Financial Ratios List Buyer Analysis of Financial Statements November 12

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					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

            www.adrna.com
                                     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

            www.adrna.com
                                      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




                www.adrna.com
                                                         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%


                   www.adrna.com
                                                               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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