The Finance Toolkit Revised 2016 Prepared for the College of Business Community Northern Illinois University

Transcription

1 The Finance Toolkit Revised 2016 Prepared for the College of Business Community Northern Illinois University By Dr. James M. Johnson, Ph.D. Presidential Professor of Finance Northern Illinois University 1

2 Introduction The Finance Toolkit is the result of many discussions among faculty in the College of Business over a number of years. There has been a desire to build tools that students may use throughout their careers in the College of Business and after they graduate. Several courses require students to understand financial statements, financial analysis, financing, and break-even analysis. This Toolkit provides a reference for students who need a handy resource to help them in their journey through the College of Business. This is resource of the College, and is available to anyone in the NIU community. Faculty may choose to use it, or refer students to it as an efficient refresher of the basic concepts contained herein. Faculty may also use the more than two hundred review questions in any manner they wish. The Finance Toolkit uses the same definitions and concepts that every student encountered in UBUS 310 and UBUS 311. This allows students to efficiently review concepts without being required to learn an entirely new set of notation or definitions. The College of Business is confident that students will move through their NIU business journey more easily by having this resource at their disposal. 2

3 Content of the Finance Toolkit The content contained in this Toolkit is the result of discussions by business faculty regarding subject matter that students need throughout their coursework. The top subjects identified through these discussions are the following: How to Read Financial Statements o Balance sheet o Income statement o Statement of cash flows Analysis of Financial Statements o Common size analysis o Peer common size analysis o Financial ratio analysis Liquidity Activity Leverage Profitability o Peer group financial ratio analysis Liquidity Activity Leverage Profitability Long-Term Financing Decisions o Cost of debt versus equity o Flexibility of debt and equity o Profitability considerations of debt and equity Break-Even Analysis 3

4 Table of Contents How to Read Financial Statements 5 Balance sheet 5 Income statement 9 Statement of cash flows 11 Analysis of Financial Statements 14 Common size analysis 14 Peer common size analysis 17 Financial ratio analysis 20 Liquidity 20 Activity 21 Leverage 24 Profitability 27 Peer group financial ratio analysis 28 Liquidity 28 Activity 29 Leverage 30 Profitability 31 Long-Term Financing Decisions 32 Cost of debt versus equity 32 Flexibility of debt and equity 33 Profitability considerations of debt and equity 33 Break-Even Analysis 36 4

5 Financial Statements Companies that are publicly traded are required to file their financial statements with the Securities and Exchange Commission (SEC) periodically. Anyone may gain access to the financial statements of public companies by visiting 24/7 and download documents of interest without charge or registration. The main documents that companies publish electronically with the SEC are their 10-K and 10- Q s. 10-K s are annual reports. 10-Q s are quarterly reports. The 10-K for Nike is referred to several times in this Toolkit, but the values used for Nike and its peer companies are taken from finance.yahoo.com which standardizes financial statements for ease of comparison across companies. Balance Sheet The balance sheet tells us what a company owns (assets) and how it finances what it owns (with liabilities and equity). The balance sheet is a snapshot of a business at one moment in time. The balance sheet is divided into assets, and liabilities and equity. The balance sheet identity requires that assets equal the sum of all liabilities and equity. The structure of the balance sheet shows short-term, or short-lived assets and liabilities at the top, and works down into longer-term assets, liabilities and equity. Accountants define current assets and current liabilities as having a life of one year or less. Everything else, by definition, is longer term. Companies in different lines of business will have very different-looking balance sheets. For example, department stores have a lot of money tied up in inventory, which is a current asset. Software companies, on the other hand, may have very little, if any inventory because of the nature of their business. As for financing, commercial banks tend to be heavily financed with liabilities and debt, with very little equity (ownership capital). Software companies tend to have very little, or no debt, since they have little in the way of securable assets to offer as collateral to borrow money. Let s look at the balance sheets for the Nike Company for the past three years. Nike s balance sheets are shown in Table 1. These were obtained from finance.yahoo.com. Yahoo standardizes financial statements for companies to make them easily comparable with other companies. Since the intent of this toolkit is to give the reader a basic understanding of financial 5

6 statements, actual as reported financial statements are not used. The finance.yahoo.com website shows all company income statements, balance sheets and statements of cash flows in precisely the same format. Table 1. Nike Corp. Balances Sheets: Assets All numbers in thousands Period Ending Assets Current Assets Cash And Cash Equivalents 3,079,100 2,291,100 2,133,900 Short-Term Investments 2,066,800 1,164, ,200 Net Receivables 2,898,600 3,156,300 3,022,500 Inventory 2,040,800 2,357,000 2,438,400 Other Current Assets 873, , ,300 Total Current Assets 10,959,200 9,734,000 8,839,300 Property Plant and Equipment 1,931,900 1,957,700 1,891,100 Goodwill 187, , ,800 Intangible Assets 467, , ,100 Other Assets Deferred Long-Term Asset Charges 873, , ,400 Total Assets 14,419,300 13,249,600 12,442,700 Current assets are those assets that are either cash, or assets that will mature in a year or less. Cash, being the most liquid of all assets, is generally listed first. Next, if the company has more liquidity than it needs at the moment, it will list short-term investments (usually in money market instruments with a maturity of 90 days or less). Accounts receivable are shown next, and this represents money Nike s customers owe Nike for having purchased goods on credit. It is called net receivables, which means an allowance for doubtful accounts and anticipated returns and allowances have been deducted from total accounts receivable. Inventory is listed next. Other current assets include such things as prepaid expenses. Prepaid expenses means just that they are expenses Nike has paid in advance, but will benefit from within the next year, and thus are listed as current assets. These accounts combined represent total current assets, or total assets that have a life of a year or less. For Nike, this amounts to $10.9 billion for the year ending May 31, Total current assets is sometimes referred to as working capital. The second group of assets is property plant and equipment, or PP&E for short. We sometimes call these fixed assets. They include buildings, machinery, land and equipment. Since all these fixed assets (except land) wear out, the value for PP&E shown is a net number what Nike 6

7 originally paid for the depreciable assets, less accumulated depreciation, the latter of which is recording the wearing out of assets over time. To find the original cost of fixed assets and attendant accumulated depreciation, we need to look at the footnotes to financial statements. In Nike s case, for the most recent year, it lists gross (what they paid for it) PP&E of $4.4 billion, and accumulated depreciation of $2.5 billion, for a net PP&E of $1.9 billion. Land is $222 million of the total. Net PP&E is represents the remaining value of Nike s fixed assets, which would be 44 percent of original cost. Thus, Nike s PP&E is roughly half way through its estimated life. Goodwill and intangible assets are shown next. In 2012, Nike acquired Umbro, a United Kingdom global soccer brand. Nike allocated the purchase price paid (about $576 million) to identifiable intangible assets and goodwill. The identifiable intangible assets include trademarks (that have an indefinite life), Umbro s sourcing network, established customer relationships, and the United Soccer League Franchise. These intangible assets are amortized on a straight-line basis over estimated lives of 12 to 20 years. The last asset category is under the heading of deferred long-term asset charges. This includes anticipated use of tax carry-forwards and gains on derivative transactions that will not be recognizable in the current year, and thus are show as long-term assets. Total assets for Nike as of 2014 were $14.4 billion. Now let s look at the financing side of the balance sheet which shows how Nike s assets are financed. The two choices are liabilities and equity. They list their current liabilities first, which means liabilities that will be paid within a year. Liabilities and equity are shown in Table 2. Accounts payable represents the money Nike owes its suppliers for goods purchased on credit. In Yahoo s standardizing procedure, they combine accounts payable and accrued liabilities. A simple example of an accrual is as follows. Suppose I pay all my employees on the 15 th of each month, but I close my books at the end of each month. This means that each month I need to accrue 15 days worth of wages and salaries due to how I pay my employees. Short/current longterm debt includes both the current portion of long-term debt and short-term borrowings. This is another Yahoo standardizing procedure. Total current liabilities are $3.3 billion as of Liabilities having more than a one-year life are typically shown as long-term. We see that Nike has $445.8 million of long-term debt, and this has not changed much over the three years shown. Deferred long-term liability charges represent the difference between taxes paid to the government per their tax return, and the amount of taxes owed using accrual accounting the socalled timing difference between tax and book accounting. Total long-term debt and liabilities are $1.3 billion (long-term debt plus deferred long-term liability charges. 7

8 Table 2. Nike Corp. Balances Sheets: Liabilities & Equity All numbers in thousands Period Ending Liabilities and Equity Accounts Payable 3,218,200 2,902,100 2,200,200 Short/Current Long-Term Debt 146, , ,600 Other Current Liabilities ,700 Total Current Liabilities 3,364,200 3,277,000 3,321,500 Long-Term Debt 445, , ,100 Other Liabilities Deferred Long-Term Liability Charges 855, , ,500 Minority Interest Total Liabilities 4,665,000 4,556,000 4,617,100 Stockholders' Equity Redeemable Preferred Stock Common Stock 2,800 2,800 2,800 Retained Earnings 6,095,500 5,451,400 5,073,300 Treasury Stock Capital Surplus 3,440,600 2,871,400 2,497,800 Other Stockholder Equity 214, , ,400 Total Stockholder Equity 9,753,700 8,693,100 7,825,300 Net Tangible Assets 9,099,100 8,032,200 6,633,400 Financing being provided by the owners is shown last, or what we refer to as stockholders equity. The preferred stock, common stock and capital surplus accounts combined indicate how much Nike has raised by selling stock in their company. Treasury stock would be shown as a negative, if Nike repurchased some of its shares in the open market, as this would represent shares that had been sold, and were subsequently repurchased. Their retained earnings represents how much money the company has made cumulatively over its life, net of all dividends paid i.e., the portion of earnings that have not been paid out as dividends to the owners. We see that total stockholder equity for 2014 is $9.7 billion. The last line shown is labeled by Yahoo as net tangible assets, but this is a misnomer. If we deduct the asset-carrying values for intangible assets and goodwill from total stockholder equity, 8

9 we get $9.099 billion, which is really tangible net worth not net tangible assets. Some investors and lenders conservatively deduct the value of intangible assets from stockholder equity, since they believe it is debatable what those assets are worth. Income Statement The income statement indicates how much money a company earned (or lost) during a period of time month, quarter or year, as examples. Thus, they are considered dynamic because they tell a story of what happened over a period of time (unlike the balance sheet, which indicates what the business looks like at one moment). There are many synonyms for the income statement. It is variously called profit and loss, statement of operations, and statement of income, to name a few. They all mean the same thing, and answer the same question how much money did we make or lose during the period in question? The income statement begins with sales or revenue, and displays expenses generally in a certain order. Revenue is followed by cost of goods sold, or cost of revenue, which is the amount accountants have identified as the incremental cost of selling products or services. The result is called gross profit. Next, general expenses (not traceable to the sale of products) is shown. We abbreviate these general expenses and selling, general and administrative expenses, as SG&A. Other income and expenses follow, which are discussed below. Recent income statements for Nike are shown in Table 3. Table 3. Nike Corp. Income Statements All numbers in thousands Period Ending Total Revenue 19,014,000 19,176,100 18,627,000 Cost of Revenue 10,213,600 10,571,700 10,239,600 Gross Profit 8,800,400 8,604,400 8,387,400 Operating Expenses Research Development Selling General and Administrative 5,930,900 5,766,300 5,632,200 Others

10 Total Operating Expenses 5,930,900 5,766,300 5,632,200 EBITDA 2,869,500 2,838,100 2,755,200 Depreciation & Amortization (DA) 395, , ,500 Total Other Income/Expenses Net 49,200 98,000 69,200 Earnings Before Interest & Taxes (EBIT) 2,523,200 2,552,800 2,502,900 Interest Expense 6, Income Before Tax 2,516,900 2,552,800 2,502,900 Income Tax Expense 610, , ,500 Minority Interest Net Income From Continuing Ops 1,906,700 2,083,000 1,883,400 Non-recurring Events 596,300 Discontinued Operations Net Income 1,906,700 1,486,700 1,883,400 Sales or revenue represents how much product Nike sold during each year. This is not everything they sold, but product they sold in the ordinary course of business. Thus, sales of used assets, such as automobiles, for example, are not part of revenue since Nike is not in the business of buying and selling cars. Revenue represents how much they sold in foot apparel and other products in their business lines. Sales or revenue is often referred to as top line, since it tends to be the first line of the income statement. We can see from Table 3 that Nike s revenue has been relatively constant at $19 billion over the past three years. Cost of revenue, or cost of goods sold, which means the same thing, is what it cost Nike incrementally to produce the products it sold. We can see from Table 3 that Nike s cost of goods sold, or COGS, for short, has been $10.2 to $10.5 billion for each of the past three years. Gross profit is sales minus COGS. For Nike, this has been $8.3 to $8.8 billion during the past three years. Gross profit is very important to most businesses, as it is the profit out of which general and other expenses are paid. Some companies positively obsess on their gross profit, knowing that if it is not high enough, they may run into financial difficulties and/or become competitively disadvantaged. Gross profit may be improved by charging more per unit, if possible, or by producing for less cost per unit. Both would be considered a good thing, as both produce more profit with which to cover other expenses or produce an attractive profit. Next, we typically see research and development (R&D), selling, general and administrative expenses (SG&A), as general overhead deductions from gross profit. Nike shows non-recurring 10

11 expenses as well, but a purist would argue these expenses should be shown later. R&D and SG&A are general expenses Nike must incur to be in business and stay competitive. Deducting total operating expenses from gross profit produces EBITDA, which refers to earnings before interest, taxes, depreciation and amortization. EBITDA is a measure, in the minds of many, of a company s basic earning power. Many argue that a company s value is more closely tied to EBITDA than net income, as EBITDA is not distorted by the many possible plusses and minuses to produce net income: one-time restructuring charges, charges for goodwill impairment, extraordinary gains and losses, and a host of other charges and credits. EBITDA, or basic earning power, is essentially what a company earns as income without regard to ownership or tax issues, and without regard to one-time charges and credits i.e., the income it can normally produce. Nike s EBITDA has been in the $2.4 billion range for the past three years. Nike s income statement in its 10-K report to the SEC does not show depreciation and amortization. This is often included in SG&A expenses. Depreciation deductions may be found in the statement of cash flows. DA can then be deducted after the calculation of EBITDA. Other income and expense items are shown next, leading to the value for earnings before interest and taxes, or EBIT. EBIT is used by many as the amount of income available to pay interest charges due on borrowed money. Nike had very modest borrowings in the most recent year, and net interest income (income minus interest expense) in the previous two years. Income tax expense is calculated by multiplying Nike s income tax rate times its taxable income (income before tax). The result of deducting taxes from income before taxes is income from continuing operations in the $1.9 to $2 billion range during the past three years. One-time adjustments to income from continuing operations are shown next (if applicable), which are gains or losses on discontinued operations, non-recurring gains and losses, and the like. Net income represents how much profit Nike made, after deducting all expenses incurred from income. Nike s net income has been in the $1.5 to $2 billion range during the past three years. Statement of Cash Flows A company s statement of cash flows might be viewed as a gigantic footnote to its cash account. The statement of cash flows (SCF) details how a company s cash account increased or decreased from one period to the next. 11

12 The SCF separates a company s activities into three components: operating, investment, and financing activities. A company s beginning cash balance is increased (decreased) by cash flow provided (used) by operating activities, investment activities, and financing activities. The SCF can be a very useful tool for determining what a company has been doing during an accounting period. Companies that are either losing money or growing rapidly will often show negative cash flow from operating activities. Investing activities indicate how much investment, net, a company makes in capital expenditures (CAPX). Finally, the financing activities indicate whether the company raised or reduced capital on a net basis. If a company issues long-term debt, or sells shares of stock, these are forms of raising cash. If a company retires more debt that it issues, this will appear as a reduction of cash. If a company engages in a repurchase of its shares, this will also show as a reduction of cash. Finally, if a company pays cash dividends, this is another use of cash. Stock repurchases and cash dividend payments are negative financing because they are uses of cash rather than sources of cash. Table 4 shows the statements of cash flows for Nike for the past three years. Operating activities are shown first. This begins with net income, then adds back non-cash charges and deducts non-cash credits. The purpose of the adjustments is to adjust accrual accounting income (net income) for non-cash inflows and outflows. For example, depreciation is added since it is a non-cash charge to income. Gains on sales of assets are not cash income, and are therefore deducted from reported net income. Secondly, changes in non-interest bearing current assets and current liabilities are added or subtracted from income. Asset increases (decreases) are a use (source) of cash and reduce (increase) cash flow. Current liability increases (decreases) are a source (use) of cash and increase (decrease) cash flow. Short-term investments (such as commercial paper or U.S. Treasury bills) are not shown as an operating activity, since they comprise money not needed to run the business. Short-term investments are a parking lot for a company with temporary excess liquidity. Nike reported net income of $1.9 billion for Depreciation and other adjustments to net income to move it closer to cash income are about $560 million. Changes in working capital (current assets and current liabilities) added an additional $700 million to cash flow. Thus, Nike s total cash flow from operating activities totaled $3.1 billion in 2014, and was considerably higher than in the previous two years. 12

13 Increases in current assets (accounts receivable and inventory, e.g.) are a use of cash since they must be financed in some way. Decreases in current assets are a source of cash. If inventory is reduced by $100, for example, this generates $100 in cash. Increases in current liabilities (accounts payable and accruals, e.g.) are sources of cash, since their increase means the company has less that must be funded with cash. Decreases in current liabilities are uses of cash, since the business has lost some of this source of financing. Table 4. Nike Statements of Cash Flows All numbers in thousands Period Ending Net Income 1,906,700 1,486,700 1,883,400 Operating Activities, Cash Flows Provided By or Used In Depreciation 395, , ,500 Adjustments To Net Income 167, , ,200 Changes In Accounts Receivables 181, , ,300 Changes In Liabilities 298, , ,900 Changes In Inventories 284,600 32, ,800 Changes In Other Operating Activities -69,600 14,100-11,200 Total Cash Flow From Operating Activities 3,164,200 1,736,100 1,936,300 Investing Activities, Cash Flows Provided By or Used In Capital Expenditures -335, , ,200 Investments -931, , ,400 Other Cash flows from Investing Activities -1,100-15, ,000 Total Cash Flows From Investing Activities -1,267, , ,800 Financing Activities, Cash Flows Provided By or Used In Dividends Paid -505, , ,900 Sale Purchase of Stock -376, , ,700 Net Borrowings -237, ,300 28,500 Other Cash Flows from Financing Activities 58,500 25,100 63,000 Total Cash Flows From Financing Activities -1,061, ,900-1,226,100 Effect Of Exchange Rate Changes -47,500-46,900 56,800 13

14 Change In Cash and Cash Equivalents 788, , ,200 As an example of the effects of changes in cash by short-term asset and liability changes, consider the following example. A company always pays cash for its inventory. It starts with $100 in cash and buys $100 of inventory. Cash will be down $100, and inventory up $100. The inventory is a use of cash of $100. But suppose instead the company was able to purchase inventory on credit. Purchasing $100 in inventory in this case will not decrease cash, but an account payable will be established instead. Thus, inventory will be up $100, and accounts payable will be up by $100. The payables increase saves the company from a $100 reduction in cash this is why an increase in short-term liabilities is considered an increase in cash. Investing activities is the second category in the statement of cash flows. It includes long-term (more than one year) investments in capital expenditures (called CAPX), which is property, plant and equipment. It also includes purchases and sales of short-term investments. This is where a company would show funds spent to purchase another company, and monies received upon the sale of companies (divestitures). Nike is seen to have decreased its investment in CAPX over the past three years, declining from $449 million to $335 million in The third major category in the statement of cash flows is cash flow provided by, or used in, financing activities. Cash dividends have been steadily rising over the years shown, to $505 million in Sale or purchase of stock combines sales of shares and the repurchase of shares. In Nike s case, a perusal of its 10-K reveals that over $700 million of stock was repurchased, and the proceeds from selling shares or the exercise of stock options was in excess of $360 million. Thus, $377 million was spent on net retirements. New loans for 2014 less loans repaid (short and long-term) amounted to net retirements of $237 million in debt for Note that Nike had, on a net basis, no cash generated by financing activities. In fact, over $1 billion was spent for the repayment of loans, stock repurchases, and the payment of cash dividends. Nike s financing has been negative (meaning net uses of cash, not generating cash) for each of the past three years. This is not a cause for concern for Nike, however, since their cash flow from operations is more than adequate to finance new investments. Analysis of Financial Statements 14

15 How Are We Doing Over Time? Common Size Analysis Common size analysis permits us to determine how a company is changing over time, and to compare it to competitors, who are generally of differing size. In this section, we will use common size analysis to determine how Nike has changed in terms of its balance sheet and income statement over the past three years. To prepare common size balance sheets, we divide each asset and liability account by total assets. The result is a standardized balance sheet, showing everything as a percentage of total assets. Table 5. Nike Common Size Balance Sheets All numbers are a percentage of assets Period Ending Assets Current Assets Cash And Cash Equivalents 21.4% 17.3% 17.1% Short-Term Investments 14.3% 8.8% 5.2% Net Receivables 20.1% 23.8% 24.3% Inventory 14.2% 17.8% 19.6% Other Current Assets 6.1% 5.8% 4.8% Total Current Assets 76.0% 73.5% 71.0% Property Plant and Equipment 13.4% 14.8% 15.2% Goodwill 1.3% 1.5% 3.6% Intangible Assets 3.2% 3.5% 6.0% Total Assets 100.0% 100.0% 100.0% Liabilities Current Liabilities Accounts Payable 22.3% 21.9% 17.7% Short/Current Long-Term Debt 1.0% 2.8% 1.4% Other Current Liabilities % Total Current Liabilities 23.3% 24.7% 26.7% Long-Term Debt 3.1% 3.3% 3.5% Total Liabilities 32.4% 34.4% 37.1% Stockholders' Equity Capital Surplus 23.9% 21.7% 20.1% Other Stockholder Equity 1.5% 2.8% 2.0% Retained Earnings 42.3% 41.1% 40.8% Total Stockholder Equity 67.6% 65.6% 62.9% 15

16 Total Liabilities and Equity 100.0% 100.0% 100.0% The three-year common size analysis of Nike s balance sheets shows that its liquidity (cash and short-term investments) has been steadily increasing over the past three years. Cash and shortterm investments have increased from 2012 to 2014 from about 22 percent of assets to 35 percent of assets. Total current assets have increased from 71 to 76 percent of total assets during the three-year period presented. Nike s investment in property, plant and equipment (PP&E) has declined by only about two percent of assets. Thus, the increase in short-term assets has been primarily offset by a decrease in goodwill and other intangible assets. On the financing side, we see that current liabilities have declined from 27 to 23 percent of assets. Accounts payable have increased by over four percent of assets, while current portion of long-term debt and short-term notes payable have increased very slightly. Long-term debt, as a percentage of assets, has been quite flat over the past three years. Owner s equity, or the amount of financing being provided by the owners, has increased by more than four percentage points over the past three years. It is instructive to note the large investment being made by the owners of Nike, contributing approximately two thirds of the total value of all financing. We also want to determine Nike s income statement relationships over time. Has Nike become less profitable, more profitable, or seen no significant change over time? To create common size income statements, we divide all income statement accounts by total revenue, as our way of standardizing these values. This makes it easier to see what has been happening in a relative sense over time. Table 6 shows selected income statement accounts, all expressed as a percentage of revenue. Gross profit margin has improved slightly during the years shown, from 45 to 46.3 percent. Secondly, it may be noted that operating expenses (selling, general and administrative) expenses have increased by one percentage point over the three years. The result is a very steady EBITDA, or basic earning power, of approximately 15 percent of revenue. Depreciation and amortization expenses have been relatively steady at around 2 percent of revenue over the three years shown. Other income and expenses have been relatively minor, resulting in earnings before interest and taxes (EBIT) of 13.3 percent. Net income has fluctuated from a low of 7.7 percent to 10 percent over the three years. Notice the greater stability of 16

17 EBITDA, since net income is subject to all sorts of issues restructuring charges, goodwill impairment, extraordinary gains and losses, and the like. Table 6. Nike Common Size Income Statements All numbers are a percentage of revenue Period Ending Total Revenue 100.0% 100.0% 100.0% Cost of Revenue (COGS) 53.7% 55.1% 55.0% Gross Profit 46.3% 44.9% 45.0% Selling General & Administrative (SG&A) 31.2% 30.1% 30.2% EBITDA 15.1% 14.8% 14.8% Depreciation & Amortization (DA) 2.1% 2.0% 1.7% Operating Income 13.0% 12.8% 13.1% Total Other Income/Expenses Net 0.3% 0.5% 0.4% Earnings Before Interest & Taxes (EBIT) 13.3% 13.3% 13.4% Interest Expense 0.0% 0 0 Income Before Tax 13.2% 13.3% 13.4% Income Tax Expense 3.2% 2.4% 3.3% Net Income 10.0% 7.7% 9.7% How Are We Doing Compared to Peer Companies? Common Size Analysis We have put together a peer group against which Nike may be compared. Most of the time, it is difficult to assess how well a company is doing unless it is compared to competitors. Thus, a major activity in financial analysis is benchmarking a company s performance against other companies. One of the first things most analysts conclude when looking for benchmark companies is that their company cannot really be compared to anyone else! For example, if you wanted to benchmark the performance of Krispy Kreme, the donut company, you would not be able to find another donut company anywhere in the world to compare it to. All other makers of donuts are either a subsidiary of another publicly company or are private, which means there are no benchmark companies available. 17

18 So we do the best we can in benchmarking, choosing the most comparable companies we can find. Krispy Kreme might be compared to Starbucks, for example, as it is a narrow product line company that primarily sells premium coffee at the retail level. Companies chosen to benchmark Nike are Collective Brands, Rocky Brands, and Wolverine Worldwide. All these U.S. companies manufacture or outsource the manufacture of shoes used in sports, in the military, and by children. Adidas and other well-known brands of sports shoes are either foreign companies or subsidiaries of other companies. Table 7 shows a common size balance sheet comparison of Nike and its peer group. The peer group numbers are obtained by calculating each line item for each company, and determining the average of the three. Right away, it is apparent that Nike carries much more cash and short-term investments than its peer group almost triple the peer group amount in the most recent year. Accounts receivable as a percentage of sales is virtually the same for Nike and its peer group. However, Nike carries only about half as much inventory as its peer group. Table 7. Nike & Peer Company Common Size Balance Sheets Nike Peer Group Period Ending Assets Current Assets Cash And Cash Equivalents 21.4% 17.3% 12.0% 13.6% Short-Term Investments 14.3% 8.8% Net Receivables 20.1% 23.8% 20.8% 20.2% Inventory 14.2% 17.8% 28.3% 25.2% Other Current Assets 6.1% 5.8% 2.0% 1.9% Total Current Assets 76.0% 73.5% 63.1% 60.9% Property Plant and Equipment 13.4% 14.8% 13.9% 14.9% Goodwill 1.3% 1.5% na na Intangible Assets 3.2% 3.5% 13.0% 13.5% Total Assets 100.0% 100.0% 100.0% 100.0% Liabilities Current Liabilities Accounts Payable 22.3% 21.9% 15.90% 13.7% Short/Current Long-Term Debt 1.0% 2.8% 0.3% 0.3% Total Current Liabilities 23.3% 24.7% 16.2% 14.0% Long-Term Debt 3.1% 3.3% 16.6% 23.6% 18

19 Total Liabilities 32.4% 34.4% 44.1% 49.9% Stockholders' Equity Capital Surplus 23.9% 21.7% Other Stockholder Equity 1.5% 2.8% -2.5% -3.0% Retained Earnings 42.3% 41.1% 53.4% 50.0% Total Stockholder Equity 67.6% 65.6% 55.90% 50.10% Total Liabilities and Equity 100.0% 100.0% 100.0% 100.0% Nike s property, plant and equipment (PP&E) is virtually the same as its peer group. Total intangible assets, however, are much less than competitors. On the financing side, Nike generates significantly more funding from its suppliers than does its peer group. Accounts payable have been in the 22 percent of assets range for the past two years, compared to only 16 percent for the peer group. In terms of long-term financing, Nike employs much less debt financing than its peer group 3 percent versus 16 percent. Nike has much more equity per dollar of assets than its peer group. Fully two-thirds of Nike s total assets are financed by owner s equity, compared with 56 percent for its peer group. We turn our attention next to common size analysis of Nike s income statements relative to its peer group. This information is shown in Table 8. Note that Nike has a significantly lower cost of goods sold than its competitors, resulting in a gross profit margin 9 percentage points higher than its peer group. This is, in part, a tribute to Nike s strong brand appeal and its ability to premium price its products. It may also be attributed to a lower cost to produce its products. Either way through premium pricing or lower production costs Nike has a commanding lead over its peer group in gross profit margin. Achieving the highest gross profit margin in an industry puts a firm in a very enviable position. It means that the leader will have the ability to make more money than its competitors in the event of a price war. Suppose Nike and its competitors sell product for $100 per unit. If competitors drop their price to $63.20, their gross profit plummets to zero. However, if Nike price-matches its peers, at a price of $63.20 Nike still realizes a profit of $9.50 ($ $53.70)!!! Nike s operating expenses, however, are higher than its competitors 31 percent versus 26 percent in the most recent year. However, Nike s superior gross profit margin allows it to carry a higher level of operating expenses (SG&A) and still produce a higher EBITDA 15.1 versus 12.6 percent in the most recent year. 19

20 Nike and its peers have comparable depreciation expenses (DA), running about 2 percent of revenue. Nike borrows less than its peers do, as we saw in the balance sheet common size analysis of their balance sheets. Thus it is not surprising that Nike has significantly less interest expense than its peers. Nike not only enjoys a superior gross profit margin, but a higher EBITDA, and a higher net income as a percentage of revenue when compared to its peer companies. Table 8. Nike & Peer Company Common Size Income Statements Nike Peer Group Period Ending Total Revenue 100.0% 100.0% 100.0% 100.0% Cost of Revenue (COGS) 53.7% 55.1% 63.2% 63.2% Gross Profit 46.3% 44.9% 36.8% 36.8% Selling General & Administrative (SG&A) 31.2% 30.1% 26.3% 27.5% EBITDA 15.1% 14.8% 12.6% 9.4% Depreciation & Amortization (DA) 2.1% 2.0% 1.8% 2.0% Operating Income 13.0% 12.8% 10.8% 7.4% Total Other Income/Expenses Net 0.3% 0.5% 0.1% 0.1% Earnings Before Interest And Taxes 13.3% 13.3% 8.0% 5.6% Interest Expense 0.0% 0 1.3% 1.7% Income Before Tax 13.2% 13.3% 6.7% 3.8% Income Tax Expense 3.2% 2.4% 1.7% 0.9% Net Income 10.0% 7.7% 4.9% 2.9% How Are We Doing? Financial Ratio Analysis Examining financial statements can provide some insights into a company s operations. Common size analysis permits more insights to be gleaned from the basic statements, particularly regarding how a company has been performing over time, and how it is performing relative to a peer group. Financial ratios are additional tools that can be used to assess how well a company is performing in various areas. Some proponents of ratio analysis suggest that ratios breathe life into financial statements and make them more understandable. We will look at four sets of ratios in this section: measures of liquidity, measures of activity, leverage measures, and profitability measures. Liquidity 20

21 Liquidity ratios are attempts to tell us if a firm has enough liquid resources to pay bills that will come due in the coming year. The current ratio divides current assets by current liabilities. The literal interpretation of a current ratio is the amount of liquid resources a company has with which to pay each dollar of current liability, which must be paid within the year. Nike s current ratio for 2014 = Current assets current liabilities = 10,959,200 3,364,200 = 3.3 Nike s current ratio in the most recent year is 3.3, and has been steadily rising (Nike is becoming more liquid). This means that Nike has $3.30 available in liquid form to pay each $1 of current liability. Lenders prefer a company to have a relatively high current ratio, since they believe a liquid company has less credit risk. Managers prefer to have a relatively low current ratio, since current assets do not earn much of a return. This high liquidity/low liquidity issue is a common point of contention between companies and their lenders. The quick ratio is a first cousin to the current ratio. It is calculated by ignoring inventory. Thus, the quick ratio is calculated by dividing the quantity of current assets minus inventory, by current liabilities. The logic behind the quick ratio is that inventory may be slower to liquidate than other current assets if the company is forced to raise money in a hurry. The quick ratio thus indicates the ability to cover current obligations without regard to inventory. Nike has $2.70 in currents assets for each $1 of current liabilities. Nike s quick ratio for 2014 = (Current assets-inventory) Current liabilities = (10,959,200-2,040,800 3,364,200 = 2.7 Activity Activity ratios are indicators of how well a company is managing its assets. We evaluate accounts receivable, inventory, fixed assets, and total assets. The average collection period (ACP) measures how long it takes to collect an account receivable on average. It is calculated by dividing accounts receivable by sales per day, using 365 days in a year. We are using end-of-period balances to calculate our ratios, even though it is more precise to use average balances. Nike s average collection period for 2014 = Accounts receivable (sales/365) = 2,898,600 (19,014,000/365) = 55.6 days 21

22 Suppose Nike sells to its customers on terms of net 30, meaning a credit customer has 30 days to pay for its shipment before being in default. The longer the average collection period in relation to the credit term extended, the poorer job the company is doing in collecting its receivables. We do not know the average credit term Nike extends to its customers. We do know, however, that it is currently collecting money faster than it was two years ago, improving its ACP from 59 days in 2012 to 56 days in An average collection period can be longer than the credit term extended for two main reasons: (1) credit policy, and (2) collection policy. Credit policy is what a company does in deciding whether to extend credit and how much a front-end activity. Collection policy is what a company does to collect receivables after credit has been extended and shipments made. Either one can become a problem area for a company. Table 9. Nike Financial Ratios Nike Period Ending Liquidity Current ratio Quick ratio Activity Average collection period Inventory turnover Days sales in inventory Fixed asset turnover Total asset turnover Leverage Debt ratio Debt-to-equity Times interest earned na na Cash coverage na na Profitability Gross profit margin 46.3% 44.9% 45.0% Return on sales 10.0% 7.7% 9.7% Return on assets 13.2% 11.1% 14.5% Return on equity 19.5% 17.0% 23.1% Inventory ratios include inventory turnover, and days sales in inventory. They measure the same thing, but are presented differently. We calculate inventory turnover at cost, not at market (which means we are dividing cost of goods sold instead of sales by inventory). The latter is 22

23 used in a number of ratio services and corporate finance texts. We prefer inventory turns at cost, since it is more accurate in terms of how often inventory actually turns over. Inventory can choke a company severely if not properly controlled. If a company carries too much inventory, and the inventory is subject to technological obsolescence or spoilage, some of the inventory, or all of it, can easily become worthless. If inventory is not subject to these issues if the inventory is hula hoops, for example carrying too much will still have financial consequences since the inventory must be financed somehow, and stored somewhere. Inventory is considered to be a two-edged sword. If a business has too little, it may lose sales to customers when it stocks out. But if a business has too much, it may pay more than necessary for insurance, storage, and the cost of financing it. Inventory turnover is measured by dividing cost of goods sold by inventory. Nike s inventory turnover for 2014 = Cost of goods sold inventory = 10,213,600 2,040,800 = 5 times Table 9 reveals that Nike has been turning its inventory faster over the past three years, from a low of 4.2 to the current 5 times. This would put a smile on the face of most financiers moving the merchandise faster means less in financing charges and storage fees. Days sales in inventory uses the number of turns calculated in inventory turnover and divides the number of turns into 365. The result is days sales in inventory or DSI. Nike s Days sales in inventory (DSI) for 2014 = 365 inventory turns = = 72.9 days The trend revealed by looking at inventory turns is the same as the pattern seen through DSI analysis, but many business people think in terms of DSI. Nike s DSI has been reduced from almost 87 days to 73 days in 2014 a reduction of 14 days. Fixed asset turnover estimates the amount of revenue a company generates per dollar invested in net fixed assets (PP&E means the same thing). Certainly, the more revenue generated by each dollar of investment in PP&E, the more productive the company is, or would seem to be. Interpreting this ratio in real life, however, can be more problematic, because PP&E wears out over time. The net PP&E value used to divide into sales is the original PP&E cost minus accumulated depreciation. Because of this, a business with old fixed assets may appear to be more productive than a competitor with newly acquired PP&E that has not yet been depreciated. The old PP&E Company has depreciated much of the original value of its fixed assets, making 23

24 the current carrying value quite low. The new PP&E Company has not depreciated its new assets significantly, with the result being a relatively high carrying value. Because fixed asset turnover is a simple ratio, the smaller the PP&E value, the higher the resulting ratio, all other things being equal. Nike s fixed asset turnover for 2014 = Sales fixed assets = 19,014,000 1,931,900 = 9.8 Nike s fixed asset turnover is unchanged during the three years being evaluated. In each year, Nike produces revenue of $9.80 for every dollar invested in PP&E. Total asset turnover is similar to fixed asset turnover. It measures the amount of revenue a company produces per dollar invested in total assets. Total asset turnover is calculated by dividing revenue by total assets. Nike produced revenue of $1.50 per dollar invested in total assets in 2012, and this has declined to $1.30 in Nike s total asset turnover for 2014 = Sales total assets = 19,014,000 14,419,300 = 1.3 Leverage Leverage deals with borrowing money. Four ratios are highlighted in this section. The first two examine balance sheet relationships, and the second two look at income statement relationships. Balance sheet ratios have to do with who is financing the business and with psychology, odd as it may seem. Income state ratios deal with ability to pay. Here is a simple example regarding the psychology of using balance sheet ratios. Suppose you could buy a $300,000 house by putting $1,000 down and borrowing the rest. Call this the high leverage scenario. Alternatively, suppose you put $100,000 down on the purchase of the same $300,000 home. This is the low leverage scenario. In either case, what you don t put down, you borrow from a mortgage company. Now suppose that, shortly after signing the mortgage agreement, your job is outsourced. This is you, now, we are talking about. Which scenario will make it easier for you to walk away from your financial obligation? This is not an ethics discussion, but an economic dilemma. If you have put only $1,000 in harm s way, of course it is easier to walk away (aka default), since you have practically nothing to lose. But if you have contributed $100,000, you will use all available means to make your payment each month laid 24

25 off or not. This is exactly how lenders see things! They want a motivated borrower, since that increases the likelihood of repayment. This principle in the world of business is exactly the same. If a company is highly leveraged (meaning that most of its balance is financed with other people s money OPM it is much easier for the company to default. The debt ratio is the first ratio showing who (creditors, lenders or owners) are financing the business, and by how much. The debt ratio calculates the relationship between all of a company s liabilities and its total assets. Nike s debt ratio for 2014 = Total liabilities total assets = 4,665,000 14,419,300 = 0.3 All liabilities comprises creditor and lender financing. A liability is money that is owed, but does not accrue interest, such as accrued wages payable. A debt requires interest to be paid, such as bank notes. The debt ratio adds together all creditor and lender amounts and relates them to a company s total assets. For the past three years, Nike s debt ratio has been between.3 and.4, which means that all liabilities have totaled 30 to 40 percent of total assets. In other words, Nike has financed 60 to 70 percent of its assets with owner s equity. This is a very good equity cushion, meaning that equity could take quite a pounding with losses before the company would become insolvent (meaning that liabilities would exceed assets, and owner s equity would become negative). From a creditor s perspective, a low ratio is more favorable than a higher one, since the owners have more to lose when the ratio is high. Debt-to-equity calculates the ratio of long-term debt to owner s equity. This ratio assesses the relative amount of capital supplied by long-term lenders in relation to how much the owners have contributed. Nike s debt-to-equity ratio for 2014 = Long-term debt owner s equity = 445,800 9,753,700 = 0.0 This ratio identifies how much capital long-term lenders have invested in a business per dollar invested by the owners. For Nike, this ratio has been between 0 and.1 over the past three years. This means that lenders have put up very little long-term capital in relation to the shareholders. For the past two years, for every dollar the owners have contributed, the lenders have invested only ten cents. 25

26 From a lender s perspective, a lower ratio is favorable, since it means that the owners are incurring more of the risk. Attention is now turned to ability to pay measures, which employ income statement relationships. Both are designed to show how many times an interest expense obligation is covered. The times interest earned ratio (TIE) measures the number of times a company has its interest expense covered. From a lender s viewpoint, the higher the coverage times, the better. To a borrower, it may feel that it could borrow more with little risk if the coverage is relatively high. In fact, one of the distinguishing characteristics of very creditworthy borrowers is their high interest coverage relative to lesser quality companies. EBIT is the numerator in this calculation, since interest is a tax-deductible expense. EBIT is considered to be income available with which to make interest payments. Nike s times interest earned (TIE) ratio for 2014 = Earnings before interest and taxes (EBIT) interest expense = 2,523,200 6,300 = It is not possible to properly calculate this ratio for Nike, as it follows the practice of netting interest income and interest expense. After investigating Nike s 10-K, it was not possible to find interest income and interest expense broken down independently. Interest income is earned on interest bearing investments, and interest expense is paid on borrowings. Nike nets these two numbers together, and the $6.3 million interest expense is really interest income minus interest expense, or net interest. With that caveat noted, Nike s coverage of its interest obligations is extremely high. A top quality company would have interest coverage of 20 times Nike s is over 400 times. Cash coverage measures the relationship between EBITDA and interest expenses. This so-called cash coverage ratio is actually a better measure with which to determine a company s ability to meet interest payments than EBIT, since depreciation and amortization (DA) are non-cash charges. EBITDA is a better proxy for cash income. Nike s cash coverage ratio for 2014 = EBITDA interest expense = 2,869,500 6,300 = In Nike s case, the cash coverage ratio is going to be inaccurate, as is times interest earned, and for the same reason: interest expense is a net amount (interest income minus interest expense). 26