Chapter 5 Financial Analysis

1. Which of the following types of firms do you expect to have particularly high or low
asset turnover? Explain why.

A supermarket - High asset turnover. Supermarkets tend to be high volume businesses. Many
of the food products in supermarkets are perishable, and freshness is often used to differentiate
products, forcing a certain amount of inventory turnover. The typical consumer buys groceries
on a regular basis, guaranteeing grocery stores a certain level of overall business. Apart from
inventories, a supermarket’s largest assets are its warehouses and stores, all constructed to be
relatively inexpensive. Thus, high sales volumes generate a high measured level of asset
turnover.

A pharmaceutical company - High asset turnover. Drugs typically have a limited shelf life. Once
past their expiration date, drugs cannot be sold and are worthless. Consequently,
pharmaceutical companies try to limit production to quantities that will likely be sold before the
expiration date. A pharmaceutical company’s assets are relatively low for two reasons. First, its
investment in research and development is expensed rather than recorded as an asset on the
company’s books. Second, patents do not typically show up as assets on the pharmaceutical
company’s books. Thus, high sales combined with lower reported asset levels generate a high
measured level of asset turnover.

A jewelry retailer - Low asset turnover. Jewelry is typically durable, expensive, and infrequently
purchased by most consumers. Jewelry is also a strongly differentiated product. A single jewelry
store may carry over 150 different styles of watches. The consumer will choose one watch from
among the entire selection. Hence, the jewelry store must maintain a large inventory to support
its sales. Because the jewelry store’s main asset is inventory, which has a slow rate of turnover,
the typical jewelry store will show low asset turnover.

A steel company - Low asset turnover. Production of steel is extremely asset intensive. A steel
company will invest hundreds of millions of dollars in property, plant, and equipment necessary
to manufacture steel. Moreover, steel-making equipment has a useful lifetime measured in
decades. Relative to this enormous investment, a steel company’s sales will be low.
Consequently, a steel company will typically have low asset turnover.

2. Which of the following types of firms do you expect to have high or low sales
margins? Why?

A supermarket - Low margins. Competition in the supermarket industry is very intense. Different
supermarkets carry most of the same brands of food so there is little differentiation of products.
Consumers are sensitive to changes in the prices, and switching costs are very low, usually no
more than the opportunity cost of going to another supermarket. Consequently, pricing is the
major area of competition among supermarkets, leading to extremely low margins.

A pharmaceutical company - High sales margins. Drugs manufactured by pharmaceutical

companies are often protected from competition by patents, allowing them to charge monopoly
prices. Even where drugs are not protected by patents, pharmaceutical companies invest
considerable resources in differentiating their products along non-price dimensions such as
efficacy and ease-of-use. Consequently, pharmaceutical companies typically boast very high
sales margins. As an aside, drug companies argue that these high margins are necessary to
support their ongoing and expensive research for new drugs, much of which never makes it to
market

A jewelry retailer - High sales margins. Jewelry is a differentiated product where the typical
buyer cannot easily assess the quality of the item being purchased. Consequently,
differentiation among jewelry retailers falls along lines of intangibles such as service, quality,
and reputation. The greater the differentiation, the higher the expected margin.

A software company - High sales margins. Margins are high for several reasons:
1. There are relatively high switching costs for consumers learning a new system.
2. Production costs are very low—just the expense of disks or CD-ROMs and manuals, or
the costs of distributing software via the Internet and providing help on-line.
3. Most of the initial software development costs have been previously expensed.

3. Sven Broker, an analyst with an established brokerage firm, comments: ‘‘The critical
number I look at for any company is operating cash flow. If cash flows are less than
earnings, I consider a company to be a poor performer and a poor investment prospect.’’
Do you agree with this assessment? Why or why not?

Disagree. Operating cash flows and earnings numbers are both important in evaluating the
performance prospects of a company, but they will differ due to short- and long-term accruals.
Some current accruals, such as credit sales, will cause earnings to be greater than operating
cash flows while others, such as unpaid expenses by the firm, will cause operating cash flows to
exceed earnings. Non-current accruals, such as depreciation and deferred taxes, will also
cause differences between earnings and operating cash flows. The fact that operating cash
flows are not as high as earnings is not nearly as important as understanding why the two are
different. Operating cash flows could be below earnings for several reasons, each suggesting
differences in the firm’s performance and future investment prospects. For example, a firm that
introduces a successful new product will be probably have earnings exceeding operating cash
flows due to working capital needs (inventory and receivables) that affect

4. In 2005 France-based food retailer Groupe Carrefour had a return on equity of 19

percent, whereas France based Groupe Casino’s return was only 6 percent. Use the
decomposed ROE framework to provide possible reasons for this difference.

ROE can be decomposed in three steps, as follows:

ROE = Shareholders’ Equity / Net Profit Assets
= (Net Profit / Asset) x (Assets / Shareholders’ Equity)
= (Net Profit / Sales) x (Sales / Asset) x (Asset / Shareholders’ Equity)

Using this decomposition, ROE depends on a company’s return on sales, asset turnover, and
leverage. Differences in these three factors will drive differences in ROE. Without knowing
specific company information, it is possible to speculate about the root causes of Casino’s 6%
and Carrefour’s 19% ROE.

Return on Sales measures a firm’s profit per euro of sales. As a profitability measure, higher
return on sales suggests possible greater efficiency of operations or lower tax rates. Holding
asset turnover and leverage constant, a higher return on sales could explain Carrefour’s greater
ROE. This would be the case if Carrefour had implemented more effective management control
systems, designed better organized distribution facilities, or did better tax planning than Casino.
Asset Turnover assesses how productively a firm uses its assets. A higher asset turnover ratio
suggests that a fixed level of assets generates a greater level of sales, i.e., the firm put its
assets to more productive uses. Assuming return on sales and leverage are the same for both
firms, a higher asset turnover ratio would cause Carrefour’s ROE to be greater than Casino’s.

Leverage describes the capital structure of the firm. As leverage increases, the return on equity
also increases. From Step 2 of the decomposition, we see that ROE = (return on assets) x
(leverage). Holding return on assets constant, it would be possible to explain Carrefour’s higher
ROE if it were more highly levered than Casino.

5. Joe Investor asserts, ‘‘A company cannot grow faster than its sustainable growth
rate.’’ True or false? Explain why.

False. The sustainable growth rate is the speed at which a company can expand without
changing either its level of profitability or its financial policies. Mechanically, sustainable growth
rate = ROE x (1 – dividend payout ratio). From this equation, we see that ROE and the dividend
payout ratio determine the funds remaining in the firm and available to finance the firm’s growth.
If a company wants to exceed its sustainable growth rate, it can increase its return on equity by
improving its profitability (return on sales), increasing its asset turnover, or increasing leverage.
Alternatively, it can reduce its dividend payout rate, thereby increasing funds available for
reinvestment

6. What are the reasons for a firm having lower cash from operations than working
capital from operations? What are the possible interpretations of these reasons?

Cash from operations will differ from working capital from operations due to current accruals
related to operations. In general, the differences between the two methods can be reconciled
using the following approach:

Working capital from operations

– Increase (+ decrease) in accounts receivable
– Increase (+ decrease) in inventory
– Increase (+ decrease) in other assets, excluding cash and cash equivalents
+ Increase (– decrease) in accounts payable
+ Increase (– decrease) in other current liabilities, excluding notes payable and debt
Cash from operations

Cash from operations will be lower than working capital from operations when current assets
(e.g., accounts receivable, inventory and other non-cash assets) increase and when current
liabilities (e.g., accounts payable and other current liabilities, excluding notes payable and debt)
decrease.

Accounts receivable and inventory could be increasing because the firm is growing to meet
additional market demand. Conversely, accounts receivable and inventory could be growing if
the firm’s customers are having difficulty paying for goods or services, or if sales have slowed
causing inventories to climb.

Accounts payable could be decreasing because the firm’s financial position has improved and
the firm pays its suppliers sooner than before
7. What ratios would you use to evaluate operating leverage for a firm? How would you
decide if leverage was used effectively or not?
Operating leverage measures the extent to which an additional dollar of sales increases the
firm’s net income. The greater the increase in net income for a given increase in sales, the
greater the firm’s operating leverage. For example, if a firm only had variable costs, each
additional dollar of sales would be expected to generate additional income equal to the existing
net income/sales ratio for the firm. Conversely, if the firm had only fixed costs, an additional
dollar of sales would generate an additional dollar of net income (assuming the firm did not pay
taxes). Thus, understanding a firm’s operating leverage requires estimating how much of the
firm’s costs are fixed and how much are variable. This concept is complicated by the fact that in
the long run most costs are variable.

While there is no single measure of a firm’s operating leverage, several ratios can help evaluate
a firm’s operating leverage and compare it with those of other firms. Information from financial
statements is typically crude and only gives a rough approximation of operating leverage. A
more thorough analysis requires specific cost-accounting information from within the firm.
Changes in net income relative to changes in sales, or return on sales ratios relative to sales
volume, provide rough guides of operating leverage. Asset ratios, such as (Net PPE/Sales) or
(Capital Expenditures/Sales), can also provide a way of assessing how much of a firm’s
production costs are fixed. More detailed information, including (salary expense of production
workers/sales) and (raw material expenses/sales), can provide a finer picture of a firm’s
operating leverage. Estimating a firm’s operating leverage requires an understanding of which
costs are fixed and which are variable. The ratios mentioned above are very general.
Depending on the specific firm and industry, other ratios may be more useful.

8. What are the potential benchmarks that you could use to compare a company’s
financial ratios? What are the pros and cons of these alternatives?

Comparison to Firm’s Prior History.

By comparing the company with itself over time, it is possible to document changes
(improvements or declines) in the company’s performance. Changes in capital structure or
improvements in gross margins or return on assets may evolve slowly as the firm implements
the necessary changes in operations and financing. Only by looking at the pattern of these
changes over time can we see if the individual changes in financial ratios from year to year are
permanent or temporary. However, this approach does not tell us how well the firm is doing
compared to other companies. For example, a firm may appear to have performed poorly (well)
relative to its own historical performance, yet relative to other firms in the economy or its own
industry, it may have performed quite well (poorly)

Comparison to Firm’s Expected or Budgeted Performance.

This could be relative to management or external analysts’ forecasts. These types of
comparisons can be very helpful by showing how well the firm has performed relative to
expectations. An obvious limitation is that the comparisons are only meaningful if the
expectations are carefully constructed.

Comparison to Industry Average.

Industry average financial ratios provide a benchmark against which to interpret individual
company ratios. A firm’s return on sales, asset turnover, and financial leverage can be
compared to industry averages. What are the implications if a firm has a lower return on equity
or lower days payable than the industry? Are any differences consistent with the firm’s operating
policies and goals? Industry comparisons can provide only a partial picture if the industry as a
whole has performed well or poorly, or if the firm is following a different strategy from other firms
in the industry. It can also be quite difficult to assess what the appropriate industry comparison
group is, since many firms operate in more than one business segment.

Comparison to Market.
Benchmarking the performance of an individual firm against the market can be informative.
Ultimately, investors want to allocate resources within the economy as a whole. A firm that is a
strong performer relative to its industry may therefore be a relatively weak overall performer if its
industry is underperforming. However, market analysis can be difficult for many key financial
ratios which are industry specific and do not lend themselves to cross-industry comparison or
evaluation. For example, important ratios for banks include those on regulatory capital, which
are not relevant for most other industries. Working capital ratios typically differ across industries,
so that it makes little sense to compare a day’s inventory or day’s receivable for a supermarket
relative to the same ratios for a steel manufacturer. Finally, differences in ratios can arise
because of differences in business risk across industries. For example, ROEs and leverage are
likely to be very different for construction firms than for supermarkets

9. In a period of rising prices, how would the following ratios be affected by the
accounting decision to select LIFO, rather than FIFO, for inventory valuation?
The impact of the selection of LIFO rather than FIFO for inventory valuation will appear in Inventories
and Cost of materials. Under LIFO, the most recent and most expensive (during inflationary periods)
items in inventories will be the first used for accounting purposes. Relative to a firm using FIFO, the LIFO
firm will report a lower value for inventories because its ending inventories contains the oldest and least
expensive items. As a result of using its higher priced inventories first, the LIFO firm has a higher cost of
materials.

Gross margin is lower for the LIFO firm. The LIFO firm has higher cost of materials expenses which makes
its gross margin appear lower than the FIFO firm. Current ratio falls.

The current ratio equals current assets divided by current liabilities. Current assets is lower under LIFO
because inventories are lower. Hence, the value of current assets divided by current liabilities drops
under LIFO. Asset turnover increases.

Asset turnover equals sales divided by assets. Sales remains the same but assets are lower under LIFO,
so asset turnover declines.

Debt-to-equity ratio increases using the book value of equity. The debt-to-equity ratio equals (current
debt + non-current debt) divided by book value of shareholders’ equity. The LIFO decision does not
affect either the current or non-current debt levels, but LIFO has a negative net impact on the book
value of shareholders’ equity. Under LIFO, the higher cost of materials leads to lower net profit, which in
turn leads to a decrease in book shareholders’ equity.

This decrease may be mitigated if the firm has a lower tax bill due to lower taxable profit. Overall,
however, the decline in net profit is likely to be greater than the decrease in tax payments, yielding a
decline in shareholders’ equity and increasing the debt-to-equity ratio.
Average tax rate remains the same. The LIFO firm reports higher expenses which lowers profit before
tax. Because the firm reports smaller profit before tax, it has less taxable profit and, hence, has a smaller
tax liability. However, the average tax rate is likely to remain the same
Problems

1. Tesco plc is one of the world’s largest food retailers. Fiscal year 2014 (the year ended
February 28, 2015) was a rocky year for the retailer. The company’s sales and margins had
come under pressure as a result of strong competition in the industry. Further, in September
2014 company management announced that it had overstated earnings in previous fiscal years
through the accelerated recognition of supplier rebates. The events led to a management
change in which Dave Lewis took over as chief executive and John Allen took over as chairman.
In April 2015 Dave Lewis announced a record (pre-tax) loss of £6.4 billion – one of the largest
losses in UK history. This loss was attributable, at least in part, to a £4.7 billion impairment of
property, plant, and equipment, a £0.7 billion impairment of (non-operating) investment assets,
and a restructuring charge of £0.6 billion

The following tables show the standardized and adjusted income statements and balance
sheets of Tesco, for the years ended February 28, 2014, 2015, 2016, and 2017. Operating
lease obligations have been capitalized, and the operating lease expense has been replaced
with depreciation and interest expense, following the procedure described in Chapter 4. Further,
to help you better analyze the retail activities of Tesco, the net assets of Tesco Bank have been
included as one separate balance sheet item, labelled “Net investment in Tesco Bank”; Tesco
Bank’s pre-tax profit is separately reported in the income statement. Tesco’s statutory tax rate
was 23.1 percent in 2013, 21.2 percent in 2014, 20.1 percent in 2015, and 20.0 percent in 2016
1. Calculate Tesco’s net operating profit after tax, net investment profit after tax, interest after
tax, operating working capital, net non-current operating assets, non-operating investments,
business assets, debt, and capital for the years 2013–2016.

2. Decompose Tesco’s return on equity for the years 2013–2016 using the traditional approach.

3. Decompose Tesco’s return on equity for the years 2013–2016 using the alternative approach.
What explains the difference between Tesco’s return on assets and its return on net operating
assets?

4.Analyze the underlying drivers of the change in Tesco’s return on equity, also making use of
the non-financial statistics and segment infor-mation. Which factors explain the decrease in
return on equity in 2014? To what extent can you conclude that Tesco’s transformation plan is
effective in 2015 and 2016?