HA 2210 Potter 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 stockholders equity and of comprehensive income. II. Reasons for analyzing financial statements Prospective equity or credit investment Contract resolution/covenant compliance Operations 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 Strategy Growth stage of firm Accounting methods Efficiency VI. Caveats concerning financial analysis, particularly ratios. Ratios are based on imperfect accounting numbers Ratios are only one piece of puzzle Firms can window dress their accounting numbers Ratios are highly correlated, hence they can be redundant Ratios have multiple meanings

VII.

Financial leverage. Financial leverage refers to the relative proportion of a companys financing that requires fixed payments (usually debt payments are fixed and equity payments vary). Positive financial leverage occurs when the return on assets is greater than the cost of the securities that have fixed payments (usually the interest payment on the debt). See example.

VIII.

Exhibits and ratio definitions attached. Computation of financial ratios for Target Corporation and comparison of these ratios to retail industry averages. Hotel and restaurant industry averages.

IX.

Learning goals. Faced with a decision, know which ratios may help resolve your uncertainty. Know how to compute ratio given a provided formulas and a financial statement. Most important, know how to interpret the computed ratio.

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Key Driver of Ratio Differences Below is an abstraction of the steps in causal chain of priorities for many businesses. Clearly the strategy that the firm chooses to meet its mission will impact financial statement relations. View of Entity Value Creation Process Mission Goals Strategy Implementation/Execution Performance/Realization

Reasons for Cross-Sectional Differences in Ratios Industry structure

Strategy

Growth stage of firm

Accounting methods

Managerial effectiveness

Ratio Overview
As managers we are interested in measures of asset utilization, credit worthiness/risk, and overall performance 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 Turnover a (INVX) = Cost of Goods Sold / Average Inventory b. 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 or complex production or sales process), accounting method, efficiency (management control) and strategy. 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 of credit terms, the use of credit or cash sales in the numerator and late receivables. A trend for this ratio over time can give a crude indication of a company's changing credit policy.

The inverse of this ratio times 365 gives you average number of days on hand. 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 perfect solution to this timing issue.
b

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 how well 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, growth and 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 you are a short term creditor trying to determine if the company has the ability to pay you off if it liquidates. A closely related concept is working capital which is defined as current assets minus current liabilities.

6. Quick or Acid Test (QUICK) = Quick assets / Current Liabilities. This ratio measures the number of times liquid current assets cover current liabilities. This measure 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 operating characteristics. 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) / Interest Expense. This ratio measures the number of times interest expense is covered by income before interest. It is 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 measures financial 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 and financing 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 total assets, as a measure of financial leverage.

Information on key long term issuer credit risk can be gleaned by comparing a firms key metrics to those reported 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. The best 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 EBIT interest coverage (x) EBITDA interest coverage (x) CFO/total debt (%) Free cash flow/total debt (%) Total debt/EBITDA (x) Return on capital (%) Total debt/capital (%) AAA 23.8 25.5 203.3 127.6 0.4 27.6 12.4 AA 19.5 24.6 79.9 44.5 0.9 27 28.3 A 8 10.2 48 25 1.6 17.5 37.5 BBB 4.7 6.5 35.9 17.3 2.2 13.4 42.5 BB 2.5 3.5 22.4 8.3 3.5 11.3 53.7 B 1.2 1.9 11.5 2.8 5.3 8.7 75.9 CCC 0.4 0.9 5 -2.1 7.9 3.2 113.5

S&P Corporate Rating Criteria, 2006

While examining the S&P ratings criteria are useful in understanding the relation between key ratios and a firms long term credit risk assessment by S&P, there are many other factors impacting credit risk, including size 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 internally sustain critical investments, which is preferred before debt is repaid. This ratio will be used for multiple purposes and can be compared across firms and time by scaling by average total asset, or for credit risk by scaling by average debt.

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 margins of 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 interest rate 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 or operating 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.

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) we want 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 Assets Liab & SE Assets Hotel B Liab & SE

Avg. Assets =100 Avg. Liab.=0 Avg. SE = 100 EBIT = 20 Tax Rate = TR = 40%

Avg. Assets =100 Avg. Liab. = 60 Avg. 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, which is what we want to accomplish if focusing on effective use of the firms resources.

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 is done after tax, ROD can be estimated as: ROD = interest expense*(1-tax rate)/average liabilities. AA = Average assets AL = Average liabilities ASE = Average SE ROD = interest expense*(1-tax rate)/average total liabilities ROA = [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

Ratio Category Turnover 1 Inventory 2 Receivable 3 NPPE 4 Total Asset Credit Risk ST-Liquidity 5 Current 6 Quick or Acid test LT-Solvency 7 Interest coverage 8 Debt to Equity 9 Free Cash Flow/Avg. Assets Profitability 10 Return on Sales 11 Return on Assets 12 Return on Equity CR QUICK TIE D/E FCFA ROS ROA ROE INVX ARX NPPEX TAT Ratio Name Notation Target Corporation Retail Industry Set Restaurant Set Hotel Set

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.

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Target Corporation Selected Financial Data

(millions) Financial Results: Total revenues Net earnings Financial Position: Total assets 2012 2011 For the Fiscal Year 2010 2009 2008 2007

$73,301 $69,865 $67,390 $65,357 $64,948 $63,367 2,999 2,929 2,920 2,488 2,214 2,849 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 by 100 to create a trended series. Below we compute this for prior page series. What can we learn from this analysis? Horizontal/Trend Analysis 2011 2010 2009 110 106 103 103 102 87 105 98 100

Account Revenues Net Earnings Total Assets

2012 116 105 108

2008 102 78 99

2007 100 100 100

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Common-sized Income Statement Common-sized income statement: Within each year scale 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 1.000 .690 .237 .073 .010 .063 .022 .041 2011 1.000 .685 .239 .076 .012 .064 .022 .042 2010 1.000 .679 .243 .078 .011 .067 .023 .044

Net sales Cost of sales SGA Operating Income Interest Expense Income Before Tax Prov. for Income Tax Net Earnings

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 Corporation Consolidated Statements of Financial Position As of fiscal year ending 2/2/2013 and 1/28/2012 (millions) Assets Cash and cash equivalents, including shortterm investments of $130 and $194 Credit card receivables, net of allowance of $0 and $430 Inventory Other current assets Total current assets Property and equipment Land Buildings and improvements Fixtures and equipment Computer hardware and software Construction-in-progress Accumulated depreciation Property and equipment, net Other noncurrent assets Total assets Liabilities and shareholders' investment Accounts payable Accrued and other current liabilities Unsecured debt and other borrowings Nonrecourse debt collateralized by credit card receivables Total current liabilities Unsecured debt and other borrowings Nonrecourse debt collateralized by credit card receivables Deferred income taxes Other noncurrent liabilities Total noncurrent liabilities Shareholders' equity Total shareholders' investment Total liabilities and shareholders' investment 2012 2011

784 $ 5,841 7,903 1,860 16,388 6,206 28,653 5,362 2,567 1,176 (13,311) 30,653 1,122 48,163 $ 7,056 $ 3,981 1,494 1,500 14,031 14,654 1,311 1,609 17,574 16,558 48,163 $

794 5,927 7,918 1,810 16,449 6,122 26,837 5,141 2,468 963 (12,382) 29,149 1,032 46,630 6,857 3,644 3,036 750 14,287 13,447 250 1,191 1,634 16,522 15,821 46,630

$ $

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Target Corporation Consolidated Statements of Operations (millions) Total revenues Cost of sales Selling, general and administrative expenses Earnings before interest expense and income taxes Net interest expense Earnings before income taxes Provision for income taxes Net earnings 2012 2011 2010

73,301 69,865 67,390 50,568 47,860 45,725 17,362 16,683 16,413 5,371 5,322 5,252 762 866 757 4,609 4,456 4,495 1,610 1,527 1,575 $ 2,999 $ 2,929 $ 2,920

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Target Corporation Consolidated Statements of Cash Flows (millions) Operating activities Net earnings Reconciliation to cash flow Depreciation and amortization Share-based compensation expense Deferred income taxes Bad debt expense (a) Gain on receivables held for sale Noncash (gains)/losses and other, net Changes in operating accounts: Accounts receivable originated at Target Inventory Other current assets Other noncurrent assets Accounts payable Accrued and other current liabilities Other noncurrent liabilities Cash flow provided by operations Investing activities Expenditures for property and equipment Proceeds from disposals Change in accounts receivable originated at third parties Other investments Cash flow required for investing activities Financing activities Change in commercial paper, net Additions to short-term debt Reductions of short-term debt Additions to long-term debt Reductions of long-term debt Dividends paid Repurchase of stock Stock option exercises and related tax benefit Other Cash flow required for financing activities Effect of exchange rate changes on cash and cash equivalents Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period 2012 2011 2010

$ 2,999 $ 2,929 $ 2,920 2,142 105 (14) 206 (161) 14 (217) 15 (123) (98) 199 138 120 5,325 2,131 90 371 154 22 (187) (322) (150) 43 232 218 (97) 5,434 2,084 109 445 528 (145) (78) (417) (124) (212) 115 149 (103) 5,271

(3,277) (4,368) (2,129) 66 37 69 254 259 363 102 (108) (47) (2,855) (4,180) (1,744) 970 (1,500) 1,971 (1,529) (869) (1,875) 360 (16) (2,488) 8 (10) 794 $ 784 1,500 1,994 (3,125) (750) (1,842) 89 (6) (2,140) (32) (918) 1,712 $ 794 1,011 (2,259) (609) (2,452) 294 (4,015) (488) 2,200 $ 1,712

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