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Document Sample
Buyer Analysis of Financial
Statements
November 12, 2009
Bill Michels
1
Exercise: Whom would you target for
renegotiation?
Supplier A B C D
Revenue 20,000 30,000 40,000 10,000
Gross Profit 7,000 12,000 12,000 5,000
Operating Profit 1,500 3,000 2,000 1,500
Your Spend 4,000 10,000 2,000 8,000
NB: All Values in $ks
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2
Exercise: Whom would you target for
renegotiation?
Supplier A B C D
Revenue 20,000 30,000 40,000 10,000
Gross Profit 7,000 12,000 12,000 5,000
Operating Profit 1,500 3,000 2,000 1,500
GP% 35% 40% 30% 50%
EBITDA% 8% 10% 5% 15%
Your Spend 4,000 10,000 2,000 8,000
Leverage % 20% 33% 5% 80%
NB: All Values in $ks
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3
A Typical P&L
Notes Current Yr Previous Yr
Revenue 10,685,117 9,148,501
Cost of sales -5,673,350 -5,245,164
Gross profit 5,011,767 3,903,337
Distribution costs -1,462,548 -1,164,249
Administrative expenses -2,430,634 -1,840,122
Other operating income 12,000
Operating profit 2 1,130,585 898,966
Exceptional items
(loss)/profit on the disposal of tangible fixed assets 3 -3,063 667
1,127,522 899,633
Interest payable 6 -205,063 -121,109
Profit on ordinary activities before tax 922,459 778,524
Tax on profit on ordinary activities 7 -293,224 -218,783
Profit for the financial year 629,235 559,741
Dividends:
Ordinary dividend on equity shares -252,000
Retained earnings for the financial year 19 377,235 559,741
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4
Look at the P&L Again Notes Current Yr Previous Yr
Revenue 10,685,117 9,148,501
Cost of sales -5,673,350 -5,245,164
Gross profit 5,011,767 47% 3,903,337 43%
Distribution costs -1,462,548 -1,164,249
Administrative expenses -2,430,634 -1,840,122
Other operating income 12,000
Operating profit 2 1,130,585 11% 898,966 10%
Exceptional items
(loss)/profit on the disposal of tangible fixed assets 3 -3,063 667
1,127,522 899,633
Interest payable 6 -205,063 -121,109
Profit on ordinary activities before tax 922,459 778,524
Tax on profit on ordinary activities 7 -293,224 -218,783
Profit for the financial year 629,235 6% 559,741 6%
Dividends:
Ordinary dividend on equity shares -252,000
Retained earnings for the financial year 19 377,235 4% 559,741 6%
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5
Buyer Analysis of Financial Statements
Planning and Data Gathering
Learning Objectives
After completing this section,
you will be able to:
• Define supplier financial analysis
• Identify the uses of supplier financial analysis
• Determine supplier assessments needed to support
analysis
• Identify key questions to ask
• Explain what information is required to perform an analysis
• Identify sources of required information
Topic Menu
• Introduction to supplier financial analysis
• Determine use of the analysis
• Identify key financial assessments
• Ask the right questions
• Determine information needed
• Identify sources of information
Defining Supplier Financial Analysis
Conducting a supplier financial
analysis amounts to analyzing a
supplier’s financial information for the
purpose of determining:
• The supplier’s current financial
condition—how financially strong the
supplier is at a point in time, and
• The supplier’s financial performance—
how the supplier has performed
financially over a period of time.
Defining Supplier Financial Analysis
Reasons for the growing importance include:
• Increasing competition, both domestically and globally
• Dependence on suppliers for critical inputs once produced
in-house
• Pressure to search globally for the lowest-cost/highest-
value sources of goods and services
• Growing use of long-term “partnering” commitments to
suppliers
• Investor demands for higher returns in a shorter period of
time
• Constant pressure to reduce the cost of all purchased
inputs
Supplier Financial Analysis Process
Step 1 Determine Use of the Analysis
Step 2 Identify Key Financial Assessments
Step 3 Ask the Right Questions
Step 4 Determine the Information Needed
Step 5 Identify Sources of Information
Step 6 Analyze Data
Supplier Financial Analysis Process
Step 1 Determine Use of the Analysis
• Uses of Supplier Financial Analysis
• Supplier selection
• Negotiation
• Cost reduction
• Target setting
• Risk management
Supplier Financial Analysis Process
Step 2 Identify Key Financial Assessments
Key Financial Assessments
• The risk of doing business with new and existing suppliers
• Opportunity for reducing a supplier’s costs
• Current and historical financial performance
• Operating trends, such as growth or decline in sales and profits
• Supplier's ability to meet cost reduction objectives
• Cash needs for achieving a higher level of growth
• Reasonableness of revenue forecasts
• Impact of acquisitions
• "What-if" scenarios
Opportunity for Reducing Current and Historical
Supplier’s Cost Financial Performance
Supplier Financial Analysis Process
Step 3 Ask the Right Questions
• How strong and stable is the supplier now?
• Will this supplier be in business next month/year?
• How efficiently does this supplier operate?
• In which areas of the supplier’s cost structure are there opportunities to
reduce cost?
• How does the performance of this supplier compare to that of others in
the industry?
• Has the supplier the financial ability to expand?
• Has the supplier the resources to support its own suppliers?
• What other companies make up the supplier's customer base?
• Are these organizations financially stable?
• If any of these organizations went out of business, how would the supplier
be affected?
Break Out Session
• In 5 groups take about 15 minutes and
brainstorm what financial information is
required from a financial perspective to
enable a category manager to do their job
• Elect a spokesperson and prepare your
findings for the group
Supplier Financial Analysis Process
Step 4 Determine the Information Needed
Examples of Information Needed
• Ownership
• Financial structure
• Trends in financial performance
• Profitability
• Returns on capital employed
• Cash generation/flow
• Employees – Numbers and remuneration, absolute and
trends
• Other “interesting” facts
Buyer Analysis of Financial Statements
Sources of Information
17
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company?
or
Private
Company?
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
•Annual reports
•SEC reports
•Financial statements
•3rd party sources of information
Public
or Private Company Information
•Ask company officers for information
Private? •Commercial credit reports and publications
•Your own organization
•Industry experts and public interest groups
•Industry and trade associations
•Labor unions
•Local universities
•Local sources
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
•Annual reports
•SEC reports
•Financial statements
•3rd party sources of information
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
Annual Reports
•Letter to stockholders
•Products and markets
•Summary of financial data (usually for three, five, or 10 years)
•Management discussion and analysis of operations
•Independent auditor’s letter
•Detailed financial statements (with notes)
•List of subsidiaries, brand names, and addresses
•List of directors and officers
•History of stock prices
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
SEC Reports
10-K Report
• Business
• Risk factors
• Legal proceedings
• Market for the company’s common equity, related stockholder matters and issuer
purchases of equity securities
• Selected financial data
• Management's discussion and analysis of financial conditions and results of
operations
• Quantitative and qualitative disclosures about market risk
• Financial statements and supplementary data
• Exhibits and financial statement schedules
• Consolidated financial information
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
Financial Statements
•Balance sheet
•Income statement
•Statement of cash flows
Pay Attention To
•Specific accounting period
•Ensure comparing data for the same accounting period
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
Financial Statements
•Balance sheet
•Income statement
•Statement of cash flows
Assets – Liabilities = Shareholder’s Equity
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
Financial Statements
•Balance sheet
•Income statement
•Statement of cash flows
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
Financial Statements
•Balance sheet
•Income statement
•Statement of cash flows
•Notes to financial statements
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
3rd Party Sources of Information
•Commercial credit reports and publications
•Online databases
•State and federal governments
•Interviews and visual inspections
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
3rd Party Sources of Information
•Commercial credit reports and publications
•Dunn & Bradstreet
•Credit Risk Monitor
•Standard and Poor’s
www.dnb.com
www.crmz.com www.standardandpoors.com
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
3rd Party Sources of Information
•Online databases
•LexisNexis.com
•Factiva.com
•Hoovers.com
www.factiva.com
www.hoovers.com www.lexisnexis.com
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
3rd Party Sources of Information
•State and federal governments
•The U.S. Government Manual
•Secretary of State’s Office
•Local, district and federal courts
http://www.gpoaccess.gov/gmanual/index.html
http://pacer.psc.uscourts.gov/
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Public Company Information
3rd Party Sources of Information
•Interviews and Visual Inspections
•Stockbrokers or professionals who track the industry
•Trade association personnel
•Journalists and news reporters
•Local government officials—especially for small regional organizations
•The organization's receptionist and manager's administrative assistant
•The organization's warehouse personnel
•Others that come in contact with the organization on a day-to-day basis
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Private Company Information
•Ask company officers for information
•Commercial credit reports and publications
•Your own organization
•Industry experts and public interest groups
•Industry and trade associations
•Labor unions
•Local universities
•Local sources
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Private Company Information
Your Own Organization
•Your credit department
•Your organization’s sales representatives
•Your peers in strategic sourcing and procurement
•Your human resources department
•Your general counsel’s office
Credit Sales Strategic Human Legal
Department Department Sourcing Resources Department
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Private Company Information
Industry Experts and Public Interest Groups
•Financial analysts
•Press reporters – Newspapers, trade magazines
•Public interest groups – e.g. Sierra Club
•Who would want to know what I want to know?
•Who would care enough to collect the information?
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Private Company Information
Industry and Trade Associations
•Industry and market studies
•Source of key experts
Labor Unions
•Wage rates
•Outsourcing actions
•www.bls.gov
Local Universities
•Industry watchers and researchers
•Faculty – ad hoc consultants
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Private Company Information
Local Sources
•Local Media
•Local Libraries
•Chamber of Commerce
•Local Utilities, Real Estate Agents, Controllers of Industrial
Tracts
•Temporary Employment Agencies
Supplier Financial Analysis Process
Step 5 Identify Sources of Information
Obtaining Information on Foreign Companies
• The International Chamber of Commerce.
•www.iccwbo.org/
• The Export-Import Bank of the United States.
•www.exim.gov/
• Embassies, consulates, national trade development
departments or councils, and national trade associations
•Search the internet
www.iccwbo.org/ www.exim.gov/
Summary: Supplier Financial Analysis
Planning and Data Gathering
Step 1 Determine Use of the Analysis
Step 2 Identify Key Financial Assessments
Step 3 Ask the Right Questions
Step 4 Determine the Information Needed
Step 5 Identify Sources of Information
Breakout Session
• You will be given an Annual Report, 10K, news
for a company
• In your breakout group, read the data, analyze
the data and develop a financial analysis of
the company
• Elect a spokesperson and prepare to provide a
presentation of your findings to the group
Step 6 Analyze Data
Buyer Analysis of Financial Statements
Supplier Financial Analysis Process
40
Learning Objectives
Step 6 Analyze Data
• After completing this section,
you will be able to:
• Explain financial statement basics
• Describe how to use financial ratios
• List relevant financial ratios
• Demonstrate how to calculate key financial ratios
and explain the meaning of each
Topic Menu
Step 6 Analyze Data
• Financial statement basics
• Using financial ratios
• Relevant financial ratios
• Key financial ratios – descriptions, calculations and
meaning
Supplier Financial Analysis Process
• How to Analyze Supplier Financial Data
• Financial statement basics
• Using financial ratios
• Relevant financial ratios
• Key financial ratios and their meaning
Supplier Financial Analysis Process
Financial Statement Basics
• Balance sheet
• Income statement
• Statement of cash flows
The balance sheet provides a "snapshot" of the
Balance Sheet organization's financial position
—its financial resources and obligations — at a single
Basics point in time.
Total Assets = Total Liabilities + Shareholder’s Equity
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Balance Sheet Basics
What Does Each Line Mean?
• Current assets
• Accounts receivable
• Inventories
• Fixed assets
• Total assets
• Current liabilities
• Accounts payable
• Short-term debt
• Long-term debt
• Total debt or Total Liabilities
• Shareholder’s equity
Supplier Financial Analysis Process
Financial Statement Basics
• Balance sheet
• Income statement
• Statement of cash flows
Income Statement
Basics Revenue $
Current Year
10,685,117 $
Previous Year
9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Shows the results of Gross profit 5,011,767 3,903,337
a business’s
activities over a Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
given time period— Depreciation expense (252,330) (234,500)
such as a month, Other operating income 12,000
Operating profit 1,278,255 664,466
quarter or year.
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Income Statement Basics
What Does Each Line Mean?
• Revenue • Distribution
• Sales • Handling
• Customers spend • Warehousing
• Cost of sales • Transportation/shipping
• Direct costs • Admin expenses
• Variable costs • Fixed costs
• Labor and materials • Depreciation
• Gross profit • Salaries
• Gross margin • Rent and associated fees
• Variable profit • Maintenance
• Profit after costs of sales • Operating profit
• Other income • EBITDA (earnings before
• Profits from investments interest, tax, depreciation/
royalties, etc. amortization)
Income Statement Basics
What Does Each Line Mean?
• Exceptions • Profit for financial year
• Profit from sales of assets
• Net profit
• Restructuring costs
• Items not associated with trading • Dividends
and infrequent • Payments to shareholders
• Interest
• Payments to banks and others for
• Retained profit
capital borrowed • Value added to the balance sheet
• Debt finance • Goes into P&L reserves
• Profit on ordinary activities • Increase in shareholders’ equity
before tax
• Profit before tax
• Tax of profit on ordinary activities
• Payment to IRS/ Inland Revenue
Supplier Financial Analysis Process
Financial Statement Basics
• Balance sheet
• Income statement
• Statement of cash flows
Cash Flow from Operations
Statement of Cash Net Income
Accounts Receivable
$ 436,000
(194,000)
Flows Basics Inventory
Prepaid Expenses
(170,000)
(44,000)
Other Current Assets -
Depreciation Expense 24,000
Accounts Payable, Trade (12,000)
The Statement of Cash Flows Accounts Payable, Other (18,000)
is a sources and uses of funds Accrued Expenses (30,000)
Income Tax Payable 20,000
statement which identifies Other Current Liabilities -
where cash came from—such __________
Total Cash Flow from Operations $ 12,000
as cash flow from Cash Flow from Investing
operations—on the balance Land, Buildings, Equipment $ (64,000)
sheet and income statements, Other Assets 20,000
__________
and how it was used during Total Cash Flow from Investing $ (44,000)
the reporting period. Cash Flow from Financing
Short-Term Debt $ 40,000
Long-Term Debt 150,000
Net Change in Cash 16,000
Capital Stock -
Other Equity -
Dividend Payments (142,000)
__________
Total Cash Flow from Financing $ 64,000
Net Change in Cash $ 32,000
Statement of Cash Flows Basics
What Does Each Line Mean?
• Operating activities
• Investing activities
• Financing activities
• Net change in cash
Step 6 Analyze Data
Buyer Analysis of Financial Statements
Financial Ratio Analysis
Using Financial Ratios
54
Supplier Financial Analysis Process
Using Financial Ratios
Financial Ratio Analysis Basics
Three comparisons are made using ratio analysis:
1. Make a comparison against existing competitor
ratios.
2. Make a comparison against an industry standard or
average.
3. Compare the ratios against themselves to determine
changes within the organization over a three-to-five-
year period.
Supplier Financial Analysis Process
Using Financial Ratios
Financial Ratio Analysis Basics
Guiding Principles and Limitations of Financial
Ratios:
• Always keep in mind that relative analysis and trends
are important. Ratios provide meaning when
compared to prior periods, to competitors, or to
industry average.
• Use the same time period in making any comparison
• Use audited financial information whenever possible
• No single ratio will provide sufficient information to
make a valid judgment about the financial stability of
an organization
Supplier Financial Analysis Process
Relevant Financial Ratios
• Efficiency (Operational) ratios
• Liquidity (Solvency) ratios
• Profitability ratios
• Leverage ratios
Supplier Financial Analysis Process
Key Financial Ratios and Their Meaning
Efficiency Ratios
• Inventory turnover ratio
• Days receivable ratio
• Days payable ratio
Supplier Financial Analysis Process
Key Financial Ratios and Their Meaning
Efficiency Ratios
• Inventory turnover ratio
• Days receivable ratio
• Days payable ratio
Inventory Turnover Ratio
What is it?
The inventory turnover ratio is a measure of how
many times the company’s finished goods inventory
is sold and replaced over a period— typically one
year. The higher the turnover ratio, the more
efficient is the company in converting its investment
in inventory (products to sell) into sales revenue
(cash or accounts receivable).
Inventory Turnover Ratio
• How is it calculated?
Cost of Goods Sold
Inventory Turnover Ratio = Average Inventory
Source of Data
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net Profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Inventory Turnover Ratio
Sample calculation
Cost of Goods Sold
Inventory Turnover Ratio = Average Inventory
Assume the following two scenarios for Company A in a year:
Cost of goods sold equaled $100,000
Scenario 1:
•Average inventory was $50,000
•Inventory ‘turned over’ two times ($100,000/$50,000 = 2)
Scenario 2:
•Average inventory was $10,000
•Inventory ‘turned over’ ten times ($100,000/$10,000 = 10)
Inventory Turnover Ratio
What does it mean?
• Investment of capital in any asset — whether it be inventory, a new
production machine or a new information system — represents a
cost to the firm in the form of either the cost of the capital (if
borrowed) or an opportunity cost (if owner’s equity).
• A lower inventory turnover ratio compared to a prior period, a
competitor, or an industry average indicates that either the firm is
experiencing trouble in selling its products or that it is inefficient in
sales forecasting, buying products, or production planning —
relative to the benchmark.
• In general, the longer product is held in inventory, the greater is the
risk that its value will decrease due to damage or obsolescence.
• Excessive inventory is typically costly to hold and maintain, and can
lead to cash flow difficulties
Supplier Financial Analysis Process
Key Financial Ratios and Their Meaning
Efficiency Ratios
• Inventory turnover ratio
• Days receivable ratio
• Days payable ratio
Days Receivable Ratio
What is it?
The days receivable ratio measures how many days it
takes the organization to receive payment for goods
sold or services performed. It is a measure used to
quantify a firm's effectiveness in extending credit to
customers and collecting these debts. By maintaining
accounts receivable, firms are indirectly extending
interest-free loans to their clients. The faster accounts
receivable are converted to cash the greater the ability
of the organization to meet its current liabilities.
Days Receivable Ratio
How is it calculated?
Annual Net Credit Sales
Days Receivable
Ratio
= 365 ÷ Average Accounts
Receivable
Source of Data
Annual Net Credit Sales
Days Receivable Ratio = 365 ÷ Average Accounts Receivable
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data
Annual Net Credit Sales
Days Receivable Ratio = 365 ÷ Average Accounts Receivable
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Days Receivable Ratio
Sample calculation
Annual Net Credit Sales
Days Receivable Ratio = 365 ÷ Average Accounts Receivable
For example; assume the following two scenarios for Company A in a year:
Sales equaled $1,000,000
Scenario 1:
•Average accounts receivable was $250,000
•Divide sales of $1,000,000 by average accounts receivable of $250,000 to arrive at an
accounts receivable ratio of 4.
•Next divide 365 by 4, which equals 91.25.
•It takes 91.25 days to receive payment from customers.
Scenario 2:
•Average accounts receivable was $100,000
•Divide sales of $1,000,000 by average accounts receivable of $100,000 to arrive at an
accounts receivable ratio of 10.
•Next divide 365 by 10, which equals 36.5.
•It takes 36.5 days to receive payment from customers.
Days Receivable Ratio
What does it mean?
• Be aware that some companies' reports will not separate total sales into
credit sales and cash sales. This can affect the ratio depending on the size
of cash sales.
• Receivables are an asset to the firm and a use of working capital. The days
receivables ratio measures how efficiently a firm uses this asset.
• A low ratio implies either that a company operates on a cash basis or that
its extension of credit and collection of accounts receivable is efficient.
• A high value may indicate customers have payment issues and there is
potential for bad debts
• A high ratio implies the company should re-assess its credit policies in
order to ensure the timely collection of credit.
• Outstanding credit represents working capital that is not earning interest.
• Poor management of accounts receivable can create cash flow difficulties
for the firm, jeopardizing the ability to maintain operations and solvency.
Supplier Financial Analysis Process
Key Financial Ratios and Their Meaning
Efficiency Ratios
• Inventory turnover ratio
• Days receivable ratio
• Days payable ratio
Days Payable Ratio
What is it?
The days payable ratio calculates the average number
of days it takes a company to pay its suppliers for goods
and services. Accounts payable represent indirect
interest free loans from suppliers. To maximize cash
flow companies withhold payments to suppliers as long
as permissible according to agreed payment terms. In
that respect, a lower ratio can reflect effective use of
credit. However, a lower ratio could also be an
indication that a firm is having difficulties with cash
flow and paying its debts.
Days Payable Ratio
How is it calculated?
Days Payable Annual Cost of Goods Sold
= 365÷
Ratio Average Accounts Payable
Source of Data
Annual Cost of Goods Sold
Days Payable Ratio = 365 ÷
Average Accounts Payable
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data
Annual Cost of Goods Sold
Days Payable Ratio = 365 ÷
Average Accounts Payable
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Days Payable Ratio
Sample calculation
Annual Cost of Goods Sold
Days Payable Ratio = 365 ÷ Average Accounts Payable
For example; assume the following two scenarios for Company A in a year:
COGS equaled $10,000,000
Scenario 1:
• Average accounts payable was $1,000,000
• Divide COGS of $10,000,000 by average accounts receivable of $1,000,000 to arrive at an accounts payable
ratio of 10.
• Next divide 365 by 10, which equals 36.5.
• In this case the days payable ratio is 36.5 days, which means on average it takes 36.5 days to make
payment to suppliers.
Scenario 2:
• Average accounts payable was $2,000,000
• Divide COGS of $10,000,000 by average accounts receivable of $2,000,000 to arrive at an accounts payable
ratio of 5.
• Next divide 365 by 5, which equals 73.
• In this case the days payable ratio is 73 days, which means on average it takes 73 days to make payment to
suppliers.
Days Payable Ratio
What does it mean?
• Recognize that in using cost of goods sold as a surrogate for
supplier purchases, we knowingly are including costs other than
purchases in our calculation. That is acceptable if we are tracking
trends over time and are making comparisons to firms in the same
industry.
• Watch for trends showing rising number of days as it may indicate
cash flow difficulty and the potential for the company to have its
credit placed on hold.
• Watch for ratios significantly higher or lower than key competitors
or industry averages. A higher ratio could indicate cash flow
difficulties. A lower ratio could indicate unnecessarily fast payment
and poor financial management.
Now It’s Your Turn Step 6 Analyze Data
Calculate – Sprint Nextel
• Inventory Turnover Ratio
• Days Receivable Ratio
• Days Payable Ratio
• Compare to industry average
• What preliminary conclusions can be reached based on
these comparisons?
• What additional information would increase your
confidence in these conclusions?
• What follow up questions and analysis might be
appropriate?
Key Financial Ratios and Their Meaning
• Liquidity Ratios
• Current ratio
• Quick ratio
• Interest coverage ratio
Key Financial Ratios and Their Meaning
• Liquidity Ratios
• Current ratio
• Quick ratio
• Interest coverage ratio
Current Ratio
What is it?
The current ratio, also called the working
capital ratio, measures a company's ability to
pay back its short-term liabilities with short-
term assets. Short-term liabilities include
short-term debt and payables. Current assets
would be cash, inventory and receivables.
Current Ratio
How is it calculated?
Current Assets
Current Ratio = Current Liabilities
Source of Data
Current Assets
Current Ratio =
Current Liabilities
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Source of Data
Current Assets
Current Ratio =
Current Liabilities
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Current Ratio
Sample calculation
Current Assets
Current Ratio =
Current Liabilities
For example; assume the following two scenarios for Company A in a year:
Scenario 1:
•Current assets are $1,500,000.
•Current liabilities are $1,700,000.
•Divide current assets by liabilities ($1,500,000/$1,700,000)
•The current ratio is 0.88:1.
Scenario 2:
•Current assets are $1,700,000
•Current liabilities are $1,100,000
•Divide current assets by current liabilities ($1,700,000/$1,100,000)
•The current ratio is 1.55:1.
Current Ratio
What does it mean?
• The higher the current ratio, the more capable the company is of
paying its obligations.
• A ratio under one suggests that the company would be unable to
pay off its obligations if they came due at that point.
• While a ratio of less than one indicates the company is not in good
financial health, it does not necessarily mean that it will go
bankrupt because there are many ways to access financing.
• A result of two or more could indicate excess cash that could be
invested in improving the business, or it could be the result of high
levels of inventory or accounts receivable, which could be a sign of
trouble.
• A worsening trend could be an early sign of financial difficulty
Key Financial Ratios and Their Meaning
• Liquidity Ratios
• Current ratio
• Quick ratio
• Interest coverage ratio
Quick Ratio
What is it?
The quick ratio is also called the "acid test" ratio.
It is a more stringent variation of the current
ratio, examining only an organization's most
liquid assets. Quick assets are the same as
current assets other than inventory is excluded
because it is more difficult to convert into cash.
The quick ratio helps determine whether or not
an organization can meet its obligations if
adverse sales conditions occur.
Quick Ratio
How is it calculated?
Quick Ratio = Current Assets - Inventory
Current Liabilities
Source of Data
Quick Ratio = Current Assets - Inventory
Current Liabilities
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Source of Data
Quick Ratio = Current Assets - Inventory
Current Liabilities
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Source of Data
Quick Ratio = Current Assets - Inventory
Current Liabilities
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Source of Data
Sample calculation
Quick Ratio = Current Assets - Inventory
Current Liabilities
For example; assume the following two scenarios for Company A in a year:
Scenario 1:
•Current assets equal $1,000,000.
•Inventory equals $200,000.
•Current liabilities equal $600,000.
•Subtract inventory from currently assets, then divide by current liabilities
•The quick ratio equals 1.33:1.
Scenario 2:
•Current assets equal $1,000,000.
•Inventory equals $600,000.
•Current liabilities equal $600,000.
•Subtract inventory from currently assets, then divide by current liabilities
•The quick ratio equals 0.66:1.
Quick Ratio
What does it mean?
• By eliminating inventory as a current asset, we
are assessing the firm’s ability to meet current
liabilities IF sales ceased in the short-term.
• The higher the quick ratio, the more capable the
company is of paying its obligations.
• As a general rule of thumb, the quick ratio should
be between .50 and 1.0 to be considered
satisfactory as long as the collection of
receivables is not expected to be slow.
Key Financial Ratios and Their Meaning
• Liquidity Ratios
• Current ratio
• Quick ratio
• Interest coverage ratio
Interest Coverage Ratio
What is it?
The interest coverage ratio, also known as
‘times interest earned’ is used to determine
how easily a company can pay interest on
outstanding debt. The lower the ratio,
the more the company is burdened by debt
expense.
Interest Coverage Ratio
How is it calculated?
Operating Income
Interest Coverage Ratio = Interest Expense
Source of Data Operating Income
Interest Coverage Ratio =
Interest Expense
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data Operating Income
Interest Coverage Ratio =
Interest Expense
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Interest Coverage Ratio
Sample calculation
Operating Income
Interest Coverage Ratio =
Interest Expense
For example; assume the following two scenarios for Company A in a year:
Scenario 1:
•Operating income equals $10,000,000
•Interest expense equals $6,000,000
•Divide operating income by interest expense ($10,000,000/$6,000,000)
•Interest coverage ratio equals 1.67:1
Scenario 2:
•Operating income equals $10,000,000
•Interest expense equals $11,000,000
•Divide operating income by interest expense ($10,000,000/$11,000,000)
•Interest coverage ratio equals 0.91:1
Interest Coverage Ratio
What does it mean?
• When a company's interest coverage ratio is
1.5 or lower, its ability to meet interest expenses
may be questionable.
• An interest coverage ratio below 1 indicates the
company is not generating sufficient income to
satisfy interest expenses.
• Low ratios may mean suppliers are vulnerable to
interest rate rises, falling sales, or cost increases
Now It’s Your Turn Step 6 Analyze Data
Calculate – Aegis Group PLC
• Current Ratio
• Quick Ratio
• Interest Coverage Ratio
• Compare to industry average
• What preliminary conclusions can be reached based on
these comparisons?
• What additional information would increase your
confidence in these conclusions?
• What follow up questions and analysis might be
appropriate?
Key Financial Ratios and Their Meaning
• Profitability Ratios
• Gross Profit Margin %
• Operating Profit Margin %
• Net Profit Margin %
• Return on Shareholder’s Equity
Key Financial Ratios and Their Meaning
• Profitability Ratios
• Gross Profit Margin %
• Operating Profit Margin %
• Net Profit Margin %
• Return on Shareholder’s Equity
Gross Profit Margin %
What is it?
• Gross profit margin percentage is a measure that
indicates the proportion of money left over from
revenues after accounting for the cost of goods sold.
• If gross profit margin is 60%, then we know that for
each $1.00 of sales, 40% or $.40 is used to pay for
direct materials and labor (COGS), and 60% or $.60 is
left to pay all other operating expenses, interest, taxes
and hopefully have some amount remaining for profit.
Gross Profit Margin %
How is it calculated?
Gross Profit Margin % = Revenue - COGS
Revenue
Source of Data Revenue - COGS
Gross Profit Margin % =
Revenue
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data Revenue - COGS
Gross Profit Margin % =
Revenue
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Gross Profit Margin %
Sample calculation
Revenue - COGS
Gross Profit Margin % =
Revenue
For example; assume the following for Company A in a year:
•Revenue equals $10,000,000
•Cost of goods sold equals $8,000,000
•Subtract cost of goods sold from revenue, and then
divide that number by revenue
($10,000,000 - $8,000,000)/$10,000,000
•Gross profit margin equals 20%
Gross Profit Margin %
What does it mean?
• Low %’s may indicate one or both of the following:
• A highly competitive market that limits the ability of the
firm to increase price
• Inefficiencies in cost of goods sold —the cost of direct
materials and labor used in the production of the product
is excessive — which could be due to the prices paid for
these direct inputs, and/or due to using excessive
quantities of these inputs
• Low %’s may mean they are failing to generate enough
gross profit to cover their other operating and fixed
costs
Key Financial Ratios and Their Meaning
Profitability Ratios
• Gross Profit Margin %
• Operating Profit Margin %
• Net Profit Margin %
• Return on Shareholder’s Equity
Operating Profit Margin %
What is it?
Operating profit margin percentage is a measure
that indicates the proportion of money left over
from revenues after accounting for all costs
incurred in operating the normal core business.
Operating costs would include cost of goods sold
as well as all indirect costs such as depreciation,
sales, distribution and general administration
costs. Operating income and EBIT are synonyms
for operating profit.
Operating Profit Margin %
How is it calculated?
Operating Profit
Operating Profit Margin % =
Revenue
Source of Data Operating Profit
Operating Profit Margin % =
Revenue
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data Operating Profit
Operating Profit Margin % =
Revenue
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Operating Profit Margin %
Sample calculation
Operating Profit
Operating Profit Margin % =
Revenue
For example; assume the following for Company A in a year:
•Revenue equals $20,000,000
•Operating profit equals $1,000,000
•Divide operating profit by revenue ($1,000,000/$20,000,000)
•Operating profit margin equals 5%.
Operating Profit Margin %
What does it mean?
• Indicates company’s ability to manage its
manufacturing /service delivery operations and its
overheads
• Low operating profit margin percentage could indicate:
• A highly competitive market that limits the ability of the
firm to increase price and generate more revenue
• Inefficiencies in one or more elements of its operating cost
structure — COGS, conversion/manufacturing costs,
administration costs, distribution costs and so forth.
• Falling sales that are driving up fixed per unit costs
Key Financial Ratios and Their Meaning
Profitability Ratios
• Gross Profit Margin %
• Operating Profit Margin %
• Net Profit Margin %
• Return on Shareholder’s Equity
Net Profit Margin %
What is it?
• Net profit margin percentage is a measure of a firm’s
profitability after subtracting all operating expenses,
interest payments and taxes, but before accounting for
any dividends distributions. Net profit or net income is
the “bottom line” number.
• If net profit margin is 5%, then we know that for each
$1.00 of sales, 95% or $.95 is used to pay for operating
expenses, interest and taxes, and 5% or $.05 is left for
profit.
Net Profit Margin %
How is it calculated?
Net Profit
Net Profit Margin % = Revenue
Source of Data
Net Profit
Net Profit Margin % =
Revenue
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data
Net Profit
Net Profit Margin % =
Revenue
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Net Profit Margin %
Sample calculation
Net Profit
Net Profit Margin % =
Revenue
For example; assume the following for Company A in a year:
•Revenue equals $20,000,000
•Net profit equals $500,000
•Divide net profit by revenue ($500,000/$20,000,000)
•Net profit margin equals 2.5%.
Net Profit Margin %
What does it mean?
• Indicates company’s ability to manage its
manufacturing /service delivery operations and its
overheads
• Low net profit margin percentage could indicate:
• A highly competitive market that limits the ability of the
firm to increase price and generate higher revenues
• Inefficiencies in one or more elements of its operating cost
structure — conversion/manufacturing costs,
administration costs, distribution costs and so forth
• Perhaps excessively high interest or tax expense
Key Financial Ratios and Their Meaning
Profitability Ratios
• Gross Profit Margin %
• Operating Profit Margin %
• Net Profit Margin %
• Return on Shareholder’s Equity
Return on Shareholder’s Equity
What is it?
Return on equity is a measure of a company’s
profitability that indicates how much profit is
generated with the money shareholders or
owners have invested.
Return on Shareholder’s Equity
How is it calculated?
Net Profit
Return on Shareholder’s Equity =
Shareholder’s Equity
Source of Data Net Profit
Return on Shareholder’s Equity =
Shareholder’s Equity
Income Statement
Current Year Previous Year
Revenue $ 10,685,117 $ 9,148,501
Cost of goods sold (5,673,350) (5,245,164)
Gross profit 5,011,767 3,903,337
Distribution costs (1,462,548) (1,164,249)
Administrative expenses (2,030,634) (1,840,122)
Depreciation expense (252,330) (234,500)
Other operating income 12,000
Operating profit 1,278,255 664,466
Exceptional items
(loss)/profit on the disposal of tangible fixed assets (3,063) 667
Interest payable (205,063) (121,109)
Profit on ordinary activities before tax 1,070,129 544,024
Tax on profit on ordinary activities (293,224) (218,783)
Net profit (Profit for the financial year) 776,905 325,241
Dividends:
Ordinary dividend on equity shares (252,000)
Retained earning for the financial year $ 524,905 $ 325,241
Source of Data Net Profit
Return on Shareholder’s Equity =
Shareholder’s Equity
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Return on Shareholder’s Equity
Sample calculation
Net Profit
Return on Shareholder’s Equity =
Shareholder’s Equity
For example; assume the following for Company A in a year:
•Net income equals $50,000,000
•Shareholder’s equity equals $500,000,000
•Divide net income by shareholder’s equity
($50,000,000/$500,000,000)
•Return on equity equals 10%
Return on Shareholder’s Equity
What does it mean?
• Indicates the company’s performance in earning
net profit in relation to the shareholder or owner-
supplied capital (money) used to operate the
business
• Provides a good benchmark to target
improvement in others (and sharing of benefit)
• A reducing trend may indicate a competitive
market, falling sales or increasing costs or more
capital being required to operate the business
Now It’s Your Turn Step 6 Analyze Data
Calculate – Thomson SA
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin
• Return on Equity
• Compare to industry average
• What preliminary conclusions can be reached based on
these comparisons?
• What additional information would increase your
confidence in these conclusions?
• What follow up questions and analysis might be
appropriate?
Key Financial Ratios and Their Meaning
Leverage Ratios
• Debt-to-Equity Ratio
Key Financial Ratios and Their Meaning
Leverage Ratios
• Debt-to-Equity Ratio
Debt-to-Equity Ratio
What is it?
The debt to equity ratio is a measure of a
company's financial leverage calculated by
dividing its total liabilities by stockholders'
equity. It indicates what proportion of equity
and debt the company is using to finance its
assets.
Debt-to-Equity Ratio
How is it calculated?
Total Liabilities
Debt-to-Equity Ratio =
Shareholder’s Equity
Source of Data
Total Liabilities
Debt-to-Equity Ratio =
Shareholder’s Equity
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Source of Data
Total Liabilities
Debt-to-Equity Ratio =
Shareholder’s Equity
Balance Sheet
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash and cash equivalents $ 3,448,891 Accounts payable $ 6,301,442
Accounts Receivable 5,954,588 Taxes payable 1,672,000
Inventories 12,623,412 Accrued expenses 640,407
Prepaid Expense 388,960 Short-term debt 300,000
Other current assets 235,221 Other current liabilities 205,240
Total Current Assets $ 22,651,072 Total Current Liabilities $ 9,119,089
Fixed Assets Long-Term Liabilities
Property, plant and equipment 26,945,848 Long-term debt 2,500,000
Less: Accumulated Depreciation 13,534,069 Issued debt securities 300,000
Net property, plant and equipment 13,411,779 Deferred tax liability 200,000
Goodwill 110,000 Total Long-Term Liabilities 3,000,000
Other intangible fixed assets 63,214
Total Fixed Assets 13,584,993 Total Liabilities 12,119,089
Shareholder's Equity
Paid-in capital 5,000,000
Retained earnings 19,116,976
Total Shareholder's Equity 24,116,976
Total Assets $ 36,236,065 Total Liabilities and Shareholder's Equity $ 36,236,065
Debt-to-Equity Ratio
Sample calculation
Total Liabilities
Debt-to-Equity Ratio =
Shareholder’s Equity
For example; assume the following for Company A in a year:
•Total debt equals $500,000,000
•Total shareholder’s equity equals $300,000,000
•Divide total debt by total equity ($500,000,000/$300,000,000)
•Debt to equity ratio equals 1.67.
Debt-to-Equity Ratio
What does it mean?
• To what extent a company is using external (non-
shareholder) funds to manage the business.
• Highly leveraged companies may be funding growth or
be unwilling to dilute share ownership or may be failing
to generate sufficient income to meet its costs
• Relative analysis and trends are important, unless
growing steady improvement (a lowering trend) is
expected
• Highly leveraged companies may be vulnerable to
interest rate rises, falling sales, cost increases
Now It’s Your Turn Step 6 Analyze Data
Calculate – MeadWestvaco
• Debt-to-Equity Ratio
• Compare to industry average
• What preliminary conclusions can be reached based
on these comparisons?
• What additional information would increase your
confidence in these conclusions?
• What follow up questions and analysis might be
appropriate?
Cash Flow Analysis Step 6 Analyze Data
• When business operations create more cash
than they use, they have “positive cash flow”
• When business operations use more cash than
they create, they have “negative cash flow”
Cash Flow Analysis
When a business is not producing a positive
cash flow, the rate at which it uses up its cash
resources is known as “cash burn”
Cash Flow Analysis
Two key questions regarding cash flow:
1. Generating positive operating cash flow?
2. Cash burn rate?
Cash Flow Analysis Cash Flow from Operations
Net Income $ 436,000
Accounts Receivable (194,000)
Inventory (170,000)
Prepaid Expenses (44,000)
Other Current Assets -
Depreciation Expense 24,000
Accounts Payable, Trade (12,000)
Accounts Payable, Other (18,000)
Accrued Expenses (30,000)
Income Tax Payable 20,000
Other Current Liabilities -
Generating positive Total Cash Flow from Operations $
__________
12,000
operating cash flow? Cash Flow from Investing
Land, Buildings, Equipment $ (64,000)
Other Assets 20,000
__________
Total Cash Flow from Investing $ (44,000)
Cash Flow from Financing
Short-Term Debt $ 40,000
Long-Term Debt 150,000
Net Change in Cash 16,000
Capital Stock -
Other Equity -
Dividend Payments (142,000)
__________
Total Cash Flow from Financing $ 64,000
Net Change in Cash $ 32,000
Cash Flow Analysis
If operating cash flow is negative, what is the
cash burn rate and are there sufficient cash
resources to sustain that rate until operations
return to positive cash flow?
Red Flags to Watch For
• Qualified audit opinion – A qualified opinion is issued by independent
auditors when the financial statements fail to present the entity's financial
position, results of operations, and cash flows in conformity with generally
accepted accounting principles or the scope of the audit was limited.
• Going concern note – The auditor is required to include a going concern
disclosure in the audit report when the firm is not a going concern or will
not be a going concern in the near future — a firm is not a going concern
when it is dissolved, bankrupt, shut down, etc.
• Prior bankruptcy – A prior bankruptcy indicates management has
previously proven to be incapable of meeting financial obligations and
could likely put day-to-day operations at risk.
• High leverage – A relatively high level of capital used to run the business is
borrowed debt and likely indicates a relatively high level of interest
expense, which if not met can result in financial default of the firm.
• “Junk” status bond rating – A “junk” status credit rating indicates a firm
has a relatively high risk of defaulting on its debt obligations.
Summary Step 6 Analyze Data
Financial Ratio Analysis
• Financial statement basics
• Using financial ratios
• Relevant financial ratios
• Key financial ratios and the meaning of each
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