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FINANCIAL REPORTING II REVIEW OF RATIO ANALYSIS Ratio analysis is a useful tool for analyzing financial statements. Calculating ratios will aid in understanding the company’s strategy and in understanding its strengths and weaknesses relative to other companies and over time. They can sometimes be useful in identifying earnings management and in understanding the effect of accounting choices on the firm’s reported profitability and growth. Finally, the ratios help in obtaining a better understanding of a firm’s current profitability, growth, and risk which can improve forecasts of future profitability and growth and estimates of the cost of capital. In reviewing the basic financial ratios, we will examine the ratios of Best Buy for the fiscal years ended March 2, 2002 and March 3, 2001. Excerpts from Best Buy’s financial statements are included at the end of this document. Best Buy is a growing company. The following table reflects the growth in sales and income during the year ended March 2, 2002: Year Ended March 2, 2002 Sales Net Income Average book value Average assets Average debt 19,597 570 2,171.5 6,107.5 558 Year Ended March 3, 2001 15,327 396 1,459 3,917.5 163.5 % Growth 28% 44% 28% 52% 177% Note that sales and net income rose in 2002 relative to 2001. Also note, however, that total assets, book value and debt also rose during the year. Ratio analysis allows the analyst to compare the income and sales reported on the income statement relative to the assets and book value the company had to work with reported on the balance sheet. A review of the ratios follows. Profitability Ratios Return on Assets Return on assets measures a firm's performance in using assets to generate earnings (independent of the financing of the assets). This measure allows one to consider the income (before financing costs) relative to the assets that the firm had to generate the income. It, therefore, allows one to examine the income statement in relation to the resources available as reported on the balance sheet. Return on assets (ROA) is calculated as follows: Net Income + Interest Expense*(1-tax rate) Average Total Assets Best Buy (assuming that Best Buy’s income tax rate is 35% for both years) 2002 2001 ROA 570 + 28 (.65) 396 + 7 (.65) 6107.5 3917.5 = 9.63% = 10.22% Note that while Best Buy’s earnings rose from 2001 to 2002, the earnings generated per dollar of assets fell over the period. In 2001, Best Buy earned 10.22 cents before financing costs on every dollar of average assets; however, in 2002, Best Buy earned only 9.63 cents before financing costs on every dollar of average assets. The ratio, return on assets, allows the analyst to compare the earnings generating ability of the company relative to the invested assets. Disaggregating Return on Assets A firm’s return on assets reflects the income (before financing costs) generated from the firm’s assets. The ROA can be disaggregated into the sales generated from the assets and the income (before financing costs) generated from the sales. Return on assets is often disaggregated into profit margin (PM) and asset turnover (ATO): ROA = ATO x PM This disaggregation allows the analyst to better understand the source of the change in return on assets. For example, did Best Buy’s ROA fall in 2002 because it had more difficulty generating sales from the assets (ATO) or because it had difficulty generating income from the sales (PM), or both? An analysis of ATO and PM can yield insights into the source of the change in ROA. Profit Margin Ratio The profit margin ratio (PM) measures a firm's ability to control the level of expenses relative to the revenues generated. PM is calculated as follows: Net Income + Interest Expense*(1-tax rate) Revenues Best Buy PM 2002 570 + 28 (.65) 19597 2001 396 + 7 (.65) 15327 = 3.00% = 2.61% Best Buy’s profit margin increased in 2002. For every dollar in sales, Best Buy earned 3 cents in income before financing costs in 2002 and only 2.61 cents in 2001. Thus, the fall in ROA is not due to the reduction in income before financing costs per dollar of sales. Asset Turnover The asset turnover ratio (ATO) measures a firm's ability to generate revenues from a particular level of investment. ATO is calculated as follows: Revenues Average Total Assets Best Buy ATO 2002 19597 6107.5 2001 15327 3917.5 = 3.21 = 3.92 It appears that Best Buy’s fall in ROA was driven by a fall in ATO, not a fall in PM. The firm had difficulty generating sales from the assets in 2002 relative to 2001. For every dollar of average assets, Best Buy generated only $3.21 in sales in 2002 while Best Buy generated $3.92 in sales in 2001. In order to gain even more insight into the source of the change in the ROA ratio, we can disaggregate the PM ratio and the ATO ratio to determine the source of the changes in those ratios. Disaggregating the Profit Margin Ratio To better understand why the profit margin ratio changed, the analyst can examine each income and expense item on the income statement as a percentage of revenue. This will provide insight into which components of the income statement changed over the period. Best Buy Cost of goods sold/sales Selling, general and administrative expense/sales 2002 77.43% 17.82% 2001 80.04% 16.02% Best Buy’s rise in profit margin in 2002 is due to the reduction of cost of sales rather than to the reduction of selling, general and administrative expenses relative to sales. Disaggregating the Asset Turnover Ratio To better understand why the asset turnover ratio changed, the analyst can examine the productivity of important assets such as accounts receivables, inventory, and fixed assets at generating sales. Accounts Receivable Turnover The accounts receivable turnover measures the rate at which the firm collects its accounts receivables. The accounts receivable turnover is calculated as follows: Net Credit Sales Average Accounts Receivables The average number of days’ accounts receivables were outstanding during the period can be calculated by dividing the accounts receivable turnover into 365 days as follows: 365/Turnover = # of days Accounts Receivables were outstanding during the year, on average Best Buy AR turnover 2002 19497 (247 + 209)/2 2001 15327 (209 + 189)/2 = 85.95 = 77.02 4.25 days 4.74 days Most of Best Buy’s transactions are for cash or credit cards; therefore, the number of days’ sales outstanding is very small, approximately 4 days. Inventory Turnover Inventory turnover measures the average days that the firm’s inventory was on hand during the period. The inventory turnover is calculated as follows: Cost of Goods Sold Average Inventory The average number of days the inventory was on hand can be calculated by dividing the inventory turnover into 365 days as follows: 365/Turnover = # of days inventory on hand during the year, on average. Best Buy Invent turnover 2002 15167 (2258 + 1767)/2 2001 12268 (1767 + 1184)/2 =7.21 = 8.31 50 days 44 days It has taken Best Buy longer to sell its inventory, on average, in 2002 relative to 2001. While it took approximately 44 days on average to sell inventory in 2001, it took Best Buy approximately 50 days on average to sell inventory in 2002. Plant Asset Turnover The plant asset turnover measures the revenues generated by each dollar invested in plant assets. The plant asset turnover is calculated as follows: Revenues Average Plant Assets Best Buy Plant Asset Turnover 2002 19597 (1897+1444)/2 2001 15327 (1444+698)/2 = 11.73 = 14.31 Best Buy has generated fewer sales per dollar of assets in 2002 relative to 2001. While Best Buy generated $14.31 in sales per dollar of average assets in 2001, the average assets generated only $11.73 in sales in 2002. Therefore, part of the explanation for the reduction in asset turnover is the reduction in the productivity of the plant assets at generating sales. These results suggest that while Best Buy did generate greater income and sales in 2002 versus 2001, it generated less income (before financing costs) per dollar of average assets, it took longer to sell its inventory, and it generated fewer sales from each dollar of plant assets. Return to Common Stockholder Equity The return on assets examines the profitability of the firm’s assets without regard to the financing of the assets; however, equity investors are interested in the profitability of the firm after financing costs since they are the residual claimants to the business. Return on common stockholders’ equity (ROE) reflects the income per dollar of common owners’ equity. ROE is calculated as follows: Net Income - Preferred Dividends Average Common Stockholders' Equity Best Buy ROE 2002 570 2171.5 2001 396 1459.0 = 26.25% = 27.14% Best Buy’s ROE has fallen in 2002 but it has not fallen as much as the fall in ROA. Note that Best Buy’s return on equity is higher than its return on assets. This is due to the use of leverage. Financing with debt and preferred stock can increase the return to common shareholders if the return on assets is greater than the cost of debt. Cost of Debt The after-tax cost of debt is calculated as follows: Interest Expense (1-tax rate) Average Debt Best Buy After-tax cost of debt 2002 28 (.65) 558 2001 7 (.65) 163.5 = 3.23% = 2.78% Best Buy’s cost of debt is less than the return on assets, so the use of debt has made the return on equity higher than the return on assets. While the use of leverage can increase ROE, the use of leverage will also increase the risk that the company will not be able to make the required debt payments. Therefore, the use of debt has the advantage of benefiting the equityholders in good years but can be detrimental to equityholders in less profitable years. Risk Ratios As a firm relies more on debt, the risk that the firm cannot make the required payments increases. With equity, the firm is not required to pay dividends, so in a less profitable year, the firm can choose to not distribute dividends. On the other hand, the payment on debt is not optional; therefore, as the firm relies more on debt, the risk of not being able to make the payments increases. There are several ratios that help to assess the risk associated with the company. Long Term Liquidity Risk Long-term liquidity ratios measure how much the company relies on debt versus equity to finance its assets and whether the firm can pay interest and repay debt. The debt-asset ratio and the interest coverage ratios are commonly used long-term liquidity ratios. Debt-Asset Ratio The debt to asset ratio measures the percentage of the firm’s assets that are financed through borrowing. The debt to asset ratio is calculated as follows: Total Debt Total Assets Best Buy Debt to Asset Ratio 2002 820 7375 = 11.12% 2001 296 4840 = 6.12% Best Buy has relied more on debt in 2002 relative to 2001. In 2002, 11% of Best Buy’s assets are financed with debt while in 2001 only 6% of the assets were financed through debt. Interest Coverage Ratio The interest coverage ratio measures how many times earnings covers the interest charges. This measure provides a sense of the buffer the company has in earnings in order for its earnings to cover the interest expense. The interest coverage ratio is calculated as follows: Income Before Interest and Income Taxes Interest Expense Best Buy Interest Coverage Ratio 2002 964 28 2001 648 7 = 34.43 = 92.57 Best Buy’s interest coverage ratio has decreased dramatically with the heavier reliance on debt in 2002 relative to 2001. Short Term Liquidity Risk Short term liquidity ratios measure the ability of the firm to pay off debts that will be coming due in a short time period. The current ratio and the quick ratio are commonly used measures of short-term liquidity risk. Current Ratio The current ratio measures whether the firm has sufficient current assets to pay its current liabilities. The balance sheet disaggregates the firm’s assets and liabilities into their current and long-term components. The current ratio provides the ratio of current assets to current liabilities. The ratio is calculated as follows: Current Assets Current Liabilities Best Buy Current Ratio 2002 4611 3730 2001 2929 2715 = 1.24 = 1.08 Best Buy’s current ratio is relatively low. Analysts often suggest that the current ratio of a healthy company should be approximately 2.0. While Best Buy’s current ratio is well below 2.0, note that Best Buy’s current ratio has increased from 2001 to 2002. Quick Ratio The quick ratio measures whether the firm has enough assets that can quickly be converted to cash to meet current liabilities. The quick ratio only includes cash, marketable securities and receivables in the numerator of the ratio. The quick ratio is calculated as follows: Cash + Marketable Securities + Receivables Current Liabilities Best Buy Quick Ratio 2002 1855+247 3730 2001 747+209 2715 = 0.56 = 0.35 Best Buy also has a relatively low quick ratio. Analysts generally suggest that a healthy company should have a quick ratio of approximately 1.0. The lack of quick assets could hamper the ability of the firm to meet current obligations as they come due. Other Measures of Liquidity Analysts often use other measures to assess a firm’s liquidity. Often the profitability ratios also provide evidence on the firm’s ability to meet obligations as they come due. Working Capital Working capital is the firm’s current assets minus current liabilities. While the current ratio reports the current assets relative to current liabilities as a ratio, working capital provides a dollar value of the difference between current assets and current liabilities. Best Buy Working Capital 2002 4611-3730 = $881 2001 2929 – 2715 =$214 Turnover Ratios The more quickly a company sells its inventory and collects from customers, the more able it is to generate the cash necessary to pay liabilities as they come due. Therefore, a firm with a small number of days that sales are outstanding and a small number of days that inventory is on hand is more likely to be able to generate cash quickly to pay current liabilities as they come due. Often analysts calculate a firm’s operating cycle as the days’ inventory on hand plus the days’ sales outstanding. The longer the operating cycle, the higher the risk that the firm will not be able to generate the cash necessary to meet current liabilities. Operating Cycle = Days Sales’ Outstanding + Days’ Inventory on Hand Best Buy Operating Cycle 2002 4 days + 51 days = 55 days 2001 5 days + 44 days = 49 days Cash Flows from Operations If a firm is generating cash from operating its business, it is more likely to be able to obtain the cash necessary to meet its liabilities as they come due. Therefore, analysts often examine the cash flows from operations in order to assess the risk of meeting current liabilities. Best Buy CFO 2002 1578 2001 808 Best Buy generated $1,578 in cash flows from operations during the year. The cash flows from operations have increased from 2001 to 2002. How is Best Buy doing? If you recall, Best Buy had increasing income and increasing sales. The ratios allow us to determine the sales and income relative to the assets and book value that the firm had available to generate income and sales. 2002 Return on assets: Profit margin: Total asset turnover: Days AR outstanding: Days Invent on hand: 9.63% 3.00% 3.21 4 days 51 days 2001 10.22% 2.61% 3.92 5 days 44 days Plant Asset turnover: Return on equity: Debt/Asset: Current ratio: Quick ratio: 11.73 26.25% 11.12% 1.24 0.56 14.31 27.14% 6.12% 1.08 0.35 While Best Buy did have large increases in sales and earnings in 2002, it did not have increases in profitability. Best Buy also had high growth in its assets and debt in 2002. Taking into account the assets that Best Buy had to use during 2002, Best Buy looks less profitable in 2002 relative to 2001 per dollar of invested assets and book value. In addition, its key drivers of operations have become less productive. In particular, Best Buy had more difficulty in 2002 in selling inventory and generated fewer sales per dollar of plant assets. Ratio analysis leaves one with more insight into Best Buy and its changes over the year. Required: Given the review of the ratios above, calculate and interpret the following ratios for Southwest Airlines (assume a tax rate of 35% for both years): a. b. c. d. e. Return on Assets Asset Turnover Profit Margin Return on Equity Debt to Asset Ratio Southwest Airlines Income statement (in millions) Revenue Expenses: Salaries, Wages, Benefits Aircraft Costs Depreciation and Amortization Other Operating Expenses Operating Income Other Income Interest Expense Income Before Taxes Income tax expense Net Income 2005 $7,584 2,702 2,389 469 1,204 820 176 122 874 326 $548 2004 $6,530 2,443 2,044 431 1,058 554 23 88 489 176 $313 Southwest Airlines Balance Sheet (in millions) Cash Receivables Inventories Other Current Assets Total current assets PPE (net) Other Assets Total assets Accounts payable Other liabilities Debt Total liabilities Contributed Capital Retained Earnings TSE TL and SE 2005 $2,280 258 150 932 3,620 9,427 1,171 $14,218 $524 5,024 1,995 7,543 2,118 4,557 6,675 $14,218 2004 $1,048 248 137 739 2,172 8,723 442 $11,337 $420 3,547 1,846 5,813 1,435 4,089 5,524 $11,337 EXCERPTS FROM BEST BUY’S 2002 ANNUAL REPORT