mba 6101: financial accounting chapter 4: analyzing and interpreting financial statements prof....

MBA 6101: Financial Accounting

Chapter 4: Analyzing and Interpreting

Financial Statements

Prof. Larry Louie

Analysis Structure

MBA 6101 Financial Accounting

Operating Return (RNOA)

The income statement reflects operating activities through revenues, costs of goods sold (COGS), and other expenses.

Operating assets typically include cash, receivables, inventories, prepaid expenses, property, plant and equipment (PPE), and capitalized lease assets, and exclude short-term and long-term investments in marketable securities.

MBA 6101 Financial Accounting

Op vs. Nonop items for Income Stmt

General Mills ($mils)Income Statement OP/Nonop current yrSales O 13,652.1 Cost of Goods Sold O 8,778.3 Gross Profit O 4,873.8

Operating Expenses O 2,646.0 Net Operating Profit Before Tax O 2,227.8

interest expense, net N 421.7

investment gains and lossesEarnings before taxes and JV earnings n/a 1,806.1

tax expense O 622.2 after tax earnings from JVs O 110.8 minority interest expense, net of tax N - discontinued operations, net of tax N -

Net Income n/a 1,294.7 MBA 6101 Financial Accounting

Tax on Operating Profit

For General Mills:

Income tax is tricky since the income tax expense includes tax savings from net non-operating expenses, so add it back

MBA 6101 Financial Accounting

Operating Items in the Income Statement

OP/Nonopcurrent yr prior yrBalance Sheet

Cash and equiv O 661.0 417.1 Short term investments N - - Accounts Receivable O 1,081.6 952.9 Inventory O 1,366.8 1,173.4 Prepaid Expenses O 510.6 443.1 other current assets O - 67.2 Total current assets n/a 3,620.0 3,053.7

Long term investments N - - Property, plant and equipment, net O 3,108.1 3,013.9 Capitalized lease obligations O - - Equity method investments O - - Other operating long term assets O 1,750.2 1,586.7 Other nonoperating long term assets N - - Goodwill and other intangible assets O 10,563.3 10,529.4 Total long term assets n/a 15,421.6 15,130.0

Total Assets n/a 19,041.6 18,183.7

Operating Assets 19,041.6 18,183.7 Nonoperating Assets - - Total Assets (check figure) 19,041.6 18,183.7

Op vs. NonOp Assets for General Mills

MBA 6101 Financial Accounting

Liabilites and Shareholders' Equity OP/Nonopcurrent yr prior yrAccounts Payable O 937.3 777.9 Short term notes payable N 2,208.8 1,254.4 Current maturities of long term debt N 442.0 1,734.0 Interest payable NAccrued liabiliites OUnearned revenues ODeferred income tax liabiliites O 28.4 Other current liabilities O 1,239.8 2,078.8 Total current liabilities n/a 4,856.3 5,845.1

Bonds payable N - - Notes payable N 4,348.7 3,217.7 Capitalized lease obligations N - - Pension and post employment liab. O - - Deferred tax liabilities O 1,454.6 1,433.1 Other liabilities O 1,923.9 1,229.9 Total long term liabilities n/a 7,727.2 5,880.7

Total Liabilities 12,583.5 11,725.8

Total operating liabilities 5,584.0 5,519.7 Total nonoperating liabiliites 6,999.5 6,206.1 Total Liabiliites (check figure) 12,583.5 11,725.8

Minority interest N - -

Sharesholders' Equity N 6,458.1 6,457.9 Total Lia and Sh. Equity 19,041.6 18,183.7

Op vs. NonOp Liabilities and Equity for Gen Mills

MBA 6101 Financial Accounting

General Mills’ NOA

MBA 6101 Financial Accounting

General Mills’ RNOA and ROE

MBA 6101 Financial Accounting

Key Definitions

MBA 6101 Financial Accounting

Disaggregation of RNOA

MBA 6101 Financial Accounting

Net Operating Profit Margin (NOPM) Net operating profit margin (NOPM)

reveals how much operating profit the company earns from each sales dollar.

NOPM is affected by the level of gross profit the level of operating expenses the level of competition and the company’s

willingness and ability to control costs.

MBA 6101 Financial Accounting

General Mills’ NOPM

This result means that for each dollar of sales at General Mills, the company earns just over 11.4¢ profit after all operating expenses and tax.

As a reference, the median NOPM for all publicly traded firms is about 7 to 7.5¢

MBA 6101 Financial Accounting

Net Operating Asset Turnover (NOAT) Net operating asset turnover (NOAT)

measures the productivity of the company’s net operating assets.

This metric reveals the level of sales the company realizes from each dollar invested in net operating assets.

All things equal, a higher NOAT is preferable.

MBA 6101 Financial Accounting

General Mills’ NOAT

This result means that for each dollar of net operating assets, General Mills realizes $1.05 in sales.

As a reference, the median for all publicly traded companies is $2.10

MBA 6101 Financial Accounting

Margin vs. Turnover

MBA 6101 Financial Accounting

Non-operating Return Component of ROE

Assume that a company has $1,000 in average assets for the current year in which it earns a 20% RNOA. It finances those assets entirely with equity investment (no debt).

Its ROE is computed as follows:

MBA 6101 Financial Accounting

Effect of Financial Leverage Next, assume that this company borrows

$500 at 7% interest and uses those funds to acquire additional assets yielding the same operating return.

Its average assets for the year now total $1,500 and its profit is $265.

MBA 6101 Financial Accounting

Effect of Financial Leverage on ROE We see that this company has increased

its profit to $265 (up from $200) with the addition of debt, and its ROE is now 26.5% ($265/$1,000).

The reason for the increased ROE is that the company borrowed $500 at 7% and invested those funds in assets earning 20%.

The difference of 13% accrues to shareholders.

MBA 6101 Financial Accounting

MBA 6101 Financial Accounting

GAAP Limitations of Ratio analysis

1. Measurability. Financial statements reflect what can be reliably measured. This results in non-recognition of certain assets, often internally developed assets, the very assets that are most likely to confer a competitive advantage and create value. Examples are brand name, a superior management team, employee skills, and a reliable supply chain.

2. Non-capitalized costs. Related to the concept of measurability is the expensing of costs relating to “assets” that cannot be identified with enough precision to warrant capitalization. Examples are brand equity costs from advertising and other promotional activities, and research and development costs relating to future products.

3. Historical costs. Assets and liabilities are usually recorded at original acquisition or issuance costs. Subsequent increases in value are not recorded until realized, and declines in value are only recognized if deemed permanent.

MBA 6101 Financial Accounting

Special Topics – Discontinued Operations Discontinued operations are subsidiaries or

business segments that the board of directors has formally decided to divest.

Companies must report discontinued operations on a separate line, below income from continuing operations.

The net assets of discontinued operations should be considered to be non-operating (they represent an investment once they have been classified as discontinued) and their after-tax profit (loss) should be treated as non-operating as well.

Although the ROE computation is unaffected, the non-operating portion of that return will include the contribution of discontinued operations.

MBA 6101 Financial Accounting

Special Topics – Preferred Stock The ROE formula takes the perspective of the

common shareholder in that it relates the income available to pay common dividends to the average common shareholder investment.

Thus, the presence of preferred stock requires two adjustments to the ROE formula (called ROCE).1. Preferred dividends must be subtracted from net income

in the numerator. 2. Preferred stock must be subtracted from stockholders’

equity in the denominator.

MBA 6101 Financial Accounting

Liquidity and Solvency Measures Liquidity refers to cash: how much we

have, how much is expected, and how much can be raised on short notice.

Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

MBA 6101 Financial Accounting

Current Ratio Current assetsCurrent assets are those assets that a company expects to

convert into cash within the next operating cycle, which is typically a year.

Current liabilitiesCurrent liabilities are those liabilities that come due within the next year.

An excess of current assets over current liabilities (Current assets Current liabilities), is known as net working capitalnet working capital or simply working capitalworking capital.

MBA 6101 Financial Accounting

Quick Ratio The quick ratio focuses on quick

assets. Quick assets include cash, marketable

securities, and accounts receivable; they exclude inventories and prepaid assets.

MBA 6101 Financial Accounting

Solvency Ratios SolvencySolvency refers to a company’s ability to meet its debt

obligations. Solvency is crucial since an insolvent company is a

failed company. Two common solvency ratios:

MBA 6101 Financial Accounting

Vertical and Horizontal Analysis

MBA 6101 Financial Accounting

Vertical and Horizontal Analysis

MBA 6101 Financial Accounting

DuPont Disaggregation Analysis

• Profit margin Profit margin is the amount of profit that the company earns from each dollar of sales.

• Asset turnover Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets.

• Financial leverage Financial leverage measures the degree to which the company finances its assets with debt rather than equity.

MBA 6101 Financial Accounting

Return on Assets

MBA 6101 Financial Accounting

Return on Assets Adjustment

The adjusted numerator better reflects the company’s operating profit as it measures return on assets exclusive of financing costs (independent of the capital structure decision).MBA 6101 Financial Accounting

Return on Common Equity Adjustment

MBA 6101 Financial Accounting

DuPont Disaggregation for General Mills

MBA 6101 Financial Accounting

Chapter 4: Summary1. The separation of operating and non-

operating portions of the balance sheet and income statements provides valuable insights into the financial results of a company

2. Financial Ratios provide tools to evaluate the profitability, asset utilization, liquidity and solvency of a firm

3. Common size techniques assist in analyzing trends and comparing firms

4. Decomposition is a handy tool to determine answers to “why” certain results occurred.MBA 6101 Financial Accounting