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
Sales
Cost of Goods Sold
Gross Profit
OP/Nonop current yr
O
13,652.1
O
8,778.3
O
4,873.8
Operating Expenses
Net Operating Profit Before Tax
O
O
2,646.0
2,227.8
interest expense, net
N
421.7
investment gains and losses
Earnings before taxes and JV earnings n/a
tax expense
after tax earnings from JVs
minority interest expense, net of tax
discontinued operations, net of tax
Net Income
O
O
N
N
MBA 6101 Financial Accounting
n/a
1,806.1
622.2
110.8
1,294.7
Tax on Operating Profit
Income tax is tricky since the income tax expense includes
tax savings from net non-operating expenses, so add it back
For General Mills:
MBA 6101 Financial Accounting
Operating Items in the Income Statement
Op vs. NonOp Assets for General Mills
OP/Nonopcurrent yr
Balance Sheet
Cash and equiv
Short term investments
Accounts Receivable
Inventory
Prepaid Expenses
other current assets
Total current assets
Long term investments
Property, plant and equipment, net
Capitalized lease obligations
Equity method investments
Other operating long term assets
Other nonoperating long term assets
Goodwill and other intangible assets
Total long term assets
Total Assets
prior yr
O
N
O
O
O
O
n/a
661.0
1,081.6
1,366.8
510.6
3,620.0
417.1
952.9
1,173.4
443.1
67.2
3,053.7
N
O
O
O
O
N
O
n/a
3,108.1
1,750.2
10,563.3
15,421.6
3,013.9
1,586.7
10,529.4
15,130.0
n/a
19,041.6
18,183.7
19,041.6
19,041.6
18,183.7
18,183.7
Operating Assets
MBA 6101 Financial Accounting
Nonoperating Assets
Total Assets (check figure)
Op vs. NonOp Liabilities and Equity for Gen Mills
Liabilites and Shareholders' Equity
Accounts Payable
Short term notes payable
Current maturities of long term debt
Interest payable
Accrued liabiliites
Unearned revenues
Deferred income tax liabiliites
Other current liabilities
Total current liabilities
Bonds payable
Notes payable
Capitalized lease obligations
Pension and post employment liab.
Deferred tax liabilities
Other liabilities
Total long term liabilities
OP/Nonopcurrent yr
O
937.3
N
2,208.8
N
442.0
N
O
O
O
28.4
O
1,239.8
n/a
4,856.3
N
N
N
O
O
O
n/a
Total Liabilities
Total operating liabilities
Total nonoperating liabiliites
Total Liabiliites (check figure)
Minority interest
prior yr
777.9
1,254.4
1,734.0
2,078.8
5,845.1
4,348.7
1,454.6
1,923.9
7,727.2
3,217.7
1,433.1
1,229.9
5,880.7
12,583.5
11,725.8
5,584.0
6,999.5
12,583.5
5,519.7
6,206.1
11,725.8
N
-
-
MBA 6101 Financial Accounting
Sharesholders' Equity
Total Lia and Sh. Equity
N
6,458.1
19,041.6
6,457.9
18,183.7
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.
2.
Preferred dividends must be subtracted from net income
in the numerator.
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 assets are those assets that a company expects to
convert into cash within the next operating cycle, which is
typically a year.
 Current 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 capital or
simply working 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
 Solvency 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 is the amount of profit that the company earns
from each dollar of sales.
• Asset turnover is a productivity measure that reflects the
volume of sales that a company generates from each dollar
invested in assets.
• 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: Summary
1. 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