Ancient Lost Cities of the Nephilim Discovered Hidden in Plain Sight | D...

Foundations of Financial Management: An Analysis (part 8)

Beware of little expenses. A small leak will sink a great ship.

Benjamin Franklin

Financial Analysis

by

Charles Lamson

Ratio Analysis

Ratios are used in much of our daily life. We buy cars based on miles per gallon; we evaluate baseball players by earned-run and batting averages, basketball players by field goal and foul-shooting percentages, and so on. These are all ratios constructed to judge comparative performance. Financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the significance of the resultant number.

Financial ratios are used to weigh and evaluate the operating performance of the firm. While an absolute value such as earnings of $50,000 or accounts receivable of $100,000 may appear satisfactory, its acceptability can be measured only in relation to other values. For this reason, financial managers emphasize ratio analysis.

For example, are earnings of $50,000 actually good? If we earned $50,000 on $500,000 of sales (10 percent "profit margin" ratio), that might be quite satisfactory---whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have computed the appropriate ratio, we must compare our results to those achieved by similar firms in our industry, as well as to our own performance record. Even then, this "number-crunching" process is not fully adequate, and we are forced to supplement our financial findings with an evaluation of company management, physical facilities, and numerous other factors.

Classification system

We will separate 13 significant ratios into four primary categories. 

The first grouping, profitability ratios, allows us to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital. Many of the problems related to profitability can be explained, in whole or in part, by the firm's ability to effectively employ its resources. Thus the next category is asset utilization ratios. Under this heading, we measure the speed at which the firm is turning over accounts receivable, inventory, and longer-term assets. In other words, asset utilization ratios measure how many times per year a company sells its inventory or collects all of its accounts receivable. For long-term assets, the utilization ratio tells us how productive the fixed assets are in terms of generating sales.

In category C, the liquidity ratios, the primary emphasis moves to the firm's ability to pay off short-term obligations as they come due. In category D, debt utilization ratios, the overall debt position of the firm is evaluated in light of its asset base and earning power.

The users of financial statements will attach different degrees of importance to the four categories of ratios. To the potential investor or a security analyst, the critical consideration is profitability, with secondary consideration given to such matters as liquidity and that utilization. For the banker or trade creditor, the emphasis shifts to the firm's current ability to meet debt obligations. The bondholder, in turn, may be primarily influenced by debt to total assets while, also eyeing the profitability of the firm in terms of its ability to cover debt obligations. Of course, the experienced analyst looks at all ratios, but with different degrees of attention.

Ratios are also important to people in the various functional areas of a business. The marketing manager, the head of production, the human resource manager, and so on, must all be familiar with ratio analysis. For example, the marketing manager must keep a close eye on inventory turnover, the production manager must evaluate the return on assets and the human resource manager must look at the effect of fringe benefits expenditures on the return on sales.

The Analysis

Definitions alone carry little meaning in analyzing or dissecting the financial performance of a company. For this reason, we shall apply our four categories of ratios to a hypothetical firm, the Lamson Company, as presented in Table 1. The use of ratio analysis is rather like solving a mystery in which each clue leads to a new area of inquiry.

Table 1 Financial statement for ratio analysis

A. Profitability Ratios We first look at profitability ratios. The appropriate ratio is computed for the Lamson Company and is then compared to representative industry data.

Profitability Ratios---

In analyzing the profitability ratios, we see the Lamson Company shows a lower return on the sales dollar (5.9 percent) than the industry average of 6.7 percent. However, its return on assets (investment) of 14.8 percent exceeds the industry norm of 10%. There is only one possible explanation for this occurrence---a more rapid turnover of assets than that is generally found within the industry. This is verified ratio 2b, in which sales to total assets is 2.5 for the Lamson Company and only 1.5 for the industry. Thus Lamson earns less on each sales dollar, but it compensates by turning over its assets more rapidly (generating more sales per dollar of assets).

Return on total assets as described through the two components of profit margin and asset turnover is part of the DuPont system of analysis.

Return on assets (investment equals) = Profit margin X Asset turnover

The DuPont company was a forerunner in stressing that satisfactory return on assets may be achieved through prophet high profit margins or rapid turnover of assets, or a combination of both. We shall also soon observe that under the DuPont system of analysis, the use of debt may be important. The DuPont system causes the analyst to examine the sources of a company's profitability. Since the profit margin is an income statement ratio, a high profit margin indicates good cost control, whereas a high asset turnover ratio demonstrates efficient use of the assets on the balance sheet. Different industries have different operating and financial structures. For example, in the heavy capital goods industry the emphasis is on a high profit margin with a low asset turnover whereas in food processing, the profit margin is low and the key to satisfactory returns on total assets is a rapid turnover of assets.

Equally important to a firm is its return on equity or ownership of capital. For the Lamson Company, return on equity is 23.7 percent, versus an industry norm of 15 percent. Thus the owners of Lamson Company are more amply rewarded than are other shareholders in the industry. This may be the result of one or two factors: a high return on total assets or a generous utilization of debt or a combination thereof. This can be seen through Equation 3b, which represents a modified or second version of the DuPont formula.

Note the numerator, return on assets, is taken from Formula 2, which represents the initial version of the DuPont formula (Return on assets = Net income/Sales X Sales/Total assets). Return on assets is then divided by [1 - (Debt/Assets)] to account for the amount of debt in the capital structure. In the case of the Lamson Company, the modified version of the DuPont formula shows:

Actually the return on assets of 14.8 percent in the numerator is higher than the industry average of 10 percent, and the ratio of debt to assets in the denominator of 37.5 percent is higher than the industry norm of 33 percent. Both the numerator and denominator combined contribute to a higher return on equity than the industry average (23.7 percent versus 15 percent). Note that if the firm had a 50% debt to assets ratio, return on equity would go up to 29.6%.

This does not necessarily mean that is a positive influence, only that it can be used to boost return on equity. The ultimate goal for the firm is to achieve maximum valuation for its securities in the marketplace, and this goal may or may not be advanced by using debt to increase return on equity. Because that represents increased risk, a lower valuation of higher earnings is possible. Every situation must be evaluated individually.

Finally as a general statement in computing all the profitable ratios, the analyst must be sensitive to the age of the assets. Plant and equipment purchased 15 years ago may be carried on the books far below its replacement value in an inflationary economy. A 20 percent return on assets purchased in the 1990s may be inferior to a 15 percent return on newly purchased assets.

B. Asset Utilization Ratios The second category of ratios relates to asset utilization, and the ratios in this category may explain why one firm can turn over its assets more rapidly than another. Notice that all of these ratios relate the balance sheet (assets) to the income statement (sales). The Lamson Company's rapid turnover of assets is primarily explained in ratios 4, 5, and 6.

Asset Utilization Ratios---

Lamson collects its receivables faster than does the industry. This is shown by the receivables turnover of 11.4 times versus 10 times for the industry, and in daily terms by the average collection period of 32 days, which is four days faster than the industry norm. The average collection period suggests how long, on average, customers accounts stay on the books. The Lamson Company has $350,000 in accounts receivable and four million dollars in credit sales, which when divided by 360 days (used in finance and business calculations as opposed to 365 days for the sake of simplicity) yields average daily credit sales of $11,111. We divide accounts receivable of $350,000 by average daily credit sales of $11,111 to determine how many days credit sales are on the books (32 days).

In addition the firm turns over its inventory 10.8 times per year as contrasted with an industry average of 7 times. This tells us that Lamson generates more sales per dollar of inventory than the average company in the industry, and we can assume the firm uses very efficient inventory ordering and cost control methods.

The firm maintains a slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry (5 versus 5.4) as shown above. This is a relatively minor consideration in view of the rapid movement of inventory and accounts receivable. Finally, the rapid turnover of total assets is again indicated (2.5 vs 1.5).

C. Liquidity Ratios After considering profitability and asset utilization, the analyst needs to examine the liquidity of the firm. The Lamson Company's liquidity ratios fare well in comparison with the industry. Further analysis might call for a cash budget to determine if the firm can meet each maturing obligation as it comes due.

Liquidity Ratios---

D. Debt Utilization Ratios The last grouping of ratios, debt utilization, allows the analyst to measure the prudence of the debt management policies of the firm.

Debt to total assets of 37.5 percent as shown in the Equation 11 is slightly above the industry average of 33 percent, but well within the prudent range of 50 percent or less.

Debt Utilization Ratios---

Ratios for times interest earned and a fixed charge coverage show that the Lamson Company debt is being well-managed compared to the debt management firms in the industry. Times interest earned indicates the number of times that income before interest and taxes covers the interest obligation (11 times). The higher the ratio, the stronger is the interest paying ability of the firm. The figure for income before interest and taxes ($550,000) in the ratio is the equivalent of the operating profit figure presented in the upper part of Table 1 presented previously in this post.

Fixed charge coverage measures the firm's ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm. In the present case the Lamson Company has lease obligations of $50,000 as well as the $50,000 in interest expenses. Thus the total fixed charge financial obligation is $100,000. We also need to know the income before all fixed charge obligations. In this case we take income before interest and taxes (operating profit) and add back the $50,000 and lease payments.

The fixed charges are safely covered 6 times, exceeding the industry norm of 5.5 times. The various ratios are summarized in Table 2 on page. The conclusions reached in comparing the Lamson Company to industry averages are generally valid, though exceptions may exist. For example, a high inventory turnover is considered good unless it is achieved by maintaining unusually low inventory levels, which may hurt future sales and profitability.

In summary, the Lamson Company more than compensates for a lower return on the sales dollar by the rapid turnover of assets, principally inventory and receivables, and a wise use of debt. You should be able to use these 13 measures to evaluate the financial performance of any firm. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 53-61*

end

The Sea Peoples & The Late Bronze Age Collapse // Ancient History Docume...

Foundations of Financial Management: An Analysis (part 7)

Do you know the only thing that gives me pleasure? It's to see my dividends coming in.

John D. Rockefeller

Review of Accounting (part D)

by

Charles Lamson

Depreciation and Cash Funds Flow

One of the most confusing items to people learning about finance is whether depreciation is a source of funds to the corporation. In Table 1 (see below), which was presented in the last post, we listed depreciation as a source of funds (cash flow). This item deserves further clarification. The reason why we added back depreciation was not that depreciation was a new source of funds, but rather that we subtracted this noncash expense in arriving at net income and now have to add it back to determine the amount of actual funds on hand.

Table 1 Cash flows from operating activities

Depreciation represents an attempt to allocate the initial cost of an asset over its useful life. In essence, we attempt to match the annual expense of plant and equipment ownership against the revenues being produced. Nevertheless the charging of depreciation is purely an accounting entry and does not directly involve the movement of funds. To go from accounting flows to cash flows in Table 1, we restored the noncash deduction of $50,000 for depreciation that was subtracted in Table 2 (see below), the income statement, which was presented in Part 4 of this analysis.

Table 2

Let us examine a simple case involving depreciation in Table 3. Assume we purchase a machine for $500 with a five-year life and we pay for it in cash. Our depreciation schedule calls for equal annual depreciation charges of $100 per year for five years. Assume further that our firm has $1,000 in earnings before depreciation and taxes, and the tax obligation is $300. Note the difference between accounting flows and cash flows for the next two years in Table 3.

Table 3 Comparison of accounting and cash flows

Since we took $500 out of cash flow originally (year 1) to purchase equipment (in column B above), we do not wish to take it out again. Thus we add back $100 in depreciation (in column B) each year to "wash out" the subtraction in the income statement. 

Free Cash Flow 

Free cash flow (FCF) is actually a byproduct of the previously discussed statement of cash flows presented in the last post (Table 4 below). Free cash flow is equal to the value shown under Table 3.

Table 4

The concept of free cash flow forces the stock analyst or banker not only to consider how much cash is generated from operating activities, but also to subtract out the necessary capital expenditures on plant and equipment to maintain normal activities. Similarly, dividend payments to shareholders must be subtracted out as these dividends must generally be paid to keep shareholders satisfied.

The balance, free cash flow, is then available for special financing activities. In the last couple decades special financing activities have often been synonymous with leveraged buyouts, in which a firm borrows money to buy its stock and take itself private, with the hope of restructuring its balance sheet and perhaps going public again in a few years at a higher price than it paid. Leveraged buyouts are discussed more fully later in this analysis. The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to pay back the loan associated with the leveraged buyout. 

Income Tax Considerations

Virtually every financial decision is influenced by federal income tax considerations. Primary examples are the lease versus purchase decision, the issuance of common stock versus debt decision, and the decision to replace an asset. While the intent of this section is not to review the rules, regulations, and nuances of the federal income tax code, we will examine how tax matters influence corporate financial decisions. The primary orientation will be toward the principles governing corporate tax decisions, though many of the same principles apply to a sole proprietorship or a partnership. 

Corporate Tax Rates

Basically, the corporate federal tax rate is progressive, meaning lower levels of income are taxed at lower rates (Block & Hirt, 2005, p. 40). Higher levels of income are taxed at higher rates. In the illustrations in this analysis, we will use various rates to illustrate the impact on decision making. The current top rate is 21 percent, down from 35 percent by the 2017 Tax Cuts and Jobs Act (Tax Policy Center Briefing Book). However, keep in mind that corporations may also pay some state and foreign taxes, so the effective rate can get higher in some instances.

Cost of a Deductible Expense

The business person often states that a tax-deductible item, such as interest on business loans, travel expenditures, or salaries, cost substantially less than the amount expended, on an after-tax basis. We shall investigate how this process works. Let us examine the tax statements of two corporations---the first pays $100,000 in interest, and the second has no interest expense. Let's use the current top corporate tax rate of 21 percent.

Although Corporation A paid out $100,000 more in interest than Corporation B, its earnings after taxes are only $79,000 less than those of Corporation B. Thus we say the $100,000 in interest cost the firm only $79,000 in after-tax earnings. The after-tax cost of a tax-deductible expense can be computed as the actual expense times 1 minus the tax rate. In this case, we show $100,000 (1 - tax rate), or $100,000 * .79 = $79,000. The reasoning in this instance is that $100,000 is deducted from earnings before determining taxable income, thus saving $21,000 in taxes and costing only $79,000 on a net basis.

Because the dividend on common stock is non tax-deductible, we say it cost 100% of the amount paid. From a purely corporate cash flow viewpoint, the firm would be indifferent between paying $100,000 in interest and $79,000 in dividends.

Depreciation as a Tax Shield

Although depreciation is not a new source of funds, it provides the important function of shielding part of our income from taxes. Let us examine corporations A and B again, this time with an eye toward depreciation rather than interest. Corporation A charges off $100,000 in depreciation, while Corporation B charges off none.

We compute earnings after taxes and then add back depreciation to get cash flow. The difference between $337,000 and $316,000 indicates that Corporation A enjoys $21,000 more in cash flow. The reason is that depreciation shielded $100,000 from taxation in Corporation A and saved $21,000 in taxes, which eventually showed up in cash flow. Though depreciation is not a new source of funds, it does provide tax shield benefits that can be measured as depreciation * the tax rate, or in this case $100,000 * .21 = $21,000. A more comprehensive discussion of depreciation's effect on cash flow is presented later in this analysis, as part of the long-term capital budgeting decision. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 37-42*

end

Foundations of Financial Management: An Analysis (part 6)

I'm involved in the stock market, which is fun and, sometimes, very painful.

Regis Philbin

Review of Accounting (part C)

by

Charles Lamson

Statement of Cash Flows

The accounting profession designates the statement of cash flows as the third required financial statement, along with the balance sheet and income statement. Referred to as Statement of Financial Accounting Standards (SFAS) No. 95, it replaces the old statement of changes in financial position.

The purpose of the statement of cash flows is to emphasize the critical nature of cash flow to the operations of the firm. According to accountants, cash flow represents cash or cash-equivalent items that can easily be converted into cash within 90 days (such as a money market fund).

The income statement and balance sheet, that were introduced in the two previous posts, are normally based on the accrual method of accounting, in which revenues and expenses are recognized as they occur, rather than when cash actually changes hands. For example, a $100,000 credit sale may be made in December 2018 and shown as revenue for that year despite the fact the cash payment will not be received until March 2019. When the actual payment is finally received under accrual accounting accounting, no revenue is recognized (it has already been accounted for previously). The primary advantage of accrual accounting is that it allows us to match revenues and expenses in the period in which they occur in order to appropriately measure profit; but a disadvantage is that adequate attention is not directed to the actual cash flow position of the firm.

Say a firm made a $1 million profit on a transaction but will not receive the actual cash payment for two years. Or perhaps the $1 million profit is in cash, but the firm increased its asset purchases by $3 million (a new building). If you merely read the income statement, you might assume the firm is in a strong $1 million cash position; but if you go beyond the income statement to cash flow considerations, you would observe the firm is $2 million short of funds for the period.

As a last example, a firm might show $100,000 loss on the income statement, but if there were a depreciation expense write-off of $150,000, the firm would actually have $50,000 in cash. Since depreciation is a non-cash deduction, the $150,000 deduction in the income statement for depreciation can be added back to net income to determine cash flow.

The statement of cash flows addresses these issues by translating income statement and balance sheet data into cash flow information. A corporation that has $1 million in accrual based accounting profits can determine whether it can afford to pay a cash dividend to stockholders, buy new equipment, or undertake new projects.

Developing an Actual Statement

We shall use the information previously provided for Kramer Corporation in previous posts to illustrate how the statement of cash flows is developed.

But first, let's identify the three primary sections of the statement of cash flows: (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities.

Figure 1  Illustration of concepts behind the statement of cash flows

After each of these sections is completed, the results are added together to compute the net increase or decrease in cash flow for the corporation. An example of the process is shown in Figure 1. Let's begin with cash flows from operating activities.

Determining Cash Flows from Operating Activities 

Basically, we are going to translate income from operations from an accrual to a cash basis. According to SFAS 95, there are two ways to accomplish this objective. First, the firm may use a direct method, in which every item on the income statement is adjusted from accrual accounting to cash accounting. This is a tedious process, in which all sales must be adjusted to cash sales. All purchases must be adjusted to cash purchases, and so on. A more popular method it is the indirect method, in which net income represents the starting point and then adjustments are made to convert net income to cash flows from operations. This is the method we will use. Regardless of whether the direct or indirect method is used, the same final answer will be derived.

We follow these procedures in computing cash flows from operating activities using the indirect method. These steps are Illustrated in Figure 2 as follows.

Figure 2  Steps in computing net cash flows from operating activities using the indirect method

*Start with net income.

*Recognize that depreciation is a non-cash deduction in computing net income and should be added back to net income to increase the cash balance.

*Recognize that increases in current assets are a use of funds and reduce the cash balance (indirectly)---as an example, the firm spends more funds on inventory.

*Recognize that decreases in current assets are a source of funds and increase the cash balance (indirectly) that is, the firm reduces funds tied up in inventory.

*Recognize that increases in current liabilities are a source of funds and increase the cash balance (indirectly)---the firm gets more funds from creditors.

*Recognize that decreases in current liabilities are a use of funds and decrease the cash balance (indirectly) that is, the firm pays off creditors.

We will follow these procedures for the Kramer Corporation, drawing primarily on the previously presented Table 1 from part 4 (see below) and from Table 2 (also see below) (which shows balance sheet data for the most recent two years).

Table 1

Table 2

The analysis is presented in Table 3 (see below). We begin with net income (earnings after taxes) of $110,500 and add back depreciation of $50,000. We then show that increases and current assets (accounts receivable and inventory) reduce funds and decreases in current assets (prepaid expenses) increase funds. Also, we show increases in current liabilities (accounts payable) as an addition to funds and decreases in current liabilities (accrued expenses) as a reduction of funds.

Table 3 Cash flows from operating activities

We see in Table 3 that the firm generated $150,500 in cash flows from operating activities. Of some significance is that this figure is $40,000 larger than the net income figure shown on the first line of the table ($110,000). A firm with little depreciation and a massive buildup of inventory might show lower cash flow then reported net income. Once cash flows from operating activities are determined, management has a better feel for what can be allocated to investing or financing needs (such as paying cash dividends).

Determining Cash Flows from Investing Activities

Cash flows from investing activities represent the second section in the statement of cash flows. The section relates to long-term investment activities in other issuers' securities or, more importantly, in plant and equipment. Increasing Investments represent a use of funds, and decreasing Investments represent a source of funds.

Examining table 2 for the Kramer Corporation, we show the information in table 4.

Table 4 Cash flows from investing activities

Determining Cash Flows from Financing Activities

In the third section of the statement of cash flows, cash flows from financing activities, we show the effects of financing activities on the corporation. Financing activities apply to the sale or retirement of bonds, common stock, preferred stock, and other corporate securities. Also, the payment of cash dividends is considered a financing activity. The sale of the firm's securities represents a source of funds, and the retirement or repurchase of such securities represents a use of funds. The payment of dividends also represents a use of funds. 

In Table 6 (below) the financing activities of the Kramer Corporation are shown using data from Table 1 (above), the previously presented Statement of Retained Earnings from Part 4 (Table 5, below), and Table 2 (above).

Table 5

Table 6 Cash flows from financing activities

Combining the Three Sections of the Statement

We now combine the three sections of the statement of cash flows to arrive at the one overall statement that the corporation provides to security analysts and stockholders. The information is shown in table 7.

Table 7

We see in Table 7 that the firm created excess funds from operating activities that were utilized heavily in investing activities and somewhat in financing activities. As a result, there is a $10,000 increase in the cash balance, and this can be reconciled with the increase in the cash balance of $10,000 from $30,000 to $40,000, as previously indicated in table 2.

One might also do further analysis on how the buildups in various accounts were financed. For example, if there is a substantial increase in inventory or accounts receivable, is there an associated buildup in accounts payable and short-term bank loans? If not, the firm may have to use long-term financing to carry part of the short-term needs. An even more important question might be: How are increases in long-term assets being financed? Most desirably, there should be adequate long-term financing and profits to carry thoee needs. If not, then short-term funds (trade credit and bank loans) may be utilized to carry long-term needs. This is a potentially high-risk situation, in that short-term sources of funds may dry up while long-term needs continue to demand funding.

*MAIN SOURE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 31-37*

end