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BUS 365: Investments

Solution to Practice Problems

Financial Statement Analysis

1) BRIEFLY explain why the change in Net Working Capital is subtracted in the free cash flowcalculation.

Answer: The FCF calculation begins with NOPAT, which is a measure of cash flow derived

entirely from the income statement. NWC is subtracted from NOPAT in order to adjustfor 1) cash flows related to short-term assets that do not appear on the income statement

(e.g., purchases of inventory) and 2) non-cash flow items related to short-term assets and

liabilities that appear on the income statement but for which there is no associated cash

flow (e.g., goods sold on accounts receivable, goods sold that were purchased on accounts

payable).

2) Your task is to use the DuPont approach to evaluate the financial statements of an industrial

equipment manufacturer. See problem set for those financial statements, which include acommon size income statement and a common size balance sheet. What can you conclude about

the company? PLEASE keep your answer in the space belowthere is ample space provided.

Answer: The ROE for the company is currently a bit below industry average, suggesting

that the company is lagging in at least one area.

Expense Control: The profit margin is above average and has been for the past three years,

so there does not appear to be a significant problem in controlling expenses. Looking at

specific expense categories, we see that the company's cost of revenues is well belowaverage while its SG&A expenses are well above average. The most likely explanation is

that the company's reporting policies differ from its peers, although it is possible that the

differences we observe are real ones.

Asset Management: The asset turnover is well below average and has been for the past

three years. This suggests that the company is carrying more assets on its books than its

peers, all else equal. (Note that the problem is not likely to be one of low sales. If it were, we

would usually see a below average profit margin). Looking at the common size balance

sheet, we see that the company is carrying a much higher level of intangible assets than its

peers are carrying. These assets include such things as patents, which can be very valuable

if properly used. Apparently, those intangible assets have not yet generated higher sales, soour task becomes one of understanding what those assets are and what value we might

expect them to generate.

Debt Management: The equity multiplier has been near the industry average each of the

past three years, but that provides little evidence with respect to debt management. We do

see, however, that the company's after-tax interest rate on debt is above the ROIC, which

suggests the company debt is currently hurting the returns to shareholders. This may be a

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temporary situation. If not, then the company should ideally reduce its level of debt.

Note that other interpretations (e.g., recent acquisition) are entirely possible.

3) Your task is to use the DuPont approach to evaluate the financial statements of an industrialequipment manufacturer. See problem set for those financial statements, which include a

common size income statement and a common size balance sheet. What can you conclude about

the company? PLEASE keep your answer in the space belowthere is ample space provided.

Answer:

ROE: Dipped a bit below industry average after a few years slightly above average.

Overall, the ROE is fairly close to the industry average and therefore does not give cause

for great concern.

Expense Control: The profit margin is a good bit below industry average and has trailed

the industry for the past few years. Investigating further, we see that the companys Cost ofRevenues is 12.8 points above industry average while its SG&A Expenses are 11 points

below industry average. The most likely explanation is differences in accounting practices.

It seems likely that the company is booking some expenses as Costs of Revenues while the

industry books them as SG&A Expenses. The net difference of 1.8 points is roughly the

same as the current profit margin deficit, so this is the likely source of the profit margin

underperformance. Note also that the companys Free Cash Flow Yield is negative, which

could be a bad sign because over the past year, the company not only did not earn enough

money to satisfy its investors, but actually lost money.

Asset Management: The asset turnover has fluctuated around the industry average and is

currently slightly above average. Digging deeper, the only noteworthy item is the

companys cash position, which is well below average. This is certainly worthy of further

investigation because of the negative free cash flow. If that persists, then the company could

quickly find itself in a cash crunch.

Debt Management: The equity multiplier is a bit above average, but not significantly so.

This tells us very little, though, about the companys management of debt. We must look at

cash flow measures to assess that. Notice that the Interest Expense is well below Operating

Income and current assets are well above current liabilities, both of which suggest that the

company is in no real danger of missing debt payments. This is only part of the story

though. To assess whether or not debt is helping shareholders, we need to examine the

ROIC. In this case, the companys ROIC is slightly above the after-tax interest rate on

debt, suggesting that during that period, the presence of debt increased the companys

ROE. Given that it is only slightly above the after-tax interest rate on debt, we should pay

careful attention to the ROIC going forward.