Financial Reporting Choices and Bias that Affect the Quality and Comparability of a Company’s Financial Statements

Assume that our purpose for analysis is to identify and evaluate the drivers of financial success for ABC Ltd., a publicly held company in India, which is a leading car manufacturer. Further, we want to identify and understand the risks that may affect the sustainability of the company’s return. ABC Ltd. has four business divisions (segments): A, B, C, and D.

Note that this is a hypothetical company, and all the amounts used are purely for illustration purposes.

We will accomplish this purpose through a series of financial analyses as follows:

DuPont Analysis/Extended DuPont Analysis

An analyst should further explore the information provided in the company’s financial statements—this aids in establishing useful insights through a continuous disaggregation of the information into smaller components. These components can reveal a firm’s income drivers, as well as highlight weaker operations being overshadowed by stronger ones in the aggregate.

The premise of “seeking granularity” underlies the DuPont analysis. Separating the different components of ROE, aids the analyst to discover a firm’s strengths and allows the analyst to assess their sustainability. Additionally, it helps her/him to establish possible operational flaws and provides an opening for dialogue with management about possible problems.

DuPont Analysis Equation

$$\text{ROE}=\frac{\text{Net income}}{\text{Sales}}\times\frac{\text{Sales}}{\text{Average total assets}}\times\frac{\text{Average total assets}}{\text{Average equity}}$$

ROE is further granulated into five components under the extended DuPont analysis as follows:

$$\text{ROE} = \text{Tax burden}\times\text{Interest burden}\times\text{EBIT margin}\times\text{Total asset turnover}\times\text{Financial leverage}$$

In other words,

$$\text{ROE}=\frac{\text{Net income}}{\text{EBT}}\times\frac{\text{EBT}}{\text{EBIT}}\times\frac{\text{EBIT}}{\text{Sales}}\times\frac{\text{Sales}}{\text{Average total assets}}\times\frac{\text{Average total assets}}{\text{Average equity}}$$

The higher the proportion of net income to EBT, the lower the tax burden, which implies a higher ROE. Similarly, a lower interest burden reflects a higher ROE.

The EBIT margin is a profitability ratio. A higher EBIT margin indicates a higher ROE. On the other hand, the total asset turnover ratio is a measure of the effective utilization of assets. A higher ratio reflects the possibility of ROE growth. Finally, the higher the financial leverage, the higher the ROE.

Furthermore, the analyst should consider the firm’s sources of income and whether the income is generated internally from operations or externally from non-operating activities. It is advisable to remove the external sources of income as a firm has little or no control over income generated by ownership interest in an associate.

Removing equity income from associates in the DuPont analysis eliminates bias. An investor can analyze a company’s performance purely based on its asset base by eliminating the equity income from the investor’s earnings.

Moreover, total assets should be decreased by the carrying value of the investment. This is because, under the equity method, the company’s investment is reported as a balance sheet asset.

Note that in the absence of information about how the investment is financed, you should not adjust the financial leverage. In other words, you are implicitly assuming that the investment was financed using the same leverage as the rest of the company.

Assume that ABC Ltd has a 35% equity interest in XYZ Ltd. The selected financial data for ABC Ltd is as follows:

$$ \textbf{Exhibit 1: ABC Ltd.’s Selected Data on the Balance Sheet and the Income Statement} $$

$$\small{\begin{array}{l|r|r|r|r} \textbf{Rs in millions} & \textbf{2018} & \textbf{2017} & \textbf{2016} & \textbf{2015}\\ \hline\textbf{Balance sheet} & {}& {}& {}&{}\\ \hline\text{Total assets} & 80,862 & 71,865 & 72,504 & 62,332\\ \hline\text{Average assets} & 76,364 & 72,185 & 67,418 & -\\ \hline\text{Equity method investment} & 6,856 & 6,502 & 5,552 & 4,239\\ \hline\text{Shareholders’ equity} & 38,565 & 37,595 & 34,949 & 27,983\\ \hline\text{Average shareholders’ equity} & 38,080 & 36,272 & 31,466 & -\\ \hline\textbf{Income statement} &{} &{} &{} &{}\\ \hline\text{Sales} & 75,887 & 69,522 & 64,382 &{}\\ \hline\text{Profit before interest and tax} & 11,118 & 9,912 & 8,914 &{}\\ \hline\text{Profit before tax} & 10,064 & 9,075 & 7,859 &{}\\ \hline{\text{Income from associates(Not included in}\\ \text{earnings before interest and tax and earnings}\\ \text{before tax)}} & 1,497 & 1,275 & 1,228 &{}\\ \hline\textbf{Net income} & \bf{7,967} & \bf{6,894} & \bf{6,023} &{}\\ \end{array}}$$

$$ \textbf{Exhibit 2: Extended DuPont Analysis} $$

$$\small{\begin{array}{l|c|c|c|c|c|c|c} {}& {\textbf{Tax}\\ \textbf{burden}} & {\textbf{Interest}\\ \textbf{burden}} & {\textbf{EBIT}\\ \textbf{margin}} & {\textbf{Net profit}\\ \textbf{margin}} & {\textbf{Total assets}\\ \textbf{turnover}} & {\textbf{Financial}\\ \textbf{leverage}} & \textbf{ROE}\\ \hline\textbf{2016} & 76.64\% & 88.16\% & 13.85\% & 9.36\% & 0.96 & 2.14 & 19.14\%\\ \hline\textbf{2017} & 75.97\% & 91.56\% & 14.26\% & 9.92\% & 0.96 & 1.99 & 19.01\%\\ \hline\textbf{2018} & 79.16\% & 90.52\% & 14.65\% & 10.50\% & 0.99 & 2.01 & 20.92\%\\ \end{array}}$$

The net profit margin is made up of three components: EBIT margin × Tax burden × Interest burden. The tax and interest burdens indicate what is left for the company after the effects of taxes and interest, respectively.

The ROE improved slightly over the period, from 19.14% in 2016 to 20.92% in 2018. The granulation reveals that this is the result of an increasing EBIT margin and decreased effects of taxes and interest, i.e., increasing the net profit margin. Additionally, the increase in the interest and tax burden ratios indicates a decreasing impact of the effective tax and interest charges on operating earnings.

To examine ABC Ltd.’s performance on a standalone basis, we adjust the earnings by deducting the equity income and the total assets by deducting the equity investment. Analysts can also make other adjustments by removing unusual items such as restructuring charges and goodwill impairment from reported operating earnings before calculating the EBIT margin and the tax burden.

$$ \textbf{Exhibit 3: Extended DuPont Analysis (Excluding Equity Income and Investment Assets)} $$

$$\small{\begin{array}{l|c|c|c|c|c|c|c} {}& {\textbf{Tax}\\ \textbf{burden}} & {\textbf{Interest}\\ \textbf{burden}} & {\textbf{EBIT}\\ \textbf{margin}} & {\textbf{Net profit}\\ \textbf{margin}} & {\textbf{Total assets}\\ \textbf{turnover}} & {\textbf{Financial}\\ \textbf{leverage}} & \textbf{ROE}\\ \hline\textbf{2016} & 61.01\% & 88.16\% & 13.85\% & 7.45\% & 1.03 & 2.14 & 16.43\%\\ \hline\textbf{2017} & 61.92\% & 91.56\% & 14.26\% & 8.08\% & 1.05 & 1.99 & 16.90\%\\ \hline\textbf{2018} & 64.29\% & 90.52\% & 14.65\% & 8.53\% & 1.09 & 2.01 & 18.62\%\\  \end{array}}$$

Where:

$$\text{Tax Burden}=\frac{\text{Net income}-\text{Equity income}}{\text{EBT}}$$

$$\text{Total asset turnover}=\frac{\text{Sales}}{(\frac{\text{Beginning total assets}-\text{Beginning investment}+\text{Ending total assets}-\text{Ending equity investment}}{2})}$$

The adjusted ROE is lower than the reported ROE. Therefore, eliminating equity income and equity investment income decreases the ROE in this case. Note that the EBIT margin remained constant, as ABC Ltd did not include equity income from XYZ Ltd. as a part of EBIT. Moreover, the financial leverage is not adjusted since we are assuming that the investment in associates used the same capital structure as the parent company.

Asset Base Composition

Analysis of the asset base composition entails examining changes in the composition of the balance sheet over time. An essential starting point would be presenting balance sheet items as a proportion of total assets, in other words, presenting them in a standard size format.

$$ \textbf{Exhibit 4: ABC Ltd.’s Selected Data on Total Assets} $$

$$\small{\begin{array}{l|rr|rr|rr} \textbf{Rs. in millions} & \textbf{2018}&{} & \textbf{2017} &{}&\textbf{2016}&{}\\ \hline\text{Cash and cash equivalents} & 4,427 & 5.28\% & 4091 & 5.32\% & 4,021 & 4.88\%\\ \hline\text{Short-term investments} & 2,114 & 2.52\% & 4421 & 5.74\% & 8,998 & 10.92\%\\ \hline\text{Inventories} & 6,407 & 7.64\% & 5537 & 7.20\% & 5,630 & 6.83\%\\ \hline\text{Trade and other receivables} & 10,741 & 12.81\% & 10741 & 13.96\% & 11,001 & 13.35\%\\ \hline\text{Other current} & 2,798 & 3.34\% & 3450 & 4.48\% & 7,938 & 9.63\%\\ \hline\textbf{Total current assets} & 26,487 & 31.58\% & 28240 & 36.70\% & 37,588 & 45.61\%\\ \hline\text{Property, plant & equipment (PPE)} & 15,986 & 19.06\% & 14702 & 19.10\% & 13,834 & 16.78\%\\ \hline\text{Intangibles} & 5,593 & 6.67\% & 3182 & 4.13\% & 2,537 & 3.08\%\\ \hline\text{Goodwill} & 23,937 & 28.54\% & 20500 & 26.64\% & 19,434 & 23.58\%\\ \hline\text{Other non-current assets} & 11,870 & 14.15\% & 10330 & 13.42\% & 9,026 & 10.95\%\\ \hline\textbf{Total assets} & \bf{83,873} & \bf{100.00\%} & \bf{76,954} & \bf{100.00\%} & \bf{82,419} & \bf{100.00\%} \\  \end{array}}$$

It is typical for a manufacturing company to have significant investments in both current assets and fixed assets. However, the proportion of ABC Ltd.’s goodwill is significant—28.54% of total assets at the 2018 fiscal year-end. Goodwill is the difference between the acquisition price and the fair value of all identifiable tangible and intangible assets during an acquisition.

Goodwill and intangible assets are the hallmarks of a growth-by-acquisition strategy. They were composed of 35.21% of total assets in 2018, whereas in 2016, they amounted to 26.66% of total assets. An increase in ABC’s goodwill and intangible assets from 2016 to 2018 indicates that the company has been actively acquiring companies in the last three years.

Capital Structure Analysis

One limitation of using the financial leverage as a measure of capital structure is that it says nothing about nature, or riskiness, of the different financing instruments used by a company. For example, ABC’s financial leverage declined from 2.14 in 2016 to 2.01 in 2018. However, the ratio does not reveal the true nature of the leverage, as some liabilities are more burdensome than others.

The financial burden imposed by bond debt is more onerous and bears more consequences in the event of default relative to employee benefit plan obligations.

In the following illustration, we assess ABC Ltd.’s long-term capital.

$$ \textbf{Exhibit 5: Long-Term Capital} $$

$$\small{\begin{array}{l|rr|rr|rr} \textbf{Rs. in millions} & \textbf{2018}&{} & \textbf{2017}&{} & \textbf{2016}\\ \hline\text{Long-term financial liabilities} & 4,831 & 9.37\% & 5,407 & 10.78\% & 6,335 & 13.08\%\\ \hline\text{Other long-term liabilities} & 8,220 & 15.94\% & 7,210 & 14.38\% & 7,204 & 14.88\%\\ \hline\text{Total equity} & 38,505 & 74.69\% & 37,535 & 74.84\% & 34,889 & 72.04\%\\ \hline\text{Total long-term capital} & \bf{51,556} & \bf{100.00\%} & \bf{50,152} & \bf{100.00\%} & \bf{48,428} & \bf{100.00\%}\\  \end{array}}$$

ABC Ltd.’s equity financing increased from 72.04% in 2016 to 74.69% in 2018. However, the company’s long-term financial liabilities declined from 13.08% in 2016 to 9.37% in 2018, indicating a significant decrease in the financial leverage.

Given the substantial decline of the financial leverage in the long-term capital structure, an analyst can consider the possibility of changes in the company’s working capital accounts.

Let’s examine ABC Ltd.’s liquidity situation in the following illustration.

$$ \textbf{Exhibit 6: Selected Working Capital Data and Ratios} $$

$$\small{\begin{array}{l|r|r|r|r} \textbf{Rs. in millions} & \textbf{2018} & \textbf{2017} & \textbf{2016} & \textbf{2015}\\ \hline\textbf{Balance Sheet} & & & & {}\\ \hline\text{Cash and cash equivalents} & 4,427 & 4,091 & 4,021 & 3935\\ \hline\text{Short-term investments} & 2,114 & 4,421 & 8,998 & 7,349\\ \hline\text{Inventories} & 6,407 & 5,537 & 5,630 & 4,835\\ \hline\text{Trade and other receivables} & 10,741 & 10,741 & 11,001 & 8,250\\ \hline\text{Other current} & 2,798 & 3,450 & 7,938 & 5,870\\ \hline\text{Total current assets} & 26,487 & 28,240 & 37,588 & 30,239\\ \hline\text{Accounts payable} & 10,466 & 9,341 & 8,323 & 6,893\\ \hline\text{Notes payable} & 17,720 & 11,387 & 13,730 & 10,846\\ \hline\text{Other current liabilities} & 3,765 & 3,630 & 4,668 & 4,273\\ \hline\text{Current liabilities} & 30,328 & 22,735 & 25,098 & 20,389\\ \hline\textbf{Other data} & & & &{}\\ \hline\text{Sales} & 75,369 & 68,921 & 63,781 &{}\\ \hline\text{Cost of goods sold} & 32,067 & 29,040 & 27,083 &{}\\ \hline\text{purchases} & 32,937 & 28,947 & 27,878 & {}\\ \hline\text{Average daily expenditures} & 184 & 171 & 159 &{}\\  \end{array}}$$

$$\small{\begin{array}{l|r|r|r} \textbf{Working Capital Ratios} & \textbf{2018} & \textbf{2017} & \textbf{2016}\\ \hline\text{Current ratio} & 0.87 & 1.24 & 1.50\\ \hline\text{Quick ratio} & 0.57 & 0.85 & 0.96\\ \hline\text{Defensive interval ratio} & 93.9 & 112.6 & 151.1\\ \hline\text{Days sales outstanding (DSO)} & 52.0 & 57.6 & 55.1\\ \hline\text{Days’ on hand of inventory (DOH)} & 68.0 & 70.2 & 70.5\\ \hline\text{Number of days payables} & 109.7 & 111.4 & 99.6\\ \hline\text{Cash conversion cycle} & 10.2 & 16.4 & 26.0\\  \end{array}}$$

Formulas Applied

$$\text{Current ratio}=\frac{\text{Total current assets}}{\text{Total current liabilities}}$$

$$\text{Quick ratio}=\frac{\text{Total current assets}-\text{Inventories}-\text{Other current assets}}{\text{Total current liabilities}}$$

$$\text{Defensive interval ratio}=\frac{\text{Total current assets}-\text{Inventories}-\text{Other current assets}}{\text{Average daily expenditures}}$$

$$\text{Days’ sales outstanding (DSO)}=\frac{\text{Average trade and other receivables}}{\text{Sales}}\times 365$$

$$\text{Days’ on hand of inventory (DOH)}=\frac{\text{Average inventories}}{\text{Cost of goods sold}}\times365$$

$$\text{Number of days payables}=\frac{\text{Average accounts payable}}{\text{Purchases}}\times365$$

Where:

$$\text{Purchases}=\text{Cost of goods sold}+\text{Ending inventory}-\text{Beginning inventory}$$

$$\text{Cash conversion cycle}=\text{DSO}+\text{DOH}-\text{Number of days payables}$$

From the above exhibits, both the current and quick ratios have declined over the last three years. The decline can be attributed to an increase in the notes payable and the decrease in short-term investments. Similarly, the defensive interval ratio has dipped over the period due to the increase in daily expenditures and a decrease in short-term investments.

On the contrary, the company’s receivables are collected sooner, as indicated by declining DSO. Similarly, DOH is declining, indicating an increase in the inventory turnover while the increasing number of days payable indicates that ABC Ltd. is paying suppliers more slowly. Additionally, a decreasing cash conversion cycle from 26.0 days in 2016 to 10.2 days in 2018 indicates an improvement in the way the company manages its receivables, inventory, and payables.

Segment Analysis and Capital Allocation

While DuPont analysis is useful in evaluating a company’s profitability in its core operations, it does not provide answers about the health of the different businesses. Additionally, it does not establish how effectively the management has allocated capital to the businesses or subsidiaries.

Consolidated financial statements often hide standalone attributes of different subsidiaries or business divisions (segments). A company should disaggregate financial information into segments. The practice assists users in understanding geopolitical investment risks and the different economies in which it operates. In this context, a segment is a portion of a larger company that accounts for a company’s revenues or assets of more than 10%. It is different from the company’s other line(s) of business in terms of risk and returns characteristics.

As earlier assumed, ABC Ltd. has four different segments, A, B, C, and D, as shown in the exhibit below:

$$ \textbf{Exhibit 7: Sales and EBIT by Segment} $$

$$\small{\begin{array}{l|rr|rr|rr} \textbf{Rs. in millions} & \textbf{2018}&{} &\textbf{2017}&{} & \textbf{2016}&{}\\ \hline\textbf{Sales} & {}& {}& {}&{} &{} &{}\\ \hline\text{A} & 11,130 & 14.77\% & 8,959 & 13.00\% & 7,966 & 12.49\%\\ \hline\text{B} & 34,405 & 45.65\% & 32,445 & 47.08\% & 29,967 & 46.98\%\\ \hline\text{C} & 22,448 & 29.78\% & 20,669 & 29.99\% & 19,594 & 30.72\%\\ \hline\text{D} & 7,386 & 9.80\% & 6,848 & 9.94\% & 6,254 & 9.81\%\\ \hline\textbf{Total Sales} & \textbf{75,369} & \textbf{100.00%} & \textbf{68,921} & \textbf{100.00%} & \textbf{63,781} & \textbf{100.00%}\\ \hline\textbf{EBIT} & & & & & &{}\\ \hline\text{A} & 2,543 & 22.87\% & 2,058 & 20.76\% & 1799 & 20.18\%\\ \hline\text{B} & 5,351 & 48.13\% & 4,966 & 50.10\% & 4407 & 49.44\%\\ \hline\text{C} & 2,585 & 23.25\% & 2,263 & 22.83\% & 2123 & 23.82\%\\ \hline\text{D} & 639 & 5.75\% & 625 & 6.31\% & 585 & 6.56\%\\ \hline\textbf{Total EBIT} & \bf{11,118} & \bf{100.00\%} & \bf{9,912} & \bf{100.00\%} & \bf{8,914} & \bf{100.00\%}\\  \end{array}}$$

From the above table, we see that division B is the largest segment in terms of contribution proportion to sales and EBIT, while division D is the smallest. Moreover, division D’s proportion of contribution to EBIT decreased from 6.56% in 2016 to 5.75% in 2018.

The following exhibit shows ABC Ltd.’s assets and capital expenditures by segment.

$$ \textbf{Exhibit 8: Assets and Capital Expenditure by Segment} $$

$$\small{\begin{array}{l|rr|rr|rr} \textbf{Rs. in millions} & \textbf{2018}&{} &\textbf{2017}&{} & \textbf{2016}&{}\\ \hline\textbf{Assets} & & & & & &{}\\ \hline\text{A} & 14880 & 27.52\% & 6964 & 15.49\% & 5391 & 12.97\%\\ \hline\text{B} & 20162 & 37.29\% & 19656 & 43.71\% & 19269 & 46.35\%\\ \hline\text{C} & 12413 & 22.96\% & 12030 & 26.75\% & 10882 & 26.18\%\\ \hline\text{D} & 6612 & 12.23\% & 6322 & 14.06\% & 6031 & 14.51\%\\ \hline\textbf{Total Assets} & \textbf{54,067} & \textbf{100.00%} & \textbf{44,972} & \textbf{100.00%} & \textbf{41,573} & \textbf{100.00%}\\ \hline\textbf{Capital Expenditure} & & & & & &{}\\ \hline\text{A} & 486 & 12.80\% & 439 & 13.47\% & 343 & 12.66\%\\ \hline\text{B} & 1535 & 40.42\% & 1302 & 39.94\% & 1121 & 41.38\%\\ \hline\text{C} & 944 & 24.86\% & 770 & 23.62\% & 721 & 26.61\%\\ \hline\text{D} & 833 & 21.93\% & 749 & 22.98\% & 524 & 19.34\%\\ \hline\textbf{Total Capital Expenditure} & \textbf{3,798} & \textbf{100.00%} & \textbf{3,260} & \textbf{100.00%} & \textbf{2,709} & \textbf{100.00%}\\  \end{array}}$$

The above exhibit reveals that division B requires the most significant proportion of assets and capital expenditures. On the other hand, division A has the least proportion of capital expenditure, while division D has the least assets proportion. Additionally, the capital expenditures of division D have increased over the period.

In the next exhibit, we compute the ratio of proportional capital expenditures to proportional assets for each division. A ratio of more than one implies that the firm is growing the segment by allocating a higher proportion of its capital expenditures relative to total assets to the segment. In contrast, a ratio of less than one implies that the firm is allocating a smaller percentage of its capital expenditures than that of total assets to the segment.

To determine if the firm is optimizing its capital investment, we can break down the contribution to the EBIT margin of each segment. We can then compare that contribution to the firm’s ratio of capital expenditure percentage to asset percentage.

$$ \textbf{Exhibit 9: EBIT Margin and Capital Expenditure % to Assets % by Segment} $$

$$\small{\begin{array}{l|rrr|rrr} {}&{}&\textbf{EBIT Margin} &{}&{}&\frac{\textbf{Capital Expenditure %}}{\textbf{Assets %}}&{}\\ \hline\text{}& \textbf{2018} & \textbf{2017} & \textbf{2016} & \textbf{2018} & \textbf{2017} & \textbf{2016}\\ \hline\text{A} & 22.85\% & 22.97\% & 22.58\% & 0.46 & 0.87 & 0.98\\ \hline\text{B} & 15.55\% & 15.31\% & 14.71\% & 1.08 & 0.91 & 0.89\\ \hline\text{C} & 11.52\% & 10.95\% & 10.83\% & 1.08 & 0.88 & 1.02\\ \hline\text{D} & 8.65\% & 9.13\% & 9.35\% & 1.79 & 1.63 & 1.33\\  \end{array}}$$

The above exhibit reveals that division D has the lowest EBIT margin. However, it has the highest ratio of capital expenditure percentage to the percentage of the assets. We can also see that division D’s EBIT margin declined from 9.35% in 2016 to 8.65% in 2018. This implies that if ABC Ltd. continues to over-allocate its capital resources, its future overall returns might be significantly affected.

The EBIT may not tell the whole story about a firm’s ability to generate cash flow. Therefore, we will assess segmental capital allocation decisions based on cash flow generated by each segment. However, it is not typical for an entity to report segmental information. We approximate cash flow as a sum of EBIT, depreciation, and amortization.

ABC Ltd.’s depreciation and amortization expense by division is as follows:

$$ \textbf{Exhibit 10: Depreciation and Amortization Expense by Segment} $$

$$\small{\begin{array}{l|r|r|r} \textbf{Rs. in Millions} & \textbf{2018} & \textbf{2017} & \textbf{2016}\\ \hline\text{A} & 255 & 248 & 225\\ \hline\text{B} & 727 & 673 & 686\\ \hline\text{C} & 460 & 411 & 449\\ \hline\text{D} & 412 & 401 & 334\\ \hline\textbf{Total} & \textbf{1,854} & \textbf{1,733} & \textbf{1,694}\\  \end{array}}$$

The next step is to estimate the cash flows using segmental EBIT and segmental depreciation and amortization information, as shown in the table that follows:

$$ \textbf{Exhibit 11: Estimated Cash Flow}=\text{EBIT}+\frac{\textbf{Depreciation}}{\textbf{Amortization}} $$

$$\small{\begin{array}{l|l|l|l} \textbf{Rs. in Millions} & \textbf{2018} & \textbf{2017} & \textbf{2016}\\ \hline\text{A} & 3,153 & 2,661 & 2,379\\ \hline\text{B} & 6,244 & 5,805 & 5,259\\ \hline\text{C} & 3,400 & 3,029 & 2,927\\ \hline\text{D} & 1,406 & 1,381 & 1,274\\ \hline\textbf{Total} & \textbf{14,203} & \textbf{12,876} & \textbf{11,839}\\  \end{array}}$$

Using the information from the above table and prior tables, we now calculate the cash operating return on average total assets.

$$ \textbf{Exhibit 12: Cash Generation and EBIT Margins per Segment} $$

$$\small{\begin{array}{lll|l|ll} {}&\frac{\textbf{Estimated cashflow}}{\textbf{Average assets}}&{}&{}&\textbf{EBIT Margin}\\ \hline\textbf{Segment} & 2018 & 2017 & & 2018 & 2017\\ \hline\textbf{A} & 28.87\% & 43.08\% & & 22.85\% & 22.97\%\\ \hline\textbf{B} & 31.36\% & 29.83\% & & 15.55\% & 15.31\%\\ \hline\textbf{C} & 27.82\% & 26.44\% & & 11.52\% & 10.95\%\\ \hline\textbf{D} & 21.74\% & 22.36\% & & 8.65\% & 9.13\%\\  \end{array}}$$

Where:

$$\text{Average assets}=\frac{\text{Beginning asset}+\text{Ending assets}}{2}$$

The above exhibit confirms that ABC Ltd. has made a poor capital allocation decision to division D. Moreover, we can see that although division A is continuing to generate superior operating margins, it has generated lower cash flow relative to the other divisions in 2018.

Summary

The key points to consider when identifying financial reporting choices and biases that have an impact on the quality and comparability of companies’ financial statements are as follows:

1. Apply disaggregation techniques such as the DuPont analysis to review the company’s sources of income and performance. Further, eliminate equity income from associates and the investment account to get rid of possible bias.
2. The next step is to assess the balance sheet composition over time. An essential starting point would be presenting balance sheet items in a common-size format.
3. Afterward, find out if the capital structure is adequate to sustain future obligations and strategic plans. Do this by analyzing the components of the entity’s long-term capital.
4. Finally, analyze the segment information to understand a firm’s geopolitical investment risks and the different economies in which it operates. The disclosures aid in identifying revenue and profit contribution by each segment. Additionally, they will assist you in establishing the relationship between capital expenditures and rates of return as well as identifying segments that should be eliminated.

Question

Simon Liam is a financial analyst for a prominent investment firm in Canada. Liam is interested in making a long-term equity investment at XYZ Ltd., a US-based consumer company. He is assessing the trends in ROE over the last three years using the DuPont analysis. Liam has the following data:

$$ \textbf{Selected Financial Data for XYZ Ltd. (US\$ Millions)} $$

$$\small{\begin{array}{l|r|r|r} {}& \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Revenue} & 71,445 & 65,484 & 54,778\\ \hline\text{Earnings before interest and tax} & 5,267 & 3,707 & 2,606\\ \hline\text{Earnings before tax} & 4,098 & 3,111 & 2,165\\ \hline\text{Net income} & 3,035 & 2,342 & 1,573\\ \hline\text{Total asset turnover} & 0.46 & 0.43 & 0.35\\ \hline\text{Assets/Equity} & 2.76 & 3.05 & 3.1\\  \end{array}}$$

Liam will most likely describe XYZ’s three year period return on equity (ROE) as: 

   A. Stable.

   B. Declining.

   C. Increasing.

Solution

The correct answer is C.

$$\text{ROE}=\text{Tax burden}\times\text{Interest burden}\times\text{EBIT margin}\times\text{Total asset turnover}\times\text{Financial leverage}$$

In other words,

$$\text{ROE}=\frac{\text{Net income}}{\text{EBT}}\times\frac{\text{EBT}}{\text{EBIT}}\times\frac{\text{EBIT}}{\text{Sales}}\times\frac{\text{Sales}}{\text{Average total assets}}\times\frac{\text{Average total assets}}{\text{Average equity}}$$

Applying the above extended DuPont equation gives the following results:

$$\small{\begin{array}{l|ccc|ccc|c} {}& {\textbf{Tax}\\ \textbf{burden}} & {\textbf{Interest}\\ \textbf{burden}} & {\textbf{EBIT}\\ \textbf{margin}} & {\textbf{Net profit}\\ \textbf{margin}} & {\textbf{Total assets}\\ \textbf{turnover}} & {\textbf{Financial}\\ \textbf{leverage}} & \textbf{ROE}\\ \hline\textbf{2017} & 72.66\% & 83.08\% & 4.76\% & 2.87\% & 0.350 & 3.10 & 3.12\%\\ \hline\textbf{2018} & 75.28\% & 83.92\% & 5.66\% & 3.58\% & 0.430 & 3.05 & 4.69\%\\ \hline\textbf{2019} & 74.06\% & 77.81\% & 7.37\% & 4.25\% & 0.460 & 2.76 & 5.39\%\\ \end{array}}$$

Using the above computations, we conclude that the return on equity has increased from 3.12% in 2017 to 5.39 % in 2019.

Reading 16: Integration of Financial Statement Analysis Techniques 

LOS 16 (b) Identify financial reporting choices and bias that affects the quality and comparability of company’s financial statements and explain how such biases impact financial decisions.