Analysis of Financial Statements exam 2

Gross Profit Margin

Multiply by 100 to get a percentage

Why it changes: selling prices, product costs, competition, product demand, product mix, and sales volume can affect gross profit margin

• A high and increasing gross profit margin is generally better, while a low or decreasing margin can signal increased competition, lower demand, or higher product costs

DuPont Framework

Shows that a company can increase ROE in three main ways:

• Increase profitability: Earn more net income per dollar of sales by increasing profit margins

• Increase asset efficiency: Generate more sales from the company’s assets by increasing total asset turnover (aka ROA)

• Increase financial leverage: Use more debt relative to equity, which can increase ROE but also increases financial risk

  • a higher ROE does not automatically mean a company is performing better operationally

RNOA (Return on Net Operating Assets)

NOA (Net Operating Assets)

= Operating Assets — Operating Liabilities

Operating Assets:

• Accounts Receivable

• Inventories

• Prepaid Expenses / Supplies

• PP&E and Right-of-Use assets

• Intangible assets and Goodwill

• Deferred tax assets

• Equity method investments

Operating Liabilities:

• Accounts payable

• Accrued expenses

• Unearned (deferred) revenue

• Income taxes payable

• Deferred tax liabilities

• Pension obligations

• Other post-employment benefits

NOPM (Net Operating Profit Margin)

reveals how much operating profit the company earns from each sales dollar

NOAT

Measures the productivity of the company’s net operating assets

NOPAT (Net Operating Profit After Tax)

= NOPBT — Tax on Operating Profit

NOPBT (Net Operating Profit Before Tax)

= Sales — Operating Expenses

Operating Expenses:

• COGS

• SG&A: wages, advertising, occupancy, insurance, depreciation and amortization, litigation, and restructuring expenses

• Research and development

• Impairments of operating assets such as goodwill

• Income from joint ventures, partnerships, and associated companies

• Gains and losses on asset disposals

• “Other” operating expenses or income

Tax on Operating Profit

= Tax Expense + (Pretax Net Nonoperating Expense* Statutory Tax Rate)

* Tax Shield

Tax Shield

taxes a company saves by having tax-deductible nonoperating expenses

Demand for Credit — Why do companies need to borrow?

A. Operating activities

• To pay for materials and labor

• To make advance seasonal purchases

• To cover operating cash shortages or losses

• Companies have cyclical operating cash needs

  • Manufactures need cash for materials or labor

  • Advance seasonal purchases

• Cash needed for operating activities is not uniformly “low risk”

  • Cash needed to cover operating losses might not be temporary

• A willing lender could make the difference between bankruptcy and continued operations for a company

B. Investing activities

• To purchase property, plant, and equipment (PP&E)

• To purchase intangible assets

• To finance mergers and acquisitions (M&A)

• Companies require large amounts of cash for investing activities such as the purchase of property, plant and equipment or for corporate acquisitions

  • New PP&E (CAPEX)

  • Intangible assets

  • Mergers & acquisitions

C. Financing activities

• To repay a maturing bank loan or bond

• To repurchase company stock

• Companies occasionally need credit for financing activities

  • A bank loan or bond matures

  • Funds to repurchase stock

Demand for credit refers to why companies need to borrow money. Companies demand credit to fund operating activities, investing activities, and financing activities

Supply of Credit — Where can companies obtain credit?

Source	What it means
Trade credit	Suppliers let companies buy goods now and pay later, often without interest.
Bank loans	Banks provide different types of borrowing to meet a company's needs.
Lease financing	Leasing companies finance the use of assets, such as equipment.
Publicly traded debt	Companies raise money by issuing commercial paper, bonds, or debentures.

Types of bank loans and credit facilities

• Removing credit line: Provides cash for temporary or seasonal shortages; the balance can be repaid later

• Line of credit (backup credit facility): A bank commits to making funds available when needed

• Term Loan: Typically used to finance PP&E, with the asset serving as collateral and the loan duration often matching its useful life

• Mortgage: Typically used to finance real estate, with the property serving as security

• Banks structure financing to meet specific client needs

• Revolving credit line (revolvers)

  • Cash available for seasonal shortfalls

  • Bank commits to a credit line maximum, balance repaid later in the year

• Lines of credit (back-up credit facilities)

  • Bank provides a guaranty that funds will be available when needed

• Term loans (“bank loans)

  • Typically used to fund PP&E which serves as collateral

  • Loan duration matches useful life of PP&E

• Mortgages

  • Typically used for real estate transactions

  • Lender takes property as security

Supply of credit refers to the sources from which companies can obtain borrowed funds. These include trade credit, bank loans, lease financing, and publicly traded debt such as commercial paper, bonds, and debentures

Times Interest Earned Ratio

Measures a company’s ability to cover its interest expenses using its operating income. It assumes the company only needs to pay interest on its debt and can refinance the principal (the amount originally borrowed) when it comes due

• Basically, it tells us how easily a company can afford to pay the interest on its debt

• A higher ratio generally indicates a stronger ability to cover interest expenses, while a lower ratio indicates greater difficulty paying interest

Cash Flow from Operations to Total Debt

Measures a company’s ability to generate additional cash from its operating activities to cover debt payments as they come due

• Basically, tells you whether the company generates enough cash from running its business to help pay its debts when payments are due

  • Higher ratio: Generally indicates a stronger ability to meet debt obligations

  • Lower ratio: Generally indicates a weaker ability to meet debt obligations

Free Operating Cash Flow to Total Debt

Measures a company’s ability to pay its debt using the operating cash it has left after paying for capital expenditures (such as purchasing equipment or buildings)

• Basically, it shows how much cash a company has available to help pay its debts after spending money on long-term assets

Current Ratio

Measures a company’s ability to pay its short-term debts using the assets it expects to turn into cash or use up within one year

• Higher ratio: Generally better because the company has more current assets available to cover its short-term debts

• Lower ratio: Generally worse because the company may have difficulty paying its short-term debts when they come due

• A ratio below 1.0: Means the company has fewer current assets than current liabilities, which may indicate short-term liquidity problems

A very high current ratio, isn’t always better. It could mean the company isn’t using its assets efficiently

Quick Ratio

Measures a company’s ability to pay its short-term debts using its most liquid assets, without relying on selling inventory

• Higher ratio: Generally better because the company has more readily available assets to cover its short-term debts

• Lower ratio: Generally worse because the company may struggle to pay its short-term debts using its most liquid assets

• A ratio below 1.0: Means the company has fewer quick assets than current liabilities, which may indicate difficulty paying short-term debts

Key difference from the Current Ratio: The Quick Ratio excludes inventory because inventory may take time to sell and turn into cash

Working Capital

= Current Assets — Current Liabilities

The financial resources a company has available to support its day-to-day operations, such as paying employees, buying supplies, and keeping the business running after accounting for its short-term obligations. It indicates the company’s ability to meet its short-term financial obligations and fund its day-to-day operations.

• Positive working capital: Current assets exceed current liabilities, generally indicating a stronger ability to cover short-term obligations

• Negative working capital: Current liabilities exceed current assets, which may indicate difficulty covering short-term obligations

• Higher working capital: Generally provides more short-term financial flexibility, although an excessively high amount can indicate inefficient use of assets

An amount of money $, not a %

Liabilities to Equity

= Total Liabilities / Total Equity

Measures how much a company relies on liabilities compared with the amount of money invested by its shareholders to finance its assets

• Higher ratio: The company relies more heavily on liabilities to finance its assets, which generally means greater financial risk because it has more obligations to meet

• Lower ratio: The company relies less on liabilities relative to shareholders’ equity, generally indicating lower financial risk

• A ratio above 1.0: The company has more total liabilities their shareholders’ equity

• A ratio below 1.0: The company has more shareholders’ equity than total liabilities

Total Debt to Equity

= Total Debt / Total Stockholders’ Equity

Measures how much a company relies on debt to finance its operations compared with the amount invested by its shareholders

• Higher ratio: Generally means greater financial risk because the company relies more heavily on borrowing and must meet more debt obligations

• Lower ratio: Generally means lower financial risk because the company relies less on debt relative to shareholders’ equity

Total Debt to Equity may use only interest-bearing debt, while a broader Liabilities to Equity ratio uses all liabilities

Revenue Recognition Criteria

Revenue is recognized when a company fulfills its promise to provide goods or services to a customer, rather than simply when it receives cash

5 Steps:

1. Identify the contract — Determine the agreement between the company and the customer

2. Identify the performance obligations — Determine what goods or services the company promised to provide

3. Determine the transaction price — Determine how much the company expects to receive

4. Allocate the transaction price — Divide the price among the different goods or services provided, if there is more than one

5. Recognize revenue — Record revenue when each promise is fulfilled and the customer obtains control of the good or service. If the service is provided over time, recognize revenue over that period

Important rules and exceptions

Situation	When revenue is recognized
Sales on credit	When the company fulfills its performance obligation, even if cash hasn't been received yet
Right of return	Estimate expected returns and subtract them from sales to determine net sales
Gift cards	When the customer uses the gift card
Nonrefundable upfront fees	When the promised future goods or services are provided
Bill-and-hold arrangements	When control of the goods transfers to the customer
Consignment sales	If the seller acts as an agent, recognize the commission
Licenses	Depends on the contract: right to use = when available for use; promise of access = over time
Franchises	Recognize goods when transferred and services as they are delivered
Variable consideration	Recognize the expected amount to be received, subject to the applicable rules
Multiple-element contracts	Allocate the price to distinct goods and services and recognize each separately

Receiving cash does not automatically mean revenue is recognized. Revenue is generally recognized when the company fulfills its promise to the customer.

Cost-to-Cost Method (for long-term contracts)

Recognizes revenue from a long-term contract based on how much of the total expected production cost the company has incurred so far. It spreads revenue recognition over the life of the contract according to the project’s progress.

How it works:

• The company compares the costs incurred so far with the total expected costs

• That percentage estimates how much of the contract has been completed

• The company recognizes the corresponding percentage of the total contract revenue

Ex. If a company has incurred 15% of its total expected costs, it recognizes 15% of the total contract revenue

Net Sales

The total revenue a company earns from selling its goods or services after subtracting sales returns, sales allowances, and sales discounts

• Basically, the money the company earns from sales after accounting for reductions to those sales

Example:

• Total sales: $100,000

• Returned products: $5,000

• Sales discounts and allowances: $3,000

• Net sales: $92,000

Why it matters: Net sales shows how much revenue the company actually keeps from its sales after these reductions

Unearned (Deferred) Revenue

Money a company receives from customers before it has provided the goods or services, which is recorded as a liability because the company still owes the customer what they paid for

• Why it’s a liability: The company has received the money but still has an obligation to fulfill its promise to the customer

• When it becomes revenue: Once the company delivers the goods or provides the service, it reduces the unearned revenue liability and recognizes revenue

• Examples: Gift cards, advance payments, memberships, and subscriptions

Example: A customer pays $120 upfront for a one-year membership. The company initially records the $120 as unearned revenue because it still owes the customer membership services. As it provides those services, it recognizes the appropriate amount as revenue.

Analyzing unearned revenue:

• Unearned revenue increases: Customers are making more advance payments, which may indicate that more revenue and profit will be recognized in the future.

• Unearned revenue decreases: The company may be recognizing revenue from payments received in previous periods, while receiving fewer new advance payments. This could signal future declines in revenue and profit.

• Important: These are possible indicators, not guarantees. Consider both the dollar amount and the rate of change.

Key distinction to remember: Receiving cash is not the same as earning revenue. A company earns the revenue when it fulfills its obligation to the customer.

Research and Development (R&D) Expense

Costs a company incurs to research new ideas, develop new products, or improve existing products and technology

• Examples of R&D costs: Researchers’ salaries, research supplies, software licensing fees, payments to outside collaborators, and research facilities.

• Most R&D costs are expensed as incurred: The company records them as expenses when it incurs them, rather than recording them as assets to spread the cost over future years.

• Exception — general-purpose property, plant, and equipment (PPE): Equipment or buildings that can serve general purposes are capitalized as assets and depreciated over their useful lives.

Acquired R&D and IPR&D:

In-process research and development (IPR&D): Research and development projects that a company acquires from another company but that have not yet been completed.

• When a company acquires IPR&D as part of acquiring another company, it records the IPR&D as an asset.

• The asset is not amortized while the associated research is still in progress.

• Amortization begins when the project is completed and available for use; if the project is abandoned, the asset is written off.

Key distinction to remember: A company generally expenses its own R&D costs as they occur, but R&D acquired through a business acquisition is recorded as an asset.

ROE is computed as

Net Income Attributable to Controlling Interest / Average Equity Attributable to Controlling Interest

The current ratio is used to assess

Liquidity

Net Operating Profit After Tax (NOPAT) includes operating revenues less expenses such as:

• COGS

• Taxes on operating

• SG&A expenses

An example of a situation in which a company needs credit for investing activities is:

Mergers and acquisitions

When considering the results of an Altman Z-Score analysis, a score of 3.85 would suggest?

The company is healthy and there is a low bankruptcy potential in the short-term

Costco Wholesale Corporation collects annual non-refundable membership fees from customers. When should Costco recognize revenue for these membership fees?

Evenly over the membership year

Ticketmaster contracts with the producer of Blue Man Group to sell tickets online. Ticketmaster charges each customer a fee of $9 per ticket and receives $22 per ticket from the producer. Ticketmaster does not take control of the ticket inventory. Average ticket price for the event is $105.

How much revenue should Ticketmaster recognize for each Blue Man Group ticket sold?

$31 (22+9) because both the fee from the customer and the Blue Man Group producer are earned

Apple, Inc. reported research and development expense of $10,045 million on its 2031 income statement. This expense included many types of costs.

Which of the following types of costs would not be included in the $10,045 million?

Supplies and inventory related to R&D activities and new-product sales

Thomas Company receives information that requires the company to increase its expectations of uncollectible accounts receivable.

Which of the following does not occur on the company’s financial statements?

Accounts receivables (gross) is reduced