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FINANCIAL REPORTING II

REVIEW OF RATIO ANALYSIS

Ratio analysis is a useful tool for analyzing financial statements. Calculating ratios will aid
in understanding the company’s strategy and in understanding its strengths and weaknesses
relative to other companies and over time. They can sometimes be useful in identifying
earnings management and in understanding the effect of accounting choices on the firm’s
reported profitability and growth. Finally, the ratios help in obtaining a better understanding
of a firm’s current profitability, growth, and risk which can improve forecasts of future
profitability and growth and estimates of the cost of capital.

In reviewing the basic financial ratios, we will examine the ratios of Best Buy for the
fiscal years ended March 2, 2002 and March 3, 2001. Excerpts from Best Buy’s financial
statements are included at the end of this document. Best Buy is a growing company.
The following table reflects the growth in sales and income during the year ended March
2, 2002:

Year Ended Year Ended % Growth


March 2, 2002 March 3, 2001

Sales 19,597 15,327 28%


Net Income 570 396 44%
Average book value 2,171.5 1,459 28%
Average assets 6,107.5 3,917.5 52%
Average debt 558 163.5 177%

Note that sales and net income rose in 2002 relative to 2001. Also note, however, that
total assets, book value and debt also rose during the year. Ratio analysis allows the
analyst to compare the income and sales reported on the income statement relative to the
assets and book value the company had to work with reported on the balance sheet. A
review of the ratios follows.

Profitability Ratios
Return on Assets
Return on assets measures a firm's performance in using assets to generate earnings
(independent of the financing of the assets). This measure allows one to consider
the income (before financing costs) relative to the assets that the firm had to
generate the income. It, therefore, allows one to examine the income statement in
relation to the resources available as reported on the balance sheet. Return on
assets (ROA) is calculated as follows:

Net Income + Interest Expense*(1-tax rate)


Average Total Assets
Best Buy (assuming that Best Buy’s income tax rate is 35% for both years)
2002 2001
ROA 570 + 28 (.65) 396 + 7 (.65)
6107.5 3917.5

= 9.63% = 10.22%
Note that while Best Buy’s earnings rose from 2001 to 2002, the earnings
generated per dollar of assets fell over the period. In 2001, Best Buy earned 10.22
cents before financing costs on every dollar of average assets; however, in 2002,
Best Buy earned only 9.63 cents before financing costs on every dollar of average
assets. The ratio, return on assets, allows the analyst to compare the earnings
generating ability of the company relative to the invested assets.

Disaggregating Return on Assets


A firm’s return on assets reflects the income (before financing costs) generated from the
firm’s assets. The ROA can be disaggregated into the sales generated from the
assets and the income (before financing costs) generated from the sales. Return on
assets is often disaggregated into profit margin (PM) and asset turnover (ATO):

ROA = ATO x PM

This disaggregation allows the analyst to better understand the source of the change in
return on assets. For example, did Best Buy’s ROA fall in 2002 because it had more
difficulty generating sales from the assets (ATO) or because it had difficulty generating
income from the sales (PM), or both? An analysis of ATO and PM can yield insights into
the source of the change in ROA.

Profit Margin Ratio


The profit margin ratio (PM) measures a firm's ability to control the level of
expenses relative to the revenues generated. PM is calculated as follows:

Net Income + Interest Expense*(1-tax rate)


Revenues

Best Buy
2002 2001
PM 570 + 28 (.65) 396 + 7 (.65)
19597 15327

= 3.00% = 2.61%
Best Buy’s profit margin increased in 2002. For every dollar in sales, Best Buy
earned 3 cents in income before financing costs in 2002 and only 2.61 cents in
2001. Thus, the fall in ROA is not due to the reduction in income before
financing costs per dollar of sales.
Asset Turnover
The asset turnover ratio (ATO) measures a firm's ability to generate revenues
from a particular level of investment. ATO is calculated as follows:

Revenues
Average Total Assets

Best Buy
2002 2001
ATO 19597 15327
6107.5 3917.5

= 3.21 = 3.92
It appears that Best Buy’s fall in ROA was driven by a fall in ATO, not a fall in
PM. The firm had difficulty generating sales from the assets in 2002 relative to
2001. For every dollar of average assets, Best Buy generated only $3.21 in sales
in 2002 while Best Buy generated $3.92 in sales in 2001.

In order to gain even more insight into the source of the change in the ROA ratio, we can
disaggregate the PM ratio and the ATO ratio to determine the source of the changes in
those ratios.

Disaggregating the Profit Margin Ratio


To better understand why the profit margin ratio changed, the analyst can
examine each income and expense item on the income statement as a percentage
of revenue. This will provide insight into which components of the income
statement changed over the period.

Best Buy
2002 2001
Cost of goods sold/sales 77.43% 80.04%
Selling, general and administrative expense/sales 17.82% 16.02%

Best Buy’s rise in profit margin in 2002 is due to the reduction of cost of sales
rather than to the reduction of selling, general and administrative expenses
relative to sales.

Disaggregating the Asset Turnover Ratio


To better understand why the asset turnover ratio changed, the analyst can
examine the productivity of important assets such as accounts receivables,
inventory, and fixed assets at generating sales.

Accounts Receivable Turnover


The accounts receivable turnover measures the rate at which the firm collects
its accounts receivables. The accounts receivable turnover is calculated as
follows:

Net Credit Sales


Average Accounts Receivables

The average number of days’ accounts receivables were outstanding


during the period can be calculated by dividing the accounts receivable
turnover into 365 days as follows:

365/Turnover = # of days Accounts Receivables were outstanding during


the year, on average

Best Buy
2002 2001
AR turnover 19497 15327
(247 + 209)/2 (209 + 189)/2

= 85.95 = 77.02
4.25 days 4.74 days
Most of Best Buy’s transactions are for cash or credit cards; therefore, the
number of days’ sales outstanding is very small, approximately 4 days.

Inventory Turnover
Inventory turnover measures the average days that the firm’s inventory was
on hand during the period. The inventory turnover is calculated as follows:

Cost of Goods Sold


Average Inventory

The average number of days the inventory was on hand can be calculated
by dividing the inventory turnover into 365 days as follows:
365/Turnover = # of days inventory on hand during the year, on average.

Best Buy
2002 2001
Invent 15167 12268
turnover (2258 + 1767)/2 (1767 + 1184)/2

=7.21 = 8.31
50 days 44 days
It has taken Best Buy longer to sell its inventory, on average, in 2002
relative to 2001. While it took approximately 44 days on average to sell
inventory in 2001, it took Best Buy approximately 50 days on average to
sell inventory in 2002.
Plant Asset Turnover
The plant asset turnover measures the revenues generated by each dollar
invested in plant assets. The plant asset turnover is calculated as follows:

Revenues
Average Plant Assets

Best Buy
2002 2001
Plant Asset 19597 15327
Turnover (1897+1444)/2 (1444+698)/2

= 11.73 = 14.31
Best Buy has generated fewer sales per dollar of assets in 2002 relative to
2001. While Best Buy generated $14.31 in sales per dollar of average
assets in 2001, the average assets generated only $11.73 in sales in 2002.
Therefore, part of the explanation for the reduction in asset turnover is the
reduction in the productivity of the plant assets at generating sales.

These results suggest that while Best Buy did generate greater income and sales in 2002
versus 2001, it generated less income (before financing costs) per dollar of average
assets, it took longer to sell its inventory, and it generated fewer sales from each
dollar of plant assets.

Return to Common Stockholder Equity


The return on assets examines the profitability of the firm’s assets without regard to the
financing of the assets; however, equity investors are interested in the profitability
of the firm after financing costs since they are the residual claimants to the
business. Return on common stockholders’ equity (ROE) reflects the income per
dollar of common owners’ equity. ROE is calculated as follows:

Net Income - Preferred Dividends


Average Common Stockholders' Equity

Best Buy
2002 2001
ROE 570 396
2171.5 1459.0

= 26.25% = 27.14%
Best Buy’s ROE has fallen in 2002 but it has not fallen as much as the fall in
ROA.
Note that Best Buy’s return on equity is higher than its return on assets. This is
due to the use of leverage. Financing with debt and preferred stock can increase
the return to common shareholders if the return on assets is greater than the cost
of debt.

Cost of Debt
The after-tax cost of debt is calculated as follows:

Interest Expense (1-tax rate)


Average Debt

Best Buy
2002 2001
After-tax cost 28 (.65) 7 (.65)
of debt 558 163.5

= 3.23% = 2.78%
Best Buy’s cost of debt is less than the return on assets, so the use of debt
has made the return on equity higher than the return on assets.

While the use of leverage can increase ROE, the use of leverage will also increase the
risk that the company will not be able to make the required debt payments. Therefore,
the use of debt has the advantage of benefiting the equityholders in good years but can be
detrimental to equityholders in less profitable years.

Risk Ratios
As a firm relies more on debt, the risk that the firm cannot make the required payments
increases. With equity, the firm is not required to pay dividends, so in a less profitable
year, the firm can choose to not distribute dividends. On the other hand, the payment on
debt is not optional; therefore, as the firm relies more on debt, the risk of not being able
to make the payments increases. There are several ratios that help to assess the risk
associated with the company.

Long Term Liquidity Risk


Long-term liquidity ratios measure how much the company relies on debt versus equity
to finance its assets and whether the firm can pay interest and repay debt. The
debt-asset ratio and the interest coverage ratios are commonly used long-term
liquidity ratios.

Debt-Asset Ratio
The debt to asset ratio measures the percentage of the firm’s assets that are
financed through borrowing. The debt to asset ratio is calculated as follows:
Total Debt
Total Assets

Best Buy
2002 2001
Debt to Asset Ratio 820 296
7375 4840

= 11.12% = 6.12%
Best Buy has relied more on debt in 2002 relative to 2001. In 2002, 11% of Best
Buy’s assets are financed with debt while in 2001 only 6% of the assets were
financed through debt.

Interest Coverage Ratio


The interest coverage ratio measures how many times earnings covers the interest
charges. This measure provides a sense of the buffer the company has in earnings
in order for its earnings to cover the interest expense. The interest coverage ratio
is calculated as follows:

Income Before Interest and Income Taxes


Interest Expense

Best Buy
2002 2001
Interest Coverage 964 648
Ratio 28 7

= 34.43 = 92.57
Best Buy’s interest coverage ratio has decreased dramatically with the heavier
reliance on debt in 2002 relative to 2001.

Short Term Liquidity Risk


Short term liquidity ratios measure the ability of the firm to pay off debts that will be
coming due in a short time period. The current ratio and the quick ratio are
commonly used measures of short-term liquidity risk.

Current Ratio
The current ratio measures whether the firm has sufficient current assets to pay its
current liabilities. The balance sheet disaggregates the firm’s assets and liabilities
into their current and long-term components. The current ratio provides the ratio
of current assets to current liabilities. The ratio is calculated as follows:
Current Assets
Current Liabilities

Best Buy
2002 2001
Current Ratio 4611 2929
3730 2715

= 1.24 = 1.08
Best Buy’s current ratio is relatively low. Analysts often suggest that the current
ratio of a healthy company should be approximately 2.0. While Best Buy’s
current ratio is well below 2.0, note that Best Buy’s current ratio has increased
from 2001 to 2002.

Quick Ratio
The quick ratio measures whether the firm has enough assets that can quickly be
converted to cash to meet current liabilities. The quick ratio only includes cash,
marketable securities and receivables in the numerator of the ratio. The quick
ratio is calculated as follows:

Cash + Marketable Securities + Receivables


Current Liabilities

Best Buy
2002 2001
Quick Ratio 1855+247 747+209
3730 2715

= 0.56 = 0.35
Best Buy also has a relatively low quick ratio. Analysts generally suggest that a
healthy company should have a quick ratio of approximately 1.0. The lack of
quick assets could hamper the ability of the firm to meet current obligations as
they come due.

Other Measures of Liquidity


Analysts often use other measures to assess a firm’s liquidity. Often the profitability
ratios also provide evidence on the firm’s ability to meet obligations as they come due.

Working Capital
Working capital is the firm’s current assets minus current liabilities.
While the current ratio reports the current assets relative to current
liabilities as a ratio, working capital provides a dollar value of the
difference between current assets and current liabilities.

Best Buy
2002 2001
Working Capital 4611-3730 2929 – 2715

= $881 =$214

Turnover Ratios
The more quickly a company sells its inventory and collects from
customers, the more able it is to generate the cash necessary to pay
liabilities as they come due. Therefore, a firm with a small number of
days that sales are outstanding and a small number of days that inventory
is on hand is more likely to be able to generate cash quickly to pay current
liabilities as they come due. Often analysts calculate a firm’s operating
cycle as the days’ inventory on hand plus the days’ sales outstanding. The
longer the operating cycle, the higher the risk that the firm will not be able
to generate the cash necessary to meet current liabilities.

Operating Cycle = Days Sales’ Outstanding + Days’ Inventory on Hand

Best Buy
2002 2001
Operating Cycle 4 days + 51 days 5 days + 44 days

= 55 days = 49 days

Cash Flows from Operations


If a firm is generating cash from operating its business, it is more likely to
be able to obtain the cash necessary to meet its liabilities as they come
due. Therefore, analysts often examine the cash flows from operations in
order to assess the risk of meeting current liabilities.

Best Buy
2002 2001
CFO 1578 808

Best Buy generated $1,578 in cash flows from operations during the year.
The cash flows from operations have increased from 2001 to 2002.
How is Best Buy doing?

If you recall, Best Buy had increasing income and increasing sales. The ratios allow us to
determine the sales and income relative to the assets and book value that the firm had
available to generate income and sales.

2002 2001

Return on assets: 9.63% 10.22%

Profit margin: 3.00% 2.61%

Total asset turnover: 3.21 3.92

Days AR outstanding: 4 days 5 days

Days Invent on hand: 51 days 44 days

Plant Asset turnover: 11.73 14.31

Return on equity: 26.25% 27.14%

Debt/Asset: 11.12% 6.12%

Current ratio: 1.24 1.08

Quick ratio: 0.56 0.35

While Best Buy did have large increases in sales and earnings in 2002, it did not have
increases in profitability. Best Buy also had high growth in its assets and debt in 2002.
Taking into account the assets that Best Buy had to use during 2002, Best Buy looks less
profitable in 2002 relative to 2001 per dollar of invested assets and book value. In
addition, its key drivers of operations have become less productive. In particular, Best
Buy had more difficulty in 2002 in selling inventory and generated fewer sales per dollar
of plant assets. Ratio analysis leaves one with more insight into Best Buy and its changes
over the year.

Required:
Given the review of the ratios above, calculate and interpret the following ratios for
Southwest Airlines (assume a tax rate of 35% for both years):

a. Return on Assets
b. Asset Turnover
c. Profit Margin
d. Return on Equity
e. Debt to Asset Ratio

Southwest Airlines
Income statement (in millions) 2005 2004
Revenue $7,584 $6,530
Expenses:
Salaries, Wages, Benefits 2,702 2,443
Aircraft Costs 2,389 2,044
Depreciation and Amortization 469 431
Other Operating Expenses 1,204 1,058
Operating Income 820 554
Other Income 176 23
Interest Expense 122 88
Income Before Taxes 874 489
Income tax expense 326 176
Net Income $548 $313

Southwest Airlines
Balance Sheet (in millions) 2005 2004
Cash $2,280 $1,048
Receivables 258 248
Inventories 150 137
Other Current Assets 932 739
Total current assets 3,620 2,172
PPE (net) 9,427 8,723
Other Assets 1,171 442
Total assets $14,218 $11,337
Accounts payable $524 $420
Other liabilities 5,024 3,547
Debt 1,995 1,846
Total liabilities 7,543 5,813
Contributed Capital 2,118 1,435
Retained Earnings 4,557 4,089
TSE 6,675 5,524
TL and SE $14,218 $11,337
EXCERPTS FROM BEST BUY’S 2002 ANNUAL REPORT

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