Description
You have been chosen to join a team of consultants at Maryland Creative Solutions (MCS). Congratulations on your hiring! The group you will be working with has a history of helping transform troubled companies into profitable enterprises with a promising future. Your team is assigned to a client firm, Largo Global Inc. (LGI). LGI’s operational efficiency has declined over the past three years. The company’s board of directors has hired MCS to uncover the underlying issues and make recommendations to turn things around.
Maryland Creative Solutions (MCS) has provided you with background material on how its teams approach financial analysis. Using the Project 1 Review and Practice Guide , review the structure and purpose of the income statement and balance sheet. Make sure you also are familiar with the DuPont equation as well as these five groups of financial ratios: liquidity, efficiency, leverage, profitability, and market value. Study how to perform common-size and cash flow analyses. Finally, apply what you have learned so far by completing the exercises referenced in the Project 1 Review and Practice Guide.
You must review the material provided by MCS and do the practice exercises so that you are
prepared to have informed discussions with your team about company financial statements,
understand what the statements reveal about operational efficiency, and
can use this information to make recommendations for improvements.
Complete this review and practice by the end of Week 1.
You have finished reviewing the material and performing the exercises but you have some questions. Participate in the Project 1 class discussion. Respond to the two questions below by posting in the discussion; then, respond to two of your classmates’ discussion posts by the end of the week.
Answer the following questions:
Discuss the concepts that were most challenging for you in the readings and review material. How did the practice exercises help clarify these?
What did you learn that will help you analyze LGI’s financial statements?
Unformatted Attachment Preview
Project 1: Review and
Practice Guide
UMGC
MBA 620: Financial
Decision Making
Project 1: Review and
Practice Guide
Analyzing Financial Statements
Contents
The Basics of Financial Statements ………………………………………………………………………………………………… 3
Purpose of Financial Statements ……………………………………………………………………………………………….. 3
Who Can Use Financial Statements? ………………………………………………………………………………………….. 3
Generally Accepted Accounting Principles (GAAP) ……………………………………………………………………….. 3
Annual Report …………………………………………………………………………………………………………………………. 3
Key Financial Statements ………………………………………………………………………………………………………….. 3
The Balance Sheet ……………………………………………………………………………………………………………………….. 4
Two Sides of Balance Sheet ………………………………………………………………………………………………………. 4
The accounting equation: ……………………………………………………………………………………………………… 4
Net Working Capital …………………………………………………………………………………………………………………. 4
Order of Items on the Balance Sheet ………………………………………………………………………………………….. 4
Income Statements ……………………………………………………………………………………………………………………… 4
The Income Statement……………………………………………………………………………………………………………… 4
Profit and Loss: Four Key Equations……………………………………………………………………………………………. 4
Profit and Loss Statement ……………………………………………………………………………………………………… 4
Income Statement: Depreciation……………………………………………………………………………………………….. 5
Income Statement: Amortization ………………………………………………………………………………………………. 5
Income Statement: EBITDA & EBIT …………………………………………………………………………………………….. 5
Statement of Cash Flows ……………………………………………………………………………………………………………… 6
Cash Flow Statement ……………………………………………………………………………………………………………….. 6
Cash Flow Statement: Organization……………………………………………………………………………………………. 6
Cash Flows………………………………………………………………………………………………………………………………. 6
Financial Statements Analysis ……………………………………………………………………………………………………….. 7
Financial Ratios and Company Performance ……………………………………………………………………………….. 7
Liquidity ratios……………………………………………………………………………………………………………………… 7
Efficiency ratios ……………………………………………………………………………………………………………………. 7
Leverage (debt) ratios …………………………………………………………………………………………………………… 8
Profitability ratios ………………………………………………………………………………………………………………… 8
Market value ratios ………………………………………………………………………………………………………………. 8
DuPont Equation ……………………………………………………………………………………………………………………… 8
Problems/Exercises ……………………………………………………………………………………………………………………… 9
Chapter 3…………………………………………………………………………………………………………………………….. 9
Chapter 4…………………………………………………………………………………………………………………………….. 9
Solutions ……………………………………………………………………………………………………………………………………. 9
Questions and Problems, Intermediate, 3.18 …………………………………………………………………………… 9
Questions and Problems, Intermediate, 3.21 …………………………………………………………………………. 10
Questions and Problems, Intermediate, 3.26 …………………………………………………………………………. 10
Questions and Problems, Advanced, 4.31 ……………………………………………………………………………… 11
Project 1 Review and Practice Guide
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The Basics of Financial Statements
Purpose of Financial Statements
To provide a foundation for evaluating the financial health of a company
Who Can Use Financial Statements?
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•
•
•
•
•
•
•
customers
general public
government/regulators
suppliers
creditors
employees
management
stockholders
Generally Accepted Accounting Principles (GAAP)
•
•
Rules developed by the Financial Accounting Standards Board (FASB) that public companies
must abide by in developing financial statements and reporting results
Authorized by the Securities and Exchange Commission (SEC)
Annual Report
•
•
A summary of an organization’s performance over the course of a fiscal year
Usually includes three parts:
o a discussion of the business and its properties, risk factors, and legal proceedings
o equity-related issues, an analysis of the organization’s performance, market-risk exposure,
and audited financial statements
o corporate governance
Key Financial Statements
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•
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Balance sheet—snapshot of a company’s assets and funding at a point in time
Income statement—a statement showing a company’s profitability for a specific reporting
period (month, quarter, etc.)
Cash flow statement—summarizes the cash inflows and outflows from a company’s operations,
investments, and financing activities during a specific period
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The Balance Sheet
Two Sides of Balance Sheet
•
•
Left side—assets a firm owns and uses to generate revenue
Right side—sources of the funds used to acquire assets
assets = liabilities + owners’ (stockholders’) equity
Net Working Capital
net working capital = total current assets − total current liabilities
Order of Items on the Balance Sheet
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Assets listed in order of liquidity
Liabilities listed in order in which they are due to be paid
Stockholders’ equity listed last
o Common stockholders are entitled to assets remaining after all other providers of funds
are paid.
Income Statements
The Income Statement
Shows a company’s profitability during a specific reporting period (month, quarter, etc.)
net income = revenue − expenses
o
o
Revenue—includes both cash and credit sales of a company’s products and/or services
Expenses—costs of producing or providing products and services, as well as
depreciation and amortization of assets used
Profit and Loss: Four Key Equations
•
Profitability
net income = revenue − cost of goods sold − expenses − taxes
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•
Revenue
revenue − cost of goods sold = gross profit (gross margin)
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Expenses
gross profit − expenses = operating income
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Net Income
operating income − taxes = net income
Income Statement: Depreciation
The cost of a physical asset like a plant or machinery written off over the lifetime of the asset.
Depreciation is a noncash expense.
Two methods of depreciation
▪
▪
straight-line
accelerated
A company may choose one method for internal documentation and the other for tax purposes or
publicly available reports.
Income Statement: Amortization
A noncash expense associated with intangible assets
•
Examples
o Goodwill
o Patents
o Licenses
Income Statement: EBITDA & EBIT
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Earnings before interest, taxes, depreciation, and amortization (EBITDA)
o income from selling goods and services minus the cost of providing them
Earnings before interest and taxes (EBIT)
o EBITDA minus depreciation and amortization
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Statement of Cash Flows
Cash Flow Statement
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•
Operating activities, investing activities, and financing activities generate cash flows.
The cash flow statement summarizes cash flows in and out of a company during a specified
period:
net cash flow = cash inflows − cash outflows
Cash Flow Statement: Organization
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Cash at the beginning of the period
Operating activities
Investing activities
Financing activities
Cash at the end of the period
Net increase or
decrease in cash
Cash Flows
•
Statement of Cash Flows organization
o Operating Activities
▪ cash inflows
❑ sell goods and services
▪ cash outflows
❑ raw materials
❑ inventory
❑ salaries and wages
❑ utilities
❑ rent
o Investing Activities
▪ cash outflows and inflows from
❑ buying and selling long-term assets such as plant and equipment
❑ buying and selling bonds and stocks issued by other companies
o Financing Activities
▪ cash inflows
❑ issue debt
❑ issue equity
❑ borrow money
▪ cash outflows
❑ pay interest or dividends
❑ repay loan principal
❑ purchase treasury stock
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Financial Statements Analysis
Financial Ratios and Company Performance
•
Categories of Common Financial Ratios
o Liquidity
o Efficiency
o Leverage
o Profitability
o Market value
o
Indicate a firm’s ability to pay short-term obligations with short-term assets without
endangering the company. In general, higher ratios are a favorable indicator.
Current Ratio =
Quick Ratio =
o
Current assets – Inventory
Current liabilities
Indicate a firm’s ability to use assets to produce sales. These are also called turnover
ratios. In general, higher numbers are a favorable indicator.
Inventory Turnover =
Cost of Goods Sold
Inventory
Total Asset Turnover =
o
Current assets
Current liabilities
Net Sales
Total Assets
For the efficiency ratio below, a lower number is generally a positive signal.
Days Sales in Inventory =
7
365 Days
Inventory Turnover
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o
o
o
Indicate whether a firm is using the appropriate amount of debt financing. In general,
higher ratios indicate greater potential return and greater bankruptcy risk.
Total Debt Ratio =
Total Debt
Total Assets
Debt-to-Equity =
Total Debt
Total Equity
Indicate whether a company is generating adequate profit from its assets. In general,
higher ratios indicate better performance.
Net Profit Margin =
Net Income
Net Sales
Return on Assets =
Net Income
Total Assets
Return on Equity =
Net Income
Total Equity
Indicate how the market is valuing the firm’s equity. Higher ratios indicate greater
shareholder wealth.
Price-Earnings Ratio =
Market-to-Book =
Price Per Share
Earnings Per Share
Price Per Share
Book Value of Equity Per Share
DuPont Equation
•
Return on Equity (ROE)
ROE =
Net Income
Net Sales
×
Net Sales
Total Assets
×
Total Assets
Total Equity
= Net Profit Margin x Total Asset Turnover x Equity Multiplier
Shows that return-on-equity is driven by profitability, operating efficiency, and amount of leverage
(debt)
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Problems/Exercises
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Self-study problems
Questions and Problems, Intermediate, 3.18 (Balance sheet)
Questions and Problems, Intermediate, 3.21 (Income statement)
Questions and Problems, Intermediate, 3.26 (Cash flows)
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Self-study problems 4.1–4.5
Questions and Problems, Advanced, 4.31
Solutions
Blackwell Automotive Inc.
Balance Sheet as of December 31
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Nimitz Rental Company
Income Statement as of March 31
Amount
Revenues
$878,412
General and administrative expenses
352,666
Leasing expenses
108,195
EBITDA
$417,551
Depreciation expenses
131,455
EBIT
$286,096
Interest expenses
78,122
EBT
$207,974
Taxes (34%)
70,711
Net income
$137,263
Cash flow: Refer to the information in Problem 3.21
Cash flow from operations = Net income + Depreciation
= $137,263 + $131,45
= $268,718
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Ratio
Industry Average
Nederland
Current ratio
2.05
0.77
Quick ratio
0.78
0.57
Gross margin
23.9%
51.2%
Net Profit margin
12.3%
12.6%
Debt ratio
0.23
0.70
Long-term debt to equity
0.98
0.73
Interest coverage
5.62
20.6
ROA
5.3%
11.4%
ROE
18.8%
37.5%
Source: Based on information in Parrino, Kidwell, & Bates (2012)
Now that you have read this Review and Practice Guide and completed
the problems and exercises, you are ready to participate in the
discussion in Step 3.
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