Today’s Topic: More on Financial Measurements

Types, Definitions and Uses and “Typical Patterns” for High-tech Businesses

This class is not required; you can take E421 or TG401B You are responsible for managing conflicts with other courses, especially Senior Design Pick up your name cards and return them after class

Reminders

 Send your completed homework to my AOL address: [email protected]

 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 feedback is requested and appreciated

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

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 contribute targeted amounts

to earnings/growth  Earnings growth (ultimately) requires

revenue growth

 Firms use

financial statements

to develop plans, and measure/analyze/report on their performance

…..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

But…..

how

do companies maximize earnings/growth?

By providing potential

customers

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)

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, …

Financial Statement Objectives



Income statement

(for a time period) 

revenues, costs, expenses, & earnings

 Balance sheet (at a point in time)  assets, liabilities and net capital  Cash Flow statement (for a time period)  cash ($$) in and out , and uses of cash

Financial Statement Uses



Historical/current

compensation

:

financial reporting, competitive analysis, performance measurement, performance analysis, 

Future (projected) :

goal setting, goal achievement analysis (planning), financing requirements, stock price assessment

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

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

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)

Method:

How to analyze an Income 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…?

Assignment Question #1

understanding 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)

Assignment Question #2

analyzing 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 FY10 what % 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.

Google Income Statement

year ending; $M

Revenues

COGS

Gross margin

R&D expense M&S expense G&A expense

Operating income

Interest rec'd Taxes

Net income

Dec-10 %revenue %growth

29,321 100 24.0

10,417

18,904

3,762 2,799 1,962 35.5

64.5

12.8

9.5

6.8

17.8

27.7

32.3

41.1

17.6

Dec-09 %revenue

23,651 100

8,844

14,807

2,843 1,984 1,668 37.4

62.6

12.0

8.4

7.0

10,381

415 2,291

8,505 35.4

1.4

7.8

29.0

24.8

501.4

23.1

30.4

8,321

69 1,861

6,520 35.2

0.3

7.9

27.6

Financial Statement Objectives



Income statement

(for a time period) 

revenues, costs, expenses, & earnings

 Balance sheet (at a point in time)  assets, liabilities and net capital  Cash Flow statement (for a time period)  cash ($$) in and out , and uses of cash

The Balance Sheet Equation

Net worth = what you own - what you owe Net Capital = Assets - Liabilities or Assets = Liabilities + Net Capital

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

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

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)

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

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

Impact of Product Type:

IBM, prior to sale of PC division

2002 2004 % of Revenue % of OI GM% Hardware 34% 23% 31% Software 16% 37% 87% Services 50% 40% 25%

Direct Selling

Company Sales force Customers bus/govt or consumer

Indirect Selling Through “Channel Partner(s)”

Company Sales force Sales force Customers bus/govt or consumers

Company profit Channel profit Total (full-stream) profit

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”



“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)

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)

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)

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 ????

Software is different…..

 Cost of producing copies (hardware) and delivering software to customers are lower than for “physical” goods  Normally, sw COGS 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

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 sales), often approaching zero (as % of  Asset requirements to deliver service (and associated depreciation) can be large

“Good” Operating Returns in the Business Market

Higher GM % Higher R&D %

OI/Rev (%) Software Hardware Service Sold direct 27% 18% 15% Sold indirect 23% 12% -

Lower GM % Lower M&S %

…and compared to Business markets, Consumer markets…

     Typically have 5-10% lower returns, because… operating Selling is mostly indirect (ex: internet) GM% is lower (indirect selling, price comp) Lower R&D% Higher Marketing%

“Good” Operating Returns in the Consumer Market

Higher GM % Higher R&D %

OI/Rev (%) Software Hardware Service Sold direct 20% 11% 9% Sold indirect 16% 7% -

Lower GM % Lower M&S %

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)

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

But…..

how

do companies make these things happen?

By providing potential

customers

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)

Customers assess “value” compared to competitors in 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)

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)

Assignment for Next Week: Analyzing a Company Medtronic

Medical technology $16.4 B annual revenue and OI%=29.4% (last 12 months) Founded in 1949 $41.8 B market cap, current P/E = 12.5

Market share leader in several product categories

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

Medtronic Stock Price: last five years

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?

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?

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)

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