Analysis Project - Accounting Quality Analysis

McDonalds and Sonic Corp both are operating in almost similar line of business viz. fast food
industry. To get an understanding about which company is performing better, we can compare
their financial performance over a period of three years.

McDonald Sonic Corp

Ratios 2015 2016 2017 2015 2016 2017
Gross profit margin 38.5% 41.4% 46.5% 39.9% 41.1% 47.6%
Net profit margin 17.8% 19.0% 22.8% 10.7% 10.7% 13.2%
Asset turnover ratio 0.67 0.79 0.68 0.98 0.92 0.85
Inventory turnover ratio 254.13 417.32 386.78 151.50 202.00 238.50
Receivables turnover ratio 19.56 16.70 11.55 30.30 31.89 23.85
ROA 12.5% 13.6% 16.0% 10.2% 10.1% 10.3%
ROCE 20.6% 28.1% 30.7% 21.9% 20.3% 24.7%
Debt Equity ratio 3.40 -11.78 -9.04 24.50 -7.67 -3.12

Gross Profit Margin of both the companies has remained almost same over the last three years.
Net Profit Margin of McD is higher than Sonic in all years and it also shows an increasing trend
over the years. This is probably because Sonic has incurred high interest expense due to which its
net income has decreased.

Asset Turnover Ratio of Sonic is slightly higher than McD, but for both the companies it has
remained volatile. This is due to the reason as asset utilization depends upon demand which
fluctuates with high competition and changes in customer’s preferences.

Inventory Turnover Ratio is better for McD than Sonic which is due to the vast market share of
McD.

Receivables Turnover Ratio for Sonic has remained higher even when both the companies operate
on cash basis of accounting.
ROA (Return on Assets) for McD is quite higher than Sonic which is due to the fact that McD is
an established enterprise and has competitive advantage over others.

ROCE (Return on Capital Employed) is higher for McD because of the higher profits earned by it.
It also has an upward trend over three years unlike Sonic which gained momentum in last year.

Debt Equity Ratio for both companies is negative. In McD, it is due to the presence of treasury
stocks while in Sonic it is due to both presence of treasury stock and high debt amount.

Possible adjustments for Sonic Corp would include below transitory items in Income Statement
along with their tax impact:

There was a net gain on refranchising transactions in Year 2017 $6m (tax impact of $2.5m). Sale
of minority investment in refranchised transaction made a gain of $3.7m (tax impact of $1.3m).
Restructuring done in last quarter related to elimination of certain corporate position incurred a
loss of $1.8m (tax impact of $0.6m). Gain on sale of real estate amounted to $4.7m (tax impact of
$1.7m). After considering all the above transactions, the adjusted profit would have been $55m as
against current $63m.

Possible adjustments for McDonalds would include below transitory items in Income Statement
along with their tax impact:

There was a gain on sale of restaurant business in Year 2017 for net $295m (tax impact of). Equity
in earnings of unconsolidated affiliates were net $184m (tax impact of). Asset disposed off in
Australia cost net $19mn. There was a gain on the company’s sale of its business in China and
Hong Kong for net $703m (tax impact of). There were non-operating expense relating to foreign
currency and hedging activity and other expenses for net amount of $58m.

Possible adjustments for Sonic would also include off balance sheet items which are contractual
obligations and commitments of $1Bn.

Analysis of accounting methods has been identified as below:

Both the companies use straight line method for depreciation of property and equipment and
amortization of leased assets. Inventories are carried using First in First Out method by
McDonald’s as well as Sonic Corp. McDonald’s anticipates that there will be a significant impact
of change in recognition of operating leases. However, the impact will be mainly non cash and
hence will not affect the company’s cash flow. On the other hand, Sonic expects that the operating
lease commitments will be subject to new guidance and recognized as operating lease liability and
right of use assets. Hence it will significantly increase assets and liabilities position in consolidated
balance sheet.

Beneish Model is a mathematical model that uses financial ratios and eight variables of a company
to determine whether the company has manipulated the reported earnings.

Following are the eight variables:

1. DSRI - Days' sales in receivable index

2. GMI - Gross margin index
3. AQI - Asset quality index
4. SGI - Sales growth index
5. DEPI - Depreciation index
6. SGAI - Sales and general and administrative expenses index
7. LVGI - Leverage index
8. TATA - Total accruals to total assets

The above variables are combined together to get an M score. If the M score is less than -2.22, it
means that the company is not a manipulator. However, if the score is greater than -2.22, it signals
there are high probability of company being a manipulator.

McDonald’s M score has come out to be -2.36, which suggests that the company is not an
accounting manipulator.

Sonic Corp has an M score of -2.82, which means it is not an accounting manipulator.

References:

https://corporate.mcdonalds.com/content/dam/gwscorp/investor-relations-content/annual-
reports/McDonald%27s%202017%20Annual%20Report.pdf

http://www.annualreports.com/HostedData/AnnualReports/PDF/NASDAQ_SONC_2017.pdf