Financial Statement Analysis Business Ratios

Financial Statement Analysis: Business
Ratios
As stated in the introduction, financial statement analysis is a set of
techniques to analyze the financial performance of a company, to assess its
strengths and weaknesses, and to compare it to other firms in the same
industry. This is important to both investors in the financial markets and
managers in the firms.
Figure 1: Capital Markets
Three major decisions made by managers of a firm are the investment,
financing and dividend decisions. These decisions are important for financial
statement analysis because the major statements result from the firms
decision. As a result, over time various measures have evolved to provide
insight into and assess the performance of these decisions. An overview of
these measures and their interrelationships is depicted in the following figure:
Financial Statement Analysis: Business Ratios
Monday, 26 May 2014
11:05
Unfiled Notes Page 1
Figure 2: Financial Statement Analysis: A Conceptual Framework
In this chapter we will work through the above flow chart so that you acquire:
Conceptual skills required for understanding this flowchart,
Practical skills associated with what the metrics are and how they are
constructed using current real world financial statements (including
terminology, aggregation and critical accounting judgments)
Professional judgment skills including how to interpet and make
decisions from information in the current 10-K filings
To reinforce important concepts and measures we will reconcile each metric
using the 2010 10-K filing of Procter and Gamble (PG) and demonstrate how
you can immediately extend this to any current filing with the SEC
The Valuation Tutor software for this Chapter is organized as follows:
I
3.3 Fundamental Growth
The shareholders of a company are residual claimants. This means that
they own what would be left after all other obligations of the company have
been paid. The value of what they own is called the shareholders equity,
calculated as the difference between the assets and the liabilities. This is
what they would get if the company was liquidated; if the assets are worth
less than the liabilities, they would get nothing. It also represents the net
investment in the firm made by the shareholders.
Shareholders equity comes from stock sold by the company and retained
earnings. So growth in shareholders equity, which is what ultimately creates
shareholder value, is fundamentally related to earnings (equivalently, net
income) growth. Net income is the bottom line, and is what can be paid to
shareholders or retained (reinvested) by the firm. So when you buy a stock,
you buy a share of future earnings; if these are expected to grow quickly, you
will be willing to pay more for the stock. How well the company performed on
behalf of shareholders in generating the earnings is measured by the Return
on Equity (ROE). ROE is the net income divided by the shareholders equity.
Over time, shareholders equity grows if additional stock is issued or through
retained earnings. The net income is the money earned from the investment
made by shareholders, and so the ROE measures the return on this
investment and therefore ROE is intimately related to growth. As a result,
our starting point when introducing business ratios is the growth of
shareholders equity.
Consider a firm that does not pay dividends; in that case, shareholders
Consider a firm that does not pay dividends; in that case, shareholders
equity would grow by the amount of the net income. A little notation makes
this clear. Suppose the shareholders equity at time t is St, and it grows at
rate g. Then,
St+1 = St(1+g)
If the firm earns Et and pays no dividends, St+1 = St + Et, so
St+Et=St(1+g) and solving for g, you get:
g=Et/St = ROE.
If the firm pays dividends D, we get St+1 = St + Et - Dt. Let PR be the payout
ratio, the percentage of earnings that are paid, so Dt=Et*PR. Re-arranging
and solving for g gives:
g=Et(1-PR)/St = ROE*(1-PR) = ROE*RR
RR is called the Retention Ratio, the percentage of earnings retained by the
firm.
The growth rate, g, is called the fundamental growth and shows how
the growth of shareholders equity is related to earnings.
Tutor Reconciliation: Proctor and Gamble (PG)
Step 1: Bring up the Income Statement and Balance Sheet for Proctor and
Gamble as described in earlier. Be sure to select the August 13, 2010 10-K
from the dropdown. This is displayed at the bottom of the screen as follows:
We can reconcile Fundamental Growth by selecting the Consolidated
Income Statement and Consolidated Balance Sheet as follows:
Step 2: Refer to the calculator part of the Valuation Tutor screen. This has
computed fundamental growth from the following fields:
Net Income per Share = $4.47
Shareholders Equity per share = $21.49
Annual Dividend = $1.80
Dividend Payout Ratio (DPR) = 0.366 (Derived in green 1.80/4.47)
Retention Ratio (RR Derived) = 0.634 (RR = 1 DPR)
Step 3: Click on Calculate:
You can observe above the additional derived fields are:
Retention Ratio = 0.598
Return on Equity = 0.208
Growth Rate = 0.125
That is Proctor and Gambles current fundamental or accounting growth is
12.5% annualized. In the Valuation tutor cases you will learn how to interpret
this number but first:
Step 4: Where did these numbers come from?
Each of the numbers can be traced back to two primary financial statements
(Income Statement and Balance Sheet):
For convenience we relate the numbers in the 10-K to a summary grid as
depicted below and then refer to the line numbers in the summary grid. So
for example from this you can see that the Net Income is $12,736 and so on.
3.4 DuPont Analysis
As we showed, fundamental growth for a firm equals Return on Equity (ROE)
times the Retention Ratio (RR):
Growth = ROE * RR
The DuPont model re-expresses the accounting return on equity (ROE) as
the product of the Return on Assets (ROA) and Financial Leverage
(measured by Total Assets/Shareholders Equity). ROE and ROA are two
major ratios that are associated with the Financial Perspective of the
balanced scorecard.
The DuPont decomposition has an interesting history:
Among the stocks that currently make up the Dow Jones Industrial Index the
Among the stocks that currently make up the Dow Jones Industrial Index the
oldest is E. I. du Pont de Nemours And Company more commonly referred to
simply as DuPont. DuPont was originally a gunpowder mill founded in July
1802 by Eleuthre Irne du Pont and today is one of the largest chemical
companies in the world. DuPont was a pioneer with respect to management
accounting systems, including devising the accounting ratio Return on
Investment (ROI). Around 1912 their ROI approach was extended by one of
their financial officers, Donaldson Brown, who decomposed the ROI
calculation into a product of the sales turnover ratio and the profit margin
ratio. In 1914 DuPont invested in General Motors (GM) to assist the
struggling automobile company. In 1920, Pierre DuPont became chairman
of GM, and during his tenure implemented a pioneering management
accounting system that focused sharply on planning and control. By
organizing resources around this system GM grew to be the largest
automobile company in the world. In 1957 DuPont had to divest itself of
General Motors because of the Clayton Antitrust Act. The DuPont
decomposition became popular after its successful use at GM and DuPont.
As a reminder, we note that ROE = Net Income/Shareholders Equity, and
ROA = Net Income/Total Assets. ROE measures the rate at which
shareholder wealth is increasing, while ROA measures the productivity of the
assets in generating income, and therefore measures the efficiency of the
investment decision.
Formally, the DuPont formula is:
ROE = (Net Income/Sales) * (Sales/Total Assets) * (Total
Assets/Shareholders Equity)
Each term in the decomposition has a specific meaning:
Profit Margin Ratio = Net Income/Sales
Asset Turnover Ratio or Asset Use Efficiency = Sales/Total Assets
Financial Leverage Ratio= Total Assets/Shareholders Equity
Note that the product of the first two terms is ROA. The third term is related
to the financing decision; a highly leveraged firm has low Shareholders
Equity compared to Assets, while as before, the ROA results from the
investment decision. In the DuPont formula, the effects of the investment
decision are further decomposed into the product of operating efficiency as
measured by the Profit Margin Ratio and asset utilization efficiency as
measured by Asset Turnover Ratio.
Gamble as described in section 3.2. This was displayed at the bottom of the
screen as follows:
We can reconcile the DuPont decomposition by selecting the Consolidated
computed DuPont decomposition from the following per share fields:
Total Assets per Share = $45.075
Sales per Share = $27.761
Net Income per Share = $4.479
Shareholders Equity = 21.4929
Step 3: Click on Calculate for the DuPont decomposition:
You can observe above the additional derived fields are:
Sales/Total Assets = 0.6159 = Assets Turnover Ratio or Asset Efficiency
Net Income/Sales = 0.1613 = Profit Margin Ratio
Return on Assets = 0.0994 = Product of the Asset Turnover Ratio and Profit
Margin Ratio.
Total Assets/Total Equity = 2.0972 = Financial Leverage Ratio
Return on Equity (ROE) = 0.2084
So Proctor and Gambles has enhanced its ROA by exploiting financial
leverage. Later in this chapter, you will learn how to interpret these numbers
but first:
Each of the numbers can be traced back to two primary financial statements:
For convenience we relate the numbers in the 10-K to a summary grid as
depicted below and then refer to the line numbers in the summary grid. So
for example from this you can see that the Net Sales is $78,938 and the
for example from this you can see that the Net Sales is $78,938 and the
Total Assets are $128,172 and so on.
3.5 Extended DuPont Analysis
The Extended DuPont provides an additional decomposition of the Profit
Margin Ratio (Net Income/Sales) into two burden components, Tax and
Interest, times the Operating Profit Margin. This is a positive refinement of
the traditional DuPont Analysis to provide a refinement of the profit margin
ratio into the operating profit margin ratio by taking out the effects arising
from taxes and interest expense. As a result, it provides both management
and the financial analyst with finer information about a company and its
immediate competitors.
Formally, the Extended DuPont formula is:
ROE = (Net Income/EBT) * (EBT/EBIT) * (EBIT/Sales) * (Sales/Total Assets)
* (Total Assets/Shareholders Equity)
Each term in the decomposition has a specific meaning:
Profit Margin Ratio =Net Income/Sales now decomposes into:
Net Income/Earnings Before Taxes = Tax Burden Ratio
Earnings Before Taxes/Earnings Before Interest and Taxes = Interest Burden
Ratio
Earnings Before Interest and Taxes/Sales = Operating Profit Margin
Asset Turnover Ratio or Asset Use Efficiency = Sales/Total Assets
Financial Leverage Ratio= Total Assets/Shareholders Equity
Net Income is measured after taxes. So if taxes are zero the tax burden
equals one and so the lower this number, the higher the tax burden.
Similarly, if Interest Expense is zero then interest burden ratio equals one
and therefore the higher the financial leverage, the lower is this number. The
advantage of adjusting for taxes and interest is to gain better insight into the
firms profit margin by focusing upon the operating profit margin.
Note that the product of the first four terms is now ROA. This is driven by
operations, financing and the management of taxes. A nice property of the
Extended DuPont formula is that one can examine the breakdown of ROA
from the perspective of major firm decisions --- investment, financing and tax
decisions.
The remainder of this decomposition is as before. That is, the fifth term is
again related to the financing decision; a highly leveraged firm has low
Shareholders Equity compared to Assets.
Practical Note: Analysts vary in terms of how they apply the Extended
DuPont Analysis. The most common practical variation from the above
definitions is to use the US GAAP definition of income from continuing
operations. The International Financial Reporting Standards (IFRS) does not
make the distinction between income from continuing operations and so this
practical note only applies to US GAAP.
The default numbers in Valuation Tutor screens have (CO) after them to
indicate that this is in relation to Continuing Operations. The reconciliation
provided in this section will illustrate this for Proctor and Gamble using
continuing operations. Users of Valuation Tutor can apply either definition to
the net income input field and if comparing across firms you should apply the
same convention.
Gamble as described in section 3.2. This was displayed at the bottom of the
screen as follows:
We can reconcile the Extended DuPont by selecting the Consolidated
You can see from the above screen that the 10-K income statement for
Proctor and Gamble breaks out income from continuing operations ($15,047)
and taxes on income from continuing operations ($4,101) from total income
from continuing operations after tax ($10,946) versus Proctor and Gambles
Total Net Income after Tax ($12,736) which was used in the previous topic
3.4.
computed the Extended DuPont from the following per share fields:
Net Income (CO, Continuing Operations) = 3.756 per share
EBT (Earnings Before Taxes) = 5.3016 per share
EBIT (Earnings Before Interest and Taxes) = 5.6343 per share
Sales per Share = 27.7609 per share
Total Assets per Share = $45.0754 per share
Shareholders Equity = 21.4929 per share
Step 3: Click on Calculate for the DuPont decomposition:
The additional derived fields are:
Tax Burden (CO) = 0.7261
Interest Burden = 0.9410
Operating Margin = 0.2030 or 20.3%
Asset Turnover = 0.6159
Return on Assets (CO) = 0.0854.
Financial Leverage Ratio = 2.0972
Return on Equity (ROE CO) = 0.1791
That is Proctor and Gambles Operating Margin is refined to reveal the
margin from continuing operations after adjusting for Tax and Interest
burdens. Again in the next step we verify how these numbers have been
estimated from the financial statements.
Each of the numbers can be traced back to two primary financial statements:
For convenience we again relate the numbers in the 10-K to the summary
grid as depicted below and then refer to the line numbers in the summary
grid. So for example you can see that the Net Earnings from Continuing
Operations after tax is $10,946 and the Total Assets are $128,172 and so
on.
The full reconciliation can now be traced through as follows:
3.6 Profitability Ratios
These ratios provide immediate insight into how well management is running
a business. They become especially meaningful in relation to competitors in
the same industry. Two closely watched profitability ratios are:
Gross Profit Margin = Gross Profit / Sales = (Sales COGS)/Sales
Gross Profit Margin = Gross Profit / Sales = (Sales COGS)/Sales
Operating Profit Margin = EBIT / Sales
Gross Margin is the difference between a company's sales and cost of goods
sold scaled by Sales. The higher the gross margin usually implies the higher
priced its goods and or services are. For example, if two firms are operating
at similar levels of cost efficiencies but one has a higher gross margin than
the other this usually implies that the higher gross margin is either charging
higher prices or dealing with non commoditized goods and services that
carry a higher price tag
3.7 Working Capital Ratio
Working Capital is defined as Current Assets minus Current Liabilities net of
financing and tax related activities. This leads to eliminating items such as
short term debt and the current portion of long term debt as well as deferred
tax assets/liabilities. The problem group is cash and marketable securities.
The last group is usually split between the financing and investment
decisions, but predominately is influenced by the financing decision. As a
result, the usual simplifying assumption is to eliminate cash and marketable
securities from working capital. With these eliminations it largely consists of:
Accounts Receivable, Inventory and Accounts Payable. These major
components lead to the three major turnover ratios. The numerator of these
turnover ratios is usually defined relative to their closest driver. For example,
Accounts Receivable is driven by Sales on Account and therefore Net Credit
Sales is used in the numerator if available otherwise Sales. However, under
historical cost accounting Inventory as measured on the balance sheet is
more closely aligned with the Cost of Goods Sold (COGS) for an external
analyst. Finally, Accounts Payable is driven by Purchases and so either
Purchases if available or COGS is used in the numerator for this ratio.
Formally, we can define them as follows:
Accounts receivable turnover = Sales/Accounts Receivables
Inventory turnover = COGS/Inventory
Accounts payable turnover = Purchases/Accounts payable or otherwise
COGS/Accounts Payable
In addition, turnover ratios are often expressed in terms of number of days by
dividing by the turnover ratio by 365:
Number of days to Collect Accounts Receivable = 365/Accounts receivable
Number of days to Collect Accounts Receivable = 365/Accounts receivable
turnover
Number of days to Sell Inventory = 365/Inventory turnover
Number of days to Pay Creditors =365/ Accounts payable turnover
Finally, the Cash Conversion cycle is then the aggregate number of days for
collecting accounts receivable plus the number of days required to sell
inventory minus the days to pay creditors.
Cash Conversion Cycle = Number of Days to Sell Inventory + Number of
days to collect accounts receivables Number of Days to Pay Payables
When comparing across firms in some industry the extension of liberal credit
may be an important part of the firms business strategy. For example, for
Wal-Mart to successfully implement their business model they have to excel
along the Process dimension of a balanced scorecard. This is discussed
further in the following example.
As a final remark, note that when valuing a firm, changes in working capital
may be a significant source of funds but this can only last for a limited period
of time. Ultimately, change in working capital has to settle down, you should
be careful to ensure that the change in working capital is not a significant
source of funds in perpetuity!
Our objective is to reconcile the following from the 10-K:
Gamble as described in section 3.3. This is displayed at the bottom of the
screen as follows:
The above items deal mainly with the income statement apart from the
number of shares outstanding for expressing on a per share basis.
You can stretch across a little the column 1 as displayed above to make the
labels more easily displayed and read.
For Proctor and Gamble you can see the Cost of products sold ($37,919)
as P&G describe it and Net Sales are $78,938.
Similarly, total Inventories $6,384 and scrolling down reveals the working
capital items on the Balance Sheet.
Step 2: Click on Calculate and we can verify the input and derived fields for
the following:
Total Asset Turnover = 0.6159
Working Capital per Share (CA CL) = -1.9342 per share
Working Capital Turnover (Sales/WC) = -14.3524 per share
Inventory Turnover (COGS/Inventory) = 5.94
Receivables Turnover = 14.80
Payables Turnover = 2.55
Payables Turnover = 2.55
Days to Sell Inventory = 61.45
Days to Collect Receivables = 24.67
Days to Pay Payables = 69.80
Cash Conversion Cycle = 16.32
In step 1 we extracted the relevant aggregate numbers from the 10-K and so
the full reconciliation can now be traced through as follows. The first item
below being Cash and cash equivalents $2,879.
3.8 Liquidity Ratios
Liquidity ratios can be traced back to emergence of ratio analysis when
banks started to demand financial statements in the latter 19
th
century.
These ratios are designed to provide an indicator of a firms ability to repay
its debts over the next twelve months. As a result, they are computed from
the current assets and liabilities section of the balance sheet. Recall, the
previous topic introduced working capital ratios. These ratios let a user
assess how efficiently a firm is transforming its inventory into sales and how
the firm is managing to collect its receivables and pay its payables. Liquidity
ratios complement this working capital analysis by extending this to the
analysis to assess whether a firm can meet its short run or current
obligations.
A further distinction can be made in the subsequent topic, between liquidity
and solvency. Liquidity adopts a short run focus whereas solvency adopts a
longer term focus. Solvency ratios assess whether a company is likely to be
able to repay their debts in the longer run and thus whether they are a going
concern. In the next section on financial leverage we introduce debt ratios
that are relevant to assessing solvency.
The primary liquidity ratios are the Current Ratio and its major liquidity
refinements the Quick and the Cash Ratios. The Quick and Cash Ratios
focus upon a firms ability to immediately repay its obligations. These are
defined as follows:
Current Ratio = Current Assets/Current Liabilities
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable)/Current
Liabilities
Cash Ratio = (Cash + Marketable Securities)/Current Liabilities
A major property of the Quick Ratio is that Inventory is excluded from Current
Assets because this requires effort to convert into cash plus it may only be
quickly convertible at a significant discount. Similarly, for Accounts
Receivable but the discount is usually much smaller especially since the
emergence of securitization. Securitization is the process of combining
different companys accounts receivable and issuing securities against their
cash flows that are sold to investors.
Step 1: Bring up the Balance Sheet for Proctor and Gamble as described in
section 3.2. For this example we will bring up two Balance Sheets instead of
both the Balance Sheet and Income Statement. This is displayed at the
bottom of the screen as follows:
For Proctor and Gamble you can see the Total Current Assets ($18,782) as
P&G describe it and Accounts Receivable are $5,335.
Similarly, total Inventories $6,384 and scrolling down reveals the working
capital items on the Balance Sheet.
the following:
Current Ratio = 0.7735
Quick Ratio = 0.3383
Cash Ratio = 0.1186
3.9 Debt Ratios and Decomposing Financial
Leverage and Solvency
It is an open question whether the financing decision adds value to
shareholders or not. We will make two observations here. First, we have
already seen that increasing financial leverage has a positive impact upon
ROE. This follows from the DuPont analysis where ROE was the product of
ROA and Financial Leverage. However, it also increases risk and so equity
investors will require a higher rate of return. If this higher rate of return
exactly offsets the positive impact from financial leverage then it is all awash
and the financing decision has no impact upon shareholder value. If the
financing decision interacts with the investment decision, for example as per
a financial institution then the financing decision matters. As a result, when
analyzing the financing decision analysts are interested in assessing the risk
of the firm and ultimately how this risk translates into changes in the cost of
equity capital. We consider this issue formally in the Valuation part of this
book. But first, we will analyze the financing decision and then relate it to
growth forecasts for net income.
Solvency versus Liquidity
If a firms financial leverage becomes too high then questions arise regarding
whether or not a firm is likely to be a going concern. Firms go bankrupt
because they lack the cash (and or access to cash) to repay debt. Liquidity
analysis adopts a short run focus and liquidity ratios are designed to assess
a firms ability to meet their short term obligations. Solvency on the other
hand adopts a longer term focus and Debt Ratios attempt to assess a
companys ability to meet its long term obligations and thus whether it is a
going concern.
Recall from the DuPont decomposition that the Financial Leverage term is
Assets/Shareholders Equity. Shareholders equity is defined from the basic
accounting identity as:
Total Assets Total Liabilities = Shareholders or Shareholders Equity
Dividing through by shareholders Equity and rearranging then the Financial
Leverage term can be re-expressed as:
Financial Leverage = Total Assets/Shareholders Equity = 1 + Total
Liabilities/Shareholders Equity
The last term is more commonly expressed relative to Total Assets as the
Debt Ratio:
Debt Ratio = Total Liabilities/Total Assets
There are a number of variations to the Debt Ratio and the ones covered by
the Valuation Tutor calculator are listed and defined below:
Debt to Assets = (Long Term Debt + Debt Due within One Year) / Total
Assets
Debt to Capital = (Long Term Debt + Debt Due within One Year) / Total
Equity
Debt to Equity =(Long Term Debt + Debt Due within One Year) /
Shareholders Equity
Liabilities/Shareholders Equity
Long Term Debt Ratio = (Long Term Debt / Shareholders Equity)
In addition, when interest expense is focused upon this also defines a
coverage ratio:
Interest Coverage = EBIT/EBT
Gamble as described in section 3.2 as displayed above.
For Proctor and Gamble you will see that Debt Due within one year = $8,472
and the Long Term Debt ($21,360).
the following:
3.10 Degree of Operating Leverage and
Capacity
Degree of Operating Leverage (DOL)
A firms operating leverage is defined as the percentage change in the firms
operating earnings (EBIT less any non-operating income), that accompanies
a percentage change in the contribution margin. That is, the operating
income elasticity with respect to the contribution margin. This important
number predicts for an analyst what the percentage change in operating
earnings is given the percentage change in sales revenue. As a result, this
number is important for predicting EBIT given the predicted growth in Sales
Revenue. The consensus sales revenue forecast is readily available and the
DOL provides an EBIT forecast given this consensus number.
Formally, the definition of DOL is:
Formally, the definition of DOL is:
Degree of Operating Leverage (DOL) = % Change in operating income / %
Change in sales revenue
Equivalently,
Degree of Operating Leverage (DOL) = Contribution margin / EBIT
This important measure reflects the fact that a change in Sales can lead to a
more than proportional change in earnings from operations. In particular, the
higher the degree of operating leverage the higher the predicted change.
However, the relative size of the Degree of Operating Leverage is affected
by how close the firm is to their break-even point. The closer the higher is
the DOL.
The above equivalence relationship is not immediately
obvious. Understanding this requires reviewing the basics of cost volume
profit (CVP) analysis first and then we will derive the above equivalence
relationship.
Cost Volume Profit Analysis
Cost volume profit analysis studies the relationship among sales, variable
costs and fixed costs. It assumes that linear costs provides a good
description of real world cost behavior. From this assumption the accounting
income statement can be restated in avariable costing format as follows
starting from the traditional gross margin or absorption format::
Absorption Costing:
Sales
Less COGS
Gross Margin
Less Marketing and Administration
Net Income from Operations (EBIT)
A variable cost income statement highlights cost behavior (i.e., variable
versus fixed costs) and contribution margin. This immediately ties in to a
cost/volume/profit break even type of analysis:
Variable Costing
Sales
Less Variable COGS
Less Variable Marketing and Administration
Contribution Margin
Less Fixed Overhead
Less Fixed Marketing and Administration
Net Income from Operations (EBIT)
The above format allows an analyst to immediately estimate the following
important concepts:
Contribution Margin (CM) = (Sales Revenue Total Variable Costs)
Contribution Margin Ratio (CMR) = (Sales Revenue Total Variable
Costs)/Sales Revenue
Sales Revenue*Contribution Margin Ratio = Contribution Margin
The usual immediate relationships to derive from cost volume profit analysis
is to compute break even sales revenue and break even margins as follows:
Break Even (B/E) Analysis ($Sales Revenue) = Total Fixed
Costs/(Contribution Margin Ratio)
Break Even (B/E) Margin = B/E $Sales Revenue/$Sales Revenue
However, we are currently interested in deriving the equivalence relationship
from the definition of DOL and the concept of contribution margin.
Derivation of Equivalence Relationship for Degree of Operating
Leverage (DOL)
At the beginning of this topic we defined DOL and the equivalence
relationship can be derived as follows:
Degree of Operating Leverage (DOL) = % Change in operating income/%
Change in sales revenue
Assuming fixed costs remain unchanged and EBIT = Sales - Variable Costs -
Fixed Costs, it follows:
Fixed Costs, it follows:
%EBIT = (Sales - Variable Costs))/EBIT = CM / EBIT
%Sales = Sales / Sales
Taking the ratio of the above two equations and re-arranging:
%EBIT /%Sales = Sales(CM/Sales) / EBIT = Sales*CMR / EBIT = CM /
EBIT
That is:
Degree of Operating Leverage (DOL) = Contribution margin / EBIT
In the next example we apply these relationships to the 10-K data:
Step 1: Now bring up two Income Statements for Proctor and Gamble as
described in section 3.2 as displayed below.
For Proctor and Gamble you can see that the Cost of products sold =
$37,919 and the Selling, general and administration expense =$24,998.
To recast the income statement from its full or absorption costing format to a
direct or variable costing format we need to break up these costs into their
fixed and variable components. For reconciliation purposes suppose we
assume that 80% of the COGS are variable and 20% of the SA&G expenses
are variable. These percentages can be subject to more refined analysis
later but for now we are more concerned with mastering the operational
details.
the following:
The above demonstrates the power of recasting the income statement in this
manner. This lets you estimate the Degree of Operating Leverage but in
addition it further lets you estimate Break Even points for Sales Revenue and
implied Margin of Safety (i.e., Sales minus B/E Sales.
Cost Behavior Assessment Remark: Observe above that the % Variable
COGS, % Variable SG&A and % Variable Other are numbers inputted into
the calculator.
Where do these numbers come from? There are various approaches used
by professionals in the field for assessing these numbers. Clearly,
managers inside a firm have access to better information than financial
analysts outside of the firm. However, financial analysts can still make
reasonable assessments of the cost behavior. Interested readers are
encouraged to work through questions 7-13 in the problem set at the end of
this chapter. In particular, Question 9 provides the details for estimating cost
behavior using regression analysis.
Reconciling from the Income Statement
The reconciliation from the Income Statement is provided below.
:
3.11 Degree of Financial Leverage and Degree
of Total Leverage
In this section we explored operating leverage which is sometimes referred
to as first stage leverage and in the early topic on the DuPont decomposition
we introduced the term financial leverage. The degree of financial leverage
results from a second stage analysis of Earnings Before Taxes (EBT) and
Earnings Before Interest and Taxes (EBIT).
Alternatively, when viewed from the perspective of the Income Statement we
can define the degree of Financial Leverage in terms of Net Income as
follows:
Degree of Financial Leverage = % Change in Net Income/% Change in EBIT
Degree of Total Leverage
This number relates a firms operating and financial leverage to its net
income. This is a useful number for financial analysts to assess because it
allows earningsforecasts to be made starting from Sales. However, first
we consider the operational details including how to estimate this number
from the financial statements. In relation to Sales Revenue the Degree of
Total Leverage is defined as follows:
Degree of Total Leverage = Degree of Operating Leverage * Degree of
Financial Leverage
Degree of Total Leverage = (% Change in EBIT / % Change in Sales) * (%
Change in Net Income / % Change in EBIT)
Degree of Total Leverage = % Change in Net Income / % Change in Sales
Or rearranged this yields:
% Change in Net Income = Degree of Total Leverage * % Change in Sales
That is, by starting with the problem of forecasting sales revenue then the
Degree of Total Leverage can relate this forecast to an earningsforecast.
We can further decompose the Degree of Total Leverage into the product of
its two drivers, the Degree of Operating Leverage times the Degree of
Financial Leverage. In this form it can be related directly to the Contribution
Margin format of a Variable or Direct Income Statement as follows:
Degree of Total Leverage = Degree of Operating Leverage * Degree of
Financial Leverage
Degree of Total Leverage = Contribution Margin/EBIT * EBIT/Net Income =
Degree of Total Leverage = Contribution Margin/EBIT * EBIT/Net Income =
Contribution Margin/Net Income
Next consider how this is computed from the financial statements.
Step 1: Now bring up two Income Statements for Proctor and Gamble as
described in section 3.2 as displayed below.
For Proctor and Gamble you can see that the Cost of products sold =
$37,919 and the Selling, general and administrationexpense =$24,998.
Plus now Interest Expense is $946.
To recast the income statement from its full or absorption costing format to a
direct or variable costing format we need to break up these costs into their
fixed and variable components. For reconciliation purposes suppose we
are variable. These percentages can be subject to more refined analysis
later but for now we are more concerned with mastering the operational
details.
the following:
The above demonstrates the power of recasting the income statement in this
manner. This lets you estimate the Degree of Financial Leverage as well as
the Break Even points for Sales Revenue and implied Margin of Safety (i.e.,
Sales minus B/E Sales. The Degree of Total Leverage is the product of the
Degree of Operating Leverage and the Degree of Financial leverage.
The reconciliation from the Income Statement is provided below.
3.12 Earnings Season and the Importance of
Financial Statements to the Capital Markets
Todays stock markets are very sensitive to earnings season. This
happens every quarter when the companies release their previous quarters
earnings. The important numbers the market watches are, Sales Revenue
earnings. The important numbers the market watches are, Sales Revenue
and Quarterly Earnings in relation to consensus forecasts. As discussed in
the introduction to Valuation Tutor there are different models used to
estimate what a stock is worth. The simplest is called the dividend model,
covered in Chapter 6. This model takes the view that if you buy a stock, you
are entitled to receive future dividends paid by the stock. From this
perspective a stocks fair value equals the present value of the future
dividends.
Applying the above logic requires forecasting future dividends and also the
rate(s) at which these will be discounted. Future dividends are paid from
future earnings which in turn depend upon future sales revenue. As a result,
stock prices depend upon both earnings and sales forecasts. Forecasting
the future, however, is very difficult and in an influential old book by Burton
Malkiel, A Random Walk Down Wall Street, he discussed implications for
stock prices from the random walk hypothesis. This hypothesis applied to the
stock market introduces the controversial idea that that one cannot
consistently outperform market averages. Irrespective of ones view of this
hypothesis it does serve to underscore the importance of beating the
consensus forecast when observing changes in stock prices in relation to the
release of additional financial statement information over time.
Chapter 4: Interpreting Business Ratios: Case
Studies
In the last chapter you learned how to construct business ratios and
conduct activity analysis. In this chapter we show you how to use the ratios
in real world situations. We first use them to analyze the performance of
Amazon.com over time. Then, we use them for a comparative analysis of
Wal-Mart and Target. In each case, you will see how the interpretation
depends on the companys business model and strategy.
4.1 Amazon.com Stock Price History
To appreciate the importance of financial statements in understanding
To appreciate the importance of financial statements in understanding
performance, consider the stock price history of Amazon.com.
The stock price was $2.40 on July 1, 1997, rose to $86.03 on April 1, 1999,
and was at $89.06 in November of 1999, but then started to fall. In January
2000, it was $64.56. On February 1, 2001, it was at $10.19 and fell further to
$5.97 by September of 2001. Then started a slow and fairly steady increase
through 2008, and was followed by very strong gains though June 2011. On
June 1, 2011, the stock price was $191.63. Amazons performance in the
first decade of the 21
st
century has been impressive, especially considering
that the stock market (as measured by the S&P 500 Index) lost 7.67%
between January 2000 and June 2011. The price history also shows that
Amazon lost over 90% of its shareholder value in 2000-2001and then
recovered very strongly.
So what happened?
We will analyze Amazons performance in two ways. First, we will look at the
business ratios over time. Then, we will look at how Amazon changed its
business strategy and how this was reflected in both the ratios and the stock
price.
4.2 DuPont Analysis of Amazon.com
In the last chapter, we started with concept of fundamental or
accounting growth which is defined as:
Fundamental Growth = ROE * Retention Ratio
ROE is Net Income/Shareholders Equity and the Retention Ratio
is 1 Dividend Payout Ratio. Since Amazon paid no dividends,
the retention ratio is one, and therefore we will restrict our attention
to the Amazons ROE.
As background, we will refer to an article in a Fortune Magazine dated
December 18, 2000 by Katrina Brooker. The article describes Amazons
focus on growth (GBF or Get Big Fast) and an obsession with customer
satisfaction. It will be useful to keep this in mind as we take you through the
analysis. A much more detailed account of the early history of Amazon.com
is in the book Amazon.Com: Get Big Fast by Robert Spector (April 2000).
It contains fascinating details about the growth of the company and the
evolution of its strategy over time, particularly at the end of the 1990s.
to the Amazons ROE.
The DuPont decomposition of ROE is:
ROE = Net Income/Sales * Sales/Total Assets * Total
Assets/Shareholders Equity
This decomposition rewrites ROE as the product of three terms,
Profit Margin Ratio, Asset Turnover Ratio and Financial Leverage
respectively.
The following table shows the DuPont decomposition for
Amazon.com over its recent history. We will look at some of the
sub-components below.
Table 1: Amazons DuPont decomposition history
Note that in 2000 2002 Amazon had a positive ROE but both the
numerator and the denominator were negative. This is obviously
is not a good sign but does reinforce the loss of over 90% of
shareholder value in 2000-2001. The trend however reflected
steady improvement which was a good sign, also reflected in the
stock price.
Amazons financial statements allow additional information to be
extracted. For example, observe that Amazons Total Assets
increased significantly from 1998 to 1999. To understand why
requires digging further into Amazons 10-K report for information
provided in addition to the major financial statements.
You can use Valuation Tutor to access the historical 10-K for
Amazon. Select Amazon as the stock to analyze, and in the
Information Browser at the bottom, click on 10-K and then scroll
down to find the 2000 10-K (filed in March of 2001):
Amazons 2000 10-K filing covers the period of time ending
December 31, 1999 and is usually released in the first quarter of
the year.
Item 1 of the 2000 10-K reveals:
WAREHOUSING, INVENTORY, FULFILLMENT AND
WAREHOUSING, INVENTORY, FULFILLMENT AND
DISTRIBUTION
We significantly expanded our US distribution infrastructure in
1999 with the addition of new distribution facilities in Fernley,
Nevada; Coffeyville, Kansas; Campbellsville, Kentucky; Lexington,
Kentucky; McDonough, Georgia; and Grand Forks, North Dakota.
We also opened two new international distribution centers, one in
the UK and one in Germany. On an aggregate basis, these eight
new distribution centers comprised approximately four million
square feet of warehouse space. The geographic coverage of
these distribution centers and their capacity have dramatically
improved our fulfillment capabilities and will allow us to continue to
increase our volume. The new distribution centers also give us
more control over the distribution process and facilitate our ability
to deliver merchandise to customers on a reliable and timely basis.
We now have a total of 10 distribution centers, including our
facilities in Seattle, Washington, and New Castle, Delaware.
In Item 1 they further observe that:
OUR SIGNIFICANT AMOUNT OF INDEBTEDNESS COULD
AFFECT OUR BUSINESS
We have significant indebtedness. As of December 31, 1999,
we had indebtedness under senior discount notes, convertible
subordinated notes, capitalized lease obligations and other asset
financing totaling approximately $1.48 billion. With the sale of our
Premium Adjustable Convertible Securities(TM), also known as
PEACS, in February 2000, we incurred additional debt of
approximately $681 million. We may incur substantial additional
debt in the future. :
That is, Amazons investment decision had a significant impact
upon its financial statements. In particular, the expansion of
assets and debt combined with a significant jump in negative
income led to Amazons stockholders equity turning negative by
2000.
Armed with this background information we can return to the
DuPont decomposition for Amazon and how it changed over time.
Applying DuPont Decomposition to Amazon
The DuPont decomposition lets you track three important ratios:
Profitability
Asset Utilization
Financial Leverage
Each of these three items is key to understanding Amazons
performance, especially in light of the significant warehousing
investments made in 1999 that were funded by debt incurred in
1999 and 2000.
Profitability
First, consider profitability. From 1995 to 2000, there was a dot
com bubble where shares of internet companies rose to very
high levels. Many of these companies did not generate any profits,
and Amazon.com was no exception to this, as described in a
colorful manner in the Fortune Magazine article, as follows:
(FORTUNE Magazine) A year ago, getting Jeff Bezos to talk
about making money was a bit like getting Bill Clinton to define
sex. Last fall, when asked when he thought Amazon.com would
turn a profit, he hemmed, hawed, and mumbled something about
turn a profit, he hemmed, hawed, and mumbled something about
not "missing out on the big opportunities of the Internet." Pressed
further, he gave this murky response: "Look at USA Today; it took
11 years to become profitable."
Beautiful Dreamer, Katrina Brooker, Fortune Magazine Dec 18,
2000.
It turned out that Bezos was correct as the following profit margin
trends show. In the chart below you can see that the profit margin
fluctuated wildly in the early years and then ultimately settled down
into a more normal range. Table 1 reveals how negative net
income was. However, by 2002 Amazons profit margin is
signaling a significant change. It ultimately stabilized in the latter
the latter part of the decade.
Amazons profit margin behavior suggests that the 1999 asset
expansion ultimately proved to be worthwhile for Amazons
shareholders.
Asset Turnover
The second major term in the DuPont decomposition asks: how
efficiently assets are being utilized in the company. The Asset
Turnover ratio is calculated by dividing Sales Revenue by Total
Assets. This ratio provides insight into how efficiently assets are
being utilized to generate sales revenue.
The chart reveals a positive trend over the early years. That is,
Amazon appears to be learning to utilize its assets more efficiently
Amazon appears to be learning to utilize its assets more efficiently
during the first decade of the 21
st
century. This graph strongly
reinforces Amazons decision to expand its warehousing capability
in 1999 as this proved to be important for supporting the growth in
sales exhibited by Amazon (see Table 1). In addition, the
combination of the positive asset utilization trends with the positive
trends in profit margins provided even stronger reinforcement of
the investment decision made in 1999 and it was not until the
economic crisis of 2008/2009 that any real change in trends
occurred.
However, the investment decision did add a considerable amount
of debt to Amazons Balance Sheet and so the third major
component of the DuPont decomposition provides insight into how
this is reflected in the financial statements.
Financial Leverage
Finally, ROE is the product of ROA and Financial Leverage and
financial leverage reflects Amazons debt policy. Financial
Leverage only makes sense for firms that have positive
shareholders equity and so the blanks parts in the graph below
correspond to the times Amazon had a negative shareholders
equity.
1998 1999 2000
Recall that Amazon introduced some significant debt when it
invested in its own warehouses. For example, Amazons 2000 10-
K reveals that from 1998 to 1999 Amazons debt increased
significantly:
Long-term Debt 348,140 1,466,338 2,127,464
The increasing debt, combined with increasing losses, drove
Amazons shareholder equity to be negative. It took until 2005
before Amazon recorded a positive shareholders equity and the
graph depicts a significant improving trend in financial leverage as
Amazon was building up retained earnings and paying down its
debt.
4.3 Application of Working Capital Ratios to
Amazon.com
In the previous chapter, we defined the major working capital ratios:
In addition, turnover ratios are often expressed in terms of number of days by dividing
365 by the turnover ratio:
Number of days to Collect Accounts Receivable = 365/Accounts receivable turnover
Finally, the Cash Conversion cycle is the sum of the first two, the aggregate number
of days for collecting accounts receivable and the number of days required to sell
inventory.
Now, recall that it was 1999 when Amazon expanded into its own warehouses. This
was the year where the GBF strategy started to take effect but had a negative impact
in the. This was reflected in Amazons inventory management ratios as follows:
COGS increased sharply in 1999 along with Sales. However, the cost of this was the
sharp decline in inventory turnover and increase in days to sell inventory; the days to
sell inventory almost tripled to 59.69 from 22.61. The impact of the old economy
managers is evident in 2000 where the days to sell inventory were almost halved and
by 2001 were equal to 1998 levels but with a 600% increase in sales. In other words,
the GBF strategy was back in balance with at least 1998 ratio levels.
Amazons other working capital ratios are as follows:
You can see that Amazon increased the days to paying its payables especially in
You can see that Amazon increased the days to paying its payables especially in
1999 when it increased to 125.27 days; this recovered to the 1998 levels by 2000.
Similarly, on the collection front Amazons 1999 numbers increased sharply. Overall,
it can be seen that Amazons working capital strategy is to attain favorable creditor
terms but collect their payables relatively quickly.
Overall, Amazons GBF and expansion in 1999 led to a significant deterioration in
their working capital management which was subsequently rectified by their
managers
.4 The Value Chain and Amazon.com
You have seen how the performance of the company changed over time, as reflected
in the ratios and in the stock price. The DuPont analysis revealed some of the
problems that Amazon faced and illustrates that Amazons management dealt with
these problems and ultimately overcame them, so that by 2003, the Net Income
became positive and by 2005, Shareholders Equity became positive. However,
although these numbers reflect what happened we would also like to get insight into
what they to change their strategy to overcome the issues they faced in 1999 and
2000.
Business Model and Business Strategy
Recall from the Introduction that what a company does to create shareholder value is
called the business model. One way of representing what a company does is in
terms of Porters Value Chain. A value chain describes the sequence of primary
activities implied by a firms business model that add value to shareholders. This
sequence of value-adding activities converts inputs into the products or services
described in the firms business model. Figure 1, depicts a traditional generic Value
Chain:
Figure 1: Traditional Value Chain
This chain also has a set of support activities. These support activities were
Procurement, Technology, Human Resources and Firm Infrastructure in Porters
original presentation.
Valuation Tutor Note: In the above screen both the value-adding and support
activities have been depicted. This requires checking all plot checkboxes and then
checking the subset of Primary Activities beside.
Business Strategy
Porter then continued to define business strategy relative to the set of activities in a
value chain. Business strategy describes how the firm operates within its competitive
environment in an attempt to gain a competitive advantage. From a value chain
perspective, a firms strategy can be classified into the following categories:
The business performs different activities from rivals or,
The business performs similar activities in different ways
The business chooses not to perform certain activities
The Valuation tutor software lets you represent the results of your business strategy
analysis using a relative weighting system.
Example: Suppose the key parts of the business strategy revolve around sales and
marketing and then customer service. Here the weighting assigned to Sales and
Marketing may be 100% and Customer may be 75%. Suppose further the remaining
activities are weighted at 30%. In this case the value chain subsegments reflect the
various weights based upon the analysis of strategy.
Application to Amazon.com
The value chain perspective allows us to build up an understanding of the change in
Amazons business strategy from the 10-K. Let us start with the 2000 10-K, filed in
March of 2001. The business strategy is summarized as:
Amazon.com seeks to be the world's most customer-centric company where
customers can find and discover anything they may want to buy online. We intend to
continue to optimize our Internet platform to expand the range of products and
services offered to our customers and partners. This platform consists of strong
global brand recognition, a large and growing customer base, innovative technology,
extensive and sophisticated fulfillment capabilities (consisting of fulfillment and
customer service) and significant e-commerce expertise. We believe that this platform
allows us to launch new e-commerce businesses quickly, with a high quality of
customer experience, economical incremental cost and good prospects for success.
We also believe that this platform's flexibility allows us to expand the range of
products and services offered to our customers through relationships with strategic
partners on terms that are attractive to our customers, our strategic partners and us.
The filing goes on to list the expansion of the company along different dimensions
and the marketing and sales customer service efforts.
Three points emerge from this: first, Amazon has chosen to both perform similar
activities to its rivals but in different ways. At the time, most of its competitors were
traditional bricks and mortar stores, i.e. companies with physical stores. Amazon
chose instead to be a virtual store, allowing Amazon in principle to offer customers
anything they want. Second, they want to be the worlds most customer-centric
company, and so their focus is on the Customer Service part of the value chain.
Third, you can see the emphasis on growing large, in terms of the range of products
offered by Amazon itself and also growth in launching new companies and partnering
offered by Amazon itself and also growth in launching new companies and partnering
with existing companies.
In terms of the value chain, you can see that most of the focus is on Marketing &
Sales and Customer Service.
Amazon placed very little weight on Inbound Logistics and Operations. In the same
filing, under Results of Operations, they mention a current-year focus on balancing
revenue growth with operating efficiency. This is an indication that the first three
parts of the value chain were being paid less attention than the last two. We will
describe what this re-balancing was in a moment, but it is interesting that by 2003,
operational efficiency took a much more prominent role in the Part 1 of the 10-K filing.
In the 2003 10-K (reflecting information up to December 2002), the stated strategy is:
nWe seek to offer Earths Biggest Selection and to be Earths most customer-centric
company, where customers can find and discover anything they may want to buy. We
endeavor to offer our customers the lowest possible prices. Through our Merchants@
and Amazon Marketplace programs, we enable businesses and individuals to sell
virtually anything to Amazon.coms millions of customersOur business strategy is
to offer our customers low prices, convenience, and a wide selection of merchandise.
We endeavor to offer our customers the lowest prices possible. We strive to
improve our operating efficiencies and to leverage our fixed costs so that we can
afford to pass along these savings to our customers in the form of lower prices. We
also enable third-party sellers to offer products on our site, in many instances
alongside our product selection, and set their own retail prices
Here you see the mention of operational efficiencies and low prices. The remainder
of the Part 1 of the 10-K is similar to the previous years and you can access it easily
from Valuation Tutor. This means that by this time, the company was more firmly
focused on the first parts of the value chain: logistics and operations, efforts that had
started in 2000. The 2011 filing is very similar to the 2003 filing: We strive to offer
our customers the lowest prices possible through low everyday product pricing and
free shipping offers, including through membership in Amazon Prime, and to improve
our operating efficiencies so that we can continue to lower prices for our customers.
We also provide easy-to-use functionality, fast and reliable fulfillment, and timely
customer service.
Now the activities such as operational efficiency, low pricing procurement, sales and
marketing with Amazon prime receives greater emphasis. Their customer centric
focus still implies most weight provided to the customer.
The result is greater balance among the activities.
The result is greater balance among the activities.
The above took a few years to implement and the story is described next.
Greater Focus on Human Resource Management
So what did they do in 2000 to pay more attention to operational efficiency? The
answer to this question is revealed in the 10-K statement which indirectly revealed
that major changes were being implemented. Consider the following exhibit referred
to in Amazons 2000 10-K. This contained an unusual set of disclosures on sequential
days:
10.9+ Offer Letter of Employment to Joseph Galli, Jr. dated June 23, 1999, as
amended and restated September 30, 1999 filed with the Company's Annual Report
on Form 10-K on March 29, 2000).
This immediately resulted in three additional hires:
10.10+ Offer Letter of Employment to Warren C. Jenson dated September 4, 1999,
as amended and restated September 30, 1999 filed with the Company's Annual
Report on Form 10-K on March 29, 2000).
10.11+ Offer Letter of Employment to Jeff Wilke, dated September 2, 1999 filed with
the Company's Annual Report on Form 10-K on March 29, 2000).
10.12+ Offer Letter of Employment to Richard Dalzell, dated August 13, 1997 filed
with the Company's Annual Report on Form 10-K on March 29, 2000).
Note that the first of these hires was made in 1999. The three people hired by
Amazon were interesting in a number of ways. They all had old-economy
backgrounds, meaning that that they had not worked for an internet based company,
but rather in traditional manufacturing companies. Joseph Galli served with The
Black and Decker Corporation from 1980 to June 1999; Warren C. Jensen had
served as an Executive Vice President and Chief Financial Officer for Delta Air Lines
and earlier General Electric, Inc.; Jeff Wilke served with AlliedSignal. Finally, an
earlier Amazon hire, Rick Dalzell, was also included in these filings. Rick Dalzell had
previously come to Amazon from Wal-Mart Stores Inc.
These hires delegated decision making powers managers who would focus upon
controlling costs and improving operational efficiency. As described in the book by
Spector, real fiscal and operational discipline began with the hiring of Joe Galli as
chief operations officer, and his assembling of old economy veterans from the likes
of Delta Airlines, NBC, AlliedSignal, and MCI. Budgets were formalized. Every
division became accountable for expenditures. Executives had to write operating
plans that outlined specific financial deadlines and had to reach specific sales goals
and margins. Amazon employees were taught about profit-and-loss statements,
balance sheets, and cash-flow analysis.
It is not easy for a corporation or a CEO to bring about such changes as revealed in
the Fortune Magazine article dated December 18, 2000 by Katrina Brooker. Here she
describes the problems that arose from a sole focus upon GBF and customer service:
GBF also wreaked havoc in the warehouses. Last year the company spent an
estimated $200 million building seven distribution centers around the country--from
Nevada to Kentucky. The idea is that if these three million square feet of warehouse
space are run efficiently, Amazon will be able sell to as many customers as, say, Wal-
Mart at a fraction of the cost. But when Jeff Wilke, Amazon's new operations chief,
got a look at them for the first time last fall he was stunned: They were a mess. There
were defective products on the shelves and mystery shipments arriving that no one
remembered ordering. Once a truckload of kitchen knives showed up--no one knew
where it came from or where it was supposed to go. It just sat there. "We kept it all--
we just kept it," says Wilke, shaking his head. "We put it on the shelf and said, 'I don't
know. What matters is the customer.' " By the end of 1999 it seemed that GBF was
still in the saddle: While sales were up 169%, to $1.6 billion, net losses had risen from
$125 million in 1998 to $720 million.
This again emphasizes that Amazon.Com was so focused upon the last two links on
the value chain (Marketing & Sales, Customer Service) and not sufficiently on the rest
of the chain.
As noted earlier Amazon realized this and took steps to rectify this problem. The
article continues to describe this as follows:
But the truth was that behind the scenes Bezos was working to ensure that Amazon
got its spending under control. His key move, in fact, had occurred in June when he
reached into the old economy to hire Joe Galli, a 19-year Black & Decker vet.
Right off the bat, chief operating officer Galli played hardball. He hired a slew of new
managers, all with old-economy backgrounds: Delta, NBC, AlliedSignal, MCI. He
pushed Amazon to start structuring itself like, well, an old-economy company. He
forced it to set up a formal budget. He established an approval process for expenses.
For example, all major purchases--computers, distribution machines--required signoff
by top management (i.e., Galli). He hired Wilke to apply the Six Sigma methods to the
distribution centers. He also presided over the company's first major layoffs, when he
distribution centers. He also presided over the company's first major layoffs, when he
let 2% of the work force go in January.
Galli was not a popular guy. Accustomed to Bezos' freewheeling leadership,
employees found Galli heavy-handed. He was stifling innovation, they complained,
hurting Amazon's close-knit culture. "It was cruel the way he laid those people off,"
sniffs one former exec, who left in part because of Galli. The COO became notorious
last fall when he took away the employees' free Tylenol and aspirin. It was a small
perk, but for many employees Galli's move was a symbol of everything they hated
about him. The outcry was so fierce that the company restored the perk within a
week. "That was, frankly, just a mistake that Joe made. Like, oops, you know, people
do really spend a lot of time at their computers," recalls David Risher, general
manager of Amazon's U.S. virtual stores. Galli, who left in July to become CEO of
VerticalNet, insists his moves were for the good of the company. "Some steps are
less popular than others, because anytime you become more disciplined, you have to
change your behavior," he says.
While Galli got the blame, Bezos was the man behind the orders. In fact, when asked
about Galli, Bezos makes the chain of command clear: "The senior management
team was very much in step, and we knew exactly what we wanted to do." And in the
days since Galli's departure, Bezos has not let up. Gone are the days of "Get big
fast." Bezos' new motto is "Make some great cash, baby." Instead of looking for ways
to grow sales, employees look for ways to save money. "So, if its a tradeoff--two
weeks to do a project for $200 or three weeks for $100--18 months ago we would
take the two-week, $200 approach," says LeBlang. "Today I do it in three weeks for
$100." Now every division must carefully account for what it spends. Each meets
weekly to go over its numbers. Executives must also write operating plans that outline
specific financial deadlines and target precise sales goals and margins. "Now we
have discipline," says Brian Birtwistle, product manager of the online software store.
"You map out everything--what marketing you'll do for the year; what initiatives you'll
launch; what you have to do to make those numbers realistic." Sounds like Business
101, and indeed it is. To learn the basics of P&Ls, balance sheets, and cash flow
analysis, Amazon employees now take Finance 101 courses offered at the Seattle
headquarters. When they've completed that, they take Finance 102.
The last part of the article is very interesting: it points out that since operational
efficiency is measured by the tools of financial statement analysis (such as margins),
management must understand how the firms activities affect the financial statements.
Beyond managers, outside analysts also use the same tools for analyzing a
company. For example, in 2000, analysts such as Ravi Surya of Lehman Brothers
argued that Amazon lost money on every sale. According to book by Spector: Suria
stated that Amazon lost money on every sale, if you included costs for marketing,
product development, warehousing, and fulfillmentin addition to the usual fees paid
to wholesalers and distributors. Furthermore, Suria argued, all of those Amazon-built
warehouses, which were chock-full of merchandise, had severely slowed down the
pace of moving goods in and out. Therefore, in his opinion, Amazon.com had become
essentially a traditional retailer (insult!)and an inefficient one at thatand that the
company was woefully lacking from an operational aspect. Amazons shares fell
20% on the day Surias report was released.
Spector goes on to report that In October 2000, Amazon.com showed Wall Street
that it was changing its profligate ways. Analysts were pleasantly surprised when the
company reported a third-quarter loss of 25 cents a share, which was well below their
estimate of 33 cents a share. Operating losses as a percentage of sales dropped
from 22 percent to 11 percent. Gross margins were a company record 26 percent, up
from 20 percent the previous year.
4.5 The Balanced Scorecard and Amazon.com
The Balanced Scorecard approach (Arthur Schneiderman (1987), Kaplan and Norton
(1992)) can be used within a firm as a method for communicating business strategy.
It is a methodology that lets senior management communicate and implement
Describing business strategy requires multiple dimensions because of the
varying emphasis given to different activities in the value chain
There needs to exist some balance among these dimensions when an
organization implements its business model via its strategy.
Understanding major firm decisions in terms of these multiple dimensions and
their balance is necessary for conducting meaningful financial statement
analysis.
It is a methodology that lets senior management communicate and implement
business strategy at all levels of the organization. When an analyst outside the firm
conducts financial statement analysis, the Balanced Scorecard provides a framework
for gaining a better understanding of the firms business strategy. Some important
underlying themes to this approach are:
Specifically, the Balanced Scorecard views the firms business strategy from four
perspectives:
Application to Amazon.com
In the 1990s and up to the time of hiring Galli, Amazons business strategy was
unbalanced from a balanced scorecard perspective. In particular Amazon was over-
emphasizing the Customer and Learning and Growth to the detriment of the
Financial and Process dimensions.
The Financial perspective requires looking at measures that are relevant to the
valuation of the company by shareholders. These include items like return on equity,
return on assets, and stock price. For Amazon the ROE was deteriorating from 1998
to 1999 and was not a meaningful measure in 2000 because both the numerator (Net
Income) and denominator (Shareholders Equity) were negative by 2000. As a result,
the DuPont decomposition of ROA (Return on Assets) provides a meaningful
measure. In particular, the drivers of ROA (Profit Margin Ratio and Asset Turnover
Ratio) were very unstable under the GBF and Customer Obsession strategy no
matter what it costs strategy that was implemented in 1999. However, these ratios
started to stabilize after traditional cost constraints were imposed via old economy
techniques such as implementing a traditional master budget cycle at Amazon.
The Process perspective refers to the internal activities performed by a firm. This
includes identifying activities for which it is important for the firm to excel and captures
what in financial statement analysis is referred to as business efficiency. The most
relevant item here to Amazon around 1998-2000 was the inventory ratios, such
inventory turnover and days to sales inventory given Amazons warehousing
inventory turnover and days to sales inventory given Amazons warehousing
expansion plans that were implemented in 1999. From 1998 to 1999 the days to sell
inventory increased from 22.61 days to 59.69 days a whopping 264% increase in the
time inventory stayed with Amazon. With the amount of capital tied up in inventory
and warehouses it is not surprising that at this time Amazons related working capital
ratios were also out of balance with days to pay payable increasing from 86.85 to to
125.27 days or just over 4-months on average to pay their creditors in 1999. The
impact from imposing cost constraints upon their business strategy was almost
immediate. In 2000 efficiency picked up and the days to sell inventory were almost
halved to 30.26 days and days to pay payables were reduced to 84.13 which was
around 1998 levels.
The Learning and Growth perspectives refer to employee and informational
activities requiring innovation and continual improvement. For Amazon some relevant
ratios are that Sales growth did decline from 1999 to 2000 (from 269% in 1999 to
168% in 2000) but 168% is still consistent with a strategy of GBF. In addition, the
DuPont decomposition revealed that asset turnover was increasing which was a
positive trend in the light of Amazon undertaking a significant expansion into
warehousing. As a result, employees of Amazon had to go down the learning curve
along this dimension. The positive trend in asset turnover provides evidence in
support of this dimension.
Finally, the Customer perspective requires the identification of performance metrics
that measure the companys success in meeting customers expectations viewed
from the customer or outsiders perspective. Direct information on these is available in
the supporting notes to the financial statements as well as other parts of the 10-K.
For example, measures of customer service, customer ratings, customer loyalty or
retention. For Amazon the word customer is used often in its 10-K. Further, in the
supporting notes to their 1999 financials Amazon reveal the following metrics:
Amazon disclosed the following in their 2000 10-K footnotes to the statements. This
description contains some performance metrics for the Customers perspective:
Growth in net sales in 1999 and 1998 reflects a significant increase in units sold due
to the growth of our customer base, repeat purchases from existing customers,
increased international sales, and the introduction of new product offerings. These
new product offerings include music and DVD/video in June and November of 1998,
respectively, toys and electronics in July 1999 and home improvement, software and
video games in November 1999. We increased our issuance of promotional gift
certificates to customers in 1999 to promote new product lines, however, which
partially offset such growth in net sales. The Company had approximately 16.9
million, 6.2 million and 1.5 million cumulative customer accounts as of December 31,
1999, 1998 and 1997, respectively. The percentage of orders by repeat customers
increased from 64% in the fourth quarter of 1998 to 73% in the fourth quarter of 1999.
The increase in net sales in 1998 was also partially due to the launch of the UK and
German focused Web sites in October 1998.
Amazons 2000 10-K was a little less forthcoming on the customer dimension
although they reinforced their strategy in many parts of the 10-K. For example:
U.S. Books, Music and DVD/Video Segment. The U.S. Books, Music and DVD/video
segment had net sales of $1.7 billion, $1.3 billion and $588 million in 2000, 1999 and
1998, respectively. During 2000, we continued to enhance our book, music, DVD and
video stores by expanding selection, making it easier to find items, and generally
improving the customer experience. In 2000, our Book store had the largest pre-order
in our history. Over 410,000 copies of "Harry Potter and the Goblet of Fire" were pre-
ordered on our sites worldwide. We joined with Federal Express to provide
complementary upgrades to the first 250,000 customers who ordered to ensure
delivery on the day of release. In addition, we launched an e-Books store, offering e-
books in Microsoft Reader format for PCs and laptops, as well as downloadable e-
audiobooks from our strategic partner, Audible, Inc.
In summary, in 1999 Amazon pursued GBF and Customer obsession without
In summary, in 1999 Amazon pursued GBF and Customer obsession without
imposing cost constraints on their strategy. As a result when viewed from a Growth
and Customer perspective Amazon looked great. On the other hand when viewed
from their Financial and Process perspectives Amazon did not look so good awful.
So the implementation of their strategy was not in balance. However, with the steps
taken in 2000, significant improvements were made in relation to both the Financial
and Process dimensions. Ultimately, Amazons stock price reflected these steps.
Amazon has chosen to both perform similar activities to its rivals but in different ways.
At the time, most of its competitors were traditional bricks and mortar stores.
Choosing to be a virtual store on the World Wide Web allowed Amazon in principle to
offer the Earths Biggest Selection. Conceptually this illustrates why Porters
original description of a value chain was extended to embrace the world of electronic
commerce by Rayport and Sviokla (1994). They observed that the traditional value
chain model treated information processing as a supporting element of the value-
adding process and not as a source of value itself. However, the information
generated by customer-centric entities is a source of value for customer centric
businesses such as Amazon and Netflix. This activity is driven by databases and
predictive algorithms designed to make it easier for customers to find reliable product
and service ratings.
In this development Rayport and Sviokla view the value chain as a pair of chains
the traditional physical chain operating in the physical world of marketplace and a
virtual (or synthetic) chain that operates in the new information world referred to as
marketspace. This categorization provides a better description of the business model
for technology firms such as Amazon, versus a traditional bricks and mortar firms
such as Wal-Mart and Barnes and Noble who choose to extend their businesses to
have a presence in both spaces.
More recently Amazon has added to its revenue streams by offering e-commerce
services to sellers and developers some of whom compete directly against
Amazon.com. This item reflects another interesting extension of Porters original
static framework to a dynamic and more chainlike in terms of linking back to itself,
value chain.
Dynamic Value Chains and Amazon
The difference between a static and dynamic value chains is that in a dynamic chain
different entities assume different positions on the chain depending upon things like
the time of day and a customers location. For example Amazon and third party
suppliers compete with each other on Amazons own platform. The dynamic
dimension of Amazons value chain is communicated in Item 1 of Amazons 2010 10-
K. Here they report two additional parts of their business model:
Sellers
We offer programs that enable sellers to sell their products on our websites and their
own branded websites and to fulfill orders through us. We are not the seller of record
in these transactions, but instead earn fixed fees, revenue share fees, per-unit activity
fees, or some combination thereof.
Developers
We serve developers through Amazon Web Services, which provides access to
technology infrastructure that developers can use to enable virtually any type of
business.
That is, seller services and order-fulfillment part of Amazons business essentially
competes with Amazons own sales and procurement teams. Similarly, the Web
Services division enables other businesses to compete with Amazon and others.
These are examples of Amazon embracing a dynamic value chain in their business
model.
Dynamic Value Chains and Risk
The risk facing entities in todays dynamic value chains is that a company can
suddenly drop out of the chain. This was a problem that Borders bookstores faced
when competing against Amazon and Barnes and Noble. Ironically, they were still
when competing against Amazon and Barnes and Noble. Ironically, they were still
the second largest bricks and mortar bookstore when they lost their position in the
chain. This led to the recent bankruptcy court events for Borders:.
July 22, 2011 a federal bankruptcy judge approved the Borders Groups plan to
liquidate. Borders at its height in 2003 operated 1,249 bookstores and 399 at the
time of bankruptcy.
Both internal and external factors are blamed for Borders demise. Clearly, online
retailing and electronic book readers were major factors. For example, Borders
waited several years before it rolled out its version of an e-reader called Kobo. The
other major bricks-and-mortar competitor, Barnes and Noble, were much more
proactive in their response to the successes of Amazons Kindle. Barnes and Noble
developed its e-reader, the Nook which today is competing successfully against the
Kindle.
Borders also failed to adapt to a dynamic external environment and badly timed their
expansion. They expanded excessively around the same time period when Amazon
was generating significant performance gains from re-inventing the implementation of
their business model. In addition, the world was rapidly embracing digital for books,
music and movies around this time. Borders ill-timed expansion resulted in relatively
flat sales along with rising costs. The following table from a 2008 10-K reflects these
problems.
4.6 SWOT Analysis
The above Borders story underscores the importance of continually performing a
SWOT analysis. SWOT stands for: Strengths, Weaknesses, Opportunities and
Threats classified into two dimensions, internal and external. The internal
assessments are the Strengths (Internal comparative advantages) and
Weaknesses (internal disadvantages relative to competitors). The external
assessments are the Opportunities (external opportunities for generating additional
sales and earnings) and Threats (external disadvantages relative to competitors and
potential competitors).
Applied to Borders a SWOT analysis would increasingly flag significant Weaknesses
and Threats with little bright news along the dimensions Strengths and Opportunities.
For example, for Borders Weaknesses are clearly their rapidly deteriorating profit
margins combined with flat sales after their expansion phase. This is evident starting
from 2006 (see above 2008 10-K s data which covers 2003 to 2007). Threats were
from 2006 (see above 2008 10-K s data which covers 2003 to 2007). Threats were
also growing significantly from Internet book sales, growth in e-books and the shift to
digital music and movie downloads. The only potential Strength over this time period
for Borders was the strong growth exhibited in International sales. Finally, the major
potential Opportunity for Borders turned into an opportunity lost. This was the
growth in the e-book market which Borders completely missed. Instead they
allocated significant resources to expanding bricks and mortar and ran up costs at a
time when they faced significant Threats from e-commerce
4.7 Summary of Amazon.com
As you have learned item 1A of the 10-K usually provides a clear statement of a firms
business model. We have seen that for the case of Amazon that the modern concept
of a dynamic value chain, embracing both physical and virtual links, is required to
accurately describe its business model. Amazons business strategy can now be
described relative to this chain in the way described earlier. That is, recall the
concept of a business model can be classified as follows:
The business performs similar activities in different ways
The business chooses not to perform certain activities
The first two of these apply to Amazons strategy. First, the embracing of virtual
activities and the inclusion of dynamic links on the chain are examples performing
different activities from rivals. That is, initially Amazons rivals were Barnes and
Noble and Borders and by choosing a web storefront compared to a bricks and
mortar storefront Amazons business strategy was to perform similar activities in
different ways. The range of goods were then extended to the lofty objective for
offering Earths Biggest Selection and so Amazons rivals ultimately became the
Wal-Marts, K-Marts, Targets and other retailing chains as opposed to the Barnes and
Nobles and Borders..
A second major pillar of Amazons strategy was to be Earths most customer centric
. This was feasible with a web based model with real time database access to
each of the primary links on the value chain. Customers could receive immediate
support both in terms of fulfillment related questions, product information/ratings
issues and even product suggestions. If Amazon was successful at offering earths
largest selection of products then amazon could draw to the attention of its customers
products that they never previously knew existed.
Combined in this way Amazons business strategy was largely built upon the
objective of Get Big Fast (GBF) using a value chain that was internally linked so that
it was difficult for a competitor to attack any specific link. This strategy created large
amounts of shareholder value for Amazon in the 1990s as the stock price chart below
reveals.
However, you can observe from the above that after an initial phase of phenomenal
price appreciation problems started to emerge for Amazon as revealed from
Amazons Return on Equity which was becoming increasingly negative (1998 ROE
= -.90, 1999 ROE = -2.70).
4.8 Wal-Mart and Target: Strategic Differences
In the case of Amazon, we saw how getting strategy into balance had a major impact
upon stock price performance. We now examine the impact of different strategies on
ratios and stock prices by comparing Wal-Mart and Target. Our objective is to apply
Financial Statement Analysis to identify the relative strengths and weaknesses of
these companies (which are immediate competitors).
The tools we will use in this case study were introduced in Chapter 3. An overview of
how we will analyze the companies is shown in Figure 1:
Figure 1: Summary of Business Ratio Analysis
We will start with the stock price performance of Wal-Mart and Target. Then, we will
We will start with the stock price performance of Wal-Mart and Target. Then, we will
become acquainted with the business model and business strategy. After that, we
will compare them along three dimensions: profitability, operating efficiency and
financial leverage. From this, we will identify the comparative strengths and
weaknesses of Target compared to Wal-Mart.
Stock Price Performance
Consider the recent history of stock price performance of Wal-Mart and Target shown
in Figure 2:
Figure 2: TGT and WMT Stock Price
This reflects a relative performance that is quite different even though the two
companies are immediate competitors. First, you can see that WMT was less volatile
than TGT. In 2001 and 2002, there was a recession, and both stock prices fell. You
can see that TGT recovered strongly, until the deep recession of 2008, which affected
TGT much more than WMT. Again, TGT has recovered from the decline of 2008.
Even though WMT declined in 2008, it was a much smaller decline than TGT.
Why is the price behavior of these two firms so different?
To answer this question, let us first become acquainted with their respective business
models and strategies.
Business Model and Strategy
We start with Item 1 from Targets and Wal-Marts 2010 10-K. You have already seen
that this section of the 10-K contains a lot of useful information about what the firms
do and how they do it. So lets see if their business models and strategies are
different.
Target (TGT)
PART I
Item 1. Business
General
Target Corporation (the Corporation or Target)
was incorporated in Minnesota in 1902. We
operate as two reportable segments: Retail and
Credit Card.
Our Retail Segment includes all of our
merchandising operations, including our large-
Wal-Mart (WMT)
PART I
ITEM 1. BUSINESS
General
Wal-Mart Stores, Inc. (Wal-Mart, the
company or we) operates retail stores
in various formats around the world and
is committed to saving people money so
they can live better. We earn the trust of
our customers every day by providing a
merchandising operations, including our large-
format general merchandise and food discount
stores in the United States and our fully
integrated online business. We offer both
everyday essentials and fashionable,
differentiated merchandise at discounted prices.
Our ability to deliver a shopping experience that
is preferred by our customers, referred to as
"guests," is supported by our strong supply chain
and technology infrastructure, a devotion to
innovation that is ingrained in our organization
and culture, and our disciplined approach to
managing our current business and investing in
future growth. As a component of the Retail
Segment, our online business strategy is
designed to enable guests to purchase products
seamlessly either online or by locating them in
one of our stores with the aid of online research
and location tools. Our online shopping site offers
similar merchandise categories to those found in
our stores, excluding food items and household
essentials.
our customers every day by providing a
broad assortment of quality merchandise
and services at every day low prices
(EDLP) while fostering a culture that
rewards and embraces mutual respect,
integrity and diversity. EDLP is our
pricing philosophy under which we price
items at a low price every day so our
customers trust that our prices will not
change under frequent promotional
activity. Our fiscal year ends on January
31 for our U.S., Canada and Puerto Rico
operations. Our fiscal year ends on
December 31 for all other operations.
During the fiscal year ended January 31,
2010, we had net sales of $405.0 billion.
Our operations comprise three business
segments: Wal-Mart U.S., International
and Sams Club.
Our Wal-Mart U.S. segment is the largest
segment of our business, accounting for
63.8% of our fiscal 2010 net sales and
operates retail stores in different formats
in the United States, as well as Wal-
Marts online retail operations, Wal-
Mart.com
These two firms have a similar business model designed primarily around a traditional
physical value chain.
You can see that they have chosen to perform similar activities (retail) in different
ways. The initial paragraphs in Item 1 of their respective 10-Ks make clear they have
different business strategies with respect to their marketing and sales activity. Wal-
Mart is committed to saving people money which can only be implemented via a low
price strategy for all the merchandise in their stores. Target on the other hand is
committed to delivering a shopping experience that is preferred by our customers,
who are referred to as guests. Target therefore is committed to higher marketing
expenditure within their stores and a higher level of customer service. Target
continues to add that their products are both everyday essentials and fashionable
differentiated merchandise at discount prices. Thus although low prices are
important to their strategy, they are not as important a component of their business
strategy compared to Wal-Mart.
Item 1 reveals a lot of interesting information about their business strategies.
Financial statement analysis will reveal the extent to which the strategies are working.
In fact, one of the objectives of financial statement analysis is to assess how the
managers of a company are performing given the stated objectives of the corporation.
We will see below how the differences in strategy are reflected in profitability,
operating efficiency, and financial leverage.
operating efficiency, and financial leverage.
4.9 Business Strategy: Predictions
The strategies and some simple economics lead to predictions about business ratios.
For example, we would expect that in a recession some Target customers will shift to
low prices away from "shopping experience" and higher prices. In an expansion
customers may be prepared to pay a little more for "shopping experience." So we
expect relative differences to be exhibited by the business ratios for these two stocks:
First, we predict that the profit margins for Target to be relatively higher and asset
turnover for Wal-Mart to be relatively higher.
Second, we predict that Target is more sensitive to the business cycle than Wal-
Mart. In particular, we expect that Targets sales and profit margins are relatively
more sensitive to economic downturns and upturns than Wal-Mart.
Third, we predict that Targets ratios will be more volatile than Wal-Mart because
of their greater sensitivity to the economy.
Of course, strategy is not fixed but can change over time. For example, quoting from
Wikipedia, In March 2006, Walmart sought to appeal to a more affluent demographic.
The company launched a new Supercenter concept in Plano, Texas, intended to
compete against stores seen as more upscale and appealing, such as Target The
new store has wood floors, wider aisles, a sushi bar, a coffee/sandwich shop with free
Wi-Fi Internet access, and more expensive beers, wines, electronics, and other
goods. The exterior has a hunter green background behind the Walmart letters,
similar to Neighborhood Market by Walmarts, instead of the blue previously used at
its supercenters.
The following table contains the DuPont decomposition for the two companies. The
Year column refers to the 10-K year so the financials are for the year ending Dec 31
of the previous year.
From the table it is clear that overall Wal-Mart is outperforming Target in terms of both
ROE and ROA. The first two components of the DuPont decomposition identify the
two major drivers of ROA, Profit Margin and Asset Turnover.
First, as predicted, Targets profit margins are higher than Wal-Marts. Second, as
predicted, Target has a lower Asset Turnover than Wal-Mart. The product of these
two terms is the ROA. So even though Wal-Mart has a stronger ROE and ROA,
Target has the advantage in profit margins and asset turnover over Wal-Mart, as
predicted by differences in their business strategy.
4.10 Analyzing Profitability
The profit margin ratio in the DuPont can be decomposed into finer components by
working with net income from continuing operations, commonly referred to as EBIT
(Earnings Before Interest and Taxes). Dividing EBIT by Sales converts it into a
margin, and the EBIT to Sales ratio provides data that can be compared across
companies. It yields information on a companys costs relative to sales.
Two refinements discussed in the Business Ratio chapter were the Gross Profit
Two refinements discussed in the Business Ratio chapter were the Gross Profit
Margin, defined as Gross Profit expressed as a percentage of Sales, and Operating
Income Margin, which includes selling and administration costs associated with
operations.
Gross Profit Margin = Gross Profit/Sales Revenue
Operating Income Margin = Operating Income/Sales Revenue = EBIT/Sales Revenue
The primary difference between these two ratios is that the Gross Profit is defined as
Sales less COGS, and thus does not include Selling, General and Administration
(SG&A) costs. EBIT on the other hand does include Selling, General and
Administration because it is net income less interest and taxes. Under US GAAP a
further distinction is made between continuing operations versus discontinued
operations. This is not the case for IFRS.
Continuing with Target and Wal-Mart, recall that an important difference in their
business strategies hinges on shopping experience. This implies that SG&A is more
important to Target. Therefore, it is useful to compare: the Gross Profit Margin,
Operating Income Margin and also the Selling and General Administration Margin
when comparing Target and Wal-Mart. In the tables below, the year refers to the
beginning of the year (i.e., the year the 10-K became available) so 2010 refers to the
annual results from 2009. COGS is Cost of Goods Sold while SG&A is Selling,
General and Administrative Expenses.
Observe that the Gross Profit Margin is higher for Target than Wal-Mart, consistent
with their respective business strategies. Targets Gross Margin has declined over
the last three years; they have been much harder hit by the recession than Wal-Mart.
In fact Wal-Mart has managed to increase its Gross Margin over these same years!
Targets business strategy is reflected in the SG&A and its impact on Targets
profitability is reflected in the Operating Income Margin. Overall, Target maintains an
Operating Income Margin (the column titled Operating) that is a little above Wal-
Marts.
Two recent trends are that Wal-Mart has been increasing its marketing expenditure
(i.e., SG&A). This has been increasing over the last three years and suggests that
Wal-Mart is increasing its attention to shopping experience. However, you can see
that Wal-Marts increased Gross Margin has been applied to this shift in strategy so
that there has been no impact upon its Operating Margin which is level at 5.9%.
From the ratios above you can see that Target appears to be responding to its recent
declines in Gross Margin from the recession by reducing its marketing expenditure
(as revealed by the trend for the SG&A margin) in an attempt to recover their previous
Operating Margins. This has resulted in the reversal of the declines in 2009, and
Targets current Trailing Twelve Months Operating Margin is 7.40%.
These numbers and trends can be placed in context of the actual shift in Targets
business strategy since 2008. In 2009 Target modified its strategy towards Wal-Mart,
with its Expect More Pay Less marketing strategy. In July 2009 it started matching
competitors advertised prices on identical items in local markets. Further it has been
actively working with vendors to keep costs in check and has increased its reliance on
higher-margin private label goods (Barrons August 9, 2010 Right On Target). In the
next section we consider some of the implications of this strategy.
4.11 Balanced Scorecard Implications for Target
From a business strategy perspective, Target has implemented a strategy designed
From a business strategy perspective, Target has implemented a strategy designed
to work on multiple dimensions: Customer, Process and Growth in response to
declines in financial performance from the recent recession. Target has tightened its
control over costs and especially procurement activities in terms of both procurement
costs and increased in-house brands to enable it to compete more aggressively on
price as well as recovering margins. Target has broadened its Customer perspective
to embrace a 5%-discount card program to be launched in the fall of 2010. Target
has also cut back on the Growth perspective in terms of opening fewer new stores to
reduce its capital expenditure.
Barrons reported that Target planned to open 10 new stores in 2010 (compared to
hundreds prior to 2010) and 20 new stores in 2011. This reduces capital expenditure
but Target is still trying to promote growth via an aggressive remodeling strategy that
will save capital expenditures compared to opening new stores. This is a remodeling
strategy of existing (non Super Target) stores with plans extending to 1100 of its
nearly 1500 general-merchandise stores. Overall, these measures have resulted
(and expect to result) in improved financial measures (earnings forecasts and free
cash flow forecasts) and overall the market is responding positively with a recovery in
stock price from a recent low just below $25 in March 2009 to just over $50 in August
2010.
In summary, when the economy is strong Targets comparative advantage has been
on shopping experience and profit margins. When the economy weakened Wal-
Marts comparative advantage was Every Day Low Pricing and asset turnover. By
modifying its business strategy towards the Wal-Mart, Target was able to reverse its
negative stock price trends and rebuild shareholder value. That is, Target was able to
modify its comparative advantage to better fit current economic conditions. It will be
interesting to observe Targets response when the economy improves because the
management has built a strong foundation to benefit from the recovery.
4.12 Analyzing Operating Efficiency
A second important driver of growth captured in ROE is the Asset Turnover Ratio.
Total Assets consist of two sub groups: Current Assets and Non-Current Assets. As
a result,
Sales/Assets = Sales/(Current + Non Current Assets)
So the Asset Turnover Ratio can be increased if either Current Assets or Non-Current
Assets can be trimmed without affecting sales. We analyze the drivers of Asset
Turnover by separately considering Working Capital (a. below) and Operating
Leverage (b. below). This type of decomposition provides insights that are primarily
relevant to the Process Perspective of the balanced scorecard to the extent that
they result from the firms investment decision.
Analyzing Working Capital Activity
Ideally, Working Capital is defined in relation to the investment decision, which means
that financing and tax related activities should be stripped out of Working Capital
(defined as Current Assets minus Current Liabilities). This leads to eliminating items
such as short term debt and the current portion of long term debt as well as deferred
tax assets/liabilities. Similarly, we eliminate cash and marketable securities from
working capital. We will return to the role played by these balance sheet items in a
working capital. We will return to the role played by these balance sheet items in a
later section when we consider liquidity and solvency ratios.
Targets business strategy is changing with their new initiative called PFresh to roll
out groceries to the chains 1,743 stores (general merchandise and Super-Targets).
This will bring their business strategy closer to Wal-Mart and should improve
inventory turnover numbers.
Working capital, as defined above, consists of: Accounts Receivable, Inventory and
Accounts Payable. These major components lead to the three major turnover ratios.
The numerator of these turnover ratios is usually defined relative to their closest
driver. For example, Accounts Receivable is driven by Sales on Account and
therefore Net Credit Sales is used in the numerator if available otherwise Sales.
However, under historical cost accounting Inventory as measured on the balance
sheet is more closely aligned with the Cost of Goods Sold (COGS) for an external
analyst. Finally, Accounts Payable is driven by Purchases and so either Purchases if
available or COGS is used in the numerator for this ratio. Formally, we can define
them as follows:
In addition, turnover ratios are often expressed in terms of number of days by dividing
by the turnover ratio by 365:
Number of days to Collect Accounts Receivable = 365/Accounts receivable turnover
Cash Conversion Cycle = Number of Days to Collect Accounts Receivable + Number
of Days to Sell Inventory Number of Days to Pay Payables
First, we compare the Turnover Ratios:
The first row provides the Asset Turnover and the working Capital drivers of this
turnover ratio are provided by Inventory, Accounts Receivables and Accounts
Payable turnovers. Remarkably, Wal-Mart has been attaining increasing Inventory
Turnover each year and even through the US recession. This is consistent with their
business strategy in that during a recession, lower costs are more important to
consumers, and is consistent with Wal-Mart boosting its Marketing expenditure to
reinforce their strategy of saving people money so they can live better. Wal-Mart is
currently maintaining 2009 levels in their trailing twelve month numbers. The
inventory turnover is higher than Targets.
Targets inventory turnover did not fall off during the recession. From the earlier
example recall that Target experienced a recent declining Gross Margin trend. As a
result, this reinforces the conclusion that Target competed more aggressively on price
during the recession and less on shopper experience. As mentioned earlier Target
during the recession and less on shopper experience. As mentioned earlier Target
has also increased attention towards groceries (with its PFresh initiatives) in an
attempt to get better cross shopping results. To the extent that these initiatives are
successful, they should result in improved Inventory Turnover ratios.
From the Receivables Turnover, another clear difference emerges with respect to the
business strategy for Wal-Mart versus Target. Wal-Mart has higher receivable and
payable turnovers than does Target. In addition, Wal-Mart has unusually high
Receivable Turnovers. In order to gain more insight into these numbers we next
consider these ratios expressed in units of time.
Here the differences between Wal-Mart and Targets approach to working capital
management become transparent. Wal-Mart is converting receivables to cash much
more quickly than Target. Both companies take longer to pay their payables but
again Target is slower. From our earlier example, which revealed the aggressive low
quick ratio that Wal-Mart has, it can be seen that their aggressive money
management practice is built around an even more aggressive accounts receivable
policy. The Cash conversion Cycle Measure (Days to Sell Inventory + Days to Collect
Receivables Days to Pay Payables) provides a summary measure of the above:
It is clear that WMT completely dominates TGT in terms of cash conversion even
though it is clear that Targets management has focused on this over the recent few
years. The cash conversion cycle is related to how liquid the company is. We
examine this further next by considering liquidity ratios directly
4.13 Liquidity Ratios
The origin of financial statement analysis was tied to assessing a firms ability to
repay its debts. As such liquidity ratios were among the first ratios to emerge in 19
th
century financial statement analysis. The most common liquidity ratios are:
century financial statement analysis. The most common liquidity ratios are:
Current Ratio = Total Current Assets/Total Current Liabilities
Quick (or Acid) Ratio = Total Quick Assets/Total Current Liabilities
A Quick asset is an asset that is easily converted to cash. The most common
examples being cash, cash equivalents, marketable securities and accounts
receivable. Both inventories and prepayments are excluded.
From the above it is clear that Wal-Mart has a very aggressive Quick Ratio! Clearly,
Wal-Mart Management is less conservative with respect to their Quick Ratio than is
Target Management but recall Wal-Mart has a stronger cash conversion cycle than
Target.
The major difference between the Current Ratio and Quick Ratio numbers above is
Inventory. The above figures reinforce the fact that Wal-Mart can be much more
aggressive with respect to their Quick Ratio compared to Target because they are
turning over inventory at a greater rate than Target. This is suggestive at this stage
because the Current Ratio for Wal-Mart is 0.8 in the latest quarter whereas Target is
1.69.
4.14 Analyzing Capacity Activity and Productivity
First we need to convert the gross margin form of the income statement to a variable
costing for both Wal-Mart and Target.
Note: Valuation Tutor requires you to specify the percentage of the total that is
allocated to variable costs, with fixed costs making up the remainder. For a retailer
we expect the majority of COGS to be a variable cost because they are turning over
inventory at a quick rate as revealed in the working capital analysis. So we will
assume the allocation is 100% variable for COGS. For SG&A we will assume a
traditional 30% variable. and for other costs these are generally fixed so we will
assume 5% variable for other.
Armed with these assumptions we can convert the income statement into a variable
form. The table below contains both full costing and variable costing forms of the
income statement.
Notes:
Variable COGS = 100% of COGS
Variable SG&A = 30% of SG&A
Variable Credit card expenses Target = 20%
Depreciation and amortization Target 100% fixed
In the above we allow for the fact that Target has one additional line item Other
which is primarily fixed cost. Observe that the fixed component of both costs is a little
higher for Target than Wal-Mart.
Finally, a firms operating leverage is defined as the percentage change in the firms
operating earnings (EBIT less any non-operating income), that accompanies a
percentage change in the contribution margin. That is, the operating income elasticity
with respect to the contribution margin. In other words, this tells an analyst that a
percentage change in sales revenue will result in a percentage change in operating
earnings. This is a useful number to estimate especially as the consensus sales
revenue forecast is readily available in the form of high, low and average which can
then be related to earnings forecasts via the following relationship:
Degree of Operating Leverage (DOL) = % Change in operating income/% Change in
sales revenue
Equivalently,
Degree of Operating Leverage (DOL) = Contribution margin/EBIT
This important measure reflects the fact that a change in Sales can lead to a more
than proportional change in earnings from operations. In particular, the higher the
degree of operating leverage the higher the predicted change. However, the relative
size of the Degree of Operating Leverage is affected by how close the firm is to their
break-even point. The closer the higher is the DOL.
Contribution Margin Ratio = Contribution Margin/Sales Revenue
Contribution Margin Ratio = (Sales Revenue Total Variable Costs)/Sales Revenue
Break Even (B/E) Analysis ($Sales Revenue) = Total Fixed Costs/(Contribution
Margin Ratio)
Break Even (B/E) Margin = B/E $Sales Revenue/$Sales Revenue
From the above variable costing income statement for the year ending:
Wal-Mart 2009
Contribution Margin Ratio (CMR) = 0.195
Break-even (B/E) Sales Revenue = Total Fixed Costs/CMR = $285,264
Break-even (B/E) Margin = 0.699
Degree of Operating Leverage = 3.323
Target 2009
Contribution Margin Ratio (CMR) = 0.261
Break-even (B/E) Sales Revenue = Total Fixed Costs/CMR = $47,462
Break-even (B/E) Margin = 0.726
Degree of Operating Leverage = 3.652
In the above example observe that Target has a higher contribution margin than does
Wal-Mart. Thus all other things being equal Target is prepared to spend more on
advertising because the dollar contribution from increased sales is higher. However,
observe the degree of operating leverage is higher for Wal-Mart than Target. This
implies increasing advertising expenditure to increase sales will have a greater impact
on Operating Income for Wal-Mart than Target. That is, the latter measure takes into
account both fixed and variable costs. Income from Operations is an important
number in later assessments of intrinsic value. As a result, it is a number that
provides a broader measure of expenditures upon a firms assessed value
4.15 Example: Interpreting Degree of Operating
Leverage
Suppose Wal-Marts TTM Sales are expected to increase by 5% and fixed costs
remain unchanged. By how much do Operating Earnings change by?
You can verify that Operating Income has increased by 14.935% = Sales Growth
*DOL = 5*2.987.
Now consider what actually happened from 2008 to 2009. Actual sales revenue
increased by only 0.95% for Wal-Mart and 0.63% for Target. As a result, the
predicted increase in operating income is 3.21% growth for Wal-Mart and 2.37% for
Target. The actual versus predicted is provided below:
Both companies outperformed this prediction. It is instructive to understand how.
It should be noted, however, that this assumes that fixed and variable costs remain
unchanged under the increased sales growth. For example, both Target and Wal-
Mart attained better COGS in 2009 compared to 2008. That is, after the economic
crisis it appears that procurement for both companies were able to negotiate more
aggressive terms.
To get to the bottom line, however, requires one additional step which is to
understand the impact of financial leverage.
4.16 Analyzing Financial Leverage
It is an open question whether the financing decision adds value to shareholders or
not. We will make two observations here. First, we will see that increasing financial
leverage has a positive impact upon ROE. However, it also increases risk and so
equity investors will require a higher rate of return. If this higher rate of return exactly
offsets the positive impact from financial leverage then it is all awash and the
financing decision has no impact upon shareholder value. If the financing decision
interacts with the investment decision, for example as per a financial institution then
the financing decision matters.
We now examine how both Wal-Mart and Target have approached the financing
decision.
Example: Wal-Mart versus Target
As a first pass the DuPont analysis and the Debt Ratio reinforce the conclusion that
Target is carrying more leverage than Wal-Mart although Target appears to be
currently reducing its leverage to bring it more in line with Wal-Marts.
However, to focus more sharply upon the firms financing decision the Debt ratio is
further refined into the Debt to Equity Ratio which traditionally is expressed as:
Debt to Equity Ratio = (Long-Term Debt + Value of Leases)/Shareholders Equity
Long Term Debt to Equity Ratio = Long-Term Debt/Shareholders Equity
However, in todays world traditional financing approaches have changed significantly
with the use of derivatives and in particular interest rate swaps. As a result, much
financing is done short term and then swapped into desirable long term patterns using
interest rate swaps that can extend out to 30-years. This implies that the Debt to
interest rate swaps that can extend out to 30-years. This implies that the Debt to
Equity and the Long Term Debt Ratios be redefined to include short term debt.
Debt to Equity Ratio = (Total Debt + Value of Leases)/Shareholders Equity
Term Debt to Equity Ratio = Debt Issued / Shareholders Equity
The above ratios provide insight into the extent of debt leverage for the firm and
immediately raise questions regarding the amount of interest coverage the firm has.
The first ratio is relevant to a traditionally financed firm that matches long term
investment with long term financing and the second ratio is relevant to a modern firm
that exploits derivatives and swaps to manage its financing decision.
Both firms exhibit a business model built around ownership as opposed to leasing.
This is reinforced from the following excerpts from their respective 10-Ks:
Wal-Mart 2010 10-K
ITEM 2. PROPERTIES
The number of discount stores, supercenters, Neighborhood Markets and Sams
Clubs located in each state in the United States and the number of units located in
each of the countries in which we operate are disclosed as of fiscal year-end January
31, 2010 in our Annual Report to Shareholders under the caption Fiscal 2010 End-of-
Year Store Count and are incorporated herein by reference. Portions of such Annual
Report to Shareholders are included as an exhibit to this Annual Report on Form 10-
K.
United States. As of January 31, 2010, in the United States, we owned 3,214 of the
buildings in which discount stores, supercenters and Neighborhood Markets operated
and 483 of the buildings in which our Sams Clubs operated. Land on which our
stores are located is either owned or leased by the company. In the United States, we
lease the remaining buildings in which our stores and clubs operate from either
commercial property developers pursuant to capital or operating lease arrangements
or from local governmental entities in connection with industrial revenue bond
financing arrangements. All store leases provide for annual rentals, some of which
escalate during the original lease term. In some cases, the leases provide for
additional rent based on sales volume. Substantially all of the companys store and
club leases have renewal options, some of which include escalation clauses causing
an increase in rents.
International. We operate our International segment stores and restaurants in a
combination of owned and leased properties in each country in which our
International segment operates. As of the end of fiscal 2010, we owned 33 properties
in Argentina, 161 properties in Brazil, 117 properties in Canada, 125 properties in
Chile, 1 property in China, 69 properties in Costa Rica, 9 properties in El Salvador, 14
properties in Guatemala, 7 properties in Honduras, 52 properties in Japan, 530
properties in Mexico, 25 properties in Nicaragua, 11 properties in Puerto Rico and
239 properties in the United Kingdom. The remaining operating units in each such
country are leased on terms that vary from property to property. We utilize both
owned and leased properties for office facilities in each country in which we are
conducting business. As of the end of fiscal 2010, our International operations are
supported by 132 distribution facilities. Of these 132 distribution facilities, we owned
and operated 34 and leased and operated 37. Third parties owned and operated the
remaining 61 distribution facilities.
Target 2010 10-K
The following table summarizes the number of owned or leased stores and
distribution centers at January 30, 2010:
(a) Properties within the "combined" category are primarily owned buildings on
leased land.
(b) The 38 distribution centers have a total of 48,588 thousand square feet.
As a result, for the debt ratios we will compute relative to Debt and ignore leases.
The degree of Financial Leverage in terms of Net Income as follows:
Degree of Financial Leverage = EBIT/EBT
Wal-Mart 2009
Operating Income = $24,002
Earnings Before Tax = $22,118
Degree of Financial Leverage = 1.085
Target 2009
Operating Income = $4,673
Earnings Before Tax = $3872
Degree of Financial Leverage = 1.207
The above is revealing of differences in the two firms financing strategies whereby
Target has a higher degree of financial leverage than does Wal-Mart.
4.17 Corporate Debt Market: Wal-Mart and Target
Different Approaches
From the 10-K it is evident that Wal-Mart has more of a mix of short term debt and
interest rate swaps as part of its financing strategy. This is reflected in the
comparison of the long term debt to total debt ratios for Wal-Mart and Target.
comparison of the long term debt to total debt ratios for Wal-Mart and Target.
Observe that Wal-Mart is increasing its reliance on short term debt to take advantage
of the very low interest rate environment in the US whereas Target is pursuing a more
traditional approach of increasing its long term debt. However, the subtle difference
between Wal-Marts and Targets financing strategy is revealed in the following part of
the 10-K report from Wal-Mart:
We enter into interest rate swaps to minimize the risks and costs associated with
financing activities, as well as to maintain an appropriate mix of fixed and floating-rate
debt. Our preference is to maintain between 40% and 60% of our debt portfolio,
including interest rate swaps, in floating-rate debt. The swap agreements are
contracts to exchange fixed- or variable-rates for variable- or fixed-interest rate
payments periodically over the life of the instruments. The aggregate fair value of
these swaps represented a gain of $240 million and $304 million at
January 31, 2010 and 2009, respectively. A hypothetical increase or decrease of 10%
in interest rates from the level in effect at January 31, 2010, would have resulted in a
loss or gain in value of the swaps of $25 million and $24 million, respectively. A
hypothetical increase or decrease of 10% in interest rates from the level in effect at
January 31, 2009, would have resulted in a loss or gain in value of the swaps of $17
million.
You can see that Wal-Mart uses swaps to manage the cost of financing as well as to
manage interest rate risk, and they are aware of the risks of the contracts, and that
this was profitable.
On the other hand, a close reading of the 2010 10-K reveals that Targets use of
swaps is for hedging interest rate risk as opposed to reducing borrowing costs. A
relevant excerpt from Targets 10-K is:
Derivative financial instruments are reported at fair value on the Consolidated
Statements of Financial Position. Our derivative instruments have been primarily
interest rate swaps. We use these derivatives to mitigate our interest rate risk. We
have counterparty credit risk resulting from our derivate instruments. This risk lies
primarily with two global financial institutions. We monitor this concentration of
counterparty credit risk on an ongoing basis.
This implication is reinforced by comparing the borrowings and interest expense from
the two firms. For Target the debt that is not collateralized by credit card receivables
is:
2009: 707+10643,
2010: 728+12000
Targets interest expense is:
2009: 707, 6.18%
2010: 728, 5.49%
This is higher than Wal-Marts debt:
2009: 37,804
2008: 38,703
and the interest expense is:
2009: 1787, 4.72%
2008: 1896, 4.90%.
From the above it appears that Target is paying more for its non-credit card
collateralized debt than is Wal-Mart.
Qualification
While we see differences in the financing strategies, this does not necessarily mean
that one firm has a better strategy. For example, in the low interest rate environment
of 2009 and 2010, a company with a good credit rating can lock in low rates for a long
period rather than using other methods. It also depends on the companys debt
portfolio; if it had issued high interest rate debt in the past, it can take advantage of
interest rate swaps. If it has very little debt, it may be better to issue new debt at fixed
interest rate swaps. If it has very little debt, it may be better to issue new debt at fixed
rates.
We next turn to the main theme underlying leverage analysis. This is to relate the
various activities performed by a firm to growth.
4.18 Growth and Degree of Total Leverage
This number relates a firms operating and financial leverage to its net income.
With respect to Net Income:
Degree of Total Leverage = % Change in Net Income /% Change in Sales
In terms of the Contribution Margin format of the Income Statement this is:
Degree of Total Leverage = Contribution Margin/Net Income = Contribution
Margin/EBIT * EBIT/Net Income
Degree of Total Leverage = Degree of Operating Leverage * Degree of Financial
Leverage
For Wal-Mart and Target collecting together parts of the above analysis:
Wal-Mart: TTM Degree of Operating Leverage = 3.32
Target: TTM Degree of Operating Leverage = 3.65
Wal-Mart: TTM Degree of Financial Leverage = 1.085
Target: TTM Degree of Financial Leverage = 1.207
Wal-Mart: TTM Degree of Total Leverage =3.606
Target: TTM Degree of Total Leverage = 4.408
Target as revealed above carries more financial leverage and therefore it is more
sensitive to sales fluctuations than is Wal-Mart. Recall from the price chart (repeated
below for your convenience) that Target is more sensitive to the business cycle than
is a Wal-Mart.
The degree of total leverage analysis above reinforces the conclusion that Target is
riskier than Wal-Mart because of its greater operating and financing leverage.

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