Financial Statement Analysis Fall 2011 Section 2 October 17, 2011

Draft 2: Financial Statement Analysis

Group 7 NETGEAR Kyle Marshall Quan Dang Minh Hoang Shane Estes

Dai Thai

Page | 0

Financial Statement Analysis Crucial financial data from the four financial statements, particularly the balance sheet and the income statement, can be processed into ratios. These ratios make evaluating a company a much simpler task by being able to see a scalar for items of interest instead of large and variable dollar amounts. It also makes evaluating a company in terms of its industry much easier by factoring out economies of scale that may not be shared by all members of a particular industry. Of great concern to the analyst wishing to make an informed decision about the financial condition of a company are the liquidity, profitability, and capital structure ratios. The three categories are to be explored for the company NETGEAR and three of its competitors: CISCO, Juniper, & Seagate. We look at 5 years of previous data to determine any company specific trends as well as industry-wide trends. Liquidity Liquidity refers to both how much cash and cash equivalents a company holds as well as how quickly a company can generate cash. Liquidity ratios are important for determining how capable a company is in paying off its short term liabilities. Current ratio = current assets/current liabilities The current ratio is one of the short-term liquidity analysis ratios, which measures how well a company can cover its current liabilities that are due within the next year. This is a near term measurement as current liabilities are regarded as coming due within one year and current assets are projected to become cash within the next year.
Page 1 of 19

Current Ratio
3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Juniper Cisco Seagate Industry

Even though NETGEARs current ratio has been declining from 2005 to 2010, it is still quite high, ranging from 2.6 to 2.9. This is a good sign. A minimum of 1 would indicate that a company has enough assets to cover its liabilities. A value of two indicates that every dollar of liability has two dollars of assets to cover it. The reason for this high current ratio is likely due to the fact that tech companies usually have a large amount of cash on their balance sheet. The value of cash on hand can outweigh the opportunity cost of storage by being a buffer to revenue variability and macroeconomic uncertainty. Tech companies such as NETGEAR use quite a bit of cash for R&D and mergers and acquisitions. Other companies in the industry such as Cisco and Juniper also have high current ratios ranging from 2.1 to 3.0 in the last 5 years. Just by looking at the current ratio, we can tell that Cisco is doing better than its competitors since their current ratio has been increasing rapidly in recent years while Juniper and NETGEARs current ratios are declining.

Quick asset ratio = (cash + marketable securities + accounts receivable)/ current liabilities
Page 2 of 19

The quick asset or acid-test ratio is very similar to the current ratio except that it excludes inventories. This is done because liquidating inventory may not be a smooth process. It may not happen quickly; hence it is not considered in the quick test.

Quick Assets Ratio

3.00 2.50 2.00 1.50 1.00 0.50 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Juniper Cisco Seagate Industry

NETGEAR has a quick ratio, which ranges from 1.9 to 2.3. A very similar pattern is found with Cisco, Juniper and Seagate. Again, we see Cisco having the highest recent quick ratio of 2.55 as a result of having high cash and investment. This indicates that these tech companies do indeed hold a large amount of cash or cash equivalents. Operating efficiency Many liquidity ratios can be classified into a subcategory called operational efficiency. The ratios give a good indication of a companys ability generate cash in the near term to cover its financial obligations. Accounts Receivable Turnover = Sales/AR

Page 3 of 19

AR turnover shows how many times receivables are collected or turned over during the year. It gives an indication of how efficiently a company is collecting.

Accounts Receivable Turnover

10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 2005 2006 2007 2008 2009 2010

NETGEAR Juniper Cisco Seagate Industry

NETGEARs account receivable turnover for 2010 is 3.98 which is the lowest among its competitors. This could indicate that NETGEARs collection process is inefficient compared to others in the industry. Inventory Turnover = COGS/ Inventory Inventory turnover shows how many times an amount of inventory would be sold or turned over in a given period of time, notably one year. Because Cost of goods sold and inventory are recorded at historical prices, this ratio is a good indicator of how quickly inventory can be processed back into cash, even if it is processed first into a receivable.

Page 4 of 19

Inventory Turnover Ratios

16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 2005 NETGEAR 2006 Juniper 2007 Cisco 2008 2009 Seagate 2010 Industry

In the table above, NETGEAR inventory turnover is lower than industry average because it has a lower sales than average. This lower in sales could due to the fact that it is a smaller company; therefore, it has a smaller number of sales and has to compete with its larger competitors. However, NETGEAR inventory turnover is not too much below industry average. Days Sales Outstanding = 365/ ARTO DSO is an attempt to quantify the average number of days a company takes to collect on its receivables. NETGEAR has an average collection period of 91.7 for year 2010. This number is also a bad sign compared to Ciscos much lower average collection period of 50 in the same year. The average of this industry is around 40 to 50 days.

Page 5 of 19

Days Sales Outstanding

100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 2005 2006 2007 2008 2009 2010

NETGEAR Juniper Cisco Seagate Industry

NETGEAR almost doubles that of industry average in 2010. This means that it is taking too long to collects accounts receivable. Days Sales Inventory= 365/Inv.TO DSI is a measurement of how many days it takes for inventory to be turned over. We see NETGEAR consistently taking longer to roll over its inventory than its competitors.

Days Supply Inventory

90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Juniper Cisco Seagate Industry

Page 6 of 19

NETGEAR has been underperformed because a higher ratio would represent a less effective inventory management, all else being equal. In this case the inventory is too high for NETGEAR. Cash to Cash Cycle = DSO + DSI By combining the days sales outstanding and the days standing inventories into the cash to cash cycle, we get a good idea of how many days it typically takes a dollar invested into inventory to be converted back to into cash as an asset.

Cash to Cash Cycle

180.00 160.00 140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Juniper Cisco Seagate Industry

We see that NETGEAR is a little slower on the loop than its main competitors. Working Capital Turnover = Sales/Working capital Working capital, which is the numeric difference between the current assets and the current liabilities, is divided into sales for the working capital turnover. This ratio shows how every dollar above that needed for the short term obligation can generate a dollar amount of sales. NETGEAR lags its industry.
Page 7 of 19

Working Capital Turnover

14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Juniper Cisco Seagate Industry

In conclusion, while NETGEARs current and quick-asset ratios show it has an acceptable amount of liquidity. It has a poor showing in efficiency within its industry. The low account receivable turnover and high days sales outstanding number shows, for example, that NETGEARs customers dont pay as quick as others in the same industry. Its inability to collect cash timely could be a reason to worry since they wont get access to much of their assets (specifically account receivables) in order to reinvest in R&D or pay their debts. Profitability Beyond knowing the liquidity of a company, it is equally important to an investor to know if a company can not only pay its short term liabilities, but also if can pay its expenses, pay for its operations, pay its creditors, pay its taxes and ultimately pay back an equity stakeholder with profit. And can a company profit enough that it can grow as a business or increase its cash or liquid asset holdings as insurance against macroeconomic swings.

Page 8 of 19

Gross profit margin = Gross Profit/ sales Gross profit is the remainder after the costs of goods sold has been subtracted from the sales. This remainder is then divided by sales. The result is a percentage of by how much revenues exceed the costs of goods sold. The higher the number the better as all subsequent expenses for operations, interest, and taxes come from gross profit.

Gross Profit Margin

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2005 NETGEAR 2006 Cisco 2007 Juniper 2008 2009 Seagate 2010 Industry

NETGEAR's gross profit is lower than two of its competitors most likely because of its size. Both Seagate and NETGEAR are smaller in size compared to Juniper and Cisco. A bigger company could produce products for less cost than that of a smaller company. Bigger companies have the economy of scale effect. The more they produce, the less costly it is to produce the products. Therefore, it costs more to make products for NETGEAR and Seagate, than it would for Juniper or Cisco. The impact of gross profit margin being smaller is also caused by the lower sales revenues in smaller companies as well as the higher costs of goods sold. NETGEAR is underperforms based on the industry average.

Page 9 of 19

Operating Profit Margin = Operating profit/ sales The operating profit margin is found by first calculating the operating profit, which is the profit remaining after subtracting all operational expenses such as labor, rent, fuel, etc. from the gross profit. The operating profit is what the company is able to produce above its costs to operate. The operating profit is then divided by sales to give a percentage of every sales dollar that will become an operating profit. Like all of the profit margin numbers, the higher the better.

Operating Profit Margin

40% 30% 20% 10% 0% -10% -20% -30% -40% -50% 2005 NETGEAR 2006 Cisco 2007 Seagate 2008 2009 Juniper 2010 Industry

While NETGEAR is operating profit margin is positive, it still below the industry average. Net Profit Margin = net income/ sales The net profit margin ratio, or simply profitability, is the ratio between net income and sales for a given period. This measure gives a concise measurement, in percent form, of how

Page 10 of 19

much of each sales dollar actually translated into net income. A high profit margin is desirable because it means that the company is keeping more of the profits from each sale has income.

Net Profit Margin

30% 20% 10% 0% -10% -20% -30% -40% -50% 2005 NETGEAR 2006 Cisco 2007 Juniper 2008 2009 Seagate 2010 Industry

The profit margin of the industry has averaged around a respectable 10%, although a few dips in profitability for individual companies have occurred. NETGEARs profit margin has averaged around 6%, which is slightly concerning in itself. However, NETGEAR performed better than the industry in asset turnover, and it is the combined effects of both which demonstrate NETGEARs respectable ROA. Asset Turnover = sales/ total assets Asset turnover, also known as productivity, is the ratio between sales for a period and the total assets from the previous period. The asset turnover ratio gives insight into how productive a company is being with its total assets relative to sales. A high productivity ratio is desirable for a

Page 11 of 19

company because it signifies that they are making more revenue from a given amount of total assets.

Asset Turnover
1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Cisco Seagate Juniper Industry

The productivity for NETGEAR and its competitors is seemingly low. Although, NETGEAR sales more than its competitors. This is likely since NETGEAR products are available at places like Wal Mart and Best Buy and generally are cheaper to purchase than Cisco or Juniper products. This implies that they do not have a large amount of sales, but rather they make their money through other methods such as high sales margins. Although the asset turnover of each company is low, there is also a moderate amount of variance between companies in the industry. A large part of this is due to the differing product lines and services of each company. NETGEAR has historically maintained an asset turnover ratio above 1. This productivity is a positive sign in a high technology field which requires taking advantage of all assets. Return on Assets (ROA) = NI/ Total Assets = profitability x productivity Return on Assets is the ratio relating net income in a given period to the total assets in a previous period. This measurement is very important to potential investors because it helps to
Page 12 of 19

demonstrate how well a company is utilizing its assets to generate income. A large number can mean that a company is not only generating a reasonable income, but is also being very efficient with their resources. This ratio can be further disaggregated into two ratios which provide further information into a companys business activities: asset turnover and profit margin.

Return on Assets
0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 2005 NETGEAR 2006 Cisco 2007 Seagate 2008 2009 Juniper 2010 Industry

The return on assets for NETGEARs industry has varied slightly over the past five years, with individual companies having large variations. NETGEARs ROA is seemingly identical to the industry average, meaning that they are neither excelling nor lagging in their asset utilization. The most recent reported year, 2010, saw NETGEARs ROA rise to around 9% to rebound from a three year slide. This positive news is likely contributable to the end of the recession and resulting increases in net income. The current ROA is an acceptable level for the industry and should provide potential investors with confidence in the continued success of the company. Return on Equity (ROE) = Net income / owners equity Return on Equity is computed as the ratio of net income for a given year to total owners equity of the previous year. This ratio gives a more clear idea of how a company performed
Page 13 of 19

relative to owner financing. ROE is considered to be one of the most important ratios for any company, and many investors require a strong ROE before potentially investing in a company.

Return on Equity
1.5 1 0.5 0 -0.5 -1 2005 NETGEAR 2006 Cisco 2007 Juniper 2008 2009 Seagate 2010 Industry

The ROE graph of NETGEAR and several of its competitors demonstrates that the ratio has been relatively constant in the industry over the past five years. NETGEAR has maintained a positive ROE since 2006, which is a positive sign for the company. The ROE for 2010 increased for the first time in several years, providing another positive signal to shareholders of the company. In conclusion, the three profit margins for NETGEAR have been respectively positive which shows that the company is keeping more of the profits from each sale. Despite NETGEAR being a smaller company than its two competitors, Cisco and Juniper, it is very consistent with its profit margins throughout the years. NETGEAR has high sales margins, so its asset turnover is higher than industry average. NETGEAR ROA and ROE are at an acceptable level for the industry and has gradually increases since the end of the recession in 2009. This result of increase in net income provides potential investors with confidence.
Page 14 of 19

Capital structure A final an important class of ratios are those dealing with capital structure. Capital structure being the distinction of asset ownership between contributed capital and borrowed capital, how a business is financed. While borrowing will leverage a company and ideally allow it to succeed with other peoples money, the company must generate enough profit to pay for the cost of capital, the interest expense. If a company also issues debt it must be able to repay the principle as well as it matures. A company deemed a credit risk has a significant chance of default and/ or bankruptcy. For these very important reasons capital structure and credit risk of companies is of serious importance to investors.

Debt to Equity Ratio = Total Liabilities/Stockholders equity This ratio gives the proportion of debt to equity in financing the assets. NETGEAR has a low debt to equity ratio. This is due to the fact that it has no long term debt. For the last two years all of its liabilities have been current (non-interest bearing) liabilities.

Page 15 of 19

Debt to Equity
4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 2005 2006 2007 2008 2009 2010 NETGEAR Cisco Seagate Juniper Industry

Times Interest Earned Ratio = Earnings before interest and taxes/ interest expense The utility of this ratio is to see how easily a company can pay its interest expense with profits. A higher number is better. This would represent that a company can pay its obligations and have profit to spare towards interest, taxes, and net income. Because NETGEAR has no debt, it has no interest expense. Therefore, the TIE ratio for NETGEAR is undefined. Debt Service Margin Ratio = cash flow from operations/ current portion of long term debt The debt service margin allows one to see how much long term debt impacts cash flow. A ratio of one would be the minimum needed without going into default. However, a ratio of greater than one would be needed to put an investor at ease. Also because NETGEAR has no interest bearing debt, no long term liability, the debt service margin is undefined. NETGEAR may have no long term debt because its too young of a company. It may experience too much variability in its profits to take on the risk of contractual payments. It is
Page 16 of 19

also in a rapidly changing and growing industry. NETGEAR says in its 10-K that it must constantly come up with new products just to stay competitive.

Altmans Z-Score Altmans Z-Score is a method of determining the risk of an individual company defaulting/ going bankrupt in the near future. As credit risk analysis is concerned with expected credit loss, which is the chance of default x loss given default, Altmans Z-score is an approximation of the chance of default in the near term. It has been shown to be 95% accurate predicting a default in one year out and 72% accurate two years out. The Z-score is a sum of weighted ratios of liquidity, profitability, and capital structure. Altmans Z-Score =1.2[Working Capital/Total Assets] +1.4[Retained Earnings/Total Assets] +3.3[Earnings Before Interest and Taxes/Total Assets] +0.6[Market Value of Equity/Book Value of Liabilities] + 0.99[Sales/Total Assets]

Z-Scores
10.00 8.00 6.00 NETGEAR 4.00 SEAGATE 2.00 0.00 -2.00 -4.00 2005 2006 2007 2008 2009 2010 JUNIPER CISCO

The Z score for NETGEAR during 2010 was calculated as 4.83, which gives them a low bankruptcy risk for the next year. A large portion of NETGEARs high Z score can be attributed
Page 17 of 19

to their lack of long term debt, which lowers total liabilities in favor of higher owners equity. All other financial ratios, excluding the profit margin, indicate that NETGEAR is currently financially sound and not facing bankruptcy risk. Seagate has a negative Z-score of -0.09, which is the result of having a low market value and high liabilities in addition to negative operating income.

Page 18 of 19