Financial Analysis CHAPTER 4
Dec 16, 2015
Financial AnalysisCHAPTER 4
Overview of Financial AnalysisFIRST ORDER OF BUSINESS IS TO SPECIFY THE OBJECTIVES OF THE ANALYSIS
REMEMBER -- THE IDENTITY OF THE USER HELPS DEFINE WHAT INFORMATION IS NEEDED
Potential Financial Statement Users:• Creditors• Investors• Managers
– What types of questions do each of these users seek answers to?
Creditors
• Why does the firm want/need to borrow funds?
• What is the firm’s capital structure? How leveraged are they?
• How will they pay it back? What kind of cash flows are being generated by operations?
Investors
• How has the firm performed/what are future expectations?
• How much RISK is inherent in the capital structure?
• What are the expected returns from the firm?
• What is firm’s competitive position?
Managers
• Need all info creditors and investors need PLUS:
• What operating areas have contributed to success and which have not?
• What are strengths/weaknesses of company’s financial position?
• What changes are indicated to improve future performance?
Caution!!!
• Keep in mind: management PREPARES financial statements
• Analyst should be alert to potential for management to influence reporting to make data more “appealing”
• May want to supplement analysis with information apart from Annual Report prepared by management
Where to look for data...• Financial statements (and notes)• Annual Report • 10K and 10Q reports filed with SEC
(EDGAR)• Computerized data bases
– Info on industry norms/ratios– Info on particular
companies/industries/mutual funds
• Websites
Basic Tools
• Common size financial statements• Financial ratios
– Trend analysis– Industry comparisons
Common Sizing
Firm A Firm B
Sales 2531456.24 4561234.87
COGS 784564.54 1556456.24
Gr. Profit 1746891.70 3004778.63
Common Sizing
Firm A Firm B
Sales 2,531,456 4,561,234
COGS 784,564 1,556,456
Gr. Profit 1,746,891 3,004,778
Common Sizing
Firm A Firm B
Sales 2,531,456 100% 4,561,234 100%
COGS 784,564 31% 1,556,456 34%
Gr. Profit 1,746,891 69% 3,004,778 66%
Common Size Statements
• Common size income statement– expresses each income statement
category as a percentage of sales• Common size balance sheet
– expresses each item on balance sheet as a percentage of total assets
Comparisons/benchmarking
Explain how big the sun is relative to the Earth using data below.• Diameter
– Earth 12,756 KM– Sun 1,392,000 KM
• Mass– Earth 1– Sun 330,000
How big is Antares (one of the largest stars in our galaxy)?
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Ratio Analysis
• Profitability ratios• Liquidity ratios • Leverage (solvency) ratios• Efficiency ratios• Market-value ratios
Five Categories of Ratios
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Ratio AnalysisProfitability Ratios
• Measure the overall effectiveness of the firm’s management.
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Gross Profit Margin =Gross Profit
Sales
How effective is the firm at generating revenue in excess of its cost of goods sold?
Ratio AnalysisProfitability Ratios
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Income StatementExcalibur Corporation
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Net Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
$575 $1,450
Gross Profit Margin = = 39.7%
GrossProfit =Margin
Gross ProfitSales
Balance SheetExcalibur Corporation
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
$330 $1,450
Oper. Profit Margin = = 22.8%
OperatingProfit =Margin
Operating IncomeSales
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Net Profit Margin orProfit Margin =
Net IncomeSales
How much net profit is being generated from each dollar of sales?
Ratio AnalysisProfitability Ratios
Note: Net Income equals Earnings Available to CS
when there is no preferred stock.
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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
$162 $1,450
Net Profit Margin = = 11.2%
NetProfit =Margin
Net IncomeSales
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Return on Assets = Net IncomeTotal Assets
How effectively is the firm generating net income from its assets ?
Ratio AnalysisProfitability Ratios
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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40) 108Net Income% $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
$162 $2,530ROA = =
6.4%
Return onAssets
Net IncomeTotal Assets=
30
Return on Equity = Net Income Equity
How well is the firm generating return to its equity providers?
Ratio AnalysisProfitability Ratios
Balance SheetExcalibur Corporation
Assets Liabilities Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
$162 $1,700
ROE = = 9.53%
Return on Equity = Net Income Equity
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Ratio AnalysisLiquidity Ratios
Current Ratio = Current Assets Current Liabilities
• Measure the ability of the firm to meet its short-term financial obligations.
Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?
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Balance SheetExcalibur Corporation
Assets Liabilities Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
$1,230$230
Current Ratio = = 5.35x
Current Ratio = Current Assets Current Liabilities
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Ratio AnalysisLiquidity Ratios
• Measure the ability of the firm to meet its short-term financial obligations.
Quick Ratio = Current Assets - InventoryCurrent Liabilities
What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?
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Balance SheetExcalibur Corporation
Assets Liabilities
$1,230 -$625$230
Acid-Test Ratio = = 2.63x
Quick Ratio = Current Assets - Inventory Current Liabilities
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
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Ratio AnalysisLeverage Ratios
• Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt.
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Debt Ratio = Total Debt Total Assets
What proportion of the firm’s assets is financed with debt?
Ratio AnalysisDebt Ratios
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
Income StatementExcalibur Corporation
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
$230 + $600 $2,530
Debt Ratio = = 33%
Debt Ratio = Total Debt Total Assets
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Times Interest Earned Ratio =Operating IncomeInterest Expense
What is the firm’s ability to repay interest payments from its operating income?
Ratio AnalysisDebt Ratios
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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
$330 $60TIE Ratio = = 5.50x
TimesInterest =Earned Ratio
Operating IncomeInterest Expense
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
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Equity Multiplier =Total AssetsTotal Equity
What is the firm’s investment in assets relative to it’s equity?
Ratio AnalysisDebt Ratios
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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
$2,530 $1,700Eq Mult= = 1.49x
EquityMultiplier =
Total AssetsTotal Equity
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
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Ratio AnalysisEfficiency Ratios
• Help assess how effectively the firm is using assets to generate sales.
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Ratio AnalysisEfficiency Ratios
How long does it take for the firm on average to collect its credit sales from customers?
DSO – Days Sales Out. orAverage Collection Period =
Accounts Receivable Avg. Daily Sales
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
AverageCollection = Period
Accounts ReceivableAvg. Daily Sales
$430 $1,450/365DSO = = 108 days
Days in a year
Days in a year
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Inventory Turnover Ratio = COGS Inventory
Is inventory efficiently translating into sales for the firm?
Ratio AnalysisEfficiency Ratios
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
$875$625
Inventory Turnover = = 1.4x
InventoryTurnover =Ratio
COGS Inventory
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Fixed Asset Turnover Ratio = Sales
Net Fixed Assets
How effective is the firm in using its fixed assets to help generate sales?
Ratio AnalysisEfficiency Ratios
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
Assets Liabilities
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
$1,450$1,300
Fixed Asset Turnover = = 1.12x
Fixed AssetTurnover = Ratio
Sales Net Fixed Assets
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Total Asset Turnover Ratio = Sales Total Assets
How effective is the firm in using its overall assets to generate sales?
Ratio AnalysisEfficiency Ratios
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Assets Liabilities
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Balance SheetExcalibur Corporation
$1,450 $2,530
Total Asset Turnover = = 0.57x
Total AssetTurnover =
Sales Total Assets
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
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Price to Earnings Ratio =(PE)
Price per ShareEarnings per Share
How much are investors willing to pay per dollar of earnings of the firm?
(Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.)
Ratio AnalysisMarket Value Ratios
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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Assets Liabilities
Balance SheetExcalibur Corporation
Additional Info:100 shares$20.00 per share
$20 $162/100
P/E ratio = = 12.35x
P/E Ratio
Price/ShareEPS
=
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
Income StatementExcalibur Corporation
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Market (price) to Book Ratio =Price per ShareBook Value per Share
How much are investors willing to pay per dollar of book value?
Ratio AnalysisMarket Value Ratios
Assets Liabilities
Balance SheetExcalibur Corporation
$20 $1,700/100
M/B = = 1.18x
Market to = Book
Price/Share Common Equity/ # shares
Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment$2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par600 Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity$1,700
Total Liabilities and Owners Equity $2,530
Additional Info:
100 shares$20 per share
Income StatementExcalibur Corporation
Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings$62
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Ratio Industry ExcaliburProfitabilityGross Profit Margin 38% 40%Operating Profit Margin 20% 23%Net Profit Margin 12% 11%Return on Assets 9.0% 6.4%Return on Equity 13.4% 9.5%
Summary of Excalibur Corporation Ratios
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Ratio Industry ExcaliburLiquidityCurrent Ratio 5.00x 5.35x Quick Ratio 3.00x 2.63x
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Ratio Industry ExcaliburDebtDebt Ratio 35% 33%Times Interest Earned 7.0x 5.5xEquity Multiplier ?x 1.49x
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Ratio Industry ExcaliburAsset Activity Avg. Collection Period90 days 108 daysInventory Turnover 3.0x 1.4xFixed Asset Turnover 1.0x 1.1xTotal Asset Turnover 0.75x .57x
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Ratio Industry ExcaliburMarket Value PE Ratio 18.0 12.4Market to Book 2.5 1.2
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Relationships Among Ratios:The Du Pont Equation
• Ratio Analysis generally involves an examination of related ratios.
• Comparison of these relationships over time helps to identify the company’s strengths and weaknesses.
Net Inc. Net Inc. Sales Assets Sales Assets
= x
Net ProfitMargin
Total AssetTurnover
Return onAssets
= x
Return on Assets (ROA)
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Du Pont Equation
Net Inc. Net Inc. Sales AssetsEquity Sales Assets Equity
= x x
Net ProfitMargin
Total AssetTurnover
Return onEquity
EquityMultiplier
= x x
TGT vs. Wal-Mart
Net Profit Margin
Asset Turnover
Target 4.0% 1.45
Wal-Mart
3.6% 2.40
Which would you prefer?
DuPont Equation: TGT vs. Wal-Mart
Net Profit Margin
Asset Turnover
ROA
Target 4.0% 1.45 5.8%
Wal-Mart
3.6% 2.40 8.6%
DuPont Equation: TGT vs. Wal-Mart
Net Profit Margin
Asset Turnover
Equity Multiplier
ROE
Target 4.0% 1.45 2.5 15%
Wal-Mart
3.6% 2.40 2.4 21%
What is Target’s debt ratio?
What debt ratio would Target need for ROE = 21%?
–The DuPont approach is nice because it divides the firm into three tasks• expense management
– (measured by the profit margin)• asset management
– (measured by asset turnover)• debt management
– (measured by the equity multiplier)
DuPont Example
Wal-Mart Sears
Profit M. 4% 6%Ass.Turn. 3 1.5ROA ? ?Eq. Mult. 2 1ROE ? ?
DuPont Example
Wal-Mart Sears
Profit M. 4% 6%Ass.Turn. 3 1.5ROA 12% 9%Eq. Mult. 1 2ROE ? ?
DuPont Example
Wal-Mart Sears
Profit M. 4% 6%Ass.Turn. 3 1.5ROA 12% 9%Eq. Mult. 1 2ROE 12% 18%
What is the best overall ratio?
•A ratio analysis becomes relevant only when compared against a benchmark.
•Financial managers can create a benchmark for comparison in three ways
Selecting a Benchmark
1. Trend analysis2. Industry Average3. Peer group
Trend analysis
Selecting a Benchmark
Based on firm’s historical performance Allows management to examine each ratio over time, determine whether trend is good or bad for firm
Industry average analysis
Selecting a Benchmark
Another way of developing benchmark Firms in same industry grouped by size, sales, and product lines, to establish benchmark ratios
Can identify industry groups with North American Industry Classification System (NAICS)
Peer group analysis
Selecting a Benchmark
Instead of selecting an entire industry, management may select firms similar in size or sales, or who compete in same market
Average ratios of this peer group would then be used as benchmark
Peer groups can be only 3 or 4 firms, depending on industry
Ratio analysis depends on accounting data based on historical costs
Limitations of Ratio Analysis
No theoretical backing in making judgments based on financial statement and ratio analysis When doing industry or peer group analysis one often encounters large, diversified firms that do not fit into any one SIC code
Trend analysis could be distorted by financial statements affected by inflation
Limitations of Ratio Analysis
Multinational firms deal with many accounting standards Difficult to compare financial reports
Ratio Exercise
Inv turn. 5 Cash ______ Acc Pay _____
Debt to net worth
.50
Acc Rec. 14,795
Inv. ______ Stock 25,000
G. P. Margin
.30
Plant Eq. ______ Ret Earn. 35,000
Acid test
1.2
Total Assets
______
Tot. Liab & Eq.
_______
TA turnover
2
Sales ____ COGS ______