CFA Level 1 (2009) - 3

Study Session <)

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

Example: ARO Adjustments

A manufacturing firm repons all ARO liability of $100,000. In addition, the firm has a dedicated fund of $35,000 that it expects to utilize for the obligation at retirement. The firm also expects to receive income tax beneflts when the obligation is paid.

The firm reports the accretion of the ARO as an oper,uing expense in the income statement. Assuming the appropriate discount rate is 10% and the firm's tax rate is 40%, calculate the adjustments necessary to compute the debt-lO-equity ratio and the interest coverage ratio for analytical purposes.

Answer:

For calculating the debt-to-equity ratio, the ARO liability, less the expected tax savings of $40,000 ($100,000 X 40% tax rate) and the retirement fund, is treated as debt.

Thus, debt is increased $25,000 ($100,000 ARO liability - $40,000 tax savings -

$35,000 retirement fund). The result of the adjustment is an increase in the deht-LQ- equity ratio (higher numerator).

For calculating the interest coverage ratio, accretion expense of $1 0,000 ($100,000 ARO liability X 10%) is reclassified as interest expense. This is accomplished by adding $10,000 back to EBIT and adding $10,000 to interest expense. Assuming EBIT is greater than interest expense, the result is a lower interest coverage ratio.

figure 2 summarizes the ratio effects of recognizing AROs.

Figure 2: Ratio effects of AROs

Study Session 10

Cross-Reference to CFA Institute Assigned Reading #39 - Financial Analysis Techniques

~~~) Projl;'JS~r!)' Note: \/f/~ examine' IJall/{uion ratios in ilnother LOS COllc(""I'illg equity '"<.:y- III/fI)/SIJ" ata III t JI.I rCII/('W.

It should be noteo thar rhese categories are not mutually exclusive. An activity ralio such as payables lurnover may also provide informJtion abo I\( thl' liquidity of a COI11I);\I1y, for l'xample. There is no one standard Sl't of ratios for financial analysis. l)j[Tercnt analysts usc differenr ratios and difTcrclH caku!ation methods f(H similar ratios. Some ratios

are so commonly used that there is very linlc variation in how they arc ddined and calculated. We will note some alternative treatmenrs and alternative tcrms for single ratios ;lS we detail the commonly used ratios in each catcgory.

ACTIVITY RATIOS

A measure of accoulHs receivable turnover is raeivables turnol'CI':

annual sales recci vables IlIlJlOVer -- _.... '-~---

average receivables

Professor's Note: In most cases when a ratio compares a balancc shat account (ruch as rrreivablcs) with an income or cash flow item (Sitch as sales), the balance sht'ft item will be the Izvcrage ofthe account illStcad ofsimp I)' the end· ofyer" balance. Averrlges are ealwlilted by adding the bcgillning-ofyear IICCO/lllt lJalue to thc cnd-ol)'car account valuc, thm dividing the' sum by two.

It is considcred desirable (Q have a receivables rurnover figure close to the industry norm.

The inverse of the receivables turnover times 365 is the avcmge collation period, or days ofsail's outstrlnding, which is the average number of days it takes for the company's customers (Q pay their bills:

365 days of sales oustanding = ~~~~~-

receivables turnover

It is considered desirable to have a collection period (and receivables turnover) close (Q the industry norm. The firm's credit terms are another important benchmark used to interpret this ratio. A collection period that is too high might mean that customers are roo slow in paying their bills, which means too much capital is tied up in assets. A collection period that is too low might indicate that the firm's nedit policy is too rigorous, which might be hampering sales.

SUldy Session 10

Cross-Reference to CFA Institute Assigned Reading #39 - [oinanciaJ Analysis Techniques

•A measure of a firm's efFiciency with respect to its processing and inventory management is illlJi'f/tory tu9"llOlJer:

Professor)- Note: /)ay carejid allention to t/}{, numcrator ill the turnover ratios_

For imJentory turno/ler, be Stlre to lise cost ofgo ods sold, not sales.

The inverse of the inventory turnover times 365 is the average illVl'l/tU1Y processing period, number oldays olhl1l el1tOl)\ or days ofinvent01J 011 hand:

365

days of inventory on h:lI1d =

lI1vcntory turnover

As is the case with accounts receivable, it is considered desirable to have dap of inventory on h;lIld (and invemory turnover) close to the industry norm. A processing period that is too high might mean that too much capital is tied up in invcnrory and could mean that the invenrory is obsolete. A processing period that is toO low might indicate that the firm has inadequate stock on hand, which could hurt sales.

•A measure of the use of trade credit by the 11rm is the pa)'ablcs furnover ratio:

The inverse of the payables turnover ratio multiplied by 365 is the payables payment period or number ofdays ufpayables, which is the average amount of time it takes the

Prufessor's Note: we have shown days calculations fOr payables, receivables, and inventory based on annual turnover and a 365-day year. Ifturnover ratios are fOr a quarter rather than a year, the number ofdays in the quarter should be divided by the quarterly turnover ratios in order to get the "days"form of these ratios.

• The effectiveness of the firm's use of its total assets to create revenue is measured by its total asset turnover:

revenue

total asset turnover = --------

average total assets

Study Session 10

Cross-Refercncc to CFA Institutc Assigned Reading 1139 - Financial Analysis Techniqucs

Different types o(industries might have considerably dilTcrcl1l tUl"Ilover ralios. ManuEtCluring busillcsses that aretapital-intcnsive mighl have assellUl"IIOvCl" ratios lIear onc, while rctail businesses might have lurnover ratios ncar I n. As was [he case with the current assellurnover ratios discussed previously, it is desirahle for the IOLll asser turnover ratio to he close to the industry 1I0rm, Low asset turnover ratios might IllL'all rllatthe coml);IllY has tLJO much L';q)italtied up in ilS assct basL'. A lUl"IIOVer r;ltio lh;lt is too high might imply that the firm has [00 kw asselS feH potenli;li sales, or lholl the asset base i.s outdated,

•The lllili'l.atioll of fixed assets is measured by the F>:ed flsset tUr/JOller ratio:

revcnue

fixed asset turnover

average nct fixed ,lSSetS

As was thc case with the LOlal asset turnover ratio, it i,s desirable to have a fixed aSSCI \lIrnovn r;lIio close to lhc industlY Illlrm. Lo\\' fixl'd asset llllntlvcr l1li g lll IIll':lIlIILll l he company has too 111uch capiLli lied lil) in its 'ISSl'1 h,lse or i.s using lhe ;lssns it h'ls inL+filicnrly. /\ ltll'l1OVcr ratio that is 100 high llligin imply \kll rhe firm has obsolell' l'ljllipmenl, or at a minimuJn, that the firm will probably have lO incur capital expenditures in the ncar futllre to increase capacity to suPPOrt gtowing revenues. Since "net" here refels to net of accumulated depreciation, firllls with more recently acquired assets will typically have lower flxed asset tt1rtlovt'r ralios.

•How effectively a company is using its working capital is me'lsuITd hy rhe wor/'ing cilpi/rr! turnover ratio:

reven lIC w()rkin~L'apitalllll'nOVer C~ ---------

average working capital

Working capital (sometimes called net working capital) is current assets minus current liabilities. The working capital turnover ratio gives us information about thc utilization of working capital in tetms of dollars of sales per dollar of working capital. Some firms may have very low working capital if outstanding pay;lbles cqual or exceed inventnry and receivables, Tn this case the working capital turnover ratio will be very large, may vary significantly from period to period, and is less informative about changes in the firm's operating efficiency.

LIQUIDITY RATIOS

Liquidity ratios are employed by analysts to determine the firm's ability to pay its shorrterm Iiabi Ii ties,

The current rtltio is the best-known measure of liquidity:

cu rren t assets current ratio = --------

current liabilities

The higher the cllrrent ratio, the more likely it is that the company will he able to pay its short-term bills, A current ratio of less than one means that the company has

Study Session 10

Cross-Refercncc to CFA Institute Assigncd Reading #39 - Financial Analysis Tcchniqucs

negative working capital and is probably ElCing a liquidity crisis. Working capital equals currellt assets minus current liabilitics.

The quick mtio is a llIore suingelll measure of liquidity because it docs not include invellLOries and other assets that might not be very liquid:

. . cash + marketable securities + receivables qlllCk ratio == -- ' --- '

currclJt liabilities

The higher the quick ratio, the more likely it is that the company will be able to pay its shorr-tom bills. Marketable securities arc short-term debt instruments, typically liquid and of good credit quality.

Thc most conservative liquidity measure is the cash ratio:

cash ratio == cash +.._I~1;\rkctabJe securities currcllI liabilities

The higher the cash ratio, till' III(HC likely it is that thc C1ll11lnny will be able to pay its shorr-l<.:rm bills.

The current, quick, and cash ratios differ only in the assumed liquidity of the currenr assets that the analyst projeers will be used to payoff current liabilities.

The cI(fcmiue illterlJaf mho is another measure of liquidity that indicates the number of days of average cash expenditures the firm could pay with its current liquid assets:

average daily expenditures

Expenditures here include cash expenses fot costs of goods, SG&A, and research and development. If these items are taken from the income statement, noncash charges such as depreciation should be added back just as in the preparation of a statement of cash Rows hy the indirect method.

•The cash com/ersion cycle is the length of time it takes to turn the fitm's cash investment in inventory back into cash, in the form ofcolleetions from the sales of

that inventory. The cash conversion cycle is computed from days sales outstanding, days of inventory on hand, and number of days of payables:

High cash conversion cycles arc considered undesirable. A conversion cycle that is too high implies that the company has an excessive amount of capital investment in the sales process.

Srudy Session 10

Cross-Rcfcrcncc to CPA Institute Assigned Reading #39 - Financial Analysis lcchniqucs

•The remaining risk ratios help determine the firm's ability to repay irs debt obligations. The (lrst of these is the ill/crt'St cOI'crtlgl' mtio:

earnings before interest and c.\Xes ll1tercst COVL'J'age = -------,-------------

IlIlerest paymenrs

The lower this ratio, thl' more likely it is that thc fil'll1 will havc dirficulty mecting its debt paymenrs.

•A sccond ratio that is an indicator of:l company's ability [0 meet its obligations is the fixed charge COlJcrtlgl' ratio:

lIne, !c;I.,e pay 1lI1'1!IS arc added had; (() 0lwLlling c;\1'nings in the numeLllor and also added tu illll'1'est payJl1elllS in thc denolllilLllUI'. Signil1cant k;\se oLJlig;Hions wil) reduce this ratio significantly compared tu the interest coverage Lllio. Fixed charge coverage is rhe nJl)re llIeaningrul measure for companies rhat k;lse a large portion of their assets, such as some airlines.

PROFITABILITY RATIOS

•The Ilet profit mfJIgin is the ratio of nct income [0 revenue:

net ll1come

net proll t l1largi n

reven ue

Analysts should be concerned if rhis ratio is too low. The net profit margin should bc based on net income from continuing operations, because analysts should be primarily concerned about future expectations, and "below the line" items such as discontinued operations will not affect the company in the future.

Operating profitability ratios look at how good l11anageme11l is at luming their efforls into profits. Operating ratios compare the rap of the income slateme11l (sales) lO profits. The different ratios are designed ra isolate specific cosrs.

Know these terms:

Sludy Session 10

Cross-Refercnce to CFA Institute Assigned Reading #39 - Financial Analysis Techniqucs

How they rdftle in the income Jtfltemmt:

Nel sales

COSl of goods sold

Cross profit

OpeLlling cxpcnses

OpeLlling p;.-z)7i~-(EBTTT~-"-------

[merest

Earnings before taxes (EBT)

'E!xes

Earnings after [axes (EAT)

+/- Below the line jtems adjusted f(H [ax

Net incomc

Preferred dividends

Incomc availahle [0 common

The gross pm/it IWIIKin is rhe ratio of gross PIOf\t (sales less cost 0\" goods sold) [0 sales:

gross profit gross profit margin = "'---'----

revenue

An analyst should he concerned if this ratio is roo low.

The operating profit mmgin is the ratio of operating profit (gross proflr less selling, general, and administrative expenses) to sales. Operating profit is also referred to as earnings before interest and taxes (EBIT):

Strictly speaking, EBIT includes some nonoperating items, such as gains on investment. The analyst, as with other ratios with various formulations, must be consistent in his calculation method and know how published ratios arc calculated. Analysts should be concerned if this ratio is lOO low. Some analysts prefer to calculate the operating profit margin by adding back depreciation and any amortization expense to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA).

Sometimes profitability is measured using earnings before tax (EBT), which can be calculated by subtracting interest from EBIT or from operating earnings. The pretax margin is calculated as:

EBT pretax marglJ1 = ---

revenue

Another set of profitability ratios measure profitability relative to funds invested in the company by common stockholders, preferred stockholders, and suppliers of debt financing.

Study Session 10

Cross-Reference to efA Institute Assigned Reading #39 - Financial Analysis lechniques

The Ilrst of these mcasurcs is thc return on assets (ROA). Typically, ROA is calculatcd

. . I

USlllg net Income:

ncr lIlcome re(Urn on asscts (ROA) = --------

average (Otal assets

This measure is a bit miskading, however, because inren:st is excluded from nct income but rotal assets include debt as well as equity. Adding inren:st adjusred for tax back to net income puts the returns (0 both equity and debt holders in the numerator. This rcsulrs in an alternative calculation for ROA:

net income + in terest expensc (1 - tax rate) rerum on assets (RC)A) = --------------''---------

""~rage (Otal assets

A mcasure of return on assets that includes both taxes and inrerest in the nUll1eraror is the opemting return

•The return on total capital (ROTC) is the ratio of net income before inrerest and taxes to (Otal capital:

EBIT

return on tOtal capital =

average (Otal capital

Toral capital includes shorrand long-term debt, preferred equity, and common equity. Analysts should be concerned if this ratio is roo low. Total capital is the same as (Otal assets. The interest expense that should be added back is gross interest expense, not net interest expense (which is gross inrerest expense less interest income).

An alrernative method for computing ROTC is (0 include the present value of operating leases on the balance sheet as a fixed asset and as a long-term liability. This adjustmenr is especially important for firms that are dependent on operating leases as a major form of financing. Calculations related to leasing were discussed in an earlier Study Session.

•The return on equity (ROE) is the ratio of net income to average lOtal equity (including preferred srock):

net I11come

rerum on eqUIty =

average total equity

Analysts should be concerned if this ratio is (00 low. It is sometimes called rerum on (Otal equity.

Study Session 10

Cross-Reference to CPA Institute Assigned Reading #39 - Financial Analysis Techniques

• A similar ratio to the return on equity is the return on common ('qllity:

, net incol11e ~- preferred dividends return on common eqtllty = ,

average cornman equJ(y

net income ~\\'ailahle ro common average C0l111110n equity

This ratio differs from the return 01; S5lta~:~qtijty in(h'!t~t,only measures the accounting profits available to, anti;~hetapjtahiI1V~Srcdb}',;col11~1()'I\_.<;[~~~holders,

instead of common. and preferred

deducted from net I!lcome III the (llt~Jtsl,lh/~JJ.-aYsts'shO'uldbe concerned It thIS

The return on common equity is often marc thoroughly an~~iyzdausi;lgthe DUPOIll decomposition, which is described bter in this topic review.

I,C)\ YJ.d: !)('illOnSlr;\[e how ratios are relal\'d ::11<1 how 10 eva!uale a company using a combination of different ratios.

Example: Using ratios to evaluate a company

A balance sheet and income statement for a hypothetical company are shown below for this year and the previous year.

Using the company information provided, calculate the current year ratios. Discuss how these ratios compare with the company's performance last year and with the industry's performance.