Financial Analysis In Case Study

Another important aspect of analyzing a case study and writing a case study analysis is the role and use of financial information. A careful analysis of the company's financial condition immensely improves a case write-up. After all, financial data represent the concrete results of the company's strategy and structure. Although analyzing financial statements can be quite complex, a general idea of a company's financial position can be determined through the use of ratio analysis. Financial performance ratios can be calculated from the balance sheet and income statement. These ratios can be classified into five different subgroups: profit ratios, liquidity ratios, activity ratios, leverage ratios, and shareholder-return ratios. These ratios should be compared with the industry average or the company's prior years of performance. It should be noted, however, that deviation from the average is not necessarily bad; it simply warrants further investigation. For example, young companies will have purchased assets at a different price and will likely have a different capital structure than older companies. In addition to ratio analysis, a company's cash flow position is of critical importance and should be assessed. Cash flow shows how much actual cash a company possesses.

Profit Ratios
Profit ratios measure the efficiency with which the company uses its resources. The more efficient the company, the greater is its profitability. It is useful to compare a company's profitability against that of its major competitors in its industry. Such a comparison tells whether the company is operating more or less efficiently than its rivals. In addition, the change in a company's profit ratios over time tells whether its performance is improving or declining. A number of different profit ratios can be used, and each of them measures a different aspect of a company's performance. The most commonly used profit ratios are gross profit margin, net profit margin, return on total assets, and return on stockholders' equity.

  1. Gross profit margin. The gross profit margin simply gives the percentage of sales available to cover general and administrative expenses and other operating costs. It is defined as follows:
    Gross Profit Margin=Sales Revenue - Cost of Goods Sold
    Sales Revenue
  2. Net profit margin. Net profit margin is the percentage of profit earned on sales. This ratio is important because businesses need to make a profit to survive in the long run. It is defined as follows:
    Net Profit Margin=Net Income
    Sales Revenue
  3. Return on total assets. This ratio measures the profit earned on the employment of assets. It is defined as follows:
    Return on
    Total Assets
    =Net Income Available to
    Common Stockholders
    Total Assets

    Net income is the profit after preferred dividends (those set by contract) have been paid. Total assets include both current and noncurrent assets.

  4. Return on stockholders' equity. This ratio measures the percentage of profit earned on common stockholders' investment in the company. In theory, a company attempting to maximize the wealth of it stockholders should be trying to maximize this ratio. It is defined as follows:
    Return on
    Stockholders' Equity
    =Net Income Available to
    Common Stockholders
    Stockholders' Equity
Liquidity Ratios
A company's liquidity is a measure of its ability to meet short-term obligations. An asset is deemed liquid if it can be readily converted into cash. Liquid assets are current assets such as cash, marketable securities, accounts receivable, and so on. Two commonly used liquidity ratios are current ratio and quick ratio.
  1. Current ratio. The current ratio measures the extent to which the claims of short-term creditors are covered by assets that can be quickly converted into cash. Most companies should have a ratio of at least 1, because failure to meet these commitments can lead to bankruptcy. The ratio is defined as follows:
    Current Ratio=Current Assets
    Current Liabilities
  2. Quick ratio. The quick ratio measures a company's ability to pay off the claims of short-term creditors without relying on the sale of its inventories. This is a valuable measure since in practice the sale of inventories is often difficult. It is defined as follows:
    Quick Ratio=Current Assets - Inventory
    Current Liabilities
Activity Ratios
Activity ratios indicate how effectively a company is managing its assets. Inventory turnover and days sales outstanding (DSO) are particularly useful:
  1. Inventory turnover. This measures the number of times inventory is turned over. It is useful in determining whether a firm is carrying excess stock in inventory. It is defined as follows:
    Inventory Turnover=Cost of Goods Sold
    Inventory

    Cost of goods sold is a better measure of turnover than sales, since it is the cost of the inventory items. Inventory is taken at the balance sheet date. Some companies choose to compute an average inventory, beginning inventory, plus ending inventory, but for simplicity use the inventory at the balance sheet date.

  2. Days sales outstanding (DSO), or average collection period. This ratio is the average time a company has to wait to receive its cash after making a sale. It measures how effective the company's credit, billing, and collection procedures are. It is defined as follows:
    DSO=Accounts Receivable
    Total Sales/360
    Accounts receivable is divided by average daily sales. The use of 360 is standard number of days for most financial analysis.
Leverage Ratios
A company is said to be highly leveraged if it uses more debt than equity, including stock and retained earnings. The balance between debt and equity is called the capital structure. The optimal capital structure is determined by the individual company. Debt has a lower cost because creditors take less risk; they know they will get their interest and principal. However, debt can be risky to the firm because if enough profit is not made to cover the interest and principal payments, bankruptcy can occur.

Three commonly used leverage ratios are debt-to-assets ratio, debt-to-equity ratio, and times-covered ratio.

  1. Debt-to-assets ratio. The debt-to-asset ratio is the most direct measure of the extent to which borrowed funds have been used to finance a company's investments. It is defined as follows:
    Debt-to-Assets Ratio=Total Debt
    Total Assets

    Total debt is the sum of a company's current liabilities and its long-term debt, and total assets are the sum of fixed assets and current assets.

  2. Debt-to-equity ratio. The debt-to-equity ratio indicates the balance between debt and equity in a company's capital structure. This is perhaps the most widely used measure of a company's leverage. It is defined as follows:
    Debt-to-Equity Ratio=Total Debt
    Total Equity
  3. Times-covered ratio. The times-covered ratio measures the extent to which a company's gross profit covers its annual interest payments. If the times-covered ratio declines to less than 1, then the company is unable to meet its interest costs and is technically insolvent. The ratio is defined as follows:
    Times-Covered Ratio=Profit Before Interest and Tax
    Total Interest Charges
Shareholder-Return Ratios
Shareholder-return ratios measure the return earned by shareholders from holding stock in the company. Given the goal of maximizing stockholders' wealth, providing shareholders with an adequate rate of return is a primary objective of most companies. As with profit ratios, it can be helpful to compare a company's shareholder returns against those of similar companies. This provides a yardstick for determining how well the company is satisfying the demands of this particularly important group of organizational constituents. Four commonly used ratios are total shareholder returns, price-earnings ratio, market to book value, and dividend yield.
  1. Total shareholder returns. Total shareholder returns measure the returns earned by time t + 1 on an investment in a company's stock made at time t. (Time t is the time at which the initial investment is made.) Total shareholder returns include both dividend payments and appreciation in the value of the stock (adjusted for stock splits) and are defined as follows:

    Total Shareholder Returns=Stock Price (t + 1) -
    Stock Price (t) + Sum of Annual Dividends per Share
    Stock Price (t)

    Thus, if a shareholder invests $2 at time t, and at time t + 1 the share is worth $3, while the sum of annual dividends for the period t to t + 1 has amounted to $0.2, total shareholder returns are equal to (3 - 2 + 0.2)/2 = 0.6, which is a 60 percent return on an initial investment of $2 made at time t.

  2. Price-earnings ratio. The price-earnings ratio measures the amount investors are willing to pay per dollar of profit. It is defined as follows:
    Price-Earnings Ratio=Market Price per Share
    Earnings per Share
  3. Market to book value. Another useful ratio is market to book value. This measures a company's expected future growth prospects. It is defined as follows:
    Market to Book Value=Market Price per Share
    Earnings per Share
  4. Dividend yield. The dividend yield measures the return to shareholders received in the form of dividends. It is defined as follows:
    Dividend Yield=Dividend per Share
    Market Price per Share
    Market price per share can be calculated for the first of the year, in which case the dividend yield refers to the return on an investment made at the beginning of the year. Alternatively, the average share price over the year may be used. A company must decide how much of its profits to pay to stockholders and how much to reinvest in the company. Companies with strong growth prospects should have a lower dividend payout ratio than mature companies. The rationale is that shareholders can invest the money elsewhere if the company is not growing. The optimal ratio depends on the individual firm, but the key decider is whether the company can produce better returns than the investor can earn elsewhere.
Cash Flow
Cash flow position is simply cash received minus cash distributed. The net cash flow can be taken from a company's statement of cash flows. Cash flow is important for what it tells us about a company's financing needs. A strong positive cash flow enables a company to fund future investments without having to borrow money from bankers or investors. This is desirable because the company avoids the need to pay out interest or dividends. A weak or negative cash flow means that a company has to turn to external sources to fund future investments. Generally, companies in strong-growth industries often find themselves in a poor cash flow position (because their investment needs are substantial), whereas successful companies based in mature industries generally find themselves in a strong cash flow position.

A company's internally generated cash flow is calculated by adding back its depreciation provision to profits after interest, taxes, and dividend payments. If this figure is insufficient to cover proposed new-investment expenditures, the company has little choice but to borrow funds to make up the shortfall or to curtail investments. If this figure exceeds proposed new investments, the company can use the excess to build up its liquidity (that is, through investments in financial assets) or to repay existing loans ahead of schedule.

Case Studies: Table of Contents

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Financial ratio analysis is an important topic and is covered in all mainstream corporate finance textbooks. It is also a popular agenda item in investment club meetings. It is widely used to summarize the information in a company's financial statements in assessing its financial health. In today's information technology world, real time financial data are readily available via the Internet. Performing financial ratio analysis using publications, such as Robert Morris Associates’ Annual Statement Studies, Dun & Bradstreet’s Key Business Ratios, Moody’s Manuals, Standard & Poor’s Corporation Records, Value Line Investment Survey, etc., is no longer efficient. Since students and investors now have easy access to on-line databases, the assignments on financial ratio analysis can be modified accordingly to enhance learning. Based upon my experience as a finance professor and as a member of a local investment club, I have prepared this  teaching note to help students and investors in performing financial ratio analysis via an on-line database, Dow Jones Interactive. This database is a Web based, enterprise wide business news and research solution supported by Dow Jones & Company, the parent company of The Wall Street Journal.  The class assignment presented herein is designed to demonstrate how to assess a company's overall operations over time and its current financial standing in the industry.

THE FINANCIAL RATIO ANALYSIS ASSIGNMENT

Students will work on the assignment collaboratively in groups of three or four students. Each group will select an industry of interest to the group, and each student will select a company within that industry. Students will download the relevant financial data from the Internet and perform ratio analysis for the selected companies. Since successful financial ratio analysis is as much an art as it is a science, students must use common sense and sound judgment throughout the analysis. The purpose of this assignment is to provide students with the opportunity to:

  • retrieve real time financial data via the Web;
  • analyze the financial performance of selected companies;
  • practice communication skills, both in writing (through word processing) and in speaking (through giving a Power Point presentation);
  • enhance teamwork skills.

TREND ANALYSIS

To evaluate how the selected company is performing over time, more than one year's financial ratios are required. Students are instructed to follow the path shown below to retrieve the financial profile for the selected company via Dow Jones Interactive. (The initial steps may differ depending on how your library's site is organized.)

  • Go to the University Library home page
  • Click on ResearchResources
  • Click on Dow Jones Interactive (DJI)
  • On DJI page, click on Company and Industry Center
  • Click on Financial Profile
  • Select Region: Worldwide
  • Enter Company Symbol: ____________
  • Display as: Formatted report
  • Click on Get Report
  • Download the report including Key Financial Ratios, Balance Sheets, Income Statements and Key Competitors (see APPENDIX 1 for an excerpt Financial Profile of Intel)

Trend analysis provides signals as to whether the company's financial health is likely to improve or deteriorate. Each student will perform the trend analysis based upon the following financial ratios:

  • Leverage Ratios: to measure the extent to which the company's assets are financed with debt;
  • Liquidity Ratios: to measure the company's ability to pay its bills;
  • Profitability Ratios: to measure the company's ability to generate earnings;
  • Efficiency Ratios: to measure the company's ability to utilize its assets;
  • Market Value Ratios: to measure the market perception about the company's future prospects.

The downloaded four years' balance sheets and income statements are to be used to calculate the financial ratios not reported in the DJI. For example, four leverage ratios (Debt/Equity, LT Debt/ Cap, LT Debt/Tot Debt, and LT Debt/Tot Assets) are reported, but the interest coverage ratio (= earnings available for interest/interest expenses) is missing in the DJI. Students are required to obtain the earnings and interest expenses information from the income statements and calculate this ratio to measure the company's ability to service the debt. In the area of liquidity, current ratio (= current assets/current liabilities) and quick ratio (= quick assets/ current liabilities) are reported, but the interval measure (= quick assets/daily operating expenditures) is not. Students are required to obtain quick assets (= cash & equivalent + receivables) from the balance sheets and operating expenditures from the income statements, and calculate this ratio to measure how long the company can keep up with its bills using only existing quick assets. As the financial ratios in each of the five performance areas are compiled, they are analyzed across time. A sample trend analysis for Intel is presented (below) in Table 1. 

Table 1. Intel Trend Analysis


 

Performance Area

1998

1997

1996

1995

Trend

Leverage:

 

 

 

 

 

Debt % Tot Assets

25.7

33.2

28.9

30.6

Drop in leverage during 1998 

Interest Coverage 

269.7

395.8

318.4

195.4

Lower coverage during 1998 

Liquidity:

 

 

 

 

 

Current Ratio 

2.3

2.6

2.8

2.2

Lower liquidity since 1996

Quick Ratio 

1.0

1.3

1.6

1.3

Lower liquidity since 1996

Interval Measure (days)

63.8

90.8

115.3

86.4

Lower liquidity since 1996

Profitability:

 

 

 

 

 

Profit Margin (%)

23.1

27.7

24.7

22.0

Lower profitability during 1998

Return on Assets (%)

19.3

24.0

21.7

20.4

Lower ROA during 1998

Return on Equity (%)

26.0

36.0

30.6

29.4

Lower ROE during 1998

Efficiency:

 

 

 

 

 

Asset Turnover 

.835

.868

.878

.926

Lower efficiency since 1995

Receivables Turnover 

7.5

7.0

6.1

6.4

Increased efficiency since 1996

Inventory Turnover 

5.7

5.2

4.4

4.1

Increased efficiency since 1995

Market Value:

 

 

 

 

 

Price/Book Value 

8.41

5.92

6.37

3.83

Good market perceptions 

Du Pont Analysis

Since it is important to understand how the company's profitability, efficiency, and leverage are linked in its financial performance, students are required to demonstrate and evaluate its Du Pont system over time. The company's return on assets, ROA (=net income/assets), can be expressed as:

ROA = (Net Income/Revenue) * (Revenue/Assets) = Profit Margin * Asset Turnover

And the company's return on equity, ROE (=net income/equity), can be expressed as

ROE = (Net Income/Revenue) * (Revenue/Assets) * (Assets/Equity) = ROA * Equity Multiplier

Both the company's profitability (as measured in terms of profit margin) and efficiency (as measured in terms of asset turnover) determine its ROA. This ROA, along with the company's financial leverage (as measured in terms of  its equity multiplier), contributes to its ROE. As the company's use of leverage magnifies its ROE, students are required to examine ROE carefully. The changes in the company's ROE are to be noted and explained through its profit margin, asset turnover, and equity multiplier over time. The objective is to identify the company's strong area that can be capitalized upon and/or its weak area that must be improved upon. See Table 2 (below) for a sample Du Pont analysis for Intel. 

Table 2. Intel Du Pont Analysis


 

Item / Ratio

1998

1997

1996

1995

Evaluation

Net Income, $million 

(from Income statements)

6068

6945

5157

3566

 

Revenue, $million 

(from Income statements)

26273

25070

20847

16202

 

Assets, $million 

(from balance sheets)

31471

28880

23735

17504

 

Equity, $million 

(from balance sheets)

23377

19295

16872

12140

 

Profit Margin % 

(Net Income/Revenue)

23.1

27.7

24.70

22.0

Drop in profitability during 1998

Asset Turnover 

(Revenue/Assets)

.835

.868

.878

.926

Lower efficiency since 1995

Return on Assets % 

(Profit Margin* Asset Turnover)

19.3

24

21.7

20.4

Drop in ROA during 1998

Equity Multiplier 

(Assets/Equity)

1.35

1.50

1.41

1.44

Decrease in leverage during 1998

Return on Equity % 

(ROA* Equity Multiplier)

26.0

36.0

30.6

29.4

Sharp decline in ROE during 1998 

 

INDUSTRY COMPARATIVE ANALYSIS

To explain the variation in the company's financial ratios over time, the industry comparative analysis must be performed along with the trend analysis. To evaluate the company's financial performance against its key competitors, the company-to- company comparison report is retrieved from the following path.

  • On DJI page, click on Company/Industry Comparison Reports
  • Select Report: Company to Company Comparison
  • Enter First Company's Symbol: _____________
  • Enter Second Company's Symbol: _____________
  • Select Display as: Formatted report
  • Click on Get Report
  • Download the report (see APPENDIX 2 for a Company to Company Comparison Report for Intel)

The financial ratios in each of the performance areas are then analyzed across companies in the industry/group. Students compare their company's financial ratios with those of its key competitors and determine whether managerial or environmental factors cause the trend of the company's financial performance. To further assess the company's financial standing in its primary industry, the company to industry comparison report is retrieved. (See below.)

  • Back to DJI page, click on Company/Industry Comparison Reports
  • Select Report: Company to Industry Comparison
  • Enter Company Symbol: _____________
  • Select Compare to: this Company's Primary Industry (as identified by DJI)
  • Select Display as: Formatted report
  • Click on Get Report
  • Download the report (see APPENDIX 3 for a Company to Primary Industry Comparison Report for Intel)

The following specific industry norms are available in DJI and used as benchmarks in this analysis:

  • Liquidity: Current Ratio;
  • Leverage: Debt/Equity, Interest Coverage;
  • Profitability: Profit Margin, Return on Equity, Return on Assets;
  • Efficiency: Revenue/Assets;
  • Market Value: Price/Book Value, Price/Earnings, Dividend Yield.

Students will report on how the company performs as compared to the industry norms and where the company stands relative to its competitors in the industry. The company's weak and/or strong areas of performance must be identified and recommendations for improvement presented. See Table 3 (below) for a sample industry comparative analysis for Intel.

Table 3. Intel Industry Comparative Analysis


 

Performance Area

Intel

AMD*

Semiconductors

Evaluation

Leverage:

 

 

 

Excellent

Debt/Equity (%)

3

73

19

Low leverage

Interest Coverage

269.7

-

20.8

High coverage

Liquidity:

 

 

 

Good

Current Ratio

3.2

1.7

2.8

Above average liquidity

Profitability:

 

 

 

Excellent

Profit Margin (%)

26.1

-0.9

11.1

High profitability

Return on Assets (%)

19.3

-2.4

7.2

High ROA

Return on Equity (%)

28.9

-

14.1

High ROE

Efficiency:

 

 

 

Good

Revenue/Assets

.86

.64

.82

Above average 

Market Value:

 

 

 

Good 

Price/Book Value 

8.41

2.10

6.04

High price to book

Price/Earnings 

36.3

-

67.3

Below average PE

Dividend Yield (%)

0.2

0.0

0.1

Average 

* AMD, is one of Intel's key competitors in semiconductors industry

Go to additional Intel data.

CASE BRIEF AND PRESENTATION

To reinforce the teamwork effort, each group must submit a written report summarizing the ratio analyses of the companies in their industry. Students will work together and produce a group report that is concise and similar in style to an executive summary with no more than four typed pages plus exhibits. Each group will also give an oral presentation to brief the class on their analyses, their recommendations, and the limitations of their analyses. Charts and tables are required in the Power Point presentation.

The incorporation of computer technology in finance classes has become more popular than ever in this information technology rich environment. Mediated classrooms have grown rapidly in numbers throughout universities worldwide. This teaching note demonstrates how finance professors, business students, and investment club members can take advantage of the changing environment to enhance learning. Students can easily retrieve a company's real time financial data via the Internet and analyze its financial performance over time. The assignment presented herein is designed to help students/investors learn how to assess the company's overall operations and its current financial standing in the industry through teamwork and state of the art computer technology. It can be used in any corporate finance classes and/or investment clubs.

Bodie, Z. and R.C. Merton. Finance (2000),Prentice-Hall, Inc.

Brealey, R.A. and S.C. Myers. Principles of Corporate Finance (2000), 6th Edition, The McGraw-Hill Companies, Inc.

Brealey, R.A., S.C. Myers and A.J. Marcus. Fundamentals of Corporate Finance (1999), 2nd Edition, The McGraw-Hill Companies, Inc.

Brigham, E.F. and J.F. Houston. Fundamentals of Financial Management (1999), Concise 2nd Edition, The Dryden Press.

Brigham, E.F., L.C. Gapenski and M.C. Ehrhardt. Financial Management: Theory and Practice (1999), 9th Edition, The Dryden Press.

Gitman, L.J. Principles ofManagerial Finance (2000), 9th Edition, Addison Wesley Longman, Inc.

Keown, A., J.W. Petty, D.F. Scott and J.D. Martin. Foundations of Finance (1998), 2nd Edition, Prentice-Hall, Inc.

Ross, S.A., R.W. Westerfield and B.D. Jordan. Essentials of Corporate Finance (1999), 2nd Edition, Irwin/McGraw-Hill.

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Scott, D.F., J.D. Martin, J.W. Petty and A. Keown. Basic Financial Management (1999), 8th Edition, Prentice-Hall, Inc.



APPENDIX 1. FINANCIAL PROFILE


Used with permission from Dow Jones Interactive



Used with permission from Dow Jones Interactive



 

 

 

 

 


 


 


 


 


 


 


 


 

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