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Financial Statement Analysis of Microsoft

Microsoft is a company that is famous for its various products such as the Windows series. The firm is well known and is frequently cited as an example of good management. However, how good is it? As of December 1st, 2007, one share of Microsoft was approximately $33. Every investor would be curious if that price is reasonable. Also, it is too dangerous to rely completely on intuition or rumor when you buy stocks. Therefore, we decided to analyze Microsoft in a more rational, reasonable, fact-based way, and refer to that information in determining whether to buy Microsoft’s stock or not.

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The 10-K financial statement from Microsoft is an enormous document, and it would take too much time to read the entire material. We thus decided to read the report selectively and analyze the company in the following steps: First, we will calculate several useful financial ratios. Second, we will look into the firm’s major accounting policies. Third, we will observe the trend, which shows how the company performed in the recent few years. Fourth, we will compare Microsoft with its competitors. ? Body 1. Calculation of Ratios Here we present several accounting ratios that helped us analyze Microsoft.

Chapter Ratio Value(rounded off to three decimals) 2 Financial Leverage Ratio 66384/35600. 5=1. 865 3 Total Asset Turnover Ratio 51122/66384=0. 770 4 Net Profit Margin 14065/51122=0. 275 5 Return on Equity 14065/35600. 5=0. 395 6 Gross Profit Percentage 40429/51122=0. 791 Receivables Turnover 51122/10327=4. 950 7 Inventory Turnover 10693/1302. 5=8. 210 8 Fixed Asset Turnover 51122/3697=13. 827 9 Current Ratio 40168/23754=1. 691 Accounts Payable Turnover 10693/3078=3. 474 10 Debt-to-Equity Ratio 32074/31097=1. 031 11 Earnings Per Share Basic 14065/9742=1. 44 Diluted 14065/9886=1. 42

Dividend Yield 0. 4/33. 42-0. 0120, 1. 2% 12 Return on Assets 14065/66384=0. 212 13 Quality of Income Ratio 17796/14065=1. 265 Capital Acquisitions Ratio 17796/2264=7. 86 14 Financial Leverage Percentage 0. 395-0. 212=0. 183 Cash Ratio 6111/23754=0. 257 Quick Ratio 34749/23574=1. 474 Price/earnings Ratio 33. 42/1. 42=23. 535 *Microsoft’s financial statement does not report any “interest expense”, so we did not calculate “Times interest Earned” and Cash Coverage Ratio”. **Ratios that appear more than once in the book are displayed only once in the table. 2. Discussion of Accounting Policies

Even if two people work as accountants for the same company, the result might differ depending on the methods they use. These methods, or accounting policies, can change how a company looks like to outside parties like investors. In the financial statement, Microsoft has included notes on its accounting policies. (pp. 44-47) These notes helped us determine whether the management is employing a aggressive or conservative accounting policy. Being always aggressive would be reckless for a company. It might attract investors at first, but it might damage the firm in the long run.

On the other hand, an excessively conservative management might impede a company’s growth. In our opinion, Microsoft is maintaining a good balance between aggressive and conservative accounting policies. A) Revenue recognition For any company, creating revenue from delivering products or services is the most important and fundamental activity. Therefore, Revenue recognition is the most important accounting policy to discuss. There are two ways to record revenue: FOB shipping point and FOB destination. The difference between them is when the revenue is recorded?

FOB shipping point records the revenue when the product is shipped, and FOB destination records the revenue when the product is delivered. Because FOB shipping point recognizes a revenue earlier than the FOB destination, it is a more aggressive policy. Faster recognition of revenue leads to increase of income in that fiscal year. In Microsoft’s case, “revenue for retail packaged products, products licensed to OEM, and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped. (p. 44) The note also reports on policies about unearned revenues and several other less important items, but most of those policies are neutral. There are two exceptions, however; revenue related to Xbox console and hardware are recorded under the FOB shipping point, and revenue related to games published by Microsoft is recognized under the FOB destination. In short, most of Microsoft’s products are sold under the FOB shipping point method. Therefore, we think Microsoft is adopting a rather aggressive revenue recognition policy. B)Inventories

Three points in this section shows that Microsoft employs a conservative policy on inventories. First, inventories are stated at the Lower of cost or market(LCM), which is a conservative accounting policy. This policy is very important for high-technology companies like MS; it’s products’ cost and selling price are declining. Second policy is employed to avoid overstating assets and income. Next, Microsoft regularly review inventories and their estimated utility. Finally, in case the inventory’s utility decreases, the company reduces the inventory to a new cost basis.

C)Property and Equipment Depreciation is inevitable once you purchase a fixed asset. Microsoft uses the straight-line method to calculate depreciation as most other companies do. The main point is that MS uses the straight-line method over the shorter of the estimated life of the asset or the lease term. For example, if a property’s life is estimated 5~10 years and (cost)-(residual value)=$10,000, MS would choose to depreciate $2,000 respectively for five years rather than to depreciate $1,000 respectively for ten years. Microsoft is employing a conservative policy on depreciation.

In other words, MS is trying not to overstate the net value of its fixed assets. Accounting policies on other items were mostly neutral and hard to define as aggressive or conservative. Thus, we will discuss the entire company’s accounting policy based on the three major ones mentioned above. MS uses aggressive policy when recognizing revenues and conservative policy when reporting inventories and PPE. This may appear inconsistent, but we think this is a wise way of accounting. Microsoft’s policy will lead to higher revenue, which would hint good management, good quality of products, efficient marketing, etc.

A company that generates large revenue would attract investors. On the other hand, MS reports inventories and depreciation in a conservative way. This helps the company manage its inventories and PPE on a strict basis and prevent the company overstating its assets and income. In short, Microsoft emphasizes revenues from ongoing operations and manages PPE and inventory tightly. This mix of aggressive and conservative accounting policies implies that MS is a confident and careful corporation. 3. Discussion of Trend Microsoft’s 10-K report also provides information about the performance of past years.

Our discussion of trend is based on data presented for three years and over. A) Income Statement Revenue and Expense continuously increased and the resulting Net income also increased since 2003. If one looks into the Expense in detail, he can see the ‘research and development’ and ‘sales and marketing’ accounts increasing over time. This reflects the company’s effort in developing better products and promoting them. The other notable trend is the rise of EPS. This is because Net income increased and weighted average shares outstanding decreased.

B) Cash Flow Statement In the cash flow statement, we can observe that MS is using more and more cash to repurchase its stocks. This may be one factor of the increase in EPS. The net cash from investing is decreasing over the recent three years. Closer observation shows us that MS is putting less cash in purchasing investments and more cash in acquiring PPE and companies. This can be interpreted as an effort of further expansion. 4. Comparison In this report, Microsoft notes its major competitors such as IBM, Apple computer, Hewlett Packard, etc.

Among these competitors, we chose to analyze IBM in-depth. For rational comparison, we calculated Microsoft’s and IBM’s accounting ratios below. We considered the ratios in bold letters of more significance than the others and will focus on them. Microsoft IBM 1. Financial Leverage Ratio 1. 86 3. 323 2. Total Asset Turnover Ratio 0. 77 0. 581 3. Net Profit Margin 0. 275 0. 103 4. Return on Equity 0. 395 0. 192 5. Gross Profit Percentage 0. 79 0. 419 6. Receivable Turnover 4. 95 8. 474 7. Inventory Turnover 8. 209 18. 78 8. Fixed Asset Turnover 13. 827 6. 485 9. Current Ratio . 69 1. 114 10. Accounts Payable Turnover 3. 474 6. 938 11. Debt-to-Equity Ratio 1. 03 2. 621 12. Earnings per Share 1. 44 6. 11 13. Return on Assets(ROA) 0. 21 0. 06 14. Quality of Income Ratio 1. 27 1. 582 15. Capital Acquisitions Ratio 7. 86 3. 443 16. Financial leverage percentage 0. 185 0. 186 17. Cash ratio 0. 257 0. 2 18. Price/earnings ratio 23. 535 17. 214 Ratio 1: Leverage Financial Leverage Ratio(1) shows that IBM is leaning more on debts than MS is. Since dividends can be postponed but interests to debts cannot, IBM contains more risk than MS. Ratios 3&5: Sales

Higher Net Profit Margin(3) signals better management of sales and expenses, and higher Gross Profit Percentage(5) means that the company can sell products at low costs and high price. Microsoft shows higher rates in both of them, so we deduced that MS is more efficient in selling their products and generating revenues, which is the core business of a company. Ratios 9&15: Cash and Current Assets Comparison of the Current Ratio(9) of the two companies show that MS has more liquidity than IBM and thus would be able to use money effectively. MS would also be more capable in coping with sudden need of cash.

The Capital Acquisitions Ratio(15) of MS is also higher than that of IBM’s. We focused on this ratio because this is a good evidence of our trend analysis discussed above. The cash flow statement shows us that 1)Microsoft is generating more and more cash during the recent three years from operating activities 2)the company is purchasing more cash for PPE. This means MS is more capable of purchasing PPE without borrowing money from outsiders. Ratios 12&18: Earnings When we compare Earnings per Share(12), it seems that IBM is performing much better than Microsoft.

However, deeper investigation told us that we missed one factor. The number of weighted average shares outstanding of MS and IBM is 9742 and 1506 each. MS shows higher Price/Earnings Ratio(18) than IBM. Generally, high PER signals good growth prospect, but it also means higher risk. It would be too dangerous to assess a company using only this ratio. We compared several major ratios and through this, we reached the conclusion that Microsoft is better at managing sales and generating cash, which is the basic and important function of a company.

In addition, Microsoft has a stronger financial structure than IBM. From this, we agreed that Microsoft is a better company to invest in. ? Conclusion Through the four-step analysis presented above, we reached the conclusion that we will buy the stocks of Microsoft for the following reasons: First, the undeniable brand power of Microsoft. Even Apple, one of MS’s main competitors, developed a new OS called ‘X'(code name “Leopard”) which allows Windows to operate in Apple computers. Microsoft has a stable, worldwide consumer base which would ensure the company continuous revenue.

Second, Microsoft is adopting a wise accounting policy, harmonizing aggressive and conservative policies. As discussed above, its aggressive revenue recognition increases net income and therefore attract investors. On the other side, Microsoft manages its inventories and PPE conservatively. Though this results in lesser asset, it can help the company to stay somewhat alert in case of emergencies like sudden need of cash. Third, Microsoft is putting more and more effort to make and sell better products.

The income statements showed us increase in expenses for R&D and Sales&Marketing. This indicates that MS has a bright future, concentrating on its core activities. Fourth, Microsoft is better than its competitors. This is a comparison of few ratios. Ratio Company Financial Leverage Ratio EPS P/E Ratio Microsoft 1. 86 1. 44 23. 535 IBM 3. 323 6. 11 17. 214 HP 2. 114 2. 18 23. 467 Apple Computer 1. 735 3. 93 46. 36 Cisco 1. 745 0. 31 23. 948 Microsoft’s Financial Leverage Ratio comes in the middle of these companies. We judged that MS neither has too much liabilities nor too less.

This indicates a healthy financial structure. Apple shows a very high P/E Ratio. We interpreted this as a result of recent innovations such as iPod. Microsoft is not coming up with such innovative products at the moment. However, we think that Microsoft’s P/E Ratio should be rated around 30 because of the several reasons mentioned above. We therefore calculated that Microsoft’s market price of one share should equal 1. 44? 30=$43. 2, and reached the conclusion to invest in Microsoft. *based on 10-K report of Microsoft

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