: Prada’s days sales outstanding in 2015 = 365 = 34 €3,552 €327 Similarly, we calculate DSO for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Days Sales Outstanding 8 7 61 34 7 Retailers such as the ones in our examples typically do not offer credit to their customers, therefore they do not incur high levels of receivables. Gap, Inditex, and Urban Outfitters’ low level of DSO generally results from the companies’ vendors of miscellaneous goods (e.g., furniture and fixtures) and sundry services. Therefore, Nordstrom’s DSO of about two months and Prada’s of about one month deserve some attention. It turns out that Nordstrom has a credit card operation that offers Nordstrom-branded cards to its customers, which retains the receivables on its balance sheet. This accounts for Nordstrom’s lower receivable turnover ratio and higher DSO. Prada, on the other hand, sells not only through its own stores but also through franchises. Therefore, the franchises owe Prada for the products it sells to them for sale to the end customer, as well as possible royalty fees. 2.3.5 Accounts Payable Turnover The accounts payable (AP) turnover measures how long it takes a company to pay its vendors, including suppliers of inventory, services, or other noninventory items. Recall that payables are the flip side of receivables, that is, payables occur when the vendor allows the company credit in paying for goods or services rendered. Accounts payable turnover is calculated as total purchases divided by the average accounts payable. (An alternate definition substitutes cost of goods sold for purchases). Accounts payable turnover = purchases average accounts payable Applying this ratio to our Prada example gives us the following: Prada’s purchases in 2015 = COGS + ending inventory − beginning inventory =€1,001+ €655 − €450 = €1,206
19 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Prada’s average accounts payable (AP) in 2015 = (beginning AP + ending AP) 2 = (€349 + €437) 2 = €393 Prada’s accounts payable turnover in 2015 = €1,206 = 3.1 €393 Similarly, we calculate accounts payable turnover for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Accounts Payable Turnover 8.4 3.2 6.6 3.1 15.0 As with inventory and receivables, it is useful to think of accounts payable turnover in terms of the number of days it takes the company to pay its accounts payable, or days payable outstanding (DPO). This ratio is calculated by dividing the average accounts payable by the average daily purchases (that is, total purchases divided by 365). Days payable outstanding = average accounts payable purchases 365 days Alternatively, Days payable outstanding = 365 days accounts payable turnover Applying the data from Exhibit 1 gives us the following: Prada’s days payable outstanding in 2015 = 365 = 119 €1,206 €393
20 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Similarly, we calculate DPO for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Days Payable Outstanding 44 115 56 119 24 The difference between Urban Outfitters’ days payable outstanding of 24 days versus Prada’s 119 days indicates that Urban Outfitters pays its vendors much faster than Prada does. To evaluate the efficiency implication of these different days payable outstanding ratios, we would need to compare the historical numbers as well as the credit terms. Credit from suppliers serves as a form of short-term financing that can be beneficial if it is cheaper than bank credit or other sources of financing. However, an increasing trend in days payable outstanding can suggest that the company has liquidity problems, making it unable to pay its suppliers on time. 2.3.6 Cash Conversion Cycle The length of time between when a company must pay its suppliers for inventory until it collects cash from its customers is called the cash conversion cycle. It is the sum of days inventory held plus days sales outstanding less days payable outstanding. A negative cash conversion cycle typically indicates that the business purchased goods from a supplier on credit and can sell the inventory and collect cash from the customer even before the supplier requires payment to be made. Cash conversion cycle = days inventory + days sales outstanding − days payable outstanding The pertinent events that affect the cash conversion cycle—payment (for an item) to a supplier, the item (or a product that includes that item) is sold, and the customer’s payment for that sale is received—are displayed on a timeline in Interactive Illustration 4. Use the sliders to change the timing of these events, to push the cash conversion cycle to be long, short, or negative.
21 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS INTERACTIVE ILLUSTRATION 4 Cash Conversion Cycle Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2ujeHXe Using the data for Prada in Exhibit 1, we find the following: Prada’s cash conversion cycle in 2015 = 201 + 34 −119 = 116 Similarly, we calculate the cash conversion cycle for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Cash Conversion Cycle 33 (22) 77 116 39 Urban Outfitters’ cash conversion cycle of 39 days means the company must finance 39 days’ worth of sales, compared to Prada’s 116 days. Inditex, on the other hand, has a negative cash conversion cycle of 22 days; the company can sell its goods before paying its suppliers, which means it does not need to invest in financing its inventory. This is because Inditex takes longer to pay its suppliers (days payable outstanding = 115 days), not because of its receivables days outstanding (days sales outstanding = 7) or the number of days it holds inventory (days inventory held = 86). Prada, in comparison, holds its inventory longer and, as a result, has more cash tied up in its business operations.
22 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 2.3.7 Working Capital Turnover Closely related to cash conversion is the concept of working capital, defined as current assets less current liabilities. Working capital turnover is calculated by dividing net sales by the result of average current assets minus average current liabilities. Working capital turnover = sales average working capital where Working capital = current assets −current liabilities For Prada, this result is as follows: Prada’s average current assets in 2015 = (beginning current assets + ending current assets) 2 = (€1, 461+ €1,900) 2 = €1,681 Prada’s average current liabilities in 2015 = (beginning current liabilities + ending current liabilities) 2 = (€707 + €1,115) 2 = €911 Prada’s working capital turnover in 2015 = €3,552 = 4.6 (€1,681− €911) Similarly, we calculate the working capital turnover for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Working Capital Turnover 8.1 5.4 5.3 4.6 5.9
23 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 2.4 Financial Leverage Working capital turnover measures the efficiency with which a company manages its working capital to generate sales. Gap with a working capital turnover of 8.1 is the most effective of the retailers listed. Calculations for common efficiency measures are visualized in Interactive Illustration 5. Select a metric from the top row to see what items are drawn from the income statement and balance sheet to calculate that ratio. INTERACTIVE ILLUSTRATION 5 Efficiency Ratios Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2uo8MQH Having examined the drivers of profitability and operating efficiency, we next assess how capital structure affects a company’s performance. This leads to the last component of the DuPont decomposition framework, financial leverage. In the DuPont decomposition formula, the last term is also referred to as the equity multiplier and is calculated by dividing average total assets by average shareholder’s equity. Managers can successfully use financial leverage to improve a company’s performance if the return on borrowed funds is greater than the interest cost of those borrowed funds on an after-tax basis because interest cost is tax-deductible. The benefit of borrowing is that managers can operate from a larger asset base than the amount that would be financed only from shareholders’ equity. For example, if a firm
24 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS receives a $100 equity investment and has no debt, it can use that $100 to buy assets that generate revenues. If the firm borrows an additional $100 as debt, it can use the extra capital to purchase more revenue-generating assets. This would result in greater profits for shareholders as long as the business generates a higher return on its assets than what it must pay to service the debt. Interactive Illustration 6 shows how leverage affects companies’ EPS and ROE. INTERACTIVE ILLUSTRATION 6 Leverage Ratios Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2GiuO8Y The flip side of leverage is that the company becomes committed to meeting interest payments, whereas dividend payment to equity holders is discretionary. Borrowing can thus create a risk of financial distress when the firm’s performance is depressed. If the business were to suffer a loss, the debt amplifies the loss’s effect on equity holders. Therefore, companies should avoid very high levels of debt financing. Analysts use the extent of financial leverage to assess the leverage’s benefit as well as to measure distress risk. Using the ROE decomposition formula provided earlier, we can measure the impact of all non-equity financing—or any kind of debt—on the firm’s ROE. If all the assets are financed by equity, the multiplier is 1. As debt increases, the equity multiplier also increases. Equity multiplier = average total assets average equity
25 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Using the data in Exhibit 1, we calculate the following: Prada’s average total assets in 2015 = (beginning total assets + ending total assets) 2 = (€3,888 + €4,739) 2 = €4,314 Prada’s average shareholders’ equity (SE) in 2015 = (beginning SE + ending SE) 2 = (€2,688 + €3,001) 2 = €2,845 Prada’s equity multiplier in 2015 = €4,314 = 1.5 €2,845 Similarly, we calculate the equity multiplier for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Equity Multiplier 2.6 1.5 3.9 1.5 1.4 Urban Outfitters and Prada’s equity multipliers are quite similar—1.4 and 1.5, respectively—indicating that the two companies have similar capital structure strategies. However, Nordstrom has a high equity multiplier of 3.9. Recall that Nordstrom’s ROE was 31.9%, significantly higher than Prada’s 15.8%, despite Nordstrom’s lower ROA (8.1%) compared to Prada’s (10.4%). The answer lies in the significantly higher level of leverage as indicated by Nordstrom’s equity multiplier, which is more than double Prada’s. Can Prada improve its returns to shareholder equity (ROE) by taking on more debt? Prada’s managers must grapple with this question. The answer would depend on the extent of financial risk they wish to take on. Alternately, should Nordstrom’s shareholders be concerned that the company has very high debt levels? They would need to consider whether Nordstrom’s business operations can support these high debt levels without causing the firm to slip into financial distress.
26 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Another commonly used measure of leverage is the debt-to-equity ratio, which is calculated as the ratio of average total liability divided by average shareholder’s equity. Leverage ratio = average total liabilities average shareholders’ equity Using the data in Exhibit 1, we find the following: Prada’s average total liabilties in 2015 = (beginning total liabilities + ending total liabilities) 2 = (€1,187 + €1,721) 2 = €1, 454 Prada’s average shareholders’ equity (SE) in 2015 = (beginning SE + ending SE) 2 = (€2,688 + €3,001) 2 = €2,845 Prada’s leverage ratio in 2015 = €1, 454 = 0.5 €2,845 Similarly, we calculate the leverage ratio for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Leverage Ratio 1.6 0.5 2.9 0.5 0.4 Not surprisingly, Nordstrom’s leverage ratio, at 2.9, is significantly higher than Prada’s at 0.5. We can peel the onion further and compare the different retailers in terms of long-term debt versus short-term liabilities. Long-term leverage ratio = average long-term liabilities average equity
27 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Prada’s average long-term (LT) liabilties in 2015 =(beginning LT liabilities + ending LT liabilities) 2 = (€480 + €606) 2 = €543 Prada’s average shareholders’ equity (SE) in 2015 = (beginning SE + ending SE) 2 = (€2,688 + €3,001) 2 = €2,845 Prada’s long-term leverage ratio in 2015 = €543 = 0.2 €2,845 Similarly, we calculate the LT leverage ratio for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Long-Term Leverage Ratio 0.8 0.1 1.8 0.2 0.1 These ratios indicate that Nordstrom has significantly greater long-term debt compared to its equity than the other retailers in our sample do. 2.4.1 Interest Coverage Ratio As discussed earlier, one possible result of higher leverage is the risk that the company may not be able to meet its debt payment obligations. Many debt providers, such as banks, protect themselves from their creditors’ default by requiring the companies to follow certain restrictions (or covenants) defined by the ratios that measure the extent of financing risk. The interest coverage ratio is used to gauge whether a business can make the interest payments on its outstanding debt. The ratio is measured as earnings before interest and taxes (EBIT) divided by interest expense.
28 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Interest coverage ratio = EBIT interest expense which for Prada would be as follows: Prada’s interest coverage ratio in 2015 = €702 = 54 €13 Similarly, we calculate the interest coverage ratio for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Interest Coverage Ratio 28 N/A 11 54 N/A Interest coverage ratio is useful for assessing the firm’s long-term solvency by examining its ability to cover interest expense on debt, typically long-term debt. Nordstrom, with an interest coverage ratio of 11, has the lowest ability to meet its debt obligations within this sample of retailers. Although it is difficult to assess the extent of distress risk from this ratio alone, it is clear that Prada, with a ratio of 54, and Gap at 28, have a greater amount of earnings to cover interest expense. Because Urban Outfitters and Inditex did not incur much interest expense in 2015, their interest coverage ratios are less meaningful. 2.4.2 Liquidity Ratios Analysts, especially those concerned with assessing a company’s short-term liquidity (for example, a credit analyst in a bank), use measures such as the current ratio to determine if funds provided by current assets would be sufficient to meet demand from current liabilities. The current ratio is calculated as current assets divided by current liabilities. Current assets include cash as well as assets such as inventory and accounts receivable that are likely to convert to cash in the short term. Current liabilities include accounts payable, wages payable, and other items that will require cash payout in the short term. The higher the current ratio, the easier it is for the business to meet its approaching liabilities. However, if the current ratio is too high, it might indicate that the business is not managing its working capital efficiently. Current ratio = current assets current liabilities
29 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS For Prada, the current ratio is as follows: Prada’s current ratio in 2015 = €1,900 = 1.7 €1,115 Similarly, we calculate current ratio for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Current Ratio 1.9 1.9 1.9 1.7 2.3 Overall, all the retailers’ current ratios hover around similar levels. Banks and other short-term lenders often impose requirements for the current ratio level and that of other, similar liquidity ratios in a given industry. It is also helpful to compare current with historical levels of the ratio to determine whether there are any reasons for concern or whether this metric should be differentiated across similar companies. The quick ratio, or acid test ratio, is similar to the current ratio except only highly liquid current assets are considered available for paying current liabilities. This ratio measures a firm’s ability to meet current obligations even if its inventory cannot be sold immediately. It is calculated by considering cash, marketable securities, and accounts receivable, but not inventory, which is relatively less liquid; businesses in distress may have trouble turning their inventory into cash. Quick ratio = (cash and marketable securities + accounts receivable) current liabilities Applying the data from Exhibit 1, we get the following: Prada’s quick ratio in 2015 = €715 + €346 = 1.0 €1,115 Similarly, we calculate the quick ratio for the other retailers for fiscal year 2015 as follows: FY 2015 Gap Inditex Nordstrom Prada Urban Outfitters Quick Ratio 0.8 1.3 1.1 1.0 0.9
30 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS The retailers in our sample generally appear to be quite comfortable in meeting their current liabilities from highly liquid current assets though Gap and Urban Outfitters are a little less so than the other companies. 3 SUMMARY The financial analysis framework provides a methodology for assessing and digging deeper into the drivers of a company’s performance. Analysts and others can use financial ratios to compare the company’s performance to its peers or to its own historical performance. Managers can then use the insights to improve the way the business operates, by improving either its profit margins, its asset utilization, or its capital structure. In this reading, we have used the DuPont decomposition framework to provide a basic structure for ratio analysis. There are many additional ratios not covered here, and you may find somewhat different definitions from what we have used here. In order to conduct insightful financial analysis, you must develop a deep understanding of the business economics of a company and its industry to select the appropriate ratios to measure and then to interpret them correctly. As seen in our retail examples, it is also important to probe deeper to understand the causes of differences in the ratios’ measures. A good analyst typically uses a portfolio of ratios to understand the overall picture of a company and the drivers of its performance.
31 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS EXHIBIT 1 Prada Group’s Balance Sheet and Income Statement Prada Group: Consolidated statement of financial position (amounts in millions of Euros) January 31, 2015 January 31, 2014 Assets Current assets Cash and marketable securities 715 582 Trade receivables, net 346 308 Inventory, net 655 450 Other current assets 184 121 Total current assets Non-current assets 1,900 1,461 Property, plant, and equipment 1,474 1,230 Intangible assets 943 901 Other non-current assets 422 296 Total non-current assets 2,839 2,427 Total assets 4,739 3,888 Liabilities and shareholders’ equity Current liabilities Bank overdrafts and short-term loans 267 67 Trade payable 437 349 Other current liabilities 411 291 Total current liabilities 1,115 707 Non-current liabilities Long-term financial payables 255 208 Deferred tax liabilities 42 42 Other non-current liabilities 309 230 Total non-current liabilities 606 480 Total liabilities 1,721 1,187 Share capital Share capital 256 256 Other reserves 2,163 1,853 Translation reserves 131 (49) Net income for the year 451 628 Total shareholders’ equity 3,001 2,688 Non-controlling interests 17 13 Total liabilities and shareholders’ equity 4,739 3,888 Consolidated income statement For the twelve months ended (amounts in millions of Euros) January 31, 2015 January 31, 2014 Net revenue 3,552 3,587 Cost of goods sold (1,001) (939) Gross margin 2,551 2,648 Selling, general and administrative costs 1,716 1,580 Product design and development costs 133 129 Operating expenses 1,849 1,709 Earnings before interest and taxes 702 939 Net interest expenses (13) (9) Other income/(expenses) (21) (8) Income before taxes 668 922 Taxation (209) (285) Net income for the year 459 637 Net income—non-controlling interests 8 10 Net income—shareholders 451 627 Basic and diluted earnings per share in euros per share 0.176 0.245 Source: Extracted from Prada Annual Report for the year ended January 31, 2015.
32 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 4.1 Key Ratios 4 SUPPLEMENTAL READING Accounts payable turnover = purchases average accounts payable Accounts receivable turnover = sales average accounts receivable Asset turnover = sales average total assets Cash conversion cycle = days inventory + days sales outstanding − days payable outstanding Cost of goods sold = beginning inventory + purchases− ending inventory Credit purchases = cost of goods sold + ending inventory − beginning inventory Current ratio = current assets current liabilities Days inventory held = average inventory cost of goods sold 365 days Days inventory held = 365 inventory turnover Days payable outstanding = average accounts payable purchases 365 days
33 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Days payable outstanding = 365 days accounts payable turnover Days sales outstanding = average accounts receivable sales 365 days Days sales outstanding = 365 days accounts receivable turnover Equity multiplier = average total assets average equity Gross profit margin = gross profit sales Interest coverage ratio = EBIT interest expense Inventory turnover = cost of goods sold (COGS) average inventory Leverage ratio = average total liabilities average shareholders’ equity Long-term asset turnover = sales average long-term assets Long-term leverage ratio = average long-term liabilities average equity Net profit margin = net income sales
34 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS Quick ratio = (cash and marketable securities + accounts receivable) current liabilities ROA = net income average total assets ROE = net income sales total assets = net income sales total assets equity equity SG&A margin = selling, general, and administrative (SG&A) expenses sales Working capital = current assets − current liabilities Working capital turnover = sales average working capital 5 KEY TERMS accounts payable (AP) turnover Measures how long it takes a company to pay its vendors, including suppliers of inventory, services, or other noninventory items. accounts receivable (AR) turnover Measures a company’s efficiency in collecting receivables from its customers. asset turnover Measures how efficiently the company uses its assets to generate return. average collection period Measures the average number of days it takes for a business to collect payment from a customer. Also called days sales outstanding (DSO). balance sheet A financial statement that provides a snapshot of the company’s resources and the claims on those resources at a specific point in time.
35 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS cash conversion cycle The length of time between when a company must pay its suppliers for inventory until it collects cash from its customers. current ratio Measures the sufficiency of a firm’s funds, provided by current assets, to meet demand from current liabilities. days inventory held The average number of days the inventory is held before it is sold. days payable outstanding (DPO) The number of days it takes the company to pay its accounts payable. DuPont framework A ratio analysis method, originated by the DuPont Corporation in the 1920s, which decomposes ROE into subcomponents to provide a deeper look at how profit (or loss) was generated. equity multiplier The measure of the impact of debt on a firm’s ROE. financial leverage The degree to which a company uses fixed-cost financing such as bank loans, bonds, and preferred stock. The more debt and preferred stock financing a company uses, the higher its financial leverage. gross profit margin The amount of profit that is left to cover other expenses after only the cost of goods sold is subtracted from revenues. income statement A financial statement that shows an entity’s operating performance over a given period of time. interest coverage ratio Gauges whether a business can make the interest payments on its outstanding debt. inventory turnover Measures how often the inventory is sold during a given time period. profitability In the DuPont framework, the profit margin that the company achieves from each dollar of sales after all expenses have been accounted for. quick ratio Measures a firm’s ability to meet current obligations even if its inventory cannot be sold immediately. ratio analysis The use of simple calculations as financial analysis tools, which can be used to gain insights about a company’s business model and financial performance. return on assets (ROA) An indicator of the company’s profitability relative to its assets or total capital employed in the firm.
36 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS return on equity (ROE) A measure of a business’s profitability in relation to its shareholder equity. It is found by dividing net income by the book value of the equity. selling, general, and administrative (SG&A) margin The amount of SG&A expenses incurred by a company for every dollar of revenues earned. shareholders’ equity A measure of a business’s profitability that is found by subtracting liabilities from the company’s assets. It consists of contributed capital (stock) and retained earnings. statement of cash flows A financial statement showing cash sources and uses by a company over an accounting cycle. working capital The liquid capital used in day-to-day business operations. working capital turnover Measures the efficiency with which a company manages its working capital to generate sales. 6 ENDNOTES 1 Inditex, Annual Report 2014 (A Coruña, Spain: Inditex, 2015) p. 193. 2 Prada Group, Annual Report 2014 (Milan, Italy, 2015), p. 5. 3 Prada Group, Annual Report 2014 (Milan, Italy, 2015), p. 17. 4 Urban Outfitters, Inc. SEC Form 10-K, January 31, 2015 (Philadelphia, PA), p. 1. 5 Urban Outfitters, Inc. SEC Form 10-K, January 31, 2015 (Philadelphia, PA), pp. 2–3. 6 Nordstrom, Inc., SEC Form 10-K, January 31, 2015 (Seattle, WA), p. 4.
37 5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS 7 INDEX accounts payable (AP) turnover, 18, 19, 32, 34 accounts receivable (AR) turnover, 16, 17, 32, 34 asset turnover, 11, 12, 32, 34 assets, in return on equity calculation, 6, 7 average collection period, 17, 34 balance sheet, 4, 34 cash conversion cycle, 20, 21, 32, 35 cost of goods sold, 32 credit purchase, 32 current ratio, 28, 29, 32, 35 days inventory held, 16, 32, 35 days payable outstanding (DPO), 19, 20, 21, 32, 33, 35 days sales outstanding (DSO), 17, 18, 20, 21, 32, 33, 35 DuPont framework, 3, 5, 7, 35 efficiency ratios, 23 equity multiplier, 23, 24, 25, 33, 35 equity, in return on equity calculation, 6, 7 financial analysis, 3, 5, 7 financial leverage, 6, 35 Gap, 3, 4, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22, 23, 25, 26, 27, 28, 29, 30 gross profit margin, 9, 33, 35 income statement, 4, 35 Inditex, 3, 4, 8, 9, 10, 11, 12, 13, 15, 16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28, 29 interest coverage ratio, 27, 28, 33, 35 interest expense, 13 inventory turnover, 14, 15, 33, 35 leverage, 35 leverage ratio, 26, 33 liquidity ratios, 28 long-term asset turnover, 13, 33 long-term leverage ratio, 26, 27, 33 net income, 6, 7, 12, 13 net profit margin, 8, 33 Nordstrom, 3, 4, 8, 9, 10, 11, 12, 13, 15, 16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28, 29 operating efficiency, 6, 11 performance, analysis of, 3, 5, 7, 9, 10 performance, financial leverage and, 23, 24, 30 performance, mix of assets driving, 13 Prada, 3, 4, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28, 29, 31 profit margins, 6 profitability, 6, 8, 35 profitability ratios, 10 quick ratio, 29, 34, 35 ratio analysis, 3, 35 ratios, periods used in calculating, 5 return on assets (ROA), 5, 12, 13, 34, 36 return on equity (ROE), 5, 6, 7, 8, 34, 36 sales, in return on equity calculation, 6, 7 selling, general, and administrative (SG&A) margin, 9, 10, 34, 36 shareholders’ equity (SE), 5, 7, 23, 25, 26, 27, 31, 33, 36 statement of cash flows, 4, 36 Urban Outfitters, 3, 4, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28, 29, 30 working capital, 14, 22, 34, 36 working capital turnover, 22, 34, 36
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