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4-1

Module 4 Financial Statement Analysis and Interpretation

Analysis and Interpretation of Company Profitability exercise


RESOLVER EN EQUIPOS DE CLASE
Balance sheets and income statements for Procter & Gamble follow. Refer to these
financial statements of P&G to answer the requirements below.

Balance Sheets
($ millions)

6/30/2003

6/30/2002

6/30/2001

6/30/2000

Cash...................................................... $ 5,912
Marketable securities............................
300
Accounts receivable..............................
3,038
Inventories............................................
3,640
Other current assets..............................
2,330
Total current assets............................... 15,220
Plant assets............................................ 23,542
Accumulated depreciation.................... 10,438
Plant assets, net..................................... 13,104
Intangibles............................................ 13,507
Deposits and other assets......................
1,875
Total assets............................................ $43,706

$ 3,427
196
3,090
3,456
1,997
12,166
23,070
9,721
13,349
13,430
1,831
$40,776

$ 2,306
212
2,931
3,384
2,056
10,889
22,821
9,726
13,095
8,300
2,103
$34,387

$ 1,415
185
2,910
3,490
2,146
10,146
23,221
9,529
13,692
8,786
1,742
$34,366

Accounts payable.................................. $ 2,795


2,172
Current portion of long-term debt...............
Accrued expenses.................................
7,391
Total current liabilities.......................... 12,358
Deferred charges (income)...................
1,396
Long-term debt.....................................
11,475
Other long-term liabilities....................
2,291
Total liabilities...................................... 27,520

$ 2,205
3,731
6,768
12,704
1,077
11,201
2,088
27,070

$ 2,075
2,233
5,538
9,846
894
9,792
1,845
22,377

$ 2,209
3,241
4,691
10,141
625
9,012
2,301
22,079

Preferred stock......................................
1,580
Common stock, net...............................
1,297
Capital surplus......................................
2,931
Retained earnings................................. 13,692
Other equities........................................
(3,314)
Shareholders equity............................. 16,186
Total liabilities and equity.................... $43,706

1,634
1,301
2,490
11,980
(3,699)
13,706
$40,776

1,701
1,296
2,057
10,451
(3,495)
12,010
$34,387

1,737
1,306
1,794
10,710
(3,260)
12,287
$34,366

2001
$39,244
22,102
17,142
12,406
4,736
674
794
4,616
1,694
$ 2,922

2000
$39,951
21,514
18,437
12,483
5,954
304
722
5,536
1,994
$ 3,542

Income Statements ($ millions)


2003
Net sales................................................ $43,377
Cost of goods sold................................ 22,141
Gross profit........................................... 21,236
Selling, general & admin expense........ 13,383
Income before deprec & amort.............
7,853
Non-operating income..........................
238
Interest expense....................................
561
Income before taxes..............................
7,530
Provision for taxes................................
2,344
Net income............................................ $ 5,186
For fiscal years

Cambridge Business Publishers

2002
$40,238
20,989
19,249
12,571
6,678
308
603
6,383
2,031
$ 4,352

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4-2

Module 4 Financial Statement Analysis and Interpretation


Analysis and Interpretation of Profitability Ratios
1. Compute the following profitability ratios for each year shown:
a. Gross profit margin
b. Selling, general & administrative expense as a percent of sales (SGA%)
c. Net operating profit margin (PM)
d. Net profit margin.
2.

Your results in part 1 should have revealed an increase in net profit margin.
a. Is this increase due to an increase in the gross profit margin or a decrease in
selling, general, & administrative expense, or both? Provide evidence and
explain your answer.
It is due to both. Since the Gross profit margin has dropped, it reveals an
increase in efficiency of costs of goods sold; also the general and
administrative expenses have dropped inferring by the SGA increase.
b. Consider how much control that companies have or do not have over gross
profit margins. What factors must exist to allow them to increase selling prices
of their products? In what ways can they improve gross profit margins by
lowering product manufacturing costs? Explain.
For the company to increase the selling price either the situation in the
market such as loss of competition lets them or theyve changed their
segment and aim for a higher-end market, however it is more possible that
the first situation arises. If in the other hand the company wants to
increase its Gross profit margin, it may be able to do so by lowering
manufacturing costs, and so by reducing their input costs they are able to
earn more.
c.

What are the usual components of selling, general and administrative expense
for a company like Procter and Gamble? For which of these components are
companies likely able to achieve expense reductions? To what extent are these
expense reductions a short-term gain at the cost of long-term performance?
Explain.
This category includes the direct and indirect costs and all general and
administrative expenses, such as raw materials, labor force and indirect
expenses, in this case for P&G it could be salaries, pension costs,
marketing, insurance, rental, depreciation of fixed assets, commissions,
and travel expenses of executives among many others. For all these
miscellaneous expenses, reductions can be made in unnecessary personnel
or in an organizational reshuffle so that salaries in executive levels dont
make the enterprise incur in a higher SGA. However, if this realignment
of personnel and/or their benefits doesnt go as expected, the cut in
expenses in the short term, could provoke an unfavorable impact in the
long-term performance since many of the lay-offs or down-graded
individuals could have been necessary or beneficial for the operations

Analysis and Interpretation of Asset Turnover Ratios


1. Compute the following turnover ratios for 2001 through 2003:
a. Accounts receivable turnover and the average collection period.
b. Inventory turnover and average inventory days outstanding.
c. Plant asset turnover.
2.

Results from part 1 should reveal a slight improvement in receivables turnover


from 2001 to 2003. How can a company like P&G realize an improvement in this
ratio? Explain.

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4-3

Module 4 Financial Statement Analysis and Interpretation


A company like P&G could expect a better receivables turnover, meaning
more efficient credit and collection, by having less stringent policies. However
since the change is barely noticeable a policy change isnt the best explanation.
In future occasions more lenient terms of credit or a an efficient collection
could be feasible, but on the other hand a comparison of the sales growth
relative to the industry can help to assess whether credit the policies arent
hurting the revenue potential.
3.

Results from part 1 should reveal no discernable improvement in inventory


turnover from 2001 to 2003. How can a manufacturer like P&G realize an
improvement in its inventory turnover? Explain.
If the decision is to increase the turnover (as a conclusion to previous industry
analysis), the most obvious option is to possess less inventory, but if in any
way that decision could hurt revenue, other options such as an increase of
sales would be advised.

4.

Results from part 1 should reveal a slight decline in plant asset turnover from 2001
to 2003. Why is this ratio so difficult for companies to impact? Can you think of
ways in which a company can achieve an improvement in this ratio? Explain.
This radio is difficult for companies to impact since the plant assets are fixed,
and the ability to improve the radio implies either an increase in sales or an
increase in plant assets, but an increase in the first might carry an increase in
plant equipment, making the betterment exceedingly hard.

Disaggregation and Interpretation of Company ROE


1. Compute the following for 2001 through 2003:
a. Net operating profit margin (PM).
b. Return on net operating assets (RNOA).
c. Financial leverage (LEV).
d. Net borrowing costs (NBC)
e. Spread
f. Return on equity (ROE).
g. ROE from the formula: ROE = RNOA + (LEVSpread). Confirm that this
amount equals that computed in part f.
2. Drawing on results from part 1, does P&G depend more on operations (RNOA) or
financial leverage to drive its ROE? Explain.
The company depends more on the financial leverage since this ratio is
relatively higher to the return on operations, while both cannot be directly
compared, we know that the leverage is in an acceptable position while the
return on operations is markedly low.
3.

Drawing on results from part 1, is P&Gs level of ROE sufficient to attract capital?
Explain. What benchmark do you believe is appropriate in answering that
question? Explain.
First, an appropriate benchmark would be the industry, and investing
enterprises, against the later we know that the interest rate is at its lowest in
the US, so it is a good investing option. Also its worth mentioning that P$G is
a big, respectable and stable company so the risk would be optimal.
On the other hand we should see the ROE of the different companies in the
industry, and thus making having more information for the decision making.

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4-4

Module 4 Financial Statement Analysis and Interpretation


Analysis and Interpretation of Liquidity and Solvency Measures
1. Compute its current ratio and quick ratio for 2001 through 2003. Do the trends, if
any, in these ratios indicate that P&G is becoming more or less liquid? Use
computations to support your analysis and inferences.
Throughout the increasing trend in both ratios, it could be inferred that the
liquidity is in fact increasing since now they can afford almost all their current
liabilities with cash, marketable securities and receivables. Meanwhile ny
observing the Balance sheet by itself and the Current ratio we can see that the
current assets have increased at a higher rate than the short-term liabilities
2.

Compute P&Gs financial leverage (LEV) and times interest earned for 2001
through 2003. Do these ratios indicate that P&G is becoming more or less solvent?
Explain.
They indicate that P&G is becoming more solvent since it has the ability to
cover the interest and some liabilities with the assets according to the LEV
computation, and with its EBIT in the calculation of the Interest coverage

3. A well-known model of financial distress is Altmans Z-score. Altmans Zscore uses multiple ratios to get a predictor of distress. This predictor classifies
or predicts the likelihood of bankruptcy or nonbankruptcy. Five financial ratios
makeup the Z-score:
X1 = Working capital / Total assets
X2 = Retained earnings / Total assets
X3 = Earnings before interest and taxes / Total assets
X4 = Shareholders equity / Total liabilities
X5 = Sales / Total assets.
In brief, X1 reflects liquidity, X2 reflects cumulative profitability that has been
retained, X3 reflects profitability, X4 reflects financial leverage, and X5
reflects total asset turnover.
The Altman Z-score is computed as:
Z-score = (0.717 X1) + (0.847 X2) + (3.107 X3) + (0.420 X4) + (0.998
X5)
The Z-score is then interpreted as follows:
Z-score < 1.20
high probability of bankruptcy
Z-score > 2.90
low probability of bankruptcy
1.20 Z-score 2.90
gray or ambiguous area.
Compute the Altman Z-Score of P&G for 2003. Does this score indicate any concerns
about P&Gs solvency? Explain.
No, it doesnt indicate any concern about P&Gs solvency since every year since
2001 it has been in the grey or ambiguous area of the indicator.

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