FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS


Susanna Bauder, MBA, MSSF
Senior Financial Analyst
AEGON Institutional Markets, Inc.
Louisville, Kentucky 40202




Kathleen Voelker, MBA
Visiting Lecturer
Consultant
School of Business
Indiana University Southeast
New Albany, Indiana 47150




Jonathon Rakich, Ph.D
Professor of Management
School of Business
Indiana University Southeast
4201 Grant Line Road
New Albany, IN 47150
Phone 812, 246-4505

This is trial version
www.adultpdf.com
1

FINANCIAL AUDIT TEACHING AID FOR CASE ANALYSIS


ABASTRACT

This financial audit teaching aid for case analysis is a tutorial used by the authors in the capstone
senior and MBA business policy case courses at Indiana University Southeast. Its purpose is to
assist students in conducting diagnostic ratio analysis and interpretation of case financial
statements in order to draw conclusions about: (a) liquidity and capital structure risk, (b) the
corporation’s financial performance, and (c) the corporation’s activity leading to control
conclusions. A standardized financial audit form listing the indicators for each category appears
at the end of this document. This teaching aid contains the following tutorials:

• Basic accounting tutorial
• Financial ratios tutorial
• RMA (industry ratios) tutorial, and
• How to calculate financial “limits.” That is, whether additional resources can be obtained
by increasing the case company’s debt (based on its equity and/or assets relative to
industry standards) and/or by improving operations, i.e., working capital (based on
improving inventory and/or accounts receivables days relative to industry standards).


INTRODUCTION

This tutorial has been classroom tested for five years. It is most helpful to students who have
forgotten basic accounting and, more importantly, introduces them to the use of industry

averages for use in interpreting the ratios calculated from case financial statements. For senior
business policy students, the instructor provides industry numbers for the case being used in
class from the source, Annual Statement Studies, published by the Risk Management Association
(RMA). The RMA reports on numerous industries by SIC or NAICS codes. Each industry
report contains a common sized income statement and balance sheet, as well as key financial
ratios. A sample scanned RMA report appears at the end of this document. For graduate
students, the instructor provides industry numbers for the class case from the annual Troy’s
Almanac of Business and Financial Ratios published by Prentice Hall. These reports are similar
in construct to the RMA industry reports.

This paper refers to RMA industry numbers in the tutorial that are based on a class introductory
case, also included the following:

• An RMA definitional page (Appendix A).
• A sample RMA report with common sized income statement/balance sheet and key
financial ratios (Appendix B).
• A completed sample financial audit worksheet with ratio calculations that are based on a
sample case (Staples), along with an income statement and balance sheet (Appendix C
and D).
This is trial version
www.adultpdf.com
2
• A sample narrative write up students would create as they write their case analysis report,
including financial audit drawing inferences about risk, performance, control, and ability
of the company to increase resources based on the case company’s ratios relative to the
industry averages (Appendix E).

The writers have found that in case-oriented courses with financial data, it is imperative that
students evaluate financial statements through ratio analysis and compare to industry norms in
order to draw diagnostic conclusions. We are confident that this teaching aid, sources for

industry numbers, and various sample handouts will be of interest to faculty and students.


BASIC ACCOUNTING TUTORIAL

Balance Sheet: The balance sheet is a snapshot of a company’s assets, liabilities and equity on a
specific day (commonly December 31). The balance sheet provides information about
investments (what kind and how much), obligations to creditors (such as suppliers and banks),
and the owners’ equity in net resources. The balance sheet is useful for analyzing a company’s
liquidity, solvency and financial flexibility, as well as its performance (i.e. profitability).

Liquidity describes how quickly the company can convert an asset into cash, or how quickly a
liability has to be paid.

Solvency describes a company’s ability to pay its debts (liabilities) as they come due. Generally,
the more debt a company has, the riskier it is. It will need more assets to meet its obligations.

Financial Flexibility describes a company’s ability to take effective action to influence its cash
flows according to need and opportunity. Financial flexibility is often referred to as improved
operations such as reducing inventory or accounts receivables.

Liquidity, solvency and financial flexibility are calculated with the “Liquidity” and “Capital
Structure” ratios using only Balance Sheet elements.

Basic Accounting Equation

Assets = Liabilities + Equity
Assets – Liabilities = Equity (or: Assets – Equity = Liabilities)

Owned – Owed = Worth


Elements of the Balance Sheet

Assets: Things owned by the business, such as cash, money due from customers (accounts
receivables), inventory, buildings, land and equipments. Assets consist of:
Current Assets: Assets that can be converted into cash within a year or less.
This is trial version
www.adultpdf.com
3
Fixed Assets: Assets that are used or consumed over a long period of time (more than
one year) and that cannot be easily and quickly converted into cash, such as
property, plant and equipment.
Long-Term Assets: Long-Term Investments that are intended to be held for more than
one year, such as certificate of deposits, stocks, bonds and notes receivables.
Intangible Assets: Assets that have no physical substance, such as patents, copyrights,
trademarks and goodwill.
Other Assets: Any other assets that have not been described above.

Liabilities: Things the business owes to someone else (creditors) such as money owed to
suppliers (accounts payable), short term and long term debt (e.g. bank loans, line
of credit).
Current Liabilities: Money owed by the company and payable within one year.
Long-Term Liabilities: Money or obligations owed by the company that are NOT
payable with one year, such as mortgage payable, notes payable, leases, and bond
repayments.
Financial Instruments: Different ways that a company raises money, such as issuing
bonds, shares, or contracts to reduce foreign exchange risk.

Equity: What the business is worth, hence Equity = Net Worth
Capital Stock: All shares of stock representing ownership of the corporation.

Preferred Stock: A class of capital stock that has preference over common stock on
dividend payments and the liquidation of assets; usually has no voting rights.
Common Stock: Stock with voting rights, but no guarantee to dividend payments.
Treasury Stock: Common stock that was repurchased by the company and held in
the company’s treasury.
Additional Paid-In Capital: Capital contributed in excess of par/stated value by investors
Retained Earnings: Earnings kept in the company and not paid out as dividends.


Assets
=

Liabilities
+

Equity
Current Assets Current Liabilities Capital Stock
Cash Accounts Payables (A/P) Preferred Stock
Short-Term Investments Unearned Revenue Common Stock
Accounts Receivables (A/R) Accrued Liabilities Treasury Stock
Inventories Other Liabilities Additional Paid-In Capital
Prepaid Items Income Taxes Payable Retained Earnings
Long-Term Investments Long-Term Liabilities (Debt)
Property, Plant & Equipment Financial Instruments
Intangible Assets
Other Assets
Total Assets
=

Total Liabilities

+

Owners’ Equity

This is trial version
www.adultpdf.com
4
Income Statement: a report that measures the success or failure of a company’s operations over
a specific period of time (e.g. monthly, quarterly, yearly). The Income Statement provides
information about revenues, expenses, and gains and losses. The information in the Income
Statement can help you evaluate a company’s past performance, predict future performance and
help assess the risk of getting future cash flows.

“Performance” and “Activity” ratios are calculated with both Balance Sheet and Income
Statement elements.

Elements of the Income Statement (simplified)

Revenues: Inflows such as sales of goods or services, dividend revenues, & rental revenues.
Expenses: Cost of goods sold (CoGS), cost of sales (CoS), selling expenses, general &
administrative expenses, interest expenses, and income tax expenses.

Sales Revenues
Net Sales (from selling a product or service)
Cost of Sales (or Cost of Goods Sold)
Gross Profit (= Net Sales – CoGS/CoS)
Operating Expenses
Selling Expenses
General & Administrative Expenses
Income/Earnings before Interest & Tax (EBIT  Gross Profit – Operating Expenses)

Interest Expenses
Income/Earnings before Tax (EBT  EBIT – Interest Expenses)
Income Tax Expenses
Income/Earnings after Tax = Net Income = Net Profit


Both the Balance Sheet and the Income Statement are a company’s financial statements.
Financial ratios are calculated by using elements of the financial statements. Financial ratios
help you interpret and understand the relationship between elements of the financial statements.
A company’s financial ratios tell you about its liquidity, profitability and efficiency. By
comparing the financial ratios over several years, you can identify trends, problems or strengths.
By comparing a company’s financial ratios to an industry standard, you can determine how well
the company is doing, if there is room for improvement, or if the company is outperforming the
industry. Financial ratios are useful to both insiders and outsiders. Insiders, such as
management, use financial ratios to determine weaknesses and find ways to improve the
company’s operations and financial position. Outsiders, such as stockholders, creditors and
investors, use financial ratios to determine the risk of the company in terms of debt and the
likelihood of generating profit.

This is trial version
www.adultpdf.com
5
FINANCIAL RATIOS TUTORIAL
1


LIQUIDITY: Financial ratios in this category measure the company's capacity to pay its debts
as they come due.



Current Ratio

Definition: The ratio between all current assets and all current liabilities; another way of
expressing liquidity.
Formula: Current Assets .
Current Liabilities
Analysis:
• 1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in
current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible.
• One problem with the current ratio is that it ignores timing of cash received and paid out.
For example, if all the bills are due this week, and inventory is the only current asset, but
won't be sold until the end of the month, the current ratio tells very little about the
company's ability to survive.


Quick Ratio

Definition: The ratio between all assets quickly convertible into cash and all current
liabilities. Specifically excludes inventory.
Formula: Current Assets – Inventory
Current Liabilities
Analysis:
• Indicates the extent to which the business could pay current liabilities without relying on
the sale of inventory how quickly they can pay bills. Generally, a ratio of 1:1 is good
and indicates they don't have to rely on the sale of inventory to pay the bills.
• Although a little better than the Current ratio, the Quick ratio still ignores timing of
receipts and payments.


1

Adapted from the U.S. Small Business Administration website at www.sba.gov, retrieved on 2/9/2004.
This is trial version
www.adultpdf.com
6

CAPITAL STRUCTURE: Indicator of the businesses' vulnerability to risk. These ratios are
often used by creditors to determine the ability of the business to repay loans.


Debt to Equity (= Total Liabilities to Equity
2
)

Definition: Shows the ratio between capital invested by the owners and the funds provided by
lenders.
Formula: Total Liabilities (= Current Liabilities + Long-Term Liabilities)
Stockholders’ Equity
Analysis:
• Comparison of how much of the business was financed through debt and how much was
financed through equity. For this calculation it is common practice to include loans from
owners in equity rather than in debt.
• The higher the ratio, the greater the risk to a present or future creditor.
• Look for a debt to equity ratio in the range of 1:1 to 4:1
• Most lenders have credit guidelines and limits for the debt to equity ratio (2:1 is a
commonly used limit for small business loans).
• Too much debt can put the business at risk but too little debt may mean not realizing
the full potential of the business due to lack of leverage and may actually hurt overall
profitability. This is particularly true for larger companies where shareholders want a
higher reward (dividend rate) than lenders (interest rate).



Debt to Assets (= Total Liabilities to Total Assets)

Definition: Shows how well the company can cover its total debt with all its assets.
Formula: Current Liabilities + Long-Term Liabilities
Total Assets
Alternate Formula: Total Assets – Stockholders’ Equity (= Total Liabilities)
Stockholders’ Equity
Analysis:
• Shows how much of your assets are available to repay debt.
• Lenders look at this ratio to determine if there are adequate assets to make loan payments.



2
Equity is often referred to as “net worth.”
This is trial version
www.adultpdf.com
7

PROFITABILITY: The ratios in this section measure the ability of the business to
make a profit.


Gross Profit Margin

Definition: Gross profit as a percentage of sales. Indicator of how much profit is earned on
products/services without consideration of selling and administration costs.
Formula: Gross Profit
Sales

Analysis:
• The higher, the better.
• If overall cost and inflation are on the rise, then you watch for aerated decrease in sales
and therefore a decrease in profit margin.
• Compare to other businesses in the same industry to see if the business is operating as
profitably as it should be.
• Look at the trend from month to month, or year to year. Is it staying the same?
Improving? Deteriorating?
• Is there enough gross profit in the business to cover operation costs?
• Is there a positive gross margin on all products/services?


CoGS to Sales

Definition: Percentage of sales used to pay for expenses which vary directly with sales.
Formula: Cost of Goods Sold OR: 100 – Gross Profit Margin
Sales
Analysis:
• Look for a stable ratio as an indicator that the company is controlling its gross margins.


SG&A to Sales

Definition: Percentage of selling, general and administrative costs to sales.
Formula: Selling, General & Administrative Expenses
Sales
Analysis:
• Look for a steady or decreasing percentage indicating that the company is controlling its
overhead expenses.



This is trial version
www.adultpdf.com
8
Net Profit Margin

Definition: Shows how much profit comes from every dollar of sales.
Formula: Net Profit (i.e. net income)
Sales
Analysis:
• Compare to other businesses in the same industry to see if the business is operating as
profitably as it should be.
• Look at the trend from month to month, or year to year. Is it staying the same?
Improving? Deteriorating?
• Is the company generating enough sales to leave an acceptable profit?
• Trend from month to month can show how well they are managing operating or overhead
costs.


Return on Equity (also called ROE)
3


Definition: Determines the rate of return on investment in the business. As an owner or
shareholder this is one of the most important ratios as it shows the hard fact about
the business – is the business making enough of a profit to compensate investors
for the risk of being in business?
Formula: Net Profit
Equity
Analysis:

• Compare the return on equity to other investment alternatives, such as a savings account,
stock or bond.
• Compare ratio to other businesses in the same or similar industry.


Return on Assets (also called ROA)

Definition: Considered a measure of how effectively assets are used to generate a return.
Formula: Net Profit .
Total Assets
Analysis:
• ROA shows the amount of income for every dollar tied up in assets.
• Year to year trends may be an indicator but watch out for changes in the total asset
figure as the business depreciates assets (a decrease or increase in the denominator can
affect the ratio and doesn't necessarily mean the business is improving or declining.



3
Net Profit is sometimes labeled “Net Income,” Equity is sometimes labeled “Net Worth.”
This is trial version
www.adultpdf.com
9

ACTIVITY: Also called Asset Management or Efficiency ratios. Indicator of how
efficiently the company manages its assets.


Inventory Turnover


Definition: Number of times that the business turns over inventory during the year.
Formula: Cost of Goods Sold
Inventory
Analysis:
• Generally, a high inventory turnover is an indicator of good inventory management.
• But a high ratio can also mean there is a shortage of inventory.
• A low turnover may indicate overstocking, or obsolete inventory.
• Compare to industry standards.


Days in Inventory

Definition: This calculation shows the average number of days it will take to sell inventory
(number of days sales @ cost in inventory).
Formula: 365 Day .
Inventory Turnover
Analysis:
• Look for trends that indicate a change in inventory levels.
• Compare the calculated days in inventory to the inventory cycle.
• Compare to industry standards


Accounts Receivable Turnover

Definition: Number of times that accounts receivables turn over during the year.
Formula: Net Sales .
Accounts Receivable
Analysis:
• The higher the turnover, the shorter the time between sales and collecting cash.
• Compare to industry standards.



This is trial version
www.adultpdf.com
10
Days in Receivables

Definition: This calculation shows the average number of days it takes to collect accounts
receivable (number of days of sales in receivables).
Formula: 365 Days .
A/R Turnover
Analysis:
• Look for trends that indicate a change in customers' payment habits.
• Compare the calculated days in receivables to stated credit terms
• Compare to industry standards.


Sales to Net Fixed Asset

Definition: Indicates how efficiently the business generates sales on each dollar of net fixed
assets (= property, plant & equipment).
Formula: Sales .
Net Fixed Assets
Analysis:
• A volume indicator that can be used to measure the efficient use of net fixed assets from
year to year.


Sales to Total Assets


Definition: Indicates how efficiently the business generates sales on each dollar of assets.
Formula: Sales .
Total Assets
Analysis:
• A volume indicator that can be used to measure the efficiency of the business from year
to year.

This is trial version
www.adultpdf.com
11
RMA TUTORIAL

This sample Risk Management Association (RMA) tutorial uses the industry averages applicable
to Staples (SPLS) which has a NAICS code of 453210 - Retail Office Supplies and Stationary
Stores
4
(see Appendix B). The right hand column (current data sorted by sales) is used, which is
the largest sales category (25MM and over) that is available. The sample case is Staples. The
income statement and balance sheet are obtained from Compustat, an electronic database from
Standard & Poor (see Appendix D).

NOTE: You should understand financial ratio analysis before you read this section.

The upper half contains industry numbers on assets, liabilities and income stated in percentages.
The lower half contains industry numbers on specific ratios, e.g. quick ratio, current ratio, debt to
worth ratio, etc. When specific notes are presented on the RMA industry page, the median
(middle) value should be used.

Here are the sections you need to look at to calculate the industry ratios on your Financial Audit
work sheet:

Liquidity  Assets and Liabilities
Capital Structure  Assets and Liabilities
Performance  Income Data and Ratios
Activity  Income Data and Ratios

The RMA uses slightly different accounting terms. Below are RMA terms followed by some
generally known accounting synonyms:
• Receivables Net = Accounts Receivables = AR
• Fixed Assets Net = Net Fixed Assets = NFA
• (Total) Current Debt = (Total) Current Liabilities = CL
• (Tangible) Net Worth = Equity = Stockholders’ Equity = SE
• Total Debt = Total Liabilities  not given, however, you can calculate it! Remember the
accounting equation:

Assets = Liabilities + Equity OR Assets – Equity = Liabilities

Consequently, if:
Total Assets = 100
Equity = 29.2
Total Assets – Equity = Total Liabilities = 100 – 29.2 = 70.8

Now you can calculate the industry’s Debt/Equity, Debt/Assets and Current Debt/Total Debt
ratios. Remember, (Total) Debt = (Total) Liabilities, and Current Debt = Current Liabilities.

4
RMA, Annual Statement Studies – Financial Ratio Benchmarking, 2006-2007, p. 987.
This is trial version
www.adultpdf.com
12
Liquidity & Capital Structure Ratios


Current Ratio = 1.2
Quick Ratio = 0.9
Debt / Equity = 2.6
Debt / Assets = 0.708
Current Debt / Total Debt = ratio of 0.581 / 0.708 = 0.82

Performance Ratios

Gross Profit Margin %  Gross Profit = 29.5
CoGS % Sales  100 – Gross Profit number = 70.5
* Net Profit % Sales  Profit Before Taxes X 0.5 = 1.2
* RR Assets %  %Profit Bef. Taxes/Tot Assets X 0.5 = 3.1
* RR Net Worth %  %Profit Bef. Taxes/Worth X 0.5 = 11.8
SGA Exp. % Sales  All Other Expense Net = 26.8

* As a convention we analyze profit indicators as after tax net income. Therefore, for our use we reduce all “before tax” values
by 50%.

Activity Ratios

Inventory Turnover  Cost Sales / Inventory = 6.8
Inventory Days  Cost Sales / Inventory = 54
AR Turnover  Sales / Receivables = 7.5
AR Collection Days  Sales / Receivables = 49
NFA Turnover  Sales / Net Fixed Assets = 42.4
TA Turnover  Sales / Total Assets = 3.0

Note: The ratios sections of the RMA are presented in quartiles. As a convention, we use the
middle number (50

th
percentile).


LIMITS CALCULATIONS & IMPROVED OPERATIONS TUTORIAL

Limits Calculations are useful to determine if a company has the capacity to incur more debt
based on its current stockholders’ equity OR current total assets. Investors and/or banks offering
loans to a company look at the company’s current assets or equity. Assets/Equity can be used as
collateral (= security, guarantee) if the company fails to repay its debt. Here’s an example:
you’ve bought a house several years ago for $100,000. Your down payment was $10,000. You
got a mortgage (debt) in the amount of $90,000. So far, you’ve paid down $5,000 (principal) on
your mortgage. Now you still owe the bank $85,000. Let’s assume you wanted to do some
major remodeling in your house, but you don’t have any cash saved. You need to take out
another loan to pay for your remodeling. So you go to your bank and ask for an additional loan
(often referred to as a home equity loan). The bank is willing to lend you up to the equity you
have invested in your house.
This is trial version
www.adultpdf.com