FINANCIAL STATEMENTS & RATIO ANALYSIS
Three Financial Statements are important to understand: 1) the Balance Sheet, 2) the Income Statement, and 3) the Statement of Cash Flows.[1]
The financial statements for Staples, a fortune 500 company based in Framingham, MA, are discussed below.
Balance Sheet - The balance sheet offers a snapshot of the company’s financial position.
Assets are what the company owns. These items are listed in order of liquidity. For example cash is the most liquid asset - as of February 3, 2007 Staples could write checks totaling just over 1 billion dollars. (Note: an example of a “cash equivalent” is Merrill Lynch’s money market account).
· Current Assets – must be converted to cash within a year.
o Examples: cash, short-term investments, accounts receivables, and inventories.
· Non-current Assets – everything with value but that is less liquid.
o Examples: property, plant and equipment (PPE), goodwill, and intangible assets (i.e. intellectual property - items such as patents, trademarks, copyrights, business methodologies).
Liabilities are what the company owes. These items are listed in the order they must be paid.
· Current liabilities – must be paid with a year. For example, when Staples purchases supplies, it doesn’t immediately pay the suppliers.
o Examples: accounts payable (A/P), short-term debt, and the current portion of long term debt.
· Long-term Liabilities – due beyond a year’s time. For example, Staples has over $300M in long-term notes due in 2012.
Equity is a residual claim. Retained earnings are part of equity; these are earnings that have not been paid out as dividends. The stockholders’ equity listed on the balance sheet is the book value of equity. As of February 3, 2007 Staples reports 720,528,000 (weighted-average) common shares outstanding.[2]
(Assets – Liabilities) = Equity
Figure 1: Staples (Ticker: SPLS) - Balance Sheet
Source: Company 10K
Income Statement – (a.k.a. “statement of income,” “statement of earnings,” “statement of operations,” “profit and loss statement,” and “statement of operating results”) – The income statement reflects the company’s performance over the past year.
Figure 2: Staples (Ticker: SPLS) - Income Statement
Source: Company 10K
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)[3]
· EBITDA is calculated by taking operating profit and adding back depreciation and amortization expenses.
· Because it eliminates the effects of financing and accounting decisions, EBITDA can provide a relatively good "apples-to-apples" comparison of the profitability of companies across industries.
· For example, EBITDA as a percent of sales (the higher the ratio, the higher the profitability) can be used to find companies that are the most efficient operators in an industry.
· EBITDA is a good measure to use to evaluate the core profit trends, but cash is king – by looking at changes in working capital, the "true" profitability and a company's ability to continue operations are revealed.
Earnings, Before Interest and Taxes (EBIT)
EBIT = Revenue - Operating Expenses
Staples reports a 2007 EBIT of $1,519,138.
Net Income - A company’s “net income” is revenues minus costs. Synonyms for “net income” include: profit, earnings, and bottom line.
Staples 10K NOTE J Computation of Earnings per Common Share
Statement of Cash Flows - The statement of cash flows summaries the companies operating, investing, and financing activities. It summarizes how the company spends income (i.e. to pay dividends, increase inventory, finance accounts receivable, invest in fixed assets, reduce debt, and buy back common stock).
Operating Activities include depreciation, adjustments to net income, changes in accounts receivables, liabilities, and inventories.
Note: Net cash flow provided by operating activities is the most important figure in any of the financial statements.
Investing Activities include sales of fixed assets and short-term financial investments.
Financing Activities include dividends paid, sale (or purchase) of stock, and debt.
Figure 3: Staples (Ticker: SPLS) - Cash Flow Statement
Source: Company 10K
Two charges reflect the estimated costs of assets that have been used over the past year. These items reduce net income, but are not paid out in cash.
- Depreciation is a charge that applies to tangible assets, such as plant and equipment.
- Amortization is a charge that applies to intangible assets, such as patents, copyrights, trademarks, and goodwill.
Note: If the depreciation expense were not taken, profits would be overstated and taxes would be too high.
Example: Depreciation
· Suppose that Staples purchased a machine with a life of 5 years for $100,000 at the end of 2006. If the machine went into service in 2007 the cost of the machine would charged against production, for each of the next 5 years (i.e. the depreciable life of the asset).
· Depreciation is a noncash charge (the actual cash flow occurred in 2006) so it must be added back to net income to obtain the net cash flow.
RATIO ANALYSIS
1) Liquidity Ratios – Answers the question: Can the company make required payments as they fall due?
Current Ratio[4] – the ability to meet short term obligations. “Generally, a high Current Ratio indicates the company has enough liquid assets to continue normal operations.” This is the most commonly used measure of short-term solvency.
Quick Ratio (Acid Test) – the ability to meet short term obligations without relying on the sale of inventory.
Note: Thomson ONE Banker uses the following Worldscope definition:
QUICK RATIO = (Cash & Equivalents + Receivables (Net)) / Total Current Liabilities
Table 1: Liquidity Ratios for Staples
Sources and Notes: Data for calculations comes from Thomson ONE historical financials and the Company’s most recent 10K. Inventory figures were unavailable for 1999. (T) indicates the Thomson ONE formula;[5] yellow highlight indicates calculated figure equals the figures provided by Thomson ONE.
Analysis: The historical data shows the current ratio was at its highest in ’98 and that that the quick ratio peaked during ’05 and ’06. Both ratios were decreasing from ’06 to ’07. The difference in the two ratios is a result of inventory, Staples relies heavily on the sale of inventory to meet short-term financial obligations. Creditors like to see high liquidity ratios, it means the company has short-term solvency. Investors may see high liquidity ratios as an indication that the firm has money tied up in non productive assets (such as cash). A chart showing the liquidity trends is provided below.
Chart 1: Liquidity Ratios for Staples
Source: Data compiled from Thomson ONE and the most recent 10K
2) Asset Management Ratios – Answers the question: Does the company have the right amount of assets for the level of sales?
Inventory Turnover Ratio (Inventories Days Held) – measures how many times per year inventory is turned into profits.
Days Sales Outstanding Ratio – measures the average number of days from sale until cash received.
Note: Thomson ONE Banker uses the following SEC definition:
RECEIVABLES DAY SALES = (Receivables X 360)/Net Sales
Fixed Asset Turnover Ratio - measures how effectively the firm uses its plant and equipment.
Note: “Net Fixed Assets” often refers to “property and equipment” or just “plant.” A fixed asset is defined as “A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be consumed or converted into cash any sooner than at least one year's time.” Examples include: plants, buildings, real estate, equipment and furniture. “Generally, intangible long-term assets such as trademarks and patents are not categorized as fixed assets but are more specifically referred to as ‘fixed intangible assets.’”[6]
Total Asset Turnover Ratio - measures the turnover of all of the firm’s assets.
Note: Thomson ONE Banker uses the following Worldscope definition[7]:
TOTAL ASSET TURNOVER = Net Sales or Revenues / Total Assets
Table 2: Asset Management Ratios for Staples
Sources and Notes: Data for calculations comes from Thomson ONE historical financials and the Company’s most recent 10K. Inventory figures were unavailable for 1999. (T) indicates the Thomson ONE formula; yellow highlight indicates calculated figure equals the figures provided by Thomson ONE.
Analysis: Inventory turnover has been increasing since ’03 but the average number of days from the sale until the cash is received (days sales outstanding or receivables day sales) is also increasing. At the same time, the fixed asset turnover and total asset turnover have stayed the same, indicating that the firm has not increased its effectiveness of assets. A chart showing the asset management trends is provided below.
Chart 2: Asset Management Ratios for Staples
Source: Data compiled from Thomson ONE and the most recent 10K
3) Debt Management Ratios – Answers the question: Does the company have the right mix of debt and equity?
Debt Ratio – total liabilities to total assets, how the firm is financed, it measurers the proportion of company assets provided by or owned by creditors.
Note: Creditors prefer low debt ratios to cushion against losses in the event of liquidation, while stockholders prefer higher debt ratios because it can magnify expected earnings.
Times Interest Earned Ratio – the ability to pay interest expense, it measures the extent to which operating income can decline before the firm in unable to meet its annual interest costs.
where, EBIT equals “operating income.”
Note: Thomson ONE Banker uses the following SEC definition[8]:
TIMES INTEREST EARNED = (Interest Expense + Income Before Tax)/Interest Expense
Note: The SEC calculates Earnings Before Interest and Taxes (EBIT) by taking the pretax income and adding back interest expense on debt and subtracting interest capitalized.
EBITDA Coverage Ratio – also the ability to service debt, but it accounts for two shortfalls in the TIE (i.e. lease payments and depreciation/amortization charges).
Note: The SEC defines Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) as: (Gross Profit - R&D Expenditures - Selling, General & Administrative Expenses + Non-Operating Income) + Depreciation & Amortization. For Staples this is equal to Income Before Minority Income Taxes and Minority Interest plus Depreciation. The calculation is displayed in the figure below.
Figure 4: EBITDA Calculation for Staples
Note: Lease payments are found by searching the notes to the 10K. The figure used in the equation above, came from the table below.
Table 4: Minimum Lease Commitments due for Retail and Support Facilities
Source: Company 10K, “Notes to Consolidated Statements” pp. C13-C14.
Note: Principal Payments are also found be searching the 10K. The figure used in the equation above came from the table below.
Table 5: Debt and Principal Payments Due within 1 Year
Source: Company 10K, “Management Discussion and Analysis” pp. B7-B8.
Table 6: Debt Management Ratios for Staples
Sources and Notes: Data for calculations comes from Thomson ONE historical financials and the Company’s most recent 10K. EBITDA Coverage Ratio was calculated for the most recent year. (T) indicates the Thomson ONE formula; yellow highlight indicates calculated figure equals the figures provided by Thomson ONE.
Analysis (1 of 2): The debt ratio has been decreasing indicating that the firm’s debt is decreasing as a percent of total assets. Creditors like a lower debt ratio because it indicates that the firm has more of a “cushion” in the case of liquidation. Stockholders may want more leverage because it magnifies expected earnings. The chart below displays the Debt Ratio for staples over the past 10 years.
Chart 3b: Debt Ratio for Staples
Source: Data compiled from Thomson ONE and the most recent 10K
Analysis (2 of 2): The Times Interest Earned ratio for Staples has recently increased to ’03 levels. Staples has decreasing levels of debt and is becoming increasingly capable of covering interest charges. The figure below displays Staples TIE Ratio over the past 10 years.
Chart 3a: Times Interest Earned Ratios for Staples
Source: Data compiled from Thomson ONE and the most recent 10K
4) Profitability Ratios – Answers the question: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
Profit Margin on Sales – measures the profit per dollar of sales.
Basic Earning Power – measures the earning power of the firm’s assets before the influence of taxes and leverage.
Return on Assets (ROA) – measures the return on assets after interest and taxes. “This Profitability ratio assesses the profitability of a business in relation to its assets at a given point in time. Generally, the higher the return on assets, the more skillfully management is using its resources.”[9]
Note: Thomson ONE Banker uses the following SEC definition[10]:
NET INCOME TO TOTAL ASSETS = Net Income/Total Assets
Equity Multiplier – This measurement can indicate over-or under-investment of the company by shareholders.[11] The more leverage the less equity, hence a lower equity multiplier.
Note: Thomson ONE Banker uses the following SEC definition:
TOTAL ASSETS/EQUITY = Total Assets/Shareholder Equity
Return on Equity (ROE) – This ratio shows the relationship between common shares equity to net income and reflects how well the stockholders are doing in an accounting sense.
Note: Thomson ONE Banker uses the following SEC definition:
NET INCOME TO COMMON EQUITY = Net Income/(Shareholders’ Equity- Minority Interest (Liabilities)-Preferred Stock)
Table 7: Profitability Ratios for Staples
Sources and Notes: Data for calculations comes from Thomson ONE historical financials and the Company’s most recent 10K. (T) indicates the Thomson ONE formula; yellow highlight indicates calculated figure equals the figures provided by Thomson ONE.
Analysis: Staples profit per dollar of sales (Profit Margin on Sales) has been increasing. This is a good sign, indicating that Staples is managing expenses. This sentiment is also reflected in the basic earning power ratio and in ROA. The firm’s ROE is also higher, indicating that the firm has more net income per share of common stock. The equity multiplier has been decreasing indicating that the firm is using less debt today than it has in the past. In fact all profitability ratios for Staples were at the highest point in 10 years as of 2007. The chart below reflects these trends.