Analyzing and Interpreting Financial Statements

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eas70119 mod03 qxd 2 9 05 1 32 PM Page 3,Roslan Rahman. Getty Images, 3M s increase in ROE has been accompanied by a steady increase in its stock price By early 2005 3M. shares were valued at just over 82 per share which is 35 higher than when McNerney took control The. Dow Jones Industrial Average by contrast shows no net percent increase for the same time period. What is McNerney s secret There is no doubt that one of McNerney s most urgent problems at 3M was. its ballooning costs Costs had grown at twice the rate of sales in the years prior to his arrival McNerney s cost. control efforts generated an immediate savings of 500 million in 2001 That same year he also streamlined. purchasing which generated another 100 million in savings. One key to cost savings at 3M is its Six Sigma cost cutting program which was successfully applied at GE. and a number of other companies now led by former GE executives 3M is using Six Sigma for everything from. focusing sales efforts to developing new kinds of duct tape. McNerney s efforts are paying off In 2003 sales rose in each of 3M s businesses except telecom and in. come was up in all but the industrial division Further cash flows swelled by 29 to 3 79 billion and 3M s. Continued on next page,eas70119 mod03 qxd 2 9 05 1 32 PM Page 4. 3 3 Module 3 Analyzing and Interpreting Financial Statements. Continued from previous page, operating income margin widened by a full percentage point to nearly 21 3M also increased its inventory. turnover which contributed greatly to its increases in cash flows and profitability. McNerney has also increased acquisitions by 3M He hopes to use acquisitions to help grow sales 10. annually nearly double the rate of the past decade Fortunately for McNerney 3M has the cash flows and the. flexibility necessary to go shopping, 3M has funded its cash outflows for acquisitions in part with cash inflows from improved working capital.
management For example 3M s average collection period for its receivables has been reduced from 63 days. in 1999 to 52 days in 2003 Increased production efficiencies and lower cost raw materials have boosted in. ventory turnover from 3 8 times per year to 5 0 times since McNerney took control As a result the working. capital needed to run 3M has declined as a percent of sales boosting both income and cash flows. 3M s management has brought operating discipline to the business including a renewed focus on mea. sures used to evaluate financial performance This module focuses on such measures A key to company suc. cess is ROE This module explains ROE and focuses on disaggregation of ROE also called DuPont analysis. after DuPont management that first successfully applied it ROE disaggregation focuses on the drivers of. ROE This module also introduces liquidity and solvency analysis another important aspect of company suc. cess Specifically we describe the factors relevant to credit analysis and its use in setting debt ratings and terms. Sources BusinessWeek April 2004 and August 2002 Financial Times July 2002 Fortune Magazine August 2002 3M 10 K report 2004. INTRODUCTION, ffective financial statement analysis and interpretation begin with an understanding of the kinds of. questions that are both important and can be aided by financial analysis Then determining which. questions to ask is a function of the type of analysis we plan to conduct Different stakeholders of a. company have different analysis requirements Consider the following. Stakeholder Types of Questions Guiding Analysis of Financial Statements. Creditor Can the company pay the interest and principal on its debt Does the company rely too much on. nonowner financing, Investor Does the company earn an acceptable return on invested capital Is the gross profit margin. growing or shrinking Does the company effectively use nonowner financing. Manager Are costs under control Are company markets growing or shrinking Do observed changes. reflect opportunities or threats Is the allocation of investment across different assets too high or. A crucial aspect of analysis is identifying the business activities that drive company success Namely does. company return on invested capital result from operating activities or nonoperating often called financial. activities The distinction between operating and nonoperating activities is important as it plays a key role. in effective analysis, Operating activities are the core activities of a company They are the activities required to deliver a. company s products or services to its customers Operating activities include research and development of. products the establishment of supply chains the assemblage of administrative and productive product. support the promotion and marketing of products and after sale customer services. Operating activities are reflected on the balance sheet for example by receivables and inventories net. of payables and accruals and by long term operating assets net of long term operating liabilities On the. income statement operating activities are reflected in revenues costs of goods sold and operating ex. penses such as selling general and administrative expenses Operating activities have the most long last. ing persistent effects on the future profitability and cash flows of the company and thus are the primary. value drivers for company stakeholders It is for this reason that operating activities play such a prominent. role in effective profitability analysis, Nonoperating activities primarily relate to the investing and financing activities of a company They. are reflected on the balance sheet as nonoperating financial assets and liabilities which expand and con. tract as a buffer to fluctuations in operating asset and liability levels When operating assets grow faster. than operating liabilities nonoperating liabilities must increase to finance them per the accounting equa. eas70119 mod03 qxd 2 9 05 1 32 PM Page 5, Module 3 Analyzing and Interpreting Financial Statements 3 4.
tion These liabilities contract when assets decline and can even turn negative resulting in financial as. sets invested temporarily in marketable securities to provide some return until those funds are needed. again for operations On the income statement nonoperating activities are reflected in expenses and rev. enues from those financial liabilities and assets Although nonoperating activities are important and must. be carefully managed they are not the value drivers. Module 1 introduced a simple measure of financial performance called return on assets ROA de. fined as net income divided by average total assets ROA is a widely quoted measure and for that reason. it is one we should know Net income in the ROA formula however is an aggregation of both operating. and nonoperating components Accordingly it fails to distinguish between these two important activities. and drivers of company performance Likewise total assets combine both operating and nonoperating as. sets and liabilities 1 Effective analysis segregates operating and nonoperating activities and consequently. we describe the return on net operating assets RNOA that is arguably more informative. This module s explanation of financial statement analysis begins at the most aggregate level and works. down to three levels of disaggregation The most aggregate level is return on equity ROE which is gen. erally regarded as the summary measure of financial performance ROE is then disaggregated into key dri. vers of profitability and asset utilization The framework of ROE disaggregation is depicted in Exhibit 3 1. EXHIBIT 3 1 Return on Equity ROE Disaggregation,Return on Equity. Return from Return from,Operating Activities Nonoperating Activities. Return on Net,Operating Assets Financial Leverage Spread. Level 2 Profitability Asset Utilization,Level 3 Profitability Analysis Turnover Analysis. ROE disaggregation serves to answer several important questions in analyzing financial performance Ex. amples are, What is driving the company s financial performance.
Is it related solely to profitability, What aspects of company profitability are important. Is the company effectively managing its balance sheet investing and financing activities. Is the company relying more on operating or nonoperating activities. Do its assets generate sufficient revenues, These are but a sampling of questions that an analysis of ROE through its disaggregation can help answer. The first level of disaggregation separates ROE into two basic drivers return from operating activities. and return from nonoperating activities This identifies drivers by business activities The second level of. analysis examines the drivers of return on operating activities profitability and asset utilization A third. level of disaggregation explores both of those components of return on operating activities for further in. sights into the drivers of company performance, After a complete explanation of ROE disaggregation we conclude the module with a discussion of. credit analysis A major part of credit analysis involves liquidity and solvency assessments As part of that. discussion we identify the ratios typically used to determine bond investment ratings a key determinant. An alternate definition for return on assets is ROA Net income After tax interest expense Average total assets While the. numerator in this formulation seeks to focus on operating income the denominator total assets still includes nonoperating. financial components,eas70119 mod03 qxd 2 9 05 1 32 PM Page 6. 3 5 Module 3 Analyzing and Interpreting Financial Statements. of both bond prices and the cost of debt financing for many companies In that spirit we also introduce. and describe bankruptcy prediction,RETURN ON EQUITY ROE.
Return on equity ROE is the ultimate measure of performance from the shareholders perspective It is. computed as follows,ROE Net Income Average Equity, Net income is the bottom line from the income statement Net income includes revenues from all sources. both operating and nonoperating It also includes expenses from all sources including cost of goods sold. selling general and administrative expenses and nonoperating financial expenses like interest 2. ROE is disaggregated into operating and nonoperating components as follows see Appendix 3B for. its derivation,Return from Return from,Operating Activities Nonoperating Activities. RNOA FLEV Spread, This is an important disaggregation and the definitions for these variables along with their typical com. ponents are in Exhibit 3 2 this table includes additional variables that are subsequently defined The. above formula emphasizes the two key drivers of ROE operating RNOA and nonoperating FLEV. Spread activities Stakeholders prefer ROE to be driven by operating activities. EXHIBIT 3 2 Key Ratio Definitions,Ratio Definition. ROE return on equity Net Income Average Equity, RNOA return on net operating assets NOPAT Average NOA.
NOPAT net operating profit after tax Sales and other operating revenues less operating expenses such as. cost of sales taxes selling general and administrative it excludes. nonoperating revenues and expenses such as those from financial. assets and liabilities, NOA net operating assets Current and long term operating assets less current and long term. operating liabilities it excludes investments in securities short and. long term interest bearing debt and capitalized lease obligations. FLEV financial leverage NFO Average Equity, NFO net financial obligations Financial nonoperating obligations less financial nonoperating assets. Spread RNOA NFR,NFR net financial rate NFE Average NFO. NFE net financial expense NOPAT Net income it includes interest expense less revenues from. nonoperating assets net of tax, For a recent 34 year period the median ROE achieved by all publicly traded U S companies was. 12 2 from Nissim and Penman 2001 Most of this ROE is driven by RNOA as illustrated in the fol. lowing table of median values for those companies and years. ROE Disaggregation ROE RNOA FLEV Spread,1st quartile 25th percentile 6 3 6 0 0 05 0 5.
Median 50th percentile 12 2 10 3 0 40 3 3,3rd quartile 75th percentile 17 6 15 6 0 93 10 3. Numbers in the table are medians 50th percentile and quartiles 25th or 75th percentile thus the equation does not. exactly equal ROE, Net income does not include dividend payments as they are not a deductible expense in the computation of GAAP income. instead dividends are considered a distribution of income. eas70119 mod03 qxd 2 9 05 1 32 PM Page 7, Module 3 Analyzing and Interpreting Financial Statements 3 6. This table shows that companies are on average conservatively financed with a greater proportion of. equity than net financial obligations evident from FLEV 1 0 Also companies earn on average a. positive spread on borrowed monies 3 3 This is not always the case however as evidenced by. the lowest 25 of companies Most important RNOA is on average approximately 84 of ROE. BUSINESS INSIGHT 3M s Return on Equity Breakdown, The following graph shows that 3M s ROE and RNOA have increased steadily since 1999 with the ex. ception of 2001 which was impacted by costs of its restructuring program. 2003 2002 2001 2000 1999, ROE exceeds RNOA in all years The difference between ROE and RNOA lines is the return from non.
operating activities FLEV Spread Since ROE exceeds RNOA for 3M it shows that 3M is on average. 3 3 Module 3 Analyzing and Interpreting Financial Statements operating income margin widened by a full percentage point to nearly 21 3M also increased its inventory turnover which contributed greatly to its increases in cash flows and profitability

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