Learning MBA Master Degree

Evaluating Financial Statements

STUDENT: Hi, Teacher. In this Module of the course, why don’t you tell me how to analyze financial statements?

TEACHER: Good idea, especially because this is precisely the objective of this Module. First of all let me tell you that analyzing or evaluating anything involves a comparison. If a doctor is looking at the report of your blood test, his evaluation will be based on two factors:

1. Comparing your results with accepted standards.
2. These standards need not be the same for every person. They will vary depending on age, gender, and sometimes even on racial or other differences. By the same token, when we analyze a financial report we must consider differences as the type of industry or the reporting period. There are seasonal differences in many industries; when we compare the first quarter with the second, we must consider the "standard" seasonal variances of that industry.
3. Comparing your results with your own test of a prior period

Your blood test may show a higher than desirable cholesterol level, but compared with your previous test, it may show a positive tendency. You are not in perfect shape, but you are improving. The same is valid for evaluating financial results. The results may be "good" or "bad" according to a certain standard, but in comparison with previous reports they may indicate a positive or negative tendency.

STUDENT: Pretty obvious. If a small upstart company reports a net income of 1 million dollars next year, it would be a fantastic result. If IBM reports a 10 million dollars net income, it would be a disastrous result. Nut also, if IBM had reported a loss of 10 million last period, there would be a positive change.

The Objective Of The Business

But there must be some specific criteria to evaluate financial reports. Otherwise, how could investors and other interested parties arrive to a conclusion on how a company is doing?

TEACHER: Right you are. Then, first of all we should define the objectives of a business enterprise. An Economist would say the objective of a firm is "to maximize profits". But this definition is not sufficient. We need a basis for comparison. We can say, for instance, that the objective of a business is to achieve the highest possible return on the funds invested in it, compatible with maintaining a sound financial position and with a sound strategy for keeping or increasing the rate of return in the future.

STUDENT: Let me think of an example. Intel could show a tremendous return on investment next year by canceling all expenditures on research and development. But this would surely kill the firm in the medium run, being a high tech company. And Procter & Gamble could stop all expenditures in advertising, achieving a high return on investment rate for one or two years, but eventually losing market share and the appeal their brand names have to the consumer.

Return On Investment: The Concept Of ROI

TEACHER: Now that we have made this point clear, let us talk about "return on investment", ROI. Of course, ROI is a "rate", a percentage. Can you tell me how to calculate ROI?

STUDENT: Come on, Teacher, this is too easy a question. ROI is equal to Net Income divided by Investment. Example: a company that had a Net Income of $ 1000 on an investment of $ 10,000, had a ROI of 10%.

TEACHER: Good answer, but not good enough. The return you calculated is based on which type of investment?

STUDENT: This one is not so easy. You tell me.

Return On Investment: Return On Total Assets (ROTA)

TEACHER: Let’s first consider ROTA, return on total assets. Total assets is the sum of the financial resources the company is using for its operations. The components of total assets are current liabilities, long-term liabilities, and owners equity. This is a useful criteria if we want to evaluate how efficiently a firm is using the funds it manages, without considering the source of those funds. We do not care here if the funds come from short or long-term creditors, bond holders, or shareholders.

ROTA As A Tool To Evaluate Management Performance

STUDENT: It is frequently stated that this is a very efficient way to evaluate management performance. So much so that frequently managers bonuses are tied to ROTA.

TEACHER: I have some comments on that. Using ROTA to evaluate managers is good for "unit" managers, who manage operations of a division of the company but have no control on decisions like borrowing, capital investment, etc. They are assigned a certain Total Investment and must work with it.

STUDENT: And what is the difference with managers who DO have control on such decisions?

TEACHER: If a top manager’s bonus is based on ROTA, he may be motivated to reduce Total Investment by making decisions that are not in the best interest of shareholders. He may delay investment in new equipment, or rent instead of purchase capital goods, even if these are not the best decisions from a total profitability point of view. By having a lower Total Investment figure, his ROTA will be higher and so would be his bonus. This is why this type of evaluation for top management is now out of fashion, while it is still used to judge the performance of unit or division managers.

Return On Investment: Return On Owners Equity (ROE)

TEACHER: We already know that Owners Equity are the funds invested by the owners or shareholders, directly or in the form of retained earnings which belong to them. Obviously, then, ROE is a rate arrived at by dividing Net Income by Owners Equity.

STUDENT: I can see the difference now. Naturally shareholders must be very interested in this ROE rate. Which in turn must affect the market value of shares. And it sounds logical that top management performance is judged by this criterion, since they have control on the overall operation of the firm.

Return On Investment: Return On Invested Capital (ROIC)

TEACHER. There is a third criterion, Return on Invested Capital (ROIC).

STUDENT: How’s that?

TEACHER: Invested Capital are the funds the company has at its disposal for long periods of time. It is also called Permanent Capital. It is the sum of non-current liabilities plus owners equity. Here current liabilities are excluded because they may vary with fluctuations in operations and market conditions. ROIC measures the way a company is using its permanent capital.

STUDENT: And how does the famous concept of "Working Capital" we discussed in a previous Module enter into this equation?

TEACHER: As we said before, Working capital is equal to current assets minus current liabilities. If CA=$1,400 and CL=$1,000, the company is using $400 invested in current assets which are not financed (compensated) by current liabilities. This difference, the "working capital" is also financed by the long-term creditors (as bondholders) and the owners, together with the investment in plant and equipment and other long-term assets of the firm.

STUDENT: So, we also define Total Capital as equal to working capital plus non-current assets.

TEACHER: Yes indeed. This is why watching Working Capital is important since it increases the Total Capital or Permanent Capital figure. The lowest Working Capital figure compatible with efficient operations is a desirable management goal.

A Sound Financial Position

STUDENT: Teacher, I remind you of the definition you gave me before: the objective of a business is to achieve the highest possible return on the funds invested in it, compatible with maintaining a sound financial position and with a sound strategy for keeping or increasing the rate of return in the future. How does maintaining a sound financial position relate to our previous considerations on return on funds invested?

TEACHER: It is perfectly possible and many times desirable to increase return on investment by financing investments through liabilities, that is, loans. This practice is called leverage. If these investments are profitable (returns are higher that interest paid for the loans), a firm can increase the return on shareholders investment. But there is always a risk involved in borrowing. We will see how we can use some ratios as a measurement of the degree of risk involved in borrowing in comparison with other figures shown in a financial statement.

STUDENT: So let me help you a bit. A ratio is no more than a comparison of two magnitudes. Suppose we own a hypothetical company, XirSoft, where the ratio of men owners to women owners is 2 to 1 (if we are 3 owners, 1 is a woman, 2 are men). Or we can say 66,6666% of the shares are owned by males if they own 600 of the 900 shares outstanding; this is obtained by dividing the 600 shares males own by the 900 total shares outstanding. And multiplying the result of the division (0.666666) by 100 to obtain the percentage figure, because a percentage is just one form of ratio.

TEACHER: I am impressed. Now that we are well aware of what ratios are, let’s have a look of the most useful ones to analyze a financial statement.

The Most Useful Ratios?

STUDENT: I can imagine dozens of possible ratios. How can we judge which ones are useful and which ones are not?

TEACHER: This depends on each case. Each ratio has a specific meaning. And its usefulness will depend on the specific interest we have when looking at a financial report. We will look at the most important ones, divided by categories:

Overall Measures

Profitability Measures

Tests of Investment Utilization

Test of Financial Situation

Ratios For Overall Measures: Earnings Per Share (EPS)

TEACHER: Let’s assume that XirSof's Income Statement for next year shows a Net Income after taxes of $ 90,000. As we all know, there are 900 shares outstanding.

STUDENT: I see which ratio you will define: Earnings per Share. Easy: EPS are $ 100. This is important, since if I wanted to sell my shares, the buyer will certainly take this ratio into consideration.

TEACHER: Yes. Since our corporation is a private one, you may negotiate directly with the prospective buyer. But if our company eventually, as we hope, becomes a public corporation and our shares are traded at Stock Exchange, the price will be fixed by the market. An so, we will mention a ratio related to the price of the shares.

Ratios For Overall Measures: Price / Earnings Ratio

STUDENT: Let me guess. Looking into the future, I foresee that XirSoft shares will be traded on the NASDAQ stock exchange. For this future year we will show on our Income Statement a Net Income of 100 million dollars. There will be 1 million shares outstanding, which gives us an EPS share ratio of $100. But since the shares will be traded publicly, and investors will be delighted by the way XirSoft is managed and its growth potential, the price of each share on a given day will be.... $ 2,000!

TEACHER: You forgot to get to the point. The point was the P/E, Price / Earnings ratio. If, as you are assuming, we will earn $100 per share and the market price will be $2,000, the P/E ratio will be Price per Share (2000) divided by Earning per Share (100) = 20 times.

The Meaning Of The Price / Earnings Ratio

STUDENT: The P/E ratio for public companies is mentioned in all financial newspapers. And I notice very large differences. At some times giants like IBM or General Motors show a P/E ratio of 10, while some others as for instance Intel have a P/E ratio of 20. And I have seen companies with a P/E ratio of 100!

TEACHER: Yes, this was probably before the dot.com bubble burst in 2000. Many times the P/E rate can be indefinite, since the company is not making any profits. This is because the price of shares in the market reflects the expectations of investors, not just the past or present results.

STUDENT: I see. Comparing IBM with Intel, the difference in P/E ratio shows that investors at a given moment expect that Intel’s profits (earnings per share) will grow faster than IBM’s. And this also explains why Amazon.com shares commanded a high price when the company was actually loosing money; investors expected the company to grow very fast and eventually become very profitable.

Ratios For Overall Measures: Return On Total Assets

TEACHER: Well, we have already explained ROTA.

STUDENT: Certainly. If we have a Net Income of $ 200 and Total Assets of 2300, we divide 200 by 2300 and arrive at a ROTA of 8.69%. Right, Teacher?

TEACHER: Almost. But we have to introduce some refinement. The analyst looking at ROTA wants to know how efficiently the company has used its total resources, no matter where they come from. Lets assume the example above is from a company that did not borrow any money. A sister company has arrived at the same results, but part of its Total Assets were borrowed. The Net Income of $ 200 included a charge against Income of $ 20 in interest payments (net of tax deductions on the interest paid). If we do the calculation as follows: Net Income plus interest = $ 220, divided by Total Assets of 2300, 9.56%.

STUDENT: I see. This means that by borrowing and using the borrowed money effectively, the second company had a better return on Total Assets.

Ratios For Overall Measures: Return On Invested Capital

And I assume the same rationale applies when calculating ROIC.

TEACHER: Exactly. Here again we have to "add back" the cost of borrowed capital (COBC) to the Net Income shown at the "bottom line" of the Income Statement. Again, since interest paid is an expense and has already been calculated into the final Net Income, the COBC figure must be net of the tax deduction the company calculated for this expense.

Ratios For Overall Measures: Return On Shareholder’s Equity (ROSE)

STUDENT: Do we use the same calculation for ROSE?

TEACHER: No. ROTA and ROIC are measures on how the company uses the total resources it has available, disregarding the source. But ROSE is only a measure of the net profit the company makes in relation to the capital of the owners. Here the calculation is simple: ROSE is equal to Net Income divided by Owners (Shareholders) Equity.

Tests Of Profitability: Gross Margin

Now, let’s talk about Gross Margin, obviously a Test of Profitability. Want to guess what it is?

STUDENT: Sure. If an Income Statement shows

Net Sales ......... = $3,000

Less: Cost of Sales = $1,800

Gross Margin ...... = $1,200

If we express it as a percentage, Gross Margin is 40% (since 1,200 is 40% of 3,000)

TEACHER: A clear explanation, Student.

STUDENT: So, this means that a company with a high Gross Margin must be very profitable, right?

TEACHER: Well, it is a good indication. But in our example, from the Gross Margin of $ 1,200 we still have to subtract:

Operating Expenses (including depreciation), say $ 780, to arrive at the Operating Profit ($ 420).

Now we subtract Interest Payments (say $ 40) and then we have the Income Before Taxes of $ 380.

And to reach the "bottom line" (Net Income) we still have to subtract the taxman’s share, say $ 180.

Now we have the Net Income figure, $ 200

STUDENT: I see. A firm can have a high Gross Margin but if the Operating Expenses are also very high, the Net Income figure can be very low.

Tests Of Profitability: Operating Profit

And from the previous figures I see that this firm’s Operating Profit is 14%.

TEACHER: Simply brilliant, Student. Yes, since $ 420 (the Operating Profit) is 14% of $ 3000 (the Net Sales), the company has an Operating Profit of 14%.

STUDENT: I can even tell you that the Operating Expenses are 26%!

TEACHER: Excellent, Student! You are a math genius! .

Tests Of Profitability: Income Before Taxes And Net Income

And now finally we have the true Test: Net Income!

STUDENT: The famous "bottom line".

TEACHER: Yes. In our example, the company shows a Net Income of $ 200 on Net Sales of $3,000.

Profit Margin = Net Income .= $200 = 6.7%
................Net Sales .. $3000

The Meaning Of Profit Margin

STUDENT: I assume that the Profit Margin percentage is a clear indication of a company’s profitability, right, Teacher?

TEACHER: Profit Margin, also called Return on Sales, is a valid number to compare firms in the same type of business. But it would not be a valid indication of the respective profitability say, of Intel vs. Wal-Mart.

STUDENT: Why is that?

TEACHER: Because Intel, a chip manufacturer, has a much higher Total Investment relative to sales than Wal-Mart, a supermarket.

Suppose both have a net sales figure of 10 billion, Wal-Mart having a Net Income of 0.2 billion and Intel a Net Income of 1 billion (respectively, 2% and 10%). But considering that Wal-Mart has a total investment of 1 billion, while Intel has a Total Investment of 5 billion, both show a Return on Investment of 20%.

STUDENT: Understood. Good example, although I guess the figures are not the real ones for these two companies, right?

TEACHER: Of course. It was just an illustration.

Tests Of Investment Utilization: Investment Turnover

Investment Turnover is usually calculated based on Invested Capital. It means calculating how many dollars in sales are generated by 1 dollar invested in Capital.

STUDENT: Let me give you an example, then:

Investment Capital Turnover =

= Sales ...........= $ 3,000 = 1.82 times
..Investment Capital $ 1,650

And as you explained before, this means that $ 1.82 dollars of sales are generated by each dollar in Investment Capital.

The Meaning Of Investment Turnover

Here again, I guess that comparing Investment Turnover percentages from companies in different types of business is not significant.

Obviously, "Capital Intensive" companies will generate less dollars of sales per invested dollar than other types of business requiring a lower investment.

TEACHER: Right. As the saying goes, never compare apples with oranges!

Tests Of Investment Utilization: Asset Turnover

OK, here is another Investment Turnover ratio:

Asset Turnover = Sales = $3,000 = 1.36 times
.................Assets. $2,200

Tests Of Investment Utilization: Equity Turnover

and here we have one more,

Equity Turnover =
= Sales ...............= $3,000 = 2.40 times
..Shareholder’s Equity.. $1,250

The Meaning Of Asset And Equity Turnover

STUDENT: Seems to me that the last two ratios you described have interpretations very similar to Invested Capital Turnover, right, Teacher?

TEACHER: Right.

Cash... The More The Better?

STUDENT: And what about cash, Teacher? I usually read in the press that it is a good thing if a company has a large cash reserve.

TEACHER: Cash is necessary for day to day operations and is also a good reserve for bad times or future investments. Normally, cash for day to day operations is held in checking accounts which do not pay interest, while cash reserved for bad times, or for acquisitions, can be held in the form of term deposits or other forms of quasi money (very liquid assets).

Tests Of Investment Utilization: Days’ Cash

STUDENT: I see what you mean. A firm should not hold too much cash for day to day operations in non-interest paying forms.

TEACHER: Right. A very rough way to evaluate this is calculating the "Day’s Cash" figure, a ratio of how many days of routine operating expenses the firm holds.

Tests Of Investment Utilization: Days’ Receivables

A very important ratio is Day’s receivables. The calculation should only consider the sales made on credit, excluding cash sales.

This figure expresses how many days of sales are represented in the Receivables account. If we have $ 1,000 in receivables and our average sales per day are $ 50, we have a Day’s receivable figure of 20. Obviously the lower this number is, the better. Managers must pay constant attention to this figure, since it affects profits very much.

STUDENT: I see why, of course. The more money invested in receivables, the higher our working capital figure and our interest expense.

Tests Of Investment Utilization: Days’ Inventory And Inventory Turnover

And I guess we must also pay a lot of attention of money invested in inventories, and for this surely we have a similar ratio.

TEACHER: Yes, Days’ Inventory expresses how many days of sales are held in inventory.

STUDENT: But I see a problem here. Sales figures and Inventory figures are not comparable, since the former include the Cost of Sales and the Gross Margin.

TEACHER: Right you are, STUDENT:. For this reason, we should use the Cost of Sales figure to calculate Day’s Inventory.

STUDENT: Now let me show you how clever I am. I bet managers use an Inventory Turnover Ratio too! I’d say that

Inventory Turnover =
= Cost of Sales ...= x times
--Average Inventory

Indicating the speed at which merchandise moves through the firm.

Tests Of Financial Condition: Current Ratio And Acid Test

STUDENT: I see you will not need me anymore as a teacher very soon. OK, let’s move into the Financial Condition tests. They evaluate two factors:

Liquidity (ability to meet current obligations)

Solvency (ability to meet long term obligations: interest and loan repayments.

To evaluate liquidity, analysts and managers use

Current Ratio = Current Assets ----= x times
----------------Current Liabilities

The higher the ratio, the better the liquidity situation of the company. If say Current Assets are 3 times Current Liabilities, the firm should be able to meet its current obligations easily.

Acid-Test Ratio. The Current Assets figure shown above may include assets which can not quickly be converted into cash to pay for current liabilities. For this reason there is another ratio which excludes from the Current Asset figure Inventories and other items such as prepaid bills. It is called the Quick Ratio or Acid-Test Ratio.

Acid-Test Ratio = Quick Assets ...... = n times
..................Current Liabilities

Solvency Evaluation: Debt/Equity Ratios. The Eva Method Of Evaluating A Firm’s Performance

STUDENT: How about Solvency evaluation?

TEACHER: Solvency depends basically on the relationship between Current Liabilities, Long Term Liabilities and Shareholders’ Equity.

Long Term Liabilities usually express the Debt of the firm to third parties (banks, bondholders) while Shareholders’ Equity is the debt of the firm to its owners.

Obviously Debt (to third parties) is much riskier than Equity, because third parties may demand repayment on the due date while shareholders’ equity can not be demanded.

The Debt/Equity ratio is an important indication of a company’s solvency. When looking at this number, it should always be noticed whether Current Liabilities are included, since the ratio can be calculated both ways.

It is apparent that a company with a low Debt in terms of its Equity is very solvent, while a highly leveraged company with a high Debt/Equity ratio is not.

STUDENT: Teacher, I am now an expert in Financial Statements Analysis. But I am a little tired, too.

TEACHER: Granted, this was a rather difficult chapter. But it’s almost over now. Just let me tell you something about EVA.

STUDENT: No kidding! Will you tell me about ADAM, too?

TEACHER: Not Eve, EVA. EVA® (Economic Value Added) is a novel system to measure performance. This method can be applied to the whole of a firm or to specific operating areas.

It is based on assigning a "cost" to the full amount of the assets of a company: plant, equipment, net working capital, etc. The cost of the assets is based on current interest rates. This cost is compared with a company's or an operating unit's profits. The difference is the Economic Valued Added to the cost of capital.

Let's assume that a company has $1000 in assets, a yearly "capital cost" of $80 at 8% interest rate. If the year's profits are $120, the EVA is $40, or an additional 4% over the cost of capital.

This is a simple but revolutionary way to evaluate performance. At first sight the company yields a profit of 12% on asset value. Looks nice. However, if you consider that this means only a 4% profit over the cost of maintaining those assets, the picture looks different.

As the EVA method started to be used, many managers and shareholders discovered that their satisfaction with the performance of a firm was not well founded.

STUDENT: Could you please tell me the relationship between assets and capital cost. Isn't capital cost included in the assets?

TEACHER: Capital Cost as defined in EVA analysis is the "opportunity"" cost of having the money invested in the assets instead of using it to produce interest.

In other words, if you own a car worth $1,000 and the current interest rate is 8%, you are forgoing $80 a year by owning the car instead of selling it and depositing the money in the bank at 8%. This is your "capital cost" of the car.

STUDENT: I see. EVA is the "additional" value you receive OVER the alternative of selling the asset and putting the money in the bank.

TEACHER: Exactly. Back to the example of your car, if you rent it to a limousine driver for $120 (net of maintenance), you are making $40 more than if you'd sell the car and put the money in the bank. Your EVA is $40 (120 - 80) and this means an EVA of 4% on your asset of $1,000.

STUDENT: It is obvious then that the "current interest rate" is a vital information.

TEACHER: Sure, this is a KEY information, because the current interest rate (assumed as being 8% in the example) is the basis of comparison.

If the current interest were 12%, your EVA on owning and renting your car would be ZERO; you could get the same $120 by simply selling the car and depositing the money in the bank. Conversely, if the current interest rate were 2%, your EVA would be $100 (10%) since you'd get $120 by renting it and only $20 at the bank.

OK, Student, this is the end of this Course. Hope you enjoyed it and learned something too!

EVA® is a registered trademark of Stern Steward & Co