managerial accounting note 1

8/13/2019 Managerial Accounting Note 1

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HA 2210Potter

Note #1

Analyzing Financial Statements

I. Principal financial statements

Balance sheet portrays financial position of firm at point in time (page 16)Income statement portrays results of operations over a period of time (page 17)

Statement of cash flows portrays change in cash over a period of time (page 18)Also provided in a complete set of financials is a consolidated statement of stockholdersequity and of comprehensive income.

II. Reasons for analyzing financial statements

Prospective equity or credit investment

Contract resolution/covenant complianceOperations analysis/identification of areas for improvement and value creation

III. Analysis techniques

Trend analysis of a time series (page 13 & 14)Common-sized financial statements (page 15)Ratio analysis

IV. Ratios are only useful when comparing

Across firms at one time (cross-sectional analysis)

One firm across time (time-series analysis)Against a benchmark, standard or contracted amount

V. Reasons for cross-sectional differences in ratios (page 3)

Industry structure

StrategyGrowth stage of firm

Accounting methodsEfficiency

VI. Caveats concerning financial analysis, particularly ratios.

Ratios are based on imperfect accounting numbersRatios are only one piece of puzzle

Firms can window dress their accounting numbersRatios are highly correlated, hence they can be redundantRatios have multiple meanings


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Ratio Overview

As managers we are interested in measures of asset utilization, credit worthiness/risk, and overallperformance of the entity. The ratios are discussed in this order.

Turnover/Activity/Asset Utilization Ratios. These ratios highlight the investing activities of the firm.

They suggest how effective the firm is in using its costly asset resources in generating sales.

1. Inventory Turnovera(INVX) = Cost of Goods Sold / Average Inventory

b

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This ratio indicates how quickly inventory turns over, or how fast inventory items move through a

business. Turnover will be a function of production or operating characteristics (simple orcomplex production or sales process), accounting method, efficiency (management control) andstrategy. Because most firms produce or sell goods, this ratio provides an indication of the length

of a firm's production process.

2. Accounts Receivable Turnover (ARX)= Sales (or credit sales) / Average Accounts Receivable.

This ratio indicates how quickly account receivables are collected. Turnover will be a function ofcredit terms, the use of credit or cash sales in the numerator and late receivables. A trend for thisratio over time can give a crude indication of a company's changing credit policy.

a The inverse of this ratio times 365 gives you average number of days on hand.b When you scale a flow variable (an income or cash flow amount) by a stock variable (balance sheet amount) you have a

timing problem. Most analysts chose to use the average balance sheet amount to help resolve this problem, but there is no perfectsolution to this timing issue.


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3. Fixed Asset Turnover (FAT or NPPEX) = Sales / Average Net Property and Eqp.

This ratio computes the sales per dollar of fixed investment. It provides a crude measure of howwell the investment in plant and equipment is being managed relative to sales volume. The ratio

should be related to capital intensity. Variation in this ratio will also depend on strategy, growthand efficiency. Net means property and equipment after deducting for accumulated depreciation.

4. Total Asset Turnover (TAT) = Sales / Average Total Assets.

This ratio identifies sales per dollar of the firms investment. There will be substantial variation

in this ratio due to the asset structure (ex. capital intensity) of the firm.

Credit Risk Ratios. These ratios highlight the short and long term financing risk of the firm. They also

reveal the financing mix of the firm.

Short Term Liquidity/Credit Risk

5. Current Ratio (CR)= Current Assets / Current Liabilities.

Measures the number of times current assets cover current liabilities. This would be useful if youare a short term creditor trying to determine if the company has the ability to pay you off if itliquidates. A closely related concept is working capital which is defined as current assets minuscurrent liabilities.


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6. Quick or Acid Test (QUICK)= Quick assets / Current Liabilities.

This ratio measures the number of times liquid current assets cover current liabilities. Thismeasure excludes those current assets that a not readily convertible into cash. Similar to the

current ratio, differences in the acid test ratio are due to credit policy and other operatingcharacteristics. Quick assets include cash, marketable securities and receivables included in

current assets.

Long Term Credit Risk/Leverage

7. Interest Coverage or Times Interest Earned (TIE) = (Income Before Tax + Interest Expense) / InterestExpense.

This ratio measures the number of times interest expense is covered by income before interest. Itis a key measure of ability of firm to cover interest on debt.

8. Debt to Equity (D/E) =Total liabilities/Total stockholder equity

Measures the relative proportion of debt and equity in the capital structure, and as such measuresfinancial leverage. Financial risk increases as debt becomes larger proportion of capital structure.Variation in this ratio can be due to industry stability, operating cycle characteristics andfinancing strategy. All other things equal, the higher the ratio the higher the long term credit risk.

The Harvard note also recommends the debt ratio, computed as total liabilities divided by totalassets, as a measure of financial leverage.


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Information on key long term issuercredit risk can be gleaned by comparing a firms key metrics to thosereported by Standard and Poors. Below are some key metrics from S&Ps credit rating publication. Most

firms strive to have a credit rating of at least a BBB, which is the minimum investment grade rating. Thebest rating is AAA. A rating of CCC or lower indicates that the firm is currently capable of nonpayment, or

worse as the rating gets lower.

Median S&P Ratios by Debt Rating Category

Industrial Firms AAA AA A BBB BB B CCC

EBIT interest coverage (x) 23.8 19.5 8 4.7 2.5 1.2 0.4

EBITDA interest coverage (x) 25.5 24.6 10.2 6.5 3.5 1.9 0.9

CFO/total debt (%) 203.3 79.9 48 35.9 22.4 11.5 5

Free cash flow/total debt (%) 127.6 44.5 25 17.3 8.3 2.8 -2.1

Total debt/EBITDA (x) 0.4 0.9 1.6 2.2 3.5 5.3 7.9

Return on capital (%) 27.6 27 17.5 13.4 11.3 8.7 3.2

Total debt/capital (%) 12.4 28.3 37.5 42.5 53.7 75.9 113.5

S&P Corporate Rating Criteria, 2006

While examining the S&P ratings criteria are useful in understanding the relation between key ratios and afirms long term credit risk assessment by S&P, there are many other factors impacting credit risk, includingsize and the stability of future cash flows.

9. Free Cash Flow (FCF) = Cash from Operations Capex (Capital Expenditures)

Measures cash from operations after reinvestment. It measures the ability of the firm to internallysustain critical investments, which is preferred before debt is repaid. This ratio will be used formultiple purposes and can be compared across firms and time by scaling by average total asset,

or for credit risk by scaling by average debt.


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Performance/Profitability Ratios. These ratios portray the overall performance of the firm.

10. Return on Sales (ROS) or Profit Margin = Net Income / Sales, or preferred

addback interest in the numerator = (Net Income+Interest Expense(1-Tax Rate))/Sales.

Measures the return per dollar of sales. This ratio will depend on strategy and the profit marginsof industries. Firms with low return on sales can still be quite profitable if they can turn sales over

quickly.

11. Return on Assets (ROA)= [Net Income+Interest Expense(1-Tax Rate)] /Average Total Assets.

Return on a dollar of invested capital before financing choice. It can be thought of as an interestrate return on the firm's investment, similar to a savings account's interest rate. ROA is the

premier measure of performance for many companies. ROA is used by firms to manage their

business and is the basis of many incentive plans. Some firms compute using net income oroperating income in the numerator.

We will also see that ROA can be partitioned into two components, total asset turnover, TAT, and

ROS, return on sales.

12. Return on Equity (ROE) = Net Income / Average Shareholder Equity.

Return on a dollar of shareholder's capital. This amount should exceed ROA unless the firm's

cost of debt capital is higher than ROA.


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Motivation for Adding Back Net Interest Expense for Return on Asset (ROA) Calculation

To compare operating units independent of financing choice (debt financing versus equity financing) wewant to add back interest expense net of any tax benefit.That allows for an operating comparison of units

independent of financing.

Return on Assets (ROA)= [Net Income+Interest Expense(1-Tax Rate)] /Average Total Assets.

Hotel A Hotel B

Assets Liab & SE Assets Liab & SE

Avg. Assets =100

Avg. Liab.=0Avg. SE = 100

EBIT = 20

Tax Rate = TR = 40%

Avg. Assets =100

Avg. Liab. = 60Avg. SE = 40

EBIT = 20

Tax Rate = TR = 40%

Interest Rate = i =10%

Properties are identical except Hotel B finances with debt and therefore will have one additional expense,interest. After the interest addback, show that the return on assets is identical for these two hotels, whichis what we want to accomplish if focusing on effective use of the firms resources.


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Link between ROA (return on assets) and ROE (return on equity)

Financial Leverage: Whenever the return on assets (ROA) is greater than the cost of liabilities

(ROD) gains accrue to shareholders through an increasing return on equity (ROE). If analysis isdone after tax, ROD can be estimated as: ROD = interest expense*(1-tax rate)/average liabilities.

AA = Average assetsAL = Average liabilities

ASE = Average SE

ROD = interest expense*(1-tax rate)/average total liabilitiesROA = [net income + interest expense*(1-tax rate)] /average total assets

ROE = net income/ average shareholder equity

ROE = ROA + AL/ASE *[ROA ROD]

Where: AL/ASE is a measures of financial leverage and,

[ROA ROD] is spread in returns.


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Calculate ROA, ROD and ROE over the most recent year for Target. Use model from page 10 to

explain how ROA drives ROE. Our course focuses on practices that over the long run should

increase the return on assets.


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Cross-sectional Ratio Analysis

Industry sets comprised of three key firms from an industry over comparable periods. Return on sales ,, and also assets, is after adjusting for net interest

expense. Retail industry competitive set is Walmart and Costco.

Ratio

Category

Ratio Name Notation Target

Corporation

Retail

Industry Set

Restaurant Set Hotel Set

Turnover

1 Inventory INVX

2 Receivable ARX

3 NPPE NPPEX

4 Total Asset TATCredit Risk

ST-Liquidity

5 Current CR

6 Quick or Acid test QUICK

LT-Solvency

7 Interest coverage TIE

8 Debt to Equity D/E

9 Free Cash Flow/Avg. Assets FCFA

Profitability

10 Return on Sales ROS

11 Return on Assets ROA

12 Return on Equity ROE


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Target CorporationSelected Financial Data

For the Fiscal Year

(millions) 2012 2011 2010 2009 2008 2007Financial Results :Total revenues $73,301 $69,865 $67,390 $65,357 $64,948 $63,367Net earnings 2,999 2,929 2,920 2,488 2,214 2,849

Financial Position:Total assets 48,163 46,630 43,705 44,533 44,106 44,560


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Trend Analysis

Using the selected financial data from the prior page, scale the revenues, net earnings and total

assets time-series by each accounts base year amounts (base year=2007) and then multiply by100 to create a trended series. Below we compute this for prior page series. What can we learn

from this analysis?

Horizontal/Trend Analysis

Account 2012 2011 2010 2009 2008 2007

Revenues 116 110 106 103 102 100

Net Earnings 105 103 102 87 78 100

Total Assets 108 105 98 100 99 100


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Common-sized Income Statement

Common-sized income statement: Within each yearscale each line from the sales line down to

net income by its net sales. Therefore, each account within a year is represented as a proportion

of sales.

Targets Common Sized Income Statement

2012 2011 2010

Net sales 1.000 1.000 1.000

Cost of sales .690 .685 .679

SGA .237 .239 .243

Operating Income .073 .076 .078

Interest Expense .010 .012 .011

Income Before Tax .063 .064 .067

Prov. for Income Tax .022 .022 .023

Net Earnings .041 .042 .044

Many times common-sized balance sheets are prepared by scaling each balance sheet account by

total assets. Cash flow statements are also sometimes analyzed by scaling by total assets. What

did we learn from the above analysis?


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Target CorporationConsolidated Statements of Financial Position

As of fi scal year ending 2/2/2013 and 1/28/2012

(millions) 2012 2011AssetsCash and cash equivalents, including short-

term investments of $130and $194 $ 784 $ 794Credit card receivables, net of allowance of $0and $430 5,841 5,927Inventory 7,903 7,918Other current assets 1,860 1,810

Total current assets 16,388 16,449Property and equipment

Land 6,206 6,122Buildings and improvements 28,653 26,837Fixtures and equipment 5,362 5,141Computer hardware and software 2,567 2,468Construction-in-progress 1,176 963

Accumulated depreciation (13,311) (12,382)Property and equipment, net 30,653 29,149

Other noncurrent assets 1,122 1,032Total assets $ 48,163 $ 46,630

Liabilities and shareholders' investmentAccounts payable $ 7,056 $ 6,857Accrued and other current liabilit ies 3,981 3,644Unsecured debt and other borrowings 1,494 3,036Nonrecourse debt collateralized by credit card receivables 1,500 750Total current liabilities 14,031 14,287Unsecured debt and other borrowings 14,654 13,447Nonrecourse debt collateralized by credit card receivables 250Deferred income taxes 1,311 1,191Other noncurrent liabilities 1,609 1,634

Total noncurrent liabilities 17,574 16,522Shareholders' equityTotal shareholders' investment 16,558 15,821

Total liabilities and shareholders' investment $ 48,163 $ 46,630


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Target CorporationConsolidated Statements o f Operations

(millions) 2012 2011 2010

Total revenues 73,301 69,865 67,390Cost of sales 50,568 47,860 45,725Selling, general and administrative expenses 17,362 16,683 16,413Earnings before interest expense and income taxes 5,371 5,322 5,252Net interest expense 762 866 757Earnings before income taxes 4,609 4,456 4,495Provision for income taxes 1,610 1,527 1,575Net earnings $ 2,999 $ 2,929 $ 2,920


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Target CorporationConsolidated Statements o f Cash Flows

(millions) 2012 2011 2010Operating activ itiesNet earnings $2,999 $2,929 $2,920Reconciliation to cash flow

Depreciation and amortization 2,142 2,131 2,084Share-based compensation expense 105 90 109Deferred income taxes (14) 371 445Bad debt expense (a) 206 154 528Gain on receivables held for sale (161) Noncash (gains)/losses and other, net 14 22 (145)Changes in operating accounts:

Accounts receivable originated at Target (217) (187) (78)Inventory 15 (322) (417)Other current assets (123) (150) (124)Other noncurrent assets (98) 43 (212)Accounts payable 199 232 115Accrued and other current liabilities 138 218 149

Other noncurrent liabilities 120 (97) (103)Cash flow provided by operations 5,325 5,434 5,271Investing activities

Expenditures for property and equipment (3,277) (4,368) (2,129)Proceeds from disposals 66 37 69Change in accounts receivable originated at third parties 254 259 363Other investments 102 (108) (47)

Cash flow required for investing activities (2,855) (4,180) (1,744)Financing activities

Change in commercial paper, net 970 Additions to short-term debt 1,500 Reductions of short-term debt (1,500) Additions to long-term debt 1,971 1,994 1,011Reductions of long-term debt (1,529) (3,125) (2,259)Dividends paid (869) (750) (609)Repurchase of stock (1,875) (1,842) (2,452)Stock option exercises and related tax benefit 360 89 294Other (16) (6)

Cash flow required for financing activities (2,488) (2,140) (4,015)Effect of exchange rate changes on cash and cash equivalents 8 (32) Net decrease in cash and cash equivalents (10) (918) (488)Cash and cash equivalents at beginning of period 794 1,712 2,200Cash and cash equivalents at end of period $ 784 $ 794 $1,712

managerial accounting note 1

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