3.5 Assignment: Mini Case Study

Background Information

Up until this point in the course, you have been practicing financial analysis techniques on hypothetical companies. The financial statements you have been studying are intentionally simplified, to aid in your learning process. However, now we are going have an opportunity to apply the concepts and techniques you have learned to a real-world company of your choice, with all their complexities.

In this assignment, you are going to play the role of consultant, hired to evaluate a company’s financial strength in anticipation of a tremendous growth opportunity. The company is going to launch a revolutionary new product that will grow its sales by at least 50% over the next year. In addition, to support this sales growth, the company will have to grow its investment in fixed and current assets by 50%. Your job is to assess the company’s ability to support this level of growth by performing a basic horizontal (trend) and ratio analysis.

Begin by selecting a company you are interested in studying. It is highly recommended you choose a company that would be beneficial for you to learn more about, such as one that is in your current industry. However, the only requirement is that you select a publicly traded company whose financial statements are readily available. You will then be asked to dig deep into this company’s financial statements, looking at trends and ratios to assess its financial strength and readiness for rapid growth.

Instructions

1. Review the rubric to make sure you understand the criteria for earning your grade.
2. In your textbook, Analysis for Financial Management, read Chapter 2, “Evaluating Financial Performance.”

   Download and review the Higgins Chapter 2 Slides to help you further understand the chapter.

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3. In your textbook, Principles of Accounting, study Appendix A, “Financial Statement Analysis.”
4. Research the financial statements for a company of your choice.

   You can locate the annual statements (called “10-K” forms) for all public U.S. companies in the SEC’s EDGAR system. Annual statements will often include commentary explaining recent financial changes and events.
   Many free financial websites, such as Morningstar, provide financial data and ratios for public companies. Search for your company on Morningstar and then select “Operating Performance” for a list of ratios for previous years.
   Consider accessing company reports through OCLS using the Business Insights: Essentials tool. Detailed financial and investment reports are available for hundreds of companies.

5. Prepare a paper analyzing the company’s past three years of financial results:

   Begin by creating a table listing at least 10 financial ratios for the last three years (three years trend, 10 ratios, 30 ratios total). You can either calculate these ratios yourself using the financial data found, or use the ratios you find from your sources.
   The ratios you study are up to you. Use whatever ratios you find most revealing. However, you should include return on equity (ROE) and its three components: total asset turnover, profit margin, and financial leverage (asset/equity or debt/equity). 
   Evaluate and comment on any interesting trends you find. What ratios have changed significantly over the past three years? What does this indicate? Do the ratios suggest financial strength? What potential weaknesses do you see? What could the company do to improve these ratios?
   Conclude with a recommendation, based on your analysis, as to whether the company is prepared to take on a large growth opportunity.

6. Be sure to provide a detailed recommendation that demonstrates your critical thinking and understanding of financial analysis. Your finished paper should be 500 to 600 words in length.
7. Prepare your paper in Microsoft Word in a professional manner, using proper spelling, grammar, and APA style. Include a reference list. Be sure to appropriately cite your sources for your financial data and any commentary or analysis you rely upon.

   For questions on APA style, go to OCLS APA Writing Styles Guides.

 

Preview Rubric
3.5 Assignment (50 Points)

This table lists criteria and criteria group name in the first column. The first row lists level names and includes scores if the rubric uses a numeric scoring method.CriteriaLevel 4Level 3Level 2Level 1Criterion ScoreTable of Ratios15 points

(14-15 Points)

You demonstrated insightful critical thinking in researching, selecting, and presenting financial ratios in a manner that was comprehensive and clear.

13 points

You demonstrated competent critical thinking in researching, selecting, and presenting financial ratios in a manner that was clear.

12 points

(11-12 Points)

You demonstrated competent critical thinking in researching, selecting, and presenting financial ratios, with some mistakes, or in a manner that was not entirely clear.

10 points

(0-10 Points)

You demonstrated little to no critical thinking researching, selecting, and presenting financial ratios, with serious mistakes, or in a manner that was very unclear.

/ 15Interpretation of Ratios15 points

(14-15 Points)

You demonstrated clear, insightful critical thinking and provided a detailed response when you explained trends and interpreted the selected ratios to evaluate the company’s financial strength.

13 points

You demonstrated competent critical thinking and provided a full response when you explained trends and interpreted the selected ratios to evaluate the company’s financial strength.

12 points
(11-12 Points)

You demonstrated competent critical thinking when you explained trends and interpreted the selected ratios to evaluate the company’s financial strength, with some minor errors.

10 points
(0-10 Points)

You demonstrated little to no critical thinking when you explained trends and interpreted the selected ratios to evaluate the company’s financial strength, or your interpretation had multiple serious errors.

/ 15Conclusion and Recommendations10 points

Your recommendations were clear, detailed, well-founded, and insightful.

9 points

Your recommendations were clear and well-founded.

8 points

Your recommendations had minor errors, were not entirely clear, or were not well-founded.

7 points

(0-7 Points)

Your recommendations had serious errors or were unclear.

/ 10Writing Quality10 points

Your sentence structure is complete with correct spelling, punctuation, and capitalization and varied diction and word choices.

Your assignment length is correct with sources correctly cited.

9 points

Your sentence structure has minor errors (fragments, run-ons) with correct spelling, punctuation, and capitalization but limited diction and word choices.

Your assignment length is correct with sources correctly cited.
8 points

Your sentence structure has several errors in sentence fluency with multiple fragments/run-ons and poor spelling, punctuation, and/or word choice.

Your assignment length is inappropriate with several citation errors.

7 points
(0-7 Points)

Your sentence structure has serious and persistent errors in sentence fluency, sentence structure, spelling, punctuation, and/or word choice.

Your assignment length is inappropriate with several citation errors or sources are not cited.

/ 10
 

Evaluating
Financial Performance

Chapter Two

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1

The Levers of Financial Performance

A pilot uses levers to control a the flight of an aircraft.

Operating decisions are the levers by which managers control financial performance.

In this chapter, we study how financial statements help us to analyze the performance of the firm.

Our primary tool is ratio analysis.

Ch. 2 2

Higgins, Analysis for Financial Management, 12e

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2

Return on Equity

Return on Equity: The most popular measure of financial performance

= 29.6%

Why does this definition make sense?

Ch. 2 3

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3

The 3 Determinants of ROE

How is this a measure of leverage?
Ch. 2 4

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4

TABLE 2.1 ROE and Levers of Performance for 10 Diverse Companies, 2016
Ch. 2 5
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5

Questions about Table 2.1
Differences in ROE across firms is less than differences in components. Why?
What is the role of competition in ROE differences?
Is there any reason why profit margin and asset turnover should be negatively related?
Ch. 2 6

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You try it.
Calculate ROE and the levers of performance.
Ch. 2 7

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Nordstrom: Profit margin=354/14,757=2.4%; Asset turnover=14,757/7,858=1.9; Leverage=7,858/870=9.0; ROE=2.4%×1.9×9.0=40.7%
Walmart: Profit margin=13,643/485,873=2.8%; Asset turnover=485,873/198,825=2.4; Leverage=198,825/77,798=2.6; ROE=2.8%×2.4×2.6=17.5%
7

Profitability Ratios
Profit margin: The fraction of each sales dollar realized as profits
Return on assets: The combined effect of profit margin and asset turnover
Gross margin: The contribution to fixed costs and profits
Are COGS fixed or variable?
Ch. 2 8

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8

Hasbro’s Profitability Ratios

Ch. 2 9

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9

Breakeven Sales
Use gross margin to calculate Hasbro’s breakeven sales volume
Assume COGS are variable and operating expenses are fixed.
Hasbro’s 2016 operating costs were $1,968 million.
Since 56% of sales goes to cover operating costs, breakeven sales volume = $1,968/0.56 = $3,514 million.
Ch. 2 10

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10

You try it.
Calculate breakeven sales volume for Apple Inc. for 2016.
Ch. 2 11

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Gross margin=84,263/215,639=39.1%. Breakeven=24,239/0.391=$61,992.
11

Turnover-Control Ratios
Asset turnover: Sales generated per dollar of assets
Inventory turnover: Number of times inventory turns over per year
Collection period: Average number of days to collect receivables
What if you don’t know credit sales?
Ch. 2 12

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12

More Turnover-Control Ratios
Days’ sales in cash: Availability of cash relative to sales
Payables period: Average number of days to pay accounts payable
Fixed-asset turnover: Sales generated per dollar of fixed assets
What if you don’t know credit purchases?
Ch. 2 13

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13

Fixed Assets vs. Current Assets
Which is likely to be more sensitive to external events, current assets or fixed assets?
What is a self-liquidating loan?
Loan to support current assets
What happens to AR and inventory when sales go up?
What happens to AR and inventory when sales go down?
Ch. 2 14

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14

Hasbro’s Turnover-Control Ratios

Does a higher fixed-asset turnover indicate higher or lower capital intensity?
Ch. 2 15

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15

The Cash Conversion Cycle (CCC)
The average length of time between when cash goes out the door and when it comes back in
CCC= Days inventory outstanding + Collection period – Payables period
Ch. 2 16

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You try it.
Calculate the cash conversion cycle for Hyundai Motor.
Ch. 2 17
Hyundai Motor
Selected financial data
2016 (₩ billions)
Sales 93,649
Cost of goods sold 75,960
Accounts receivable 8,030
Inventory 10,524
Accounts payable 6,986

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DIO=10,524/(75,960/365)=51, Coll. Pd.=8,030/(93,649/365)=31, Pay. Pd.=6,986/(75,960/365)=34, CCC=51+31-34=48 days
17

Financial Leverage
What does increased financial leverage do to ROE?
Is increased leverage a good thing?
Southern Co. vs. Alphabet
JPMorgan Chase
Have another look at Table 2.1, and describe what you see, along with an explanation.
Ch. 2 18

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18

TABLE 2.1 ROE and Levers of Performance for 10 Diverse Companies, 2016
Ch. 2 19
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19

Leverage and Liquidity Ratios 1
Balance Sheet Ratios

Debt-to-assets ratio: Percent of assets paid for by creditors
Debt-to-equity ratio: Financing supplied by creditors for every dollar from shareholders
Ch. 2 20

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20

Leverage and Liquidity Ratios 2
Coverage Ratios

Times interest earned: Income available in relation to interest payments
Times burden covered: Income available in relation to all debt service
Which coverage ratio is more important? Why?
Ch. 2 21

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Stryker’s tax rate is $206/$1,212 = 17%
21

Leverage and Liquidity Ratios 3
Market Value Leverage Ratios

Market debt-to-equity ratio: Today’s value of financial burdens compared to shareholders’ expected value
Market debt-to-assets ratio: Today’s value of financial burdens compared to value of expected future income
What if you don’t know the market value of debt?
Ch. 2 22

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22

Leverage and Liquidity Ratios 4
Liquidity Ratios

Current ratio: Liquid assets compared to imminent debts
Acid test (Quick ratio): Very liquid assets compared to imminent debts
Ch. 2 23

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23

ROE: The Timing Problem
Is ROE forward-looking?
Does ROE have a long-term perspective?
Ch. 2 24

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24

ROE: The Risk Problem
Does ROE take into account business risk?
What is the impact of leverage on ROE?
Return on invested capital: A measure of return on capital independent of the amount of leverage

Ch. 2 25
= 17.5%

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ROIC Is Not Distorted by Company Financing
Ch. 2 26
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26

ROE: The Value Problem
Should we calculate return on book equity or market equity?
Earnings yield: ROE using market value of equity instead of book value
Price-to-earnings ratio: Inverse of earnings yield; commonly used measure of performance

Is this a better measure of performance than ROE?
Ch. 2 27

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27

ROE or Market Price?
Which is the better way to measure financial performance?
We have just discussed problems with ROE.
What about problems with stock price?
How do operating decision affect stock price?
Managers (should) know more about the company than outside investors.
Stock price depends on many factors outside management’s control.
Ch. 2 28

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28

Comparing ROE to Stock Price
Market-to-book vs. ROE (weighted-average)
Figures 2.1 and 2.2 coming up
Slope and dispersion (R-squared)?
Where is Hasbro relative to others in Figure 2.1?
Where are Apple and Amazon in Figure 2.2?
Ch. 2 29

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Ch. 2 30
FIGURE 2.1 M/B vs. ROE for 20 Toy/Gaming/Leisure Firms
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Ch. 2 31
FIGURE 2.2 M/B vs. ROE for 82 Large Corporations
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31

Ratio Analysis
Ratio analysis is the systematic use of the ratios previously defined to understand financial performance.
Caveats to keep in mind:
Ratios don’t tell the whole story; they’re more like clues that point to issues requiring further investigation.
There are no universally “correct” values for ratios.
Ch. 2 32

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32

Using Ratios Effectively
Ratio values need to be understood in context.
It is important to compare ratios to something else.
Comparable companies
Changes in a company’s ratios over time
Ch. 2 33

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FIGURE 2.3 The Levers of Performance Suggest One Road Map for Ratio Analysis

Ch. 2 34
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34

Example of Ratio Analysis
Analyze the profitability measures
What do the various measures tell you?
What is Hasbro’s trend over time?
How does Hasbro compare to the industry?
Analyze the levers of ROE
Which levers explain the changes in ROE over time?
Analyze the control ratios
Is Hasbro managing assets efficiently?
How do they compare to prior performance and industry performance?
Analyze the leverage ratios
What’s the trend in their use of debt?
How do they compare to the industry?
Is their amount of leverage concerning?
Ch. 2 35

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35

TABLE 2.2 Ratio Analysis of Hasbro
Ch. 2 36
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36

Common Size Financial Statements
Add insight in analyzing a company
Helps in recognizing trends over time
Can compare to other companies without scale effects
What do common-size figures tell you compared to typical ratios?
For example, collection period vs. AR/Assets
For example, inventory turnover vs. Inventory/Assets
What do you learn about working capital
Fraction of assets that are short-term
What do you learn about COGS?
Small changes in percentages can be large relative to net income
Ch. 2 37

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37

TABLE 2.3 Hasbro Common-Size Balance Sheets
Ch. 2 38
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38

TABLE 2.3 Hasbro Common-Size Income Statements
Ch. 2 39
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39

TABLE 2.4 Definitions of Principal Ratios Appearing in Chapter
Ch. 2 40
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40

TABLE 2.4 Definitions of Principal Ratios Appearing in Chapter (cont.)
Ch. 2 41
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41

Sheet1

Selected financial data
($ millions)
Nordstrom Walmart
Sales 14,757 485,873
Net income 354 13,643
Total assets 7,858 198,825
Shareholders’ equity 870 77,798

Profit margin 2.4% 2.8%
Asset turnover 1.9 2.4
Leverage 9.0 2.6

ROE 40.7% 17.5%

NordstromWalmart
Sales14,757 485,873
Net income354 13,643
Total assets7,858 198,825
Shareholders’ equity870 77,798
Profit margin2.4%2.8%
Asset turnover1.9 2.4
Leverage9.0 2.6
ROE40.7%17.5%
Selected financial data
($ millions)