7ce_Ch13_How_Well_Am_I_Doing_Financial_Statement_Analysis (1)

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LEARNING OBJECTIVES AND CHAPTER COMPETENCIES After studying Chapter 13, you should be able to demonstrate the following competencies: COMPETENCY Know Apply LO1 PREPARE FINANCIAL STATEMENTS IN DIFFERENT FORMATS. CC1 Prepare and interpret financial statements in comparative and common-size forms. LO2 COMPUTE VARIOUS FINANCIAL RATIOS TO ASSESS FINANCIAL PERFORMANCE. CC2 Compute and interpret financial ratios used to measure common shareholders’ well-being. CC3 Compute and interpret financial ratios used to measure short-term creditors’ well-being. CC4 Compute and interpret financial ratios used to measure long-term creditors’ well-being. “How Well Am I Doing?”— Financial Statement Analysis 13 Paulo Vilela/Shutterstock

“How Well Am I Doing?”—Financial Statement Analysis 633 Note to student: See Guidance Answers online. Critical thinking question What role do you see for financial analysis using a tool like financial ratios for a company besieged by a crisis of its own making compromising its integrity? ? ON THE JOB REPORTING FOR INTERNAL USE AND DECISION MAKING AT VENDASTA A Vendasta is a Canadian technology company that provides an end-to-end platform used exclusively by local experts (channel partners) who sell digital products and services to small and medium businesses. These channel partners use the software platform and its associated products to help over 5.5 million business clients leverage digital avenues of attracting and keeping customers/clients. Tools range from social media marketing, to online directory listing syncing, to email and document cloud solutions. Vendasta also provides marketing services to customers who need help fulfilling these services for their growing client base. Vendasta’s professional channel partners pay a monthly subscription and purchase products to enhance the services they provide to their clients. These purchases provide Ven- dasta with monthly recurring revenue . Vendasta pays soft- ware expenses and cloud costs to host the platform and digital solutions for its partners. The direct costs allow for a stable margin on sales. Besides hosting and product costs, Vendasta’s largest expenses are wages, salaries, and bene- fits to support company operations as well as the research, development, marketing, and sales of the Vendasta plat- form. For a growing software as a service (SaaS) company, these expenses are high and often delay profitability. The company uses common industry ratios, known as “SaaS metrics,” to better understand the overall health and viability of its business. These metrics allow the company to address cost issues and guide decision making in relation to pricing and sales strategies. Vendasta relies heavily on the LTV:CAC ratio, which is: Lifetime value of a customer (LTV) : Cost of acquiring a customer (CAC)* *LTV = Average monthly revenue × Average months of lifetime CAC = Total sales and marketing expenses ÷ Number of new customers acquired. If the costs to acquire a customer fall short of the total cost of the consumer-facing price points of the software and its associated products, it’s an indicator of risk to the viability of the company. In order to improve the LTV:CAC ratio, Vendasta added a lower tiered self-sign-up subscription with a de- creased sales spend. In turn, this decreased the cost to acquire these customers. When these partners find success within the platform, the cost to convert them to a higher sub- scription is lower than the cost to sign them up on a higher subscription from the beginning. This new level of subscrip- tion allowed Vendasta to allocate sales and marketing efforts to partners with a higher monthly recurring revenue. Shutterstock/NakoPhotography A Look Back A Look at This Chapter A Look Ahead Chapter 12 introduced the concepts of decentralization and performance measurement to evaluate different types of responsibility centres. In Chapter 13, we focus on the analysis of financial statements to help forecast the financial health of a company. We discuss the use of trend data, comparisons with other organizations, and the analysis of fundamental financial ratios. We cover the cash flow statement in Chapter 14, which is available on Connect. We address how to classify various types of cash inflows and outflows, and how to interpret information reported on the cash flow statement.

634 Chapter 13 I ncreasingly, firms have to look to the financial markets for much-needed financial capital. Companies must present their past performance and future expectations in accordance with established guidelines for financial reporting and clearly express their financial prospects to the financial marketplace. This is accomplished using financial statements. All financial statements are essentially historical documents. They explain what happened during a particular period. However, most users of financial statements are concerned about what will happen in the future. Shareholders are concerned with future earnings and dividends. Creditors are concerned with the company’s future ability to repay its debts. Managers are concerned with the company’s abil- ity to finance future expansion. Despite the fact that financial statements reflect the past, they can still provide valuable information on all of these forward-looking concerns. Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios. In this chapter, we consider some of the more important ratios and other analytical tools that financial analysts use. Managers are also very concerned with the financial ratios discussed in this chapter, as the ratios provide indicators of how well the company and its business units are performing. Some of these ratios would ordinarily be used in a balanced scorecard, as discussed in Chapter 12, although the specific ratios selected depend on the company’s strategy. For example, a company that wants to emphasize responsiveness to customers may closely monitor the inventory turnover ratio discussed later in this chapter. Similarly, the gross margin ratio provides a strong signal regarding the outcomes of efforts to reduce the cost of goods sold. In addition, since they must report to shareholders and may wish to raise funds from external sources, managers must pay attention to the financial ratios used by external investors to evaluate the company’s investment potential and creditworthiness. Limitations of Financial Statement Analysis in Business Today Although financial statement analysis is a highly useful tool, it has two limitations that we must mention before proceeding any further. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Comparison of Financial Data Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies’ financial data. For example, if one firm depreciates its assets using the double-declining balance method and another firm by the straight-line method, then direct com- parisons of financial data between the two firms may be misleading. Sometimes, enough data are presented in footnotes to the financial statements to restate data on a comparable basis, but the analyst should evaluate the data’s comparability before drawing any definite conclusions. With this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation. The Need to Look Beyond Ratios An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future, but this may not be appropriate. Conclusions based on ratio analysis must be regarded as tentative. Ratios should not be viewed as an end but, rather, as a starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely completely answer any questions by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. The analyst should look at industry trends and at changes in technology, in consumer tastes, in the economy at large, and within the company itself. For example, recent turnover in a key management position might provide a basis for optimism about the future, even though the past performance of the company (as shown by its ratios) may have been mediocre.

“How Well Am I Doing?”—Financial Statement Analysis 635 FINANCIAL PERFORMANCE AT TIM HORTONS USING NON-GAAP METRICS B For businesses to succeed financially, they need to increase revenue and manage costs. For a company in a highly volatile industry where cash burn rates are high, good cash management and liquidity are extremely important. Fast-food restaurants must particularly focus on quick turnover (especially because much of the food and many of the ingredients are perishable) and must watch costs very carefully. Managers must therefore pay close attention to key ratios such as cost to sales (or gross margin), inventory turnover, and (of course) sales growth. Although ratios related to long-term borrowing and equity will be important, any company will likely not succeed over the long term if it cannot manage its operations well to generate revenues and build a healthy cashflow. What about investors? It is interesting to see what companies think might matter to their investors. Consider Tim Hortons. In addition to traditional financial metrics, Tim Hortons reports certain “non-GAAP” financial metrics—that is, metrics that do not have standardized meanings under generally accepted accounting principles (GAAP) and as such may differ from similarly labelled measures of other companies. Nonetheless, in the words of the company, “We believe that . . . non-GAAP measures are useful to investors in assessing our operating performance, . . . [providing] them with the same tools that management uses to evaluate our performance and . . . [being] responsive to questions we receive from both investors and analysts.” One non-GAAP measure is earnings before interest, taxes, depreciation, and amortiz- ation (EBITDA), which is used to assess the operating performance of the business. Financial analysts typically study both the traditional financial measures of performance and the non-GAAP measures that are reported by companies, keeping in mind that the self-reported measures that are not subject to any reporting standards will have to be viewed cautiously. IN BUSINESS CREDIT ANALYST You work for a company that sells industrial products to businesses. Your company routinely sells products to customers on credit—expecting to be repaid within a specified period. A potential customer has asked for an extension of the payment terms on a very large sale to a date later than your company usually allows. You have been asked to determine the creditworthiness of this customer and have been provided with a copy of the customer’s financial statements and accompanying footnotes that were included in the customer’s most recent annual report. What other information should you obtain before you begin your analysis? Note to student: See Guidance Answers online. DECISION POINT Statements in Comparative and Common-Size Forms Few figures appearing on financial statements have much significance standing by themselves. It is the relationship of one figure to another—and the amount and direction of change over time—that is import- ant in financial statement analysis. How does the analyst focus on significant relationships? How does the analyst extract the important trends and changes in a company? Three analytical techniques are widely used: (1) dollar and percentage changes on statements, (2) common-size statements, and (3) ratios. The first and second techniques are discussed in this section; the third technique is discussed in the remainder of the chapter. To illustrate these analytical techniques, we analyze the financial statements of Brickey Electronics, a producer of computer components. LO1 Know Apply CC1: Prepare and interpret financial statements in comparative and common-size forms.

636 Chapter 13 Dollar and Percentage Changes on Statements The starting point for financial statement analysis is to put statements in comparative form. This consists of putting two or more years’ data side by side. Statements cast in comparative form can reveal movements and trends and may give the analyst valuable clues as to what aspects of the financial results to probe. Examples of financial statements placed in comparative form are given in Exhibit 13–1 and Exhibit 13–2. These statements of Brickey Electronics reveal that the company has been experiencing substantial growth. The data in these financial statements are used as a basis for discussion throughout the remainder of the chapter. EXHIBIT 13–1 Comparative Balance Sheet BRICKEY ELECTRONICS Comparative Balance Sheet December 31, Year 1 and Year 2 (dollars in thousands) Increase (Decrease) Year 2 Year 1 Amount Percentage Assets Current assets: Cash $ 1,200 $ 2,350 $(1,150) (48.9)%* Accounts receivable, net 6,000 4,000 2,000 50.0% Inventory 8,000 10,000 (2,000) (20.0)% Prepaid expenses 300 120 180 150.0% Total current assets 15,500 16,470 (970) (5.9)% Property and equipment: Land 4,000 4,000 –0– –0–% Buildings and equipment, net 12,000 8,500 3,500 41.2% Total property and equipment 16,000 12,500 3,500 28.0% Total assets $31,500 $28,970 $ 2,530 8.7% Liabilities and Shareholders’ Equity Current liabilities: Accounts payable $ 5,800 $ 4,000 $ 1,800 45.0% Accrued payables 900 400 500 125.0% Notes payable, short term 300 600 (300) (50.0)% Total current liabilities 7,000 5,000 2,000 40.0% Long-term liabilities: Bonds payable, 8% 7,500 8,000 (500) (6.3)% Total liabilities 14,500 13,000 1,500 11.5% Shareholders’ equity: Preferred shares ($100 par; 20,000 shares issued) 2,000 2,000 –0– –0–% Common shares (unlimited authorized, $12 par; 500,000 shares issued) 6,000 6,000 –0– –0–% Additional paid-in capital 1,000 1,000 –0– –0–% Total paid-in capital 9,000 9,000 –0– –0–% Retained earnings 8,000 6,970 1,030 14.8% Total shareholders’ equity 17,000 15,970 1,030 6.4% Total liabilities and shareholders’ equity $31,500 $28,970 $ 2,530 8.7% *Since we are measuring the amount of change between year 1 and year 2, the dollar amounts for year 1 become the base figures for expressing these changes in percentage form. For example, cash decreased by $1,150 between year 1 and year 2. This decrease expressed in percentage form is computed as follows: $1,150 ÷ $2,350 = 48.9%. Other percentage figures in this exhibit and Exhibit 13–2 are computed in the same way.

“How Well Am I Doing?”—Financial Statement Analysis 637 EXHIBIT 13–2 Comparative Income Statement and Reconciliation of Retained Earnings BRICKEY ELECTRONICS Comparative Income Statement and Reconciliation of Retained Earnings For the Years Ended December 31, Year 1 and Year 2 (dollars in thousands) Increase (Decrease) Year 2 Year 1 Amount Percentage Sales $52,000 $48,000 $4,000 8.3% Cost of goods sold 36,000 31,500 4,500 14.3% Gross margin 16,000 16,500 (500) (3.0)% Operating expenses: Selling expenses 7,000 6,500 500 7.7% Administrative expenses 5,860 6,100 (240) (3.9)% Total operating expenses 12,860 12,600 260 2.1% Net operating income 3,140 3,900 (760) (19.5)% Interest expense 640 700 (60) (8.6)% Net income before taxes 2,500 3,200 (700) (21.9)% Less: Income taxes (30%) 750 960 (210) (21.9)% Net income 1,750 2,240 $ (490) (21.9)% Dividends to preferred shareholders, $6 per share (see Exhibit 13–1) 120 120 Net income remaining for common shareholders 1,630 2,120 Dividends to common shareholders, $1.20 per share 600 600 Net income added to retained earnings 1,030 1,520 Retained earnings, beginning of year 6,970 5,450 Retained earnings, end of year $ 8,000 $ 6,970 HORIZONTAL ANALYSIS Comparison of two or more years’ financial data is known as horizontal analysis or trend analysis . Horizontal analysis is facilitated by showing changes between years in both dollar and percentage forms, as has been done in Exhibits 13–1 and 13–2. Showing changes in dollar form helps the analyst focus on key factors that have affected profitability or financial position. For example, observe in Exhibit 13–2 that sales for year 2 were up $4 million over year 1 but that this increase in sales was more than negated by a $4.5 million increase in cost of goods sold. Showing changes between years in percentage form helps the analyst gain perspective and gain a feel for the significance of the changes taking place. A $1 million increase in sales is much more significant if the prior year’s sales were $2 million than if the prior year’s sales were $20 million. In the first situation, the increase would be 50%—undoubtedly a significant increase for any firm. In the second situation, the increase would be only 5%—perhaps just a reflection of normal growth. TREND PERCENTAGES Horizontal analysis of financial statements can also be carried out by com- puting trend percentages . Trend percentages state several years’ financial data in terms of a base year. The base year equals 100%, with all other years stated as some percentage of this base. To illustrate, consider McDonald’s Corporation, the largest global food service retailer, with more than 38,000 restaurants worldwide. McDonald’s enjoyed consistent growth in income during 2016–2021 (except in 2020), as is shown by the following data: 2021 2020 2019 2018 2017 2016 Sales $23,223 $19,208 $21,364 $21,258 $22,820 $24,622 Net income $ 7,545 $ 4,731 $ 6,025 $ 5,924 $ 5,193 $ 4,687

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