Financial Statement Analysis: A Valuation Approach

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Chapter 6

• The Analysis of Financial Statements

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Objectives of Analysis

• Objectives will vary depending on the
• perspective of the financial statement user
• specific questions that are addressed by the
  analysis
• Potential financial statement users
• Creditors
• Investors
• Managers

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Objectives of Analysis (cont.)

• Creditor
• Ultimately concerned with the ability of an
  existing or prospective borrower to make interest
  and principal payments on borrowed funds.
• Questions that might be raised by a creditor
• What is the borrowing cause?
• What is the firms capital structure?
• What will be the source of debt repayment?

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Objectives of Analysis (cont.)

• Investor
• Attempts to arrive at an estimation of a
  companys future earnings stream in order to
  attach a value to the securities being considered
  for purchase or liquidation.
• The investment analyst poses questions as
• How has the firm performed/what are future
  expectations?
• How much risk is inherent in the existing capital
  structure?
• What are expected returns?
• What is firms competitive position?

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Objectives of Analysis (cont.)

• Management
• Management relates to all questions raised by
• Creditors, Investors, Employees, General public,
  Regulators, Financial press
• Looks to financial statement data to determine
• How well the firm has performed and why?
• Which operating areas have contributed to success
  and which have not?
• What are strengths/weaknesses of companys
  financial position?
• What changes should be implemented to improve
  future performance?

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Objectives of Analysis (cont.)

• Keep in mind Management prepares financial
  statements
• Analyst should be alert to potential for
  management to influence reporting to make data
  more appealing
• May want to supplement analysis with other
  sources of information apart from the Annual
  Report prepared by management

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Sources of Information

• The main sources of information are the financial
  statements themselves and the notes to the
  financial statements.
• The analyst will want to consider the following
  resources
• Proxy Statement, Auditors Report, MDA,
  Supplementary schedules, Form 10-K, Form 10-Q

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Sources of Information (cont.)

• Proxy statement contains information about the
  board of directors, director and executive
  compensation, option grants, audit-related
  matters, related party transactions, and
  proposals to be voted on by the shareholders.
• Auditors report contains the expression of
  opinion as to the fairness of the financial
  statement presentation.
• MDA presents a detailed coverage of the firms
  liquidity, capital resources, and operations.

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Sources of Information (cont.)

• Supplementary schedules are required for
  inclusion in an annual report and are frequently
  helpful to analysis. For example companies that
  operate in several unrelated lines of business
  provide a breakdown of key financial figures by
  operating segment.
• Form 10-K contains much of the same information
  as the annual report issued to shareholders. It
  also shows additional detail such as schedules
  listing information about management, a
  description of material litigation and
  governmental actions, and elaboration of some
  financial statement disclosures.

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Sources of Information (cont.)

• Form 10-Q provides quarterly financial
  information.
• Other sources
• Computerized data bases
• Info on industry norms/ratios
• Info on particular companies/industries
• Ever-expanding financial and investment websites
• Articles in popular/business press

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Tools and Techniques

• Various tools and techniques are used by the
  financial statement analyst in order to convert
  financial statement data into formats that
  facilitate the evaluation of a firms financial
  condition and performance, both over time and in
  comparison with industry competitors.
• These include
• Common-size financial statements
• Express each account on the
• balance sheet as a percentage of total assets
• income statement as a percentage of net sales

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Tools and Techniques (cont.)

• Financial ratios
• Standardize financial data in terms of
  mathematical relationships expressed in the form
  of percentages, times, days.
• Trend analysis
• Requires the evaluation of financial data over
  several accounting periods.
• Structural analysis
• Looks at the internal structure of a business
  enterprise.
• Industry comparisons
• Relate one firm with averages complied for the
  industry in which it operates
• Most important Common sense and judgment

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Common-Size Financial Statements

• Common-size balance sheet (exhibit 2.2)
• Inventories have become more dominant over the
  five-year period in the firms total asset
  structure.
• Holdings of cash and marketable securities have
  decreased from a 20 combined level in 2003 and
  2004 to about 10 in 2007.
• The company has opened 43 new stores in the past
  two years, and the effect of this market strategy
  is also reflected in the overall asset structure.
• Due to the inventory requirements of the new
  stores company shifted from cash and cash
  equivalents to inventories.

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Common-Size Financial Statements (cont.)

• Buildings, leasehold improvements, equipment, and
  accumulated depreciation and amortization have
  increased as a percentage of total assets.
• On the liability side, the proportion of debt
  required to finance investments in assets has
  increased, primarily from long-term borrowing.
• Common size income statement (exhibit 3.3)
• Reveals the trends of expenses and profit margins
• CoGS has increased slightly in percentage terms,
  resulting in a small decline in the gross profit
  percentage.

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Common-Size Financial Statements (cont.)

• To improve this margin, the firm will either have
  to raise its own retail prices, change the
  product mix, or find ways to reduce costs on
  goods purchased for resale.
• In the area of operating expenses, depreciation
  and amortization have increased relative to
  sales, again reflecting costs associated with new
  store openings.
• Selling and administrative expenses rose in 2005,
  but the company cotrolled these costs more
  effectively in 2006 and 2007 relative to overall
  sales.

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Key Financial Ratios

• The general four categories of key financial
  ratios
• Liquidity
• Measures a firms ability to meet cash needs as
  they arise
• Activity
• Measures the liquidity of specific assets and the
  efficiency of managing assets

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Key Financial Ratios (cont.)

• Leverage
• Measures the extent of a firms financing with
  debt relative to equity and its ability to cover
  interest and other fixed charges
• Profitability
• Measures the overall performance of a firm and
  its efficiency in managing assets, liabilities
  and equity

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Key Financial Ratios (cont.)

• Ratios are valuable analytical tools and serve as
  screening devices, indicate areas of potential
  strength and weakness and reveal matters that
  need further investigation, but ...
• They do not provide answers in and of themselves
• They are not predictive
• There is no
• one definitive set of key financial ratios
• uniform definition for all ratios

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Key Financial Ratios (cont.)

• standard that should be met for each ratio
• rules of thumb that apply to the interpretation
  of financial ratios.
• Each situation should be evaluated within the
  context of the particular firm, industry and
  economic environment.
• Note analysts sometimes use average numbers in
  the denominator of ratios that have a balance
  sheet account in the denominator, especially when
  the companys balance sheet accounts vary
  significantly from one year to the next.

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Liquidity Ratios Short-Term Solvency

• Current Ratio
• Measures ability to meet short-term cash needs
• Shows the ability of a firm to meet its debt
  requirements
• Current assets/current liabilities
• Current liabilities are used as the denominator
  because they are considered to represent the most
  urgent debts, requiring retirement within one
  year or one operating cycle.
• The available cash resources to satisfy these
  obligations must come primarily from cash or the
  conversion of the cash of other current assets.

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Liquidity Ratios Short-Term Solvency (cont.)

• Some analysts eliminate prepaid expenses from the
  numerator since they are not a potential source
  of cash but represent future obligations that
  have already been satisfied.
• In order to interpret the significance of this
  ratio it is necessary to evaluate the trend of
  liquidity over a long period and to compare the
  firms ratio with industry competitors.

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Liquidity Ratios Short-Term Solvency (cont.)

• The current ratio is limited by the nature of its
  components.
• The actual amount of liquid assets may vary
  considerably from the date on which the balance
  sheet is prepared.
• Accounts receviable and inventory may not be
  truly liquid.

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Liquidity Ratios Short-Term Solvency (cont.)

• Quick or Acid-Test Ratio
• Measures ability to meet short-term cash needs
  more rigorously by eliminating inventory
• Inventory considered as the least liquid current
  asset and the most likely sources of losses
• (Current assets-Inventory)/Current liabilities
• Cash Flow Liquidity Ratio
• Focuses on ability of the firm to generate
  operating cash flows as a source of liquidity
• (CashMarketable securitiesCash flow from
  operating activities)/Current liabilities

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Liquidity Ratios Short-Term Solvency (cont.)

• Average Collection Period
• Average number of days required to convert
  receivables into cash.
• Net accounts receivable/average daily sales
• The ratio is calculated as the relationship
  between net accounts receivable (net of the
  allowance for doubtful accounts) and average
  daily sales (sales/365 days)
• Helps gauge liquidity of accounts receivable
  (ability to collect cash from customers) and may
  help provide information about a companys credit
  policies.

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Liquidity Ratios Short-Term Solvency (cont.)

• For example If the average collection period
  increasing over time or is higher than the
  industry average, the firms credit policies
  could be too lenient and accounts receivables are
  not sufficiently liquid.
• On the other hand, if credit policies are too
  restrictive, as reflected in an average
  collection period that is shortening and less
  than industry competitors, the firm may be losing
  qualified customers.

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Liquidity Ratios Short-Term Solvency (cont.)

• The average collection period should be compared
  with the firms stated credit policies. If the
  policy calls for collection within 30 days and
  the average collection period is 60 days, the
  implication is that the company is not stringent
  in collection efforts.
• Other explanations, such as depressed economy
• Also a firm that has a relatively strong
  financial position within its industry can extend
  credit for longer periods than weaker competitors.

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Liquidity Ratios Short-Term Solvency (cont.)

• Days Inventory Held
• Average number of days it takes to sell inventory
  to customers.
• Measures the efficiency of the firm in managing
  its inventory.
• Inventory/average daily cost of sales
• The faster inventory sells, the fewer funds tied
  up in inventory
• On the other hand too low number may also
  indicate understocking and lost orders, a
  decrease in prices, a shortage of materials or
  more sales than planned.

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Liquidity Ratios Short-Term Solvency (cont.)

• A high number of days inventory held could be the
  result of carrying too much inventory or stocking
  inventory that is obsolete, slow moving, or
  inferior.
• On the other hand there may be different reasons
  to increase inventory such as rise in demand,
  expansion and opening of new retail stores.
• The industry is also important
• Perishable goods-low days in inventory
• When making comparisons among firms it is
  important to check the cost flow assumption as
  well.

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Liquidity Ratios Short-Term Solvency (cont.)

• Days Payable Outstanding
• Average number of days it takes to pay payables
  in cash.
• Offers insight into a firms pattern of payments
  to suppliers
• Accounts payable/average daily cost of sales
• Delaying payment of payables as long as possible,
  but still making payment by the due date is
  desirable.

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Cash Conversion Cycle or Net Trade Cycle

• Normal operating cycle of a firm that consists
  of
• Buying or manufacturing inventory, with some
  purchases on credit
• Selling inventory, with some sales on credit
• Collecting the cash
• Cash conversion cycle measures this process in
  number of days and is calculated as
• Average collection periodDays inventory
  held-Days payable outstandingCash conversion or
  net trade cycle

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Cash Conversion Cycle or Net Trade Cycle (cont.)

• Helps the analyst understand why cash flow
  generation has improved or deteriorated by
  analyzing the key balance sheet accounts that
  affect cash flow from operating activities such
  as
• Accounts Receivable
• Inventory
• Accounts Payable

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Activity Ratios Asset Liquidity, Asset
Management Efficiency

• Accounts Receivable Turnover
• Another measure of efficiency of firms
  collection and credit policies
• Measures how many times on average accounts
  receivables are collected in cash during the
  year.
• Net sales/net accounts receivable
• Inventory Turnover
• Another measure of firms efficiency in managing
  its inventory
• Measures how many times inventory is sold during
  the year
• Cost of goods sold/inventory

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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)

• Payables Turnover
• Another way to gain insight into a firms pattern
  of payment to suppliers
• Measures how many times payables are paid during
  the year.
• Cost of goods sold/ accounts payable

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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)

• Fixed Asset Turnover
• Assesses effectiveness in generating sales from
  investments in fixed assets
• Net Sales/Net property, plant, equipment
• Important for a capital-intensive firm such as a
  manufacturer with heavy investments in long-lived
  assets.
• Total Asset Turnover
• Assesses effectiveness in generating sales from
  investments in all assets.
• Net sales/Total assets

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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)

• Generally higher these ratios the smaller is the
  investment required to generate sales and thus
  the more profitable is the firm.
• When the asset turnover ratios are low relative
  to the industry or the firms historical record,
  either the investment in assets is too heavy
  and/or sales are sluggish.
• However is for example the firm have undertaken
  an extensive plant modernization or placed assets
  in service at year-end then it may have lower
  asset turnovers. These situations may generate
  positive results in the long-term.

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Leverage Ratios Debt Financing and Coverage

• Debt Ratio
• Considers the proportion of all assets that are
  financed with debt
• Total liabilities/total assets
• Long-term Debt to Total Capitalization
• Reveals the extent to which long-term debt is
  used for the firms permanent financing (both
  long-term debt and equity)
• Long-term debt/(long-term debtstockholders
  equity)

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Leverage Ratios Debt Financing and Coverage
(cont.)

• Debt to Equity
• Measures the riskiness of the firms capital
  structure in terms of the relationship between
  the funds supplied by creditors (debt) and
  investors (equity).
• Total liabilities/stockholders equity
• Each of these debt ratios measures the extent of
  the firms financing with debt.
• The proportion of debt in the capital structure
  of a company is important due to the trade-off
  between risk and return.

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Leverage Ratios Debt Financing and Coverage
(cont.)

• Debt carries a fixed commitment in the form of
  interest charges and principal repayment.
• Failure to satisfy these charges may result in
  bankruptcy.
• Moreover, a firm with too much debt has
  difficulty obtaining additional debt financing
  when needed.
• The credit may available only at high rates of
  interest.
• Debt however also introduces the potential for
  increased benefits to the firms owners.
• When debt is used successfully, if operating
  earnings are more than sufficient to cover the
  fixed charges associated with debt, the returns
  to shareholders are magnified through financial
  leverage.

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Leverage Ratios Debt Financing and Coverage
(cont.)

• Times Interest Earned
• Indicates how well operating earnings cover fixed
  interest expenses
• Operating profit/Interest expense
• Cash Interest Coverage
• Measures how many times interest payments can be
  covered by cash flow from operations before
  interest and taxes
• (Cash from operating activitiesinterest
  paidtaxes paid)/interest paid

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Leverage Ratios Debt Financing and Coverage
(cont.)

• In order for a firm to benefit from debt
  financing, the fixed interest payments that
  accompany debt must be more than satisfied from
  operating earnings.
• The operating return (operating profit divided by
  assets) must exceed the cost of debt (interest
  expense divided by liabilities)
• Higher the times interest earned ratio the
  better.
• Keep in mind! If a company is generating high
  profits but no cash flow from operations the
  ratio is misleading.

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Leverage Ratios Debt Financing and Coverage
(cont.)

• Fixed Charge Coverage
• Broader measure of how well operating earnings
  cover fixed charges
• (Operating profitrent expense)/(interest
  expenserent expense)
• Rent expenseoperating lease payments
• Rent expenses are added back to the numerator
  because they were deducted as an operating
  expense to calculate operating profit.
• Operating lease payments are similar in nature to
  interest expense in that they both represent
  obligations that must be met on an annual basis.

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Leverage Ratios Debt Financing and Coverage
(cont.)

• Cash Flow Adequacy
• Measures firms ability to cover capital
  expenditures, long-term debt payments and
  dividends each year
• Cash flow from operating activities/(capital
  expendituresdebt repaymentsdividends paid)
• Companies over the long run should generate eough
  cash flow from operations to cover investing and
  financing activities of the firm.
• If purchases of fixed assets are financed with
  debt, the company should be capable of covering
  the principal payments with cash generated by the
  company.
• A larger ratio would be expected if the company
  pays dividends because cash used for dividends
  should be generated internally by the company.

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Profitability Ratios Overall Efficiency and
Performance

• Gross Profit Margin
• Measures ability to translate sales into profit
  after consideration of cost of products sold
• Gross profit/net sales
• Measures the ability of a company both to control
  costs of inventories or manufacturing of products
  and to pass along price increases through sales
  to customers.

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Profitability Ratios Overall Efficiency and
Performance (cont.)

• Operating Profit Margin
• Measure of overall operating efficiency
• Measures ability to translate sales into profit
  after consideration of operating expenses
• Operating profit/net sales
• Net Profit Margin
• Measures ability to translate sales into profit
  after consideration of all expenses and revenues,
  including interest, taxes and nonoperating items
• Net earnings/net sales

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Profitability Ratios Overall Efficiency and
Performance (cont.)

• Cash Flow Margin
• Measures ability to translate sales into cash
  (with which to pay bills!)
• Shows relationship between cash generated from
  operations and sales
• Cash flow from operating activities/net sales

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Profitability Ratios Overall Efficiency and
Performance (cont.)

• Return on Total Assets (ROA) or Return on
  Investment (ROI)
• Measures overall efficiency of firm in managing
  investment in assets and generating profits
• Indicates the amount of profit earned relative to
  the level of investment in total assets.
• Net earnings/ total assets
• Return on Equity (ROE)
• Measures rate of return on stockholders
  investment
• Net earnings/Stockholders equity

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Profitability Ratios Overall Efficiency and
Performance (cont.)

• Cash Return on Assets
• Measures firms ability to generate cash from the
  utilization of its assets
• Useful comparison to ROA
• Cash flow from operating activities/total assets

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Market Ratios

• Four market ratios of pariticular interest to the
  investor are
• Earnings per common share
• Price-to-earnings
• Dividend payout
• Dividend yield

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Market Ratios (cont.)

• Earnings per Common Share
• Provides the investor with a common denominator
  to examine investment returns
• Net earnings/average shares outstanding
• Price-to-Earnings
• Relates earnings per common share to the market
  price at which the stock trades, expressing the
  multiple that the stock market places on a
  firms earnings
• Market price of common stock/ earnings per share

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Market Ratios (cont.)

• Dividend Payout
• Determined by the formula cash dividends per
  share divided by earnings per share
• Dividends per share/earnings per share
• Negative signalling effect
• It is unusual for a firm to reduce cash dividends
• Dividend Yield
• Shows the relationship between cash dividends and
  market price
• Dividends per share/market price of common stock

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Analyzing the Data

• There are general five steps in financial
  statement analysis
• Step 1 Establish objectives of the analysis
• Who are you and why are you interested in this
  company?
• What questions would you like to have answered?
• What info is vital to the decision at hand?
• Step 2 Study the industry in which the firm
  operates and relate industry climate to current
  and projected economic developments

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Analyzing the Data (cont.)

• Step 3 Develop knowledge of the firm and the
  quality of management
• How well does this firm appear to be run?
• Are they taking advantage of opportunities?
• Are they innovative, forward-looking, etc?
• Step 4 Evaluate financial statements
• Tools include
• Common-size financial statements
• Key financial ratios
• Trend analysis
• Structural analysis
• Comparison with industry competitors

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Analyzing the Data (cont.)

• Areas include
• Short-term liquidity
• Operating efficiency
• Capital structure and long-term solvency
• Profitability
• Market ratios
• Segmental analysis (when relevant)
• Quality of financial reporting
• Step 5 Summarize findings based on analysis
• Reach conclusions about the firm relevant to your
  established objectives

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Short-Term Liquidity

• It is important to creditors, suppliers,
  management, and others who are concerned with the
  ability of a firm to meet near-term demands for
  cash.
• R.E.C. common-size balance sheet
• Inventories have increased relative to cash and
  marketable securities in the current asset
  section
• There has been an increase in the proportion of
  debt, both short and long-term.
• Policies and financing needs related to new store
  openings.

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Short-Term Liquidity (cont.)

• Five year trend of selected financial ratios and
  a comparison with industry averages
• Liquidity analysis involves the prediction of the
  future ability of the firm to meet prospective
  need for cash
• This prediction is made from the historical
  record of the firm, and no one financial ratio or
  set of financial ratios or other financial data
  can serve as a proxy for future developments.
• R.E.C. ratios are somewhat contradictory
• The current and quick ratios have trended
  downward over the five-year period, indicating a
  deterioration of short-term liquidity.

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Short-Term Liquidity (cont.)

• The cash flow liquidity ratio improved strongly
  in 2007 after a year of negative cash generation
  in 2006.
• The average collection period for accounts
  receivable and the days inventory held ratio also
  improved in 2007
• These ratios measure the quality or liquidity of
  accounts receivable and inventory
• The average collection period increased to a high
  of 20 days in 2006, which was recessionary period
  in the economy, then decreased to a more
  acceptable 15-day level in 2007.

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Short-Term Liquidity (cont.)

• Days payable outstanding has varied each year,
  but increased overall.
• As long as the company is paying the bills, this
  does not have to indicate a problem.
• The net trade cycle worsened from 2003 to 2006
  due to increasing collection period and longer
  number of days inventory was held.
• In 2007 a significant improvement in management
  of current assets and liabilities has caused a
  decrease in conversion cycle and make it much
  closer to the industry average.

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Short-Term Liquidity (cont.)

• The common-size balance sheet for R.E.C. Inc.
  revealed that inventories now compromise about
  half of the firms total assets.
• The growth in inventories has been necessary to
  satisfy the requirements associated with the
  opening of new retail outlets but has been
  accomplished by reducing holdings of cash and
  cash equivalents.
• Represents a trade-off of highly liquid assets
  for potentially less liquid assets.
• The efficient management of inventories is
  critical ingredient for the firms ongoing
  liquidity.
• In 2007, days inventory held improved.

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Short-Term Liquidity (cont.)

• What is the ability of the firm to produce cash
  from operations?
• Recession in economy in 2006 reduced sales
  growth.
• Inventories and receivables increased too fast
  for the limited sales growth.
• The company also experienced some decrease of
  credit availability from suppliers who have also
  felt the effects of the recession.
• Thus it has negative cash flows in 2006.
• In 2007, the company generate positive cash flow
  from operations and progress managing inventories
  and receivables.
• No major problems related to the liquidity of the
  firm.

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Operating Efficiency

• R.E.Cs fixed asset turnover has decreased over
  the five year and is now below the industry
  average.
• The asset turnover ratios shows a downward trend
  in the efficiency with which the firm is
  generating sales from investments in fixed and
  total assets.
• The total asset turnover rose in 2007.
• Might be due to improved management of
  inventories and receivables.
• The fixed asset turnover ratio is still
  declining, a result of expanding offices and
  retail outlets.
• Should improve if the expansion is successful.

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Capital Structure and Long-term Solvency

• Debt implies risk.
• The fixed commitments must be met in order for
  the firm to continue operations-disadvantage
• Shareholder returns are magnified through
  financial leverage when used successfully-advantag
  e.
• The debt ratios for R.E.C. reveal a steady
  increase in the use of borrowed funds.
• The total debt has risen relative to total assets
  
• Long-term debt has increased as a proprotion of
  the firms permanent financing
• External (debt financing) has increased relative
  to internal financing.

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Capital Structure and Long-term Solvency (cont.)

• The important questions then
• Why debt has increased?
• Financing the investments in capital assets
• Does the firm employ the debt successfully?
• Financial leverage index (FLI)ROE/Adjusted ROA
• Adjusted ROAnet earningsinterest expense(1-tax
  rate)/total assets.
• Effective tax rateIncome taxes/earnings before
  income taxes
• FLIgt1 (return on equity exceeds return on assets)
  the firm is employing debt successfully.
• R.E.C. data indicates a successful use of
  financial leverage

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Capital Structure and Long-term Solvency (cont.)

• How well does it cover its fixed charges?
• Given the increased level of borrowing, the times
  interest earned and cash interest coverage ratios
  have declined over the five year period.
• Times interest earned stayed above the industry
  average.
• Cash interest coverage indicates that the firm is
  generatign enough cash to actually make the cash
  payments
• R.E.C. leases the majority of its retail outlets
  so the fixed charge coverage ratio, which
  considers lease payments as well as interest
  expense, is a more relevant ratio.

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Capital Structure and Long-term Solvency (cont.)

• It has decreased due to store expansion and
  higher payments for leases and interest.
• Although below the industry average the firm is
  covering all fixed charges by more than two times
  out of operating earnings.
• The cash flow adequacy ratio has dropped below
  1.0 in 2005, 2006, and 2007.
• The company does not generate enough cash from
  operations to cover capital expenditures, debt
  repayments, and cash dividends.
• Firm has to increase cash from operations
• Reducing accounts receivable and inventories.

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Profitability

• Profitability looks promising after poor year in
  2006.
• Except the cash flow margin, the profit margins
  are below their 2003 and 2004 levels but have
  improved in 2007 and above industry averages.
• The gross profit margin was stable.
• A positive sign eventhough there were new store
  openings with many sale and discounted items to
  attract customers.
• The operating profit margin increased although
  the firm was expanding with increases in
  operating expenses.
• The net profit margin also improved in spite of
  increased interest and tax expenses and a
  reduction in interest revenue from marketable
  securities.

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Profitability (cont.)

• Cash flow margin because of high cash generation
  from operations in 2007 was at its highest level.
• After declining steadily through 2006, ROA, ROE
  and cash return on assets increased in 2007.
• R.E.C. is well positioned for future growth.
• It will be important to monitor the firms
  management of inventories.
• Account half of total assets and have been
  problematic in the past.
• The expansion will necessitate a continuation of
  expenditures for advertising.

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Profitability (cont.)

• R.E.C had negative cash flow from operations in
  2006. Thus it should be watched as well.
• Negative cash flow occured in the year of modest
  sale and earnings growth.

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Relating the RatiosThe Du Pont System

• The Du Pont System helps the analyst see how the
  firms decisions and activities over the course
  of an accounting period interact to produce an
  overall return to the firms shareholders, the
  return on equity.
• By reviewing this relationship between ratios,
  the analyst can identify strengths and
  weaknesses.
• Also can trace potential causes of any problems
  in the overall financial condition and
  performance of the firm.

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Relating the RatiosThe Du Pont System (cont.)

• The summary ratios used are the following

(1) Net profit margin
(2) Total asset turnover
(3) Return on investment
Net income Net sales Net
income Net sales X Total assets
Total assets
(3) Return on investment
(4) Financial leverage
(5) Return on equity
Net income Total assets
Net income Total assets X Stockholder equity
Stockholder equity
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Relating the RatiosThe Du Pont System (cont.)

• Return on investment (profit generated from the
  overall investment in assets) is a product of the
  
• Net profit margin-profit generated from sales
• Total asset turnover-the firms ability to
  produce sales from assets
• Return on equity (overall return to shareholders,
  the firms owners) is derived from the product of
• Return on investment
• Financial leverage-proportion of debt in the
  capital structure

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Relating the RatiosThe Du Pont System (cont.)

• ROE of R.E.C. is below earlier year levels but
  has improved since its low point in 2006.
• The profit margin and asset turnover are lower in
  2007 than in 2003 and 2004.
• The combination of increased debt (financial
  leverage) and the improvement in profitability
  and asset utilization has produced an improved
  overall return in 2007.
• The firm has borrowed (increased) debt to finance
  capital asset expansion and has used its debt
  effectively.

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Relating the RatiosThe Du Pont System (cont.)

• The 2007 improvement in inventory management has
  impacted the firm favorably, showing up in the
  improved total asset turnover ratio.
• The firms ability to control operating costs
  while increasign sales during expansion has
  improved the net profit margin.
• The overall return on asset is now improving as a
  result of these combined factors.

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Projections and Pro Forma Statements

• The investment analyst, in valuing for example
  securities for investment decisions, must project
  the future earnings stream.
• Pro forma financial statements are projections of
  financial statements based on a set of
  assumptions regarding future revenues, expenses,
  level of investment in assets, financing methods
  and costs, and working capital management.
• They are basically utilized for long-range
  planning and long-term credit decisions.

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Summary of Analysis

• Strengths of R.E.C.
• Favorable economic and industry outlook
• Firm well-positioned geographically to benefit
  from expected eonomic and industry growth
• Aggressive marketing and expansion strategies
• Recent improvement in management of accounts
  receivable and inventory
• Successful use of financial leverage and solid
  coverage of debt service requirements
• Effective control of operating costs

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Summary of Analysis (cont.)

• Substantial sales growth
• Partially due to market expansion
• Reflect future performance potential
• Increased profitability in 2007
• Strong and positive generation of cash flow from
  operations
• Weaknesses
• Sensitive to economic fluctuations and weather
  conditions
• Negative cash flow from operating activities in
  2006

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Summary of Analysis (cont.)

• Historical problems with inventory management
• Weakness in overall asset management efficiency
• Increased risk asociated with debt financing
• The general outlook for the firm is promising.
• Sound credit risk with attractive investment
  potential.
• The management of inventories, a continuation of
  effective cost control and careful timing of
  further expansion will be critically important
  for the firms success.