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Performance Indicators, Reporting, and Assessment:

Financial executives and other senior management officials must have the skills to carefully, thoroughly, and accurately assess corporate financial and operational performance. Accordingly, the expected outcomes for this week are associated with demonstrating proficiency with creation, analysis, and interpretation of financial statements, ratios, and other performance indicators.

A principal expected outcome for the week is to become proficient with the calculation and use of the traditional financial and operational ratios to assess liquidity, profitability, capitalization, management effectiveness, and market value.

Explain why the principal values of calculating financial ratios are to make comparisons over time and to develop comparisons with other companies.

Additional outcomes include the ability to explain the use of common-size financial statements, how to prepare an integrated ratio analysis, and to acquire an understanding of the principal challenges of ratio analysis.

Becoming familiar with and learning how to calculate and use value-based or economic value-added measures of performance (EVA, MVA, CFROI, SVA, CVA, and REVA) are important outcomes this week. These measures are often used in addition to the traditional financial and operational ratios that are used to examine company performance.

Another important objective is to understand the 4 C?s of credit analysis or factors to consider in corporate credit analysis. It is useful to understand how creditors use these indicators in the process of making credit decisions.

Observation:

For a video presentation about EVA and MVA including an interview with Joel Stern (of Stern-Stuart, the developers of the EVA and MVA measures), visit:

https://www.youtube.com/watch?v=ZCaeMTSTWYs

1.

1. Prepare a written analysis of the financial ratios resulting from the Week 2 eVal Financial Forecast of the selected company. This must include trend analysis (historical and projected) and comparative analysis (cross-sectional or industry). The analysis needs to examine strengths and weaknesses revealed by the data. Remember, in a written ratio analysis the actual ratio data need to be included in the written analysis in addition to presentation in any accompanying tables or figures (graphs).

Table 1 eVal Assumptions for Financial Forecast Using eVal Company Name Target Corporation Current Year Forecast Explanation of Assumptions Income Statement Assumptions Sales Growth 1.6% 2.0% The current year's sales have grown by 1.6% as compared to the previous period and they are expected to grow by 2% above the current year next year. Cost of Goods Sold/Sales 70.0% 72.0% COGS for target is currently at 70% which leaves the company with only 30% Gross profit. The COGS is estimated to increase to 72%; proportional to the sales growth. Targetdirectly currently has not incurred any R&D expense and it didn't - - SG&A/Sales 66.0% 69.1% incur any R&D in the previous annual fiscal year ended 30 January, 2016. Target currently has not incurred any R&D expense and it didn't incur any R&D in the previous annual fiscal year ended 30 January, 2016. This is expected to increase by approximately 3.1% next year. Dep&Amort/Avge PP&E and Intang. 2.2% 3.7% Depreciation is currently at 2.2% and this expected to increase to 3.7% come next year 2017. Net Interest Expense/Avge Net Debt 0.9% 1.5% Net iterest/average net debt is currently 0.9% and this is estimated to grow to 1.46% next year due to new debt. 0.0% Following the company's trend that Target receives income from operating activitvities, there's no non-operating income currently and it's therefore not possible to estimate. R&D/Sales Non-Operating Income/Sales 0.0% Effective Tax Rate Minority Interest/After Tax Income 31.6% 0.0% 30.7% 0.0% Target's effective tax rate 2016 is at 31.6%. This rate had dropped from 34% and it's even expected to drop further to approximately 30.66% next year. There's no minority interest for Target Corp. currently. Other Income/Sales 0.9% 1.2% Other income/sales is currently 0.9%. This may increase slightly to approximately 1.2% next year. Ext. Items & Disc. Ops./Sales Pref. Dividends/Avge Pref. Stock 0.0% 0.0% 0.0% 0.0% There are no extra ordinary items in Target's financial statements in the current year. Target has no Preferred dividends but Common Stock dividends. 16.0% - 17.8% - Balance Sheet Assumptions Working Capital Assumptions Ending Operating Cash/Sales Ending Receivables/Sales The current operating cash is only 16%. This may only increase slightly to about 17.8 next year. Ending Inventories/COGS 71.7% 71.7% The inventories of Target Corp. are very high at 71.7%. It's hard to estimate whether this may decrease or increase next year as the company faces changing seasonality. Ending Other Current Assets/Sales 10.0% 14.0% Other current assets may increase by 4% to around 14% in the following year. Ending Accounts Payable/COGS 89.0% 89.0% Ending Taxes Payable/Sales 2.0% 0.6% Accounts payables may not change much next year, it's therefore difficult to forecast. Taxes payable are expected to drop and therefore this may decrease to around 0.6% next year. Ending Other Current Liabs/Sales Other Operating Asset Assumptions 0.8% 1.2% Other current liabilities may increase slightly to around 1.2% as there's no efficient trend. Ending Net PP&E/Sales 141.0% 130.0% Ending Investments/Sales Ending Intangibles/Sales 0.1% 0.0% 0.1% 0.0% Ending Other Assets/Sales Other Operating Liability Assumptions 1.7% 2.0% Other Liabilities/Sales Deferred Taxes/Sales Financing Assumptions 9.8% - 8.5% - Current Debt/Total Assets Long-Term Debt/Total Assets Minority Interest/Total Assets Preferred Stock/Total Assets Dividend Payout Ratio 31.0% 31.0% - 44.0% 35.4% 34.0% - 48.2% The company's PPE exceeds the sales revenue currently. But may drop by approximately 10% due to increase in sales and depreciation. Target's investments are currently minimal and the change may be insignificant next year. There are no intangibles in Target's financial statements currently. The other asstes/sales are at 1.7%. There may be an insignificant change in the following year. Other liabilities are currently at 9.8%. There's a possibility that this may decrease slightly to an estimated 8.5% next year. The current debt/total assets is currently at 31%. It's forecasted to increase to 35.4% as the company mainly receives financing from debt and may add more current debt next year. Target's long-term debt/total assets ratio is at 31% in the current year. This is estimated to increase to 34% due to new long-term debt plans in progress. Target's payout ratio is currently at 44% and is one of the highest ratios. It's estimated to increase to around 48.2% next year following the trend over the past three years. SAMPLE RATIO DISCUSSION ANALYSIS 1. Prepare a written analysis of the financial ratios resulting from the Week 2 eVal Financial Forecast of the selected company. This must include trend analysis (historical and projected) and comparative analysis (cross-sectional or industry). The analysis needs to examine strengths and weaknesses revealed by the data. Remember, in a written ratio analysis the actual ratio data need to be included in the written analysis in addition to presentation in any accompanying tables or figures (graphs). Following is an analysis of the financial ratios in Week 2's eVal Financial Forecast for Microsoft Corporation. Trend Analysis Five-year timelines will be used for historical and forecasted data for comparison purposes (red highlighted items reflect areas of interest): Annual Growth Rates Analysis Historical (2011 - 2015). Sales grew 5.4%, 5.6%, 11.5%, and 7.8% during the historical period at an average yearly rate of 7.6% and an actual growth rate of 33.79% over the period. Assets grew 11.6%, 17.4%, 21.0%, and 2.2% at an average yearly rate of 13.05% and an actual growth rate over the period of 62.11%. Common equity decreased from 16.3% to -10.8% over the period (-166.26%) due to negative growth rate in 2015 contributable to a reduction in retained earnings. Earnings, however, was sporadic contributable to a large non-operating loss every third year. Earnings dropped -26.7% in 2012, increased 28.8% in 2013, increased 1% in 2014, but decreased again -44.8% in 2015 for an actual decrease of -47.33% over the period. Microsoft's sustainable growth rate is lowest in the years of the large nonoperating loss and reflects 19.5%, 15.2%, and 2.5% in the last three-years. Forecasted (2016 - 2020). Sales are projected to decline in 2016 by -6.9% attributed to Microsoft's transition period, and then continue to grow at a declining rate from 9.3% to 7.2%. Over the period sales are projected to increase 37.30%, which is comparable to the historical timeframe. Assets are predicted to grow 36.32% (a lot slower than the 62.11% historical data); caused by a forecasted negative gain in 2016. Common equity is expected to increase from -3.1% to 6.8% over the period (+319.35%) due to several positive growth rates across the period (a reverse of the historical data). Projected earnings will continue to be sporadic, contributable to the pattern of large non-operating loss every third year. Forecasted earnings are anticipated to increase 67.2% in 2016, increase 12.0% in 2017, decrease -31.3% in 2018, increase 66.7% in 2019 and increase 9.2% in 2020 for a projected growth rate of 40% over the period (a reverse of the historical data). Microsoft's sustainable growth rate is also lowest in years of a projected continued pattern of large non-operating loss, but expected to average at 10.98% across the forecasted years. Forecasted (2021 - 2027). Sales are expected to grow at a steady declining rate through the rest of the eVAL forecast from 6.5% until the terminal rate of 3%. Similarly, assets and common equity are also projected to grow from 6.3% to 3% and 6.1% to 3% respectively. Conversely, earnings and sustainable growth rate are forecasted to follow the same pattern as the historical data and earlier forecast. Profitability and Margin Analysis Historical (2011 - 2015). The company's return on equity for 2012 - 2014 averaged .279, decreasing by -47.64% to .144 in 2015 with the $9,650 million non-operating loss. Similarly, return on assets averaged .227, decreasing by -52.02% to .107 in 2015 for the same reason. Microsoft's gross margin decreased -13.39% (.814 to .705) over the five-year period, as did the EBIT margin (-22.42%) (.388 to . 301) and net operating margin (-59.88%) (.324 to .130). The large drop in net operating margin attributable again to the non-operating loss. Forecasted (2016 - 2020). The company's return on equity is expected to increase 8.49% over the period (.259 to .281), with a decrease from .282 to .178 in 2018 consistent with a projected non-operating loss. Similarly, return on assets is forecasted to increase 8.89% over the period (.180 to .196), but decrease from .197 to .124 in 2018 for the same reason. Microsoft's gross margin is expected to steadily decline -1.76% over the five-year period (.738 to .725), while EBIT margin is anticipated to remain around .308 with no change and net operating margin sporadically increase 2.14% (.234 to .239) with a drop to .152 in 2018 attributable to the patterned non-operating loss. Forecasted (2021 - 2027). Return on equity and return on assets is projected to continue the same pattern as the historical data and earlier forecast. Gross margin and EBIT margin are expected to continue steadily decreasing (.721 to .705 and .307 to .305 respectively), while net operating margin should maintain the same sporadic pattern. Turnover Analysis Historical (2011 - 2015). The company's net operating asset turnover dropped -17.02% from .987 to .819. Similarly, the net working capital turnover decreased -15.88% from 1.448 to 1.218. The average days receivables dropped slightly by -4.10% during the period (from 76.16 to 73.04 days), while the average days inventory increased 18.48% (from 31 to 36.7 days) and the average days payables dropped -12.66% (from 105.10 to 91.79 days). The aggregate of these average day measures caused the cash conversion cycle (CCC) to increase 774.17% from 2.06 days to 17.97 days over the period. Forecasted (2016 - 2020). The company's projected net operating asset turnover is anticipated to increase 6.63% (from .769 to .820). While, the net working capital turnover is forecasted to change from 1.092 to 1.171 (+7.23%). The forecasted average days receivables is expected to drop -6.81% during the period (from 72.44 to 67.50 days), while the average days inventory and average days payables is anticipated to drop -13.08% (from 42.37 to 36.82 days) and -15.70% (from 98.40 to 82.95 days) respectively. The individual average day projections are expected to cause an increase in the cash conversion cycle by 30.31% (from 16.41 to 21.38 days). Forecasted (2021 - 2027). Net operating asset turnover is projected to increase from .821 to .822, while net working capital turnover is expected to decline from 1.168 to 1.152. Microsoft's CCC is forecasted to increase as average days receivables increase from 67.72 to 68.83, average days inventory increases from 36.94 to 37.77, and average days payables increases from 83.27 to 85.51 days. Leverage Analysis Historical (2011 - 2015). In lieu of repatriating overseas funds at a higher tax rate, Microsoft has begun to increase its leverage to fund corporate initiatives. The company's debt to equity ratio over the historical period increased 92.17% (.230 to .442), while its CFO to total debt ratio decreased -63.39% (1.844 to . 675) due to increased leverage and the large non-operating loss in 2015. Subsequent to debt is a company's ability to service that debt. Microsoft's current ratio decreased slightly over the period by -3.96% (2.604 to 2.501). The company's quick ratio also decreased minimally by -.52% (2.306 to 2.294). The reductions were not enough to significantly affect payments. The EBIT interest coverage increased to 1878.13 in 2015 after four years of negative amounts caused by a positive net income expense. Forecasted (2016 - 2020). Microsoft is on track to continue to use leverage to fund corporate initiatives. The company's debt to equity ratio is forecasted to increase slightly by .92% (.432 to .436), while its CFO to total debt ratio can expect to increase 29.43% (from .666 to .862). The forecast for Microsoft's ability to service its debt is promising. The company's current ratio is projected to decrease slightly over the period by -.39% (2.526 to 2.516). Likewise, the quick ratio is also projected for a slight decrease of -.47% (2.322 to 2.311). The EBIT interest coverage is anticipated to increase 6.96% (from 1517.46 to 1623.09). Forecasted (2021 - 2027). Microsoft is expected to continue its leverage in lieu of repatriating funds. Debt to equity is projected to increase from .437 to .442 and CFO to total debt from .616 to .807. The company is forecasted to maintain high current and quick ratios, declining from 2.513 to 2.501 and 2.308 to 2.294 respectively. The EBIT interest coverage is also projected to decline from 1618.26 to 1596.41. Comparative Analysis (CSI Market, n.d.). The chart below reflects Microsoft compared to the Software and Programming Industry: Microsoft falls well below standards in its sales (8.41% to Industry's 13.37%), earnings (-8.26% to .64%), and free cash flow (.92% to 7.02%) growth rates. The negative 5-year average earnings are attributable to a one-time non-operating loss every third year. Conversely, the company is above industry standards with return on equity (26.73% to 21.59%) and return on assets (14.07% to 11.62%). Microsoft falls slightly below standards in gross margin comparisons (72.32% to 74.38%), but through good expense management beats the industry in operating (30.82% to 25.12%) and net margin (24.53% to 19.05%) comparisons. The company's asset turnover beats the industry (.52 to .51), but falls short in its receivable turnover (6.26 to 7.95) and inventory turnover (11.38 to 16.57). While Microsoft's debt to equity ratio is higher than the industry (.39 to .17) because of increasing debt in lieu of repatriating overseas funds, its debt coverage falls substantially short (.72 to 1.55). And finally, the company does well at beating the industry with short-term liquidity. Its current and quick ratio both beat the industry (2.57 to 2.43 and 2.04 to 1.48 respectively). Strengths and Weaknesses Annual Growth Rates Analysis Microsoft's sporadic earnings are a weakness to its operations. Microsoft's financials have been clouded by several one-time charges over the years, resulting in very inconsistent and confusing results; making it hard to forecast trends. Harry (2016) comments that the firm has taken so many one-time charges (due to bad acquisitions) that it seems that it is part of the normal operations. Microsoft shows strengths, however, in its sustainable growth rate averaging 12.4% in actual years and 10.98% in earlier forecasted years. This means at a projected sustainable rate of 10.98% the company can grow at that rate without any additional financing. If the firm wishes to grow faster than this number, they will need to incur additional financing. Profitability and Margin Analysis Microsoft is doing well on its return on equity and return on operating assets (except in years of one-time charges). The company beats the industry standard on both accounts. Despite its dropping margins over the actual and forecasted periods, Microsoft still maintains a good gross, EBIT, and net operating margin. The firm beats the industry's EBIT and net operating margin standards, and falls slightly below the gross margin standard. This shows Microsoft's strength in expense management, to beat the industry's EBIT and net operating margins, after being below standard in gross margin. Microsoft needs to eliminate the one-time charge every three years to maintain stable margins across the horizon. Turnover Analysis Microsoft's asset turnover is almost the same as the industry's - meaning it does well at utilizing its assets to generate sales. The company shows strength in its working capital turnover reflecting a high level of working capital to support the generation of sales across historical and forecasted data. Microsoft's cash collection cycle averages 18.8 days actual and 20.4 days in the early forecast, which is a great strength, indicating how fast the company can convert the purchase of inventory to cash from its customers. The company shows efficiency in reducing its days collectible, going from 76.16 days in 2012 to a projected 67.50 days in 2020. Conversely, the firm has increased the days inventory from 31 to 36.8 days and decreased the days payable from 105.10 to 82.95 over the same period, causing a slight increase to the CCC in the forecasted years. Despite the slight increase, the company's CCC is still a strong strength. The lower a company's CCC the better its liquidity and the quicker it can pay its debts. Leverage Analysis Microsoft's debt to equity ratio is at a reasonable level, considering its usage of debt to fund operations. However, the declining CFO to total debt ratio over the historical and forecasted period has dropped to below 1.0 and is a weakness that needs addressing. The low long-term CFO ratio does not impede Microsoft's short-term liquidity where debt payment is the most concern. The company's current and quick ratios are great strengths providing excellent liquidity to the firm. The current ratio averages 2.5 actual and forecasted, while the quick ratio averages 2.3 actual and forecasted. Both are above industry standards. Additionally, the company shows strength in its EBIT Interest Coverage - 1878.13 in 2015 and the forecasted period averages 1607.69. This indicates how many times the EBIT will cover the debt service. Conclusion The continuous innovation and fast pace of the technology sector and software industry will continue to keep companies fighting for that competitive advantage. Microsoft in particular will continue to find its way as the company transitions its focus to the cloud and integrates its core products into that platform. Overall the forecasted ratios show similar patterns to the historical data. Of major concern is that the analysis points to Microsoft continuing to fluctuate in its earnings if the company doesn't figure out a way to eliminate the \"one-time\" charges every third year. This will continue to hamper margins, cloud its financial statements, and may keep investors away. 2. What are the most important things that you learned from the study of this week's readings and assignments? Remember to always include appropriate references. References: CSI Market. (n.d.). Microsoft corporation. Retrieved June 22, 2016, from http://csimarket.com/stocks/fundamentals_glance.php?code=MSFT Harry, J. (2016, June 21). Microsoft's margins seem to be in free fall - Not a good sign. Retrieved from http://seekingalpha.com/article/3983368-margins-crack-microsofts-armor? app=1&auth_param=1dases:1bmipng:ced0abc11afff6334529843d07167c3e&dr=1 - alt3 Stewart, B. (Spring 2009). EVA momentum: The one ratio that tells the whole story. Journal of Applied Corporate Finance, (21)2. Retrieved from http://eds.a.ebscohost.com. ezproxy.umuc.edu/eds/pdfviewer/pdfviewer?vid=1&sid=ed2c3577-3a7a-4918-87b9e05eac6e15b5%40sessionmgr4003&hid=4113