1st exercise

1
1st exercise Hints

• Among the 3 most RD intensive industries are
  (alphabetically)
• Computer communications equipment
• Computer peripherals
• Games and Toys (includes specialty games)
• Wholesalers typically have high inventory, high
  volume, and low margin.

2
ACCY 291 Financial Statement Analysis
Financial Analysis (conventional ratios)
3
RecapFinancial analysis framework
i-free debt
i-bearing debt ---------- OE
Assets
Capital structure
Primary goal of the firm?Maximize the Value of
the IC providers (aka Enterprise value). ?
Maximize Free Cash Flow in each period. Or,
(almost equivalently) Maximize NOPAT,
while Minimizing the size of
IC. (Operating activities) Further, managing
capital structure may bring additional benefits
to shareholders.
4
Value maximization (increase in value) ? Size
increase (expansion)
i-free debt
Assets
OE 1 bil 100 mil shares
1. Value of the OE increased to 2 bil ? value
___ per share.
2. Additional equity capital infusion of 1 bil
Book value of OE ? _______. Market value of
OE ? _______. If you were a shareholder of
this firm, did this action increase your net
worth (wealth)?
5
Which of the following should be maximized?

• Sales
• Accounts receivable
• Cost of goods sold
• Inventory
• Selling and administrative expense
• Tax expense
• Prepaid expenses
• Accounts payable
• Deferred revenue
• Accrued expense payable
• Bonds payable
• Owners equity

6
Interest-bearing, interest free debts and Capital
structure
LIABILITIES CVS WAG
Accounts Payable 6,077.3 3,733.3
Notes Payable 2,085.0 878.5
Accrued Expenses 2,556.8 2,104.4
Taxes Payable 0.0 28.1
Debt (Long-Term) Due In One Year 47.2 0.0
Other Current Liabilities 0.0 0.0
Total Current Liabilities 10,766.3 6,744.3
Long Term Debt 8,349.7 0.0
Deferred Taxes (Balance Sheet) 3,426.1 158.2
Investment Tax Credit 0.0 0.0
Minority Interest 0.0 0.0
Liabilities - Other 857.9 1,306.8
TOTAL LIABILITIES 23,400.0 8,209.3
SHAREHOLDERS' EQUITY
Preferred Stock 203.0 0.0
Common Stock 15.9 80.1
Capital Surplus 26,831.9 558.5
Retained Earnings (Net Other) 9,891.5 11,971.3
Less Treasury Stock 5,620.4 1,505.9
TOTAL SHAREHOLDERS' EQUITY 31,321.9 11,104.0
TOTAL LIABILITIES EQUITY 54,721.9 19,313.3
Book
Market
7
Perspective on conventional ratio analysis

• Conventional ratio analysis can be considered as
  an elaboration of NOPAT/ICap.
• To maximize NOPAT/ICap, you need to
• Maximize NOPAT (or EBIT)
• The components
• Maximize sales (typically measured by ??)
• Minimize cost of goods/sales
• Minimize SA/Sales etc.
• Minimize ICap (the components of it)
• The components
• Minimize Cash, AR, INV, PPE, etc.
• Maximize AP etc.
• ? Typical efficiency ratios

8
Measurement of ROA and ROIC (RONA)
B/S
D
Assets
NOPAT
OE
? A poor, but widely used, measure of ROA
9
RONA (ROIC) is a better measure of enterprise
profitability than ROA, although ROA is more
popular
Max i- free debt
Min. Assets
i-debt
OE
Sales-Oper. Expenses-taxNOPAT
If 1 bil of i-bearing debt is replaced by
1 bil of i-free debt (is this a good outcome?)
what happens to ROA? what happens to ROIC, RONA?
10
Theoretically, what would you compare ROA, RONA
against?
Consider buying a rental property for 1
million Annual rental income Year
1 50,000 earned 5 Year 2 70,000 earned 7 Year
3 40,000 earned 4 .. The benchmark? The
theoretical benchmark for ROIC?
11
Cost of Capital

• Cost of Capital or Weighted Average Cost of
  Capital (WACC)??
• Suppose you need to raise 6 billion of capital,
  of which 2 billion in debt and 4 billion in
  equity.
• Cost of debt 6, Cost of equity12, Tax 40

i-D 2 bil
Assets
OE 4 bil
12
WA Cost of Capital

• Without Tax
• With Tax.

i-D 2 bil
Assets
OE 4 bil
OE, i-D, V Measured in market values
13
Note on WA Cost of Capital
RA
WACC
100 debt
No debt
14
ROA (ROIC) Decomposition
15

• Decomposition of ROA, ROIC

Why decompose?
2002 NOPAT margin Groceries 2.5 Variety
Stores 2.6 Metal Products 3.6 Petroleum
Refining 5.3 Electric Utilities 8.7 Pharmaceutic
als 16.0 2002 Turnover Groceries 2.66 Metal
Products 1.13 Petroleum Refining 1.16 Electric
Utilities 0.39 Pharmaceuticals 0.74 ROANOPAT
margin x Turnover Groceries 6.6 Metal
products 4.2 Petroleum Refining 6.5 Electric
Utilities 3.3 Pharmaceuticals 11.9
16
Roadmap of conventional ratio discussions
Leverage
Session 3, 4
E.P.S.
ROE
Mkt Price of stock
ROA ROIC
Session 4, 5, 6
NOPAT Margin
Asset Turnover
AR Days
INV Days
SA/ Sales
Gross Margin
Session 2
AP Days
Session 3
PPE Turns
17
Efficiency/Turnover RatiosAsset side FY2007
ASSETS CVS WAG
Cash Equivalents 1,084.1 254.8
Receivables - Total (Net) 4,579.6 2,236.5
Inventories - Total 8,008.2 6,790.5
Prepaid Expenses 0.0 0.0
Current Assets - Other 477.5 228.7
Current Assets - Total 14,149.4 9,510.5
Plant, Property Equip (Net) 5,852.8 8,199.9
Investments 0.0 0.0
Intangibles 30314.0 1,060.2
Deferred Charges 4037.9 0.0
Assets - Other 367.8 543.0
TOTAL ASSETS 54,721.9 19,313.6
Too big or too small? Relative to what?
18
Efficiency Ratios

• Days in AR (receivable) AR/Sales, or AR/daily
  sales
• Days in inventory INV/CGS, or INV/daily product
  sold
• Days in payable AP/expenses, or AP/daily
  operating expenses
• PPE turnover Sales/PPE
• Ratios are well defined when there is a
  cause-effect relation,
• so that denominator drives numerator, or vice
  versa.
• Days in can be converted to Turnovers
• Strong efficiency ratios typically imply
  higher/lower Current ratio?

19
CVS days in AR
Days in AR 4,579/(76,329/365) ? 22
209 mil/day sales
Sales made
Cash collected
AR/Sales and Sales/AR are similar ratios.
20
Be able to assess the significance of efficiency
ratio

• If CVSs INV days
• Inventory balance 8,008
• Daily products sold (in cost)
• CGS 60,221 mil ______mil/day

21
Be able to assess the significance of efficiency
ratio

• If CVSs INV days, now at 48.5 days, improves to
  44.5 days, what is the benefit?
• CVS CGS 165 mil/day
• What happens if it takes 1.0 billion to make it
  happen?
• What happens if the firm grows at 6/year? (Cost
  of capital10)

22
Efficiency ratio summary
23
Efficiency/Turnover RatiosRight hand side
LIABILITIES CVS WAG
Accounts Payable 6,077.3 3,733.3
Notes Payable 2,085.0 878.5
Accrued Expenses 2,556.8 2,104.4
Taxes Payable 0.0 28.1
Debt (Long-Term) Due In One Year 47.2 0.0
Other Current Liabilities 0.0 0.0
Total Current Liabilities 10,766.3 6,744.3
Long Term Debt 8,349.7 0.0
Deferred Taxes (Balance Sheet) 3,426.1 158.2
Investment Tax Credit 0.0 0.0
Minority Interest 0.0 0.0
Liabilities - Other 857.9 1,306.8
TOTAL LIABILITIES 23,400.0 8,209.3
SHAREHOLDERS' EQUITY
Preferred Stock 203.0 0.0
Common Stock 15.9 80.1
Capital Surplus 26,831.9 558.5
Retained Earnings (Net Other) 9,891.5 11,971.3
Less Treasury Stock 5,620.4 1,505.9
TOTAL SHAREHOLDERS' EQUITY 31,321.9 11,104.0
Payables/ (Expenses causing these payables/365)
24
Working capital (AR, INV, AP) turnover ratios are
useful

• Why useful?
• Current, not outdated, values.
• Can be fixed over the short run.
• Have information values (supply demand
  conditions).
• Have direct implications for financing needs.

Operating Cycle, Cash Cycle 2006 US firms
average AR Days 60 INV Days 50 AP Days
53 These are merely crude measures that help
provide an intuition for the operation.
25
Examples -- INV turnovers (represented by INV/CGS
or INV days)
26
Turnover (efficiency) characteristics

• With economies of scale, we expect to see
  (generally but not always)
• improvement on Operating margins (e.g.,
  SA/Sales heading lower)
• Inventory days improving.
• Best Buy Example during growth (1996-2000).

27
Efficiency Ratios

• Factors/Events affecting the ratios.
• AR days
• INV days
• AP Days

28
Income statements of CVS Walgreens, FY2007
Fiscal Year Ending CVS WAG
Sales (Net) 76,329.5 53,762.0
Cost of Goods Sold 60,221.8 38,518.1
Gross Profit 16,107.7 15,243.9
Selling, General, Admin Expenses 10,219.8 11,417.3
Operating Income Before Depreciation 5,887.9 3,826.6
Depreciation, Depletion, Amortization 1,094.6 675.9
Operating Income After Depreciation 4,793.3 3,150.7
Interest Expense 468.3 0.0
Non-Operating Income/Expense 33.7 38.4
Special Items 0.0 0.0
Pretax Income 4,358.7 3,189.1
Income Taxes - Total 1,721.7 1,147.8
Minority Interest 0.0 0.0
Income Before Extraordinary Items Discontinued Op. 2,637.0 2,041.3
Extraordinary Items 0.0 0.0
Discontinued Operations 0.0 0.0
Net Income (Loss) 2,637.0 2,041.3
NOPAT? ______________ using reported tax
rate NOPAT? ______________ using normal tax rate
29
Footnote (12) on taxes
30
Note on taxes

• Statutory (a.k.a. basic) tax rate
• Marginal tax rate
• Effective tax rate
• Reported tax rate
• For multiperiod comparisons of financial
  performance, use one fixed tax rate
  representative of the normal average tax rate,
  or analyze profit rates on pre-tax basis (e.g.,
  EBIT rather than NOPAT).
• All else fails, use average reported tax rate
  (sometimes called effective tax rate).

31
EBIT and NOPATDefinition for our discussions
Financial assets
______ Income
i-free debt
i-bearing debt
?_____
Operating assets
OE
______ Income
Assets
Some authors define NOPAT as one excluding
interest income.