Chapter 5

Financial Analysis

Question 1. Which of the following types of firms do you expect to have particularly
high or low asset turnover? Explain why.

Supermarket—High asset turnover. Supermarkets tend to be high volume businesses.

Many of the food products in supermarkets are perishable, and freshness is often used to
differentiate products, forcing a certain amount of inventory turnover. The typical
consumer buys groceries on a regular basis, guaranteeing grocery stores a certain level
of overall business. Apart from inventories, a supermarket’s largest assets are its
warehouses and stores, all constructed to be relatively inexpensive. Thus, high sales
volumes generate a high measured level of asset turnover.

Pharmaceutical Company—High asset turnover. Drugs typically have a limited shelf-

life. Once past their expiration date, drugs cannot be sold and are worthless.
Consequently, pharmaceutical companies try to limit production to quantities which can
be expected to be sold before the expiration date. A pharmaceutical company’s assets are
relatively low for two reasons. First, its investment in research and development is
expensed rather than recorded as an asset on the company’s books. Second, patents do
not typically show up as assets on the pharmaceutical company’s books. Thus, high sales
combined with lower reported asset levels generate a high measured level of asset
turnover.

Jewelry Retailer—Low asset turnover. Jewelry is typically durable, expensive, and

infrequently purchased by most consumers. Jewelry is also a strongly differentiated
product. A single jewelry store may carry over 150 different styles of watches. The
consumer will choose one watch from among the entire selection. Hence, the jewelry
store must maintain a large inventory to support its sales. Because the jewelry store’s
main asset is inventory, which has a slow rate of turnover, the typical jewelry store will
show low asset turnover.

Steel Company—Low asset turnover. Production of steel is extremely asset intensive. A

steel company will invest hundreds of millions of dollars in property, plant, and
equipment necessary to manufacture steel. Moreover, steelmaking equipment has a
useful lifetime measured in decades. Relative to this enormous investment, a steel
company’s sales will be low. Consequently, a steel company will typically have low
asset turnover.
Question 2. Which of the following types of firms do you expect to have high or low
sales margins? Why?

Supermarket—Low margins. Competition in the supermarket industry is very intense.

Different supermarkets carry most of the same brands of food so there is little
differentiation of products. Consumers are sensitive to changes in the prices, and
switching costs are very low, usually no more than the opportunity cost of going to
another supermarket. Consequently, pricing is the major area of competition among
supermarkets, leading to extremely low margins.

Pharmaceutical Company—High sales margins. Drugs manufactured by

pharmaceutical companies are often protected from competition by patents, allowing
them to charge monopoly prices. Even where drugs are not protected by patents,
pharmaceutical companies invest considerable resources in differentiating their products
along non-price dimensions such as efficacy and ease-of-use. Consequently,
pharmaceutical companies typically boast very high sales margins. As an aside, drug
companies argue that these high margins are necessary to support their ongoing and
expensive research for new drugs, much of which never makes it to market.

Jewelry Retailer—High sales margins. Jewelry is a differentiated product where the

typical buyer cannot easily assess the quality of the item being purchased. Consequently,
differentiation among jewelry retailers falls along lines of intangibles such as service,
quality, and reputation. The greater the differentiation, the higher the expected margin.

Software Company—High sales margins. Margins are high for several reasons:

1. there are relatively high switching costs for consumers learning a new system,
2. production costs are very low—just the expense of disks or CD-ROMs and manuals,
or the costs of distributing software via the Internet and providing help on-line, and
3. most of the initial software development costs have been previously expensed.

Hence, software companies tend to enjoy large margins.

Question 3. James Broker, an analyst with an established brokerage firm,

comments: “The critical number I look at for any company is operating
cash flow. If cash flows are less than earnings, I consider a company to
be a poor performer and a poor investment prospect.” Do you agree
with this assessment? Why or why not?

Disagree. Operating cash flows and earnings numbers are both important in evaluating
the performance prospects of a company, but they will differ due to short- and long-term
accruals. Some current accruals, such as credit sales, will cause earnings to be greater
than operating cash flows while others, such as unpaid expenses by the firm, will cause
operating cash flows to exceed earnings. Non-current accruals, such as depreciation and
deferred taxes, will also cause differences between earnings and operating cash flows.
The fact that operating cash flows are not as high as earnings is not nearly as important
as understanding why the two are different.

Operating cash flows could be below earnings for several reasons, each suggesting
differences in the firm’s performance and future investment prospects. For example, a
firm that introduces a successful new product will be probably have earnings exceeding
operating cash flows due to working capital needs (inventory and receivables) that affect
cash flows but not earnings. Yet, provided inventory can be sold and receivables
collected, this difference is a positive sign that the firm’s sales are growing and that the
firm has good investment prospects. In contrast, firms that are declining are likely to
have earnings lower than cash flows, as working capital needs are diminished.

In summary, earnings are likely to be a better signal of future cash flow performance
than current cash flows, particularly for firms with long working capital (operating)
cycles. Of course, earnings exceeding cash flows can be a negative signal for future cash
flow performance if management is reporting aggressively, making analysis of cash
flows a useful financial tool.

Question 4. In 1995 Chrysler has a return on equity of 20 percent, whereas Ford’s

return is only 8 percent. Use the decomposed ROE framework to
provide possible reasons for this difference.

ROE can be decomposed in three steps, as follows:

Net Income
1. ROE = Shareholders’ Equity

Net Income Assets

2. = Assets x Shareholders’ Equity

Net Income Sales Assets

3. = Sales x Assets x Shareholders’ Equity

Using this decomposition, ROE depends on a company’s return on sales, asset turnover,
and leverage. Differences in these three factors will drive differences in ROE. Without
knowing specific company information, it is possible to speculate about the root causes
of Ford’s 8 percent and Chrysler’s 20 percent ROE.

Return on Sales measures a firm’s profit per dollar of sales. As a profitability measure,
higher return on sales suggests possible greater efficiency of operations or lower tax
rates. Holding asset turnover and leverage constant, a higher return on sales could
explain Chrysler’s greater ROE. This would be the case if Chrysler had implemented
more effective management control systems, designed better organized production
facilities, or did better tax planning than Ford.
Asset Turnover assesses how productively a firm uses its assets. A higher asset turnover
ratio suggests that a fixed level of assets generates a greater level of sales, i.e., the firm
put its assets to more productive uses. Assuming return on sales and leverage are the
same for both firms, a higher asset turnover ratio would cause Chrysler’s ROE to be
greater than Ford’s.

Leverage describes the capital structure of the firm. As leverage increases, the return on
equity also increases. From Step 2 of the decomposition, we see that ROE = (return on
assets) x (leverage). Holding return on assets constant, it would be possible to explain
Chrysler’s higher ROE if it were more highly levered than Ford.

Question 5. Joe Investor asserts: “A company cannot grow faster than its
sustainable growth rate.” True or false? Explain why.

False. The sustainable growth rate is the speed at which a company can expand without
changing either its level of profitability or its financial policies. Mechanically,
sustainable growth rate = ROE x (1 – dividend payout ratio). From this equation, we see
that ROE and the dividend payout ratio determine the funds remaining in the firm and
available to finance the firm’s growth. If a company wants to exceed its sustainable
growth rate, it can increase its return on equity by improving its profitability (return on
sales), increasing its asset turnover, or increasing leverage. Alternatively, it can reduce
its dividend payout rate, thereby increasing funds available for reinvestment.

Question 6. What are the reasons for a firm having lower cash from operations
than working capital from operations? What are the possible
interpretations of these reasons?

Cash from operations will differ from working capital from operations due to current
accruals related to operations. In general, the differences between the two methods can
be reconciled using the following approach:

Working capital from operations

– Increase (+ decrease) in accounts receivable
– Increase (+ decrease) in inventory
– Increase (+ decrease) in other assets, excluding cash and cash equivalents
+ Increase (– decrease) in accounts payable
+ Increase (– decrease) in other current liabilities, excluding notes payable and debt
Cash from operations

Cash from operations will be lower than working capital from operations when current
assets (e.g., accounts receivable, inventory, and other non-cash assets) increase and
when current liabilities (e.g., accounts payable and other current liabilities, excluding
notes payable and debt) decrease.
Accounts receivable and inventory could be increasing because the firm is growing to
meet additional market demand. Conversely, accounts receivable and inventory could be
growing if the firm’s customers are having difficulty paying for goods or services, or if
sales have slowed causing inventories to climb.

Accounts payable could be decreasing because the firm’s financial position has
improved and the firm pays its suppliers sooner than before.

Question 7. ABC Company recognizes revenue at the point of shipment.

Management decides to increase sales for the current quarter by filling
all customer orders. Explain what impact this decision will have on the
following:

Days receivable for the current quarter. Increase, provided that, prior to the transaction,
quarterly sales are less than receivables. To see this, let receivables and quarterly sales
prior to the transaction be R and S respectively, and the increased $X of credit sales
remain unpaid at the end of the quarter. The change in quarterly days receivable will
then be as follows:

Days Receivable before transaction = R x 365

S

Days Receivable after transaction = R + X x 365

S + X

Difference = X (R – S) x 365
S (S + X)

Thus, if R < S, days receivable will increase after the transaction. This is especially
likely for companies with short credit periods (less than one quarter) and those that
measure days receivable on an annual basis, since annual sales are very likely to exceed
receivables.

Days receivable for the next quarter. No change. Since sales would have been recorded
in this quarter if they had not been accelerated, there is not likely to be any change in
days receivable.

Sales growth for the current quarter. Increase. Management’s decision will move sales
from the next quarter into the current quarter, making sales appear to grow relative to the
previous quarter.

Sales growth for the next quarter. Decrease. Sales for the current quarter have increased,
and sales for the next quarter have declined. Sales growth for this next quarter will
therefore decline.
Return on sales for the current quarter. Increase. Provided additional sales make a
positive contribution to the bottom line (net income), the transaction will increase return
on sales. If the net margin on the sales is negative, return on sales will decline.

Return on sales for the next quarter. Decline. As noted above, the transaction reduces
sales for the next quarter. Provided these sales make a positive contribution to the
bottom line (net income), the transaction will reduce return on sales. If the net margin on
the sales is negative, return on sales will increase.

Question 8. What ratios would you use to evaluate operating leverage for a firm?

Operating leverage measures the extent to which an additional dollar of sales increases
the firm’s net income. The greater the increase in Net Income for a given increase in
sales, the greater the firm’s operating leverage. For example, if a firm only had variable
costs, each additional dollar of sales would be expected to generate additional income
equal to the existing Net Income/Sales ratio for the firm. Conversely, if the firm had only
fixed costs, an additional dollar of sales would generate an additional dollar of net
income (assuming the firm did not pay taxes). Thus, understanding a firm’s operating
leverage requires estimating how much of the firm’s costs are fixed and how much are
variable. This concept is complicated by the fact that in the long run most costs are
variable.

While there is no single measure of a firm’s operating leverage, several ratios can help
evaluate a firm’s operating leverage and compare it with those of other firms.
Information from financial statements is typically crude and only gives a rough
approximation of operating leverage. A more thorough analysis requires specific cost-
accounting information from within the firm. Changes in net income relative to changes
in sales, or return on sales ratios relative to sales volume, provide rough guides of
operating leverage. Asset ratios, such as (Net PPE/Sales) or (Capital
Expenditures/Sales), can also provide a way of assessing how much of a firm’s
production costs are fixed. More detailed information, including (salary expense of
production workers/Sales) and (raw material expenses/Sales), can provide a finer picture
of a firm’s operating leverage. Estimating a firm’s operating leverage requires
understanding which of the firm’s costs are fixed and which are variable. The ratios
mentioned above are very general. Depending on the specific firm and industry, other
ratios may be more useful.

Question 9. What are the potential benchmarks that you could use to compare a
company’s financial ratios? What are the pros and cons of these
alternatives?

Comparison to Firm’s Prior History. By comparing the company with itself over time,
it is possible to document changes (improvements or declines) in the company’s
performance. Changes in capital structure or improvements in gross margins or return on
assets may evolve slowly as the firm implements the necessary changes in operations
and financing. Only by looking at the pattern of these changes over time can we see if
the individual changes in financial ratios from year to year are permanent or temporary.
However, this approach does not tell us how well the firm is doing compared to other
companies. For example, a firm may appear to have performed poorly (well) relative to
its own historical performance, yet relative to other firms in the economy or its own
industry, it may have performed quite well (poorly).

Comparison to Firm’s Expected or Budgeted Performance. This could be relative to

management or external analysts’ forecasts. These types of comparisons can be very
helpful by showing how well the firm has performed relative to expectations. An
obvious limitation is that the comparisons are only meaningful if the expectations are
carefully constructed.

Comparison to Industry Average. Industry average financial ratios provide a

benchmark against which to interpret individual company ratios. A firm’s return on
sales, asset turnover, and financial leverage can be compared to industry averages. What
are the implications if a firm has a lower return on equity or lower days payable than the
industry? Are any differences consistent with the firm’s operating policies and goals?
Industry comparisons can provide only a partial picture if the industry as a whole has
performed well or poorly, or if the firm is following a different strategy from other firms
in the industry. It can also be quite difficult to assess what the appropriate industry
comparison group is, since many firms operate in more than one business segment.

Comparison to Market. Benchmarking the performance of an individual firm against

the market can be informative. Ultimately, investors want to allocate resources within
the economy as a whole. A firm that is a strong performer relative to its industry may
therefore be a relatively weak overall performer if its industry is underperforming.
However, market analysis can be difficult for many key financial ratios which are
industry specific and do not lend themselves to cross-industry comparison or evaluation.
For example, important ratios for banks include those on regulatory capital, which are
not relevant for most other industries. Working capital ratios typically differ across
industries, so that it makes little sense to compare days inventory or days receivable for
a supermarket relative to the same ratios for a steel manufacturer. Finally, differences in
ratios can arise because of differences in business risk across industries. For example,
ROEs and leverage are likely to be very different for construction firms than for
supermarkets.

Question 10. In a period of rising prices, how would the following ratios be affected
by the accounting decision to select LIFO, rather than FIFO, for
inventory valuation?

The impact of the selection of LIFO rather than FIFO for inventory valuation will appear
in Inventory and Cost of Goods Sold. Under LIFO, the most recent and most expensive
(during inflationary periods) items in inventory will be the first used for accounting
purposes. Relative to a firm using FIFO, the LIFO firm will report a lower value for
inventory because its ending inventory contains the oldest and least expensive items. As
a result of using its higher priced inventory first, the LIFO firm has a higher cost of
goods sold.

Gross margin is lower for the LIFO firm. The LIFO firm has higher cost of goods sold
expenses which makes its gross margin appear lower than the FIFO firm.

Current ratio falls. The current ratio equals current assets divided by current liabilities.
Current assets is lower under LIFO because inventories are lower. Hence, the value of
current assets divided by current liabilities drops under LIFO.

Asset turnover increases. Asset turnover equals sales divided by assets. Sales remains the
same but assets are lower under LIFO, so asset turnover declines.

Debt-to-equity ratio increases using the book value of equity. The debt-to-equity ratio
equals (short-term debt + long-term debt) divided by book value of shareholders’ equity.
The LIFO decision does not affect either the short-term or long-term debt levels, but
LIFO has a negative net impact on the book value of shareholders’ equity. Under LIFO,
the higher cost of goods sold leads to lower net income, which in turn leads to a decrease
in book shareholders’ equity.

This decrease may be mitigated if the firm has a lower tax bill due to lower taxable
income. Overall, however, the decline in net income is likely to be greater than the
decrease in tax payments, yielding a decline in shareholders’ equity and increasing the
debt-to-equity ratio.

Average tax rate remains the same. The LIFO firm reports higher expenses which lowers
income before tax. Because the firm reports smaller income before tax, it has less
taxable income and, hence, has a smaller tax liability. However, the average tax rate is
likely to remain the same.