FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS_PART1 ppt

FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS Susanna Bauder, MBA, MSSF Senior Financial Analyst AEGON Institutional Markets, Inc Louisville, Kentucky 40202 sbauder@insightbb.com Kathleen Voelker, MBA Visiting Lecturer Consultant School of Business Indiana University Southeast New Albany, Indiana 47150 kvoelker@insightbb.com Jonathon Rakich, Ph.D Professor of Management School of Business Indiana University Southeast 4201 Grant Line Road New Albany, IN 47150 Phone 812, 246-4505 jrakich@ius.edu This is trial version www.adultpdf.com FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS ABASTRACT This financial audit teaching aid for case analysis is a tutorial used by the authors in the capstone senior and MBA business policy case courses at Indiana University Southeast Its purpose is to assist students in conducting diagnostic ratio analysis and interpretation of case financial statements in order to draw conclusions about: (a) liquidity and capital structure risk, (b) the corporation’s financial performance, and (c) the corporation’s activity leading to control conclusions A standardized financial audit form listing the indicators for each category appears at the end of this document This teaching aid contains the following tutorials: • • • • Basic accounting tutorial Financial ratios tutorial RMA (industry ratios) tutorial, and How to calculate financial “limits.” That is, whether additional resources can be obtained by increasing the case company’s debt (based on its equity and/or assets relative to industry standards) and/or by improving operations, i.e., working capital (based on improving inventory and/or accounts receivables days relative to industry standards) INTRODUCTION This tutorial has been classroom tested for five years It is most helpful to students who have forgotten basic accounting and, more importantly, introduces them to the use of industry averages for use in interpreting the ratios calculated from case financial statements For senior business policy students, the instructor provides industry numbers for the case being used in class from the source, Annual Statement Studies, published by the Risk Management Association (RMA) The RMA reports on numerous industries by SIC or NAICS codes Each industry report contains a common sized income statement and balance sheet, as well as key financial ratios A sample scanned RMA report appears at the end of this document For graduate students, the instructor provides industry numbers for the class case from the annual Troy’s Almanac of Business and Financial Ratios published by Prentice Hall These reports are similar in construct to the RMA industry reports This paper refers to RMA industry numbers in the tutorial that are based on a class introductory case, also included the following: • • • An RMA definitional page (Appendix A) A sample RMA report with common sized income statement/balance sheet and key financial ratios (Appendix B) A completed sample financial audit worksheet with ratio calculations that are based on a sample case (Staples), along with an income statement and balance sheet (Appendix C and D) This is trial version www.adultpdf.com • A sample narrative write up students would create as they write their case analysis report, including financial audit drawing inferences about risk, performance, control, and ability of the company to increase resources based on the case company’s ratios relative to the industry averages (Appendix E) The writers have found that in case-oriented courses with financial data, it is imperative that students evaluate financial statements through ratio analysis and compare to industry norms in order to draw diagnostic conclusions We are confident that this teaching aid, sources for industry numbers, and various sample handouts will be of interest to faculty and students BASIC ACCOUNTING TUTORIAL Balance Sheet: The balance sheet is a snapshot of a company’s assets, liabilities and equity on a specific day (commonly December 31) The balance sheet provides information about investments (what kind and how much), obligations to creditors (such as suppliers and banks), and the owners’ equity in net resources The balance sheet is useful for analyzing a company’s liquidity, solvency and financial flexibility, as well as its performance (i.e profitability) Liquidity describes how quickly the company can convert an asset into cash, or how quickly a liability has to be paid Solvency describes a company’s ability to pay its debts (liabilities) as they come due Generally, the more debt a company has, the riskier it is It will need more assets to meet its obligations Financial Flexibility describes a company’s ability to take effective action to influence its cash flows according to need and opportunity Financial flexibility is often referred to as improved operations such as reducing inventory or accounts receivables Liquidity, solvency and financial flexibility are calculated with the “Liquidity” and “Capital Structure” ratios using only Balance Sheet elements Basic Accounting Equation Assets = Liabilities + Equity Assets – Liabilities = Equity (or: Assets – Equity = Liabilities) Owned – Owed = Worth Elements of the Balance Sheet Assets: Things owned by the business, such as cash, money due from customers (accounts receivables), inventory, buildings, land and equipments Assets consist of: Current Assets: Assets that can be converted into cash within a year or less This is trial version www.adultpdf.com Fixed Assets: Assets that are used or consumed over a long period of time (more than one year) and that cannot be easily and quickly converted into cash, such as property, plant and equipment Long-Term Assets: Long-Term Investments that are intended to be held for more than one year, such as certificate of deposits, stocks, bonds and notes receivables Intangible Assets: Assets that have no physical substance, such as patents, copyrights, trademarks and goodwill Other Assets: Any other assets that have not been described above Things the business owes to someone else (creditors) such as money owed to suppliers (accounts payable), short term and long term debt (e.g bank loans, line of credit) Current Liabilities: Money owed by the company and payable within one year Long-Term Liabilities: Money or obligations owed by the company that are NOT payable with one year, such as mortgage payable, notes payable, leases, and bond repayments Financial Instruments: Different ways that a company raises money, such as issuing bonds, shares, or contracts to reduce foreign exchange risk Liabilities: Equity: What the business is worth, hence Equity = Net Worth Capital Stock: All shares of stock representing ownership of the corporation Preferred Stock: A class of capital stock that has preference over common stock on dividend payments and the liquidation of assets; usually has no voting rights Common Stock: Stock with voting rights, but no guarantee to dividend payments Treasury Stock: Common stock that was repurchased by the company and held in the company’s treasury Additional Paid-In Capital: Capital contributed in excess of par/stated value by investors Retained Earnings: Earnings kept in the company and not paid out as dividends Assets = Current Assets Cash Short-Term Investments Accounts Receivables (A/R) Inventories Prepaid Items Long-Term Investments Property, Plant & Equipment Intangible Assets Other Assets Total Assets = Liabilities + Current Liabilities Accounts Payables (A/P) Unearned Revenue Accrued Liabilities Other Liabilities Income Taxes Payable Long-Term Liabilities (Debt) Financial Instruments Total Liabilities Equity Capital Stock Preferred Stock Common Stock Treasury Stock Additional Paid-In Capital Retained Earnings + Owners’ Equity This is trial version www.adultpdf.com Income Statement: a report that measures the success or failure of a company’s operations over a specific period of time (e.g monthly, quarterly, yearly) The Income Statement provides information about revenues, expenses, and gains and losses The information in the Income Statement can help you evaluate a company’s past performance, predict future performance and help assess the risk of getting future cash flows “Performance” and “Activity” ratios are calculated with both Balance Sheet and Income Statement elements Elements of the Income Statement (simplified) Revenues: Expenses: Inflows such as sales of goods or services, dividend revenues, & rental revenues Cost of goods sold (CoGS), cost of sales (CoS), selling expenses, general & administrative expenses, interest expenses, and income tax expenses Sales Revenues Net Sales (from selling a product or service) Cost of Sales (or Cost of Goods Sold) Gross Profit (= Net Sales – CoGS/CoS) Operating Expenses Selling Expenses General & Administrative Expenses Income/Earnings before Interest & Tax (EBIT Gross Profit – Operating Expenses) Interest Expenses Income/Earnings before Tax (EBT EBIT – Interest Expenses) Income Tax Expenses Income/Earnings after Tax = Net Income = Net Profit Both the Balance Sheet and the Income Statement are a company’s financial statements Financial ratios are calculated by using elements of the financial statements Financial ratios help you interpret and understand the relationship between elements of the financial statements A company’s financial ratios tell you about its liquidity, profitability and efficiency By comparing the financial ratios over several years, you can identify trends, problems or strengths By comparing a company’s financial ratios to an industry standard, you can determine how well the company is doing, if there is room for improvement, or if the company is outperforming the industry Financial ratios are useful to both insiders and outsiders Insiders, such as management, use financial ratios to determine weaknesses and find ways to improve the company’s operations and financial position Outsiders, such as stockholders, creditors and investors, use financial ratios to determine the risk of the company in terms of debt and the likelihood of generating profit This is trial version www.adultpdf.com FINANCIAL RATIOS TUTORIAL1 LIQUIDITY: Financial ratios in this category measure the company's capacity to pay its debts as they come due Current Ratio Definition: Formula: The ratio between all current assets and all current liabilities; another way of expressing liquidity Current Assets Current Liabilities Analysis: • 1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in current liabilities Look for a current ratio above 1:1 and as close to 2:1 as possible • One problem with the current ratio is that it ignores timing of cash received and paid out For example, if all the bills are due this week, and inventory is the only current asset, but won't be sold until the end of the month, the current ratio tells very little about the company's ability to survive Quick Ratio Definition: Formula: The ratio between all assets quickly convertible into cash and all current liabilities Specifically excludes inventory Current Assets – Inventory Current Liabilities Analysis: • Indicates the extent to which the business could pay current liabilities without relying on the sale of inventory how quickly they can pay bills Generally, a ratio of 1:1 is good and indicates they don't have to rely on the sale of inventory to pay the bills • Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments Adapted from the U.S Small Business Administration website at www.sba.gov, retrieved on 2/9/2004 This is trial version www.adultpdf.com CAPITAL STRUCTURE: Indicator of the businesses' vulnerability to risk These ratios are often used by creditors to determine the ability of the business to repay loans Debt to Equity (= Total Liabilities to Equity2) Definition: Formula: Shows the ratio between capital invested by the owners and the funds provided by lenders Total Liabilities (= Current Liabilities + Long-Term Liabilities) Stockholders’ Equity Analysis: • Comparison of how much of the business was financed through debt and how much was financed through equity For this calculation it is common practice to include loans from owners in equity rather than in debt • The higher the ratio, the greater the risk to a present or future creditor • Look for a debt to equity ratio in the range of 1:1 to 4:1 • Most lenders have credit guidelines and limits for the debt to equity ratio (2:1 is a commonly used limit for small business loans) • Too much debt can put the business at risk but too little debt may mean not realizing the full potential of the business due to lack of leverage and may actually hurt overall profitability This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate) Debt to Assets (= Total Liabilities to Total Assets) Shows how well the company can cover its total debt with all its assets Current Liabilities + Long-Term Liabilities Total Assets Alternate Formula: Total Assets – Stockholders’ Equity (= Total Liabilities) Stockholders’ Equity Analysis: • Shows how much of your assets are available to repay debt • Lenders look at this ratio to determine if there are adequate assets to make loan payments Definition: Formula: Equity is often referred to as “net worth.” This is trial version www.adultpdf.com PROFITABILITY: The ratios in this section measure the ability of the business to make a profit Gross Profit Margin Definition: Formula: Gross profit as a percentage of sales Indicator of how much profit is earned on products/services without consideration of selling and administration costs Gross Profit Sales Analysis: • The higher, the better • If overall cost and inflation are on the rise, then you watch for aerated decrease in sales and therefore a decrease in profit margin • Compare to other businesses in the same industry to see if the business is operating as profitably as it should be • Look at the trend from month to month, or year to year Is it staying the same? Improving? Deteriorating? • Is there enough gross profit in the business to cover operation costs? • Is there a positive gross margin on all products/services? CoGS to Sales Definition: Formula: Percentage of sales used to pay for expenses which vary directly with sales Cost of Goods Sold OR: 100 – Gross Profit Margin Sales Analysis: • Look for a stable ratio as an indicator that the company is controlling its gross margins SG&A to Sales Definition: Formula: Percentage of selling, general and administrative costs to sales Selling, General & Administrative Expenses Sales Analysis: • Look for a steady or decreasing percentage indicating that the company is controlling its overhead expenses This is trial version www.adultpdf.com Net Profit Margin Definition: Formula: Shows how much profit comes from every dollar of sales Net Profit (i.e net income) Sales Analysis: • Compare to other businesses in the same industry to see if the business is operating as profitably as it should be • Look at the trend from month to month, or year to year Is it staying the same? Improving? Deteriorating? • Is the company generating enough sales to leave an acceptable profit? • Trend from month to month can show how well they are managing operating or overhead costs Return on Equity (also called ROE)3 Definition: Formula: Determines the rate of return on investment in the business As an owner or shareholder this is one of the most important ratios as it shows the hard fact about the business – is the business making enough of a profit to compensate investors for the risk of being in business? Net Profit Equity Analysis: • Compare the return on equity to other investment alternatives, such as a savings account, stock or bond • Compare ratio to other businesses in the same or similar industry Return on Assets (also called ROA) Definition: Formula: Considered a measure of how effectively assets are used to generate a return Net Profit Total Assets Analysis: • ROA shows the amount of income for every dollar tied up in assets • Year to year trends may be an indicator but watch out for changes in the total asset figure as the business depreciates assets (a decrease or increase in the denominator can affect the ratio and doesn't necessarily mean the business is improving or declining Net Profit is sometimes labeled “Net Income,” Equity is sometimes labeled “Net Worth.” This is trial version www.adultpdf.com ACTIVITY: Also called Asset Management or Efficiency ratios Indicator of how efficiently the company manages its assets Inventory Turnover Definition: Formula: Number of times that the business turns over inventory during the year Cost of Goods Sold Inventory Analysis: • Generally, a high inventory turnover is an indicator of good inventory management • But a high ratio can also mean there is a shortage of inventory • A low turnover may indicate overstocking, or obsolete inventory • Compare to industry standards Days in Inventory Definition: Formula: This calculation shows the average number of days it will take to sell inventory (number of days sales @ cost in inventory) 365 Day Inventory Turnover Analysis: • Look for trends that indicate a change in inventory levels • Compare the calculated days in inventory to the inventory cycle • Compare to industry standards Accounts Receivable Turnover Definition: Formula: Number of times that accounts receivables turn over during the year Net Sales Accounts Receivable Analysis: • The higher the turnover, the shorter the time between sales and collecting cash • Compare to industry standards This is trial version www.adultpdf.com Days in Receivables Definition: Formula: This calculation shows the average number of days it takes to collect accounts receivable (number of days of sales in receivables) 365 Days A/R Turnover Analysis: • Look for trends that indicate a change in customers' payment habits • Compare the calculated days in receivables to stated credit terms • Compare to industry standards Sales to Net Fixed Asset Definition: Formula: Indicates how efficiently the business generates sales on each dollar of net fixed assets (= property, plant & equipment) Sales Net Fixed Assets Analysis: • A volume indicator that can be used to measure the efficient use of net fixed assets from year to year Sales to Total Assets Definition: Formula: Indicates how efficiently the business generates sales on each dollar of assets Sales Total Assets Analysis: • A volume indicator that can be used to measure the efficiency of the business from year to year This is trial version www.adultpdf.com 10 RMA TUTORIAL This sample Risk Management Association (RMA) tutorial uses the industry averages applicable to Staples (SPLS) which has a NAICS code of 453210 - Retail Office Supplies and Stationary Stores4 (see Appendix B) The right hand column (current data sorted by sales) is used, which is the largest sales category (25MM and over) that is available The sample case is Staples The income statement and balance sheet are obtained from Compustat, an electronic database from Standard & Poor (see Appendix D) NOTE: You should understand financial ratio analysis before you read this section The upper half contains industry numbers on assets, liabilities and income stated in percentages The lower half contains industry numbers on specific ratios, e.g quick ratio, current ratio, debt to worth ratio, etc When specific notes are presented on the RMA industry page, the median (middle) value should be used Here are the sections you need to look at to calculate the industry ratios on your Financial Audit work sheet: Liquidity Assets and Liabilities Capital Structure Assets and Liabilities Performance Income Data and Ratios Activity Income Data and Ratios The RMA uses slightly different accounting terms Below are RMA terms followed by some generally known accounting synonyms: • Receivables Net = Accounts Receivables = AR • Fixed Assets Net = Net Fixed Assets = NFA • (Total) Current Debt = (Total) Current Liabilities = CL • (Tangible) Net Worth = Equity = Stockholders’ Equity = SE not given, however, you can calculate it! Remember the • Total Debt = Total Liabilities accounting equation: Assets = Liabilities + Equity OR Assets – Equity = Liabilities Consequently, if: Total Assets = 100 Equity = 29.2 Total Assets – Equity = Total Liabilities = 100 – 29.2 = 70.8 Now you can calculate the industry’s Debt/Equity, Debt/Assets and Current Debt/Total Debt ratios Remember, (Total) Debt = (Total) Liabilities, and Current Debt = Current Liabilities RMA, Annual Statement Studies – Financial Ratio Benchmarking, 2006-2007, p 987 This is trial version www.adultpdf.com 11 Liquidity & Capital Structure Ratios Current Ratio = 1.2 Quick Ratio = 0.9 Debt / Equity = 2.6 Debt / Assets = 0.708 Current Debt / Total Debt = ratio of 0.581 / 0.708 = 0.82 Performance Ratios Gross Profit Margin % CoGS % Sales * Net Profit % Sales * RR Assets % * RR Net Worth % SGA Exp % Sales Gross Profit = 29.5 100 – Gross Profit number = 70.5 Profit Before Taxes X 0.5 = 1.2 %Profit Bef Taxes/Tot Assets X 0.5 = 3.1 %Profit Bef Taxes/Worth X 0.5 = 11.8 All Other Expense Net = 26.8 * As a convention we analyze profit indicators as after tax net income Therefore, for our use we reduce all “before tax” values by 50% Activity Ratios Inventory Turnover Inventory Days AR Turnover AR Collection Days NFA Turnover TA Turnover Cost Sales / Inventory = 6.8 Cost Sales / Inventory = 54 Sales / Receivables = 7.5 Sales / Receivables = 49 Sales / Net Fixed Assets = 42.4 Sales / Total Assets = 3.0 Note: The ratios sections of the RMA are presented in quartiles As a convention, we use the middle number (50th percentile) LIMITS CALCULATIONS & IMPROVED OPERATIONS TUTORIAL Limits Calculations are useful to determine if a company has the capacity to incur more debt based on its current stockholders’ equity OR current total assets Investors and/or banks offering loans to a company look at the company’s current assets or equity Assets/Equity can be used as collateral (= security, guarantee) if the company fails to repay its debt Here’s an example: you’ve bought a house several years ago for $100,000 Your down payment was $10,000 You got a mortgage (debt) in the amount of $90,000 So far, you’ve paid down $5,000 (principal) on your mortgage Now you still owe the bank $85,000 Let’s assume you wanted to some major remodeling in your house, but you don’t have any cash saved You need to take out another loan to pay for your remodeling So you go to your bank and ask for an additional loan (often referred to as a home equity loan) The bank is willing to lend you up to the equity you have invested in your house This is trial version www.adultpdf.com 12 .. .FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS ABASTRACT This financial audit teaching aid for case analysis is a tutorial used by the authors in the capstone senior and MBA business policy case. .. standardized financial audit form listing the indicators for each category appears at the end of this document This teaching aid contains the following tutorials: • • • • Basic accounting tutorial Financial. .. interpreting the ratios calculated from case financial statements For senior business policy students, the instructor provides industry numbers for the case being used in class from the source,