In this section, we will look at how we can use ratios to help evaluate a firm’s performance and financial position. Ratios are most useful when compared to some standard. That standard of comparison may be the performance of a competing company, last year’s performance by the same company, or an industry average.
This illustration provides a summary of the three different types of comparisons.
In performing vertical analysis, we express each item in a financial statement as a percentage of the same base amount. For instance, we can express each line item in an income statement as a percentage of sales. In a balance sheet, we can express each item as a percentage of total assets.
Thisillustration provides common-size income statements for Under Armour and Nike. The red arrow indicates the direction in which to read this statement.Nike reports net income of $2.2 billion while Under Armour reports only $129 million. We must keep in mind that Nike is a much larger company, reporting sales over $24 billion compared to less than $2 billion for Under Armour. Because of its greater size, we expect Nike to report a greater amount of net income. To better compare the performance of the two companies, we can use vertical analysis to express each income statement item as a percentage of sales. Under Armour’s gross profit equals 47.9% of sales ($879 ÷ $1,835) compared to Nike’s 43.4%. This means that Under Armour earns a slightly higher gross profit for each dollar of sales, consistent with its business strategy of focusing on high quality performance apparel. However, Under Armour’s higher gross profit is offset by its proportionately higher operating expenses, 36.5% of sales compared to 30.8% for Nike. The net result is that operating income, as a percentage of sales, is slightly lower for Under Armour. Finally, Nike’s net income, as a percentage of sales, exceeds Under Armour’s by over 2%. This is explained by Nike’s slightly better operating income as a percentage of sales, and it appears Nike has a lower portion of income reduced for income tax expense.
Vertical analysis of the balance sheet is useful. For this, we divide each balance sheet item by total assets to get an idea of its relative significance. This illustration provides common-size balance sheets for Under Armour and Nike. Focusing on the asset portion of the balance sheet, we discover that Under Armour has a higher percentage of current assets than Nike and a slightly higher share of assets invested in property and equipment. Nike has a higher percentage of intangible assets. Looking at liabilities and stockholders’ equity, we see that Nike has a slightly higher portion of current liabilities. Nike’s higher current liabilities will result in a lessfavorable current ratio and acid-test ratio. Both companies maintain similar proportions of long-term liabilities (7.6% and 7.9%) and are financed to a much greater extent by equity than by debt. Finally, it’s interesting to note the relative contributions of common stock and retained earnings for the two companies. Both companies have been profitable over the years, resulting in retained earnings balances that exceed the common stock balances. In other words, the earnings retained in the two companies over the years exceed the original amounts invested in the two companies.
We use horizontal analysis to analyze trends in financial statement data for a single company over time. This will help us compare the growth in sales and growth in cost of goods sold or operating expenses. These comparisons can help identify areas of concern or, perhaps, indications of better things to come.
This illustration provides income statements over two years for Under Armour. The final two columns show the dollar amount and percentage changes.We calculate the amount of the increases or decreases by simply subtracting the 2011 balance from the 2012 balance. A positive difference indicates the amount increased in 2012. A negative amount represents a decrease, which we record in parentheses. We calculate the percentage increase or decrease based on the formula shown on the previous slide.The horizontal analysis of Under Armour’s income statement demonstrates steady growth in company operations. Gross profit increased 23.3% ($166 ÷ $713), operating income increased 28.2% ($46 ÷ $163), income before tax increased 29.9% ($47 ÷ $157), and net income increased 33.0% ($32 ÷ $97). The growth in these income measures definitely is a positive sign. However, note that gross profit did not grow as quickly as sales. Under Armour increased sales, but the cost of those sales (cost of goods sold) grew at an even greater rate. The growth in sales came with slightly smaller markups on product costs. Nevertheless, an increase in net income of 33% is impressive.
This illustration provides balance sheet information for Under Armour for 2012 and 2011, with amount and percentage changes in the final two columns.Using horizontal analysis, it’s important to look at both the amount and the percentage changes. For example, if we focused solely on the percentage changes, “Intangible assets” had a fairly large decrease of 20%. However, in dollar amount, the decrease in “Intangible assets” is only $1 million, which is small compared to the company’s total assets exceeding $1 billion. The horizontal analysis of Under Armour’s balance sheet further reflects its growth in operations during the year. Each of the asset categories increased, with the exception of a slight decrease in intangible assets. Under Armour had a stock offering again in 2012, as reflected in the $54 million increase in common stock. The company used some of the proceeds from the stock offering to reduce long-term liabilities. Retained earnings increased $127 million, or 34.7%, due primarily to net income of $129 million during the year.
In this section, we will review 14 ratios classified into two categories: risk ratios and profitability ratios. When calculating ratios, we measure income statement accounts over a period of time and measure balance sheet accounts at a point in time. Therefore, ratios that compare an income statement account with a balance sheet account should express the balance sheet account as an average of the beginning and ending balances.
This illustration summarizes eight risk ratios, the chapters in which we discussed them, and how they’re calculated.We divide the eight risk ratios into six liquidity ratios and two solvency ratios. Liquidity refers to a company’s ability to pay its current liabilities. The accounts used to calculate liquidity ratios are located in the current assets and current liabilities sections of the balance sheet. Solvency refers to a company’s ability to pay its long-term liabilities as well.
The receivables turnover ratio measures how many times, on average, a company collects its receivables during the year. A low receivables turnover ratiomay indicate that the company is having trouble collecting its accounts receivable. A high receivables turnover ratio is a positive sign that a company can quickly turn its receivables into cash.The illustration shows the calculation of the receivables turnover ratio for Under Armour and compares it to Nike’s. In calculating the receivables turnover ratio, we have assumed that Under Armour’s sales are all credit sales. The bottom half of the fraction is the average accounts receivable during the year, calculated as beginning receivables plus ending receivables divided by two.
We often convert the receivables turnover ratio into days and call it the average collection period. The shorter the average collection period, the better.This illustration shows the average collection period for Under Armour and Nike. Under Armour’s average collection period of 30.9 days is 365 days divided by the receivables turnover ratio of 11.8. It takes Under Armour an average of over one month (30.9 days) to collect its accounts receivable. Nike’s average collection period, at 48.7 days, is about 18 days longer.
The inventory turnover ratio measures how many times, on average, a company sells its entire inventory during the year. A high inventory turnover ratio usually is a positive sign. It indicates that inventory is selling quickly, less cash is tied up in inventory, and the risk of outdated inventory is lower. However, an extremely high inventory turnover ratio might be a signal that the company is losing sales due to inventory shortages.This illustration provides the inventory turnover ratios for Under Armour and Nike. Inventory at Under Armour turns over, on average, about 3.0 times per year compared to 4.5 times per year at Nike. The slower inventory turnover at Under Armour is a negative sign, indicating a greater risk of slow-moving inventory items.
We can convert the inventory turnover ratio into days and call it the average days in inventory. As you can imagine, companies try to minimize the numberof days they hold inventory.We calculate the average days in inventory in this illustration. Under Armour’s average days in inventory is 121.7 days, calculated as 365 days divided by the inventory turnover ratio of 3.0. In comparison, Nike’s average days in inventory is much lower at 81.1 days.
The current ratio compares current assets to current liabilities. It’s probably the most widely used of all liquidity ratios. A high current ratio indicates that a company has sufficient current assets to pay current liabilities as they become due.This illustration presents the current ratios for Under Armour and Nike. Under Armour’s current ratio of 3.6 means the firm has $3.60 in current assetsfor each $1 in current liabilities. Under Armour’s current ratio is higher than Nike’s current ratio of 3.0. A company needs to maintain sufficient current assets to pay current liabilities as they become due. Thus, a higher current ratio usually indicates less risk.However, a high current ratio is not always a good signal. A high current ratio might occur when a company has difficulty collecting receivables or carries too much inventory.
The acid-test ratio is similar to the current ratio but is a more conservative measure of current assets available to pay current liabilities. Specifically, the top half of the fraction includes only cash, current investments, and accounts receivable. Because it eliminates current assets such as inventories and prepaid expenses that are less readily convertible into cash, the acid-test ratio may provide a better indication of a company’s liquidity than does the current ratio.This illustration shows the calculation of the acid-test ratio for Under Armour and Nike. Under Armour’s acid-test ratio is 2.1 to 1 and compares favorably with Nike’s ratio of 1.8 to 1. Both companies appear to have more than enough liquid assets available to pay current liabilities as they become due.
Other things being equal, the higher the debt to equity ratio, the higher the risk of bankruptcy. Debt holders have the ability to force a company into bankruptcy for failing to pay interest or repay the debt in a timely manner.This illustration shows the calculation of the debt to equity ratio for Under Armour and Nike. Under Armour has a debt to equity ratio of 41.6%, or about $0.42 in liabilities for each $1 in stockholders’ equity. Nike’s debt to equity ratio is higher, at 49.0%.Note that additional debt can be good for investors, as long as a company earns a return on borrowed funds in excess of interest costs. More debt increases the risk of bankruptcy, but it also increases the potential returns investors can enjoy.
We use the times interest earned ratio to compare interest payments with a company’s income available to pay those charges. Interest payments are more often associated with long-term liabilities than with current liabilities such as wages, taxes, and utilities.We calculate the times interest earned ratio by dividing net income before interest expense and income taxes by interest expense. To get to this amount, we just add interest expense and tax expense back to net income. We use net income before interest expense and income taxes as a reliable indicator of the amount available to pay the interest.This illustration shows how the times interest earned ratio is calculated for both Under Armour and Nike. Under Armour’s interest expense of $5 million is not listed separately on the income statement, but rather, is obtained from the notes to the financial statements. The times interest earned ratio for Under Armour is 41.8. That means Under Armour’s net income before interest and taxes was 41.8 times the amount it needed for interest expense alone. In comparison, Nike has an even better times interest earned ratio of 91.4. Both Under Armour and Nike generate more than enough income to cover their interest payments.
This illustration summarizes the six profitability ratios we have examined, the chapters in which we discussed them, and how we calculate them. These six ratios focus on profitability, the primary measure of company success.Profitability ratios measure the earnings or operating effectiveness of a company. Not only is profitability necessary just to survive as a company, it’s theprimary indicator used by investors and creditors in making financial decisions.
The gross profit ratio indicates the portion of each dollar of sales above its cost of goods sold. We calculate this ratio as gross profit (net sales minus cost of goods sold) divided by net sales. Gross profit ratios vary by industry.This illustration presents the calculation of the gross profit ratio for Under Armour and a comparison with Nike. With a gross profit ratio of 47.9%, Under Armour sells its merchandise for about twice what it costs to produce. In comparison, Nike has a gross profit ratio of 43.4%. Nike’s gross profit is still quite high, but not as high as Under Armour’s.
Return on assets measures the income the company earns on each dollar invested in assets. We calculate it as net income divided by average (not ending) total assets. Average total assets are calculated as beginning total assets plus ending total assets divided by 2.This illustration provides the calculation of return on assets for Under Armour and a comparison to Nike.Under Armour earned a return on assets of 12.4%, which is lower than Nike’s return on assets of 14.6%. As we learned in Chapter 7, we can further separate return on assets into two ratios: profit margin and asset turnover.
Profit margin measures the income earned on each dollar of sales. We calculate it by dividing net income by net sales. This illustration provides the calculation of profit margin for Under Armour and Nike. Under Armour has a profit margin of 7.0%, meaning that for every dollar of sales, 7 cents goes toward net income. Nike has a higher profit margin of 9.2%. Now let’s look at asset turnover, the second factor influencing return on assets.
Asset turnover measures sales volume in relation to the investment in assets. We calculate asset turnover as sales divided by average total assets. This illustration presents the calculation of asset turnover. Under Armour’s asset turnover is 1.8. Under Armour generates $1.80 in sales for every dollar it invests in assets. Nike’s asset turnover is just slightly lower at 1.6.
Return on equity measures the income earned for each dollar in stockholders’ equity. Return on equity relates net income to the investment made by owners of the business. The ratio is calculated by dividing net income by average stockholders’ equity. Average stockholders’ equity is calculated as beginning stockholders’ equity plus ending stockholders’ equity divided by 2.This illustration shows the calculation of return on equity. Under Armour has a return on equity of 17.8%. Its net income is 17.8 cents for every dollar invested in equity. Nike has an even higher return on equity of 22.0%.Nike’s return on assets is 2.2 percentage points higher than Under Armour’s, while its return on equity is 4.2 percentage points higher than Under Armour’s. This is because of financial leverage —the amount of debt each company carries. Recall that Nike has a higher debt to equity ratio. Both Under Armour and Nike enjoy returns well in excess of the interest cost on borrowed funds. By carrying greater debt, Nike is able to provide a higher return on equity in relationship to its return on assets, further benefiting the investors in the company.
The price-earnings (PE) ratio compares a company’s share price with its earnings per share. The PE ratio is an indication of investors’ expectations of future earnings for the company. This illustration presents the PE ratios for Under Armour and Nike. At the end of 2012, Under Armour’s closing stock price is $48.53, and the company reports earnings per share for 2012 of $1.23. This represents a PE ratio of 39.5. The stock price is trading at 39 times earnings. In contrast, the PE ratio for Nike is 22.4. Stocks commonly trade at a PE ratio somewhere between 15 and 20. At 39.5, Under Armour has a very high PE ratio. It appears that, at least at this point in time, investors are more optimistic about Under Armour’s future earnings potential than Nike’s, as shown by the price they are willing to pay for Under Armour stock.
In this section, we will look at how earnings persistence and earnings quality is measured.
To make predictions of future earnings, investors look for the current earnings that will continue or persist into future years. Some items that are part of net income in the current year are not expected to persist. We refer to these as one-time income items. The prime examples are (1) discontinued operations and (2) extraordinary items.When using a company’s current earnings to estimate future earnings performance, investors normally should exclude discontinued operations and extraordinary items.
A discontinued operation is the sale or disposal of a significant component of a company’s operations. We report any gains or losses on discontinued operations in the current year, separately from gains and losses on the portion of the business that will continue. This allows investors the opportunity to exclude discontinued operations in their estimate of income that will persist into future years.
For an example of accounting for discontinued operations, let’s consider Federer Sports Apparel, which has two business activities: a very profitable line of tennis apparel and a less profitable line of tennis shoes. Let’s say that during 2015, the company decides to sell the tennis shoe business to a competitor, and the total gain from discontinued operations is $1.5 million. We report the gain “net of tax.” This means the $1.5 million gain (before tax), less $500,000 in related taxes, is reported on the income statement as a $1 million gain.This illustrationshows the income statement presentation of discontinued operations for Federer Sports Apparel.With discontinued operations reported separately in the income statement, investors can clearly see the reported net income excluding the effects of the discontinued tennis shoe segment, $4.0 million in this situation. Investors then can use the income excluding discontinued operations, $4.0 million, to estimate income that persists into future periods.
To be an extraordinary item, an event that produces a gain or loss must meet two conditions. It must be (1) unusual in nature and (2) infrequent in occurrence. Unusual in nature means that the event is not normal for that type of company. Infrequent in occurrence means the company does not expect the event to happen again in the near future.A company must consider the definition of extraordinary in the context of the environment in which it operates. For example, uninsured losses from a naturaldisaster such as a flood, earthquake, or hurricane would normally be reported as an extraordinary loss in the income statement. However if, due to lower land prices, a grower planted in a flood zone with the expectation of periodic flood losses, the loss would be included as part of operating costs and not categorized separately as an extraordinary item.
We report extraordinary items separately, net of taxes, near the bottom of the income statement just below discontinued operations. To illustrate, let’s assume Federer Sports Apparel suffers an uninsured loss to property and equipment from an earthquake. This event meets both criteria for an extraordinary item—it is unusual in nature and infrequent in occurrence. If the loss (net of taxes) is $600,000, we would report it separately as an extraordinary item in the income statement as shown in this illustration.As we do with discontinued operations, we report extraordinary items separately near the bottom of the income statement to allow investors to see that these are one-time items that should be excluded in estimating income that will persist into future periods.
This illustration provides a summary of items reported in the income statement as “other revenues and expenses” rather than as extraordinary items.The sale or disposal of a significant component of a company’s operations is recorded as discontinued operations. However, the sale or disposal of most assets is reported, not as discontinued operations, but rather as other revenues and expenses.Many items meet one, but not both, criteria for extraordinary item treatment. In that case, they are correctly excluded from extraordinary items. Commonexamples include losses due to the write-down of receivables, inventory, or long-term assets; gains or losses on the sale of long-term assets; losses due to an employee strike; or losses due to business restructuring. Each of these items is reported in the income statement as “other revenues and expenses” rather than as extraordinary items.
Quality of earnings refers to the ability of reported earnings to reflect the company’s true earnings, as well as the usefulness of reported earnings to predict future earnings.
Let’s move one year forward to 2016 for our example company, Federer Sports Apparel.Mr. Nadal, as chief financial officer (CFO), is responsible for all the accounting, finance, and MIS operations of the business. He has developed a reputationfor his conservative, patient, yet powerful management style.This illustration and the next illustration present the preliminary financial statements for 2016, prepared under the supervision of Mr. Nadal.
After completing the preliminary financial statements for 2016, Mr. Nadal retires, and the company hires a new CFO, Mr. Djokovic. In contrast to Mr. Nadal,Mr. Djokovic has a more aggressive, quick-hitting management style. Mr. Djokovic has made it clear that he is now in charge and some changes will need to be made. These are the changes he proposes. Estimate of bad debts. At the end of 2016, Mr. Nadal decided to play it safe and recorded an allowance equal to 10% of accounts receivable, or $150,000. Mr. Djokovic proposes changing the estimate to be 6% of accounts receivable, or $90,000. This change would increase net accounts receivable and decrease bad debt expense by $60,000.Write-down of inventory. Mr. Nadal recorded a $200,000 write-down of inventory. Mr. Djokovic insists the write-down was not necessary because the decline in inventory value was only temporary. Therefore, he proposes eliminating this entry, which would increase inventory and decrease loss on inventory write-down by $200,000.Change in depreciation estimate. For the building purchased for $11 million at the beginning of 2015, Mr. Nadal recorded depreciation expense of $1 million in 2015 and 2016, using the straight-line method over 10 years with an estimated salvage value of $1 million. Beginning in 2016, Mr. Djokovic proposes calculating depreciation over a total of 20 years instead of 10 and using an estimated salvage value of $500,000. That change decreases accumulated depreciation and depreciation expense in 2016 by $500,000. Loss contingency. At the end of 2016, the company’s lawyer advised Mr. Nadal that there was a 70% chance of losing a litigation suit of $1,500,000 filed against the company. Mr. Nadal recorded the possible loss. Mr. Djokovic argues that the likelihood of losing the litigation is reasonably possible, but not probable. Therefore, he proposes removing the litigation entry from the accounting records. The change would remove the loss and decrease liabilities by $1,500,000.
This illustration presents the preliminary income statement prepared by Mr. Nadal, the effect of the accounting changes, and the updated income statement prepared by Mr. Djokovic.The four proposed accounting changes cause net income to more than triple, from $850,000 to $3,110,000. Notice that all four changes proposed by Mr. Djokovic increase net income: The change in the estimated allowance for uncollectible accounts increases net income $60,000; the elimination of the inventory write-down increases net income $200,000; the change in useful life to calculate depreciation method increases net income $500,000; and the elimination of the litigation liability increases net income $1,500,000. Note that income tax expense did not change because all of these changes affect financial income but not taxable income.
This illustration presents the balance sheet prepared by Mr. Nadal, the effect of the four accounting changes, and the updated balance sheet prepared by Mr. Djokovic.The balance sheet also improves from the proposed adjustments. Total assets increase due to increases in receivables and inventory plus a decrease in accumulated depreciation. Total liabilities decrease due to the elimination of the $1.5 million litigation liability. Stockholders’ equity also goes up, due to the increase in retained earnings caused by the increase in reported net income for the year.
Thisillustration provides the statement of cash flows as revised by Mr. Djokovic.Interestingly, the proposed changes have no effect at all on total operating cash flows or on the overall change in cash. Net cash flows from operating activities remain at $1,700,000 after the four proposed transactions. The net increase in cash remains at $1,500,000. None of the proposed changes affects the underlying cash flows of the company. Rather, each improves the appearance of amounts reported in the income statement and the balance sheet.
Mr. Nadal represents conservative accounting practices. Conservative accounting practices are those that result in reporting lower income, lower assets, and higher liabilities. The larger estimation of the allowance for uncollectible accounts, the write-down of overvalued inventory, the use of a shorter useful life for depreciation, and the recording of a contingent litigation loss are all examples of conservative accounting.In contrast, Mr. Djokovic represents aggressive accounting practices. Aggressive accounting practices result in reporting higher income, higher assets, and lower liabilities. Mr. Djokovic’s lower estimation of the allowance for uncollectible accounts, waiting to report an inventory write-down, choosing a longer useful life for depreciation, and waiting to record a litigation loss all are examples of more aggressive accounting. Everyone involved in business, not just accountants, needs to recognize the difference between conservative and aggressive accounting practices.