• An assessment of a company’s past, present and future financial condition
• Purpose is to diagnose company’s financial strengths and weaknesses
• Primary tools
– Financial Statements
– Ratios

• The balance sheet shows a firm’s assets
(what it owns) and liabilities (what it owes)
• The difference between a firm’s assets and liabilities is the firm’s net worth
• A snapshot in time

Assets
• Current assets:
– Cash & securities
– Accounts
Receivable
– Inventories
• Fixed assets:
– Tangible assets like
PPE
– Intangible assets
Liabilities and Equity
• Current liabilities:
– Accounts payable
– Short-term debt
• Long-term liabilities
• Shareholders' equity

• The income statement summarizes revenues and expenses for the business
• Covers an interval of time (monthly, quarterly, annually)
• Major components:
– Revenues
– Expenses
– Taxes
– Extraordinary Items

Sales revenue
- Cost of goods sold
= Gross profit margin
- Operating expenses
= EBITDA
- Depreciation & Amortization
= EBIT (Operating income)
- Interest payments
= Taxable income
- Taxes
= Net Income

• Accounting definition of earnings ignores unrealized changes in market value of assets and liabilities
• Accounting profit does not recognize cost of equity capital
• Accounting profit may not contain all relevant costs
– e.g., opportunity cost of entrepreneur’s time

• Summarizes the levels of cash being generated or consumed by the business
• Covers an interval of time (monthly, quarterly, annually)

Cash flow from operations
Net income
+ Depreciation
- Increase in accounts receivable
- Increase in inventories
+ Increase in accounts payable
Total cash flow from operations
Cash flow from investing activities
- Investment in plant and equipment
Cash flow from financing activities
- Dividends paid
+ Increase in short-term debt
= Change in cash

• Excel example

• A means of evaluating and diagnosing performance
• Ratios standardize numbers and facilitate comparisons
– Comparing performance to competitors or industry standards
(horizontal comparison)
– Comparing performance to prior history (vertical comparison)
• Examine a variety of areas
– Liquidity
– Solvency
– Efficiency
– Profitability
• Remember that ratios are meaningless unless you have something to compare

• Liquidity
– ability to cover short-term obligations
• Solvency
– ability to cover long-term obligations; examines mix of debt and equity
• Efficiency
– amount of activity generated by resources deployed
• Profitability
– amount of profit generated by resources deployed
• Market value (if applicable)
– some of these ratios (e.g. price-earnings ratio, market-to-book ratio) are useful in valuation analysis, such as valuing private firms

• Current Ratio
– The ratio between all current assets and all current liabilities.
– Formula:
• Current Assets
Current Liabilities
• Quick Ratio
– The ratio between all assets quickly convertible into cash (this excludes inventory) and all current liabilities.
– Formula:
• Cash + Accounts Receivable + Short-Term Investments
Current Liabilities

Current Ratio:
1829.5 / 2246.1 = 0.81
Quick Ratio:
(219.2 + 720.1 + 195.2)
/ 2246.1 = 0.51

• Debt to Equity
– Shows the ratio between capital invested by the owners and the funds provided by lenders.
– Formula:
• Total Liabilities
Total Equity
• Interest coverage ratio
– A measurement of the number of times a company could make its interest payments with its earnings before interest and taxes; the lower the ratio, the higher the company’s debt burden.
– Formula:
• Pretax Operating Income + Interest Expense
Interest Expense

Debt to Equity:
(2246.1 + 1191.5 +
7653.5 + 1194.5 +
152.9) / 3938.7 = 3.16

Interest Coverage
Ratio:
(2719.6) / 451.3 = 6.03

• Gross Profit Margin
– Indicator of how much profit is earned on products without consideration of selling and administration costs.
– Formula:
• Sales - COGS
Sales
• Net Profit Margin / Return on Sales (ROS)
– Shows how much profit comes from every dollar of sales.
– Formula:
• Net Income
Sales

Gross Profit Margin:
5552.1 / 15717.1 = 35.3%
Net Profit Margin:
1965.2 / 15717.1 = 12.5%

• Return on Equity (ROE)
– Determines the rate of return on the investment in the business.
– Formula:
• Net Income
Equity
• Return on Assets (ROA)
– Considered a measure of how effectively assets are used to generate a return.
– Formula:
• Net Income
Total Assets
• Return on Invested Capital (ROIC)
– Formula:
• Net Income
Total Liabilities + Stockholder’s Equity – Current Liabilities

Return on Equity:
1965.2 / 3938.7 = 49.9%
Return on Assets:
1965.2 / 16377.2 = 12.0%
Info from income statement and balance sheet
Info from income statement and balance sheet
Return on Invested Capital:
1965.2 / (12438.5 + 3938.7 –
2246.1) = 13.9%
Info from income statement and balance sheet

• Days in Receivables
– This calculation shows the average number of days it takes to collect accounts receivable (number of days of sales in receivables).
– Formula:
• Accounts Receivable
Sales / 365 days
• Compare to industry standards.
• Accounts Receivable Turnover
– Number of times that trade receivables turnover during the year.
– Formula:
• Net Sales
Accounts Receivable

• Days in Inventory
– This calculation shows the average number of days it will take to sell inventory
– Formula:
• Average Inventory
Cost of Goods Sold / 365 days
• Inventory Turnover
– Number of times that inventory is turned over (sold) during the year.
– Formula:
• Cost of Goods Sold
Average Inventory

• Asset Turnover
– Indicates how efficiently business generates sales on each dollar of assets.
– Formula:
• Sales
Total Assets
• Days in Accounts Payable
– This calculation shows the average length of time trade payables are outstanding before they are paid.
– Formula:
•
Accounts Payable
COGS / 365 days
• Accounts Payable Turnover
– The number of times trade payables turnover during the year.
– Formula:
•
COGS
Accounts Payable

Assigned Efficiency Ratios
Days in Receivables:
720.20 / (15,717.1/365) =
16.73
Days in Inventory:
(694.9 + 654.5)/2 /
(10,165.0/365) = 24.23
Inventory Turnover:
10,165.0 / (694.9 +
654.5)/2 = 15.07
Asset Turnover:
15,717.1 / 16377.2 = 0.96
Some Additional Efficiency Ratios
AR Turnover:
15,717.1 / 720.20 = 21.8
Days in Accounts Payable:
1,426.3 / (10165.0/365) = 51.21
Accounts Payable Turnover:
10165.0 / 1,426.3 = 7.13

• ROE = (Net Income/Sales) x (Sales/Total Assets) x (Total Assets/Equity
= profit margin x asset turnover x leverage multiplier
• DuPont equation shows how three different areas combine to determine
ROE
– expense management (measured by the profit margin)
– asset management (measured by asset turnover)
– debt management (represented by the debt ratio or leverage multiplier)

Brinker International, Inc.
NYSE: EAT
Darden Restaurants, Inc.
NYSE: DRI
Outback Steakhouses, Inc.
NASDAQ: OSI

Profitability Performance (Most Recent Year)
• Net Margin
– 4.63%
– 5.04%
– 6.50%
• Return on Equity
– 15.40%
– 16.70%
– 17.40%
Source: Hoover’s Online

• High Margins
• High Efficiency
• High Leverage

• Use company’s financial statements
– Income Statement and Balance Sheet
• Examine and compare common ratios
– Across time
– Across companies
• Use three year period (2000 – 2002)

50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
2000
Gross Margin %
2001 2002
A
B
C

120.00
100.00
80.00
60.00
40.00
20.00
0.00
2000
Inventory Turnover
2001 2002
A
B
C
Higher = better
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
2000
SG&A / Sales
2001
A
B
C
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
2002
Lower = better
2000
AP Turnover
2001 2002
A
B
C

80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
2000
Long-Term Debt / Equity
2001 2002
A
B
C
Higher = more levered
Lower = more levered
50.00
45.00
40.00
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
2000
Interest Coverage Ratio
2001 2002
A
B
C

• Company A
– High margins
– Less efficient
– Low leverage
• Company B
– Moderate margins
– Moderate efficiency
– High leverage
• Company C
– Low margins
– High efficiency
– Moderate leverage
They run very similar businesses and deliver similar results, but the paths are very different.

• Company A
– What value does it deliver to justify its higher margins? Are the margins sustainable?
• Company B
– Is a middle of the road strategy with higher leverage a good one?
• Company C
– What is the source of its operating efficiencies? Are the efficiencies sustainable?

• A few additional clues
– 2002 sales ($millions)
• A: 2,362
• B: 4,369
• C: 2,887
– Sales growth (2002 – 2003)
• A: 14.4%
• B: 6.4%
• C: 13.5%

Using Financial in New Ventures

How to use financial ratios in new ventures?
• Remember, financial statements are pro-forma
(expectations about what financial position will be)
• Could use average industry ratios as a starting point for generating pro-forma statements
• Pro-forma statements should reflect the underlying strategy of the firm

Adjusting ratios according to your strategy
Key restaurant ratios
Inventory turnover
(Wages & benefits)
/ sales
Liquidity
Gross profit margin
Operating costs / sales
Low Cost
Strategy
Differentiation strategy

• They are outcome measures; if you have a problem with a ratio, you still have to figure out what’s causing the problem
• Choosing the right comparison data is sometimes difficult
– What’s the right industry?
– Published industry averages are just rough guidelines
– Who are the competitors?
– Accounting practices can differ across firms
• Seasonality may affect ratios
• We have only discussed ratios generated from financial statements
– These are based on historical data; we would like something that helps predict future performance
– Operational / marketing measures may be more critical
– Recall the Balanced Scorecard

• SG&A to Sales
– Is company controlling overhead expenses?
• Direct labor utilization
– Often critical in professional services companies
• Customer acquisition cost
– Compare to lifetime value of a customer
• Others (company-specific)
• Create a Balanced Scorecard

Kaplan and Norton (1992)

• A set of measures that gives top management a
“fast but comprehensive view of the business”
• Brings together, in one management report, disparate elements of company’s competitive agenda (customer measures, internal measures, financial measures, etc.)
• Authors use analogy of dials and instruments in an airplane cockpit

• No single measure is adequate
• It’s important to examine the means used to achieve financial outcomes
• Many operational measures translate into future financial results
• Traditional measures might give misleading signals regarding continuous improvement and innovation (focus on short-term results)

• Customer Perspective : How do customers see us?
• Internal Business Perspective : What must we excel at?
• Innovation and Learning Perspective :
Can we continue to improve and create value?
• Financial Perspective : How do we look to shareholders?

• Zipcar case on Monday
– This requires some financial thinking / analysis
– Think about what key measures / ratios should be for the business