1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

2. MODULE A FINANCIAL STATEMENTS AND EXTERNAL DECISION MAKING

3. Overview: Financial Statements and External Decision Making Topics –Financial statements reflect the aggregate outcomes of many managerial decisions. –External decision makers use financial statements to make assessments of profitability and risk.

4. –Ratio calculations are used to help understand profitability and risk. –External decision makers also assess the accounting quality reflected in a firm’s financial statements.

5. Ratios Used to Assess Profitability Return on assets (ROA): General assessment of profitability (all capital providers point of view) –ROA assesses net profitability of operating activities per dollar of average investment, which is a measure of how profitable a company is regardless of how the company’s assets are financed.

6. Return on Common Equity (ROCE): Assessment of profitability from the viewpoint of common stockholders –ROCE assesses net profitability, after preferred dividends, per dollar of common stockholders’ investment Earnings Per Share (EPS) –Reflects net income, after preferred dividends, available to an average common share of stock The topic of EPS is discussed later in the text.

7. Return on Assets (ROA) ROA = Net income + Interest expense, net of income taxes Average total assets ROA = Net income + Interest expense (1-t) Average total assets where “t” = effective (or statutory) tax rate

8. Return on Common Stockholders’ Equity (ROCE) ROCE = Net Income – Dividends on Preferred Stock Average Common Stockholders’ Equity

9. Decomposition of ROCE ROCE subcomponents: ROA, common earnings leverage ratio, and capital structure leverage ratio ROCE = ROA  Common earnings leverage ratio  Capital structure leverage ratio

10. The common earnings leverage ratio captures the negative effects of capital structure on ROCE: Net income – Preferred dividends Net income + (1-t) Interest expense The capital structure leverage ratio captures the positive effect of leverage on ROCE: Average total assets Average common stockholders’ equity

11. How ROCE Components Combine ROCE = ROA Common Earnings Leverage Ratio Capital Structure Leverage Ratio Net income + [interest expense  (1-t) ]  Net income – preferred stock dividends  Average total assets Net income + [interest expense  (1–t)] Average common stockholders’ equity

12. NOTE: On the previous slide, the denominator in ROA cancels the numerator in the capital structure leverage ratio (shown in blue) and the numerator in ROA cancels the denominator in the common leverage ratio (shown in green). Got it?

13. Reduced ROCE Formula The final reduced form ROCE formula is: ROCE = Net income – preferred stock dividends Average common stockholders’ equity

14. Decomposition of ROA ROA subcomponents: Net profit margin ratio and asset turnover ratio. The net profit margin ratio measures the prefinancing income per dollar of sales. Net profit margin ratio = Net income + [interest expense x (1-t)] sales

15. As with all targets, financial and otherwise, analysts and decision makers should state in advance exactly what they are shooting for … because, if we aim at nothing we are likely to hit it!

16. The asset turnover ratio measures the ratio of sales per average dollar invested in net assets. Asset turnover ratio = Sales Average total assets

17. How ROA Components Combine ROA = Net Profit Margin RatioAsset Turnover Ratio Net income + [interest expense  (1-t)]  Sales Average total assets

18. Analysis of Risk Three major future-oriented risks assessed by external decisions makers: –Firm risks –Industry risks –General economic risks Generally, GAAP-based financial statements do not do a good job in helping assess these risks.

19. GAAP-based financial statements are used to assess two types of risk: –Short-term liquidity risks –Long-term solvency risks

20. Short-Term Liquidity Risks Working capital: The excess (deficit) of current assets minus current liabilities. WC = CA - CL

21. The current ratio shows the amount of current assets per dollar of current liabilities. Current Ratio =CA ÷ CL Rule of thumb for minimum current ratio is 2:1

22. The quick ratio shows the amount of quick assets, cash plus marketable securities plus accounts receivable, per dollar of current liabilities. Quick Ratio = Cash + Marketable securities + Accounts receivable Current liabilities

23. Activity ratios measure the speed at which current assets turn into cash inflows and current liabilities turn into cash outflows. Accounts Receivable Turnover Ratio = Sales Average accounts receivable Inventory Turnover Ratio = Cost of goods sold Average inventory

24. Accounts Payable Turnover Ratio = Purchases Average accounts payable Cash Flow from Operations to Current Liabilities Ratio = Cash flow from operations Average current liabilities

25. Long-Term Solvency Risk Several ratios are used to assess a company’s ability to service current debt requirements, i.e., to remain a going concern! Long-term Debt to Equity Ratio = Long-term debt Shareholders’ equity Long-term Debt to Total Assets Ratio = Long-term debt Total assets

26. Interest Coverage Ratio* = Income before income taxes + Interest expense Interest expense *Interest coverage ratio often is labeled times interest earned (sometimes “the thin ice” ratio). In general, bankers should not earn more than owners!

27. Operating Cash Flow to Total Liabilities Ratio = Operating cash flow Average total liabilities Operating Cash Flow to Capital Expenditures = Ratio Operating cash flow Capital expenditures

28. Usefulness of Ratios in Predicting the Future External users, particularly financial analysts, use ratios to help explain the present and to predict the future. –Why are ratios at their current levels? –Will the ratios continue at this level? –If not, how & why will they change?

29. In addition to ratios, individuals trying to explain and predict should study: –Industry conditions –Firm’s competitive strategy –Accounting quality Compared to WHAT?

30. Industry Conditions GAAP-based financial statements provide little information about industry conditions, such as: –Industry growth rate –Firm concentration –Product differentiation –Scale economies –Cyclicality and exit barriers –Legal barriers to entry –Relative bargaining power of buyers and suppliers and access to distribution channels

31. Firm Competitive Strategy GAAP-based financial statements provide little information about industry conditions, such as: –Cost leadership versus product differentiation –Demonstration of acquisition of unique core competencies and value chain

32. Accounting Quality Accounting quality includes general characteristics of information that enable external decision-makers to assess and predict sustainability of current financial characteristics.

33. Accounting quality comes from... –Truthful reporting (lack of earnings manipulation) –Persistence of earnings –Adequate disclosure –Using conservative assumptions in applying GAAP GAAP-based financial statements are useful in assessing these characteristics, particularly adequate disclosure and degree of conservatism in assumptions.

34. End of Module A