NORTHEASTERN UNIVERSITY

COLLEGE OF BUSINESS ADMINISTRATION

M aster of Science in F inance

Review Module #2

FINANCIAL STATEMENT ANALYSIS

 LEARNING OBJECTIVES

 Be able to perform a complete ratio analysis of a firm's balance sheet beginning with the
extended Du Pont analysis and using the "tree" format illustrated in the packet

 Be able to construct an indirect cash flow statement using the format illustrated in the
packet

 Be able to relate how the strategic choices interact to impact ROE

 DU PONT ANALYSIS

Finance theory proposes that the primary goal of the firm is (should be?) to maximize stock price
per share. However, we also know that value, as is measured in the market place, is subject to
change on a daily basis. To objectively proxy for this primary goal, we will use Return on Equity.

ROE = PM X TATO X EM
(Profitability) (Asset Eff.) (Leverage)

Net Income Available Common

ROE =
Shareholder′s Equity

Sales
TATO = Total Assets

Net Income Available Common

PM = Sales

Assets Debt + Equity Debt

Equity Multiplier = Equity = Equity = 1 + Equity
 Sample Du Pont Analysis

Firm ROE PM TATO EM

Home Depot 15.75% 5.08% 1.82 1.70

Lowe's 11.55% 2.20% 2.39 2.20
Sears -41.29% -7.51% 0.63 9.16
K Mart 14.72% 2.49% 1.99 2.97
Wal-Mart 23.01% 3.67% 2.84 2.21
J.C. Penney 19.24% 4.07% 1.41 3.35

Motorola 8.81% 3.41% 1.25 2.07

Texas Instruments 13.96% 3.32% 1.43 2.94
Intel 19.59% 18.25% 0.72 1.49

IBM -17.97% -14.71% 0.39 3.13

Dell 27.53% 5.05% 2.17 2.51

Kodak 17.48% 5.68% 0.87 3.54

Xerox -26.32% -6.95% 0.43 8.81

1. Note differences by industry.

2. Note differences within an industry based on strategy choices.

3. Note differences based on performance.

 Master of Science in F inance
Ratio Definitions

PROFITABILITY

Net Income Available Common Net Income Available Common

ROE = ROA = Total Assets
Shareholder′s Equity
Net Income Available Common EBIT ( 1-T )
PM = Sales BEP = Total Assets

ASSET EFFICIENCY
Sales Sales
TATO = Total Assets FATO = Fixed Assets
COGS Ending Inv. X 365
INV T/O = Inv. Days =
Ending Inventory COGS

Acct. Pay. Accounts Receivable

Pay. Period = Credit Purch. Per Day ACP = DSO = Credit Sales Per Day
Acct. Pay. X 365 Accounts Receivable X 365
= Credit Purch. = Credit Sales

DEBT MANAGEMENT (Payables Period is also a bellwether of debt management)

Total Debt Total Debt

Debt Ratio = Total Assets D/E Ratio =
Common Equity

Assets EBIT
Equity Multiplier = Equity TIE = Interest Expense

EBIT EBIT + Lease Expense

TBC = FCC=
Interest +   Interest+LeaseExpense+ 
Princ.Repay. Princ.Repay.
 1-T   1-T 

LIQUIDITY

CA CA- INV
Current Ratio = CL Quick Ratio = Acid Test = CL

 Comments on Financial Ratios

 Profitability

 Return on Equity (ROE) is the rate of return on common stockholders’

equity.
 Return on Assets (ROA) is the rate of return on all assets.
 Profit Margin (PM) is the amount of net income that is produced from each
dollar of sales.
 Basic Earning Power (BEP)is the operating earnings (without the influence
of debt and taxes) generated by the firm’s assets.

 Asset Efficiency

 Total Asset Turnover (TATO) the amount of revenues (sales) generated

from each dollar of assets.
 Fixed Asset Turnover (FATO) the amount of revenues (sales) generated
from each dollar of fixed assets
 Inventory Turnover is a measure “on average” of how many times a year a
company sells (or “turns”)its inventory.
 Inventory Days is a measure “on average” of how long goods remain in
stock before being sold.
 Average Collection Period (ACP) or Days Sales Outstanding (DSO) is a
measure of how long it takes a company to collect its credit sales “on
average”
 Payables Days is a measure “on average” of how long it takes a company to
pay for credit purchases. This measure provides information about asset
efficiency since current liabilities are typically satisfied by current assets.
It also provides information-ion about debt management. Increasing
payables days can be an early warning signal of financial distress.

 Debt Management
  The Debt Ratio is the percentage of assets that are financed by debt
(including short-term liabilities).
 The Debt to Equity Ration (D/E) is the amount of debt that is employed per
dollar of equity
 The Equity Multiplier is the amount of total assets employed per dollar of
equity. The equity multiplier captures the “leverage” effect of combining
debt with equity.
 Times Interest Earned (TIE) is the number of times that income available to
pay interest exceeds the interest obligation.
 Times Burden Covered (TBC) is the number of times that income available
to service debt exceed the total debt payment (interest and principle)
obligation.
 Fixed Charge Coverage (FCC) is the number of times that income available
to service debt and fixed lease payments exceed these combined fixed
payment obligations

 Liquidity Management

 The Current Ratio is the number of times that current assets (assets
expected to become cash within one year) exceed current liabilities
(obligations to be settled in cash within one year).
 Quick Ratio (Acid Test) is the number of times that current assets exclusive
of inventories exceed current liabilities. This ratio is a more stringent test
of liquidity since it does not assume that inventories will necessarily be
sold.

 Caveats to Using Financial Ratios

 Net income is not cash

 Assets are book value, not market value
 Ratios are influenced by seasonality
 Random occurrences influence ratios
 Ratios are measures at a point in time
 COMMON SIZE FINANCIAL STATEMENTS

A very useful tool that is often used to remove size effects from financial statements and to gain
insight into the management and credit worthiness of the firm is to prepare common size financial
statements. These statements reveal trends that are often not seen by examining the actual
financial statements. The use of common size statements should be combined with ratio analysis.
A suggested framework is presented on the next page.

 Common Size Balance Sheet

To prepare a common size balance sheet, you simply divide all balance sheet entries by
total assets and express each account as a % of total assets. By comparing successive
years (it is helpful to put several years data side by side), one can identify changes in
current assets, liabilities, or fixed assets as a % of total assets.

 Common Size Income Statement

To prepare a common size income statement, you simply divide all income statement
entries by net sales and express each entry as a % of net sales. By comparing successive
years, one can identify any changes in profit margins, operating expenses, or productions
costs
 A FORMAT FOR ANALYSIS

ROE
|
|
ROA-------------- |
| |
| |
Pr ofit________________Asset Efficiency_________________Debt Management
| | |
PM TATO EM
| | |
| | |
| | |
GPM FATO D/E
| | |
| | |
| | |
%Op Exp. Inv. T/O D/A
| | |
| | |
| | |
%Int. Exp. Inv. Days TIE
| |
| |
| |
DSO FCC
| |
| |
| |
Liquidity - - - - - - - - - Pay Days
CR

QR
 THE CASH FLOW STATEMENT

One of the most important tools to be used in analyzing the financial statements of a company is
the cash flow statement. Today, there are basically two variations of the cash flow statement that
are used for financial reporting purposes and analysis -- the direct cash flow statement and the
indirect cash flow statement. Additionally, some analysts use a sources and uses statement.
Although there are advantages to the direct statement, the indirect statement is generally more
convenient

 Cash Flow Statement Format

Both the direct and indirect cash flow statements used for financial reporting have three
sections -- Cash From Operations, Cash From Investing Activities, and Cash From
Financing Activities. A suggested approach for formulating an Indirect Cash Flow
Statement is on the next page. This approach is good to get you started, but it is not
foolproof or universally correct. Remember that our goal is to analyze the firm and not to
produce documents for reporting purposes. Sometimes, you need to think a bit!

 The Direct Statement vs the Indirect Statement

The primary difference between the direct and indirect statement occurs in the Operating
Income section. A direct cash flow statement lists receipt of revenues and disbursement
of expenses on a cash basis. The indirect cash flow statement begins with net income
from the income statement (prepared on an accrual basis), and adjusts net income to derive
cash from operations.
 INDIRECT CASH FLOW STATEMENT

Cash Flow Fr om Oper ations

1. Start with Net Income.
2. Add Back Depreciation.
3. Check Changes in Operating Assets.
Note: Operating assets are all current assets except Cash.
Increase ⇒- (Use)
Decrease ⇒+ (Source)
4. Check Changes in Operating Liabilities.
Note: Operating liabilities are all current liabilities except short-term debt.
Increase ⇒+ (Source)
Decrease ⇒- (Use)

Cash Flow Fr om Investing Activities

5. Check Changes in Long-term Assets.
Note: It is best to look at the change in assets before depreciation whenever possible
Increase ⇒- (Use)
Decrease ⇒+ (Source)

Cash Flow fr om Financing Activities

6. Check Changes in Financing Actions
 Notes Payable
 Long-term Debt
 Common Stock
Increase ⇒+ (Source)
Decrease ⇒- (Use)

7. Now check dividends.

 Dividends paid are a use of cash and are considered a part of financing

8. Check Against the Change in the Cash Account

Sum of #1 - #6 = Change in Cash Account 
Change in Cash Account
+ Beginning Cash
= Ending Cash
 SUGGESTIONS FOR EFFECTIVE ANALYSIS

 Trend Analysis

Use several years of data to identify trends. Put the ratios, common size
statements, and cash flow statements side by side by accounting period (e.g, place
2004, 2005, and 2006 side by side).

 Ordered Approach

Look at the cash flow statement first to identify major sources and uses of cash.
Then look at the applicable accounts on common size statements and at the
appropriate ratios to gain insight as to the cause of the changes -- was the change
driven by sales growth? changes in profitability? asset mismanagement? etc.
Calculate the % sales growth from the previous year for each year. The need for
cash is often driven by growth.

 Off-balance-sheet Financing

Look beyond definitions of ratios to gain true insight into a company's financial
position. As an example, many companies use "off-balance-sheet" financing in
the form of long-term operating leases. One firm might borrow money on a long
term basis and purchase fixed assets while another firm chooses into long-term
leases. In either case, the firm has the use of a fixed asset and is obligated to make
fixed payments over some period of time. In the debt case, the firm show s greater
use of debt, while in the leasing case, the firm will appear to be less levered. As a
solution to this problem, value a lease as if it were debt (use your financial
calculator and a guess at the cost of debt to get the present value of the stream of
lease payments) and then recalculate the ratios.

 Small Firms

Small firms may pose unusual situations. First, many small firms' financial
statements are compiled, not audited. The accountant does not assure the
correctness of compiled statements. Be aware of "misplaced" accounts (ie.,
short-term liabilities listed as long-term). Second, the distinction between divi-
dends and wages for the closely held company is often blurred. Consider what
would be a reasonable salary. Many small firms are subchapter S. This means that
the income of the firm is declared as income on the owner's personal income tax
return. Thus, dividends often reflect cash required to pay the firm's taxes.
 Focus of Financial Analysis

When analyzing a firm's financial statements, remember that your goal is to gain
insight into the financial management of the firm -- not to be an accountant or
strictly adhere to rote ratio definitions (although you should be sure and know those
definitions). Thus, think about what you are trying to measure and ask yourself
the question "Does the ratio capture what I want to measure?" If so, use the ratio.
If not, do not be afraid to think about the situation and modify your approach. eg.
the lease situation mentioned above

 Some Useful Accounting Relationships

 For the wholesale distributor and most retail firms:

Ending Inventory = Beginning Inventory + Purchases - COGS

Thus, for the wholesale distributor and most retail firms:
Purchases = Ending Inventory -Beginning Inventory + COGS

 For manufacturing firms:

Ending Inv. = Beginning Inv. + Purchases + Labor - COGS

We should attempt to calculate exact purchases. Often times, however, we
will not have detailed information that allows calculations of exact
purchases for manufacturing firms. In these cases, we can calculate
purchases the same way as we do for the wholesale distributor with the
understanding that our calculations are upwardly biased.

 For all firms:

Net Fixed Assets = Gross Fixed Assets - Acc. Depreciation

As long as the firm has not sold any fixed assets:

Depreciation = Acc. Dep.(Year 0) - Acc. Dep. (Year -1)

Change in Retained Earnings = NI - Dividends

Dividends = NI - Change in Retained Earnings
 A PRIMER ON CAPITAL INVESTMENT AND DEPRECIATION

In analyzing any company, one is generally interested in how much the company has invested in
new fixed assets over the period of analysis and the amount of non-cash expense that the company
has incurred in the form of depreciation. Unfortunately, different reporting practices often dictate
that we have to do some work in order to obtain this information.

 Depreciation Expense

The additional amount of fixed assets that a firm depreciates over the course of the
year. This is found on the income statement, although we can calculate from the
change in the balance sheet accounts.

 Accumulated Depreciation

The total amount that we have depreciated fixed assets over time. In other words,
the sum of all depreciation expenses over the number of years that we have owned
the assets. This is found on the balance sheet.

Notes: We never depreciate land.

Depreciation expense in period t = change in Accumulated Depreciation from t-1 to t.
New Investment in F ixed Assets in period t = change in Gross F ixed Assets from t-1 to t.

 CAPITAL INVESTMENT AND DEPRECIATION -- EXAMPLES

Case 1 -- The Easy Case

2007 2006

Gross Fixed Assets 50,000 40,000

less Accum. Dep. 27,000 23,000
Net Fixed Assets 23,000 17,000

New Investment = 50,000 - 40,000 = 10,000

Depreciation Expense = 27,000 - 23,000 = 4,000
Delta Net fixed Assets = 23,000 - 17,000 = 6,000

Note: The new investment is simply the change in net fixed assets plus the depreciation expense.

New Investment = Delta GFA = Delta NFA + Dep. Exp. = 6,000 + 4,000 = 10,000.

Case 2 -- Gr oss Fixed Assets Not Repor ted

 2007 2006

Net Fixed Assets 23,000 17,000

But, from the income statement we know that depreciation expense is 4,000.
Therefore, we can back into new investment as follows.

New Investment = Delta NFA + Dep. Exp. = 6,000 + 4000 = 10,000.

Case 3 -- The Impossible Case

2007 2006

Net Fixed Assets 23,000 17,000

In this case, depreciation expense is not explicitly listed on the income statement (ie. it is lumped
together with other expenses in an account called operating expenses). We are stuck, so do the best
you can. Since NFA increased, we know that the company purchased new assets.

Approximate Investment = Delta Net Fixed Assets = 6,000.

Depreciation = 0

We know that we are understating investment by the amount of the correct depreciation and that
we are understating depreciation by the same amount. Thus, the cash flow statement will still
balance, but the Operations section will be understated and the Investment section will be
overstated.

Case 4 -- The Impossible Case II

2007 2006

Net Fixed Assets 15,000 17,000

Again, depreciation expense is unavailable. In this case, net fixed assets decreased slightly.
Although a variety of events could have happened, it seems likely that the decrease is due to
depreciation and that there was no new investment in fixed assets.

"Best Guess" Depreciation expense = 17,000 - 15,000 = 2,000

"Best Guess" Investment = 0.

Case 5 -- Asset Wr ite-Off

Suppose that during 2007, the company writes off an asset at 15,000 that is completely
depreciated.

2007 2006

Gross Fixed Assets 35,000 40,000

less Accum. Dep. 12,000 23,000
Net Fixed Assets 23,000 17,000

When a company writes off an asset, the accountant removes the asset from the books. Thus, we
must reduce GFA by 15,000. Correspondingly, we must remove the depreciation that has
accrued on this assets from the books. Thus, we must reduce Acc. Dep. by 15,000 since the asset
was fully depreciated. Note that since the asset was fully depreciated, the Net Fixed Assets
account is unaffected.

A problem arises in estimating new investment and depreciation, however, since the write-off
masks what really happened over the course of the year. Take the above case. GFA and Acc.
Dep. have decreased. To get at the truth, we must reconstruct how the balance sheet would have
looked had the write-off not occurred. This means we have to "undo" the write-off by adding the
15,000 back to GFA and Acc. Dep.

Reconstructed Balance Sheet

2007 2006

Gross Fixed Assets 50,000 40,000

less Accum. Dep. 27,000 23,000
Net Fixed Assets 23,000 17,000

Now, we are back in familiar territory!

New Investment = 50,000 - 40,000 = 10,000

Depreciation Expense = 27,000 - 23,000 = 4,000
 EXAMPLE OF FINANCIAL STATEMENT ANALYSIS-- MURCHESON CARPET
COMPANY
Murcheson Carpet Company, Inc.
Balance Sheet
October 31, 2005, 2004, and 2003

ASSETS 2005 2004 2003

CURRENT ASSETS:
Cash $ 41,582 $ 43,429 $ 16,811
Accounts Receivable 51,034 30,926 32,914
Inventory 43,244 40,018 65,443
Prepaid Expenses 3,061 2,202 1,275
TOTAL CURRENT ASSETS 138,921 116,575 116,443
EQUIPMENT
Leasehold improvements 780 780 780
Fixtures and equipment 10,332 10,332 10,222
Service vehicles 39,666 39,666 40,073
50,778 50,778 51,075
Less: Accumulated Depreciation (38,338) (33,453) (27,589)
NET EQUIPMENT 12,440 17,325 23,486
TOTAL ASSETS $151,361 $133,900 $139,929
LIABILITIES & SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Current Maturities of Long-term Debt $ -0- $ -0- $ 2,225
Accounts Payable 17,021 20,626 14,344
Accrued Liabilities 3,058 4,007 3,734
Loans From Shareholders 35,000 -0- -0-
TOTAL CURRENT LIABILITIES 55,079 24,633 20,303
SHAREHOLDERS' EQUITY:
Common Stock-$10 Par Value 1,000 1,000 1,000
Retained Earnings 95,282 108,267 118,626
TOTAL SHAREHOLDERS' EQUITY 96,282 109,267 119,626
TOTAL LIAB. & SHAREHOLDER'S EQUITY $151,361 $133,900 $139,929
 Murcheson Carpet Company, Inc.
Statement of Income and Retained Earnings
F or the Years Ended October 31, 2005, 2004, and 2003

2005 2004 2003

Net Sales $591,351 $660,532 $650,026
Cost of Sales * 454,661 515,289 511,798
GROSS PROFIT 136,690 145,243 138,228
OPERATING EXPENSES:
Officers' salaries 64,200 50,100 50,100
Depreciation expense 4,885 7,858 6,407
Vehicle expense 6,696 7,638 12,647
Other expenses 34,825 39,410 38,308
110,606 105,006 107,462
PROFIT FROM OPERATIONS 26,084 40,237 30,766
OTHER INCOME (EXPENSE):
Discounts earned 13,707 18,657 20,781
Gain (loss) on disposal of assets -0- (463) 2,400
Interest Income 1,376 1,217 1,283
Interest expense -0- (53) (370)
15,083 19,358 24,094
INCOME BEFORE TAXES 41,167 59,595 54,860
Provision for Income Taxes -0- -0- -0-
NET INCOME 41,167 59,595 54,860
Retained Earnings, Beginning of year 108,267 118,626 92,156
Less Dividend Paid (54,152) (69,954) (28,390)
RETAINED EARNINGS, END OF $ 95,282 $108,267 $118,626
YEAR

* 85% cost of material (COGS) and 15% direct installation labor (paid directly to sub contractors).
Inventory is valued at material cost only.
 Murcheson Carpet Company, Inc.
Common Size Balance Sheet
October 31, 2005, 2004, and 2003

ASSETS 2005 2004 2003

CURRENT ASSETS:
Cash 27.47% 32.43% 12.01%
Receivables - Trade 33.72% 23.10% 23.52%
Inventory 28.57% 29.89% 46.77%
Prepaid Expenses 2.02% 1.64% 0.91%
TOTAL CURRENT ASSETS 91.78% 87.06% 83.21%
EQUIPMENT
Leasehold improvements 0.52% 0.58% 0.56%
Fixtures and equipment 6.83% 7.72% 7.31%
Service vehicles 26.20% 29.62% 28.64%
33.55% 37.92% 36.51%
Less: Accumulated Depreciation (25.33%) (25.98%) 19.72%
NET EQUIPMENT 8.22% 12.94% 16.79%
TOTAL ASSETS 100.00% $100.00% $100.00%

LIABILITIES & SHAREHOLDERS' EQUITY

CURRENT LIABILITIES
Current Maturities of Long-term Debt -0- -0- 1.59%
Accounts Payable 11.25% 15.40% 10.25%
Accrued Liabilities 2.02% 2.99% 2.67%
Loans From Shareholders 23.12% -0- -0-
TOTAL CURRENT LIABILITIES 36.39% 18.39% 14.51%
SHAREHOLDERS' EQUITY:
Common Stock-$10 Par Value 0.66% 0.75% 0.71%
Retained Earnings 62.95% 80.86% 84.78%
TOTAL SHAREHOLDERS' EQUITY 63.61% 81.61% 85.49%
TOTAL LIABILITIES & SHAREHOLDER'S EQUITY 100.00% 100.00% 100.00%
 Murcheson Carpet Company, Inc.
Common Size Statement of Income and Retained Earnings
F or the Years Ended October 31, 2005, 2004, and 2003

2005 2004 2003

Net Sales 100.00% 100.00% 100.00%
Cost of Sales 76.89% 78.01% 78.74%
GROSS PROFIT 23.11% 21.99% 21.26%
OPERATING EXPENSES:
Officers' salaries 10.85% 7.58% 7.71%
Depreciation expense 0.83% 1.19% 0.99%
Vehicle expense 1.13% 1.16% 1.95%
Other expenses 5.89% 5.97% 5.89%
18.70% 15.90% 16.54%
PROFIT FROM OPERATIONS 4.41% 6.09% 4.72%
OTHER INCOME (EXPENSE):
Discounts earned 2.32% 2.82% 3.20%
Gain (loss) on disposal of assets -0- (0.07%) 0.37%
Interest Income 0.23% 0.18% 0.20%
Interest expense -0- 0.01% 0.06%
2.55% 2.92% 3.71%
INCOME BEFORE TAXES 6.96% 9.01% 8.43%
Provision for Income Taxes -0- -0- -0-
NET INCOME 6.96% 9.01% 8.43%
 Murcheson Carpet Company, Inc.
Statement of Cash F lows
F or the Years Ended October 31, 2005 and 2004

2005 2004
Cash Flow From Operations
Net Income $41,167 $59,595
Depreciation 4,885 7,858
Change in Accounts Receivable (20,108) 1,988
Change in Inventory (3,226) 25,425
Change in Prepaid Expense (859) (927)
Change in Accounts Payable (3,605) 6,282
Change in Accrued Liabilities (949) 273
Cash Flow From Operations 17,305 100,494

Cash Flow From Investing Activities

Increase in Fixtures and Equipment 0 (110)
Sell/Purchase of Service Vehicles 0 *(1,587)
Cash Flow From Investing 0 (1,697)

Cash Flow From Financing Activities

Current Maturities of Long-term Debt 0 (2,225)
Change in Loans From Shareholders 35,000 0
Dividends (54,152) (69,954)
Cash Flow From Financing (19,152) (72,179)

Change in Cash Position (1,847) 26,618

Beginning Cash 43,429 16,811
$41,582 $43,429

*Plug to balance the cash flows. A service vehicle was sold and written off, and a new vehicle
was purchased, masking the observed relationship in gross fixed assets.
 Murcheson Carpet Company, Inc.
Ratio Analysis
F or the Years Ended October 31, 2005 and 2004

2005 2004 2003

Over all Per for mance Measur es

ROE* 42.76% 54.54% 46.25%

ROA* 27.20% 44.51% 39.21%
BEP 36.25% 58.44% 54.30%

Pr ofitability Measur es

PM* 6.96% 9.02% 8.44%

GPM 23.11% 21.99% 21.26%
% Operating Expense 18.70% 15.90% 16.53%
% Interest Expense 0% 0.01% 0.06%

Asset Efficiency Measur es

TATO 3.91 4.93 4.65

FATO 47.54 38.13 27.68
Inv. T/O 8.94 10.95 7.82
Inv. Days 41 33 47
DSO 32 17. 18.

Debt Management

EM 1.57 1.24 1.17

D/E 0.57 0.24 0.17
D/A 0.36 0.19 0.15
TIE NA 1,125 149
Payables Days 16 18 NA
Payables Days# 16 17 12
*Based on pre-tax income -- Subchapter S Corporation
#Uses Cost of Sales X .85 as estimate of purchases
 Analysis

1. First, note that sales were basically stable from 2003 to 2004 (up 1.5%), but declined about
10.5% from 2004 to 2005. It is worth noting that the economy was moving into a
recession in the latter half of 2005, but we also want to be on the alert for policy changes.
2. Cash Flow Statement: Net income provides the single largest source of cash in each of the
two years. The other substantial sources of cash are inventory in 2004 and a loan form
shareholders (the owner) in 2005. The major uses of cash are dividends (each year) and
accounts receivable in 2005.
Implications: Income appears to be a very important source of financing, so profitability
should be closely analyzed. The large use of cash to fund accounts receivable should also
be explored. Finally, it is interesting that the owners pay themselves large dividends
while making a loan back to the company. This could suggest a temporary liquidity need,
perhaps arising from accounts receivable.
3. Common Size Balance Sheet: The large use of cash for receivables is verified by an
increase in receivables from 23% to over 33% of assets. A large reduction in inventory
from 2003-2004 is also evident, providing the source of cash that was identified on the cash
flow statement. Cash seems to be very variable from year to year. Note, however, that
current assets represent 0-90% of assets while current liabilities represent only 14-18% (if
we exclude the loan from the owner). There is no long-term debt. Finally, there is a
significant reduction in retained earnings as a percentage of assets form 2004-2005.
Implications: Once again, the increase in receivables suggests that collections should be
explored. The company is very liquid and follows a very conservative working capital
policy -- most of the current liabilities are financed by owners’ equity. There appears to
be a substantial amount of unused debt capacity. The fluctuating cash is not a problem.
4. Common Size Income Statement: Net Profit Margin appears to be healthy, ranging from
7-9%. Note that Gross Profit Margin actually appears to be on an increasing trend.
Operating expenses increase notably form 2004-2005, but the increase is due to an increase
in Officers Salaries (who are the owners). Other expenses have declined.
Implications: The company seems to be very profitable. One wonders if the decline in
sales from 2004-2005 is related to the increase in Gross Profit Margin -- have prices
increased or costs decreased. Operating expenses seem to be reasonable, and perhaps
even declining.
5. Income Statement: Income declined from $59,595 to $41,167 (2004-2005). The major
source of the decline is a $14,000 increase in officers salaries. Dividends decreased by
almost $16,000 from 2004-2005. Note that the company (as a subchapter S)pays not
taxes. Taxes are paid by the owners.
Implications: As a subchapter S corporation, it does not really matter (except for “red
flagging” the IRS in extreme situations) if the owners take compensation as salary or
dividends. The increase in salary was more than offset by a decrease in dividends. Profit
would be at 2003 levels if the salaries had remained constant and profit margins would
have actually increased.
6. Ratios: ROE is very high ranging from 43-55% (note that theses are pre-tax, but who
among us would not take it?) Inventory ranges from about 1-1½ months of sales on hand.
Receivables were collected in about ½ month in 2003 and 2004. The 2005 number has
increased to about one month, still a reasonable collection period (30 days, same as cash?).
Implications: The company seems to be doing very well. The one question the still
remains is the increase in receivables from 2004-2005. Even the 2005 receivables do not
seem way out of line, however.
7. Over all Impr essions: The company seems to be a very profitable, reasonably well-run,
“Mom and Pop” organization. It is very conservatively financed (about 85% equity) and
the owners seem to recognize this as they are removing equity from the company through
large dividend payments. This strategy would suggest that the business is mature and not
poised for high growth. In fact, the increase in gross profit margin coupled with the
decrease in sales suggest that the owners may be looking to make more income on less
sales. The only minor issue that seems worth pursuing is the recent increase in receivables
coupled with a loan from the shareholders. Since we are looking at a point in time and this
is a small company, one or two orders could be making this difference. It might be worth
following up on the receivables and the shareholder loan with the owners to gain more
insight.

 Prologue
The receivables increase was due to one rather large order from a local municipality
that had just been billed prior to the end of the fiscal year. The large dividends
were to (i) cover tax obligations and (ii) reduce the exposure of equity to litigation
risk (the owners’ personal assets are protected from litigation against the firm).
The dividends had to be paid prior to the end of the fiscal year. The loan from the
shareholders was to provide temporary liquidity until the municipality paid its bill.
The loan was repaid in about one month. The owners were attempting
(successfully) to increase profitability, even if it meant a decline in sales, as long as
they maintained a minimum income level.