FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS_PART2 ppt

Price of the House: Your Down payment: Your Principal paid: Your money invested in the house: $100,000 $10,000 _$5,000 $15,000 The bank determines that you have paid a total of $15,000 toward the house This is your equity you have invested in your house This equity can be used as a security by the bank, so the bank is willing to offer you up to $15,000 in a home equity loan Now you can use the full amount or less, whatever you need to your remodeling Limits Calculations Based on Equity It works in a similar way with a company To determine the amount debt can be increased based on the company’s current equity, you need three items: The company’s Total Shareholder Equity The company’s Total Liabilities The Industry D/E ratio (Debt/Equity = Total Liabilities/ Equity) To determine the company’s potential debt capacity, multiply the company’s SE by the Industry D/E ratio Note, the higher the Industry D/E ratio, the higher is the company’s debt capacity The result indicates how much debt the company could potentially incur Now you need to subtract the company’s current Total Debt These are liabilities (debt) the company has already incurred The remaining amount is the debt that the company could incur based on its equity If the amount is negative, the company has already incurred all the debt it can It has maxed out its debt capacity and cannot incur more debt This is trial version www.adultpdf.com 13 Limits Calculations Based on Assets To determine the amount debt can be increased based on the company’s current assets, you need three items: The company’s Total Assets The company’s Total Liabilities (i.e., debt) The Industry D/A ratio (Debt/Assets = Total Liabilities/Total Assets) Again, to determine the company’s potential debt capacity, multiply the company’s TA by the Industry D/A ratio Note here too, the higher the Industry D/A ratio, the higher is the company’s debt capacity Subtract the company’s current Total Liabilities (i.e debt) The remaining amount is the debt that the company could incur based on its assets If the amount is negative, the company has already incurred all the debt it can It has maxed out its debt capacity and cannot incur more debt NOTE: Increasing debt is based EITHER on equity OR on assets, NOT on both! Improved Operations tell us if a company could save money by improving its operations in accounts receivable collections and inventory turnover Improved Operations Based on Accounts Receivables Remember that Accounts Receivables are dollars owed to the company by customers Depending on the industry, customers have to pay for their goods immediately, in 10, 20, 30 or 60 days It is up to the company to determine its credit policy However, the faster the company gets its money, the better The longer a company waits for accounts receivables to be paid, the longer the company has to use other funds (potentially debt!) to pay for its day-to-day operations The industry AR days serves as a measure to determine if the company does better (lower AR days) or worse (higher AR days) than other companies in the same industry This is trial version www.adultpdf.com 14 You need three items to calculate improved operations based on AR days: The company’s AR days The industry’s AR days The company’s Accounts Receivables To determine if the company can improve operations based on AR days, you subtract the industry AR days from the company’s AR days If the result is negative, the company is already doing better than the industry and cannot improve its operations further based on the industry number If the result is positive, divide it by the company’s AR days to derive a percentage that A/R days can be improved Now multiply the result with the company’s accounts receivables This is the amount by which operations can be improved Remember, the bigger the gap between the company’s and industry’s AR days, the more the company can improve Improved Operations Based on Inventory Inventories are supplies, materials or merchandise the company bought to produce goods and sell them The faster the company produces its goods and sells them, the faster it makes money If inventory sits in warehouses or on shelves for a long time, it doesn’t generate any revenue for the company A high number in inventory turnover days means that the company needs more days to sell its inventory A low number in inventory turnover days means that the company needs fewer days to sell its inventory Therefore, the faster the company turns over its inventory, the better You need three items to calculate improved operations based on Inventory days: The company’s Inventory days The industry’s Inventory days The company’s Inventory To determine if the company can improve operations based on Inventory days, you subtract the industry Inventory days from the company’s Inventory days If the result is negative, the company is already doing better than the industry and cannot improve its operations further based on the industry number If the result is positive, divide it by the company’s Inventory days This is trial version www.adultpdf.com 15 to derive a percentage that inventory days can be improved Now multiply the result with the company’s Inventory This is the amount by which operations can be improved Remember, the bigger the gap between the company’s and industry’s Inventory days, the more the company can improve This is trial version www.adultpdf.com 16 APPENDIX A—RMA DEFINITIONS This is trial version www.adultpdf.com 17 APPENDIX B—RMA INDUSTRY PAGE FOR OFFICE SUPPLIES STORES This is trial version www.adultpdf.com 18 APPENDIX C—FINANCIAL AUDIT FOR STAPLES This is trial version www.adultpdf.com 19 APPENDIX D—STAPLES INCOME STATEMENT This is trial version www.adultpdf.com 20 APPENDIX D (cont.)—BALANCE SHEET FOR STAPLES This is trial version www.adultpdf.com 21 APPENDIX F—SAMPLE WRITTEN FINANCIAL AUDIT FOR STAPLES Compound annual growth rates for the period 2003 to 2007 Assets Sales Net profit Total liabilities Stockholders’ equity Net working capital 8.6% 10.1% 19.4% 3.9% 11.8% 9.5% Liquidity Staples appears to have relatively low risk and should have no trouble meeting its short-term obligations as they come due Current ratio (CR) is higher than the industry average (1.75; 1.2 I) and is at its highest point of the period Quick ratio (QR) is also higher than the industry average (0.96; 0.9 I) and has remained fairly steady over the period, indicating no major problems or fluctuations in the company’s inventory controls Net working capital (NWC) has shown a compound annual growth rate of 9.5% and is at its highest point of the period As inventories could be easily liquidated if necessary, Staples has minimal risk Capital Structure Staples has low risk and, thus, should have a low cost of capital D/E is less than a quarter of the industry average (0.58; 2.6 I) and D/A is only slightly more than half of the industry average (0.37; 0.78 I) Both ratios are at their lowest points of the period In addition, 79% of Staples’ total liabilities are current Management seems to be conservative in its use of debt capital, giving the company options in pursuing its future growth strategy and the flexibility to seize new opportunities as they arise Staples has a low risk capital structure at this time Performance Staples is clearly outperforming the industry Although GPM is only slightly higher than the industry average (30.58%; 29.5% I), NPM is over four times that of the industry (5.14%; 1.2%) and these ratios have remained steady over the period GPM is impressive in light of the fact that the company is known for its low prices and wide selection of products This indicates that Staples is efficient and likely experiences economies of scale and scope Operating expenses (SAE) have remained stable over the period and are significantly lower than the industry average (20.3%; 26.8% I), leading to a strong bottom line Contributing factors likely include: economies of scale in advertising, efficient distribution, broad geographic presence, strong brand awareness, advantages of chaining to support their cost leadership position – including extensive use of IT, and low bureaucratic costs Strong performance is reflected in superior ROA (11.02%; 3.1% I) and ROE (17.41%; 11.8% I) Staples is performing well Activity There does not appear to be significant issues with control Inventory turnover is slightly lower than the industry average (6.55 times; 6.8 I), and inventory days of 55.72 are slightly above the industry (54.0) This is likely due to the extensive selection of products available, centralized distribution centers, and the largest number of stores in the industry A/R turnover is more than three times that of the industry (23.56 times; 7.51 I) with AR days outstanding of 15.49 being much lower than the industry (49.0) Control here is excellent, keeping cash flows strong FA turnover is very low (8.96 times; 42.4 I) and only slightly more This is trial version www.adultpdf.com 22 than 21% that of the industry This significant difference may be explained by Staples’ rapid growth, including various acquisitions and foreign expansion Staples operates more stores than its competitors and supports them with a strong distribution network, including a large and expensive distribution system with a number of distribution centers and warehouses, and a sophisticated IT infrastructure If sales continue to outpace the investment in FA, turnover should increase TA turnover is also below the industry average (2.14 times; I) but has increased over the period Staples’ focus on low prices contributes to keeping these turnover ratios low Control could be improved but, issues are not critical in light of the company’s strong profitability and growth Limits Staples has the ability to raise additional funds through debt and/or improving operations (see Limits Calculations Tutorial) Debt to equity parity with the industry could result in an increase of $11,548 million in debt (unlikely) or $3,097 million based on assets (possible) Since accounts receivable collection days are better than the industry, there would be no improvement of freeing up working capital However, decreasing inventory days to the level of the industry could result in $63.3 million in freed up working capital This is trial version www.adultpdf.com 23 Appendix F This is trial version www.adultpdf.com 24 ... APPENDIX D (cont.)—BALANCE SHEET FOR STAPLES This is trial version www.adultpdf.com 21 APPENDIX F—SAMPLE WRITTEN FINANCIAL AUDIT FOR STAPLES Compound annual growth rates for the period 2003 to 2007... www.adultpdf.com 17 APPENDIX B—RMA INDUSTRY PAGE FOR OFFICE SUPPLIES STORES This is trial version www.adultpdf.com 18 APPENDIX C? ?FINANCIAL AUDIT FOR STAPLES This is trial version www.adultpdf.com... money, the better The longer a company waits for accounts receivables to be paid, the longer the company has to use other funds (potentially debt!) to pay for its day-to-day operations The industry