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Download financial statement analysis project and more Study Guides, Projects, Research Business Accounting in PDF only on Docsity! 1 Using A Project/Case Study To Teach Financial Statement Analysis In The Introductory Business Finance Course John T. Rose, Baylor University ABSTRACT This study presents a project, written in the form of a case study and accompanied by a Microsoft Excel template, to be assigned to an introductory course in business finance. The objective is to give introductory finance students an application of financial statement analysis beyond that provided by the typical end-of-chapter problems. The project is designed to enable students to link together the information provided by the several analytical tools—common size financial statements, analytical ratios, and the cash flow statement—and so obtain a complete picture of a firm’s financial performance over the past several years and relative to the average firm in the industry. INTRODUCTION ntroductory finance textbooks must necessarily cover a wide range of topics to give students an overview of the finance discipline and simultaneously prepare finance majors to move on to upper-level finance courses. With most topics, limited coverage (usually, one or two chapters) accompanied by end-of chapter problems is sufficient to give students an adequate introduction to the subject matter. Some topics, however, may be so briefly covered as to generate little substantive understanding, let alone interest, on the part of the student. A good example is “financial statement analysis,” which typically follows an overview of the balance sheet and income statement. In a single chapter (or the equivalent thereof presented in multiple sections across two or more chapters) the author may 1) introduce common-size financial statements, 2) present a listing and discussion of the principal analytical financial ratios, including the ratio decomposition provided by the DuPont Identity, and 3) discuss the concept of free cash flow and/or the accounting statement of cash flows. 1 Such coverage is usually concluded with an array of end-of-chapter problems and questions requiring students to, among other things, calculate and interpret the various analytical ratios, including the DuPont Identity, for a firm. Other problems may focus on free cash flow and/or the accounting statement of cash flows. Calculating financial ratios, working problems related to a firm’s cash flow, and even answering interpretive questions pertaining to calculated data, however, is only the first step in financial statement analysis, which essentially involves “telling a story” about a firm’s financial performance over the past few years and relative to other firms in the industry. 2 And while some of the more challenging end-of-chapter problems do push students 1 See, for example, Block and Hirt [2008], Brealey, Myers, and Marcus [2004}, Brigham and Houston [2007], Gitman [2006], Keown, Martin, Petty, & Scott, Jr. [2006], Megginson and Smart [2006], Moyer, McGuigan, and Kretlow [2006], and Ross, Westerfield, & Jordan [2007]. Of these, Block and Hirt [2008], Brigham and Houston [2007], Gitman [2006], and Megginson and Smart [2006] given attention to both the accounting statement of cash flows and the concept of free cash flow. By contrast, Brealey, Myers, and Marcus [2004] and Moyer, McGuigan, and Kretlow [2006] focus almost entirely on the accounting statement of cash flows and barely mention free cash flow. At the other extreme, Keown, Martin, Petty, and Scott, Jr. [2006] and Ross, Westerfield, and Jordan [2007] merely note the accounting statement of cash flows but spend considerable time on free cash flow or, as labeled in Ross et al., “cash flow from assets.” 2 For an excellent tutorial on the cash flow statement that speaks of the “story” within the statement, see Hertenstein and McKinnon [1997]. I Journal of Business Case Studies – March 2008 Volume 4, Number 3 2 to analyze individual areas of firm performance over time or relative to peer-group data, rarely do textbook problems require students to link common-size financial statements, analytical ratios, and cash flow data to tell a complete story about a firm’s financial condition. Yet until students learn to tie together the information from the several analytical tools available to the financial analyst, they will never see the breath of information contained in the financial data nor how the information gleaned from one tool is reinforced and illuminated by information provided by other tools. This study presents a project, written in the form of a case study, which may be assigned in the introductory finance course to give students an appreciation of financial statement analysis beyond that provided by solving the typical end-of-chapter problems. 3 In so doing, the project/case study is consistent with the new AACSB International’s Eligibility Procedures and Standards for Business Accreditation (approved in 2003; revised in 2004 and again in 2005), which mandate in Strategic Management Standard No. 13 that individual teaching faculty members should, among other things, actively involve students in the learning process. 4 Additionally, the project/case study serves to enhance students’ practical skills which Bennis and O’Toole [2005] argue is often sacrificed in business education in favor of a preoccupation with theory and quantitative proficiency. Finally, if assigned to be done by students working in small groups, the project/case study is consistent with another requirement of AACSB Standard No. 13, namely, that faculty members should encourage collaboration and cooperation among students, as well as Standard No. 14, which requires that individual students should, among other things, contribute to the learning of others. 5 Of course, assigning such a collaborative project introduces the “free rider” issue, namely, the possibility that the weaker students may simply let the stronger students do most, if not all, of the work. To deal with this issue, the instructor may ask students to complete a “colleague evaluation” of the contribution of each of their group members, which can be factored into the project grade for students identified by their group members as making little or no contribution to the project solution. Such an evaluation requirement not only encourages students to participate fully with their group, but it also gives them experience in personnel performance evaluation which many of them will someday be required to do as part of their professional managerial responsibilities. Alternatively, the instructor may give an exam on the project after it is completed, or include some project-related questions on the next general exam, in order to provide an incentive for all students to contribute to the project solution. The project outlined below is set in the case context of a student who has been offered employment with a hypothetical firm and wishes to determine if the firm is in sound financial condition before deciding whether to accept the job. 6 Thus, the project requires students to use financial statements of the firm, plus a Microsoft Excel template provided by the instructor, to 1) construct common-size financial statements, 2) calculate financial ratios, 3) prepare cash flow statements, and 4) answer a series of analytical questions addressing the firm’s financial performance in the areas of liquidity, solvency, asset management, profitability, and cash flow, as well as the market’s assessment of the firm’s financial condition. In addition, students may be asked to obtain industry data 3 As originally designed, this project required that students link only common-size financial statements and financial ratios. I am grateful to my colleague Ernest Fletcher, who suggested that the linkage be extended to include the cash flow statement. In fact, this the second of two projects developed by the author to be assigned in the introductory finance course. The first project—a hypothetical capital budgeting project—is presented in the context of a case study in Rose and Delaney [2005] and again in a different case scenario in Coldwell and Rose [2006]. 4 Projects, like case studies, represent an important pedagogical tool to involve students actively in the learning process. For a discussion of active learning (sometimes termed “student-centered”) techniques in teaching finance, see Moore [1999] and the literature cited. Additionally, Bruner, Gup, Nunnally, Jr., and Petit [1999] reviewed the literature of the previous twenty-five years on the relevant issues in incorporating case studies in finance instruction. More recently, Nunnally and Evans [2003] discuss the benefits of using integrative cases in the introductory finance course to help students understand the linkages between finance and the other business disciplines, and Yobaccio, Kennedy, and Schumacher [2006] present a student-centered program to integrate statistics and introductory finance. 5 For a recent discussion of the merits of team/group learning in introductory finance classes, see Ingram and Adams [2003]. 6 Clearly, this case context is not necessary to analyze the firm’s financial performance. The objective of such a context is to draw students into the project as a more practical and interesting assignment than an end-of-chapter problem. In addition, perhaps it will encourage students to use their knowledge of financial statement analysis to analyze a firm’s financial condition before interviewing with the firm and certainly before accepting employment with the firm. Journal of Business Case Studies – March 2008 Volume 4, Number 3 5 OVERALL EVALUATION 9. Based on your answers to the questions above, what is your overall evaluation of PCM’s financial condition? (Pull all your analysis together in answering this question.) 10. What is the market’s assessment of PCM’s financial condition? Explain. Does the market’s assessment confirm or refute your analysis? 11. Based on your evaluation of PCM and the market’s assessment of the firm, would you accept employment with the company? Explain. TEACHING NOTES Teaching notes available from author. REFERENCES 1. Bennis, W. G. and J. O’Toole. How Business Schools Lost Their Way, Harvard Business Review, 83 (May 2005), 96-104. 2. Block, S. B. and G. A. Hirt. Foundations of Financial Management, 12 th ed. New York, NY: McGraw- Hill/Irwin, 2008. 3. Brealey, R. A., S. C. Myers, and A. J. Marcus. Fundamentals of Corporate Finance, 4 th ed. New York, NY: McGraw-Hill/Irwin, 2004. 4. Brigham, E. F. and J. F. Houston. Fundamentals of Financial Management, 11 th ed. Mason, OH: Thomson South-Western, 2007 5. Bruner, R. F., B .E. Gup, B. H. Nunnally, Jr., and L. C. Pettit. Teaching with Cases to Graduate and Undergraduate Students, Financial Practice and Education, 9 (Fall/Winter 1999), 138-146. 6. Coldwell, C. L. and J. T. Rose. Teaching and Application in Introductory Finance: Using an Excel-based Case Study as a Pedagogical Tool, Journal of Business Case Studies, 2 (First Quarter 2006), 23-27. 7. Gitman, L. J. Principles of Managerial Finance, 11 th ed. Boston, MA: Pearson Addison Wesley, 2006. 8. Hertenstein, J. H. and S. M. McKinnon. Solving the Puzzle of the Cash Flow Statement, Business Horizons, January/February 1997, 69-76. 9. Hruby, G., D. Kahl, and M. Newman. Integrating Real-World Experience with the Classroom Experience: Two Different Approaches, Advances in Financial Education, 1 (Fall 2003), 28-40. 10. Ingram, V. and J. S. Adams. Effects of Team Learning on Success Rates in Introductory Finance Classes, Journal of Financial Education, 29 (Fall 2003), 28-39. 11. Keown, A. J., J. D. Martin, J. W. Petty, and D. F. Scott, Jr. Foundations of Finance, 5 th ed. Upper Saddle Rich, NJ: Prentice Hall, 2006. 12. Megginson, W. L. and S. B. Smart. Introduction to Corporate Finance. Mason, OH: Thomson South- Western, 2006. 13. Moore, S. Cases vs. Lectures: A Comparison of Learning Outcomes in Undergraduate Principles of Finance, Journal of Financial Education, 25 (Fall 1999), 37-49. 14. Moyer, R. C., J. R. McGuigan, and W. J. Kretlow. Contemporary Financial Management, 10 th ed. Mason, OH: Thomson South-Western, 2006. 15. Nunnally, B. H. Jr. and M. D. Evans, Case Teaching and the Integrative Process, Journal of Financial Education, 29 (Spring 2003), 75-86. 16. Rich, S. P. The Real-Time Restructuring Project: Maximizing Student Learning with Minimal Professor Effort, Journal of Financial Education, 31 (Winter 2005), 64-75. 17. Rose, J. T. and C. J. Delaney. Meeting the Mandate(s): Using a Project/Case Study to Comply with the New AACSB Accreditation Standards, Journal of Financial Education, 31 (Summer 2005), 89-98. 18. Ross, S. A., R. W. Westerfield, and D. D. Jordan. Essentials of Corporate Finance, 5 th ed. New York, NY: McGraw-Hill, 2007. 19. Yobaccio, E. J., K. Kennedy, and P. Schumacher. A Multidisciplinary and Student-Centered Approach to Teaching Quantitatively in Introductory Finance, Advances in Financial Education, 4 (Spring 2006), 1-13. Journal of Business Case Studies – March 2008 Volume 4, Number 3 6 Exhibit 1 Plush Carpet Mill, Inc. Balance Sheets ($000) December 31 2003 2004 2005 Assets Current assets Cash 1,512 1,176 1,097 Accounts receivable 6,237 10,271 15,919 Inventories 4,536 7,838 12,570 Prepaid expenses 3,780 5,140 6,840 Total current assets 16,065 24,425 36,426 Gross fixed assets 6,300 9,080 12,918 Less: Accumulated depreciation 2,050 2,958 4,250 Net fixed assets 4,250 6,122 8,668 Intangible assets 567 588 605 All other noncurrent assets 1,323 1,790 1,985 Total Assets 22,205 32,925 47,684 Liabilities and Stockholders Equity Current liabilities Notes payable 1,205 3,243 6,323 Current maturities--L.T.D. 1,008 1,460 2,246 Accounts payable 3,570 5,958 9,955 Income taxes payable 84 336 336 Accruals 1,995 3,360 5,016 Total current liabilities 7,862 14,357 23,876 Long-term debt 2,940 6,100 9,350 Total Liabilities 10,802 20,457 33,226 Stockholder’s equity Common stock10 3,360 3,360 3,360 Paid-in capital 2,100 2,100 2,100 Retained earnings 5,943 7,008 8998 Total stockholders’ equity 11,403 12,468 14,458 Total liabilities & equity 22,205 32,925 47,684 Market price per common share 17.25 17.71 18.43 Plush Carpet Mill, Inc. Income Statements ($000) 2003 2004 2005 Sales revenue 50,400 65,100 81,312 Less: Cost of goods sold 35,431 45,872 57,098 Gross profit 14,969 19,228 24,214 Less: Operating expenses Gen. & Adm. and Selling 12,331 15,099 17,296 Depreciation 630 908 1,292 Total operating expense 12,961 16,007 18,588 Operating income (EBIT) 2,008 3,221 5,626 Less: Interest expense 335 756 1,343 Earnings before taxes (EBT) 1,673 2,465 4,283 Less: Income taxes (34%) 569 838 1,456 Net income 1,104 1,627 2,827 Dividends paid 314 562 837 102,000,000 shares authorized at $3 par. Number of shares issued and outstanding in 2003-05: 1,120,000. Journal of Business Case Studies – March 2008 Volume 4, Number 3 7 Exhibit 2 Financial Statement Analysis Project Template Financial Performance Spreadsheet Names: Company Name: Plush Carpet Mill, Inc. Industry Dec. 31, 2003 Dec. 31, 2004 Dec. 31, 2005 Average Balance Sheet ($000) $ % of TA $ % of TA $ % of TA % of TA Assets Current Assets Cash & marketable securities A B A B A B E Accounts receivable A B A B A B E Inventories A B A B A B E Prepaid expenses A B A B A B E Total current assets A B A B A B E Gross fixed assets A B A B A B Less: Accumulated depreciation A B A B A B Net Fixed assets A B A B A B E Intangible assets A B A B A B E All other noncurrent assets A B A B A B E Total assets A B A B A B E Liabilities and Stockholders' Equity Current Liabilities Notes payable A B A B A B E Current maturities--L.T.D. A B A B A B E Accounts payable A B A B A B E Income taxes payable A B A B A B E Accruals and other current liabilities A B A B A B E Total current liabilities A B A B A B E Long-term debt A B A B A B E All other noncurrent liabilities A B A B A B E Total liabilities A B A B A B E Stockholders' equity Common stock A B A B A B Paid-in capital A B A B A B Retained earnings A B A B A B Total stockholders' equity A B A B A B E Total liabilities & equity A B A B A B E Industry 2003 2004 2005 Average Income Statement ($000) $ % of Sales $ % of Sales $ % of Sales % of Sales Sales revenue A B A B A B E Less: Cost of goods sold A B A B A B E Gross profit A B A B A B E Less: Operating expenses Gen. & Adm. and Selling A B A B A B Depreciation expense A B A B A B Total operating expenses A B A B A B E Operating income (EBIT) A B A B A B E Less: Interest expense A B A B A B E Earnings before taxes (EBT) A B A B A B E Less: Income Taxes (34%) A B A B A B Net income A B A B A B Common stock dividends (000) A A A Number shares common stock (000) A A A Earnings per common share (EPS) A A A Price per common share A A A Evaluation Trend Industry Industry Analysis Analysis Financial Ratios 2003 2004 2005 Average 2003-05 2005 Firm liquidity Current ratio (times) C C C E F F Quick or Acid-test ratio (times) C C C E F F