1. Financial Statement Analysis / Entrepreneurial Finance

2. Financial Analysis Overview
An assessment of a company’s past, present and future financial condition
Purpose is to diagnose company’s financial strengths and weaknesses
Primary tools
Financial Statements
Ratios

3. Financial Statements

4. Main Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows

5. The Balance Sheet
The balance sheet shows a firm’s assets (what it owns) and liabilities (what it owes)
The difference between a firm’s assets and liabilities is the firm’s net worth
A snapshot in time

6. Liabilities and Equity
Balance Sheet Items
Assets
Current assets:
Cash & securities
Accounts Receivable
Inventories
Fixed assets:
Tangible assets like PPE
Intangible assets
Liabilities and Equity
Current liabilities:
Accounts payable
Short-term debt
Long-term liabilities
Shareholders' equity

7. Anheuser-Busch Example
December 30, 2006 (from annual report)

8. Income Statement
The income statement summarizes revenues and expenses for the business
Covers an interval of time (monthly, quarterly, annually)
Major components:
Revenues
Expenses
Taxes
Extraordinary Items

9. Income Statement Format
Sales revenue
- Cost of goods sold
= Gross profit margin
- Operating expenses
= EBITDA
- Depreciation & Amortization
= EBIT (Operating income)
- Interest payments
= Taxable income
- Taxes
= Net Income

10. Anheuser-Busch Example

11. Accounting vs. Economic Earnings
Accounting definition of earnings ignores unrealized changes in market value of assets and liabilities
Accounting profit does not recognize cost of equity capital
Accounting profit may not contain all relevant costs
e.g., opportunity cost of entrepreneur’s time

12. Cash Flow Statement
Summarizes the levels of cash being generated or consumed by the business
Covers an interval of time (monthly, quarterly, annually)

13. Cash Flow Statement Format
Cash flow from operations
Net income
+ Depreciation
- Increase in accounts receivable
- Increase in inventories
+ Increase in accounts payable
Total cash flow from operations
Cash flow from investing activities
- Investment in plant and equipment
Cash flow from financing activities
- Dividends paid
+ Increase in short-term debt
= Change in cash

14. Anheuser-Busch Example

15. Statement Connections
Excel example

16. Ratio Analysis

17. Why do ratio analysis?
A means of evaluating and diagnosing performance
Ratios standardize numbers and facilitate comparisons
Comparing performance to competitors or industry standards (horizontal comparison)
Comparing performance to prior history (vertical comparison)
Examine a variety of areas
Liquidity
Solvency
Efficiency
Profitability
Remember that ratios are meaningless unless you have something to compare

18. Major Ratio Categories
Liquidity
ability to cover short-term obligations
Solvency
ability to cover long-term obligations; examines mix of debt and equity
Efficiency
amount of activity generated by resources deployed
Profitability
amount of profit generated by resources deployed
Market value (if applicable)
some of these ratios (e.g. price-earnings ratio, market-to-book ratio) are useful in valuation analysis, such as valuing private firms

19. Liquidity Ratios Current Ratio Quick Ratio
The ratio between all current assets and all current liabilities.
Formula:
   Current Assets Current Liabilities
Quick Ratio
The ratio between all assets quickly convertible into cash (this excludes inventory) and all current liabilities.
Cash + Accounts Receivable + Short-Term Investments        Current Liabilities
Current Ratio
Comments:
One problem with the current ratio is that it ignores timing of cash received and paid out. For example, if payments are this week, and inventory is the only current asset (and it won't be sold until the end of the month), the current ratio tells very little about a company's ability to survive.
If the ratio is less than one, the company has negative working capital.
A high working capital ratio isn't always a good thing; it could indicate that the company has too much inventory or are not investing excess cash.
Quick Ratio
Indicates the extent to which current liabilities could be paid without relying on the sale of inventory
Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments.

20. Anheuser-Busch Example
Current Ratio:
/ = 0.81
December 30, 2006 (from annual report)
Quick Ratio:
( ) / = 0.51

21. Solvency Ratios Debt to Equity Interest coverage ratio
Shows the ratio between capital invested by the owners and the funds provided by lenders.
Formula:
Total Liabilities   Total Equity
Interest coverage ratio
A measurement of the number of times a company could make its interest payments with its earnings before interest and taxes; the lower the ratio, the higher the company’s debt burden.
Pretax Operating Income + Interest Expense
Interest Expense
Debt to Equity
Comments:
Comparison of how much of the business was financed through debt and how much was financed through equity.
A ratio greater than one means assets are mainly financed with debt; less than one means equity provides a majority of the financing.
If the ratio is high (financed more with debt) then the company is in a risky position - especially if interest rates are on the rise.
Too much debt can put a business at risk... but too little debt may mean the business is not realizing its full potential. This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate).
Interest Coverage Ratio
Also called “Times Interest Earned”
An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations.
The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.

22. Anheuser-Busch Example
Debt to Equity:
( ) / = 3.16

23. Anheuser-Busch Example
Interest Coverage Ratio:
(2719.6) / = 6.03

24. Profitability Gross Profit Margin
Indicator of how much profit is earned on products without consideration of selling and administration costs.
Formula:
Sales - COGS Sales
Net Profit Margin / Return on Sales (ROS)
Shows how much profit comes from every dollar of sales.
Net Income  Sales
Gross Profit
Comments:
Compare to other businesses in the same industry to see if the business is operating as profitably as it should be.
Look at the trend from month to month. Is it staying the same? Improving? Deteriorating?
The results may be skewed if the company has a very large range of products.
ROS
Trend from month to month can show how well operating or overhead costs are being managed.

25. Anheuser-Busch Example
Gross Profit Margin:
/ = 35.3%
Net Profit Margin:
/ = 12.5%

26. Profitability Return on Equity (ROE) Return on Assets (ROA)
Determines the rate of return on the investment in the business.
Formula:
Net Income Equity
Return on Assets (ROA)
Considered a measure of how effectively assets are used to generate a return.
  Net Income     Total Assets
Return on Invested Capital (ROIC)
   Net Income      Total Liabilities + Stockholder’s Equity – Current Liabilities
ROE
Comments:
Very common measure of profitability
Has a number of drawbacks
Timing – uses historical, not forward-looking, information
Value – uses book values, which are often not representative of true value
Risk – ignores risk as a consideration
Compare the return on equity to other investment alternatives.
Compare ratio to other businesses in the same or similar industry.
ROA
ROA shows the amount of income for every dollar tied up in assets (from owners and lenders).
Year to year trends may be an indicator ... but watch out for changes in the total asset figure as you depreciate your assets (a decrease or increase in the denominator can affect the ratio and doesn't necessarily mean the business is improving or declining).
ROIC
Avoids the distortion of leverage contained in ROE.

27. Anheuser-Busch Example
Return on Equity:
/ = 49.9%
Info from income statement and balance sheet
Return on Assets:
/ = 12.0%
Info from income statement and balance sheet
Return on Invested Capital:
/ ( – ) = 13.9%
Info from income statement and balance sheet

28. Efficiency Days in Receivables Accounts Receivable Turnover
This calculation shows the average number of days it takes to collect accounts receivable (number of days of sales in receivables).
Formula:
Accounts Receivable       Sales  /  365 days
Compare to industry standards.
Accounts Receivable Turnover
Number of times that trade receivables turnover during the year.
  Net Sales            Accounts Receivable
Days in Receivables
Comments:
Can use average AR for increased precision
A high ratio indicates that the company is having problems getting paid for services or products.
The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season.
Look for trends that indicate a change in customers' payment habits.
Compare the calculated days in receivables to stated terms.
AR Turnover
The higher the turnover, the shorter the time between sales and collecting cash.
Compare to industry standards.

29. Efficiency Days in Inventory Inventory Turnover
This calculation shows the average number of days it will take to sell inventory
Formula:
Average Inventory Cost of Goods Sold / 365 days
Inventory Turnover
Number of times that inventory is turned over (sold) during the year.
Cost of Goods Sold Average Inventory
Days in Inventory
Comments:
This is mathematically the same formula as in HBR article (just looks a bit different)
Look for trends that indicate a change in inventory levels.
Compare to industry standards.
Inventory Turnover
Generally, a high inventory turnover is an indicator of good inventory management.
But a high ratio can also mean there is a shortage of inventory.
A low turnover may indicate overstocking or obsolete inventory.

30. Efficiency Asset Turnover Days in Accounts Payable
Indicates how efficiently business generates sales on each dollar of assets.
Formula:
     Sales         Total Assets
Days in Accounts Payable
This calculation shows the average length of time trade payables are outstanding before they are paid.
Accounts Payable    COGS     /   365 days
Accounts Payable Turnover
The number of times trade payables turnover during the year.
       COGS             Accounts Payable
Asset Turnover
Comments:
Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover - it indicates pricing strategy.
This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.
A volume indicator that can be used to measure efficiency of business from year to year.
Days in Accounts Payable
Compare the calculated days in payables to the terms offered by suppliers.
Compare to industry standards.
Accounts Payable Turnover
The higher the turnover, the shorter the time between purchase and payment.
A low turnover may indicate that there is a shortage of cash to pay bills or some other reason for a delay in payment.

31. Anheuser-Busch Example
Assigned Efficiency Ratios
Some Additional Efficiency Ratios
Days in Receivables:
/ (15,717.1/365) = 16.73
AR Turnover:
15,717.1 / = 21.8
Days in Inventory:
( )/2 / (10,165.0/365) = 24.23
Days in Accounts Payable:
1,426.3 / ( /365) = 51.21
Accounts Payable Turnover:
/ 1,426.3 = 7.13
Inventory Turnover:
10,165.0 / ( )/2 = 15.07
Asset Turnover:
15,717.1 / = 0.96

32. The DuPont Equation
ROE = (Net Income/Sales) x (Sales/Total Assets) x (Total Assets/Equity
= profit margin x asset turnover x leverage multiplier
DuPont equation shows how three different areas combine to determine ROE
expense management (measured by the profit margin)
asset management (measured by asset turnover)
debt management (represented by the debt ratio or leverage multiplier)

33. Using Ratio Analysis to Better Understand Profitability

34. Seemingly Similar Companies
Brinker International, Inc.
NYSE: EAT
Darden Restaurants, Inc.
NYSE: DRI
Outback Steakhouses, Inc.
NASDAQ: OSI

35. Seemingly Similar Performance
Profitability Performance (Most Recent Year)
Net Margin
4.63%
5.04%
6.50%
Return on Equity
15.40%
16.70%
17.40%
Source: Hoover’s Online

36. Potential Paths to Performance
High Margins
High Efficiency
High Leverage

37. Beginning the Investigation
Use company’s financial statements
Income Statement and Balance Sheet
Examine and compare common ratios
Across time
Across companies
Use three year period (2000 – 2002)

38. Margin Performance

39. Cost Efficiency
Higher = better
Lower = better

40. Leverage
Higher = more levered
Lower = more levered

41. Summary
Company A
High margins
Less efficient
Low leverage
Company B
Moderate margins
Moderate efficiency
High leverage
Company C
Low margins
High efficiency
Moderate leverage
They run very similar businesses and deliver similar results, but the paths are very different.

42. Questions to Consider Company A Company B Company C
What value does it deliver to justify its higher margins? Are the margins sustainable?
Company B
Is a middle of the road strategy with higher leverage a good one?
Company C
What is the source of its operating efficiencies? Are the efficiencies sustainable?

43. Who is Who? A few additional clues 2002 sales ($millions)
B: 4,369
C: 2,887
Sales growth (2002 – 2003)
A: 14.4%
B: 6.4%
C: 13.5%
A: Outback
B: Darden
C: Brinker

44. Using Financial in New Ventures

45. How to use financial ratios in new ventures?
Remember, financial statements are pro-forma (expectations about what financial position will be)
Could use average industry ratios as a starting point for generating pro-forma statements
Pro-forma statements should reflect the underlying strategy of the firm

46. Adjusting ratios according to your strategy
Key restaurant ratios
Low Cost Strategy
Differentiation strategy
Inventory turnover
(Wages & benefits) / sales
Liquidity
Gross profit margin
Operating costs / sales

47. Limitations of Ratios
They are outcome measures; if you have a problem with a ratio, you still have to figure out what’s causing the problem
Choosing the right comparison data is sometimes difficult
What’s the right industry?
Published industry averages are just rough guidelines
Who are the competitors?
Accounting practices can differ across firms
Seasonality may affect ratios
We have only discussed ratios generated from financial statements
These are based on historical data; we would like something that helps predict future performance
Operational / marketing measures may be more critical
Recall the Balanced Scorecard

48. Other Values to Consider
SG&A to Sales
Is company controlling overhead expenses?
Direct labor utilization
Often critical in professional services companies
Customer acquisition cost
Compare to lifetime value of a customer
Others (company-specific)
Create a Balanced Scorecard

49. The Balanced Scorecard
Kaplan and Norton (1992)

50. What is it?
A set of measures that gives top management a “fast but comprehensive view of the business”
Brings together, in one management report, disparate elements of company’s competitive agenda (customer measures, internal measures, financial measures, etc.)
Authors use analogy of dials and instruments in an airplane cockpit

51. Why do it? No single measure is adequate
It’s important to examine the means used to achieve financial outcomes
Many operational measures translate into future financial results
Traditional measures might give misleading signals regarding continuous improvement and innovation (focus on short-term results)

52. The Four Perspectives Customer Perspective: How do customers see us?
Internal Business Perspective: What must we excel at?
Innovation and Learning Perspective: Can we continue to improve and create value?
Financial Perspective: How do we look to shareholders?

53. The Balanced Scorecard
Note that the objectives, measures, and targets will obviously vary from company to company.

54. Next Time Zipcar case on Monday
This requires some financial thinking / analysis
Think about what key measures / ratios should be for the business