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Today’s Topic: More on Financial Measurements

Today’s Topic: More on Financial Measurements. Types, Definitions and Uses and “Typical Patterns” for High-tech Businesses.

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Today’s Topic: More on Financial Measurements

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  1. Today’s Topic:More on Financial Measurements Types, Definitions and Uses and “Typical Patterns” for High-tech Businesses

  2. This class is not required;you can take E421 or TG401BYou are responsible for managing conflicts with other courses,especially Senior DesignPick up your name cards and return them after class

  3. Reminders • Send your completed homework to my AOL address: carlpavarini@aol.com • Class presentation materials are on the course website: stevens.edu/sse/tgcourse • Class participation is 25% of your grade • Inform me via email if you will be missing a class • Ongoing feedbackis requested and appreciated

  4. Class Participation Grades • D,F: poor attendance and participation; inattention (web surfing, texting, talking, sleeping, etc) • C: good attendance and attention, but little/no active class participation • B: 2-4 active contributions per class (answers, comments, questions, stories, disagreements, challenges, …) • A: particularly insightful or useful contributions (not necessarily more frequent!) You will receive an interim cp grade at mid-term; If you want to know how you’re doing……ASK ME

  5. So far………. • Companies try to maximize the wealth of their owners --- market cap (stock price) plus dividends • Stock price and the ability to pay dividends are driven by earnings, and beliefs about future earnings growth • Individual products and services are expected to contributetargeted amounts to earnings/growth • Earnings growth (ultimately) requires revenue growth • Firms use financial statements to develop plans, and measure/analyze/report on their performance

  6. …..therefore, in terms of business objectives….. • A company’s basic financial objective is to grow its earnings quickly and sustainably, in order to raise its stock price and have the ability to pay its owners dividends • Products are successful if and only if they attain their targeted contribution to corporate earnings

  7. But…..how do companies maximize earnings/growth? By providing potentialcustomers a better (value - price) proposition than competitors while managing costs and expenses so as to make profits (earnings) (these are the topics for upcoming classes)

  8. Financial Measurements(can apply to company, product, project, …) • Types (items): revenues, costs, expenses, earnings, assets, depreciation, liabilities, cash, investments, …. • Reports (formats):income statement, balance sheet, cash flow statement, …

  9. Income statement (for a time period) Balance sheet (at a point in time) Cash Flow statement (for a time period) revenues, costs, expenses, & earnings assets, liabilities and net capital cash ($$) in and out , and uses of cash Financial Statement Objectives

  10. Financial Statement Uses • Historical/current: financial reporting, competitive analysis, performance measurement, performance analysis, compensation • Future (projected): goal setting, goal achievement analysis (planning), financing requirements, stock price assessment

  11. Financial Statement Timing • For external and internal reporting: annual & quarterly (10Q and 10K; required for public companies; see www.sec.gov) • For internal operations: monthly, weekly and (sometimes, e.g. sales) daily • May be historical, current or projected

  12. Key Concepts • Operations vs. total (e.g., OI vs. NI) • Normalizing results: return measures (e.g., OI as % of revenue; operating return on assets) • Knowing what “good” results are: competitive (industry) analogs/benchmarks --- today • Cash vs. non-cash

  13. The Income Statement Revenues - Cost of Goods Sold (COGS) = Gross Margin (gross profit) - M&S expense - R&D expense - G&A expense = Operating income (EBIT) - Interest - Taxes = Net income (earnings)

  14. Method: How to analyze anIncome Statement • (First, “calculate the percentages”) • Operating income vs. net income • In-period operating performance: costs, expenses and earnings as a % of revenue; compare to benchmark(s) • Cross-period performance (trends): relative change in rev, costs, expenses, earnings… improvements vs. deteriorations, and why • And…?

  15. Assignment Question #1understanding that technical people affect income statement results How can technologists impact the line items of the income statement? (cite two examples for each line item: revenues, COGS, M&S expense, R&D expense, G&A expense, interest, and taxes)

  16. Assignment Question #2analyzing Google’s (GOOG) income statement • For FY10 (calendar 2010), what were GOOG’s revenues ($), and relative (%rev) gross margin, operating income, and net income? • How did operating income change from FY09 to FY10(on both a total $ and relative basis)? What were the major financial determinants of the total $ change (revenues? COGS? R&D exp? SG&A exp?)? Of the relative (%rev) change? • Why did relative operating income and relative net income change differently from FY09 to FY10? Taxes? Interest? Other? • For FY10what % of revenue came from each of GOOG’s product categories? Which products had the highest and lowest gross margin %? • How has GOOG stock performed compared to the Nasdaq index over the last year? Speculate as to why.

  17. Google Income Statement

  18. Income statement (for a time period) Balance sheet (at a point in time) Cash Flow statement (for a time period) revenues, costs, expenses, & earnings assets, liabilities and net capital cash ($$) in and out , and uses of cash Financial Statement Objectives

  19. The Balance Sheet Equation Net worth = what you own - what you owe Net Capital = Assets - Liabilities or Assets = Liabilities + Net Capital

  20. The Balance Sheet Assets Current Assets: Cash +Accts Rec. +Inventory +Prepaid expenses + Net PP&E: PP&E at cost - Depreciation Total Assets Liabilities & Capital Current Liabilities: Accounts Payable +Accrued taxes +Accrued expenses + Short term debt + Long term debt Total liabilities + Retained earnings/loss + Owners’ equity Total liabilities&capital

  21. Cash Flow Statement Net operating cash flow (cash from operations) + Net cash from investing activities: capital expenditures +short term investments +securities (long term) + Net cash from financing activities: debt financing +stock financing Net change in cash

  22. Net Operating Cash Flow Net operating cash inflows: revenues - change in accts rec - Net operating cash outflows: COGS- depreciation + operating expenses + change in prepaid exp - change in accrued exp + change in inventory - change in accts payable Net operating cash flow (NOCF)

  23. Key Concepts • Operations vs. total (e.g., OI vs. NI) • Normalizing results: return measures (e.g., OI as % of revenue; operating return on assets) • Knowing what “good” results are: competitive (industry) analogs/benchmarks --- today/now • Cash vs. non-cash

  24. Typical Patterns: Financial Results Vary by …. • Product type: hardware vs. software vs. services • Customer: business/government vs. consumer • Method of selling: direct vs. indirect sales …. so we’ll need 12 (3x2x2) benchmarks

  25. Impact of Product Type: IBM, prior to sale of PC division 2002 2004 % of Revenue% of OIGM% Hardware 34% 23% 31% Software 16% 37% 87% Services 50% 40% 25%

  26. Direct Selling Company Customers bus/govt or consumer Sales- force

  27. Indirect Selling Through“Channel Partner(s)” Company Customers bus/govt or consumers Sales- force Sales- force Company profit Channel profit Total (full-stream) profit

  28. Impact of Customer Type: Business/gov’t. compared to consumer • higher selling price (higher value products) • higher gross margin % (less price competition) • higher R&D % (more complex products) • lower marketing % (fewer customers) • higher selling expense % (more direct selling) • net: higher operating return on sales (OI/rev) • in bus/hw market: OROS of 12-20% is “good” • in consumer/hw market: OROS = 8-13% “good”

  29. “Good” Operating Return (OI/Rev)… • Higher in business markets (12-25%) …compared to consumer markets (4-15%) (higher value products, less competition) • Highest with software products (5-10% higher) …compared to hardware or services (volume leverage from very high gross margin %) • Higher when selling direct (4-8% higher) …compared to selling through others (don’t have to share the total profit)

  30. Typical Financial Structure: “Hardware” for Business/Gov’t • List price 100 • Average selling price 80 (60-90 range) • Distributors’ price 60 (45-70 range) • COGS 40 (20-60 range) • Direct-sale gross margin = 50% (40/80) • Indirect-sale gross margin = 33% (20/60) • Distributor’s gross margin = 25% (20/80)

  31. Typical Financial Structure:“Hardware” for Consumers • List price 100 • Average selling price 90 (70-100 range) • Distributor’s price 75 (70-80 range) • COGS 60 (50-70 range) • Direct-sale gross margin = 33% (30/90) • Indirect-sale gross margin = 20% (15/75) • Distributor’s gross margin = 17% (15/90)

  32. So, for indirect sales…. • Price per unit (to producer) is lower • Revenues are lower for a given volume of sales • Gross margin % is lower • Given that companies are trying to maximize earnings/growth….why does any company choose to sell indirectly ????

  33. Software is different….. • Cost of producing copies and delivering software to customers are lower than for “physical” goods (hardware) • Normally, swCOGS are 10-20% of revenues (when sold indirectly; even lower when direct) • So, manufacturer’s indirect-sale gross margins are 80% to 90% …..very high!! • Conversely, development (R&D) expense is typically higher than many other products, often 20-35% compared to 10-20% for hardware

  34. And, so are Services…... • May be managed “for profit,” or to support the sale of hardware/software • If “for profit,” gross margins are typically 35 - 55% (salaries of people who provide the services are included in COGS, as is the depreciation on capital equipment used) • R&D expense usually much lower (as % of sales), often approaching zero • Asset requirements to deliver service (and associated depreciation) can be large

  35. “Good” Operating Returnsin the Business Market Higher GM % Higher R&D % Lower GM % Lower M&S %

  36. …and compared to Business markets, Consumer markets… • Typically have 5-10% lower operating returns, because… • Selling is mostly indirect (ex: internet) • GM% is lower (indirect selling, price comp) • Lower R&D% • Higher Marketing%

  37. “Good” Operating Returnsin the Consumer Market Higher GM % Higher R&D % Lower GM % Lower M&S %

  38. The Income Statement Revenues - Cost of Goods Sold (COGS) = Gross Margin (gross profit) - M&S expense - R&D expense - G&A expense = Operating income (EBIT) - Interest - Taxes = Net income (earnings)

  39. So, Successful Companies Have High Levels of Earnings and Earnings Growth via……. • High revenues……better products and/or better sales/marketing than competitors • High gross margins (%)…..low costs to produce and deliver products • “Low” expenses…..right-sized and efficient M&S, R&D, and G&A • Low tax payments; low interest payments or high interest receipts

  40. But…..how do companies make these things happen? By providing potentialcustomers a better (value - price) proposition than competitors while managing costs and expenses so as to make profits (earnings); thereby maximizing shareowner wealth (company valuation) (these are the topics for upcoming classes)

  41. Customers assess “value” compared to competitorsin multiple dimensions……. • Product performance/features (fit to market) • Price/performance vs. competitors • Availability (time to market) • “Info” on product/uses/benefits (marketing) • Reliability/maintainability • Sold the way customers want to buy (channels) • Customer service and support • Costs to use (life-cycle cost)

  42. The Income Statement Revenues - Cost of Goods Sold (COGS) = Gross Margin (gross profit) - M&S expense - R&D expense - G&A expense = Operating income (EBIT) - Interest - Taxes = Net income (earnings)

  43. Assignment for Next Week:Analyzing a Company Medtronic Medical technology Founded in 1949 $16.4 B annual revenue and OI%=29.4% (last 12 months) $41.8 B market cap, current P/E = 12.5 Market share leader in several product categories

  44. Getting Info on Medtronic • Company website: www.medtronic.com - especially “Investor Relations” section • Yahoo: finance.yahoo.com - enter “MDT” (Medtronic’s stock ticker symbol) • Securities Exchange Commission: ww.sec.gov - select “search for company filings,” enter MDT, see esp. the 10K annual report filed 6/28/11

  45. Medtronic Stock Price: last five years

  46. Assignment Questions -- 1 • What business is Medtronic in? • What product categories does it compete in? • Who are its customers? • How does it sell its products? • Who are its competitors? • Is its financial performance good? (use the annual income statement for YE Apr11 (FY11); suggestion: use the version in the SEC 10K report) • Is it improving or deteriorating? In absolute terms? In relative (% revenue) terms? Why? • What were the major determinants of the change in relative operating income from FY10 to FY11?

  47. Assignment Questions -- 2 • Why did MDT stock price fall significantly during Aug 2011? (suggestion: see Associated Press (AP) news item, Aug 23, 2011) • How has MDT’s stock price fared vs. the overall stock market (use the Nasdaq index) in the last year? Why? • What opportunities & challenges does Medtronic face in accelerating its revenue and profit growth in the future? (see esp. 10K data, “management’s discussion…”) • If you owned MDT stock, would you sell it right now?

  48. Method: How to analyze an income statement • (First, “calculate the percentages”) • Operating income vs. net income • In-period operating performance: costs and expenses as a % of revenue; compare to benchmarks • Cross-period performance (trends): relative change in rev, costs, expenses, earnings… improvements vs. deteriorations, and why • Going-forward opportunities and challenges/ risks for each line item (esp. rev and op inc)

  49. Topics for Next Class Finish financial measurements topic …and… Functions within a company: growth and profit responsibilities, how technical people “fit,” compensation in high-tech industries

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