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Upstate NY Real Estate Poughkeepsie Partners (“PP”) owns a number of commercial properties in suburban towns north and west of New York City

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Upstate NY Real Estate Poughkeepsie Partners (“PP”) owns a number of commercial properties in suburban towns north and west of New York City. The firm previously rented one property to a department store renowned for jewelry and fine china. The department store vacated the property two years ago. This occurred despite the fact that the tenant broke a ten-year lease after only three years of occupancy and subsequently filed for bankruptcy. PP viewed any effort to recover early lease termination penalties a waste of time and money. Interest expense, high real estate taxes, insurance, and security costs make it extremely expensive to hold vacant property in this area. Although PP is eager to find a new tenant, it does not want another unexpected vacancy to have a serious negative effect on its investment returns. PP wants to be as sure as possible that the new tenant will be financially stable and will be likely stay for at least the full term of the lease. Mission Furniture, a well-known furniture chain that targets affluent customers with traditional tastes, has expressed interest in your open store location. Using data provided by Mission Furniture, and financial ratios from chapters 13 and 14 of the Brooks textbook, make a decision on behalf of PP. Mission Furniture Statement of Income (millions of USD) Account Sales Cost of Goods Sold Gross Profit Selling & Administrative Depreciation Other income (expenses) Earnings Before Interest and Taxes Interest Expense Earnings Before Taxes Taxes Net Income Common Dividends 20x5 947.3 436.6 510.7 315.6 21.3 -11.9 161.9 0.6 161.3 45.9 115.4 16.9 20x6 995.1 472.8 522.3 320.8 21.3 -9.2 171 0.6 170.4 60.5 109.9 23.1 20x7 989 466.6 522.4 332.3 21.3 1.4 170.2 0.8 169.4 55 114.4 27.1 Mission Furniture Balance Sheet (millions of USD) Account Current Assets Cash Accounts Receivable Inventory Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Current Liabilities Accounts Payable Short Term Debt Other Current Liabilities Total Current Liabilities Long Term Debt Other Long Term Liabilities Total Liabilities Shareholder Equity Common Stock Retained Earnings Total Shareholder Equity Total Liabilities & Shareholder Equity 20x5 20x6 20x7 81.9 26.4 198.2 63.8 370.3 289.4 81.8 741.5 61.6 27 186.9 64.2 339.7 277 81.7 698.4 57.4 28 187.1 66.5 339 275.2 88.8 703 26 101.1 8 135.1 9.2 50.2 194.5 22.2 4.7 7.4 34.3 4.5 52.4 91.2 20.4 4.2 6.4 31 3.2 5.5 39.7 240 307 547 741.5 240 367.2 607.2 698.4 240 423.3 663.3 703 Instructions to Upstate NY question To complete the first part of your post, read the attached Upstate NY Real Estate .pdf file and indicate your leasing decision. Cite specific ratios and trends obtained from Mission’s data, and any other supportable opinion you may have of Mission’s business and the macroeconomic environment. Keep your decision to 300 words or less. Working Capital Management Chapter 13 General • Working capital management – operational side of budgeting • Managing the current assets and current liabilities to improve the flow of funds • Maintaining efficient levels of both current assets and current liabilities so that a company has greater cash inflow than cash outflow • Not only the amount of cash flow but also the timing of the cash flow Cash conversion cycle • Time between the initial cash outflow and the final cash inflow of a product • Three components o Production cycle – time it takes to build and sell the product o Collection cycle – time it takes to collect from customers o Payment cycle – the time it takes to pay for suppliers and labor • Cash conversion cycle (CCC) = production cycle + collection cycle – payment cycle • Business operating cycle – production cycle + collection cycle o Production cycle = days in inventory = average inventory/cost of goods sold per day o Collection cycle = days in receivables = average AR/credit sales per day o Payment cycle = days in payables = average AP/cost of goods sold per day • Try to speed up receivables • Try to slow down payables Managing accounts receivable and credit policy • Collecting accounts receivable o Lag schedule converting accounts receivable to cash o Some accounts receivable not collected – bad debt • Credit policy o Policy on how customers will qualify for credit ? Credit screening – distinguishing good customers from bad customers o Policy on the payment plan for creditors ? Payment terms including early payment provisions o Policy on attempting to collect on overdue bills ? Finance charges, new payment date, additional assessments ? Use of collection agency, court action, write off as bad debt Float • Float – the lag time involved in the process of clearing a check • Represents the difference between the cash balance in the books versus the bank • Disbursement float – delay between writing the check and transferring funds from your account • o For a cash conversion cycle perspective try to lengthen the disbursement float Collection float – delay between receiving the check and depositing the fund in your account o For a cash conversion cycle perspective try to speed up the collection float ? Lockbox – post office box at a central post office near the company’s bank ? Electronic funds transfer (EFT) – system of transferring funds from one bank to another – eliminates the collection float ? Debit cards – direct deduction from bank Inventory management • Inventory is one of the most important assets because it generates revenue • Need the correct level of inventory o Too much inventory leads to storage cost, spoilage and obsolescence o Too little inventory leads to shortages and stock outs • ABC inventory management o Group inventory into categories ? A type – large-dollar items or critical inventory – monitor daily ? B type – moderate-dollar items or essential inventory – monitor periodically ? C type – small-dollar items or nonessential inventory – infrequent monitoring • Redundant inventory o Inventory not used in current operations o Serves as a backup role if needed • Just in time (JIT) o Address lead time and safety stock issues in order to reduce any excess inventory o Produce only necessary items using necessary materials at the necessary time o Try to eliminate waste and improve productivity o Can be an application of the economic order cost model • Economic order cost • Minimize the sum of order cost and carrying cost o Order cost = annual demand/quantity of each order o Carrying cost = quantity of order/2 • Optimal order level where the order cost and carrying cost are equal • Increase the number of orders o Order size is lower o Order cost is higher o Carrying cost is lower • Decrease the number of orders o Order size is higher o Order cost is lower • • • • o Carrying cost is higher EOQ = square root of (2 x annual demand x order cost/carrying cost) Reorder point – level of inventory at which a company should place an order o Reorder point = days of lead time x daily usage rate Safety stock – additional inventory to allow for uncertainty in inventory usage or the time to receive orders Average inventory = EOQ/2 + safety stock Financial Analysis Chapter 14 General • Benchmarking – compare a company’s current performance against its own previous performance or against another company in the industry • Compare performance – based on a standard o Over time – shows trends o Current – against other similar companies • Common-sized financial statements – measure in percents (relative measure) versus dollars (absolute measure) – overcomes size differences between companies • Ratios are a starting point – means to an end • Ratios help to ask questions and find areas for further evaluation • Measure of past performance to help in predicting future performance Financial ratios • Information from financial statements – mostly balance sheet and income statement • Relative measures with values given in percents or times • Performance indicators Liquidity ratios • Measures a company’s ability to meet its short-term debt obligations in a timely basis • Current ratio = current assets/current liabilities • Quick ratio = (current assets – inventory)/current liabilities • Cash ratio = cash/current liabilities Long-term solvency ratios (debt ratios) • Measure a company’s ability to meet its long-term debt obligations • Debt ratio = total liabilities/total assets • Times interest earned = EBIT/interest expense • Cash coverage ratio = (EBIT + depreciation)/interest expense Asset management ratios (asset utilization) • Measure how efficiently a company uses its assets to generate revenue or how much cash is tied up in other assets like inventory or receivables • Inventory turnover = cost of goods sold/average inventory • Days’ sales in inventory average inventory/cost of goods sold per day • Receivables turnover = sales/average accounts receivable • Days’ sales in receivables = average accounts receivable/sales per day • Total asset turnover = sales/average total assets Profitability ratios • Measure how effectively the company is turning sales or assets into income • Profit margin = net income/sales • Return on assets = net income/average total assets • Return on equity = net income/average total owners’ equity Market value ratios • Measures the firm’s performance against the firm’s perceived value from the trading value of the shares or number of shares • Does the share price of the firm appear reasonable based on its performance? • Earnings per share = net income/number of outstanding shares • Price to earnings ratio = price per share/earnings per share o PE ratio tell you how long before you double your money o High PE ratios should represent growth companies o Low PE ratios should be mature companies • Price/earnings to growth ratio = price earnings per share/earnings growth rate x 100 o (PEG) ratio – adjust the PE ratio to account for growth o PEG ratio less than 1.0 are undervalued – buy opportunity o PEG ratio near 1.0 are properly valued o PEG ratio greater than 1.0 are overvalued – sell opportunity o Firms with high PE ratios need to have high growth rates in earnings to justify the current price • Market to book value = market value per share/book value per share o Value less than 1.0 would be troubling because it would signal that the firm has not been able to generate earnings for the owners o Low market-to-book may indicate that the market for shares of the company is depressed o Depressed – prices are low and market’s expectation of turning profits in future are also low DuPont Analysis • Operating efficiency – profit margin = net income/sales • Asset management efficiency – asset turnover = sales/average total assets • Financial leverage – equity multiplier = average total assets/average total equity • Multiply three ratios together to get return on equity = profit margin/average total equity Industry ratios • Can vary across industries • Benchmark the ratios by industry • Understand that industries operate differently in terms of borrowing, cash management, capital intensity, labor intensity, competition and regulation Financial Management: Core Concepts Fourth Edition Chapter 13 Working Capital Management Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Learning Objectives 13.1 Model the cash conversion cycle and explain its components. 13.2 Understand why the timing of accounts receivable is important and explain the components of credit policy. 13.3 Understand the concept of float and its effect on cash flow and explain how to speed up receivables and slow down disbursements. 13.4 Explain inventory management techniques and calculate the economic order quantity (EOQ). 13.5 Account for working capital changes in capital budgeting decisions. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 The Cash Conversion Cycle (1 of 3) In order to manage working capital efficiently, a firm has to be aware of how long it takes them, on average, to convert their goods and services into cash. This length of time is formally known as the cash conversion cycle. The cash conversion cycle is made up of three separate cycles: 1. The production cycle, i.e., the time it takes to build and sell the product, 2. The collection cycle, i.e., the time it takes to collect from customers (i.e., collecting accounts receivable) and 3. The payment cycle, i.e., the time it takes to pay for supplies and labor, i.e., paying accounts payable. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 The Cash Conversion Cycle (2 of 3) cash conversion cycle = production cycle + collection cycle − payment cycle 13.1 The production cycle and the collection cycle together make up the operating cycle, so the cash conversion cycle can also be calculated as follows: Cash conversion cycle = operating cycle − payment cycle. Figure 13.1 The cash conversion cycle. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 The Cash Conversion Cycle (3 of 3) – The production cycle begins when a customer places an order and ends when the product is shipped out. – The collection cycle begins when the order is filled and ends when payment is received. – The payment cycle begins when labor is hired or raw materials are received to start production and ends when the firm pays for purchases, raw materials and other production costs. • Firms typically have to pay for production costs before they receive payment from their customers, a longer cash conversion cycle would tie up their finances and vice-versa. • Must keep track of these various cycles and try to shorten the cash conversion cycle so as to free up much needed funds. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (A) Average Production Cycle Calculated in three steps. First calculate average inventory as shown in Equation 13.2 average inventory = beginning inventory + ending inventory 2 13.2 Next, calculate the inventory turnover rate as follows: cost of goods sold inventory turnover = average inventory 13.3 Lastly, calculate the average production cycle as follows: production cycle = 365 inventory turnover 13.4 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (B) Average Collection Cycle Makes up the other leg of the operations cycle. It measures the number of days taken by a firm, on average, to collect its accounts receivables. To measure it we first calculate the average accounts receivable, i.e., beginning accounts receivable + ending accounts receivable 2 13.5 Then we measure the accounts receivable turnover rate as follows: accounts receivable turnover = credit sales average accounts receivable 13.6 Finally, we calculate the average collection cycle, i.e., Average collection cycle = 365 ÷ A/R turnover rate. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (C) Average Payment Cycle • Also calculated with the same three steps… • Except that we use the average accounts payable and accounts payable turnover to do it. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (D) Putting It All together: The Cash Conversion Cycle (1 of 4) • Production cycle + Accounts receivable cycle − Payment cycle = Cash conversion cycle • The number of days between when a firm incurs an outflow to start production until it receives payment on a credit sale. • So if a firm can shorten its production cycle or its collection cycle, or both, while keeping its payment cycle constant or lengthened, it can shorten the number of days that it would typically have to finance its operations for, thereby reducing its financing costs and increasing its profits. • Thus, shortening the cash conversion cycle essentially requires the efficient management of receivables (credit policy), inventory, and payables. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (D) Putting It All together: The Cash Conversion Cycle (2 of 4) Example 1: Measuring Cash Conversion Cycle Mark is has just been appointed as the chief financial officer of a mid-sized manufacturing company and is keen to measure the firm’s cash conversion cycle, operating cycle, production cycle, collection cycle, and payment cycle, so as to see if any changes are warranted. He collects the necessary information for the most recent fiscal year, and puts together the table below: Blank Ending Balance $600,000 Accounts receivable $40,000 $36,000 Total sales $800,000 Inventory $10,000 $6,000 Cost of goods sold $640,000 Accounts payable $9,000 $5,000 Cash sales $200,000 Credit sales Beginning Balance Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (D) Putting It All together: The Cash Conversion Cycle (3 of 4) Example 1: Answer First, we calculate the average values of the three accounts: Average A/R → ($36,000 + $40,000) ÷ 2 = $38,000 Average inventory → $(10,000 + 6,000) ÷ 2 = $8,000 Average A/P → ($9,000 + $5,000) ÷ 2 = $7,000 Next, we calculate the turnover rates of each: A/R Turnover = Credit sales ÷ Avg. A/R → $600,000 ÷ $38,000 → 15.7895 Inventory turnover = Cost of goods sold ÷ Avg. Inv → $640,000 ÷ $8,000 = 80 A/P turnover = Cost of goods sold ÷ Avg. A/P = $640,000 ÷ $7,000 = 91.43 Finally we calculate the collections cycle, the production cycle, and the payment cycle by dividing each of the turnover rates into 365 days, respectively. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.1 (D) Putting It All together: The Cash Conversion Cycle (4 of 4) Example 1: Answer (continued) Collection cycle = 365 ÷ A/R Turnover → 365 ÷ 15.7895 → 23.12 days Production cycle = 365 ÷ Inv. Turnover → 365 ÷ 80 → 4.56 days Payment cycle = 365 ÷ A/P Turnover → 365 ÷ 91.43 → 3.99 days So the firm’s operation cycle = Collection cycle + Production cycle = 23.12 + 4.56 = 27.68 days Cash conversion cycle = Operating cycle − Payment cycle = 27.68 − 3.99 → 23.69 days. So on average, the firm has to finance its credit sales for about 24 days. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 Managing Accounts Receivable and Setting Credit Policy • The efficient management of accounts receivable → critical step in shortening the cash conversion cycle. • Lax credit policy → ↑ defaults Strict credit policy→ lost sales • Firms have to establish well-balanced credit and collection policies to efficiently manage working capital. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (A) Collecting Accounts Receivable • The timing of collecting payments from customers is hardly uniform. • A certain percentage of customers always pay on time, while a small percentage is always late. • Firms have to analyze their historical collection patterns and accordingly plan for the future. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (B) Credit : A Two-Sided Coin • One firm’s accounts receivable is another firm’s accounts payable. • The cash conversion cycle decreases with a shortening of the collection cycle but increases with a lengthening of the payment cycle, • If a firms shortens it collection cycle by tightening its credit policy, its suppliers could do the same, which would negate the effectiveness of the strategy. • Firms must establish good credit policies regarding screening, payment terms, and collecting of over-due bills. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (C) Qualifying for Credit (1 of 4) • Often depends on the customer’s background, business potential, and competitive pressures. • There is usually a trade-off between paying the high screening costs and the lost cash flow due to defaults resulting from poor screening. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (C) Qualifying for Credit (2 of 4) Example 2: Evaluating Credit Screening Cost Go-Green Golf Carts Inc. has developed an environmentally friendly golf cart, which costs $2,500 to produce and will sell for $4,000. Market analysis shows that the firm will be able to sell 2,000 carts per year, if it allows credit sales. However, there is a chance that 1% of the customers may default. If the firm does not offer credit terms, 40% of the sales will be lost. It has also been determined that if the firm offers credit only to creditworthy customers by screening the buyers, the default rate will be zero, i.e. the 20 potential defaulters will be screened in advance. Should the firm proceed with credit sales and if so, should it screen the clients and at what cost? Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (C) Qualifying for Credit (3 of 4) Example 2: Answer Profit earned on all-cash sales = 0.6 × 2,000 × ($1,500) → $1,800,000 Profit earned on credit sales (no screen) = ( 0.99 × 2,000 × 1,500) − (20 × 2,500) → $2,920,000 i.e., 99% of 2,000 customers will pay and provide a $1,500 profit, while 1% of 2,000 or 20 customers will default causing a loss of $2,500 each. Additional profit generated by granting no-screen credit → 2,920,000 − $1,800,000 = $1,120,000 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (C) Qualifying for Credit (4 of 4) Example 2: Answer (continued) Benefits of screening = 20 × $2,500 = $50,000 Maximum cost per customer for screen = $50,000 ÷ 2,000 = $25 Let’s say the firm proceeds with the credit terms and successfully screens out the 20 bad credit clients at a cost of $25 per screen. Profit = (1,980 × $1,500) − $25 × 2,000 = $2,920,000 → the amount it would earn if all 2,000 sales were on credit and 20 customers defaulted. If the credit screen costs more than $25 it would be better for them to merely grant credit and hope that the default rate is not > 1%!! Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (D) Setting Payment Policy (1 of 4) • An important part of credit policy is to determine how many days of free credit to grant customers and whether or not to offer discounts for paying early, and if so, how much of a discount? • Discounts, if high enough, tend to be mutually beneficial, since the seller frees up cash and the buyer pays less. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (D) Setting Payment Policy (2 of 4) Example 3: Cost of Foregoing Cash Discounts Let’s say that a firm grants it customers credit on terms of 1/10, net 45. You are one of the customers who have an invoice due of $10,000. You have a line of credit with your bank that is at the rate of 9% per year on outstanding balances. Should you avail of the discount and pay on day 11 or wait until the 45th day and make the full $10,000 payment? Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (D) Setting Payment Policy (3 of 4) Example 3: Answer If you pay by day 11, you will owe $10,000 × (0.99) = $9,900 If you pay by day 45, you will owe $10,000 You benefit by $100 for a 35-day period. If you could invest $9,900 over a 35-day period and end up with more than $10,000, you would be better off holding off the payment and investing the money rather than taking the discount. The holding period return = $100 ÷ $9,900 = 1.01% over a 35-day period The APR = HPR × 365 ÷ 35 = 1.01 × 10.428% → 10.53% The EAR = (1 + HPR)365 ÷ n − 1 = (1.0101)365 ÷ 35 − 1 = 11.05% Since you can borrow at 9% per year, it would be better to borrow the money, pay on day 10, and take advantage of the discount. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (D) Setting Payment Policy (4 of 4) Example 3: Answer (continued) Alternate method: Calculate the APR and EAR implied by the discount being offered using Equations 13.12 and 13.13 as follows: discount rate 365 ? 1 − discount rate days between payment dates 13.12 APR = (1% ÷ (1 − 1%)) × (365 ÷ days between payment days) = (0.01 ÷ 0.99) × (365 ÷ (45 − 10) → 0.0101 × 10.428 → 0.1053 or 10.53% discount rate ? ? 1 + ? ? 1 − discount rate ? ? 365/days between payment dates −1 13.13 EAR = (1+ (0.01 ÷ 0.99)365÷35 − 1 = (1.0101)10.428 − 1 = 11.05% Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.2 (E) Collecting Overdue Debt • A firm’s collection policy involves sending collection notices, taking court action, and eventually writing off bad debts. • The cost to the firm escalates at each step. → Firms should carefully establish and monitor their credit policy involving: – screening, – payment terms, and – collection procedures • So as to maximize benefits while minimizing costs. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.3 The Float (1 of 2) • “Float” →the time it takes for a check to clear, is of two types: – Disbursement float is the time lag between when a buyer writes a check to when the money leaves his or her account. – Collection float is the time lag between when a seller deposits the check to when the funds are received in the account. Note: The collection float is part of the disbursement float, so if the seller or his bank can speed up collection it will automatically shorten the disbursement float. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.3 The Float (2 of 2) Figure 13.5 Disbursement and collection float. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.3 (A) Speeding Up the Collection (Shortening the Lag Time) • Firms attempt to speed up collections in a variety of ways including: – Lock boxes which are post office boxes set up at convenient locations to allow for quick pick up and deposit of checks by the firm’s bank. – Electronic fund transfers (EFT) which occur directly from the buyer’s account. For example by accepting debit cards. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.3 (B) Slowing Down Payment (Lengthening the Lag Time) • Getting more difficult with the advent of Check 21 (electronic clearing of checks between banks) and acceptance of debit cards. • One method that continues to be popular, though, is the wide-spread use of credit cards, which allows for a month long float. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 Inventory Management: Carrying Costs and Ordering Costs • Managing inventory essentially involves the balancing of carrying costs (i.e. storage costs, handling costs, financing costs, and costs due to spoilage and obsolescence) against ordering costs (i.e. delivery charges), which tend to offset each other. • To keep carrying costs down requires more frequent orders of smaller sizes, but could result in lost sales due to stock-outs. • Fewer, larger orders lowers ordering costs, but requires carrying larger amounts of inventory. • There are four cost-minimizing methods that firms can use to manage inventories efficiently: – The ABC inventory management model; – Stocking redundant inventory; – the Economic Order Quantity method; and – the Just in Time approach. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (A) ABC Inventory Management Involves categorizing inventory into three types: – Large dollar or critical items (A-type); – Moderate dollar or essential items (B-type), – Small-dollar or non-essential items (C-type). Each type is monitored differently with respect to the frequency of taking stock and re-ordering. Table 13.1 Inventory Categories for Corporate Seasonings Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (B) Redundant Inventory Items • Involves maintaining back-up inventory of items that are currently not needed frequently, but could be used in emergencies. • Avoid higher costs due to stoppages. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C) Economic Order Quantity • Method to determine the optimal size of each order by balancing ordering costs with carrying costs so as to minimize the total cost of inventory. • The Trade-off between Ordering Costs and Carrying Costs: occurs because with larger order sizes, fewer orders are needed, reducing delivery costs, and the costs resulting from lost sales due to shortages. However, higher levels of inventory are held, thereby increasing costs associated with storage, handling, spoilage, and obsolescence. Figure 13.7 Inventory costs. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-2) Measuring Ordering Costs (1 of 2) • Involves multiplying the number of orders placed per period by the cost of each order and delivery, i.e., S Total annual ordering cost = OC ? Q 13.14 Where OC = cost per order; S = annual sales; and Q = order size. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-2) Measuring Ordering Costs (2 of 2) Example 4: Measuring Ordering Cost Nigel Enterprises sells 1,000,000 copies per year. Each order it places costs $40 for shipping and handling. How will the total annual ordering cost change if the order size changes from 1,000 copies per order to 10,000 copies per order. Answer At 1,000 copies per order: Total annual ordering cost = $40 × 1,000,000 ÷ 1,000 → $40,000 At 10,000 copies per order: Total annual ordering cost = $40 × 1,000,000 ÷ 10,000 → $4,000 As order size increases, ordering costs decline due to fewer orders Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-3) Measuring Carrying Costs (1 of 5) • Involves multiplying the carrying cost by the half the order quantity, i.e., Q Total annual carrying cost = CC ? 2 13.15 • The model assumes that inventory is used up at a constant rate each period so when it is at its half way point a new order is received, meaning that on average we are holding about half the inventory each period. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-3) Measuring Carrying Costs (2 of 5) Example 5: Measuring Carrying Cost Nigel Enterprises has determined that it costs them $0.10 to hold one copy in inventory each period. How much will the total carrying cost amount to with 1,000 copies versus 10,000 copies being held in inventory. Answer With 1,000 copies in inventory Total annual carrying cost = $0.10 × 1,000 ÷ 2 = $50 With 10,000 copies in inventory Total annual carrying cost = $0.10 × 10,000 ÷ 2 = $500 As order size increases carrying costs go up proportionately. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-3) Measuring Carrying Costs (3 of 5) • To arrive at the optimal order quantity, we can use Equation 13.17 2 ? S ? OC EOQ = CC 13.17 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-3) Measuring Carrying Costs (4 of 5) Example 6: Calculating EOQ With annual sales of 1,000,000 copies, carrying costs amounting to $0.10 per copy held and order costs amounting to $40 per order. What is Nigel Enterprises’ optimal order size? Please verify that your answer is correct. Answer S = 1,000,000; OC = $40; CC = $0.10 EOQ = [(2 × 1,000,000 × $40) ÷ 0.1]1 ÷ 2 = 28,285 (rounded to nearest whole number) With order size = 28,285 Total order cost = (1,000,000 ÷ 28,285) × $40 = $1,414.2 Total carrying cost = 28,285 ÷ 2 × 0.1 = $1,414.2 Total inventory cost = $2,828.4 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-3) Measuring Carrying Costs (5 of 5) Example 6: Answer (continued) Verification: With Q = 28,000 → OC = (1,000,000 ÷ 28,000) × $40 → $1,428.6 → CC → 28,000 ÷ 2 × 0.1 → 1,400 Total cost → 2,828.6 > $2,828.4 With Q = 29,000 → OC = 1,000,000 ÷ 29,000) × 40 → 1,379.31 → CC → 1,450 Total cost = $2,829.31 > $2,828.4 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-4) Reorder Point and Safety Stock (1 of 3) Inventory gets used up every day → lead time necessary for additional supplies → firms must determine a reorder point → to avoid a stock-out. The reorder point = daily usage × days of lead time Once the inventory hits the re-order point, the next order is placed so that by time it is delivered, the firm would be just about out of inventory. An additional protection measure is to build in some safety stock or buffer so as to be covered in case of delivery delays as follows: Average inventory = EOQ ÷ 2 + safety stock Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-4) Reorder Point and Safety Stock (2 of 3) Figure 13.6 Inventory flow. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-4) Reorder Point and Safety Stock (3 of 3) Example 7: Measuring Re-order Point and Safety Stock Calculate Nigel Enterprises’ re-order point and safety stock assuming that deliveries take 4 days on average with a possibility of 2 day delays sometimes. Answer EOQ = 28,285; daily usage rate = 1,000,000 ÷ 365 → 2,740 Reorder point = 4 × 2740 = 10,960 (without safety stock) With safety stock built in we calculate average inventory as → Average inventory = EOQ ÷ 2 + safety stock Safety stock = 2 days usage = 2 × 2740 = 5,480 So Nigel Enterprises should reorder when the inventory drops to 10,960 + 5,480 → 16,440 copies. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.4 (C-5) Just in Time • An inventory management system which tries to keep inventory at a minimum by following lean manufacturing practices, i.e. producing only what is required, when it is required and keeping finished goods in storage for as little time as possible. • JIT inventory management, if practiced successfully would eliminate waste and improve productivity significantly. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 13.5 The Effect of Working Capital on Capital Budgeting • Inventories and Daily Operations: For capital budgeting → the initial investment required for working capital, i.e., inventory and accounts receivable, as part of cash outflow at time 0. • Also, need to account for: – Periodic fluctuations in working capital, and – Cash inflow from recovery of working capital at the end of a project’s useful life, i.e., drawing down on the inventory and collecting the receivables. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 1 Measuring Cash Conversion Cycle. John Gray is really concerned that his company’s working capital is not being managed efficiently. He decides to take a look at the firm’s operating and cash conversion cycles to see what’s going on. Using the data provided below, help John measure his firm’s collection, production, payment, operating, and cash conversion cycles respectively. Cash sales $350,000 Credit sales $600,000 Total sales $950,000 Cost of goods sold $600,000 Blank Ending Balance Beginning Balance Accounts receivable $45,000 $32,000 Inventory $22,000 $9,000 Accounts payable $6,000 $5,000 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 1 (Answer) (1 of 2) First, we calculate the average values of the three accounts: Average A/R → ($45,000 + $32,000) ÷ 2 = $38,500 Average inventory → $(22,000 + 9000) ÷ 2 = $15,500 Average A/P → ($6,000 + $5,000) ÷ 2 = $5,500 Next, we calculate the turnover rates of each A/ R turnover = Credit sales ÷ Avg. A/R → $600,000 ÷ $38,500 → 15.58 Inventory turnover = Cost of goods sold ÷ Avg. Inv → $600,000 ÷ $15,500 = 38.71 A/P turnover = Cost of goods sold ÷ Avg. A/ P = $600,000 ÷ $5,500 = 109.09 Finally we calculate the collections cycle, the production cycle, and the payment cycle by dividing each of the turnover rates into 365 days, respectively. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 1 (Answer) (2 of 2) • Collection cycle = 365 ÷ A/R turnover → 365 ÷ 15.58 → 23.43 days • Production cycle = 365 ÷ Inv. turnover→ 365 ÷ 38.71 → 9.43 days • Payment cycle = 365 ÷ A/P turnover→ 365 ÷ 109.09 → 3.35 days • So the firm’s operation cycle = Collection cycle + Production cycle = 23.43 + 9.43 = 32.86 days. • Cash conversion cycle = Operating cycle − payment cycle = 32.86 − 3.35 → 29.51 days. So on average, the firm has to finance its credit sales for about 30 days. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 2 Credit screening cost-benefit analysis: Mid-West Marine Products currently sells its light-weight boat lifts for $3,500 each. The unit cost of each lift is $2,600. On average, the firm sells 2000 lifts a year on a cash basis. Consumer credit check is offering Mid-West a credit screening system at the rate of $25 per screen, and assures them that the system will be at least 99% accurate. Mid-West’s research indicates that if they offer credit terms, it will boost their sales by 40% per year. They have also learned that the typical default rate in their industry is around 3%. a. Should Mid-West start offering credit terms? b. If they do offer credit, should they do so with or without CCC’s credit screening services? Please explain. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 2 (Answer) (1 of 2) Current profit (all-cash sales) = 2,000 × ($3,500 − $2,600) = $1,800,000 With credit terms…Unit sales = 2,000 × (1.4) = 2,800 lifts Profit (with credit and no screening) = $900 × 2,800 × 0.95 − 0.03 × 2,800 × ($2,600) → $2,394,000 − 218,400 = $2,175,600 Profit (with credit screening) = ($900 × 2,800 × 0.99) − (0.01 × 2,800 × ($2,600)) = $2,494,800 − $72,800 → $2,422,000 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 2 (Answer) (2 of 2) Increase in profit from screen = $2,422,000 − $2,175,600 = $246,400 Maximum cost of screening per customer = $246,600 ÷ $2,800 = $88 At $35 per screen, it is definitely worthwhile to offer credit terms with screening service provided by Consumer Credit Check. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 3 • Cost of foregoing cash discounts: Your raw material supplier has been accepting payments on 30 day terms with no interest penalty. • Recently, you received an invoice which stated that the supplier would offer terms of 1 ÷ 10, net 30. • You have a line of credit with your bank at an EAR of 14.5% per year on outstanding loans. • Should you accept the discount offer? Please explain why or why not. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 3 (Answer) At terms of 1 ÷ 10, net 30 you will get 1% off and be allowed to pay in 10 days, otherwise the full amount is due in 30 days HPR = 0.01 ÷ 0.99 = 1.0101% EAR = (1 + HPR)365 ÷ 20 − 1 = (1.0101)18.25 − 1 = 20.129% Since you are able to borrow at 14.5%, you are better off taking the cash discount and effectively earning an EAR of 20.129% Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 4 Economic order quantity (EOQ). The Always-Stocked Party Store wants to stay true to its name, especially since the “Out-to-Get-You” Party store is opening up very close by. One of their main sellers, the Mega-Keg, costs $2 to stock and accounts for sales of 3,600 kegs per year. Each order for kegs cost roughly $200 and takes on average 5 days to be delivered, with the possibility of 2 day delays. a. What is the optimal order size for Mega-Kegs? b. At what point should the kegs be re-ordered to assure that the store never runs out? Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 4 (Answer) EOQ = [2 × 3,600 × $200 ÷ $2]1 ÷ 2 = 849 EOQ = 849; daily usage rate = 3,600 ÷ 365 →10 Reorder point = 5 × 10 = 50 (without safety stock) Safety stock = 2 days usage = 2 × 10 = 20 So the store should reorder when the inventory drops to 50 + 20 → 70 kegs. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 13.2 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 13.3 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 13.4 Invoice Payment Options, Amounts, and Dates for Peak Construction’s Bill from Space Lumber Company Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Copyright Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Financial Management: Core Concepts Fourth Edition Chapter 14 Financial Ratios and Firm Performance Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Learning Objectives 14.1 Create, understand, and interpret common-size financial statements. 14.2 Calculate and interpret financial ratios. 14.3 Compare different company performances using financial ratios, historical financial ratio trends, and industry ratios. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 Financial Statements • Just like a doctor takes a look at a patient’s x-rays or cat-scan when diagnosing health problems, a manager or analyst can take a look at a firm’s primary financial statements, i.e., the income statement and the balance sheet, when trying to gauge the status or performance of a firm. • Income statement: periodic recording of the sources of revenue and expenses of a firm. • Balance sheet: provides a point in time snap shot of the firm’s assets, liabilities and owner’s equity. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 (A) Benchmarking (1 of 6) • The financial statements → constitute fairly complex documents involving a whole bunch of numbers. • Absolute values – tell us something about the amount of assets, liabilities, equity, revenues, expenses, and taxes of a firm. – difficult to really gauge what’s going on, primarily because of size and maturity differences among firms. – requires “benchmarking” against some standard. • One common method of benchmarking a is to compare a firm’s current performance against that of its own performance over a 3-5 year period (trend analysis), by looking at the growth rate in various key items such as sales, costs, and profits. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 (A) Benchmarking (2 of 6) Table 14.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands) Account 2013 2014 2015 2016 2017 $18,460 $19,934 $21,529 $23,252 $25,112 +8.0% Cost of goods sold $7,853 $8,638 $9,502 $10,452 $11,497 +10.0% Selling, general, and administrative $4,739 $5,307 $5,945 $6,658 $7,457 +12.0% Depreciation $1,300 $1,250 $1,202 $1,156 $1,112 −3.8% EBIT $4,568 $4,739 $4,880 $4,986 $5,046 +2.5% $178 $178 $178 $178 $178 0.0% Taxes $1,402 $1,456 $1,502 $1,536 $1,555 — Net income $2,988 $3,105 $3,200 $3,272 $3,313 +2.6% Sales Interest Annual % Change Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 (A) Benchmarking (3 of 6) • Another useful way to make some sense out of this mess of numbers is to re-cast the income statement and the balance sheet into common size statements, by expressing each income statement item as a percent of sales and each balance sheet item as a percent of total assets. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 (A) Benchmarking (4 of 6) Figure 14.3 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 (A) Benchmarking (5 of 6) Figure 14.4 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.1 (A) Benchmarking (6 of 6) • Benchmarking is a good starting point to detect trends (if any) in a firm’s performance and to make quick comparisons of key financial statement values with competitors on a relative basis. • More in-depth diagnosis requires individual item analyses and comparisons which are best done by conducting ratio analysis. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 Financial Ratios (1 of 2) • Financial ratios are relationships between different accounts from financial statements—usually the income statement and the balance sheet—that serve as performance indicators. • Being relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 Financial Ratios (2 of 2) Five key areas of a firm’s performance can be analyzed using financial ratios: 1. Liquidity ratios: Can the company meet its obligations over the short term? 2. Solvency ratios: (also known as financial leverage ratios): Can the company meet its obligations over the long term? 3. Asset management ratios: How efficiently is the company managing its assets to generate sales? 4. Profitability ratios: How well has the company performed overall? 5. Market value ratios: How does the market (investors) view the company’s financial prospects? Can also conduct a Du Pont analysis which involves a breakdown of the return on equity into its three components, i.e. profit margin, turnover, and leverage. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (A) Short-Term Solvency: Liquidity Ratios (1 of 2) • Measure a company’s ability to cover its short-term debt obligations in a timely manner. • Three key liquidity ratios include: The current ratio, quick ratio, and cash ratio. current ratio = current assets current liabilities quick ratio (or acid ratio test) = cash ratio = 14.1 ( current assets − inventories ) cash current liabilities current liabilities 14.2 14.3 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (A) Short-Term Solvency: Liquidity Ratios (2 of 2) Table 14.2 2017 Liquidity Ratios for Cogswell Cola and Spacely Spritzers Liquidity Ratio Cogswell Cola Spacely Spritzers Current ratio 1.0596 1.0286 Quick ratio or acid ratio test 0.8379 0.5465 Cash ratio 0.2707 0.2147 • Cogswell has better liquidity and short-term solvency than Spacely, but, higher investment in current assets also means that lower yields are being realized since current assets are typically low yielding. • So, we need to look at the other areas and inter-related effects of the firm’s various accounting items. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (B) Long-Term Solvency: Solvency or Financial Leverage Ratios (1 of 3) • Measure a company’s ability to meet its long-term debt obligations based on its overall debt level and earnings capacity. • Failure to meet its interest obligation could put a firm into bankruptcy. • Equations 14.4, 14.5, and 14.6 can be used to calculate three key financial leverage ratios: the debt ratio, times interest earned ratio, and cash coverage ratio. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (B) Long-Term Solvency: Solvency or Financial Leverage Ratios (2 of 3) total assets − total equity total liabilities debt ratio = or total assets total assets times interest earned = EBIT interest expense EBIT + depreciation ) ( cash coverage ratio = interest expense 14.4 14.5 14.6 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (B) Long-Term Solvency: Solvency or Financial Leverage Ratios (3 of 3) Table 14.3 2017 Financial Leverage Ratios for Cogswell Cola and Spacely Spritzers Financial Leverage Ratio Cogswell Cola Spacely Spritzers Debt ratio 0.6042 0.6398 Times interest earned 28.3483 6.8879 Cash coverage ratio 34.5955 9.7757 Cogswell Cola has relatively less debt and a significantly greater ability to cover its interest obligations by using either its EBIT (times interest earned ratio) or its net cash flow (cash coverage ratio) than Spacely Spritzers. Leverage must be analyzed as a combination of debt level and coverage. If a firm is heavily leveraged but has good interest coverage, it is using the interest deductibility feature of taxes to its benefit. Having a high leverage with low coverage could put the firm into a risk of bankruptcy. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (C) Asset Management Ratios (1 of 2) • Measure how efficiently a firm is using its assets to generate revenues or how much cash is being tied up in other assets such as receivables and inventory. • Equations 14.7-14.11 can be used to calculate five key asset management ratios. cost of goods sold inventory 365 day's sales in inventory = inventory turnover sales receivables turnovery = accounts receivable 365 day's sales in receivables = receivables turnover sales total asset turnover = total assets inventory turnover = 14.7 14.8 14.9 14.10 14.11 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (C) Asset Management Ratios (2 of 2) Table 14.4 2017 Asset Management Ratios for Cogswell Cola and Spacely Spritzers Asset Management Ratio Inventory turnover Days’ sales in inventory Receivables turnover Days’ sales in receivables Total asset turnover Cogswell Cola Spacely Spritzers 8.5671 4.7733 42.6050 76.4677 9.9218 18.3873 36.7878 19.8506 1.0698 1.1305 While Cogswell is more efficient at managing its inventory, Spacely seems to be doing a better job of collecting its receivables and utilizing its total assets in generating revenues. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (D) Profitability Ratios (1 of 2) Profitability ratios such as net profit margin, returns on assets, and return on equity, measure a firm’s effectiveness in turning sales or assets into profits. net income sales net income return on assets = total assets net income return on equity = total owners' equity profit margin = 14.12 14.13 14.14 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (D) Profitability Ratios (2 of 2) Table 14.5 2017 Profitability Ratios for Cogswell Cola and Spacely Spritzers Profitability Ratio Cogswell Cola Spacely Spritzers Profit margin 0.1319 0.1020 Return on assets 0.1411 0.1153 Return on equity 0.3566 0.3201 As far as profitability is concerned, Cogswell is outperforming Spacely by about 3%. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (E) Market Value Ratios (1 of 3) Used to gauge how attractive or reasonable a firm’s current price is relative to its earnings, growth rate, and book value. net income number of outstanding shares price per share price-to-earnings ratio = earnings per share price/earning per share price/earnings-to-growth ratio = earnings growth rate ?100 earnings per share = market-to-book-value = market value per share book value per share 14.15 14.16 14.17 14.18 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (E) Market Value Ratios (2 of 3) • Potential investors and analysts often use these ratios as part of their valuation analysis. • Typically, if a firm has a high price to earnings and a high market to book value ratio, it is an indication that investors have a good perception about the firm’s performance. • However, if these ratios are very high, it could also mean that a firm is over-valued. • With the price/earnings to growth ratio (PEG ratio), the lower it is, the more of a bargain it seems to be trading at, vis-à-vis its growth expectation. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (E) Market Value Ratios (3 of 3) Ratio Cogswell Cola Spacely Spritzers P÷E 15.41 13.01 PEG 1.28 0.86 P÷B 5.49 4.17 The ratios seem to indicate that investors in both firms seem to have good expectations about their performance and are therefore paying fairly high prices relative to their earnings book values. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (F) DuPont Analysis (1 of 2) Involves breaking down ROE into three components of the firm: 1. operating efficiency, as measured by the profit margin (net income ÷ sales); 2. asset management efficiency, as measured by asset turnover (sales ÷ total assets); and 3. financial leverage, as measured by the equity multiplier (total assets ÷ total equity). Equation 14.19 shows that if we multiply a firm’s net profit margin by its total asset turnover ratio and its equity multiplier, we will get its return on equity. net income sales total assets ? ? sales total assets total equity net income = total equity return on equity = 14.19 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.2 (F) DuPont Analysis (2 of 2) $3,313 $25,112 $23, 474 $3,313 ? ? = $25,112 $23, 475 $9, 291 $9, 291 = 0.1319 ?1.0698 ? 2.5265 = 0.3566 or 35.66% $857 $8, 403 $7, 433 $857 Spacely Spritzers' ROE = ? ? = $8, 403 $7, 433 $2, 677 $2, 677 = 0.1020 ?1.1305 ? 2.7766 = 0.3201 or 32.01% Cogswell Cola's ROE = Cogswell has better operational efficiency, i.e. it is better able to move sales dollars into income, but Spritzer is more efficient at utilizing its assets, and since it uses more debt, it is able to get more of its earnings to its shareholders. Although these 14 ratios are not the only ones that can be used to assess a firm’s performance, they are the most popular ones. It is important to look at the overall picture of the firm in all five areas and accordingly reach conclusions or make recommendations for changes. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 External Uses of Financial Statements and Industry Averages Financial statements of publicly traded companies and industry averages of key items provide the raw material for analysts and investors to make investment recommendations and decisions. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (A) Cola Wars (1 of 6) Table 14.6 Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (as of December 31, 2010) Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (A) Cola Wars (2 of 6) Table 14.7 Some Key Ratios for PepsiCo and Coca-Cola (5-Year Period) Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (A) Cola Wars (3 of 6) Table 14.8 Six Year Returns for PepsiCo and Coca-Cola Blank PepsiCo Coca-Cola Year Price Year End Dividends Annual Return Cumulative Return Price Year End Dividends Annual Return Cumulative Return 2011 $66.35 $2.129 8.08% 8.08% $34.99 $0.94 16.00% 16.00% 2012 $68.43 $2.149 6.37% 7.12% $36.25 $1.02 6.52% 11.07% 2013 $82.94 $2.241 24.48% 12.19% $41.31 $1.12 17.05% 12.74% 2014 $94.56 $2.533 17.06% 13.08% $42.22 $1.22 5.15% 10.70% 2015 $99.92 $2.764 8.59% 12.01% $40.56 $1.32 -0.59% 8.36% 2016 $104.63 $2.962 7.68% 11.14% $42.00 $1.40 6.77% 7.95% Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (A) Cola Wars (4 of 6) Table 14.9 Key Financial Ratios for PepsiCo and CocaCola (as of December 31, 2016) Ratio or Account PepsiCo Coca-Cola Return on equity 59.03% 25.90% Return on assets 8.87% 6.56% Current ratio 1.25 1.40 PEG ratio 3.46 4.82 Market-to-book-value ratio 14.09 8.36 Inventory turnover 10.36 6.16 Debt-to-equity ratio 5.61 2.78 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (A) Cola Wars (5 of 6) Table 14.9 Continued Ratio or Account PepsiCo Coca-Cola Net income (in millions) $6,329 $6,527 Gross margin ratio 55.10% 60.67% Earnings before taxes margin 13.62% 19.43% Earnings per share $ 4.64 $ 1.42 P/E ratio 24.88 31.51 $104.63 $42.00 Current price Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (A) Cola Wars (6 of 6) • One of the first things we notice in looking over the 5 years of data is how similar many of the ratios are from year to year, showing remarkable consistency for these two companies. • We also can see that the gross margin of Coca-Cola is consistently higher than that of PepsiCo. • The debt to equity ratio of both firms is mostly falling over the 5-year period. • We also can see that ROE has been very good for both companies, although slightly better for PepsiCo. • Finally, PepsiCo has very strong and growing earnings per share over this period, outperforming Coca-Cola’s EPS, but PepsiCo is also more expensive (higher current price per share). Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 14.3 (B) Industry Ratios Table 14.10 Financial Ratios: Industry Averages • Industry ratios are often used as benchmarks for financial ratio analysis of individual firms. • There can be significant differences in various key areas across industries, which is why comparing company ratios with industry averages can be very useful and more informative. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 1 Constructing an Income Statement. Using the income and expense account information for Tri-Mark Products Inc. listed below, construct an income statement for the year ended 31st December, 2017. Shares outstanding: 1,575,000 Tax rate: 35% Interest expense: $3,540,000 Revenue: $950,500,000 Depreciation: $50,000,000 Selling, general, and administrative expense: $85,000,000 Other income: $1,350,000 Research and development: $5,200,000 Cost of goods sold: $730,000,000 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 1 (Answer) Tri-mark Products Incorporated Income statement for the year ended 31st Dec. 2017 ('000s) Revenue $950,500 Cost of goods sold $730,000 Gross profit $220,500 Operating expenses Selling, general and administrative expenses $85,000 R&D $5,200 Depreciation $50,000 Operating income $80,300 Other income $1,350 EBIT $81,650 Interest expense $3,540 Taxable income $78,110 Taxes $27,339 Net income $50,772 Shares outstanding $16,740 EPS $3.03 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 2 Constructing a Balance Sheet. Construct Tri-Mark Incorporated’s 2017 year-end Balance Sheet using the asset, liability, and equity accounts listed below: Retained earnings $60,500,000 Accounts payable $57,000,000 Accounts receivable $43,000,000 Common stock $89,676,000 Cash $6,336,000 Short-term debt $1,500,000 Inventory $42,000,000 Goodwill $30,000,000 Long-term debt $74,000,000 Other non-current liabilities $15,000,000 PP&E $225,000,000 Other non-current assets $14,000,000 Long-term investments $25,340,000 Other current assets $12,000,000 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 2 (Answer) Tri-mark Products Inc. Balance Sheet as at year ended 31st December 2017(‘000s) Liabilities: Current Assets Cash Accts. rec. Inventory Blank Blank Current Liabilities $6,336 Blank Accounts payable $43,000 Blank Short-term debt Total current liabilities. Blank $58,500 Blank Blank $57,000 $1,500 Other current $12,000 Blank Long-term debt $74,000 Total current $103,336 Blank Other liabilities $15,000 Total liabilities Blank Blank Owner’s equity L- T Inv. PP&E $25,340 $225,000 $147,500 Blank Goodwill $30,000 Common stock Blank $189,676 Other assets $14,000 Retained earnings Blank $60,500 Total OE Blank $250,176 Total liab. and OE Blank $397,676 Blank Total assets Blank $397,676 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 3 • Common size statements: Re-state Tri-Mark Incorporated’s 2017 financial statements as common-size statements and comment on them. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 3 (Answer) Assets Blank Blank % of Total Assets Liabilities: Blank Blank % of Total Assets Current Assets Blank Blank Blank Current Liabilities Blank Blank Blank Blank Cash $6,336 0.02 Blank Accounts payable $57,000 0.14 Blank Accts. rec. $43,000 0.11 Blank Short-term debt $1,500 0.00 Blank Inventory $42,000 0.11 Total current liab. Blank $58,500 0.15 Blank Other current $12,000 0.03 Blank Long-term debt $74,000 0.19 Blank Total current $103,336 0.26 Blank Other liabilities $15,000 0.04 Blank L- T Inv. $25,340 0.06 Total liabilities Blank $147,500 0.37 Blank PP&E $225,000 0.57 Blank Owner’s equity Blank Blank Blank Goodwill $30,000 0.08 Common stock Blank $189,676 0.48 Blank Other assets $14,000 0.04 Retained earnings Blank $60,500 0.15 Total Assets Blank $397,676 1.00 Total OE Blank $250,176 0.63 Blank Blank Blank Blank Total liab. and OE Blank $397,676 1.00 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 4 (1 of 2) Compute and analyze financial ratios. Using the 2017 income statement and balance sheet of Trimark Products Inc., as constructed in problems 1 and 2 above, compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability? Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 4 (2 of 2) Ratio Industry Average Current ratio 2.200 Quick ratio (or acid test ratio) 1.500 Cash ratio 0.135 Debt ratio 0.430 Cash coverage 10.600 Day’s sales in receivables 29.000 Total asset turnover 2.800 Inventory turnover 20.100 Day’s sales in inventory 11.500 Receivables turnover 32.000 Profit margin 0.045 Return on assets 0.126 Return on equity 0.221 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 4 (Answer) (1 of 2) Blank Trimark Industry Average Current ratio 1.766 2.200 Quick ratio (or acid ratio test) 1.048 1.500 Cash ratio 0.108 0.135 Debt ratio 0.371 0.430 Cash coverage 37.189 10.600 Day’s sales in receivables 16.512 12.000 Total asset turnover 2.390 2.800 Inventory turnover 28.808 30.100 Day’s sales in inventory 12.670 11.500 Receivables turnover 22.105 30.000 Profit margin 0.053 0.045 Return on assets 0.128 0.126 Return on equity 0.203 0.221 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 4 (Answer) (2 of 2) Analysis: Liquidity: Trimark’s liquidity ratios are below the industry average indicating that they might need to look into their management of current assets and liabilities. Leverage: Trimark’s debt ratio is much lower than the industry average and its cash coverage is more than 3 time the average, indicating that if it needs to borrow long-term debt it should not have much of a problem. Asset management: Trimark’s asset turnover ratios are all below the average. It needs to tighten up collections, and manage its inventory more efficiently. Profitability: Trimark has a good control on cost of goods sold. Its net profit margin is better than the industry and so is its ROA. The industry, however, is returning a higher rate to the shareholders on average, primarily due to the higher debt levels. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 5 DuPont Analysis. Based on the ratios calculated in problem 4 above, and in conjunction with the industry averages given, conduct a DuPont analysis on Trimark’s key profitability ratios. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 5 (Answer) (1 of 2) According to the Du Pont breakdown, we have ROE = net profit margin × total asset turnover × equity multiplier → ROE = NI ÷ S × S ÷ TA × TA ÷ equity Note: since we don’t have the accounting information for the average, we have to figure out the industry’s equity multiplier by some algebraic manipulation. Equity multiplier = total assets ÷ equity Now, debt ratio = total debt ÷ total assets Total assets = total debt + equity → (Total debt ÷ total assets) + (equity ÷ total assets) = 1 → Equity ÷ total assets = 1 − (total debt ÷ total assets) → TA ÷ E = 1 ÷ (1 − TD ÷ TA) Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Additional Problems with Answers Problem 5 (Answer) (2 of 2) Trimark Industry Debt ratio 0.371 0.430 Total asset turnover 2.390 2.800 Profit margin 0.053 0.045 Return on assets 0.128 0.126 Return on equity 0.203 0.221 Equity multiplier = 1 ÷ (1 − debt ratio) 1.59 1.75 Blank Despite a lower total asset turnover ratio, Trimark’s ROA (12.8%) is better than that of the industry (12.6%), primarily due to its higher net profit margin. The industry, however, has a higher ROE (22.1%) due to its higher debt ratio and correspondingly higher equity multiplier. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 14.1 Cogswell Cola Balance Sheet Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 14.2 Cogswell Cola Income Statement Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Copyright Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.