MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

Baginski & Hassell

MODULE A

FINANCIAL STATEMENTS AND EXTERNAL DECISION MAKING

Overview: Financial Statements and External Decision Making

Topics
Financial statements reflect the aggregate outcomes of many managerial decisions. External decision makers use financial statements to make assessments of profitability and risk.

 Ratio calculations are used to help understand profitability and risk. External decision makers also assess the accounting quality reflected in a firms financial statements.

Ratios Used to Assess Profitability

Return on assets (ROA): General assessment of profitability (all capital providers point of view)
ROA assesses net profitability of operating activities per dollar of average investment, which is a measure of how profitable a company is regardless of how the companys assets are financed.

 Return on Common Equity (ROCE): Assessment of profitability from the viewpoint of common stockholders
ROCE assesses net profitability, after preferred dividends, per dollar of common stockholders investment

Earnings Per Share (EPS)

Reflects net income, after preferred dividends, available to an average common share of stock

The topic of EPS is discussed later in the text.

Return on Assets (ROA)

ROA =
Net income + Interest expense, net of income taxes Average total assets

ROA =
Net income + Interest expense (1-t) Average total assets where t = effective (or statutory) tax rate

Return on Common Stockholders Equity (ROCE)

ROCE =
Net Income Dividends on Preferred Stock Average Common Stockholders Equity

Decomposition of ROCE
ROCE subcomponents: ROA, common earnings leverage ratio, and capital structure leverage ratio
ROCE = ROA Common earnings leverage ratio Capital structure leverage ratio

The common earnings leverage ratio captures the negative effects of capital structure on ROCE:
Net income Preferred dividends Net income + (1-t) Interest expense

The capital structure leverage ratio captures the positive effect of leverage on ROCE:
Average total assets Average common stockholders equity

How ROCE Components Combine

ROCE =
Common Earnings Leverage Ratio Net income preferred stock dividends Net income + [interest expense (1t)] Capital Structure Leverage Ratio Average total assets Average common stockholders equity

ROA Net income + [interest expense (1-t) ] Average total assets

NOTE: On the previous slide, the denominator in ROA cancels the numerator in the capital structure leverage ratio (shown in blue) and the numerator in ROA cancels the denominator in the common leverage ratio (shown in green).
Got it?

Reduced ROCE Formula

The final reduced form ROCE formula is: ROCE = Net income preferred stock dividends Average common stockholders equity

Decomposition of ROA
ROA subcomponents: Net profit margin ratio and asset turnover ratio.
The net profit margin ratio measures the prefinancing income per dollar of sales. Net profit margin ratio =

Net income + [interest expense x (1-t)]

sales

As with all targets, financial and otherwise, analysts and decision makers should state in advance exactly what they are shooting for because, if we aim at nothing we are likely to hit it!

The asset turnover ratio measures the ratio of sales per average dollar invested in net assets. Asset turnover ratio =
Sales Average total assets

How ROA Components Combine

ROA =
Net Profit Margin Ratio Net income + [interest expense (1-t)] Asset Turnover Ratio

Sales

Sales

Average total assets

Analysis of Risk
Three major future-oriented risks assessed by external decisions makers:
Firm risks Industry risks General economic risks Generally, GAAP-based financial statements do not do a good job in helping assess these risks.

 GAAP-based financial statements are used to assess two types of risk: Short-term liquidity risks Long-term solvency risks

Short-Term Liquidity Risks

Working capital: The excess (deficit) of current assets minus current liabilities.

WC = CA - CL

The current ratio shows the amount of current assets per dollar of current liabilities. Current Ratio = CA CL

Rule of thumb for minimum current ratio is 2:1

The quick ratio shows the amount of quick assets, cash plus marketable securities plus accounts receivable, per dollar of current liabilities.
Quick Ratio = Marketable + securities + Current liabilities Accounts receivable

Cash

Activity ratios measure the speed at which current assets turn into cash inflows and current liabilities turn into cash outflows. Accounts Receivable Turnover Ratio = Sales Average accounts receivable

Inventory Turnover Cost of goods sold Ratio = Average inventory

Accounts Payable Turnover Ratio

Purchases Average accounts payable

Cash Flow from Operations to Current Liabilities Ratio =

Cash flow from operations Average current liabilities

Long-Term Solvency Risk

Several ratios are used to assess a companys ability to service current debt requirements, i.e., to remain a going concern! Long-term Debt to Long-term debt Equity Ratio = Shareholders equity Long-term Debt to Total Assets Ratio = Long-term debt Total assets

Interest Coverage Ratio* = Income before income taxes + Interest expense Interest expense *Interest coverage ratio often is labeled times interest earned (sometimes the thin ice ratio).

In general, bankers should not earn more than owners!

Operating Cash Flow to Total Liabilities Ratio = Operating Cash Flow to Capital Expenditures = Ratio

Operating cash flow Average total liabilities Operating cash flow Capital expenditures

Usefulness of Ratios in Predicting the Future

External users, particularly financial analysts, use ratios to help explain the present and to predict the future.
Why are ratios at their current levels? Will the ratios continue at this level? If not, how & why will they change?

 In addition to ratios, individuals trying to explain and predict should study:

Industry conditions Firms competitive strategy Accounting quality
Compared to WHAT?

Industry Conditions
GAAP-based financial statements provide little information about industry conditions, such as: Industry growth rate Firm concentration Product differentiation Scale economies Cyclicality and exit barriers Legal barriers to entry Relative bargaining power of buyers and suppliers and access to distribution channels

Firm Competitive Strategy

GAAP-based financial statements provide little information about industry conditions, such as:
Cost leadership versus product differentiation Demonstration of acquisition of unique core competencies and value chain

Accounting Quality
Accounting quality includes general characteristics of information that enable external decision-makers to assess and predict sustainability of current financial characteristics.

 Accounting quality comes from ... Truthful reporting (lack of earnings manipulation) Persistence of earnings Adequate disclosure Using conservative assumptions in applying GAAP GAAP-based financial statements are useful in assessing these characteristics, particularly adequate disclosure and degree of conservatism in assumptions.

End of Module A