Financial Accounting

Financial Statement Analysis

Dr. Charles W. Mulford

Scheller College of Business

Georgia Institute of Technology
Atlanta, GA 30332-0520
(404) 894-4395
[email protected]
 Financial Accounting C.Mulford: Financial Statement Analysis: 1

Financial Analysis Ratio Formula Sheet

Profitability Ratios
• Gross margin ratio Gross profit / sales
• Operating income ratio Sustainable operating income / sales
• R&D expense percent R&D / sales
• SGA expense percent SGA / sales
• Net margin ratio Sustainable net income / sales
• Effective tax rate Income tax provision / Income before taxes
• Return on total assets Sustainable net income / total assets
• Return on equity Sustainable net income / shareholders’ equity
• DuPont Analysis Net margin ratio X total asset turnover X total assets to equity
• Economic value added (EVA) (Return on total assets% – Cost of capital%) x Total assets

Liquidity Ratios
• Current ratio Current assets / current liabilities
• Quick ratio Cash + ST investments + accounts receivable / current liabilities
• Defensive interval Cash + ST investments + accounts receivable / Daily spending on
operating expenses and interest

Leverage Ratios
• Total assets to equity Total assets / shareholders’ equity
• Total liabilities to equity Total liabilities / shareholders’ equity
• Debt to equity Debt financing / shareholders’ equity
• Times interest earned EBITDA / interest expense
• Altman's Z bankruptcy 3.3(EBT/TA)+1.2(WC/TA)+.6(MktEq/BkDebt)
1.4(RE/TA) + 1(Revenue/TA)
• Book value per share Common shareholders’ equity / number of
shares outstanding
Activity Ratios
• Receivables turnover Revenue / accounts receivable
• Days receivables 365 / receivables turnover
• Inventory turnover Revenue / inventory
• Days inventory 365 / inventory turnover
• Payables turnover Revenue / accounts payable
• Days payables 365 / payables turnover
• Cash cycle Days inventory - Days payables + Days receivables
• Fixed assets turnover Revenue / PP&E
• Cash cycle Days inventory - Days payables + Days
• Days fixed assets 365 / fixed assets turnover
• Total assets turnover Revenue / total assets
• Days total assets 365 / total assets turnover
Cash Flow Ratio
• Net cash margin Operating cash flow / sales
• Capital expend. To depreciation Additions to PP&E / depreciation expense
Valuation Ratios
• Earnings per share (EPS) Net income / common shares outstanding
• Price / earnings ratios (PE) Market price / EPS
• Price to book value Market price / book value per share
Financial Accounting C.Mulford: Financial Statement Analysis: 2

Financial Statement Analysis

The financial statements for BGS Technologies are provided

below:
BGS Technologies
Income Statement
Year Ended December 31, 2015

Sales $ 1,000,000

Cost of goods sold 550,000

Gross profit 450,000

Research and development expense 100,000

Selling, general and admin. expenses 150,000

Operating income 200,000

Other income (expense):

Nonrecurring item - Lawsuit settlement (150,000)
Interest income 50,000
Interest expense (25,000)

Income from continuing operations before taxes 75,000

Income tax provision 28,500

Income from continuing operations 46,500

Gain from discontinued operations (net of tax) 140,000

Extraordinary item - (loss) from flood (net of tax) (30,000)

Gain from change in accounting for inventory (net of tax) 10,000

Net Income $ 166,500

Financial Accounting C.Mulford: Financial Statement Analysis: 3

BGS Technologies
Balance Sheet
As of December 31, 2015
Assets
Current Assets:
Cash and cash equivalents $ 25,000
Short-term investments 50,000
Accounts receivable 80,000
Inventory 150,000
Total current assets $ 305,000

Property, Plant & Equipment:

Land 80,000
Buildings 475,000
Equipment, furniture & fixtures 310,000
Less: accumulated depreciation (320,000)
Net property, plant and equipment 545,000
Total Assets $ 850,000
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 55,000
Current portion of long-term debt 20,000
Income taxes payable 10,000
Total current liabilities $ 85,000

Noncurrent Liabilities:
Long-term debt 150,000

Total liabilities 235,000

Stockholders' Equity:
Common stock (100,000 shares) 10,000
Additional paid-in capital 290,000
Retained earnings 315,000
Total stockholders' equity 615,000
Total Liabilities and Stockholders' Equity $ 850,000
Financial Accounting C.Mulford: Financial Statement Analysis: 4

BGS Technologies
Cash Flow Statement
Year Ended December 31, 2015

Cash Provided (Used) by Operating Activities:

Net income $ 166,500

Depreciation expense 32,000
(Increase) Decrease in operating current assets (45,000)
Increase (Decrease) in operating current liabilities (8,000)
Cash provided by operating activities 145,500

Cash Provided (Used) by Investing Activities:

(Increase) in property, plant & equip. $ (315,000)
Decline in ST investments 110,000
Cash (used) in investing activities: (205,000)

Cash Provided (Used) by Financing Activities:

(Decrease) in long-term debt (50,000)
Dividends paid (30,000)
Increase in common stock 10,000
Increase in additional paid in capital 140,000
Cash provided by financing activities 70,000
Increase in cash and equivalents 10,500

Cash and cash equivalents, beginning of year 14,500

Cash and cash equivalents, end of year $ 25,000

Financial Accounting C.Mulford: Financial Statement Analysis: 5

Analyzing the Income Statement

How is BGS Technologies doing?
Financial ratios provide a framework for comparison with:
 Prior years
 Other companies in the same industry
 Other investment alternatives

Selected profitability ratios:

 Gross profit or gross margin ratio = gross profit / sales
Measures percentage of each sales dollar available to cover
selling, general and administrative expenses, financing
costs, and to provide a return to investors. Measures basic
profitability of company's product line.

For BGS Technologies: $450,000 / $1,000,000 = 45.0%

 Operating income ratio = operating income / sales

Measures percentage of each sales dollar available to cover
financing costs and to provide a return to investors.
Measures overall profitability of core company operations,
before interest and income tax effects.

For BGS Technologies: $200,000 / $1,000,000 = 20%

Before calculating the operating income ratio, operating

income should be adjusted for included nonrecurring items.
Examples include restructuring charges, merger-related
expenses and acquired in-process research and development.

This adjustment is not applicable for BGS Technologies.

Financial Accounting C.Mulford: Financial Statement Analysis: 6

A closer look at operating profit.

Two operating expense categories which can play a significant

role in changes in operating profit over time are research and
development (R&D) and Selling, general and administrative
expense (SGA).

Management has more control over R&D and SGA spending

than over cost of goods sold. Thus changes in operating profit
over time can typically be more readily explained by changes
in these expense categories than by changes in gross profit,
which is determined by spending on cost of goods sold.

 R&D expense percent = R&D / sales

Measures the percent of each sales dollar invested in
research and development.

Changes in operating profit from one period to the next

may be due to discretionary changes in research and
development spending.

For BGS Technologies: $100,000 / $1,000,000 = 10%

 SGA expense percent = SGA / sales

Measures the percent of each sales dollar spent on operating
overhead.

Changes in operating profit from one period to the next

may be due to discretionary changes in spending on SGA.

For BGS Technologies = $150,000 / $1,000,000 = 15%

Financial Accounting C.Mulford: Financial Statement Analysis: 7

Exercise in Understanding Changes in Operating Profit

Pharmaceuticals, Inc.

For the quarter ended December 31, 2015, Pharmaceuticals

reported an improvement in operating profit to $1,731 from an
operating loss of $403 during the same quarter in 2014.

Use the following data to make requested calculations:

(amounts in thousands)

For 3 months ended December 31, 2015 2014

Sales, net $19,550 $14,937

Cost of goods sold 14,989 12,188
Gross profit 4,561 2,749
Research and development 205 218
Selling, general and administrative 2,625 2,934
Operating profit (loss) $1,731 $(403)

Calculate gross margin and operating margin.

Calculate the R&D percent and SGA percent.

What has the company done to improve its performance?

Financial Accounting C.Mulford: Financial Statement Analysis: 8

Back to selected profitability ratios.

 Net margin ratio = net income / sales.

Measures percentage of each sales dollar available for

shareholders. Measures overall profitability of the
company after inclusion of all expenses.

For BGS Technologies: $166,500 / $1,000,000 = 16.5%

Caution: the net margin ratio is influenced greatly by items

of income or expense that will not recur and may not
provide an accurate assessment of the operating
performance to be expected in future years.

For BGS Technologies, the following are nonrecurring:

 Lawsuit settlement (pretax) $(150,000)

 Gain from discontinued operations (after tax) 140,000
 (Loss) from flood (after tax) (30,000)
 Gain from change in accounting for inventory 10,000

A more accurate measure of the net margin ratio requires

that a sustainable measure of net income first be computed,
as shown below:
 Financial Accounting C.Mulford: Financial Statement Analysis: 9

Income from continuing operations

before taxes (as reported) $ 75,000
Adjust for Nonrecurring item - lawsuit settlement 150,000

Sustainable Income from continuing operations

before taxes 225,000
Income tax provision (using 38% tax rate) (85,500)

Sustainable net income $ 139,500

Recomputed net margin ratio = 14.0%

Note: the company’s 38% effective tax rate is calculated as

follows:

 Effective tax rate = Income tax provision / Income from

continuing operations before taxes, or, $28,500 / $75,000.

At present this is about right for a combination of the U.S.

federal tax rate (34%) plus state tax rate (4%) combined. If the
rate were significantly less than 38%, the 38% should be used in
computing sustainable earnings.
 Financial Accounting C.Mulford: Financial Statement Analysis: 10

Exercise in Calculating Sustainable Net Income

Trey Systems, Inc.

Use the income statement for Trey Systems, Inc. provided

below to calculate sustainable net income for the year ended
September, 2015 (amounts in thousands).
Revenues $ 175,676

Cost of sales 93,808

Gross margin 81,868

Marketing 48,688
Product development 8,414
General and administrative 10,233
Restructuring charge 9,000
Total operating expenses 76,335

Operating income 5,533

Interest income (expense) (5,944)

Gain on sale of fixed assets 2,926

Income before income taxes and

extraordinary charge 2,515

Provision for income taxes 956

Income before extraordinary

charge 1,559

Extraordinary charge on repurchase

of debt, net of taxes 377
Net income $ 1,182
Financial Accounting C.Mulford: Financial Statement Analysis: 11

Trey Systems, Inc. (cont’d)

Calculation of Sustainable Net Income

Amount
Income from continuing operations
before income taxes

Add: Nonrecurring pretax expenses:

_____
_____
_____

Deduct: Nonrecurring pretax income:

_____
_____
_____

Sustainable pretax income _____

Less income taxes (_____)

Sustainable net income _____

Financial Accounting C.Mulford: Financial Statement Analysis: 12

Additional profitability ratios:

 Return on total assets = sustainable net income / total assets

Measures effectiveness of management in employing the

resources available to it (can be compared with investment
alternatives available to management)

For BGS Technologies: $139,500 / $850,000 = 16.4%

Note that sustainable net income is used in the

calculation.

 Return on equity =
sustainable net income / shareholders' equity

Measures effectiveness of management in employing

shareholders' equity funds (can be compared to investment
alternatives available to shareholders).

Will exceed return on assets provided return on assets

exceeds interest rates incurred on borrowed funds.

For BGS Technologies: $139,500 / $615,000 = 22.7%

Note again that sustainable net income is used in the

calculation.
Financial Accounting C.Mulford: Financial Statement Analysis: 13

Using Return on Assets and Return on Equity

to Compare Performance Across Companies

Thiokol Corp. and Wyman-Gordon, Inc.

In a recent fiscal year, Thiokol Corp. reported sales of $889.5

million and net income of $51.4 million. For the same year,
Wyman-Gordon, reported sales of $499.6 million and net
income of $25.2 million, about half the income of Thiokol.

Both companies are in the same industry, aerospace and

defense.

Use the data provided below to compare financial performance

for the two companies (amounts in millions).

Thiokol Wyman-Gordon
Sales $ 889.5 $ 499.6
Net income $ 51.4 $ 25.2
Total assets $ 818.3 $ 375.9
Shareholders’ equity $ 447.9 $ 109.9

Calculate:

Return on assets _____ _____

Return on equity _____ _____

Why is Return on equity so different for the two companies?

Financial Accounting C.Mulford: Financial Statement Analysis: 14

Economic Value Added (EVA)

Measures value added by management calculated as the incremental

rate of return on a firm's assets over the firm's total cost of capital.

EVA = (After-tax return on total assets% – After tax cost of capital%)

x Total assets

A positive measure indicates that the company is creating value.

For BGS Technologies:

Co. has $235,000 in liabilities and $615,000 in shareholders' equity.

Total liabilities and equity is $850,000

Relative debt is 235 / 850 = 27.65%.

Relative equity is 615 / 850 = 72.35%

Cost of debt financing:

Interest expense / total liabilities = $25,000 / $235,000 = 10.64%

To tax effect at 35% = 10.64% x .65 = 6.92%.

Cost of equity financing: assume 11% long-term cost of equity capital.

The cost of equity financing is already an after-tax measure.

To compute cost of capital:

Debt: 6.92% x 27.65% = 1.91%

Equity: 11% x 72.35% = 7.96%

Total cost of capital 9.87%

EVA = 16.4% - 9.87% ($850,000) = $55,505 in value created over cost

of capital.
Financial Accounting C.Mulford: Financial Statement Analysis: 15

Using EVA

Ziegler is considering adding a new customer projected to generate

$300,000 in new sales annually with a pre-tax profit margin (including
adequate projections of bad debts) of 20%.

Taxes consume 35% of pre-tax profit.

Manufacturing capacity is available to handle the new business. No

new hires are necessary.

To generate this business, Ziegler must carry inventory of $40,000 and

accounts receivable of $35,000.

Assuming a cost of capital of 9.87%, will the new business add

economic value?
Financial Accounting C.Mulford: Financial Statement Analysis: 16

Analyzing the Balance Sheet

How does BGS Technologies look? As with analysis of the income

statement, the correct response is, compared to what?
Typical comparisons:
 Prior years
 Other companies in the same industry
 Debt covenants established by lenders to protect their
credit position
Financial ratios provide a framework for comparison. Selected liquidity
ratios:

 Current ratio = current assets / current liabilities

Measures the ability of the firm to service current obligations.
For BGS Technologies: $305,000 / $85,000 = 3.59

 Quick ratio or acid test ratio = quick assets* / current liabilities

* Cash and cash equivalents, ST investments and accounts
receivable: $25,000 + $50,000 + $80,000 = $155,000
Measures the extent to which current obligations are covered by the
company's most liquid of assets.

For BGS Technologies: $155,000 / $85,000 = 1.82

 Defensive Interval = Quick assets / Daily spending on operating

expenses and interest.

Conservative measure of how long a company can operate on liquid

assets with no additional revenue.

Daily spending on operating expenses and interest = Spending / 365 =

($550,000-$32,000+$100,000+$150,000+$25,000) / 365 = $2,173 / day.

For BGS Technologies: $155,000 / $2,173 = 71.3 days.

Financial Accounting C.Mulford: Financial Statement Analysis: 17

Borrowing Oneself Into Financial Health?

A condensed balance sheet for CSV Corp. is provided below.

Calculate the current and quick ratios.

Assume CSV borrowed $15,000 using long-term debt.

Recalculate the company’s current and quick ratios.

CSV Corp. balance sheet (amounts in thousands):

2015
Cash $ 1,400
Accounts receivable 3,600
Inventory 5,800
Total current assets 10,800
Property, plant and equipment 10,200
Total assets $ 21,000

Accounts payable $ 4,200

Accrued expenses payable 6,400
Total current liabilities 10,600
Long-term debt 4,400
Shareholders’ equity 6,000
Total liabilities and shareholders’ equity $ 21,000

Calculated current ratio: _____

Calculated quick ratio: _____

Assume $15,000 borrowed using long-term debt:

Revised current ratio: _____

Revised quick ratio: _____

Financial Accounting C.Mulford: Financial Statement Analysis: 18

Selected leverage ratios:

 Total assets to equity = total assets / shareholders' equity

Measures the number of dollars of total assets held for every $1 of

shareholders’ equity. The higher the ratio the higher the level of
liabilities financing.

A ratio of 1 indicates no debt financing. A ratio of 2 indicates equal

amounts of debt and equity financing.

For BGS Technologies: $850,000 / $615,000 = 1.38

 Total liabilities to equity = total liabilities / shareholders'

equity

Measures the number of dollars of total liabilities owed for every $1 of

shareholders’ equity. The higher the ratio the higher the level of
liabilities financing.

For BGS Technologies: $235,000 / $615,000 = .38

 Debt to equity = Debt financing (current and noncurrent

portion of LT debt plus notes payable) / shareholders' equity

For BGS Technologies: ($20,000 + $150,000) / $615,000 = .28

Measures the number of dollars of debt financing for every $1 of

shareholders’ equity. The higher the ratio the higher the level of debt
financing.
Financial Accounting C.Mulford: Financial Statement Analysis: 19

Average total assets to shareholders’ equity for selected

technology-related industries:

Aerospace and Defense 3.0

Computers and Peripherals 2.0
Drugs 2.0
Software 2.1
Semiconductors 1.7
Telecommunications Equipment 1.6
Telecommunications Services 3.9

In contrast, financial institutions tend to have high leverage

ratios. For example, commercial banks have a total assets to
shareholders’ equity ratio of 12.9.
Financial Accounting C.Mulford: Financial Statement Analysis: 20

Selected leverage ratios (cont’d):

Income Statement Measures of Leverage

Times interest earned = EBITDA / Interest expense

EBITDA: Earnings before interest expense, income taxes,

depreciation and amortization. Earnings before interest
expense and income taxes are earnings available to pay interest
and taxes. By adding back such non-cash expenses as
depreciation and amortization, EBITDA becomes a measure of
cash flow, but one that ignores changes in working capital
accounts. It measures the number of times that cash flow
available for interest covers interest. In effect, a measure of
how far earnings can fall before debt service of interest
becomes a significant problem.

Before calculating EBITDA, known nonrecurring items of

income and expense should be removed.

For BGS Technologies:

EBITDA =

Sustainable net income $139,500

Interest expense + 25,000
Income tax expense + 85,500
Depreciation expense + 32,000
EBITDA $282,000

Times interest earned = $282,000 / $25,000 = 11.3.

Financial Accounting C.Mulford: Financial Statement Analysis: 21

Selected leverage ratios (cont’d):

Altman's Z bankruptcy predictor:

3.3(Earnings before taxes / Total assets) + 1.2(Working capital / Total

assets) +.6(Market value of equity / book value of debt) +
1.4(Retained earnings / Total assets) + 1(Revenue / Total assets).

Z < 1.8 indicates high bankruptcy risk within 1 year

Z > 3.0 indicates low bankruptcy risk within 1 year

Z between these two scores is not a clear indicator.

Z was development for larger, public companies. Private companies

and smaller companies will tend to give signs of increased bankruptcy
risk.

For BGS Technologies:

Altman's Z bankruptcy predictor =

3.3(75+150) / 850) + 1.2((305-85)/850) + .6(615/235) + 1.4(315/850)

+ 1(1,000 / 850) =

.8735 + .3106 + 1.57 + .5188 + 1.1765 =

4.45
Financial Accounting C.Mulford: Financial Statement Analysis: 22

Selected leverage ratios (cont’d):

 Book value per share = common shareholders' equity /

number of shares of common stock outstanding.

Measures the amount that each shareholder would receive if

the company's assets were to be sold and liabilities
liquidated at book value.

For BGS Technologies: $615,000 / 100,000 = $6.15 / share

If the market price of BGS Technologies were less than $6.15

per share, BGS would be worth more in liquidation than as a
going concern. Such low valuations occur when companies
are having financial difficulties and losses are expected to
recur in the future.

 Price to book value:

Market price per share / book value per share.

For BGS Technologies, assuming a $20 share price,

$20 / $6.15 = 3.25.

The company would be selling at 3.25 times book value.

Financial Accounting C.Mulford: Financial Statement Analysis: 23

The shares of technology firms tend to trade at prices well in

excess of book value, in fact, at multiples of book value.

Recent market price to book value multiples for selected

technology-related industries:

Aerospace and Defense 3.1

Computers and Peripherals 4.2
Drugs 7.5
Software 7.7
Semiconductors 3.4
Telecommunications Equipment 6.0
Telecommunications Services 4.9

Reasons for these high valuations relative to book value vary,

including the immediate expensing of research and
development expenditures and the high growth prospects of
these firms generally.

Other industries which sell at a high multiple to book value are

those where high spending on marketing costs are the norm.
Like research and development, marketing costs are expensed
immediately.

Softdrinks 9.4
Household products (brands) 5.1
 Financial Accounting C.Mulford: Financial Statement Analysis: 24

Selected activity ratios:

 Receivables turnover = Revenue / accounts receivable

Measures the number of times during the year that total accounts
receivable were created with new sales and then collected.

For BGS Technologies: $1,000,000 / $80,000 = 12.5 times.

More intuitive is Receivables in days:

Receivables in days = 365 / Receivables turnover

Measures the average number of days it will take to collect the ending
balance in accounts receivable. Measures management's success in
collecting outstanding receivables.

For BGS Technologies: 365 / 12.5 = 29.2 days

 Inventory turnover = revenue / inventory

Measures the number of times during the year, in terms of revenue,

that total inventory is purchased and then resold.

For BGS Technologies: $1,000,000 / $150,000 = 6.67 times.

More intuitive is inventory in days:

Inventory in days = 365 / Inventory turnover

Measures the average number of days it will take to sell the

ending balance in inventory. Measures management's success in
controlling inventory.

For BGS Technologies: 365 / 6.67 = 54.7 days

 Financial Accounting C.Mulford: Financial Statement Analysis: 25

 Payables turnover = revenue / accounts payable

Measures the number of times during the year, in terms of revenue,

that total accounts payable is borrowed and then repaid.

For BGS Technologies: $1,000,000 / $55,000 = 18.2 times.

More intuitive is Payables in days:

Payables in days = 365 / Payables turnover.

Measures the average number of days management will delay

payment of the ending balance in accounts payable. Measures
management's use of financing from vendors.

For BGS Technologies: 365 / 18.2 = 20.1 days

 Cash cycle =
Inventory in days - Payables in days + Receivables in days.

Measures how many days it takes for a company to go through a

complete cash cycle.

A cash cycle is the length of time inventory is carried, (Inventory in

days) less the portion of that period financed by vendors, (Payables in
days), plus once inventory is sold, the length of time required to
convert resulting accounts receivable back to cash, (Receivables in
days).

Companies with shorter cash cycles are more efficient in their

management of current assets and better able to generate cash flow.

For BGS Technologies: 54.7 – 20.1 + 29.2 = 63.8 days.

Financial Accounting C.Mulford: Financial Statement Analysis: 26

 Fixed assets turnover = revenue / property, plant & equipment

Measures the number of times during the year that fixed assets
(PP&E, net) are recovered through Sales.

For BGS Technologies: $1,000,000 / $545,000 = 1.83 times

More intuitive is Fixed assets in days:

Total assets in days = 365 / Fixed assets turnover.

Measures the average number of days required to recover fixed

assets through sales. This ratio measures efficiency in the
management of investments in fixed assets.

For BGS Technologies: 365 / 1.83 = 199.5 days.

 Total assets turnover = revenue / total assets

Measures the number of times during the year that total assets are
recovered through Sales.

For BGS Technologies: $1,000,000 / $850,000 = 1.18 times

More intuitive is Total assets in days:

Total assets in days = 365 / Total assets turnover.

Measures the average number of days required to recover total

assets through sales. This ratio measures efficiency in the
management of investments in Total assets.

For BGS Technologies: 365 / 1.18 = 309.3 days.

Financial Accounting C.Mulford: Financial Statement Analysis: 27

Exercise in Calculating Activity Ratios

United Instruments, Inc.

Selected Financial Statement Statistics as of Dec. 31, 2015 (amounts in

millions):

Accounts receivable $ 544

Inventory 337
PP&E, net 1,526
Total assets 2,707

Accounts payable 272

Sales 2,690

Calculate the following ratios and comment:

Accounts receivable turnover and Days receivables:

Inventory turnover and Days inventory:

Accounts payable turnover and Days payables:

Cash cycle:

Fixed assets turnover and Days fixed assets:

Total assets turnover and Days total assets:

Financial Accounting C.Mulford: Financial Statement Analysis: 28

Combining Profitability and Activity Ratios

DuPont Analysis

We know that Return on equity is calculated as:

Net income / Shareholders’ equity,

We can expand this ratio as follows:

Return on equity =

Net income Sales Total assets

-------------- X --------------- X ------------------------
Sales Total assets Shareholders’ equity

which provides us with:

Return on equity =

Net margin X Asset turnover X Financial leverage.

(asset multiplier) (debt multiplier)

For BGS Technologies:

Return on equity, 22.7% =

$139,500* $1,000,000 $850,000

------------ X -------------- X ------------
$1,000,000 $850,000 $615,000

.14 1.18 1.38

*Sustainable net income calculated earlier.
Financial Accounting C.Mulford: Financial Statement Analysis: 29

We can use these three important measures of financial

performance and position to help us determine the more
important contributors to changes in Return on equity through
time and to differences in Return on equity across companies.

Is the company generating its Return on equity through

 High margins?

 Low asset investments and thus high turnover?

 High debt financing?

Financial Accounting C.Mulford: Financial Statement Analysis: 30

A Significant Increase in Return on Equity

Using DuPont Analysis to Understand Why

Gentrol, Inc.

Selected financial statement data (in thousands):

Quarter ended December 31, 2015 2014

From the income statement:

Net income (sustainable) $ 1,373 $ 1,287

Sales $ 15,389 $ 13,845

From the balance sheet:

Current assets $ 4,664 $ 4,269

Property, plant and equipment 931 962
Other assets 360 18
Total assets $ 5,955 $ 5,249

Current liabilities $ 3,480 $ 2,049

Long-term debt 1,997 14
Total liabilities 5,477 2,063

Shareholders’ equity 478 3,186

Total liabilities
and Shareholders’ equity $ 5,955 $ 5,249
Financial Accounting C.Mulford: Financial Statement Analysis: 31

Gentrol, Inc. (cont’d)

Calculating return on equity, we have:

2015: $1,373 / $478 = 287.2%

2014: $1,287 / $3,186 = 40.4%

How has the company boosted its return on equity?

Using DuPont Analysis:

Return on equity =

Net margin X Asset turnover X Financial leverage.

(asset multiplier) (debt multiplier)

For 2015, return on equity, 287.2% =

$1,373 $15,389 $5,955

------------ X -------------- X ------------
$15,389 $5,955 $478

.089 X 2.58 X 12.46

For 2014, return on equity, 40.4% =

$1,288 $13,845 $5,249

------------ X -------------- X ------------
$13,845 $5,249 $3,186

.093 X 2.64 X 1.65

Financial Accounting C.Mulford: Financial Statement Analysis: 32

Gentrol, Inc. (cont’d)

We can see that the company’s net profit margin and asset
turnover actually declined in 2015 from 2014.

The significant increase in Return on equity is due to a

significant increase in its use of debt financing - the debt
multiplier - which adds to the company’s risk level.
Financial Accounting C.Mulford: Financial Statement Analysis: 33

Using DuPont Analysis to Compare Corporate Performance

Intel Corp. and IBM

In a recent year, Intel Corp. and IBM report remarkably similar

measures of return on equity:

Intel Corp. return on equity: 28.8%

IBM return on equity: 28.2%

Using DuPont Analysis we see that,

Return on equity =

Net margin X Asset turnover X Financial leverage.

(asset multiplier) (debt multiplier)

For Intel Corp.:

.215 X .93 X 1.44

For IBM:

.088 X .90 X 3.58

Financial Accounting C.Mulford: Financial Statement Analysis: 34

Intel Corp. and IBM (cont’d)

From this analysis we better understand the performance of the

two companies.

 IBM is much less profitable than Intel Corp.

 The two companies have remarkably similar asset turnover

rates.

 IBM uses debt to lever a lower profit margin to a return on

equity that is similar to Intel’s.
Financial Accounting C.Mulford: Financial Statement Analysis: 35

Using DuPont Analysis to Compare Corporate Performance

Exercise Using Data for

Thiokol Corp. and Wyman-Gordon, Inc.

Use the data provided below to compare financial performance

for the two companies (amounts in millions).

Thiokol Wyman-Gordon
Sales $ 889.5 $ 499.6
Net income $ 51.4 $ 25.2
Total assets $ 818.3 $ 375.9
Shareholders’ equity $ 447.9 $ 109.9

Using DuPont Analysis we see that,

Thiokol Corp.:

Return on equity = _____

Net income Sales Total assets

-------------- X --------------- X ------------------------
Sales Total assets Shareholders’ equity

Net margin X Asset turnover X Financial leverage.

(asset multiplier) (debt multiplier)

Return on equity =

_____ X _____ X _____

Financial Accounting C.Mulford: Financial Statement Analysis: 36

Thiokol Corp. and Wyman-Gordon, Inc. (cont’d)

Wyman-Gordon, Inc.:

Return on equity = _____

Net income Sales Total assets

-------------- X --------------- X ------------------------
Sales Total assets Shareholders’ equity

Net margin X Asset turnover X Financial leverage.

(asset multiplier) (debt multiplier)

Return on equity =

_____ X _____ X _____

Financial Accounting C.Mulford: Financial Statement Analysis: 37

Analyzing the Cash Flow Statement

How is BGS Technologies doing on a cash flow basis?

Cash Provided (Used) in Operating Activities:

Is the company generating positive cash flow from operating

activities?

 Positive cash flow: management has more discretion in

decision making

 Negative cash flow: eventually management must look to

third parties for cash, may restrict decision making.
 Lenders - debt financing
 Shareholders - new stockholders' equity

BGS Technologies is generating positive cash from

operating activities in the amount of $145,500. This is cash
that can be used to increase its investments, to reduce debt
levels or to pay dividends.

 Net cash margin =

operating cash flow / Sales

A cash flow counterpart to the Net margin ratio. The

percentage of each sales dollar resulting in operating cash
flow.
For BGS Technologies:

$145,500 / $1,000,000 = 14.5%

Financial Accounting C.Mulford: Financial Statement Analysis: 38

Cash Provided (Used) in Investing Activities:

Is the company investing in new property, plant and equipment

or liquidating itself?

BGS Technologies increased its investment in property,

plant and equipment in the amount of $315,000.

 More than enough to replace, property, plant and

equipment consumed in operations during the year.

 Depreciation expense - a crude measure of property,

plant and equipment consumed in operations, $32,000.

BGS Technologies helped to finance its investment in

property, plant and equipment by selling ST and LT
investments, $110,000.

 Capital expenditures to depreciation expense - measures

extent to which new investments in property, plant and
equipment are replacing productive capacity consumed in
operations.

For BGS Technologies: $315,000 / $32,000 = 9.84.

BGS Technologies is adding significant amounts to
productive capacity.
Financial Accounting C.Mulford: Financial Statement Analysis: 39

Cash Provided (Used) in Financing Activities:

Is the company financing itself with debt or equity?

BGS Technologies issued $150,000 in new equity financing

during the year, reduced long-term debt in the amount of
$50,000 and paid dividends in the amount of $30,000 during
the year.

Overall, cash increased by $10,500 during the year.

Financial Accounting C.Mulford: Financial Statement Analysis: 40

Analyzing Cash Flows

Central Communications, Inc.

Use the cash flow statement provided below to comment on

the company’s cash flows provided (used) by operating,
investing and financing activities. During 2015, the company
reported sales of $ 104,324.

Central Communications, Inc.

The Statement of Cash Flows
(amounts in thousands)
2015
Cash and equivalents beginning of period $ 10,633
Cash flows from operations:
Net income (loss) 1,000
Depreciation and amortization 7,729
Deferred taxes 679
Trade receivables (9,411)
Inventories (5,646)
Other assets (1,392)
Accounts payable 2,786
Other liabilities and accrued expenses (682)
(4,937)
Cash flows used for investing:
Purchase of short-term investments (68,702)
Proceeds from sale and maturities of short-term
investments 84,354
Purchase of property and equipment (10,615)
Purchase of intangible assets
Note receivable from officer (300)
4,737
Cash flows from financing:
Proceeds from sale of common stock, net of issuance costs 2,412
Principal payments on capital leases and long-term
obligations (177)
2,235
Net change in cash and equivalents 2,035
Cash and equivalents, end of period $ 12,668
Financial Accounting C.Mulford: Financial Statement Analysis: 41

Central Communications, Inc. (cont’d)

Comments on cash flow

Operating activities:

Net cash margin:

Investing activities:

Capital expenditures to depreciation:

Financing activities:
Financial Accounting C.Mulford: Financial Statement Analysis: 42

Selected valuation ratios:

 Earnings per share (EPS):

Net income / common shares outstanding

Measures the amount of net income attributable to each share.

To get a clearer picture of performance, sustainable net

income should be used in the calculation.

For BGS Technologies: $139,500 / 100,000 = $1.40.

 Price / earnings ratio (PE):

Market price per share / Earnings per share

Measures the pay back period, or the number of years to

recover the market price of the stock through earnings
assuming earnings per share do not change.

For BGS Technologies: Assuming BGS was trading at $20

per share, the PE ratio would be $20 / $1.40 = 14.3.