Financial Statement Analysis

Basic Financial Analysis Tools

  • Common size financial statements

    • Used to compare different companies or to compare a company to itself over time.

    • Express financial statement items as a percentage of a common base (e.g., sales for income statement, total assets for balance sheet).

  • Trend statements

    • Used to identify patterns in a company's financial data over a period.

    • Involves selecting a base year and then expressing all the data in subsequent years as a percentage of the base year value.

  • Financial ratios

    • Used to evaluate various aspects of a company's financial performance and condition.

    • Examples include profitability ratios, liquidity ratios, solvency ratios, and efficiency ratios.

Types of Financial Analysis

  • Analysis for a given year:

    • Comparing financial data for one company within a single year.

    • Involves examining various financial statement items and calculating ratios to assess the company's performance in that year.

  • Time series analysis:

    • Examining a company's financial performance over a period to identify trends.

    • Involves analyzing financial data over multiple periods (e.g., years, quarters) to identify patterns and changes in the company's performance.

  • Cross-sectional analysis:

    • Comparing multiple companies at a single point in time (e.g., end of 2025).

    • Involves comparing the financial ratios and other performance metrics of different companies in the same industry to identify leaders and laggards.

  • Benchmark comparison:

    • Evaluating a company's performance against industry standards or key competitors.

    • Involves comparing a company's financial ratios and other performance metrics to those of its peers to assess its relative performance.

The Importance of Deeper Analysis

  • Financial statements alone don't always provide a complete picture.

    • Financial statements are prepared using accounting standards and may not reflect the true economic reality of a company.

  • Analysts need additional information, including:

    • Economic conditions

    • Macroeconomic factors, such as GDP growth, inflation, and interest rates, can impact a company's financial performance.

    • Industry fundamentals

    • Factors such as industry structure, competition, and regulatory environment can affect a company's profitability and growth prospects.

    • Management's areas of discretion

    • Management has discretion over certain accounting choices and estimates, which can impact the reported financial results.

Management's Discretion

  • Estimates:

    • Managers have discretion over certain estimates, such as the estimate of bad debts.

    • The allowance for doubtful accounts is an estimate of the amount of accounts receivable that a company expects to be uncollectible.

    • This discretion can lead to earnings management.

    • Earnings management is the practice of using accounting techniques to manipulate a company's reported financial results.

    • Earnings management is common but can be problematic if it becomes extreme.

    • Aggressive earnings management can mislead investors and other stakeholders about a company's true financial performance.

  • Timing of transactions:

    • Managers can control when to record discretionary expenditures like advertising based on what quarter it fits best in.

    • Companies can choose to accelerate or defer advertising expenses to smooth out their earnings over time.

  • Choice of methods:

    • GAAP allows choices between methods (e.g., LIFO and FIFO).

    • Companies can choose between different inventory costing methods, such as LIFO (last-in, first-out) and FIFO (first-in, first-out), which can impact the reported cost of goods sold and net income.

Impact of Discretion on Financial Statements

  • Management’s discretion over estimates, timing, and choices affects:

    • Balance sheet

    • Management's accounting choices can impact the reported amounts of assets, liabilities, and equity on the balance sheet.

    • Income statement

    • Management's accounting choices can impact the reported amounts of revenues, expenses, and net income on the income statement.

    • Financial ratios

    • Management's accounting choices can impact the financial ratios that are calculated using the financial statement data.

Example of Accounting Choices Impact

  • An accounting class divided into groups demonstrated how different accounting choices (permitted under GAAP) could significantly alter financial statements and ratios, even when analyzing the same company.

    • This example illustrates the importance of understanding the accounting choices that a company has made when analyzing its financial statements.

Conflict of Interest and Disclosure Requirements

  • Companies must disclose potential conflicts of interest.

    • Disclosure of conflicts of interest is important for transparency and accountability.

  • Extensive disclosure requirements in accounting are necessary for a reliable stock market, promoting investor confidence through rigor and checks and balances.

    • The SEC requires companies to disclose a wide range of information in their financial filings to protect investors and ensure fair and efficient markets.

Common Size Financial Statements

  • Purpose: To spot changes in a company's cost structure and profit performance.

    • Common size financial statements make it easier to compare companies of different sizes or to compare a company to itself over time.

  • Common size income statements: List everything as a percentage of sales.

    • In a common size income statement, each item is divided by sales to express it as a percentage of sales.

  • Common size balance sheets: Recast items as a percentage of total assets.

    • In a common size balance sheet, each item is divided by total assets to express it as a percentage of total assets.

Example: Kroger Common Size Income Statement

  • Sales are expressed as 100%.

    • This provides a common base for comparing other items on the income statement.

  • Example: In 2017, Kroger's operating profit was 1.7% of sales, and net earnings were 1.6%.

    • This indicates that Kroger's operating profit and net earnings were relatively low compared to its sales.

  • Cost of goods sold was 78% of every sales dollar, indicating low margins typical for grocery stores.

    • This indicates that Kroger's cost of goods sold is a significant portion of its sales, which is typical for grocery stores due to their low margins.

  • Change Analysis: Refer to the textbook chapter for an example of change analysis between years '16 and '17 for Kroger.

    • This example illustrates how common size income statements can be used to identify changes in a company's cost structure and profit performance over time.

Trend Income Statement

  • Method: Select a base year and express everything as a percentage of that base year.

    • Trend income statements make it easier to identify patterns in a company's financial data over time.

  • Calculation:

    • Percentage change between years = (Sales<em>Current−Sales</em>Base)Sales<br>Base\frac{(Sales<em>{Current} - Sales</em>{Base})}{Sales<br>{Base}}

  • Example: Sales in 2017 were 13% higher than in 2014, but net earnings were lower due to rising costs.

    • This indicates that Kroger's sales growth was offset by rising costs, which resulted in lower net earnings.

Common Size Balance Sheet

  • Method: Use assets as the %, and see how each asset makes up that %.

    • Common size balance sheets make it easier to compare the asset structure of different companies.

  • Example: For Kroger, plant property and equipment constitute almost 57% of total assets, followed by inventory.

    • This indicates that Kroger has a significant investment in plant property and equipment, which is typical for a grocery store chain.

  • Consistent cash levels may indicate a company rule or creditor requirement to maintain a certain cash balance (e.g., 1% of total assets).

    • This indicates that Kroger may have a policy or requirement to maintain a certain level of cash on hand.

Trend Analysis for Balance Sheet

  • Method: Compare values to a base year (set to 100).

    • Trend analysis for the balance sheet makes it easier to identify changes in a company's asset structure over time.

  • Calculation:

    • Percentage change: (Balance<em>Current−Balance</em>Base)Balance<br>Base\frac{(Balance<em>{Current} - Balance</em>{Base})}{Balance<br>{Base}}

  • Example: Inventory in 2016 was 7% more than in 2015, and plant property and equipment increased, indicating new asset purchases.

    • This indicates that Kroger increased its investment in inventory and plant property and equipment in 2016.

Common Sized Balance Sheet: Liabilities & Stockholders’ Equity

  • The % value is the total liabilities and stockholders' equity.

    • This provides a common base for comparing the different components of liabilities and stockholders' equity.

  • Long-term debt may constitute a significant portion (e.g., 32%).

    • This indicates that Kroger relies on long-term debt to finance a significant portion of its assets.

  • Trade accounts payable represents amounts owed for inventory.

    • This indicates that Kroger finances a portion of its inventory purchases through trade credit.

  • Accumulated earnings refer to retained earnings.

    • Retained earnings represent the portion of a company's net income that has been retained and reinvested in the business.

  • Non-controlling interest: Reflects the portion of subsidiaries not wholly owned by the parent company.

    • This indicates that Kroger has investments in subsidiaries that are not wholly owned.

Financial Ratios and Profitability Analysis

Return on Assets (ROA)

  • Formula: EarningsBeforeInterestAverageAssets\frac{Earnings Before Interest}{Average Assets}

    • ROA measures how efficiently a company is using its assets to generate earnings, without considering the impact of debt.

  • Indicates how well assets are being used to generate income.

    • A higher ROA indicates that a company is generating more income from its assets.

  • Components:

    • Operating Profit Margin: EarningsBeforeInterestSales\frac{Earnings Before Interest}{Sales}

    • Measures how much of each sales dollar contributes to income.

    • Asset Turnover: SalesAverageAssets\frac{Sales}{Average Assets}

    • Measures how well assets are used to generate sales.

  • ROA = Operating Profit Margin * Asset Turnover

    • This formula shows that ROA is driven by both profitability (operating profit margin) and efficiency (asset turnover).

Adjustments to Earnings for ROA Calculation

Analysts adjust reported earnings by:

  • Removing non-recurring profits to determine sustainable profits.

    • Non-recurring profits can distort a company's ROA and make it difficult to compare its performance over time.

  • Eliminating after-tax interest expense.

    • Interest expense is excluded from the numerator of the ROA calculation because ROA measures the return on a company's assets, regardless of how those assets are financed.

  • Addressing distortions related to accounting quality.

    • Accounting quality refers to the extent to which a company's financial statements accurately reflect its underlying economic performance.

Kroger’s Return on Assets: Example

  • Adjustments made for interest expense net of tax savings and one-time tax law changes.

    • These adjustments are necessary to ensure that Kroger's ROA is comparable to that of other companies.

  • ROA was consistent from 2014-2016 but dropped in 2017.

    • This indicates that Kroger's asset utilization declined in 2017.

  • Desirable ROA: High ROA, which can be achieved by boosting profit margin or asset turnover.

    • A high ROA indicates that a company is generating a high return on its assets, which is desirable for investors.

Reasons for Decreasing ROA

  • Kroger's ROA decreased because of:

    • Reduced current asset turnover

    • This indicates that Kroger was not using its current assets as efficiently in 2017 as it was in previous years.

    • Reduced long term asset turnover

    • This indicates that Kroger was not using its long-term assets as efficiently in 2017 as it was in previous years.

  • This situation signals to analyse a drop in the utilization of assets

    • When ROA decreases, it is important to analyze the underlying factors that are driving the decline to identify potential areas for improvement.

Industry Competition and Benchmarking

  • Competition drives down ROA towards a certain level.

    • In competitive industries, companies are constantly striving to improve their efficiency and profitability, which puts downward pressure on ROA.

  • Companies with consistently higher ROA have a competitive advantage.

    • Companies that can consistently generate a higher ROA than their competitors are likely to have a sustainable competitive advantage.

  • Examples:

    • Average ROA for grocery industry ≈ 5.9%.

    • This provides a benchmark for evaluating Kroger's ROA.

    • Publix achieves above-average ROA through high margins and lower turnover.

    • This indicates that Publix is able to generate a higher profit margin than its competitors, even though its asset turnover is lower.

    • Sprouts has both above-average margin and turnover.

    • This indicates that Sprouts is able to generate both a higher profit margin and a higher asset turnover than its competitors.

Achieving Superior Performance

  • Companies can achieve superior performance via:

    • Product and service differentiation

    • Companies can differentiate their products or services to command a premium price and generate higher profit margins.

    • Low-cost leadership

    • Companies can focus on being the low-cost provider in their industry to attract price-sensitive customers.

Return on Common Equity (ROCE)

  • Formula: NetIncome−DividendsPaidtoPreferredShareholdersAverageCommonEquity\frac{Net Income - Dividends Paid to Preferred Shareholders}{Average Common Equity}

    • ROCE measures how efficiently a company is using shareholders' equity to generate earnings.

  • Indicates how well the company is using shareholders' money to generate income.

    • A higher ROCE indicates that a company is generating more income for its shareholders.

Factors Affecting ROCE

  • ROCE is affected by ROA and financial leverage (use of debt).

    • Financial leverage can amplify or diminish ROCE, depending on the relationship between ROA and the cost of debt.

  • High financial leverage can amplify or diminish ROCE depending on ROA.

    • If a company's ROA is higher than the cost of debt, then financial leverage will amplify ROCE. However, if a company's ROA is lower than the cost of debt, then financial leverage will diminish ROCE.

Relationship between ROCE, ROA, and Financial Leverage

  • ROCE consists of: Return on Assets, Common Earnings Leverage, and Financial structure leverage.

  • Common Earnings leverage looks at earnings going to shareholders

  • Financial structure leverage measures if assets are equity or debt financed.

Example: Debt, and Equity

  • Illustrative example of how varying levels of balance sheet capital structure (debt vs. equity) affects returns:

  • Company 1: No Debt

    Identical Operations

    $\2,000,000 Assets (All Equity)

  • Company 2: High Debt

    Identical Operations

    $\2,000,000 Assets (1MM Equity, 1MM Debt)

  • Good Earnings Scenario: The return on common equity is much higher for the firm that has debt because the smaller pool of equity benefits, however, the opposite is also true.

  • Bad and Neutral Scenario: Using bad debt can be bad; debt did not help. However, in a neutral earnings year ROA and ROCE are equal even though the high debt had to pay interest.

Credit Risk Assessment Tools

  • Liquidity: Ability to pay debts coming due.

    • Companies with strong liquidity are more likely to be able to meet their short-term obligations.

  • Solvency: Ability to pay long-term debts.

    • Companies with strong solvency are more likely to be able to meet their long-term obligations.

  • Credit risk is the risk of nonpayment; lenders assess creditworthiness and charge higher interest rates to riskier borrowers.

    • Lenders charge higher interest rates to borrowers with higher credit risk to compensate for the increased risk of nonpayment.

Measuring Credit Risk

  • Corporate borrowing may involve issuing bonds, which are rated by agencies like Moody's.

    • Bond ratings provide an indication of the creditworthiness of the issuer.

  • Bond ratings range from AAA (least risky) to junk bonds (most risky).

    • AAA-rated bonds are considered to be the safest investments, while junk bonds are considered to be the riskiest.

Drivers of Ability to Pay

  • The ability to generate cash from operations, asset sales, or financial markets influences creditworthiness.

    • Companies that can generate cash from a variety of sources are more likely to be able to meet their obligations.

Debt Covenants

  • Lending agreements include debt covenants to ensure lenders get paid.

    • Debt covenants are restrictions that are placed on borrowers to protect lenders.

  • Types of debt covenants:

    • Affirmative: Requires the borrower to affirm financial statements every quarter.

    • Affirmative covenants require the borrower to take certain actions, such as providing regular financial reports to the lender.

    • Negative: Restrics borrowing from any other lender without approval.

    • Negative covenants restrict the borrower from taking certain actions, such as incurring additional debt.

    • Financial: Requires maintaining ratios within a range.

    • Financial covenants require the borrower to maintain certain financial ratios within a specified range.

  • Debt Covenant Violoations: The remedy for affirmative covenants is communication; for all others, the bank can "call the debt".

    • If a borrower violates a debt covenant, the lender may have the right to call the debt, which means that the borrower must repay the debt immediately.

Sources and Needs for Cash

  • The slide states that cash sources and needs are well aligned, but it is very important to understand them

  • The chart shows that companies can get cash from the operations, investing, and financing activities.

  • Companies can get cash from the selling goods, buying selling assets, either borrowing or issuing shares of stock.

  • Companies can need the cash to sustain operations, research and development, either paying back debts or issuing dividends.

Short Term Liquidity Ratios

  • Short Term Liquidity - Ability to pay your debts as they come due, ability to pay your current liabilities.

  • Ratios

    • Current Ratio: CurrentAssetsCurrentLiabilities\frac{Current Assets}{Current Liabilities}, want above 1.

    • A current ratio above 1 indicates that a company has more current assets than current liabilities, which suggests that it is likely to be able to meet its short-term obligations.

    • Quick Ratio: QuickAssetsCurrentLiabilities\frac{Quick Assets}{Current Liabilities}, want this above 1 also, and should be lower than Current Ratio.

    • The quick ratio is a more conservative measure of liquidity than the current ratio because it excludes inventory from current assets.

    • Accounts Receivable Turnover: CreditSalesAverageAccountsReceivable\frac{Credit Sales}{Average Accounts Receivable}, smaller the number is better, getting money faster.

    • Accounts receivable turnover measures how efficiently a company is collecting its receivables.

    • Inventory Turnover: CostofGoodsSoldAverageInventory\frac{Cost of Goods Sold}{Average Inventory}, you want this to be low as well, you are turning it over every certain amount of days. Should be a low number.

    • Inventory turnover measures how efficiently a company is managing its inventory.

    • Accounts Payable Turnover: InventoryPurchasesAverageAccountsPayable\frac{Inventory Purchases}{Average Accounts Payable}, This has some value, to see how often we are paying off the purchasers for the inventory Purchases.

    • Accounts payable turnover measures how efficiently a company is paying its suppliers.

Operating Cycle

  • The operating cycle is how long it takes to sell inventory and then collect the cash from the customers.

    • The operating cycle is a key measure of a company's efficiency and liquidity.

  • Companies better its cash conversion cycle to understand the cash flow.

    • The cash conversion cycle is the length of time between when a company pays for its inventory and when it receives cash from its customers.

  • A typical company pays its suppliers before it collects from its customers, which is why understanding this cash conversion cycle is so important.

  • Illustration of typical Cash-Conversion Cycle Days.

    • Purchase Inv = Day 0

    • Pay for Inv = Day 60

    • Sell Inv = Day 72

    • Collect = Day 162

Liquidity Analysis: Examples

  • Days Inventory

  • Days A/R

  • Days A/P

  • Resulting Operating Cycle Lengths

    **Costco & Amazon get paid before they even have to pay their suppliers!!

Kroger’s Short-Term Liquidity

  • Not looking good. They do have a low Current Ration & a Low Quick Ratio.

    • This indicates that Kroger may have difficulty meeting its short-term obligations.

  • The good thing there things are pretty consistent in between 2014-2017, but the lack of cash is concerning for its Short Term Debt Creditors.

    • This indicates that Kroger's short-term liquidity has been a concern for several years.

Long-Term Solvency Ratios

  • Remember now Solvency is different than Liquidity. This is the ability to pay or longer-term debts, to pay the Principle.

Ratios

  • Debt Ratios - Looking at what we have, sell them off the long run, and if we do, who goes to debt vs Assets, or Liability in Long run!

    • Debt ratios measure the amount of debt that a company has relative to its assets or equity.

    • Long Term Debt to Assets

    • This ratio measures the proportion of a company's assets that are financed with long-term debt.

    • Long Term Debt to Intangible Assets

    • This ratio measures the proportion of a company's intangible assets that are financed with long-term debt.

  • Coverage Ratios - How many times given the income that we have, would we be able to pay for our current interest, would we be able to sell that income

    • Coverage ratios measure a company's ability to cover its debt payments.

    • Interest Coverage

    • This ratio measures a company's ability to cover its interest expense with its earnings before interest and taxes (EBIT).

    • Cash Flow from Operations Divided by Average Current plus Long Term Debt

    • This ratio measures a company's ability to cover its debt payments with its cash flow from operations.

Kroger's Long-Term Solvency Ratios

  • Looking at Long Term Debt to Assets, We Are Still Growing, especially the last analysis, but what's that telling us?

    • This indicates that Kroger is continuing to increase its use of long-term debt to finance its assets.

  • Something's growing, is either that we taking on more debt.

  • Or Did we do what, can we still the same level of debt for that for so for what portion of that be goes to pay on those long term debts. what part or are asked are financed with us that. This is a more refined measure.

  • What we got remember we got to keep in our patent and that is going to play. So in cash in the beginning so this we got to keep his intangible asset.

  • Kroger needs to improve the two numbers & They may have

Basic Financial Analysis Tools

  • Common size financial statements

    • Used to compare different companies or to compare a company to itself over time.

    • Express financial statement items as a percentage of a common base (e.g., sales for income statement, total assets for balance sheet).

  • Trend statements

    • Used to identify patterns in a company's financial data over a period.

    • Involves selecting a base year and then expressing all the data in subsequent years as a percentage of the base year value.

  • Financial ratios

    • Used to evaluate various aspects of a company's financial performance and condition.

    • Examples include profitability ratios, liquidity ratios, solvency ratios, and efficiency ratios.

Types of Financial Analysis

  • Analysis for a given year:

    • Comparing financial data for one company within a single year.

    • Involves examining various financial statement items and calculating ratios to assess the company's performance in that year.

  • Time series analysis:

    • Examining a company's financial performance over a period to identify trends.

    • Involves analyzing financial data over multiple periods (e.g., years, quarters) to identify patterns and changes in the company's performance.

  • Cross-sectional analysis:

    • Comparing multiple companies at a single point in time (e.g., end of 2025).

    • Involves comparing the financial ratios and other performance metrics of different companies in the same industry to identify leaders and laggards.

  • Benchmark comparison:

    • Evaluating a company's performance against industry standards or key competitors.

    • Involves comparing a company's financial ratios and other performance metrics to those of its peers to assess its relative performance.

The Importance of Deeper Analysis

  • Financial statements alone don't always provide a complete picture.

    • Financial statements are prepared using accounting standards and may not reflect the true economic reality of a company.

  • Analysts need additional information, including:

    • Economic conditions

    • Macroeconomic factors, such as GDP growth, inflation, and interest rates, can impact a company's financial performance.

    • Industry fundamentals

    • Factors such as industry structure, competition, and regulatory environment can affect a company's profitability and growth prospects.

    • Management's areas of discretion

    • Management has discretion over certain accounting choices and estimates, which can impact the reported financial results.

Management's Discretion

  • Estimates:

    • Managers have discretion over certain estimates, such as the estimate of bad debts.

    • The allowance for doubtful accounts is an estimate of the amount of accounts receivable that a company expects to be uncollectible.

    • This discretion can lead to earnings management.

    • Earnings management is the practice of using accounting techniques to manipulate a company's reported financial results.

    • Earnings management is common but can be problematic if it becomes extreme.

    • Aggressive earnings management can mislead investors and other stakeholders about a company's true financial performance.

  • Timing of transactions:

    • Managers can control when to record discretionary expenditures like advertising based on what quarter it fits best in.

    • Companies can choose to accelerate or defer advertising expenses to smooth out their earnings over time.

  • Choice of methods:

    • GAAP allows choices between methods (e.g., LIFO and FIFO).

    • Companies can choose between different inventory costing methods, such as LIFO (last-in, first-out) and FIFO (first-in, first-out), which can impact the reported cost of goods sold and net income.

Impact of Discretion on Financial Statements

  • Management’s discretion over estimates, timing, and choices affects:

    • Balance sheet

    • Management's accounting choices can impact the reported amounts of assets, liabilities, and equity on the balance sheet.

    • Income statement

    • Management's accounting choices can impact the reported amounts of revenues, expenses, and net income on the income statement.

    • Financial ratios

    • Management's accounting choices can impact the financial ratios that are calculated using the financial statement data.

Example of Accounting Choices Impact

  • An accounting class divided into groups demonstrated how different accounting choices (permitted under GAAP) could significantly alter financial statements and ratios, even when analyzing the same company.

    • This example illustrates the importance of understanding the accounting choices that a company has made when analyzing its financial statements.

Conflict of Interest and Disclosure Requirements

  • Companies must disclose potential conflicts of interest.

    • Disclosure of conflicts of interest is important for transparency and accountability.

  • Extensive disclosure requirements in accounting are necessary for a reliable stock market, promoting investor confidence through rigor and checks and balances.

    • The SEC requires companies to disclose a wide range of information in their financial filings to protect investors and ensure fair and efficient markets.

Common Size Financial Statements

  • Purpose: To spot changes in a company's cost structure and profit performance.

    • Common size financial statements make it easier to compare companies of different sizes or to compare a company to itself over time.

  • Common size income statements: List everything as a percentage of sales.

    • In a common size income statement, each item is divided by sales to express it as a percentage of sales.

  • Common size balance sheets: Recast items as a percentage of total assets.

    • In a common size balance sheet, each item is divided by total assets to express it as a percentage of total assets.

Example: Kroger Common Size Income Statement

  • Sales are expressed as 100%.

    • This provides a common base for comparing other items on the income statement.

  • Example: In 2017, Kroger's operating profit was 1.7% of sales, and net earnings were 1.6%.

    • This indicates that Kroger's operating profit and net earnings were relatively low compared to its sales.

  • Cost of goods sold was 78% of every sales dollar, indicating low margins typical for grocery stores.

    • This indicates that Kroger's cost of goods sold is a significant portion of its sales, which is typical for grocery stores due to their low margins.

  • Change Analysis: Refer to the textbook chapter for an example of change analysis between years '16 and '17 for Kroger.

    • This example illustrates how common size income statements can be used to identify changes in a company's cost structure and profit performance over time.

Trend Income Statement

  • Method: Select a base year and express everything as a percentage of that base year.

    • Trend income statements make it easier to identify patterns in a company's financial data over time.

  • Calculation:

    • Percentage change between years = (Sales<em>Current−Sales</em>Base)Sales<br>Base\frac{(Sales<em>{Current} - Sales</em>{Base})}{Sales<br>{Base}}

  • Example: Sales in 2017 were 13% higher than in 2014, but net earnings were lower due to rising costs.

    • This indicates that Kroger's sales growth was offset by rising costs, which resulted in lower net earnings.

Common Size Balance Sheet

  • Method: Use assets as the %, and see how each asset makes up that %.

    • Common size balance sheets make it easier to compare the asset structure of different companies.

  • Example: For Kroger, plant property and equipment constitute almost 57% of total assets, followed by inventory.

    • This indicates that Kroger has a significant investment in plant property and equipment, which is typical for a grocery store chain.

  • Consistent cash levels may indicate a company rule or creditor requirement to maintain a certain cash balance (e.g., 1% of total assets).

    • This indicates that Kroger may have a policy or requirement to maintain a certain level of cash on hand.

Trend Analysis for Balance Sheet

  • Method: Compare values to a base year (set to 100).

    • Trend analysis for the balance sheet makes it easier to identify changes in a company's asset structure over time.

  • Calculation:

    • Percentage change: (Balance<em>Current−Balance</em>Base)Balance<br>Base\frac{(Balance<em>{Current} - Balance</em>{Base})}{Balance<br>{Base}}

  • Example: Inventory in 2016 was 7% more than in 2015, and plant property and equipment increased, indicating new asset purchases.

    • This indicates that Kroger increased its investment in inventory and plant property and equipment in 2016.

Common Sized Balance Sheet: Liabilities & Stockholders’ Equity

  • The % value is the total liabilities and stockholders' equity.

    • This provides a common base for comparing the different components of liabilities and stockholders' equity.

  • Long-term debt may constitute a significant portion (e.g., 32%).

    • This indicates that Kroger relies on long-term debt to finance a significant portion of its assets.

  • Trade accounts payable represents amounts owed for inventory.

    • This indicates that Kroger finances a portion of its inventory purchases through trade credit.

  • Accumulated earnings refer to retained earnings.

    • Retained earnings represent the portion of a company's net income that has been retained and reinvested in the business.

  • Non-controlling interest: Reflects the portion of subsidiaries not wholly owned by the parent company.

    • This indicates that Kroger has investments in subsidiaries that are not wholly owned.

Financial Ratios and Profitability Analysis

Return on Assets (ROA)

  • Formula: EarningsBeforeInterestAverageAssets\frac{Earnings Before Interest}{Average Assets}

    • ROA measures how efficiently a company is using its assets to generate earnings, without considering the impact of debt.

  • Indicates how well assets are being used to generate income.

    • A higher ROA indicates that a company is generating more income from its assets.

  • Components:

    • Operating Profit Margin: EarningsBeforeInterestSales\frac{Earnings Before Interest}{Sales}

    • Measures how much of each sales dollar contributes to income.

    • Asset Turnover: SalesAverageAssets\frac{Sales}{Average Assets}

    • Measures how well assets are used to generate sales.

  • ROA = Operating Profit Margin * Asset Turnover

    • This formula shows that ROA is driven by both profitability (operating profit margin) and efficiency (asset turnover).

Adjustments to Earnings for ROA Calculation

Analysts adjust reported earnings by:

  • Removing non-recurring profits to determine sustainable profits.

    • Non-recurring profits can distort a company's ROA and make it difficult to compare its performance over time.

  • Eliminating after-tax interest expense.

    • Interest expense is excluded from the numerator of the ROA calculation because ROA measures the return on a company's assets, regardless of how those assets are financed.

  • Addressing distortions related to accounting quality.

    • Accounting quality refers to the extent to which a company's financial statements accurately reflect its underlying economic performance.

Kroger’s Return on Assets: Example

  • Adjustments made for interest expense net of tax savings and one-time tax law changes.

    • These adjustments are necessary to ensure that Kroger's ROA is comparable to that of other companies.

  • ROA was consistent from 2014-2016 but dropped in 2017.

    • This indicates that Kroger's asset utilization declined in 2017.

  • Desirable ROA: High ROA, which can be achieved by boosting profit margin or asset turnover.

    • A high ROA indicates that a company is generating a high return on its assets, which is desirable for investors.

Reasons for Decreasing ROA

  • Kroger's ROA decreased because of:

    • Reduced current asset turnover

    • This indicates that Kroger was not using its current assets as efficiently in 2017 as it was in previous years.

    • Reduced long term asset turnover

    • This indicates that Kroger was not using its long-term assets as efficiently in 2017 as it was in previous years.

  • This situation signals to analyse a drop in the utilization of assets

    • When ROA decreases, it is important to analyze the underlying factors that are driving the decline to identify potential areas for improvement.

Industry Competition and Benchmarking

  • Competition drives down ROA towards a certain level.

    • In competitive industries, companies are constantly striving to improve their efficiency and profitability, which puts downward pressure on ROA.

  • Companies with consistently higher ROA have a competitive advantage.

    • Companies that can consistently generate a higher ROA than their competitors are likely to have a sustainable competitive advantage.

  • Examples:

    • Average ROA for grocery industry ≈ 5.9%.

    • This provides a benchmark for evaluating Kroger's ROA.

    • Publix achieves above-average ROA through high margins and lower turnover.

    • This indicates that Publix is able to generate a higher profit margin than its competitors, even though its asset turnover is lower.

    • Sprouts has both above-average margin and turnover.

    • This indicates that Sprouts is able to generate both a higher profit margin and a higher asset turnover than its competitors.

Achieving Superior Performance

  • Companies can achieve superior performance via:

    • Product and service differentiation

    • Companies can differentiate their products or services to command a premium price and generate higher profit margins.

    • Low-cost leadership

    • Companies can focus on being the low-cost provider in their industry to attract price-sensitive customers.

Return on Common Equity (ROCE)

  • Formula: NetIncome−DividendsPaidtoPreferredShareholdersAverageCommonEquity\frac{Net Income - Dividends Paid to Preferred Shareholders}{Average Common Equity}

    • ROCE measures how efficiently a company is using shareholders' equity to generate earnings.

  • Indicates how well the company is using shareholders' money to generate income.

    • A higher ROCE indicates that a company is generating more income for its shareholders.

Factors Affecting ROCE

  • ROCE is affected by ROA and financial leverage (use of debt).

    • Financial leverage can amplify or diminish ROCE, depending on the relationship between ROA and the cost of debt.

  • High financial leverage can amplify or diminish ROCE depending on ROA.

    • If a company's ROA is higher than the cost of debt, then financial leverage will amplify ROCE. However, if a company's ROA is lower than the cost of debt, then financial leverage will diminish ROCE.

Relationship between ROCE, ROA, and Financial Leverage

  • ROCE consists of: Return on Assets, Common Earnings Leverage, and Financial structure leverage.

  • Common Earnings leverage looks at earnings going to shareholders

  • Financial structure leverage measures if assets are equity or debt financed.

Example: Debt, and Equity

  • Illustrative example of how varying levels of balance sheet capital structure (debt vs. equity) affects returns:

  • Company 1: No Debt

    Identical Operations

    $\2,000,000 Assets (All Equity)

  • Company 2: High Debt

    Identical Operations

    $\2,000,000 Assets (1MM Equity, 1MM Debt)

  • Good Earnings Scenario: The return on common equity is much higher for the firm that has debt because the smaller pool of equity benefits, however, the opposite is also true.

  • Bad and Neutral Scenario: Using bad debt can be bad; debt did not help. However, in a neutral earnings year ROA and ROCE are equal even though the high debt had to pay interest.

Credit Risk Assessment Tools

  • Liquidity: Ability to pay debts coming due.

    • Companies with strong liquidity are more likely to be able to meet their short-term obligations.

  • Solvency: Ability to pay long-term debts.

    • Companies with strong solvency are more likely to be able to meet their long-term obligations.

  • Credit risk is the risk of nonpayment; lenders assess creditworthiness and charge higher interest rates to riskier borrowers.

    • Lenders charge higher interest rates to borrowers with higher credit risk to compensate for the increased risk of nonpayment.

Measuring Credit Risk

  • Corporate borrowing may involve issuing bonds, which are rated by agencies like Moody's.

    • Bond ratings provide an indication of the creditworthiness of the issuer.

  • Bond ratings range from AAA (least risky) to junk bonds (most risky).

    • AAA-rated bonds are considered to be the safest investments, while junk bonds are considered to be the riskiest.

Drivers of Ability to Pay

  • The ability to generate cash from operations, asset sales, or financial markets influences creditworthiness.

    • Companies that can generate cash from a variety of sources are more likely to be able to meet their obligations.

Debt Covenants

  • Lending agreements include debt covenants to ensure lenders get paid.

    • Debt covenants are restrictions that are placed on borrowers to protect lenders.

  • Types of debt covenants:

    • Affirmative: Requires the borrower to affirm financial statements every quarter.

    • Affirmative covenants require the borrower to take certain actions, such as providing regular financial reports to the lender.

    • Negative: Restrics borrowing from any other lender without approval.

    • Negative covenants restrict the borrower from taking certain actions, such as incurring additional debt.

    • Financial: Requires maintaining ratios within a range.

    • Financial covenants require the borrower to maintain certain financial ratios within a specified range.

  • Debt Covenant Violoations: The remedy for affirmative covenants is communication; for all others, the bank can "call the debt".

    • If a borrower violates a debt covenant, the lender may have the right to call the debt, which means that the borrower must repay the debt immediately.

Sources and Needs for Cash

  • The slide states that cash sources and needs are well aligned, but it is very important to understand them

  • The chart shows that companies can get cash from the operations, investing, and financing activities.

  • Companies can get cash from the selling goods, buying selling assets, either borrowing or issuing shares of stock.

  • Companies can need the cash to sustain operations, research and development, either paying back debts or issuing dividends.

Short Term Liquidity Ratios

  • Short Term Liquidity - Ability to pay your debts as they come due, ability to pay your current liabilities.

  • Ratios

    • Current Ratio: CurrentAssetsCurrentLiabilities\frac{Current Assets}{Current Liabilities}, want above 1.

    • A current ratio above 1 indicates that a company has more current assets than current liabilities, which suggests that it is likely to be able to meet its short-term obligations.

    • Quick Ratio: QuickAssetsCurrentLiabilities\frac{Quick Assets}{Current Liabilities}, want this above 1 also, and should be lower than Current Ratio.

    • The quick ratio is a more conservative measure of liquidity than the current ratio because it excludes inventory from current assets.

    • Accounts Receivable Turnover: CreditSalesAverageAccountsReceivable\frac{Credit Sales}{Average Accounts Receivable}, smaller the number is better, getting money faster.

    • Accounts receivable turnover measures how efficiently a company is collecting its receivables.

    • Inventory Turnover: CostofGoodsSoldAverageInventory\frac{Cost of Goods Sold}{Average Inventory}, you want this to be low as well, you are turning it over every certain amount of days. Should be a low number.

    • Inventory turnover measures how efficiently a company is managing its inventory.

    • Accounts Payable Turnover: InventoryPurchasesAverageAccountsPayable\frac{Inventory Purchases}{Average Accounts Payable}, This has some value, to see how often we are paying off the purchasers for the inventory Purchases.

    • Accounts payable turnover measures how efficiently a company is paying its suppliers.

Operating Cycle

  • The operating cycle is how long it takes to sell inventory and then collect the cash from the customers.

    • The operating cycle is a key measure of a company's efficiency and liquidity.

  • Companies better its cash conversion cycle to understand the cash flow.

    • The cash conversion cycle is the length of time between when a company pays for its inventory and when it receives cash from its customers.

  • A typical company pays its suppliers before it collects from its customers, which is why understanding this cash conversion cycle is so important.

  • Illustration of typical Cash-Conversion Cycle Days.

    • Purchase Inv = Day 0

    • Pay for Inv = Day 60

    • Sell Inv = Day 72

    • Collect = Day 162

Liquidity Analysis: Examples

  • Days Inventory

  • Days A/R

  • Days A/P

  • Resulting Operating Cycle Lengths

    **Costco & Amazon get paid before they even have to pay their suppliers!!

Kroger’s Short-Term Liquidity

  • Not looking good. They do have a low Current Ration & a Low Quick Ratio.

    • This indicates that Kroger may have difficulty meeting its short-term obligations.

  • The good thing there things are pretty consistent in between 2014-2017, but the lack of cash is concerning for its Short Term Debt Creditors.

    • This indicates that Kroger's short-term liquidity has been a concern for several years.

Long-Term Solvency Ratios

  • Remember now Solvency is different than Liquidity. This is the ability to pay or longer-term debts, to pay the Principle.

Ratios

  • Debt Ratios - Looking at what we have, sell them off the long run, and if we do, who goes to debt vs Assets, or Liability in Long run!

    • Debt ratios measure the amount of debt that a company has relative to its assets or equity.

    • Long Term Debt to Assets

    • This ratio measures the proportion of a company's assets that are financed with long-term debt.

    • Long Term Debt to Intangible Assets

    • This ratio measures the proportion of a company's intangible assets that are financed with long-term debt.

  • Coverage Ratios - How many times given the income that we have, would we be able to pay for our current interest, would we be able to sell that income

    • Coverage ratios measure a company's ability to cover its debt payments.

    • Interest Coverage

    • This ratio measures a company's ability to cover its interest expense with its earnings before interest and taxes (EBIT).

    • Cash Flow from Operations Divided by Average Current plus Long Term Debt

    • This ratio measures a company's ability to cover its debt payments with its cash flow from operations.

Kroger's Long-Term Solvency Ratios

  • Looking at Long Term Debt to Assets, We Are Still Growing, especially the last analysis, but what's that telling us?

    • This indicates that Kroger is continuing to increase its use of long-term debt to finance its assets.

  • Something's growing, is either that we taking on more debt.

  • Or Did we do what, can we still the same level of debt for that for so for what portion of that be goes to pay on those long term debts. what part or are asked are financed with us that. This is a more refined measure.

  • What we got remember we got to keep in our patent and that is going to play. So in cash in the beginning so this we got to keep his intangible asset.

  • Kroger needs to improve the two numbers & They may have