Analyzing an Annual Report

(or AAARP, analyzing an annual report by paul)

(Are the statements aggregated or detailed? Do they report details in the footnotes? Is the report
easy to read?)

Income Statement
1. What is the growth in revenues? (Aggregate or detailed revenues?)
2. Margins over time (you may need to compute these)
a. Gross margin percentage
b. Operating margin percentage
c. Income continuing operations
d. Profit margin (net income)
3. How much does an expense need to change to increase EPS by a penny?

Balance Sheet

1. What is the debt structure? (debt to assets)

2. What is the current ratio (and the change in the ratio)?
3. What is the change in equity?
4. What are the largest two or three assets?
5. What are the largest two or three liabilities?

The Statement of Cash Flows

1. What is the trend in net income to the trend in cash from operations (CFO)?
2. What is the ratio of CFO to net income?
3. What is the comparison of (CFO less capital expenditures) to net income?
4. Is CFO greater than CFI?

Footnotes

1. What are the major accounting methods (inventory, depreciation, etc.)?

2. How do they and when do they recognize revenue? How fast do they collect the cash?
3. What are their major estimated expenses (bad debts, obsolete inventory, returns, etc.)?
4. When do they pay for expenses?
5. What are the commitments and contingencies?
Adding the 10-K information

Common sized income statement 2018 2017 2016

Net Sales 1.00 1.00 1.00
Cost of sales 0.60 0.63 0.53
Gross Profit 0.40 0.37 0.47

A. Revenue analysis
1. How do they recognize revenue?
2. Examine segment footnote and item 7 MD&A (international revenue?)
3. Examine item 1 business
a. What basis do they compete?
b. Who are major competitors?
c. Segment information
B. Gross margins
1. Inventory method (if LIFO then need some adjustments)
2. Examine critical accounting policies and estimates in item 7 MD&A
a. Are Bad debts significant?
b. Is Obsolete inventory significant?
3. Examine item 15 Exhibits and financial statement schedules (valuation and qualifying
accounts)
4. Examine item 1A risk factors and item 7a Quantitative and qualitative disclosures about
market risk.

C. Cash flow analysis (see other videos)

D. Performance Graph (item 10). Is the data consistent with the graph?
E. How are executives compensated (GAAP vs Non-GAAP)? (item 11 executive compensation),
pay ratio?
 Things to consider in your analysis
1. Inflation
2. COVID
3. Supply chain disruptions
4. Revenues change because of price and volume
5. Gross margins change from changes in revenue and changes in cost of goods sold
6. Cost of goods sold changes from price and types of products sold.

Illustration of Intelligize, excel ratio sheet, and Calcbench.

Top five rising risk factors

1. Health epidemics and diseases
2. Internation trade restrictions and protectionism
3. Natural disasters, climate change & extreme weather
4. Anti-corruption law
5. Employee misconduct

Top risk factors

1. Failure to compete effectively
2. Misc business issues
3. Dependence on employees, management, and key personnel
4. Cybersecurity, data privacy, and information technology
5. Operational disruptions
 Ratios and Financial Statement Analysis
Purpose of Ratios: to reduce a large amount of historical data into a smaller and hopefully more useful
form.

Financial Comparisons
Objectives:
1. to detect changes in the financial position of the firm over time (time-series).

2. to detect differences with similar firms or with industry averages (cross-sectional).

Disadvantages:
1. There are no ‘standards’ for comparison.
2. Ratios reflect historical information.
3. Ratios are a function of accounting methods.
4. Financial statements can be manipulated.
 Ratios
1. Solvency Ratio

Current assets
Current Ratio 
Current liabilities

Interpretation: Measures the firm’s ability to cover its current liabilities

2. Activity ratios
Sales
Asset turnover 
Total assets

Sales
Receivable turnover 
Ending receivables
360 days
Average collection period 
receivableturnover ratio

Cost of goods sold

Inventory turnover 
Ending Inventory
360 days
Days supply in inventory 
inventoryturnover ratio
Interpretation:
Asset turnover: measures the firm’s ability to generate sales based on the amount of assets (or its
ability to control assets given sales); an increase implies that sales are growing faster than assets.
Receivable turnover: Measures the firm’s ability to control receivables in relation to sales; an increase
implies that sales are growing faster than receivables.
Inventory turnover: Measures the firm’s ability to control inventory in relation to sales; an increase
implies that cost of goods sold is growing faster than inventory.

What does a turnover ratio imply about the growth rates for the items used in the ratio?

Decrease in asset turnover implies? Sales growth < Asset growth

Decrease in receivable turnover implies? Sales growth < Receivable growth

Decrease in inventory turnover implies? CoGS growth < Inventory growth

3. Capitalization Ratios

Total Liabilities
Debt / Equity 
Stockholders' Equity

Long  term Debt


Stockholders' Equity

Income before interest and taxes

Times Interest Earned 
Interest expense

Cash from operations before cash interest and cash taxes

Coverage ratio 
Cash interest

Interpretation: the debt/equity ratio measures the amount of debt the firm carries and the times
interest earned or coverage ratio measures the firm’s ability to make the payments.
4. Profitability ratios

(Sales  Cost of Goods Sold)

Gross margin ratio(%) 
Sales

Net Income
Return on Sales(profit margin%) 
Sales

Net Income + (Interest expense)(1- tax rate)

Return on assets =
Total Assets

Net Income
Return on equity =
Stockholders' equity

Interpretation: Gross margin represents the markup of sales over costs; an increase indicates that sales
are growing faster than cost of goods sold.

Decomposing ROA and ROE

 Income   Income   Assets 

ROE =    
    

 Equity   Assets   Equity 

= (ROA) × (Leverage)

 Income   Income   Sales 

ROA =        
 Assets   Sales   Assets 

= (Profit margin) × (Assets Turnover)

 Income   Income   CFO 

Profit margin =    
 Sales   CFO   Sales 

= (Accruals margin) × (Cash flow margin)

Structured Ratio Analysis

Return on Equity Income Assets

ROA = Lev. 
= Assets X Equity

Income Sales
Profit margin = Asset Turnover =
Sales X Assets

Cost of goods Sold

Every Expense Gross Margin Inventory
to Sales Sales

Sales
Receivables

Expenses
Sales
Operating
Leverage Cash Flow
Analysis

Debt/Asset Current Assets

Current Liabilities
And

Cash coverage or
Times interest
earned
Empirical Evidence
Relation of ROE to ROA and Capital Structure

Capital Structure Leverage Ratio

Low Leverage Middle Third High Leverage
ROA ROE
High Chemicals (15.8%) Depart. Stores (13.9%) Telecom. (13.6%) 15.3%
ROA Paper (13.9%) Food Process. (15.1%) Grocery store (18.8%)
Publishing (15.8%)

Middle Elec. Equip. (10.4%) Textiles (7.6%) Utilities (12.4%) 10.1%

ROA Glass Prod. (9.0%) Trans. Equip (10.9%)
Metal Prod. (9.0%) Wholesalers -
Scien. Instru. (12%) durables (9.2%)
Low Industrial Equip (8.4%) Insurance (12.2%) 8.9%
ROA Oil and Gas (1.3% Petroleum (11.1%)
Primary metals (3.1%) Wholesalers –
nondur (11.7%)

ROE 12.3% 8.7% 13.5%

* Dollar General * Dollar Tree
Profit margin = 5.7% Profit margin = 1.8%
CFO/Sales = 6.8% CFO/Sales = 5.0%
Income to CFO = 0.85 Income to CFO = 0.36
Case 1
Sales remain flat from 2020 to 2021

Balance Sheet December 31 December 31 Balance Sheet December 31 December 31

ASSETS 2020 2021 ASSETS 2020 2021
Cash and cash equivalents $ 1,270 $ 1,270 Cash and cash equivalents $ 1,270 $ 13,270
Accounts receivable 37,500 37,500 Accounts receivable 37,500 37,500
Inventories 88,000 100,000 Inventories 88,000 88,000
Prepaid expenses 10,900 10,900 Prepaid expenses 10,900 10,900
Total current assets 137,670 149,670 Total current assets 137,670 149,670

LIABILITIES LIABILITIES
Accounts payable $ 29,900 $ 29,900 Accounts payable $ 29,900 $ 29,900
Accrued liabilities 17,635 17,635 Accrued liabilities 17,635 17,635
Deferred Income 5,900 5,900 Deferred Income 5,900 5,900
Line of credit 1,100 1,100 Line of credit 1,100 1,100
Total current liabilities 54,535 54,535 Total current liabilities 54,535 54,535

Current Ratio 2.52 2.74 Current Ratio 2.52 2.74

1. Which expense(s) is(are) growing faster than Revenue?
Examine the following data: Which company's drop in inventory turnover is worse?
Prior year Current year
Company A Company B Company A Company B
Cost of goods sold 10,000 10,000 12,000 12,000
Ending inventory 80 2,174 152 3,000
Inventory turnover 125 4.6 79 4

Expected inventory 96 2,609

Unexpected inventory -56 -391
As a percent of cost of goods sold -0.50% -3.30%

Expected inventory = (Cost of goods sold current year)/(inventory turnover prior year)
Unexpected inventory = Expected inventory less current year inventory.
Supporting computations
Company A
Expected inventory = 12,000/126 = 95.2
Unexpected inventory = 95.2-151.9 = -56 (0.5% of cost of goods sold)
Company B
Expected inventory = 12,000/4.5 = 2,667
Unexpected inventory = 2,667-3,000 = -333 (2.7% of cost of goods sold)

For margins, the interpretation is easier. Unexpected gross margin is how much the current years margin is different
from what the gross margin would be if the gross margin percentage did not change.
Did the company collect more or less cash in 2015 relative to 2014?

Balance Sheet January 31 Balance Sheet January 31 Balance Sheet January 31

ASSETS 2014 ASSETS 2015 ASSETS 2015
Cash and cash equivalents $ 1,270 Cash and cash equivalents $ 5,135 Cash and cash equivalents $ 5,135
Accounts receivable 37,500 Accounts receivable 42,000 Accounts receivable 44,000
Inventories 88,000 Inventories 88,000 Inventories 88,000
Prepaid expenses 10,900 Prepaid expenses 10,900 Prepaid expenses 10,900
Total current assets 137,670 Total current assets 146,035 Total current assets 146,035
Property and equipment, net 167,500 Property and equipment, net 176,465 Property and equipment, net 176,465
Other assets 90,000 Other assets 85,000 Other assets 85,000
Total assets $ 395,170 Total assets $ 407,500 Total assets $ 407,500

Income Statement Income Statement

For 2015 For 2015
Sales 501,000 Sales 551,100
Cost of goods sold 197,000 Cost of goods sold 216,700
Gross margin 304,000 Gross margin 334,400
Selling and administration 230,000 Selling and administration 253,000
Depreciation expense 2,600 Depreciation expense 2,600
Other operating expenses 1,200 Other operating expenses 1,320
Interest expense 29,484 Interest expense 29,484
Income before taxes 40,716 Income before taxes 47,996
Tax expense 14,251 Tax expense 16,799
Net Income 26,465 Net Income 31,197

% of sales uncollected 8.38% % of sales uncollected 7.98%

% of sales collected 91.62% % of sales collected 92.02%
Cash collected from cust. 496,500 Cash collected from cust. 549,100
Receivable turnover 11.93 Receivable turnover 12.53
Day 5 Breakout room problem

Here is an example of a mail-order company that primarily sells clothes. You are given four
ratios without the financial statements. See if you can answer the questions below.

1/28/00 1/29/99 1/30/98 1/31/97 2/2/96

Inventory turnover 4.48 3.43 2.79 4.27 3.38
Receivable turnover 74.3 65 81.8 128 128
Gross margin % 44.9% 44.9% 46.6% 45.5% 45.9%
Sales Growth (3.75%) 8.5% 12.9% 8.45% 3.9%

Steps
1. What happened to sales?

2. Are inventories and receivables significant?

3. Examine the gross margin. What are the implications?

4. Which year are we most concerned about? What information would you really like to have (if
I gave you one more piece of information)?