Chapter 4 PP

Chapter 4Using Financial

Statementsfor Investing and Credit

Decisions

© Cambridge Business Publishers, 2013

1

Financial Performance Decisions

Credit-granting decisions Involve judgment about a firm’s ability to make

timely payments towards Existing debt Pending credit obligations

Investment decisions Involve determining an appropriate intrinsic

value for a security based on a firm’s ability to generate future payoffs that exceed the resources used to generate those payoffs


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Trend Analysis on the Income Statement

Examining a firm’s financial statement to observe any trends in account balances

Sometimes called longitudinal analysis or ocular regression

Examine key performance indicators such as Revenue Income from operations Net income

Watch for one time charges


3

Avis Budget Group’s Income Statement Trends

Trend AnalysisOperating

revenues and expenses decreased

proportionately, while one-time

charges decreased significantly

causing a decrease in net loss.


4

Avis Budget Group, Inc. (in $millions) Year Ending Dec. 31

Consolidated Statements of Operations 2009 2008 Revenues $5,131 $5,984 Expenses Operating expenses 2,636 3,147 Depreciation and lease charges, net 1,521 1,785 Selling, general and administrative 551 655 Interest expense 447 450 Restructuring charges 20 28 Impairment 33 1,262 Total expenses 5,208 7,327 Loss before income taxes (77) (1,343) Benefit from income taxes (30) (219) Net income (loss) $ (47) $ (1,124)

Trend Analysis on the Balance Sheet

Examine key performance indicators Total assets Property, plant, and equipment Current portion of long-term debt Long-term debt Debt compared to equity

Capital intensive business Requires a large investment in property, plant, and

equipment and/or intangible assets Impaired assets are ‘written down’ with a loss

reported on the income statement


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Avis Budget Group’s Balance Sheet Trends

Trend Analysis

Though current assets increased, a large decrease in

plant assets caused total assets

to decline. Both current debt and long-term debt

increased. Shareholders’

equity also increased.


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Assets December 31Current Assets 2009 2008Cash And Cash Equivalents $ 482 $ 258 Net Receivables 290 360 Other Current Assets 958 455

Total Current Assets 1,730 1,073 Long Term Investments 398 650 Property Plant and Equipment 6,409 7,649 Intangible Assets 554 542 Other Assets 1,002 1,404 Total Assets $10,093 $11,318 LiabilitiesCurrent LiabilitiesAccounts Payable $ 1,272 $ 901 Short/Current Long Term Debt 12 10

Total Current Liabilities 1,284 911 Long Term Debt 2,833 2,671 Other Liabilities 5,754 7,643 Total Liabilities 9,871 11,225 Stockholders' Equity Common Stock 9,099 9,198 Retained Earnings (2,691) (2,644)Treasury Stock (6,149) (6,267)Other Stockholders’ Equity (37) (194) Total Stockholders’ Equity 222 93 Total liabilities & Stockholders' Equity

$10,093 $11,318

(in $millions)

Trend Analysis on the Statement of Cash Flow

Key performance indicators Primary source of cash for the period should

be from operating cash flow Net increase in cash from all activities for

the period Discretionary cash flow availability


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Avis Budget Group’s Cash Flow Trends

Avis Budget Group, Inc. Year Ending Dec. 31

Consolidated Statements of Cash Flows 2009 2008

Cash Flows From Operating Activities

Net Income ($ 47) ($1,124)

Depreciation 1,487 1,727

Adjustments To Net Income (27) 1,021

Changes In Accounts Receivables 52 50

Changes In Liabilities (9) (33)

Changes In Other Operating Activities 35 63

Net Cash Flow from Operating Activities 1,491 1,704

Cash Flows From Investing Activities

Capital Expenditures (6,814) (8,691)

Other Cash flows from Investing Activities 6,980 6,595

Net Cash Flows From(for) Investing Activities 166 (2,096)

Cash Flows From Financing Activities

Sale/ Purchase of Stock - (33)

Net Borrowings (1,393) 558

Other Cash Flows from Financing Activities (72) (62)

Net Cash Flows from(for) Financing Activities (1,465) 463

Effect Of Exchange Rate Changes 32 (27)

Change In Cash and Cash Equivalents $ 224 $ 44


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(in $millions)

Although less than prior year, the

company had a positive cash flow

from operating activities. Cash flow

from investing activities increased dramatically from prior year. These cash flows were

used to pay off debt in the current year.

Common-Size Financial Statements

A widely used technique for analyzing financial performance

Allows the financial statement user to readily compare Different size firms or Performance of the same firm that changes size

over time All income statement items are expressed as a

percentage of net revenues All balance sheet items are expressed as a

percentage of total assets


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Revenue, Returns, and Discounts

Gross revenue– Sales Discounts– Sales Returns= Net revenue


10

Sales Discounts Price reductions that are incentives for quick

payment Sales returns

The value of goods allowed to be returned by customers who are dissatisfied with a product

Avis Budget Groups’ Common-Size Income Statement

Avis Budget Group, Inc. Year Ending Dec. 31

Consolidated Statements of Operations 2009 2008 Revenues 100.0% 100.0% Expenses: Operating expenses 51.4% 52.6% Depreciation and lease charges, net 29.7% 29.8% Selling, general and administrative 10.7% 10.9% Interest expense 8.7% 7.5%

Restructuring charges 0.4%

0.5%

Goodwill impairment 0.6% 21.1% Total expenses 101.5% 122.4% Loss before income taxes -1.5% -22.4% Benefit from income taxes 0.6% 3.6% Net income (loss) -0.9% -18.8%


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Selling, general and

administrative expense declined,

but the non-recurring items

caused the most impact on the

substantial change in net loss

for the year.

Avis Budget Groups’ Common-Size Balance SheetAssets Year Ending Dec. 31 Current Assets 2009 2008

Cash And Cash Equivalents 4.8% 2.3%Net Receivables 2.9% 3.2%Other Current Assets 9.5% 4.0%

Total Current Assets 17.2% 9.5%Long Term Investments 3.9% 5.7%Property Plant and Equipment 63.5% 67.6%Intangible Assets 5.5% 4.8%Other Assets 9.9% 12.4%Total Assets 100.0% 100.0%LiabilitiesCurrent Liabilities

Accounts Payable 12.6% 8.0%Short/Current Long Term Debt 0.1% 0.1%

Total Current Liabilities 12.7% 8.1%Long Term Debt 28.1% 23.6%Other Liabilities 57.0% 67.5%Total Liabilities 97.8% 99.2%Stockholders' Equity Common Stock 90.2% 81.3%Retained Earnings -26.7% -23.4%Treasury Stock -60.9% -55.4%Other Stockholder Equity -0.4% -1.7%Total Stockholder Equity 2.2% 0.8% Total liabilities & Stockholders' Equity 100.0% 100.0%


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While cash and other current assets

increased significantly, PP&E and other non-

current assets decreased.

Accounts payable and debt increased while

other liabilities increased. The equity accounts increased as a percentage of total

assets.

Key Financial Ratios

Ratios have no generally accepted definitions Variations often based on personal preference Key issue is to use consistent components

Enhance comparability Global application of ratios

Executed exactly the same worldwide Some ratios are not relevant in all countries

Such as countries without credit systems


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How Well is Google, Inc. Doing?December 31 2012 2011

Assets

Current Assets

Cash and cash equivalents $14,778 $9,983 Short term investments 33,310 34,643 Net receivables 9,729 6,387 Inventory 505 35Other current assets 2,132 1,710

Total Current Assets 60,454 52,758 Long term investments 1,469 790 Property, plant and equipment 11,854 9,603 Intangible assets 18,010 8,924 Other long term assets 2,011 499 Total Assets $93,798 $72,574

Liabilities

Current LiabilitiesAccounts payable $ 10,893 $7,148Current portion of long-term debt 2,549 1,218Other current liabilities 895 547

Total Current Liabilities 14,337 8,913Long-term debt 2,988 2,986 Other long-term liabilities 4,758 2,530Total Liabilities 22,083 14,429

Stockholders' Equity

Common stock 23,373 20,540 Retained earnings 48,342 37,605 Total Stockholders' Equity 71,715 58,145 Total Liabilities & Stockholders' Equity $93,798 $72,574

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Years Ending December 31 2012 2011 Total Revenue $50.175 $37,905 Cost of Revenue 20,634 13,188 Gross Profit 29,541 24,717

Operating Expenses Research Development 6,793 5,162 Selling General and Administrative 9,988 7,813 Total Operating Expenses 16,781 12,975

Income from Continuing Operations 12,760 11,742 Total Other Income /(Expense) 710 642

Earnings Before Interest and Taxes 13,470 12,384 Interest Expense 84 58

Income Before Tax 13,386 12,326 Income Tax Expense 2,598 2,589

Income from continuing operations 10,788 9,737 Discontinued operation (51) Net Income $10,737 $9,737

Years Ending December 31 2012 2011Operating Activities Net Income $ 10,737 $ 9,737 Adjustments To Net Income 5,882 4,828Net Cash Flow From Operating Activities 16,619 14,565 Investing ActivitiesCapital Expenditures (3,273) (3,438)Investments 785 (13,703)Other Cash flows from Investing Activities (10,568) (1,900)

Net Cash Flow From Investing Activities (13,056) (19,041)

Financing ActivitiesNet borrowings 1,328 726Other Cash Flows from Financing Activities (99) 81

Net Cash Flow From Financing Activities 1,229 807

Effect of Exchange Rate Changes 3 22 Change In Cash and Cash Equivalents $ 4,795 $(3,647)

Using ratios to analyze financial data is helpful.

All numbers in millions

Analyzing Profitability

Refers to how much income was generated by a business Particularly relative to the amount of total assets

invested Key ratios

Return on shareholders’ equity (ROE) Return on assets (ROA) Return on sales (ROS) Gross profit margin ratio


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Profitability Analysis


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Return on Shareholders’

Equity

Net Income – Preferred Stock DividendsShareholders’ Equity=

Indicates the rate of return generated by a business for its common shareholders.

Google, Inc. 2012:

$9,737 – $0$58,145

= 16.7%

$10,737 – $0$71,715 = 15.0%

Google, Inc. 2011:

Google generated an decrease in its return on equity, an unfavorable change.



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Return on Assets

Net Income + Interest Expense (1- Tax rate)Total Assets=

Indicates the rate of return generated on a company’s investment in assets from all sources.

Google, Inc. 2012: $10,737 + $84(1 – 0.190*)$93,798 = 11.5%

Google, Inc. 2011:

Google generated 11.5 cents of profit for every dollar invested in assets in 2012, an unfavorable change from 2011.

*2012 tax rate = $2,598/$13,689= 19.0% 2011 tax rate = $2,589/$12,326 = 21.0%

$9,737 + $58(1 – 0.210*)$72,574 = 13.5%



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Return on Sales

Net IncomeNet Sales=

Indicates the percentage of net income remaining from a dollar of sales after subtracting all expenses.

Google, Inc. 2012:

$9,737$37,905

= 25.7%

$10,737$50,175

= 21.4%

Google, Inc. 2011:

Google generated 21.4 cents of profit per dollar of sales in 2012 compared to 25.7 cents in 2011.



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Gross Profit Margin Ratio

Net Sales – Cost of Goods SoldNet Sales=

Indicates the percentage of income generated from sales after deducting the cost of goods sold.

Google, Inc. 2012: $50,175 – $20,634 $50,175

= 58.9%

Google, Inc. 2011:

Google generated 58.9 cents of gross profits from each sales dollar in 2012 compared to 65.2 cents in 2011.

$37,905 – $13,188 $37,908

= 65.2%

Analysis of Asset Management

Refers to how well management uses a company’s assets to generate profits

Common ratios used to calculate Receivable turnover Receivable collection period Inventory turnover Inventory-on-hand period Asset turnover

Desired effects Collect receivables as quickly as possible Sell inventory as quickly as possible Generate large amounts of sales using assets


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Asset Management


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Receivable Turnover

Net SalesAccounts Receivable =

Indicates the number of sales/collection cycles experienced by a firm.

Google, Inc. 2012: $50,175$9,729

= 5.16 times

Google, Inc. 2011:

Google’s sales/collections cycles numbered 5.16 in 2012, down from 5.94 times in 2011.

$37,905 $6,387

= 5.94 times

Asset Management


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Receivable Collection

Period

365Net Sales / Accounts Receivable =

Indicates the number of days required, on average, to collect an outstanding account receivable

Google, Inc. 2012: 365$50,175 / $9,729

= 70.8 days

Google, Inc. 2011:

Google required 70.8 days on average to collect an outstanding receivable in 2012, an unfavorable increase from 61.5 days in 2011.

365$37,905 / $6,387

= 61.5 days

Asset Management


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Inventory Turnover

Cost of Goods SoldInventory=

Indicates the number of production/sales cycles experienced by a firm

Google’s inventory turnover numbered 40.9 in 2012, down from 376.8 times in 2011. These numbers are not really relevant since Google maintains so small a level of inventory.

Google, Inc. 2012: 20,634$505

= 40.9 days

Google, Inc. 2011: 13,188$35

= 376.8 days

Asset Management


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Inventory-on-Hand Period

365Cost of Goods Sold / Inventory=

Indicates the number of days, on average, required to sell the inventory currently on hand

Google required 8.9 days on average to sell its inventory in 2012, an unfavorable increase from 1.0 days in 2011, however these numbers are not really relevant since Google maintains so small a level of inventory.

.

Google, Inc. 2012: 365$20,634 / $505

= 8.9 days

Google, Inc. 2011: 365$13,188 / $35

= 1.0 days

Asset Management


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Asset Turnover

Net SalesTotal Assets=

Amount of sales generated from each dollar invested in assets.

Google, Inc. 2012: $50,175$93,798

= 0.54

Google, Inc. 2011:

Every dollar invested in Google’s assets generated $0.54 of sales revenue during 2012, up from $0.52 in 2011.

$37,905 $72,574

= 0.52

Analysis of Liquidity

Refers to the amount of liquid resources available to pay current obligations as they come due

Common liquidity measures Cash and marketable securities to total assets Quick ratio Current ratio Accounts payable turnover Days’ payable period

Goal is to maintain an adequate but not excessive liquidity


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Liquidity


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Cash and Marketable Securities to Total

Assets

Cash + Marketable SecuritiesTotal Assets=

Percentage of total assets held as highly liquid assets.

Google, Inc. 2012: $14,778 + $33,310 $93,798

= 0.51

Google, Inc. 2011:

About half of Google’s assets are highly liquid at the end of 2012, down from 62% at the end of 2011.

$9,983 + $34,643 $72,574

= 0.62

Liquidity


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Quick Ratio Cash + Marketable Securities + Accounts Receivable

Current Liabilities

=

Amount of liquid assets available to pay short-term liabilities.

Google, Inc. 2012:$14,778 + $33,310 + $9,729

$14,337= 4.0

Google, Inc. 2011:

Google’s liquid assets are 4.0 times as large its current obligations at the end of 2012, down from 5.7 at the end of 2011, indicating lower, but still high liquidity.

$9,983 + $34,643 + $6,387 $8,913

= 5.7

Liquidity


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Current Ratio

Current AssetsCurrent Liabilities=

Amount of current assets available to service current liabilities.

Google, Inc. 2012:$60,454$14,337 = 4.2

Google, Inc. 2011:

Google’s current assets are 4.2 times as large as its current obligations at the end of 2012, down from 5.9 at the end of 2011, indicating lower, but still high liquidity.

$52,758$8,913

= 5.9

Liquidity


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Accounts Payable Turnover

Cost of Goods SoldAccounts Payable=

Number of account payable cycles experienced by a firm.

Google, Inc. 2012:$20,634$10,893 = 1.9 times

Google, Inc. 2011:

Google’s experienced 1.9 payment cycles in 2012, a slight increase from 1.8 during 2011.

$13,188$7,148

= 1.8 times

Liquidity


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Days’ Payable Period

365Cost of Goods Sold ÷ Accounts Payable=

Number of days, on average, required to pay an outstanding account payable.

Google, Inc. 2012:365

$20,634 ÷ $10,893 = 192.7 days

Google, Inc. 2011:

On average, it took Google 192.7 days to pay an outstanding account payable during 2012, a little quicker than the 197.8 days during 2011.

365$13,188 ÷ $7,148

= 197.8 days

Credit Risk Analysis

What are creditors concerned about? Downside risk

The risk of not getting paid interest and principal Common measures

Long-term debt to total assets Long-term debt to shareholders’ equity Interest coverage ratio


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Solvency


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Long-term Debt to Total Assets Ratio

Long-term Debt +Current Portion of Long-Term Debt

Total Assets

=

Percentage of total assets provided by creditors.

Google, Inc. 2012:$2,988 + $2,549

$93,798= 5.9%

Google, Inc. 2011:

Google financed 5.9% of its assets with debt as of the end of 2012 up slightly from 5.8% at the end of 2011, but still a very low debt financing amount.

$2,986 + $1,218$72,574

= 5.8%

Solvency


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Long-term Debt to Shareholders’

Equity Ratio

Long-term Debt +Current Portion of Long-Term Debt

Shareholders’ Equity=

Relative investment of long-term creditors versus shareholders in a business.

Google, Inc. 2012:$2,988 + $2,549

$71,715= 7.7%

Google, Inc. 2011:

Google’s debt-to-equity ratio is 7.7% in 2012, up slightly from 7.2% in 2011, but still very low.

$2,986 + $1,218$58,145

= 7.2%

Solvency


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Interest Coverage

Ratio

Net Income Before Taxes + Interest ExpenseInterest Expense

=

Extent to which current operating income covers current debt service charges.

Google had relatively no interest expense in 2012 or 2011, so this ratio is not really relevant.

Google, Inc. 2012:

Google, Inc. 2011:

$13,386 + $84$84

$12,326 + $58$58

=

=

160.4

213.5

Off-Balance Sheet Liabilities

Liabilities not reported on the balance sheet Such as operating leases Exist due to certain complex accounting

standards Can be found in notes to financial statements Investors must exercise due diligence

i.e. read the entire set of financial statements including notes


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Benchmarking

What is benchmarking? Comparing with similar companies

Also known as cross-sectional analysis Ratios of companies in the same industry are

compared North American Industry Classification System

A system for classifying companies into common industry groups

Makes it easy for companies to benchmark against their competitors


37

ROE Model Framework

Used to evaluate a firm’s overall enterprise performance

Shows that a business can increase its overall performance by increasing any of the following ratios:


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Return on Equity (ROE)

Return on Sales (ROS)

Asset Turnover (AT)

Financial Leverage (LEV)

ROE Analysis of Google, Inc.


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The decrease in ROE was due to an decrease in ROS to 21.4% in 2012 down from 25.7% in 2011.

Google, Inc. 2012 2011

Total revenues $50,175 $37,905

Net income

10,737 9,737

Total assets 93,798 72,574

Shareholders' equity 71,715 58,145

ROE Analysis

ROE = Net income ÷ Shareholders' Equity 15.0%* 16.7%

ROS = Net income ÷ Revenues 21.4% 25.7%

AT = Revenues ÷ Total Assets 0.54 0.52

LEV = Total Assets ÷ Shareholders' Equity 1.31 1.25

* Difference due to rounding

Financial Statement Analysis Limitations

Measurement concerns Market value can be subjective Historical cost is reliable, but not current

Incomplete data Some assets and liability values are omitted from

the balance sheet due to conservatism, such as Trained workforces Management talent Internal processes Brand recognition


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END OF CHAPTER 4

Chapter 4 PP

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