Month: September 2021


Given the obsession with cash, it’s not surprising that there is a separate ­financial statement dedicated to it: the statement of cash‑flows. Many ­finance professionals consider the statement of cash‑flows a company’s most important ­financial statement. Rather than focusing on the income statement, which has the problems of noncash expenses and managerial discretion, or a balance sheet, which has the problems of historical cost accounting and conservatism, many people in fi­nance focus on the statement of cash‑flows because it looks purely at cash.

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Which of those many ratios is the most important for managers to focus on?

This question is controversial, but many ­financial analysts focus on return on equity (ROE), since that number measures the returns to owners, who are arguably the ultimate bosses within a company. Because ROE is a widely used measure, it’s important to understand the factors that contribute to an ROE. The DuPont framework, a method of analyzing a company’s ­financial health originated by the DuPont Corporation in the early part of the twentieth century, provides a useful way to understand the levers of ROE.

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After the retailers and service companies, we’re left with a motley crew – Microsoft, Nordstrom, Duke Energy, P­fizer, and Dell.

Three of the companies, C, D, and F, have barely any PP&E, while the remaining two companies have very significant PP&E. One is likely Duke Energy, which has power plants, and the other is likely Nordstrom, a brick-and-mortar retailer. But which is which?

To double-check, look at the three remaining companies and gauge their property, plant, and equipment. Dell, Pfi­zer, and Microsoft don’t really do any heavy manufacturing so their low levels of PP&E make sense.

Which of the two companies with signifi­cant property, plant, and equipment is Duke Energy and which is Nordstrom? The key differentiating factor here is inventory.

Nordstrom would have a large amount of inventory, while Duke Energy has very little (electricity can’t be stored). So, company L turns out to be Duke Energy, and company J is retailer Nordstrom.

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When reviewing the receivables collection period, we saw that the companies were divided between those that collect quickly and those that take considerably longer. What kinds of companies would collect from customers so quickly? Since retailers sell goods directly to consumers, their receivables. The collection period is going to be short because customers pay immediately via cash or credit. In contrast, businesses that do business with other businesses give credit for a minimum of thirty days.

So, the retailers are A, B, H, I, and K. Which companies on the list are retailers that sell directly to consumers? Amazon, Barnes & Noble, Kroger, Walgreens, and Yum! are all retailers.

We can exclude Nordstrom here because the chain has its own brand charge card, so its customers, unlike those of the other companies, can take a long time to pay for their purchases. Through its charge card, Nordstrom behaves more like a bank than a retailer.

These ­five companies differ dramatically in the way that they turn over their inventory. Some turn over inventory quickly (company H). Others take a long time (for example, company B).

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Looking at the ratios, service companies are relatively easy to spot. Since they provide services rather than tangible goods, they don’t hold inventories – which points to companies E, G, M, and N. So, which four companies can we match to E, G, M, and N? Two of the companies have “service” in their name: the parcel delivery service, which is UPS, and the social networking service, which is Facebook.

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Ratios are the language of business, and ­- finance people love to create them, talk about them, ‑ flip them upside down, break them apart, and so on. Ratios make numbers meaningful by providing comparability across companies and through time. For example, Coca-Cola’s net pro­fit for 2016 was $7.3 billion. Is that a lot of money for the company? It’s hard to tell without context. Alternatively, knowing that Coca-Cola’s net profi­t was 16 percent of its revenue (net pro­fit divided by revenue) is much more helpful.

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