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30
Chapter 2
Financial Statement and
Cash Flow Analysis
OPENING FOCUS
Accounting is the language of business, but, as we know, the elements of language can be changed and rearranged to make different stories. So too with accounting information. Studies by professors from Duke University in the USA have shown that execu- tives are adept at making changes to accounting information, perfectly legally, which can have a dramatic impact on the ‘bottom line’. John Graham and Campbell Harvey, with their colleague Shivaram Rajgopal from Washington University, surveyed over 400 finance executives in large companies. What they discovered was that companies focus very heavily on ‘bottom line’ earnings, particularly earnings per share. The vast majority of companies would defer a good, profitable project if by taking it on in this accounting period they
would impact on the earnings per share number in a manner that would surprise the stock market. Managers would trade off good value projects in favour of smoother earnings. None of these practices are in any way fraudulent or illegal. Rather they show how closely the managers watch the analysts who watch the earnings of the companies that the managers manage. By contrast, other research, such as that by Rebecca Rosner, shows that companies that later go into bankruptcy engage pre bankruptcy in accounting manipulation of a more substantive nature. This chapter provides you with the basic skills to analyse and interpret, from a finance perspective, the accounts of modern corporations.
Sources: Campbell Harvey, John Graham and Shivaram Rajgopal (2006) ‘The Economic Implications of Corporate Financial Reporting’,
Journal of Accounting and
Economics
, 40; Rebecca Rosner (2003) ‘Earnings Manipulation in Failing Firms’,
Contemporary Accounting Research
, 20(2): 361–408.
Accounting for the numbers
LEARNING OBJECTIVES
After studying this chapter you should be able to :
(^) List and define the key financial statements that firms are required to provide to their shareholders.
(^) Evaluate a firm’s cash flows using its financial statements, including the statement of cash flows.
(^) Calculate and interpret liquidity, activity and debt ratios.
(^) Review the popular profitability ratios and the role of the DuPont system in analysing the firm’s returns.
SMART FINANCE
Use the learning tools at www.cengage.co.uk/megginson
Part 1 The basic tools of finance 1 The scope of corporate finance
2 Financial statement and cash flow analysis 2.1 Financial statements 2.2 Cash flow analysis 2.3 Analysing financial performance using ratio analysis 2.4 Summary and conclusions 3 Present value
Part 2 Valuation, risk and return 4 Valuing bonds 5 Valuing shares 6 The trade-off between risk and return 7 Risk, return and the capital asset pricing model
Part 3 Capital budgeting 8 Capital budgeting process and techniques 9 Cash flow and capital budgeting 10 Capital cost and capital budgeting
Part 4 Capital structure and dividend policy 11 Raising long-term equity financing 12 Capital structure 13 Dividend policy
Part 5 Additional topics in corporate finance 14 Entrepreneurial finance and venture capital 15 International financial management 16 Risk management 17 Mergers, acquisitions and corporate control
harmonize internationally the rules underlying the presentation of accounting statements. Again, thinking of accounting as a language, the existence of different grammars – ways in which the language can be meaningfully put together – can cause confusion. Thus, in recent years the International Accounting Standards Board (IASB) has come to the forefront of the debate. In February 2006 the SEC reaffirmed its commitment to convergence and its wish to work with the IASB on the required convergence issues. Thus, the emergence of a world standard for accounting information, a world grammar, appears possible. In this chapter we use data taken from the Thomson ONE database. Worldscope is a trade name of Thomson Financial, the providers of Banker One Business School Edition, a subscription to which is bundled with this text. In that package are accounts and statements from a large number of companies. However, the material in the pack- age is a small sample of what is generally available from Worldscope, as the entire dataset covers 96 per cent by market value of world equity markets. Worldscope data are harmonized, based on analysis of original statements from companies. This harmonization is undertaken by the analysts at Thomson, and the resulting data are designed to be internationally comparable. Worldscope data are used worldwide by thousands of academics, analysts, bankers and investors. However, despite this de facto world standard, you should realize that the Worldscope data and accounts have no legal basis. A further issue is that the analysts at Worldscope on occasion use slightly different formulae for ratios from those that appear here. On the Thomson ONE site, right click- ing on a number, ratio or element of a statement will show you how it is made up. The key financial statements of any company are (1) the balance sheet, (2) the income statement and (3) the statement of cash flows. Companies may well, in their annual or quarterly reports, use different names. However, the information presented is the same. (In the USA an important further requirement is to provide a statement of retained earnings.) Our concern in this section is to review the information presented in these statements. Throughout, we present the financial statements from the 2006 annual report of LVMH, the French-based luxury goods producer, as an example of the use of standards and methods.
Balance sheet
A firm’s balance sheet presents a ‘snapshot’ view of the company’s financial position at a specific point in time – the financial year-end. By definition, a firm’s assets must equal the combined value of its liabilities and shareholders’ equity. Phrased differently, either creditors (lenders) or equity investors (owners) finance all of a firm’s assets. A balance sheet shows assets on the left-hand side and the claims of creditors and shareholders on the right-hand side. Both assets and liabilities by convention appear in descending order of liquidity, or the length of time it takes for accounts to be converted into cash in the normal course of business. The most liquid asset, cash, appears first, and the least liquid, fixed assets, comes last. Similarly, accounts payable represents the obli- gations the firm must pay with cash within the next year, whereas the last entry on the right-hand side of the balance sheet, shareholders ’ equity, quite literally never matures. This ‘double entry’ system is not new. Fra Luca Bartolomeo de Pacioli published the Summa , a coherent account of double entry bookkeeping and accounting, in 1494, but balance sheets in recognizably modern form are available from the early 14th century. Table 2.1 presents LVMH’s balance sheet as at 31 December 2006. As is standard practice in annual reports, the table also shows previous year accounts for comparison. Cash and cash equivalents are assets such as current account balances at commercial banks that can be used directly as a means of payment. ‘Other current assets’ represent very liquid, short-term investments, which financial analysts view as a form of ‘near cash’. Such securities would include short, fixed-term deposit accounts. Accounts
Chapter 2 Financial Statement and Cash Flow Analysis 33
receivable represent the amount customers owe the firm from sales made on credit. Inventories include raw materials, work in progress (partially finished goods) and finished goods held by the firm. Note also that LVMH is obviously owed rebates on income tax paid, which it expects to receive within the year, which makes it a current asset. The entry for property, plant and equipment is the book value of all real property, structures and long-lived equipment owned by the firm. Net property, plant and equipment represents the difference between this original value and accumulated depreciation – the cumulative expense recorded for the depreciation of fixed assets since their purchase. Tax authorities allow companies to depreciate, or charge against taxable earnings, a fraction of a fixed asset’s cost each year to reflect a decline in the asset’s economic value over time. The one fixed asset that is not depreciated is land, because it generally does not decline in value over time. To obtain the gross value of these assets for LVMH it is necessary to examine the account notes. Finally, brands and other intangibles include valuable items such as patents, trademarks, copyrights, exploration rights or other tradable assets. Although intangible assets are usually noth- ing more than legal rights, they are often extremely valuable, as the discussion of the market value of global brands in the Comparative Corporate Finance insert later in this chapter vividly demonstrates. In the case of LVMH, the value of the brands would reflect the world leading position it holds in areas of luxury goods, with brands such as Louis Vuitton, Pucci, Dior and Tag Heuer. Turning our attention to the other side of the balance sheet, current liabilities include accounts payable, which are amounts owed for credit purchases by the firm; short-term borrowings comprise outstanding short-term loans, such as overdrafts and term loans typically from commercial bank, and also include the short-term component of long- term debt, in other words the part of long-term debt that will be repaid within one year;
34 Part 1 The Basic Tools of Finance
TABLE 2.
Balance sheet for LVMH, end-2004, 2005 and 2006 (€mn)
2006 2005 2004 2006 2005 2004 Current assets 9 165 8 516 7 412 Current liabilities 6 356 6 591 6 076 Inventories and work in progress 4 383 4 134 3 598 Short-term borrowings 2 100 2 642 2 529 Accounts receivable 1 461 1 370 1 364 Accounts payable 1 899 1 732 1 581 Income tax 512 317 113 Income tax 692 373 201 Other current assets 1 587 1 225 1 302 Provisions 255 305 259 Cash and cash equivalents 1 222 1 470 1 035 Other current liabilities 1 410 1 539 1 506 Fixed assets 19 620 19 537 18 105 Long-term liabilities 10 835 10 978 10 766 Brands and other intangibles 8 227 8 530 7 838 Long-term borrowings 3 235 3 747 4 188 Goodwill 4 537 4 479 4 048 Provisions 983 949 883 Property, plant and equipment net 5 173 4 983 4 541 Deferred tax 2 862 2 925 2 458 Investments in associates 126 128 115 Other non-current liabilities 3 755 3 357 3 237 Non-current financial assets 504 451 718 Other non-current assets 658 660 628 Equity 11 594 10 484 8 675 Deferred tax 395 306 217 Share capital 147 147 147 Share premium account 1 736 1 736 1 736 Treasury shares 1 019 972 1 006 Minority interests 991 1 025 893 Translation adjustment 119 292 200 Group share of net profit 1 879 1 440 1 194 Reserves 7 979 6 816 5 911 Total assets 28 785 28 053 25 517 Total liabilities and equity 28 785 28 053 25 517
earnings or margin) equals revenue minus expenses. LVMH’s income statement, however, has several measures of ‘income’ appearing at different points. The first income measure is gross profit, which is the amount by which sales revenue exceeds the cost of goods sold (the direct cost of producing or purchasing the goods sold). Next, various operating expenses, including selling expense, general and administrative expense, are deducted from gross profits. The resulting operating profit of €3172 million represents the profits earned from the sale of products, although this amount does not include financial and tax costs. Other income, earned on transactions not directly related to pro- ducing and/or selling the firm’s products, is added to operating income to yield earnings before interest and taxes (EBIT) of €3052 million. When a firm has no ‘other income’, its operating profit and EBIT are equal. Next, €53 million of interest expense – representing the cost of debt financing – is subtracted from EBIT to arrive at pre-tax income, in this case €2099 million. The final step is to subtract taxes from pre-tax income to arrive at net income, or net profit after taxes, of €2160 million. Net income is the proverbial ‘bottom line’ and the single most important accounting number for both corporate managers and external financial analysts. As we have seen earlier, LVMH has minority interests, and the share of income attributable to those outside interests is deducted in the last stage.
36 Part 1 The Basic Tools of Finance
TABLE 2.
LVMH income statements for the years ended 31 December 2004–2006 (€mn)
2006 2005 2004 Revenue 15 306 13 910 12 481 Cost of goods sold 5 481 5 001 4 373 Gross profit 9 825 8 909 8 108 Marketing and sales expenses 5 364 4 892 4 512 General and administrative expenses 1 289 1 274 1 224 Operating profit 3 172 2 743 2 372 Other income and expenditure 120 221 199 Earnings before interest and taxes (EBIT) 3 052 2 522 2 173 Net finance charges 53 143 220 Income tax 839 711 551 Net profit or income after taxes 2 160 1 668 1 402 Minority interest 281 228 208 Income to shareholders 1 879 1 440 1 194
ow much is a global brand name worth? Interbrand Corporation, a New York-based consulting firm, has been trying to answer this question for several years, and Business Week has been publishing the rankings annually since 2001. The accompanying table details what this firm considers the 25 most valuable brands of 2006. The total brand values are large and are dominated by brands of
US-based companies. Additionally, the rankings are remarkably stable from year to year; the 2003 rankings listed the same top five, in order, and only one new brand entered the top 25 during 2004. Although American companies are not required to disclose estimated brand values in their financial statements, large publicly traded British and Aus- tralian firms must do so. Brand values do, however,
COMPARATIVE CORPORATE FINANCE
Assessing the market values of global brands
H
Chapter 2 Financial Statement and Cash Flow Analysis 37
have a significant effect on US accounting rules in one important area – accounting for the ‘goodwill’ created when a firm is acquired by another company for more than the acquired firm’s book value. This premium over book value represents the higher market (versus
book) value of intangible assets such as patents, copyrights and trademarks, as well as brand names and business relationships that are not accounted for at all. Charges arising from goodwill impairment can have a dramatic effect on reported earnings.
RANK BRAND COUNTRY SECTOR VALUE ($mn) CHANGE OVER YEAR 1 Coca-Cola US Beverages 67 000 1% 2 Microsoft US Computer 56 926 5% 3 IBM US Computer 56 201 5% 4 GE US Diversified 48 907 4% 5 Intel US Computer 32 319 9% 6 Nokia Finland Telecom 30 131 14% 7 Toyota Japan Automotive 27 941 12% 8 Disney US Media/Entertainment 27 848 5% 9 McDonald’s US Restaurants 27 501 6% 10 Mercedes Germany Automotive 21 795 9% 11 Citi US Financial 21 458 7% 12 Marlboro US Tobacco 21 350 1% 13 Hewlett-Packard US Computer 20 458 8% 14 American Express US Financial 19 641 6% 15 BMW Germany Automotive 19 617 15% 16 Gillette US Personal Care 19 579 12% 17 LVMH France Luxury 17 606 10% 18 Cisco US Computer 17 532 6% 19 Honda Japan Automotive 17 049 8% 20 Samsung South Korea Electronics 16 169 8% 21 Merrill Lynch US Financial 13 001 8% 22 Pepsi US Beverages 12 690 2% 23 Nescafé Switzerland Beverages 12 507 2% 24 Google US Internet 12 376 46% 25 Dell US Computer 12 256 7% Source: Interbrand Corporation.
Statement of cash flows
The statement of cash flows provides a summary of a firm’s cash flows over the year. This is accomplished by isolating the firm’s operating, investment and financing cash flows and reconciling them with changes in its cash and marketable securities during the year. LVMH’s statement of cash flows for the year ended 31 December 2006, is presented in Table 2.4. We should also stress that other information presented in financial statements can be very useful to financial managers and analysts. This is especially true about the ‘notes’ to financial statements.
Notes to financial statements
A public company’s financial statements include detailed explanatory notes keyed to the relevant accounts in the statements. These notes provide detailed information on
A few additional points can be made about the classification scheme in Table 2.3. 1 A decrease in an asset, such as the firm’s inventory balance, is an inflow of cash because cash that has been tied up in the asset is released. Managers can use it for some other purpose, such as repaying a loan. In contrast, an increase in the firm’s inventory balance (or any other asset) is an outflow of cash because additional inventory ties up more of the firm’s cash. Similar logic explains why an increase in any liability is an inflow of cash, and a decrease in any liability is an outflow of cash. 2 Our earlier discussion noted why depreciation and other non-cash charges are considered cash inflows. Logic suggests that if net income is a cash inflow, then a net loss (negative net profits after taxes) is an outflow of cash. The firm must balance its losses with an inflow of cash, such as selling off some of its fixed assets (reducing an asset) or increasing external borrowing (increasing a liability). Note (from Equation 2.1, page 41) that a firm can have a net loss (EBIT – taxes) and still have positive cash flow when depreciation and other non-cash charges
Chapter 2 Financial Statement and Cash Flow Analysis 39
TABLE 2.
The inflows and outflows of corporate cash
INFLOWS OUTFLOWS Decrease in any asset Increase in any asset Increase in any liability Decrease in any liability Net income (profit after tax) Net loss Depreciation and other non-cash charges Dividends paid Sale of shares Repurchase or retirement of shares
(1) Operating flows
Labour Accrued wages
Accounts payable Materials
Depreciation
Production
Products or services
Operating (incl. depreciation) and interest expense
Sales revenue
Payment Refund Cash sales
Accounts Collection receivable
Overhead
Payment
Payment Purchase Sale Fixed assets
Purchase
Borrowing
Cash and marketable securities
Business equity
Debt (short-term and long-term)
Repayment
(3) Financing flows
Sale of shares
Payment of cash dividends
Repurchase of shares Equity
Sale
(2) Investment flows
Taxes
FIGURE 2.
The pattern of cash flows through a firm The firm’s reservoir of liquidity, containing both cash and marketable securities, is impacted by changes in (1) operating flows, (2) investment flows and (3) financing flows.
Developing and interpreting the statement of cash flows The statement of cash flows summarizes the inflows and outflows of cash during a given period. Accountants construct the statement of cash flows by using the income statement for the year, along with the beginning- and end-of-year balance sheets. The procedure involves classifying balance sheet changes as inflows or outflows of cash; obtaining income statement data; classifying the relevant values into operating, investment and financing cash flows; and presenting them in the proper format. 2 The statement of cash flows for LVMH for the year ended 31 December 2006 appears in Table 2.4. Note that the statement assigns positive values to all cash inflows and neg- ative values to all cash outflows. Notice under the investment activities section that the statement records the increase in gross fixed assets, rather than net fixed assets, as a cash outflow. Depreciation accounts for the difference between changes in gross and net fixed assets, but depreciation expense appears in the operating activities sec- tion of the statement. Thus, the focus on changes in gross fixed assets avoids double counting depreciation in the statement. For a similar reason, the statement does not show a specific entry for the change in retained earnings as an inflow (or outflow) of cash. Instead, the factors that determine the change in retained earnings – profits or losses and dividends – appear as separate individual entries in the statement.
40 Part 1 The Basic Tools of Finance
(^2) For a description and demonstration of the detailed procedures for developing the statement of cash flows, see any recently published financial accounting text.
Applying the Model
Below we see the current assets and liabilities of Juventus Football Club for the financial years ending June 2004 and 2005 (in millions of euros).
ELEMENT 2005 2004
Cash 6.54 53. Short-term investments 2.04 2. Accounts receivable 71.08 61. Inventory 0 0 Accounts payable 17.01 12. Short-term debt 24.97 0 In terms of current assets, accounts receivable increased during the year, representing an outflow of cash for Juventus. Cash decreased, representing a cash inflow. It may seem strange to think of a decrease in cash balances as a source of cash, but that simply means that Juventus used some of its cash flow to ‘disinvest in liquidity’ rather than use the cash for another purpose. Not surprisingly, the club has no inventories (although some might consider the stock of players that are not gaining first team places as equivalent). On the liabilities side, accounts payable increased, representing a cash inflow for Juventus, while short-term debt increased, representing an inflow of cash for the club.
during the period are greater than the net loss. Therefore, the statement of cash flows treats net income (or net losses) and non-cash charges as separate entries.
Note that because depreciation is a non-cash charge, it is added back to determine OCF. Non-cash charges , such as depreciation, amortization and depletion allowances, are expenses that appear on the income statement but do not involve an actual outlay of cash. Almost all firms list depreciation expense on their income statements, so we focus on depreciation rather than amortization or depletion allowances, but they are treated in a similar fashion. Substituting the values from the LVMH 2006 income statement (from Table 2.2) into Equation 2.1, we derive LVMH operating cash flow:
OCF 3052 784 474 2742
LVMH OCF is €2742 million. Next, we convert this operating cash flow to free cash flow (FCF) by deducting the firm’s net investments (denoted by the ‘change’ symbol ) in fixed and current assets from operating cash flow, as shown in the following equation:
FCF OCF FA ( CA AP accruals)
Note that because they occur automatically with changes in sales, only spontaneous current liability changes are deducted from current assets to find the net change in short-term investment. From the preceding calculation, we know that LVMH’s OCF in 2006 was €2742 million. Using Table 2.1 we can calculate the changes in gross fixed assets, current assets, accounts payable and accruals between 2005 and 2006. Substituting these values into Equation 2.2, we derive the following:
FCF 2742 (252)(649 167 (138)) 2374
LVMH thus has free cash flow in 2006 of €2374 million available to pay investors who provide the firm with debt and equity financing.
42 Part 1 The Basic Tools of Finance
non-cash charges Expenses, such as depreciation, amortization and depletion allowances, that appear on the income statement but do not involve an actual outlay of cash.
5 How do depreciation and other non-cash charges act as sources of cash inflow to the firm? Why does a depreciation allowance exist in the tax laws? For a profitable firm, is it better to depreciate an asset quickly or slowly for tax purposes? Explain. 6 What is operating cash flow (OCF)? What is free cash flow (FCF), and how is it related to OCF? 7 Why is the financial manager likely to show great interest in the firm’s statement of cash flows? What type of information can be obtained from this statement?
CONCEPT
REVIEW
QUESTIONS
2.3 ANALYSING FINANCIAL PERFORMANCE USING
RATIO ANALYSIS
Analysis of a firm’s financial statements is of interest to shareholders, creditors and the firm’s own management. In many cases, the constituents of a firm want to compare its financial condition to that of similar firms, but doing so can be very tricky. For example, suppose you are introduced to a new acquaintance named Bill who tells you that he runs a company that earned a profit of €10 million last year. Would you be impressed? What if you knew that Bill’s last name was Gates? Most people would agree that a profit of €10 million would be a great disappointment for Microsoft, the firm run by Bill Gates. The point here is that the sales, profits and other items that appear on a firm’s financial statements are difficult to interpret unless we have some way to put the numbers in perspective. To analyse financial statements, we need relative measures that normalize size differences. Effective analysis of financial statements is thus based
EQUATION 2.
on the knowledge and use of ratios or relative values. Ratio analysis involves calculating and interpreting financial ratios to assess a firm’s performance and status.
Using financial ratios
Different constituents will focus on different types of financial ratios. The firm’s creditors are primarily interested in ratios that measure the short-term liquidity of the company and its ability to make interest and principal payments. A secondary concern of creditors is the firm’s profitability; they want assurance that the business is healthy and will continue to be successful. Both current and prospective shareholders are interested in ratios that measure the firm’s current and future levels of risk and return, because these two dimensions directly affect the firm’s share price. The firm’s managers must be concerned with all aspects of the firm’s financial situation, so they use ratios to generate an overall picture of the company’s financial health and to monitor the firm’s performance from period to period. The managers carefully examine unexpected changes to isolate developing problems. An additional complication of ratio analysis is that, for any given ratio, what is normal in one industry may be highly unusual in another. For example, by dividing a firm’s earnings available for shareholders by its sales, we obtain the net profit margin ratio. Net profit margins vary dramatically across industries. An outstanding net profit margin in the retail grocery industry could look paltry in the software business. Therefore, when making subjective judgements about the health of a given company, analysts usually compare the firm’s ratios to two benchmarks. First, analysts compare the financial ratios in the current year with previous years’ ratios, hoping to identify trends that help them evaluate the firm’s prospects. Secondly, analysts compare the ratios of one company with those of other ‘benchmark’ firms in the same industry (or to an in- dustry average obtained from a trade association or third party provider). We discuss the use of ratios by examining those for LVMH: note that the emphasis is on interpretation as opposed to detailed calculation. We focus on this company merely as an example, and you should note that the ratios presented in the remainder of this chapter can be applied to nearly any company. Of course, many companies in different industries use ratios that focus on aspects peculiar to their industry. For example, airlines pay close attention to the ratio of revenues to passenger miles flown. Retailers diligently track the growth in same-store sales from one year to the next. We cover the most common financial ratios and group them into five categories: liquidity, activity, debt, profitability and market ratios.
Liquidity ratios
Liquidity ratios measure a firm’s ability to satisfy its short-term obligations as they come due. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, liquidity ratios are good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio. The current ratio , one of the most commonly cited financial ratios, measures the firm’s ability to meet its short-term obligations. It is defined as current assets divided by current liabilities, and thus presents in ratio form what net working capital measures by subtracting current liabilities from current assets. The end-2006 current ratio for LVMH is computed as follows:
How high should the current ratio be? The answer depends on the type of business under consideration and on the costs and benefits of having too much versus too
CR CA
CL
Chapter 2 Financial Statement and Cash Flow Analysis 43
ratio analysis Calculating and interpreting financial ratios to assess a firm’s performance and status.
liquidity ratios Measure a firm’s ability to satisfy its short-term obligations as they come due. current ratio A measure of a firm’s ability to meet its short-term obligations, defined as current assets divided by current liabilities. net working capital Profitability that represents the percentage of each sales euro remaining after all costs and expenses, including interest, taxes and preference share dividends, have been deducted.
The average collection period , or average age of accounts receivable, is useful in evaluating credit and collection policies.^3 It measures the average amount of time that elapses from a sale on credit until the payment becomes usable funds for a firm. It is computed by dividing the firm’s average sales per day into the accounts receivable balance. On average, in 2006 it took LVMH 34 days to receive payment from a credit sale.
The average collection period is meaningful only in relation to the firm’s credit terms. If LVMH extends 30-day credit terms to customers, an average collection period of 34.37 days may indicate a poorly managed credit or collection department, or both. The lengthened collection period could also be the result of an intentional relaxation of credit term enforcement in response to competitive pressures. Firms use the average payment period to evaluate their performance in paying suppliers. It measures the average length of time it takes the firm to pay its suppliers. It equals the firm’s average daily purchases divided into the accounts payable balance. To calculate average daily purchases, an analyst may have to estimate the firm’s annual purchases, often by taking a specified percentage of cost of goods sold. This estimate is necessary because annual purchases are not reported on a firm’s published financial statements. Instead they are embodied in its cost of goods sold. In a fashion similar to the average collection period, the average payment period is meaningful only when viewed in light of the actual credit terms extended to the firm by its suppliers. The fixed asset turnover measures the efficiency with which a firm uses its fixed assets. The ratio tells analysts how many euros of sales the firm generates per euro of fixed asset investment. The ratio equals sales divided by net fixed assets (fixed assets less intangibles):
FAT Sales NFA
ACP Accounts^ Receivable ASPd
ASPd Sales^ Revenue 360
Chapter 2 Financial Statement and Cash Flow Analysis 45
fixed asset turnover A measure of the efficiency with which a firm uses its fixed assets, calculated by dividing sales by net fixed asset investment.
average collection period The average amount of time that elapses from a sale on credit until the payment becomes usable funds for a firm. Calculated by dividing accounts receivable by average sales per day. Also called the average age of accounts receivable.
companies in three different industries, this becomes evident. In all cases we select as a peer group only those companies that are in the Europe/Africa region.
INDUSTRY COMPANY INVENTORY PEER TURNOVER AVERAGE RATIO Commercial printing Wyndeham Press plc 19.22 19. Packaged foods and meats Cadbury Schweppes 4.18 17. Gas distribution Gaz de France 13.03 63.
(^3) The average collection period is sometimes called the days’ sales outstanding (DSO). As with the inventory turnover ratio, the average collection period can be calculated using end-of-year accounts receivable or the average receivables balance for the year.
average payment period A measure of the average length of time it takes a firm to pay its suppliers.
The fixed asset turnover for LVMH in 2006 is 1.34. This means that the company turns over its net fixed assets 1.34 times a year. Put another way, LVMH generates just over €1.34 in sales for every €1.00 of fixed assets. As with other ratios, the ‘normal’ level of fixed asset turnover varies widely from one industry to another. An analyst must be aware that (when using this ratio and the total asset turnover ratio described next) the calculations use the historical costs of fixed assets. Because some firms have significantly newer or older assets than others, comparing fixed asset turnovers of those firms can be misleading. Firms with newer assets tend to have lower turnovers than those with older assets, which have lower book (accounting) values. A naïve comparison of fixed asset turnover ratios for different firms may lead an analyst to conclude that one firm operates more efficiently than another, when, in fact, the firm that appears to be more efficient simply has older (i.e. more fully depreciated) assets on its books. Also, for a company with large values of brands and other intan- gibles, it is not clear that excluding these from the analysis is in fact correct. The total asset turnover ratio indicates the efficiency with which a firm uses all its assets to generate sales. Like the fixed asset turnover ratio, total asset turnover indi- cates how many euros of sales a firm generates per euro of asset investment. All other factors being equal, analysts favour a high turnover ratio because it indicates that a firm generates more sales (and ideally more cash flow for investors) from a given investment in assets. LVMH’s total asset turnover in 2006 equals 0.53, calculated as follows:
Debt ratios Firms finance their assets from two broad sources – equity and debt. Equity comes from shareholders, whereas debt comes in many forms and from many different lenders. Firms borrow from suppliers, from banks and from widely scattered investors who buy publicly traded bonds. Debt ratios measure the extent to which a firm uses money from creditors rather than shareholders to finance its operations. Because creditors’ claims must be satisfied before firms can distribute earnings to shareholders, current and prospective investors pay close attention to the debts on a firm’s bal- ance sheet. Lenders share these concerns because the more indebted the firm, the higher the probability that the firm will be unable to satisfy the claims of all its creditors. In general, the more debt a firm uses in relation to its total assets, the greater its financial leverage. Fixed-cost sources of financing, such as debt and preference shares, create financial leverage that magnifies both the risk and the expected return on the firm’s securities. 4 The more a firm borrows, the riskier its outstanding shares and bonds, and the higher the return that investors require on those securities. A detailed discussion of the effect of debt on the firm’s risk, return and value is included in Chapter 12. Here we emphasize the use of debt ratios to assess a firm’s indebtedness and its ability to meet the fixed payments associated with debt. Broadly speaking, there are two types of debt ratios. One type focuses on balance sheet measures of outstanding debt relative to other sources of financing. The other
FAT Sales TA
46 Part 1 The Basic Tools of Finance
financial leverage Using fixed-cost sources of financing, such as debt and preference shares, to magnify both the risk and expected return on a firm’s investments.
total asset turnover A measure of the efficiency with which a firm uses all its assets to generate sales; calculated by dividing the value of sales a firm generates by the value of assets used.
(^4) By fixed cost we mean that the cost of this financing source does not vary over time in response to changes in the firm’s revenue and cash flow. For example, when a firm borrows money at a variable rate, the interest cost of that loan is not fixed through time, but the firm’s obligation to make interest payments is ‘fixed’ regardless of the level of the firm’s revenue and cash flow.
that Worldscope defines gross profit as Net sales less COGS less Depreciation, while the ratio below, as before, does not adjust for depreciation:
The operating profit margin measures the percentage of each sales euro remaining after deducting all costs and expenses other than interest and taxes. As with the gross profit margin, the higher the operating profit margin the better. This ratio is of interest because it tells analysts what a firm’s bottom line looks like before deductions for payments to creditors and tax authorities. The net profit margin measures the percentage of each sales euro remaining after all costs and expenses, including interest, taxes and payments to preference shareholders, have been deducted. Net profit margins vary widely across industries.
Probably the most closely watched financial ratio of them all is earnings per share (EPS). The earnings per share represent the monies earned on behalf of each outstanding ordinary share. The investing public closely watches EPS figures and considers them an important indicator of corporate success. Many firms tie management bonuses to meeting specific EPS targets. Earnings per share are calculated as follows:
The value of LVMH’s earnings per share outstanding in 2006 is €3.98. This figure represents the money amount earned on behalf of each share outstanding. The amount of earnings actually distributed to each shareholder is the dividend per share. The return on total assets (ROA) , often called the return on investment (ROI), measures the overall effectiveness of management in using its assets to generate returns.^5 The return on total assets for LVMH in 2006 equals 6.53 per cent:
A closely related measure of profitability is the return on equity (ROE) , which captures the return earned on the ordinary shareholders’ (owners’) investment in the firm. For a firm that uses only shares to finance its operations, the ROE and ROA figures are identical. With debt or preference shares on the balance sheet, these ratios usually differ. When the firm earns a profit, even after making interest payments to creditors and paying dividends to preference shareholders, the firm’s use of leverage magnifies the return earned by ordinary shareholders, and ROE exceeds ROA.
ROA Net^ income TA
EPS Net^ income
Shares
NPM Net^ income Sales
OPM
Operating profit Sales
GPM
Gross profit Sales
48 Part 1 The Basic Tools of Finance
operating profit margin A measure of profitability that represents the percentage of each sales euro remaining after deducting all costs and expenses other than interest and taxes.
net profit margin A measure of profitability that represents the percentage of each sales euro remaining after all costs and expenses, including interest, taxes and pref- erence share dividends, have been deducted.
return on total assets (ROA) A measure of the overall effectiveness of management in generating returns to ordinary shareholders with its available assets. return on equity (ROE) A measure that captures the return earned on the ordinary shareholders’ (owners’) investment in a firm.
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(^5) Naturally, all other things being equal, firms prefer a high ROA. However, as we will see later, analysts must be cautious when interpreting financial ratios. We recall an old Dilbert comic strip in which Wally suggests boosting his firm’s ROA by firing the security staff. The reduction in expenses would boost the numerator while the reduction in security would lower the denominator.
Conversely, if the firm’s earnings fall short of the amount it must pay to lenders and preference shareholders, leverage causes ROE to be less than ROA. For LVMH, the return on equity for 2006 is 16.2 per cent, substantially above its return on total assets:
DuPont system of analysis Financial analysts sometimes conduct a deeper analysis
of the ROA and ROE ratios using the DuPont system , which uses both income and balance sheet information to analyse the ROA and ROE ratios into component parts. This approach highlights the influence of the net profit margin, total asset turnover and financial leverage on a firm’s profitability. In the DuPont system, the return on total assets equals the product of the net profit margin times total asset turnover. By defini- tion, the net profit margin equals earnings available for ordinary shareholders divided by sales, and total asset turnover equals sales divided by total assets. When we multiply these two ratios together, the sales figure cancels, resulting in the ROA measure:
Naturally, the ROA value for LVMH using the DuPont system is the same value we calculated before, but now we can think of the ROA as a product of how much profit the firm earns on each euro of sales and of the efficiency with which the firm uses its assets to generate sales. Holding the net profit margin constant, an increase in total asset turnover increases the firm’s ROA. Similarly, holding total asset turnover con- stant, an increase in the net profit margin increases ROA. We can push the DuPont system one step further by multiplying the ROA by the ratio of assets-to - equity (A/E), or the equity multiplier. The product of these two ratios equals the return on equity. Notice that for a firm that uses no debt and has no preference shares, the ratio of assets-to-equity equals 1.0, so the ROA equals the ROE. For all other firms, the ratio of assets-to-equity exceeds 1. It is in this sense that the ratio of assets-to-equity represents a leverage multiplier.
ROE ROA EM
We can apply this version of the DuPont system to LVMH in 2006 to recalculate its return on common equity:
ROE 0.062 2.48 0.
Note that for LVMH the ratio of assets-to-equity is 2.49, which means that LVMH’s return on equity is over twice as large as its return on total assets. Of course, using financial leverage has its risks. Notice what would happen if LVMH’s return on total assets were a negative number rather than a positive one. The financial leverage multiplier would cause LVMH’s return on equity to be even more negative than its ROA. The advantage of the DuPont system is that it allows the firm to break down its return on equity into a profit-on-sales component (net profit margin) that ties directly to the income statement, an efficiency-of-asset-use component (total asset turnover) that ties directly to the balance sheet and a financial-leverage-use component (assets-to- equity ratio) that also ties directly to the balance sheet.
Market ratios
Market ratios relate the firm’s market value, as measured by its current share price, to certain accounting values. These ratios provide analysts with insight into how
Sales TA
Net^ income Sales
Net^ income TA
ROE Net^ income SE
Chapter 2 Financial Statement and Cash Flow Analysis 49
duPont system An analysis that uses both income and balance sheet information to break down the ROA and ROE ratios into their component pieces.
