Analyzing Financial Statements Chapter 3 Analyzing Financial Statements Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter Overview Readers of Financial Statements Types of Financial Analysis Management Decision Making Financial Tricks Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Readers of Financial Analysis Owners Track and evaluate management’s performance Lenders Determine the risk of the business defaulting on its loan Managers Compare actual and budgeted results Government Ensure that taxes have been paid Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Readers of Financial Analysis cont. Suppliers Evaluate the company’s ability to pay its obligations Investment Analysts Evaluate the company’s performance Mergers and Acquisitions Highlight financial strengths, upside potential, and future value Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Types of Analysis Vertical Analysis Used to analyze variable expenses All accounts are sized using either: Total revenue or Departmental revenue Variable expenses should increase or decrease with the level of sales Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Sample Vertical Analysis Shae's Income Statement For the month ended June 30, 2008 Revenues: Amount Percent Food $ 890,000 78.20 Beverage 220,000 19.33 Others 28,100 2.47 Total Revenues $ 1,138,100 100.00 Cost of Sales: $ 320,400 36.00 48,400 22.00 15,455 55.00 Total Cost of Sales $ 384,255 33.76 Gross Profit: $ 569,600 50.05 171,600 15.08 12,645 1.11 Total Gross Profit $ 753,845 66.24 Accounts are divided by total revenues $1,138,100 Cost of Sales is divided by its respective revenue amount EX: Food $320,400 / $890,000 = 36% Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Sample Vertical Analysis cont. Operating (Controllable) Expenses: Amount Percent Salaries and Wages $ 352,811 31.00 Employee Benefits 105,843 9.30 Total Labor Cost 458,654 40.30 Direct Operating Expenses 68,286 6.00 Marketing 39,834 3.50 Utilities 44,386 3.90 Administration & General 28,453 2.50 Repairs and Maintenance 25,038 2.20 Music and Entertainment 31,867 2.80 Total Operating Expenses $ 696,517 61.20 Operating Income $ 57,328 5.04 Other (Non-controllable) Expenses: Rent $ 8,000 0.70 Depreciation 20,470 1.80 Interest 4,500 0.40 Total Non-controllable Expenses $ 32,970 2.90 Income Before Income Taxes $ 24,358 2.14 Accounts are divided by total revenues $1,138,100 Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Types of Analysis Horizontal Analysis Tracks and Analyzes: Income Statement Balance Sheet Focuses on both $$ and % changes Analyzes changes over time Month to Month Year to Year Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Sample Horizontal Analysis Danforth Hotels Horizontal Analysis for the Balance Sheets As of December 31 (in millions) 2007 2008 $ change % change Cash $ 82 $ 298 $ 216 263.4 Accounts Receivable 288 269 (19) -6.6 Marketable Securities 100 112 12 12.0 Inventory 193 158 (35) -18.1 Other current assets 64 90 26 40.6 Total Current Assets 727 927 200 27.5 Furniture, Fixture & Equipment, net 3,641 3,520 (121) -3.0 Management and Franchise Contracts, net 383 347 (36) -9.4 Goodwill 1,230 - 0.0 Long term Investments 568 599 31 5.5 Other long term assets 260 328 68 26.2 Long Term Assets 6,082 6,024 (58) -1.0 Total Assets $ 6,809 $ 6,951 $ 142 2.1 Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Sample Horizontal Analysis cont. 2007 2008 $ change % change Accounts Payable and Accrued Expenses $ 540 $ 601 $ 61 11.3 Current maturities of long-term debt 329 118 (211) -64.1 Accrued Taxes 4 - 0.0 Total Current Liabilities 873 723 (150) -17.2 Long Term Debt 3,709 3,560 (149) -4.0 Total Liabilities 4,582 4,283 (299) -6.5 Owner's Equity 1,807 1,998 191 10.6 Retained Earnings 420 670 250 59.5 Total Owner's Equity 2,227 2,668 441 19.8 Total Liabilities and Owner's Equity $ 6,809 $ 6,951 $ 142 2.1 Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Types of Analysis Trend Analysis Calculations and data points Over a specified period of time Presented on line graphs and bar charts Examples RevPAR Food Cost Payroll Cost Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Types of Analysis Published Industry Averages Management can compare operating results Examples Smith Travel Research HOST Report Operating results Smith Travel Research STAR Report Occupancy, ADR, and RevPAR Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Types of Analysis Ratio Analysis Used to asses financial health Five categories: Liquidity Solvency Activity Operating Profitability Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Liquidity Ratios Measures ability to meet short-term obligations Current Ratio Accounts Receivable Turnover Average Collection Period Operating Cash to Current Liabilities Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Solvency Ratios Measure ability to meet long-term obligations Operating Cash Flow to Long-term Debt Long-term Debt to Total Capitalization Debt-to-equity Ratio Times Interest Earned (TIE) Fixed Charge Coverage Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Activity Ratios Gauge effectiveness of how assets are managed Food Inventory Turnover Beverage Inventory Turnover Fixed Asset Turnover Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Operating Ratios Determine how efficient the operation is Food Cost Percentage Beverage Cost Percentage Labor Cost Percentage Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Profitability Ratios Effectiveness of achieving profit margins and ROI goals Profit Margin Return on Assets Return on Investment Return on Equity Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Management Decision Making Employee Scheduling Based on: Accurate revenue forecasts Productivity goals Customer service goals Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Management Decision Making Food and Beverage Pricing Track sales of each menu item Calculate each items gross profitability Set menu prices Remove unprofitable items from the menu Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Management Decision Making Revenue Management Goal is to maximize RevPAR Strategies Close lower levels of pricing during high demand Open all pricing levels during times of low demand Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Management Decision Making Profit Flexing Utilized when revenues fall behind budget Adjust pricing and reduce expenses Without impacting customer service Maximize remaining revenue opportunities Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Management Decision Making Cost-volume-profit Modeling Also known as Breakeven Analysis Target the amount of revenue required to reach the owner’s goal Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Cost-volume-profit Equations Breakeven Volume of Sales = Fixed costs (sale price – variable cost) Desired Occupancy % = Rooms sold Rooms available for sale Desired Volume = Fixed Costs + Desired Profits Sale Price – Variable Cost Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Breakeven Volume Example Sale price = $250 a night Fixed costs = $40,000 per month Variable cost = $35 per room Breakeven Volume of Sales = Fixed costs (sale price – variable cost) = 40,000 (250 - 35) 215 186 rooms Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Financial Tricks Window Dressing Making a company’s financial statements look more favorable Example Company does not pay invoices Makes year-end balance sheet look better Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Financial Tricks Off-balance-sheet Financing Company does not show debt associated with real estate joint ventures As long as it owns a “relatively” minor percentage of the joint venture Legal under GAAP Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Financial Tricks Capitalize Current Operating Expenses Reduces current expenses Increases profits Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Financial Tricks Improper Revenue Recognition Revenues are recorded before they are actually earned Violates matching principle Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved