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Price of the House: $100,000
Your Down payment: $10,000
Your Principal paid: _$5,000
Your money invested in the house: $15,000

The bank determines that you have paid a total of $15,000 toward the house. This is your equity
you have invested in your house. This equity can be used as a security by the bank, so the bank
is willing to offer you up to $15,000 in a home equity loan. Now you can use the full amount or
less, whatever you need to do your remodeling.


Limits Calculations Based on Equity

It works in a similar way with a company. To determine the amount debt can be increased based
on the company’s current equity, you need three items:

1. The company’s Total Shareholder Equity
2. The company’s Total Liabilities
3. The Industry D/E ratio (Debt/Equity = Total Liabilities/ Equity)

To determine the company’s potential debt capacity, multiply the company’s SE by the Industry
D/E ratio. Note, the higher the Industry D/E ratio, the higher is the company’s debt capacity.
The result indicates how much debt the company could potentially incur. Now you need to
subtract the company’s current Total Debt. These are liabilities (debt) the company has already
incurred. The remaining amount is the debt that the company could incur based on its equity. If
the amount is negative, the company has already incurred all the debt it can. It has maxed out its
debt capacity and cannot incur more debt.

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Limits Calculations Based on Assets

To determine the amount debt can be increased based on the company’s current assets, you need
three items:
1. The company’s Total Assets
2. The company’s Total Liabilities (i.e., debt)
3. The Industry D/A ratio (Debt/Assets = Total Liabilities/Total Assets)

Again, to determine the company’s potential debt capacity, multiply the company’s TA by the
Industry D/A ratio. Note here too, the higher the Industry D/A ratio, the higher is the company’s
debt capacity. Subtract the company’s current Total Liabilities (i.e. debt). The remaining
amount is the debt that the company could incur based on its assets. If the amount is negative,
the company has already incurred all the debt it can. It has maxed out its debt capacity and
cannot incur more debt.




NOTE: Increasing debt is based EITHER on equity OR on assets, NOT on both!


Improved Operations tell us if a company could save money by improving its operations in
accounts receivable collections and inventory turnover.

Improved Operations Based on Accounts Receivables

Remember that Accounts Receivables are dollars owed to the company by customers.

Depending on the industry, customers have to pay for their goods immediately, in 10, 20, 30 or
60 days. It is up to the company to determine its credit policy. However, the faster the company
gets its money, the better. The longer a company waits for accounts receivables to be paid, the
longer the company has to use other funds (potentially debt!) to pay for its day-to-day operations.
The industry AR days serves as a measure to determine if the company does better (lower AR
days) or worse (higher AR days) than other companies in the same industry.

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You need three items to calculate improved operations based on AR days:
1. The company’s AR days
2. The industry’s AR days
3. The company’s Accounts Receivables

To determine if the company can improve operations based on AR days, you subtract the
industry AR days from the company’s AR days. If the result is negative, the company is already
doing better than the industry and cannot improve its operations further based on the industry
number. If the result is positive, divide it by the company’s AR days to derive a percentage that
A/R days can be improved. Now multiply the result with the company’s accounts receivables.
This is the amount by which operations can be improved. Remember, the bigger the gap
between the company’s and industry’s AR days, the more the company can improve.




Improved Operations Based on Inventory

Inventories are supplies, materials or merchandise the company bought to produce goods and sell
them. The faster the company produces its goods and sells them, the faster it makes money. If

inventory sits in warehouses or on shelves for a long time, it doesn’t generate any revenue for the
company. A high number in inventory turnover days means that the company needs more days
to sell its inventory. A low number in inventory turnover days means that the company needs
fewer days to sell its inventory. Therefore, the faster the company turns over its inventory, the
better.

You need three items to calculate improved operations based on Inventory days:
1. The company’s Inventory days
2. The industry’s Inventory days
3. The company’s Inventory

To determine if the company can improve operations based on Inventory days, you subtract the
industry Inventory days from the company’s Inventory days. If the result is negative, the
company is already doing better than the industry and cannot improve its operations further
based on the industry number. If the result is positive, divide it by the company’s Inventory days
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to derive a percentage that inventory days can be improved. Now multiply the result with the
company’s Inventory. This is the amount by which operations can be improved. Remember, the
bigger the gap between the company’s and industry’s Inventory days, the more the company can
improve.




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APPENDIX A—RMA DEFINITIONS



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APPENDIX B—RMA INDUSTRY PAGE FOR OFFICE SUPPLIES STORES


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APPENDIX C—FINANCIAL AUDIT FOR STAPLES


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APPENDIX D—STAPLES INCOME STATEMENT


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APPENDIX D (cont.)—BALANCE SHEET FOR STAPLES

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APPENDIX F—SAMPLE WRITTEN FINANCIAL AUDIT FOR STAPLES


Compound annual growth rates for the period 2003 to 2007

Assets 8.6%
Sales 10.1%
Net profit 19.4%
Total liabilities 3.9%
Stockholders’ equity 11.8%
Net working capital 9.5%

Liquidity. Staples appears to have relatively low risk and should have no trouble meeting its
short-term obligations as they come due. Current ratio (CR) is higher than the industry average
(1.75; 1.2 I) and is at its highest point of the period. Quick ratio (QR) is also higher than the
industry average (0.96; 0.9 I) and has remained fairly steady over the period, indicating no major
problems or fluctuations in the company’s inventory controls. Net working capital (NWC) has
shown a compound annual growth rate of 9.5% and is at its highest point of the period. As
inventories could be easily liquidated if necessary, Staples has minimal risk.

Capital Structure. Staples has low risk and, thus, should have a low cost of capital. D/E is less
than a quarter of the industry average (0.58; 2.6 I) and D/A is only slightly more than half of the
industry average (0.37; 0.78 I). Both ratios are at their lowest points of the period. In addition,
79% of Staples’ total liabilities are current. Management seems to be conservative in its use of
debt capital, giving the company options in pursuing its future growth strategy and the flexibility
to seize new opportunities as they arise. Staples has a low risk capital structure at this time.

Performance. Staples is clearly outperforming the industry. Although GPM is only slightly
higher than the industry average (30.58%; 29.5% I), NPM is over four times that of the industry
(5.14%; 1.2%) and these ratios have remained steady over the period. GPM is impressive in
light of the fact that the company is known for its low prices and wide selection of products.
This indicates that Staples is efficient and likely experiences economies of scale and scope.
Operating expenses (SAE) have remained stable over the period and are significantly lower than

the industry average (20.3%; 26.8% I), leading to a strong bottom line. Contributing factors
likely include: economies of scale in advertising, efficient distribution, broad geographic
presence, strong brand awareness, advantages of chaining to support their cost leadership
position – including extensive use of IT, and low bureaucratic costs. Strong performance is
reflected in superior ROA (11.02%; 3.1% I) and ROE (17.41%; 11.8% I). Staples is performing
well.

Activity. There does not appear to be significant issues with control. Inventory turnover is
slightly lower than the industry average (6.55 times; 6.8 I), and inventory days of 55.72 are
slightly above the industry (54.0). This is likely due to the extensive selection of products
available, centralized distribution centers, and the largest number of stores in the industry. A/R
turnover is more than three times that of the industry (23.56 times; 7.51 I) with AR days
outstanding of 15.49 being much lower than the industry (49.0). Control here is excellent,
keeping cash flows strong. FA turnover is very low (8.96 times; 42.4 I) and only slightly more
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than 21% that of the industry. This significant difference may be explained by Staples’ rapid
growth, including various acquisitions and foreign expansion. Staples operates more stores than
its competitors and supports them with a strong distribution network, including a large and
expensive distribution system with a number of distribution centers and warehouses, and a
sophisticated IT infrastructure. If sales continue to outpace the investment in FA, turnover
should increase. TA turnover is also below the industry average (2.14 times; 3 I) but has
increased over the period. Staples’ focus on low prices contributes to keeping these turnover
ratios low. Control could be improved but, issues are not critical in light of the company’s
strong profitability and growth.

Limits. Staples has the ability to raise additional funds through debt and/or improving
operations (see Limits Calculations Tutorial). Debt to equity parity with the industry could result
in an increase of $11,548 million in debt (unlikely) or $3,097 million based on assets (possible).

Since accounts receivable collection days are better than the industry, there would be no
improvement of freeing up working capital. However, decreasing inventory days to the level of
the industry could result in $63.3 million in freed up working capital.


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Appendix F


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