(b) Using your analysis, list reasons for and against investment in Facebook’s common stock — Analyze financial statements excerpts from the company 2013 Form 10-K should include

As noted under the “Short-term liquidity” section in the prior section Facebook has a stable cash conversion cycle. The fixed and total asset turnover ratios have increased as a result of sales increasing at a faster rate than fixed and total assets. The firm has doubled the amount of capital expenditures compared to 2011 and has made acquisitions each year. These investments appear to be paying off in increased sales and profits for Facebook.

Capital structure and long-term solvency

The capital structure of Facebook is low risk. The debt ratio has decreased from 22.2% in 2012 to 13.6% in 2013 due to a significant decrease in long-term debt and capital lease obligations. According to the notes to the financial statements, Facebook has paid off all outstanding amounts under credit facilities and currently has no long-term debt outstanding. The firm does has off-balance sheet items consisting of total minimum operating lease payments of $978 and commitments in the amount of $258 million to construct data center sites and maintain network infrastructure. The total amount of these items is less than the reduction of the long-term debt that has been eliminated from Facebook’s balance sheet in 2013. The firm should have no issues paying these items in the future.

The firm’s financial leverage index is above one indicating that debt is used successfully. The coverage ratios, both accrual and cash-based, have all increased in 2013 as a result of increasing profits and CFO. Rent expense in 2013, was also less than 2012, adding to the improvement of the fixed charge ratio. The cash flow adequacy ratio has been above one all three years. In 2012 the ratio dropped to about one as a result of CFO only increasing slightly from 2011 while capital expenditures doubled that year.

Facebook’s long-term solvency is excellent with little debt, reasonable commitments and significant CFO.

Profitability

Profitability has been volatile over the three year period. In 2012, despite a 37% growth in sales, operating expenses grew 191% causing significant declines in both operating and net profit margins.A better financial picture emerged in 2013 as sales grew 55% and operating expenses increased only 0.19%.

Sales changes were a result of both volume and price changes. In 2013, advertising revenue increased 63% while payments and other fees revenue increased 9%. An increase in News Feed ads combined with a substantial price per ad was key to increasing overall sales as News Feed ads are higher priced compared to other ad placements on Facebook. In 2012, most of the increase to sales came from volume and to a much lesser extent an increase in price. Sales increases were generated from both advertising and payment and other fee revenues. It should be noted that mandatory payments for all game developers occurred on July 1, 2011. A trend toward more international revenues from marketers and developers has occurred over the period from 2011 to 2013. In 2011 56% of this type of revenue was generated in the United States, but in 2013 the amount has dropped to 46%.

Gross profit margin decreased from 2011 to 2012, but rebounded in 2013. The decline in 2012 was due to expansion of data centers, a 65% increase in headcount, and increased compensation expenses triggered by the completion of the Facebook IPO in this year. The lack of expenses related to the IPO in 2013 combined with significant sales price and volume increases resulted in the gross profit margin returning to a level similar to 2011.

Selling, general, and administrative expenses increased significantly in 2012, but stabilized in dollars in 2013. The increase in this year is probably a result of the IPO combined with an increased headcount as Facebook expanded its operations.

Research and development (R&D) followed the same trend as other operating expenses, with expenses increasing significantly in 2012 and stabilizing in 2013. This is expected as the firm expands after the IPO. R&D on a percentage basis has increased overall in the three year period which is positive. As a relatively new high technology firm, investment in R&D is important for Facebook to maintain cutting edge technology.

Operating profit as a result of the above-mentioned increases in expenses dropped from 47% in 2011 to 11% in 2012 before rebounding to 36% in 2013.

Interest expense decreased as a percentage of sales, but not in dollars. In 2014, there should be minimal interest expense as the firm has minimal debt.

Facebook has a large effective tax rate which appears to be in the 40%-45% range. The abnormally high tax rate in 2012 is a result of non-deductible share-based compensation, losses arising in countries where there is no tax benefit, and the expiration of the federal tax credit for research and development activities.

Net profit margin has followed the same pattern as operating profit margin.

Cash flow margin and cash return on assets have both increased due to the increasing CFO which was previously discussed. The return on assets and return on equity ratios have also improved as the result of the large increases in sales combined with power expenses relative to sales in 2013.

Facebook is in a good position at the end of 2013 to continue innovating and expanding their operations. They currently have cash and short-term investments to support this expansion. It is unlikely that Facebook will be able to sustain growth rates at the levels obtained in 2012 and 2013, but the firm should be able to continue to grow while controlling costs in the future.

Market Measures

Because Facebook did not go public until 2012, it is hard to assess the PE ratio which was extremely high at 1331 at the end of 2012. The PE ratio has dropped back to a level of 88 at the end of 2013 which is still high, but much lower than 2012. The drop in ratio occurred as the earnings per share has increased significantly so the market has not continued to reward Facebook after their IPO. Facebook is not paying dividends which is expected. As a new public firm in the midst of expansion it is important for the firm to retain funds to grow their operations.