Financial Statement Analysis

Accounts Receivable Turnover Ratio

The A/R turnover ratio measures the average number of times that receivables from sales are collected
during a year.

An underlying assumption of this ratio is that sales occur evenly throughout the year, hence average A/R
can be estimated using the average of beginning and ending A/R balances. When sales are seasonal, or
uneven, the beginning and ending balances may not be representative of the average A/R balance. This
is one of the reasons that most retailers have a fiscal year ending on January 31 and not December 31,
because the sales in that industry are seasonal. A/R turnover also can be analyzed in days instead of
times per year. There are two conventions used for number of days in a year—360 and 365. When
performing calculations, be consistent and state your assumptions.

Note: The CMA exam uses the 365-day convention in all formulas requiring an assumption for the
number of days in a year.

Days’ sales in receivables/outstanding (DSO) (also known as average collection period) measures the
liquidity of receivables.

An internal analyst compares days’ sales in receivables with the company’s credit terms to determine
how efficiently the company manages its receivables. If a company’s credit term is 30 days, days’ sales in
receivables should not be substantially over 30 days. If significant differences are found, attention
should be focused on collections policies. As is the case with many ratios, the analyst should examine
extreme values in days’ sales in receivables. For example, a firm wiThexceptionally low days’ sales in
receivables may have excessively tight credit policies that can result in lost sales.
The internal analyst also must make a distinction between cash sales and credit sales; only credit sales
should be included in these ratios. Further, days’ sales in receivables is not relevant for primarily cash
businesses, such as fast food restaurants. If cash sales are included, liquidity will be overstated. An
increase in the amount of time it takes to turn over receivables indicates deteriorating liquidity.
Note that sometimes the days’ sales in receivables is calculated using ending values of A/R instead of
average receivables as shown. However, the formula just shown is the one that is tested on the CMA
exam.

Inventory Turnover Ratio

The inventory turnover ratio measures the average number of times that inventory was sold during a
year. Inventory is one of the most significant assets in determining liquidity, because the inventory
account often is more than half of the total current assets. The inventory of a retailer is the merchandise
available for sale. In a manufacturing environment, inventory includes raw materials, work in process,
and finished goods. Only the finished goods inventory (if a number is separately available) should be
used in computing this ratio.

If sales are fairly constant, a lower number of days or a greater number of turnovers of inventory
indicates better inventory control and stronger liquidity. Generally, successful companies are those that
are able to keep their inventory low with high turnovers while still meeting customer orders on a timely
basis. With recent adoption of just-in-time inventory policies and an efficient supply chain management,
the inventory turnover ratio has increased.

Working Capital Terms and Concepts

Working capital is a measure of a company’s ability in the short run to pay its obligations.

1. Current assets are cash and other assets that the firm expects to convert into cash in a year or less.
These assets are usually listed on the balance sheet in order of their liquidity. Typical current assets
include cash, marketable securities (sometimes also called short-term investments), accounts
receivable, inventory, and others, such as prepaid expenses.
2. Current liabilities (or short-term liabilities) are obligations that the firm expects to repay in a year or
less. They may be interest bearing, such as short-term notes and current maturities of long-term debt,
or noninterest bearing on such as accounts payable, accrued expenses, or accrued taxes and wages.

3. Working capital refers to the difference between current assets and current-liabilities.

Working Capital Accounts and Trade-Offs

Short-term cash inflows and outflows do not always match in their timing or magnitude, creating a need
to manage the working capital accounts. The objective of the managers of these accounts is to enable
the company to operate effectively with the smallest possible net investment in working capital. To do
this managers must make cost/benefit trade-off s. The trade-off s arise because it is easier to run a
business with a generous amount of net working capital, but it is also more costly to do so. Working
capital assets are costly for the firm to hold because they must be financed by borrowing or selling
equity or by using cash from operations that could otherwise be paid out to the firm’s investors. The
working capital accounts that are the focus of most working capital management activities are as
follows:

1. Cash (including marketable securities): The more cash a firm has on hand, the more likely it will be
able to meet its financial obligations if an unexpected expense occurs or take advantage of an
unexpected investment opportunity. If cash balances become too small, the firm runs the risk that it will
be unable to pay its bills; and if this condition become chronic, creditors could force the firm into
bankruptcy. The downside of holding too much cash is that the returns on cash are low even when it is
invested in an interest-paying bank account or highly liquid short-term money market instruments, such
as U.S. government Treasury securities.

2. Receivables: The accounts receivable at a firm represent the total unpaid credit that the firm has
extended to its customers. Accounts receivable can include trade credit (credit extended to another
business) or consumer credit (credit extended to a consumer), or both. Businesses provide trade and
consumer credit because doing so increases sales and because it is often a competitive necessity to
match the credit terms offered by competitors. The downside to granting such credit is that it is
expensive to evaluate customers’ credit applications to ensure that they are creditworthy and then to
monitor their ongoing credit performance. Firms that are not diligent in managing their credit
operations can suffer large losses from bad debts, especially during a recession when customers may
have trouble paying their bills.

3. Inventory: Customers like firms to maintain large finished goods inventories because when they go to
make a purchase, the item they want will likely be in stock. Similarly, large raw material inventories
reduce the chance that the firm will not have access to raw materials when they are needed, which can
cause costly interruptions in the manufacturing process. At the same time, large inventories are
expensive to finance, can require warehouses that are expensive to build and maintain, must be
protected against breakage and theft, and run a greater risk of obsolescence.

4. Payables: Accounts payable are trade credits provided to firms by their suppliers. Because suppliers
typically grant a grace period before payables must be repaid, and firms do not have to pay interest
during this period, trade credit is an attractive source of financing. For this reason, financial managers do
not hurry to pay their suppliers when bills arrive. Of course, suppliers recognize that they provide
attractive financing to their customers and that trade credit is expensive for them. Consequently,
suppliers tend to provide strong incentives (either by providing discounts for paying on time or charging
penalties for late payment) for firms to pay on time. As you might expect, firms typically wait until near
the end of the grace period to repay trade credit. The financial manager at a firm that is having serious
financial problems may have no choice but to delay paying its suppliers. However, besides incurring
monetary penalties, a manager who is consistently late in making payments runs the risk that the
supplier will no longer sell to his or her firm on credit.

When the financial manager makes a decision to increase working capital, good things are likely to
happen to the firm—sales should increase, relationships with vendors and suppliers should improve,
and work or manufacturing stoppages should be less likely. Unfortunately, the extra working capital
costs money, and there is no simple algorithm or formula that determines the “optimal” level of working
capital the firm should hold. The choice depends on management’s strategic preferences, its willingness
to bear risk, and the firm’s line of business.

THE OPERATING AND CASH CONVERSION CYCLES

A very important concept in working capital management is known as the cash conversion cycle. This is
the length of time from the point at which a company actually pays for raw materials until the point at
which it receives cash from the sale of finished goods made from those materials. This is an important
concept because the length of the cash conversion cycle is directly related to the amount of capital that
a firm needs to finance its working capital. The sequence of events that occurs from the point in time
that a firm actually pays for its raw materials to the point that it receives cash from the sale of finished
goods is as follows:

(1) the firm uses cash to pay for raw materials and the cost of converting them into finished goods
(conversion costs), (2) finished goods are held in finished goods inventory until they are sold, (3) finished
goods are sold on credit to the firm’s customers, and finally, (4) customers repay the credit the firm has
extended them and the firm receives the cash. The cash is then reinvested in raw materials and
conversion costs, and the cycle is repeated. If a firm is profitable, the cash inflows increase over time.
Financial managers generally want to achieve several goals in managing this cycle:
• Delay paying accounts payable as long as possible without suffering any penalties.
• Maintain the minimum level of raw material inventories necessary to support production without
causing manufacturing delays.
• Use as little labor and other inputs to the production process as possible while maintaining product
quality.
• Maintain the level of finished goods inventory that represents the best trade-off between minimizing
the amount of capital invested in finished goods inventory and the desire to avoid lost sales.
• Offer customers terms on trade credit that are sufficiently attractive to support sales and yet minimize
the cost of this credit, both the financing cost and the risk of nonpayment.
• Collect cash payments on accounts receivable as quickly as possible to close the loop.

All of these goals have implications for the firm’s efficiency and liquidity. It is the financial manager’s
responsibility to ensure that he or she makes decisions that maximize the value of the firm. Managing
the length of the cash conversion cycle is one aspect of managing working capital to maximize the value
of the firm.

Operating Cycle
The operating cycle starts with the receipt of raw materials and ends with the collection of cash from
customers for the sale of finished goods made from those materials. The operating cycle can be
described in terms of two components: days’ sales in inventory and days’ sales outstanding.

Cash Conversion Cycle

The cash conversion cycle is related to the operating cycle, but the cash conversion cycle does not begin
until the firm actually pays for its inventory. In other words, the cash conversion cycle is the length of
time between the actual cash outflow for materials and the actual cash inflow from sales. To calculate
this cycle, we need all of the information used to calculate the operating cycle plus one additional
measure: days’ payables outstanding.
Days’ payables outstanding (DPO) tells us how long, on average, a firm takes to pay its suppliers. Recall
that it is calculated by dividing 365 days by accounts payable turnover and that accounts payable
turnover equals COGS divided by accounts payable.
A negative cash conversion cycle of –40 days means that the company receives cash from its customers
an average of about 40 days before it pays its suppliers. In other words, instead of the company having
to invest in inventories and receivables, its suppliers finance all of these current assets and then some.

Profitability Analysis
Profitability is a firm’s ability to generate earnings over a period of time with a given set of resources. It
is analyzed by examining the elements of revenues, the cost of sales, and operating and other expenses.
There are a number of ways an investor can look at return on his or her investment. Some returns
involve the price of the stock as it trades in the securities markets. Although there are actions a
company can take to make its stock more attractive to investors, return on market price depends on
when each investor purchases and sells the stock. Thus, the analyst of a company’s financial and
operating performance cannot make this calculation for the individual investor. An analyst, can,
however, examine how the investor’s contribution to the company performed on a per-share basis.

Earnings per Share

Earnings per share (EPS) is an important measure investors use to determine whether to purchase a
security. It is used as a basis for comparison in the price earnings and earnings yield ratios. EPS expresses
net income on a per-share basis. Notice in the formula that preferred dividends are subtracted from net
income because preferred dividends take priority in payout and are therefore not available to common
shareholders.

The current year’s preferred dividends are subtracted from net income because EPS refers to the per-
share earnings available to common shareholders. Net income minus preferred dividends is the income
available to common stockholders. Common stock dividends are not subtracted from net income
because they are a part of the net income available to common shareholders. The weighted average
number of common shares is the number of shares outstanding during the year, weighted by the
portion of the year they were outstanding.

Things to know about the weighted average shares outstanding calculation:

 The weighting system is days outstanding divided by the number of days in a year, but on the
exam, the monthly approximation method will probably be used.
 Shares issued enter into the computation from the date of issuance.
 Reacquired shares are excluded from the computation from the date of reacquisition.
 Shares sold or issued in a purchase of assets are included from the date of issuance.
 A stock split or stock dividend is applied to all shares outstanding prior to the split or dividend
and to the beginning-of-period weighted average shares. A stock split or stock dividend
adjustment is not applied to any shares issued or repurchased after the split or dividend date.

DILUTED EPS
Before calculating diluted EPS, it is necessary to understand the following terms:
  Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock
that would decrease EPS if exercised or converted to common stock.
 Antidilutive securities are stock options, warrants, convertible debt, or convertible preferred
stock that would increase EPS if exercised or converted to common stock.

The numerator of the basic EPS equation contains income available to common shareholders (net
income less preferred dividends). In the case of diluted EPS, if there are dilutive securities, then the
numerator must be adjusted as follows:
 If convertible preferred stock is dilutive (meaning EPS will fall if it is converted to common
stock), the convertible preferred dividends must be added to earnings available to common
shareholders.
 If convertible bonds are dilutive, then the bonds’ after-tax interest expense is not considered an
interest expense for diluted EPS. Hence, interest expense multiplied by (1 – the tax rate) must
be added back to the numerator.

Dividend Payout Ratio

The dividend payout ratio is a near complement to the percentage of shareholders’ equity. However, it
considers EPS on a fully diluted basis, which is a more conservative measure than comparing earnings
against currently outstanding shares of common stock only.

Dividend Yield
The dividend yield is a measure of the cash return realized by the investor, against the current market
value of the stock, by the payout of the dividend. This ratio is helpful to investors seeking income from
their securities investments.

Sustainable Equity Growth

Although some companies fail because of ever-declining revenues, companies also fail by attempting to
grow too fast. Many small businesses, in particular, go under because they take on a contract with
deadlines that cannot be met with their current staff , equipment, capital, and expertise. The
sustainable growth ratio indicates the maximum earnings growth a firm can have without resorting to
other means of financing. The key to sustainable growth is retaining sufficient earnings to reinvest in
growth rather than paying out too much in earnings as dividends. This can be calculated as 1 minus the
dividend payout ratio multiplied by return on equity (ROE).
Return on investment (ROI) measures profitability by dividing the net profit of the business unit by the
investment in assets made to attain that income. ROI is also called the accounting rate of return or the
accrual accounting rate of return. The formula used by the ICMA for ROI is:

Return on Assets
Calculation of RO A in its simplest form, as shown next, uses net income and the value of all assets. As
noted, ROA is essentially the same set of factors as ROI, although calculations may mix and match the
factors differently.

DuPont Model for ROA

The DuPont model breaks apart the formula for ROA just cited and calculates ROA by multiplying the net
profit margin by asset turnover. Those two components are implied by the simpler formula given earlier
but are not separately visible in it. There is also a revised version of the model that focuses more on ROE
than ROA.

Calculating Return on Common Equity

ROE measures the return made on the common shareholders’ equity rather than return on total assets .