Business Policy & StrategyChapter 8Accounting and Finance

Murdick, Moor, Babson & Tomlinson

Sixth Edition, 2000

Financial Analysis For Nonfinanciers

• Who are Nonfinanciers?– The large group of businesspeople

who say, “I had some accounting and finance courses in school, but never liked them.”

– business people who know something about the subject but want to learn more.

Why Bother to Learn Financial Analysis

• It is one of the most important tools for analyzing the health of a business firm in its entirety or the subdivisions of the firm.– It points out symptoms that help to pinpoint a

problem within a firm.

Just How Good Is Financial Analysis?

• Financial analysis is used as a beginning point in firm investigations by bankers, professional investors, and securities analysts.– Study financial

statements, trend analysis, and ratio comparisons to the appropriate industry.

• Advantages– trends do persists

– points up symptoms of basic problems that need to be improved

– it is a quantitative appraisal

– can help firms raise needed funds

– figures are more precise than words and can often help the manager pinpoint exactly where problems lie.

Just How Good Is Financial Analysis?

• Limitations– accountants tend to focus on the

past

– financial trends may or may not portend the future

– wide fluctuations in figures keep ratios from being useful or meaningful

– accounting data represent what the accountants believe, or interpret as true

– financial analysis is only mastered by few.

Just How Good Is Financial Analysis?

Major Sources of Financial Information

• General Sources– Moody’s Manual– Standard & Poor’s Manuals and Surveys– Major brokerage houses

• i.e.. Merrill Lynch, Morgan Stanley Dean Witter

– Annual reports sent to stockholders - 10k – read the FINE print, boring but useful

Major Sources of Financial Information

• Additional General Sources – Trade Associations

• i.e.. National Retail Merchants Association

– Publications by Federal government agencies• Current Industrial Reports, Statistical Abstract

– Internet

Major Sources of Financial Information

• Ratio Reports– Robert Morris Associates and Dun & Bradstreet

• supply industrywide ratios for manufacturing, wholesaling, and retailing firms

– Almanac of Business and Industrial Ratios– Annual Statement Studies

Ratio Comparisons

• Be sure to use the appropriate industry category

• Industry comparisons must be used with restraint

• Why industry figures are used to compare companies?– Relatively easy to get and can be used as a

benchmark to give added meaning to the company being analyzed.

How can Accounting help people in business make decisions?

• Accounting helps by answering five basic questions:– How is the enterprise doing?– Which alternative plan is most attractive?– What is going wrong with the business and how

do you remedy it?– How can all activities be coordinated?– How well does the firm deal with the

environment?

How the enterprise is doing

• Financial accounting provides reports on:– Profit– ROI (return on investment)– Growth of assets and equity– Market Share/ growth of market share– Debt levels, turnover ratios

Choosing the most attractive alternative plan:

• Accounting provides managers with enough information to choose between alternatives

• Accounting focuses on past events which helps managers predict the future of the business

• This enables managers to choose the best alternative for the company

Coordinating Activities:

• Information that is needed to coordinate activities can be transmitted with accounting procedures

• Provides reports for managerial appraisal of results

• Enables predictions to be made for the consequences of proposed plans

How well the firm deals with its environment:

• Accounting information is essential for effective management dealings with the environment

• For example, – Internal Revenue Services– SEC– FCPA (Multinational firms)

How to start an Analysis?

• Every business activity is derived from the combination of the sales forecast and the business plan

• To analyze a business’ trends it is best to start with the five most recent years

• Information found in certain ratios will tell you what state your business is in.– (information found in: balance sheet and profit-and-loss

statements, statement of cash flows also)

Key Information of the Profit-and Loss Statement

• What is the Profit-and-Loss statement?– A financial summary of the operations of a company by

sales, costs, expenses, income, etc. for a specific period of time.

• From the Profit-and-Loss statement you can figure out the profit percentage on sales for each of the past years.

• Enables a company to compare the trends in profits (or losses)

Ratios

• Profitability Ratios– Measures the total effectiveness of a company’s

management in generating profits

• Liquidity Ratios– Indicate a firm’s ability to meet short-term financial

obligations (current and quick ratios)

• Financial Leverage Management Ratios– Measure the degree to which a firm is financing its

assets with fixed-charge sources of funds such as debt, preferred stock, or leases

• Asset Management Ratios (Turnover)– Indicate how efficiently a firm is utilizing its assets to

generate sales

Profitability Ratios

• Net profit marginNPAT/ Sales- Shaft it was 5.53% profit earned per dollar of sales

• Net profit per share of common stock• Net profit to net worth (ROI)

-measure of business relative to other opportunities for investing money

• Net profit before taxes may be more useful sometimes

Liquidity Ratios

• Quick Ratio (acid test)Current assets – Inventories / Current Liabilities

– Degree of assurance a company can offer its creditors

• Current RatioCurrent Assets / Current Liabilities

– Shaft example:» $169,400/ $11,400 = 15.4

» $1.00/ 15.4 = .0649

» Convert each $1 of assets to .07 cents to cover their debt

– To what extent CA cover your CL

Liquidity Ratios

• Fixed assets to net worth– Portion of Net Worth covered by assets – Preferably a low number

• Funded debt to net working capital

• Current liabilities to net worth

• Current liabilities to Inventory

• Total Liabilities to net worth

Leverage Ratios

• Current debt to net worth • Total debt to net worth

– These two ratios indicate the proportion of total debt and current debt to the equity of the owners

– amount of equity required to finance the company’s debt

– It it’s too high, additional funds will be hard to raise

Asset Management Ratios(Turnover)

• Accounts Receivable – money owed to firm A/RAccounts Receivable/Credit Sales/365

– Quality of receivables of a company

• Bad Debts – percent written off, age the A/R• Net sales/ net worth• Assets to Sales

– Total investment needed to generate sales

• Net Sales to Inventory– Good to compare this result with other industries– Inventory maintenance can be costly

Breakeven Analysis

Total Revenue = Total Costs

Total Costs = Fixed Costs + Variable Costs

Consider Economies of Scale

How Breakeven is helpful…

• Whether or not to add SALES or ADVERTISING expense in order to INCREASE VOLUME

• Merits of DECREASING PRICES to increase VOLUME

• How advisable is it to borrow capital improvements needed to INCREASE CAPACITY

• Whether to AUTOMATE PRODUCTION -or- OFFICE WORK

Depreciation and Valuation of Inventories

• Direct deduction from profits– Rapid Depreciation vs. Slower depreciation

• Valuating inventories can overstate and understate your inventories which affects the taxes the firm pays– LIFO vs. FIFO– LIFO may deflate the firm’s reported earnings,

but it also reduces the firm’s income taxes

LIFO and FIFO

• FIFO – first inventory to arrive, is the first inventory to be sold.

• LIFO – last inventory in is the first out to be sold.

• A high valuation on year end inventories (which may be less than book value) will reduce the cost of goods sold, which increases profits (and taxes paid).

Problems Encountered on the Income Statement

• Poor sales trend • Bad products• High prices• Production problems

– Develop better products

– Find the problem areas in production and fix them

• High number of returned goods– Poor quality– Product does not meet the consumers

expectations

• Increasing trend of COGS percentage– Retailers might be charging too much

» Set up pricing standards

• Material Cost Increasing– Waste in the

production process

– Price of material increasing

– Transportation prices increasing

• Increasing percentage of direct labor– Wages are increasing

without increasing productivity

– Poor labor market

• Increasing Sales Expense– Sales management problems– High advertising cost– Increased warehouse or shipping expense

• Increasing inventory percentage to sales turnover– Poor marketing policy– Poor manufacturing-marketing coordination– Poor manufacturing policy